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Privatization is the process whereby the ownership of the state’s productive assets, often utilities or large industrial enterprises, is transferred into private hands. This has been a major activity for governments in both the developed and the developing worlds since Prime Minister Thatcher’s first modern privatization programme in the UK between 1979 and 1984. The cumulative revenues raised from the process globally probably exceeds $1.25 trillion dollars, while the role of state-owned enterprises in the economies of high income countries has declined from around 8.5% GDP on average in 1984 to around 6% in 1991 and probably below 5% in 2005 (see Megginson 2005). The reduction in state ownership has probably been even more dramatic in less developed countries, from around 16% GDP in 1981 to around 5% in 2004. Privatization is intended to improve corporate efficiency and generate revenues for the state, and there is now probably sufficient experience in different economic and institutional environments to evaluate its impact relative to expectations.

Privatization has been a particularly important phenomenon in the transition process in central and eastern Europe from planning to a market system. This is because Communist regimes had placed almost all the productive assets of the economy in state hands for ideological reasons, and to facilitate the planning process. As a result, countries like Czechoslovakia and the Soviet Union contained virtually no private sector at all – typically in excess of 90% of assets were state owned and even in countries with slightly larger private sectors, like Poland or Hungary, private ownership was concentrated in agricultural and handicraft activities; industrial firms were all in state hands. This meant that privatization was a central aspect of building a market economy in all the transition economies. Indeed, to quote Dusan Triska in 1992, ‘privatization is not just one of the many items on the economic program. It is the transformation itself’ (see Estrin 2002).

This article addresses the privatization process in central and eastern Europe, focusing on the objectives, the methods and, most importantly, the impact of the ownership changes. Privatization always had some ideological content in the transition economies, especially in the early years, when the reformers wished to create a ‘capitalist class’ supporting the radical changes that were required to build a market economy. But the fundamental objective of privatization in transition economies, as in developed and developing ones, has been to enhance company performance. We enquire whether privatization has succeeded in this objective in the remainder of this article.

Why Privatize?

We begin by identifying why reformers in the transition economies placed such emphasis on privatization. Transforming state-owned assets into private hands can improve corporate efficiency (see Vickers and Yarrow 1985), and, particularly with the privatization of infrastructure, the benefits can spill over to the rest of the economy. To understand why, one must compare company objectives and corporate governance under state and private ownership. It is normally argued that the fundamental difference between state-owned and private firms rests in their objectives: the latter focus exclusively on profit, which generates close attention to costs and to the demands of customers. State-owned firms may be interested in profits too, but they will almost certainly be expected by their owners to satisfy other objectives as well, for example, politically determined targets such as creating or maintaining employment in economically depressed regions or holding prices below average costs for redistributive reasons. In this situation, profits become a secondary criterion, or indeed an irrelevance, and business decisions become politicized. Inefficiencies can thrive because they are not a central concern of the owner, and managers can exploit the lack of clarity in company objectives to ensure an easy life for themselves and employees (see Shleifer and Vishny 1994).

Therefore, an important motive for privatization is to focus attention on profits as the sole objective for the enterprise sector. But the problems of state ownership go beyond just diffuse and non-commercial objectives. In a socialist economy, the system of administered prices also means that privatization and market liberalization are needed to reveal opportunity costs. Moreover, even in a market economy, when a public-sector firm operates in a competitive market and the government tries to enforce an objective of profit maximization on its management, weaknesses in corporate governance can still cause inferior performance to what might be achieved under private ownership. The problem is centred on the asymmetry of information held by managers and owners; outside owners – private or state – can never have full access to the information about corporate performance that is in the hands of managers. Thus, it is hard for them to establish whether poor results are a consequence of unforeseen circumstances or managers exploiting firm profits for their own purposes. Whenever ownership and control are separated, firm-specific rents can be used to satisfy management’s aim – for example, lower effort or managerial power, via the size of the firm – rather than profits. However, a private ownership system places more effective limits than does state ownership on their discretionary behaviour, via external constraints from product and capital markets which largely operate through the market for corporate control, and through the internal constraints imposed via statutes and monitoring by the owners themselves (see Estrin and Perotin 1991).

