Russian Privatization Results Ers

/3605S Public Disclosure Authorized Russ uP OCC 14H

Public Disclosure Authorized C,reating Phvate Enterpnses and Public Disclosure Authorized Eficient Markets

Editeclbv Public Disclosure Authorized Ina WV.Lieherrnan land Joln Nellis with Enna Karlova, Joyita Mukheijee, and Suhail Rahuja

Russia:Creating PrivateEnterprses and EfficientMarkets

.,~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

The findings,interpretations, and conclusionsexpressed in this document are entirelythose of the authors and shouldnot be attributed in any manner to the WorldBank, to its affiliatedorganizations, or to the members of the Executive Directors or the countries they represent.

To order copies of this book, please contact: Rose Malcolm RoomG4127 The Private Sector DevelopmentDepartment The WorldBank 1818H Street NW WashingtonDC 20433 USA Telephone:202-473-7495 Fax: 202-522-3742

Contents

1 Introduction 1 John Nellis

Part 1 Privatization 5 2 An Overview of Privatization in Russia 7 Ira W, Liebermanand SzehailRahbija 3 Privatization in the Regions: Primorsky Krai 35 AlexandraV¢croux 4 Investment Funds and Privatization 45 Mark St. Gilesand Sallv Buxton 5 Voucher Investment Funds 5-5 Andrei lolgmig and YbtnrMilner 6 Techniques of Mass Privatization: Implementing the Voucher Auction Program October 1992 to June 1994 63 Jei/;ev L. Schwartz and Zoanne L. Nelson 7 Next Steps in Privatization: Six Major Challenges 75 Andrel Shleijer and Maxim Boycko

Part 2 Capital Market Development 87 8 Capital Markets Development and Financing Russia's Transformation 89 Claidia Mlorgenstern 9 Securities Market Development and Privatization 111 RogerLeeds and .AichaelHarman

Part 3 Corporate Governance and Restructuring 123 10 Ownership, Governance, and Restructuring 125 Joseph Blasiwith assistance!%oni Darya Rinina and Katertna Grachova 11 Corporate Governance during the Transition to Private Ownership 141 Lerov P Jonesanozd Natalia TLkanova 12 Restructuring Large Enterprises in Preparation for Privatization: A Case Study I59 H akan J. Wilson 13 Newly-Privatized Enterprises: A Survey 171 Leila W'l}bsterwith JuerNentFranz, kor Artemiev,and Harold Wackman

Co\ 11.NTS

Part 4 The Emerging Private Sector: Constraints and Regulations 185 14 Constraints to Private Enterprise in the FSU:Approach and Application to Russia 187 MarieSheppard 15 Private Sector Manufacturing in St. Petersburg 203 LeilaW'ebster and Joshta Charap 16 CompetitionLaw and Policy 221 R. ShyamKhemani

Synopsisof Conference Proceedings 229 GraceLao and John Nellzs Glossary 245 EnnaKarlova Contributors 251

RUSSIA:CREATING PRIVATE ENTERPRISES AND EFFICIENT MARKETS

Acknowledgments

The editorswish to acknowledgethe sup- Directorof the WorldBank's Private Sector port and assistanceof the manyofficials- Development Department, encouraged and in particularthe tirelessand dedicated and supportedthe idea of the conference support staff-of both the RussianState and the productionof the book. Editorial Committeefor the Managementof State assistancewas providedby Peter Fidler, Property (GKI) and the World Bank's BruceRoss-Larson, and Vmce McCullough, ResidentMission in Moscow,who greatly and desktop publishingwas handled by assistedthe authors in their work. Roger Heather Imboden. Gloria Orraca-Tetteh Gale, the IFC ResidentRepresentative in prepared the manuscripts,Susan Marcus Moscow,was consistently helpful in provid- designedthe cover,and Suzanne Smith pro- ing informationand interpretingevents for vided adviceon production. the editors and authors.Magdi Iskander,

Ac KLNOXWlE DGMNtENTS

CHA PTER 1

Introduction John Nellis

Stunning accomplishments About 40 million Russian citizens had becomeowners of sharesin privatized Privatization is the one bright spot in the firms. ... by the end of generally bleak Russian economic land- These achievements border on the June 1994, between scape. Starting from less than zero' in miraculous, having taken place in the ab- 12,000 and 14,000 November 1991, a small,determined, and sence of consensus on the desirability, often beleaguered group of Russian scope, and pace of liberalizing reform in medium-size and reformers-with some important external general, and privatization in particular, and large enterprises support'-has been able to: in the absence of what would normally be had been trans- * Devise and implement, in the face of considered the requisite adrinistrative and strong resistance, a "corporatization" financial resources to implement, monitor, ferred to private program that turned about half of and enforce a privatization program of this ownership... Russian state-owned enterprises into magnitude. Yet it was done. The onlv joint stock companies; potentially comparable privatization expe- * Persuade the most important 'insider" riences are those of the former East stakeholders who might have opposed Germany and the former Czechoslovakia. privatization-workers and managers-to take part in the process by Comparisons to Germany and the for- offering them shares in the firms in mer Czechoslovakia which thev work for free or at a low price; In Germany the Treuhandanstaltsucceeded * Conceive and implement a voucher in putting more than 10,000 enterprises in program, giving 144 million participat- private hands between 1991 and 1994. This ing Russians a chance to become, along achievement cannot and should not be with insiders, owners of enterprises; minimized. Nonetheless, German privati- * Create a national voucher auction sys- zation was a case of integration of a for- tem in more than 85 regions, with 750 merly socialist economy into a functioning, bid reception centers; and indeed flourishing, market economy, an ex- * Facilitate the creation of some 650 pri- ercise that differs sharply from the total vate investment funds that compete for transition that Russia confronted. In vouchers and convert them to diversi- Germany, an irreplicable combination of fied shareholdings in newly privatized West German legal and administrative in- enterprises. stitutions, West German managers, and The result is that bv the end of June West German money eased many of the 1994, problems of the integration. * Between 12,000 and 14,000 medium- The mass privatization program of the size and large enterprises had been former Czechoslovakia, which transferred transferred to private ownership; 1,491 firms into private ownership in 1992 * These firms employed more than 14 and 1993, with a "second wave" coming in million people, or about half of those both successor states that will touch an ad- employed in Russia's industrial sec- ditional 1,300 firms, is the best and per- tor; and haps only comparator to the Russian

privatization program. The Czech and different initial conditions, the period of Slovak privatization programs are remark- "extraordinary politics"4 was both shorter able achievements. Indeed, a few Czechs lived and less intense than in other have suggested that their privatization economies in transition. This point must method is superior to Russia's since no spe- be grasped, both to comprehend how tru- cial inducements have been given to insid- ly impressive Russian privatization results ers. Outsiders, in the form of external have been, and to understand why the investors and investment funds, have Russian process has unfolded as it has, played a major ownership and governance with the defining characteristic being the role from the outset, and some Czech prac- provision of financial rewards or equity titioners and external observers now criti- stakes to all the various actors and agen- cize Russia for not having followed the cies involved-meaning that the approach Transfer of same course. was thoroughly decentralized.5 Had the ownership to Without disputing the impressive Russian reformers attempted to follow the Czechoslovakian achievements, it has to be Czechoslovak route of centralized admin- insiders was a stressed that Russia embarked on privatiza- istration of the process, and had they tried striking step.... tion in circumstances very different from to treat enterprise insiders as one poten- External investors those of the former Czechoslovakia. First, tial purchaser like any other, it is likely that complete pre-communist Russia in 1917 was marked- little privatization would have occurred. will complete the ly different from pre-communist Czech- restructuring of oslovakia in 1948; it was less industrialized What happens next firms begun by the and less capitalist. Second, the length of the communist period in Russia was almost The Russian privatization team thus opted transfer of double that in Czechoslovakia, meaning for the method that they judged would ownership. that in Russia collectivist approaches and yield results-and they got them. But as a habits had more time to take root and be- consequence, the results were tentative come deeplv ingrained. Third, and para- and partial. Transfer of ownership to in- doxically, Czechoslovakia benefitted from siders was a striking step, but only a first an absence of reform communism. Unlike step. It must now be followed by equally Hungary, Poland, and to some extent essential second steps opening ownership Russia, Czechoslovakia basicallv main- of privatized firms to external investors tained the central planning system until the and owners. These, in turn, will bring verv end. The successor governments thus needed capital, market access, managerial have not had to debate the scope and pace know-how, and a bottom-line mentality to of liberalizing reform with entrenched, de- privatized companies. External investors centralized stakeholders such as the will complete the restructuring of firms Solidarity movement in Poland, the work- begun by the transfer of ownership. A sig- ers' councils in Hungary, or the relatively nificant percentage of'restructured firms empowered enterprise managers, members will become profitable as well as national- of cooperatives, and leaseholders created in ly and internationally competitive, and perestroika Russia. The inheriting regime in Russia will be well launched on the process Czechoslovakia in 1990 was less con- of growth and integration into the global strained by decentralizing forces than al- economy. Such is the hope. most other successor regimes in Eastern and Central Europe-circumstances of Issues to be resolved which Vaclav 1laus and his reform team have made the most.3 To put it mildly, much stands in the way of ALlin all, the obstacles to Russian priva- the achievement of this grand aspiration. tization were more numerous and more Ignoring the evident macroeconomic and daunting than those encountered in Ger- macropolitical deficiencies of present-day many and Czechoslovakia, or indeed in any Russia, and concentrating solely on the other countrv that has seriously embarked privatization process, one encounters a on the process. In Russia, because of these number of critical issues and questions:

2 Rr SSIA: CREAn.NC PRIVATEENTERPRISES AND EFFICIENT .MARKETS

* Insiders fear that the restructuring state into businesses? Who willfuind and brought about by external investors will provide these resources? AnLd what paral- cost them their jobs, thus they do their lel refi)rms are requziredin the financial best to prevent or minimize sales of sector and capital market development to large blocks of shares to external in- support these actionzs? vestors. WVhatare the mechanisms bv * Important as privatization is, it is only which secondaryc trading, leading to a part of the transition process, along- restructuring, will be amplified and side new entrants and greenfields in- entrenched > vestments. What does the nonprivatized * The voucher scheme expired on June private sector look like, and how, ifat all, 30, 1994. The current political con- do its activities differ from the privatized figuration will apparently not tolerate sector? a second voucher issue. However, Small-scale 12,000-14,000 enterprises remain un- Approach of the study privatization corporatized, unprivatized, and lacking the voucher mechanism to spur their These are the many complex themes ad- schools both new divestiture. WVhat will happen to this dressed in detail in the chapters of this owners and important set offirms? book. The authors are, without exception, consumers in * Small-scale privatization in Russia is actors in the privatization process, either impressive in absolute terms (with as officials of the Russian Government, market economics, some 85,000 small business units di- advisors to the Russian privatization body and has proven vested), but lags relative to similar pro- (the State Committee on Property Man- critical in job grams in, Poland, Hungary, Estonia, agement or GKI, as it is known from its and the Czech Republic, where a much Russian initials), officials of international creation... larger percentage of the entire smaUl- financial institutions working with the scale base has been divested. Small- GKM(half of the authors in this volume are scale privatization schools both new staff of the World Bank or the Inter- owners and consumers in market eco- national Finance Corporation), university nomics, and has proven critical in job professors on contract to the GKI, or staff creation, essential to the absorption of of private sector consulting firms em- surplus labor flowing out of the large ployed by the GKI. One author-who enterprise sector. Why has Ruissiaexhib- heads an investment fund in Moscow- ited thbs comparatively poor performance comes directly from the emerging Russian regarding snmall-scaleprivatization, and private sector. what does it nmean,for the economic future Given the active roles of the authors, of the couentry? the volume is as prescriptive as it is analyt- * Twelve to fourteen thousand medium ical; that is, chapters concentrate not sim- and large firms are now in private ply on what was done and why, but on what hands. But there are few who believe remains to be done, on the questions listed that their future operations will be left above that have not been answered, and on entirely to determination by pure mar- how they may be resolved. In addition, the ket forces, since the current Russian volume contains a detailed summation of variant of the market deviates so the proceedings of a conference held in sharplv from the textbook model. Pri- Washington, D.C., onJune 21-22, 1994, in vatized firms urgently require technical which the draft versions of the chapters assistance (tto help in the preparation were presented and discussed and in which of business plans and in restructuring), presentations on the accomplishments and credit to finance working capital, remaining problems of the Russian privati- trade, and investments, and equity in- zation program were made bv Anatoly jections to provide both long-term Chubais, Russian Deputy Prime Mlinister, money and active governance. How by MlaximBoycko, President of the Russian can these needlsbe met in ai manner that Privatization Center, and several resident does not reintroduce the hearl hand ofthe advisers to the GKI.

INTRODt [11(F)N 3

The thrust of these presentations by the need for reform in all these areas is direct practitioners was threefold: acute, and considerableactivity is under * Russia's voucher-ledmass privatization way However,a recurring theme in the program, without precedent in terms of conference, on which there was univer- size and speed, is a major success. Why? sal agreement, was that the priority mat- Because the links between the enter- ter was the development of capital and prises and the state have been severely securities markets. This is seen as critical fraved, if not yet totally cut, and a mass to assist investors in acquiring property of property owners-who, presumably, and protecting savings and to address will support further reform-has been the problem of improved corporate gov- created. The first and overarching goal emance in the privatized firms. of the process, to make reform irre- Privatized firms versible, seems to have been achieved. urgently require Initial inquiries into the behavior of Notes firms after sale reveal that restructuring technical firms after sale asrevidencedthat re uctur 1. Less than zero in the sense that the reformers technical ~~~~~~isunder way, as evidenced by product were not faced simnplywith the privatizationof a assistance..., diversification, labor shedding, and mass of state-ownedenterprises, but also had to credit, ... and changes in top management. deal with the quasi-private entities that had been n The next stage of privatization will entail created during the late perestroika period. See John equity in'ections... selling the remaining shares and the re- Nellis,1991, "ImprovingthePerformance of Soviet maining thousands of enterprises for Enterprises", World Bank Discussion Papers 118, cash, through auctions and tenders. The Washington, D.C. government proposes that a substantial 2. From the G-7 countries through bilateral pro- amountthe generated , cash remaini grams and from the European Bank for Recon- amount ofrtne generated cash remamr m struction and Development, the World Bank the firm to finance needed restructur- Group, and the European Community.Equally im- ing. To increase the attractiveness of portant, the Russianprivatization team knew how firms to investors, the real estate on to put these external resources to effective use. which the companv sits must be clearly 3. One potentially massive set of decentralizing tradable and clearlv included in the deal. factors that existed in 1990-the federal nature of This approach will address essential the state and the tensions between the Czech and needsof newly privatized firms, but 1 Slovak territories-has, of course, been resolved bv needs of newly pn'vatizedfirms, but wifl the dissolurionof the federation. necessarily be a slower process than tedsouo4. The phraseftefdrnn is from Leszek Balcerowicz and transfer through voucher auctions. And Alan Gelb, ";Ivacropoliciesin Transitionto a Market it has already provoked vehement op- Economy: A Three Year Perspective," paper pre- position from regional governments and sented to the World Bank's Annual Bank Con- municipalities, who see the new ap- ference on Development Economics, Washington, proach as a threat to their lucrative con- D.C., April 1994. The authors argue that a period trol over local real estate. In mid-July of "extraordinary politics",ccurred in a number of 1994 the Russian Parliament rejected Eastern and Central European countries when the 1the p rsesan par e prejecte old communist elites were discredited, but devel- the prpoedseono , pa oped interest groups were few,fragmented, and dis- but it was promptly promulgated by a organized. This allowed refQrming technocrats to presidential decree. take command,greatly raising the 'probability that * A fundamental contribution of the mass difficult,normally controversial, economic policy privatization program has been its ca- measureswill be accepted"(p. 11). The period lasts, pacity to reveal the need for and spur re- say the authors, for one or two years, and then "pol- form in other aspects of the economy. itics as usual" tend to regain their supremacy. Legalinrtheforms, lanspratiftion,opro- 5. Given the complexityof the program and the Legallandreforms, privatization, pro- lack of politicalconsensus, itwas imperative that the tection of shareholder and creditor process be decentralized; privatization could not rights, social safety net reforms, and the have been accomplished without the active involve- closely related issue of how to dispose of ment of the regional and local authorities and the ancillarv or social assets of firms-the regional voucher auctions.

4 RUSsIA:CREATING PRIVATE ENFERPRISESAIND EFFICIENT IARKETS

Part One

PRIVATIZATION

CHAPTER 2

An Overviewof Privatizationin Russia Ira W Lieberman and Suhail Rahuja

Russia's size makes its privatization pro- enterprises in this industry has proceeded gram probablvthe largest saleof assets ever slowlyand informally,away from the public conducted. From December 1992 to glare. An analysis of the privatization of In Russia, large- February 1994, nearly 9,500 large-scale en- these enterprises-which, in any event, has scale enterprises terprises, employing 11 million people, been limited-is not within the scope of have been privatized were privatized, creating 40 million new this paper. shareholders. The speed with which the As the first country to embrace com- essentially by a program has been enacted is impressive munism, Russia has an industrial and com- closed subscription given Russia's recent political turbulence mercial base that is more heavilydistorted to the employees and its dire macroeconomicperformance. by communist planning than most. This Indeed, these numbers will rise even high- section of the chapter begins by highlight- followed by an er by the end of the voucher auction pro- ing some of the most salient points of the open voucher gram in June 1994. environment in which the Russian privati- This chapter describes the design, im- zation program has been carried out. It dis- autio plementation, and progress of the Russian cusses the degree of state ownership and large-scaleprivatization program. The pro- industrial concentration that existed in the gram is the centerpiece of Russia's formal Soviet Union (and by proxy in Russia) pri- privatization process. In contrast to other or to the collapse of communism. formerly communist countries,which have Privatization is alwaysan intensely po- used a variety of methods to achieve their litical process and nowhere was this more privatization goals, Russia's reliance on a true than in Russia. To understand why large-scalemass privatizationprogram has managers and workers were able to influ- imposed a high degree of conformityon the ence the privatizationprogram in Russiato privatizationprocess. In Russia,large-scale the degree that they did, it is necessary to enterprises have been privatizedessentially understand the political forces unleashed by a closed subscription to the employees by the Gorbachev reforms. Thus, this sec- followed by an open voucher auction. In tion includes a brief introduction to this respect, it differs from the Czech and Gorbachev's economic reforms.' It also Slovak Republics and Poland, where a provides a highlyabbreviated chronologyof menu of privatization techniques (such as the major Russian privatizationlaws, aswell IPOs, trade sales, mutual fund schemes) as a description of the major institutions re- was part of the overall privatization pro- sponsible for enacting privatization. gram. The uniformityin the method of pri- The second section coversthe basic aim, vatization not only captures most of the scope, and structure of the privatization ways that large enterprises in Russia have program and compares and contrasts the been privatized, but also explainsthe speed Russian program with the Czech, Slovak, of privatization. and Polish schemes. It then describes each iNot all Russian enterprises, however, of the program's major elements:corporati- have followed the prescribed privatization zation, vouchers, open subscription,vouch- route. Russia's significantdefense industry, er funds, voucher auctions, and the public for example, has been excluded from the information campaign. The next section privatization program.The privatizationof provides the latest data on the progress of

AGNOVERVIEW OF PRIVATl`TON IN RussIA 7

the program, as well as recent evidence on maticallyincreased the scope and complex- the low values currently being placed on ity of the privatizationprogram, as well as shares sold through voucher auctions. It al- the need for an effective post-privatization so summarizespreliminary research on ini- corporate governance system. tial trends in share ownership after voucher auctions. The last sections highlight devel- Gorbachev'sreforms opments in Russia's capital markets and provide brief remarks on foreign invest- Gorbachev's reforms of 1985-90 were the ment in Russia. first systematic attempt to dismantle the central planning apparatus. The reforms The industriallegacy had considerable impact on the privatization program. The broad aims of the re- Privatization is Until the Gorbachev reforms of 1985, the forms were to transfer decisionmaking always an intensely USSR followed a classic central-planning power from the branch ministries and the political svstem. The state plaved an overwhelming central agencies to enterprise managers, political process role in the economy In all Eastern bloc and to allow (and encourage the formation and nowhere was countries, the state was the dominant eco- of) nonstate forms of enterprises. this more true than nomnicplayer, but there was a notable vari- Enterprise managers' new rights were ation between the USSR and Eastern bloc laid out in the 1988 Law on State Enter- in Russia. countries. In the Soviet Union it has been prises. Managers were given leeway to re- estimated that in 1985, 96 percent of the tain and allocateinternally generated funds net material product (NMP) was produced (particularly for wages and bonuses), by the state sector (Milanovic 1989). In changeproduct design, expand into foreign 1984 in China, the figure was 82 percent markets, seek foreign joint venture part- and in Hungary, 74 percent. Only the for- ners, and borrow from outside the official mer Czechoslovakia and East Germany funding sources. Most important, manda- had higher figures-97 percent (1986) and tory production targets were replaced with 96.5 percent (1982) respectively It has "state orders." Enterprises were now free, been estimated that there were 47,000 state after fulfillingstate orders, to produce and enterprises in the USSR industrial sector.2 sell as much output as they could. Initially, If energy and large servicefirms are includ- this meant little, since state orders covered ed, the total rises to 55,000. 90 percent of industrial output. State or- Soviet state enterprises were large and ders, however,were progressivelycurtailed monopolistic.Of the 7,664 product groups and managers were given real power over distributed by the former Soviet Gossnab output decisions. And from 1989 on, (Committee of Deliveriesand Supplies),77 branch ministries were reduced and reor- percent were produced by just one firm. ganized,considerably restricting their pow- The high degree of industrial concentration er over state enterprises. These ministries and the sizeof the Sovietmarket meant that have since sought to reassert themselves(as the average Soviet enterprise was far larger holding companies, joint stock companies, than its counterpart in either the Westernor trade associations, and so on), forcing the Eastern bloc.3 The average number of em- privatizationprogram to require corporati- plovees for the largest 952 firms in manu- zation at the lowest institutional level. facturing and energy was over 8,500; the Cooperatives and leaseholds were per- average for all 25,000 enterprises in these mitted from 1988, and small private com- sectors was 821, ten times the equivalent panies, limited-liability companies, and figurefor a range of Western countries.The joint stock companieswere permitted from largestenterprises in the former USSR (AV- 1990. Cooperatives were frequently sub- TOVAZ, which produced cars, and KA- contractors or spin-offs from state enter- MAZ,which made trucks and tractors) each prises and were often set up to exploit emploved 100,000 employees. This indus- privilegedaccess to scarce goods.Likewise, trial legacy of a high degree of both state leaseholdingswere usuallysubunits of large ownership and industrial concentration dra- state enterprises. Groups of workerswould

8 RussIA:CREATING PRIATE ENTERPRISES AND EFFICIENT MARKETS lease space and equipment from their state bv Grigorv Yavlinskvand StanislavShatalin enterprise. Leaseholderswere free to accu- in mid-1990, had mentioned privatization mulate new assets through retained earn- but had never contained a detailed program. ings or bank loans, with these assets These packageswere ultimatelyabandoned. becoming the propertyof the leaseholders. Although the 1991 law has since been Agreements to buy out the leased assets amended, it remains a blueprint for privati- were also commnon.A recent survey of pri- zation. It laysdown procedures,outlines the vate sector manufacturing activity in St. organizationalinfrastructure for implemen- Petersburg shows how a cooperative or tation, and mandates a detailed annual pri- leasehold functions in practice.4 vatization program.Even at this early stage, As intended, Gorbachev's reforms the law foresawworkers receivingdiscount- transferred power from planners to worked shares in the enterprise in which they ers, managers, and regional authorities. worked, state enterprises converting into The first steps What was not anticipated was the manner joint stock companies, and vouchers being toward privatization in which these groups began to exploit their distributed. But given the political turbu- new-found freedoms. State enterprises be- lence and uncertaintygenerated by the coup were taken by the gan rapidly increasing workers' wages, in August 1991, the breakup of the Soviet Gorbachev bonuses, and welfareexpenditures. This led federation, and Yeltsin's initial focus on government in July to a sharp declne in after-tax profits remit- macroeconomicstability, little was done to ted to the state and a federal budget crisis. establishthe necessarvlegal and institutional 1991... Spontaneousprivatization became pre- framework required for privatization. Not valent as managers began to divert profits surprisingly,by January 1992 the number of and assetsboth legally(through cooperatives enterprisestransferred to privateand collec- and leaseholds)and illegallvThe demise of tive ownershiphad reachedonly 70 and 922, the Communist Party and its associatedor- respectively (Chubais and Vishevskaya gans of control made this possible. This 1993). process accelerated in 1991 as employees The privatizationprogram as it unfold- used the purchaseoption in leaseagreements ed in 1992 and 1993 washeavily influenced with a new right to set up joint stockcompa- by the differences between the Yeltsinpres- nies, often buyingleased assets at book val- idency and the Russian parliament. The ues-a fractionof their true value. Similarly, parliament acted as a remnant of the com- local authoritiestook control of infrastruc- munist past and an obstacle to smooth pas- ture in their area (water,electricity, and so on) sage of the program. Quarrels over the and demandedcontrol over enterpriseswith- form and speed of the 1992 privatization in theirjurisdiction. Governments at all levels program erupted throughout the first half lost manyof their ownershiprights to enter- of the year. Significantcompromises were prises, which had been ceded to workers, made to the anti-reform camp in the pas- managers, and local authorities. Russia's sage of privatization legislation through mass privatizationprogram, by necessity,had Parliament. The 1992 annual privatization to recognizeand incorporatethese new and program itself was not passed until mid- competingownership claims. 1992.5 A large number of other enabling decrees and laws covering details were is- Legislativeand institutionalftamework sued from 1991 onward. Topics covered delineation of ownership between federal The first steps toward privatization were and local authorities, the corporatization taken by the Gorbachevgovernment in July process, vouchers, investment funds, auc- 1991, when the former Soviet Union tions, tenders, and other sales procedures. Supreme Sovietpassed a law on "The Basic Along with progress on the legislative Foundations of Denationalizationand Pri- front, an institutional infrastructure was al- vatizationof Enterprises." An equivalentlaw so established. The State Committee for was passed by the RussianSupreme Soviet a the Management of State Property (known few davs later. Previous reform packages, as the GKI) was reoriented to drive for- such as the "500 days"program put forward ward the privatization program. The GKI

AN OVERVIEWOF PRArIAzMON i\ Russux 9

is responsible for formulating and imple- 20,000 medium-sized enterprises the op- mentingprivatization policy. It has also been tion of joining the program. These figures responsiblefor preparing annual privatiza- underestimate the true numbers. Data on tion programs, drafting privatization laws the number of large and medium-size en- and decrees, distributing vouchers, licens- terprises prior to privatization are sketchy, ing investment funds, and enforcing priva- and during the course of the privatization tization legislation.The GKI is supported program some enterprisessplit into smaller by regional (oblast) and municipal sub- independent units. Russia's privatization sidiaries (KIs) attached to local or munici- programs dwarfs those in the Czech and pal administrations.The head of each oblast Slovak republics and in Poland.In the first is nominated by the governor of the oblast waveof the Czech and Slovakmass privati- for approval by the central GM. The head zations, 2,776 enterprises were sold, of The privatization of each municipal KI is appointed bv the lo- which 1,492 were privatized in voucher auc- program as it cal mayor.Regional and municipalproperty tions. In the second wave, 900 enterprises committees ensure that each state enter- are to be privatized in the Czech Republic. unfolded in 1992 prise sets up a privatization commission, In Poland, 600 enterprises are to be priva- and 1993 was produces a privatization plan, and is later tized in the mass privatization scheme.6 heavily influenced corporatized. Only the privatizationof more than 10,000 The Russian Parliament, in an effort to firms by Germanv's Treuhandanstaltcomes by the differences exercise greater control over the privatiza- near to Russian totals. The administrative between the Yeltsin tion program, created a rival agency to the complexitvof the Russian programwas fur- presidency and the GK, the Federal Property Fund, which re- ther compounded by the inability of the ported directly to the Parliament. In addi- center to control, for both technologicaland Russian parliament. tion to the Federal Property Fund, property politicalreasons, the oblasts (propertycom- funds were created at the localand munici- mittees and property funds). With eighty- pal level.The heads of oblastproperty funds eight oblasts, the program had to be were appointed by and reported to oblast decentralized, as opposed to the Czech, soviets until the latter were abolished in Polish, and German schemes,which were October 1993, following the failed coup. tightlv administered on a national level. In These property funds assume the state's comparison with the Czech or Polish pro- stake in an enterprise from the GKTor KI grams, the Russian mass privatizationpro- (as relevant)after corporatization of the en- gram has been a much more complex terprise. The local property fund exercises politicaland logisticaloperation. ownership rights on behalf of the state and is responsiblefor the management and dis- Principles persal of the state's remainingstake, such as publishing the legal notice announcing an In drafting the Russian program, reform- auction and distributing property titles. ers focused on a few key principles: Tensionhas arisenbetween the GMl and the Speed. As the power of the center re- Federal Propertv Fund, compounded by the ceded, managers and workers found overlap in administrative roles. Infighting, themselves in a governance vacuum. however,generally has not filtered down to On the one hand, the best assets were the local or municipal level. Indeed, coop- being systematicallylooted bv sponta- eration between the local and municipal neous privatizations. On the other, the property committees and property funds is state was bailing out loss-making en- the norm, and this has ensured a measure of terprises (either directly through sub- continuitvin the privatizationprocess. sidies or indirectly through financing by the state-owned banks) on such a Mass privatizationprogram scale that macroeconomic stability was threatened. It was therefore es- Russia's privatization program is extremelv sential to establish a privatization pro- ambitious. It entails privatizingsome 5,000 gram by which many firms could be large state enterprises and gives 16,000 to quickly privatized.

10 Ru SSuA:CRLATING PRIvArE ENTERPIRISESANr) EflFICILNT MLRKETS

* 7ransparencj,andji rness. Proper regu- * The creation of financialintermediaries lation and procedures were required to and institutions; and ensure that each privatization was ad- * Voucher auctions. equately reviewed, that a transparent Like the Czech and Slovak scheme, environment was created, and that the Russian scheme was "bottom-up." The bidding was as fair and competitive as state's privatization role is limited to possible. providing enterprises with a conceptual * Political keasibilitv. There had to be framework and common privatization do- enough incentives to ensure the sup- cuments and to reviewing and approving port of all directly-affected stakehold- the plans submitted to them. Moreover, as ers (workers and managers) and of with the Czechs and Slovaks, Russian in- those who implemented the process dividuals and firms are free to start up (oblast authorities). voucher funds that can accumulate vouch- Russia's * Political popularitr and equiitV. Market ers and bid for enterprises, subject to min- privatization reforms have led to a marked decline in imal criteria. living standards for most Russians. It There were, however, substantial differ- program ... entails was important to offer incentives to the ences between the Russian and Czech and privatizing some general public. If privatization were Slovak programs. Russian managers and S,000large state successful, it would be the first reform workers won substantial privleges not avai- that would bring benefits to the gener- able to their Czech and Slovak counter- enterprses and al public through short-term financial parts. They secured big (often majority) gives 16,000 to rewards and access to goods and ser- shareholdings in a "closed subscription" be- 20,000 medium- vices. Reformers had to create a large fore equitv was put up for general sale. Thev and powerful constituency that would were also able to ensure that outsiders sized enter have a vested interest in ensuring the played a far smaller role in Russian mass pri- option of joining continuance of economic reforms. vatization than they did in the Czech and the program. * Demand. The program had to stimulate Slovak Republics. There was no scope in demand for assets as public savings are Russia for outsiders to submit alternative too low and foreign investment too un- privatization plans to the authorities as certain to ensure that more than a small there was in the former Czechoslovakia. fraction of the assets on offer can be Many different and competing privatization sold, even at book values unadjusted alternatives emerged out of the Czech and for inflation. Slovak mass privatization scheme, such as * Decentralization. The program had to voucher auctions, direct sales, competitive be "bottom-up" in approach-that is, auctions and tenders, and combinations enterprises had to carrv most responsi- thereof. In Russia, the most common way bility for developing their privatization for outsiders to participate in privatization plans. Moreover, implementation and has been through a voucher auction, an ef- supervision of privatization had to be at fective wav of dispersing outside share own- the local level. ership and, as a consequence, of limiting * Governance. Privatization had to trans- and diluting their influence. Finally, in fer state assets to economic agents with Russia there was no single grand Czech- both the incentives and the expertise to style auction in which the shares of a thou- undertake the restructuring required to sand or more enterprises were allocated at build a healthv and profitable economy. once and in which all voucherholders were free to bid. Russia's size, the number of en- Framework terprises up for sale, and the lack of a communications network made such an auction To reconcile these objectives, the large- technically difficult. Further, the autonomy scale privatization program was built on: each enterprise and oblast had over the * A mass privatization program; speed of the privatization process meant * The distribution of privatization that a single grand auction was also politi- vouchers; cally difficult. An attempt to hold such an

AN OVEIEVIF.vU)F PRIVAFIZAnOX IN R,ssL% 11

auction would have led to lengthy delays in rubles as of January 1, 1992. Mledium-size the privatization process. In Russia, most enterprises were defined by exclusion. enterprises are auctioned a few at a time by Small enterprises follow a different privati- the local property fund to voucherholders zation procedure than large enterprises. who live in the region over a period of time Mlost small-scale enterprises are owned by determined by local players. In 1993, a municipal authorities who are responsible voucher depositorv network and a national for their privatization, whereas most auction center were established that helped large-scale properties are owned by the fed- mitigate the parochial nature of auctions. eral or oblast authorities. Further, although Russian policymakers rejected the federal authorities are responsible for the "top-down" approach of the Polish voucher privatization of federal properties, oblast scheme because of three main concerns. property committees and funds carry out A series of laws First, the Polish scheme emphasizes allocat- the tasks of privatizing federal properties, passed by ing a selectedgroup of enterprises to twen- getting the approval of the GKI or the ty or so government-sponsored investment Federal Property Fund before proceeding Parliament in funds. The funds in Russia could easily with the privatization. All enterprises, 1991-92 evolve into a powerful constituency arguing whether federal, local or municipal, large or categorized state for subsidies and cheap credits for the com- small, were allocated to one of five broad panies thev managed, effectivelv hindering categories in the 1992 state program. property as federal, the efficient and speedv restructurng of local (oblast), or these enterprises. Second, in the Polish Mandatoryprivatization. This includes muntlricipaland scheme, enterprises essentially play a pas- firms in wholesale and retail trade, con- sive role in the privatization process. In struction and construction supply, food allocated Russia, the influence managers and workers processing, light industry, textiles, furni- responsibility for have made such an approach unfeasible, ture, agricultural produce, road transport, privatization to and the privatization process has to directly and all loss-making enterprises (except incorporate their interests. Finally, the those that fall into one of the other cate- property Polish scheme requires a delay of eighteen gories). Most small-scale enterprises fell committees and months or so before voucherholders can into this category, together with some property funds at convert their vouchers into the shares of 5,000 large enterprises. By having a mutual funds, and an unspecified time will mandatory category, the Russians created a the appropriate elapse before citizens can directly hold eq- pipeline of firms to be privatized.' This put level. uity in the privatized enterprises. Thus, the pressure on oblast authorities to begin pri- political benefits of involving the general vatization as quickly as possible. public in the mass privatization scheme at the earliest opportunity would be lost. Privatization with the approvalof the federal GKI (after consultation with sectoral Firststeps ministries). This includes large firms that either dominate the market they operate in, A series of laws passed bv Parliament in employ over 10,000 people, or have assets 1991-92 categorized state property as fed- worth over 150 million rntbles onJanuary 1, eral, local (oblast), or municipal and allo- 1992 (such as railroads, airlines, shipping cated responsibility for privatization to lines, alcohol, tobacco, pharmaceuticals, property committees and propertv funds at and medical equipment). When these en- the appropriate level. State enterprises terprises are privatized, the state can retain were also characterized as small or large for a controlling stake for up to three years. the purposes of the privatization program. A large state enterprise was defined as an Privatization permitted with government enterprise with more than 1,000 employees approval. These are firms in industries of or assets over 50 million rubles as of strategic importance (natural resources, January 1, 1992.7 A small enterprise was de- steel, defense, information and wireless fined as an enterprise with fewer than 200 agencies, grain storage, and so on). Given employees or assets less than 1 million the opposition of anti-reformers in gov-

12 RussiA: CREATING PRVATE ENTERPRISESAND EFFICIENT MARKETS ernment, privatization of these industries vatization commission (which carries out has been slow. the practical tasks of the corporatization procedure) was determined by the chief ex- Privatization forbidden in 1992. This ecutive of the enterprise. The onlv require- catesorv included entities such as major ments were that the commission have natural resource industries, the Central between three and five members, one of Bank, social infrastructure, television and whom had to be from the workers' collec- radio stations, ports, and nuclear productive. The original 1991 Privatization Law tion facilities. envisaged a much larger privatization commission, with representatives from local Local privatization programs. This cate- state property commnittees, local citizens, gorn includes most social infrastructure un- officials of financial agencies, managers, der the auspices of local authorities (such and workers. To accelerate privatization Corporatization is as mass transit systems, health, education, and strengthen the role of managers, the the process by and cultural and sports facilities). composition of comrnissions was curtailed in a presidential decree of July 1992 (Presi- whlch a state Corporatzzation dent's decree 721). enterprise becomes The KIs can do little to hinder the enter- a joint stock Corporatization is the process by which a prise's proposals on privatization. For exam- state enterprise becomes a joint stock com- ple, the KIs had to approve asset valuations company with a panv with a legal identity It is no longer an prepared by the privatization commission, legal identity. adjunct to a branch ministry. It has its own but they had little information on which to charter (rights and obligations of share- assess or contest the validity of manage- holders), a board of directors that has the ment's valuation. NManagementhad a big in- right to appoint and dismiss management centive to underestimate the valuation since and operates under the same commercial the valuation was taken as the founding cap- law as the private sector. All large-scale en- ital of the privatized firm and, hence, the ba- terprises, except those for which privatiza- sis on which managers and workers bid for tion is forbidden, must be corporatized. shares in the closed subscription. Indeed, Subdivisions of large enterprises can also this methodology was modified by the July corporatize as a first step toward indepen- decree to favor speed (and, thus, insiders). dence. Medium-size enterprises can be pri- The original 1991 Privatization Law envis- vatized through either the small (which aged that the valuation would be calculated does not require corporatization) or large on a market or discounted cash flow basis. privatization program. Given the understandable difficulties of To be corporatized, an enterprise had to making projections under Russian condi- submit a privatization plan, a valuation of tions, the methodology was changed to one its assets (as of July 1, 1992), and a joint based on book values (as of July 1, 1992).1 stock charter to the local property commit- With inflation running at over 1,000 percent tee by October 1, 1992.9 Tight deadlines in 1992, this was a huge transfer of wealth wvereset for the corporatization process, as from the state to insiders. well as for particular stages. In practice the timetable was untenable. Manv enterprises Closed subscrtption tiled late, and even a year after the original deadline the process was still far from com- One of the major decisions managers and plete. Insofar as the intention was to create workers make as part of corporatization a pipeline of firms ready for privatization, is over the closed equitv subscription. however, the tight deadlines had the de- Employees have three choices: sired effect. Power over the privatization process Option 1. Managers and workers are was in the hands of enterprise insiders, with given 25 percent of the enterprise's equitv the balance of power usuallv lying with in preferred, nonvoting shares. 1 They also managers. Thus, the composition of the pri- have the option to subscribe for another 10

A.NOVEMREW OF PM'AiZA110N IN RuSSL, 13

percent of ordinary (voting) equity on fa- prise employees (including managers) are vorable terms. These include: also given the right to acquire a further 20 * A 30 percent discount from the book percent of the votingcapital at a 30 percent value (taken on Julv 1, 1992), discount to book value. Option 3 has rarely * Payments are in equal quarterlv install- been used. ments over three years (considerablyre- A vote on which option to choose is ducing the real value of the pavment, made at a general meeting of the workers' given inflation), collective.A two-thirdsmajority is required * An initial down payment (payable with- to choose option 2 or 3. If there is no such in 90 davs) of not less than 15 percent majority,option 1 applies.'3 of the book value, and Employees also had two other impor- * Up to 100 percent of the amount owed tant subscription privileges-Personal Pri- can be paid for in vouchers. vatizationAccounts and the ShareFund for Acquisitionof both the 25 percent non- Employees of the Enterprise (FARP). Pri- votingstock and the 10 percent votingstock vatization accounts are part of an enter- are subject to ruble limits to prevent exces- prise's social fund. This is composed of sive giveawaysin enterprises that have high such items as a housing fund, wage fund, asset valuesrelative to total employment.'2 bonus payments, and, more recently,priva- In addition, enterprise managers (di- tization accounts.Each year part of the en- rector, deputy director, chief engineer, and terprise's net income is allocated to the chief accountant) have the option of ac- social fund. Employees can use these pri- quiring up to 5 percent of voting equity at vatization accounts to finance their share book value (for which they can pay with purchases in the closed subscription vouchers and cash). Mlanagersand workers (though inflationhas reduced their value in can sell their stock to whomever they real terms). FARPs allow certain groups of choose,but sale of the nonvoting preferred employeesto subscribe for up to 5 percent stock does not change its status. of the enterprise's capital after the closed subscription and the voucher auction. Option2. Emplovees can buy 51 percent FARPs apply to those who could not par- of the ordinary shares of the enterprise for ticipate in the closed subscription, such as 1.7 times the book value (as ofJulv 1, 1992). former or retired employees. There are no discounts or deferred payment Significantrestrictions were placed on terms and no sales of nonvoting shares. the use of shares in the hands of the local Vouchersand cash can be used to pay for the property fund after the closed subscription. shares (no less than 50 percent must be in The fund may not vote more than 20 percent vouchers). The entire payment must be of the equity Anv stock held by the fund in made in 90 days. The 70 percent markup on excess of this (40 percent in the case of op- the book value was an inadequate attempt tion I or 29 percent in the case of option 2) bv the GKI to compensate for inflation. has the statusof nonvoting,preferred shares with a minimumdividend equal to the bank Option 3. This is open only to enter- discount rate. Only on sale to a private in- prises with more than 200 employees and vestor will these shares become common assets of between 1 million and 50 million stock. These restrictions were imposed to rubles as of Januarv 1, 1992. iMlanagers as- thwart local property funds from trying to sume responsibility for running the enter- maintain direct control over enterprises. prise under a contract with the local Because substantial equity ended up in the property committee. They agree to main- hands of insiders, however, these restrictions tain both the competitiveness of the enter- had unintended consequences. Under op- prise and a certain number of jobs for at tion 1, for example, insiders who took up least two years. If the terms of the contract their full subscription received 15 percent of are fulfilled, managers can acquire 20 per- the equity, but because of the restriction on cent of the voting capital at book value property funds'voting rights, had 47 percent wvithpayment over three years. All enter- of the voting rights; they do not need to buy

14 RussIA: CREATINGPRIVATE ENTFRI'E>SES AND EFFICIENT MNWKETS

many more shares in open subscription to Vouechers gain voting control. Under option 2 insiders can subscribe for majoritv control, but even Vouchers wvere put on sale a month ahead of when thev fail to subscribe for their full al- schedule (from October 1, 1992) at Sber- lotment or subscribe for their full allotment bank, the state savings bank, to demon- and then sell their shares, the 20 percent vot- strate that privatization had started in a ing limit on the funds provides insiders with meaningful way and to build support for the considerable leeway before they lose voting program. The main characteristics of the control.'4 voucher scheme were: The scale of equitv transfer offered * For a fee of 25 rubles, each Russian through closed subscription is enormous- would receive one voucher with a de- a reflection of the strength of implicit own- nomination of 10,000 rubles. AUIcitizens ership claims spawned by the Gorbachev would receive a voucher regardless of ... by the end of enterprise reforms. Managers and work- age, residence, workplace, or income. January 1993, ers. through their de facto control of enter- * Vouchers could be accepted by a pnva- prises and their vocal representation in tization agencv anywhere in the Russian four montbs after Parliament, were able to mold privatiza- Federation for the sale of state assets. the first sale, tion legislation. Enterprise workers have Once received bv the agency, the vouch- 95 percent of received more generous concessions than er would expire. in any other privatization program in the * Vouchers were bearer documents and Russians had world (Bovcko, Shleifer, and Vishnv 1993). could be used to buy shares of the en- collected their Not only did thev receive 35 percent of the terprise in which the voucher holder vouchers (some equity on generous terms under option 1 works or to purchase shares at the auc- or 51 percent under option 2 (with an option of anv other enterprise in the portunity to increase their shares in open Russian Federation, traded in a com- subscription), they also had a voice, mercial or investment tender, exchanged through the workers' council, on the for shares of a voucher investment fund, choice of option. iMore importantly, they sold for cash, or used to pay for housing were able to prevent the immediate domi- and small-scale propertv nance of strong powerful outside share- * Vouchers were originally to be valid holders. In acquiring stakes, managers and from December 1, 1992, to December workers invested little of their own money, 31, 1993, but the deadline was extend- but were usually able to subscribe for the ed to July 1, 1994 because of delays in full amount open to them. After taking in- the privatization program. to account the effects of intlation ( 1,000 * Only the Russian Federation could is- percent) and the use of discounts, vouch- sue vouchers and only federation ers, pavback periods, and privatization ac- vouchers could be accepted by privati- counts, the actual contribution made bv zation agencies. No local vouchers were workers and managers has been negligible. permitted. Closed subscription has represented a sig- The Russian privatization voucher dif- nificant transfer of wealth from the state to fered in important aspects from the Czech workers and managers. and Slovak voucher. It was less expensive. The original privatization plan envis- The Czech and Slovak voucher cost about aged only option 1, which did not offer $35 roughlv the average weekly wage) and immediate majority control, inhibited out- the program was self-financing. The sider involvement, and represented a de Russian voucher first went on sale at facto veto on future restructuring. Option around 5 cents. This led to both a higher 2 offered both substantial equitv and im- take-up rate and rapid disbursement. The mediate control. Not surprisingly, more GKI estimates that bNrthe end of Januar than 70 percent of corporatized state en- 1993, four months after the first sale, 95 terprises chose option 2. The rest chose op- percent of Russians had collected their tion 1 and only a handful of enterprises vouchers (some 146 million). Four months chose option 3. into the Czech and Slovak sale, only 2 mil-

A.NOIRxmx cOlF PRIVAJ1ZAn(\NIN RlSIA 15

lion of an eligible 10.5 million participants backed by valuable assets. Third, in the had bought voucher booklets.' 5 The event of an illiquid voucher market, an in- Russian voucher had a nominal denomina- sistence on using only vouchers would delay tion of 10,000 rubles (unlike the Czech and the privatization process until investors and Slovak vouchers, which were denominated employees had bought the required vouch- in points, not currency units), and Russians ers. Finally, assigning a nominal value to could sell their vouchers for cash, unlike the vouchers had ramifications for the payment Czechs and Slovaks. decision. If the voucher's market value falls Russian reformers had several reasons below its nominal value and if there are no for allowing voucher trading (Boycko limitations on how many vouchers can be 1993). First, any restrictions on trading subscribed, then no investor (either in the would limit an individual's portfolio closed or open subscription) will use cash to choices. Second, some people, especially pay for privatized assets. the poor, could sell their vouchers to increase their consumption. Third, given that Open subscrtption many people would want to sell their vouchers even if it were illegal to do so, a The privatization commission has to lay out black market was bound to emerge-an of- a proposal for the sale of the equity remain- ficial market could be somewhat regulated. ing after the closed subscription. The three Fourth, tradabilitv would allow large and choices for the enterprise are a voucher auc- powerful shareholders to emerge. It would tion, a voucher auction combined with permit individuals, firms, and voucher commercial tender, or a voucher auction funds to acquire as many vouchers as they combined with investment tender. Each of wished, which is precisely what happened. these options could also be followed by a One argument against voucher tradabil- sale of shares for cash. A minimum of 29 itv is its possible effect on inflation-vouch- percent of the total equity had to be sold in ers. functioning as high-denomination bills, a voucher auction. 17 wvouldadd to the money stock. In addition, Under a commercial tender, the enter- distributing vouchers leads to an increase in prise is sold (in an auction room or by sealed the wealth of all citizens which, in tum, bid) to thehighest bidder accepting specific would increase their consumption and thus conditions. An investment tender is a much inflationary pressure; borrowing against longer process, suitable for large enterpris- vouchers for current consumption would es. The evaluation criteria are not restricted only result in an increase in the relative price solely to price, but mav also include invest- of goods consumed by the poor (food, ment, employment guarantees, and so on. clothes, and so on). Restricting the use of Commercial and investment tenders are vouchers so that they are not redeemable for rare. In February 1994 a presidential decree goods and services mitigated their inflation- was issued in anticipation of the increase in arv consequences, but the most potent tenders likely to occur after the end of method was to ensure that there was a rapid voucher auctions in July 1994. The decree supply of enterprise shares, thereby rein- simplified the procedures required for in- forcing the equity-linked basis of vouchers., 6 vestment and commercial tenders. A related issue was allowing vouchers Given the absence of control from the and cash to be used as altemate forms of center, the nature and speed of the sale of payment. The decision on payment de- the remaining equity has been negotiated pended on satisfving a number of policy ob- between the enterprise, local politicians, the jectives and constraints. First, it was K1, and the local property fund. This has left important to ensure that local authorities re- a large amount of discretion over the form ceived cash from share sales and thus had of the open subscription in the hands of the the incentive to sell the shares in the first insiders. Insiders may trv to delay the sale place. Second, it was important that a direct either to keep equity in the hands of the link was made between vouchers and assets property fund, which is likely to be more re- on sale, thereby ensuring that vouchers were sponsive to their interests and to share their

16 RussIA:CREAnNG PRIVATE ENTERPRISES A.ND EFFICIENTMARKETS concern over outsider control, or to allow l'obtcherflnds time to accumulate enough capital to buy some or all of the remaining equity In Russian investment funds are all privately voucher auctions,local property funds and sponsored. The state is limitedto providing enterprises have often tried to evade the 29 and ensuring compliancewith a prudential percent minimum by selling a smaller per- regulatory framework. Legislation, includ- centage through a seriesof auctionsin which ing a presidential decree issued in October small stakes are sold. The situation deterio- 1992, followedby an Investment Company rated so much that another decree was is- Law in 1993, allowed for the creation of sued after the April 1993 presidential both voucher and nonvoucher investment referendum reiteratingthe 29 percent target funds. The voucher funds are licensed and and threatening disciplinarymeasures for regulated by the GMEand the nonvoucher failure to complywith the target (presiden- funds by the Ministryof Finance. ... by May 1994, tial decree of May8, 1993).Compliance has Investment funds were slow to emerge. there were 624 improved considerablvsince this decree. The first investment fund licenseswere not During 1993 it was common to find lo- issued until December 1992, three months licensed investment cal property funds retaining 20 percent of after vouchers first went on sale. There funds (mostly the equitv in privatized enterprises, believ- were logisticalhurdles to the formation of voucher funds) ing that once 80 percent of the equlty had funds, such as raising finance, registering, been sold (most comronly in an enterprise and so on. There was also a lack of public with 550 choosing option 2, with 51 percent sold to understanding of investment funds, due in investment fund the emplovees and a minimum of 29 percent part to poor marketing. Even so, the num- managersand 21 sold through a voucher auction) they were ber of funds has grown rapidlv. It is esti- under no obligation to sell more. The "80 mated that by May 1994, there were 624 million percent" rule, however, required that 80 licensed investment funds (mostlyvoucher shareholders percent of enterprise equity had to be sold funds), with 550 investmentfund managers controlling 45 for vouchers. If the proceeds of the closed and 21 million shareholders controlling 45 . .c . subscriptionwere not entirelvin the form of million vouchers-about 30 percent of the million vouchers... vouchers, then the propertv fund (having total number issued (Price Waterhouse sold 29 percent through the voucher auc- 1994). By May 1994 voucher funds had in- tion) has to sell from the remaining20 per- vested 27.6 million vouchers. Moscow city cent to complywith federal legislation.The has the highest concentration of funds with GIMhas used this rule to push the property more than 120 (the Moscow oblast has funds to sell more equity for vouchers be- about 150), while the St. Petersburg oblast fore the voucher expiration date. has about 35. The largest fund has more Local property funds have also reduced than two million shareholdersand four mil- their stakes by using the option of sellingup lion vouchers. Voucher and nonvoucher to 5 percent of the share capital offered in funds can subscribe for cash, though this the voucher auction for cash (that is, up to has not vet been a priority and little cash has 5 percent of the minimum 29 percent). been raised. This will change after the ex- Property funds are reluctant to sell further piration of vouchers in mid-1994. shares for vouchers,and most arewaiting for Investment funds and managersare reg- the expirationof vouchersat the end ofJune ulated in a number of wavs,such as the form 1994,when they hope to sellshares for cash. and nature of investmentfunds, licensingre- In contrast to the 5 percent cash sales, the quirements, the relationshipbetween funds proceeds from these cash sales will not and fund managers,portfolio investmentre- accrue solely to the local propertv fund. strictions, valuation procedures, reporting They xill be split with the federal property requirements, the rights of shareholders, fund, the local KI, the central GKI, and the and so on. Legislation saw voucher funds federal and oblast authorities.Local proper- acting as passive portfolio investors,playing tn funds will retain the option of selling much the same sort of role as their Westem shares throughan investmentor commercial mutual fund counterparts. (The Investment tender beyond the June voucher deadline. Company Law was based on the 1940 U.S.

.kNOVERVIEW OF PR\AThZATI(ANI\ RuAŽi\ 17

Investment Company Act.) In particular, latter are used in voucher auctions, the for- various restrictions were placed on voucher mer for speculation. funds'portfolios. Funds were not allowed to As the pace of voucher auctions in- invest more than 5 percent of their assets in creased, funds focused on acquiring blocks one enterprise, to own more than 15 per- of equity in specific enterprises and indus- cent of the debt instruments of an enter- tries. There seem to be two broad explana- prise, or to invest outside of Russia. One tions for this behavior. The first is that, like important restriction was that a fund could Czech funds, Russian funds see more prof- not own more than 10 percent of the stock it in acting as proactive restructurers of of an enterprise. This rule (later changed) corporate assets rather than as portfolio in- initially placed voucher funds at a disadvan- vestors. Singly or in concert, Russian funds tage not only to insiders, but also to other have challenged management at sharehold- The licensing private investors who faced no such restric- ers meetings and have sought to remove conditions that tions, and severely limited the corporate them or otherwise promote restructuring. governance role thev could plav In compar- To gain control, manv funds have ignored funds and ftund ison, in the Czech Republic, the limit is set the 10 percent restriction. Because of the managers have to at 20 percent. Thus in the Czech Republic widespread disregard for the rule and becom ply with have it would require three voucher funds voting cause it was felt that funds were being un- together to control an enterprise, whereas in fairly penalized, the limit was raised to 25 been kept to a Russia it initially required six. percent in the 1994 privatization program. mini'mum both to The funds' behavior has been quite dif- The second reason for acquiring blocks of encourage the ferent from that originally envisaged. There equitv is the exact opposite of the first. seem to have been two stages of develop- Manv managers have sought to expand formation of funds ment. At first the funds were active partici- their shareholdings beyond the level grant- and to leave little pants in the voucher market. In addition to ed to them in the closed subscription. discretionary power trading vouchers for capital gains, funds Funds often acquire shares in voucher auc- were selling vouchers to raise cash to meet tions or in the secondary market with the inin the hands of their current expenses, since they found tention of selling them back to management oblast KIs... themselves in a position with little or no in- at a markup. This practice has proven to be terest or dividend income and an iliquid a lucrative source of profits with which to share portfolio. Their only cash reserves pay dividends, though in doing so funds are were their founders' capital. The voucher forsaking a long-term investment role and market wvasthe only avenue by which funds instead fulfilling the role of a broker. could be obtained for current expenses. To The licensing conditions that funds and the extent that cash proceeds from vouch- fund managers have to complv with have er sales did not come out of trading gains, been kept to a minimum both to encourage the fund was paving expenses out of prin- the formation of Funds and to leave little cipal. The government took the view that discretionarv power in-the hands of oblast the resulting sell-off of v'ouchers by the Kls, on whom most of the regulatorv bur- funds was undermining voucher prices and, den falls. Twvopoints are worth noting: in a May 1993 presidential decree. forbade foreign fund managers are treated no dif- funds from trading in vouchers. This belief ferently from domestic and state enterpris- seems unfounded-fluctuations in the es are forbidden from setting up voucher voucher market are more a reflection of the funds. The latter condition was imposed vag.aries of Russian politics on the because it Nvasfeared that state enterprises prospects for privatization-though con- might create funds to buv stakes in priva- cern about funds eating into their capital tized companies, thus defeating the pur- bases seems reasonable. It appears that pose of privatization."8 some funds are evading this rule by ex- Bv decree, Russian voucher funds have ploiting ambiguities in the legislation. They to be closed-ended-that is, thev have a purchase vouchers for cash in the market fixed number of shares in issue. An investor but keep them separate from vouchers they subscribes capital during specific offer pe- receive in exchange for their shares. The riods, and once the fund is set up, the in-

18 R;SSIA: CREATING PRIvATF ENTmRIRISES ANDEFFICIENT MNARKTTS vestor recoups investment bv selling vouchers, particularly on television. Manv have er fund shares on the secondary market. made exaggerated claims about future div- Unlike investors in open-ended funds, in- idends, causing concern among policy- vestors in a closed-ended fund cannot sub- makers. Thus there is a regulation scribe more capital or ask the fund to forbidding Russian voucher funds from redeem shares. making guarantees on future performance. Though voucher funds are closed- This rule was instituted because of the ex- ended, manr, have developed a lopsided na- perience of the Czech and Slovak authori- ture in that they have semi-continuous sub- ties. In the former Czechoslovakia, several scription periods (in contrast to the limited investment funds guaranteed tenfold re- offer period of a Western closed-ended turns or more on a citizen's coupon book a fund). These funds fall halfway between a year after shares began trading. Authorities closed-ended fund and an open-ended feared that if enough people cashed in fund in that thev subscribe for vouchers on their fund shares at the same time, these a semicontinuous basis without being ob- funds might have to liquidate a substantial ligated to redeem their shares. This has portion of their portfolios to make good on caused a number of problems, including their promises, leading to a steep fall in the the rate at which funds are exchanging their stock market and seriously undermining shares for vouchers. Mlost funds are issuing the credibility of the nascent capital mar- their own shares for a fixed number of kets in the eyes of the general population. vouchers (normally ten shares for each To prevent this kind of scenario in Russia, voucher), with little or no attempt to up- Russian voucher funds were forbidden date the price of their shares on any net as- from making guarantees. set valuation basis. Thus, one group of Still, there are many examples of mis- shareholders is being short-changed at the leading claims. Indeed, a large number of expense of another. If a fund's assets are unlicensed funds are operating. There have worth more than the price at which that been a number of scandals in which fund fund's shares are being sold, shareholders' shareholders have been defrauded. investments are being continuously dilut- Recently the GE has made strides in im- ed, whereas if the fund's assets are worth proving good practice in the industry. A less than the price at which fund shares are Funds Monitoring Unit was set up in being sold, then future shareholders are be- NIoscow to collect information on developing short-changed. Funds have claimed ments in the industrv from oblast KIs, ana- that they are prevented from changing their lyze funds' financial statements, and prices because of a NMinistryof Finance reg- initiate action against unlicensed funds and ulation that prevents shares of the same is- other illegal behavior. Two trade associa- sue being sold for different prices. If they tions have been formed, the Association of did not engage in these semicontinuous Investment Funds and the League of subscriptions, this problem would not oc- Investment iManagers. The latter has self- cur. The situation is further complicated by regulatory status with the GKI and the the fact that no attempt is made to recalcu- Ministrv of Finance and was modeled after late share prices (the ratio at which fund the ASD in the U.S. and the CIDA in shares are exchanged for vouchers) with Canada. the voucher market price. Thus there is lit- The connections between banks and tle relationship between fund share prices the voucher funds are looser in Russia than (to the extent that the' exist) on the pri- in the Czech Republic. In the Czech marv or secondarv market and net asset val- Republic, a small number of privatized for- ues. Indeed, so long as funds engage in mer state banks dominate the banking sec- semi-continuous subscriptions, they have tor. All major investment management little interest in seeing, a secondary market companies are owned by the big banks. in their shares emerge. Thus, through their direct credit relation- Like their Czech and Slovak counter- ships and their influence over investment parts, funds have been agoressive advertis- funds, Czech banks have emerged with a

AN OFTR%`I'.,()F PR1VA1ZYA1i(iNIN Rtv.i.', 19

large amount of control over enterprises. In in other oblasts. At that auction, authorities Russia the banking sector is fragmented. verify the receipt and confirm it has not There are over 2,000 banks, most of which been used in another auction. On verifi- are privately established. Although Russian cation, the voucherholder's account is banks have established funds, they do not debited. This depository system relieved the dominate the fund industry. voucherholder of the need to carry large numbers of vouchers around the country. Vbucher auctions In addition, an 'All Russia Auction Center" has been in place since March Most state enterprises are sold locally, 1993. Although the center is based in though a national and inter-oblast auction Moscow, auctioned enterprises can come scheme has been created. In a typical re- from anywhere in Russia and can be sold Russian interest gional auction, the shares of between five concurrentlv through a large number of groups or stake- and twenty enterprises are sold. Bidders oblasts. Twelve regions participated in the must report to the voucher auction center first auction of Zil, the car manufacturer, holders (workers, or to a satellite bid center within a specified and the national auction scheme has grown managers, bureau- period-normally two to six weeks. In the since to include 72 regions. The center is re- crats, politicians, voucher auction, voucherholders have two served almost exclusivelv for the largest en- choices. They can submit anv number of terprises, almost all of which are or investors) have vouchers, not specify the number of shares federally-owned properties. Initially, the a keen interest in they expect, and accept the strike price that choice of whetherto go through the nation- privatization, clears the auction (type 1 bid). Or they can al auction center was voluntary, but since submit any number of vouchers with a spe- October 1993it has been mandatoryfor en- given the possible cific maximum price, that is, the maximum terpriseswith capitalover 250 millionrubles rewards. number of shares per voucher (type 2 bid). as ofJanuary 1, 1992.Almost all of these en- Those who bid at or above the strike price terprises are outside the mandatoryprivati- are then allocated shares. Those who bid zation category because of their size, and below the strike price do not receive any instead fall in the categoryrequiring federal shares and have their vouchers returned for GKI approval.Because of the politicalclout use in a future auction. the sheer size of the enterprise gives them, There is a large variationin the speed at managers of these enterprises have con- which regions hold auctions. Determined siderable discretion over their passage opponents can stall privatization, prevent through the privatizationand national auc- shares from being sold to voucherholders tion process. In many cases they are able to from outside the region, or both. By March negotiate special terms not available to 1994, some regions had sold shares in over firms privatizedon a localbasis. In addition 370 state enterprises, while others had sold to the national auctioncenter, a more limit- shares in less than 20. ed inter-oblast voucher auction has been As auctions took place, the government created in whichthe shares of an enterprise became concerned that the intra-oblast na- in one oblast are offered to voucherholders ture of the auctionswas helpingthose forces in at least three regions.There are no re- seekingto fragment the RussianFederation. quirements regarding whether a property It was thought that if inter-oblastholdings has to go through this limited inter-oblast could be encouraged, the unity of the auction, but it appearsthat most have capi- Federation would be strengthened. Thus a tal of about 100 millionrubles. voucher depositorv scheme and a national auction network were introduced during Publ/c informatzoncampatgn 1993 to facilitate inter-oblastholdings. The voucher depositorv scheme consists of 30 Privatizationis an intenselypolitical process centers around the country;it allowsvouch- everywhere,including in Russia.Russian in- er holders to deposit vouchers at one of the terest groupsor stakeholders(workers, man- centers in exchange for a receipt. The re- agers, bureaucrats,politicians, or investors) ceipt is used to bid at a voucher auction held have a keen interest in privatization,given

20 RUSSiA:CREAI1NG PRIVATE ENTERPRISESAND EFFWICENTrNARKETS

the possiblerewards. Policvmakers felt that privatization as a defensive measure; it there was a need for an information cam- served to ensure that outsiders did not gain paign to mold the public into a constituency control. The fact that many medium-scale with a clear interest in pushing forward the enterprises chose the large privatization program. scheme is indicative of the certaintv that it The campaign had to overcome indif- provides against outsiders gaining control ference and hostility to both economic re- of the enterprise. Of the closed-subscrip- form and privatization. Various media were tions options, option 2, which gives insiders used in the campaign-advertising on na- immediate majority control, is the most tional television, on the radio, in print, and popular; 78 percent of medium-sized en- in prime-time weekly programming devot- terprises took this route. Option 1 was ed specifically to privatization issues. chosen by 18 percent of medium-size Regional information offices were set up enterprises. This option was usuallv chosen By March 1994, and regional training seminars held. An when the company was too capital-inten- over 8, 700 educational brochure, "Privatization in sive to buy outright (which is presumably Your Pocket," was produced, and mass why the percentage is higher for large en- medium-size publicity "privatization days" were orga- terprises) or when managers feared giving enterprises had nized. The campaign was split into phases. workers voting shares. been privatized The first was an aggressive promotion of the voucher-distribution program. The sec- Voucher auctions through the ond distinguished privatization from hyper- large-scale inflation (which many thought stemmed By October 1992, even though vouchers privatization from pnrvatization) bv portraying privatiza- were being distributed a month ahead of tion as the principal means for economic schedule, little progress had been made on process. change. The next phase dealt wviththe irre- bringing enterprises to the market. So at the versibility of privatization. In this phase, the end of October the federal GKI asked local campaign moved beyond discussing vouch- Kls for enterprises that had already been ers by highlighting the national voucher corporatized, transformed into joint stock auctions and identifying privatization suc- status, and were ready, at short notice, to cess stories. take part in voucher auctions. Bolshevik Another use of public information was Biscuit Company, a cake and confectionery to increase transparencv in privatization. baker based in Moscow, was chosen, after The privatization law required advertising hurried negotiations with its management, for enterprises that were to be sold in na- to be the first company to go through the tional or local media. Additionally, at bid auction. It was done at breakneck speed in centers, information on companies to be December 1992, amid a blaze of publicity auctioned was provided (such as sales and and considerable Western technical assis- export figures, number of employees, ma- tance. In that month, eighteen enterprises jor products, and so on). Xhile this re- from eight oblasts or cities (including IIos- quirement increased the cost of the public cow, Vladimir, Yaroslavl, and Perm) repre- information program, it was critical to senting a variety of industries (including keeping privatization transparent. The pro- trucking, cement, and microchip produc- vision of public information also signified a break from the communist past. Table 2.1 Overview of corporatization in Russia,March 1994 Large enterprises Medium-sizeenterprises Total Progress of mass privatization Number Number Number Method chosen of firms Percent of firms Percent of firms Percent

Corporatization Option 1 758 33 1,551 18 2,309 21 Option 2 1,377 60 6,748 77 8,125 74 By Miarch 1994, over 8,700 medium-size Opton 3 22 0 83 0 610 0 enterprises had been privatized through the Unknown 125 5 348 4 473 4 large-scale privatization process (table 2. 1). Totalnumber of firms 2,284 8,734 11,018 This was mainly because insiders perceived Source GKI/RPC PerformanceCenter

AN OxT.RExmwol PPRIVA1`IZXoNIN RuSSIA 21

tion) went through the process. By March The figures become more dramatic 1994 some 9,500 enterprises in 81 regions, among individual enterprises (Boycko, accounting for 10.8 million workers, had Schleifer, and Vishny 1993). Zil, the au- sold shares through voucher auctions tomaker, with more than 100,000 employ- (table 2.2). It is estimated that of the ees, a readv market for its goods, and vouchers submitted bv April 1994, 80 mil- substantial real estate holdings, is, accord- lion have been used in closed subscrip- ing to the voucherauction, worth only $16 tions and voucher auctions and 5-10 million.The second most valuable compa- million have been used in small-scale pri- ny that was auctioned by June 1993 was a vatizations, leases, FARP housing, and so Moscow hotel with 154 employees. Ural- on. By May 1994 some 45 million vouch- mash and PermskyMotors, each with over ers had been collected bv voucher funds, 30,000 employees,are valued at $7 million Bolshevik Biscuit of which 27.6 million have been invested. and $4 million, respectively. Boycko, Company... was Shleifer, and Vishny argue strongly that Assetvalues these low valuationsare a result of the po- [auctioned] at sition of outsiders in relation to insiders breakneckspeed in Calculations based on voucher auctions and the government. They point out that December 1992, and the voucher market price show asset much of the value of an outsider's stake in valuations to be uniformnlylow. This sug- a company is expropriated by insiders, ei- amid a blaze of gests either a worthless capital stock or ther through workers' demands for high publicity and (more plausibly) that most wealth is re- wages,managers making asset sales to their considerable tained by insiders. own companies, illegallychanging share- Russianassets should be valued based on holder charters, and rigging shareholder Western technical an aggregate and on an individual basis. meetings,and governmentregulations, tax- assistance. Assumethat the assets sold at auctions are es, restrictionson layoffs,and so on. Paying representativeof Russianindustrv as a whole. dividends to outsidersis a low priority.With BvJune 1993, 15 percent of Russian indus- so few shareholders' rights, it is not sur- trv had gone through voucher auctions, sell- prising that the worth of minority stakes is ing an averageof 20 percent of the equity seriouslydevalued. (about 3 percent of all Russian equity) for S150 million.This implies that the whole of Skareownership Russianindustry is worth just $5 billion-the value of one U.S. Fort,une 500 company Mianagersand workers have been aggres- (Boycko,Shleifer, and Vishnv1993). sivein consolidatingtheir shareholdings,us-

Table 2.2 Voucher auctions in Russia,December 1992 to February 1994

Number of Chartercapital Weightedaverage Vouchers Weighted Number of Number of employees sold (millions chartercapital accepted average enterprisessold regions (thousands) of rubles) sold(percent) (thousands) auctionrate'

December 1992 18 8 44 513 17 158 3.2 January 1993 107 21 189 706 12 229 3.1 February 1993 197 30 206 1,629 19 612, 2.7 March 1993 436 51 536 5,160 25 2,202 2.3 April 1993 612 61 829 6,528 23 4,158 1.6 May 1993 581 53 609 5,306 21 4,305 1.2 June 1993 897 74 812 7,209 18 4,360 1.7 July 1993 907 62 754 8,170 23 6,641 1.2 August1993 894 66 924 6,903 21 4,255 1 6 Septemcer 1993 786 66 838 7,123 20 4,745 1.5 October 1993 963 74 906 8,289 19 4,557 1 8 November 1993 883 64 1,021 8,461 19 2,832 3 0 December 1993 1,047 65 1,101 9,635 19 4,002 2.4 January 1994' 643 66 746 11,552 23 3,925 2.9 Februar, 19941 475 53 1,333 14,636 24 3,920 3.7 Total 9,446 82 10,848 101,551 21 50,091 2 0

a Thousandsof rubles share per voucher b F,qure; for Janjary and Februaryof 1994 are pre minary Source CK /RPC Performance Center

22 RussLA:CREATING PRIVATEENTERPRISES AND EFFICIENTMLARKETS ing voucher auctions and the secondary the corporate governance landscape for market to pick up further shares.The effect some time to come. of this activityis clear from two recent survevs (table 2.3)19 The Blasi survey shows Small-scalepnzvatiZati.on that, on average, 70 percent of a privatized enterprise's equity ends up in the hands of Control over the small-scale privatization insiders, and of that, 17 percent is owned by program is concentrated in the hands of management. Of the remaining30 percent, municipal authorities. This was a result of a 16 percent is held by local property funds. December 1991 presidential resolution on Even so, outsiders have been active in the division of state property (and hence re- the voucher auction process. Outsiders sponsibility for privatization) between the hold about 14 percent of enterprise shares, federal, oblast, and municipal authorities. of which 9.5 percent is with large share- Essentiallyall small-scaleenterprises (such holders-investment funds, wealthy indi- as retail shops, cater-ingfacilities, and con- viduals, and private firms and, to a limited sumer services)were transferred to munici- extent, foreigners. palities. Given the sheer number of small An interesting feature has been the ex- enterprises and the time scale envisaged,it tent to which managers have increased was technicallyand politicallyunfeasible for their stakes. In the closed subscription, the federal authorities to carrvout the small- managers would have received somewhere scale program. between 5 and 10 percent of an enterprise's equitv. After bidding in voucher Scope.The 1992 annual state privatiza- auctions and buying shares from workers, tion program placed heavy emphasis on their holdings rose considerablv.Their in- small-scaleprivatization. Wholesale and re- fluence is not limited to equitv ownership tail networks in the marketing of industrial alone. Often workers' collectives have goods, catering facilities (restaurants and thrown in their lot with managers, pledging cafes), and consumer services, along with their shares to managers either informally or wholesale and retail networks from other in- forimally (through trust arrangements). dustries that had a significant number of Insider ownership, with managers in the dri- small enterprises, were placed in the man- ving seat, will be an inescapable feature of datorv privatization category.

