or~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~K r Policy, Research, and External Affairs Trade, Finance, and Public Sector Tor-hnicpi nlpoartmlmnt Europe, Middie East, and North Africa Regional Office The World Bank September 1991 WPS 768 Goulng to Market Privaftizti0%n in C entral CnZI aste rn EuropC Manuel Hinds and Gerhard Pohl Insig1hts inito the major tas;k of privati7;16011 facing Easlem European countries: about the key (cclisions to he miiade n(d abhout such importilit issLc, as % hethicr to sell state eiterprises or give tlhemil av av (anid lo horn and in % hat sequeilce). Us ecokUrag e1 ( die et czd 4c ,! .,r gii lo.s. .. ,¼, , nl. ( s . e .rc os. n cF,:.: It SI:W. 3* ':.' -.. aA c jCa .ti.K t .. I':. :- . Policy, Research. and External Aitairt; I ride, Finance, and Public SeJ;oi WPS 768 TI [i. IMIVr i` AI)dI-O i L IOl IlIIC T'hI k'd. I-in,inCC . :11id PLublic. SC C I( I )I\ ikion. T'cl.Iinical I )cjxi full CIII. 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Going to Market: Privatization in Central and Eastern Europe Manuel Hinds and Gerhard Pohl lable ot Contents Introductioni: Economic Reforms and Privatization 1 Privatization: Key Choices 4 State Assets to Be Privatized 5 Privatization: Sale or Give-Away 7 Enterprise Restructuring: Dealing With the Past 8 The Role of Foreign Investors 9 Privatization: Key Decisions 10 Privatization or Restructuring First? 10 Enterprise and Bank Restructuring 12 Old Claims on Property 13 Management and Employee Participation 14 Designing the Privatization Process 14 Selling Enterprises 15 Uncompensated Transfers 16 Balancing Pros and Cons 20 Privatization: !nitial Country Experiences 20 Paper presented at the World Bank/Treuhandanstalt Seminar on Privatization in East Gerrnany and Eastern Europe. Berlin, May 6-7, 1991 Going to Market: Privatization in Central and Eastern Europe Manuel Hinds and Gerhard Pohl The World Bank' Introduction: Economic Reforms and Privatization The ultimate objective of economic reforms in Central and Eastern Europe is the creation of flexible and efficient market economies. Attaining this objective requires comprehensive action on at least four fronts: macro-economic stabilization, price and market reforms, privatization of state enterprises, and redefining the role of the state. Each of these is a momentous undertaking, and none of these can succeed without considerable and simultaneous progress in the other areas.2 This paper discusses primarily issues and options in the privatization of large industrial enterprises. However, other elements of the reforms are closely linked and influence and constrain the choices to be made in the privatization of state enterprises. The reforms on which these countries have embarked is perhaps the most significant economic development of the next twenty years. Unfortunately, there is very little to guide us in this monumental undertaking. Western economists, policy makers and businessmen have acquired considerable experience in operating historically grown and complex market economies, but there is little experience in managing a sudden transition from a command to a market economy. True, other countries have introduced stabilization and economic reform programs in the past, but there is no precedent for the economic experiment on which Eastern European countries have embarked. Moreover, these changes are taking place against a background of new and fragile democratic institutions, enormous external dislocations, and a vacuum of legal and customary rules to regulate private sector activity. Privatization is one of the most challenging elements of these reforms. The task of privatization in Eastern Europe is frequently misunderstood by making misplaced analogies to recent privatization programs in the United Kingdom, France, Chile and other places. These all involved "massive", but comparatively insignificant, divestiture of state enterprises into private hands. They also happened in very different circumstances. In all these countries, state enterprises had operated in a predominantly market environment, sometimes facing substantial competition from the private sector. Even where they did not face much competition, they were operating within a business culture and institutional setting dominated by private enterprise. By contrast, the formerly centrally planned econon. es not only lack the institutional infrastructure of market economies, the nmagnitude of the task i: totally different. State enterprises in Eastern Europe accounted for the overwhelming part of output (65 % in Hungary, 82 % in Poland, I The findings, interpretations and conclusions contained in this paper are entirely those of the authors and should not be attnbuted to the World Bank, to its affiliated organiaztions, or to members of its Board of Directors, or to the countnes they represent. 2 The interlinkages between different elements of economic reform in Central and Eastern Europe are discussed. for example, in Fisher and Gelb 1 1990) and World Bank (1991). 2 and over 95 % in the GDR. CSSR and USSR). State enterprises output at the height of the French nationalizations in 1982 accounted for only 16%, and in pre-Thatcher Britain for 11% of output 3, and these figures include a considerable part of natural monopolies (electric power, etc.). Even in Chile. where state-owned enterprises once accounted for 25% of output (but far less in terms of employment), the privatization program involved, on average, less than 2% of total output and employment per year. The declared objective of reducing state-ownership to levels resembling those of western Europe within, say, five years, would entail privat.zing 10-20% of output and employment per year. This will require entirely different solutions. Moreover, privatization is taking place at the same time as other far-reaching economic and political reforms, and before the barest elements of the legal framework of a market economy and a rudimentary capital market are in place and functioning. It may be useful to briefly touch on some of the other elements of economic reforms in Eastern Europe that are closely interlinked with privatization. Macroeconomic stability is a prerequisite if the longer-term structural reforms are to succeed. A number of Eastern European economies have experienced considerable macro-economic instability in the past, as witnessed by high inflation and excessive external indebtedness, particularly in Poland and Yugoslavia. These difficulties were, in part, related to an incomplete shift away from central planning. As Eastern European countries are privatizing their economies, past sources of government revenues are likely to dwindle rapidly, creating severe budgetary pressures, if corrective action is not taken immediately. One of the first and most urgent tasks is to limit fiscal deficits through expenditure cuts and revenue measures, and to ensure that credit to state enterprises and the private sector remains tightly controlled. The economic restructuring will inevitably create strong pressures for budgetarv largesse and easy credit--which, if accommodated, could lead to an inflationary spiral. In an inflationary environment, structural reforms are unlikely to succeed.4 Market economies can only function effectively in an environment of reasonable price stability. Macro-economic stabilization also includes external balance through adoption of a realistic exchange rate policy. ri-ce and markei refurms are, oi course, wLe mosL imporLant eiemenL in tie transition Eo market economies, and need to be undertaken early on in the process. Freeing prices can elicit an immediate and dramatic increase in the availability of goods. Given the inherited, highly monopolistic structures in production and distribution, price liberalization should be accompanied by strong measures to enhance competition. The opening of the economy to international competition 'S p .rh.aps thee m isn i.portant element of competition policy for the mostly small economies of Eastern Europe. This includes abolishing foreign trade monopolies and quantitative restrictions on trade, and ready access to foreign exchange by moving early on to "internal" or, current account, convertibility. Competition can also be enhanced by breaking-up monopolistic structures in industry Milanovic (1989) It is important to distinguish here between high and continuing inflation, fueled by excessive credit creation, and a one-time price adjustment following in the wake of price liberalization or a large devaluation of the currency. In the latter case, pnce increases contnbute towards reestablishing macroeconomic equilibnum. 3 and trade. Finally, conventional anti-monopolv policies (e.g., prohibition and surveillance of unfair trade practices and large horizontal mergers) will also have a place--but onily in the longer run. T.hc superior performance of rmarket economies is to a large extent due to more extensive decentralization of decision-making and clearer assignment of rights and responsibiliiies to individuals than in a comimiand economy. This immediately raises the question of roDertv riigh, that is, the rights to use, benefit from, and dispose of assets. Private ownership is the most far-reaching and clearly defined property right, and incudes exclusive assignment of al! three rights. Guaranteeing private propei-tv rights is not enough. Property rights and contractual obligationa need to be spelled out in considerable Jetail in civil, commercial, company and other economic laws. Re-enacting pre- war civil and coinmercia.' codes may be a starting point. but economic laws and regulations will need to be expanded and upd.te0 .o reflect modern commercial practices, Proauct marke;s arp no. enough. A market economy cannot develop without functioning factor marketEs4-tl. dev'oeprnent of labor and capital mark-ets is thus essential. Financial sector development is crie of the rnc.st tmportant elements in the liberalization and development of factor markets, and is intimately lin:ed to enterprise reform and privatization. The same is true with labor markets: liberah.7,-i wage cbetermination entails automatically the privatization of human capital that had previously been .. onfsca-d through compressed wage scales and repression