In Anglo-Saxon countries, the constraints on managerial discretion in large part derive from stock markets (see Megginson 2005). The quality of managerial decision-making and the extent of managerial discretion are an input in the choices of traders in equity markets, whose judgement on company performance is summarized in the share price. If the managerial team is thought to be incompetent or inefficient, the share prices will be reduced, putting pressure on managers to improve their performance. A persistently poor showing by a quoted company may also generate external pressure by encouraging a takeover bid. In this case, the stock market can be viewed as a market for corporate control, with alternative teams vying for the right to manage the enterprise. However, the effectiveness of these disciplines relies to some extent on the concentration of ownership. If ownership is highly dispersed, each individual owner has only a slight incentive to monitor effectively, and as there is a free rider problem monitoring may be inadequate.

Governance also comes from the way that the managerial market operates, with managerial performance, pay and job prospects assessed by movements in share prices. Payment mechanisms such as management stock option schemes can also be put in place to align the incentives of owners and managers. In countries such as Japan or Germany, however, the mechanisms can be different, with less reliance on an adversarial market for corporate control and more extensive use of internal governance constraints. Ownership is typically highly concentrated in the hands of banks, funds or families who are granted board representation and undertake close monitoring of managerial performance directly, and use the managerial market and management incentive schemes.

Either way, it is hard for the state to imitate these market-based constraints. State-owned firms are not subject to private capital market disciplines, so neither the competitively driven informational structure nor the market-based governance mechanisms can be substituted for in full. State employees are usually civil servants and do not compete in the wider managerial market, though Western governments have recently tried to reduce the labour market segmentation between the public and private sectors. Moreover, though the government’s ownership stake is concentrated, the state is rarely directly represented on the boards of public sector companies and usually does not have the capacity in the supervisory ministries to undertake the necessary scale and quality of monitoring (see Vickers and Yarrow 1985).

These arguments have particular resonance in the transition economies of central and eastern Europe. The economic problems of the socialist system were largely a result of the impact of state ownership and planning on investment allocation, incentives and efficiency (see Gregory and Stuart 2004). Firms did not attempt to maximize profits, and productive efficiency was a low priority. Instead, weak monitoring of managers by the state as owner and the absence of external constraints gave management almost total discretion to follow their own objectives – rent absorption, asset stripping, employment, social targets. The softness of budget constraints (Kornai 1990) that goes with the political determination of resource allocation was a further source of incentive problems, since managers did not have to bear the consequences of their own actions. Mistakes were condoned and losses were subsidized.

Methods of Privatization in Transition Economies

It is therefore clear why privatization was so important in the transition process. Nonetheless, reforming governments might in principle have left privatization until the track records of particular firms in the market environment had become firmly established and until the stock of domestic savings in private hands was sufficient to ensure the success of a competitive bidding process for the assets. But the state was probably not able to manage its assets effectively in the intervening period, and managers and workers began very rapidly to steal the assets (Canning and Hare 1994). The collapse of communism had left state-owned firms with limited internal structure to handle the new requirements of the market-place and no mechanisms to monitor or enforce governance on state-owned firms (see Blanchard et al. 1991). The authorities had either quickly to create structures whereby the state as owner could control enterprise decisions or face a gradual dissipation of the net worth of the enterprise sector by consumption, waste or theft. These stark alternatives persuaded many reforming governments and their Western advisors to consider rapid privatization. (Boycko et al. 1995 – the first of these an insider to Russia policymaking at the time – make a similar point concerning Russia. They argue that Russia had to undertake a massive and speedy ownership change in order to break the tradition of rent-seeking behaviour and the long-standing links between the state and the enterprise sector. They argue that, in order to gain political support for the privatization process, substantial stakes had to be given to insiders – the managers and workers in firms – so that they did not block the process.)

The sheer scale of privatization required in the transition economies posed considerable practical problems. As we have seen, the Communist heritage meant that the majority of firms in the economy needed to be privatized. At the aggregate level, the stock of domestic private savings in these countries was too small to purchase the assets being offered. This led the reformers to innovate with privatization methods.