Table 2.3 Distribution of shareholders, Blasi survey (percent)

Insiders Property Outsiders Typeof firm Workers Managers Total Fund Small Large Total Option

Food 20 60 80 0 15 5 20 2 Z I (auto manufacturer) 35 5 40 25 15 20 35, 1 Machine tools - - 60 30 10 0 10 2 Radio 55 10 60 20 20 0 20 1 Tru.cking 90 3 93 0 3 4 7 1 Chalk 55 5 60 31 0 9 9 1 Trucking - - 80 20 0 0 0 . 1 Steel 89 11 100 0 0 0 0 Lease Steel 29 35 64 10 3 23 26 2 M,1etal 66 18 84 0 15 1 16 2 Furniture 46 5 51 49 No voucher auction yet 2 Textile 92 5 97 0 3 0 3 WAnomen'swear 90 - 90 10 0 0 0 1 M4achinetool 33 18 51 30 1.5 17.5 19 2 Pasta 57 4 61 20 - - 18 2 Viheat 28 45 73 18 8 1 9 2 Department store 10 30 40 20 12 28 40 1 Tricking 45 30 75 22 2 1 3 1 Trc.irng 58 5 63 30 6 1 7 2 Mean 53 17 69 1 6 - - 13

- Indicates data not aval.abieor not meaningful a Tre average number of empioveesof the firmssurveyed was 6,897. uz.rce Boycko,Shleifer, and Vishny 1993)

0V\OER\`I 1)'0FPRIuV.1tz.A10tN IN RL,SSLA 23

Russia'ssmall-scale privatization is larg- with the option to buy after a year. Federal er than in other Eastern European coun- authorities, however, have not indicated tries. The GM estimated the number of the valuationmethodology and legal proce- retail and serviceoutlets at the beginning of dures by which the premises can be sold. 1992 was about 270,000, of which a third This gap has effectivelystalled the follow- were in the mandatoryprivatization catego- on sale of enterprise premises, even though ry. Given the exclusionof many enterprises there are thousandsof bidders who (in the- from the mandatorycategory measuring the ory) can exercisetheir option. This has led extent of the program is difficult. to a reluctance by entrepreneurs to take part in auctions and tenders. Framework.The 1991 privatization law Privatization legislation also provides and the 1992 annual state privatizationpro- for liquidation of small enterprises. In this gram outline the main features of the small- case, a businessis halted, its bank accounts scale program, leavingmunicipalities to fill closed, employeesdismissed, and all assets in the details.The legislationstipulated that sold. All liabilities are transferred to the small enterprises were not to be corpora- municipalauthorities and paid off with the tized (unlike large-scale enterprises) and proceeds raised from the sale of the assets. were to be sold for cash through either an Apart from a few progressive municipali- auction or commercial tender. In auction, ties, liquidationhas rarely been used. the enterprise is sold to the highest bidder, Bidding is open to all interested do- with no special conditions attached. AUpo- mestic parties,such as workers' collectives, tential bidders have to preregister, deposit Russian firms, or individuals. Foreign par- 10 percent of the price as a sign of good ticipation is allowed only at the discretion faith, and bid in person. of the municipal Soviet, which effectively Ilhe tender process gives municipalities excludes foreigners. Federal legislation greater discretion, which thev have been gives workers and managers substantial quick to use. They can impose post-privati- privileges.If they bid successfully,they re- zation conditionson potential bidders, with ceive a discount on the purchase price; if the highest bidder satisfying these condi- they are unsuccessfulor do not bid, they re- tions acquiring the enterprise. Restrictions ceive part of the cash from the sale. Toqual- can cover emplovment,investment, change ify for the bidder's discount, at least a third of business profile, the financing of social of the employeesmust form into a partner- programs, and the preservation of histori- ship or joint stock company. cal buildings. Bidding can be open or If the employees'bids are successful, closed. Commercial tenders have been they get a 30 percent discount and can pay used for most sales.The two most common over three vears, with a down payment of restrictionsare a moratorium on layoffsand not less than 25 percent of the purchase on changingthe line of business. There was price. Given that there is no adjustment for a failed attempt at the federal level to im- inflation, the three-year payment period pose a three-yearlimit on post-privatization dramaticallv reduces the real value of the restrictions. Such restrictions can be in purchase price.If the emplovee partnership force from between one and fifteen vears. or company does not wvinthe bid (or does Because of the limited liquidity of the not bid) in an auction, thev receive 30 per- Russian real estate market and the low val- cent of the cash proceeds, up to an individ- ue of the enterprise's other assets, usually ual limit of twenty times the national accessto real estate is the only asset of real minimum monthly salarv If a competitive value that ownership of a privatized small tender was held, employeesreceive 20 per- enterprise brings. Federal legislation has cent of the purchase price, up to an indi- stopped short of giving entrepreneurs the vidual limit of fifteen times the national right to buy the premises on which an en- minimum wage. terprise stands. For residential or multiunit buildings,a successfulbidder acquires the Progressreport. Small-scale privatization right to lease the premises for fifteenyears, started in the city of Nizhny Novgorod

24 RuSsiA: CREATING PRivAT ENTERPRISESAND EFFICIENT MARKETS

(With considerable assistance from the * Yakutsk (Sakba Republic). No auctions Table 2.4 International Finance Corporation) in April or tenders have ever been held and Methodof 1992, nine months before the large-scale small enterprises were sold exclusively privatization Percentage program began. Nizhnv Norgorod was cho- to workers' collectives. Auctions 20 sen as a pilot city because of the political Taganrog(Soute Central region). Almost Commercialtender 50 commitment of the oblast and city authori- all of the small enterprises slated for Leasewith rights to buy 30 ties (both executive and legislative) to pri- privatization were leased under Gor- vatization. In April 1992 alone, some 6,700 bachev's leasing policv One lease enter- small-scale enterprises were sold through- prise was an eighty-sevenstore monopoly out Russia. The municipality patently failed to break- Since then, Russia has made progress, up a torg. though it is apparent that small-scale priva- * Vladivostock (FarEast region). The torgs tization has not catalyzed the growth of the were not liquidated, but reorganized small-scale sector. The GE estimated that and leased to the workers' collectives. by MLlarch1994, 75 percent of the 94,300 This has left few enterprises that can be wholesale and retail networks in the 1992 sold through auction or commercial mandatory privatization categorv had been tender. The IFC is exploring ways of privatized. Another 30,000 nonretail enter- dismantling the torgs. Mlunicipal offi- prises can be added to those estimates, cials have introduced an additional making a total of about 100,000. eightv enterprises into the privatization The mixed success of the program can pipeline and are looking at ways of in- be attributed to several causes. First, the troducing another 500 previously ex- number of small enterprises per capita and cluded enterprises. per unit area in Russia was low to begin PPetropavlovsk-Kamchatski (Far East re- with. This has been compounded by ex- gion). The authorities sold only unprof- cluding a large number of enterprises from itable enterprises and held profitable the program. Second, even for those in- ones. The mayor has also recentlv trans- cluded in the program, the nature of their ferred responsibility for privatization privatization has been uneven. It was orig- from the KI to a department reporting di- inallv hoped that many of the practices recdy to himself, stalling privatization. adopted in Nizhny Novgorod (such as * Nakhodka (Far East region). The city K[, transparent procedures, the exclusive use department of trade, and the municipal of auctions, lack of restrictions, and the liq- Soviet excluded forty of the city's lar- uidation of enterprises prior to the sale of gest enterprises from privatization "to assets) would serve as a model for other demonstrate the city's ability to manage municipalities. But with few exceptions, property and trade enterprises." this has not happened. GMl figures illus- * Ptomaine (Western Siberia region). The trate this (table 2.4). municipal Soviet removed sixty small en- Commercial tenders have clearly been terprises from the program. Moreover, the favored technique. Mlore than two- the municipal Kl is interested in estab- thirds of auctions and tenders have been lishing "mixed enterprises," in which it won by workers' collectives. There are nu- retains an equity stake. Those enterpris- merous instances of post-privatization re- es that have been sold have been placed strictions on changes of business profile under particularly onerous conditions. In and employment. It is estimated that more the case of one cafe, the KI went so far as than 90 percent of auctions and tenders to insist that each servingof dumplings be have been of enterprises as going concerns, limited to 200 grams per customer. rather than liquidation prior to sale. * Voronezb (Central region). eighty percent The International Finance Corporation of the municipalitv's enterprises have estimates that 14 percent of all municipal been leased with right-to-buy provisions objects have been removed from the priva- by the workers' collectives. Some of tization process. It has also identified many these enterprises, on privatization, have abuses: tried to resurrect the old torgs.

AN OVERVIEW OF PRIVAnAnTON IN RUSSLA 25

* Xhlogda(North region).The municipal creditis poor and wholesalesupply and trans- Sovietflouted federal legislationby sell- portation conditionsare unreliable.It willbe ing all enterprises to workers' collec- critical for municipalitiesto drasticallyre- tives for book value without using duce both their involvement in the running auctions or commercial tenders. of small enterprises and the tax burden, and take up the supervisory roles more tradition- Conclusion. The problem of the small ally associated w,ith municipal authorities in number of retail outlets has been com- the West, such as trade promotion, encour- pounded by a failure to privatize what there agement of investment, and so on. Only if is and to privatize it efficiently To rectify the progress is made on all these fronts will situation, privatization procedures should Russian consumers benefit from the flour- be modified, the connection between priva- ishing small-scale private sectors that are a The problem of the tization and a commercial real estate market feature of other Eastern European countries. small number of strengthened, and the business environment for small scale entrepreneurs improved. 1994 program retail outlets has To increase the privatization pipeline been compounded torgs should be liquidated, enterprises ex- The 1993 privatization program was never by a failure to cluded in the 1992 privatization program enacted because of political opposition. should be brought in, and the scope of the Instead the 1992 program remained in privatzze what there 1992 program must be widened. force. The 1994 program retains the same is and to privatize it But privatization is only one input into structure of the 1992 program, in part clari- efficiently. the development of the small-scale private fying the 1992 program, in part incorporat- sector. Another is a liquid commercial prop- ing the presidential decrees issued in 1993 in emr market. Because of a lack of supporting lieu of the 1993 program, and in part adding legislation, privatization has become a surro- new components. New components include gate for such a market. But given the restric- bringing new industries within the scope of tions placed on changes in business line and the program (such as agro-industries) and the bias toward workers' collectives, it is a giving a mandate to develop privatization poor one. Federal authorities should quickly programs in others (such as health care). lav down the methodology by which owners Further, the 1994 program clarified and of privatized enterprises can buy premises strengthened shareholders' rights. Changes and allow these owners to sell or lease their to a joint stock company's charter now re- propertv. This will lay the basis for the emer- quire the approval of holders of three-quar- gence of new businesses (though restrictions ters of the company's equity The same is on changes in business profile will continue true for a change in the company's capital. to slow down reallocation of resources). All limitations on the sale of shares in an Allowing owners to buy their premises would open joint stock companv are now forbid- underscore the federal authority's commit- den, and companies with more than 10,000 ment to not changing the "rules of the shareholders must have a board with at least game." In contrast to Western retailers, who nine members, of which no more than a rarely owvntheir premises, but who have well- third can be employees of the company defined and legally enforceable property In addition, new rules were included for rights, Russian entrepreneurs are likely to specific types of investors. Thus, the limit on have hostile municipalities as landlords. the stake a voucher fund could hold in any The way in which municipalities have one enterprise was increased to 25 percent, conducted the privatization process does not a recognition of the widespread flouting of bode well for the future. It is not just a ques- the previous 10 percent limit on voucher don of post-privatization restrictions; entre- funds. Restrictions were placed on banks, preneurs also usually face excessive currentlv one of the most profitable and municipal taxes as well. For example. busi- cash-rich sectors in Russia. There was signif- nessmen in Ornol, a city in the Central region, icant anecdotal evidence that banks were us- face citv taxes of up to 48 percent of profits, ing their cash resources to buv up large with federal levIes on top of that. Access to amounts of equity Banks are now forbidden

26 RutSsi,: CRI:ATTM&PRIVA1 E ENTERPRISESAND EFFICIENT .MARKETS

to own more than 10 percent of an enter- and false trades. Little or no self-regulation prise's equitv and cannot have more than 5 has emerged, and mistrust of exchanges is percent of their assets in the shares of any widespread. As a consequence, the ex- one enterprise. changes are becoming less relevant, at least for the equity market. The Moscow Central Capitalmarket development Exchange,the oldest and one of the largest Russian exchanges, had a 1993 turnover of In contrast to the privatizationprogram, in just 780 million rubles-less than $1 mil- which both the rules and impetus were gen- lion. Most trades (up to 85 percent) are erated bv the center (and the implementa- conducted through the over-the-counter tion left to local agents), the development market. Most of the activity on this market of much of Russia's capital markets over has consisted of brokers accumulating the last three years has been initiated and blocks of equity for enterprise managers ... the development implementedby private sector interests. To wishing to increase their shareholdingsin of much of Russia's a large degree this should be welcome,but their own companies. this development has taken place against a In addition to managersand investment capital markets backdrop of little effective government or funds, banks have also been particularlyac- over the last three self-regulation.The lack of central direc- tive in acquiring equity in privatized enter- years has been tion can be partiallyblamed on the division prises.The most liquid stocks in Russia(or of regulatoryresponsibilities between vari- those that have the appearance of being the initiated and ous bodies, such as the GKI, the Central most liquid) are bank shares. These banks implemented by Bank, and the Ministry of Finance. Thus are not privatized state banks, but instead private sector the GMIis responsiblefor licensingvouch- have been privatelyestablished. In manycas- er investment funds, the Ministry of es they have built their capitalbases through interests. Finance for brokers and all other types of primaryissues. Indeed, manyhave had more investment funds, and the Central Bankfor than one issue.In a sense,many appear to be banks. But a Russian Securities and Ex- in a continuous subscription mode. A large change has recently been established on number of these banks (through their bro- which all the relevant central bodies have kerage operations) make markets in their representation and work has begun on own shares, and given the extent to which building both an institutionaland regulato- these banks are issuingprimary stock, they ry framework. have a prima facie conflict of interest be- Russia's numerous regional exchanges, tween their position as a primaryissuer and some of which appeared as early as 1990, their position as a dealer in their own shares. were all privately sponsored. These ex- Given that nascent equitymarkets (both pri- changes initially focused on trading com- mary and secondary) are driven by players modities, ranging from grain and metals to who have little interest in seeingtruly liquid auto parts and computers. With the distri- and transparent markets appearing,it is not bution of vouchers in 1992, most of these surprising that they have not appeared. exchangesmoved into vouchertrading, and Efforts have begun to rectifythis situationby with the acceleration of the privatization bypassingthe privatelysponsored exchanges. program in 1993, most now make markets The Russian Securities and Exchange will in the shares of privatized enterprises. sponsor the creation of NASDAQ-typeex- Alongwith the creation of these exchanges, changes in Moscow and St. Petersburg. numerous brokerages have been estab- Along with growth in trading, develop- lished. It is estimated that by the end of ment in the capital market infrastructure 1993, there were 200 to 300 brokers in has occurred, such as registrars, deposito- Russia,with many established by banks. ries, clearing agents, and settlement cen- Though exchanges have proliferated, ters. But it has been haphazard on both an best practices on the exchanges have not. institutional and regulatory front. For ex- There is little real liquidityand transparen- ample, most enterprises wiUmaintain their cy on the exchanges.There is anecdotalev- own share registry, a source of obvious idence of considerable price manipulation abuse. Or brokers, with management's

A.NOVERVIEW OF PRRATILAnTONIN Russi, 27

support, combine the role of registrar and August 1993, the Central Bank announced the main market-maker in an enterprise's that non-Russianentities would be allowed, stock. Further, few companies have issued for the first time, to buy rubles on the for- share certificates,entry in the share register eign exchangemarkets and open ruble ac- being the main form of ownership confir- counts in Russiafor investment. mation. This has lead to lengthy delays as Foreign investors could buy shares in investors(or their brokers) check share reg- the secondarv market from workers and isters before clearing trades. Steps are now managers. The problem is that the embry- being taken to improve practices within the onic secondary markets (and insiders' re- registrar industry.An enterprise with more luctance to part with shares) make it likely than 1,000 shareholders must now have an that this approachwill take a considerable outside registrar (though there are few re- amount of time. A foreign investor could ... the new entities sources currently devoted to ensuring en- conceivablybegin negotiations with an en- must be forcement). Twenty-five to thirty best terprise beforeit goes through corporatiza- practice third-partyregistrars are to be cretion and trv to securean equity stake ahead restructured to run ated across Russia and a Registrar Support of privatizationor bid in a commercial or more efficiently, Center, which is to form the nucleus of a investment tender. The success of any of and enjoy the self-regulatoryorganization, is to be estab- these approaches depends on the circum- lished in Moscow.It is also envisaged that a stances of each enterprise and the enthusi- benefits of registrar specializing in companies with asm of managersand local authorities. corporate more than one million shareholders (of Despite the hurdles faced by foreign in- governance. which there are around sixtyto eighty com- vestors, a number of venture capital funds panies) will be created. For clearing and have been established in Russia. In addi- settlement, a best practice system is to be tion, the RussianPrivatization Center and established in Moscow and St. Petersburg, the Group of Seven are coordinating ef- the intention being to replicate the system forts to set up other equity funds under the in two other cities. auspicesof bilateraldonors. The U.S. gov- emnment,for example,has established the Foreigninvestment Russian-AmericanEnterprise Fund, similar to those established earlier in Hungary, Legally,the Russian privatization program Poland, and the Czech Republic. It has al- does not discriminate against foreign in- so establisheda seriesof funds through the vestors. In reality, there is a built-in bias Overseas Private Investment Corporation against outsider ownership, be it domestic (OPIC) for capital-intensiveindustries and or foreign.The 1992 privatization program a fund for defense conversion.The Euro- broadly treats foreign investors as it does pean Bank for Reconstruction and Deve- domestic investors. There are restrictions lopment and the International Finance related to foreign ownership in strategic in- Corporationhave created a number of ven- dustries such as fuels, energy,minerals, de- ture funds throughout Russia. fense, or certain small-scale industries The establishmentof a liquid secondary (wholesaleand retail trade, public catering, market is vital to the successof such funds consumer services, auto transportation, because it provides an exit vehicle for the and construction). Approval is needed sale of equity holding in a given company. from the Russian government, the republi- Moreover,without a liquid capital market, can government, or the municipal authori- emergingmarket funds-a source of capi- ty for strategic industries. tal-will be unable to invest in Russia. There are no restrictions on foreigners purchasing vouchers per se, but there are Conclusion other hurdles. To acquire vouchers, a Western investor has to have access to "At present, many people do not seem rubles, and the onlypractical way to acquire to understand that real privatization is them is through ongoing operations. not over as soon as a mechanicaltrans- Progress has been made in this area. In fer of title has been made, even if po-

28 RUSSIA: CREATING PRIVATEENTERPRISES AND EFFICIENT NARKETS

liticallvthis is considered to be the pri- the need for extensive central oversight of mary task. Transferof title is only the the process in general, and the need for ex- initial and largely superficial stage of tensive central reviewof privatizationplans privatization:the new entities must be in particular, which the Czech and Slovak restructured to run more efficiently, programs required. Indeed, decentraliza- and enjoy the benefits of corporate tion was central to the program'sspeed. The governance."(Federov1993 GKI laid down the ground rules for local oblasts to follow,using moral suasion, in- So wrote Boris Federov,the former Deputy centives (sale of shares for cash), and presi- Prime Minister for Finance and Economy dential decree to ensure implementation.It and a key reformer in the Yeltsingovem- never attempted to carry out implementa- ment. With a lack of progress on other tion itself.Had it done so, the process would fronts, privatization stands as one of the probably have ground to a halt. Decen- More important is few reforms to be carried out in Russia. tralization also emasculated the power of whether, after the Indeed, the sheer volume of "mechanical manv central branch ministries.With imple- transfers of titles" that have been carried mentation carried out on a local level, there transfer of title out indicates how successfulthe program was little formal role for many branch min- takes place, the has been. Clarifying the line of causation istries to play and little they could do to hin- privatization between the program's design and the ra- der the process. Thus a potential source of piditv of its implementation is a valuable delay was mostly eliminated. program has truly part of understanding what lessons can be Decentralization did bring its own prob- created a learned from the Russian program. But, as lems. With so many oblasts to monitor, framework within Federovstates, the volumeof transferof ti- whether local privatizationprograms fol- tles is only one criterion by which the lowed central ground rules depended heav- which economic Russian privatization program should be ilv on localattitudes. Abuseswere common, agents have the judged. More important is whether, after and there are wide discrepancies among incentives and the the transfer of title takes place, the privati- oblasts in the speed and scope of privatiza- zation program has truly created a frame- tion. In the more progressive oblasts, most means to carry out work within which economic agents have of the enterprises in the mandatorycatego- the restructuringof the incentives and the means to carry out ry have been sold, whilein others, privatiza- Russian enterprises. the restructuring of Russianenterprises. tion has not yet reached the halfwvaymark. The most strikingfeature of the Russian In vet others, privatization rates fall well privatization program is its speed. A large below even halfway.Likewise, though depart of this is explained by the privileges centralization considerablvreduced the in- granted to insiders. With so much equity fluence of many ministries, it did not availablefor so little cost, this is not surpris- eliminate it. Keystrategic ministries such as ing. But other facets of the program's design oil, gas, defense, and so on were able to ex- also helped expedite the process. First and empt certain large enterprises within their foremost, like the Czech Republic and range of control from the mandatorvsection Slovakia,Russia adopted a mass privatiza- of the mass privatizationprogram. In these tion program.Thus, they immediatelyside- industries, the ministry,in conjunction with stepped the problems of Hungary and managersand to a lesserextent workers,has Poland, which laid primary emphasis on a been able to dictate the nature and speed of mixture of trade sales and IPOs. The case- privatization with little outside scrutiny. by-casenature of these methods has meant There are no publiclv available figures on that in both countriesprivatization has been the number of enterprises that have been extremelyslow, with considerableloss of po- excluded from the large privatizationpro- litical capital and momentum. Unlike the gram, though it is not unreasonable to Czechs and the Slovaks,however, Russian assume that they number in the thousands. reformers restricted the menu of privatiza- In addition, numerous enterprises were tion options availableand made no provi- "grandfathered" into privatization under sion for competing privatization plans. the leasing law established during the Russian policymakers thereby eliminated Gorbachev reforms.

A'; OVRVI-E'XOF PRIVATIZATI71N Rt sSIA 29

The manner in which vouchers were closed and open subscription and through distributed also contributed to the speed of secondary-market acquisitions, has meant the program. Setting the price at which that insiders have emerged from the priva- vouchers were sold to the public so low tization program in Russia in a far more clearly led to a rapid distribution. Further, dominant position than elsewhere. This will the distribution of vouchers at the earliest have serious consequences. First, there is possible opportunity not only jumpstarted the conflict of interest betwveen insiders' the program, but helped ensure its irre- role as employees and their role as share- versibilitv. Once vouchers ,vere in the holders. Any internally generated restruc- hands of the general population and the ex- turing that threatens managers or involves pectation had been created that the vouch- large-scale layoffs will be muted. But the ers would be converted into shares, it was consequences of insider giveaways are ... state enterprises much harder for opponents of privatization much larger than simply the blunting of in- mugst be to reverse the program. Indeed, once sider incentives to restructure, because the vouchers had been distributed, the pres- extent of the insider giveawavs has circum- depoliticized to sure was on the GKI to move quickly on scribed the scope outside shareholders have make them respond voucher auctions. to influence and replace insiders. There has to the pressutresof Privatization, though a necessary step to- been no direct replacement of insiders as an ward restructuring, is clearlv insufficient. As immediate consequence of the Russian pri- the market rather Bovcko, Shleifer, and Vishny (1993) write, vatization program, unlike the Czech pro- than politicians." state enterprises must be depoliticized "to gram (which made explicit provision for it). make them respond to the pressures of the Thus the main channel for outside influence market rather than politicians." Privatization in Russia will not be voucher auctions, but alone will not raise sufficiently the costs to the development of liquid capital markets. politicians of interfering in the running of Of course, outsiders emerged through enterprises. To avert interference, an effec- the voucher auction process. There are sub- tive corporate governance svstem and an stantial numbers of Russian voucher funds economicallv rational mechanism for the al- and cash-rich private individuals and firms. location of capital must follow privatization. Potentially profitable firms have quickly at- Only then will commercial decisionmaking tracted their interest. In this context, al- be out of the reach of Russian politicians. Of lowing voucher trading has clearly proved course, the corporate governance and capi- beneficial in fostering the growth of large tal allocation mechanisms that evolve are not blockholders and is, as such, a useful anti- independent of the privatization program, as dote to the power of insiders. In this regard, might be the case say in a Western European it made a lot of economic sense to raise the privatization program. The nature of the 10 percent ownership limit on voucher Russian privatization program will critically funds to 25 percent in the 1994 program. affectthedevelopmentofRussia'scorporate Given the limits placed on outsiders in governance and capital market systems; or, the privatization program, if outsiders are to use Earle, Frydman, and Rapaczynski's ever to influence and overturn insiders, a (1993) more encompassing term, Russia's liquid, transparent, and vibrant equity mar- mass privatization program will substantial- ket combined with a vigorous market for ly affect its "private propertv regime." corporate control will be necessary Giving equity to managers and workers Progress toward these goals has so far been has been a feature ot most privatization pro- patchy. Though there are numerous pri- grams, hoth in and beyond Eastern Europe. vately sponsored exchanges throughout Insider equity holdings will obviously, to Russia, there is little liquidity or trans- some extent, align insider objectives with parencv. As a consequence most trading those of shareholders. As such, insiders will now takes place on the over-the-counter have a much greater interest in resisting the market. (The development of the market in costly interventions of politicians. Howvever, vouchers provides some comfort that the the amount of equity insiders (particularly obstacles to a liquid market in shares are managers) have emerged with, both in the not insuperable.)

30 Rl;ssIA: CREAnN6 PRrvATE ENTERPRISESAND Ei IICII-NT LARKETS

V ith resptct to the market for corpo- valuable asset mav turn out to be its lobby- rate control, wxhenoutsiders have threat- ing connections and power. ened takeovers, insiders have employed a The Russian mass privatization pro- variety of extralegal methods to repel them. gram must be seen as the first phase of re- One common source of abuse is the control form. It represents a transfer to new, private many enterprises have over their own share owners, wvhonow have the responsibility to re,istries, allowvingthe registries to ignore restructure and modernize their companies or misrepresent inconvenient trades. or to sell ownership on the secondary mar- Discipline so far has actually been provid- ket to agents who can restructure. To com- ed by outside majority shareholders or the pete in world markets, these companies discipline provided by the potential for a (noxwlargely decapitalized and obsolescent majority shareholder to emerge from a by Western standards) need access to capi- group of minority shareholders). tal markets. Russian managers must recog- Mukchhas already Further, and perhaps more important, nize that it is in their interests to raise been accomplished the intluence outsiders gain from their po- capital in secondary markets or to seek for- sition as minority shareholders is less than eign investors. ln a short time, blt would be expected. Aside from the prob- Over time, workers and managers of because of the iems that one might expect from a lack of firms that surv-ive transition will sell their nature of the minoritv investor protection rights and the shares to outsiders when they realize that risks of investingin an emplovee-dominat- thev can get a high price, and capital struc- Russianprivatization ed shareholdingstructure, the availability tures willgraduallv change. It is unrealis- program, much of cheapcredits from the CentralBank has tic to expect all of this to emerge from remains to be done. undercutthe powerof outsideminority in- mass privatization alone. The ultimate vestors.Lacking the powerof a majorityin- success of the privatization program is vestor, the major influence a minority closelylinked to a tightercredit policyand investor has is based on an enterprise's the developmentof capital markets, the need to returnto the marketto raisecapi- latter in part a function of the former. tal. So long as the Central Bank provides iMvluchhas alreadybeen accomplishedin a cheap credits."insiders have everyreason short time, but because of the nature of to distributethe profitsof the enterprisein the Russianprivatization program, much the form of wages,bonuses, and other remainsto be done. compensationsto themselvesrather than pay dividends to shareholders"(Earle, Bibliography Frydman,and Rapaczynski1993). Like- wise,with littleneed to oo to minoritvin- Boycko,Maxim and Andrei Shlejfer 1993 "The vestorsfor financing,enterprises have little VoucherProgram for Russia," in A. Aslundand needto restructure. R. Lavard.eds., Ckanging the Economic SYstem in In the absence of hard bud,et con- Russia.St Nlartin's Press. straints on enterprises,the impact of the Boycko,Maxim, Andrei Shlrifer, and Robert WX! wholeprivatization process will be serious- Vishn.1993. "Privatizing Russia." Paper pre- *y undermined.The weak positionof paredfor the BrookingsPanel on Economic Activitv. Russianminority shareholders is borneout Charap,Joshua,and Leila Webster. 1993. Sunev by the lowvalues that have been placed on of PrnateManubfcturers in St. Petersburg.Tech- stakes sold through voucher auctions. nicalPaper 228, World Bank. Washington. D.C. Withoutgreater control on the part of the Chubais,Anatoi; and Nlaria Vishevskava. 1993. CentralBank of its credit policy,Russia's "lain Issuesof Privatizationin Russia," in A. capital markets wvillremain moribund. Aslundand R. Layard,eds. Changingthe Indeed,considering the marketfor corpo- EconomicSystem in RussiaSt 'Martin'sPress. ratecontrol, if outsiderswere to gaincon- Commissionof EuropeanCommunities, Euro- and Develop- trol of an enterprise,the degreeto which ment,peanBankand thefor State ReconstruCtiOn Committeeot the Russian theywould deviate from insiders in lobbv- Federationfor the Mlanagementof State Pro- ing foraccess to CentralBank credits is a p (GK. 1993.The Privatization Manual, moot point.A managementteam's most vols.I and 2.

A\x0VViw( rSol PIV TZAIIO.xNN Rt->SIA 31

Debevoise and Plimpton. 1993. "Privatization in St. Giles, Mark and Sally Buxton. August 1993. The Russian Republic." draft. "The Role of Investment Funds in the Russian Djelic, Bozidar, and Natalia Tsukanova. 1993. Privatization Programme." London. Draft. 'Voucher Auctions: A Crucial Step toward Pri- The State Committee of the Russian Federation for vatization." Radio Free Europe.,Radio Liberty the Managementof State Property August 1992. Research Report. vol. 2 (30). "The Russian Privatization Program: A Guide The Economist. July 1993. "Russian industry: the For Foreign Investors." Draft. revolution begins." Thomas, Scott and Heidi Kroll. July 1993. "The Earle, John, Roman Frydman, Andrzej Political Economy in Russia." Draft. Rapaczynski, et al. 1993. "The Privatization World Bank. 1992. "Russian Economic Reform: Process in Russia,Ukraine and the Baltic States," Crossing the Threshold of Economic Reform." chapter 1. Central European University Press. Washington, D.C. Earle, John, Roman Frydman, and Andrzej Rapaczynski. 1993. "Transition Policies and the Notes Establishment of a Private Property Regime in Eastern Europe." 1. A more detailed analysis is provided in European Bank for Reconstruction and Develop- Gorbachev'sStruggle ]?r Economic Reform by A. ment. July 1993. "Privatization in Russia." Aslund. Discussion Paper for the Consultative Group in 2. Nellis (1991) points out that these numbers Paris. are likely to be underestimates, since a significant . April 1993. "Privatizing the Bolshevik number of enterprises are made up of subunits that Biscuit Factorv."Draft. in the West would be considered independent Federov, Boris. 1993. "Privatization with Foreign firms. Indeed, as privatization has got under way,a Participation." in A. Aslund and R. Layard, eds., significantminority of enterprises has splintered in- Changingthe Economic Svstem in Russia. St to smallerunits. Martin's Press 3. For a contrary view on industrial concentra- Harding, April. 1993. "Small-scale Privatization in tion in Russia,see Annette Brown, Barry Ickes, and Central Europe: Lessons for Europe." Draft. Randi S. Ryterman, "The Myth of Monopoly: A International Finance Corporation. 1992. "Nizhny New View of Industrial Structure in Russia," Novgorod: First Privatization in Russia." Draft. October 1993,World Bank. . 1992. "Small-Scale Privatization in 4. See chapter 10. Russia:The Nizhny Novgorod: Model (Guiding 5. The 1992 state privatization program, entitled Principles)." Draft. "State Program of Privatization of State and July-November 1993. "Russia: Small- Municipal Enterprises in the Russian Federation Scale Privatization Monthly Report." Draft. for 1992," was issued in conjunction with the October 1993. "Large-Scale Priva- "Amendments and Additions to the Law of RSFSR tization in Russia." Draft. on Privatization of State and Municipal Enterprises Lieberman, Ira. 1993."Poland's mass privatization in the RSFSR." program." World Bank. Draft. 6. For a more detailed comparison of these mass Milanovic, Branko. 1989. Liberalization and privatization programs, see Ira W Lieberman, EntrepreneurshipDy,namics of Reform in Socialism AndrewEwing, Michal Mejstrik, Jovita Nlukherjee, and Capitalism. New York:Armonk, MIE Sharpe. and Suhail Rahuja, "MIassPrivatization in Central Nellis, John. 1991. Improving the Performance of and Eastern Europe: A Comparative Analysis." Soviet Enterpnses Discussion Paper 118. The World Bank, forthcoming. World Bank, Washington, D.C. 7. The privatizationlaws and decrees sometimes - -.1993. "Bolshevik Biscuit in Private define large enterprises as those with over 1,000 H-lands."Transition Vol. 4 (2). The World Bank, employees and book value of over 50 million Washington, D.C. rubles, and sometimes as those with over 1,000 Phelps. Edmund, Roman Frydman, Andrzej emplovees or book value of over 50 million rubles. Rapaczynski,and Andrei Shleifer. March 1993. There is a similarinconsistencv in the definition of "Needed mechanisms of corporate governance small enterprise. and finance in Eastern Europe." Xbrking Paper 8. See section on small-scale privatizations 1, European Bank for Reconstruction and herein. Development, London. 9. The privatization plan included information Price Waterhouse.June 1993-March 1994. "Funds such as the firm's name, its location, the type of MonitoringReport." Draft, propertyit was(federal or obiast , its legalform, the Sawver/lMillerGroup. October 1993. "Priva- numberof workers it employed,basic financial in- tizationand PopularMandates: Using Commu- formationon the firm,its shareholdingsin other nicationsto Ensure SustainableReform." firms,its business activities, the productsit manu- Washington,D.C. Draft. facturesor servicesit offers,the outcomeof the

32 RUSSIA:CREATING PRIVATE ENTERPRISES AND EFFICIENT %IARKETS vote on the closed subscription, and an outline of 14. Emplovees may fail to subscribe for the full how equity remaining after the closed subscription allotment if the enterprise is particularly capital- is to be disposed. intensive. 10. "Interim Methodological Guidelines for the 15. It was only after vigorous marketing by one Valuationof Properties Targeted for Privatization," particular investment fund that participation grew issued as Supplement 2 to the "Acceleration dramatically In the end, almost three-quarters of Decree." those eligible collected their coupon books. 1 1. Holders of preferred shares receive fixed div- 16. In reality, the potential inflationaryimpact of idends of 10 percent of the previous year's profits. vouchers was a nonissue given that, because of oth- If the holders of the common stock receive higher er causes, inflation was in excess of 1,000 percent dividends on a per share basis than preferred share during 1993. holders, then dividends on preferred shares have to 17. GKI regulation of February 12, 1993. Note be increased to match those on common shares. this regulation refers to the percentage of each en- 12. Referring to the 25 percent nonvoting stock, terprise's equity that has to be sold specificallyin each employee cannot receive shareswith a book val- the voucher auction. The 80 percent rule refers to ue greater than twenty times the minimummonthly the total percentage of each enterprise's equity that salaryguaranteed by law.Referring to the 10 percent has to be sold for vouchers, including vouchers col- voting stock, each employee can not receive shares lected in the closed subscription, the voucher auc- with a book value more than sixtimes the minimum tion, and so on. monthly salary guaranteed by law. The minimum 18. A state company is defined as one that was monthly salary guaranteed by law as of July 1, 1992 more than 25 percent state-owned. was 800 rubles. This has since been adjusted. 19. Surveys have been carried out by Joseph 13. Options 2 and 3 were included in the privati- Blasi and Katarina Pistor of the GKI. Quoted in zation program because of the considerable lobby- Boycko, Shleifer and Vishny (1993) and in ing power of enterprise managers and workers.The Webster (1993). original program had only option 1.

A.NOVERVIEW OF PRIVAnTION IN RUSSiA 33

CHAPTER 3

Privatization in the Regions: Primorsky Krai AlexandraVacroux

The distance between Vladivostok,the cap- sions between municipaland krai-levelgov- ital of Primorskvkrai (region),and Moscow ermmentswithin regions. In addition, be- spans seven time zones and 5,778 miles. cause the privatization of bigger Soviet A study of Under communist rule, this geographical enterprises has stimulated more political lob- privatization in separation did not prevent Primorsky and bving and maneuvering than the sale of Primorsky krai nine other far eastern regions from being smallerestablishments, a discussionof large- fully integrated into the economic and po- scale privatizationin Primorskvkrai provides reveals more tbaii liticallfe of the former SovietUnion. Since insights into how the interactions between the difficult and the dissipation of the USSR, the highly cen- political actors (such as officials) and eco- evolving relationship tralized bureaucracyand Communist Party nomic actors (enterprise managers and en- structures that linked the regionsto the cen- trepreneurs)are shapingRussia's future. between the center ter have been all but eliminated.As a result, Primorskv krai is an interesting venue and the regions in Russian regions have had to adapt to a low- for a case study because it is both far from post-communist er level of economic support and a higher and important to Mloscow.The krai's strate- degree of politicalautonomy than before. gic location near key Asian markets, cou- Rtissia. Primorsky krai has adapted to post- pled with its three major ice-free ports and Soviet Russiain much the same wva'as less- valuable natural and industrial endow- distant regions.As before, regionalofficials ments, provide both Moscow and the re- still rely on personal contacts in federal- gion with an interest in maintainingcontrol level state offices to obtain financialand po- over local resources. While it is impossible litical support for residents and enterprises. to test any hypothesesor theories with a sin- As elsewhere, Primorsky officialshave de- gle case, a study in this pivotal region veloped new strategies to demonstrate and should yield suggestiveconclusions about augment local autonomy Designed to ex- how privatization is being implemented in tract the maximum amount of resources the Russian regions. from the federal government while ceding as little control as possibleover regional as- The economy of Primorskvkrai sets, these strategies are being applied across all policy areas, and have con- The Primorve area of Asian Russia forms tributed to growing antagonism between the western banks of the Sea of Japan. It regions and the central government. In shares borders with the Khabarovskvkrai in Primorskv krai, the power strugglebetween the north, China in the west, and North region and center has been particularly Korea in the southwest. Population esti- acute in the area of privatization. mates for the region converge at 2.3 million A study of privatization in Pnimorsky krai but probably do not take into account the reveals more than the difficult and evolving significant military presence.' Just over relationship between the center and the re- three-quarters of the population lives in ur- gions in post-communist Russia. It illustrates ban areas of the krai. the conflict between the executive and leg- The region has abundant natural re- islati.e branches of government (both of sources, including ore and mineral deposits, which were assigned privatization responsi- diverse chemical and timber reserves, and bilities and affords a,glimpse into the ten- marine products. The regional economy

PF1%.i;; X%1-IN1:\ 1RN: i 1 PRIM)R\KY KRAi 35

depends primarilyon fisheries,forestry, the Municipal governments have respond- nonferrous metal industry, sea transport, ed well to the cash incentivebuilt into the and the ship repair industrn Though it oc- small-scale privatization process. In cupies only 2.7 percent of the far eastern Nakhodka, for example,city sovietDeputy land mass, Primorskv krai accounts for 80 Chairman Oleg Oksuzian emphasized that percent of the area's marine transport ca- the city deliberatelypursued an aggressive, pacitv As a result, the region's three large small-scaleprivatization strategv in order to seaports serve as the departure point for cover the municipaldeficit. 6 The monetarv much of Russia's raw material and con- incentive to sell small businesses has also sumer goods exports.2 created problems. In Vladivostok,the de- Krai administrationsources claim that 5 lineation of krai and citv property led to percent of regional enterprises (sixteen in conflictbetween the different levelsof gov- In Nakhodka... the all) were part of the military-industrialcom- ernment. Sergei Soloviev,Chairman of the city soviet deputy plex.' Other officialstatistics indicate that Vladivostok city soviet, complained that in late 1993 the defense industrv employed the Primorsky krai administrationsuccess- chairman. .. 20,300 (8.3 percent) fewer workers than it fully designated a few hairdressers, movie emphasized that the did in 1992. (If accurate, this suggests that theaters, and other "clearly municipal" city deliberately the distressed military complex may actual- businesses as krai property to earn income Iy play a much more important role in the from their privatization.7 Since small-scale puarsuedan local economythan is suggested by admin- privatization began, there have been com- aggressive, small- istration figures.) The downturn in the lo- plaints that privatized stores fail to meet the scale privatization cal defense industry can be attributed to a needs of the population. Some interviewed reduction in federal government orders public officialsclaim that the reprofilingof strategy in order to combined with its fadure to pay for 250 bil- small shops after privatization has made it cover the municipal lion rubles worth of orders it placed. Enter- difficult for the population to get basic ne- deficit. prises in other economic sectors are also cessities such as bread and milk, but this having trouble adapting to the current tran- author has not come across any surveys or sition period.4 privatized stores in Primorsky krai that Despite current economic difficulties, would confirm or deny this claim. many of which are afflictingenterprises all To overcome some of the perceived over Russia,Primorsky has the potential to shortcomings of small-scaleprivatization, develop rapidly. The region, and Vladi- some municipalofficials in Primorsky krai vostok in particular, is a transportation hub have turned to local legislation.Oksuzian for Russia with easy access to foreign mar- provided examplesof this behaviorwhen he kets. In addition, it has a generous supply explained that the Nakhoda sovietpassed a of raw materials, a strong industrial base, regulationthat allowsthe localproperty fund and a highly-qualifiedlabor force common to withdrawan enterprisefrom auction within defense-related enterprises. out specifyinga reason if the offered price is perceived to be too low; another regulation Small-scaleprivatization reduces the pavmentperiod granted to winning labor collectivesfrom 3 years to 6 Primorsky GKI data for April 1, 1993, in- months if "someoneelse is standingbehind dicates that the region had 1,835 small- the collective"(as someinvestors might take scale businesses eligible for privatization. advantageof the 30 percentdiscount to col- Of these, 929 51 percent) had been priva- lectives).More studvis neededto determine tized by the end of the first quarter of 1993. whether the use of supplementarylocal pri- The krai's Statistics Department reported vatizationregulations is widespread.If so, it that 65 percent of all enterprises were pri- could be distortingsmall-scale privatization vatized through competitive tenders, while by givinglocal authorities more discretion 31 percent were privatized through auc- than was intended and bv discouragingthe tions. More than half of the small privati- restructuringof smallbusinesses. zations may have been completed with The restructuringand reorganizationof some restrictions on their future activity.5 small businesses is also hampered by a

36 RussiA: CREATINm PRivATEENTERPRISES AND EFFICIENT LMARKETS shortaggeof credit. Both privatized and new privatization. However, an enterprise that small enterprises report that thev have diffi- has completed voucher auction should not cultv obtaining affordable financing. Unlike be considered private so long as the prop- large enterprises, small businesses do not re- erty fund continues to hold shares. ceive government assistance and must find Moreover, privatizing an enterprise does their own sources of financial support. In not necessarily create a more efficient and principle, both state and commercial banks productive business, but it may instead are willing to lend money to smaller opera- serve to betray the inherent unprofitability tions, but given the high inflation, thev are, of an operation. Mlerely distributing shares naturally, mostly interested in providing to private investors does not necessarilv short-term, high-interest loans. One reason stimulate an enterprise to behave different- given to explain this phenomenon is that ly in the short-run.9 Thus one should not banks apparently fear that small businesses assume that the pace of voucher auctions is The vouicher are disguised mafia operations created to synonymous with the pace of plenarypriva- auction is a get cash and vanish. Moreover, banks may tization, nor can it serve as a proxv for the , . be attracted to large enterprises that are un- rate of genuine industrial or corporate critical stage in likelv to close and that have access to alter- transformation. A region's ability to suc- an enterprise's native sources of financing to bail them out. cessfullv organize many voucher auctions privatization, for To begin to rectifv this problem, the krai's can serve, however, as an indicator of how it transfers a third Anti-Monopolv Committee and Japan's committed local privatization officials are Mvinistrv of International Trade and In- to completing privatization, and of how or more of an dustry have jointly created a center to sup- quickly the state's stake in the large enter- enterprise from port small and medium-size businesses. The prises is being diminished. Japanese have contributed $30 million to The Primorskv GKI and property fund state to private this program and are expected to agree moved quickly to design and set up a hands. shortlyto set up four "adaptingcenters" for voucherauction systemin late 1992 and businessesin the near future.8 early1993. The fund, responsiblefor orga- nizingthe distributionand sale of shares, Large-scaleprivatization used an unconventionalapproach and put large enterprises up for auction in two- The privatizationof a large enterpriseis an month "waves"of 40 to 50. Bv the third incrementalprocess. First the enterpriseis quarter of 1993, the fund had completed corporatized.Then, up to 51 percentof the voucherauctions for almost100 enterpris- joint stock company'sshares are distrib- es, andwas amongthe top 15 regionsin the uted among workers and managersin a numberof enterprisessold. This brisk pace closedsubscription. The amount of stock ofvoucher auctions suggests that Primorsky distributedwithin the enterpnrsedepends officialswere reform-oriented and respon- on whichbenefits option was selectedby siveto policiesformulated in iMvoscow.This the laborcollective. Once the wvorkershave impressionwas consistentwith the results votedon an option,the propertyfund pre- of the April 1992 referendum,in which pares a voucher auction for the sale of no more Primorskv voters supported Yeltsin less than 29 percent of the company's and his reformsthan in Russiaon average. sharesfor privatizationvouchers. After the Regionalofficials appeared to be commit- voucher auction, some shares remain with ted to implementing federal privatization the regionalpropertv fund. These shares, policy Given this apparent support for usuallyamounting to 20 percentor moreof voucherauctions and large-scaleprivatiza- the stock,are earmarkedfor the auctionor tion,many observers were taken by surprise tender(for vouchersor cash)atalaterdate. by the joint krai administrationand the The voucherauction is a criticalstage in Councilof Peoples' Deputies announce- an enterprise'sprivatization, for it transfers ment that, as of August1993, privatization a third or moreof an enterprisefrom state wouldbe curbedostensiblv to savelocal en- to privatehands. It is also the firstoppor- terprisesand voucherholdersfrom the im- tunityfor outsideinvestors to participatein pact of bankruptcies.

PR[VXI17ATI()NIN TilE RE(;IONS: PRiM.oRSsk;KREu 37

Primorskv's (ultimately unsuccessful) Fecderalgovernment plavers bid to stop the privatization of large enter- priseswas not the only one of its kind-sim- Governmentofficials hierarchically superior ilar attempts were made in Novosibirsk and to localplayers mav also get involved in re- Cheliabinskin April 1993. Nevertheless,be- gionalprivatization. As institutions compet- cause it happened in a region perceived to ing for jurisdictionover the process, the be successful,the stoppage led many jour- federalGKI and property fund willcompete nalists,officials, and business people to ask at the locallevel if necessaryand will, on oc- what had gone wrongwith large-scalepriva- casion,join a localcontest between fund and tizationin PrimorskvThe conflict mobilized committee.In some cases, the federal level and exposedthe institutions and individuals organizationscreate tensions between local involvedin the Primorskv privatizationpro- privatizationorgans that had been effective- Federal GK1 relied cess, allowing one to clearly identify the lead- ly cooperating. The Federal Property Fund, on a strategy of ing political and economic actors. An for instance, tried on a number of occasions analysisof the interaction among these ac- to denv localpropertv funds the right to sell carrots... and tors illuminatesthe dvnamic underk-ingthe 29 percent of federalenterprises at voucher sticks... to large-scaleprivatization process in Primor- auctions.This intervention,which frequent- encourage local skykrai: at the sametime, it illustrateshow ly took placeafter the localfund and local privatizationis affectingthe regions, and GKIhad finalizedauction preparations, ap- officialsto follow howthe regionsare influencingthe overall peared to be motivatedby the Federal privatization processof privatizationin Russia. PropertyFund's desire to delayauctions un- legislation. til theyhad put in place a more lucrative Localgovernment znstitzifions mechanismfor privatization FederalGMI relied on a strategyof car- The mainplayers in Primorsky'sprivatiza- rots (promisesof technicaland financialas- tion processare, first and foremost, those sistance)and sticks (such as threats of that wieldsignificant economic and polit- annulledauctions) to encouragelocal offi- ical influence. Regional governmental in- cials to follow privatization legislation. stitutions responsible for privatization Meanwhile, the Federal Property Fund (that is, the local GKI and property fund) -which was brought under control of the have the authority to determine what will governmentfollowing the dissolutionof the be privatized and when. While they can be SupremeSoviet in October-generally act- successfullv countered bv recalcitrant ed as a brake on privatization. One of the directors who manage to swav federal of- Fund's Deputy Chairmen even lobbied ag- ficials against their enterprise's privatiza- gressively for a new variant of privatization tion, local privatization institutions have that would have sold large enterprises to administrative powers that give them employees. The fundamental philosophical leverage over local enterprises. gap between the Federal Property Fund and Local executive branch players (the re- Federal GM, a reflection of the diverging gional administration and GKI) are distinct views on privatization held by the govern- from legislative branch players (local sovi- ment and Parliament, intensified the juris- ets, deputies, and the regional property dictional struggle between funds and GKls fund). In addition, while the local GKI is at all levels of overnment. It did not, how- often closely aligned with the regional ad- ever, prevent local fund officials, assigned ministration (the head of an oblast or krai personal responsibility for the sale of enter- GM serving, by law, as a Deputy Governor prises, from having closer relationships with of the oblast or krai), the regional property the more supportive Central GMI than with fund tends to operate fairly independentlV the Federal Property Fund. of the regional soviet. Thus the local administration, local GMI, local legislature, Enterprises and local property fund should all be considered separate actors, each with their own As in Soviet times, large enterprises contin- incentives and po-wers. ue to play an important role in regional eco-

38 RUSsLA:CREATING PRiVArE ENT.RPRISES AND ElFICIENT MAL4RKETS

nomics and politics, though this role has ful role in Primorskv 's privatization process. changed as factories and firms become Representatives from Primorskv's political more independent. The centrally-planned parties and movements independently tes- economic system meant that regional polit- tified that their organizations have had no ical officials existed in large part to secure influence on the design or implementation compliance with industrial plans. Cor- of large-scale privatization. This is partly be- respondingly, enterprise production vol- cause privatization legislation is drafted at ume was a major determinant of regional the federal level, and therefore faLlsunder (and personal) success. As part of the tran- the jurisdiction of national rather than local sition from communism, the state has been party structures. Nonetheless, given the im- gradualv ceding its control over the econ- portance of privatization in redistributing omy and enterprises have begun concen- regional assets, the passivity of local parties trating on obtaining private contracts. But and movements would seem to reflect ei- The strategy used despite a reduction in enterprise depen- ther ineffectiveness or a marked lack of am- by entrepreneurs dence on government, enterprise perfor- bition-or both. mance remains critical to the growth of Labor movements have also been inert. to exert influence local economies and local officials. Big en- Though workers received great benefits in on the politics of terprises are still the largest taxpayers, em- the 1992 Privatization Program, the organi- privatization plovers, and suppliers in most, if not all, zations that claim to represent them have regions. C' In many cases, they also contin- faded to translate this victory (and their has gradually ue to be the primarv providers of housing Soviet legacy of newspapers, offices, and shifted fromn and social services. personnel) into political power. Miost unilateral to unions have been marginalized by the sepa- Entrepreneugrs ration of industry and state. Deprived of of- collectveacton ficial authoritvywithin factories, and lacking over the course The potentially high rewards of privatiza- grass roots legitimacv among workers, they of 1993 tion have also stimulated the involvement usually cannot affect the course of privati- of actors who did not inherit political or zation within any given enterprise. The economic power from the Soviet regime. Primorskv Krai Federation of Trade Unions Mlany of them can be considered entre- has tried to transform itself into a consult- preneurs. These include both investors ing operation for workers in privatizing en- (such as wvealthyindividuals and voucher terprises. But the complexitv and specificity investment funds) and organizations that of each large-scale privatization, often cou- have sprung up to support and profit from pled wvith friction among workers, makes it the voucher system and large-scale priva- difficult for them to have an impact on the tization (for example, stock exchanges labor collective, let alone on management."' and brokerage firms). All these have made or expanded their fortunes through priva- Primnorskys privalization crisis tization, and are interested in seeing the process continue. They have expressed Privatization in Primorskv started in much this interest more than once by launching the same way as in other parts of the coun- public relations campaigns to counter the tir The regional State Propertv Committee more virulent attacks against the privati- and property fund were created, staffed, zation program. The strategy used by en- and assigned responsibilities that included trepreneurs to exert influence on the the privatization of large enterprises. A politics of privatization has gradually municipal level administrator, Gennadv shifted from unilateral to collective action Tokulenko, was appointed Chairman of the over the course of 1993.11 GE; in contrast, Valerii Lutsenko, a former general director of an association of lo- PoJztiCalplavers cal enterprises, wvas selected to chair the local property fund. Only actors with official political power or When the first privatization program wvas economic assets appear to play a meaning- being debated in the spring and summer of

PHIVAr[I\AI1()IN I-lit (II();NS: PRI.\aR) KkRAI 39

1992, enterprise managers in Primorsky and in the middle of last year, PA-KTis a holding across Russia opposed corporatization and company whose founders include 31 large privatization. Primorsky's privatization insti- enterprises. A publicity brochure prepared tutions began to work with resistant direc- by Anatoly Pavlov, President of PAKTI,list- tors and slowlv convinced them that ed the organization's goals: to expedite the privatization was necessarv and advanta- structural reorganization of the Primorskv geous. Directors came to understand that krai economy; to further regional interests privatization could make them personally in the Pacific Basin; to facilitate the devel- wealthv that they would not necessarily lose opment of competitive technologies and their dominions, and that foreign (and do- services, with foreign participation if pos- mestic) investors would be more attracted to sible; to preserve and increase the effec- private companies. According to Lutsenko, tiveness of krai industry by means of ... many enterprises bv the fourth quarter of 1992 skeptical di- inter-regional cooperation and by encourag- developed close rectors had been persuaded to prepare their ing development of small and medium en- enterprises for transformation into open terprises; to create an economically efficient relationships with joint stock companies. Along the way, many financial investment system that can pro- privatization enterprises developed close relationships vide insurance against seasonal and struc- agencies, since an with privatization agencies, since an infor- tural fluctuations in markets; to transfer mal alliance with the fund or GKI was a capital from nonprofitable to profitable informal alliance means to ensure that one's interests would branches of industrv;and to create a social- with the fuind or be taken into account as much as possible. ly stable and economically protected struc- GK[NJwas a means to ''Theseclose relationships were cited by GKI ture for voucher investment by krai citizens and fund officials as being one of the main and Russian voucher funds during the peri- ensu re that one's reasons that Primorsky became one of the od of economic instability and bankruptcy interests would be fastest corporatizing and privatizing regions Though there are many financial-indus- taken into account in Russia. trial groups forming in Russia, PAKT is one Primorskv GEI data on corporatization of the most controversial. Uniting krai en- as much as possible. by Januarv 1993 reveal two interesting terprises across a wide spectrum of indus- facts. First, labor collectives chose to buy tries (from ship repair to meat processing), out 51 percent of their enterprise in nearly PAKT aspires to replace the old branch mo- 90 percent of large enterprises. This is sig- nopolies that dominated the local economy nificantly higher than the corresponding (The regional anti-monopoly committee has national statistic of 77.8 percent. 3 Second, apparendv ruled that PAKf is not a mo- the amount of charter capital being priva- nopolv) The PAKT leadership is currently tized (through voluntarv corporatization vorking with member enterprises to devel- and sale of shares) exceeds the amount sub- op a unified restructuring plan. Where two ject to compulsory corporatization and pri- members compete in the same market, vatization. These facts imply that by 1993, PAKT will determine which is most cost- directors of medium and large companies effective and reprofile the other for produc- in Primorsky had become aware of the po- tion in areas in which it is has a comparative tential gains from corporatization and pri- advantage. The stated goal of the organiza- vatization. They do not explain, however, tion is for associated enterprises to provide why Primorskv's labor collectives are so of- all the inputs and finished products re- ten in favor (and able) to buv up over half quired by other PART enterprises. 4 of enterprise stock. Privatization has served as both a cata- Besides working closely with fund and Iyst and instrument in the development of committee officials, some enterprises joined PAKT. Boris Fadeev, PAKT General Direc- forces and created a financial-industrial tor, stated at a public roundtable that "the structure called PAKT-the Primorsky central principle in the earliest stage [of Manufacturers Shareholders Corporation. PAKTI was to protect future member-com- Initiated by local enterprise directors (with- panies' independence during privatization. out pressure from Moscow), but allegedly That is, we made sure that as the enterpris- approved by Prime Minister Chernomyrdin es were converted to joint stock companies,

40) RussIA:CREATING PRIVATEENTEF-RPRISES AND EFFICIENT MARKETS local majority interest was maintained economic control were pushing krai enter- against the capital pouring into Primorve prises toward bankruptcy and risking mas- from all over Russia."5 PAKThas pursued sive lavoffs, strikes, and "social-political this objectiveby participatingin the vouch- dissatisfaction with current economic re- er auctions of memberenterprises. The cor- form among krai residents." The adminis- poration either buys shares for the holding tration and legislatureacted upon the letter's company or it givesmoney or credits to the recommendationsand issued a joint regula- enterprise so that it (presumablymanage- tion that allowed the local government to ment) can obtain a majorityof shares.1 t This temporarilyhold on to its shares in "crucial approach has alarmed observers who have and sociallysignificant" enterprises (a cate- denounced the use of privatization as a gorywhich encompassed64 krai enterprises means of reconsolidatingregional econo- and 108 federal enterprises); create a re- mies (and politics) in the hands of directors. gional governmental commission charged ... some enterprises PAKT's economic strength is difficult with deciding which enterprises wverebank- joined forces and to assess. Members claim that thev repre- rupt and formulatinga plan for restructuring sent the best of far eastern enterprises, the local economy; and halt al Primorsky created a financial- while opponents deride them as moribund voucher auctions. industrial structure defense factories. As a group, the PAK' The announcement of this regulation called PAKT- enterprises employ 90,000 people (9 per- created a stir across Russia.Local and na- cent of the local workforce) and had a tional investors began dumping their shares the Primorsky combined charter capital estimated at 2.5 in privatized Vladivostok companies. Pri- Manuifacturers billion-10 billion rubles (S2.5 million-$10 morskv krai traders bovcottedthe securities Shareholders million) as of August 1993, according to market and the Vladivostok International figures from the Pavlov PART handout. Stock Exchange canceled trading in Corporation. Regardless of their actual economic puis- protest. The head of the stock exchange, sance, PAIT members have amassed a Viktor Sakharov,launched a publicitycam- great deal of political power. On Mlay19, paign opposingthe move. He was joined by 1993, Evgenii Nazdratenko, General investment funds who had purchased Director of the far eastern mining compa- shares of local enterprises, and who threat- ny "Vostok"-a PAKT member-became ened to take the local administration to Governor of Primorskvkrai. By the end of court. In addition, AnatolyChubais, Chair- the summer he had appointed three more man of the federal GKI and a Deputy Prime PAKT industrialists to serve as Deputy NMinisterof the RussianGovernment, called Governors in his administration. the local administrationto warn that stop- The new administration has aggressive- ping voucher auctions was tantamount to ly tried to help local enterprises find state violating presidential decrees. Coming on or private investment. As in other regions, top of pressure from entrepreneurs, the krai officialshave also sought to increase duress applied by a top-level federal gov- the authority of the regional administra- ernment officialprecipitated a cancellation tion in relation to the federal government. of the krai decision. In a departure from more conventional re- Given the extent to which the directors' gional strategies, the new administration lobby has captured the Primorsky krai ad- tried to increase its power bv openly chal- ministration,it is unlikelythat Nazdratenko lenging the center's right to implement reacted against the wishesof local enterprises form in Primorskv krai. This challenge and PAKT.But why would the krai's indus- came in the form of a local regulation that trialists want to stop large-scale privatiza- fundamentally altered the large-scale pri- tion if they had becomeconvinced that both vatization process. they and their enterprises would benefit In early August,Vladimir Kolesnichenko from the process? wrote a letter to the Chairman of the Krai A credible answer lies in the rapid de- Soviet and Krai Governor Nazdratenko. velopment and integration of Russian fi- The letter stated that the Russian govem- nancial markets. When voucher auctions ment s austerity policy and the absence of started in late 1992, investors who wanted