of private sector activity. But reform and iibera?ization of capital and labor markets have to go hand-in-hand: as long as enterprises are not foily pr;vatized. wage controls must be kept in place to prevent a wage-price spiral. Managers whn are nct responsible to private owners will simply accommodate unrealistic wage demands. Redefinin& the role of the state is one of the most pressing challenges facing econornic reforms in socialist economies, and in some sense the "mirror" image of market and private sector development. The former, all-encompassing role of the state must be "un-bundled" into separate ownership, financing and regulatory roles. The first two must be reduced through privatization and financial sector development and the third needs to be strengthened. Governments have an essential role in market economies--to supply "public" goods such as defense, internal order and a legal framework for private sector activities; to correct for monopolies, "externalities" (such as environmental costs), and other market failures; to provide basic social services and a safety net to alleviate hardship (particularly through unemployment insurance); and finally to finance these activitics through the collection of taxes and other levies. In the context of privatization and private sector development, the most important new role of the government is establishing a legal framework to facilitate private sector activity and to ensure that the private sector is not discriminated against (e.g. through entry restrictions, higher taxes, or limited access to finance). This involves not onlv eliminating the primacy of state ownership, but also remnoving any remaining subtle discrimination of private sector activity, and establishing a legal and regulatory framework as discussed above. Privatization: Key Choices Privatization can be understood as one essential aspect of pricc and market reforms. It entails both unshackling private sector development through removal of government restrictions on private 4 economic activity, and divestiture of state assets, particularly state enterprises, into private hands. In the long run, the former is probably going to be the most important. The strength and productivity of Eastern European countries, twenty years hence, will probably depend more on enterprises and a; ivities that do not yet exist, than on dinosaurs inherited from central planning. But on the other hand, these economies now dispose of a considerable stock of capital that can be put to better use: factories, infrastructure, housing, research and educatior facilities, and, last but not least, a considerable endowment of human capital in the form of a fairly well trained labor force. Much of this capital stock is inadequate and reflects the technological and commercial isolation of the past. Some facilities will have to be entirely scrapped. But much can be reorganized and upgraded to function more efficiently in a market environment. This is the task of privatization. Privatization is not an objective in itself. The ultimate objective is to create an efficient economy operating within a democratic political system. Private property rights do not refer simply to material possessions, they are a far more complex system of rules that govern the behavior of economic agents in a market economy. Property rights have their historical origin in the recognition of ownership rights over land and material assets, but the economic significance of the latter has dwindled. Land used to be the most important productive asset, besides labor. More recently it was steel mills and railroads. Today's entrepreneurial fortunes are made with computer software or marketing and management concepts. Issues of corporate management and control ("governance") and intellectual property rights are thus vastly more important, but our legal and political thinking is still steeped in the historical roots of real property.' Private property rights need not be absolute: a reasonable degree of equity can be introduced through income and inheritance taxes which attenuate private ownership rights without stifling private initiative. State Assets to Be Privatized The task of privatization can be better understood, if we takLe a quick look at the assets to be privatized. Table I gives an estimate of the structure of the capital stock for a market economy, west Germany, and for a formerly centrally planned economy, Hungary, expressed in relation to national income to facilitate comparison. The two are fairly similar, with the total reproducible capital stock equivalent to three times GNP in Germany and four times GNP in Hungary, with the difference reflecting primarily the high level of inventories and inefficient use of the productive capital stock in the planned economy. Land is typically about another 100% of GNP. with perhaps half of that amount reflecting urban land values (location rents). ' The political populanty of propeny restitution in Germany, Czeeboslovakia and Hungary is a case in point. Economically speaking, these programs compensate only a select group of people. and perhaps unjustly: those with inherited land and real estate possessions. But the socialist state has expropriated many others as well, for example, tbose with particular scientific and technical, or entrepreneurial skills. In a market economy. these could have earned high incomes and some would count today amrong the wealthiest individuals. Instead, they are now going empty banded. While restitution may be politically popular and reflect a sense of 'justice', it redresses pa-t injustice In highly selective ways and does little to enhance economic efficiency, except perhaps to make the reintroduction of private property nghts a more credible policy change. 5 Table 1: Estimates of the Net Capital Stock l(rcentage of GNP) F 7-22M " t n y qgry 1977 1977 Reproducible asseu 325 405 Housing 106 73 Other structures 117 135 Machinery and equipment 47 69 Inventories 21 70 Livestock 2 8 Consumer durables 33 51 Land 108 150 Total 433 555 Source: World Bank: World Development Report 1989. p. 97 Most of the capital stock is easily divisible--land, housing, inventories, livestock herds and consumer durables--accounting for about three quarters of total assets. The productive capital stock (including the service sector and inventories, but excluding housing and infrastructure), is about two- fifth of reproducible assets, or around 150% of GNP. A lot of this is again in fairly easily divisible form (commercial buildings, small enterprises, etc.), leaving a surprisingly small core of the economy, where large entities are predominant and that cannot be easily transferred to individuals-- primarily the industrial sector. In west Germany, for example, the industrial sector accounts for only 18% of total fixed assets (worth about 60% of GNP at replacement costs), and manufacturing for 12% (worth about 40% of GNP), with the difference being mostly public utilities (electric power, gas, water, etc.). Some of the manufacturing capital stock is again in relatively small-scale activities. Some idea of the likely magnitude of "large-scale" privatization can also be obtained from stock market capitalization. In west Germany, for example, this is around 25% of GNP, with the remainder (35% of GNP) reflecting equity in small companies and debt financing.67 Lbarge scaie privaLization programns in Easeuin Eutupe art: u1us iikeiy W invuive a surprisingly small share (10-15%) of total national assets, worth, may be, around 25-50% of GNP. The typically larger size of firms in centrally planned economies would tend to increase this value to the upper end of the range, while the outdated technology and poor competitiveness in international markets would tend to depress the value of the industrial capital stock. This is The numbers given here are based on Goldsmith's estimates of economic (replacement) values of the capital stock, presented in Table 1. The sectoral data are derived from percentage shares of gross (undepreciated) reproducible assets and net replacement values of the total reproducible capital stock (Source: Germany: Statistical Yearbook, 1990). Goldsmith's estimates of the value of reproducible assets closely correspond to replacement values given in the latter source. ' In other countries, stock market capitalization tends to be larger (for example, around 50% of GNP in the US). However, the recent trend to management buy-outs (MBOs) may significantly reduce stock market capitalization. In recent years, share capital affected by MBOs in the US was equivalent to about 2% of GNP per year (Jensen, 1989). Note that stock market ca, italization figures include commerce, banking and other services and, in the US. a sigmficant pan of public utilities (railroads, electric power, telecommunication). Equity values are prim-arily determined by future profitability, and are typically less than the economic value of assets controlled by an enterprise, due to other sources of financing (loans, leasing, securities). 6 particularly true. if public utilities (railroads. electricity, telecommunications) are excluded from privatization for the time being. These illustrative figures also demonstrate the importance of "small scale" privatization prograns that has been largely overlooked in the academic privatization debate, focussing mostly on privatization of large state enterprises. "Small-scale" privatization programs, involving not only shops and restaurants, but housing and agriculture as well, could become a major stimulus for entrepreneurial activity and private sector development. Assignment of clear property rights over the large amounts of easily divisible real estate assets would make it much more easier for entrepreneurs to obtain financing, as they could then offer valuable collateral to banks and other creditors. This is particularly important in the early years of private sector development in Eastern Europe--as long as it remains very diffirlt to assess the profitability of entrepreneurial ventures, and as long as new sma2i companies have not yet developed a "track record". Bankers everywhere base their credit judgements on inertia (net worth, track .