Complementarities, Managers and Mass Privatization Programs after Communism

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EUROPEAN UNIVERSITY INSTITUTE, FLORENCE

ROBERT SCHUMAN CENTRE

Complementarities, Managers

and Mass Privatization Programs

after Communism

SIMON JOHNSON

and

HEIDI KROLL

EUI Working Paper RSC No. 94/14

BADIA FIESOLANA, SAN DOMENICO (FI)

WP

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All rights reserved.

No part of this paper may be reproduced in any form

without permission of the authors.

© Simon Johnson and Heidi Kroll

Printed in Italy in October 1994

European University Institute

Badia Fiesolana

I - 50016 San Domenico (FI)

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Complementarities, Managers and Mass Privatization Programs After Communism

by Simon Johnson* and Heidi Kroll**

*: The Fuqua School of Business, Duke University **: U.S. Agency for International Development

Simon Johnson gratefully acknowledges financial support from Xerox Faculty Research Funds and from the National Council for Soviet and East European Research.

Helpful comments were provided by John Earle, John McMillan and participants at the Workshop on Privatization held at the European University Institute in Florence, December 1993.

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Abstract

We construct a model of the privatization process in post-communist countries which allows a general form of complementarity between policy parameters that affect managerial incentives. Complementary privatization measures are more likely to promote the restructuring of state enterprises. This analysis provides criteria for the assessment of coherence and the likelihood of success in actual privatization programs. The available evidence suggests the most favorable complementarities are found in programs based on tradeable vouchers and spontaneously-created intermediary funds because they establish mechanisms for controlling managers while limiting influence costs. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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1. Introduction

Since the fall of communism in Eastern Europe and the former

Soviet Union, a growing number of countries in the region have

opted for programs to speed up the privatization process through

the free distribution of shares in hundreds or even thousands of

enterprises. Two fundamentally different approaches to this

process, now known as "mass privatization", have emerged.

Under the laissez-faire model adopted in the former

Czechoslovakia (now divided into the Czech and Slovak Republics)

and subsequently the Russian Federation, the government issues

vouchers to citizens and leaves them free to choose whether to

use vouchers to bid directly for shares in companies through

voucher auctions, or to invest them instead in private investment

funds, which in turn bid for shares in companies.

Under the guided model, as pioneered in Poland, the government

establishes a system of investment funds to serve as

intermediaries between citizens and privatized companies. The

shares of enterprises to be privatized are distributed among the

financial intermediaries, and citizens are restricted to holding

shares in the financial intermediaries instead of those of

privatized companies.

Although the guided model is widely considered to have the

theoretical advantage of directly providing stronger corporate

control, there is growing evidence to suggest that this advantage

has not been realized in practice. For example, implementation

of the guided model in Poland has been delayed by political

opposition, an outcome that mass privatization was intended to

avoid. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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In contrast, implementation of the voucher approach has

succeeded in achieving a rapid pace of privatization in both the

former Czechoslovakia and the Russian Federation — in the latter

case despite repeated attempts by the Russian parliament during

1992-1993 to dilute the privatization program and to block its

implementation.

Equally encouraging are the consequences of voucher

privatization for the distribution of share ownership. Contrary

to earlier predictions, significant concentration of

shareholdings in the hands of institutional and individual

investors has occurred spontaneously, on the initiative of

investors, in both the former Czechoslovakia and Russia. This has

occurred despite manager and worker attitudes which were

initially very suspicious of privatization.

Why has privatization proceeded faster in the Czech Republic

and Russia than in Poland? To what extent is the difference due

to structural features of the guided and laissez-faire models,

as opposed to particular political circumstances and

personalities?

An appropriate model of privatization is needed to help us

address these issues, but such a model is not presently

available. One recent model is that proposed by Gates, Milgrom

and Roberts (1993) which examines the complementarities between

privatization and price liberalization. However, it does not

evaluate alternative privatization schemes and it also does not

generate such interesting results once prices have been

liberalized — as they have been in most post-communist countries

by the time privatization schemes are implemented.

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An alternative model is that of Boycko, Shleifer and Vishny

(1993a) who assume a government which has different preferences

from managers. The government wants to subsidize employment and

the managers are more interested in profits. As they put it, "In

our view, the main reason for the inefficiency of state firms is

not poor design of managerial incentives, but rather the

insistence by the government that firms produce inefficiency."

In this context, privatization is desirable because it puts

greater distance between government and managers.

Boycko, Shleifer and Vishny (1993a) evaluate various

privatization schemes to determine that ownership by outside

blockholders is better than manager ownership and that worker

ownership is the worst possible outcome. However, their model

does not deal with differences between the guided and

laissez-faire approaches.

The same authors have an interesting paper on the voucher

approach in Russia, but this argues that it was adopted primarily

for political reasons (Boycko, Shleifer and Vishny 1993b). While

this explanation is most likely correct — particularly because

the authors were closely involved in the policy decision — it

does not help us evaluate schemes in other countries.

Given that the available literature does not provide a

satisfactory framework for comparing privatization schemes across

countries, our paper develops a new model which can be used to

assess actual privatization programs. There are three core

assumptions in the model.