P1JT.ATnAIBIONIN I ii RI (,RI)N: PRIM(o,Si, KFAi 41

to participate in auctions outside their re- regional interests, it seems to have retained gion were obliged to travel to the local auc- enough power to enforce its important eco- tion centers and place bids in person. nomic policies. Quickly, brokerage firms emerged and began to take orders from nonlocal bidders Conclusions across Russia. Primorskv and the distant Far East were not initially protected from This case study of privatization suggests a this outside investment bv their remote- number of conclusions about politics in ness. Though nonlocal bidders tried to ob- Primorskv krai. It is important to keep in tain controlling shares in local enterprises, mind that a single case study cannot yield in- thev rarely succeeded. formation about whether a region is typical By mid 1993, however, the Vladivostok or atypical. For example, from the above In short, the central International Stock Exchange had become analysis, one cannot assume that pro-priva- government has not one of the most active in Russia. GRI had tization forces are strong enough to defeat put into place a depository system that al- gradualists and anti-privatizers across been cut out of lowed bidders to deposit their checks in a Russia. Nor is it possible to identify which regional politics, local depository and bid in remote voucher factors most influence the privatization thouwghit does not auctions with a receipt. In addition, many process in Russia as a whole. A regional case Russian regions had set up voucher auction studv can, howvever,act as a map for future appear to exert centers that allowed them to run nation- research: conclusionsdrawn from the analy- direct, daily control wide auctions, and Primorsky krai was un- sis of one region can serve as hypotheses to over local politics der pressure to put its enterprises up for be tested in other case studies. Similarly,the sale in national auctions.17 In short, it ap- factors (variables) isolated in one case studv and economics. peared as if the voucher auctions for local can serve as the starting point for additionr- enterprises would soon be opened to paral studies w-hichcompare the importance of ticipation by powerful national investors. these and other variables in other regions. Russian industrialists, not surprisingly,favored privatization when they realized it Center-peripheryrelations meant transferring property rights from the state to themselves. When there was even a The relationship between the central gov- risk that thev would lose control over their ernment and the Russian regions has con- enterprises, or receive no direct benefit, man- tinued to evolve since the coDlapseof the agers resisted the process. Managerial oppo- Soviet Union. Bv their actions, it seems sition would be even more likely in cases clear that Primorsky krai authorities would where continued state ownership is per- like to be responsible for regional issues, ceived to be less intrusive than diffused though the privatization crisis revealed that shareholder ownership. In Primorsky, the the region is neither wholly autonomous nor composition of the regional administration forgotten. When its juri6diction was threat- ensures that the state would be highly svm- ened by local actors, the Russian State pathetic to enterprise concems. Together, Propertv Committee responded assertively these factors, coupled with the administra- to correct the region's deviation from fed- tion's obvious desire to increase its control eral privatization legislation. Prime Minister over the local economy and the groxving Victor Chernomvdrin's tour of the Far East threat posed by outside investors, explain in August provided additional evidence that why large-scale privatization was essentially the center still supervises regional activities. canceled inAugust 1993. Simply put, the krai In short, the central government has not government's decision to halt voucher auc- been cut out of regional politics, though it tions and manage the economy more closely does not appear to exert direct, daily con- was consistent with the self-interests of local trol over local politics and economics. enterprises and the regional government. It is difficult to assess the extent to The center's ability to overrule these concur- which the relationship between Primorskv rent interests demonstrates that, although krai and the center is a function of region- .Moscowvmay have ceded its right to define al specificities. Primorsky's rich natural re-

-42 RE sSLX:CREATING PPi%iAII ENTERPRISESAND EFFIICIENI MNLARKETS sources. proximity to Asia, and access to Bv August, the PAKT Vice President international transportation networks have wvouldsav that it is no secret that the new contributed to a regional sentiment that [local] government is from PAK.T."1 9 the krai could survive without the assis- PAKT's ability to compete in regional elec- tance (and demands) of the central gov- tions will provide an ongoing indicator of ernment. This is not the case in many of the its political power. One could hypothesize other Russian regions. that, while emplovees of PAkT enterprises would be more likely to support "their" The regionialpolitics of privatization candidates, the rest of the population may be indifferent (or perhaps even hostile) to Economic actors have eclipsed political structure devoted to advancing the future parties and movements in the regional pol- of certain large enterprises. A PAKT can- itics of privatization, and perhaps in polit- didate's defeat of other candidates would ical life as a whole. Even the trade unions, provide evidence that there is popular endowed with a legacy of potentially fun- support for PAKT's mission. gible resources, have been outmaneuvered The Primorskv krai experience demon- bv more motivated and dynamic enterprise strates that, while privatization reduces state managers. Research completed in the sum- control over enterprises, it does not guaran- mer of 1993 indicated that these aggressive tee that the regional economy will beconie entrepreneurs and savvy bureaucrats are more competitive and diversified.20 Wide- playing the biggest role in shaping Russian spread voucher privatization may actually capitalism, for they seem to best appreci- inhibit progress toward a competitive, decen- ate the potential gains. tralized Russian market bv empowering large The elections for the national legisla- enterprises to recentralize the economy along ture in December of 1993 and for local leg- geographical rather than industrial lines. islatures in the spring of 1994 may mobilize Instead of striving for greater independence, sluggish political actors into campaigning some enterprises in Primorskv are pursuing and lobbying. Bv that time, it will probably new dependencies that will ally them with be too late to intluence the voucher auc- other (possiblv struggling) enterprises. PAKF tion phase of large-scale privatization. does not include all large krai enterprises, Parties and movements mav then try to in- and its membership does not appear to be influence the post-privatization process (that creasing dramatically, despite the high profile is, private and public investment policies) of PAKT leaders in local politics. In the long or they may select some other issue areas term, therefore, it seems unlikelv that PAKI in which to act. will succeed in monopolizing the krai economy In the short term, however, PART's po- Interaction of politics and economics liticaland economic influence mav slow the development of an open and competitive re- The large-scale privatization process in gional economv. Primorskv krai is allowing managers to consolidate control over enterprises and, Notes to some extent, over the local economv. In the latter regard, Primorskv's industrial- 1. PrimorskvKrai StatisticsDepartment, Third ists have gone further than those in other QuarterReport tor 1993,as extractedin UTtroRossii, regions. Enterprises of Novgorod have al- October26, 1993. so united in a corporation, and "financial- 2. From an "EconomicMap" of Primorskykrai industrial groups" have become popular produced bv the Cartography Laboratoryof the across Russia, though none of these orga- Russian Academy of Sciences' Far Eastern nizations seem to have succeeded in Institute for Economic Research, 1992. Far Eastern AerogeodesingskyEnterprise. Note that amassing PAKT's level of open political in- ~Iship repair" is usually a euphemism for military fluence. In April 1993, a PAKT director maintenance. stated in an interview that the organiza- 3. Accordingto a brochure distributed by the tion "had no political program thus far."" Primorskvkrai administration(Przmorski Region,

PRI'.ATIjil(.N IN n ii-RiRCIoNS: PRIRSMK Km 43

1993. Ussuri Publishers, p.8), these enterprises al- 135, p.3. For examples of attempted influence in legedlv produced 13 percent of the krai's industri- other areas of reform, see "Entrepreneurs do not al output. agree with the firing of Glaziev," in Kommersant- 4. In an August 1993 letter to the Governor, V Daily, August 25, 1993, no. 161. p.3; "Entre- Kolesnichenko, Deputy Governor for Economic preneurs discussed the initiators of monetary Reform, and V Ignatenko. a representative of the reform," in Kommersant-Dadly,July 28, 1993, p.l; Primorskvkrai property fund, estimated that a one- "Young capitalists aspire to power in a Russian third of Primorskv krai's industrial enterprises and province [Vologda]," in Izvestia, September 10, one-sixth of construction-related enterprises were 1993, p.2; and "Volskyand Skokov fight for influ- bankrupt. The perception that the economy is in ence on industrialists," in Kommersant-Daily, trouble is widespread in the local administration August 28, 1993, no. 141. For an illustration of (though it is difficult to evaluate the data used to cal- politicians' efforts to mobilize entrepreneurial sup- culate the ratios mentioned in the letter). port, see articles discussingGaidar's Association of 5. These restrictions may include obliging the Privatizing and Private Enterprises (such as new owner to finance social services affiliated with "Chubais decided to strengthen his position from the enterprise, retain a certain number of workers, the 'top down' to "bottom up,"' Kommersant-Daily, or invest a specified amount in the enterprise. The September 4, 1993, no. 169.) tender may also specify that the buyer cannot 12. InterviewinVladivostok,April22, 1993,with change the business' primary activity.These condi- Anatoly Shalamanov. Deputy Chairman of the tions are permitted bv section 5.6 of the 1992 Primorsky Krai Federation of Trade Unions (PKF- PrivatizationProgram. TU), and YuriKinash, Head of the Social-Economic 6. Interview in Nakhodka, April 28, 1993. Department, PKFTUT.A draft regulation signed by 7. Interview in Vladivostok, April 22, 1993. VPChubai, the Chairman of the PKFTU, notes that 8. Interview with Yuri Uskov; Deputv Head of "the influence of trade unions on privatization has Primorsky krai GKAP and President of the Far been practicallylimited, and a large part of the col- Eastern Intemational Center for Small and Medium lective's social achievements have been liquidated" Businesses,August 19, 1993, Vladivostok. (unnumbered draft dated December 16 1992). 9. Directors and privatization ofiicials alike have 13. Boycko, Shleifer,Vishny (1993), p.19 . mentioned in interviews that large enterprises do 14. Tepliuk (August 19, 1992 meeting) and Boris not institute significant changes immediately fol- Fadeev,PAKT General Director, quoted in "PAKT: lowing privatization, in part because a sharehold- United We Stand," Vladivostok News, 9 July ers' meeting is required before major restructuring 1993 (no. 13), pp.1,3. can take place. (This comment was made, for ex- 15. Fadeev,"PAKT: United We Stand," p.1. The ample, by Georgii Pikus, Senior Vice President of desire to keep out nonregional investors is not the Far Eastem Shipping Company, and by Valerii unique to Primorsky krai. Primorsky has appar- Lutseriko, Chairman of the Primorskv krai proper- ently been fairly successful in keeping national in- ty fund on April 22, 1993.) Boycko, Shleifer, and vestment funds and other non-Primorsky investors Vishny (1993) emphasize the difference between from taking a large number of shares at voucher the "largely formal transfer of ownership of cash auctions. ("East is Faster Than West," DelovoiMir, flow and control" and "real changes in operations." 9 June 1993, no. 107-675.) 10. The 1993 third-quarter report on the 16. Tepliuk asserted that PAKT has managed Primorsky krai economy stated that only 35 percent to buy 20 to 25 percent of member enterprises of the workforce is employed in the "nongovern- through voucher auctions., mental sector." Primorskv Krai Statistics Depart- 17. Interview with Lutsenko, April 22, 1993. ment, ThirdQuarter Reportfor 1993, as excerpted in 18. Leonov interview, April 23, 1993. 'tro Rosszi,October 26, 1993. 19. Tepliuk meeting, August 19, 1993. 11.The Russianpress frequently covers stories of 20. Boycko, Shleifer, and Vishny (1993, espe- entrepreneurs trvng to influence politics and eco- cially sections 2, 5, and 7) emphasize that priva- nomic reform. For an example of support for tization must be supplemented with measures privatization, see "Investment Funds support designed to increase the competitiveness of the Chubais," in Kommersant-Daily,July 20, 1993, no. Russian market after privatization.

44 RUSsIA:CREATING PmRIATEENTERPRISES AND EFFICIENT NMARTETS

CH-APTER4 Investment Funds and Privatization Mark St. Gilesand SallyBuxton

If Russia's fledglingfinancial services indus- on all aspects of the Mass Privatization try is to achievegreater efficiencyand legit- Program, presented a completed law that imacy, there will have to be considerable took the form of an Ukaz signed by In Russia, voucher revision of the present set of regulations and President Yeltsin. Three "schedules" were investment funds the wav the business is supervised. Given also issued coveringmodel prospectus,fund face a more the extraordinarypace of change in Russia charter, and contractual agreements. and the demands created by the privatiza- Observers and foreign firmsadvising on competitive tion program, it is remarkable that the fi- investment funds have been, in turn, excit- environment than nancial services industrv has developed as ed, challenged, worried, frustrated, and de- do those in other rapidlv and as well as it has. Relentlesspo- lighted by the progress of events. The litical pressure to transform the Russian enthusiasm and intelligence of many peo- privatization economy has left litde time for the consul- ple in the government and the private sec- processes in Eastern tation and debate that would normally tor have prevented the hectic pace of ro accompanymajor policy changesin estab- development from creating greater disas- p lished free-market economies. There was ters than those that have already come to no existing infrastructurefor an investment light. Even the accounting and manage- funds industry;nor did it have the financial ment problems that investment funds face expertise around which to construct the now seem solvable, despite some gloomy management and ancillaryservices for new predictions following the scandal of the businesses.Even basic financialvocabulary Moscow-based "TechnicalProgress" oper- had to be invented for Russia. ation and, more recently,problems at the li- Early in the planning of Russia's Mass censed fund Nefte-Almaz. Nevertheless, PrivatizationProgram (MPP) it was decid- action is needed to stabilize the financial ed that investment funds should play a sig- services industrv in Russia to forestall fu- nificant role. Funds were to provide an ture problems. outlet for the vouchers of citizenswho did not work for enterprises being privatized, Voucher investment funds and for those who did but wishedto diver- sifv their investments into a professionally In Russia,voucher investment funds face a managed fund. Moreover,the Ministry of more competitive environment than do SocialProtection wanted to create funds for those in other privatization processes in disadvantaged citizens (orphans, disabled, Eastern Europe. The issue of vouchers in chronicallysick, pensioners, and so on). The bearer form (that is, tradable for cash) of- resulting"special" funds are structurallythe fered an option not availableto citizens of same as voucher investmentfunds. other countries, such as the former Drafting the necessarylaw began in July Czechoslovakia.Vouchers can also be used 1992. Deadlines were tight, but the State as a form of currency to bid directly for Committee of the Russian Federation for state-owned enterprises (SOEs) at auction, the Managementof State Property (known as opposed to purely for funds, as in the as Goskomimushchestvo,or GKI), togeth- proposed Kazakh and Polish programs. er with the Ministry of Finance and mem- Sponsors of funds therefore face strong bers of an internationalconsortium advising competition for customers and have, in

INVLST.MENTFUNDS AND PRrVATnZAI10N 45

some cases, made exaggerated claims as to United States. Provision for open-ended the returns investors could expect. funds is made in the regulations,but given By MIarch1993, these factors, and the the problems of valuationand liquidity,such fact that approval for the first investment fundswill probably remain inappropriatefor funds was not granted until early December the foreseeablefuture. (three months after the first issue of vouch- The main provisions of the legislation ers), gave rise to concern that the industry's for investment funds are: development would be slower than hoped. This was compounded by worries about po- Form and nature of funds. This covers litical uncertainties. funds other than specialized investment To make matters worse, there was a ma- funds (that is, those that accept vouchers). jor fraud in St. Petersburgin February 1993. Such funds are licensed bv the Ministryof By the end of July The sponsorsof a fund, which had gathered Finance, whereas specialized investment 1994... thgeremay at least 300,000 vouchers, disappeared- funds are licensed by the GM. In theory, with all the vouchers.This was widelypubli- both open-ended and closed-ended funds be some 45 million cized and led many to believe that fund may be created under this regulation, shareholdersin the sponsors were criminals. The "Technical though in practice, open-ended funds are 600 funds. Progress"scandal in Moscow sharpened the inoperable in the current market. One im- perceptions of politicians, regulators, and portant provision is that state bodies can- the publicof potential dangers in the system. not establish funds; the restriction defines Some of these fears proved groundless. such a body as one in which the state has an Major marketing campaigns by legitimate interest of more than 25 percent. This was operators and a campaign of public infor- to meet a concern that investment funds mation (including the regular publication might be used to retain or regain control of of lists of licensed funds in leading news- enterprises to be privatized. papers) have counterbalanced some earlier worries. In hindsight, many concerns arose Foundingand registeringof funds. The from delays-in putting groups of founders Ukaz also established the procedure for together and raising finance, issuingshares, founding and registering funds and the re- getting licenses. planning and implement- quired capital paid in bv the founders. ing marketing campaigns, implementing There is no ban on the participation of for- campaigns, and coping with shareholder eigners either as fund managementcompa- registrationand securities custody in an un- nies or founders of funds. developed market. At the end of 1993, there were an esti- Investmentlimitations.Investment restric- mated 600 funds nationwide with perhaps tions coverthe maximumpercentages of the 15-20 million shareholders. By the end of portfolio that can be invested in any one se- July 1994, when vouchers expire and the curity in the voting sto6k of any one issuer, first wave of mass corporate privatization and in affiliatedcompanies. Borrowing is al- will be completed, there may be some 45 so restricted.The lirnit on investmentsin a million shareholders in the 600 funds. singlecompany (a maximumof 10 percentof the votingstock) caused muchdebate. Some Investment fund regulations institutionalmanagers wanted the limit to be increasedto make it easier to exert pressure The law on investment funds took the form on companiesto improvetheir effectiveness, of a PresidentialUkaz (no. 1186). It created but the countervailingargument (that this a regulatoryframework for both nonvouch- might placetoo much power in the hands of er and voucher investment funds. Voucher financialinstitutions) won. The limit waslat- investment funds were permitted only as er increasedto 25 percent. It is too early to open (not open-ended) joint stock compa- determinewhether fund managers,in formal nies. These would be called investmenttrust or informalcombination, are starting to use companies in the United Kingdom or theirvoting power.There have been one or closed-ended investment companies in the two instances of shareholders flexingtheir

46 Russ>: CREAING PRfvATE ENTI.RPRISES A,ND EFFICIENT N.t\RKETS muscles,and the emergenceof a sharehold- * They are licensedby the GKI or by re- ers riglhtscampaign is encouraging. gional KI; They cannot be open-ended funds; Alanageizentand supervision. This regu- * Since funds are intended for mass own- lation establishes the supremacv of fund ership, the investment restrictions are shareholders voting at an annual general more onerous. The restrictions include meeting to determine key matters such as no investmentoutside the Russian Fed- appointment of directors and auditors, ap- eration, and the funds are not permit- proval of annual accounts and dividends, ted to accumulate more than 5 percent chang,es in the charter of the fund, and liq- of all vouchers in issue (approximately uidation. Duties of fund directors are also 7.5 million); and defined, as is the requirement for formal * Permitted charges are higher (an all-in- contracts with the depository and auditor. clusive 10 percent) than the 5 percent Maximum management charges are laid ceiling on nonvoucher funds. down ( 10 percent for voucher investment funds and 5 percent for other). Model documents

Distribution ofpro/its.The phrasing of the The section on model documents was de- section on distribution-in which dividends, signed to provide guidance for founders of interest, and trading profits are distributed, funds, fund management companies, and subject to a decision bv directors-seems their professional advisers. Another aim was likely to cause difficulties over excessive div- to make the task of the licensing body easier idend payments and taxation of funds. Most by having a standard against which to judge fund regimes (except in the United States) licensing applications. In theory, an applica- treat income from investments and interest tion using the "standard format" documents as separate from capital gains for tax pur- may be given a "fast track" to a license. poses. Some regimes forbid the distribution Much of the information contained in of capital in any form. the documents is repetitive. The significant points are: Reporting to shazreholdersand regulators. Funds are required to report quarterly to Model charter This is the founding doc- shareholders and to regulators, providing a ument of a fund whose provisions include: balance sheet and portfolio breakdown, a * The legal nature of the fund and details profit and loss account, a statement of net of its founders; asset value per share, a statement of fees, * Investment objectives and a description and information about changes in manage- of investment policies and restrictions; ment or in other contractual arrangements. * A statement of the opening capital of a Guarantees of future performance or re- fund; turns are outlawed. Even so, problems con- 0 Rights of shareholders; ceming the difference between a guarantee * General meetings; and a forecast continue and overenthusias- * Terms of reference; tic marketing has raised expectations to un- * Valuation and distribution of profit justified levels, particularly in relation to statements; dividends. * Arrangements for, and cost of, management; Lzuidaztion. This must be the subject of * Details of the custodian of the fund's shareholders' approval at a general meeting. assets; * Accounting and reporting; Specialized investment funds * Audit; and * Liquidation. These funds are covered bv provisions more or less similar to those for ordinary in- Mvlodeldepository agreement. This agree- vcstment funds. The main differences are: ment establishes the important relationship

JŽ.. 'NL>IFl'.N)L N -. D PR'AI>X11(N 47

between the depository,the fund, and the tion. To protect fund shareholders,it also manager and defines the duties and re- provides for revocationof the contract by sponsibilitiesof each partv. The important the directors of the fund (on the grounds of role a depositorv must play in investor pro- inadequate or nonfulfillmentof the contract tection is emphasized, but banks have been by the management company) and sets unwilling to undertake depositorv func- maximum expensesand chargespavable bv tions. They are unconvinced of the com- the fund to the managementcompany. In mercial viability of such operations in an essence, the management companv is re- environment where banking operations quired to: have been so profitable. Funds and man- *Manage the assets of the fund within agement companies have been obliged to the terms of the charter; create their own paralel operations, a less *Report to the directors, detailing in- than ideal solution. It is somewhat surpris- vestment strategyand decisions; ing that the major firms engaged in global *Present a formal annual report to fund custodyhave not taken more interest in this shareholders; field, but once the market becomes better *Report quarterly to directors on fund established, separate custodians and de- expenses; positories willlikely emerge. *Prepare quarterly fund accounts; The depositoryis similarto the custodian *Carry out administrativework on behalf (or trustee) in other fund markets in that it: of the fund; • Holds all the assets and cash of the * Maintain confidentialityand carry out fund; duties (such as payment of dividends) * Receives all the interest, dividends, and correctly; other income; * Issue reports to fund shareholders;and a Executes transactions in securities * Market the fund. and for cash on instructions from the The agreement entitles the manager to: manager; * Deal in securities for the fund, within • Applies monev to the payment of divi- the terms of the Charter and Russian dends according to the decision of federal law; directors; *Represent the fund at meetingswith in-

4 Confirms notices received from in- vestee companies and relevant orga- vestee companies relating to meetings, nizations; capital changes, and dividends; * Appoint a representative to attend * Informs the board of the fund and the meetings of the board of directors; and manager if there are any breaches of the *Request necessarypowers from direc- Russian Federation Law or the fund's tors to sign documents,and so on. charter; and The directors of the fund are required to: * Maintains accounts of the capital and * Assign the manager,any necessary au- income of the fund and of expenses for thorizationas signatoryfor the fund; and statutory, regulatory, and shareholder * Monitor the manager's satisfactory information purposes. performance within the management vManagersmust provide depositories contract. with all necessarv cooperation to enable The agreement specifiesa fixed annual them to fulfilltheir functions. remuneration to the manager or management company based on a standard calcu- Fzundmanagement agreement. This agree- lation of the fund's averagenet asset value ment defines the role of the fund manage- over a year. The agreementalso determines ment company or the fund manager and whether a performancefee is payable and, their responsibilitiesin relation to the fund, if so, at what level and on what criteria. It its directors, and shareholders. It requires also prohibits the management company thc management company to act in accor- from investingthe fund's assets in itself or dance with the charter of the fund, the in affiliated organizationsand from making Russian Federation fund, and other legisla- agreementswith other investment funds or

48 RussIA:CREATING PRivATE ENTERPRISESAND EFFICIENT MARKETS with investeecompanies in which 5 percent ganizations were barred from launching or more of votingequity is held without the funds. Thus the balance was tilted toward authority and prior agreement of the board the applicant to obtain a license to operate of directors. funds. This was not entirely risk-free.To be Finally, the agreement specifies the licensed, management company applicants term of the contract and provides for ter- had to provide details of their company,its mination with particularnotice periods, to- officers,and its capitalization,together with gether with fees payable upon such a rudimentary business plan and a declara- termination. It also lays down the legal re- tion that none of the key officersor employ- sort for contractual disputes. ees had been convicted of criminaloffenses. The investment funds also needed a 11- Alodelprospectus. This document out- cense. That application included details lines the minimumrequired contents of the about the founders, the directors, the aims issue or other prospectus of the fund, which of the fund, the amount of founders' capital, include: and the amount of shares to be issued.That * Investment purpose, policy,and limi- funds are closed-ended presentssome prob- tations; lems. Specificamounts of capital need to be * Information on the size of the charter authorized and issued; when a tranche is ex- capital; hausted, a new tranche must be created, but * Details of the value of a singleshare, the not until three months after the closing of type of shares to be issued, and the the previous offer. Since fund sponsorsfind starting price on subscription; it difficultto estimate demand, what would - First and lastdate of placementof shares; ideallybe a continuous offering from a sup- - Information on the founders, its direc- ply of "shelf" stock has become a series of tors, and their background, and similar secondary issues.The problems of this pro- information on the management of the cedure were compounded by the initialre- company or manager; quirement to issue quarterly (at least) * Details of the depository and indepen- valuationsof vouchers held at a mandatory dent auditor; 50 percent discount to their 10,000 rubles * Charges and expenses payable by the facevalue. This, however,has been rescind- fund; ed and vouchers can be valued at marketval- * The most recent accounting report of ue (later increased to 40,000 rubles). If the fund; equity is to be preserved between incoming * Shareholders' rights; and existingshareholders, the valuationreg- * The form and powers of the annualgen- ulation needs to be reviewed. eral meeting; Originally, the fund and its manage- * A set of warningsto investorsregarding ment company were to be separate entities; risk and inabilityto guarantee results in this would have protected shareholders dividends or capital growth; and against the possibilitythat a "self-managed" * A summary of the investment portfolio fund might have financial problems where and results in dividends or capital excessive management expenses were growth over the last reporting period, charged against the fund's income.A fund including a cost to net asset ratio. that contracted with a management company, even though the latter might find it- Issues self in financial difficulties, would be immunized against any threat to sharehold- Several practical issuesemerged in the ear- ers' equity. But many funds have been set lv stages of implementingthese regulations. up on the basis of self-management,and it now seems that excess expenses are eating Licensing into shareholder equity. Regional KIs were given the task of li- How could it be assured that fund sponsors censing both funds and the fund manage- are fit and proper?In Russia,government or- ment companies. This has raised a number

INVESTMENT FUNDS AND PRIVAnZATION 49

of concerns. The first is some loss of con- in funds' portfolios at 5,000 rubles, but, to re- trol over the process. Not all Ms have been dress the balance, a value of 23,600 rubles scrupulous in providing information to the was established for 1993 year-end valuations. central database, which means it is not pos- With the voucher price at 11,000 rubles in sible to be precise about the number of September 1993 and predicted to rise fur- funds in existence. Nor is it possible to de- ther, funds that kept a stock of vouchers for termine whether regulatorv disciplines are attractive future opportunities would be at a being applied evenly. disadvantage compared with funds that in- The real problem of licensing, however, vested all their vouchers (and were thus able is the failure of unscrupulous operators to to carry the shares of companies in which seek a license, either bv deliberately ignor- they were invested at the equivalent of face ing the law or through a series of ruses that value if thev could establish a market price or The valuation appear to eliminate the need to be licensed. at a 50 percent discount if not traded). This problem will grow These funds operate as "trust companies" threatened the preservation of equitv among or argue that by purchasing vouchers from differentclasses of shareholdersand seemed as more funds take subscribers for cash and then directly in- likely to cause competitive disadvantages to in cash or raise cash vesting the vouchers in the fund or trust, funds when net asset values were published through market the requirement to be licensed as a vouch- in comparative form. erinvestment fund is irrelevant. But even if These problems come from the unre- sales, as companies this were true, a license would need to be solved question of whether a voucher is a start to be listed, obtained from the Ministry of Finance; in security or whether it is a claim on future and if the voucher most cases, this does not occur. assets, in which case its current value is ir- National and regional regulators are relevant.Mlost funds have adopted a prag- pricescontinue to taking their responsibilities seriously, but matic approach,offering (usually)between rise. there havebeen notablescandals involving one and ten sharesper voucherand requir- unlicensedfunds. Year-end filings of results ing cash subscriptionsto be made at the (due by the end of February1994) uncov- voucherprice on the dav of subscription. ered severalproblems that will need to be This way, subscribersenter the fund on dealtwith. There is the possibilityof further equal terms.Cash subscriptionshave typi- compensation of distressed investors. callyaccounted for betweenzero and five Beyondthat, furthertraining and technical percentof subscriptions,though this figure assistanceare needed to consolidateand increasedas the voucherperiod drew to a improvethe quality,of regulation. closein June 1994. In a countrvas large as Russia,creating The valuationproblem will grow as a regionally-basedsecurities supervisory more funds take in cash or raise cash svstemis rational,but prudent regulation throughmarket sales, as companiesstart to and planningis required. be listed,and if the voucherprices continue to rise. It can be argued that net asset Subscriptiontofimn'ds valuecalculations are unimportant,or less importantfor closed-endedfunds than for Voucherinvestment funds were originally de- open-endedones. But with semicontinu- signedto providea home for vouchersnot ous subscription,even without opportuni- destinedto be appliedto the sharesof enter- ties to redeem,it is necessaryto adjust the prisesor soldfor cash.It was felt, however, subscriptionexchange rate, however crude. that cash subscriptionsshould also be al- And, once the sharesof funds themselves lowed.This created a dilemma.A fund with can be traded, a guidelineto calculatenet bothvouchers and cash would have a poten- assetvalue will be needed. tial valuationproblem during a continuous Sincea voucheris a bearerdocument, offering.This problem wvas compounded by marketsin vouchersquicklv sprang up on the banon changingan issueprice basis dur- streetcorners and in the slightlymore formal ingthe issueof a trancheof sharesbased on exchangesthat operate all over Russia. any one prospectus.This was made even These exchangesare the centersof entre- harderby the requirementto valuevouchers preneurialtrading activity, providing some

50 RUSSIA: CREATING PRI%VAnTENTERPRISES AND EFFICIENT NLARKETS

liquidity for the trade of goods and com- Research shows that the better fund modities. Nationwide trading quickly har- managers are investing their funds' vouch- monized re,ional variations in voucher ers, wvithsome funds more than 5() percent prices-to the point that the day's voucher invested, hut they are still hard pressed for price became announced in the media. The cash. Their portfolios have become more decision to free voucher valuationwas sen- illiquid, as higher percentages are invested sible, but there is still inequityin the issue in shares rather than in vouchers. price. given the prohibitionon varning the 'exchangerate" during the issueof a tranche Inv-estmzentactivities based on each prospectus.Later-subscribing shareholders thus get a bargain at the ex- Having obtained operating licenses and pense of those who subscribedearlier. gathered subscriptions, managers must in- Now that active trade in the shares of vest. This is proving to be the most difficult Now that active newly-privatized enterprises is beginning to task vet. Data and accounts to be analyzed trade in the shares develop, the valuation problem is becom- are generally inadequate. But the fact that ing more acute. MNostbusiness is done off- companv accounts and profit and loss ac- of newly-privatized market, and there is no coherent scheme counts fall short of international standards enterprises is for collectingand publishingprices. This is has proven less of a challengethan the un- beginning to a great concern, since the inabilitvto estab- even flow of information about forthcom- lish a fair valuation undermines the most ing auctions. Only the most progressive develop, the fundamental principleof collectiveinvest- managers have been able to track the re- valuiationproblem ment funds. sults of auctions and derive statistical data Is becoming more A decisionin May 1993preventing funds on valuations. Local pressure to prevent from trading vouchers was a surprise: it was outsiders from participating in bidding for acute. based on the mistakenbelief that such trad- regional companies is common, and some- ing was driving the price down. Liquidityin times successful.Moreover, there is a grow- the voucher market provided funds with ing security problem that derives from cash needed to pav fund managementfees. transporting large amounts in bearer docu- Apart from founders' capital, subscribedin ments. Physicallytransporting the vouchers cash, funds have no regularrevenue streams is risky and it consumes resources. Repre- from dividendsand interest. sentatives of the fund must accompanythe The fact that the voucher price rose af- vouchers to the auction and often must go ter the Mlav1993 decision wvasunrelated to through nonstandard bidding systems- the ban. It was a function of stronger de- devised they suspect, simply to make life mand for shares at auctions,which entered difficult for nonlocals. into full swing in the summer of 1993. Shrewd fund managers made the calcula- DiVidendsto shareholders tion, based on auction results, that the net asset value of "RussiaIncorporated" was a The payment of dividends is the prime, and considerable underestimate of the real val- in some cases the sole, objective of manv ue of the enterprises to be privatized in the managers. Given that for taxation and ac- MlassPrivatization Program. The price of counting purposes the whole portfoliois re- the voucher rose from a low levelof 4,000 garded as inventory, all capital gains are rubles in earlv 1993to 1 1,000rubles bvJuly, regarded as trading profit, taxed, and paid and to nearly 30,000 rubles bv end 1993. out to shareholders. NManypredicted a further rise until the the- This has led to competition among oretical expiry date June 30, 1994. The managers as to who can promise and pay price hit 42,000 rubles in June 1994 as the the biggest dividend. Many shareholders final phase was announced. Many fund have been manipulatedby claimsand coun- managers are ignoring the restriction on terclaims. Some advertising claims divi- voucher trading or circumventingit (for ex- dend payments of severalhundred percent, ample, they are paying managcment ex- but such dividends have been paid to about penses and commissionsin Vouchers. twenty among thousands of shareholders.

>.'.iTL\L l Fu ND), \ND) PRfV\'\Z',11 51

Long-term capital growth is misunder- foundation of a savings industry that en- stood or ignored by the public. The better compasses pension, life insurance, and in- managers find this frustrating, since they vestment funds. are pressed to liquidate their most promising investments, pay tax on the gains, and Charging pay the net amount as dividends. The process is seriously eroding share- There has been much debate on fund holder equity in many cases, particularly charges, which are high by international when excessive management expenses are standards. Annual charges are capped at 10 taken into account. In the more serious percent for voucher investment funds and cases, funds may become inadvertent 5 percent for other types of funds. Typical "Ponzi" schemes as new subscriptions are charges in developed fund markets range The opportunities used to satisfy the appetite of existing from 0.25 percent for money market funds are enormous for shareholders for unrealistic returns. This to 3.0 percent for highly specialized funds mav result in some surprises when year-end of a venture or emerging market tvpe. To be domestic or foreign accounts are filed, as expenses have eaten fair, the Russian figures represent a total ex- management awav the value of smaller funds and as the pense ratio-stated charges elsewhere may companies that supply of new shareholders starts to run not include a range of items taken as a sep- dry One solution would be to halt any dis- arate charge on the fund's income or assets. have the patience tribution of capital gains or capital itself; The charges are not as extreme as they to deal with initial the latter is illegal since charter capital is appear since they are levied as an asset val- ditficurlties and nominally sacrosanct. ue heavily discounted by the accounting rules. Charges on real asset values, when the vision to see Taxcation thev emerge, will likely be 3 to 4 percent. tvhat cotuld be. Those who argue in favor of this high The Russian fiscal regime may tax divi- maximum stress the start-up nature of dends to shareholders at least twice. much of the expenditure, the large number Realized gains will be taxed at normal cor- of small shareholders (with vouchers at porate tax rates in the hands of the fund 25,000 rubles and the exchange rate at and must then be distributed as if they were 1,300 rubles to the dollar, the average hold- short" gains, as in the United States. This ing is $20), and the need to encourage the is a contrast to the system known in most of formation of funds and management com- Europe, where the concept of fiscal trans- panies as commercial enterprises. In any parencv is universally accepted (though not event, charges are governed by regulation always rationally applied). Under this sys- that is subject to administrative change tem, realized capital gains made inside the rather than by decree-changes that would fund are not taxed, but the shareholder is take time. It is thus argued that time will de- taxed when the eventual gain is realized as termine whether the hi,ghcharges are press- a result of the sale of fund shares. Some ing too hard on shareholders' equity. As it proposals to adopt a more equitable taxa- happens, a number of managers have tak- tion regime seemed likely to create even en a commercial view and opted to lower greater complexities through taxing short charges to roughly 4 percent. The main and long gains at different rates, as well as problem remains liquidity from which to having another rate for gains that are not pay the managers their fees, together with distributed, but reinvested. cost overruns that result from excessively It is always a long process to change a fi- ambitious marketing expenditures. nance ministry's mind on taxation. But it is important that a regime be established that Conclusion does not disadvantage shareholders in funds compared with those who invest di- Investment bv the better funds in enter- rectlv. This is particularly necessary if in- prises being privatized is moving at a fast vestment funds, or any kind of pooled or pace. Any business that evolves in less than managed funds, are intended to form the a year against a background of inadequate

52 RussIA: CRE.UINI; PRVA.TLENT:RI'RISES AND EFFICIENT NIARKETS

financialinfrastructure and in an uncertain gue that dishonest operators are undermin- politicaland economicclimate, is inevitably ing the entire system. going to have initial difficulties.But if the Still, the investment funds business is technical and logisticalproblems discussed quickly becoming established. It will go here are not addressed quickly, scandals through a difficult period as problems are and collapses may discredit the whole exposed in 1994, but if solutions to those process. problems are forthcoming, the business Not all funds are fraudulently or in- should grow and eventually flourish. The competentlymanaged. Many are strivingto opportunities are enormous for domestic or meet the highest international standards. foreign management companies that have Some managers are becoming frustrated at the patience to deal with initial difficulties the failure to address problems-they at- and the vision to see what could be.

INVESTIMENTFUNDS AND PRIVATZATION 53

CH-APTER 5 Voucher Investment Funds Andrei Volginand Yuri Milner

All established processes undergo a dra- * 18 percent had exchanged the voucher matic and rapid change when a country as for stock in privatized companies big and as complex as Russiadrastically al- * 28 percent had exchanged the voucher The option of ters the nature of its economywithin a few for shares in voucher funds. exchanging years. The implementation of Russia's sys- The option of exchanging vouchers for vouchers forshares tem of voucher investment funds is an ex- shares in investment funds proved to be cellent case in point. In a short span of quite popular, despiteanumberof apparent in investment funds eighteen months, investment funds were obstacles. Initially there was a great deal of proved to be quite conceived, then collected vouchers from speculation that lower-class and elderly cit- pular despite a citizens and invested them. In 1992, less izens would sell their vouchers immediately than ten small funds existed in Russia. A lit- for cash. However, available information in- number of apparent tle more than a year later, more than 640 dicates that a large proportion of working- obstacles. funds were competing for individual class voucherholders decided to invest in vouchers. As of mid-1994, voucher invest- funds. Furthermore, inexperiencewith se- ment funds have millions of shareholders, curities and market operations and a lackof and have proven to be the most activeplay- understanding of the nature of investment ers on the privatizationfield. funds was supposed to create a reluctance As the first stage of Russian privatiza- to invest. A third factor impeding fund in- tion-voucher auctions-comes to an end, vestment was that no infrastructureexisted investment funds will try to survive in a for the distribution of the funds' shares. highlycompetitive environment, while main- Given such obstacles, the fact that 28 per- taining their imagesas sound financialinsti- cent invested in funds is quite remarkable. tutions. This chapter analyzes the present Most funds hired their own salesforces status of voucher investment funds, de- to collect vouchers. Inter-regionalfunds es- scribeshow they arose, and reflectson perti- tablished networks of sales offices in dif- nent characteristicsof their present forms. ferent cities. In addition, severalfunds used existing networks of Sberbank (a state- Voucher sales and their results owned savings bank with 42,000 local branches) and post offices. This approach Approximately 150 million vouchers were proved more effective in terms of collecting distributed in Russia,with each eligibleindi- vouchers, but was quite expensive. Some vidualreceiving one voucher.Some emplov- funds invited individuals to send in their ees of companies undergoingprivatization vouchers by mail. Unfortunately,due to the used their vouchers to purchase stock in poor quality of the Russian postal service, their own firms. All other voucherholders thousands of vouchers were lost in transit. had to either take part in a voucherauction, exchangetheir vouchersfor sharesin invest- Kinds of vouchers ment funds, or sell them on the open market for cash.A survevcarried out in June of In order to analvze the role of voucher 1994, revealedthat: funds in Russia, one must disaggregatethe * 30 percent of those questioned had sold funds into categories and identifv them bv the voucher their representative characteristics. There

VOULHIF R INVESTMIEXT FL'NDS 55

BOX 5.1 expertise of their managers with advertising Voucher fund classification by type of promoters and managers slogans such as "leading foreign investors

lbticherfieniLdpromoted bv large they weredesigned by industrialplants trust us." Some funds appealed to sectoral Financzdl Institutions (nonspecialists)to encourage employ- interests of valuable assets (for example, oil, Special fund manaigementcompanies ees to buy shares of their companies at gold, and diamonds), while others targeted wereset up bv a fewlarge banks. Most of voucherauctions. Some amateur funds specific social groups including the rmilitary, these funds raised their capital with were also started by individuals and vouchers from the banks' individual private companies. Of the amateur veterans, and police officers. clients and from employeesof institu- funds that were set up, few have sur- Several funds even turned to gimrnick tional c-ustomers.These fund manage- viveddue to their lack of capitalor pro- advertisements to lure the attention of indi- ment companieschose to pursue verv fessionalexpertise. vidual investors. One fund advertised that conservativeinvestment strategies. Most Manyamateur funds wereorganized investors could win a luxury apartment in of the assetswere invested in privatized by localor regionalauthorities. Although Moscow whe another claimed-falselv- companies that were and remain the regulationssupposedly prohibited autho- it habe an ertcate of Honor banks'customers. ritiesfrom directly promoting funds, local that It had been given a certificate of Honor bureaucratsdesigned numerous ways to by the King of Belgium. In most cases false IVoucherfundspromoted by smaller indirectlycreate and supportfunds. advertising backfired on the fund. Inter- financial and consultingfirms estingly,in many cases the appeal of an ad- Nlanvinvestment funds were . organized Fraudfunds ~~~~~~~~~~~~~~~~~vertisingv s campaignc didldi notn seem to bear a bv brokers or investmentconsultants strong correlation to the actual content of workingin the fieldof financialservices. Unfortunately,a number of funds were g Thesefunds have followed a rangeof in- set up with only one goal in mind-to the advertisement. Instead, advertising suc- vestmentstrategies and have usedvarv- collectas muchmoney and vouchersas cess appeared to be based on the frequency ing investment techniques without a possible and then subsequentlydisap- with which advertisements appeared on discemablepattern. pear. These funds capitalized on the Russian television or radio programs. Rus- naiveteof Russianinvestors and on the sian investors proved to be Iighly responsive Mmateur"unmds lackof well-developedof Russianfinan- advertisements he most requendy Amateur funds were so called because cial regulatory law. to adverutsements heard most frequenty and were attracted by funds with large advertising budgets. are several ways to classify voucher funds. Box 5.1 offers a classification criteria based Registrar system on the goals of promoters and managers, while Box 5.2 characterizes funds accord- Fund managers had no prior experience in ing to their size and geographic spread. placing large issues, but surprisingly their actions proved quite effective. Most funds Advertising and public relations issued certificates of shares, while only a few maintained book-entry systems. There was MNlostfunds started to market their shares no depository and registrar system available within one or two months after their regis- for voucher funds in 1992. Consequently, tration. Each fund had to overcome the li- the creation of registrars was very time-con- abilitv of being a new and untested suming and expensive. In a number of large institution and had very little time to build funds reviewed, between ten and thirty-six confidence based on actual results. The people were simultaneously entering in most successful marketing strategies in- computers information about shareholders. cluded aggressive advertising and huge A two to three month delay in registering public relations campaigns. In fact, most shareholders was the norm. voucher funds spent 3 percent to 10 per- Under registrar guidelines fund share- cent of their assets on advertising. holders either had to apply to registrars Marketing approaches tried to capitalize personally (quite a difficult feat for share- on the strengths of each individual fund. holders of inter-regional funds), or they had Regional funds that promoted local invest- to apply through a fund's local office that ment sought to exploit sentiments of region- acted as a transfer-agent for registrars. alism or nationalism in ethnicly homogenous However, most funds scrapped their de- areas, while large firms claimed that stability centralized system of local offices after they was naturally associated with size. Some finished selling shares, thus further compli- funds tried to stress professionalism and the cating the process.

56 RUSSIA: CREAnNG PRivAnE ENIhEPRISES AND EFFICIENT MARKETS

Tradingand liquidity Voucherfunds classifiedby size and geographicspread BOX5.2

The lack of an efficient registrar system Smnallregionalfunds cesstoinformationservesas a definite ad- placed severe limits on the organization of Several hundred small regional funds vantagefor regionalfunds, the closerre- a liquid secondarv market for fund shares. were started.With 1,000-10,000share- lationship with managementcan also holders and capital of $20,000- operateas a seriousshortcoming from a However, now that regulations on registrar $300,000they do not havethe resources shareholder'sperspective. and depository activities have been intro- to cover the expensesof fundmanage- duced, it has become possible to increase ment. Recognizing this, many small Inter-regionalfunds the number of secondary transactions by funds have alreadystarted the process Betweenforty and sixty inter-regional developing local secondarY markets. of mergingwith largerones. funds possess 40,000-250,000 share- For example, Adamant Financial Cor- holdersand enjoya capit-albase of $1 Largerregionalfunds million-$10million. These funds have poration (Derzhava fund manager) became There are aboutfifty regionalvoucher expandedtheir marketingand invest- a market-maker in Derzhava shares in fundscomprising 50,000-300,000 share- ment activitiesacross a number of dif- Januar- 1994. The volume of secondarv holders,possessing a capitalbase of $1.5 ferentregions. transactions has increased to about 20,000 million-$12million. Most of theassets in shares a month (0.8 percent of shares out- thesefundsareinvestedwithintheirown Largenationalfunds region.Due to the localnature of invest- Five large voucherfunds in Russiapos- standing) in approximately 500 transac- ments,regional funds tend to havemuch sessIroihion-3 million shareholders and tions in Ioscow and five local offices. better informationwith regard to the sta- acapitalbaseof $25 million-$50million. Unfortunatelv, there is still no use of tus of privatizedcompanies, and also Thesefunds profited from aggressive ad- stock exchanges because of the inadequate tend to enjoy more personal relations vertisingin all regionsof Russia,and trading, clearing, and settlement systems. with firmmanagement. While greater ac- from sharesales by post offices. Secondary markets for funds shares are thus based solely on market-makers. Many managers have begun the process of buving and ment funds. At the same time, fund selling funds shares, but most markets are managers are not admitted to these insufficiently liquid due to poor registrar markets directly. systems, insufficient sales infrastructure, or * Privatized companies do not follow full inadequate cash reserves of fund managers. disclosure principles. Investment man- In their transactions, fund managers prefer agers have partial and conflicting in- to deal with each other face to face for the formation about the same companies folloxving reasons: and prefer to deal in a more confiden- There is a lack of public corporations tial manner. with listed stocks. MvIost corporate In these circumstances, everv transac- stocks attract just a few investors; usu- tion on the market takes a great deal of ally large institutions or top corporate time, effort, and money. Counterparts have management, both fighting for control, to meet each other face-to-face to sign con- with the result that liquid secondary tracts (to date there are no other wvaysto markets do not exist. manage this in the Russian legal system). * Trading, financial information, deposi- Furthermore, taxes on securities' transac- torv. custodial, clearing and settlement tions are paid independently, and then the systems are being developed, but they contract and confirmations of tax payments are still embryonic and ineffective. have to be brought to the registrar of the * While some "networks" exist, there are company to transfer the stocks. no obvious leaders in trading svstems. To some extent, these issues do not pre- Consequently, fund managers hesitate sent major problems since most funds are to join any one particular network be- not activelv managed and have onlv three cause the probability of their customers to ten transactions each month. Voucher being members of the same trading sys- speculations were something of an excep- tem is very low. tion, but in their case there wvasno need to * There is not enough competition be- register deals. tween banks and brokers in existing It is still too early to discuss the possi- trading systems, and the high cost of bility of "opening" existing funds. First of commissions is prohibitive for invest- all, the low liquidity of the stock market

. INT STMENXXFt ND' 57

makes it impossible to raise cash quicklyby (1,940 rubles to the dollar times 0.5) in selling stocks, and also prohibits the use of June 1994. Fund managers are forced to net asset valuation (NAV) as a basis for buv and sell assets much more than neces- share prices. Secondly,registrar and depos- sary,simply to keep the balance value clos- itorv systems need to expand in order to er to the market price. serv e a large number ot transactions more Some fund managers initially employed efficiently, and fund managers need timeto too many people, an especially pressing develop their back offices. The final reason problem for small funds. At the same time, vhy it is premature to 'open" existing funds any increase in management fees would is that special accounting for closed invest- damage funds. Consequently, fund man- ment funds and mutual funds needs to be agers are looking for ways to strike a bal- introduced. Currentlh; funds cannot create ance between the quality of management Unifortunately, and cancel shares simultaneously and its costs. Unfortunately, most managers there is still no use W'hile it will take at least two or three manage small funds, and therefore the re- years for mutual equitv funds to appear alistic alternatives open to them are ex- of stock exchanges on the market, it is possible that open panding their businesses by raising becauise of the money-market funds could be started in additional capital, launching new invest- inadequfate trading, six to twelve months, if the accounting ment and pension funds, or simply getting cladearing, tranding svstem for open funds is introduced. out of the frav clearing, anld settlement systems. Commissions Investments

Most funds pay their fund managers the le- Very few funds followed one specific in- gal limit of compensation, or 10 percent of vestment strategy throughout the privatiza- average net assets as a fund-management tion process. Most funds changed their fee. While some have complained that this investment objectives repeatedly, thereby payment is exceedingly high, it is important making the classification task more diffi- to take note of several considerations. First, cult. Nevertheless, some of the most popu- the fees are usually paid after the end of a lar investment approaches may be defined. quarter and high inflation reduces the real value of payment compared to the real val- The speculative approach ue of assets at the end of the period. Second, Russian fund managers have to 1Many fund managers made their invest- spend a great deal of money finding in- ments purely on a speculative basis, with formation on privatized companies and de- the hope of immediately reselling the veloping their activity. These start-up stocks. Privatization in Russia provided fer- investments should increase the perfor- tile ground for speculative adventures for mance of portfolios significantly to the ben- two reasons. First, managers and insider- efit of funds' shareholders. Third, net assets owvnersin privatized companies fought for are now calculated on the basis of the his- control against external investors. Quite of- torical costs of assets. The book value of a ten top-level management used the cash of particular holding may be exactly the same the company to do so. This practice was tor a fewvyears in spite of a rise in the mar- technically illegal, but impossible to effec- ket price. Furthermore, all balance values tively control. Consequently, there was al- of stocks must be multiplied bv 0.5, except ways at least one buyer interested in stocks 'with market value.' The Securities keeping control of a company regardless of Commission is supposed to announce the price. Second, the voucher auction proce- list of such securities, but to date the an- dure was guided by the principle that the nouncement has vet to come. Therefore, a more vouchers invested, the higher the lot of stocks bought in January of 1993 for stock price. While it was nearly impossible 1() million rubles had a NAV of approxi- for a single investor to buy all of a compa- mately $11,236 (445 rubles to the dollar nv's shares, in many situations large in- times 0.5) in January of 1993, and $2,577 vestors bought lots of shares from other

58 Russt,a: CRLATINGPRi%v\xE ENTER'RISES AND ErRI([INTI ARKETS participants at an auction. Frequently, it For the next several years, industry ori- was more efficient to take part in the auc- ented investment funds will remain among tion xvith a small amount of vouchers and the most stable. But when amateur and use saved cash to buv stocks after the fraud funds disappear and competition auction. among funds and between other institu- Mvlanyfunds benefited as a result of this tions becomes severe, fund managers using favorable environment for speculation. At the sector specific approach will probably the same time, it was hard to predict have to revise their investment strategies. w hether large investors would participate in a particular auction, or if an auction would Short-term speculation plus venture prevent insiders or large external investors investments from buying shares at the higher price. Furthermore, in many cases it was easier Some fund managers decided to finance and less expensive for large investors to buy new ventures or develop new investment shares from emplovees who had obtained projects and have invested a substantial them at a discount. One voucher fund part of their assets in business centers, in- bought 15 percent of the shares outstanding dustrial plants, or high-technology compa- for the same amount it had previously paid nies. The huge discrepancy between funds' for 4.6 percent of the company's shares. As a assets and capital required for any serious result, although speculative funds benefited greenfields venture forced managers of from lucky reselling, thev also held many these funds to be very active in forming var- nonliquid stocks of poor investment quality. ious financial groups, or issuing stocks of Some funds concentrated on specula- new companies. The First Voucher Fund tions with vouchers. Buying small lots of now promotes a First Pension Fund to in- vouchers from individuals or small dealers, crease capital available to finance their nu- and then selling them in big lots to various merous projects. Many smaller funds have companies proved to be a profitable busi- followed this policy, and some thirty to forty ness. However, several sharp unpredictable private pension funds have been started re- changes in the price of vouchers (three cently by voucher fund managers. This times a gain in price of 100 percent to 150 group of funds has not managed to an- percent within a week, once a loss of 60 per- nounce any positive results thus far, though cent within three days) brought big losses a quick and high return for investors was for voucher speculators, because voucher promised in their advertising. prices went up when most speculators held cash and vice versa. Overall, speculative Long-term portfolio investments plus venture funds have thus far produced quite moder- investments ate results compared to other funds. This group of funds started with long-term Sector specifc approach portfolio investments in privatized companies. MIanagers of these funds are now de- MIany funds chose specific industrial sec- veloping restructuring and investment tors as their investment priorities. Better projects mainly for the companies where knowledge of specific industries was sup- they have major holdings. Fund managers posedly a serious advantage of these funds expect large returns on capital invested in the mass privatization environment. from the increased efficiency these compa- Sector specific funds ended with almost no nies should, it is hoped, soon enjoy. stocks of poor investment qualitv in their Portfolios of these funds may be easily portfolios. But most of these funds were divided into active and passive components. promoted by companies from the same in- Managers try to be active investors in a se- dustry, and therefore managers had-and lect set of privatized companies and there- have-other goals in mind besides simply fore attempt to influence their management. insuring the top performance of portfolios In most cases, fund managers would prefer for the benefit of their clients. to have dominant control of the company so

VI.(CHERINVESIEILNT FuNus 59

that post-privatizationrestructuring, unpop- dividual income tax which can be no lower ular with employees,can be performed as than 12 percent on dividendsreceived from quickly and decisivelyas possible. Invest- investment funds or on capital gains. ment funds are allowedto purchase up to 25 Inflation levies heavy burdens on in- percent of the common stocks of any one vestment funds as well. If a stock was company,and they activelydo so in the firms bought in January 1993, for 10,000 rubles in which they have a major interest. Twoor ($22.47 at the current exchange rate) and three voucher funds often share effective sold in June 1994, for 20,000 rubles control of these companies. As passive in- ($10.31), the fund would have to pay a 38 vestors in other companies,fund managers percent tax on 3,800 rubles ($1.96), even are not terribly involved in their manage- though this investmenttumed out to be a ment, but still carefullymonitor the actions net loss. The existing tax of companies'top executivesto prevent any The existing tax systemwill kill invest- system will kill serious damage. ment funds if substantial change is not Uncertainties and persisting problems forthcoming.As it currentlystands, the sys- investment funds if have forced managersto select stocks more tem significantlyhinders and distorts the substantial change carefully and pay attention to investment investment decisionsof fund managers. is not forthcoming. quality rather than speculative potential. This group of managers has not promised Accounting any immediate profits for investors and, consequently,the financialposition of these Investment funds do not have a specialsys- funds is much more stable than most others. tem of accounts and accounting procedures; yet they still use accounting Diversifiedfunds principles of normal enterprises. Con- sequently, accounting is inconvenient and Most regional funds diversified their port- costlyfor fund managersbecause they must foliosand currentlyhold shares from 70 to go through many uselesssteps and proce- 240 (usually)small companies.The average dures. It is also impossiblefor investors to investmentsof $15,000 to $20,000 are too evaluate the current position and financial smallto make a difference,and operational results of investmentfunds, and numerous costs and the costs of protecting funds' opportunities for account manipulationex- ownership rights are high. Due to over-di- ist. It is quite possible that manipulations versification, all future prospects of these cannot be prevented before a truly liquid funds are closelyintertwined with the eco- stock market developsor before funds hold nomic situation in Russiain general. listed securities.However, a way should be found to make accountingmore appropri- Taxation ate for fund managersand investors in the intenm. Investmentfunds in Russiaare not tax transparent for final investors.Funds pay tax on Prospects profits (38 percent in vMoscow)that is equivalent to a capitalgains tax. SinceJanuary of Although many investment funds did not 1994,voucher funds have receiveda tax ex- announce any dividend payments after emption on dividends received within two 1993, the financialpositions of most funds years of initial registration. However, this are not terrible. Speculationswith equities privilege does not cover dividends from of privatized companieshave proven prof- 1993,and most voucher funds willcelebrate itable enough and the potential for long- their second birthday before the end of term growth is great. But many fund 1994. Most funds will thus not be able to managers still feel uneasyin the fund man- reap the fruits of this tax relief. agement business.MIost managers want to Investment funds must pay municipal diversify their business, seek the right to taxes (for roads, police support, and edu- buy real estate, borrow money,or provide cation), while investors have to pay an in- commercial loans. They want to continue

60 RussIA:CREEAING PRivATE ENTEERPRISES AND EFFICIENT NLARKETS

their business expansion but not in fund Portfolzo investments. It is difficult to management, because other typesof finan- imagine voucher funds becoming nor- cial services are not nearly as regulated. mal portfolio investors, at least in the Mvloreover,the current dissatisfactionof in- near future. Some new investment vestors makes it difficultto raise more cap- funds will be managed accordingto es- ital in existing funds, and the tax systemis tablished portfolio principles. viewed as unfair. Few opportunities for quick profits Possible scenarios for voucher funds remain in the fund management busi- include: ness. Fund managers may hope for high * Bankruptcy.Many small voucher funds and stable profits, but this will only come will merge with each other, with larger about in an environment of equal treat- funds, or willeventually be managed by ment of all financial services and with the large groups. Some fund managerswill implementation of a fair tax system. As simply disappear, unable to survivein foreign investment in Russian equities the new competitive environment. grow and the Russian private sector ac- * Holdings. Many sector-oriented funds tively invests, the liquidity of the Russian will prefer to hold portfoliosof closely- stock market will continue to improve. related stocksover a longperiod of time This will create a more comfortable en- and will choose to be activelyinvolved vironment for portfolio management. in managingthese companies. The first international fund management * Investmentcompanies. The most popular groups have started their operations in role for a fund manager to behaveis that Russia. It is hoped that thev will increase of investmentconsultant, broker,or in- foreign investments substantially and vestment banker. Manv funds willtake will introduce high standards of fund on more of a role as providersof invest- management. ment servicesand financialadvice. In the next century, Russian fund * V½ntureand portfolio investments.Some management companies will continue to funds willcontinue to followstrategies grow. They will manage more funds with of long-term portfolio and venture in- larger assets and play an increasinglyvital vestments. These funds will be among role in the restructuring of the Russian the most active plavers on the post- economy and the development of a sound voucher stock market. financial system.

%LU( HER INVESTMENT FUNDS 61

ClL4PTER6

Techniques of Mass Privatization: Implementing the Voucher Auction Program October 1992 to June 1994 Jeffrey L. Schwartz and Zoanne L. Nelson

This paper presents a summarn of the opera- the timely implementation and contributed The deliberate lack tional phases of the voucher auction process to the success of the program. This design of complexity in which was adopted by the Russian govern- also made it possible to effectivelv use tar- the process facili- ment in 1992 as part of the mass privatization geted international technical assistance and program. The overall results of the voucher financing to support the program's replica- tated the timely auction program's transfer of more than tion throughout the country. As the coordi- implementation 12,000 enterprises from government to pri- nating ministry, the GN has been highly and contributed to vate hands are well known. In part, the suc- effective in using technical assistance to cess of mass privatization in Russia is due to support the program's design and imple- the success of the the program's design and mechanics, which mentation. Technical assistance has been program. allowed for rapid replication and implemen- provided by professional staff and private tation across the country. Between October consultants supported by USAID, the 1992 and January 1993, the Russian govern- World Bank, and the EBRD. ment issued each Russian citizen a privatiza- In outlining the design and mechanics tion voucher; almost 150 million vouchers of the voucher auction privatization pro- were distributed. A mechanism of publicly- gram, this paper examines the three oper- held voucher auctions was established by the ational components of the program. The government to provide the opportunity for first step in the mass privatization program citizens to invest directly in large-scale enter- was the mass corporatization of enterpris- prises undergoing privatization or to partici- es which were to be privatized. The key pate in one of more than 600 voucher steps in the mass corporatization process in%cstment funds which were licensed to op- are outlined in the first section. The public erate n Russia. and operational focus of the mass privati- The mass privatization program was ini- zation program were the public voucher tiated bv the State Committee of the auctions which were conducted in almost Russian Federation for the Management of every region across the Russian Federation. State Property (Goskomimushchestvo, The main elements of the regional vouch- GKIM. According to the Russian Privati- er auction process are outlined in second zation Center, as of April 30, 1994, eighty - section. The last section summarizes the six of the eighty-nine regions in Russia had operations for national auctions, such as initiated voucher auction programs, and for the mass privatization of enterprises approximatelv 11,000 enterprises had been which were simultaneously auctioned in privatized. The program was scheduled to multiple regions. be completed with the expiration of privatization vouchers on June 30, 1994. Key steps in the corporatization and The overall design of the mass corpora- preparation for privatization of an enter- tization and privatization program included prise in the mass privatization program the use of simple and standard procedures at cach level of the process. The deliberate The initial phase of the mass privatization lack of complexity in the process facilitated program involved the preparation and mass

TlEciH\IcQLFSOF .M1AS.APRIVAI1,' vn IMP.EM.IENTINGJ THE VOUCHERAUCTION PROGRAI-t 63

corporatization of thousands of enterprises options for privatizing the enterprise. The across the country.The mass corporatization three privatizationoptions involveda range process includedstandard proceduresfor the of share allocations to enterprise insiders selectionof privatizationoptions, the draft- (enterprise managers and employees) and ing of a privatizationplan includinga stan- outside investors. Shares available to out- dard valuation of an enterprise's assets,the side investors were distributed through transformationof enterprisesintojoint stock, voucher auctions or investment tenders. companies and the compilation of docu- Each of the privatizationoptions specified ments to register the sharesto be distributed that 29 percent or more of availableshares and sold at internal and public auctions. would be distributed through voucher auctions unless the enterprise belonged to a Phase 1: Preparationforpprivatization group of enterprises whereby less shares In practice, options wererequired to be sold, such as energy,ex- 1 and 2 have been There were three key preparation steps re- traction, and refiningenterprises. The share quired to transform an enterprise into a allocations for the privatizationoptions are predominant joint stock company.The Director General summarized in table 6.1. A dominant fea- choices for of each enterprise was responsible for es- ture of the mass privatizationprogram was enterprises tablishing a working commissionfor priva- the availability of large percentages of tization of the enterprise. The commission shares to employeesand managersin enter- undergoing was charged with the followingtasks (see prises tobe privatized.Each of the three op- privatization. figure 6.1). tions involved between 50 and 60 percent of the initial sharesof newlyprivatized com- Vl uation of assets.Enterprises' valua- panies to be distributedto enterprise man- tions were mechanicallyderived summaries agers, employees, or the Enterprise of an enterprise's assets. These valuations Employees' ShareholderFund (EESF). were primarily driven by book values and The selection of privatization option 2 were prepared according to requirements or 3 required the approvalof two-thirdsof specified in GKI Regulation No. 763p. the employees either in a general meeting of the workers' collective or by obtaining Pnvatization options.According to the signatures of the employees.If options 2 or 1993 State Program of Privatization in 3 were not selected,option 1 was chosen by Russia, each commission was required to default. In practice, options 1 and 2 have provide informationtotheemployeesofthe been predominant choices for enterprises enterprise in order to choose one of three undergoing privatization. Approximately 70 percent of enterprises selected option 2 Figure6.1 Preparationof a Russianenterprise and approximately30 percent of enterpris- for voucher privatization es selected option 1. Less than one percent of enterprises selected,option 3. Many of Local the largest enterpriseschose option 1 by de- Doument committee s lcoPntstock Documents Employees s package * document i company i Shares i and shares fault due, in part, to difficultiesin organiz- preparation review/ registration registered to the fund ing a workers' meeting or difficulties for approval employees in purchasing the majority

* Corporatization * Privatizatio n ./ a o * Commission planos amountof sharesfor largeenterprses wth creation Valuation and,subscription high levels of statutory capital. privatization Jont stock government toMThe key elementsof the privatization option company consideratbon employees charter options are summarizedbelow.

