Economics 140/240 Professor Vladimir Treml Spring 1998 PROPERTY RIGHTS AND PRIVATIZATION From World Bank, FROM PLAN TO MARKET: WORLD DEVELOPMENT REPORTS, 1996. Washington DC, Oxford University Press, 1996, pp.48-49 Property rights are at the heart of the incentive structure of market economies. They determine who bears risk and who gains or loses from transactions. In so doing they spur worthwhile investment, encourage careful monitoring and super-vision, promote work effort, and create a constituency for enforceable contracts. In short, fully specified property rights reward effort and good judgment, thereby assisting economic growth and wealth creation. In addition, a wide distribution of property rights can counteract any concentration of power in the political system and contribute to social stability. What are property rights? Property rights include the right to use an asset, to permit or exclude its use by others, to collect the income generated by the asset, and to sell or otherwise dispose of the asset. In market economies these rights are defined in law, usually in great detail Ownership rights to an asset may be split-for example, a widow may have rights to the income from property left by her deceased spouse to her children-but this division is also clearly specified. In transition economies these rights are not at first clearly defined or allocated. Indeed, often such distinctions are not even recognized. In mature market economies the distribution of property rights across the population and the legal forms through which they are exercised are relatively stable, having evolved over centuries. In most transition economies the initial assignment of property rights is both rapid and partial; it could well be inefficient. Many buildings and plots of land, for example, have been restored to precommunist owners who are neither willing nor able to care for them. Similarly, most former state farms in Russia were privatized as large joint-stock corporations-typically not the most efficient ownership form for agriculture. Thus, for property rights to become fully effective, it is especially important that they be tradable and free to evolve. Is privatization necessary? Does it matter whether property is public, private, or something in between? The first obvious test is whether privatization improves performance. An extensive empirical literature (mainly from the 1980s) comparing public and private enterprises in industrial market economies concludes generally, but not uniformly, that private firms exhibit higher productivity and better performance than public enterprises. More recent analyses of performance before and after privatization in industrial and developing countries reach stronger conclusions in favor of private ownership. For example, an analysis of sixty-one privatized companies in eighteen countries (six developing and twelve industrial) showed, in at least two-thirds of the divestitures, postprivatization increases in profitability, sales, operating efficiency, and capital investment-all this, surprisingly, with no evidence of falling employment. In established market economies and middle- to high-income developing economies there is little doubt that private ownership is a significant determinant of eco- nomic performance. Because most privatizations in Central and Eastern Europe (CEE) and the Newly Independent States (NIS) are quite recent, judgments on their impact are just beginning to emerge. The first signs are encouraging in many cases, less so in others. A recent study of Hungarian firms found that new private companies in the sample were quicker than state firms to adjust their labor forces as demand changed. Privatized firms at first resembled state firms, but, encouragingly, after a year or two their behavior looked more like that of new private firms. Enterprise surveys in Poland in 1993 and Russia in 1994 concur that new private firms behave differently from, and better than, state firms, exhibiting more dynamism and generating higher profits. In the Polish survey (and a similar one in Slovenia) privatized firms also outperformed state companies, although this may in part reflect the fact that the better state firms were the first to be privatized. Other research supports the positive effects of privatization but suggests that these vary by type of private owner. In Russia and Ukraine owners who had bought their small business units at competitive auctions invested more and realized better performance than insiders who had obtained their shops at near-giveaway prices (although even the insider-owned firms did better than state-owned shops). The likely impact of the mode of privatization and of the identity of the new owner is discussed further below. Poland has been slower to privatize than many other transition economies. Some argue that its 6 percent average annual growth since 1994 shows that privatization is unnecessary. But this assessment is incomplete; what Poland's experience illustrates is rather the importance of determined macroeconomic reforms imposing financial discipline on companies, the emergence of large numbers of new private firms, and managerial expectations of eventual privatization in state firms themselves. Most of Poland's growth has been fueled by expansion of the new private sector, not by well-performing state firms. Also, the turnaround in some Polish state firms in the early 1990s was stimulated in part by managers' belief that privatization was just around the corner. From Martin C. Schnitzer, COMPARATIVE ECONOMIC SYSTEMS, 7th ed., South-Western Publishing Co., 1997, pp. 221-226 Privatization By far the most important problem in converting a socialist centrally planned economy to a market economy is privatization of state-owned enterprises. Privatization can be defined as the general process of involving the private sector in the ownership or operation of a state-owned enterprise. It can refer to the purchase of all or part of a state-owned company; it also covers the privatization of management. State-owned enterprises occupied all areas of economic activity in the socialist economies, and for the most part they never achieved the efficiency, productivity, and related performance levels expected of them. Despite efforts to reform them, their performance level deteriorated during