-cord), and rightly so. Privatization: Sale or Give-Away? In the privatization debate, and in the advice offered by onrushing western accounting and management experts, a number of "fallacies of composition" have been committed by drawing misplaced analogies from individual privatization transactions for the privatization process in its entirety. One of the most conspicuous fallacies is the frequently heard statement that "savings of the population are insufficient to buy the existing capital stock" While it is true that an individual buys shares with money deposited in his savings account, economy-wide all that happens is a reallocation of claims among different entities.8 In analyzing privatization options, it is useful to regard the socialist state as an intermediary, and the people as the ultimate owners of all assets ("ownership by the whole people"). There are only two sorts of claims: residual claims of the "whole people" on enterprises and other assets, intermediated by the state, and "par value" claims of individuals intermediated by the state bank or its affiliates.9 That is, the deposits in the savings bank branch of the state bank have been onlent mostly to state enterprises. State enterprises do not pay explicit dividends to the "whole people", any return on capital is reinvested, or paid out in the form of higher wages, worker amenities, or a slower work rhythm. If individuals "buy" state enterprise shares from the "whole people" (themselves) with their savings, their net worth as the "whole people" goes down by an equivalent amourt, and the transfer of their liquid assets to the treasury is similarly compensated by an I Most of the trading that goes on is merely an adjustment of portfolios among investors, without any n'et change in the stnrcture of financial assets. Total issue of new shares (including privatization programs) have been very small compared to the outstanding stock of shares and have hardly affected the structure of financial claims. When an investor pays the treasury for the shares of the privatized state enterprise, government revenues increase and, keeping all other things equal, the govemnment will end up with a siightly higher balance in its bank account. The government has exchanged its residual claim on enterpnse profits against a 'par value' claim on the bank--which the bank may have lent to the enterprise. Before, interest payments by the state enterpnse were ultimately used to pay interest oin the individual's bank account--now they are used to pay interest on the treasury's bank account. 9 There are also 'par value' claims on enmerpnses held by the state bank (i.e., resulting from mon-y creation). and individuals may also hold pas value claims on the state, depending on the past fiscal policy stance. The lattet would implicitly redkuce the value of the residual claim on the state, beld by thec 'whole people>. 7 equivalent increase in their residual claims on the state. A "free" distribution of shares, by contrast, is merely the exchange of well defined residual claims of individuals for an ill-defined residual claim of the "whole people". However, the "whole people" can decide to sel assets to individuals, but this is phirixasiiy a ihanFgt itl -usf-l puii.yv, wiwJid jimy b, ww Itevu. ol CxamInple, by deciining tax revenues, due to the transition to a market economv. The choice of sale, free distribution, or some combination is a question of efficiency, social fairres a-,ud fiscal considerations, and not of savings and wealth. The problem of state ownership is that the residual claims on enterprises remained confused and unclear. As the saying goes, cwnership by all is ownership by nobody. The problem of the socialist enterprise is that nobody is really in charge, anld nobody has a strong incentive to increase efficiency (that is, the return on capital). The objective of privatization is to eliminate that diffuse intermediary, the state, and assign responsibilities again to individuals. The capital stock of the socialist state has been built by compressing evervbody's consumption. The socialist state has also prevented many individuals from developing their full economic and entrepreneurial potential. It is thus very difficult, if not impossible, to assign property rights in an entirely "fair" way. Uncompensated distribution on a per capita basis is certainiy among the most attractive solutions.'° More important than the mode of distribution, however, are the incentives provided to new owners and managers to use these assets in the most efficient way possible. Enterprise Restructurinig: Dealing With the Past Changing to a market system Is a pre-condition for the real task ahead: that of turning socialist econornies into roodern societies which are better at serving the needs of their citizens. This requires adapting the stock of capital to the country's comparative advantage. But the present stock of capital is technically obsolete, rundown, and produces obsolete and poor quality products. As a result, even if the conditions for the functioning of a market are met, many enterprises will not be competitive in world markets. A thorough restructuring of enterprises will be necessary to adapt the economy to the new realities of the market place. Economic reforms ana enterprise restructuring are part of the same problem. Wrong incentives of the past have allocated resources to unsuitable capital equipment, which now affects the flows of income, providing meager returns or even creating losses. The current reforms aim at redirecting the flows, so that they build stocks adequate for the exploitation of the countries' comparative advantage. Stopping the financing of loss-making enterprises would contain the bleeding. However, it does not solve the problem of the viability of enterprises and banks. Both have non-performing assets, enterprises in form of unsuitable physical capital, and banks in form of financial claims on l The situation in east Germany as a somewhat special case. Economically, the unification treaty can be seen as a deal where the Federal Republic of Germany is taking over all state assets and liabi.ities of the former German Dcmocratic Republic in exchange for very substantial incoms support payments (fiscal transiers are of the order of 50% of east German GNP dunng 1991 ). State enterpnses are pnvatized exclusively through sales, but It is unlikely that sales proceeds will be sufficlent to retire state debts inhented from the past. The most valuable assets taken over are probably land aod the housing stock. Tne sale of the former will eventualiy pay for some of the costs of income support, while the receipts from housing pnvatizations will accrue to east German local governments, and vwill presumably be used to Improve local infrstrjucture, including schools, roads and sewer systems. Sales will probably involve financing on preferential terms, i.e. a partly compensated transfer. 8 troubled enterprises. Thus, even if they stop making losses at the margin, they would still incur financial losses because their income would not cover their interest expenditures on past debt financing of unproductive capital. While the leverage of state enterprises in socialist economies is generally quite low, the debt burden of individual enterprises has often very little to do with their cash flow and debt service capacity, particularly if they are heavily exposed to one of the recent external shocks: collapse of Comecon trade, reduction of military expenditures, opening to Western competition, and so on. For individual enterprises, the burden of debt can be so high that it is a constraint to their future development. Losses caused by past investments in obsolete or inadequate machinery are already there, and it is better to recognize them immediately. Thus, the restructuring of enterprises has two dimensions: phvsical restructuring of productive capacity--replacing and upgrading machinery, laying off redundant workers and increasing productivity--and financial restructurin --removing debts that would make the new firms financially insolvent, even if they are economically productive. In market economies, the problems caused by financial insolvency of firms are resolved through bankruptcy and reorganization procedures involving a composition of claims. Enterprises whose "going concern" value after restructuring is expected to exceed liquidation value, and which promise a reasonable return on additional funds, are normally kept in business, with the creditors sharing the losses of the past." They are then usually given new management whose task is to make the firms lean, efficient and profitable. In Eastern Europe, the sequence would have to be the same. That is, financial restructuring must be done before privatization, even if the physica: restructuring is carried out after privatization. The Role of Foreign Investors Privatization programs and government policies more broadly reflect an ambiguous attitude to foreign investment. On the one hand, most governments realize that foreign technology and management could enormously contribute to the modernization of their economies. On the other hand, there i9 a populist fear that foreign investment could ultimatelv mean foreign control and exploitation. The reality is that foreign investment will probably be the most constrained resource. The onrush of foreign investment, feared by some, has not materialized. The reason is that political risk are stili perceived as very high, and the unclear legal environment, language barriers, poor infrastructure and low productivity add further to this. Several Easterr. European countries are already liberalizing their recently introduced foreign investment laws to attract more foreign capital. As discussed further below, there is indeed a possibility of unfair gains for foreign investors, but only if privatization programs combine too much reliance on sales programs (which could depress asset prices) with open access to foreigners. If this is avoided (by using a considerable element of uncompensated transfers), there are no ; i-fall gains to be made by foreign investors, and high ex- post returns will mostly reflect their contribution to increasing productivity. Ultimately, most of the I Usuall) in exchange for a claim on future profits, i.e. a part of the share capital. The considerable equity owtership of some German banks derives from resiru.zluring and reorganization exercises of the interwar penod. 