Local committee's Local committee's industrial departments administrative departments OPTION1. Enterprise insiders can obtain control of up to 50 percent of the Enterpr,se shares. Fiftv percent of the shares are avail-

Enterprise Local committee able to outside investors through voucher J- - -- * Fauctions or investment tenders. From the T,e range 2 6 months authorized capital,

64 RussIA:CREATING PRIVAET ENTERPRISES AND EFFICIENT AAR)ETS

* Employees are given preferred nonvot- * If a group of workers or any physical or ing shares representing 25 percent of the legal person takes the responsibility to charter capital. These shares are distrib- fulfill the privatization plan and to en- uted free of charge to all members of the sure the solvency of the enterprise, and ,work collective provided the value does receives the consent of the general as- not exceed 20 times the legal minimum semblv of the work force under an remuneration for the employee; agreement which should not exceed * Common shares constituting up to 10 one year, the group has the right with- percent of the charter capital, but not in a specified period to acquire 30 per- exceeding six times the legallv estab- cent of the common shares at the lished minimum remuneration of one nominal price. employee, are sold by closed subscrip- * Enterprise workers (including mem- tion to the work force at a 30 percent bers of the above group) can purchase discount from the nominal price of a common shares constituting 20 per- share. Payment can be made in install- cent of the charter capital not ex- ments over a three-month period with a ceeding 20 times the minimum 50 percent initial payment of the nomni- remuneration at a 30 percent discount nal price; from the nominal price payable over a * Management can acquire common three month period with a 25 percent shares constituting five percent of the initial payment. charter capital at a nominal price not to * If the managing group cannot fulfill the exceed 2,000 times the legal minimum provisions of the agreement, the shares remuneration; and of the group will be sold to the public at * The work force may establish an Enter- a specialized voucher auction (or for prise Employees' Shareholding Fund cash after July 1, 1994). (EESF) which is eLigible to receive 10 * Shares transferred to the EESF should percent of the charter capital with a two not exceed 10 percent of the charter year option to purchase the shares at capital. their nominal value. Transfer of the Table 6.2 illustrates the allocation of shares from the EESF to the employees shares among intemal and external in- is conditional upon the completed sale vestors for selected enterprises. of 80 percent of shares including the sale for vouchers of the shares estab- Privatization plan. The privatization lished by legislation. plan for an enterprise details basic information on a company and its privatization. OPTION 2. Enterprise insiders can ac- This includes a sign valuation of the enter- quire 56 percent of the shares and 44 percent are available to investors through Table 6.1 Allocation of shares under privatization options 1, 2, and 3 voucher auctions and future cash sales or (percent) investment tenders: Description Option I Option2 Option3 * Employees have the right to buv common votingshares representing51 per- Freeto empioyees 25 20 Sold to empioyeesat 1.7 index of nominal value cent of the authorized capital at a price (cash or vouchers) 10 51 equal to 1.7 times the nominal value of Sold to management at nominalvalue (cash or vouchers) S the shares and Sold to employee group committed to fulfilling * The EESF mav retain up to 5 percent the prvatization plan and managing the enterprise to be purchased within two years. at nominal value after one year (cash only) 30 Sold to EnterpriseEmployees' Shareholder Fund (EESF)with two-year right to purchase (cash only) 10 5 10 OPTION 3. Enterprise employees and Subtotal retained by enterprise 50 56 60 managers can acquire 60 percent of the Voucher auction (minimum percentageby law) 29 29 29 shares with 40 percent of the shares to be Investment, tender, retained by government, or other 21 15 11 sold through voucher auctions and invest- Subtotal availableto investorsor government 50 44 40 ment tenders or cash sales. Total 100 100 100

TECIHNIOUESOF .LissPRivxr\nzxON: IMPLEMNENTINGnHF. VOUCHERAuCTION PROGRAM 65

prise's assets and the proposed number tal number and nominalvalue of shares, and allocationof shares to be issued. A typ- the percentage of preferred and com- ical privatization plan depicts the following mon shares, and the form of shares (ac- information: tual certificates or central registrar). * Summary characteristics and informa- The plan should include a table which tion including the name, address, summarizesthe proposed placement of ownership status, bank name and ac- the shares to employees and manage- count numbers, names and addresses ment, along with external placements of wholly-owned and partially-owned (such as voucher auction and invest- subsidiaries, number of employees, ment tenders). founding capital, list of products The privatizationplans were signed by made by the enterprise, and informa- the chairman and members of the auction tion regarding the location of compa- comniissionand chairman and members of ny plants and operations. The plans the local propertycommittee. also include lists of all social, as well as productive, assets. Articles of the joint stock company. A * The selected privatization option and model corporate charter was provided in the names of the commissionmembers. the attachment to Presidential Decree No. * The distribution of shares according to 721 entitled, "Regulations for the Com- the privatization option including the mercialization and Transformation of calculation of shares outstanding, and State Enterprises into Open Joint Stock for whom specified amounts of shares Companies." The decree provided a de- are available. tailed example of a company charter in- * The proposed placement of the shares cluding the company's purposes and the of the enterprise including the new role of the board of directors and compa- name of the joint stock company,the to- ny's management.

Table 6.2 Distribution of shares for selected Russian enterprises

Saransk Lukoil Factory Kogalim- Krasnoyarsk Tomsk Orbita Amurenergo neftegas Krasnoyarsk TsBK Neftekhimiches (semi- (electric util- (oll drilling Tire (cellulose, Tekstilmash Factory ZIL conductor ties and ther- and gas Factory paper and (textile (oil-based Company (principal industry) (automobiles) devices) mal power) extraction) (tires) cardboard) looms) chemicals) Privatizationoption I 1 1 1 2 2 2 2

Internal placement(percent) Preferredstock placement for employees(option 1 only) 25.0 25.0 18.5 18.6 0.0 0.0 0.0 0.0 Closedsubscription of common stockforemployees 10.0 10.0 5.6 10.0 51.0 51.0 51.0 51.0 Commonstock placement for managers(option 1 only) 5.0 3.6 5.0 5.0 0.0 0.0 0 0 0.0 EnterpriseEmployees' ShareholdingFund (EESF) 10.0 100 10.0 0.0 5.0 0.5 0.0 5.0 Totalinternal placement 50.0 48.6 39 1 33.6 56 0 51 5 51 0 56.0

Externalplacement (percent) Voucherauctions 35 0 29.0 11.9 17.3 29.0 29.0 29.0 44.0 Retainedby governmentor holdingcompany 13.0 20.0 49 0 38.0 15.0 19.5 20.0 0.0 Distributionto populationin the far north andemployees of the oil transportationcompanies and subcontractors 0.0 0.0 0 0 9.7 0.0 0 0 0 0 0 0 Investmenttenders 0.0 0 0 0.0 0.0 0.0 0 0 0°0 0 0 Cashsale 2.0 2.4 00 1.4 0.0 00 00 0.0 Totalexternal placement 50.0 51.4 60 9 66 4 44 0 48 5 49 0 44 0 Totalshares (percent) 100.0 1000 1000 100.0 100.0 1000 100.0 1000

Note: Figuresare rounded to the first number after the decimal point. SourcePrivatization Planof the Enterprises.

66 RuSSIA: CREATING PRIVATFENTEFRPRISES AND EFFICIEN T ..L\TS

Phase 2. Transformationto a joint stock Distribution of shares. Upon registration, company the company had fifteen days to conduct a closed subscription auction in order to either Enterprises changed their legal status to joint transfer the shares free of charge to the em- stock companies through the registration of ployees under option 1, or to make available their privatization plans and founding docu- for purchase the shares under options 1, 2, or ments by the Local and Federal Property 3. Employees, pensioned employees, and un- Committees. The process included: der certain regulations, the employees of suppliers or native inhabitants of the regions, Approval. Privatization plans were to be submitted applications for the receipt or pur- submitted by October 1, 1992 to the in- chase of shares. Applications were processed dustrial departments of the local property to determine the allocation of shares. management committees. The committees Typically 29 were required to approve these plans with- Share registry. Following the distribution percent of an in seven days of their submission. If a plan of shares to employees, the list of applicants was not approved, the committee had one formed the basis for drawing up a register enterprise s shares week to amend and approve the plan. The of shareholders. These lists were later ex- were allocated to be approval of the central govemment and the panded to include new shareholders such distributed through GKI were required for certain size compa- as the winning participants in voucher auc- nies and industries.1 tions and investment tenders. public voucher auctions. Registration. Within the property com- Phase 4: Voucher privatization mittees, the industrial department submitted an application, foundation documents In accordance with govemment regulation for registration, and a prospectus for the and the approved privatization plans, a per- registration of a securities issue for ap- centage of shares from each enterprise was proval by the administrative department. allocated for distribution by the govem- The enterprise is considered transformed ment to external investors through public into a legal joint stock company upon its voucher auctions. The percentages for dis- registration. The new shares of the enter- tribution through closed and public auc- prise are registered by the finance depart- tions were specified in the privatization ment of the regional authority plans. Typically 29 percent of an enterprise's shares were allocated to be distrib- Board of directors. As part of the legal uted through public voucher auctions. registration and transformation process, Voucher auctions were conducted by sell- the enterprise formed a Board of Direc- ers designated in the privatization legislation. tors which by law included the director The local property committee transferred the general or a representative from that of- enterprise's registration documents to the fice, a representative of the property com- seller who assumed responsibility for the mittee, a representative of the work force, shares created in the process of privatization. and a representative of the local authori- Sellers were generally the Federal Property ties. The board of directors' composition Fund for companies which were federally and duties were outlined in the model cor- owned, or the appropriate local property porate charter included in the attachment fund for companies that were under owner- to Presidential decree No. 721. ship of the territories, regions, the cities of St. Petersburg or MNoscow,and municipalities. Phase 3: Distrihution of sharesto employees The sellers managed the voucher priva- (closed subscrnption.) tization process. At the regional level, voucher auctions included a number of According to the privatization option cho- fundamental steps. sen, enterprises were obliged to allocate Assigning an auction commission to pro- shares within the company according to the vide oversight to the conduct of the auc- approved privatization plan. tion and approval of the auction results

TEC(-INIQLES OF MASS PRRAIUZA1ION: INIPLE.IENTING THE VOuciHERAuCTION PROGRP\UI 67

* Arranging for publication of required an- voucher privatization program. To establish nouncements for the upcoming auction voucher auction programs, regions devel- * Conducting the voucher auction oped similar systems of processing voucher * Compiling and calculating the results of auctions which included the basic steps out- an auction, legitimizing the auction by lined below. the signing of a protocol of auction results, and ensuring that the sharehold- Pipelinemanagement ers are entered into the share registry of the enterprise Working with the local property committee, * Announcing the results of the auction the property fund identified enterprises to the public which were eligible for selling shares through * Ensuring the cancellation or return of voucher auctions. They then performed a The location and vouchers minimum level of due diligence on the en- reach of voucher * Conducting a cash sale auction for a terprises, and generallv organized an auction small percentage of shares to cover the "wave" for the auctioning of several enter- auctions was a expenditures of conducting the auction. prises simultaneously.A typical wave would function of the size include anvwhere from five to fifty compa- of the enterprises. .. The regional voucher auction process weeknies beingperiod. auctioned simultaneously in a two The initial voucher auction phase of the The location and reach of voucher auc- mass privatization program emphasized the tions was a function of the size of the en- development of regional voucher auction terprises: companies with a fixed asset value capabilities to conduct auctions for of less than 250 million rubles could be auc- medium-sized, local enterprises in the re- tioned only in the seller's region, enterpris- gions where companies conducted their pri- es with a fixed asset value of between 250 mary activities. Eighty-six of the eighty-nine and 500 million rubles were required to be regions in the Russian Federation had initi- offered in at least five regions, and enter- ated and conducted regional voucher auc- prises with a value of greater than 500 mil- tions prior to the program's close at the end lion rubles were to be auctioned nationally of June 1994. The Russian Federation Committee for Bid collectioni the Nlanagement of Property (GKI) was responsible for overseeing and supporting the The local propertv fund established a re- development of regional auction capabilities gional auction center and several bid recep- and ensuring that local regional programs tion locations throughout the region conformed to the laws, decrees, and regula- depending upon the size of the region and tions governing the mass privatization pro- distribution of the population. Over 750 bid gram. Following the program's basic design, collection sites were operating nationwide regions participating in the program estab- (approximately 10 sites per region) during lished comparable systems providing the the last six months of the voucher auction opportunity for citizens to invest in priva- program.' Each region operated a central tization vouchers through auction centers or regional auction center which was run by bid reception centers located in cities and the property fund or their designated towns throughout the regions. The use of ba- agents. The propertv fund or agent general- sic auction procedures and decentralized bid ly subcontracted with commercial or gov- reception centers facilitated a widespread emient entities to open a network of bid implementation of the program. The use of reception sites which received applications common bid reception and auction proce- for voucher auctions. Consultants at the bid dures also made it possible to integrate re- collection sites provided basic information gional voucher auction capabilities into a (drawn from the privatization plans) to po- national system to conduct auctions simulta- tential applicants about the voucher auction neouslv in multiple regions for the largest process and companies being auctioned. Russian enterprises participating in the Additional staff accepted and processed ap-

68 RusSIA: CREAIING PRvAATEENITERPRISES AND EFFICIENT NIARKETS

plications,and submitted the collected ap- regions. Regions wverepermitted to develop plicationsto the regionalauction center for and use their own software provided that it processingand calculatingauction results. was tested and certified by GKI. Most regions used versions of the standard auction TypeI versustype 2 bids software issued by GKI. Results of the auctions were presented Two types of bids were allowed under the in a protocol which was approved by the voucher auction program. Each applicant, Auction Commission.Attached to the pro- whether an individualor legalentity, was en- tocol summarizingthe auction resultswas a titled to selectthe type of bid to be made in list of winning applicants which was trans- an auction.If an applicantsubmitted a type ferred to the share register of the company. 1 bid, he would automaticallybecome a After auction results were announced, the winner in the auction and receive some vouchers of winning applicants were can- number of shares in the auction.Tvpe 1 bid- celed and the vouchers of the losing type 2 ders were indifferentto the strike price (the bids were returned to the applicantsfor re- number of shares per winning voucher). submission in subsequent auctions. Under a type 2 bid, the applicant specified the minimum strike price at which he was Cashsale willingto accept shares in the company If the calculated strike price was equal to or Todefray the operatingcosts for localvouch- lower than the indicated bid, the applicant er auctions and to provide incentives for became a winner (for example,an applicant agents operating local bid receptioncenters, who specifieda strikeprice of fiveshares per post voucher auction cash sales were orga- voucher would be a winner in an auction nized in regions which conducted voucher where the strike price was five shares per auctions. These were typicallysimple open vouchers or lower). An estimated 95 per- outcryauctions where lots withvar ingnum- cent of all bids in the voucher auction pro- bers of shares were sold for cash. Regional gram were tvpe 1 bids. property funds could sellup to 5 percent of the amount of sharessold through the vouch- Auction resultsprocessing er auction for enterprises which sold less than 29 percent of their shares,or they could Once the auction was closed, all bids were sellup to 10 percent of the sharesallotted to entered into a computerized database pro- voucher auctions if 29 percentor more of an gram. The auction results were calculated enterprise's shareswere sold throughvouch- according to an algorithm which deter- er auctions. Proceeds from cash auctions mined the strike price of sharesper vouch- were collected by the propertyfund and re- er. If there were no splits in the number of distributed to participatingagents which op- shares being offered at the auction at least erated bid reception centers. Agents were 80 percent of the shareswere to be sold. If generally reimbursed on the basis of the there was a split in sharesbeing offered (for number of vouchers which were collected example, 300,000 shares of 1,000 rubles and canceled (the presentationof a cancella- nominalvalue were split to 600,000 shares tion protocol to the sellerwas necessarv in or- of 500 rubles nominal value), one of two der to receive compensation). Lists of things occurred.If there was a split in shares winners of shares in cash sale auctionswere being offered and less than 29 percent of also forwardedto the companyor its registrar the shareswere offeredfor the auction,then to be included in the shareregistry. 95 percent of the shares were to be sold. However,if a split occurred and 29 percent Examplesof regionalvoucher auction of the shares or more were offered, then 90 systems percent of the shares were to be sold. To ensure the accuracyof voucher auc- To illustrate the operations and results of re- tion calculations, GKI developed and dis- gional voucher auction programs,the activi- tributed standard auction software to the ties of fiveregions are summarizedbelow.

T iElcNIQUESOF NlAss PRIVAAnZON: IMPLEMENTINGTHE VOUCHER AucTION PROGRAIM 69

SverdlovskRegional Auction CenterThe ed this arrangementand developed its own property fund designated the Ural Stock center. This was a trend in severalregions as Center (USC), a commercial entity, to act the privatizationprogram was drawing to a as the agent for the region. The fund plaved close and propertv funds were seeking to a key role in creating this entity in cooper- identifv future roles for their organization in ation with a private consulting firm with the post-voucher privatization svstem. funding provided by USAID. Initial fund- Bid reception netwvork.There were six bid ing of the bid process was provided bv US- reception centers that were operated di- AID until the introduction of post-voucher rectly by the propertv fund and its agent. auction cash sales enabled the system to be- In addition, twentv-three bid reception come self-financing. sites were operating in the region at the *Bid reception netwLork.The USC opened local postal offices and district property approximately 30 bid reception sites to fund or committee offices. provide coverage in the 20 districts of Atuction soqttare. The property fund the region. Locations were primarilv in used the GkI standard auction soft- the local house of culture or the district ware for calculating local and national propertv funds or committee offices. auctions. * Auction softwvare.The property fund de- * Auctions results. Saratov property fund veloped their own software wvhichwas has auctioned approximately 250 enter- certified by GN for use in local auc- prises in twenty-five auction waves, each tions, but uses the GM standard auc- wave consisting of approximately ten tion software for national auctions. companies. Enterprises were auctioned * Auctzions results. By the end of June for a two week period. 1994, the property fund conducted an estimated sixteen auction waves for a Orenburg Regional Atuction Center The total of 350 enterprises. property fund signed an agreement with a local currencv exchange to act as their rep- OnmskRegional Auction Center The re- resentative in the region. The exchange regional auction center was managed direct- ceived start-up funding from the local lv by the property fund and was created property fund and committee. At the re- with start-up technical assistance and fund- quest of GM. periodic technical assistance ing provided by USAID. After the intro- wvasprovided with funding from USAID. duction of post-voucher auction cash sales, * Bid reception network. Up to twenty bid the operation became self-financing. reception points were operating in * Bil reception network. The propertv fund Orenburg through an agreement with subcontracted xwiththe local Sberbank the local Sberbank. (government-owned savings bank) * Auction software. The property fund branches, which opened two bid collec- used the GM standard auction soft- tion sites in the citv of Omsk and twvoin ware. other population centers in the region. Auctions resuilts.Approximatelv 100 en- * Auction software. The property fund terprises have been auctioned, each used the GMI standard software for cal- company being auctioned for four culating the local and national auctions. weeks. The property fund auctioned * Auctions results. Omsk property fund companies individually as opposed to conducted an estimated twenty waves grouping them into waves. of auctions for a total of 194 enterprises. Auctions were typically held for a pe- Tula Regional Auction Center The prop- riod of two weeks. erty fund managed the regional auction center directlv The voucher auction pro- Saratov Regional Auction Ceentei The gram had been financed by the property property fund originally delegated the auc- fund without outside assistance. Periodic tions to the local stock exchange. Towards the technical assistance wvasprovided at the re- end of the program, the propert fund end- quest of GM with funding from USAID.

70 Russri,: CREATINC PRRATE ENTERPRISES AND EFFICIENTMUARKETS

* Bid 1c`Cpttmn1 ?Wttuork. Over forty bid re- remained essentially the same as regional ception sites were opened bv the prop- auctions except that bids were received in ertv fund bv subcontracting with a local bid reception centers across the coun- privatelv-hcld bank to open sites in try The bid reception process for national twven tV-ive branch offices and with the district property funds and committees Table 6.3 Participating regions in the National Auction System in another fifteen locations. • Aecizwtn solitare. T'he property fund The following regions in the Russian Federation part cipated as selling agents for the national * 4ZSilxttzpropertyfund Lauction system Regions with an asterisk offered companies to be privatized through the used the GKI standard auction soft- national system. wvare. 1. Abakan 41 Nefteyugansk * Auctions results. 166 enterprises were 3 Arkhangelsk 43 Novgorod auctioned by the property fund in thir- 4. Astrahan 44 Novosibirsk tv-eight auction waves. Each enterprise 5. Barnoo 45.Omsk Oblast* 6. Belgorod 46 Orel was auctioned over a tnwo week period. 7. Blagoveshensk 47 Orenburg 8. Bryansk * 48. Penza *

The National Auction System 9. Cheboksari * 49 Petropavovsk Kamchatski * 11 Cherckessk 51. Petrozavodsk * 12 Chita *52 Pskov In February 1993, the National Auction 13 Dudinka * 53 Rostov-on-Don Svstem ( NAS ) was created as a mechanism 14 Ekaterinburg * 54. Ryazan * for conducting voucher auctions for large 1 .rkutskt 5. Samekard Russian enterprises in multiple regions si- 17 Ivanovo * 57.Saransk * multaneouskt It was designed as an 'over- 18 zhevsk 58. Saratov * 19 Kaliningrad *59 Smolensk lay" o the regional auction system utilizing 20 Kaluga 60. St.Petersburg * the processes and procedures that had al- 21 Kemerovo * 61.Stavropol 22 Khabarovsk 62. Sycktyvkar ready been implemented at the regional 23 Khanty-Mansijsk * 63.Tambov level. The National Auction System en- 24. Kirov 64.Tomsk * Russiato 25 Kostroma 65 Tula abled voucherholders throu,ghout Russia to 26 Krasnodar * 66 Tumen participate in voucher auctions for the 27 Krasnoyarsk 67.Tver largest enterprises without travelling to the 28 Kurgan 68. Ufa 29 Kursk *69. Ulan-Ude region where the companies were located. 30 Kyzyl 70 Ulyanovsk * Russian legislation stipulated that en- 31 Leningraskaya Oblast * 71. Vladikavkaz 32 Lipetsk 72. Vladimir terprises with a fixed asset value greater 33 Magadan 73.Vladivostok than 500 million wvere to be offered for sale 34. Malhachkaia 74. Volgograd 35 Maikop 75 Vologda nationallv.3 The first company to be auc- 36 Moscow 76.Voronezh tioned through the NAS was the giant au- 37 Moscow Oblast 77 Yakutsk 38 Murmansk 78 Yaroslavl tomaker ZIL which was offered in twelve 39 Nahodka * 79. Yoshkar-Ola regions throughout Russia. These twelve 40 Nalchick 80.Yuzhno-Sahalinsk regions included the locations of ZIL plants, major suppliers, major investors and Table 6.4 Performance results of the National Auction System voucher investment funds. From MIarch 1993 until the conclusion of the voucher May 1, 1993 May 1, 1994 June 30, 1994 auction program on June 30, 1994, 313 Number of companies companies were auctioned through the so d (closed) 3 113 313 sod or nprocess 3 157 313 NAS in eighty regions. Regional participa- Total charter capital (thousand rubles) tion in the NAS is presented in table 6.3 sold 6,082,034 239,060.698 439,425,289 and a summaroftheprformancresultssold or in process 6,082,034 316,532,042 439,425,289 and a summary of the performance results Vouchers collected 1,149,038 23,763,134 34,060,139 of the NAS is presented in table 6.4. Bids received 80,526 269,697 325,270 To coordinate the national auction sys- Number of snaresregions 26 79 80 tem, the National Network Center (NNC) offered 1,910,764 83,086,466 118,917,045 wasunder initiated the auspiccs GKJ.rof sold' 4,701,750 160,188,649 239,102,861 Number of regions transmitting Thc NNC facilitates the cooperation bid data electronically 0 36 40

among participants to conduct national auc- a 'lumber of sharessold will exceednumber offered in the case of share splitting during the calculat on of tions. The procedures for national auctions the auction

TI., HI{\()l LS 01 NL) , PRil\-Ui,'\t1) IMPILL.\IENI1NG i, Ii %I:LH()iER ALucioN PROGRAM 71

auctions was typicallv four weeks as op- local bid reception networks. All regions posed to two weeks for local auctions. The participating in the NAS received initial NNC was responsible for essentially the training and inspections by NAS staff prior same basic functions as the regional auction to participation in the system to ensure centers. These main functions are summa- compliance with national auction standards rized below and summarized in figure 6.2 and procedures. which outlines the auction process at the regional and national levels. Announcing the auction

Managingthe auction pipelinze The NNC worked with the sellers to ensure that the legal requirements for announcing The NNC worked closely with the GKM,re- auctions in the national press were met be- gional and federal property funds, local fore any deadline. property committees, and the enterprises to coordinate the pipeline and to schedule Commencing the auction those companies to be auctioned nationally Privatization plans and other essential doc- Contracting with the seller umentation necessary for the bid reception sites to conduct an auction were delivered The NNC drafted and arranged for the to all participating regions. Each region signing of contracts between the regional confirmed that the bid collection had com- property fund responsible for selling an en- menced in their region. terprise, and participating propertv funds in other regions which accepted bids for Closing the auction shares through local bid reception centers. The NNC was required to invite all regions At the end of an auction, regions collected to participate in the auctioning of enter- the applications and entered them into the prises available for national auctions. standard computerized database program. The actual bids and vouchers were main- Developing regionalparticipatzon tained at the local bid reception centers where application bids were offered. The By the end of the program, seventy-nine re- summary auction data from participating gions had participated as agents in the regions was then carried by hand or trans- NAS: shares of companies slated for na- mitted electronically to the NNC. Upon re- tional auctions were offered through their ceipt, the data was tested for accuracy and completeness prior to being incorporated into the national database for the calcula- Figure6.2 Sequenceof regionaland nationalvoucher auctions tion of the auction results.

Calculatereare Process Return Conduct Compiling and calculating the auction agents KAnnounce Coniduct auculteon Announce_Poes>Ptr odc fo r aucton acton ct results auction losingc cash auct,onresults results vouche, sales In the presence of a member from the auc-

* Sign agency * Eld centers Compile Cancel * To type 2 tion commission, the NNC compdledthe agreements receive auction bids winning bidders data from participatingregions and calcu- Distribute applications Calculate vouchers aucton and auctlion * Update share lated the auction results. A draft protocol enterprise results Register with the auction results was prepared and information Signauction * Distribute protocol shareholder presented to the auction commission for notifications approval.

Regionalvoucher auction (19 weeks total) 4 2 Hee~s ><, ' Processingthe auction results 2 wveeks 2 weeks 3 weeks t2 weeks

National voucher auction (24 weeks total) Following approval of the auction by the

4 42 ,ee*S 4s'eeks 6 weeks 2*4weeks commission, the NNC prepared summa-

72 RussLA: CREATNG PRIVATEENTERPRISES AND EFFICIENT NARKETS rv reports for the selling property fund, ties of these general agents include the fol- enterprise, participating property funds, lowing steps: and winning applicants. Each new share- *Polling potential investors, holder was issued a notification of owner- *Collecting applications and deposits ship confirming the information that was prior to the auction, to be entered into the share registry of the *Agreeing with local agents in other re- enterprise. Results of the auction were an- gions to participate in the auction, nounced in the Federal press. At the local *Connecting the agents to a telecommu- level, winning vouchers were canceled nication network to conduct a simulta- and destroyed and losing voucher bids neous auction in multiple regions, were returned. *Conducting the auction in an open out- cry format (lots of shares are sold to the iational cashsales highest bidder), Cash sales for *Processingthe auction results, and national auctions In addition to managing national voucher -Coordinating distribution of proceedsto auctions, the NNC coordinates a post- the participating voucher auction agents. have generated voucher auction cash sale to sell a percent- significantfunds to age of the company's shares for cash. The Regionalauctzon defray the system's proceeds from these cash sales are used to defray the costs of conducting national auc- In certain cases, given the relatively low operatingcosts. tions. The percentage of shares offered for percentage of total shares available for sale is the result of the difference between the cash sale and the limited number of the amount of shares available for the potential investors interested in purchas- voucher auction and the amount of shares ing shares, cash sales for national auctions actually distributed during the voucher are conducted in the region where the auction. The maximum level of shares selling property fund and enterprise are availablefor cash sales is the same as for re- located. The NNC works with the local gional cash sales: either 5 percent of the property fund or their designated agent to shares sold in the voucher auction if less conduct the cash sale using one of a vari- than 29 percent of the enterprise's shares ety of formats: were put up for auction or 10 percent if 29 * Open out-cry.The shares are divided in- percent or more of the shares were avail- to varying sized lots which are auc- able for auction. tioned to the highest bidder. Upon conclusion of the cash sale, pro- *Brokering. Shares are placed on the exceeds are distributed to participants in the changeat a fixedprice which canbe mod- voucher auction to finance the operational ified by the broker according to the costs of conducting the auction.The NNC buyers'demand. This approachwas used monitors the cash auction process until all in a number of regions,with activelocal funds have been distributed. Since the in- stock exchanges such as Vladivostok. ception of the National Auction System, Closedtender During specified time pe- several mechanisms have been created to riods, closed bids are accepted in sealed implement the post-voucher auction cash envelopes that are opened on the an- sale. These include the following. nounced date by the auction commission. Shares are sold to the highest Interregzonalopen cashauctions bidder in the amount indicated by the bidder until all shares are sold. The NNC has overseenthe managementof Cash sales for national auctions have gener- cash sales in up to four regions simultane- ated significantfunds to defray the system's ously.Cash salestypically are managed by a operating costs. By the end of April 1994, third partv general agent including broker- cash sales had been conducted for seventy age companies or stock exchanges which companies which had been auctioned by are responsible for organizing and con- thirtv-nine property funds in national auc- ducting the cash auction. The responsibili- tions. These cash sales generated approxi-

TECHNIQUES OF MIASSPRIVAT17iX1ON: IIMPLEMENTING THE VOUCHER AUc(IO1N PROGRAM 73

mately 7.4 billion rubles or an estimated $4.1 privatization programs, including efforts million.While the results for the largest com- aimed at providing restructuring and finan- panies generated the largest proceeds, the av- cial assistance to newly privatized enterpris- erage result for national cash sales was es, will be the development of standard 105,000,000 rubles or $58,500. approaches, tools, and systems which also can be widely replicated and implemented Conclusion with targeted international technical assistance and financing. Between early 1993 and mid- 1994, voucher auctions were conducted nationally and lo- cailv in eighty-six regions across the Russian Federationfor shares in more than 12,000 The authorsof this paperare managementconsul- medium-sizeand large conpanies. The suc- tants with PriceWaterhouse's International Priva- cessfulcompletion of the mass corporatiza- tizationGroup. Thev directed and participatedin a tion and privatization of an unprecedented programof technicalassistance, supported by US- number of companies was the result of a AID,to work with the GKI in the development and number of political and economic factors. implementationof the national auction system. This paper has focused on the standard op- 1. In practice it was not always possibleto meet eratingprocedures utilized in the corporati- thesedeadlines as there werelogistical and politi- zation and voucher pr-ivatization programs. cal delaysin both the preparationand approvalof The use of standard program procedures fa- the plans. 2. The last six months of the voucher auction cilitated the rapid and geographically far programwas the first half of 1994. reachingimplementation of voucher privati- 3. Some large enterprises below these levels zation. One of the main challenges in de- were offered the option to use the National signing and supporting post-voucher Auction System.

74 RussIA: CREATING PRIVATEENTERPRISES A.ND EFFICIENT 1MARKETS

CHIAPTER 7

Next Steps in Privatization: Six Major Challenges Andrei Shleifer and Maxim Boycko

BvJulv 1, 1994,mass privatization in Russia enforcement, and other reforms essential was officiallycomplete. Some 15,000medi- for a market economy,rather than concen- um- and large-scale enterprises will have trating their lobbyingefforts in favorof fur- ... privatization been privatized through distribution of ther subsidies. is not the goal, shares to insiders and voucher auctions. In Yet despite these successes, privatiza- but a means of a situation incomprehensiblefive years ago, tion has only started the long and arduous two-thirds of the Russian industrial labor process of restructuring the Russian econo- accomplishing a forcewill be employedby privatizedfirms. mv: which, after all, is its ultimategoal. largergoal of Equally as astonishing, over 50 milLion MIost enterprises continue to be run un- economic develop- RussianswilL have become shareholdersin challenged by the old management teams, either privatized enterprises or investment which often lack the human capital and in- ment and stability funds.This transfer of ownershiphas been terest to initiate significantrestructuring. in Russia. accomplishedin approximatelyeighteen %Whilethese enterprisesdabble with re- months,with relatively few major scandals structuringand try new productsand mar- or severesetbacks. kets, their management is principally The successfulsale of state-owneden- dedicatedto preservingtraditional product terprisesdoes not tell the entire story of lines,which may haveno markets,as their economictransformation. While privatiza- core activity.In many cases, enterprise tion maybe labeleda success,privatization managers have consolidatedtheir control is not the goal,but a meansof accomplish- by buyingshares in the aftermarketand are ing a largergoal of economicdevelopment simplv killing time hoping for a miracle and stabilityin Russia.Therefore, after the (and credits). Enterprisesthat do wvantto transfer of ownershiphas taken place, a restructureoften lack the capitalto move more significant change in enterprise re- aggressivelv Private markets have not suc- structuring must occur. In some instances, ceeded in delivering capital to privatized there are real economic successes behind firms, so the government continues to be these numbers as well. Most privatized the principal source of finance. Of course, enterprises have begun to restructure. They with government finance, the hope of de- are changing their product Lines, reducing politicizing privatized firms is entirely in employment, starting joint ventures with vain. Finally, the legal and regulatoryenvi- foreign companies, and so on (WorldBank ronment in Russia has greatly discouraged 1994). Corporate governance mechanisms foreign investment, which Russia needs as are rapidly becoming established, as large an important source of knoxvledge and cap- investors, who accumulated their blocks in ital. Despite the joy over the speed and suc- voucher auctions and in post-auction trad- cess of the Russian privatization program, ing, begin to actively challenge and displace the limited progress that has been attained old-school managers. Perhaps most impor- in enterprise restructuring, indicates that tantlv, privatization has created a political the real work has only just begun. constituency of owners who have begun to This slowness is both economicallv and lobby the government for further reform in politically troubling. The restructuring of corporate governance, including the cre- the Russian economy is necessarv tor a suc- ation of securities markets, improved law cessful transition to a market-based econo-

NE.Tr STPS IN PRIVACIZATON: S;D;%Lj\IR CI-ILLENGES 75

mv. Newly privatized enterprises must cre- Vishny 1993 and 1994). As long as enter- ate jobs if reforms are to be sustainable. prises, privatized or not, continue to ad- They must produce goods that are attractive dress the wishes of the politicians and to consumers both in Russia and abroad if bureaucrats in exchange for subsidies, no production is to grow. A substantial number genuine restructuring can take place. And of privatized enterprises must show their while privatization has gone a long way to- ability to survive in private markets for the ward reducing political influence over government to significantlv reduce its influ- firms, politicians continue to dominate the ence on the economy If privatization fails to allocation of export rights, capital, space, deliver a substantial restructuring, its politi- and other essential "inputs." cal opponents in Russia will be only too The second goal of restructuring poli- ready to renationalize the economy when cies is to provide private capital to priva- As long as enter- they gain political power. tized firms, so that they have the resources prises, privatized or Perhaps the most important factor of to restructure. Undoubtedly, firms can restructuring is that, in the short run, enter- make manv improvements with their own not, continue to prise restructuring is essential for macro- capital, such as employment reduction and address the wishes economic stabilization of the Russian modest changes in the product lines. Yet se- of the politicians economy Stabilization is not just a matter of rious restructuring requires a more sub- moving towards a balanced equilibrium. To stantive change in operations. It requires an and bureaucrats in succeed, stabilization requires a viable influx of capital. exchange for sub- economy that can survive with limited sub- The third goal is to facilitate manage- sidies, no genuine sidies and generate tax revenues on which ment turnover. Many managers in Russia the government can support itself. In recent are unqualified or ill-motivated to oversee restructuring can months, the Russian government has shown the restructuring of their enterprises, so a take place. an interest in stabilization, but has done change in management is a precondition very little to accelerate reforms that will de- for a change in operations. Barberis, crease the social price-tag associated with it. Boycko, Shleifer, and Tsukanova (1994) The restructuring of the Russian economy, have found that, in a sample of small-scale therefore, must be accelerated for the sake privatizations in Russia, complete owner- of both growth and stabilization. ship change is the best predictor of restruc- Not surprisingly, both the reformers and turing. These goals suggest six policy the conservatives in Russia support enter- priorities, listed below in no particular or- prise restructuring. The question at issue der. It is apparent that these priorities can however, is how is restructuring to occur? be implemented as viable reforms and that This paper addresses this question on two the political climate in Russia is ripe for levels. The first part of this paper will broad- them to be imposed. Ivoutline six key strategies for enterprise restructuring. Although progress in these six Transition to cashprivatz^ation areas might vary in degree, it is reassuring to observe that the political conditions exist to With voucher privatization completed, the make some progress possible in all of them. political imperative of creating millions of The second part of this paper discusses one shareholders has vanished. As a conse- of these strategies, namely the transfer of so- quence, it is now possible to move to cash cial assets from enterprises to local govern- privatization, which will take the form of ments, in greater detail in order to illustrate cash sales of shares. These shares can be how the broad strategies can be translated residual stakes that the government still into viable economic policies. owns in alreadv privatized firms or they can be shares in state enterprises that have so far Six priorities of restructuring escaped privatization. The principal point is that proceeds from share issues will be, to a Policies that promote restructuring have significant extent, retained by enterprises three goals. The first, overarching, goal is and can be used to finance restructuring. In depoliticization (see Boycko, Shleifer, and the case of new privatizations, some of the

76 RussiA: CREMING PRrvATEENTERPRISES AND EFFICIENT MLAlRKETS cash proceeds will also be kept by local gov- in most cases remain unchallenged by ernments and by privatizationauthorities to shareholders. Part of the problem is that increase their incentivesto privatize.Prime managers and workers own over 50 percent MrinisterChernomvrdin has endorsed this of most privatized firms. Outside share- approach and has bravely rejected the no- holders often have trouble even exercising tion that privatizationproceeds should be a their minority rights. They have difficulty source of federal revenue. getting information, communicating with Politically,cash privatizationis the most fellow shareholders, voting their shares, sustainable approach to privatizationat this getting share transactions registered, and juncture. It is sure to enjoy broad support so on. Many outside investors believe that of the relevant stakeholders, including minority shareholdingsin Russian compa- enterprise managers, local officials, and nies are worthless. MIoscowpoliticians concerned with finding The situation with creditor rights is ... cash privatiza- resources for enterprises in a regime of (rel- even worse. Neither the commercial banks tion... is sure to ative)austerity. Cash privatizationalso ad- nor creditor enterprises have any legal dresses all three objectives of restructuring mechanisms for collecting what is owed enjoy broad sup- that were mentioned above. them. The new bankruptcy procedure port of the relevant First, cash privatization is likely to move largely ignores the creditors and gives the stakeholders more firmsinto privateownership, initiat- controlnrghts in bankruptcyto a new gov- ing the process of their depoliticization. ernment agency,rather than to the creditors includingenterprise Cash sale of residual government blocks al- who have actually lent the money. managers, local so reduces the risk of local officialsusing The shortcomings of corporate gover- officials, and their power to vote these blocks to influ- nance pose severe problems for enterprise . .i . ence privatized firms. restructuring. First, many directors inca- Moscow polticians Second, cash privatizations in which pable of overseeingenterprise restructuring concerned with proceeds are retained by enterprises supply are entrenched at the helm, while the most finding resources privatized firms with sorely needed capital obviousmechanisms for throwvingthem out, and, in this way, provide them with re- such as outside shareholder insurgencyor for enterprisesin a sources for restructuring. The need for ex- bankruptcy, remain fairly ineffective. regime of (relative) panding private ownership of large Second, the likelihood that investors wl austerity enterprises and buildinga politicalcoalition supply private capital to enterprises, given for reform through large-scaleprivatization the weaknessof both shareholder and cred- is not as great now as it was in 1992 and itor rights, is remote. With private capital 1993, when mass privatization started. provisionlacking, enterprises relv on public Rather, privatization should be seen pri- capital, which, of course, preserves political marilyas a mechanismfor getting necessary control over firms.Improvements in corpo- capital to firms. rate governance, includingboth sharehold- Third, cash privatization speeds up the er and creditor rights, are thus essential for process of managementturnover as suppli- speedingup restructuring. ers of capital demand control in exchange Fortunately,privatization has created a for cash. As in Western economies, incum- political constituency of new owners and bents give up control only when they have commercial lenders who are exerting polit- to, and, as some recent surveysshow, bring- ical pressure for putting in place gover- ingin new capital may be the best wayto re- nance mechanisms.New regulations giving move control from them. outside investorsmore rights, including the right to vote and to transfer shares, are be- Corporategovernance and legal reform ing implemented. These regulations will become more important as employeescon- Although substantial progress has been tinue sellingtheir shares and long run own- made in improving corporate governance ership structures emerge. If corporate procedures in the last few months (such as governance regulations are sufficientlvag- the decree on independent share regis- gressive, outside investors will begin sup- trars ). managersof privatized Russianfirms plying capital to the privatized firms once

N i-.T511PS IN PRMAwnZA.O:N.SLx MLAJORCFHALLENGES 77

they can obtain tangible control rights in re- problem that significantly slows down en- turn for their capital. terprise restructuring. Tax laws in Russia The progress with creditor rights has are inconsistent and impossible to obey, been excruciatingly slow, as control over and scare away both domestic and foreign bankrupt firms has been turned over to a investors. Contract law does not exist and new government agency. In fact, many contracts are not enforced by courts. The would argue that rather than being labeled result, of course, is that organized crime en- progress the decision to turn bankruptcy isters to protect property rights and enforce sues over to a government agency consti- contracts (Shleifer 1994). Laws governing tutes a step backward. This central agencv creditor rights and collateral do not exist, has the power to decide whether to try to and, as a consequence, only government- restructure these firms using government and mafia-enforced lending play important The iveakness of the subsidies or to liquidate them. The one fun- roles. legal system has damental principle of bankruptcy, namely The weakness of the legal system has that of private creditor rights, has been com- been a major deterrent to the provision of been a major pletely ignored. As a result, the new bank- capital and know-how to the Russian en- deterrent to the ruptcy procedure will not only fail to terprises. It has been the greatest complaint provision of capital promote restructuring, it will delay it for a of foreign investors, whose role in enter- number of reasons. First, the enormous prise restructuring is likely to be prominent. and knowv-how to powers of the bankruptcy agencywill onlyin- The weakness of the legal svstem also the Russian crease political control over firms, as man- strengthens the role of the bureaucracy as enterprises. agers beg (and perhaps bribe) bureaucrats the arbiter of disputes and the protector of for restructuring subsidies, rather than face last resort, and so retards the desired effect the alternative of liquidation. The goal of de- of depoliticizing firms. All of these factors politicization is thus defeated. Second, if pri- point to a sore need for legal reform in tax, vate creditors have no rights and a bankruptcy, and commercial law, and in government agency decides the fate of a land and other reform to speed up restruc- firm, private loan markets are unlikely to de- turing. A genuine demand for such reforms velop. Third, the agency is likely to be cap- now exists, primarily because privatized tured by the existing management and and newly private firms need legal protec- therefore work to keep that management in- tion and commercial laws to restructure. stalled, rather than threaten the stability of Critics of privatization, who argued that le- their jobs. A new approach to bank-ruptcy gal reform had to precede privatization, that gives power to creditors instead of the simply have missed the boat in their assess- government is needed if private credit mech- ment of political capital. A year ago the po- anisms are to work in Russia. litical demand for legal reform did not exist. We conclude our discussion of gover- At this post-privatization point in the nance bv noting that a wide variety of gover- Russian economic refcrrm process, ho%vev- nance mechanisms exist around the world. er, legal reform is both essential and politi- Some countries, such asJapan and Germany, cally feasible. have developed governance mechanisms based largely on bank debt. Other countries, Creationlof secturitiesmarkets such as the United States, have equity-based governance mechanisms. It is not vet clear New equity issues are likely to become an what type of system will emerge in Russia. A important source of capital for privatized mechanism that gives control rights to the firms in Russia, in part because of continued private suppliers of capital is essential if they problems xvith bankruptcy and creditor are to turn resources over to privatized firms. rights that stifle the private loan market. The mode of financing that accommodates iNManyfirms are already planning to issue eq- the investors' needs most efficiently will uitv, but are concerned about their ability to dominate. distribute shares to investors. These firms The shortcomings in corporate gover- are providing the needed demand for the nance are just a few examples of a legal services of a securities market that can fa-

78 Rls,SLr: CREAniNO PRP.AiE ENTERIRISES AND EFFIcIENT MARKETS

cilitate the distribution of shares. NManyoth- ernments, wvho v iewvcontrol over real estate ers needc securities markets as well. Some as the most convenient mechanism for con- potential blockholders need them as a way trolling both business and corruption in- to consolidate share ownership and to buy come. Indeed, in large cities, such as sharcs from the workers. Foreign investors Moscow and St. Petersburg, real estate is unwilling to participate in disorganized mar- probably the most valuable asset enterprs- kets are waiting for organized securities es have (as conhrmed by the extremely high markets before they begin investing in valuation of firms in these cities-see Russia. The time for securities markets has Boycko. Shleifer, and Vishnv 1993). Not come. Thev hold the potential both to ad- surprisinglv, the governments of these cities, dress the capital needs of the Russian firms including MIoscow citv mayor Luzhkov, and to facilitate corporate governance. have passed various decrees designed to The difficultv in creating capital markets maintain government control over the leas- There are several in Russia is to make them a mechanism of ing of real estate and to prevent the creation components of land depoliticization, rather than the reverse. of private real estate markets. In this politi- Many countries have opted for one central- cal environment, the creation of private reform in Russia, ized exchange, a choice that offers signifi- propertv in urban land has been as slow as including the cant benefits of transparency and liquidity that in agricultural land. reorganization of In principle, one centralized exchange also Since control over agricultural land is can offer firms raising capital access to the connected to the politically sensitive sub- collective farms, largest possible number of investors. In ject of food security, the bureaucracy has the creation of Russia, however, establishing one central- managed to prevent both privatization of private ownersbip ized exchange is not desirable at this point, land and registration of ownership of the since such an exchange is likely to become existing private land plots. At the moment, rights in small land controlled by the Central Bank or the it is clear that Russia is not politically ready plots.., the creation Msvinistryof Finance. The result would be for a genuine reorganization of collective Of ownership rights that a government agency, rather than mar- farms. Although the government has ac- ket forces, would determine who gets capi- cepted some models for farm reorganiza- In land used by the tal. A less centralized network of exchanges, tion, such as the so-called IFC model, enterprises, and the controlled by broker dealers rather than a participation in reorganization is voluntary privatization of real government agency, could offer greater ben- and few collective farms will join, especial- efits in terms of smaller political influence at ly given their fear of losing subsidies. There estate. the current stage of the Russian economic is no serious program for mass reorganiza- reform process. tion of collective farms. Thus, for the near future, collective farms in Russia are likely Land and real estate relormn to remain intact and will continue to waste an enormous amount of public resources. There are several components of land re- At the same time, prospects for consoli- form in Russia, including the reorganization dation of ownership rights over personal of collective farms, the creation of private land plots, and land under enterprises, in ownership rights (including transferability) particular, are much better. Mvlakingthe land in small land plots used for both recreation under enterprises a private asset that enter- and small-scale farming, the creation of prises both own and trade can do a lot to oxnership rights in land used by the enter- stimulate restructuring. First, it eliminates prises. and the privatization of real estate. the principal mechanism of local political Over the last two years, despite President control over firms, namely the control over Niitsin's forceful efforts to decree change, real estate. Not only do enterprises benefit, land reform in Russia has been systemati- all others who need or have land indirectly callv sabotaged bv the agrarian interests benefit as well, as the local governments lose and, most notably, by the State Committee their monopoly over urban real estate. This on Land MNanagement (Roskomzem). will open doors for local business growth in Mlorwover, privatization of real estate has Russia, an area where progress has been been delayed in most instances by local gov- conspicuously lacking. Second, because en-

NEx,i Sl1 R' iNIiN PR111 11ZAICON2 Cl-URCHALLENGES 79

terprisesown a lot of land and buildingsthat competitionis an essential element of a na- they don't need, sale of this land can pro- tional restructuringstrategy. vide enterprises with badly needed capital Progressin this area in Russia has been (without a social cost), which they can use relativelyslow The central government has for restructuring. Third, land under enter- imposed a varietyof foreign trade barriers, prises can be used as collateral, providing includingtariffs and quotas. Localgovern- enterprises with debt capital. This can be ments have also caught the disease, impos- the beginning of private loan markets in ing many administrative barriers to Russia,as banks will begin to lend to firms interregional trade. Both the central and if thev can grab land and buildings in the the localgovernments have instituted a va- event of a default. Thus, establishing prop- riety of licensing requirements that handi- erty rightsin enterprise land can become a cap entry.Perhaps the greatest danger is the At the core of the very effectiveand productive restructuring constant risk of formation of the industrial problem with the strategy. holding companies,which aim to monopo- In Russia, the principal mechanism of lize their industries and extract credits from Russian social urbanreal estate reform is registrationof in- the central government (Boycko et al 1993 safety net is the terests in land and real estate. Until now, and Joskowet al 1993).Russia does not yet undeniable fact control over registration has been shared by have an active competition policy many overlapping jurisdictions, including Nonetheless, even in this area there are that the majority various agencies of the local governments signs of progress. First, so far the privatiza- of social services and Roskomzem, a conservative federal tion agency has resisted most major efforts are provided by agency.However, it appears that there are to form financialindustrial groups. As a re- now two factors that make progress in land suit, except in a few regions, such as enterprises. registrationmore likely.First, privatized en- Yekaterinburg,these groups have not taken terprisesand other business interests have a hold on a major scale. Second, the anti- genuine interest in this reform and are cre- monopolyagency is beginning to develop a ating enough political pressure actually to rational pro-competitionpolicy, that focus- make it happen. Second, local governments es on monopolisticabuses rather than on are finding themselves in great need of tax regulationof all large firms. Third, Russian revenues. Registration of urban real estate trade, despite all the regulations,is expand- willbe a first step toward creating the most ing.While we continue to be skepticalabout natural tax base for local revenues and, the likelihoodof an aggressivecompetition hence, conditions for real estate taxation. policy,it does not appear to be quite as re- From a politicalviewpoint, the registration mote as it did a year ago, when Boycko, of real estate is more likely to happen now Shleifer,and Vishnv(1993) wrote. than it was in the recent past. Social safety net Competition policy Perhaps the singlemost important deterrent The principaldriving force behind restruc- to effective enterprise restructuring in turing in most countries is product market Russiais the socialsafety net. At the core of competition. Under competitive pressure, the problem with the Russian social safety firms change their products, reduce costs, net is the undeniablefact that the majority fire incompetent managers, reduce labor of social services are provided by enter- forces, and take many other actions associ- prises. This includes such servicesas hous- ated with restructuring. Moreover,product ing, kindergartens, and hospitals, which market competition leaves less room for enterprises provide to their employees free politicalcontrol of firms, since competitive or at a price substantiallvbelow cost. Even firms cannot offer politicians the rents to unemploymentinsurance is now effectively dissipateon politicallymotivated activities, paid by enterprises. From an efficiency such as excess employment. For this rea- standpoint, the logic behind this svstem son, as stressed by Joskow, Schmalensee, seems incredible, as enterprises are forced and Tsukanova (1993), product market to keep people on long-term vacations at

80 RussIA:CREATING PRIvATEENTERPRISES A.ND EFFICIENT .ANLRjF.Ts

verv low wages, rather than lav them off. gartens), medical care, sports and cultural Effectivelv, a Russian worker now relies on facilities, and so on, unquestionably repre- his enterprise for both income and con- sents a substantial financial burden on en- sumption, whether or not the worker is pro- terprises. One estimate places the cost of ductively employed by the enterprise. social assets between 5 and 25 percent of This situation presents severe problems total labor cost. Another estimate reports for restructuring. First, pavringfor the social that the cost of social assets for Russian em- safety net is a tremendous financial burden ployees represents up to 80 percent of en- that takes up an enterprise's resources that terprise profits (Yasin 1994). In a business might be better used elsewhere.It also drains environment where enterprises are barely substantial management time, which can surviving, these expenses are enormous. serve as a large cost as well. Second, commit- Maintenance of social assets also consumes ments to the social safety net keep some a large amount of top management time. potential investors, particularlv foreign in- Some reports indicate that directors of vestors, from taking equity positions since large enterprises spend hours organizing they are afraid of the social liabilities. This plumbing repairs for employee housing and might explain the prevalence of joint ventures kindergartens. with foreigners, rather than direct invest- By far the largest expense is represent- ments by them. But joint ventures are no sub- ed by housing, which, according to World stitute for substantial equity investments Bank estimates, is over half of total social from the viewpoint of restructuring. Third, asset costs. (This total does not include on- social commitments give enterprises enor- the job unemployment insurance.) Enter- mous leverage in bargaining with the central prises subsidize the housing of their government for cheap credits and subsidies. employees, including, most importantly, This constitutes one of the principal deter- utilities and maintenance expenses. In rents to the depoliticization of privatized some cases, enterprises own the housing; in firms. Fourth, by tying workers to firms, others, they pay for it even though the enterprise-provided social safety nets reduce housing is controlled by the local govern- the mobility of labor and hinder the formation ments. Interestingly, the World Bank esti- of a vibrant and productive private sector in mates that onlv approximately 60 percent Russia. There is little doubt that restructuring of the residents in enterprise housing are in Russia is dramatically inhibited by the ex- employees; the rest are outsiders benefit- isting social safety net arrangements. ting from the generous subsidies. There are two approaches to solving this The second largest expense is on the problem. The first is the creation of a social maintenance of child care (kindergartens), safety net, such as unemployment insurance, which represents between a quarter and a outside of firms. While the issue of creating third of the total. According to a study by an unemplovment insurance program is ur- the Russian Privatization Center, it cost gent, it will onlv be created when significant about 25,000 rubles a month to support open unemplowment (above the current 2 one child in a kindergarten in 1993. Of this, percent) appears in Russia. As a result, this the parents paid between 5 and 20 percent, issue is not addressed below. The second and the rest was paid for by enterprises. complimentary approach is the transfer of The key point about these numbers is that social assets from enterprises to the local the full cost of child support is a substantial governments. In the next section, a method fraction of an adult's monthly income, per- to transfer social assets is presented that is haps as much as 50 percent for the less ad- both politically feasible and potentially pro- vantaged workers. This implies that a full ductive as a restructuring strategyx privatization of these organizations would deprive many people of their services. This Transferring social assets would bear tremendously harmful social costs upon the Russian populace. The same Maintenance of social assets for employees, problem applies to housing, where many including housing, child care ikinder- occupants are simply unable to afford the

N:lrT SE PN IN PRIVAnJUAnON: SLN NLAIM)R(CA-LLENGES 81

full cost of living in the apartments they oc- sponsibilitv for these services when enter- cupy. In the cases of both kindergartens prises already do the job? The answer is that and housing, some subsidies are essential as public financing of social services through part of the social support of the population. enterprises is extremely inefficient. This type Not surprisingly; many privatized firms of equation does not bode well for a country have found the maintenance of kinder- whose economic viability is intertwined with gartens to be too expensive and have been the degree to which it can successfully re- closing them down. Nloreover, in many structure newly privatized enterpnses. cities, kindergartens occupy valuable real First, there is no guarantee that the sub- estate that enterprises would rather lease to sidies are used for the social safety net onlrv commercial entities. As a result, the num- Some undoubtedly are used to increase the ber of kindergartens in Russia has been production of goods that the management ... using enterprises falling. (It is important to remember that is dedicated to producing. Inevitably, some as providers of birth rates in Russia have also fallen sharply of the subsidies also go into managers' and mothers have been getting fairly ex- pockets (Blanchard 1994). Mvuchmore of social services tensive leave when they have children-so the subsidy is wasted than would be the means that enter- the demand for child care has fallen sharply case if the money were directly dedicated to prises have to as well.) social safety net expenditures. This type of financing of services by en- Second, the provision of safety net ser- survive if social ser- terprises creates serious economic and so- vices through enterprises greatly reduces vices are to survive. cial problems. When credit constraints on labor mobility A person quitting a job with This is a dangerous enterprises tighten, the first things cut are a firm risks losing benefits, including hous- these social expenditures. The most direct ing, in addition to employment. If the implication for an consequence of this is that the govern- housing were provided by the municipality, economy whvere ment's attempts at financial tightening are the employee would be more likely to thousands of firms made with a maximum social cost, since leave, thus providing greater efficiency in thev immediatelv translate into a reduction the marketplace. appear to be going of vital social expenditures. Further com- Third, using enterprises as providers of out of business. plicating the matter is the fact that the ex- social services means that enterprises must isting arrangement gives enterprises survive if social services are to survive. This tremendous bargaining power with both is a dangerous impLication for an economy the national and the local government for where thousands of firms may be going out credits and subsidies. As a result, local gov- of business. ernments such as Yaroslavl have been in- Fourth, social safety net commitments creasing their subsidies to enterprises in (perhaps even more than environmental recent months. Of course, when local gov- obligations) make firms extremely unat- ernments give subsidies to enterprises, they tractive investment candidates. As a result, demand political quid pro quos that are not enterprises lose access to the capital typically consistent with restructuring. The needed for restructuring. In sum, enter- extreme version of this problem is that an prise financing is a poor way to maintain so- enterprise in Russia cannot go bankrupt, cial services. since, if it does, its employees not only lose The privatization program attempted to jobs, but also housing, child care, and so on. solve this problem, but it was not very suc- Because the social obligations of enterpris- cessful. In the program, enterprises were es are so high, the new bankruptcv proce- given the option to transfer their social as- dures probably will lead to an attempted sets to the budget of the local government, rehabilitation of all firms using government if the latter agreed. In some cases the local subsidies and to virtually no liquidations. governments have accepted responsibility This analysis raises the obvious question: for the social assets, but in the majority of wvhat is wrong with the provision of social cases thev have refused. As a result, despite services (including unemployment insur- rapid progress with privatization, most so- ance and housing) through enterprises? cial assets remain financed by the now pri- \Vhy create new institutions that take re- vatized firms.

82 RussiA: CREAI.N(, PRMxrTEENTERPRISES AND EFI(CIEN1 MNARKETS

For the reasons outlined above, most will be less attached to firms, therefore, la- people who have looked at this problem- bor mobility should increase. In sum, the both in Russia and in the West-have transfer of social assets Xwill promote de- found the situation unacceptable. Indeed, politicization of enterprises and increase a consensus proposal seems to be emerging their access to private capital. on how to deal with the social assets. The A possibly crucial obstacle standing in essence of this proposal is the transfer of the way of this transfer could be firm man- responsibility for social asset financing to agers. Managers understand that a transfer local governments. Some versions of the of social assets to local governments is, ef- proposal allow for continued subsidization fectivelv, surrendering the one hostage that of social assets bv enterprises on a declin- allows them to extract money from the gov- ing scale, even after the local government ernment. Whv would managers agree to assumes the responsibility, give this up? The managers of viable firms The transfer of However, if the temptation for local are likelv to embrace the transfer because it housingand governments to dump these social assets will free up resources thev need for re- back on the enterprises is to be avoided, a structuring. The managers of bankrupt kin dergartenstns to clean break must be made. The link be- firms may, in some cases, recognize that the municipal govern- tween enterprises and the provision of so- inevitable shift to a market-based economy ments has to be cial services should be severed immediately wllD eventuallv doom their enterprise. There is also an issue of whether individual Therefore, managers might accept the mandatory, since social assets should become juridical per- transfer, as the additional resources it cre- they are not sons. Alternatively, they can become part of ates would allow them to stall a little longer. interested in the local government or part of some pseu- In a few cases, this extra time could be in- do-independent corporations controlled by centive enough for managers to give up assuming the the local government. It makes a great deal their hostages. On the other hand, most additional costs. of sense to make kindergartens and apart- managers of nonviable firms xvillresist giv- ment buildings juridical persons, since this ing up, in which case some central govern- would greatly simplify their privatization ment encouragement (such as a threat to and condominiumization in the future. eliminate credits anyWay)could be in order. This would also allow simpler mechanisms The transfer of housing and kinder- for foreign aid support of social assets. gartens to municipal governments has to be However, to advocate immediate privatiza- mandatorv, since thev are not interested in tion of social assets would be foolish since assuming the additional costs. This raises the that might deprive too many people of ac- next question: wvherewill the local govern- cess to their services. ments get the monev to finance these addi- The transfer of social assets to local gov- tional expenditures? It is quite possible that ernments obviously provides enormous some of the main benefits of the transfer will benefits to privatized enterprises, since materialize in the form of local government substantial liabilities are now gone. These finance reform that will be stimulated bv the firms will be in better shape to use their own transfer. resources to restructure, as well as in a bet- First, the local governments are likely to ter position to attract additional resources generate revenue by raising some prices (in- from both domestic and foreign investors. cluding prices of utilities and kinder- At the same time, enterprises will lose much gartens). They may trv to discriminate of their political clout and, hence, the abil- against those who are qualified to pay for ity to obtain credits. Both the central and the services so that only the poor are subsi- local governments will lose some of their in- dized. Either way, the price under the bud- terest in supporting, the inefficient firms getarv pressure may come closer to the and some of them might decline signifi- marginal cost. cantlv or even go banklrupt. This is exactly Second, the local governments will try what rcstructuring should accomplish-it to raise revenue through taxation, as they should allow viable firms to survive and have alreadv tried in the last two years (for nonviable ones to go under. Also, workers other purposes, including enterprise subsi-

NE:.EX75B 11I IN PIRI\VA\I' \MNOV SIX .\I )R CIiALLENGES 83

dies). This is a healthy development, since will not survive. Populist politics work in the Russiangovernment has not been an ef- Russia in ways very similar to those else- fective tax collector.One strategy for taxa- where in the world. tion will be to tax enterprises for the The greater risk is that the local gov- servicesthe local government provides (as ernments willuse their responsibilitvfor so- in Yaroslavl).An examplewould be the pav- cial assets to lobbv the central government roll tax, which makes sense since the level for more funds or for the right to retain of services is roughly proportional to em- more of the tax revenuesthey collect. This ployment.An alternativewav to finance so- is Russian-stylefiscal federalism, in which cial expenditures isreal estate taxation. The local governments, by threatening sepa- great advantage of this is that, to raise such ratism and social unrest, extract resources revenues, local governments have to ex- fromMoscow (whichof course financesthe At the same time, pand their tax base-which, in Russia, expenditure by printing money). In fact, the problem of means privatization of real estate. This re- Russia's record in this regard has been dis- form, as mentioned above, is desperately mal. Triesman (1993) provides remarkable fiscal federalism needed. evidence that the separatist regions of must be addressed Third, the local governments will try to Russia have been able to extract vast sums sooner rather than use privatization as a mechanism for raising of money from the central government. funds to support social spending. This, ev- Opposing Yeltsinseems to be a reliableway later. idently,is what happened in Poland and the to get cash. Other evidenceindicates that former Czechoslovakia.If this approach is regional governments have been keeping adopted, privatization of real estate (the more and more of their tax revenues at the conspicuous laggard in the Russian pro- expense of remittances to the central gov- gram), will accelerate, which will give a big ernment (see Freinkman 1994 for boost to small scale privatization and new Yaroslavl.)The result is that the central gov- business development.Putting social pres- ernment financesits expenditures-includ- sures on the local budgets may turn out to ing agriculture and enterprise subsidies, be the most successfulstrategy for getting defense, and so on through-inflationary local governments out of the business of finance. controllinglocal assets. There is no easy solution to this prob- These three types of financingare all de- lem. Many scholarshave recentlyexpressed sirable. In fact, if the transfer of social as- great enthusiasm for fiscalfederalism using sets to localgovernments entails a decrease the example of China. They believe that of local subsidiesto enterprises, an increase this arrangement creates hard budget con- in real prices charged for social services, straints for local governments and enter- privatizationof local assets and real estate, prises. Russiaalso has fiscalfederalism, but and a switch to payrolland real estate tax- the result has been much less satisfactory. ation by local governments,the whole local The central governmenthas been unable to government in Russia, and not just indus- deny subsidiesto regionalgovernments for trial firms, willbe restructured. This would enterprise and agriculturesupport. As usu- move all reform (including stabilization) al, superficialanalogies between China and rapidlyforward. Russia do not work. Of course, in Russia, things often hap- At the same time, the problem of fiscal pen differentlv from what is expected. In federalismmust be addressed,and it should the case of the transfer of socialassets, there be addressed sooner rather than later. The are two significantrisks. The first risk is that fiscal relationshipbetween Moscowand the local governments will simply ignore these regions,currently best describedas bargain- assets and continue to spend monev on oth- ing over tax remittancesand transfers,prob- er activities,such as enterprise and agricul- ably cannot continue in the long run. In ture support (as they do, to some extent, in manv countries (including,for example,the Yaroslavl).This strategy is probablv not the United States, Italy, and China), the rela- greatest danger, since it is likely to lead to tionship has been determined by a kind of massivesocial unrest that localgovernments constitutional convention that determines

84 RussiA: CREXrENG PRJv,xrEENITRPRISES AND EFFICIENT MALnRKETS

the nature of cash flowsbetween the capital program turns out to be relatively straight- and the regions. These conventions have forward to implement. proven to be an effective antidote for sepa- Research by the RPC estimates that the ratism. Russiadesperatelv needs such a con- initial subsidy that may be needed to fi- vention in the immediate future. The nance the transfer is $10 per child per successof all economicreforms in Russiawill month. If a region manages to bring 10,000 depend on the central governmentin Russia childreninto the program, the direct cost of negotiatinga long-termconstitutional agree- the subsidywill be roughly $1 million in the ment with the regional governments about first year and perhaps $2 million over three tax remittancesand regionalsubsidies. years. Note that the city of Yaroslavlhad under 10,000 children in kindergartens in Foreignaid 1993,the city of Vladimirhad under 20,000 and the city of Yekaterinburg, Russia's The previous section illustrates how the fourth largest, under 60,000. Not all of transfer of social assets from enterprises these children, of course, are enrolled in will entail significant fiscal tensions be- kindergartens supported by privatized en- tween the various levels of government. terprises and not all privatized enterprises One mechanism for reducing these ten- willchoose to join the program. Thus, even sions is foreign aid. In fact, the Tokyopack- if one were to double the expenditure to age that G-7 has proposed in 1993 allows take overhead and other extraneous ex- for substantial amounts of aid to be used penses into account, the $20 million bud- to support the social safety net. The transi- get for the pilot can take care of about tional support of the financing of social as- 50,000 children, which easily covers half a sets as thev are transferred from the dozen major metropolitan centers in enterprises to local governments is a very Russia.Recall that the total WorldBank as- good use of these funds. It will prevent the sistance to the Russian social safety net, closing of kindergartens and heat and util- promised in Tokyo but hitherto undis- itv cutbacks, while also facilitating enter- bursed, is at least several hundred million prise restructuring. It will also, indirectly, dollars. reduce pressures on the federal budget One potential problem with this pro- and, hence, support stabilization. gram is that it will not stick. Specifically,lo- T his raises the question of how to de- cal governments will take the subsidies,but sign a foreign aid project in support of the then renege on their commitment to finance transfer of social assets from enterprises. the social infrastructure after subsidies ex- While such projects are still discussedon a pire and either close the kindergartens or grand scale, the Russian Privatization dump them back on the localgovernments. Center (RPC) as proposed the World Bank This is a legitimate concern, for it under- a $20 miLlionpilot project (financed from scores the need to combine this program the loan alreadv allocated to the RPC) that with fiscal reform of the local government, may show how foreign assistance funds which includes accelerated privatization, could be used to support the transfer of expansion of the tax base, and introduction kindergartens. The RPC proposes to start of new taxes to financelocal government ex- its program in several regions. All kinder- penditures. Once the local governmentsre- gartens currently supported by privatized alize they can afford these expenditures, enterprises in these regions willbe eligible. they might show a willingnessto take them The RPC proposes to use foreignassistance on (just as the governments in the West funds to subsidize the kindergartens ac- have), especiallywhen they learn that these cepted by the local governments on a de- expenditures win votes. cliningscale for three years. Over time, the The above analysisis not intended to be local government assumes greater and definitive. Rather, it shows that a reason- greater responsibility over the finances of ably small amount of aid, properlydesigned each kindergarten, until, after three years, and administered, can go a considerable it is fullv responsible. Organizationally,the way toward addressing a major social prob-

NEXT-S IEpS IN PRRV.TI7ATON: SDNNIAJOR CHALLENGES 85

lem in Russia-encouragement of enter- this stage of enterprise reform as they have prise restructuring-and perhaps even to- been with privatization. wards reform of local government finance. As of this writing, the World Bank has not References approved the use of the RPC loan for this purpose. Barberis, Nick, Maxim Boycko, Andrei Shleifer, and Natalia Tsukanova. 1994. "Why Does Conclusion Privatization Work? Evidence From Small Scale Privatization in Russia." Draft. Blanchard, Olivier. 1994. Comment on Shleifer. In this paper, the priorities of the next stage Draft. of the Russian enterprise reform and enter- Boycko, Maxim, Andrei Shleifer, and Robert W prise restructuring, have been presented. Vishny.1993. "PrivatizingRussia," Brookings Six major reform challenges-cash privati- Paperson EconornicActivity. zation, corporate governance and legal re- . 1994. "A Theory of Privatization." form, creation of the securities markets, Draft. form, andreationofstae securits comaetin Freinkman, Lev. 1994. "The Transformationof land and real estate reform, competition The RegionalFiscal System in Russia:The Case polcy, and social safety net reform-have of Yaroslavl."World Bank. Draft. been outlined, and an argument has been Joskow,Paul, RichardSchmalensee, and Natalia presented claiming that the Russian econo- Tsukanova. 1994. "Anti-MonopolyPoLicy in my is politically ready for these reforms on Russia." Brookings Papers on Economic some scale. The final portion of this paper Activity:Microeconornics. Forthcoming. is dedicated to looking beyond the general- Shleifer, Andrei. 1994. "Establishing Property ities in order to portray how one critical re- Rights."Paperpresented at World BankABCDE. form, the transfer of social assets from Triesman,Daniel. 1994. WorldBank. 1994. enterprises to local governments, can actu- Yasin,Evgeny. 1994. "Conception of the Separa- ally be implemented with modest amounts tion of the Social Sphere of the Enterprises." of foreign assistance. We can onlv hope that Paper prepared for Prime Minister the Russian reformers are as successful at Chernomyrdin.