First, there is a reform team within the government that seeks

to maximize social welfare. The rest of the government has

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different objectives and one important goal of the reformers is

to put greater distance between the state enterprises and the

ministries, ie., to reduce the influence costs of lobbying.

Second, managers of state enterprises divide their available

effort between three alternative activities: restructuring,

lobbying and theft. The basic intuition is that managers will

engage in serious restructuring only when it is relatively

attractive to do so. A full model which provides a more detailed

justification and examination of this assumption is provided in

Johnson (1994). In the present paper we move directly to the

decision problem of the economic reformers — how to increase

restructuring while eliminating lobbying and theft.

Third, the reform team can set parameters which affect the

incentives faced by managers on these three activities. We make

a formal assumption that allows a form of technical

complementarity between these choice variables: increasing the

value of any variable does not preclude an increase in any other

variable. We make a further technical assumption that ensures the

choices of incentives facing managers are complementary from the

point of view of the reformer. An increase in one incentive

increases the returns to raising another incentive. The effect

is that a set of policies is more effective if it contains a

package of complementary changes in incentives. In effect we set

up a model which displays complementarities of the

Edgeworth-Milgrom-Roberts form (Milgrom and Roberts, 1990 and

1992).

The most important use of the model is to provide criteria

which can be used to examine the advantages and disadvantages of

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actual privatization programs, in terms of complementarities.

Coherent and success programs, according to our model, should be

those which have managed to increase the incentive to restructure

while reducing the incentive to lobby and to steal.

Empirically, we find laissez-faire privatization schemes have

displayed a definite advantage because they make it possible for

outside stockholders to acquire sufficient ownership so that they

both want to and can exert control over managers. At the same

time, the Czech and Russian versions of the laissez-faire model

have avoided the lobbying and high influence costs which have

slowed down privatization in countries such as Poland and

Ukraine. In terms of our criteria, voucher privatization schemes

do better when vouchers have a paper form, rather than being a

bank account, which is tradeable from the moment of issue.

Section 2 describes the development of the privatization

debate and the facts which are now accepted by almost all

participants in that debate. Section 3 uses those facts to build

a model of privatization design. Section 4 assesses two

privatization programs in Eastern Europe and Section 5 does the

same for five programs in the former Soviet Union. Section 6

reassesses voucher privatization and Section 7 provides some

policy implications.2

2. The Privatization Debate

The implicit assumption in the privatization debate is that

state enterprise need to be fundamentally restructured if they

are to survive and provide reasonable jobs for the future. The

question is how best to er and support this restructuring. In

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Eastern Europe and the former Soviet Union an important part of

the debate has concerned how to privatize large numbers of big

state enterprises — a process commonly referred to as "mass

privatization."

The implementation of mass privatization was preceded by a

theoretical debate over the desirable pace and methods of

privatization in post-communist countries. The debate was framed

in terms of a choice between rapid privatization through the free

distribution of shares versus the gradual, case-by-case sale of

state enterprises through public offerings or investment tenders.

The case for the gradualist approach rested on the premise that

the free distribution of shares is incompatible with the

development of effective ownership.1

In rebutting the gradualist view, advocates of rapid

privatization stressed that speed is urgent for political as well

as economic reasons. A gradual, case-by-case approach to

privatization not only delays the realization of efficiency gains

from private ownership, but more importantly it heightens the

risk that a political backlash will derail the entire

privatization process before it has made much headway. The shared

goal of mass privatization programs is to ensure that as many

enterprises as possible are transferred to private ownership

while the window of opportunity remains open.2

A second plank of the rebuttal addressed the feasibility of

combining rapid privatization through the free distribution of

shares with the development of effective ownership and corporate

governance. In the shared views of this new literature, large

shareholders with an incentive to exercise effective oversight

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over enterprise management are critical to the development of

corporate governance.

Even advocates of rapid privatization predicted that voucher

schemes would lead to a dispersed pattern of share ownership and

thus compromise the development of effective corporate control.

The guided model was proposed as a way to avoid the pitfalls of

voucher privatization.3

The aim of the guided model is to avoid the fragmentation of

share ownership associated with mass privatization by limiting

direct participation in privatized companies to a small number

of financial intermediaries. The theory behind the guided model

is that financial intermediaries will assume a lead role in

supervising company management, thus ensuring effective corporate

governance from the outset of privatization. The case for the

guided model is also based on the assumption that former

communist countries lack the individual or institutional

investors who normally exercise corporate governance in the West.

The question which we pursue below is derived from this

debate: to what extent do either the laissez-faire or guided

versions have the features which have been ascribed to them? To

answer this question we provide a theoretical framework within

which we can compare key features of the two approaches and then

use this framework to study how privatization policies have

worked in practice.

3. The Model

We assume there is a group of economic reformers with the goal

of encouraging the restructuring of state enterprises.4 The

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problem for the reformers is how to alter the incentives facing

managers, so that they want to restructure. The situation is

complicated because there are two other activities which managers

may engage in: lobbying of the government and stealing assets

from the firms which they run.