9 gains will be captured by the labor force in terms of rising wages (and perhaps appreciati: - exchange rates). Privatization: Key Decisions There are three major factors determining the maximum speed at which privatization can be carried out. One is the physical limits imposed by all the institutional arrangements needed to carry out the design and implementation of the privatization program itself. Another is the speed at which the minimum institutional arrangements essential for the functioning of a market economy can be put in place -;&e laws and provisions regulating private activity--and the main obstacles removed--such as monopolistic privileges now enjoyed by many enterprises. In addition, political factors also play an important role in determining the speed at which privatization can take place. Privatization or Restructuring First., One of the most important decisions is whether such restructuring should be carried out by the private sector or by the governme .. A. fairly widely shared opinion is that private owners would be better at restructuring than the government, for exactly the same reasons that are cited to justify privatization (stronger incentives to perform, direct link between risks and rewards, better knowledge of local conditions, etc.). It is, however, sometimes recommended that restructuring of enterprises should be carried out before privatization. Three main arguments are used to support this recommendation. The first is that the structure of the economy in these countries is monopolistic, and monopolies should be broken before privatization. The second is that the enterprises are in such a bad state that either nobody would like to buy them, or the price that could be obtained for them would be too low. The third one is that labor and financial problems should be resolved before transfer to the private sector. The first argument does not seem to be generally valid. There are two kinds of monopolies in these countries. One comprises what is usually called natural monopolies. non-tradeable activities with strong returns to scale such as electric power, telephone, railways and water supply. It is not yet clear whether these pub'ic utilities will be privatized. The other category comprises enterprises which would not have grown to such size in a market environment. These include enterprises producing easily tradeable goods, and enterprises engaged in non-tradeables, such as domestic retail trade. The monopolistic power of these enterprises is often exaggerated. In the case of tradeable goods, these domestic "monopolists" may actually be very small by international standards and, in the absence of foreign trade restrictior's, they will now face stiff competition from imports, and may not be able to survive. In these cases, the problem is more to ensure that import competition is not restricted, once their problems beco-me evident. For enterprises engaged in non-tradeable goods and services, the problem is more serious and should be dealt with by appropriately structuring privatization transactions. Retail shops, hotel chains, gasoline stations and the like can be privatized in such a way as to enhance competition in local markets. There is not much danger in erring on the safe side and breaking these artificial and bureaucratic organizations into smaller entities than required for effective competition>. Sme rationalization can occur later through mergers and acquisitions. 10 The other argument, that it is advisable to invest in the socialized enterprises to enhance their sale value, would be valid if the government could obtain higher returns on the restructuring investment than the private sector. This is highly doubtful given the track record. These enterprises are iri such a sorry state precisely because of the inefficiencies associated with state ownership. If they are to survive, their best chance is privatization first to establish strong incentives to perform, and subsequent restructuring by owners and managers who have a personal stake in the succ-, and profitability of the company. Past experience is highly relevant in this respect. During the 1970s, some governments in the region invested heavily in modernizing the socialized enterprises, financed by external borrowing. The result was a deterioration of the international financial position, because the investments were not able to generate the cash flow needed to service the debts incurred to finance them. The losses now accumulated in the banking system (both in valuation losses of the stock of the external debt and in collection losses) were ultimately caused by these inefficient investments. The third argument for early restructuring, eliminating labor and financial problems, carries more weight. One of the reasons for the la..k of interest among foreign investors is their overstaffing. Foreign investors frequently do not want to use their name and corporate identity involved in a painful restructuring exercise. Some initial restructuring may thus be desirable, and could be carried out before or during the privatization phase. Such restructuring does not require investment. Restructuring could thus be done in two stages: the first, which would not include major investments, could be carried by the government, or after partial privatization, while major investment should await full privatization. Enterprise and Bank Restructuring There is a two-way inmeraction between the processes of privatization and financial development. A healthy financial system can only exist when it provides service to healthy customers. But too many former state enterprises are financially unviable. On the other hand, the creation of healthy enterprises will require the existence of a sound financial system. Solving this quandary is central to the sequencing of reforms. Ideally, the banks should be privatized immediately, thus establishing the financial discipline that is essential for the restructuring of the enterprises. There are, however, some problems that make this difficult. The initial financial restructuring of enterprises would leave the banking system with a considerable amount of non-performing assets, recognizing the costs of poor investment decisions of the past. Since the banks share only in the losses and not in any gains, this will leave them with considerable negative net worth. Moreover, the final restructuring and recapitalization of the banking system cannot be completed until all the losses coming from the rtstructuring of the enterprises are known, which presupposes that the enterprises would be privatized and restructured before the banks. Thus, if the banks are pr.v,rized before the enterprises, it is quite likely that the government would have to bail out the banks sometime after their privatization. Since this would be obvious from the start of the process, this would reduce the incentives for the bariks to manage their portfolios prudently, largely eliminating the advantages to be gained from early privatization. On 11 the other hand, if enterprises are privatized before the banks, the new private sector would confront a bureaucratic and unresponsive banking system. Quite likely, the still socialized banks would give priority to the state enterprises, crowding out the emerging private sector. The allocation of resourcps to loss-making ente rise,s wu!d continue, endargering the success of the privatization effort. This problem could be solved by splitting the banking system, creating private banks which would lend to new private ventures and Drivatized enterprises, while leaving the old banks to clear up past loans. This could be handled in a number of different ways, all would include a separation of old from new loans, and perhaps the transfer of non-performing assets to the government. One solution would be to privatize existing banks in their entirety, with a state guarantee for all old loans. New loans would be the full responsibility of the privatized banks. This is undesirable since the " commercial" wings of the former monobanks are too large and too bureaucratic to provide efficient banking services. A better solution would be to break-up existing banks, and license new private banks who would be offered parts of the existing balance sheet, personnel and branches, with a "put option" for a predetermined part of the portfolio. Banks would then have some time to evaluate the portfolio and return non-performing or otherwise impaired assets to the government, in exchange for interest bearing government securities. In both cases, the rejectec assets could be concentrated in a liquidation shell, with the banks collecting on behalf of the government on an agency basis. Such a split of the exi.ir,g purtio;io ol the banks would impose some financial discipline, and would provide an incentive to state enterprises to accelerate their privatization and restructuring efforts. 