86 RUSSLA:CREATING PRiVATEENTERPRISES AND EFFICIENT MARKETS

Part Two

CAPITALMARKET DEVELOPMENT

CHAPTER 8

Capital Markets Development and Financing Russia's Transformation Claudia Morgenstern

For Russia, the development of capital mar- markets development? And finally, an kets is a necessity, not a luxurv. Given the obligatorv gaze into the crystal ball will at- scale of the tasks that its financial sector will tempt to identify ways in which healthy ... the political be called upon to perform in the coming market development might be encouraged success of mass decade, Russia cannot relv principallv on its and major risks avoided. *t banking sector to provide necessarv finan- This paper must be prefaced by severail ivaizalon cial services through classic intermediation caveats. It should be recalled that almost depends on the of deposits and loans. Furthermore, the the onlv safe generalization that can be rapid development mass privatization program has produced made about Russia is that Russia is rarely of capital markets an ownership pattern of financial assets susceptible to generalizations, and this is more akin to that of countries with highly- particularly true when talking about the be- institutions. developed equitv markets. W\hen it comes ginnings of capital markets activities. Each to Russia's capital markets, the question is region has its own institutional characteris- not whether, but how to promote their tics and activity patterns, with Moscow, St. healthv development. Petersburg, and vladivostok especially dis- Over the last two decades, long before tinctive. Both the extreme youth and the "emerging markets" became fashionable, a characteristics of the emerging Russian eq- substantial portion of the International uitv markets dictate that "data" about mar- Finance Corporation's (IFC) activities has ket activities and institutions are more been devoted to promoting capital mar- anecdotal than the results of formal sur- kets. IFC's emphasis on capital markets de- veys, and are more qualitative than quanti- velopment is predicated on the fact that the tative. In addition, conditions in Russia are principal source of financing for sustainable so fluid that any analvsis of the market is economic development must be domestic partly out of date by the time it is present- savings. Applving experience from other ed. 1The final caveat is a familiar one-that emerging markets to Russia requires a close the following are personal observations reexamination of assumptions often taken which do not necessarily reflect policies of for granted. Transition economies present a the International Finance Corporation. number of issues that are not found in most other emerging markets. But even within The importance of capital markets the category of transition economies, it is to Russia safe to sav that Russia is unique. The objective of this paper is to exam- A number of factors which characterize ine some of the distinctive characteristics of Russia's transition economy make the de- what has been witnessed over the last year velopment of capital markets a key objec- and a half, since the launch of voucher auc- tive of Russia's reforms. Each of these tions. First, whv is the existence of healthv factors has important implications for poli- and active capital markets so important to cies that have been and will be pursued by Russia's transformation? Second, what are the Russian government. some of the factors special to Russia that Perhaps the most urgent reason to pay are likely to affect the process of capital attention to Russian capital markets is

CAPITAL .NMRKETsDfI ELOPM\:NT.N\ i) FINANCING RussLXs TR\NSFOPWATION 89

that the politicalsuccess of mass privati- directed credits or are, in effect, merely zation depends on the rapid develop- the corporate treasury departments of ment of capitalmarkets institutions.The large enterprises. It is unlikelythat the mass pnivatizationprogram represents banks will be institutionallycapable of an implicit contract betveen govern- meeting the enormous demand for fi- ment and citizenry that the assets dis- nancingenterprises in the coming sever- tributed in mass privatizationrepresent al years. Furthermore, giventhe current meaningful property rights. Privatization economic environment facing Russian has created a huge class of small share- enterprises, most commercially viable holders, who need basic capital markets enterprises will need additional equity infrastructure (registrars and transfer Enterprises are unlikely to have suffi- agents, secondarv markets, shareholder cient retained earnings to build up their Well-functioning voting, and dividend payment arrange- capital base, and heavy reliance on bank capital markets ments) to realize the property rights thev lending would leave the corporate sec- have acquired. tor over-leveraged. Finally even on the are also important * WIH-functioningcapital markets are also debt side, in the current macroeconom- sources of important sources of disciplines and in- ic climate, banks will not be able to pro- disciplines and centives for restructuring enterprises. vide much intermediation of term Privatizationis simplvnot completewith- structure. Enterprises will have to look out the development of a properly func- to the capital markets for an important restructturing tioning and competitive financial sector. part of their long-term financing. enterprises. In its absence, enterprises will, of neces- * Discussion of the importance of Russian sits; continue to structure their planning capital markets tends to focus primarily and operations around their ability to lob- on the urgent financial needs of enter- by the government and legislature for prises. But markets are a two-way street, subsidies, privileges, and protections. and in Russia it is equally appropriate to Capital markets provide a particularly take a populist view and look to the effective form of financial sector disci- needs of the general public in promoting pline. The transformation of the Russian capital markets development. The cre- economy requires that managers be ac- ation of a range of reliable financial ser- countable to enterprise owvners,not to vices for individuals will be a critical Igovernmentbureaucrats. Small and large element of the transformation of the shareholders alike must be able to disci- Russian economy-the Russian public pline nonperforming managers, either needs a variety of ways to acquire prop- through direct exercise of voting rights or erty and provide for their own financial by 'exiting" their investment in the sec- securirt; From an economic standpoint, ondarv market, thereby threatening the the emergence of attractive savings vehi- value of the managers' economic stake as cles is necessary to pool domestic savings the market price for the enterprise's for investment. Politically,the availabili- shares drops. For these reasons, Russian tv of reliable savings vehicles is also es- policvmakers have repeatedly adopted sential. The Russian public has seen rules to strengthen minority share- intlation eradicate savings, destroving holders' rights. the most widelv-distributed form of pri- Of course one of the most vital func- vate propertv.Given the lack of credit for tions to be performed by Russia's capi- durable goods and housing, individuals tal markets will be to improve the access who want to buv a car or a residence by enterprises to new capital. Russia's must save. young banking industry is small relative This is not just theorv-recent econom- to the productive sector and quite inex- ic surn'evs confirm a rapid increase in perienced. Only a handful of banks are Russian savings. But the Russian public has actually in the commercial lending busi- no place they trust to place their savings. It ness. The balance have been acting prin- is, therefore, not surprising there has been a cipally as conduits for subsidized similarly rapid proliferation of nonbank

90 RLuSsiA:CREM\TiNG PRIVA IiE ENTERPRISES AND) EFiE(IENI .MARKETS financialproducts, including purported eq- The more unusual role for Russia's gov- uitv investments such as the infamous ernment securities markets is likelv to be in NiMMAVO, targeted at retail investors. The the area of municipal finance. As responsi- advertisements can be found evervwhere in bilitv for services like health, education, Moscow-on television, billboards, and and housing shifts from large enterprises to even in the Metro. Vith eroding confidence local authorities, there is a huge and grow- in the government or enterprises to ensure ing demand for cash to fund these services. employment or provide for old age, the pub- This desperation, when matched with the [ic's interest in financial products like pen- increasing appetite of Russians for non- sions and insurance is also certain to grow. bank savings instruments, is likely to pro- Concern about the quality of many new duce an explosion in municipal bonds, products wvas behind two presidential de- many of which will be of verv low quality. crees in June 1994. One introduced truth- But if the municipal securities markets are in-advertising standards, and the other developed with care, municipal securities began better regulation of the distribution could plav an important role in helping lo- of new issues and financial reporting by is- cal authorities manage their revenue and suers.' The decreeswere followed inJulyby expense streams. Especially in infrastruc- accelerating pressure against apparent ture projects, where user fees can generate Ponzi schemes through a string of warnings cash flows that, at least for Russia, are fair- by pubLic officials against practices of ly predictable, like airport reconstruction or MIvNMMand other so-called finance or in- expansion, revenue bonds could make an vestment companies. important contribution. It remains to be seen whether the exam- Organized capital markets will play a ple of MMM's coLlapse and the govern- critical role in attracting larger volumes ment's enforcement of restrictions on of foreign investment to Russia. Interest advertising by IMIMMN'scompetitors will have of foreign investors in making portfolio a salutarv effect on the expectations and be- investments in Russian securities has havior of small investors. At least initially,the been growing rapidly Well-functioning principal impact has been on INIMNIitself, capital markets will also contribute to not on promoters of similarly dubious retail the climate for foreign direct invest- products. The lesson learned by manv ment, because publicly-traded Russian Russians seems to have been that buving in- enterprises will be encouraged to meet to pyramids can be highly lucrative, as long higher standards of information (espe- as you time your exit before the crash. ciallv financial reporting) and gover- Further government action may be required nance. As the marketplace insists on explicitly to outlaw p\Tamids and other higher standards, the financial interests fraudulent activity. The NINIM episode has, of Russian enterprises will create greater however, highlighted the existence of a sig- economic incentives for development of nificant potential demand for nonbank fi- the Russian auditing and legal profes- nancial products at the retail level. sions and the adoption of corporate Most of the attention paid to Russia's transparencv and governance standards, capital markets has been devoted to eq- even for enterprises that are not publicly uities because of the vast number of traded. shareholders and pubLicly-held compa- * A strong emphasis on capital markets rues that Russian privatization has pro- development has the further advantage duced, virtually overnight. But important of reducing systemic risk in the rapidly institutional innovations have also been growing Russian financial system. Even happening in the government securities if banks were able to take in sufficient markets, with the support of a team at the deposits to meet enterprise financing Central Bank. These are important first demands (and increase their capital suf- steps in developing a range of govern- ficiently to support those deposits), such ment securities that will facilitate the con- a strategy would be dangerous. With no duct of monetarv policy experience in assessing commercial

(.uI MA1El.NI;R}Di,\ li iAMENTA.ND FINA\NCIN; RussLjS TP.\NS:OiiL-\nM(N 91

credits and limited mechanisms to se- The post-privatizationmarket isa 'onie-wvay cure loans with adequate collateral, the controlmarket" majority of banks would have balance sheets loaded with questionable assets. Current share transfer activity is dominat- This would represent a significantdan- ed bv a post-privatization"control market," ger for the solvencyof the Russian fi- which is characterizedby one-way transfer nancial system. Encouraging the direct of shares from small holders who acquired provisionof capitalbv investors through their shares in privatization. Buyers are capitalmarkets instruments, rather than most often enterprise managers,using a va- relyingon intermediation through bank riety of techniques to sop up small share- balance sheets, would help to limit an holdings. Sometimes they buy in their excessive expansion of risk in the na- personal capacity.In other cases, the enter- The control market tion's deposit-taking and payment sys- prise sets up an affiliated investment com- is not a particularly tems. Of course, given Russia's decision pany to do the acquisition, using enterprise to pursue a universal banking model, resources.Other closelyrelated businesses, auspicious environ- these protections will be undermined in such as the enterprise's principal suppliers ment for the rapid the absence of appropriate controls over or customers, may also make up part of the development of the conduct by banks of securities activ- insider group of buyers. ities and careful surveillanceof their fi- As voucher investmentfunds and other collective institu- nancial condition. strategic investors have become better or- t.ions that make up ganized during the year-and-a-half of an active secondary Characteristics of Russia's emerging voucher auctions, an increasing number of equity markets share purchases havebeen arrangedby bro- market... kers on behalf of outside investors. During Russia'smass privatizationprogram is truly 1994, these outsiders increasinglvhave in- one of the most amazing undertakings in cluded emerging market surfers hoping to economichistory.3 In the course of approx- catch the world's next great emerging mar- imately 18 months, the majorityownership ket wave and longer-term foreign investors of over 12,000 Russian enterprises was acquiring stakes in critical sectors at what transferred into private hands. The number appear to be, relative to fixed assets, bar- of Russian citizens owning shares in priva- gain-basement prices. The potential com- tized enterprises or in voucher investment petition between insiders and outsiders is funds is somewherebetween 30 millionand becoming an important feature of the con- 40 milLion.These facts alone have had, and trol market. willcontinue to have, a profound effect on The control market is not a particularly the shape of Russia's capital markets. auspiciousenvironment for the rapid devel- Internationalbankers and investorsfamiliar opment of collectiveinstitutions that make with the typicalsequence of emerging mar- up an active secondaryrrnarket-particular- kets development must take all their old, ly stock exchanges or organized over-the- comfortable assumptionsand simply stand counter trading systems and clearing and them on their heads. settlement arrangements..Despite the fact The scope of the privatization program that there are more than 100 exchanges li- is not the onlv feature of Russia's capital censed to trade in securitiesin Russiatoday markets that will make its development (down from several hundred over the last pattern unique. A number of other charac- severalyears), virtually all tradingof equities teristics are affecting the institutionaliza- takes place off-market. Successful ex- tion process, especially in the equity changes in most cities are those that are markets. Most of these characteristics tend open to the public for the auctioning of to encouragefragmentation rather than in- bearer instruments, principally vouchers tegration of market structures. Some of but recently new issuesof documents pur- these characteristicsappear to be transito- porting to represent an equity interest. ry, but others willmost likelybe around for Exchange-basedtrading is estimated to be some time to come. no more than 10 percent of the transaction

92 RUsSLA:CREATING PRRVATEENTERPRISES AND EFFICIFNTI LkRfETS

volume in registered shares, even for shares centage of transactions. As a result, of companies where a control market does there has been no great pressure to stan- not dominate. dardize inter-broker procedures and Most economic incentives faced by se- manage inter-broker counterparty oblig- curities intermediaries during the control ations through collective institutions. market stage operate to discourage rather The limited amount of broker-to-broker than encourage collective action by market trading has not necessarily been bad for participants. There are recent signs that the long-term competitive health of the these incentives are starting to shift in a Russian securities industrv. It has al- healthier direction, but the control market lowed the entry of entrepreneurs with continues to create impediments to institu- modest capital into the brokerage busi- tion-building in the secondarv markets. ness without creating concerns over the The following description of the control lack of prudential surveillance of finan- market, although impressionistic, may help cial condition by regulatory authorities. explain why none of the existing exchanges By the time conditions are ripe for a real have succeeded in attracting or stimulating secondary market, brokers will have had significant trading volumes to date. the opportunity to build up their capital base from operations. Hopefully, once The brokers'princzpalcustomers, and often efficiency gains of an organized market the brokersthemselves, hatve little economic in- begin to appear attractive, brokers will terestin transparencyand liquidity.4 also have greater incentives to introduce • During the post-privatization control financial responsibility and accept a cer- market, issuers are usually not interest- tain degree of regulation to make the ed in having an active market for their system work. shares. Brokers' customers (whether they are managers or outside investors) Investors particziating in the control mar- are principally interested in vacuuming ket do not value the price formation function up small holdings at as advantageous a of a liquid trading market. price as possible. If a control battle be- * When brokers use exchanges to trade tween insiders and outsiders is possible, equities, the exchange is rarely used as secrecv is also of prime interest to the a way to find the best current price or broker's customer. determine a market value for the * A broker who is assembling blocks on shares. iMany transactions on exchanges behalf of a client will usually prefer to are entered into merely, as one young have little or no price and volume trans- Russian fund manager has put it, to parency The broker's trading activity "beautify" the company, for advertising will not lure competition from other bro- or price-manipulation purposes. kers (who might steal the client) or from * The general public does not yet seem at- other investors. Lack of transparency tracted to trading gains. Most activity also allowvsthe broker to achieve much reflects a "bond" mentality driven by more substantial spreads, and published the issuer's promises of exceptionally prices can be more readily manipulated. high current payout (often plus a lottery-type premium) rather than an "eq- Control market transactionpatterns do not uitv" mentality that looks to price involve turnover of securitiesbetween interme- appreciation. The large amount of cur- diaanes,and consequently there is little "two- rent retail activity in new issues is in re- waY trading"that would benefitfrom collective sponse to mass advertising rather than lormalization or institutional support. information on the issuer's prospects. * Trading is currentlv dorninated by one- To the extent trading gains are an at- wav transactions between off-market traction for small investors, the gains small sellers ar.d large buyers. Although are simply the result of the issuer's re- broker-to-broker volumes are increas- demption practices or "marketing, thev still remain fairly rare as a per- making" activities and not the reflection

CAj'uiiL %LMRKETSDEVELOPMENT .m) FINANCING RussiA'sTRANSFOR.LTI7ON 93

of investors' supply and demand in a participants. Brokers are especially sus- true secondary market. picious of collective institutions, such as Brokers actin, as distributors or re- exchanges or depositories, because of sellers of the new mass-distributed is- the potential for abuse of information sues viewv their role either as order such institutions could gain from having processors (acting for the issuer) or as a "view of the market" or knowing wholesalers (acting for their own ac- about the activities of brokers. count). The provision of services to a * In order to control risk, each broker customer base of potential repeat intends to develop its own trade con- vestors is rarely part of their calculus. tracting, securities delivery, re-registra- The dealers have fexwexpectations that tion, and payment procedures. Firms investors might want to trade through are reluctant to rely on outside institu- them as well as buy new products, and tions to perform these functions, even if for future sales to the same investors, they control those institutions, in a the distributors rely on mass advertising sense, through collective ownership. by the issuer to bring them to the door. Each broker must be assured that the Analyzing the potential market value of collective facilitv is as competent to per- a share is extremely difficult, given the form the function as the firm's own in- limited financial information available ternal staff. Currently, the back-office on companv performance, the inability processing capacity in which a broker to project future profitability from past has invested is often viewed as an im- performance, and the frequent desire of portant source of competitive advan- managers to, at best, hide cash flow tage. As a result, brokers are hesitant to and, at worst, siphon it off. It is not un- give up this advantage when the common for managers to avoid paving prospective return is an increase in the dividends to make it cheaper to buy up overall efficiencv of the market. shares from discouraged small investors Similarly, successful brokers have had and employees. Consequentlv, share to develop a sophisticated network of prices often remain tied to some multi- contacts that allows them to find shares ple of nominal value, since the nominal and determine an appropriate price to value was originally set in relation to the pay for them. Unless an exchange or historical value of the enterprise's fixed formal over-the-counter market can do assets-onlv quasi-reliable financial in- a much better job of reducing search dicator available. Furthermore, most costs and determining market price, the Russians' experience with securities was brokers will continue to internalize limited to state bonds, so thev tend to these functions. endow the notion of nominal value of shares with excessive meaning, using it In most regiozzsof Russia, brokers viewv as a reference to establish dividend ex- their principal customers as the issuers rather pectations and determine market value. than the investors. This is particularly the The recent experience with vouchers, case when the broker is a stock department which had a nominal value but a widely of a bank that has a financial relationship tluctuating market price, will hopefullv with the issuer. go some way to changing these expec- * This accounts, in part, for the high de- tations. gree of integration often found within a securities firm (or affiliated group). The Each broker sees control of economic en- same firm acts as broker, market-maker vironment as a higher priority than operating (in the sense either of being the princi- etficiency, especiall.v where efficiency gains pal firm advertising for sellers on behalf would be achievable only throubghgiving tip of a single purchaser or of using the in- some control over opertizons to others. formation in the issuer's register to lo- * It would be difficult to exaggerate the cate potential sellers), transfer agent, level of distrust among many market registrar, and depositor-.y

94 RlssLA: CREATn.N(PRmvAT ENTERI'NIRIS AND EITlFNT NLRiEI's

The broker otten giVeS IUway somne of his great deal more paper than a certificated sert.tcesto the losierThis has been especially one. For a variety of highly practical rea- prevalent in the performance of registrar sons, in today's environment Russian in- functions,where the broker's objectiveis not vestors and market participants often to make moneyon the registrarbusiness but prefer a certificated securitv.Furthermore, to monopolizethe transactionflow for a giv- given the uncertainty under current en issuer,making money through transaction Russian law regarding finalitvof transfer of charges, commissions and spreads, often registered certificates (that is, without re- borne disproportionatelyby small sellers. registration due to the absence of a "bona Clearly,such a strategyis not consistentwith fide purchaser" rule for registered securi- the establishmentof an active and competi- ties), a preference for bearer paper is wide- tive tradingmarket. The good news, howev- spread among small traders, who also find er, is that, as the market developsin regions the immediacy of trading without re-regis- Arguments for an like Moscowvand St. Petersburg, there are tration attractive. across-the-board healthysigns of functionalsegregation, if not For a number of practical reasons, the specialization. privatizationprogram did not require enter- imposition of book- prises to incur the cost and administrative entry arrangements Thereis no singles-stenz fbr et idencingown- burden of issuingcertificates for shares dis- ignore the impor- ersoizand trainsteroqtsectirittes tributedduring pnrvatization.Consequently, privatization did result in a large number of tant economic The most immediatelyvisible factor in the uncertificated shares being handled by functions that post-privatizationstage is a subject usually book-entrv. But these book-entry arrange- certificates reserved for back-office specialists, comments are not maintained bv a centralized puter svstem designers, and legal scholars, depositoryset up to facilitatesecondarv mar- but wvhich has been a topic of heated debate ket activitv, as contemplated by the G-30 in Russia for the last two years. Some for- recommendations for international stan- eign advisers have advocated that Russia dards. Instead they are the responsibilityof take a single great leap fonvard, skipping issuers and their registrars,scattered in thou- the stage of market developmentwhich re- sands of locations across Russia,and con- lies on certificated securities to evidence trolled bv the issuers rather than bv the ownership and effectuate transfer. They markets. have argued that immediate introduction Realistically,it is to be expected that of book-entry systems would avoid getting Russia will have, for some time to come, a Russian citizens in the bad habit of relying number of share ownership and transfer on documents. Russiawould not have to in- systems operating in parallel. This is not cur the costs involved in converting to a necessarilya negative characteristic-a va- "paperless" system at a later date, once ac- riety of mechanisms may more easily active trading starts to develop. commodate the highly heterogeneous Arguments for an across-the-boardim- nature of both the securities being issued position of book-entry arrangements ig- and investor preferences.The different sys- nore the important economic functions tems will, however,have an impact on trad- that certificates perform. They also over- ing behavior, the evolution of market look the fact that a systemof uncertificated institutions, and the ways foreign investors securities, in order to perform the same can enter the Russian markets. Because of functions as a certificate-based system, their importance, they wvillbe reviewed in would require an immediate installation of some detail. highly sophisticated, nationwide communications and accounting infrastructure as Dtrect holdings of uncertificated registered well as a reliable arrangement for delivering securities Equity securities in Russia are, by confirmations and periodic account state- law, required to be registered rather than mcnts, which the Russian postal system bearer instruments. For at least the next cannot provide. It is often forgotten that an decade or so, the largest number of regis- u.certificated system actually generates a tered shareholders xvillbe small individual

C.UiAMT.LNLuoKm:rs Dl\ 1:1,)PiL\N1 N\ DFI\ N( ING RUssIx' TRAvoK()MATiON 95

investors (employees and voucher auction form of stock certificates rather than regis- winners) who own shares they received dur- ter extracts. Given the cash-on-the-barrel- ing privatization. Typically, these small head nature of the market, it is not shareholders wv-illown the shares in their surprising that large investorswant to have own name, not through a nominee. Of these their securities at hand, ready for delivery, shares, a substantial portion are uncertifi- if they decide to sell. cated, because the privatization program permitted newly privatized companies to Indirectholdingsofregisteredsecurities. It confirm ownership of shares upon the is difficult to overstate the potential for shareholder's request by the issuance of a market efficiencygains if traded shares can confirmation (called a register extract) be "delivered" by a broker merely by in- rather than by a stock certificate. structing a depository to transfer shares These small shareholders willjustifiably held in the broker's account to the account expect the issuer's registrar to maintain of another member of the depository.For a their records of ownership and to provide customer of a brokerage firm who wants to the basic services of processing sharehold- be able to move quickly to sell his shares er entitlements, such as voting rights and when the price is right, maintaining the dividends. Sales among friends or transfers shares in the broker's custody is particular- by gift or inheritance can be performed by ly attractive, and the costs of that custody the registered owner trotting along to the service will be significantlyless if the bro- company's registrar, often located on the ker can hold the shares in street name company s premises or at a nearby bank rather than in the customer's name. branch. Such nonmarket shareholdershave Depository and custodial services using no need to use the servicesof market insti- nominee arrangements are starting to tutions, such as a broker or depository,un- emerge in Russia, and the process should til the time they want to obtain a market be assisted by the recent depository regu- price for their shares. lations issued by the RFCSE (Commission on Securities and Exchanges under the Direct holdzngsof certificatedregistered President of the Russian Federation), secuerities.A large number of Russia's citi- which defined nominee arrangementsas a zens exchanged their vouchers for shares of valid type of custodial serviceand clarified a voucher investment fund (VIF). Most of- rights and duties of depositories and their ten these funds issued pieces of paper customers.5 called certificates,with the name of the in- It is unreasonable, however, to expect vestor written on the document and en- large numbers of shares to move immedi- tered in the VIF's shareholder register. ately into nominee holdings for a varietyof Whether many of these documents satisfy reasons. As mentioned above,the large ma- all of the safety features that should be met jority of shareholdersare small unit holders by negotiable securities is highlyquestion- who have no need to pay for custodial ser- able, but the documents are in theory ca- vices and will, accordingly,remain direct pable of being used to effect transfer of VIF holders. The brokers are only now starting shares in the secondary market. It must be to see repeat investors as a developing recalled that VIFs are closed-end funds, so client base of prospective customers.It will trading in their shares is not outside the take a while for those customers to have the realm of possibility,and several large VIFs confidence in both the qualityof operations have taken steps to list their shares with and the financialstrength of the brokers to trading markets. be willing to leave their shares in street The shareholdings of large investors name. Only as the one-waycontrol market also often take the form of direct holdings shifts to a two-way trading market, with of certificated, registered shares. Investors brokers on both sides of anonymoustrades, engaged in assembling blocks of shares in will there be a significantneed for central- privatized companies often insiston receiv- ized depository services to effect rapid de- ing confirmation of re-registration in the liveryof shares.

96 RuSSLk: CREATIN(; PFRATE ENTEFRPRISESAND EFFICIENT NIARK;TS

Bearersecutrities. Given the difficulties in further advantage-while the shares are on getting in and out of a company register at deposit with the company, management in the time of a trade, first to confirm owner- effect has the ability to vote the shares. ship (if the shares are uncertificated) and AViA's strategy cleverly appeals to sev- then to re-register the shares in the name of eral characteristics of many small Russian the buyer, it is not surprising that a growing investors-they think of buying securities number of bearer instruments are finding as buying paper rather than financial assets their way into the Russian marketplace. The (the term for securities in Russian means principal use of bearer instruments is by valuable paper); they prefer an emphasis on very large offerings targeted at verv small in- current return (dividends, interest, or vestors. The classic example is AVVA, the "guaranteed" future redemption price) All-Russian Automobile Alliance, which is a rather than appreciation, an attitude which shell company affiliated with AvtoVaz. the physical dividend coupon helps to rein- AWA was established to raise $3 billion force; and they prefer their "up-side" to be through a nationwide distribution of shares in the form of tangible premiums (lotteries over the next four years to finance a pro- for cars, houses) rather than as trading posed joint venture with General Motors. gains. To give some comfort to investors This paper will pass over the merits, or lack that the value of their investment is not be- thereof, of the company and its offering to ing eroded by inflation, AVVA adjusts the focus exclusively on the type of security that primary distribution price of the shares up- AVVAhas quite imaginatively invented and wards weekly to reflect inflation and that other issuers have rapidly copied. changes in the U.S. dollar exchange rate Russia's joint stock company regula- with the ruble. tions require company shares to be regis- The push for bearer equity instruments tered securities, but AVVAwanted to avoid is coming from a number of market partic- the costs and delay of establishing a regis- ipants and exchanges, who view bearer trar and transfer agent system large enough, shares as a way to rapidly replace the lost and with sufficient geographic outreach, to trading activity in vouchers (which for most handle inputting the ownership informa- purposes expired at the end of June 1994). tion on all the small investors they hope On the debt side, a growing number of would buy the shares. Furthermore, with- state and local authorities are issuing bonds out organized trading markets hooked di- in bearer rather than registered form be- rectlv into the bookkeeper for the AVVA cause of the lower up-front expense re- issue, small investors would find it difficult quired to create an easily tradable security. to transfer the securities if they were regis- Apart from the attractions to the investor in tered-under Russian lav, each time regis- terms of confidentiality and tax avoidance, tered securities are transferred it is at least bearer instruments have the benefit to the highly advisable, if not legally necessary, to issuer that they do not require institutional return to the registrar for re-registration. infrastructure to support primary distribu- AVV7A'ssolution was to create bearer tion and secondary trading. Transfer is ef- depository receipts, which can be converted fected simply bv phvsical delivery and is not into shares held on deposit with the compa- dependent on getting in and out of the ny: The receipts have dividend coupons, "book," whether a depository or the is- which can be clipped and taken along to a suer's register. dividend payment agent if and when divi- There are a number of policy reasons to dends are declared. Ingeniously, the receipt discourage the proliferation of bearer instru- also serves as a lottery ticket for a series of ments. They create considerable costs, such drawings for new cars (to be purchased from as physical safekeeping, anti-counterfeiting AvtoVazwith a portion of the proceeds of the measures, provisions for lost, stolen, or de- offering). To reduce the incentive to convert stroved documents, and so on. In the current the receipt into shares, the lottery ticket ceas- environment in Russia, the widespread ac- es to be valid when exchanged for shares. ceptability of bearer paper would seem to be From AVA7Asstandpoint, the scheme has a an invitation to fraud by any enterprising

C(AIA LARKETS DEVkiOi()MLNT AND)FINANCING RussiA's TRSN EORNiAtIi)N 97

scam artist who produces handsome certifi- this year, in its first regulations,the RFCSE cates issued by shell or fly-by-nightcompa- choseto issue two important sets of ruleson nies.The difficultiesin handling shareholder registrar and depositoryoperations. These entitlementswhen equity interestsare repre- rules help to resolve a number of practical sented by bearer documents should also not questions about the nature of the responsi- be underestimated. It is likely that bearer biities of these typesof institutionsand the documents will prove unacceptable to for- legalrights of investors,as wellas give guid- eign investors,wvho will demand the certain- ance on how to effect a transferor pledge of tv that theirproperty rights will be recognized shares. by the issuer.Finally, because bearer instru- Although the registration process re- ments can be transferred by anyone on the mains highlyimperfect, a growingnumber street corner or in the NMetro,they draw sig- of Russian issuers and registrarshave a ba- nificant activity away from the organized sic understanding of the function and are markets where regulationand transparency beginning to perform it with some regulari- are easierto introducebecause they are more tv.This process has been greatlyassisted by consistentwith economicincentives of mar- USAID-funded projects, which have sup- ket participants.The important market disci- ported the disseminationof how-to infor- pline, created by brokers' accountabilityto mation, demonstration registrarpilots, and theircustomers, is completelyundermined in development of procedures and software the street-cornertrading of bearer securities. for registrars interested in improving their By diverting retail demand into bearer in- operations. Shareholdersand potential instruments, registered securities are made vestors have a growingset of shared expec- uncompetitive,and intermediaries are dis- tations about the basic standards of couragedfrom investing in the operatingsys- performance that issuers and registrars are, tems and infrastructurenecessary to support in theorv,obliged to meet. the participationof retail investors in orga- Currently,there are four major concerns nized markets. about the future developmentof the regis- Most costs associated with bearer cer- tration function: tificatesare not direct costs, and advocates The function willbe performed at a low of bearer equitv instruments do not appear standard of operatingefficiency and re- concerned about how those costs will ulti- liability,due to the ease of entry into the matelvbe paid. Strategiesto limit the use of business by small, unqualified regis- bearer instruments should, therefore, also trars (often captive operations of their address how the deficienciesin infrastruc- client issuer) and the lack of regulatory ture, which bearer instruments help to over- oversight; come, can be mitigated. The fragmentationof the registrarindus- try will make interfacesslow, expensive, Thereare large and trimediatedemandsfor and unreliable,betmeen the plethora of complexinfrastructture to suipportsecuirities small registrarsand clearingand settle- ownershipand transfer ment arrangementsfor tradingmarkets; The likelihoodthat smallerindependent In the post-privatizationstage, a major dif- registrars will not be commerciallyvi- ficulty in the emergence of equity market able, both because of their lack of busi- activityhas been the absence of legal rules ness experienceand becauseissuers are and commercial practices with respect to reluctant to pay for the service;and evidence of ownership, registration, trans- * The risk that current efforts to produce fer procedures, and nominee holdings. A legislationgoverning securities issuance presidentialdecree in October 1993 was a and trading (Civil Code, Joint Stock major step forward in clarifyingthe role of Company Laxv,Securities MIarket Law) securities market infrastructure institu- will utilize legal concepts or implicitly tions."The decree required companieswvith dictate institutionalarrangements which more than 1,000shareholders to use the ser- will be incompatible -,ith emerging vicesof an independent registrar.In Aprilof practice in this area.

98 RuISSIA: CREAING(RPvRc,VT ENI1:RI'RISES AND EFFICIENT MARn-TS

Depositories are, in theorv, one of the competitive with bearer securities, the principall protections for small investors in development of low-cost customer ac- investment funds, which are required, by counting services will be kev. law. to have their cash and securities han- * The participation of significant foreign dled by an independent depository. Few in- institutional investment in the markets vestment funds have followed the spirit of will require the rapid creation of custo- this requirement, and the forthcoming dial arrangements that meet interna- shake-out of the VIF industry will also tional standards. There are increasing probably have an impact on the deposito- indications that foreign banks or do- ries. Surviving VIFs wvillbe pushed to regu- mestic and foreign joint ventures will larize their relations with independent shortly be developing services to satisfy depositories. which will hopefully stimulate client expectations. the development of this important industry Horror stories segment by creating greater demand for The Russian pa,yments s-ls/emdoes not satzsy abound about the quality depository services. the requirements/tr efficient and reliable Depositories that provide services to shareissuance or transfer inefficiency of the permit more immediate trading (brokers Russian payments holding securities for customers) and sup- Horror stories abound about the ineffi- system... port clearing and settlement (depositories ciency of the Russian payments system, and holding securities for brokers or other fi- many of the cash flow problems of Russian nancial institutions) are also beginning to industrv have been attributed to its inade- emerge. quacies. In the last year or so, however, the Critical issues for depository develop- Central Bank of Russia (CBR) has made ment concern chiefly the legal principles on strides in improving processing. Equally which the depositorn/depositor relation is important, the private banking svstem has based (including restricting potential not stood idle but has invented a variety of claims bv third parties to assets held on be- ways to make funds move, principally half of the depositor), the financial capaci- through large correspondent banking net- tv of depositories, and potential conflicts of uvorks that can handle inter-regional pay- interest in the case of affiliations between a ments. Common estimates are that good depository and other financial service funds (that is, credit to a CBR settlement providers. account) can be moved within a maximum In addition to actions that the RFCSE of three da%ysin Moscow and two weeks in- can take or encourage, the marketplace is ter-regionally. Nonetheless, it would be a likely to provide certain incentives for the major leap from today's pavment system to development of both the registration and a svstem capable of supporting clearing and depositorv functions. settlement systems for securities that Some large issuers are already demon- achieve delivery versus payment (DVP), es- strating an appreciation of the impor- pecially inter-regionally or internationally, tance of quality registration services. wvithout awkward and costly pre-position- Enterprises which are interested in ob- ing of funds. taining new capital by issuing, shares To date, the general unreliability of the have an economic incentive to assure process of transferring and re-registering new investors that their shares will be shares has meant that the inadequacy of the reliably transferrable property rights payment system has not been a binding and that they wvillbe able to enjoy share- constraint on the development of the equi- holder entitlements (voting, dividends, ty markets. Due both to the characteristics and the likc)L of current supply and demand and to the * As the volume of secondarv market ac- awkward mechanisms for delivery of secu- tivitv becomes more important, the de- rities and payment, the market is charac- mand by investors will grow for brokers terized by cash-on-the-barrelhead. Often, to proviJde reliable depositorv services. a trade is not treated as binding until phys- In fact, tor registered securities to be ical cash and securities have changed

C(AI'I-.::I 1.x DlvriADil [('I'I \AN)FIN \N( IN-, RussiL ' TR-\NSiNM()xiIu\ 99

hands. Furthermore, investors otten dis- pationby investorsfrom abroad and other re- trust the issuer or its registrar, fearing that gions. So do Vladivostokand Novosibirsk, re-registration of a large number of shares both uith major ambitions to be financial in the name of an outside purchaser will be capitals of large subnational regions ot refused or at least delayed excessivelv. Russia. The prospects for other areas are Accordinglv,some large buyers require, less self-evident.There is evidence of an prior to payment, the delivery of new stock Urals center formingaround Xekaterinburg. certificatesalreadv registered in the name iNizhnvNovgorod hopes to develop a Volga of the buyer. Where the transfer of a large Region market, with itself as a leader, but packet of shares is involved, ingenious whetherthe proximityto Moscowwilltug the arrangementsmust be devised, sometimes VolgaRegion within Mvloscow'sinstitutional flying representatives of both buyer and dominationremains to be seen. The South seller to the city where the company's reg- would seem to be a candidate for another ister is located and using foreign banks to large subnationalcatchment basin, but the move the funds. center of that regionis not obvious. As the transfer of shares becomes more In the area of capital markets develop- standardized and reliable, and as potential ment, the regional bias of Russia's eco- trading volume grows, the current "pay- nomic and political arrangements was ment after delivery" arrangements willbe- reinforced bv the fact that the large-scale come less acceptable for investors and privatizationprocess was dominated bv re- brokers alike. In order to reduce the expo- gional distribution patterns for shares. sure to sellers, some sort of mechanism for Most companiesselected the privatization achievingDVP will be required. The diffi- option that resulted in 51 percent of the culties in moving funds will then become a shares goingto employees.In addition, the bottleneck to market development. It can- organizers of large-scaleprivatization auc- not be expected that the CBR will have a tions and sellersof the privatizationshares redesigned payment system in operation were the local property committees and by that time, so special funds settlement funds. Although some companies went arrangements will need to be developed through a system of inter-regional or na- for the equity markets which meet the safe- tional auctions, the bulk of the enterprises ty expectations of large investors, especial- were auctioned only in voucher auction lv foreign portfolio managers. centers located in the oblast in which the enterprise was headquartered. Some intre- Rtisszzi'scapital markets have a strong pid investors, particularly voucher funds, regzonalbias traveled to auctions around the countrv. But obviously;the great majorit, of the di- As anyone who has traveled or worked in rect shareholdersof a newlv privatized en- Russiawill confirm, Moscow is not Russia. terprise are residents of the oblast where Apartfrom the political ambitions of the re- the enterprise was auctioned. gions to be independent of Moscow, the This regional.pattern is likelyto continue sheer geographic scale and diversity of the in the future for manv of the medium-sized countrydictate that there will be a number enterprisesthat willhave&public distribution of economic centers. Although Moscow of their shares.Especially in the current en- wvillbe an international money center, it is vironmentof little availableinformation on both politicallyand economically unrealis- the financialcondition and prospects of en- tic to expect other parts of Russiato look to terprises,it is the "locals"who typicallypos- MNvoscowinstitutions to serve all their sess the most reliable and relevant financingneeds. information,with regard to both new issues Just Nvhichcities wvill develop viable inde- and secondarvtrading. As wasfound during pendent financialsectors is somewhat diffi- the voucher auction process, the neighbors cult to predict. St. Petersburg stands out, and employeesare likelyto have a feel for with its large privatization program and rapid what has been happening to the company's growth in financial activity, including partici- cash flow, any problems wvith major cus-

100 RuSSLA:CREATIN(; PRIuAvs ENERPRISES AND Eli':(.IENT iNL.\RKETS tomers or suppLiers,the company's capital unlikely.Russia has an absurdly high num- investment patterns, how plans tor restruc- ber of licensed exchanges,given the small turing operations have proceeded, and so amount ot current activity Moreover, the forth. Furthermore,a medium-sizedcompa- brokers conduct most of the limited trans- ny may have strong local name recognition action volume off-market rather than but little abilitvto raise its profile with in- through a formal trading market. Although vestorsin a nationalcontext. Yet such a com- there has been some consolidationof ex- pany may alreadyhave a substantialnumber changes, most of the reduction in number is of shareholders,often numberingin the sev- simplydue to the disappearanceof money- eral thousands. A regionalover-the-counter losing structures. market to support occasionaltrading, like This raises a troublesomequestion. If, in- the old U.S. "pink-sheets" system, might deed, a two-wav trading market starts to serve these companieswell, and could be or- emerge in the coming year, will brokers Russia has an ganized at low cost. channel their activit,vinto a small number of absurdly high effective institutions, or willthere be a pro- There is a strikingheterogeneity- of isszers liferationof new institutionsaLl trying to be- number of licensed and investors come the market (whether national or exchanges,given regional), the depository,the setflement or- the small amount The foregoing comments suggest another ganization, and so forth? important force pushing toward multiplici- The apparent motivations behind the of current activity. tv of market structures. There is, and will proliferation of trading institutions give continue to be, an extreme diversitvin the some cause for concern. It is difficultto ac- types of companies (size, sector, current count for the survivalof such a large num- condition, prospects) wvithpublicly-distrib- ber of exchanges unless they are the result uted shares. As foreign investors become of some market participants tryingto dom- more interested in Russia,and as financial inate a particular market by imposing their institutions look for waysto provide a wider structures on others. Someof this behavior range of products to retail investors, the may be attributable to Russian experience, types of investors likelyto be interested in when success was achievedby using influ- investingin shares willcontinue to diversify. ence to obtain grants or charters for eco- This suggests that a one-size-fits-all nomic privilegesfrom a mercantilistTsar or trading structure is an inappropriate design a central planner. Consequently,at the be- to satisfy Russian requirements.These fac- ginning of the transitionprocess, before the tors, combined with the natural regional- potential profitabilityof a particularmarket ization of market activities, make a single could be determined, people with ambi- central market, and central infrastructure tions to be players organizedthemselves in- supporting it, not onlv politically impossible to what might be best understood as and operationally and technologically im- lobbying groups or clubs. They were not practical, but also probablv not healthy for really interested in the immediate commer- the long-run ability of the capital markets cial viability of the club as a provider of ser- to meet the needs of both Russian issuers vices to the market. Instead, the club was and investors. established so it could stake out its position in the market-to-come and use its influence Other souercesof market fragmentation with political and bureaucratic mentors to capture a variety of privileged profit oppor- Many of the factors previously discussed are tunities at the expense of other potential sufficient to explain on economic grounds competitors. why Russian markets are fragmented, but By the current stage in Russia's econom- there appear to be other sources of frag- ic transition, attitudes have started to shift mentation as well. The last several years sharply As brokers gain concrete experience have seen a remarkable number of attempts running brokerage operations, the more se- to create trading institutions, despite the rious among them are thinking about who fact that their early profitabilitv was highly their potential clients are, how the market is

CAPITAkL1NL\RKETS DEVEI.OI'M\IN1 AND FINANCING Russt,s TRP.NSFOPNIAII(xN 101

likely to evolve, and how they can position for nonbank financial instruments with the themselves competitively to provide services growing interest by enterprises to use the their clients wvillwant to buv. These brokers markets to raise new capital. Many man- willdemand quality services from collective agers are starting to realize that continued institutions, and on a commercially accept- lobbying of the Duma and government will able basis. Such a shift in attitudes should, in not produce sufficient financing resources turn, lead to a much smaller number of com- for the restructuring and modernization peting market institutions. ahead of them. Equallv important is that The danger, of course, is that some of the managers who have succeeded in consoli- lobbying groups w.-illbe able to attract suffi- dating control positions, often through the cient political and bureaucratic support so as acquisition of shares in the current control to undermine the viabilitv of those institu- market, are noxv willing to see a more active tions trying to operate on a commercial ba- and transparent secondary market in their sis. It is unlikely that any lobbying group will shares develop. Sophisticated managers be able to succeed in creating a marketplace have realized that eventually they will have attractive to market participants, issuers, to complv with greater disclosure, fuller and investors. But such initiatives may have protections for minority shareholders, and negative power, that is, the ability to block the like. However, these managers have other, more realistic and modest initiatives. tried to postpone compliance with higher standards until thev were comfortable that Prospects thev were operating from a position of strength. Given the extremely fluid conditions in The appearance of new corporate issues Russia's emerging markets, it would be fool- by enterprises whose managements have a hardy to predict wvhatmarket activitv will strong interest in active trading in their look Like a year from now. Certain factors shares will be a necessarv condition for the can, however, be identified which will affect emergence of collective institutions that the pattern of development, for good or for form an efficient secondary market. This is ill, and which can be grouped in two main because it will accelerate the shift of incen- categories: tives of securities intermediaries. Brokers The constantly shifting constellation of will cease organizing their business around economic incentives and disincentives of supporting managers' control objectives Russian market players-issuers (both and wvillstart to look at investors as a po- companies and local authorities), in- tential customer base. vestors (both domestic and foreign), and A change in brokers' focus from issuer intermediaries, and to investor can represent the beginning of a Actions taken and not taken by the virtuous circle, as the desire for new prod- Russian government and legislature. uct to meet the inter,sts of investors will Bilateral and multilateral assistance, create an incentive for brokers to work with both at the policy level and to support mar- enterprises to bring new products to market development projects, have to date and ket. Broker-to-broker activity will grow, in- will in the future play an important role in ac- creasing the attractivehess of efficiency celerating positive developments and con- gains offered by collective institutions and solidating gains. But such assistance can only reducing the imperative of controlling risk stimulate and build on, not substitute for, through internalizing all functions. Control undertakings of the Russian private and market disincentives with respect to market public sectors. transparency will be reduced. And incentives will increase to improve transparency Shzttingmarket incentives-the rosy scenario in order to enhance the attractiveness of the market to investors. The brightest hopc on the development If shifting incentives begin to produce horizon is the apparent convergence of a quality new issues and the beginnings of or- rapidly rising demand by Russian citizens ganized trading, participation by foreign

102 RussIA: CREATING PRIv\TE ENITRPRISES ANI) EFFICIENT NLARKETS portfolio investors in Russian equities will in the financial sector. By far the largest accelerate rapidly. This in turn would pro- body of rules are the constantly evolving in- Vide a host of other, highly important, fi- dustrv customs and practices (including nancial incentives for positive broker rules of industry organizations such as stock behavior and the development of market in- exchanges and clearinghouses) that allow stitutions, particularly in the areas of cus- market participants to do business with tody and clearing and settlement. Leading each other efficiently. Russian brokers are already investigating The Russian approach to date, some- ways to improve the qualitv of their services times consciouslv and sometimes by de- in these areas in order to meet the standards fault, has been to leave much of the rule that foreign institutional investors insist up- development and institution-definition pro- on. Participation by foreign investors would cess to private actors. This is not to suggest also have important benefits in generallv im- that there are no Russian laws or regulations proving the quality of disclosure and corpo- concerning the issuance and trading of se- rate governance practices by domestic curities. On the contrarv, a variety of gov- issuers. Availabilitv of foreign funds for pri- ernment bodies are responsible for the mary offerings would reduce some of the licensing of exchanges, securities intermedi- pressures on large offerings to raise all of the aries, and investment funds, and licenses financing domestically And finall, despite can be, and have been, withdrawn. Brokers the bouts of xenophobia wvhich will no are subject to examination requirements. doubt continue to be reflected in Russian New issues of securities must be described political debate, a high degree of foreign inin a prospectus registered wviththe NMinistry terest will enhance the confidence of of Finance or Central Bank. A growing body Russian investors and improve the credibil- of rules concerning corporate governance ity of the markets generally can be found in laws, presidential decrees and privatization regulations. Ministry of Policy development and implementation Finance regulations provide a basic outline for a securities market regime that has a For the shifting incentives of market par- number of features familiar to developed ticipants to produce healthy development markets. of market institutions, certain areas of pol- In some wavs, these rules have helped icy will require attention. Unfortunatelv, to shape the institutions and practices that common to most policy issues is a set of are appearing in Russia todav But in other problems that cannot be resolved exclu- ways, these rules have been irrelevant to sivelv on technical grounds but are part of market activity This should not come as a a major debate over the structure and reg- surprise, because people tvpically trv to ulation of the financial sector. Before ex- avoid or ignore rules that are incompatible arruning specific issues on wvhich policy with their economic circumstances or ob- attention is required. the broader regulato- jectives. This is especially true in Russia tory debate needs to he reviewved. day -where economic opportunities and interests are in a constant state of flux. Designing a regulator-v stnrcture. Capital There are several reasons wvhymanv of the markets are, in an abstract sense, nothing formal rules concerning the capital markets but a set of commonly recognized rules. have bcen irrelevant to market develop- Unlike tangible property, financial assets ment. First, the rules often do not resolve have only those characteristics that society basic matters regarding the issuance and agrees they have, and they can be produced, transfer of securities. Most of these ques- possessed, and transferred only through tions are being settled pragmatically by recognized institutional arrangements. rapidly emerging industry practice, but on Some rules are found in basic law on con- some matters there remains a fundamental tracts, negotiable instruments, secured legal vacuum that custom alone cannot fill. transactions, and so on. Others are in spe- Second, compliance wvithlaw and regula- cial laws and regulations governing activities tions often has been unnecessary or impos-

C_A:-ITL DiL\KEThDlxii.. l'Ml1:0NTAM .FINANCINM RuSSL-XS TKAWNSOI

sible for new market participants. Russia's ty to suspend licenses is usually on the securities industry is going through a num- grounds of failure to file mandatorv reports ber of stages at an extremely rapid rate. or meet certain objective qualifications. Brokers have only recently begun to engage Licenses are generally not taken away for in certain tvpes of primary and secondary failure to conduct the business in accor- market activities that present important dance with the spirit of the laws or regula- questions of rule compliance. Similarly, in- tions. It is easy to be sympathetic with the vestment funds were first authorized by rulemakers'suspicion, if daily reports in the regulations issued in late 1992, but only Russian press accurately depict the chaos now are independent custodians starting to being created by constant changes in rules offer services that will allow funds to com- and interpretation, especially by middle- ply with the spirit of the regulations. A third level functionaries in the tax and customs source of difficulty can be attributed to the services. multiplicity of sources of rules-legislature, Without important functions tied to presidential decree, government decree, oversight or surveillance, the responsible and ministry regulations, instructions and agencies have usually chosen to react to the like. Each rulemaking body has its own problems only once they have become high- set of urgent practical problems to solve, in- lv visible. Even then, the authorities have of- stitutional ambitions, and constituencies, ten been slow to take action, and when they resulting in a piecemeal approach to rule- do act, the outcome is uncertain. Setting making which often creates technical in- aside possible corruption, bureaucratic in- consistencies and policv conflicts. fighting, or simple incompetence as reasons One of the greatest problems with the for slow response, it is clear that pursuing ef- rules has been the almost complete "dis- fective enforcement action is difficult at connect" with mechanisms for their en- best. Prosecutors are overworked and inex- forcement. Of course, enforcement is perienced in bringing these sorts of cases, effective only if the majority complies with and courts are inexperienced in reviewing the rules, so that discipline need be applied them. The definitions of, and evidentiary onlv to deviant behavior at the margin. If rules for, "economic crimes" such as fraud, noncompliance is sufficiently widespread, so misused under the Soviet system, remain attempts at enforcement are fairly useless. murky. And standing is also highly uncertain However, that does not explain the lack of for private parties to bring suit, if they have enforcement against clearly deviant be- been damaged by another person's failure havior, that is, fraudulent or obviouslv un- to comply with regulatory standards. The re- sound practices. There are a complex set of form of administrative law and the civil and factors that explain, in part, the lack of en- criminal court system is beyond the scope of forcement. Mvlanyof these factors seem to this paper, but it is part of the background underlie the broader problem of introduc- for understanding the constraints on intro- ing sensible economic regulation in Russia ducing a sensible regulatory regime. It also more generally. helps explain why Russian regulators seem Even though the laws and regulations to swing from one extreme to another- governing securities activities contain quite from being paralyzed to conducting armed a bit of detail defining acceptable behavior, raids of companies which are alleged to the duties expressly assigned to the govern- have violated the rules. ment regulatory authorities are typically Although the process of rule develop- limited to such matters as licensing or reg- ment for the Russian capital markets has istration functions. Retlecting rulemakers' been fairly chaotic over the last year or so, deep suspicion that government bureau- the Russian reliance on industry practice crats Nvillabuse their authority and have lit- and market discipline, rather than bureau- tle understanding of the new economic cratic controls, is beginning to show results. structures, the licensing procedures are A legitimate equity market is starting to ap- mostly a matter of assuring compliance pear, in which participants (brokers, in- with form requirements. Similarly. autholi- vestors, and issuers) have begun to place

104 RussiA: CREATINGPpavATE ENTERlPRuSES AND EFFICIENT MARKETS

valueon the qualityof products and services their own ambitions to build or control mar- as well as on that important intangible,rep- ket structures. This configuration of con- utation. Brokers are beginning to organize flicting interests has, to date, generallv themselves into associations to formalize produced inaction, but in the wake of trading practices, and they are looking for MNlNMMit is likely that new laws or regula- ways to increase the amount of new product tions will be produced. available for trading which meets higher The lawmaking process introduces sev- standards. Similar self-regulatory functions eral risks for the organized equity markets will be played bv the new clearing and set- that are emerging. For manv aspects of tlement organizations (CSOs) being estab- Russia's infant markets, it is premature to lished with USAID assistance. For example, codify appropriate industry practice and in- as the CSOs begin to offer more complex stitutional structures in laws and regula- services to improve efficiency, such as net- tions. This would not be a significant ... pressutres are ting, the success of the CSOs will depend problem if rules could be drafted around building for the increasinglv on the financial qualifications basic principles or economic functions and operating practices of participating bro- which would be flexible enough to accom- adoption of a kers. The CSOs will undoubtedly need to modate the rate of innovation and changing comprehensive oversee the financial condition and opera- economic incentives in the markets today Securities Market tions of their participants, much as is already But compliance with form requirements done by several of the private bank clear- plavs an extremelv important role in Russian Law, togetber with inghouses that handle pavments. lawmaking and enforcement. Premature more aggressive Despite these recent signs of progress, codification on the basis of legal form rather regIflation pressures are building for the adoption of a than economic function would simply en- comprehensive Securities Market Law, to- courage the invention of clever and non- gether wvith more aggressive regulation. transparent arrangements that slip through There is a significant range of views with re- loopholes or bypass the intent of the rules. spect to both the future shape of the capital Of the coming battles over a securities markets and the manner of regulating them. markets law, the one which is likelv to be The battle is not simplv between those with most vigorously fought will be over the as- a deeply ingrained hostility towards finance signment of regulatory functions among capital and those for whom an effective fi- government entities and between govern- nancial sector is a top prioritv Among peo- ment and the securities industry. Foreign ple who see the importance of capital advisers have almost universally recom- markets to Russia's future, an important mended a single, specialized, and profes- power struggle is occurring over such issues sionally-staffed agency, which would as institutional structure (especially the rel- consolidate regulatory authority of the se- ative role of universal banks and specialized curities markets and oversee the self-regu- brokers), limiting versus encouraging in- latory activities of market participants. dustrial-financial linkages, government es- Given the existing bureaucratic interests tablishment of specific markets versus and other political forces that are at play, competition among private market struc- however, such a straightforward solution tures, and the degree and allocation of reg- appears unlikelvy ulatory control (within the government and The outcome of this battle is unpre- between government and industry). dictable. Proposals to increase the regulato- Complexity is added by the multiplicity of rv authority of existing ministries will be government ministries which already claim opposed vigorouslv by manv Russian some jurisdiction over the securities mar- reformers and market participants. Their kets, or which have ambitions to do so. opposition is based on the conviction that Furthermore, central bureaucratic initia- the ministries will undermine the essential tives are certain to be attacked from the re- contribution of capital markets to Russia's gions, not only by market participants who economic transformation. The reformers do not wvantto be forced to use central in- look to the capital markets, much more than stitutions but also by local authorities with to the banks, to ensure that financial re-

CAPITAL-NL%?uo DEVELOPMENT:rTs AND FINANCiNG RusslAs TRANsFOIC\NATIo\ 105

sources will be pooled and allocated to com- itv of financial products available to small merciallv viable businesses on market rather Russian investors. This is not only necessary than administrative criteria. Privatization, to address investor protection. Given the which is rapidly movin, assets out of the dominance of advertising over market infor- hands of the state, is only the first step in the mation in distributing securities to Russia's creation of a market-oriented economv inexperienced investing public, offerings by Currently much of the Russian economy re- responsible issuers wvillbe drowned out by sides in a neverland betveen bureaucratic the siren calls of Ponzi schemes. controls and market forces. The Russian Some product enhancement will come government remains dominated by struc- from the market itself. Legitimate operat- tures that are obsolete but that have bud- ing enterprises interested in attracting sig- getary resources and are looking for a nificant domestic and foreign capital will The nightmare of mission. Redeploving their staff, who have begin to differentiate themselves in the both Russian little understanding of markets but a tradi- marketplace on the basis of product quali- tion of control, is an unpromising strategy. tv Thev will improve their access to capital reformers and the For a generation to come, Russia will have by showing that they comply with interna- new entrepreneurial to bear the costs of these anachronistic gov- tional standards for prospectus disclosure, class is illustrated all emient structures while encouraging them financial reporting and corporate gover- to atrophy. In the meantime, there will be in- nance. These quality standards will also be- too vividly by the sufficient resources for regulatorv capacitv come increasingly important for brokers current Russian tax appropriate for a market economy engaged in underwriting the securities and system... The nightmare of both Russian reform- for trading markets that want to have a rep- ers and the new entrepreneurial class is utation for reliabilitv. illustrated all too vividly bv the current There are, however, a range of harmful Russian tax system-a proliferation of poor- activities which have been impervious to ly written rules administered byapparatchzks. market discipline. The most common Compliance by legitimate business is virtu- fraudulent and abusive practices today do ally impossible, which pushes otherwise not involve the organized markets. Instead, healthv market activity into nontransparent these scams internalize all market func- arrangements and leaves legitimate business tions, from production, through distribu- at the mercv of local power barons, corrupt tion, to exit for the investor. Pvramid middle-level bureaucrats, and criminals. schemes are not harmed economically bv There is considerable potential for bureau- the refusal by legitimate market partici- cratic interference in the markets, for arbi- pants to do business with them. An Mi'ILM trarv abuse of power, and for corruption is simply indifferent to such threats. when current government structures are giv- The MMNINI-typeproblem is not, how- en regulatory authority Russian policymak- ever, a securities market problem, and it ers are therefore faced wvitha dilemma which cannot be controlled by normal securities will require a careful balance between ob- market regulation. Instead, it is a broader jectives and constraints, and this in a politi- matter of fraudulent or unsound practices cal system which has difficulty achieving in the arena of retail financial products, balance through anything resembling an whether they are called securities issued open process. by a joint stock company, shares in an investment fund, deposits with a finance Prioritiesfor policY. Setting to one side company, investment contracts w ith an in- policy issues that would be presented by a surance company: or any other form of fi- comprehensive securities market law, there nancial promise to a small saver. Any are several areas wvhich need immediate attempt to attack this problem needs to be policv attention. Some call for disciplinarv based on economic effect, not legal form, action while others have market develop- in order to hold in check creative Russian ment objectives. scam artists. The objective should be to The political fallout from MKNIdictates place competition among different tvpes of that immediate attention be paid to the qual- financial products on a healthy basis.