Both lobbying and theft have been important problems in some

postcommunist countries. Lobbying for extra resources of various

kinds was an important activity for state enterprise managers

during communism. A manager had to put considerable effort into

lobbying various ministerial and party contacts to ensure that

his firm received sufficient resources. With the breakdown of the

planned system in these countries there has generally been

greater pressure from managers for subsidies and other forms of

monetary transfer.

There may have been some theft by managers in the communist

system, but it was limited by the existence of party and secret

police supervision. A common feature in all these countries has

been that when these control mechanisms disintegrated managers

became practically unsupervised. "Theft" is a controversial term

to use for what follows, because the property which managers

acquire is frequently not owned by anyone but it is hard to find

a descriptive value-neutral expression.

This type of theft has taken various forms in different

countries. It most commonly appears as a type of "spontaneous

privatization," in which managers and possibly workers initiate

their own acquisition of property rights.5 In order to take

possession of assets managers often have to work quite hard —

for example in setting up new legal structures, actually moving

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assets and ensuring that the newly acquired assets generated some

revenue.

In this context it seems reasonable to model the reformers as

wanting to encourage restructuring, stop lobbying and prevent

further theft. But the required policy is not simple because of

possible interactions between the incentives to engage in

particular activities. For example, Johnson (1994) shows that in

this type of model, privatization can increase the incentive to

restructure while also raising the effort devoted to lobbying and

theft.

The reformers therefore need to change all three parameters

simultaneously and this explains why a coherent package of

measures is needed. If the reformers act to encourage

restructuring, they should also address the issues of theft and

lobbying. The remainder of this section outlines a formal model

in which this is true.

The model used here is a much simplified version of one

developed from first principles in Johnson (1994 )6 The full

model provides a detailed derivation which generates a more

complicated problem for the reformers than that presented here.

The full model shows that, under some conditions,

complementarities among different policy parameters may exist.

However, it also shows that those complementarities do not

necessarily exist. Because our main intent here is to provide a

model which has some usable empirical content, we present only

a simplified reduced form in what follows.

The net benefit function from the three activities — benefits

minus the cost of effort for each — is given by B(e), where e

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is a vector of efforts. The manager cares about his share of the

benefits on each activity, given by al on restructuring, a2 on

lobbying and a3 on theft. The reformers can therefore choose

among a vector of policy parameters, denoted (a). The reformers

cannot affect the functional form of B(e) and nor can they write

contracts for managers which are directly dependent on the

allocation of effort or on performance.

Managers care about their own return on different kinds of

effort, but social welfare depends on the total amount of the

three activities which actually take place. A higher level of

restructuring increases social welfare, through raising B(e),

while both more lobbying and more theft reduce B(e) and lower

social welfare. The social welfare function is given formally by:

Maxa pyg(x) - ppc + B (e ) - l/2ra2

s . t . e = E

Where E is a vector of effort levels which is optimal for the

manager.

In other words, the reformer must reckon that the combination of

effort levels will be optimal for the manager.

The other terms in the social welfare function are derived

from the assumed underlying structure: (pyg(x) - p^) is profit

from a production process which does not require managerial

effort and (l/2ro2) is the risk premium. As is evident from this

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formulation, we are assuming that the wealth maximization

principle hol d s .

We use this statement of the reformers' optimization problem

to derive plausible results about the structure of privatization

programs. To do this we first need to define precisely what we

mean by a program and how we can judge it.

Definition 1:

A privatization program is a set of measures which raise a, and

alter a 2 or a 3 or both, with the express intention of raising

social welfare through increasing the amount of restructuring.

Definition 2:

1. A coherent privatization program reduces the effort which goes

to lobbying and theft and increases the effort devoted to

restructuring. 2. A successful privatization program results in

positive effort devoted to restructuring and zero effort devoted

to lobbying and theft. 3. An incoherent privatization program

does not effectively reduce lobbying and theft. The effort

devoted to restructuring may or may not increase.

4. An unsuccessful privatization program results in no

restructuring.

Empirically we will not be able to determine for certain

whether a program is coherent or successful, but we can make an

informed judgment. To this end, it is helpful to have a

proposition which summarizes our results and makes an explicit

link between coherence, success and the benefit parameters.

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Proposition 1:

a) Coherence and success in a privatization program are more

likely to be achieved with the following combination of measures.

i. A reduction in the benefit parameters for lobbying (a2) and

theft (a3). ii. An increase in the benefit parameter for

restructuring (a,). In order to eliminate lobbying and theft, the

restructuring benefit parameter will have to be increased more

if the benefit parameters on lobbying and theft are higher.

b) Coherence and success in a privatization program are less

likely to be achieved with the following combination of policies.

i. Increasing the return to lobbying (a2) or theft (a3) at the

same time as increasing the return to restructuring (a,).

ii. Not reducing the return to lobbying (a2) or theft (a3) at the

same time as increasing the return to restructuring (a,).

Proof. Part (a) follows because a lower value of a 2 makes it

more likely that lobbying will not be optimal for the manager.

A lower value of a 3 makes it more likely that theft will not

occur in the optimal solution. A higher value of a, makes it more

likely there will be restructuring in the optimal solution. Note,

however, that unless a 2 and a 3 are zero, we cannot be sure that

there will not continue to be some lobbying and theft in

equilibrium.