2 Old Claims on Property While most of the productive capital stock and a good part of the housing stock were created over the past forty years as state property, many other assets were once owned by individuals (Table 1). Former owners, or their heirs, are now claiming back their assets. This has created a difficult legal and economic problem that threatens to bog down privatization and economic restructuring. Certainly, the criteria needed to solve this problem are not exclusively economic; they include value judgments that only each society can make. However, two economic implications should be kept in mind in dealing with this problem. First, honoring these claims is not necessarily the fairest way to deal with past depravation. Second, monetarv compensation would be easier and more efficient than physical restitution. Honoring claims arising from expropriation will assign property rights over only a small part ot assets, as owners can be identifiea oniy for a small part ot exprepriatea assets. in tact, it is only for one class of assets, real estate, that the connection can be clearly established between the now existing assets and the assets that were expropriated. This is impossible to do in the case of industrial and other enterprises. Measuring how much of an existing enterprise is the result of the "natural" reproduction of the original assets can only result in arbitrary decisions. Also, even if this were possible, giving compensation to the people whC !c-st r^a! esta:t assc:s wcu! do Justiec to only a limited number of individuals. u Financial sector reform Issues are discussed in more deLail. for example, in Lone and Sagam (1991) 12 The attraction of restitution programs is that they would take care, in one simple stroke, of most land (worth. may be, 100% of GNP), a good part of the housing stock (worth, may be, another 50% of GNP) and some of the productive assets. But in view of the large amounts of assets involved, the long time elapsed since the expropriation, and poor or non-exiqting recordq. it is almost certain that there would be many conflicting claims, bogging down the legal system for years if not decades, paralyzing investment and economic activity. Not only is this a nightmare, it would still leave about half of the assets in state hands. It would also not deal convincingly with questions of social equity, in particular, the randomly inflicted depravation of the past. (shouldn't political prisoners receive some compensation too, and perhaps more?). Management and Employee Participation Privatization programs should provide fair treatment and equal opportunities to the entire population. The problem is that a portion of the population would have an initial advantage in using these opportunities, either because they occupy important positions in enterprises or government, or because they had accumulated some wealth in the old regime, perhaps by illegal means. Equality of opportunity cannot be perfect. But something can be done to avoid the worst abuse of power. In a number of Eastern European countries, the influence of state enterprise workers is strong, and the notion of worker ownership popular. There are few, if any, good reasons to support such claims. The present capital stock has been built with the forced savings of all groups of the population, farmers, teachers, civil servants and industrial workers alike. There is thus no good reason to treat any one group preferentially. Moreover, due to the external shocks, profitability now varies considerably across enterprises. Giving shares in any enterprise on preferential terms to its workers would thus entai! a rather arbitrary distribution of the common good. Problems can arise, in particular, if privatization is largely left to the enterprises and those who now control them. In the present economic uncertainty, it is very difficult to put a value on any enterprise with reasonable confidence. This uncertainty invites all kinds of insider deals to transfer asse;s on favorable terms to managers or close associates, sometimes with the help of foreign investors. The decentralized privatization program in Hungary, for example, has already given rise to several highly publicized privatization deals on all-too favorable terms. These problems argue for a simple, rapid, and relatively centralized privatization process, to prevent abuses of power. It also implies that issues of corporate control, or "governance" during the transition deserve far more attention than they have received so far. Insider dealing is not only a problem in privatization transactions, but in neariy all commerciai dealings. The legai vacuum and dearth of accounting information invite abuse. Designing the Privatization Process The ultimate objective of the socialist countries in transition is to create efficient market economies. As discussed earlier this is not possible without dominant private ownership and clearly defined property rights. The question is how to get there in an equitable, rapid and efficient way. While large corporations are today an important element of market economies, most economic activity is nevertheless carried out by relatively small enterprises. Large corporations, such as IBM, are surprisingly vulnerable to more innovative upstarts. This implies that "small scale" privatization 13 is going to be a crucial element of the privatization process. Many activities, particularly in trade and services. but also in industry and agriculture are best carried out by individual entrepreneurs and small firms. Removal of all restrictions against private sector activities is the first and most important step, followed by privatization of small establishments through auctions or competitive bidding procedures. The initial lack of capital can be overcome by making extensive use of rental and leasing arrangements for real estate. Early privatization of the housing stock would provide many new entrepreneurs with sufficient start-up capital in form of well-secured loans. This leaves, however, a considerable amount of assets that are rather lumpy and far beyond the financial capabilities of individuals or small groups of people. For these large industrial state enterprises, the most logical form of privatization is conversion into joint stock corporations, and distribution of shares to the general public. However, the management and control of such widely held "public" corporations involves considerable "principal-agent" problems that can be alleviated through appropriate design of the privatization process and appropriate company legislation regulating "corporate governance". The key challenge is to ensure that management acts in the interest of owners. That requires intensive monitoring, for example, by a group of core investors, by representatives of the shareholders, or by creditors. But these groups can and will only do so, if they have the incentive and the power to monitor and control managers. The first requires a significant stake in the company, the second clearly defined legal rights and liability rules. Privatization programs will have to combine several different methods to meet the needs of different sectors and different types of enterprises and assets. Very large industrial enterprises will require a different approach than smaller enterprises, and will in turn be very different from the methods appropriate for trade, agriculture and services. The following focuses on privatization of medium- and large-scale industrial enterprises. Privatization methods need to combine a transfer of asset that is perceived as fair, with an immediate and effective management and control of the enterprise. There are two basic forms of privatization: selling the enterprises and giving them away. Both of them can be designed to meet both criteria. Selling Enterprises As discussed earlier, the state assets alreadv belong to the people. It is just unclear what belongs to whom. The problem is that assets are heterogeneous and some are indivisible. Any distribution will have to assign different assets to different people. Pertectly equal treatment is tnus not possible, and different "packages" of assets need to be compared, that is, valued. Sales can introduce an element of choice and improve the perceived fairness and efficiency of the privatization program. But the problem in relying exclusively on sales is that liquid assets are only a small fraction of the assets to be privatized (and are, in some sense, already a claim on these assets). The government could, of course, sell state property in exchange for liquid assets, but sales programs would have to be either very slow, reflect,ng the limited volume of liquid assets, or would require issuing an equivalent amount of purchasing power to buy the assets. Issuing unrestricted money that can also buy consumer products would most certainly create enormous price ihstability, since the value of all assets to be sold is several times larger than money in circulation. Reasonably rapid sales programs, relying on available liquidity, would enormously magnify present inequities: due to 14 lacking purchasing power, asset prices would be very low. and assets would be raffled mostly by those with influence or those who have illicitly accumulated considerable wealth in the past--the nomenklatura and criminal elements. One alternative would be issuing a specially created claim on state property that can only be used to buy state property, but would not serve as money, such as the voucher system proposed in Czechoslovakia, not unlike the distribution of "monopoly money" in that board game. This is, theoretically, a quite attractive solution. The problem, however, is that reasonably stable asset markets do not exist at present. People would have enormous difficulties to chose among all the millions of assets for sale and it would take rather long until the market would clear. Actually there is no guarantee that it will clear, the information requirements are just too large. In order to work, voucher programs would have to be carried out in several tranches, involving each time a limited range of assets, and would, in effect, not be all that different from outright assignmnent of property. An alternative to vouchers would be the issuance of tied low interest loans by the govermment for the purchase of existing assets. This would, in effect, represent a partially compensated transfer of assets. This may be useful, for example, in the priva.ization of the housing stock, or the privatization of small enterprises. The danger with such a scheme is that it may become a permanent government policy, that would be difficult to stop and could create considerable fiscal difficulties, if extended to new investment. This mroblems highlight the difficulties in making asset sales more than an adjunct to a predominantly uncompensated transfer of assets. Uncompensated Translfers Uncompensated trzansfers emerge thus as the most equitable, quick and efficient Vpproach to privatization in Eastern Europe. Giving away the enterprises and other assets would almost instantaneously create clear ownership and property rights, would provide strong performance incentives, and would create capital markets virtually overnight. It would also be an answer to the politically thorny problem of foreign participation in the privatization program, as asset prices would not be excessively depressed, and sales proceeds would accrue to individuals. In the case of large enterprises, uncompensated transfers