For selected firms, many transition economies used auction or public tender, as have been the norm in the West. Such sales could in principle be to domestic or foreign purchasers but, in practice, only Hungary and Estonia were willing or able to sell an appreciable share of former state-owned assets to foreigners. Foreign capital ended up purchasing about 20% of the privatized assets in Hungary and up to 50% in Estonia, but even in these countries the preponderance of foreign ownership gave rise to public disquiet. Moreover, foreign direct investment flows to the transition economies were modest in the early years, when privatization was taking place, and were highly concentrated towards the Czech Republic, Hungary and Poland (United Nations 2004; Meyer 1998). In practice, sales of state-owned enterprises have mainly been to a country’s own citizens: either to external capital owners or to insider management–employee buyouts. Managers and employees were the more common initial buyers, perhaps because they had insider knowledge about their company’s business prospects. Some governments, such as in Romania, actively encouraged the emergence of insider-owned firms.

Some countries also experimented with restitution to former owners; the former East Germany, Hungary, the former Czechoslovakia and Bulgaria are prominent examples. Restitution has the advantage that it immediately creates a property-owning middle class and re-establishes ‘real ownership’. However, the process of restitution entails legal complexities. For example, suppose that a factory has been built on a plot of land formerly owned by a noble. Does the noble receive the land back, and therefore rental for the factory? Or should the noble be compensated for the value of the property at the time of its seizure and, if so, how is such an evaluation to be made some 80 years later? Restitution also raises the deep question of how the assets accumulated during the Communist era, when consumption levels were held down for national capital accumulation, should be distributed. Since the burden of lower consumption was imposed on everyone, the argument that the distribution of the resulting assets should be egalitarian has been a powerful one.

To increase the pace of privatization, a number of transition countries began to experiment with ‘mass privatization’. This entails placing into private hands nominal assets of a value sufficient to purchase the state firms to be privatized. To avoid the inflationary consequences of such wide-scale ‘money’ creation, the new assets must be non-transferable and not valid for any transaction other than the purchase of state assets. This was largely achieved using the instrument of privatization vouchers or certificates. It was hoped that any deficiencies in the resulting corporate governance mechanism arising from the fact that the ownership structure was initially diffuse would be addressed by capital market pressures leading to increased ownership concentration (Boycko et al. 1995).

Mass privatization has been carried out in a number of different ways, but the differences can be summarized around two issues. The first was whether the vouchers or certificates were distributed on an egalitarian basis to the population as a whole or whether, as in Russia and many other countries of the former Soviet Union, management and employee groups received many of the shares, perhaps to diffuse potential opposition to privatization. Second, policymakers needed to determine whether vouchers were intended to be exchanged directly for shares in companies, or whether the vouchers should be in funds that own a number of different companies. In the Czech and Slovak republics and in Russia, vouchers were exchanged directly for shares, although financial intermediaries soon developed in the market. In the Polish scheme, vouchers were exchanged for shares in government-created funds that jointly owned former state-owned enterprises.

Every country used a variety of privatization methods and everywhere different sorts of firms were sold in different ways. For example, in most transition economies small firms were usually sold to the highest bidder, and utilities were often floated on stock markets. However, it was possible by the time the bulk of privatization was completed in the late 1990s to discern the predominant method used in each country, and we report the most widely used summary in Table 1 from the EBRD’s Transition Report, 1998. Mass privatization was the most common privatization method across the transition economies; 19 of the 25 countries listed used some form of mass privatization as either a primary or secondary method. Moreover, management–employee buyouts (MEBOs) also proved important, perhaps because transition governments sometimes did not have the authority to take on entrenched insiders in firms. Thus, nine countries used MEBOs as their primary method, and six as their secondary method. Most transition economies therefore eschewed the conventional method of privatization, by direct sale. In fact, only five countries used this as their primary privatization method, though these were among the most developed transitional economies.