The amount of lobbying and theft could go up, even though the

benefit parameters on these activities are reduced.

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Part (b) is the converse of part (a). Again the actual outcome

will depend on the parameter values and on the particular

functional form of the benefit functions.

Proposition 1 emphasizes the need to evaluate privatization

programs in terms of the relative incentives on three activities:

restructuring, lobbying and theft. Empirically, we need to

determine both how policy instruments affect those incentives and

how the balance of incentives has changed in particular

situations.

In our assessment of actual privatization programs, we

consider a, to be measured by the ownership share obtained by

managers in a privatization program. This measures the direct

benefit managers get from restructuring.

Corporate control, in the role usually proposed for

privatization programs, is designed to prevent managers from

stealing and to force them to restructure. It therefore lowers

a3. The need for some sort of control in this model is obvious —

managers may be just as content to benefit through theft rather

than restructuring, but this is bad from the social perspective.

Whether managers can lobby effectively is described by a 2.

Measures which prevent lobbying, such as eliminating subsidies

or allocating credits on a purely commercial basis, should reduce

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One advantage of this general formulation is that it allows

the form of subsidies to change. For example, if explicit

subsidies are no longer available but the possibility of credit

at negative real interest rates has taken its place, then what

matters is how this has affected a2. If a privatization program

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increases a, and reduces a 3 but increases a 2 then, as we shall see

in several real world cases, this may constitute an incoherent

and unsuccessful program.

The problem for the economic reform team is therefore to find

one or more instruments which act in three dimensions. They need

to watch out for the complementary effects between different

types of effort from the manager's point of view. There is also

a real danger of unwanted spillover effects, in the sense that

they may work hard to raise the return to restructuring, a,,

without realizing that the same privatization program actually

raises the return to lobbying, a 2.

Our assessment of privatization programs uses the concepts

developed in our model. We shall point out instances in which

complementarities have worked for and against the program, as

well as various forms of spillover effect. For each program we

shall attempt to judge its coherence and success. This will lead

us to some more general observations about the role of voucher

schemes.

4. The East European Experience

Based on our model, we can now assess the privatization

programs on offer in terms of how they affect the benefit

parameters and in terms of their overall "coherence" — using the

precise definition of the previous section.

Poland

Under the Polish version of mass privatization with financial

intermediaries, 60 percent of the shares of participating

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enterprises will be distributed to 20 financial intermediaries,

called National Investment Funds, to be established and licensed

by the Ministry of Privatization.

For each enterprise, 33 percent of the shares will be

distributed to a designated "lead fund" which will assume the

dominant role in supervising and restructuring the enterprise.

Another 27 percent will be distributed equally among the other

funds. Fund managers will be selected from among investment

bankers, international fund managers and consulting firms through

a tender for fund management contracts. Their compensation will

be linked to the funds' performance.

These funds are designed to impose strong corporate control

over privatized firms. Bringing in foreign experts and giving

them strong financial incentives is intended to limit the ability

of managers to do as they please with the firms. In terms of our

model, this constitutes an attempt to reduce the theft parameter

very sharply.

After the funds have been in operation for a year, special

"investment certificates" will be distributed to the population.

The certificates will entitle holders to a fraction of a share

in a fund. Despite the use of a voucher-like instrument to

distribute shares in the investment funds, citizens will have no

freedom of choice with regard to the funds in which they hold

shares.

As mentioned in the introduction, a leading justification for

mass privatization was to circumvent political opposition to

privatization by speeding up the privatization process. In

Poland, however, mass privatization has been blocked by political

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opposition and in fact has become a rallying point for this

opposition.

The program encountered strong opposition from Polish workers,

who understandably feared that privatization would lead to

layoffs. In the

program, workers will receive up to 15 percent of the shares in

their enterprise free of charge and the remaining 30 percent will

be retained by the government for eventual disposal. Many workers

saw this an inadequate compensation for the loss of their

previous control rights in these firms. Opponents also objected

that the procedures for selecting fund managers would allow

foreigners to gain control of Polish companies. After several

years of delays and wrangling over the details, the Polish

parliament finally enacted a bill to implement the program in

1993.

In terms of our model, the Polish program was designed to

reduce the theft parameter, but at the same time it did not

adequately reduce — and may even have increased — the lobbying

parameter. As a result, privatization was slowed down and

presumably restructuring has similarly been slowed. This would

appear to be a case of an incoherent privatization program.

Czech Republic

Under the Czechoslovak privatization program, eligible

citizens are entitled to purchase a voucher booklet for a small

fee, and to register it for about $34. Each voucher is divisible

into 1000 points, which voucher-holders are free to invest

directly in companies or in financial intermediaries.

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Enterprises participating in the voucher privatization program

are privatized in two waves through a centralized and

computerized national auction. Shares are allocated to individual

investors and financial intermediaries through a multiple-round

auction procedure in which the price of company shares in terms

of voucher points can be adjusted upwards or downwards in

response to excess demand or supply. During the so-called "zero

round," voucher holders decide what proportion of their points

to invest in financial intermediaries rather than directly in

companies.