106 RUSSLA: CREM\rNG Piuv-iE, E. :RPRRisiJAS\ Ei 11i(1NT.\LRKEITS

A second, closelyrelated area willbe to have not yet developed an activesecurities tame some aspects of the primarv markets, intermediation business in the same way such as addressing the proliferation of bear- brokerage firms have. er instruments, reducing the offering periods Despite the limited presence of banks for new issues, and controlling redemption in the markets to date, the more sophisti- activities hv issuers. Currentlv: the distinction cated specialized brokers are anxious about between the retail distribution and secondary the potential domination of the securities trading of bearer securities is hopelessly industry by the banks once the markets blurred, with the concomitant obliteration of start to look attractive. The larger banks are responsibility of those engaged in distribut- better capitalized, have access to financing ing new issues for wvhatthey sell to the pub- through deposits, inter-bank instruments lic. Dealers are discipLined neither by the and the Central Bank, and often have im- market, since reputation is not an asset for portant political mentors. Another source dealers handling bearer securities for small of potential conflict between banks and investors, nor by the legal and regulatory brokers is that banks are often the backers regirnes. of securities exchanges, which transact lit- The development of secondarv market tle business but succeed in blocking other institutions is also weakened by these prac- initiatives due to their greater financial and tices. Pricing is managed by the issuer, by political staving power. Banks are also frequent increases in primary offering viewed wvith suspicion because of the inter- prices during indefinite offering periods locking ownership with industrial groups and, on the seLlside, by either redemption that are potentially some of Russia's most policies or manipulation of the limited important issuers of securities. amount of secondary trading. Of course, Given the importance of a healthy se- the issuer's pricing policies are designed to curities industrv for rapid capital markets attract more funds from new investors, not development, the relative role of brokers establish a true market price for the shares and banks should be treated with care, es- based on the value of the company or its pecially because of the risks to the financial prospective performance. system presented by under-regulated uni- Once again, these are areas for govern- versal banking structures. At the very least, ment rulemaking because market disci- policies should address issues such as pro- pline is unlikely to have much influence on tection of bank deposits from inappropri- the most abusive practices. In addition to ate securities market risk, controLling the causing harm to investors, these practices most egregious forms of conflicts of inter- undermine the healthy development of the est, and levelling the playing field between organized markets. Although street-corner banks and specialized securities firms. markets have had a role to play in the early Another area requiring emphasis is the stages of development, they are fraught investment fund industrv The rosy scenario with dangers and, in the long run, they vill for Russia's capital markets is driven bv a do little to raise large amounts of capital for shift in the attitudes and behavior of issuers legitimate businesses. and intermediaries in response to the inter- A third area of policy conicern is the fu- ests of large investors. But healthy develop- ture role of the banks in the securities in- ment in the long run will also depend on a dustrvy A number of banks have been growing appetite for investments by ordi- involved in securities activity (such as act- narv Russians, either directlv or through col- ing as registrar or market maker), usually lective investment vehicles. With the end of providing services to enterprises that are ei- voucher auctions, the VIFs are entering a ther a client or shareholder of the bank, of- new stage of their business, and they can be tentimes both. Those banks that have either a positive force for market develop- issued shares to increase their capital also ment or a source of difficulties. First, they use their securities departments to manage should be encouraged to stop taking in new thu distribution and trading of their own sharcholders and become true closed-end shares. Generally, however, Russian banks funds, as required by law,v.The larger and

( . i'i.\1 NLIoL 1 Di \i11 )D[ N T11 ANI) FSNANCi, RusSi.\'s TiK\N R)R.AI IF)N 107

more promising funds are obvious candi- adopt operational regulations and messag- dates for listing on trading markets. But this ing formats that meet international stan- must be accompanied by disclosure of their dards for electronic funds transfers. Finality portfolios and net asset value, as well as in- of transfer and allocation of risk are depen- formation on income and administrative ex- dent on how basic Russian law will resolve penses. Consequently it is important that such matters as the legal characterization of there be clarification of accounting and re- payment orders, principles governing net- porting requirements applicable to the ting, and arrangements for secured transac- funds industry which take into account the tions and insolvency illiquid nature of much of the funds' current Only a year-and-a-half ago, Russia's portfolios. Those funds with strong name mass privatization program began to create recognition and good distribution networks a critical mass of issuers, investors, and se- should be encouraged to create new prod- curities around which intermediaries have ucts, differentiated bv investment policies begun to organize market structures. These and portfolio management strateg. The institutional arrangements are maturing at a growing Russian financial press would cer- remarkable pace. For market forces to con- tainlv be an eager conduit for information tinue to work, however, policies are needed on legitimate investment opportunities and to provide basic certainty regarding intangi- market prices to the general public. Finally, ble property rights and payments, remove the current process of consolidation of the impediments or distortions to institutional more than 600 VIFs must be watched care- development, and prune away the fraudu- fullvyAlthough there are positive signs that lent and abusive practices that are damaging the market is producing appropriate con- the credibility of the infant markets and solidation, scandals in large funds could making legitimate financial products un- cripple investor confidence to such an ex- competitive. Development of Russia's capi- tent that the domestic demand for invest- tal markets will progress in zigs and zags, ments will drv up. with moments of euphoria mixed with dis- Russian policymakers interested in the aster. There are, however, grounds for opti- development of the capital markets cannot mism that the capital markets will begin to limit their attention to specialized securities plav their appointed role in supporting markets laws and regulations. The future Russia's transformation. shape of Russia's capital markets, and the degree to which they will be able to integrate Notes w%ithinternational markets and attract foreign capital, will also be affected gready bv l.Aprimeexampleofhowquickvdevelopments fundamental legal reform iritiatives, at the can take on importance is the collapse of the \MfM level of the Civil Code or other basic law. For A/O pyramid scheme, which took place between the example, in the area of securities ownership conference at which this paper was presented and and transfer, the institutional superstructure publication. Although MININIdid not, in tact, in- must be built on a solid foundation of legal volve the securities markets, it brought to the fore concepts,theincluding Civil C defni- .someimportant aspects of both financial products conceofs,secluriti chertin pCiles dini-e being peddled to the public atd government regu- tion of securities, certain principles in the lation or lack thereof. Several points made in the general law on obligations, and the rules re- originalpresentation have been expanded, given the garding finality of transfer, obligations and potential impact of the MMM episode. defenses of issuers and transferors, and rela- 2. Decree of the President of the Russian Federa- tions between nominees and beneficial own- tion No. 1183,June 10, 1994. Decree of the Presi- ers. Draft laws often try to use traditional dent of the Russian Federation No. 1233, June 11, concepts, which do not alwavs serve as an 1994. adequatebasis fo3. Although the entire range of capital markets, adequate basis for a modern securities sys- from money markets through government securi- tem, especially one involving securities that tiesto corponratedebtand equity markets, wvillhave are uncertificated or immobihlzed in deposi- important contributions to make to Russia's trans- tories. Similarly, in modernizing the Russian formation, the balance of this paper will focus al- payments system, it will not be enough to most exclusively on the equity markets. The results

108 RUSSIA:CREATING PRIvATE ENTERMrISES A.ND EFFICIENT INL.-TTS of Russia's mass privatization program have creat- 6. Decree of the President of the Russian ed a remarkable set of opportunities and problems Federation No. 1769, October 27, 1993. that wvilloccupy Russian bankers and brokers, en- To understand securities infrastructure issues in terprises, government policymakers, legislators, the Russian context, a note on Russian vocabularv foreign investors, foreign financial institutions, is in order. The term registrar is used in the RFCSE and multilateral organizations for years to come. Regulations to denote an agent of the issuer, 4. Throughout this paper, unless otherwise whetherperforming the functions(in U.S. terms) of specified, broker is used as a short-hand for a li- registrar or transfer agent. The term depositorv in- censed financial institution acting as a securities cludes any institution keeping securities accounts, intermediary, whether as agent or principal and directly or indirecdy, on behalf of owners, whether whether a firm specializing in securities activities the securities are held in the name of the owner or or the stock department of a bank. in the name of the institution as nominee. Thus, de- 5. The Commission on Securities and pository covers (in U.S. terms) a depository, a cus- Exchanges under the President of the Russian todian, or a broker-dealer holding customer Federation was formed by President Yeltsinwith securities. Until the RFCSE's Regulations,the term the appointment of its initial members in March depository was used in common parlance to de- 1993. Its eight members are representatives of var- scribe any keeper of securities accounts, whether for ious government bodies with some jurisdiction the issuer or the investor. Needless to say,the regu- over securities activities:Ministry of Finance, State lations introduced critical distinctions in these dif- Committee for the Management of State Property ferent economic functions by defining different sets GEL), Anti-monopoly Committee, Central Bank, of legal rights and obligations. These distinctions are and Federal Property Fund. Its chairman is cur- essential in any modeemsystem for share ownership rentlv the Chief of the State-Legal Department of and transfer (other than those which combine reg- the President. The commnissionhas lirnited au- istrv and depositorv functions in a central book-en- thoritv and no independent staff. try institution, such as in the Czech Republic).

C.wrA,'LM1ARKETS DEVELOPMENTA..D FINANCING RussiA's TRANSFORNATION 109

CHIAPTER 9

Securities MarketDevelopment and Privatization Roger Leeds and Michael Harman

The extraordinarylevel of politicaland eco- correctly noted that the privatization pro- nomic turmoil in Russia notwithstanding, gram has been implemented so quickly be- the privatization program has defied the cause it is "understood, accepted and With an incredible navsavers.Today, the country can boast an supported by the people. 2 However, this 3s percent of the estimated 40 million private shareholders considerableachievement willbe lost if this ~ in companies once 100 percent state- mass of nascent shareholders.1. . cannot soon Russianpopulation owned. Tens of thousands of small enter- trade their stock in a liquid, regulated mar- suddenly trans- prises have undergone privatization, and ketplace. This is only beginning to happen. formed into direct thousands of the larger enterprises are con- The ultimate objective, of course, is to or indirect share- ducting primarv share offerings and be- rapidlytransform these thousands of enter- coming publicly-tradedcompanies in 1994. prises into more productive, efficient assets holders, the This rapid transformation has been possi- for the benefit of their shareholders and the importance of a ble largelybecause of the 1992 distribution country-at-large.In Russia the process is of vouchers-which then could be ex- well established and straightforward (figure changed for shares in privatized compa- 9.1). Although steps 1 and 2 are important market cannot be nies-to almost ever-v Russian citizen. prerequisites, enterprise managers must be overemphasized. Despite a continuous array of roadblocks, induced to undertake the painful but essen- the Russian privatization program has in- tial restructuring measures that lead to en- deed become the catalyst for market-ori- hanced enterprise performance. Herein lies ented reforms and it has established solid the direct linkagebetween privatizationand foundation for the development of a secu- securities market development. Managers rities market. A widespread transformation are most likelyto change their behaviorand of ownership has occurred and a new class actions to optimize enterprise performance of shareholders has been created. when they are held accountable by an active, Althoughthe voucher privatizationpro- informedgroup of shareholderswho have a gram has been a success, a number of seri- vested interest in enterprise performance, ous structural problems remain. Foremost and periodicallyhave the right to vote for a among them is the absence of a functioning slate of directors and managerswho willact secondarysecurities market,that would per- in their interest. Enterprise performanceal- mit these new shareholders to trade their so is affected by accessto capital at compet- holdings. \Xi5than incredible 35 percent of itiverates. In large measure this depends on the Russian population suddenly trans- perceptions of future performance,which in formed into director indirect shareholders,1 tum is reflected by the price the public is the importance of a viable secondarymar- willing to pay for the company's shares. ket cannot be overemphasized.The public, Thus, restructuringis most likelyto succeed so assiduouslvcourted during the creation when management is held accountable by a and implementation of the privatization group of shareholders who are well in- program,wvill lose confidencein the process if the fundamentals for securities market Figure 9.1 development are not in place. Anatoly l 2 3 Chubais, Deputy Prime Minister and head Corporatization Privatization Restruuingcu--- of Russia's privatizationagency (GN), has -- _

SEULLRIIIHSMARKEKT DEVELOPMENT AND PRVA-TIZATTON 111

formed about the enterprise and have the damental conditionsresults in a predictable capacityto efficientlybuy and sell shares de- array of consequences,such as a lack of in- pending on their view of future enterprise vestor confidence,unacceptably high trans- performance. action costs, and a high incidence of fraud. As in all emerging economies, public In short, the systemis inequitable and re- participation on this level hinges on an ac- tards the essential task of enterprise re- tive secondary securities market with a structuring and economicgrowth. number of characteristics: To address these key problems a techni- * In/firmationand public disclosture.Infor- cal assistanceprogram was created in 1993 mation is of reasonably high quality, by Russia's privatizationagency 3 In brief, timely;and equallyaccessible to all mar- the mandate was to rapidlycreate the insti- ket participants. tutional and regulatoryinfrastructure that The share registry * Intermedzaries.Market intermediaries would permit shareholders to easily gain ac- ultimately (brokers and dealers, custodians) are cess to and trade their stock, and to ensure well trained and handle client accounts that their holdingswould be secure. This, it determines all fairly was hoped, would lead to broad public par- shareholder rights... * Tradtng.Share trading and prices are ticipation in shareholding and securities not easily manipulated bv any one par- trading and wouldpressure the managersto tv and networks of communication are undertake enterprise restructuring. More- sufficient to order and execute trades. over, enhanced secondarymarket liquidity * Registration.Share ownership is regis- almost certainlywould increasepublic con- tered to the party which actually owns fidencein securitiesmarkets, which, in turn, the shares and that owner receives the would encouragemore of the public to en- rights to those shares. trust their savings to equity markets that * Clearingand settlement. Clearing and would be channeled to capital-short enter- settlement of transactions is completed prises. A secondaryobjective was to begin on a timelyand accurate basis. training a new generation of registrars, * Regulation.Prudential regulations gov- transfer agents, and other participantsin the erningstandards of behaviorfor issuers, functions and operations of the securities intermediaries, and investors are fair, markets. reasonable, and effectivelyenforced. When the Russian privatization pro- The needfor viablesecurities markets gram was launched in 1992, none of these conditions were in place. Assertive govern- A number of factors explain whv Russian ment intervention was required to create securities markets have not been effective- the basic conditions that would permit a ly meeting the interestsof either the poten- secondarvequity market to serve as a cata- tial suppliers or the users of equity capital. lyst for enterpriserestructuring, aswell as an First was the nature qf the privatization outlet for domestic savings. The govern- program itself,which inadvertentlvcreated ment recognized a clear need to create an disincentivesfor enterprises to raise capital organized institutional infrastructure (that through public markets, although now is. brokers and dealers, custodians, share many have begun to do so. By mandating registrars, clearing and settlement agents) the saleof sharesfor vouchersthrough pub- that forms the core of the securities market. lic auctions, a significantpercentage of to- Of course, these institutional participants tal equity value has been absorbed outside would require trained professional staff, the markets. Moreover, most of the re- technically able to record, transfer, and maining equity, under the unique rules of trade securities.And, as in all developed se- Russia'sprivatization program, has been al- curities markets, there was a need for the located to the enterprise employeesat very physicalinfrastructure-a reliable commu- attractive, heavilydiscounted prices. Thus, nicationsnetwork that uwouldallow for trad- onlya small fractionof total equity has been ing to occur in a timely, inexpensive, and available for sale to outside investors, pri- transparent manner. Absence of these fun- marly through market auctions.

112 Ru'sSIA: CREATING PRmvATEENTERPRISES AND EFFICIENTrMLsRKETS

Shareregistration independence of the registration process from corporate management when many In the absence of an efficient secondary corporations managed their own registra- market, once an enterprise is privatized tion books. Several enterprise directors most shares remain frozen in individual ac- were said to take extreme measures to pro- counts because reg,istration of ownership tect their own interests, such as refusing to transfer is controlled by the enterprise man- record share transfers in the share register, agers themselves. Registration refers to the physically threatening shareholders, tam- process of noting the owners of a company's pering with proxy votes, and creating share- outstanding shares in a registration book, or holder trust organizations to ensure that a share register. The share registry ultimately majority of votes supported the positions determines all shareholder rights, including taken bv corporate management. who should obtain dividends, updated in- These problems were compounded by Clearing procedures formation on the company's activities, and the absence of regulations and investor pro- ensure that the two the right to vote for companydirectors and tection regarding the registration process. other corporate decisions at shareholder As a result, shareholders were without re- brokers agree on the meetings. If the register is not controHled course when abuses occurred. terms of the trade and operated in a manner that is indepen- which is to be dent from enterprise management, which is Clearing and settlement settled. Settlement often the case in Russia, shareholders' rights are undermined. By controlling the register, While efficient share registration facilities procedutres ensure the directors can effectively impede the are a necessarv first step to the operation of that the two transfer and trading of shares. any functioning securities market, modern Given this role, registrars must have two markets go further. The absence of good brokers actually important features. First, good operational clearing and settlement procedures, anoth- exchange the funds and administrative procedures must be in er prerequisite for a self-functioning secu- for securities at an place to ensure that share ownership is reg- rities market, also limited secondary istered accuratelv and in a timely manner. If market trading in Russia. These procedures agreed upon time registration is not accurate, the wrong assure that the contract entered into by two and place. shareholder might be recorded and the cor- brokers who execute a trade results in the rect shareholder's rights could be lost. Slow timely exchange of funds for securities be- re-registration wvillreduce market liquidity tween the two brokers. Clearing proce- by making it difficult for a new buyer of dures ensure that the two brokers agree on shares to quickly resell those shares to an- the terms of the trade which is to be settled. other investor. Settlement procedures ensure that the two Another key feature is that the registrar brokers actually exchange the funds for se- must not have a vested interest in the own- curities at an agreed upon time and place. ership and rights of any particular investor. Mlanyundeveloped markets do not have If, for instance, the registration process is formal clearing and settlement procedures controlled by corporate management, the and the processes are done informally. The management mav wvishto avoid registering a two counterparties to the trade review with shareholder who amasses enough shares to one another the terms of the trade and then have significantcontrol over the corporation, agree upon a time to exchange funds and se- since that control poses a threat to corporate curities. Such informal procedures increase management. For this reason, in most devel- the likelihood of settlement errors and de- oped securities markets, the registration lays due to clearing mistakes, particularly in book is controlled by an independent third higher volume markets. They also increase part! the chance of settlement failures since there The Russian ad hoc system of share reg- are no mechanisms for sanctioning failures. istration suffered from administrative prob- If one broker fails to settle obligations, the lems in the earlv days of privatization which trade is simply canceled. slowed equity trading. Mvloreimportantly, In a market with low trading volume, there were serious problems concerning the settlement delays and failures do not sig-

Sii .i iRmiLsNLRsKI:I D[E%i L)PMENE .\ND PRIVATION 113

nificantly upset market activity. But in high- cedures in the early 1990s. Until recently, er volume markets, settlemenit delays and most trades wvere settled on a cash basis, ei- failures can caLusea series of defaults by ther privately or through brokers. There other market participants. Consequently, were no clearing or settlement institutions. the likelihood of frequent settlement fail- Consequently clearing and settlement were ures in a securities market can significantly slow and often inaccurate, with many de- reduce interest in share trading, particular- faults. Moreover, there were limited facili- lv among foreign investors-and among ties and procedures for efficiently clearing domestic investors as well. inter-bank credits, and there were no means For these reasons, most developed se- for the safekeeping of share certificates. As curities markets have formalized clearing a result, transaction costs were extremely and settlement procedures that normally high. These inconveniences created disin- are operated through some type of central- centives for broad-based public participa- ized clearing and settlement organization tion in the country's securities markets. (CSO). After a trade is completed, the doc- In addition to these problems, the phys- umentation for the trade is fornvarded to the ical infrastructure needed for an efficient CSO. The CSO then confirms the terms of securities market has been absent in Russia. the trade with the two brokers who execut- Although intra-regional trading is possible ed the trade. It then makes certain that se- if somewhat cumbersome, it is extremely curities and funds are settled on time. In difficult to execute inter-regional trades. addition, most clearing and settlement or- Most importantly, telephone communica- ganizations "net" trades-they calculate a tion in Russia remains rudimentary, partic- net amount of funds or a net amount of se- ularly between outlying regions. Moreover, curities that any one broker must submit to there are limited facilities and procedures the clearing corporation to settle all of the for efficiently clearing inter-bank credits, trades contracted on anv one date. Netting for settling trades or for providing for the trades significantly reduces the volume of safekeeping of traded securities. As a re- funds and securities that must flow from sult, transaction costs can be extremely one broker to another. This, in turn, reduces high and these inconveniences create disin- settlement errors, delays, and defaults, and centives for broad public participation. allowvssecurities markets to handle higher Given this array of problems, coupled trading volume, thereby instilling greater with the rapid emergence of a huge number confidence in the market. of new shareholders, it is hardly surprising Funds and securities can be settled phvs- that pressure began to mount in Russia to icallv or electronicallv The trend in funds improve the climate for trading securities. settlement is for counterparties to settle The loudest clamor came from the have- their obligations electronically through the nots among the investing public, the small regular banking system. On the securities and medium-size shareholders and their side, most developed securities markets are government representatives. Equally dissat- increasingly doing book-entry settlement. isfied were the growing number of invest- Institutions, called depositories or custodi- ment funds that have become very popular ans, or the CSO itself, will store physical with the public and are an increasingly in- share certificates of shareholders and main- fluential force for securities market reform. tain a central book noting for whom they are 'Todate, there are approximately 650 funds, holding certificates. To settle trades, the de- and they control an estimated 40 percent of pository either debits or credits its book for all distributed vouchers. And finally pres- a broker's holdings of certificates. This im- sure for reform has come from an emerging mobilization of share certificates significant- group of broker and dealer firms and other ly increases the efficiency and reliabilitv of entrepreneurs who have gained substantial settlement and reduces the risk that certifi- experience in the market and have a direct cates will be lost or stolen. stake in expanding public participation. An Not surprisinglv, Russia had minimal if inefficient securities market that dampens anv formalized clearing and settlement pro- public enthusiasm is hardly in their interest.

114 Rissi\: CREAING PRIVATEPEyNz'RIpSE:- \ND E 1i1iIENFI.\L-\RRTS

Technicalassistance for securitiesmarket Strategicassessment: Addressing the needlsof development stakeholders

This diverse combination of factorswas the The strategic assessment portion of the as- stimulus that led the Russian privatization signment-the diagnostic phase-identi- agency(GM) to accelerateimplementation fied the specific nature of the constraints of a technical assistance program to pro- that were inhibiting the market reform mote the development of efficient securi- process in Russia and recommended an ac- ties markets. The immediatepriority was to tion plan for implementing practical solu- design and implement a program that tions to these constraints. Given the would provide Russiawith the necessaryin- extraordinary regional diversity of Russia, stitutional and regulatoryinfrastructure for interviews were conducted with officials securities markets to operate more effi- and market participants from the geograph- The immediate ciently, and to protect the rights of the mil- icallv strategic cities of Moscow, St. priority was to lions of new Russian shareholderswho are Petersburg, Ekaterinburg, Novosibirsk,and struggling to understand and use the new Vladivostok. In each of these cities there is designianzd inple- markets. Mlore specifically, the program at least some financial infrastructure and a ment a prograim was designed to: reasonablv high level of voucher activity that would provide * Support the development of an effec- A representative sampling of institu- tive and efficient securities market tional participants, such as banks, brokers, Russia with the regulatory framework and of govern- and investment funds, offered opinions necessarv intstitit- ment and quasi-government regulato- about the most important constraintsto the tional and regtila- rv institutions. development of the market and made sug- * Accelerate the development of the se- gestions as to how they might be overcome, tory infrastructure curities market infrastructure-an es- This preliminary stage focused on gaining for secuirities sential prerequisite for achieving broad first-hand knowledge from the key institu- markets and to public participation in the market- tional stakeholders in the securitiesmarket through the creation of model frame- and on mapping out an implementation protect the rights of works and procedures for independent strategy that would be practical, relatively the millions of nlew share registration, securities transfer simple to implement, and responsive to Russian sbare- and safekeeping arrangements, and their needs. guidelinesfor secondarymarket trading Of all the institutionalrepresentatives in- holders and settlement. All agreed that this re- terviewed,three groups playthe mostpromi- form must occur, not onlv in Moscow, nent role in the market, and hold the greatest but in other important regionalcenters stake in the development of a functioningse- across the countrv as well. curitiesmarkets: brokers and dealers,invest- * Create specific institutions to serve as ment funds, and commercialbanks. pilot organizations for security settlement and cash clearing operations. Figure9.2 Work schedule Such organizations are critical to resolving liquiditv constraints and to Task Monthst-2 Months3-4 Aornts5-6 MAonth7-3 r ' building the public faith in the sec- St_a_g. ondary market. assessment With these broad objectives,the priva- Development tization agencyturned to foreign technical of standardse_ experts to rapidlyundertake the design and Plot implementation of a results-orientedwork mplementation program. Overall, more than 100 foreign *Developmentof specialistsand Russianprofessionals would operationalplans be directlyinvolved in this pioneeringeffort - to stimulate rapid securities market development. Sequentially,the work proceeded Roll Out Phase in the stages shown in figure9.2. _ ._ _ L I [

SE(.T FTIUS .M-%RKETDEVE LOPMENTAND PRiVATIZATION 115

Brokersand aealers.As members of the viewswere an important input to the strate- largest category of independent security gic assessment. registrars, brokers and dealers are key to Alfa-Capital,for example, is one of the breaking the control that enterprise man- largest investment funds in Russia, with agers have maintained over the registration more than 1.5 million subscribers in their of their firm's shares. If brokers can induce first closed-ended fund offering. Due to a the enterprise managers to cede control of strong initial performance, the firm has the registrar function, they are in a strong started to establish a position of influence position to stimulate secondary trading. in the marketplace. Alfa has significant For example, one of the more success- blocks in twentv-twoissues and sits on the ful firms of brokers and dealers, located in boards of four enterprises. As with the oth- the Moscow region. is OLMIA.Originally er leading funds, as the management of The influence of an investment advising company founded Alfa Capital has gained control of selecten- Russsian investment in the late 1980s, the firm now employs terprises it has begun to use its influence to over 100 people and maintains eight force restructuring. Recent publicity over funds also has Moscow locations. Having convinced sev- the proxybattle to remove the management grown very quickly. eral large issuers of the importance of hav- of the Bolshevik Biscuit Company, in which ing an independent registrar, OLMA holds Alfa Capital maintains a large minority the registers of nine privatized enterprises. share, has brought the importance of in- Through its affiliateorganizations in thirty- vestment funds to the attention of man- five cities, OLMIAhas been involvedin the agement and government alike. This is issue of 200,000 shares via auction, and in preciselyhow the architectsof Russia's pri- the collectionof over one million vouchers. vatization program hoped it would work- In the secondary market, the vast majority a core shareholder with a significant of the firm's activities have been in trans- financial stake in an enterprise's perfor- actions related to issues for which they hold mance gains control and serves as the cata- the register. For example, OLMA is con- lyst for much needed restructuring. sidered the market maker for both TsUtJM From the perspective of the securities and Cosmos, two of the most significantis- market infrastructure, these investment suers in Moscow.It is unlikelythat the cur- funds can fulfilla very important role. With rent volume of trading activitv in these their own requirements for controllingsales issuesw,ould have occurred if the share reg- and registry through national networks, istrar had remained with the enterprises. Alfa Capital, for example, maintains relationships with 600 representative organiza- Investment ftunlds. The influence of tions in 200 cities. Their systems can easily Russian investment funds also has grown be adapted to become clearinghouses and very quickly.An estimated 40 percent of all third-party registers for other enterprises. vouchers are controlled bv these funds, The further development of the securities which quickly have become an important market will only contribute to the success mechanism for Russian citizens to partici- of the investment funds. By taking advan- pate in the privatizationprocess. The expla- tage of low share prices and improved se- nation for the popularity of the funds is curitv and liquidityin the securities market, clear-investors exchange the right to use investment funds are expected to become their vouchers to obtain shares in one en- significant players in the future Russian terprise in favor of an opportunitv to invest market. in a diversifiedportfolio, managed bv well- informed professionals.Some of the invest- Commercialbanks. Starting severalyears ment funds-relatively large pools of ago from a centralized svstemwith a single investment capital. with strong market re- state bank, the commercialbanking system search-are considered to be among the now includes 2,000 banks registered in first Western style investorgroups to emerge Russia. Although, the numbers are decep- in the Russian market. Due to their market tive because most of these banks maintain knowledge and significant position, their less than 100 million rubles of capital

II( RUSSIA:CREATING PRIVAtE ENTERPRISES AND EFFICIENT MkARKETS

(S60,000)4 and therefore have little impact Consistent with these recommenda- on the securitiesmarket. There are stilla siz- tions in October 1993, President Yeltsin able number of larger banks with over 200 signed the Decree on vMeasuresto Provide million rubles of capital that play a signifi- for the Rights of Shareholders. The decree cant role in the market. Based on the made significantstrides towards the estab- German universal bank model, the com- lishment of a legal frame-workfor a trans- mercial banks hope to develop in all arenas parent securities market. These included of the financialmarket. Some already are provisions that all enterprises with over providinga fullrange of commercialand in- 1,000 employeeswould be required by law vestment banking servicesto their clients. to use a third-party, independent register; As their wealth and influence have con- that a shareholder'sright to have ownership tinued to expand, these national banks changesrecorded in the companyregister in have become ideal candidates to fulfillthe a timely manner would be protected; that As another independent registrar function. The addi- there must be regular dissemination of in- indicator of the tional costs to the banks of providing these formation on investment funds and owner- services are insignificant relative to the op- ship issues; and that the concept of nominee growing interest in portunity to broaden the range of services ownershipbe introduced (by which a finan- securities markets, thev can offer to their corporate clients. As cial advisor is allowed to hold a singlegen- some banks also are a result, a new and significantprovider of eral account on behalf of clients). The registrar serviceshas emerged. decree was less successfulin establishingef- becoming partial As another indicator of the growingin- fective enforcement mechanisms, a prob- owners of most terest in securitiesmarkets, some banks also lem that continues to undermine the exchanges. are becoming partial owners of most ex- effectivenessof the established safeguards. changes. For examplebanks participated in the creation of the MvioscowInternational Guidelinesforindependent registrars and a Stock Exchange(MISE), the RussianInter- pilot program national Money and Stock Exchange (RLMISE),and even in the Alfa-Capital The Russian financialinstitutions most af- Investment Fund. At the same time, as the fected by the October 1993 decree were the attractivenessof banking has become more registrars.In order to provide technicalsup- apparent, other securities markets players port to this fledglingcategory of enterprises have begun to examine seriouslythe indus- that were becomingincreasingly important trv as a possiblenew line of business.Several to the successof securitiesmarkets, the first brokers and dealers in St. Petersburg and task was to develop guidelinesand require- MIoscow.for example, have applied for ments for share registrar operations. The banking licenses and some of the larger documentationwas extensive.For example, funds report that they too may petition the it included generaldescriptions of the func- Central Bank for limited banking licenses. tion and purpose of registrars, procedural The strategic assessment identifiedtwo descriptionsfor manual operation of a regis- fundamental problems that need to be ad- trar, the informationto be tracked in the reg- dressed in the near term. First, the analysis ister according to international standards, clearly revealed that enterprises restricted and suggestionsof appropriatemethods and access to the register for the re-registration formats for future electronic communica- of shares and used this control to limit share tion between enterprises, banks, and regis- trading, which severelyarrested the devel- trars, domesticallyand internationally. opment of the securitiesmarket and imped- ed much needed enterprise restructuring. Pilot implementation:A nationalnetwork of Second, the lack of a structured and trans- registrars parent clearing and settlement mechanism greatly retarded the evolution of the mar- Once the operational guidelines were in kets. To correct these problems a series of place, the next task was implementationon concrete recommendationswere made to a pilot basis. The immediate need was to the privatizationagency. put in place a set of institutions that would

SE(:; RIT1IL .%\tRKi1 DFvT-LOP\I1 ST .\ND PRIvuIZxnON 117

satisfy the functional guidelines and speci- tention of national or even regional regis- fications and serve as an example that could trars, but that are required to maintain their be replicated by other institutions through- share register with an independent regis- out the country The first challenge was to trar. Because the profitability of running rapidly create a network of independent these local operations is questionable, com- share registrars. Once selected, each model munity registers are usually associated with registrar was provided with training, com- local or national government institutions puters, and software to increase their share- that are able to underwrite the group's ac- holder capacity and to ensure compliance tivities. A logical choice would be one of the with the recommended guidelines. institutions created to support the national After surveying a representative set of voucher auction process. For most of these active registrars, pilot organizations were se- types of organizations, the education and National registrars lected on the basis of an objective set of cri- implementation process begins at ground are typically teria designed to pinpoint those that had the zero. There is little or no experience with or potential to become model registrars. Three even exposure to the concepts and opera- independent classes of registrars were identified, each tions of a register. organizations with distinct characteristics. From each of Once the pilot institutions were select- created to service a these categories pilots were selected. ed, each was provided with technical assistance to ensure that thev could operate single issuer, National registrars. National registrars according to the defined functional stan- usually a large are typically independent organizations dards and guidelines. After an initial dis- investment fund, created to service a single large issuer, usu- cussion and a review of the basic intentions ally a large investment fund, larger broker, of the technical assistance, a series of meet- larger broker, or or super-regional bank. These organiza- ings were conducted to present the con- super-regional tions maintain strong national reputations cepts and issues raised. At that point, a bank. and are able to service and attract large na- more detailed audit of the operating proce- tional issuers. However, they do not be- dures was conducted for each pilot institu- come registrars to make a profit. Rather, tion, including an investigation of the they become registrars to strengthen their capacity to undertake both manual and abilitv to control the trading activity in the electronic procedures. market for specific issues. For banks, being After the current condition of the enter- a registrar also becomes an additional prise was determined, the business planning means of attracting new business and is an- process began as an iterative process be- other step along the road to becoming a tween expatriate technical experts, the en- universal bank. terprise management, and the local consultants. The result was a realistic work Regional registrars.These are often bro- program for each pilot institution. A multi- kers or smaller banks that provide registrar tude of operational issues were considered, services to a few regional issuers who are including the quantitv of enterprise issues quite active in the oblast's or larger geo- available in the region, the registrar's com- graphic region's markets, but wvho raise lit- petitive advantage in the market, possible re- tie national interest. As with investment gional expansion, and projections on market funds, these organizations become regis- growth. Detailed operating targets for the trars in order to serve as the market maker first year were agreed upon and a marketing on local issues. Constraints to growth are plan was developed to achieve these goals. usuallv related to a lack of technical under- Finally computer hardware and software re- standing of registrar operations and proce- quirements wvereassessed and assistance was dures. This could be remedied though the provided to install the appropriate systems. pilot program. The final portion of the registrar technical assistance program was to determine Commnzmnityregtitrars. Communit' regis- and resolve training needs. For the region- trars are designed to support small issuers al and local registrars the training needs that are not large enough to warrant the at- were fairly straightforward and standard-

118 RUSsLA:CREATING PivmATE ENTERPRISES AND EFFICIENT MALRKETS ized training classes could be organized to that Investor 1 decides to sell shares to meet their needs. For the national registrars Investor 2. Investor I contacts his broker, the trainingneeds were more sophisticated. MlarketParticipant 1, who sends a seLltrans- Standard training programs ranged from action to the CSO. Likewise,Investor 2 con- the more pedestrian overview of registrar tacts his broker, Market Participant 2, who activities and functions, to more detailed in turn sends a buv transaction to the CSO. courses on fee structures and marketing At the close of the trade day, all trades are programs. matched and setded. Data (such as price, To ensure that this ambitious initiative number of shares, and terms of settlement) would be sustainableafter work on the pilots are confirmed, and the trade declared is completed by vear-end, a RegistrarSup- matched. At that point, the CSO reduces port Center (RSC)was created. Designedto serveas an informationclearing house for is- Figure9.3 Registrarimplementation plan suers, registrars, and related organizations, the RSC is funded initiallvbv donor fhnanc- Create model ing,but eventuallywill become self-sufficient registrarsto through member and user contributions, implement The RSC is expectedto keep track of issues recommended and legislationrelated to registrars,as wellas to organize seminarsand trainingprograms v and to test newvsoft-ware products. It is hoped Expand TrainRussian that this type of self-sustainingsupport ser- capacity consultantsto Vicewill become the modelof howan indus- of registrars sustainwork to servicelarge of expatriate trv advisory organizationcan provide issuers team ongoing support effectiVelyto the financial communitvand serve as a singlesource for ' timelvand accurateinformation.

Roll-ouetphase Pilotselection ,

Based on the practical experience gained v during the pilot stage, a "roll-out" was designed in 1994, to replicate the project - Pilotevaluations Businessplan preparation throughoutthe nation.The roll-out will relv * Softwareenhancement - Implementation Coptrhdwe increasingly on the experiences of Russian Computer hardware consultants who have participated in the pi- Registrarsupport center lot implementationsalongside foreign ex- - perts. Msoving Lnto geographic regions beyond the scope of the original project, National roll-out these consultants wvillprovide services to other organizations that wish to become independent registrars. A schematic of the Figure 9.4 registrar implementation program is provided in figure 9.3. Investr 1 a t p

Clearing and settlement organizations Settlement - - [ ~~~~~~~~Commercialand clearing Commercial A similar progression of steps wvasfollowed C bank1 operations bnc to create formalized clearing and settle- w/ centralbank ment organizations and depositories strategically located throughout the countrv. The operations of the CSO are straight- centel forward, as illustrated in figure 9.4. Assume regionalbank)

S-1RiTiEs M.AKiTr DI.i% i'(ENFIR ANr)DPRVAIvZATION 119

the nominee accountfor Market Participant Mvioscowand St. Petersburg, the first two 1 and increases the nominee account of CSO sites, the programmingeffort alreadv Market Participant 2 by the number of is under wav and will serve as the model shares indicatedin the transaction.Once the CSO system to be rolled out to other day'sbatch processingis completed, a single regions. consolidated financial adjustment notification is sent to the settlement bank to net the Regionalversus national implemnentation financialpositions of market participantsfor thatdav. Sinceallaccountsareheldatacom- As with the registrars,CSOs will be estab- mon bank, settlement of cash occurs very lished on a region-by-regionbasis rather quickly. than through a singlenational system. This This structure provides a much safer is the only practical solution since inter- and more efficient method for the settle- regional cash settlement can take months ment of shares traded than does the current because of extremelypoor communication system of physicallytransferring cash and links. Although somewhat more efficient, securitieswith each trade. The stocks nev- intra-regionaltransfers can require several er physicallyleave the C SO, and cash needs days as well. The proposed regional to be transferred only via electronic or pa- approach to CSOs takes advantage of the per transfer order. As a result, it is expect- stronger regional links and supports the ed that members will be able to trade in expected heaxy regional trading patterns. higher volumes,with less risk of default on With the exception of a few strategic payment and reduced settlement costs. national issues,early evidence suggeststhat Demands on the banking system-current- the public is interested primarily in securi- lv overburdened by the volume of payment ties trading on a regionallevel, and there is orders-also willbe reduced by providing a little likelihood of significant of cross- single consolidated transaction for each regional tradinguntil the national commu- member organization. And the common nications networks undergo vast depositorywill provide a general safekeep- improvements. ing facilityin various issues. By the end of 1995, the technical assis- The implementation phase of the CSO tance project intends to establish a series of project required the identification of possi- CSOs positioned in geographicallysignifi- ble pilot organizationsin the selected cities cant locations across the Russian Federa- and the establishment of ties with the tion. Each organizationwill function under prominent financialorganizations in the re- identicalgovernance structures and partic- gion. Only after bringing these financial ipant requirements,with identical comput- market playerstogether in a common mem- er or manual procedures.At some point in ber agreement did the C SO start to evolve. the future, once the national banking sys- In this wavathe approach to CSO creation tem and the telecommunicationsnetwork was developed specificallyto address the become more efficient, there are plans to needs of the Russian market. link CSOs' activities between regions, The CSO framework developed for thereby establishinga seamless, electroni- Russiawill be feasibleas long as the volume cally-linkednational securities clearing and of trades remains low, which is likely to be settlement system. the case for a significant period of time. Until this more advanced system ar- Eventuall; however, the CSO wvilladvance rives, however, members that want to trade from a paper-dominated environment to an in the issues of another CSO must have electronic mechanism for matching and set- correspondent bank accounts in that re- tling trades. As with the registrar portion of gion. Trades then will be transmitted elec- the project, a detailed technical evaluation tronically between CSOs. But settlement of each region's potential trading volume of funds will have to occur locallv to meet was undertaken to determine the eventual settlement timing requirements. An expla- computer configuration that would be re- nation of the interim solution is presented quired to support the organization. In both in figure 9.5.

120 RuSSLE: CREATINGPRI,ATE ENTERPRISESAND EFFICiENT ALRKETS

Once the national system is functional AID), and a core of highlytrained foreign and fully automated, settlement can occur specialistsworking effectivelyXvith Russian through the central bank. This more per- counterparts has led, in a reasonablyshort manent solution,projected for a time when time period, to a set of tangible results that the nation's communicationsinfrastructure contribute to the dual objectivesof securities is modernized, wiLl,in practice, resemble markets development and enhanced private the schematic of the regional CSO itself. enterprise performance. By Mvarch1994, af- The onlv additional informationrequired in ter about eight months of work: the national svstem xvillbe fields to track * The capabilities of fifteen registrars in the locationof the bank and the securityac- seven cities had been enhanced, allow- counts on trade transactions and bank set- ing them to meet the basic needs of tlement transactions. more than 10 million shareholders; The Registrar Support Center that Conclusion eventuallvwill be self-sustainingwas up and running, providing an institutional The creation of this basic institutional and anchor for future training and other as- regulatory infrastructure that provides the sistance to existing and newly-created essential foundation for efficientsecurities registrars; market trading is inexorablvlinked to the * A core of local specialists and consul- ultimate success of privatizationin Russia. tants were trained and in position to If most medium-size and large enterprises continue the roll-out of new registrarsin are goingto survivein Russia,thev must un- other regions; dergo significant restructunrng and they A network of four regionalclearing and must expand their capital base. Both of settlement organizations was estab- these achievementshinge upon the wilLing- lished, each with identical govemance ness of segmentsof the publicto participate structures and participantrequirements; in equity markets, which will occur only if * The initial securities market regulatorv they believe that the markets are reasonably framework was put in place, although a safe, efficient and fair. considerable challenge remains to ex- Attainment of this level of confidence, pand the scope of regulation (that is, in- and therefore participation. requires that formation disclosure) and upgrade the marketplace satisfy a number of rea- enforcement capabilities;and sonable investor expectations. Thev must, * The fundamentals are in place for a for example, have accessto reLiableinfor- gradual transition from a regional to a mation about the enterprises on a timely national securities trading system. and equal basis so that thev can make investment decisions; they must have a high Figure 9.5 Inter-regionalclearing and settlementoperations trading level of comfort so that trades can be con- summated relativelyquicklv, easily, and Bysd I Tradeagreement S safely;and, they expect their vote to count broker broker for something-they expect to be able to 2. Entry of buy side 2 Entry of sell side hold managers accountable for enterprise Regional CSo1 RegionalCS02 performance.When these basic conditions Depository 3 Tradenotification 6 Record in can be met, there is every expectation that _ Depository depos;tory nominee Settlement ___ _ Settlement obligation to CSO broad segments of the population will be and clearing 7 Tradenotification and clearing preparedto risk their savingsto participate operations, operations, in the equirv markets, clearing center clearing center In theqezu1tnmarkes4 Fundssettlement v 5. Tradeconfirmation The recent expenrence in Russia provides Regional encouraging evidence that a well-designed Clearing and adequatelv-financed program of techni- Center cal assistance can make a difference. Close Buy-side cooperation between the government (the account, privatization agency), a foreign donor (US- sell-sideaccount

SDE(13:Tm1DKLRuKET DEVEoi()iRENT AND PRRATZAlTION 121

Know-how has been transferred, some Notes new institutionshave been created, and others significantlyupgraded. The public isgrad- The authors wish to thank Jonathan Bulkley and ually gaining confidence in securities markets Alison Harwood for their significant contributions and the early evidence suggests increased to this paper. market participation, directlv or indirectly 1. Compared to only 19 percent in the U.S. Although, of course, there is much to be done 2. WallStreetJournal, December 19,1993, p. A5. 'hough of course,thereismuchtobedon3. The project was funded by the United States before a single, electronically-lnked national Agency for International Development (AID), securities market is a reality, the fundamen- and executed by private consultants, including the tals now are in place, which has given an im- authors. measurable boost to the achievement of the 4. As of May, 1994 the exchange rate was 1,800 nation's privatization goals. rublesto the dollar.

122 RussiA: CREATINGPRIVATE ENTERPRISES AND EFFICIENT MIARKETS

PartThree

CORPORATEGOVERNANCE AND RESTRUCTURING

CHAPTER 10

Ownership, Governance, and Restructuring Joseph Blasi with assistance from Darya Panina and Katerina Grachova

In Russia,senior managers of enterprisesim- almost uniform across all 150 companies, plement privatization.Who, then, is better the entire sample will be discussed. qualified to comment on the progress and The twentv-three interviews conducted problems of privatization? From August before April 1993 were in enterprises in the 1992 to March 1994, on behalf of the process of considering or filing documents Russian Center for Privatization(RPC) and for privatization.Most had completed their Russian State Property Agency (Gla), 150 closed subscription, but not their voucher interviewswere conducted in 150 different auctions. The 127 interviews from April to enterprises, with general directors and se- March 1994 were carried out in enterpris- nior managers of privatized firms-a small es which had completed their voucher auc- but significantsample of 7,000 medium-size tions and were nearing the end of the first and large enterprisesthat had participatedin phase of the privatization process. The in- voucher privatization by February 1994. terview data provide additional quantita- Interviews were also conducted with local tive information not examined in privatization officials. Their insights on program-wide statistics and provide direct issues previouslydiscussed with general di- feedback about privatization methods and rectors provided the opportunirtyto cross- post-privatizationdevelopments inside the check observationsmade by the directors. enterprises in the senior managers' own The interviewscovered 2.1 percent of the words. This information is of general inter- enterprises participatingin the privatization est. It is also of specificutility to officialsat program. Themes discussed were financial the GKI and the RPC to help with policy statistics,inter-enterprise relationships, cur- analysis, regulatory changes, and further rent ownershippatterns, desirablepatterns, planning and to serve as a basis for outside corporate governance, labor-management policy advice and analysis to the GEMand relations and labor shedding, plans and the RPC. problems for restructuring,credit, needs for Most of the 150 interviews were in what technical assistance, and general observa- Russians classify as medium-sized enter- tions of the privatizationprogram. prises (that is, more than 500 employees) This paper distills from the interviews' with an average of 2,800 (median 1,200) basic concepts and trends and offers a tex- employees. Thirty-three or 38 percent of tual analysisof these interviews.Our find- the eighty-eightregions in Russia were vis- ings are based on a statisticalanalysis of the ited. The city of Moscow and the Mloscow employment and current ownership infor- region were two of the thirty-three regions mation for 127 enterprises in thirty-three examined and no other enterprises within a regions and on the analysisof the twenty- three hour drive from Moscow were in- five most recent enterprises visited in sev- cluded in the study.The other thirty-onere- en regions during Februarv and NMarchof gions chosen were intentionallywell-off the 1994. As research is still in progress, and beaten path. Five were in Siberia or adja- ten to twentv new enterprise interviews are cent to Siberia, six were north of Mloscow, being added weeklv, it was decided to ten were south of Moscow, five were due freeze the research in twvorecent periods. east, and five due west. The researchers re- NW'herethe answers to questions have been peatedly varied requests to local officials so

O0.NERKS,1j8GOVERNANCE, AND RESTRU(TURING 125

that they could not easily control the type of the program as put forwavardby the of enterprise being presented. For exam- government. ple. the team requested specific enterpris- Wfhvthis contradiction. One obvious es focusing on a far away town or one explanation is that those who feared the industrv group or they requested general consequences ot privatization and op- directors unfriendly to privatization. With- posed any change from a state-owned sys- out exception,officials of every region and tem, nonetheless, saw that it was town chosen eventually responded posi- preferable to control the divestiture tively to the fact that someone was sent process rather than have it controlled bv from MKIoscowwho wvaswilling to patiently external agents. Thus, they condemned the sit and listen to their ideas and those of program at the same time that they imple- their local industrv leaders. This simple mented it. It was a case of following the At the same time fact removed most barriers. rules while trying to undermine them. that managers and The litmus test of enterprise managers Did enterprises cooperate? support is their attitude toward state ver- workers ivere sus private ownership. Almost all enter- making decisions, The state must not have any owner- prises still have the state as part-owner following the ship. The state must not be involved in after privatization, since most property the structures that make profit. In all funds hold "golden shares" or are prepar- procedural rules put countries with a developed economy, ing "packets." Golden shares are stakes the forward by the GKI, the state is financed only by taxes. local propertyfund held back in enterpris- and filing the neces- -Senior economist, steel plant for ma- es in the hope that they could be sold for a sary documents, chine building,Mloscou area higher value later. Packets refer to ownership stakes that the local privatization au- they or their repre- Clearly, the answer is yes, because most thorities expect to sell at future voucher or sentatives in trade firms rapidly corporatized, chose closed- cash auctions or at investment tenders. subscription options, and went through The average amount of the enterprises' unions, industry voucher auctions. That thev would do this shares still held in state hands (bv the associations, and wasnot initiallyobvious to observers inside Federal Property Fund) after privatization pCarliamentary or outside Russia. At the same time that was roughly 17.6 percent. The ownership managers and workers were making deci- stake held by the state is reduced bv about factions... were sions, following the procedural rules put 5 percent to 12.9 percent when one takes bitterly denouncing forward by the GKI, and filing the neces- into account Fund Acktzionirovania the privatization sarv documents, thev or their representa- Rabotnikov (FARP) shares that are as vet tives in trade unions, industrv associations, unpurchased, but reserved for wvorkers. program. and parliamentaryfactions, along with the The RussianParliament added to the pri- communist and nationalist extremes, were vatization program the right of workers to bitterlydenouncing the privatizationpro- purchasean additional5 to 10 percent of gram.Twenty-three interviews were con- sharesusing FARP. When asked to specify ductedbefore voucher auctions began in howmuch state ownership would be opti- December.These discussions contain re- mal,most senior managers answered zero; peatedand strongdenunciations of priva- in fact, lessthan 5 percentof those 150 tization, criticism that rules and generaldirectors interviewed defended regulationswere unworkable, claims that any futureownership role of the state in the (short)schedule to completeprivatiza- theirenterprises. Thus, despite continued tion was unachievable,and talk of plans to criticism of privatization,almost all senior change the direction of the program mana,,ers overnvhelminglysupport the throughpolitical action. Yet, almost every basic principle.Nevertheless, most gener- enterprisecompleted the process,more or al directorsexpressed mixed feelings about less on time. Indeed, even enterprises the specificmechanisms of thisparticular whererespondents were most critical pro- privatizationprogram by freelyoffering duced a detailed written privatization their ideas for redesigningthe entire plan,which usually followed the outlines program.

126 R ussLA:CREAIING PRIvAII ENTIRIRPFSA MS)ELI f I( ILENl.\L-RKS

Ownership results ( 10 percent) whose current ownership at the time of the interview was not majority Accordin_gto GKI's 1992 rcport, 63.7 per- employee ownership, seven had originally cent of all enterpr-isesgoing through the chosen option I and six option 2. The re- program chose closed subscription,that is, duction in ownership in the six enterprises majority employee ownership; 70.7 percent that originally chose option 2 reflects sales of medium-sized tirms and 60.8 percent of of shares by employees to outsiders. large firms also chose that option. About 55 Although the price of shares is a better percent of the 127 post-privatization enter- deal under option 1, most enterprises still prises in our sample chose option 2; but a choose option 2. This is evidence that the significant 45 percent went for option 1, overvhelming concernis for majorityown- which does not give emplovees and man- ership. Of course, the more the liquidity or agers quick control of enterprises. Why? access to finance that insiders had, the Part of the answer is that in larger firms it greater the likelihood of enterprises choos- may be difficult for workers to raise the ing option 2. As inflation increased, insid- funds to apply option 2. But, it must also be ers found thev could use resources im realized that insiders can fairly easilv enterprise accounts to make a cash pur- achieve majoritN employee ownership no chase, and this is precisely what they did. matter which closed-subscription option Indeed, many enterprises reported that they choose due to subsequent opportuni- thev easily effected the purchase and had ties to buy shares in various auctions. resources left over for participation in Instead of serving as two distinguishable voucher and cash auctions. forms of ownership (one majority insider What was the ownership pattern after and one majority outsider), the options privatization? Enterprise managers were have instead served as two mechanisms to asked to describe the current ownership of achieve similar goals for insiders. their companies. The average total employ- Thus, the initial decision on \vhich op- ee ownership in the interviewed firms, in- tion to choose is not motivated by majoritv cluding FARP (which is essentially a employee ownership. The reason is that supplementarv employee share ownership most of the enterprises achieved majority opportunity) is about 65 percent; without employee ownership anyway. no matter FA.RP it is about 63 percent. As noted, few what option they initially chose. Rather, it is enterprises that had chosen option 1 or op- motivated bv an evaluation of means. The tion 2 failed to achieve majority employee decision is based on many aspects of the sit- ownership. In the case of firms that chose uation: wvhethermajority emplovee owner- option 1, insiders bought more shares on ship can be quicklv and easily secured after the voucher or cash auctions and repur- option 1 by buying more shares in auctions chased shares from outsiders who partici- or on the secondary market; xvhether em- pated in voucher or cash auctions. plovees and managers can afford to pay the Among the 127 post-privatized firms, higher price for option 2; the perception by the average equity stake owned by top man- the wvorkforce that option 1 shares are a agement is about 8.6 percent (median 5 per- better deal because they get '5 percent of cent). The average outsider (nonstate) the shares free, a discount on another 15 ownership stake is about 21.5 percent (me- percent. and pay only the pre-inflation en- dian 20 percent). A significant number of terprise value; how strong the desire is to enterprises (57 percent) achieved sizable gain immediate control of enterprises be- outsider stakes (20 percent on average) and fore other mechanisms for selling shares to individual citizens acquired meaningful outsiders kick in; and the perception (real stakes. Blockholder stakes are defined here or imagined) of immediate threats to the as those comprising of more than 5 percent control of outside buvers of shares. Of the of stock. It is the 43 percent of enterprises 127 enterprises studied after privatization, without blockholder stakes where there is a 90 percent achievedr majority employee potential for consolidation of shares in the ownership. Of the thirteeni enterprises or coming months (tables 10.1 and 10.2).

Ow\ERHm' GWERN.\AN(1., AN) RiwRI 'I'RIXNG 127

What do these numbers sav about the Table 10.1 Distribution of share results of privatization? They provide a ownership ('percent) powerful explanation of how, with a seventy-year history of communist control Average Median of enterprises and state ownership, the GKI All insiders 65 60 managed to privatize 7,000 medium-sized Topmanagement 8.6 5 and enterprises in less , rw'o e All outsiders(nonstate) 21. 5 20 and large enterpnses m less than two years. State 12.9 12 Indeed, insider ownership incentives seem to explain why the grass roots of Russian so- cietv across most regions cooperated. Table10.2 Distribution of outsider Senior managers favored majority insider stakes ownership, over any kind or structure, as the (percent) Privatization equals initial form of ownership because they fa- Enterpriseswith blockholderstakes 57 mafia ownership, vored separation from the state. Enterpriseswithout blockholderstakes 43 Privatization equals mafia ownership, Average Median said Ruslan said Ruslan Khasbulatov, former Speaker of Khasbulatov, the Russian Parliament, who repeated it fre- Allocntekrhprldesin the sample 6 former Speaker of quentlv on Russian television before his ar- Individualcitizens 4 1 rest in October 1993. Careful study of the Only enterprses with shares the Russian data, however, suggests that sweeping individualcitizers 7 2 5.7 Parliament... claims that privatization has been hijacked bv the Russian mafia is open to serious question. In our interviews, enterprise general the privatization program that no one in- directors were asked to identify major out- tended to achieve. That is, throughout side buyers of shares. In more than 90 per- 1992, many enterprise directors and sup- cent of the cases, they were investment porters of employee ownership said that the funds registered with the government, com- government's claim that the program was in panies with previous ties to the enterprise, the interests of workers was a fraud, be- identifiable specific Russian or foreign in- cause it did not provide employees with suf- vestors, or individuals in the local commu- ficient access to credit for shares, and nirtv The assertion of mafia ownership or because employees and managers would control was never made by enterprise man- never be able to buy a controlling stake. agers. While mafia interests may be lurking Some Western supporters of employee behind some ownership agents, the data ownership took up this issue and repeated does not reveal such an involvement. the claims. This criticism was featured W"hat accounts for the gap between prominently in the pre-privatization inter- claims of mafia involvement and the facts views (before the spring of 1993). While in- on the ownership distribution in the enter- siders in some bigger epterprises could not prises? In interviews where the word mafia fund 51 percent of the shares under option was mentioned, it became clear that many 2 immediately, there were very few where a senior managers consider this a catch-all dominant insider stake of 40 to 51 percent phrase to describe any unknown, un-wanted, was not easily achieved 'after the voucher or unpredictable outside buyers who might auction. threaten their control of the enterprise. This The real argument about employee desire to tightly manage change is under- ownership is whether the 7,000 largest non- standable given the decades of state owner- military enterprises in a big economic pow- ship and control and the acute uncertainty er like Russia should be closely held of what will happen after privatization, but companies, controlled by small groups, or it is inconsistent with an efficient market open. public corporations with potential for economy. investor involvement and ownership stakes Substantial employee ownership in the by all citizens of Russia. Enterprise man- majority of enterprises also disproves the agers saw 100 percent ownership as a way of claim that insider ownership was a goal of ensuring that their firm would not become

128 RUssIA: CREXANGPRIVATE ENTERPRISES AND EFFICIENT MNARKETS

a public corporation easily open to un- average of 8.6 percent. This is hard to ex- wanted investors.When they did not suc- plain given the overwhelming desire of ceed in making the privatization program managers to control their firms. Frustration equal, 100 percent inside ownership, they over the low levelof top managementown- used a varietyof methods to make sure that ership is a major message in almost every they achieved majority employee owner- one of the 150 interviews.Most managers ship and insider control. Despite the fact that discussed this problem pointed to four that they served as straw men in the argu- reasons for low top management owner- ments about the ownership format of pri- ship. First, they lacked personal funds to vatization, the opposites of the ownership participate in closed subscription,voucher, spectrum-closely-held companies with or cash auctions to the desired extent. many owners-do not represent the only Second, nonmanagement workers would options for these firms. have been upset if managersacquired large Privatizationhas The issue of management support for stakes. Third, managers felt that the gov- achievedmore employee ownership is more than aca- ernment undercut them by not providing demic. A purported government plot them with special deals in order to acquire employee ownership threatening employee interests and owner- equity. And fourth, a few senior managers than in the U.S. ship motivated the Russian Parliament to felt that tying up their money in a firm's stock market, which consider radical changes to the program in shares was less important than controlling February 1993, and again in October 1993. shares by marshaling their influence with has more employee In February,a wide-rangingpublic discus- workers or getting a friendly investor they ownershipthan any sion took place on a fourth closed sub- could influence. Westernstock scription option that would allow 90 There is no question, however,that gen- percent of all enterprises to be purchased eral directors expect to consolidateand ex- market.- on state-givencredit at purchaseprices that pand their holdings. A small survey of were not adjusted for inflation.This option twenty-five enterprises in seven regions of would virtuallyeliminate the voucher pro- our sample showed that 52 percent of se- gram by allowingonly 10 percent outsider nior managers had plans to repurchase em- participation. Large blocks of stock would ployee shares (twogeneral directors did not have been put in trusts whose dividends answer the question posed). Moreover, 32 and votes were controlled by senior man- percent of the senior managershad plans to agers (Blasi 1993). This proposal failed to organize a trust to collectand vote the em- win approval after a tough public fight was ployee shareholding, use proxv voting to waged by the Deputy Prime IMIinister maintain control over the shares (one-third Anatoly Chubais and the GKI. of the general directors refused to answer In October 1993, in an attempt to "re- this question). cover the good features of option 4," there Privatization has achieved more em- was a proposal patterned on the American ployee ownership than in the U.S. stock ESOP (the Khasbulatov proposals) that market, which has more employee owner- would allow employees and managers to ship than any Western stock market (Blasi borrow money from the Russian govern- and Kruse 1992). In the U.S., 7,000 firms ment to repurchase the shares bought by in the market have less than 5 percent outsiders (Rutgaiser 1993). Again, these broad-based employee ownership.But em- shares were to be held in trust and voted by plovee ownership has been growingwith an the general director. The proposed law average of about 15 percent employee own- would eliminate outside ownershipentirely ership in roughly 1,500 of these corpora- and destroy the voucher program; but the tions, and the set of firms with employee bill was never introduced because it was ownership greater than 20 percent is rapid- overtaken by the other events of October ly growing. Some defenders of more insid- 1993. er ownership in Russia claim they are A most surprising fact arising in the in- emulating widespreademployee ownership terview is the low percentage of top man- in the U.S., which is, of course, incorrect. agement ownership in the enterprises, an The senior managers gave inaccurate and

OwXXERSHIP,Go%ERNANCE, AND REs7UCT'RING 129

exaggerated statistics about U.S. employee ostensiblyin support of expanding employ- ownership that provided their argument ee ownership in general, and making it eas- with the necessarv legitimacvand to cover ier to secure employee ownership through their desire to have significant ownership state-provided credits in particular.Clearly, stakes for top management. ownership agendas (such as the option 4 and the Khasbulatovproposal) were simple Optimalownership attempts to cloak managers' self-interest, (which the public would have had a hard Top managementwas asked how they would time swallowing)with the mantle of almost design the ownership of the firm to maxi- complete employeecontrol throughnear to- mizethe efficiencvof the enterprise.The re- tal insider ownership; the ultimate result sults are revealing(table 10.3). would have been the end of the voucher ... enterprise Top managers' main complaint with program by givingadditional credits to em- managers... believe post-privatization ownership structures is ployeesto repurchase all the sharesthat had that they have a small stake. Managersuni- been awarded to outsiders. that substantial top versally want to increase their stakes (and In both option 4 and the Khasbulatov management gain control) and drasticallyreduce broad- proposal, the general director of the firm ownership is based workerownership. The percentagere- would be the sole trustee of employee-own- duction in employee ownership, managers ership shares, with fufllvoting control over necessaryfor the propose, is on average 33 percent (median these shares. Option 4 also gave managers efficiency of an 26 percent). The proposed percentage in- income over the dividends of many of those enterprise..,. and crease in outsider ownership is on average shares. As noted, manv enterprise managers 5.5 percent (median10 percent).Manage- aredesigning share buyback programs to re- that, in Russia at ment would like to see its own ownership purchase employee shares and to consoli- the present, outside stake increaseby an average of 31.4 percent date and expand top managementholdings. investors cannot or (median25 percent). This data tends to con- It is too earlv to tell, however, whether man- firm the widely held notion that general di- agement-dominated trusts or simply pur- will not play this rectors wish to personallv control their chases of shares from workers will be the role. companies. Indeed, they wish to control dominant method of attempted top enter- most of the top management ownership prise manager control over these corpora- stake, although data on the general directions. Against the back-drop of these tor's optimal ownership for himself (or her- agendas, it is an impressive achievement self) was not available for each company that the government's programmanaged to When asked what the total optimal rank- hold top management ownership to such and-fileemployee stake should be, general reasonable levelsand to introduce substan- directors indicated roughly 15 percent. This tial levelsof outside ownership.In addition, is an interestingcoincidence, given the U.S. the program resulted in small levelsof state average for rank-and-file employee owner- ownership, and the government succeeded ship stake is 15 percent in public companies in holding back legislativeproposals to ex- with employeeownership. pand insider ownershipeven more in 1993. This data calls into question the sinceri- In their part, enterprise managersoffer ty of intensive campaigns by managers, an economic analysis to support their claims. ThevTbelieve that substantial top Table10.3 Optimalownership of post-privatizedRussian enterprises accordingto the seniormanagers. management ownershipis necessaryfor the (percent) efficiencyof an enterpriseon the reasoning Average Median that large enterprises need single or core groups of influential owners, and that, Optimal employee ownership (excluding top management) 32 35 presently, outside investors are unwilling to Optimal top management ownership 40 30 Optimal outsider ownership 27 30 play this role. There is some logic to this ar- Optimal general director ownership 31 20 gument. Mianagersdo not, however, gener-

Note A textual ana ,ssof all 150interviews confirms these trends. An iodated analysis of all data will be ally know or appreciate the role that stock available in March 1994 Top management s defined by the general director as the top five to ten members market investors and independent boards of theexecutive team Source Summer 1993, Januaryand March 1994 samplesof 74 enterprises plav in developing a well-functioningfirm.

130 RussIA:CREATING PRIVAIF. ENITRPRISES AND EFFICIEN NIARKETS

More than three-quarters of the interviewed investors and xve would reserve 20 per- enterprise managers say that thev truly be- cent for them. The rest 30-40 percent lieve the largest Russian companies should would be distributed among the em- optimally he more than a third owned bv the ployees of the enterprise but top man- top hve to ten managers. N0itness these agement should get thie ma'oritv of this, statements: say 30 percent. -Metalproductsplant, 1;)ronejz The problem is not with private ownership but with the abilitv to control em- Look at the situation we have todav. The ployees. It is possible to have 51 percent top management has only 5-10 percent owvnedby employees and the rest given of the shares and the labor collective has to managers in a voting trust that gives 30-40 percent. Thev are shareholders management the possibility to control but they are not ready to consider them- the enterprise. Managers must per- selves as owners. The enterprise needs a suade the state that they can reallv man- real owner. It is evident that those who age and if managers run the enterprise feel themselves responsible for their en- properlv the state should sell them terprise and interested in increasing shares at nominal value. Managers profits will concentrate big amounts of would work hard for their ownership in shares in their hands in order to control order to get shares from the state. I the company: think that almost all would support that -Clothing plant, Tver the government would seLlthem shares under this method. And there is one In realhtm,we w ant at least 60 percent to more feature. Shares should be owned be concentrated in the hands of the top by management professionals. Now managers and the rest to belong to small they are bought by people who have outsiders. Employees are interested in nothing in common with production dividends but not investments but man- who got their money from trade opera- agers are more interested in big pro- tions. This is a neszativefeature that pre- grams for the development of the plant. vents the development of production. It is better when all shares are accumu- -Textile facton, Kzurskl lated in the hands of several owners. -Steel plant. I logoda region TIhe optimal distribution of ownership would be for top management, employ- Top managers were almost uniformly ees and the outside investor who brings negative in their evaluation of broad-based a lot of money, for each have a third of employee ownership. They consider majori- the company. tv employee ownership to be a transitional -Electronicsplantzz rs, avl phenomenon. In general. many top managers have plans (or hopes) to develop em- Managers should get at least 25 percent ployees into responsible shareholders. This of the shares. By this I mean the top ten is somewhat disingenuous given their own people. The employees should have 25 spirited attacks against the government's percent of the shares and the rest should motives for including employee ownership be in the hands of citizen, preferably in the program and how it operates. The pri- equal amounts to two to three suppliers vate opinions of enterprise managers are in- of the firm. teresting, given the respectful public tone -Food-processing plant, N.ln .\v Notgorod surrounding both the option 4 and the Khas- bulatov employee ownership initiatives: The optimal structure is for 40-50 percent to be in the hands of suppliers and Wevwant to create a controlling share- customers wxhosupply raw materials holder group and we have a strategy to and bux our machines. Our enterprise accomplish this by the end of the year. would be open to foreign and domestic \Xe will start buLing shares sold to our

'X'.i Ri' (I MVFRN.\N-, .k\i) Ri [bRI i 'RIN(, 131

employees through the closed sub- people. It seems surprisingbut people scription and sold to them on the steal and drink even more. I think that voucher auction. The optimal owner- those employees who want to have ship structure is for the top man- shares for profit shouldhave nonvoting agers-fourteen people in our firm of shares. 1,100-to have a majority of the own- -H'ouseholdapplianceplant,Novosibirsk ership of the enterprise. Now all employees are shareholders but not an Attitudes about management owner- owner. Employees you see are not the ship favor sole proprietorship and closely- same thing as an owner. I would sav held companies whose shares are not that top management would have no traded on exchanges. Senior managers more than 60 percent while the gener- have trouble recognizingthat several5, 10, Attituides about al director himself should have 33 per- or 20 percent shareholders can own shares management cent of the shares. in their enterprise and intluence its direc- ownagershifavor-Department store,Nilny Notgorod tion through a board of directors or ownership favor through contacts with management. They sole proprietorship Nothing changed with employee own- believe that day-to-day executive control and closely-held ership. The ownership of every em- by management is not possible without an plovee is too small and we do not ownership stake in excess of 30 percent companies whose suspect there will be significant divi- and further stakes in the hands of investors shares are not dends. Employees started working bet- chosen by top management. traded on ter but it is not because of employee Further study is necessary to under- ownership but because of unemploy- stand the extent to which generaldirectors exchanges. ment. in Russian firms expect to control most of -Steel plant, Cherepovetz the top management ownershipblock personally. Such enterprises should belong to one How does this data on top manage- person, but our employeeswill not un- ment ownership and expectationscompare derstand this. They are interested in with the West? Managementownership is their salaries but not in the manage- widespread in the U.S. and has recently ment of the enterprises. They do not been studied in detail (Blasi,Gasaway, and want to have a headache because of the Kruse 1994). Average top management problems of the enterprise since they ownership is 10.9 percent in the 7,000 have a lot of their own problems. But public U.S. companies; considerably less our tradition of equal rights influences in Fortune 1,000 companies(usually under the process of privatizationand a lot of 2 percent) and somewhat larger in smaller time will pass before everything is public companies. There is no relationship made property. between the size of top management own- -Food-processingplant, Riazan ership and superior economic performance in the U.S. stock market. Russian Regarding employee ownership, em- general directors often claim,wrongly, that ployees do not understand what own- they are emulating Western management ership means to them. The only ownership practices. The more central advantage of employee ownership is questions are whether a widelyheld public that the state now has no right to in- companv with numerous small sharehold- terfere in the business of the enter- ers is what Russia's emerging capitalist prise. firms need to restructureand to operate ef- -Textilefactorv, Ivanovoregion ficiently; and whether existing management can or should play the historical role Anywayworkers did not become own- of the capitalist entrepreneur-the core ers. Emplovees just stay to be hired owner or investor.Examining issues in cor- people. And now they spit and swear. porate governance will facilitate a closer We need dozens of years to change consideration of these problems.

