Time to Rethink Privatization in Transition Economies?

• Author: John Nellis
• Position: Senior Manager of the Enterprise Group in the World Bank's Private Sector Development Department

Privatization has won the day in transition countries . . . or has it? Where have privatization efforts-particularly those in Central and Eastern Europe and the former Soviet Union-succeeded, where have they failed, and how can these countries best pursue further privatization?

Privatization appears to have swept the field and won the day. More than a hundred countries, on every continent, have privatized an estimated 75,000 state-owned companies. Assessment after assessment has concluded that privatization leads to improved performance of divested companies and that privately owned firms outperform state-owned enterprises. This has been conclusively proved in industrial and middle-income countries, and there is increasing evidence that privatization yields positive results in lower-income and transition countries as well.

In the transition countries, the evidence of good results comes mainly from Central and Eastern Europe and the Baltic states. Evidence-early and fragmentary, but impossible to ignore-from farther east-Armenia, Georgia, Kazakhstan, the Kyrgyz Republic, Moldova, Mongolia, Russia, and Ukraine-shows less promising results:

* Private ownership often does not lead to restructuring (that is, making changes to position a firm to survive and thrive in competitive markets).

* Some partially state-owned firms perform better than privatized companies.

* In some countries, there are few differences in performance between (wholly) state-owned and privately owned firms.

* In other countries, there are clear performance improvements only in those very few firms sold to foreign investors.

What is the explanation for these poorer results, and what should the affected transition governments, and those who assist them, do to improve these results?

Russia's experience

Russia's privatization experience illustrates the problems. The mass privatization program of 1992-94 transferred ownership of more than 15,000 firms through a distribution of ownership vouchers. A worrisome result of this program was that "insiders"-managers and workers combined-gained control of an average of about two-thirds of the shares of privatized firms. Still, by the fall of 1994, hopes were modestly high that privatization would lead the way toward rapid transition to a market economy. Financial discipline would, it was anticipated, start to force secondary trading in shares of insider-dominated companies and introduce outside ownership, and transparent and sound methods would be used to privatize the half or more of industries still in state hands.

This, by and large, did not happen. First, insiders-particularly the workers in the newly privatized firms-deeply feared outside ownership and a loss of control (and jobs). Second, because the financial and physical conditions of many firms were unattractive, not many outsiders were interested in acquiring their shares. Third, there was an acute lack of defined property rights, institutional underpinnings, and safeguards for transparent secondary trading; this further discouraged outside investors. Fourth, various Russian governments failed to put in place supporting policies and institutions-such as hard budget constraints, reasonable taxes and services, and mechanisms to permit and encourage new business entrants-that might have channeled enterprise activity to productive ends.

Worse was to come: a donor-led effort to persuade the Russian government to sell at least a few large firms using transparent and credible "case-by-case" methods produced few results. Much of the second wave of privatization that did take place-in particular, the "loans-for-shares" scheme, in which major Russian banks obtained shares in firms with strong potential as collateral for loans to the state-turned into a fraudulent shambles, which drew criticism from many, including supporters of the first, mass phase of Russian privatization.

Others concluded that not just the second phase of privatization but the whole approach was wrong; that it should have been preceded (not accompanied) by institution building; and that the proper way forward would be to concentrate on strengthening the structures of the state, especially mechanisms to manage public firms.

Czech Republic's experience

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