The Czechoslovak government intentionally avoided assigning

a dominant role to financial intermediaries out of a concern that

such intermediaries would simply replicate the industrial

bureaucracies (the branch ministries) of the traditional central

planning system.

In effect, the government wanted to reduce influence costs by

withdrawing from the issues of post-privatization allocation of

resources. The government was willing to accept a lower level of

corporate control over managers. However, at least to some extent

this lower level of control has not materialized.

Financial intermediaries nonetheless emerged as a key player

in the privatization process, despite the absence of direct

government intervention to ensure the outcome. Some of the

investment funds mounted aggressive advertising campaigns in

which they offered to repurchase their shares after a period of

time at prices 10 to 15 times the original cost of purchasing and

registering a voucher booklet. These tactics succeeded in

persuading two thirds of all voucher-holders to invest all of

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their points in investment funds, and by the end of the zero

round, investment funds had gained control of 72 percent of all

voucher points. The tactics of the investment funds were

instrumental in persuading eligible citizens to participate in

the program by purchasing voucher booklets.

The auction rules gave priority to individual investors over

the investment funds whenever there was excess demand for shares.

Despite this handicap, the investment funds emerged holding more

than 70 percent of the shares in the nearly 1,500 companies

privatized in the first wave. Reports suggest some of the larger

investment funds have begun to assert an active role in

supervising and restructuring companies in their portfolio. They

have demanded seats on newly formed corporate boards and have

begun to press for job reductions and other measures to cut costs

and make companies more efficient and commercially viable.

In effect, private intermediary funds have emerged and

spontaneously exerted corporate control over enterprises. This

is the best of both worlds: because the funds are private, the

level of lobbying is presumably lower than if they had been set

up by the state; and because the funds are seeking corporate

control, they directly reduce the benefits from theft in

privatized enterprises.

To be sure, the investment funds remain highly controversial.

The main concern has been that once shares begin trading on the

new Prague stock exchange, the investment funds will be under

pressure to sell large blocks of shares in order to raise cash

to pay out the returns their promised to investors.

Notwithstanding this concern, the emergence and prominence of

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investment funds can be considered a positive development because

it contributes to the development of effective corporate

governance. It probably also reduces the level of lobbying both

during the privatization process (which has prevented progress

in Poland) and after privatization. At least according to our

model, this should free up effort for restructuring.

In terms of "coherence," our approach suggests that the Czech

program has a distinct advantage over the Polish program. The

Polish program aimed to reduce the theft parameter directly but

— the inadvertent result of a complicated political process —

created incentives which induced a great deal of lobbying and

effectively stalled privatization. A program of the Polish type

could potentially be just as coherent as the Czech variety, but

only if the reform team finds some way to prevent lobbying during

and after privatization.

5. The Post-Soviet Experience

In this section we determine that privatization programs in

non-Russian republics of the former Soviet Union differ in

several significant regards from the Russian program. In

particular, it appears that the Russian program is more coherent

and that privatization in Russia has moved faster than elsewhere.

Russia

The Russian voucher program has been described as a simplified

version of the Czechoslovak privatization program. Beginning on

October 1, 1992, the Russian government distributed vouchers with

a face value of 10,000 rubles to Russian citizens. By the end of

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January 1993 over 96 percent of vouchers had been distributed.

Voucher-holders are free to decide whether to use their vouchers

to bid directly for shares in companies or to invest them instead

in private investment funds.

The first pilot voucher auctions were held in December 1992.

With over 2,300 medium and large enterprises accounting for 15

percent of the industrial workforce privatized through voucher

auctions by mid-1993, the pace of mass privatization in Russia

is unprecedented. In the second half of 1993 over 600 companies

per month were being privatized.

This rapid pace stands in marked contrast to all other parts

of the former Soviet Union and to Poland. The Russian program has

not got bogged down by political lobbying by particular

interests. At the very least, the design of the program either

reduced the amount of lobbying or made lobbying consistent with

progress in privatization. There are similarities between Russia

and the Czech Republic in this regard, but the Russian version

of voucher privatization is more decentralized and

market-oriented than the Czechoslovak voucher program in at least

three key respects.

First, Russian voucher-holders were explicitly given the right

to resell their vouchers for cash, and a large and liquid market

for these vouchers has developed with organized exchanges in

major cities throughout the countries. Among the main

justifications for this policy was the argument that imposing a

ban on the resale of vouchers would compromise the goal of

effective ownership by preventing individual investors from

accumulating vouchers and using them to acquire large stakes in

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companies — in other words, establishing incentives for

outsiders to impose some controls on insiders. A further

justification was that banning the sale of vouchers would result

in a black market for vouchers, with the attendant problems of

bribery and corruption.

Second, the organization of voucher auctions is far more

decentralized in the Russian program. The architects of the

program regarded regional decentralization as a necessity in view

of the large size and regional diversity of the country.

According to Boycko and Shleifer,

... the sheer number of enterprises to be privatized in

Russia, the size of the population, and the underdeveloped

communication networks make a single computerized auction in

Russia a logistical nightmare.

The Russian program features a two-track system of nationwide

auctions for selected large and well-known companies and regional

auctions for the remaining companies. Most companies will be sold

through regional voucher auctions.