132 RUSSLA:CREATING PRn:ATE ENIERPRISES AND EFFICIENT NARKETS

Corporate governance The "traditional" method of board election (as practiced in most U.S. corporations) in- The trends in corporate governance in the volves a nominating committee controlled interviewed enterprises were uniform. Top bv the existing board and the chief execu- managers have engaged in actions that es- tive officer. Management determines a slate sentiallv turn the firms into closed corpora- of nominees and can usually garner 51 per- tions, take them out of the market of cent of the votes necessary to elect the en- corporate control, emasculate employees as tire slate from passive shareholders and shareholders, restrict outsider access to in- institutional investors spread across the formation, and tightly control boards and countrv who generally vote the manage- shareholder meetings and registries. ment slate. In Russia, this traditional Most senior managers reported putting method is made easier because the general off the first general shareholder meeting for director does not have to guess about col- Top managers have as long as possible. Often, a reason (or ex- lecting the votes of diffused outsiders. A engaged in actions cuse) was that the 10 to 20 percent of majoritvofsharesisusuallvheldbyinsiders, g g shares held by the Federal Property Fund most if not all of the nominees are insiders, that essentially turn had not been sold. Once the meetings were and the result is more predictable. Despite the firms into held, less than 10 percent of interviewed the predominance of insiders, the wariness closed corporations, firms allowed confidential voting of shares. of rank-and-file employee shareholdmng is The typical pattern is for shares to be vot- clear in board structure; less than 5 percent take them out of ed bv a show of hands. In larger enterprises, of the companies have nonmanagement- the market of cor- representatives of employee shareholders employee representatives on their boards are chosen and given proxies to attend the Nevertheless, a closer analvsis of the r meeting-that is, all employee sharehold- outside board representation issues indi- emasculate ers do not participate. Almost all senior cate some ferment: employees as share- managers who discussed a shareholder . In November and December of 1993, holders, restrict meeting in detail reported that thev could general directors were asked whether predict with confidence that the main deci- thev would support a mechanism such outsider access to sions they supported would be voted in be- as cumulative voting for boards that information, and fore the meeting. Frequently, the managers would allow minoritv shareholders to tightly control reported that this was due to their implicit attain board seats. The sample was boad and re- control of the employee shares-"because small but there was a growing willing- boards and sbare- I have good relations with the labor collec- ness to accept cumulative voting. holder meetings tive"-their explicit personal control of the Perhaps, this can be explained bv a and registries. votes in a trust, or a public method of em- recognition that potential large outside ployee voting of shares at the meeting that investors will demand board seats. rendered unlikely disputes with manage- * In January 1994, President Yeltsin man- ment's position. dated new shareholder meetings before How are the boards of directors struc- the end of April 1994 with cumulative tured in the 127 post-privatized firms? Top voting. In February and NMarchof 1994, management members numericallv domi- interviewers tried to ascertain specifical- nate the boards in over 90 percent of the ly whether the Yeltsin decrees on cumu- firms with a majority of the members. Most lative voting were being implemented. Russian general directors come to a board The general directors were exceedingly meeting with other managers wvho are their unwilling to discuss this issue and many direct report. Fewer than 5 percent of the expressed strong disagreement with the boards include more than one outside citi- law mandating cumulative voting. There zen or commercial or foreign shareholder. is little evidence that cumulative voting In almost ever' enterprise visited before has been implemented except in a very Februarv 1994, insider shareholders usually small number of firms. In several of controlled a majority of the shares, and used these cases, we discovered that cumula- the traditional method of board selection to tive voting had been redesigned by the elect a board entirelv composed of insiders. enterprise to appear to abide bv the new

OWNERIH1ip,GNETRNAN(, ANn RFSTRUC:1TRING 133

regulation while giving insiders firm noritv shareholders can be expanded, control over the new voting mechanism. blockholders already have an ownership To further complicate these findings, a foothold in this significant number of substantial percentage, 32 percent or privatized firms. And an important fu- eight out of the twenty-five firms visited ture agenda for Russian privatization is in seven regions in February and NMarch policies that encourage the sale of the of 1994 were found to have nongovern- shares that remain in government hands ment, outside shareholders on their to new blockholders in firms that do not boards of directors. In three of the cas- have large outsider stakes. es the outsiders outnumbered the senior These disparate impressions do not lend managers. In the eight cases, outsiders themselves to a clear conclusion. But they ownership stakes were 53 percent do suggest that outside board representa- Clearly, (voucher fund), 47 percent (commercial tion may be more widespread than original- firm), 28 percent (commercial firm), 20 lv thought. Thev suggest that private percent (businessman), 16 percent arrangements with outside shareholders, entrenchment (commercial firm), 10 percent (voucher not the government decree, seems to be the regarding boards, fund), 10 percent (voucher fund) and 0 initial explanation for this phenomenon. shuareholder percent (local expert). Unfortunately, in They suggest that industry group alliances none of these cases was there evidence (kereitzu) mav be a better explanation for a meetings, and that the outsiders elected as a result of lot of emerging outside board representa- shareholder registers the new cumulative voting decree. All tion relative to independent outsiders. A leaves the door total in the twenty-five firms, there were more definitive statement on the incidence fortv-four outside governrnent and non- of cumulative voting will onlv be possible in openz to abuse... government board members out of 187 the mid-summerafter many of the 127 en- board members. Only twenty-one of the terprises have been revisited and that data fortv-four board members were not gov- is analyzed. emmnentrepresenting government own- If there were an inquirv regarding the ership stakes. Of these twenty-one shareholder register, almost all senior man- board members, could be considered agers would say that shareholders can see members of commercial firms that had only the number of shares they personally an alliance or kereitzu arrangement vith own in the register. In every firm inter- the general director. This pattern is fur- viewed, the shareholder register was main- ther reflected in examining the top out- tained by management, although this was side shareholder of the twentv-five due to a change bv government decree. firms. 36 percent of the top outside There is inconclusive evidence about how shareholders could be considered to be manv firms are honoring the decree. commercial firms that had an alliance or Clearly, management entrenchment re- kereitzu arrangement with top manage- garding boards, shareholder meetings, and ment. And 60 percent of the general di- shareholder registers leaves the door open rectors have a positive attitude towards to abuse, including decisions by manage- associations or holding companies in ment to dilute outside shareholder interests their industries that could potentially by sales of new shares to insiders, changes plav this role. in the corporate charter which enhance the * The average outsider stake of 21.5 per- rights of insiders, and attempts to have the cent (20 percent at the median) in the insider-dominated board of directors take 127 post-privatized firms can be further decisions that should be taken bv the share- analyzed for blockholders who have holders meeting. It is not possible, however, more than a 5 percent holding. In 46 to ascertain the extent to which such viola- percent of the firms there is no block- tions of shareholder rights were taking holder. Among the 54 percent of firms place. In October and December of 1993, that have blockholders, the average President Yeltsin issued regulations to se- stake is 19.63 percent ( 15 percent at the cure shareholder rights, with a decree on median). To the extent that rights for mi- shareholder registers and the 1994 privati-

134 RussIA:CREATING PRrVATE ENTERPRISES AND EFFI(IENT %LARITTS

zation program. These regulations produce Communist past. where production volume a set of simple rules: wvasmore important than profits and com- * Changes in the corporate charter, the petitive markets. It was impossible to ob- charter capital, or major transactions af- jectivelv clatifv whether the general fecting 25 percent or more of the charter director s restructuring plans were naive capital require a majority vote of 75 per- hopes or whether they resulted from careful cent of shareholders in general meeting. business planning. Few general directors, * There is cumulative voting for the board however, provided evidence that they had of directors. Employees cannot com- an objective analysis. prise more than one third of the board, Almost every general director said that which must have at least seven members their biggest problem was shortage of cash or nine members where companies have to carm' out large capital projects. Only one more than 10,000 shareholders. firm, a supplier to the Siberian oil industry, It was impossible to * Annual shareholder meetings must be had readily available capital inputs. Every clarify held within 120 davs of the end of the other firm was receiving state credits, but fiscal vear with basic rules of financial these wvere, in almost everv case, a mere whether the general disclosure. fraction of those needed for capital invest- director's These regulations begin to address some ment. This may suggest that firms are bor- restructuring plans shareholders' rights problems, but many rowing to pay wages and buv raw materials more remain. Further research is needed to and that even continued cheap credits at were naive hopes or clarifv the level of awareness of these new increased levels would not succeed in re- wvhetherthey regulations and the extent to which they are structuring the enterprises. Before the res- resulted from being followed. Initiallx, it does not seem ignation of kev government reformers in that privatization has a big impact on cor- Januar 1994. the government was report- careful b ess porate governance. But this should be put edly debating whether it could manage to planning. in context; there is growing discomfort of continue existing credits. investors in Western economies with man- Another major problem for enterprises agement entrenchment and its impact on was high taxes that curtailed their ability to corporate performance. Independent direc- use internal financing. Unfortunately, from tors staged coups in few major U.S. corpo- the perspective of the enterprise, even a rations in 1992 and 1993. Even so, government that chooses to offer extensive management-dominated boards are the state credits may still impose high taxes on rule in most Wlestern economies (Oxford profits, thereby eliminating the ability of Analvtica 1992). Since the goal of privatiza- firms to meet their capital requirements. tion is not simply to change from state to pri- High taxes on profits are seriously discour- vate ownership, but to create private aging capital investment through retained incentives so that the companies can be ra- earnings. A preliminary conclusion would tionallv restructured and improved, where be that real enterprise restructuring will not are the implications of our findings for re- take place without substantial outside in- structuring prospects? vestment. This is an objective barrier to restructuring. Restructuring There are also some subjective barriers. The main problem is the expectations of se- Almost even, enterprise manager had ex- nior managers about their power and own- tensive plans to buy machinerv and imple- ership. Enterprise directors were asked to ment capital investment to rebuild, expand, estimate the total investment capital need- or renovate. Few general directors envi- ed to restructure the enterprise. They were sioned shrinking the business (that is, sales asked for the total ownership they wished to of units), reducing product lines, or focus- have for top management and for outsiders. ing on clear high-margin products or ser- They were asked who they preferred as out- v\ices. Evenr general director wanted to side investors. And they were asked for their expand and had a strong bias towards more attitudes about majority outside investor production. Unfortunately, this echoes the ownership.

O\\-KRMI{Ii, Go%VRNAN. E. AN ) RISIFRI:i'URING 135

Consider a hypothetical case where an ownership, it should be noted that man- outside Russian or foreign investor comes agement's main concern is to retain control to the enterprise ready to invest the capital in order to direct the firm as thev see fit. top management believes is necessary.The Personal ownership,trusts, employeeprox- first problem is that the total capital need- ies, kereitzu, and domination of the board ed for restructuring, translated into share are the various means used to implement capital, represents a far greater percentage this desire. Moreover, most of the enter- of outside ownership than management has prises are receiving state credits through allotted in their minds. The second prob- commercial banks that are supplied with lem is that even if management is prepared credit bv the Central Bank. These credits to reduce the stake of insiders in general, are presentlysupplied without any attempt they want to reduce it in their own favor. to evaluate their end-use, the expected Moreover, most of This would not be a bad idea if managers profitability of the (purported) investment, the enterprisesare put real capital into the firm, based on the or the firm's ability to repay the credits. real value of assets (in a firm with good Keeping enterprises afloat through cheap receiving state prospects). But managers universally say credits simply magnifies the fairy-tale envi- credits through that they lack cash. Thus, managers want to ronment in which top management lives, commercial banks increase the ownership stake of a small and gives them another incentive to avoid group(themselves) who lack cash.Since an makingrational decisions. that are suipplied outside investor's infusion will dilute not There is insufficient information, too, with credit by the only the stake of employees, but also the on what the shares of enterprises are worth. Central Bank. current small stake of top management (5 One reason is that the sellingprice of most to 10 percent), then management generally enterprises in the closed subscription and opposes, or at least is deeply suspicious of, the voucher auction was based on pre-in- their involvement. flation valuations of fixed assets, and does The third problem is that 60 percent of not take into account current prospects. top managers oppose majority investor Also, the lack of a stock market further re- ownershipfor reasons of control. There is a stricts the abilityof the enterprises to raise lack of data about what employees think, capitalat realisticprices. Moreover,there is but the general directors' adoption of this little data on which to base an objective view is certainlv troubling. The fourth and analysisof the expansion and restructuring final problem is that a third of general di- plans of general directors. And finally,the rectors feel that outside investors should be corporate governance structure and related suppliers, producers, or customers predilectionsof general directors prevents with whom their enterprise currently does them from getting input from anyone oth- business. Yet, many possible partners are er than members of their board. Thus, any like the enterprises in a difficult situation policyto restructure enterprises willhave to seeking their investment. tackleeach and all of these problems. To these attitudes of management, one Senior managersw ere asked what kind must add a number of technical problems of "knowledge-oriented" technical assis- in arranging restructuring through capital tance they would require, if it were provid- infusions. General directors are so fixated ed for free. Responsesreveal an interest in on arrangingthe ownership, that some are detailed information about equipment and sellingstakes at "bargain basement prices" technologiesin their industrv and certifica- to related suppliers, producers, and associ- tion of products, operating in foreign mar- ations.as well as making plans to sell more kets and preparingdocuments for exporting equity to other suppliers, customers, and (in terms of laws, currencies and technical producers. This scarcelv answers the ques- arrangements), marketing, preparing busi- tion of who willput significant amounts of ness plans and managingthe financesof the money into the firm. W('hileit is true that entire enterprise, stock markets, the laws arrangements of sweetheart equity deals and legal norms of joint stock companies, for friendlyoutsiders contradicts the notion and likely investment partners overseas. that management is fixated on retaining Mlany enterprise managers have specific

136 RussIA:CREATING PRWATE ENTERPRISES AND EFFICIENT NLARKUTS

questions about how banks, suppliers, pro- governancethe generaldirectors favor. Most ducers, and consumers operate in other of the technical assistance gaps limit the countries. achievementof "perspective"in their facto- It was surprising that many general di- ry, their industry, their products, and their rectors, who were generallywilling to speak own performance. This perspectiveis exact- for hours on many subjects, had cryptic or lvwhat thev need to deal with boardsthat are no answers regarding technical assistance incapableof givingtechnical blunt criticism, needs. One generaldirector said that he felt capitalinvestment plansthat may not be ob- as if he was being asked to choose foods in jectively correct, and preferences for man- a cafeteria, without knowingthe menu. In agerial ownership that may be unrealistic. fact, enterprise managers in our sample The eVidenceis not all bad news. There have only a sketchy,impressionistic, and in- are preliminarysigns of restructuring.From complete idea of their technical assistance a sample of forty enterprises surveyed, 58 Managersdo not needs. percent reported new productdevelopment. have.., basic Several needs which-in the opinion of Fifty-eightpercent of enterprisesalso report- the interviewers-were evident from man- ed contactswith foreigninvestors and about information about agers' discussionsof their problems and op- one-third reported specificdiscussions about major world erations were never clearly identified joint ventures with foreigninvestors. Fifteen mtetitor *Managers appear to need more under- percent of the enterprises survevedwere al- co standing of how to negotiatewith a do- ready involvedin joint ventureswith domes- potential major mestic or foreign investor, price a tic or foreign investors.There is also some suppliers, and proposed investment, and establish the evidence that general directors wished to de- potential customers rights and responsibilities of both crease enterpriseobligations regarding social parties; assets such as housing,kindergartens, and s outside the rmer 'Thev lack information on accounting on. Onlv one-third of the general directors Soviet Union... systems that would allow them to care- wanted to expand socialassets or keep exist- fullv discern the components of the re- ing services, while two-thirds had given or al cost of products and which ones are planned to give the social assets to the mu- high- and low-margin; nicipalities to manage. a Managers do not have the names, telephone numbers, fax numbers, and ba- The role of employees sic information about major world competitors, potential major suppliers, One might assume that all these majority and potential customers outside the employee-owned enterprises are in fact be- former Soviet Union, various sources having just like the employee-controlled for technology, research, and machin- firm which Western theoretical economists ery, and internationally known investors have been discussing for the past twenty or financial organizations that invest in vears. Each general director interviewed their industrv. was asked to comment on the role of the la- * Thev do not have enough information bor collective or the trade union, the level on measuring productivity and how and growth of wages and benefits after pri- their performance compares with com- vatization, the enterprise's plans for con- petitors in Russia and wvorldwxide; tinued funding in the social sphere (such as * They do not have enough training in fi- for housing), and trends in employment. nancial analysis to compute a reason- The findings were uniform. able estimate of the stake of their firm Some economists have predicted that thev' would have to sell to an outside in- emplovee-controlled firms would divert vestor (and at what price) to turn profits into wages and benefits for workers around the business. and away from capital investment, that effi- There is an interesting relationship be- cient management would be interrupted bv thveen the technical assistance gaps, the worker control exercised by a worker-domi- objective and subjective bariers to restruc- nated board of directors, and that employee turing, and the closed system of corporate ovnership would exist as a threat to outsider

O&EAi. i1Ii)GC VERNAN(E, AND R: IRLRCTIiRING 137

shareholder ownership. Lookint at the sur- Third, the boards of directors are not at face, one might be tempted to conclude that all worker-controlled. There are nonman- in present-day Russial, after seventy years of agement employee representatives on these Communism, the employee-controlled boards in fewer than 5 percent of the cases. nightmare of theoretical economists was iNlostboard members are top managers who coming true and that employee ownership is report directly to general directors-who al- the central barrier to restructuring firms pri- so control the shareholder register, the agen- vatized to insiders. da of the board meeting, the by-laws of the W%eargue differently First, in our view, joint-stock company, and credit relations. these post-privatized enterprises are not em- Workers in the jobs studied are passive as ployee-controlled as defined by theoretical both shareholders and trade union mem- economists. The senior managers bers. There are verv few firms where work- interviewed report that the collective bar- ers can confidentially vote their shares, and gaining relationship between the union and so take a big risk opposing management. Top management has totallv broken down in the managers interviewed tend to view the em- post-privatized enterprise. General directors ployee shareholder in the same way that en- report that they are unilaterally making de- trenched managers of American firms often cisions on wage increases and the norm is to see the little old lady in Wisconsin who owns increase wages every tew months based sole- ten shares-they are a technical nuisance, a lv on inflation. But they report that they are problem to be effectively managed through either decreasing benefits to workers, charg- the manipulation of board meetings and ing workers for benefits they once received shareholders meeting. for free (such as housing), or planning to Fourth, managers also report that the \vithdraw the firm from serving social wel- trade union in most companies is a perfunc- fare functions. Xhile managers report that tory organization. Indeed, the overwhelming they think workers are onlv interested in conclusion about employee ownership is salaries and dividends, they do not report near complete passivity on the part of the any significant worker voice in the determni- Russian worker. This is not surprising since nation of salaries or dividends. Thus, these it is entirely consistent with fifteen years of firms are more management-dominated social scientific research on employee share- than worker-controlled. holders in many other countries. Second, it would be easy to conclude One might expect that the Russian ma- that post-privatized enterprises lack cash joritv employee ownership firm had at least and money for investment because they are protected workers by stabilizing or increas- putting it into salaries. A more detailed sta- ing employment. Even this turns out to be tistical analysis is required, but there is little incorrect. Since 1991, post-privatized firms evidence that salaries, which are not exces- have cut employment by21 percent. Indeed, sive, bear any significant relationship to cap- some general directors said that firings and ital investment needed by the enterprise. layoffs, not employee ownership, are among This begs the question about who is setting the reasons some workers are being more salaries. It is not the workers. Nlost managers careful about the wvaythey work. This does are raising salaries periodically to keep pace not mean that employment preservation is w%ithinflation, but they indicate that they not a priority When asked how many addi- make the decisioni about the timing and the tional employees could be cut if there were extent of the raise based on business and so- no social considerations, senior managers cial considerations. Nlany general directors said about 20 percent. There is no evidence are engaged in a tenuous balancing act as that employee ownership is the reason for they trv to maintain capacity deal with mas- this restraint; it is probably related more to sive receivables, and get enough credits to the lack of a comprehensive social safety net buy raw materials and pav salaries. Aside in the Russian Federation. If a social safety from other factors wveakeningwvorker intlu- net existed and new business development ence, this does not seem to be fertile ground picked up in Russia, it is unlikely that em- for worker control. ployee ownership wvould give workers

138 RE_TlSLA:CREATING PRIV\TE EN ITERPIaI_SANI) EJEtICILNNINLRTETS

enough control to prevent large reductions Bibliography in employment. Is workerownership a threat to outside Blasi, Joseph. 1988. EImploYee Ownership shareholder rights if the firm is not emplov- Revolution or Ripoff 5 New York: Harper Collins. ee-controlledl,?INot o n the basis of the infor- Blasi,Joseph and Kruse,Douglas, 1992. The Newst marionobtained in our interviews. On the Owners: 7he AI.ass Emergence of EmeSployee mation obtained In our interviews. On the Ownership in Public Companies antd WYhat It contran; management entrenchment in Alea,isto Amer:can BusinessNe\ York: Harper enterprises that are legally majority Collins. employee-owned, but not employee con- Blasi, Joseph. 1993. An Analsis oqf Option 4. trolled, is the major threat to outside share- Institute of NManagementand Labor Relations, holder rights. In fact, entrenchment is the Rutgers University, New Brunswick, New major threat to the rights of insider share- Jersey, and Russian Privatization Center, holders, too. It might be healthierfor corpo- MNioscow,Russia. Unpublished manuscript. The crucial question holders, too.,,, mightbeBlasi, Joseph, James Gasaway and Douglas. Kruse. rate governance If employee shareholders 1994. Top Management Ownership In The US. is who will play the could confidentially vote their shares at Pablic Stock M arket. Rutgers University, New roles of core owners shareholder meetings, with the results audit- Brunswick, N.J. Unpublished manuscript. ed bv outside accountants. Employee share- Bovcko,Nlaxim, Andrei Shleifer,and Robert W capitalproviders, holders might elect outside professionals to VishnyAugust 1993. PrivatizingRuissa. MNloscow, and monitors serve as independent monitors of manage- Russia:Russian Prinvatization Center. Paper pre- of ment on the boards of directors. And it pared for the BrookingsInstitution Panel on management in the xwould be healthv for corporate governance EconomicActivity; September 9-10, 1993. restructuringpost- OxfordAnalvtica.BoardsofDirectorsandCorporate ointtstock orpmgor patios, pandtherle are GotvernanceTrends in tke GC Couztr.ies Over the privatized firm? joi~nt stock corporations, and the like are .Next Ten 1'ars. August 1992. Oxford. England: used to collect employee shareholder votes OxfordAnalstica Limited. that could not be voted by top management. Rutgaiser, Valerv Speech to the Conference on Rather, all votes should be passed through Emplovee Ownership and Privatization, the legal entity to the individual employee Supreme Soviet of the Russian Federation. shareholder. September 1993. (Speaker was advisor on em- ,hie employee ownership played an plovee ownershipto Ruslan EIhasbulatovand drafter of the legislative proposal.) important role in providing an incentive for State Committee of the Russian Federation for the workers to participate in privatization, the Mlanagementof State Propertv Annual Report. role of employee ownership is not the cen- 1992. Kremlin, Nloscow;Russia. tral issue in determining the future develop- State Committee of the Russian Federation for the ment of Russian privatization. The crucial Management of State Property and European question is who will plav the roles of core Bank for Reconstruction and Development. The PrivtiainMna,VlIan 1193 owners, capital providers, and monitors of 'atation Manual Vol. I and II 1993. Mloscow,Russia: The Commission of the management in the restructuring post-priva- EuropeanCommunities. tized firm? Can it realistically be inherited by Decree of the President of the Russian Federation existing managers, simply because they are "On IMeasures for Securing Shareholders' there? WXhilethey desire this role, they do Rights", Number 1769. October 27, 1993. not have the financial means necessary to Kremlin, Moscow, Russian Federation. bankroll their firms. Can it be external share- Decree of the President of the Russian Federation holders who face daunting resistance by "On The Privatization Program For 1994", Number 2284. December 24, 1993. Kremlin, managers to their entrv into the power struc- r lNl~~~~~~~~~~~%oscow.vRussianFederation. ture, unless picked bv management? The policy challenge now is to assess whether Note there are anv levers to simultaneouslv encourag shareholderrights and corporae'The author is grateful to Maxim Bovcko, Andrei courage shareholder rights and corporate - Shleifer, Dimitri Vasiliev, Johnathan Hav, and gove- nance input for outside providers of Charhel Ackermann for their encouragement and capital, appropriate rewards for retaining support. 'Ihanks are also due to the local officials skilled management, and a modicum of rea- of privatization agencies, and senior managers in sonable employee representation. enterprises for their cooperation.

0.' '.F.R 11) t;G\ I.RsNAXI:NA) R' I RLr IlIRING 139

CHAPTER 11 Corporate Governance during the Transition to Private Ownership Leroy P Jones and Natalia Tsukanova

Who governs Russianenterprises according complicated hierarchv of state bodies, to whose interests? Prior to 1987 the inter- staffed by the infamousnomenklatura. Their ests of the state were dominant; after full power resided first of all in their responsibil- The evolution of privatization,the interests of the sharehold- ity for appointingthe chief executiveofficers corporate gover- ers should reign supreme. This paper deals (CEOs). This, of course, is the kev corporate nance in Russia is a wViththe transitional intermediate period, governanceissue and, as a result, the nomen- asking who will control the enterprises in klatura had great power over decisions os- five-year story of a the absence of concrete policy measures, tensiblv in managers' hands. Other notable remarkable who should exercise that control, and how powers included making investment deci- nsforma can policy bridge the gap? sions and setting quantities and pricesunder tra tion These are important questionssince the the planned economysvstem. from one of the performanceof an economyultimately rests Firm managers also enjoved significant world's most cen- upon the responses of economic agents to discretion. First, they exercised operational tralized governance theLrenvironment. Privatization is simply a control over production. Second, they had fundamentalchange in corporate govemance. some control over employment and wage struictures to one of Since full privatizationwill take years under policy.Finally, they had an information ad- the most decentra- the best of circumstances,the question of vantageover the other parties that provided lized, with virtually transitionalgovemance mechanisms becomes them with bargaining power in investment centralto economicperformance. If the pace and production decisions.Still, they wereful- complete autonomy of liberalizationis an inversefunction of eco- lydependent on the branch ministryboth be- given to the mana- nomicperformance-as recentevents suggest cause they could be dismissedbv the- branch v~~ersand wvorkers... it is-then transitiongovemance is central to and because the ministryprovided them with g the w,holeliberalization effort. inputs and effectivelybought the outputs.

Evolution of corporate governance 1987 to 1992

The evolution of corporate governance in In 1987, the Law on State Enterprise Russia is a five-yearstory of a remarkable (Associationof Enterprises) was passed in transformation from one of the world's accordance with the proclaimed policy of most centralizedgovernance structures (in more democratic socialism.It stated that the 1987) to one of the most decentralized, CEOs "should be elected by the conference wvithvirtually complete autonomy given to of the workers' coliectivefor a period of five the managersand workers (by 1993). years."The appointment then had to be con- firmedby some higherbodv (usuallya branch The classicalSoviet corporate ministry). If an appointment was not con- governancemodel firmedthen new electionshad to take place.' While this measure eventuallvdramati- The classicalSoviet system (pre-1987) is well callyincreased the powers of managersand known. Under Sovietsocialism, two parties workers, the process was an evolutionary exercised primary governance rights over one. InitialHy,when workers' collectivesand state assets: state bureaucrats and, to a less- branch ministries disagreed, the burcau- er extent, managers of firms. There existed a crats very often managed to appoint their

CORPORATE GoVERNANCE DURINGTHIE TRANsITIoN TO PRIVATEOWNERS[IHP 141

candidates because they still h ad many vided that all firms wveresubject to the same levers to pull. Over time, however, these taxes and wvre free to use the rest of the powers eroded and in recent years there is surplus at their discretion, subject only to virtually no evidence of successful attempts control by the State Revenue Service. by higher bodies to appoint or dismiss a There was little room left for the branch CEO. Interviews at dozens of enterprises ministries in control over the distribution of revealed only a handful of managerial surplus. changes and these were all precipitated by In sum. as the ministries lost their control death or near bankruptcy. Mlanagers seem rights, managers increased their powers by to have mastered the art of reappointing default. Some of the control rights were in themselves. theory gained by the workers, but in practice The erosion of control of the ministerial the bulk of essential governance rights came bureaucrats was manifest in other areas as to be exercised effectively by managers. well. One of the key functions exercised by the branch ministries in the classical Soviet Post-1992: Corporatization and model was to provide firms with inputs and privatization to allocate outputs to customers. This svstem collapsed with the disintegration of the In 1992, privatization was introduced, with Soviet Union. Firms were thus forced to as- corporatization as a first step. The ultimate sume this role, making the period of goal is to shift corporate governance to an 1990-91 verv difficult, as they sought to de- entrepreneurial class. The critical question velop their own complicated network of re- is how long this will take. There is room for lations with partners. Though prices were concern on this score because in Russian liberalized in 1992, the centralized alloca- medium-sized and large enterprises, the tion of resources was replaced much earlier initial step has, in most cases, only legit- by these quasi-market mechanisms. imized worker and manager control, mere- Control over the distribution of surplus ly converting it from lefwcto to delure. also shifted. The ministries used to have al- The initial distribution of shares (after most complete discretion in allocating the corporatization but before true privatiza- firms' revenues. An attempt to restrict the tion) is spelled out in the 1992 privatiza- discretion of the ministries was made in tion program2 with two primary variants.3 1987-89. Over this period two famous Under option 1, workers and managers re- models called hozraschyot (self-account- ceive 25 percent of the shares for free but ing) and self-management were developed the shares are nonvoting (preferred type and introduced in most of the Russian in- A). They can also buy up to an additional dustries. According to these models the 15 percent of common shares carrying vot- revenues or profits obtained by the firm ing rights. The balance of the shares is ini- were to be distributed according to certain tiallv held by the government, but only 20 fixed norms (percentages). After transfer- percent (of total shares outstanding) will ring a certain percentage of the budget to be voting, with the remainder (40 percent the ministerial fund, the firm was free to if workers and manag,ers take their full 15 use the rest of the money for investments percent) being nonvoting (preferred type and wages. One important consequence of B). Accordingly; even where workers and this new order was the transfer of some managers buy all available optional shares, control over investment decisions from the the government will have a 57 percent ma- ministries to the firms' managers. At the joritv (20 out of a possible 35 percent vot- same time, ministries still retained a lot of ing shares) in the stockholders meeting. control, as they were responsible for deter- Option 2 is considerably simpler. Wor- mining the mentioned norms for each indi- kers and managers buy 51 percent of the vidual enterprise. shares, with the balance held by the gov- The 1991-92 "Budget System" and ernment. Under this sclheme all shares are "Tax on Profits" laws further eroded the voting from the outset and there are no powers of the branch ministries. These pro- preferred shares.

142 RuSSIA: CREATING PRIVATFE.THRI'RI.Su AND EFIE:I:IINTNLMRKETS

Since the majority of firms chose option In those cases where workers and man- 2, w\orkers and managers wvillinitiall, have a agers are not the majority, generating a voice majoritv vote in most corporatized firms. for capital will require cobbling together a Furthermore, government shares are likely majority coalition betwveengovernment and to be sold for voLuchers,therebv further re- private shares. This, in turn depends upon ducing the government share under option the ability of private shareholders to con- 2 on a one for one basis. Under option 1, centrate their voice. In other Eastern however, voucher sales come from the pre- European privatization plans, this has been ferred type B stock (which becomes com- accomplished through the vehicle of mutu- mon on sale) and thus dilutes both worker al funds or their equivalent. By combining and manager and government voting rights. their votes into a single voice, individual For example, if 10 percent of the shares are shareholders can achieve the economies of sold to voucherholders, voting rights would scale necessarv to make it worthwhile to in- be: government 44 percent (20 out of 45 vest in acquiring the information required percent); workers/managers 33 percent (15 to play a significant role in governance. In out of 45 percent); and voucher-holders 22 Russia, this role has been attenuated by a percent (10 out of 45 percent). provision limiting such pooling to 10 per- In sum, shortlv after corporatization, cent of the voting shares of any one compa- managers and workers have a majoritv of nv by any one investment fund. Still, several shares in the vast majority of enterprises, such funds could accumulate to a significant The onlv exception is where firms which voice. have chosen option 1 and either fewer than Unfortunatel,v the experience of vouch- 5 percent of the shares go to voucherholder auctions to date suggest that this may be ers or larger voucher sales are offset by a futile hope in many cases. A survey of auc- workers and managers taking up less than tion consequences in seven provinces is the the maximum 15 percent of common stock. only hard evidence available, and it is dis- Even in cases when they do not hold a couraging. The ty-pical pattern is for an op- majoritv of shares, wvorkersand managers tion 2 firm to offer twenty-nine percent of uill still control the board of directors, its shares for sale at auction with the re- which consists of the general director (with maining 20 percent of nonworker or man- two votes), representatives of workers, an ager shares remaining in government hands. appropriate legislative body; and a relevant The result has generally been that workers property fund wuith one vote each). and managers buy up to 80 percent of the Shareholder percentages are irrelevant un- shares sold. To the extent that this study is til, for example, a vote needing a three- representative, voucher sales have thus not quarters of the common shares arises (such diminished worker and manager control, as a vote to change the charter to some oth- but enhanced it. er board composition).4 This will be difficult The scope for a voice for capital is fur- to obtain. but is at least mathematically pos- ther reduced by the efforts of almost every sible under option I .' However, this change industry to create a holding company for must be approved by a two-thirds vote of shares of privatized members of that indus- the workers holding type A preferred stock, tir- The phenomenon was so wide-spread and this is unlikelv: Accordingly, workers that GKI had to develop a specific policy to- and managers will control three-fifths of the wards such proposals. As a result, some of board under most foreseeable circum- the holdings were created with the permis- stances. Leaving the legislative vote aside as sion of the GKI, some of the plans were re- an unpredictable sw,ing vote, any vote for jected and never implemented; and, in capital via the board must bc exercised certain cases, holding companies were through the single vote from the propertv formed even without GKI approval. fund appointee or the general director. The An additional corporate governance latter is appointed by the shareholders, vho, problem occurs for those enterprises that as alreadv noted, are the mana,ers and are not subject to privatization. This is by workers themselves in most cases. no means an insubstantial list. The 1992

CORP(RATI: GAIVRN \NI( 1 111. 1111:TRAN\SITION TO PRIVAII: OWNvI RSI UPI 143

pnvatization plan identifies three categories activities remain outside the current priva- of firms that are not to be privatized or that tization process. The more important ones are to be privatized selectively The follow- may be broadly characterized as public util- ing list gives some of the more economically ities or natural monopolies. important entries in each categorv. What has happened to corporate governance in the firms for which privatization is 1. Enterprises not to be privatized in 1992 not mandatory? As with enterprises sched- * Energy enterprises and facilities uled for privatization, there has been con- * Pipeline enterprises and facilities siderable devolution of power to managers *•MXter-use and amelioration systems as the enterprises have taken advantage of and structures the 1987 and 1988 laws to form au- * Television and radio broadcasting cen- tonomous legal entities. Compared to the ters others, however, parent ministries retain * Port facilities larger govemance rights. * Electricity, thermal energy, and gas supplv Why worry? 2. Enterprises to be privatized only with government decision Are there any reasons to be concerned with * Mining enterprises legitimizing worker and manager control? * Fuel and energy enterprises (coal, oil, and gas) A vote for capital * Communications enterprises * Commercial banks The first reason has to do with providing a 3. Enterprises to be privatized only with GKI voice for capital. Left to their own devices, decision rational workers and managers will be mo- * Enterprises included in the Register tivated by self-interest to extract a maxi- of Mslonopolies mum of surplus in the form of higher * Large enterprises with more than wages and benefits, and pass a minimum 10,000 workers and more than 200 mil- through to profit where it is subject to lion rubles in assets double leakage from taxes and dividends. * Railroad, air, maritime, and river The arithmetic is simple: 100 rubles of transport enterprises benefits taken above the line is worth 100 * Medical equipment and pharmaceuticals rubles to managers and workers; for 100 * Alcohol, liquor, wine, and tobacco rubles of benefits taken below the line, 32 enterprises rubles leaks to corporate taxes and 33 rubles to the government shareholder as It is important to note that list 3 is re- dividends. Unless Russian workers and stricted primarily on the demand (for pri- managers are narrow-minded-which vatization) side rather than the supply side they are not-they will run the company so because in practice, GKI has encouraged they get the full 100 rubles rather than the privatization wherever possible. Being on residual 35 rubles. the list does have two important effects, Rational workers and managers will, of however. First, because of the importance course, pass some surplus through to prof- of such enterprises, GKI pays more atten- it since some retained earnings will be nec- tion to proposals from them. Second, there essary for investment to maintain the is much less pressure on such enterprises to companv in the long run. However, this in- be forthcoming with proposals. Still, some vestment will still be suboptimal because of very important list 2 and 3 enterprises have the first round leakage to taxes and because already been privatized by mid-1993. The future changes in corporate governance oil industry and the huge Uralmash (heavy mav be expected to reduce their ability to equipment) and Zil (automobiles) con- pay high wages and thus further diminish cerns are prominent examples. None- their share of future returns to the current theless, many economically important sacrifice required for investment. If work-

144 RussLA:CREAI1NG PRPiATE ENTERPRISES AND EFFICIENT NIARKETS

ers are irrational, the situation is consider- of nonemployee shares. Thus far, this paper ably worse. A number of managers whom has assumed that the Coase Theorem6 we interviewed argued that workers were holds and that if workers and managers can short-sighted and would not undertake appropriate the bulk of the surplus, they even the (already suboptimal) level of in- will act to maximize the surplus to be so ap- vestment required by self-interest. propriated. Sadly, there is considerable rea- The first evil of inaction, then, is an in- son to believe that this does not hold in appropriate functional distribution of val- Russia, at least in the short to medium term. ue added. Too much will go to workers and As is argued below, managers and workers too little to government and capital. The have in fact been in this position for sever- result will be too low levels of government al years, and the response of the state sec- services, savings, and investment. Since we tor to market forces has thus far been are talking about enterprises which consti- considerably less than dramatic. ... the first task tute well over half of the Russian economy, To understand what is going on, it is of corporate the resulting macroeconomic impact useful to consider the results of one de- would be devastating to the growth tailed available study of enterprise re- governance during prospects of the economy. Note that this sponse. One of many puzzles in Moscow the transition is to will ultimately harm the working class as a today is the proliferation of street-side provide a vote for whole as low investment precludes the cre- kiosks which provide an abundance of var- ation of real jobs and the capital accumu- ied consumer goods. The question is, why capital. lation that makes real wages rise. have these retail outlets prospered in com- Accordingly, the first task of corporate petition with established former state governance during the transition is to pro- stores which have been privatized? NMore vide a vote for capital. Without pressure generally, why have other privatized small for return to capital, the whole economy establishments in Moscow-notably will suffer. restaurants-exhibited so little entrepreneurial response after privatization? At A vote for managerial change least part of the answer is suggested by a fascinating study of 452 establishments in A case can be made that the foregoing evil seven cities. The study confirms the lack of is no great evil because the real problem in response in Moscow but finds considerable Russia today is to get enterprises to gener- response in the other cities. The difference ate surpluses in the first place. If this can be is attributable to the method of privatiza- accomplished by giving the bulk of the ben- tion. In Moscow, enterprises were simply efits to workers and managers, then the ef- turned over to the previous workers, who ficiency goal will have been reached and continued to do things the same old way. functional distribution is a second-order In the other cites, auctions were used, question. There are two classes of response which resulted in control being shifted to to this argument. The first is that some en- an entrepreneur who was both capable of terprises (particularly those involved in re- initiating change, and motivated to do so source extraction for export) are already as well. Eventually, control of the Moscow very profitable. For example, the average establishments will be transferred to true monthly wage in mining in Sverdlosk in entrepreneurs through bankruptcy or sim- June 1992 was 40,000 rubles, compared to ple recognition of the self-interest of cur- an average wage in the region of 6,000. rent owners. Until then, however, inertia Whv should the surpluses of mining be dominates, with patterns established over used for consumption by well-placed min- seventy years of socialism triumphing over ers rather than for investment which bene- the profit opportunities provided by prop- fits the working class as a whole? erty rights in markets. The second class of response is far more The same phenomenon is occurring in important, because it questions whether many of the larger state enterprises. To be the desired increase in efficiency and sur- sure, there is wide variety in managerial plus will in fact take place without the vote response, at least as exhibited in interviews.

CoRPORAIT GOVERNANCE DURINGTHE TRANSMTIONTO PRIVATE OWNERSHIIP 145

Some managers are aggressivelypursuing transition a significantportion of the shares new business opportunities, but many- in many companieswill be in the possession perhaps most-seem merely to be bewail- of voucherholders and other small in- ing their fates and cryingfor government to vestors. Because these shares willbe wide- bail them out. The point is that enterprise lv desired, small investors wvillnot be able reform requires management to profound- to bring their collective voice to bear on the lv change its ways, and many managers are operation of the enterprise. Their interests not readv or able to do so. Some will have can be protected only bv the vote of the sin- to be fired and others will have to face a re- gle large strategic investor-the govern- al threat of being fired before Widespread ment. In the absence of such a role for the change occurs. This has not happened to government shares, Russian citizens are any significant extent thus far, and is unlikelv to receive little return from their For the health of likely to happen soon with continued con- vouchers and will be rightfullv disenchant- the enterprises and trol by managers and workers. One ed with the privatization program.7 distinguished observer of the Russian econ- the economy, omv has argued that given a choice between The bottom lzne protection for the massive infusions of new capital with exist- interests of capital ing managers and no capital with new man- None of this should be taken as an attack agers, he would predict a higher growvthrate on managers and workers. Their interests must be added. with the latter. This may be something of an are fundamental and must be promoted vig- overstatement, but the sentiment should be orously. The point, however, is that in a mar- applauded. Thus, we have a second and ket economy, an enterprise must be run to critical role to be played by corporate gov- benefit the providers of both capital and la- ernance-to use the hiring and firing and bor. If either is neglected, the enterprise wil incentive power of the shareholders to en- decline. Some workers and managers- sure that managers either change or are raised under seventy vears of socialism- changed. may not fully appreciate this point at first, but in the long run their interest is inextri- A vote for exit cablv linked to that of capital. An enterprise that does not protect the interests of capital The third evil of inaction is straight-for- will not attract capital, and without capital ward. In a market economy, firms that out- the productivity gains which raise real wages live their usefulness must die. If they are to are not possible. The current system pro- die, sooner is better to avoid wasting addi- tects onlv labor interests. For the health of tional resources. The interest of workers the enterprises and the economv, protection and managers do not promote this end. for the interests of capital must be added. They would prefer to suck every last re- To argue that governance could be im- source from the firm and its creditors in the proved is not to say it will be improved. form of wages and benefits. Once again, Reforming corporate governance in a way their wage gains outweigh their dividend which reimposes the old form of state con- losses and their role as employees domi- trol in a new guise will not be a step for- nates their role as owners. The interest of ward. Thus far we have only argued that capital does promote this end, since a time- there is room for considerable improve- ly shut-down can at least preserve some of ment in corporate governance. It remains the assets or preclude additional losses be- to be seen whether there is a scheme for ac- fore more and more money is poured in. A complishing this which is likely to do more voice for capital is therefore required to en- good than harm. sure appropriate exit rates. Policies to improve corporate A vote for the small shareholder governance

Another perspective on the evils of inaction The ar,guments thus far may be succinctly is provided by recognizing that during the summarized:

146 Rt SSiA:CRE.AING, Ps rxI ENTERPRISFS A.Ni E :INLARiETS

* Empirically, the period 1987 to 1993 from the budget throughlsallesto the gOV- saw a re%olution in corporate gover- ernment rather than through sales to a nance as the bulk ot powers wverede- market, and the goods are produced by centralized from state organs to the onlv one or a feW supp)liers so supply is managers and workers of largely au- not competitive. tonomous enterprises. 2. Utilities, and other secivites who sell to * Normatively, the change was undoubt- consumers and producers. There is lit- edlv a majorstep forvard for both stat- tle actual or potential competition in ic and dvnamic efficiencv. their core markets and, therefore, they * Nonetheless, serious governance prob- may be expected to remain in govern- lems remain. In the context of monop- ment hands for some period of time. olv output markets and near monopsony In contrast, the last two regimes pro- in the provision of (largely state) credit, duce for markets that are actually or po- The challenge... is manager and worker control results in tentiallv faced with competitive pressures, to develop measures an inadequate voice for capital, change, whether from domestic or foreign sources. and efficiencv Thev are distinguished as follows: that promote better This analysis is hardly unique. Within 3. Transitional firms are those slated for management and Russia, there are manv wvhoshare at least privatization, but for whom the process financial discipline some of the major tenets. A distinguished is not complete. Commission under Professor Misin has re- 4.Alzved enterprises are those where corpo- of enterprises in a centlv compiled a draft report on Basic ratization has been completed, but in manner that is Provisions of State EnzterprkseRetfrnm. They which the governmentretains significant consistent with. sav that at present, the enterprises are"con- share-holdings. . . trolled neither bv the market, which has not Note that this last definition is considerably the transition to a been put in place,... nor by the State as the broader than the official Russian definition market economy. owner. Rather than looking to markets for which classifies an enterprise as private if revenues, these entities "put pressure on the government's share is less than 25 per- the Government with a view to receiving cent." The government definition is useful privileges and subsidies .... " because it encourages firms to ro through The challenge, then, is to develop mea- voucher auctions to achieve special privi- sures that promote better management and leges accorded to those who pass the 2 5 per- financial discipline of enterprises in a man- cent trip wire. One such privilege is the right ner that is consistent wvith,and that hastens to bid for and hold shares of other compa- rather than retards, the transition to a mar- nies, including the right to participate in ket economv. The balance of this paper asks voucher auctions. Passing this threslhold is, how this rnight be accomplished. therefore, necessarv for achieving the formation of holding companies. Governance regime Nonetheless, for reasons explained above, it is clear that even a 24.5 percent A useful first step in this direction is taken government shareholding could be so vot- by the commission in abandoning the hope ed to improve the efficiency of the firm. of having a single governance regime for all Therefore, regime 4 has consciously been enterprises and instead identifying differ- defined as including mixed (public and pri- ent structurcs as appropriate for different vate) firms rather than only those that are typesor enterprises. T'his paper folloxwsthis not officially privatized. lead, but extends it, identifying four (rather Table 11.1 provides a matrix linking gov- than their three) regimes. Three regimes ernance regimes (the columns, representilng are specified based upon the nature of the types of enterprises) wvith the essential markets in which they operate and the last defining characteristics of each regime (the is subdivided according to progress on pri- rows). As such, it provides both a summarv vatization. Briefly, the re,im's are: of recommendations and a disciplining an- I. lonopovll govenmvzet .E:W,piL'rs who de- alvtic dev ice which ensures that nmaljorissues rivc the bulk of their operating revenues are not left unresolved for particular types.

(V)HI"t'RA . Al 'l,';ANl(I DI NRI\,I'li fRANSMON TO PRIYVAEOWNI-R.iui1 uP 147

Regime 1: Monopolv gotvernmentstupplzers ble for true enterprises. Further, structuring them as independent entities does not suf- Pure government suppliers include such list fice to create a market, for they are then 1 organizations as the National Archives; monopolists facing a monopsonist, but the assets of the Armed Forces (geological and monopsonist is in control because it has the meteorological surveys); agencies con- money. cerned with hygiene. epidemiologv, and If such entities are indistinguishable plant protection; and patent, standards, from government, to the extent that market and machine testing facilities. It is difficult mechanisms do not operate, then there is to distinguish such entities from the gov- no great harm in treating them as part of the ernment itself. Like the government, thev government apparatus. That is, they are produce important public goods, whose part of a hierarchical chain of commnand, value is impossible to determine in any their employees are state employees, and practical wav. One can therefore not con- they are funded as part of the regular bud- duct the sort of cost-benefit calculus possi- get process.

Tabie11.1 Corporategovernance regimes of different kindsof enterprises

Government suppliers Utilities, and other services Transitional Mixed pubic and private

Examples Weapons researchand Railways,telecommunica- Enterprisesundergoing Consumersand producers; design Institutes, patents tions, electric utilities, corporatization actual and potential and standards, meteorology pipeline operators domesticand imports competition

Market (main buyer of Government; near- Consumersand producers; Consumersand producers; All companiesthat have output; competitive monopolistic or strategic little potential core compe- actual and potential undergone corporatization condit,ions) industries tition domestic and import but are still partly competition government-owned

Role of government Dominant Carefullyselected and Selectedfinance for restruc- Prohibited(reliant on capi- finance structured subsidiesand turing in anticipation of tal markets) credit guarantees privatization

Corporatization No Yes Ongoing-to be expedited Done

Privatization Not now Not necessarilynow (but Ongoing-to be expedited Done (lessthan 50 percent encouragedwhere feasible) government-owned)or partially done (more than 50 percent government- owned)

Legal form Departmental enterprise Joint stock company (or Existinglaws Joint stock company (state law and public public corporation with employees) special law)

Board None State-controlled majority; None According to shares minority representationof workers, experts, banks, and so on

Entity appointing CEO Government Supervisoryboard, with Workers collective Shareholdersboard approval of interdepartmental commission

Control devicesto mimic Competit ve bidding proce- Performancecontract care- None None markets dures to be developed fully designed and signed where multiple suppliers by interdepartmental com- exist mission

Price-setter Government Autonomous commission Market Market for each industry

Encouragedwherever tech- None into regime, free into Free Entry Restricted nically feasible industry

Exit Explicitgovernment policy From industry, policy; from Explicit government policy Free needed regime, okay needed

148 RussuA:CREATING PRmP 4TE ENTERPRISES AND EFFICIENT NLkARbLTS

An intermediate category of enterprises Illustratively, but most importantly, is occurs in industries where economies of the status of workers. If they are state scale are such that many suppliers are pos- employees, then management is re- sible. Now the government monopsonist stricted in hiring, firing, and promoting can use competitive bidding procedures according to the needs of the enterprise among government-owned firms in strate- and the consumer rather than according gic industries and bidding among private to dictates of law. For example, most en- suppliers in nonstrategic sectors. Arma- terprises need trained cost accountants, ments may fit in the first category and pro- a commodity that is in scarce supply in ducers of stamps, state insignia, and the Russia and available only at a premium like in the second. The former could, and wage beyond government standards. should, in the long run, be placed in regime Managers must be given the freedom to 2, and the latter in regime 4. manage in response to market conditions and this is almost impossible un- Regime 2. Utilities der state regulations. Direct state statts inhibits the transition. How should utilities and other services be Russian utilities have extremely large governed? There are three options. First, capital needs. M\/lultilateraland bilateral thev could be managed like regime 1 orga- lending and grant-giving institutions, to nizations. Second, they could be managed say nothing of private bankers and in- using the fiduciary mechanisms described vestors, are highly unlikely to provide above. Third, thev could be run along the funds to direct state structures. Further- lines of public enterprises in mixed more, corporatization now facilitates economies. This paper rejects the first op- privatization in the long run and com- tion but sees some merits in both of the petitive restructuring (for example, pri- other two alternatives. vatizing electrical generation while Intemational experience demonstrates maintaining a public grid) in the short to convincingly that direct government control medium run. is not appropriate. Instead, utilities should In sum, regime 2 is much more like be corporatized as semi-autonomous bod- regime 4 than regime 1, because both serve ies. Reasons include the following: independent customers rather than the Consumer needs should dominate. government. This similarity is reflected in Management of such enterprises should the fact that manv of the enterprises in be psychologically oriented to look first regime 2 are already well into the planning to the market for policy guidance and stage for privatization (communications, then to ministries. Direct government airlines, and ports). There can be no ques- control reverses this orientation. Quality tion that regime 1 mechanisms of direct of service and efficiency suffer as a re- state control are simply not appropriate. sult. Managers must be given a com- The choice between the remaining two mercial orientation, meaning they look mechanisms, however, is not so simple. first to the market for solutions to their In addition to the obvious definitional problems. Returning them to direct distinction based on the share of govern- state control encourages the traditional ment ownership, regime 2 differs from mentality; corporatization helps trans- regime 4 in two principal ways: form that mentalitv and fosters a new * Limited competition. Regime 4 firms face market orientation. actual or potential competitive markets. Government rules are inflexible. Mlanage- This competition may be from domestic ment of such enterprises must be free to production or imports (once a modicum respond quickly and effectively to of stabilization is achieved, the dollar changing market conditions. They must ceases to be a store of value, and the ex- also be able to quickly acquire necessary change rate falls). Regime 2 firms, in con- inputs at market prices Without cum- trast, largely produce nontradables bersome administrative requirements. which are natural monopolies in at least

C(RP(RAiE GOVERNANCE DURIN(. THE TRANSMON TO PRIVAIT OWNERSIIP 149

their core activities.The number of such term and, if this is the case, we examine two activities is smaller than generally alternativecontrol mechanisms. thought, and competitive restructuring Under both options, there will need to can reduce the realm still further, but be an independent authority or authorities there remains a core of activities for to regulate prices.This subject will be left which pricesuill have to be regulated. for others to elaborate, but there is an im- Finance. As an instrument of social pol- mense volume of international experience icy, the government may wvant to subsi- to be tapped. dize consumption of some regime 2 In an earlier memo on this subject for commodities in a selective and GKI, Robert Anderson surveyed interna- carefully-structured fashion. To meet tional experience with controlling public en- their capital needs the government may, terprises and identified two broad patterns: on a case-by-case basis, decide to pro- Informal control via board of directors. vide additional equity capital or guar- Following the pattern of private enter- antee loans. No such facility should be prises, shareholders appoint a board of available to regime 4 firms. capable and experienced individuals The above reasons have led the majori- who then represent shareholders, pur- ty of the world's mixed economies to run suing their interests through whatever these activities, as public enterprises owned means seem appropriate to the board and controlled by the government. In these given the circumstances of the company. countries the public enterprise sector gen- * Formal control viaperformance contracts. erally generates around 10 percent of GDP Other countries judge that part-time The United States and followers such as the boards are an imperfect control on full- Philippines have, however, largely followed time managers. They relv instead on the altemative approach of regulated pri- formal performance contracts with vate operation. Here, the public enterprise management which specify goals to be sector amounts to only about 3 percent of achieved and provide explicit monetary GDP In the presence of monopolv, both incentives varving with the degree of forms of governance have proven highly attainment. imperfect. However, during the 1980s the If the first mechanism is chosen, how- weight of world preference clearlv swung ever, there is a major danger to be avoided. towards regulated private enterprises. In most countries where the board method Wholesale privatizations in the United has been attempted, board members are Kingdom, Chile, IMexico,and Argentina, as part-time political appointees who have well as partial privatization (selling minori- neither the time nor the experience to ef- tv shares to diversified shareholders) in fectivelv contribute to governance. Stereo- Japan, and small-scale privatizations in nu- typically, they receive a packet of material a merous other countries clearly illustrate few davs before the rneeting, and peruse it this change. It must be noted, however, that in the limousine on the way to the meeting. despite pronouncements to the contrary, In such circumstances the enterprise plays privatization has been of significant magni- them like a fiddle and, except as a check on tude (reducing the sector by more than 10 the more egregious forms of managerial percent) in only a handful of mixed malfeasance, the enterprise is controlled by economies. Furthermore, these have all the CEO. been the more advanced mixed economies, If the board method is chosen, there- characterized by developed capital markets fore, the private fiduciary method recom- and legal institutions. Which governance mended below for regime 4 should be mechanism is the lesser evil for Russia at adopted. This provides the essential incen- this stage is a tough call, as the choice is be- tives for the fiduciary to do his or her job tween two highly imperfect alternatives.9 well. We confess a fondness for the sym- Whichever choice is made in the long run, metrv of thus privatizing the fiduciary role, many of these activities wvillremain in gov- but recognize that it may not prove feasible ernment hands for the short to medium on a wide enough scale to cover all applic-

150 RussiA: CREA-ING PRivATE ENTERPRISESAND EFFICIENT NARKETS able firms. Accordingly,we go on to con- * Preparation and commissioningof de- sider the alternative. tailed studies on governanceissues with While performancecontracting is central attendant policy recommendations. to the proposedregime 2 governance,it is by * Development of computerized data- no means the onlyelement. The broadques- bases developed on a priority basis with tion is what should the governmentshare- attention first to critical information holder do when it controls a majorityof the (for example, subsidies) on the largest shares?As an aid to answeringthis question, firms using readily availabledata. 10 This it is useful to begin with a distillationof the would evolve over time into a more literature on multidivisionalor multination- comprehensive performance informa- al firms,which face the same classof hierar- tion system. chicalproblem. Lessons from this literature * Negotiation, monitoring and evaluating suggest that the head office should: the performance contract system for I.Appoint the General Director; regime 2 where this method is adopted. 2.Provide resources (including realloca- - Recommending appointment and reas- tion of surplus and major investment signment of managersin regime2 based decisions); on assessments of performance. 3. Set objectives; * Selecting and monitoring regime 4 4. Monitor performance according to fiduciaries. those objectives; The other important governance func- 5.Reward or penalize according to tion is finance and while the capstone insti- achievementof those objectives; tution should be involvedin this activity,its 6. Plan and coordinate across subsidiary principal locus should probably be else- units; and where in the government. The creation of a 7.Do nothingelse. new and independent body to carry out Performancecontracting is carryingout these activities is urgently needed. This in- activities3, 4, and 5. It is essential to pro- stitution would require both a senior policy viding motivation and guidance in its own board and a secretariat to provide informa- right, but is also essential if the other function and analvsis and carry out day-to-dav tions are to be carried out. Perhaps the activities. Further, the secretariat must be most essential item on the Listis the pre- autonomous from government rules and scription "Do nothing else." However, if regulations so that it can attract the neces- the government does not set targets and in- sary highly qualified staff. centivize performance, then managersare likelyto pursue their own set of interests.It Regine 3: Transitionalfirms makes sense for the government to look over their shoulderson day-to-dayactivities Regime 3 is for transitional enterprises. to prevent abuses. In short, if the govern- Inclusion in this sector is preciselyas de- ment does not control results through per- fined in the YasinReport, namely: formance contracting, then the alternative is to control the processes through which ... enterprises in Federal ownership results are achieved. Performance contract- which were not included in Type I and ing is thus central to the governanceof pub- for that or some other reason did not lic enterprises. South Korea provides a undergo corporatization or privatiza- model of positive experience to be tapped tion, but which are capable of operat- if this option is adopted. ing in the market independently on a A capstone governance institution is commercial basis. needed to carrv out governance activities on behalf of the state. This could most effi- To promote interim efficiency in this cientlvbe done by makin, it responsiblefor sector it can be argued that they should be both regimes2 and 4. The generalstructure subject to the governance structure which of its responsibilities was given above. we will propose for regime 2. There are Priority activities include the following: clear benefits associated with this idea.

Cop)R:QRATTGoVERAN\.XCE 1), RING 1I1E 1TRANSMOON 1O PRAVWIE ON-ERSI iI' 151

There are, however, also two offsetting ment has minority status, the impact willbe costs to this approach, both of which im- limitedto the sort of informed lobbyingpre- pede the speed of transition to a market viously described for the board. In cases economy where the government shares constitute a * Conversion to the new form of gover- controllingmajority, or where such a major- nance willconsume considerable scarce ity can be had in conjunctionwith the prox- human resources at both the enterprise ies of private shareholders, considerably and government levels.These resources more can be accomplished.How can these could be better employed in developing votes be exercised effectively?We propose means to adapt to market forces. privatizingthe governancefunction through * Psychologically,it will reorient man- the use of private fiduciaries. agers to look backward to the state, The people are the principal-the ulti- The property rather than fornvard to the market for mate owner of the shares in question. The fuindsand GKI solutions to their problems. The pace at problem is how to get the ultimate agent- which regime 3 withers away will ac- the enterprise-to act in the interest of this share a fundamental cordinglybe attenuated. principal. The people are a rather diffuse limitation on their The costs of building a new governance group, and consequently one or more inability to exercise structure greatly outweigh the benefits."' termediate agents must represent their in- Governancefor the transitionalenterprises terests. As we have seen, one such the corporate should therefore be status quo. There is no intermediarywill be some representativeof government escape from their current plight other than the RSFSR,institutionalized in the proper- function. privatization. In an effort to put further tvfund,GKI,or perhapsotherbodies.But, pressure on these firms to privatize expedi- one additional layer is needed to act in the tiously, the state should not render any fi- default capacity. nancial assistance to the enterprises of Who is the default agent? It is widely regime 3, except in the context of a con- recognized that after a company's corpora- crete restructuring plan leading to privati- tization and privatization by GIG, govern- zation. In sum, the transitional regime ment shares are transferred to the should be just what its name implies. All appropriate federal, regional, or municipal policies towards enterprises in this regime propertv fund, making them the default should be explicitly designed to minimize agent. What is not so widely recognized is the transition period. that the GKI is entitled to keep controlling blocks of shares for up to three years in large Regime 4: Mixed enterprises enterprises, enterprises that dominate markets, or those engaged in natural resource- How can a voice for capital and change be based activities (list 2 and list 3 firms). introduced in regime 4 enterprises? Given The property funds and GE share a fun- the crippled board and minority status of damental limitation on their ability to exer- outside shareholders, the scope seems lim- cise the corporate government function. ited indeed. NMostobservers, therefore write Both are subject to lirnitations on salaries these firms off as a done-deal. Before aban- which make it impossible for them to at- doning the board, however, we should note tract-or at least keep-the highly skilled that it is onlv crippled and not quadriplegic. people necessary to do a sophisticated job. Even one board member can make a differ- There are other limitations as well, involving ence if he is trained to ask the right ques- the bureaucratic inheritance of the old sys- tions. People are willing to do some things tem, but the salary constraint alone is suffi- in private but not in public, and a board cient to indicate that the governance member can get things discussed and thus function should be delegated to some au- put in the public record of the meetings. If tonomous body or bodies not subject to bu- well-qualified, the same person could pre- reaucratic constraints. sumably perform the same function as the FortunateIv, this seems to be a noncon- government s minority representative to the troversial conclusion. Representatives of shareholders meeting. WX'herethe govem- the Federal Property Fund assert that, with

152 RussIA:CREAIING PRIRArE ENTERPRISES AND EFFICIENT MNLARKETS

only eighty employees and no plans to hire usual constraint on cartel behavior (self-in- more, they intend not to exercise the gov- terest of members in cheating on their pro- ernance function, but to delegate it. The duction quotas) would be precluded by the same principle lies behind the joint decision holding company's power to appoint and of the property fund and GKI to form the reward the general directors. The leaders of Russian Privatization Center (RPC) to ex- the associations are smart enough to assure ercise privatization functions. The same interviewers that they have no intention of sort of thing needs to be done for the gov- doing anv such thing, but would encourage ernance function. competition among their member firms. We shall refer to this third partv or par- They are also smart enough to know that in ties as a fiduciary, to emphasize that it is act- such a situation it would be contrary to their ingon behalf of the propertvfund and GKI, self-interest to do so and that in a market who in turn are acting on behalf of the svstem the primary guiding light is that of Russian people. Who should the fiduciary self-interest. or fiduciaries be? Another major goal is the promotion of The most obvious candidates for the change. Would the old leadership force the fiduciarv role are the old branch ministries replacement of incompetent management and their offspring associations and apex upon the enterprises? Would their response corporations. As we saw above, there is to poor performance be to expedite change considerable support among the industrial- or delay it through cross-subsidization of ists for the branch ministries to be the pri- losing enterprises through transfer pricing marv fiduciaries, and, in some cases (such and the use of captive banks? Similarly, as oil), they have alreadv been empowered would they promote the goal of promoting in that role. They have one powerful asset: exit, or delav it out of (expensive) loyaltv to knowledge. The apex organs are reposito- old friends? ries of information about the industry, and The answers to all these questions are its managers, technology, suppliers, and self-evident to those whose self-interest is buvers (especially in former CIS republics not involved, and accordingly the old branch and Eastern Europe). These strengths can ministries should be rejected as fiduciaries. and should be utilized, at least in the form It would be the same old people doing the of consulting firms, selling their services to same old things. These individuals should be autonomous members of the industry ac- encouraged to use their critical knowledge as cording to the needs perceived bv au- consultants to the industries, but with the re- tonomous enterprises in light of alternative lationships intermediated by markets rather means of providing such services (whether than hierarchies. internal or external). Another possibility is to appoint inde- Another issue is whether or not thev pendent private financial or management should also be given shareholder rights specialists as fiduciaries. Their interests over the associated firms putting them in a would be linked to that of the nation hierarchical position of dominance. There through an appropriately structured set of are a number of wavs of answering this incentives to be described in the next sec- question. One is to look at the list of jobs tion. In essence, this would mean privatiz- to be done (evils to be avoided) bv the fidu- ing the government's corporate governance ciarv as laid out above. The goal of provid- function in addition to privatizing the coming a vote for capital would be promoted panv itself. by this structure, since their income would Who might these fiduciaries be? At partially be a function of the dividends of one extreme-perhaps representing wishful the subsidiaries. With regard to the other thinking-is Singapore Airlines (a public en- goals. however, the picture is less sanguine. terprise and arguably the world's best airline) The job of avoiding consumer exploita- as trustee for Aeroflot shares. Such a trustee tion would not only not be accomplished would not only vote the shares, but provide but wvould be retarded. One wvould essen- management consulting services and play an tiallv be creating a super-cartel where the active role in the search for a private buyer or

CORPO(RsiE Go%IRNA.\N(E DERIN6 1 IE TRKENSITIONTO PRIVATE OWNERSHIP 153

partner for the enterpr-ise.At the oppositeex- difficulty specifying an incentive scheme tremiie, a purely domestic financial-manage- that adequatelv links the interests of the merit compainv might take on a portfolio of trustee to those of the nation. Most impor- smaller companies, but play the minimalist tantl, it *villtake time to find and contract role of appointing the general directors- trustees, and corporate governance will still signing incentive contracts with them that have to be exercised in the interim. promote the trustees' interests (and there- Accordingl; it is imperative to establish a fore, because of the tmistee incentives, pro- fiduciary of last resort (FLR) to take on all mote the public interest) and taking one seat tmustsnot dispensed using the above scheme. on the boards to monitor and promote per- There are two critical distinctions. First, the formance. Mlany intermediate possibilities FLR would be a publicly-owned body while exist. A particularly appealing one involves a the trustees of first resort would be private. partnership between domestic and foreign Second, the FLR would not be compensated financial-management consultants. primarily through a share in the profits of the How would such a trustee be selected? firms whose shares it was voting. Rather, it Competitive bidding is the obvious market- would be an autonomous body whollyowned based answer, with the award going to the bv the state and compensated primarily by bidder willing to accept the lowest pay- fixed payments (ideally,with funds provided ment 1 to do the job. However, the lowest by some international or foreign donor). bidder might simply be the least intelligent Performance incentives could and should be or the one least able to do the job. To avoid provided, but these would not be the prima- this, tvo things would have to be done. ry form of funding, preciselv because the First, bidders would be prequalified (in bulk of the firms involved would be those for terms of their ability to do the job . Second, which such incentives were deemed inade- each would submit both a price and a plan quate by the market. as to how they would exercise their fiducia- What we have in mind is something ry responsibility The selection committee structurally equivalent to the Russian would consider the quality of the plan and Privatization Center (RPC), which is joint- the bidders' ability to implement it, in addi- lv owned and operated by the Federal tion to the price in determining the winner. Properttv Fund and GKI with foreign fund- This scheme has considerable merit in ing. In fact, since the property fund and that it uses market mechanisms and is thus GKI are the concerned shareholders, the consistent with the current reform phioso- RPC (or its twin) would be a prime candi- phy and that it also places the shares in the date for the FLR role. Wherever it is locat- hands of those with the skills most needed in ed, it would have two functions: first, it Russia today The enterprises have consider- uwould select and monitor the fiduciaries of able cngineering and technical skills, but are first resort; second, it would appoint, train woefully lacking in the entrepreneurial, fi- and supervise those selected to vote the nanciaLl.and market management areas. government shares in residual enterprises. The critical question, of course, is whether or not there is a potential supply of The urgency of governance reform sucII trustees. This will depend in part on the incentives to be offered. First, howev- Many informed observers-both Russian er, wc consider cases where no private fidu- and toreign-believe that reform of corpo- ciary is forthcoming. rate governance is not a priority Their ar- Even under the most optimistic assump- guments mav be summarized as follows: tions it is doubtful that the supply of trustees * At this critical juncture in Russian histo- will be sufficient to handle all of the impor- r:, the government simplv has too many tant regime 4 entities. Most significantly,it is higher priority concerns (democracy, unlikclI to uvork when government and pri- macroeconomic stabilization, privatiza- vate shareholders are in a minoritv. Some tion) and too few skilled economic man- fil-msiiay have such blcak prospects that no agers to divert resources to another trustcc will take them on. Others may have difficult and controversialreform.