Privatization Impacts in Transition Economies, Table 1 Methods of privatization
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The Scale of Privatization

There was an extremely speedy ownership change in most transition economies. Few countries had contained a private sector of any significance in 1990. Exceptions were Hungary and Poland, where there had been long-standing private firms in agriculture and crafts, and the private sector already represented over 30% of GDP (see Estrin 1994). But in the transition economies as a whole the private sector contribution to GDP was usually less than 20%. The growth in the private sector share during the 1990s, reported in Table 2, is extraordinary. As early as 1995, the private sector share was above 50% in nine countries, though in eight former republics of the Soviet Union it remained below 30%. By 2002, the private sector in 13 additional nations had reached at least 50% of GDP and in only two laggards, Belarus and Turkmenistan, was private sector activity still below 25% of GDP. Thus the privatization process in the transition economies was in many countries effective in transferring the bulk of economic activity from state to private hands in the space of hardly more than a decade.

Privatization Impacts in Transition Economies, Table 2 Private sector percentage shares in GDP and employment, 1991–2002
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This remarkable performance should not conceal real concerns raised at the time about the quality of privatization, and therefore about its consequences for enterprise restructuring. First, there are questions about how real the privatization has been. In many transition economies, the state continued to own golden shares or significant shareholdings in companies. For example, the Russian state retained more than a 20% share in 37% of privatized firms, and kept more than a 40% share in 14% of the firms that it privatized. Only in half of privatized firms did the Russian government sell its entire holding. Thus, the clean break between the state as owner and the enterprise sector has perhaps been more notional than real. In a survey of privatized firms undertaken by the EBRD in 1999, reported in Table 3, we show that in 20 of the 23 countries the state has retained some shares post-privatization. On average, the state retained some shares in around 20% of privatized firms, with more than a 20% shareholding in around 12% of the firms. It is suggestive that retained state shareholdings are negligible in some of the leading transition economies – for example, the Czech Republic, Hungary and Latvia – but the state has tended to keep a larger share in less advanced transition economies: more than 15% of privatized firms in Albania, Belarus, Georgia, Lithuania, Poland, Romania, Russia and Ukraine, and more than 30% of privatized firms in Bulgaria, Croatia, Slovenia and Uzbekistan. State ownership has also been retained in many developed OECD economies, including via the use of ‘golden shares’. According to Bortolotti and Faccio (2006), governments were actually the largest stakeholder or held special control powers (golden shares) in 62.4% of privatized OECD companies.

Privatization Impacts in Transition Economies, Table 3 Percentage of privatized firms with retained state shareholdings
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But widespread retained state ownership is not the only indication that privatization may not have ensured the establishment of effective corporate governance mechanisms in transition economies. The long ‘agency chains’ implicit in mass privatization may not provide appropriate incentives for corporate governance. Voucher privatization led to ownership structures that were highly dispersed (Coffee 1996). Typically the entire adult population of the country, or all insiders to each firm, were allocated vouchers with which to purchase the shares of the company. The desire for equitable and politically acceptable outcomes dominated the need to create concentrated external owners who would have a large enough stake to be motivated to maintain oversight of management. However, it was possible that financial intermediaries could aggregate individual voucher holdings and carry out effective monitoring of management, and in Czech Republic, Poland, Slovenia and Slovakia some effort was made to ensure such concentrated intermediate agents did emerge. This was often associated with fraud and the outright theft of assets by managers to avoid their use by the new owners – so-called ‘tunnelling’ (Johnson et al. 2000).

The way that mass privatization was carried out in many countries also sometimes led to majority ownership that was not best suited to accelerate restructuring, for example by insiders. This was probably largely for political reasons, especially in countries where the pro-reform forces were politically weak. According to Earle et al. (1996), insiders held a majority shareholding in 75% of firms in Russia immediately post-privatization (1994) and outsiders only 9%. Insider ownership was predominantly in the hands of workers. However, this created little problem for management because worker ownership was so highly dispersed. Indeed Blasi et al. (1997) argue that control was effectively in the hands of management in Russian employee-owned firms. Outsider ownership is also typically highly dispersed, with much of it in the hands of banks, suppliers, other firms and an assortment of investment funds. In Russia, it appears from a variety of studies (see Estrin and Wright 1999, for a survey) that outside shareholding has increased at the expense of the state and insiders during the 1990s, but ownership is also becoming increasingly dispersed and the greater degree of outside ownership may largely represent the fact that former insider voucher owners have left the firm but retained their shares.