the 1980s. Despite massive government investment in science and technology, state enterprises operated far below existing Western technological standards. To some extent, this resulted from undefined property rights that inhibited those enterprises from acting in an entrepreneurial fashion. Sequencing of Privatization. Privatization does not take place in a vacuum. Before property can be privatized, certain preconditions must exist. First, there must be macroeconomic adjustments. There must he a price system that gives correct signals not only about the real value of the assets and companies to be privatized, but also about their chances of survival in an open market exposed to international competition. Second, there must be a proper legal framework that establishes ownership rights, titling procedures, and arrangements for the transfer of property. In addition, labor and social security laws are needed to establish employer and worker rights and labor contracts. Third, there is the matter of asset valuation. In principle, the value of a state-owned enterprise is the price it fetches in the marketplace. One way to value enterprise assets is to use foreign auditors. Fourth, restructuring is necessary. This refers to the breakup of former state monopolies into more salable forms. Also, removal of any large or open-ended liability for an enterprise may be necessary before it can be sold. Method of Privatization. There are a number of ways in which state enterprises can be privatized. One way is to distribute to every person a share of equity in the enterprises being privatized. This is called the voucher method, referring to the vouchers, or certificates, that each person receives, giving him or her an entitlement in equity shares. A second method has been through the use of public auctions. This is typically used in the sale of small enterprises, such as restaurants and dry cleaning establishments. The problem has been that those who have the money to buy them were usually part of the nomenklatura elite of the old communist system. A third way is to give away state-owned enterprises to workers and managers. This is the easiest and quickest way to privatize, but there is a problem managers in that workers and managers were often the cause of inefficiency in those state enterprises. A fourth way is to sell state enterprises to workers and managers. A fifth way is to sell state enterprises to foreign companies. Privatization of Industry . In the former Soviet Union each sector of industry was managed by its own ministry in Moscow, whose bureaucrats picked the managers to run the state-owned enterprises. People were picked who could be relied on to meet the objectives of the economic plan that each ministry was responsible for implementing. Emphasis was placed on physical output planning, and success for a manager was based on fulfilling or overfulfilling the output target specified by the plan. The reforms of the 1980s were designed in part to give managers more latitude in the choice of inputs used in the production process and in the choice of products to be produced and sold within the framework of the economic plan. The first part of privatization proved to be easy. Small enterprises, such as shops and cafes, were usually bought by their workers. However, it was decided to use a voucher system for larger firms. By the autumn of 1992, every Russian citizen was given a free voucher having a face value of 10,000 rubles, worth about $25 at that time. The voucher holder had three options: to sell it for cash; to put it into an investment fund that would pool vouchers and invest them in large blocks; or invest it directly at auction in an enterprise. The first auction was held in December 1992. By June 1994, when all vouchers were set to expire, shares in 2,621 medium-sized and large enterprises had been auctioned off. By the end of that month, 86 percent of the Russian industrial labor force was working in the private sector. July 1994 Privatization Edict. In July 1994 President Yeltsin issued an edict that changed the process of privatization. First, shares in privatizing companies that had previously been sold for vouchers now could be sold for cash. Second, workers in an enterprise about to be privatized retained their priority rights to acquire shares in the privatized enterprise. Three options were carried over from the voucher privatization process. They are as follows: 1. Workers can buy up to 51 percent of the common stock at par value. 2. If the enterprise is insolvent, workers can acquire control by initially buying 30 percent of the common stock at a discount with an option to obtain the shares that remain in state ownership. 3. Members of a labor collective can receive preferred nonvoting stock equal to 25 percent of the authorized capital free of charge and can buy up to 10 percent of the voting stock at a discount. Management can buy up to 5 percent. Foreign investors were given several options for acquiring stock in privatized companies. After shares have been distributed to workers and management on the basis of one of the above three options, the remainder can be sold through an authorized state or municipal property fund, through commercial competition, or at auction. These auctions deal in cash rather than investment vouchers. On March 7, 1996, Boris Yeltsin signed a decree stating that owners of farmland, including those who own it indirectly through shares in collective farms, can buy, sell, or mortgage their land, provided it stays in agricultural use and in Russian hands. The decree also allows a free market in the small landholdings of some 40 million people, formerly passed on only through inheritance. As of March 1996 more than nine-tenths of Russian agriculture is controlled by large, inefficient, undercapitalized collective farms, which are run pretty much as they were in the old Soviet Union. Most often, they are run by managers who are indifferent to free market forces. RESULTS OF RUSSIAN PRIVATIZATION OF MIDDLE-SIZE AND LARGE ENTERPRISES From: Joseph Blasi et al., KREMLIN CAPITALISM: PRIVATIZING THE RUSSIAN ECONOMY, Cornell University Press, 1997 p. 193 Ownership of Privatized Enterprises, Russia, 1996 Percent Insiders 58 Managers 18 Workers 40 Outsiders, Russian Citizens 6 Firms and organizations 26 Foreigners 2