In regional auctions, bids for shares in a company located

in a given region (oblast) can be placed only at bid reception

centers located within the limits of the same region. Investors

are entitled to use their vouchers to bid for shares in companies

in any region of the country regardless of their place of

residence, but the cost of physically transporting vouchers

across regions limits an investor's ability to place bids.for

companies located outside his or her region.7

Third, a further salient feature of the Russian privatization

program, and an important difference from the Czech scheme, is

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its provision for a high proportion of employee share ownership

from the outset of privatization. This is largely a consequence

of the generous concessions granted to insiders (managers and

workers) to persuade them to acquiesce in the privatization of

their enterprises.

Under the privatization program, workers' collectives were

allowed to choose from among three options for employee benefits.

According to a survey conducted by the Russian State Committee

for the Management of State Property (Goskomimushchestvo, or G K I ), approximately 64 percent of companies undergoing privatization

selected the so-called "second option" of a worker-management

buyout, under which workers and managers can purchase through

closed subscription 51 percent of the equity at a price of 1.7

times the book value. Workers can use vouchers to pay for 50

percent of the price of the shares, provided the full price is

paid within 90 days.

Most of the remaining companies (some 34 percent) chose the

first option, which entitles workers to receive free of charge

nonvoting shares equal to 25 percent of the share capital and

allows them to purchase voting shares equal to 10 percent of the

share capital at a 30 percent discount off the book value. Top

managers are allowed to purchase another 5 percent of voting

stock at book value under this first option.

As a result of these concessions, most enterprises go into

voucher auctions with a majority of their shares already owned

by their employees. Voucher auctions offer insiders the

opportunity to purchase additional shares in the companies which

employ them, and preliminary results confirm that insiders —

(31)

managers and workers — are taking advantages of this opportunity-

in an effort to ensure that control by insiders is preserved.

In one region, for example, workers and managers appear to

have purchased an average of 80 percent of the equity put up for

sale in the course of five voucher auctions (Djelic and

Tsukanova, 1993, p.15).8

Despite the importance of internal privatization, the Russian

program is proving surprisingly successful at encouraging

outsiders to acquire appreciable stakes in newly privatized

companies. The most visible cases involving very large and

nationally prominent companies have been publicized in the

Western press. Alpha Capital, a Russian investment bank, acquired

26 percent of the equity of the Bolshevik Biscuit Factory in

Moscow, the first Russian company to be auctioned for vouchers

in December 1992. An 8 percent stake in the Vladimir Tractor

Factory was acquired by Mr. Iosif Bakaleinik, the factory's

former deputy director and a graduate of Harvard Business School.

In both cases the largest outside shareholders initiated

corporate takeover battles and demanded changes in management and

business strategy. In the auction of ZIL, a leading Russian auto

maker, 8 bidders emerged holding 20 percent of the equity sold

at the auction (at which 35 percent of ZIL's equity was put up

for sale), with the largest bidder obtaining a 9 percent stake.

Another active institutional investor. Bioprocess, purchased

18.5

percent of Uralmash, a manufacturer of heavy equipment and one

of Russia's largest and best-known companies. The founder and

chief executive of Bioprocess, Kakha Bendukidzhe, is reported to

(32)

have accumulated the start-up capital for this and other

large-scale investments from exports of oil and other products.

According to one report, Bendukidze managed to gain control of

about 300,000 vouchers, one of every 500 issued by the

government.

In short, our assessment is that the Russian program is an

excellent example of design coherence. It provides high-powered

incentives to insiders which favor restructuring, but it also has

allowed the development of influential outside owners.

Particularly impressive given the recently high levels of

industrial lobbying in Russia, the program has effectively

prevented lobbying from blocking privatization.

Ukraine

Despite the passage of several key privatization laws in 1992,

including a law on privatization vouchers (called privatization

certificates), Ukraine has made little progress in transferring

medium and large state enterprises to private ownership. The main

reason is the lack of political will to implement mass

privatization on the part of the Ukrainian government, which has

been paralyzed by opposition to most aspects of market reform —

including privatization. Privatization issues have been a key

issue in the internal power struggle during 1991-93.9

However, the absence of strong leadership is compounded by the

design of the Ukrainian voucher program, which is inherently

difficult and time-consuming to implement.

Ukrainian privatization certificates are nontradeable and,

more © The Author(s). European University Institute. produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

(33)

importantly, are not issued in paper form. Instead, Ukrainian

citizens wishing to use their certificates to pay for state

assets must open a special deposit account in the local savings

bank and the value of the certificate (fixed at 55,000 Ukrainian

coupons in 1993) will be credited to the account.

While the paperless voucher accounts eliminate the need to

print and distribute paper vouchers (and the associated expense),

the Ukrainian banking system is technically ill-equipped to

handle the extra bookkeeping required for setting up the

accounts, and clearing and settling payments. In practice, the

Ukrainian approach has already slowed down the privatization

process.

In addition, plans for selling shares of companies in exchange

for privatization certificates focus on public subscriptions

conducted by mail on a nationwide basis over a 6-month period,

an approach that is complicated, time-consuming and dubious in

terms of its reliability.