This pattern of extensive employee ownership seems broadly consistent with the evidence for other CIS countries. In Ukraine, insiders owned 51% of shares in all privatized firms in 1997 – managers 8% and workers 43% – while outsiders held 38% and the state residue share was 11%. In Ukraine, insiders have actually increased their shareholdings, while managers have been buying shares from workers. Thus, rather than evolving towards the structure of firms owned by a concentrated group of outsiders, as was hoped by reformers, enterprises in the CIS appear to have remained primarily owned by dispersed groups of employees or outsiders. However, the situation appears to have been somewhat different in central Europe, where many of the most important firms in the economies are now quoted on the relevant national stock exchanges or owned by large foreign firms – for example, Skoda and Volkswagen. As we have seen, foreign ownership was predominant in Hungary, ownership by new entrepreneurs was common in Poland, while investment-fund ownership predominated in the Czech Republic.

The Impact of Privatization

In this section, we analyse the impact of privatization on economic and company performance in the transition economies. This can be considered from the macro-economic and the microeconomic sides, and we provide some information on both. We start by considering the effects on government resources, and exploring the relationship between private sector shares, privatization methods and revenues and economic growth. We then summarize the findings of the very large literature about the effects of privatization on company performance.

In Table 4, we present the cumulative revenues from privatization in each of the transition economies, from 1995 to 2002. The sums were relatively modest in most countries in 1995; cumulative revenues were less than 2% of GDP in 15 countries of the 23 covered, and exceeded 20% in only one country, namely, Hungary. The situation had changed appreciably by 2002. Cumulative revenues from privatization exceeded 5% of GDP in 14 countries, exceeded 10% of GDP in eight and were greater than 30% in Hungary and Slovakia. Thus, even in countries which used mass privatization the selling of state assets proved to be a significant source of government revenue through the financially demanding period of early transition, and may therefore have contributed to macro-stability and growth. However, there is no empirical evidence linking growth to the private sector share. Bennett et al. (2007) explore the impact of privatization on growth, but, while they identify a positive effect from the use of the mass privatization method, they do not find any significant relationship between growth and the private sector share. There is a limited amount of academic work for other economies, which explores the impact of privatization on growth rates. In an early study, Plane (1997) looks at the effects of divestiture on growth in a sample of 35 developing countries. He also controls for the problem of reverse causality by identifying separately the factors that determine a successful privatization programme. He finds that the impact of privatization on economic growth is indeed positive, and is strengthened when privatization occurs in infrastructure or in industrial sectors. Zinnes et al. (2001) use a fairly short sample period to undertake an aggregate growth study for the transition economies. They conclude that, while privatization does not actually increase growth, there is a positive impact when the privatization process is accompanied by institutional reforms.

Privatization Impacts in Transition Economies, Table 4 Privatization revenues (cumulative, in percentage of GDP), 1995–2002
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To turn to the microeconomic evidence, there have been a large number of studies of how privatization affects the performance of firms in transition economies. The most complete of these is by Djankov and Murrell (2002), which surveys the findings of more than 100 empirical studies of transition economies and uses a meta-analysis of the results to draw conclusions. Despite the plethora of material, the overall findings remain ambiguous. This is partly because the studies employ a variety of data-sets, measurements and methods which produce contradictory results. For example, there are many ways of measuring company performance, including profitability, productivity, sales growth, export growth, and restructuring; and their findings differ. To begin with productivity, there is a wide variance in results across countries and samples, with private ownership found to yield positive, zero or negative effects. There is, however, convincing evidence that sale to foreign owners yields a positive effect, and that privatization is more likely to improve performance in central Europe than in the former Soviet Union. More recent literature strongly confirms the results with respect to foreign direct investment (for example, Sabirianova et al. 2005). However, it is harder to discern positive effects from privatization when profitability is the performance measure, though once again some studies find a positive impact when the firm is sold to a foreign owner, and very few studies isolate a positive significant effect of privatization on revenues. There are fewer studies of the impact of privatization on exports, and these tend to be positive, especially when foreigners take over the former state-owned firm, and restructuring activity seems to have been significant in privatized firms in central Europe, but not in Russia, Ukraine and other countries of the former Soviet Union.