would be effected through shares, which could then be traded immediately, forming the basis for the creation of a stock exchange and other institutions facilitating the mobility of risk capital. This would benefit the financial system in two major ways. It would increase its flexibility and it would reduce the risk of the banking system, as enterprises wouid remain only moderateiy ieveraged, compared to a privatizatlon program based on sales transactions th-at would have to be financed by bank credit. Uncompensated transfers can be organized in several ways which can be subsumed into two categories: (a) giving the shares directly to the population, and (b) giving the shares to some interinnediary institutions. For thC first solution, two alternatives have been proposed: government deteimined allocation or, alternatively, inclusion of some element of choice through the issuance of vouchers that can be used to buy shares. Direct Transfer of Shares. This method has the advantage that all enterprises are allocated to the pub!ic. including the worst. One nrohlem is how to eneitre a fair di%trihution of shares 15 Splitting each enterprise into millions of shares is impractical, as ea;n share would then be worth only a few cents. Different enterprises would thus have to be given to different groups of people. This mnay turn out to be inequitable, since it is at present very difficult to value enterprises with any degree af areimacy. Voihfare riqn nllit-i't'f hnt not kols'r thiz n-rn rcim hi't -ofW nf 'n intrrmnvdiary can help to postpone the valuation problem, until economic conditions are more settled (see below). Another problem is how to ensure that the enterprises will obtain the most capable and motivated management available. Initially, the ownership of the enterprises would be too dispersed to make it worth for any one individual or group to devote the necessarv time and efforts to ensure that they are managed efficiently. This leaves managers free to do whatever they want which may be empire building, rather than using existing resources in the most efficient way, and maximizing shareholder value. This is also a problem of widely held, or "public", joint stock corporations in market economies, and is one of the reasons for the recent spate of management buy-outs, which involve taking these companies "private", with a much larger ownership stake of management, and much higher reliance on debt financing. A number of protecticns can be built-in to reduce these problems. These include, first, detailed financial accounting standards and liability rules to curb fraudulent actions and abuse of managerial discretion. Second, dividend payments and debt financing can help to force managers to obtain reasonably high returns, rather than waste cash-flow. Third, management incentives can be aligned more closely with owner interests, by linking remuneration to long-term profitability (e.g., through stock options). Fourth, it may be useful to have "core" investors, controlling a significant minority of shares, say 10-30%, who would then have a strong incentives to monitor and control management. Domestic financial institutions, or foreign joint-venture partners could fulfil this role. Finally, an active stock .rarket would eventually provide some discipline on management through corporate takeovers. Distribution Through Vouchers. Under this scheme, the government would distribute free vouchers to the population, to be used only in bidding for the enterprises. The advantage of the vouchers is that they would allow the population to choose the enterprises they want to own, while the direct allocation of shares would give them a pre-defined portfolio. Also, the vouchers would result in an immediate market "valuation" of enterprises, as people bid for the shares. The voucher system, however, entails also considerable practical problems. The most important one is that, given the present uncertainty about the prospects of different enterprises, most people will not be able to make an informed choice. There is, however, a small number ot people, mostly present managers, who have a fairly good sense of the future profitability of enterprises, at least within their sector. Free choice will lead many people to make the wrong decisions, but a few insiders stand to gain considerably. The bidding process would be more like a lottery than an informed choice.'3 " In the discussions about this mrechanism of prIvatization--mainly in Czechoslovakia--there has been widespread concern about the effects that issuing these instruments could have on the rate of inflation. Tne vouchers, bowever, would not be Inflationary, even if they are traded aganust mnoney, becauee the total stock ol money would remain unaffected hy such trading. Tbeir pnce in terms of money would fluctuate (because of enormous valuation uncertainttes) vvthout affecting pnces and inflation. This assumes that the propensity to consume is fairly similar for net buyers and sellers of vouchers. This teems a reasonable assumption. given the relatively equal distnbution of income and wealth 16 There are also more technical problems. The bidding process would take place between only cne seller and millions of buyers, and would consist of only one act. This is completely different to the bidding that takes place in a stock markets, where there are many sellers and buyers and transactions go on continuously. In the vouchers proposal, all people would be bidding simultaneously, without knowing what effect their own actions, and those of all the other bidders, would have in the price of the shares. Only when all bids are tallied, would people know what the price of the shares was, which, of course, would affect how they would have wished to bid."4 A related problem would be that the government would be able to sell only (what appears to be) the most attractive enterprises. To solve this problem, it would have to repeat the process. Still, the government would not be sure of selling all the enterprises, since people would not bid for loss- making enterprises. Distribution Through Intermediaries. Under these schemes, the government would give part or all of the shares to intermediary institutions, which, in turn, would be owned by the citizens. There are two main variations. In the first, the intermediary institution would be responsible for the management of the enterprises--totally or partially--so that they in fact become holding companies. In the other, the institutions are financial institutions, which would not intervene in the management of the enterprises; they would influence management only indirectly, through selling or buying of shares. The most important advantage of the intermediary approach is that it would postpone the valuation until economic conditions have become more stable, financial information more reliable, and valuation feasible. It would thus entail a reasonably fair and equal distribution of shares. Giving these intermediaries the power to manage the enterprises could create some problems. One is that all the enterprises in the country would be managed by a small number of investment companies, whose managers would then acquire tremendous power. Decisions would be centralized, the risk of bureaucratization would be high, and there would be a danger of collusion and restraints on competition. Quite likely, the task of managing so many enterprises would be well beyond the capabilities of these funds; most probably, they would concentrate their efforts on a limited number. Holding corporations are thus undesirable as a permanent solution. However, the holding corporation is an attractive concept, if used as a transitional device to manage the privatization process. It is then important to make the holding companies self- terminating. Their statutes, for example, could provide for a terminal date by which they have to sell all enterprises (through direct sales, stock market flotations, management buy-outs, etc.). Alternatively, one could specify that they have to pay out fairly high dividends to their shareholders, which couid, in effect, be met only by a reasonably rapid process of divestiture. 5 Tnese holding corporations would be similar to the German Treuhandanstalt which has a time-limited mandate to privatize all companies under its control. At the end of the process, the holding company would disappear, and shares would be held directly by individuals (as private equity of owner-managers for One possible solution to this would be to carrv the auction in several steps, with several tnal bids, so that people could know what the others are doing. This would be rather time-consumir.g. More fundamentally, there is no guarantet that the process would converge to an equilibnum pnce. The problem could be solved only if the bids are staged in such a way that people bid with only pan of the vouchers, and buy a certain portion of the shares, thus establishing a pnce that could serve as a parameter for subsequent ponfolik decisions But, most probably, the pnces established in this way would be initially quite unstable, and would converge to equilibnum only after mnany iterations. Li See Blanchard (1990). An earlier proposal is discussed e.g. in Pohl and Byrd t1987). 