Opposition from the industrial lobby has also blocked mass

privatization in Ukraine. The Ukrainian program provides for the

preferential sale of shares to employees at nominal value, up to

a limit of 1.5 times the face value of their privatization

certificates. This is much less generous than the concessions

given to Russian managers and workers, and the pressure for 100

percent employee ownership, or very high majority control for

employees, is at least as strong, if not stronger, in Ukraine

compared to Russia.

In terms of our model, the Ukrainian program can be deemed

not coherent. One problem was that government was not willing

(34)

initially to give large enough share to workers, so it was

relatively beneficial to engage in lobbying. The outcome was as

in the Polish case — almost no progress with privatization.

Kazakhstan

The national privatization program of Kazakhstan is a hybrid

which has elements of both the laissez-faire and guided models.

Under the program, the government of Kazakhstan will distribute

to the population voucher-like instruments called "privatization

investment coupons." Like Ukraine's privatization certificates,

investment coupons are established as personal accounts in

branches of the national Savings bank and are nontradeable. Each

citizen will receive an equal amount. Unlike both Russian and

Ukrainian vouchers, however, Kazakhstan's coupons are denominated

in points rather than currency u n i t s .

Despite the use of vouchers, the Kazakhstan program shares two

basic features with the guided model. First, a system of

investment privatization funds operating on a commercial basis

will be established as intermediaries between citizens

(coupon-holders) and privatized enterprises. At present it seems

that the spontaneous foundation of funds will be permitted.

Second, coupon-holders will not be allowed to directly exchange

privatization investment coupons for shares in companies being

privatized.

At the same time, the Kazakhstan program is more

market-oriented than the guided model in at least two respects.

First, shares in enterprises to be privatized will be allocated

to investment funds through open auctions, in which the

(35)

investment funds bid for shares of companies with the

privatization coupons invested by private citizens. No more than

10 percent of the shares in each company can be given to

employees free of charge.

Second, in an attempt to compensate for the restriction on the

use of vouchers, the program offers voucher-holders significant

freedom of choice with regard to placement of their vouchers in

privatization investment funds.

In particular, voucher-holders have the right to invest their

coupons in several privatization investment funds, and they have

decision-making freedom with regard to both the choice of

privatization investment funds and the number of privatization

investment coupons placed in the chosen funds.

It is still too early to judge the extent of corporate control

or influence costs which will arise from the Kazakh program. This

program offers an interesting experiment because it has almost

all the key features of a laissez-faire program, without allowing

the direct purchase of shares with vouchers. It therefore closely

resembles the Czech program. It remains to be seen whether it

will match the Czech success to date.

Moldova

Moldova's privatization program for 1993-94 is shaped by a

concern to ensure widespread ownership of Moldovan enterprises

by Moldovan citizens, while preventing undesirable elements (the

mafia, nomenklatura and foreigners, particularly Russians) from

buying up the best assets.

(36)

Paper vouchers called "patrimonial bonds" were designed as the

key vehicle for achieving this objective. Each citizen receives

a floor value of b o nds, plus additional bonds depending on years

of employment. The bonds are nontradeable, although shares

purchased with the bonds will be tradeable right away.

Managers and workers are entitled to use their bonds to

purchase up to 20 percent of the book value of shares prior to

the public share offering. This share is much lower than is

available in Russia and more in line with what has been offer —

and lobbied against — in Ukraine.

Small enterprises such as shops will also be auctioned in

exchange for patrimonial bon d s . This is a departure from the

usual approach in the region which entails cash auctions for

small-scale privatization, with voucher auctions reserved for

shares in medium and large enterprises.

Distribution of patrimonial bonds began in September 1993. The

first pilot voucher auction for small-scale enterprises was held

in October 1993, and share offerings for medium and large

enterprises are planned to begin early in 1994. The use of

vouchers has already complicated the sale of small enterprises

because the value of each person's voucher is ordinarily

insufficient to purchase an entire shops. Since patrimonial bonds

are not tradeable, individual citizens must form groups to pool

their vouchers in order to participate in the bidding for

small-scale enterprises. This is a cumbersome process.

This problem will not arise in the share offerings for medium

and large enterprises. However, the use of vouchers with unequal

amounts of value for different citizens will tend to complicate

(37)

bidding and the processing of bids in voucher auctions for

enterprise shares compared to the auction method used in Russia's

voucher program.

Our preliminary assessment is therefore that the Moldovan

program is vulnerable to lobbying because it offers only a small

ownership stake on advantageous terms to insiders and the

cumbersome nature of the process will give ample opportunity for

opponents to try to alter the content of the program. It also

remains unclear if effective intermediary funds will emerge. The

program must therefore be judged as somewhat less coherent at

present than the Russian program.

Kyrgyzstan

Kyrgyzstan's plans for mass privatization are in flux.

Following the passage of a privatization law in early 1992, the

initial approach featured "special means of payment" accounts,

denominated in rubles, that could be used to purchase housing as

well as shares in companies, but could neither be traded nor

transferred. In an effort to allocate voucher bidding power to

citizens according to their contribution to the economy, the

value of each account would depend on the recipient's salary and

number of years worked. Workers received preemptive rights to

purchase 20 percent of the shares in their enterprise at a

discount of up to 30 percent off their nominal value.