The variation in results is not merely a consequence of the wide variety of measures and countries with which the effects of privatization have been tested. Some serious methodological problems bedevil work of this sort, most importantly that of selection. This is the situation when firms with particular characteristics – for example, superior performance – were systematically chosen for privatization. In such a case, while one observes what appears to be superior performance among firms that have been privatized, the correct interpretation is not that privatization enhances performance but that it was the better firms that were chosen for privatization. The converse applies if the state chooses to keep the best firms for itself and to sell only the less productive ones; in this case, privatization will appear to lead to worse performance. Unfortunately, very few studies of privatization in the transition economies have been able to do much to address this problem of reverse causality. The data-sets upon which the empirical work has been based have been small and usually derived from sample survey questionnaires that did not contain sufficient information to control for the selection problem.

Even so, Djankov and Murrell (2002) conclude on the basis of the weight of the evidence that the impact of privatization on company performance has probably been positive and significant, though not in every circumstance. Two factors are usually cited as being particularly influential in determining whether privatization acts to enhance company performance. The first is the nature and characteristics of the new private owners. We noted that foreign owners lead to an improvement on most measures of performance. There is also some evidence, though it is less convincing, that sale to domestic private owners also improves performance, though it can be important for the ownership shares to be concentrated. However, there is almost no evidence that company performance is improved when firms are sold to insiders, either managers or workers. This is probably because insiders have exploited their control to resist the changes in behaviour required to make firms competitive in the market environment, rather than to promote them. We observed above that insider ownership was a fairly common phenomenon, especially in the former Soviet Union, and this probably goes some way to explain why economic performance in many of those countries was weaker than in, for example, much of central Europe, such as Hungary, Poland and the Czech Republic, where foreign direct investment flows were much greater.

The second factor is the institutional and business environment in which privatization takes place. We noted above that privatization relies on improved corporate governance, but that in turn depends on a competitive market environment and the enforcement of property rights. In countries where the legal system is not functioning effectively, and businesses face high level of corruption and weak standards of financial discipline, it is hard to imagine how private ownership on its own might be expected to improve company performance. For example, sharper performance is meant to come from tighter financial disciplines to eradicate waste and reduce cost, but these will not bind in situations when budget constraints remain soft, as occurred post-privatization in many countries of the former Soviet Union, with firms financing their deficits not through direct government subsidies but by not paying their bills, especially to their workers, to the government in taxes, and to the state-owned utility companies.

These two limiting factors affect some privatizations in all transition economies, but on average have been more likely to pertain in the economies of the former Soviet Union than those of central and eastern Europe. Thus while the macroeconomic work suggests a clear positive impact from privatization on economic growth, the results from the microeconomic literature are more modulated. The positive effects from privatization are found not to be automatic. They depend on to whom the firm was sold – foreigners, outsiders or insiders – and on the broader business environment in which the firm operates. The latter in particular tends to be better in central Europe and especially in the new accession economies to the European Union. Privatization methods may also have played an important role (see Bennett et al. 2007).

Conclusion

The most impressive feature of privatization in the transition economies has been the speed and scale at which it occurred. The reforming governments of the late 1980s and early 1990s managed successfully to transfer the huge state-owned sector into largely private hands in a time period of hardly more than a decade, and to do so they had to use innovative privatization methods. However, this led them to introduce private ownership into situations where other crucial aspects of the business environment were not yet sufficiently developed to support the private economy. We find that privatization appears to have provided governments with much-needed revenues. However, at the enterprise level the results on performance are more patchy, though on balance the effects of privatization have probably been positive, especially when the new owners were foreigners. The most serious problem for privatization as a policy has been its use in a weak legal and institutional environment. In such cases, it rarely appears to have improved company performance.

See Also