17 small companies, or shares in larger companies listed on stock markets), or indirectly, through ownership by financial institutions, such as mutual funds. Alternntively, the5fe intermediaries rcoild he set ut a financial institutions ripht from the start. However, it is unlikely that this would work, given the enormous restructuring requirements of existing state cnterprises. Most of these enterprises need to be restructured to spin-off non-essential activities, reduce overstaffing, close-down unprofitable activities, introduce new products, and so on. Given the poor quaiity of available financial information, an "arms length" relationship with owners would be inefficient for the time being. But such institutional investors could be created soon, and play an important and useful role in a few years. The better approach thus seems to combine rapid privatization with a longer-term (5-10 year) involvement in the restructuring of the economy through privatization agencies set-up as self- terminating holding companies. These holding companies would be able to hire foreign advisers to help in the privatization and restructuring process. Rather than focussing on individual deals, it seems more appropriate to use them to develop policies and operating procedures, including commercial and company law, accounting and auditing standards and guidelines for privatization and restructuring. Balancing Pros and Cons The methods summarized in the previous paragraphs--and the variations that they can have-- should not be compared as alternatives but as complementary possibilities that can be used as building blocks. Each of them has features that make them attractive for the solution of specific aspects of the privatization process, and there is no reason why they cannot be combined to suit the needs of a particular country. Thus, selling a controlling stake could assure control and could bring in foreign management and technology, while giving away some shares could ensure that all citizens have an opportunity to gain from the restructuring of the economy. For small and medium-sized enterprises, management or employee buy-outs may be the appropriate solution, and rental and leasing could be employed in many cases to alleviate "shortages" of equity capital, resulting from the egalitarian distribution of wealth. Most importantly, privatization in Eastern Europe does not simply mean transferring ownership of enterprises into private hands. It must also include the simultaneous creation of a legal and regulatory environment that makes private activity feasible and efficient. Privatization: Initial Country Experiences Political views about market-oriented reforms and the future role of private sector activity in Eastern European countries have changed very rapidly over the past year or two. This can be ascribed to two rather different factors: on the one hand, free elections have brought formerly rcpressed political currents to power, who's predilections for radical market reforms are based more on democratic values and an admiration for Western political institutions, than on economic reasoning. On the other hand, there is an increasing body of empirical evidence that half-way houses between planning and market do not function well in practice. The failure of worker management in Yugoslavia is an invaluable contribution to today's economic policy debate in Eastern Europe, and 18 has already helped other countries to avoid the politically attractive, but logically flawed. model of "market socialism", and to opt instead for a market economy "without further adjectives". The . eed of chanpe in the nolitics o ronenqiit ihnfit th- rnle, evtnt, qnt,se. mdnd techniques of privatization in Eastern European countries is such that it is almost impossible to give an overview that is valid for more than a few weeks. Some countries have already tak-en very far-reaching decisions. and are now preoccupied with implementation decisions. Others are just now debating privatization laws in their national assemblies, and may have similar political programs in place in only a few weeks. Others have been at the forefront of reforms a few months ago, but their programs now look modest, compared to some of the latecomers. The Soviet Union is a case in point. In October 1990, at the time of debate on the ill-fated Shatalin 500 day reform plan, political consensus did not reach much beyond commercialization, or "de-state-ization", of state enterprises. Six months later. the privatization bill introduced by the government into the Soviet parliament, uses the word "privatization" for the first time without adjectives. At the same time, the privatization programs of the Russian and other republics (covering smaller enterprises, land and real estate) go already considerably beyond the All-Union proposals. After years of failure with partial market-oriented reforms of state enterprises in the reformist countries (Hungary, Poland, Yugoslavia), that permitted greater self-management, but failed to impose financial discipline, most Eastern European countries now share the central political goal of widespread privatization. Small enterprises, mostly in retail trade and services, are being privatized rapidly, mainly through local auctions."6 But few large-scale firms have been privatized to date, with the exception of east Germany where sales now number in the hundreds. But a number of countries are now putting the legal foundations and administrative mechanisms in place to distribute or sell shares in large enterprises to the population, and to find foreign partners who can contribute technology, management and marketing expertise. One problem, that afflicts countries that have introduced partial enterprise reforms and decentralization earlier on, is how to recentralize control over enterprises to facilitate full and fair privatization. In these countries, workers and unions have considerable control over enterprise management, and property rights are blurred by populist self-management concepts that entail extensive, but non-transferable worker ownership, implying rather perverse economic incentives that stifle efficiency and investment and strangle labor markets. The political question in these countries (particularly Yugoslavia, but also Hungary and Poland) is how to wrest control over enterprises from WUtktls ijd wlltiuiu.. .'ste Hwullgaidn guvetitiliti., fui exalpie, is pieStIlliy considering a proposai that would eliminate self-management by the end of 1992, and would enforce conversion of all state enterprises into corporate form by the end of 1993. " In Poland. for example, at least 20.000 outlets have been sold, and about half of retail trade is in pnvate hands. In the CSFR, the government plans to sell some 100.000 small-scale establishments in 1991-92. mainly tbrough auctions organized by local governments. whicb started in February 1991. Hungary plans to transfer olvne'sh'p of ahout 10.000 shops and service establishment.' into pnvate hands in 1991 The Leningrad and Moscow City Councils have similarly starned to auction some small establishments under rather flexible guidelines, adopted by USSR Council of Ministers in February 1991. Most of the small-scale pnvatizations in Eastern Europe involve only the commercial establishment (i.e., mostly location rents, plus furniture and equipment), and not the Lonnected (and much more valuable) real-estate. 19 A second, fairly widespread. problem are "wild" privatization deals. whereby managers, workers, or the nomenklatura engage in transactions on very preferential terms, benefitting themselves or close associates. This is usually closely associated with self-management and worker ownership concepts, but may also involve other influential groups. While preferential treatment of any of these groups is questionable on equity ground, minority employee ownership plans are perhaps the most justifiable, particularly if the worker ownership is limited, and preferably capped in terms of a few months of salary equivalent (rather than a percentage of total equity). It may also be the only way to get workers and unions to relinquish self-management rights. Far more problematic are management and nomenklatura buy-outs on highly preferential terms. While privatization programs should be as decentralized as possible, and leave considerable initiative to management (e.g. in finding foreign partners, etc.), there has to be a regulatory framework and central supervision of the process that ensures a reasonable degree of transparency and fairness, and checks egregious abuses. Hungary. The basis for the privatization program in Hungary was the Law on Economic Association of October 1988, that allowed state enterprises to convert themselves into joint stock companies. The law also permitted enterprise to issue new shares and to sell these to individuals. For self-managed firms (about ?0% of the total), the decision rested with enterprise councils. Because they were dominated by managers, this led to a spurt of spontaneous privatization deals, often on advantageous terms for managers and outside investors, brought in by management. The Transformation Law of 1989 was enacted to address some of these abuses, and to provide more rigorous oversight over the privatization process. The State Property Agency (SPA) was set up in March 1990 to limit undervaluation in management initiated privatization deals, and to initiate privatization from above. It has now a staff of about 120. As of February 1991, The SPA has evaluated about 160 prop3sals, including transformations into corporate form, creation of joint ventures, sale of assets, and sales of shares. Only ten proposals involved sales of shares, and only three of these have been fully sold, one to a foreign investor. Some 300 further proposals are currently under consideration. In late 1990, the SPA has initiated the privatization "from above" of a first batch of 20 large state enterprises. These transactions are to be completed within 18 months. A second group of enterprises is now being selected. So far, the Hungarian government is only contemplating sales of enterprises, rather than "free" distribution of shares to citizens. Some eminent Hungarian economists, including Janos Kornai, have argued strongly that the government has not only the budgetary need, but also the fiduciary duty to the public to sell state-owned assets at the highest possible price. That seems to overiook the fact that these assets already belong to the whoie peopie . it aiso ignores that rapid sales-only programs would tend to depress asset prices, giving an unfair advantage to those who have accumulated funds under the old system. Hungary has also opted for compensating former owners of land and real estate, but through monetarv compensation, rather than physical restitution. Poland. Earlier reforms had expanded self-management and the role of worker councils, and ownership rights had become very ambiguous. Workers and managers argued that these autonomous enterprises could issue shares to anybody, including themselves. A wave of spontaneous privatizations in 1989 was quite correctly branded as unjustified self-enrichment of particular groups. In response, the government tried--not entirely successfully--to reclaim title over all state