The pace of implementation has been slow. Shares in medium and

large enterprises have been distributed to managers and workers

through closed subscription, but only 70 percent of the

population had received their voucher accounts by August 1993.

(38)

Results of the first auction for the sale of shares in August

1993 were disappointing.

In light of this experience, Kyrgyzstan is revising its

approach to mass privatization. The emerging approach reflects

the influence of Russia's voucher program. For example, changes

likely to be introduced include the printing and distribution of

paper vouchers that will be tradeable. However, it is likely that

the allocation of vouchers will still reflect an individual's

employment history. Vouchers will be denominated in points, with

the number of points depending on a person's salary and length

of service. The introduction of tradeable paper vouchers will be

a major improvement over the nontradeable special means of

payment accounts, but as explained above the use of vouchers with

unequal bidding power will tend to complicate the way auctions

are conducted.

While it is too early to offer a full assessment of the

Kyrgyzstan program, several elements suggest it is not fully

coherent. First, not much appears to have been done to reduce the

incentive for managers to lobby the government. As in Ukraine,

the low level of privileges on offer to insiders in firms may

increase the amount of lobbying. Second, the structure of the

voucher program has been such as to make it harder to form

intermediary funds and thus develop outsider corporate influence.

However, this aspect of the program may be changing in the

direction of the Russian variant.

In the former Soviet Union, the approaches adopted outside

Russia tend to be more complex, and less market-oriented, than

the Russian voucher privatization. Greater inherent complexities

(39)

and a larger role for the state in detailed decision-making about

individual privatization cases makes it easier for opponents of

these programs to lobby effectively. The lower level of

incentives offered to managers and workers also makes it more

likely they will devote considerable effort to lobbying. So far

it seems the non-Russian privatization programs are not proving

successful and they are beginning to emulate elements of the

Russian model.

6. Voucher Schemes Reassessed

Early theoretical discussions predicted that voucher schemes

would lead to the fragmentation of share ownership due to the

large number of participants. This argument failed to recognize

that the desired concentration of share ownership can develop

spontaneously and investor-initiated fashion based on the free

distribution of shares through vouchers. The reason is that

professional investors have an incentive to acquire an

appreciable stake in newly privatized companies in order to

exercise control over management and ensure that managers act to

increase the return on their investment. In terms of our model,

the outside investors want to ensure that more of the managers'

effort goes to restructuring, which benefits all owners, as

opposed to activities — referred to in our model as theft —

which benefit only insiders.

At the same time, many individuals either have no interest in

becoming shareholders, or would prefer to diversify their

portfolios through mutual funds. Provided such individuals are

allowed to transfer their vouchers to other people, either by

(40)

selling them or investing them in investment funds, individual

and institutional investors will accumulate vouchers and acquire

large shares in privatized companies on their own initiative.

There is now sufficient empirical evidence to suggest that this

process actually works in at least two post-communist countries.

In the Czechoslovak case, the aggressive tactics used by

investment funds to attract voucher points were instrumental in

promoting the concentration of share ownership. Their offer to

repurchase shares from investors has been criticized as

potentially destabilizing, but there is an element of

self-fulfilling prophecy in the strategy. Investment funds that

are most successful in attracting voucher points have the

leverage to acquire sizable stakes in companies offering what

investment fund managers consider to be the most profitable

investment opportunities.

Furthermore, if these funds as large minority shareholders can

reduce the effort devoted to theft or increase the effort which

goes into restructuring, then they can raise the value of

everyone's equity holding. Over the longer term, acquisition of

large shareholdings will enable investment funds to order changes

in management and structural changes that will improve the

profitability of the companies in their portfolio.

In the Russian case, the tradability of vouchers appears

to have been the critical factor in enabling individual and

institutional investors to accumulate sufficient vouchers to

build up large stakes in newly privatized companies. Not only did

strategic investors have access to a large and liquid market for

vouchers, but for a long period of time they could purchase

(41)

vouchers at bargain prices — possibly because many potential

investors were discouraged about the possibility of exerting

control over managers.

A corollary to this argument concerns the social and economic

origins of large investors. As noted earlier, a key assumption

behind the guided model of mass privatization is that

post-communist countries lack the individual or institutional

investors who are considered critical to corporate governance in

the West. The guided model therefore assigns a dominant role to

government-established financial intermediaries in an attempt to

simulate the behavior of these missing investors. One result, if

the Polish experience is anything to go by, is that influence

costs remain high at least in a transitional period and this will

slow down privatization.

To judge from the Russian experience, however, the validity

of the assumption that there are no potential active investors

is questionable. The Russian privatization process has been

distinguished by the rapid emergence of large individual and

institutional investors with aspirations to assert control over

the companies in which they hold stakes. As a rule, these

investors are successful traders and exporters who accumulated

their start-up capital by exploiting new business opportunities

created by the reform process.

The story of Kakha Bendukidzhe, a prominent "corporate raider"

in the Russian privatization process, is a typical example.

Bendukidzhe and his colleagues started their company. Bioprocess,

while they were still working for a state-owned biological

research lab, and they were able to draw on the resources of the