assets. After several months of political debates, the State Enterprise Privatization law was adopted in July 20 1990. It is a compromise, and intentionally quite vague, allowing a wide range of privatization techniques. A Ministry of Ownership Changes has been established to oversee the process. Proposals made in 1990 envisaged a mixture of distribution to the general population, with a preferential share for employees, and a larger controlling stake retained for sale to a "core investor", with foreign investors permitted to buy up to 10% without approval. A privatization program for 1991 was approved by Parliament in March 1991 and is even more flexible. Several routes are to be tried, including share distribution, outright sales to foreign investors, and management buy-outs. During the past nine months, five enterprises have been privatized through public offering, two by direct sales to foreigners and one through a management buy-out. About 50 smaller enterprises were privatized through a sale of assets, and around 100 through leasing. About 100 larger enterprises were converted into joint-stock corporations with a supervisory board and half of these are slated for privatization. During 1991 the government intends to incorporate another 1,000 larger enterprises to establish a privatization "pipeline". At least five Privatization Funds are to be established during 1991 to initiate a program of mass distribution of shares to the population (expected for the end of 1991). Individual sales to foreign and domestic investors are also to continue, and the government hopes to privatize 50-60 small and medium enterprises per month through asset sales. Perhaps in view of the large territorial changes, restitution is not high on the political agenda. Czechoslovakia. Like Poland, the CSFR also favors mass distribution of shares in enterprises to the population. A large-scale privatization law ("Law on Transfer of State Property to Other Persons") was passed in the Federal Assembly in February 1991. It combines privatization initiatives of enterprises with state oversight and control. Eniterprises prepare, on their own accord or after mandate by their controlling agency ("founder"), a "privatization project", which contains all relevant information about the enterprise and the proposed privatization (similar to a prospectus), and is submitted to the founding organ and the ministry of finance. After approval, the enterprise is transferred to the National Property Fund who then proceeds with privatization by sale, distribution through vouchers, or some combination. While earlier proposals had heavily focussed on auctions with freely distributed vouchers, the law is not specific and permits a variety of techniques. The privatization law does not impose any restrictions on foreign ownership. A law on small-scale privatization was passed in October 1990 and took effect in November. Small scale privatization is to take place mostly through auctions to Czech and Slovak nationals, with foreigners permitted to participate in a second round, if a property was not sold in the first round, or through purchases from successful bidders, after a sho-t minimum holding period. The government hopes to auction off 100,000 small-scale establishments during 1991-92 (mostly on a leasehold basis). Czechoslovakia has also opted for restitution of property to former owners. Restitution can be in kind, in vouchers to purchase enterprise shares, and partly (up to $ 1,000) in cash. The cut-off date for restitution is 1948. Land was never formally expropriated, although the government used it as it saw fit. The restitution process will, in all likelihood, considerably slow down the process of privatization, as restitution claims will have to be resolved first. Yugoslavia has to deal with the most entrenched worker self-management ideology of all the countries. The government's strategy has been to remove self-management rights, and to provide .irms with the legal means to sell assets--not surprisingly--with preferential treatment of the work 21 force. The 1988 Enterprise Law and the 1989 Law on Social Capital limit self-management rights and allow self-managed firms to be transformed into joint-stock corporations at the initiative of the workers' councils. Results to date have been disappointing. Few enterprise sales have taken place and the Development Funds that are to oversee privatization are onlv now being created. There is considerable regional variation in the aims and extent of privatization. In Slovenia, the Development Fund sees itself primarily as a privatization agency, while the Serbian Development Fund concentrates on enterprise restructuring, with modest privatization aims. Romania. The government is committed to an ambitious privatization program that includes both sales and uncompensated transfers, A 30% share in all enterprises is to be reserved for citizens. The program is still in its design phase. A draft privatization law was to be presented to Parliament in early April 1991. Bulgaria. Several drafts of a privatization law have been produced, but a clear privatization strategy has not yet emerged, partly due to the unclear delineation of responsibilities within the government. Some pilot privatization of small enterprises are to go ahead over the next few months. Albania. A decree, permitting private ownership and private economic activity, was passed by the People's Assembly in March 1991. The decree also allows for the privatization of state- owned enterprises in industry, commerce and services, and case-by-case privatization of public utilities by decision of the Council of Ministers. The government intends to start with small-scale (trade, services) privatization during 1991. Implementation strategies for the privatization of larger enterprises are still under consideration. Soviet Union. (,uidelines for small-scale privatization were issued by the USSR Council of Ministers in February 1991. These regulate mostly the form of privatization (competitiveness, openness, equality of bidders, etc.), while the scope and speed is largely left to the republics and local governments. Small-scale privatizations will be carried out by committees on privatization and demonopolization, directed by city and regional councils. A few auctions are already under way in Moscow and Leningrad. A "large-scale" privatization law was introduced into the Soviet parliament on April 5, 1991, and mentions for the first time at the All-Union level, private property, although it uses still mostly "conservative" terminology, such as denationalization. The State Property Fund, created in August 1990, will determine de-nationalization and privatization programs for All-Union enterprises. A%4uLJk-lw a. aLiU lv;a' a-u horiUes havcU consw.dcrabj'e-.. &&I in s.3nihA;;t6 L4AM.,& . t4.va+.zJ8 strategies, and in regulating economic activity. For example, the Russian republic has eliminated Article 154 of the penal code (economic crimes), proclaimed all ownership forms as equal, and permits private ownership of land. Russian laws aim at forcing the privatization process and extend it to a wider array of entities, including large industrial enterprises, while All-Union laws still talk mostly about denationalization (cnmmr.rri1li7ation), H4owever, there remains considerable overlap in jurisdiction, and thus, uncertainty. 22 References Blanchard, Olivier, Radiger Dornbusch, Paul Knruman. Richard l,avard and Jl.wrence Summers: "Reform in Eastern Europe." mimeo, WIDER World Economy Group, 1990. Fischer, Stanley and Alan Gelb: "Issues in Socialist Economic Reforms" mimeo, World Bank, 1990. Hinds, Manuel: "Issues in the Introduction of Market Forces in Eastern European Socialist Economies" World Bank, 1990. Jensen, Michael: "Eclipse of the Public Corporation". Harvard Business Review, September-October 1989. Lipton, David and Jeffrey Sachs: "Privatization in Eastern Europe: The Case of Poland." Brookings Papers on Economic Activity, 1990. Long, Millard and Silvia Sagari: "Financial Reform in Socialist Economies in Transition." mimeo, World Bank, 1991. Milanovic, Branko: Liberalization and Entrepreneurship: Dynamics of Reform in Socialism and Capitalism, New York, 1989. Milanovic, Branko: "Privatization in Post-Communist Societies." mimeo, World Bank, 1990. Pohl, Gerhard, William Byrd and others: "China: State Enterprise Management and Organization - Reform Issues and Options." mimeo, World Bank, 1987. World Bank: "The Transformation of Economies in Central and Eastern Europe: Issues, Progress, and Prospects" mimeo, World Bank, 1991. PRE Working Papet Serus Contact Autho Loa WPS742 The Cost of the District Hospital. A. J Milts A Case Study frorm Malawi WPS743 Antiduiniping Eriforcement in the Angelika Eymann August 1991 N Artis Furopean CommnmTi,lty ludger Schuknecht 37947 WPS744 Stainioesr Stci in Sweden. Anti- Gunnar Fors August 19q1 N. Artis dumping Attacks Good International 37947 C(t:zenship WPS745 The Meaning of "Unfair in U.S J Michael Finger August 1991 N. Artis Import Policy 3794, WPS746 Tho Impact of Regulation on D-mitri Vittas August 1991 W. Pitayatonakatni Financial Intermediation 37666 WPS747 Credit Policies in Japan and Korea: Dimitri Vittas August 1991 W. Pitayatonakain A Review of the Literature 37666 WPS748 European Trade Patterns After the Oleh Havrylyshyn August 1991 N Castillo Transition Lant Pritchet' 37947 WPS749 Hedging Commodity F rice Risks in Stijn Claessens August 1991 S. Lipscomb Papua New Guinea Jonathan Coleman 33718 WPS750 Reforming and Privatizing Poland's Esra Bennathan August 1991 B. Gregory Road Freight Industry Jeffrey Gutman 33744 Louis Thompson WPS751 A Consumption-Based Direct Tax for Charles E. McLure, Jr. August 1991 CECSE Countries in Transitioni from Socialism 37188 WPS752 Inflation and Stabilizatiorn in Robertode Rezende August 1991 L. Ly Yugosl3via Rocha 37352 WPS753 The CMEA System of Trade and Martin Schrenk August 1991 CECSE Payments: The Legacy and the 37188 Aftermath of Its Termination WPS754 Estimating Returns to Scale with James R. Tybout August 1991 S. Fallon Large Imperfect Panels M Daniel Westbrook 37947 WPS755 Hedging Crude Oil Imports in Stijn Claesse s August 1991 D. 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