154 R:SSIA: CREXVYIN6PRivUri EANiERPRIDESAND EFFEICENTMNARKETS

* Any attempt at reforming corporate ity, but would suggest that getting a governancewvould slow down the priva- GDP boost of approximatelv 5 percent tization program as the possibilityof an annually would seem to warrant alternative governance structure would expenditure of scarce resources. reduce the pressure on many enterpris- * To minimize the impact on the pace of es to privatizequickly: privatization, two features would be * Anv reform effort would be likely to necessary.First, a quick and definitive reimpose a semblance of the old state decision would have to be made assign- governance structure. This would be ing a limited number of enterprises to worse than the current evils of pure regime 2. Second, nothing should be worker and management control. done with regime 3, and thev should not There is much wisdom in these arguments be eligiblefor even the limited financial and any proposed reform must explicitly assistance which might be accorded to address these concerns. regime 4. The counter-argument rests on two * To avoid returning control to the old propositions: state structures, the apex organization * The state sector is going to remain large of the new governance regimes would for several vears. For the sake of illus- have to be outside of those structures. tration, assume that regime 2 enterpris- A new and autonomous bodv would es will account for 20 percent of GDP have to be created to exercise strictly Assume further that regime 4 enterpris- limited functions (specified in the sec- es will produce another 30 percent. tion above) for regime 2 firms and to - Corporate governance can make a dif- appoint and monitor fiduciaries for ference, most importantly,by providing regime 4. a voice for changingmanagers. Again by Whether or not these counter-arguments wav of illustration, assume that it can carry sufficientweight can only be decided produce a 5 percent annual increment at the highest levels of the Russian govern- in efficiency (defined simply as the ratio ment. If, and when they are accepted, then of real outputs to real intermediate in- this paper has provided some preliminary puts). suggestions on how the reform of corporate If these premises are accepted, then imple- governance might proceed. mentation of corporate governance reform will add 5.5 percent to the annual growth Conclusion rate of GDP The calculation is simple. If the relevant enterprises produce 50 percent Since this paper was written in 1993, the of value added, then their output will be on GKI has made extraordinary progress in the order of 120 percent of GDP completing privatization transactions. The Increasing this bv five percent while hold- question here is how quickly this remarkable ing inputs constant will then make real change in structure will translate into GDP 5.5 percent (0.5 multiplied by 120) changes inbehavior. It is of course much too higher than it uvould have been without re- soon for definitive conclusions, but the use- form. These numbers of course only repre- ful papers by Blasi and by Webster in this vol- sent broad orders of magnitude. Note, ume provide some fascinating insights. On however, that they are conservative in at the question of who controls the enterprise, least one critical respect. They assume that Blasi reports two results which will not sur- the only gain is in static operating efficien- prise readers of the foregoing: first, insiders cy and ignore the dynamic impact on in- dominate outsiders in terms of board repre- vestment and innovation. sentation and decisionmaking power and If some variant of the foregoing argu- second, among insiders, managers over- ment is accepted, then how are the three whelminglv dominate workers.'3 This corre- earlier objections to be met? sponds to our earlier observation that the * Ve are not in a position to assess the ex- immediate impact of privatization would be tent of limited economic reform capac- conversion of defacio managerial control to

CoR

de lure. How has the resulting managerial percent had specificdiscussions about joint control been exercised? ventures, and 15 percent were already in- Of particularimportance is the observa- volved in joint ventures.15 This is certainly tion that "Since 1991, post-privatized firms encouraging,but one needs to know how have cut employment by 21 percent."14 If many of these contacts will be brought to this were the result of concrete actions by fruition. Talkingabout doingthings is better managers it would be impressive evidence than not talking,but actuallyimplementing that they were capable of rapid change and them is something entirely different. were pursuing the interests of capital and Similarly,in interpretingthe 15 percent in- not merelylabor. There is room for concem volved in actualjoint ventures,one wonders as to whether this is the correct interpreta- how manywerebegun priorto privatization. tion. Consider Uralmash, the famed heavy In sum, there are two extreme carica- In sum, there equipment producer in Yekaterinburg. In tures of Russianmanagers. One saysthat the are two extreme 1991 it had 62,000 employees, but at the best people rose to the top in the old system time of our visit in 1992 it was down to only and the capabilitieslearned there will allow caricatures of 48,000. Further enquiry revealed that none them to excelin the new market economyas Russian managers. of this was due to layoffsor restructuring- well. The other extreme says that the capa- all had been voluntarydepartures for better bilitiesnecessary to succeedin a bureaucrat- opportunities elsewhere. As of 1994, em- ic system are totally different from those ployment had been further reduced to only required in a market systemand true change 23,000 workers and only 3,000 of this de- will come only when management is cline represented action by management changed. The truth is presumably some- (subsidiarieshived off in the process of pri- where in between.If experiencereveals that vatizationj. Voluntary departures of such the latter extremeis closerto the mark,then magnitudeare of course wonderfulnews for real change in the large and medium-sized proponents of rapid reform because it industrysectors in Russiawill come onlywith shows the creationof many new jobs in the further changesin corporategovernance. private sector. As evidence of changes in managerialbehavior, however, they are less Notes than convincing.How much of the 21 percent average reduction was voluntary (as in This is a condensed versionof a much longer pa- Uralmash), how much was active labor- per. Copies of the completepaper are available shedding by management? Our own inter- from the authors. 1. Article 6 of the Law,passed by the USSR views suggest that, at least through 1993, SupremeSoviet on June 30, 1987.The procedure voluntary departures dominated. Until fur- of elections was further elaborated in the ther evidence is in, one should not equate Regulation of the Central Committee of the cuts in the labor force with management-in- ComrnunistParty and the Councilof Ministriesof duced restructuring. February8, 1988. 1 It has also been reported that after pri- 2. Resolutionof the Supreme Soviet of the vatization, management was changed in RussianFederation N.2 980-1, State Program of about 10 percent of the cases. To the extent Pnvatization of State and Municpa!Zly Owned this represents the ascendancy of m Enterprisesof the RussianFedeation for 1992, June this represents the ascendancy ormodemn 11, 1992. market-oriented management, this is in- 3. A third optionis available,but has been cho- pressive. However, some part of it presum- sen by fewenterprises and is thereforeignored here. ably reflects the retirement or death of 4. Followedby another vote to actuallyfill the old-style managers and their replacement newlyapportioned seats via a simplemajority vote by like-minded fellows. Learning how of commonshareholders. much of the 10 percent falls in each cate- 5. For example,changewould be possible if work- gorvuiscrucial to interpretation. ers and managersbuy only6.5 percentof their op- goryei tionalshares (20/26.5=.755).Altematively, change Survey evidence for active restructuring couldalsooccurifworkersandmanagersbuythefull illustrates that 58 percent of managers en- 15 percent, but governmentsells all its preferred gaged in new product development, 58 per- sharesto independentinvestors who are inducedto cent had contacts with foreign investors, 33 votewith the govemment[(20-+40)/75=.80].

156 RussiA:CREATING PRIVATEENTERPRISES AND EFFICIENT MLRKETS

6. As long as someone has the property rights, it not object strenuously to there being five evils of doesn't matter who. inaction, we are content with four, which seem 7. Some would argue that there is a fifth evil of more than sufficient to justify our conclusion. inaction, namely continued managerial usurpation 8. Article No. 9 of the Law of Russian Federa- of surplus and assets through a variety of sweet- tion "On Privatization of State and Municipal heart deals with private companies which kick Enterprises." back a percentage to the managers' accounts. 9. To avoid misunderstanding, note that this While agreeing that this is a problem, we do not statement applies only to the last 10 percent or so see it as one whose primary solution lies in actions of GDP World experience convincingly demon- by the government as shareholder. There is a much strates that privatizing the other 90 percent is un- more direct solution: relying on a third party which equivocally a good thing. has both the self-interest and potentially better in- 10. We understand that the first steps in this di- formation, namely the workers. In the previous rection are under way at the Ministry of Finance. cases, the interests of workers and managers over- 11. There may be an exception for a very small lapped and government action was essential. In number of very large enterprises which it is impos- this case, their interests diverge, since any diver- sible to privatize for a very long time. If so, thev sion to managers is in large part at the expense of should be placed in regime 2. workers. Accordingly,the most efficient solution is 12. The "x" in the incentive scheme described to educate workers to the potential for abuse and below. perhaps provide them easy access to a remedy 13.Joseph Blasi, "Ownership, Governance, and (perhaps a regional ombudsman). The govern- Restructuring" (this volume, pp. 125-139) ment representative on the board might also play 14. Ibid. a role here, but this is not central. While we would 15. Ibid.

Co()RpoRIE GOVERNANCE DURING THE TRANSMON TO PPuVATmOWVNERSHIP 157

CHLAPTER12

Restructuring Large Enterprises in Preparation for Privatization: A Case Study Hakan J. Wllson

The essence of transition,from planningto privatization, and it went through the the market, is that Russianenterprises must voucher auction process in early 1994. change and adapt to a new and continu- From 1992 on, a French investment ously changing environment. MIuch has group and an investment bank (referred to been accomplishedin privatization,but it is henceforth as Investment Bank) worked the success (or failure) of enterprise re- with management to create joint ventures structuring that will ultimatelv determine with international firms. Some globalcom- the speed of transition to a market econo- petitors were interested in cooperatingwith my This case study illustratesthe daunting Enterprise and a Korean multinationalpro- difficulties facing large manufacturingen- vided sophisticated technology and ma- terprises in Russia, what remedial actions chinery for more advanced production. are needed, and how thev can be carried With more than 250 product groups, a out. The objective of the chapter is to pre- weakening militarv demand, uncertainty sent the measures necessary for successful over potential partner objectives, and a restructuring. rapidlv deteriorating economy, management found it increasinglydifficult to iden- Background tify a corporate direction with which it could feel confident. Managementalso rec- The chapter draws from an actual case of ognized the need for restructuring to deal enterprise restructuring, but some specific with the complexity of Enterprise's struc- enterprise information is concealed for ture, with inevitable layoffs,and to create a competitive reasons and to provide anony- legal structure to allowfor joint ventures at mity to participants. The firm will be re- the subsidiary level. ferred to as "Enterprise." Enterprise was Consultants (a management consulting created in the 1950sas an amalgamationof firm) and Investment Bank were hired to six separate manufacturing enterprises, assist Enterprise in assessing its strategic some of which dated back to the 1920s.In position, and to undertake necessary re- 1990, the company had 32,000 employees structuring. Investment Bank's interest was and made a range of products for both the to create and financiallvsupport a joint ven- militarysector and civilianindustries. It had ture, take an equity position in the compa- developedconsumer products to balance its nv, or both. To this end, Investment Bank military order book and to exploit its tech- would help finance new investments, if nologies.Due to its strategicimportance to guaranteed an equity stake and if selected the military, Enterprise was not explicitly for financing a future deal. Consultants re- targeted for privatizationin 1991,but a new cently decided to expand their European managementteam and strongforeign inter- operation outside the United Kingdom, est came at a time when the companyfaced and were willing to invest both in learning an uncertain future as a militarycontractor. and in building a reputation in Russia.Thev Thus, it took the opportunityto identifyvi- were financed partlv by Investment Bank able strategic directions, includinghow to and partly by themselves. Later in the pro- privatize quicklv.In mid-1993,Enterprise ject, Bilateral Donor would come in and succceded in getting cabinet approval for provide additional financialsupport.

RLESrRtCTU RING L\RGE ENTERPRISESIN PR PARATIONFOR PRIVATIZAION: A CASE STUDY 159

Structuiralorganization until 1991 development, prototypes, preparation for serial production, development of produc- In the early 1990s, Enterprise's productive tion tools, and maintenance. Roughly 6,000 capacitv was split more or less equally be- employees worked in this department (in- tween military and civilian production. On cluding over 2,000 skilled engineers in re- the military side, the development and pro- search and development). Production of duction of a small series of specialized ap- individual parts, processes, and assembly plications was dominant. Mlost civilian was allocated to individual production production was based on the same tech- units. Assembly would always go to those nology but had been developed separately units responsible for assembly of similar There were three main nonmilitary prod- products. The marketing and supplv de- ucts and the most important end-users partment obtained external raw materials were industries, hospitals, and schools. and parts. Specially tailored components Recently, some products had been devel- were produced by the components parts oped to target the consumer market. unit in the technical department. Altogether, there were more than 250 Production unit 76 was an exception. It product groups, ranging from toys to ad- assembled two of the more profitable non- vanced military hardware. Many civilian military products, and provided parts and products were made only by order (a reflec- processes to other units. Unit 76 was also tion of how military production operated). responsible for elements of product devel- Mloreover, there were many development opment, production preparation, mainte- projects in the pipeline, originating both in nance, and supply. All production units, the central research and development de- including 76, reported directly to the direc- partment and in individual production units tor general, who, in addition to other du- or complexes. ties, assumed direct responsibility for To meet the requirements of 250 prod- production, partly because he had been uct groups, the organizational structure manager of 76 during its creation, before emphasized specialization according to being promoted to director general. Over- functional expertise (figure 12.1). all, the production units employed almost The technical department had been re- 16,000 workers and engineers. Production sponsible for applied research and product and development decisions were taken by the management group-that is, the direc- Figure12.1 Existing organization tors of the central units. The department of economv served ssiohareholders individual units, as well as the whole corporation, with accounting and cost calcula- ManagementGroup tions. Costs for complete products or parts * Director-General were calculated based, on the use of re- *Drectors sources, estimated when the product was originally developed, and current resource Director. Director. ] Director :Director, Director, Director, Finance Econory Marketing Technical Personnel Social costs;inventory accountigwas based on and and andSupply Departments and Units t rs n mt Wth l Research Accounting Securtyte rst-, rst-out meto. Wt lted and Devel- Securesp- Kesnarh&gaetonne opment Central ply,and InRdgcah&r Personnei housien, computer capacity, bookkeeping and cost Newly accounting logisticsof ,Development manage- farms, accounting weredone manually employing Newly ~~forall un,ts supply A so rent, union dachas, established andfor the distributed Production Issues,and spor facili- severalhundred economists. unitto aggregated andtwo preparation security ties some secure accounts Enterprise healthcare The departmentof marketingand sup- financing stores Pouto ade anddircati stores [support plyhandled the major and difficulttask of allocationmao of financial securing ipt.Nlarketing t h extent resources Component inputs. 1 (to the Lproduction that it was done) was carried out through contacts vith government-controlled dis- Produrtion| Director-reneralact- |PTK7631 twoembryo tributorsin the formerSoviet Union. Two units ngas director of most 12 lo3 businessunits e w t productionants mainnon- exceptions were the stores in the city in imilitary which Enterprise was located and in

160 RussIA: CREATINGPRIVATE MNARKETS AND EFFICIENT ENTERPRISES

Mloscow, where consumer products were documentation. For example, Enterprise sold and some industrial products ordered. staff working with Consultants had con- The two stores also provided minor repair tracts drawn up to establish their terms of services and served as reception and deliv- reference and guarantee them their old jobs erv points for products to be repaired at the at the end of the project. main factory. There were major gaps in the functions The personnel department not only cov- performed because, for decades, directives ered management of 32,000 employees, but from Moscow had largely replaced the need also supported the workers' council and infor market information. Basic research was ternal security. The finance and innovation provided by central laboratories in department, which had been created in Moscow, St. Petersburg, and in the city of 1992, oversaw financing and cash-flow is- Enterprise, and the military took an active sues, as well as directed investments to part in supervising the development of mil- promising developments. It also attempted itary applications. Supply was organized na- to function as an internal trouble shooter or tionally, and some key suppLies came from consulting service. other monopoly suppliers and from other Finally, the social department, employ- republics in the Union (figure 12.2). ing 5,000 workers, provided housing, kin- The most critical deficiencies were in dergarten, limited health services, and basic marketing, sales, distribution, and after- food and groceries at the company cafete- sales service. Enterprise had almost no con- nas and stores (produced at a nearby farm). tact with end-users, and did not have real It also offered sports facilities near the fac- marketing, sales, or service capabilities, nor torv and two dachas for employee vaca- its own distribution channels. Isolated from tions-one next to the farm outside the city strategic decisions on production and prod- and one in Crimea. uct development and from customer access and contact, Enterprise, in the early 1990s, Flow of information was a large, centralized, overstaffed, in- crediblv complex, bureaucratic production There were two distinct information and employment organization. flows-bottom up, from individual units to production units (or from central depart- Structural changes in the early 1990s ments) up to management and top down, from management (or individual directors) The shocks experienced by the Russian to departments, production units, individ- economy from the early 1980s on are com- ual units, or even to individual employees. mon knowledge. Less well-known were the The first flow (bottom up) provided basic performance data-production volumes, resource use, worker attendance, cost of Fs- puts, maintenance needs, development re- Market Researchand Supply Production Marketing Salesand After-sales sults, and so on. The second flow (top research development distribution service down) provided decisions-on product mix and production targets, resource Perormed by Enterprise: Emphasison Extensive -ProductionLimited Two sales In sales allocation, personnel, suppliers, inputs, * applied orgarniza-preparation arrangement offices in St. offices(for maintenance, development,schedules, and research tionto *Productionof for export Petersburgsmall repairs) applicationsseure components,and in Mos- or if sent to so on. Even trivialdecisions were often re- development supplies and produc- cow. Limited factory in production ttonmachin- arrange- Samara ferred upward, as senior management di- machinery ery ment of dis- rected all aspects of the operation. *Assembly tribution Performedexternal to Enterprise: This resulted in a centralized organiza- Directives Basicresearch Organized Allocated Centrally from by central labo- and guided according coordinated tion with rigid operating procedures. Major central ratories. bycentral to central salesand ministries Guidanceby directives. directives. distribution decisions were communicated through ex- central direc- Somecon- tives. sumerprod- ecutive memorandums from the director ucssold general, and all decisions required formal direct

REsrRUCTURINGLARGE ENTERPRISES IN PREPARATIONFOR PRAVATIZATION:A CASE STUDY 161

effects of the shocks on an organization ical input, labor, also experienced drastic such as Enterprise. They had a huge influ- changes as manyskilled and entrepreneurial ence on the need for the scope and pace of workers and engineerseither left for better restructuring. The external shocks most rel- opportunities or spent their time at Enter- evant to Enterprise were a drastic fall in de- prise workingfor themselves.Those who re- mand for military products, the political mained became dissatisfied with their chaos combined with the disintegration of shrinkingreal wagesand reduced benefits. the Soviet Union, hyperinflation,elimina- Idle capacity caused bv reduced and tion of central planning,drastic reduction of shifting demand and limited availabilityof soft credits or subsidies, foreign competi- key inputs, was further aggravated by in- tion, and privatizationof both suppliersand creased competition. For example, the customers (figure 12.3). transistor radio market was an easy target The external shocks These external shocks led to significant for cheap Far Eastern and Chinese con- most relevant to changes in the industrial structure in which sumer products. While some imports did Enterprise operated. Militarvorders, rep- not offer the same technical quality,their Enterprise were a resenting half of turnover, dropped rapidly, designs were more attractive, and they drastic fall in whereas industrial and medical demand for rapidly gained market share. demand of military core products remained relatively stable. Enterprise's hospital products, on the With increasingly independent and cost- other hand, were in a rapidly growingseg- proaucts, the conscious consumers, demand became ment of the increasinglv important medical political chaos more qualitv- and service-oriented. Con- equipment industry. This relatively new combined with the sumers also seized the opportunity to buy product group offered good-quality prod- newly available foreign products, and, as a ucts to both hospitals and patients, with disintegrationiof result, Enterprise's consumer goods fared lower costs to all. A few big international the Soviet Union, badly with their old design and limited fea- companies had come to dominate the hy perinflation, tures. To make matters worse, the payment world market and many more wanted to en- svstem proved inadequate to absorb the ter. The Russian market was quickly be- elimination of rapid increase of transactions. It was not coming important, and Enterprise, among central planning, unusual for cash payments (from customer a few local suppliers, became a target for drastic reduction of to their local bank to Enterprise's bank in acquisition itself the Citv to Enterprise) to take 60-90 days. Structural changes adversely affected soft credits or Inflation and an increasinglyhard budget the performance of Enterprise. By the ear- subsidies, foreign caused further problems for Enterprise, its lv 1990s, Enterprise experienced severe competition, and clients, and suppliers. And for the first time supplv shortages and a marked departure in Enterprise's history, customers would from its healthv financial position during privatization of sometimes default on pavments. the late 1980s. Although the situation was both suppliersand Enterprise experienced important kept under control through soft credits customers. changes in both up- and downstream sup- from Moscow, it was becoming more and plies. As privatization gained momentum, more difficult to obtain these subsidized manv traditional suppliers changed their loans. Nevertheless,there were some prod- product mix, volumes,customer base, and ucts that were highlyprofitable, especially prices. In particular, energy prices rapidly the few export earners. 'Thetrend toward a approached world market levels,and the lo- streamlined product range alleviatedsome cal energy supplier quickly evolved into the problems, but the shift in product mix and largest provider of medium and long-term volumes was painstakinglyslow. finance.Limited and irregularavailability of Further aggravationwas caused by the key supplies reduced capacity utilization, lack of internal financial information, even for goods still in demand. Moreover, especially short-term cash-flow analysis. downstream activities suffered severe dis- Accounting could not provide relevantand ruptions. Local distribution organizations timelv information in a changing environ- quickly went through privatization, and ment with high inflation.Consequently, al- Enterprise suddenly had to deal with many though the books may have balanced, there profit-orientedprivate firms.The most crit- were frequent liquiditycrises caused by the

162 RuSSiA: CREATING PRIVATEMA\RKETS AND EFFICIENT ENIERPRISES

volatile pavment system, defaulting cus- Restructuring tomers, changesin demand, and sudden input price increases. The joint effort to restructure Enterprise Operationally,all this had three major began at the end of 1992 with discussions effects. First, inventory of less attractive between management, Investment Bank, product groups was piling up quickly,and and Consultants. It was agreed that Cons- production could not adjust accordingly. ultants would field a team starting January Second, at the same time, many workers 1993 to perform a diagnosis and generate were underutilized, causing poor morale preliminary recommendations. Enterprise and lower product qualitv. Mlanvqualified would further strengthen the team by workers left. And third, due to lack of adding its own members as needed. Given funds, lower overall activity,and a sense of positiveresults, the agreement would be ex- lethargy, the deterioration of the machine tended bevond the initial three months. The park and buildings accelerated. first task for the consulting team was to get These developments prompted sub- to know the client. There was little infor- stantial changesin conduct by Enterprise- mation available on Enterprise or its mar- and by its increasinglyprivate and active kets, merely brochures for some civilian competition. Enterprise reacted to the fall products. The consulting team had four in demand by reducing its work force from objectives: 32,000 to 25,000 by the end of 1992, part- * To make a rough assessment of the fun- ly through retirement and resignations. damental viability of Enterprise, its Moreover, there was a stronger emphasis products, markets, and capabilities on revenue-generatingproducts and on re- * To assess management's willingnessto search and development focused on con- change and its ability to implement sumer goods, both of which had further tough recommendations cost-cutting effects. * To build trust and a relationship with To retain key staff and survive in this client team members and key managers new environment, Enterprise began to pay and be accepted by the organization important employeesbetter, increasingthe * Tocreate a common platform for gener- salarv spread considerably. The company ating preliminarvrecommendations and also began to delegate greater authority to managers and to create units to handle the Figure 12.3 Structural changes early 1990s missingfunctions. For example,production e_l_ unit 76, with its small product-develop- External L1 Changesin Changesin shocks structure conduct performanceChangesin ment, economy,and sales functions,was an L _____ L attempt to create the embrvo of a *Hyperinflation strategic*1 *Eliminationofcentral Demand*Drasticdrop in 'FocusedEfficiencyproduct Profitability-Largevariations in business unit. planning purchasingpower, lineon consumer product profit mar- *Drasticreduction of budgetallocations, products gins Externallv,Enterprise began to link up softcredits and overalldemand -Drasticcost cutting 'Negativeor break- 'Rapidentry of Changes in consumer through lay-offs, even performance with key suppliers formallv and informal- foreigncompetition behavior,new con- focusedproduction, overall lv). Upstream, the com any secured long- allowed sumers,changes in and price negotia- 'Export earnings of lx'). Upstream, the company secured long- 'Privatizationof demandpatterns tionswith suppliers criticalimportance term contracts with some parts suppliersby suppliersand paymentand credit sprea to keepkey dueto inflation providing some financing as an incentive. and drasticfall system staff Negativecash flow, Downstream, the race was on for control in demand for supply in supply businesssystem, and volat le military products 'irponespeciallymaktn areuetliidy over distribution channels. Established 'Politicalchaos Ifor example,no and sales a recurrentliquidity and disintegr-ationof longer produced, crisis contacts allowed Enterprise to continue to SovietUnion sold elsewhere,or Verticalintegration Operational producedin hostile and capacity OBil-pertonalg use much of the existing distribution net- republic) Changes inventoryof less 'Disruptedsales. 'Disruptionin supply Inventoryof less works, but this did not provide the neces- service,distribution (for example,no attractive product channels~ ~~slonesewere, 'rIdle or underutilized sarv direct customer contact. The textbook c elsewroe, r leor directThe Competition ~~~~~~~~~~~~~~~~~~~~producedinhostile lao solution would be to create a new distribu- 'Rapid entry of -puce'Increased deteriora- foreigncompetitors 'Disrupted salesser- tion of capital tion set-up, but Enterprise'sinternational vice,distribution channels competitors were already working on this channels in the service-intensive hospital-product * Rapidentry of for- market. eign competitors

RESTRi_(:TlRIN( LNI-ARGENTURPRISES IN PREPARATIONFOR PRrVAn-ZA-nON:A CASE S rbODY 163

to agree on a detailed work plan, scope simpleand focused, four keyareas of analy- of the engagement. and time frame sis were identified (figure 12.4). A mock annual report was drawn up, and the team set about designing draft or- Financialsitzation ganizationcharts to be filledin based on information generated by the client team The first criticalneed was to understand the members. This initial six-weekexercise al- short-term financialsituation of Enterprise. so served to demonstrate the effort and Was there need for immediatedefensive ac- quality of information required to perform tions to sustain the companyin the short a fact-based restructuring. run, or was cash-flowpositive? The answer Was the restructuring of Russian enter- was inconclusive. The emphasis was on prises qualitatively different from that of cash only and the team took great pains to The first critical tvpicalwestern clients? Clearly,the history eliminate revenues not readilyavailable to need was to under- and tradition of Enterprise were different the company. It seemed that there was from those of anvwestern company,as were enough liquidity to meet short-term de- stand the short- the degree and the types of external shocks mand, but even this was uncertain. Some term financial it faced. On the other hand, the mandate soft credits were also anticipated,but it was situation of was to help transform this company to a unclear whether they would materialize. situation of profitable business competing directly with The analysisrevealed that pricing did not Enterprise. large multinational corporations in a mar- reflect cash production costs,and that a set ket economy.The obvious conclusion: re- of price changes and production stops structuring is much more complex for a would improve liquidity.The short-term Russian enterprise, given the greater effort cash issue resurfaced severaltimes in 1993, required, power of old habits, and cultural causing much turbulence for Enterprise sensitivity. But basic business conditions and the project team. still apply Having successfullycreated the mock Products,organization, and partners annual report, the team designed a structural approach to help Enterprise become Second, it was thought that product analy- "sustainablycompetitive." To keep matters sis would identify winners and losers among Enterprise's products and deter- Figure12.4 Structuralapproach to restructuring mine the future of its product portfolio. The "annual report" outlined Enter- neartern IsIsnar-ter positive?Isreal net income prise'sproducts and estimatedthe volume financialsitua-ofa ofproduction. With animproved under- tion positive? is disposable cash-flow positive? standing of the economic importance of the

Are existingproducts Are productsattractive and broader product groups to Enterprise, the Is product j competitive? Do revenuesmeet production consulting team brainstormed with man- offering c costs. agement to determine where production competitive? rWallproducts be attractive and Areproduct developments competive? should be focused. Based on existig m- potentiallycompetitive. Willnet valueof revenuesmeet dustry understanding, supported bv west- Canclient development,investment, and become a productioncosts? ern market information, the team and viable Does structure make Is relevantinformation readily management decided to concentrate on Is orgnizaton reoures effctively?k available? entity? decisionsand allocate two industrial products as the most promis- Isoganization resourceseffectively? Areincentives in line wtth client tomutllpout stems rms (and system) objectives? ing business areas and also look closely at effectiveand jIsorganization appropriatelyclsy efficient? Doesorganization deliver staffed? possess one consumer product (because of its rela- quicklyand efficiently againstdecisions? Doesorganization pess tive importance to Enterprise). Icientskills and capabilities? ' nlssam Should businessresponsibility be Organizational analysis aims at creating Shouldorganization be delegated? a structure to support the production and (Given needs..... ) chan^ed7Cajonvetrscsericl Should client be d Can Joint ventures close critcal sale of the most promising products. The restructuredto - meet market Is clientnatural owner of existing goal was to change the organization from situation? Shouldproduct offering productsm bechangedc1 Shoulddevelopment be monolithic and centralzed one, to a set of redlrected? product-oriented business units with dele-

164 RussIA: CRETI:NG PRIvATENIARKETS AND EFFICIENT ENTERPRISES

gated authority and profit responsibility understanding of both former Soviet and Another important objective was to reduce international markets. Since international the complexity of the organization, as well market information was readily available, as to train managers and workers to close the issue was how to analyze the domestic skills gaps. markets. It turned out that Enterprise's The assessment of potential partners managers and engineers had a wealth of in- was based on the strategic position of each formation on other producers in the former sub-unit and its investment needs (in sys- Soviet Union because of their previous con- tems, skills, and capabilities, as well as cap- tacts. The team was able to put this infor- ital). It also perceived partner aspirations mation to use and suggest a marketing and the value to both parties (Enterprise strategy For example, the research and de- and partner) of cooperation. The assess- velopment department had rough segmen- ment covered direct competitors with com- tations of end-user markets, which the team ... top management plete business systems and world market broke down by purchasing power and geo- was still inclined to presence, suppliers of key functions, and graphic location to identify test groups. . . capabilities in important markets onlv. Data were then collected through in-depth cross-subsidize and interviews with representatives of the test continue making Progress groups, and some information was available products 'udged from GOSPLAN in Moscow.This provid- po csug The initial diagnosis began in January 1993 ed a deeper understanding of market size important to and took about three months, with an ad- and share, the development of competitor society"... ditional three months to generate prelimni- products and distribution, and Enterprise nary recommendations. The plan was that product attributes. management had to accept the results and As better-quality information and analy- be willing to push ahead before the team ses became available, Consultants began to could continue. Initially, the Consultants spend considerable time with management expected to move more quickly and either implementing the improvement plan. Not finish the engagement by late summer 1993 surprisingly as soon as one problem was or increase the scope of the project. In resolved, new obstacles and questions would ality, it took longer, for three reasons. First, arise. For example, the need to merge profit the process was expected to be a series of responsibility with key business systems iterations-starting broadly, then gradually highlighted the concem of top management zeroing in on key issues. But lack of infor- that it would lose control. Would sub-unit mation and the inevitable unanticipated sit- managers perform as expected, or would uations caused delavs. Second, as trust they retain the benefits at their units? started to develop and personal relations Corporate govemance had to be clearly de- were built, Consultants and management fined and control mechanisms put in place. engaged in time-consuming, but produc- If sub-units were organized around good tive and frank technical discussions. Third, products onix; how would the rest of the management asked for assistance on items product groups be organized? The obvious not included in the original terms of refer- answer, to eliminate most of the product ence. vIanagers, including the director gen- range, met considerable resistance. In the eral, increasingly requested day-to-day help consultants' view, it was reasonable to insu- with operational issues. late viable products from loss-makers, but By early spring 1993, the team had top management was still inclined to cross- achieved a rough understanding of Enter- subsidize and continue making products prise, its products, its capabilities and the judged 'important to society," if only to re- market situation and had devised a prelim- tain the option to produce these products at inary strategic plan for product focus, busi- a later stage when the economy had devel- ness unit organization, and joint venture oped. Eventually, new, more business- arrangements. The team then began imple- oriented sub-unit managers would force the menting and modifying the plan. A major issue, and as privatization became a real pos- effort wvasmade to increase knowledge and sibility, top managers increasingly empha-

RLSIRmIVTUR1N(-,L\RGA: ENTERPRISES IN PREPARAnON FOR PRIVAIIZA(V\: A C.SE STUDY 165

sized profit generation over societal commit- groups reported frequently to top managements and questionable long-term options. ment and to each other. After a short Discussions on how to organize compa- teething period, the working groups gener- ny-wide support functions focused on three ated momentum that quicklly pushed elements. First, managers pointed to solu- changes through. The change process, how- tions of international competitors, especial- ever, caused tension to build between es- lv those with centralized research and tablished operations and the proposed development. It could not easily be shown changes until it became clear that a resolu- that those companies had gone through a tion was required. The conclusion was that period of decentralized research. It was on- gradual transition was not only costly (as I when synergies of central research and de- products were eliminated without subse- velopment outweighed the cost of removing quent layoffs and asset reductions), but direct control from profit centers that it could actually jeopardize the whole re- made sense. The conclusion was that the restructuring program. Management decided turns from investment on research were in- to give itself one month to create a func- significant (for the time being) compared tional new organization while temporarily with the value of instilling market behavior. shutting down operations, giving all A second discussion centered on how to nonessential staff leave. An important by- deal with social units. The social commit- product of this month was the identifica- ment to workers and their families was tion of the staff (and resource) needs of deeply ingrained in top management, and each business unit, based on projected sales they only reluctantlv agreed to divest these of profitable products. services. The third discussion concerned the In the final analvsis, that one month of links between functions. The team spent concentrated implementation of the pro- considerable effort describing to manage- posed changes proved critical to the success ment how information could and should of the transition. The clear deadline pro- flow,how decisions could be made, and how vided top management and consultants future units would interact. The proposed with a sense of now-or-never and pushed sub-unit managers became invaluable alles, them to a massive effort to finalize key and many worthwhile ideas were developed pieces. By the end of the month, the new and tested in the two pilot business units. As organization was more or less in place-re- the new organization and core products sulting in the immediate elimination of over ,were established, the focus of the consult- 10,000 workers.' The new, redimensioned ing service shifted to implementation. product market sub-units had the ball and The transition phase was the most were starting to run with it. taxing-both for enterprise employees and for consultants. The emphasis of the work Results shifted from analvsis to process, and the pressure on individual team members and There were five concrete results from the managers intensified. One reason was that restructuring project: man m anagers got involved as the * The nonmilitary product range was cut focus shifted from strategic design to im- from well over 100 to 3 core groups, plementation. The team was thus tem- representing more than a 50 percent porarily augmented and two consultants (and increasing) share of turnover, 80 were assigned to each pilot sub-unit man- percent of profit, and 45 percent of em- agement unit while the project manager ployment (direct and indirect). Of the and another consultant supported the di- original 250 product groups, only 90 re- rector general and corporate center. mained, and those were mainly in the Groups were set up to work out details of military sector. the structure and functions of the corporate * The new organization is considerably center and sub-unit organizations, includ- smaler and simpler, and the size of the ing staffing, resource needs, transfer pric- organization continues to decrease as ing, and myriad other details. The working more products are judged nonviable or

166 RussuR: CREXTINGPR;VATE ALRiETS AND EFFICIENT ENTERPRISES

unsuitable for Enterprise. The new sub- controlled or ignored. A gradual under- units have not vet begun to expand their standing has emerged that the decisions staffs. but are likely to as output and of these consumers, rather than the de- product sophistication increases. There cision of a few bureaucrats in Moscow, has been some limited recruitment to fill determine the fate of the Enterprise. key functional gaps, but the emphasis has been on finding suitable staff inter- Conclusions nallv and retraining them. The present corporate structure is that of a holding Corporate restnrcturing requires much ef- company, with incorporated strategic fort and time, often years of intensive, sin- business units to stress formal account- gle-minded concentration of resources. ability,to increase flexibility,and to facil- It cannot be imposed successfully from itate foreign investments (figure 12.5). the outside (by shareholders, govern- Corporate Enterprise was successfully privatized in ments, or the public). It canionly be insti- restructuring a voucher auction in November 1993, gated from within b managers able to with strong interest from Moscow- carr the organization xviththem. Any re- requires much effort based investors and brokerage firms. structuring must therefore be undertak- and time, often Almost all workers, including those ter- en with full cooperation of management years of intensive, rninated, invested their vouchers in the and the understanding of emplovees, company Once privatized, Enterprise customers, and suppliers. Restructuring single-minded was free to pursue an equity injection in the former Soviet Union is certainly no concentration of from Investment Bank in two of the less difficult than it is elsewhere, and resources, [and] can business units, or subsidiaries. probablv more demanding in intensitv - Due to lower costs, concentration on vi- and quality of effort. After one year only be instigated able products, and improved marketing, this particular restructuring effort had from within by distribution, and sales functions, Enter- stopped the financial bleeding of Enter- managers able to prise has returned to positive net earn- prise and set the stage for implementing g ings in 1994. Mlore important, cash-flow a new corporate strategy. It will be an- carry the organiza- is positive, and the company has begun other two to three years before Enter- tion with them. to reduce its debts to the energy com- prise is fullv restructured. panv. In addition, with hard-currency in- * Basic business practices still app/v. The jections in two business units, these basic advice provided by consultants sub-units have begun to invest in three advising management in Russia was the areas-equipment (to improve qualitv and process control), employee training, and creation of computer-supported Figure 12.5 Organizationalchange management information and account- Director General Director General| ing svstems. The ~~~~~~~~~~~~~~~~~~ Proo uctn EnmyadStrategicnoy n Te wvorking mode of Enterprise has prepaatio accounting pcan changed dramaticallv. The orientation FResearcn and _Marketing andL Public FMarketing ano and skills of both managers and work- developms eations ers have already improved considerably, 1Fnanceand PeronnelandL as measured bv output and more quali- L *=rinnovat security tative assessments, and there is greater Centerprovides Centerimplements Corporatecenter Corporatecenter researchand sales,distribution, providesstrategic providesaggre. emphasis on horizontal interaction for development, marketing,service, objectivesand gateaccounting, production prepa- personnel,social financing treasury func- information and decisions.Activities ration,production services,and tions,and central planning, financ- accountingand e rsonnel func- are increasingly driven bv profit, and ing,and resource treasuryfunctions. tions * ~~~~~~~~~~~allocation. customers are, if not paramount, con- . .ocation.

siderablvmore important than ever be- M R Suply unlt A Market'ng fore. WVhen mentioned (aind they are Production| Product on| Production Production serh ales& c mentioned often), they represent not inits unitts units units usinessunit8 abstract end-users or intermediaries but lProduction coreof important individuals who cannot be BasicR&D commoncomponents

RpETmK(ITT'RIN(iL-ARi;l ENIEI M'RISE> IN PRIRUA110NFOR PRIVAIIZAI1ON:A CAOESn:1a1)Y 167

same as anvwhere else. Given the limit- voreover, the diagnosis provides a ed time available to management and foundation for trust-based relation- lack of long-term capital, it is important ships, without which advisors cannot thatthe advisorstŽcus on thefindamental help management accept and imple- aspectsof the business, with a view to ment difficultchanges. changesthat are self:sustazningand that * What must be clearlyemphasized is that createa momentumzof continuouspositive managersin formerlysocialist countries change.Rather than fine-tuning market find themselves in uncharted waters. strategies,which is time-consumingand Not only is the transition to a market requires considerable local knowledge, economynew and confusing,but the in- concentrate on getting the basics right. teraction with international organiza- Twokev limitingfactors that must be ad- tions, financiers,donors, and advisors dressed early on: the complexityof large can give rise to misunderstandings and functionalorganizations and the lack ofrel- suspicion.The value of patience and evantskillsfora market-based economy and long-termperspective on behalf of for- profit-drivenorganization. Both factors are eign parties cannot be overstated. to a large degree a function of the orga- Financiersmust know that returnson in- nizationalstructure of typicalSoviet-style vestments,even if potentiallysignificant, enterprises.This complexitycan be re- will take time to materialize--andoften duced only through drastic reorganiza- will not. Participation in restructuring ton, simplification, and down-sizing. could well be viewed as a long-termop- The greatestlever for self-sustainableand tion, and valuedaccordingly. Equally, bi- continuousbuilding of skillsis to create a lateraldonors must permit advisorsand new structure for which both managers managementsufficient time to turn the and workers are responsible that gives companyaround and greatfreedomof op- them authoritv over cost and revenues, eration.NMost important, however,advzi- quality and product decisions, produc- sors should not e.xpect any substantial tion, sourcing,and marketing. impactuntil trusthas been establishedbe- * At the outsetof a restructuringeffort, advi- tween the consultantsand the managers, sorsand financiers should perform a quick another aspect of the process that will diagnosisof theenterprise focusing on its take time. The ingredients of a trust- current financialstatus and the attitudes basedrelationship are no different in the of management. The abilities and will- former Soviet Union than elsewhere, ingness of top managers to change, only more pronounced. Honesty, in- which will decide the outcome of the tegrity,long-term perspective, personal project, can be assessed only by working relationships, and high international direcdy with them. Equally important is standards of quality-these are every- to evaluate the potential viabilityof the where the building blocks of change. company,the attractiveness of products, The restructuring effort wiEl often the cost situation over time, and the change direction during the project, competitive structure of the market in partlydue to what the consultantslearn, which it operates. No doubt there will but also as the client develops an un- be many basket cases (and only a few derstandingof the company's situation. shining stars). If managersare unwillzng Although much hard strategic thinking or unable to implementtough changes, or and analvsisare required, there will be if the company is not potentiallv viable, substantialtactical elements in working conssultantsshould withdrawfrom the situ- with managers. Often, the biggest dis- ation. In addition, it makes good sense cussionwill center not on the strategy or to begin the study with an analysisof the even the organizational structure re- current financialsituation. Often, cash- quired, but on the less tangible interac- flowwill be negative and immediate at- tion between units in the organization. tention must be given to near-term The topics of debate will include any- solutions of the liquidity crisis. thing from suppliers, customers, tech-

168 RussiA: CREATNG PRIAATEMNLARKETS AND EFFICIENr ENIERPRISES

nology changes, competitors, and mar- The solutionwas to retain the eliminatedworkers ket behavior, to the soft link between on a separate payrollwhere they would receive units and functions within units, incen- their current (nominal)wage indefinitely. With in- tive schemes, information flows, and flation,the cost of this payrollbill would soon be decisionmaking in a rapidly changing insignificant.In addition,management assumed a great deal of responsibilityto activelyoutplace market environment. In the final analy- workers. In manv instances,ex-employees would sis, this is where the successor failure of acquireor evenbe givenindividual assets, and con- restructuring will be determined. tinue to supplyEnterprise and other companies as subcontractors.Others would receive short-term Note training for other employment opportunities. Some would be employedin privatecompanies of 1. Even thoughworkers were immediatelyeim- top managers.Many, however, would have to fend inated, legallythey couldnot be fired that quickly. for themselves.

RESTRUCTURING LARGE ENTERPRISES IN PREPARATEONFOR PRIVAnIATION: A CASE SnJDY 169

CJLAPTER 13

Newly-Privatized Enterprises: A Survey Leila Webster with Juergen Franz, Igor Artemiev, and Harold Wackman

Project objectives combined population of 8.4 million (6 percent of the Russia's total population). The primary objectiveof the surveywas to The survey was carried out from document the characteristics, problems, October 18-28, 1993 by a team ofW'estem and needs of medium-sized and large pri- and Russian interviewers.Two-person sur- vatized enterprises in Russia. The survey vey teams spent two to three hours with each was carried out during the preparation and enterprise manager,completing a question- pre-appraisal of an enterprise restructuring naire made up of quantitative and qualita- operation. Findings from the survey were tive questions and visiting their factories utilizedin the design of a subsequent oper- when possible. ation. Specificareas of interest included: The sample was based on lists of all pri- * The characteristics of medium-sized vatizedfirms provided by the oblast propert- and large privatized firms as regards funds inVladimir and Moscow(table 13.1). ownership, governance,labor and capi- In each oblast, two lists were obtained: one tal management,finance, post-privatiza- for enterprises privatizedthrough the mass tion behavior,and future strategies; privatization program (MIPP) and one for * Firms' main problems in demand, in- privatizedleasehold companies (PLCs). puts, finance,and labor; Firms were to be evenl1distributed be- * Firms' potential demand for credit in tween the two oblasts. Half were to be pri- terms of use (workingcapital or invest- vatized leasehold companies and half ment), nature (debt or equity), term should have come through the MvIPPIn ad- (short, medium, or long), currencies(ru- dition, half of the sample firms were larger bles or foreign); and their relationships than the average privatized Russian firm with major actorsin the financialsystem (which has 1,100 workers) and the other (banks,domestic and foreigninvestors); half smaller. Small firms with fewer than * Technical assistance requirements and 250 workers were excluded if possible. The potential design of this assistance: sectoral distribution was to focus mainlyon * Firms' general capacity to stav afloat in manufacturing with 70 percent of sample the near term, undertake necessary re- firms drawn from manufacturers and 10 structuring in the medium term, and percent each from construction, services, evolve into viable companies in the and transport (table 13.2). future. The final sample was fairly representative of privatized firms in the two oblasts Method Table13.1 Privatizedfirms by oblast and origin Two oblasts close to Russia's capital were selected for sampling-lMloscow oblast Mlass- Prvatized (whichexcludes th cit, of,Mo privatzation leasehold (which excludes the city of Svlosco%v)and program companies Total Percent Vladimir oblast (located about 200 kilome- Moscow oblast 105 351 456 61 ters trom Moscow). The total area of the Vladmi,r oblast 194 96 290 39 two oblasts is 75,000 square kilometers Total 299 447 746 100 (twice the area of the Netherlands) with a (percentage) (40) (60) (100)

.NE'X'LY-PRJVA1IZI:DENrREiIKms1s: A SURVEY 171

with two exceptions. Because the survey in- shares, 10 percent of shares were held back cluded numerous large firms, the average by the propertv funds for later sale to work- sample firm size is almost twice that of the ers and managers, and the remaining 39 average firm in the population. Stratification percent were sold to the public through by sector also resulted in a disproportionate voucher auctions and investment tenders. number of manufacturers in the sample. Managers owned an average of 17 percent of their firms, 21 percent in leaseholds The firms and 13 percent in MPP firms. On average, employees owned 61 percent of shares, 75 Half of the firms moved into the private percent among leaseholds and 50 percent sector in bits and pieces under leaseholds among mass-privatized firms. Among lease- and half came through the mass privatiza- holds, the small portion of shares not yet tion program. In both cases, there was little purchased belonged to the Russian state. evidence that managers had sorted through Among mass privatized firms, owners oth- assets, chosen the best, and discarded un- er than managers and workers were oblast wanted parts. This was particularly surpris- property funds (average 20 percent), insti- ing for privatized leaseholds where it was tutional investors (average 19 percent), and thought that these managers have been ac- individuals (averagelO percent). tive in asset stripping. NMorethan 60 per- The average labor force was 1,518 em- cent of the firms had been private for over ployees, but the median was 752, reflecting a year and only 5 percent had been priva- a cluster at the small end and relatively few tized in the previous six months. firms with more than 2,500 workers. Aver- Almost all former leaseholds were ei- age monthly sales in September were $1.04 ther closed joint stock or limited liability million but the median ($266,000) was companies and, as required by law, all mass considerably less, again due to a cluster of privatization enterprises were open joint firms at the small end. At an average of stock companies. Among mass privatized $400,000, sales of former leaseholds were firms, a quarter had chosen option 1, a third the size of mass privatization firms. whereby workers could claim 25 percent of Sectors with the highest sales included fab- shares free of charge with the option of pur- ricated metal products and paper prod- chasing an additional 10 percent at a price ucts, the lowest sales were in services and established by GM. Managers could pur- construction. chase 5 percent of shares, and the remain- Manufacturing firms operated in all ma- ing 60 percent were to be sold to the public jor sectors. Sixty percent were producing through voucher auctions and investment basic consumer goods. Nonbasic consumer tenders. Almost three-quarters chose op- goods such as porcelain and art products tion 2, wherein workers and managers were the main products for 10 percent of could collectively purchase 51 percent of firms. Twentv percent manufactured non- Table13.2 Characteristicsof the sample consumer goods such as electric cables, water pumps, and locomotives, and 10 percent Population Objective Actual sample produced constructionmaterials. Forty-five

Number of firms 746 100 92 firms derived all revenuesfrom one activity. Moscow (percent) 61 50 52 Among those that had diversified, thirtv- Vladimir (percent) 39 50 48 massprivatization program (percent) 40 50 48 twobegan manufacturing a secondproduct, Privatizedleasehold companies (percent) 60 50 52 ten started up trading activities, sixteen Number of employees Lessthan 250 (percent) 51 few 12 wereivolvedwithservices(usually repair), Lessthan 1,1 00 (percent) 89 50 58 and four took on minor leasing activities. In Morethan 1,1 00 (percent) 1 1 50 42 general, enterprises diversified to make up Mean 880 - 1,518 Median 280 1,100 752 for shortfalls in revenues. For example, a Sector number of specialized construction compa- Manufacturing (percert) 48 70 76 Construction(percent) 18 10 10 nies broadened their scope to all forms of Transport(percent) 13 10 8 construction. Manufacturers of auto-parts Services (percent) 20 10a 7 offered repair services.

172 RussiA: CREATINGPRIvATE ENTEFRPRISES AND EFFICIENT NLMRKETS

Some cross-investment was apparent. hoped to resume former levels of produc- Among the two-thirdsof firmsthat invested tion in which case they would need what in at least one other business, most bought thev had. shares in a bank. Other investmentswere mainlv in trading companies, raw material Finance suppliers,and other manufacturingcompa- ries. One in five PLCs made other invest- 'Xbrking capital. Managers reported ments, compared with one in ten of mass that inadequate working capital was their privatized firms. Forty-fivepercent of large biggest problem with financing. Problems firmsowned shares in three or more compa- mainlywere due to delayed payments from nies compared with 7 percent of medium- customers and high interest rates. Mana- sized and 8 percent of small companies. gers could not get paid by their customers The major problems affectingbusiness- and could not borrow to cover gaps at a The major es were delayed payments from customers, price they considered reasonable. Reve- problems affecting high taxes (managers claimed they were nues were critically influenced by demand paving profits taxes of 80-90 percent), in- uncertainties and input and payment prob- businesseswere sufficient working capital, weak demand lems. More specifically,cash flow reported- delayed payments and falling orders, inadequate funds for in- ly did not cover operating costs (inputs, from customers, vestment, and inflation (table 13.3). These salaries,overhead, interest, and taxes) in 35 problems were inter-related.Working capi- percent of enterprises. Comparisonsacross high taxes..., tal was eroded by high taxes, falling orders, firm groupings vield a profile of firms with insufficient working and inflation. Delayed payments, particu- the most severe problems covering their capital weak larly with high inflation, exacerbated the operating costs. These tended to be: problem. MNanagerswere hamstrung in * Producers of goods such as plastics, their efforts to move into new, more prof- glass, fabricated metal parts, and some orders, inadequate itable products by lack of residual funds for textiles (68 percent of all sample firms funds for invest- investment. Few managers complained of producing intermediate products) more problems associated with government reg- so than producers of finished goods (13 ment, and inflation. ulations, except for tax. percent of all such firms). X Construction firms (five out of a sample Capital total of six) and manufacturers producing constructionmaterials (four of nine). Fz-redassets. Most firms (95 percent) * Mass-privatizaton firms (47 percent) owned all of their buildings and equip- more frequently than among leaseholds ment. Former leaseholds purchased their (21 percent). assets in stages over the previous 3 to 4 * Fairly equally distributed by size, with vears and mass privatization firms bought about a third each of small, medium- them as part of the privatization package. sized, and large firms failing to cover Ownership of land was less clear because their costs. Among large firms, one in of legal uncertainties. Half of managers five adequately covered costs, com- said that they had a long-term lease from paredwithonlyoneintwenty-foursmall the state, 27 percent were simply using the firms and one in fourteen medium firms. land with no legal agreements, and 20 percent claimed they owned the land and had Payments. Receivables were up to date formal title to it. (or late by 30 days or less) in about half of Forty percent of enterprises had sold firms, but late by 90 days or more in a quar- mostly old) machinery or buildings in the Table13.3 Largestproblem affecting samplefirms previous 12 months to new private firms. (percentage of firms) Mlost manufacturers, however, were hesitant to setl off unused equipment, even payment High taxes working capital demand investment Inflation Other though much was idle. Some wanted to hold on to their equipment because, in 13 12 12 10 10 10 33 their view, its value was rising daily; others Note Managerswere askedto nametheir tnree largest problems in order of importance.

.NL.wL,-PRIvATIzEF)ENmuuRI'RISESs A SUR-E. 173

ter of companies. Half of receivables from A few banks dominated in both oblasts: private firms were up to date, compared Unicom Bank in NMoscow oblast and with a quarter of receivables from state en- Moscow Industrial Bank and RosseLkhoz- terprises. For transport and construction bank in Vladimir oblast. On average, enter- companies with mainly in-state customers, prises paid nominal interest rates of about almost all receivables were late. The worst 190 percent, with a range of 150 to 250 per- offenders were in other CIS countries. cent. Short-term loans were used mainly to iMtanagershad little formal recourse against pay for inputs (69 percent of firms) and em- those who delayed payments, and most re- ployees' salaries (23 percent). Among the lied on informal means of collection. relatively few managers who had difficulty Personal harassment, including persistent obtaining short-term loans, the main prob- telephoning and threats to cut off (or can- lems were reportedlv that their banks didn't Obtaining a short- cel) further shipments, was the most com- have enough money to lend or they pre- term loan from a mon approach. Only 15 percent of firms ferred favored clients with large accounts. filed claims in courts-a procedure that Only 12 percent of enterprises received bank was easy... took 6 to 8 months during which time no long-term loans (longer than 12 months) in interest was paid on the debt. Extracting the previous year. Most long-term loans payments from large, powerful customers, were soft loans from the government, some upon whom many managers relied for fu- through association with agricultural con- ture contracts, was difficult. cerns and others in the name of reconstruction or imminent bankruptcy. Almost all Prepayment. Requiring advance pay- had been obtained more than 6 months ments with orders was a widespread prac- previously, and managers had little expec- tice. This approach did appear to lower tation of receiving additional soft loans. arrears, and may also have dampened demand in the industrial sector as managers Relatonshzps with banks. Forty percent delayed production until they could obtain of managers had no problems with their prepayments from customers, which were banks. Those who did, complained about needed for prepayments to suppliers. delays in transactions between different Others had the opposite problem wherein banks and different cities and across the customers paid in advance (at current network of former republics. MIany man- prices) while producers, who could not af- agers claimed that banks delayed financial ford to stock raw materials, ended up pay- transfers intentionally to maximize their ing higher input prices due to delays in earnings. Other widespread complaints in- procuring their raw materials. Textile and cluded lack of confidentiality, focus on clothing producers who pre-paid for sup- short-term profits, and high fees for routine plies of cotton from Uzbekistan were par- services such as cash withdrawals, opening ticularly disadvantaged. Locating solvent of new accounts, and exchange of foreign customers and extracting payment from currency. them was an important key to success. Some managers described improvements in banking practices over the previ- Use of institutitonal credit. Obtaining a ous year. Firms were reportedly no longer short-term loan from a bank was easy, and required to conduct all transactions 77 percent of sample firms obtained one or through the banks. Accountholders were more loans with terms of fewer than 12 free to withdraw unlimited cash from their months in the previous year. Many ob- accounts if they had a good explanation for tained four or five such loans, typicallv with its use, their bank had sufficient funds on terms of three months or less. Loans were hand, and they were willing to wait a few secured with equipment and inventories. days for delivery. Intermediating transac- Managers of smallcr firms demonstrated a tions across the borders of former republics greater reluctance to take loans (62 per- was a prominent area in which financial ser- cent, compared with 83 percent of medi- vices worsened. NManagersreported waiting um-sized and large firms). months for payments, unable to ascertain

174 RUsSIA: CREMXINGPRiVA1k ENTERNRISESAND EFFICIENT LkRKETS

whether the delavywas the fault of the cus- payments-both in the context of a devas- tomer or of the respective bank. tating recession. Keeping enterprises afloat Two-thirds of firms owned shares in depended far less on lobbying ministry of- banks, usually 1 percent or less in the local ficials for subsidies than on making profits branch. Not surprising, the larger the firm, in the marketplace-after paving numer- the more likelv it was to be a shareholder in ous high taxes. Provision of basic social ser- a bank (87 percent of large firms, 44 per- vices for workers became problematic for cent of small ones). Ownership appeared to manv managers, most of whom were caught confer several advantages, including rela- in the dilemma of feeling responsible for tivelv easy access to short-term credit facil- these services but recognizing that they ities, marginally lower interest rates; and could no longer afford them. ongoing relationships between managers The data suggest a strong network and bankers. among managers of privatized firms. More Most managers than half belonged to at least one industry were middle-aged, lanagers association, many of which were descen- dants of sectoral ministries that formerly well-educated men MvIostmanagers were middle-aged, well-edu- coordinated production among state enter- with long cated men with long management histories. prises. Typically organized as joint stock management The youngest were in their early thirties and companies, these organizations offered their manaemn the oldest were in their early sixties, with an shareholders and members bulk purchasing histories. average age of forty-nine. Only 16percent of of raw materials, assistance with distribu- managers were under 40. Fully 85 percent tion, technical information, and a voice in had university degrees and an additional 9 Moscow politics in exchange for equity. percent had post-university education. The Fortv-five percent of enterprises invested in continuitv of management from pre- to post- other companies (almost 20 percent in three privatization periods was clear from the fact or more companies) conveying the impres- that half of the managers interviewed had sion of a fairlv dense network of cross-in- been general managers and 30 percent had vestment. Many managers continued to rely been managers of technical departments in heavily on former suppliers and customers. their enterprises before privatization. Estimates were that about fortv of the Labor ninety-two firms surveyed were led by highlv competent managers who appeared able The average and median numbers of work- to bring their firms through the transition ers per firm in October 1993 were 1,518 successfully-assuming the business envi- and 752, respectively, down from an aver- ronment did not entirely hobble their ef- age of 1,591 and a median of 800 twelve forts. Nineteen managers were judged to months previously (a 6 percent drop). Most be poorly-prepared to make the transition, managers reported their employees were and the remainder were rated as average working full-time, although about 15 per- with a mix of strengths and weaknesses. cent said part-time work was often cut back Many managers maintained their pow- due to falling orders and insufficient cash erful positions with privatization, but inter- flo-wfor pavrolls. views made it clear that the combination of Si.xtv percent of managers had laid off economic crisis in Russia and the speed of workers in the previous 12 months-on av- privatization radically altered the content erage, 10 percent of their labor force. Three- of managers' jobs. The difficulty of acquir- quarters of enterprises engaged in ing scarce raw materials had been replaced construction, chemical products, and textiles by the difficulty of paving for inputs in the laid off workers, reflecting the severe de- context of high inflation and falling rev- mand problems faced in these sectors. A enues. Production quotas were gone, but in quarter of firms had not made significant their place had come pressures to find mar- changes in the size of their labor force, and kets where production could be sold and 15 percent of firms hired additional work- strategies formulated by which to collect ers-on average, 8 percent of the labor force.

NEtiw.v-PRIvAnZAEDENTER:RI'RISES. A itRx rE 175

More layoffscan be expected. particu- of sample firms provided housing for most larly among large firms. Just over 40 of their employees. Fifty-seven percent percent of managers acknowledged they maintainedownership of the housing facili- had more workers than they needed. ties, with 28 percent transferred to munici- Moreover, fewer large firms laid off work- pal governments, and 14 percent transferred ers than small and medium-sized ones, and to employees. But regardless of owner- large firms were more likely to report excess ship-even where employees purchased labor than other firms-particularly in the their flats-the financial burden of main- nonmetallic minerals and the fabricated taining housing facilities and providing utili- metals sectors. ties remained with the enterprises. Nonetheless, over half of the managers said thev had difficulties holding on to their Production and sales Sixty percent of skilled workers, in part because of their in- managers had laid ability to pay competitive wages. In some Average monthly sales in September were cases, the most talented employees left to $1.04 million with a median of $266,000. off workers in the work independently as private entrepre- Forty-seven percent of firms had monthly previous 12 months neurs in their own companies. The excep- sales below $417,000 (annual sales of $5 -on average, 10 tion was among compames in small towns million). On average, the highest sales were of , .in which thev were the primary employers found among enterprises involved in heavy percent of their in the area. These firms had not lost work- industry; for example, fabricated metal labor force. ers because their employees had few other products ($2.4 million per month) and pa- options. Most managers were taking active per products ($1.2 million), and the small- measures to hold on to their best employ- est among services firms, such as business ees. Some initiated binding, long-term con- and household services ($150,000) and tracts. One firm selected a few of its transportation ($108,000). Sales in two- employees for contracts, offering them ac- thirds of firms were constrained by lack of cess to low-priced cars at the end of two demand or orders for their products, and in years if their performance was good. In an- one third by an inability to fill more orders other, 20 out of 1,300 employees had been than they currently had. Forty percent re- singled out for individual contracts. Many ported mounting inventories. managers took steps to raise labor produc- Almost a third of managers (31 percent) tivity by linking employees' salaries and reported that at least one of their primary performances more closely. products was subject to price controls or The average monthly salary for a skilled profit margins. Some controls were associat- worker was 110,442 rubles ($90) in edwith sector, for example, petroleum prod- September, 1993, up from 26,374 rubles in ucts, agriculture, and wholesale trade. A few Januarv 1993-an increase of 420 percent were subject to price controls because the in the nine-month period. Monthly salaries firrmswere registered aS monopoLies. Most for unskilled workers grew from an average price controls, however, originated with of 12,208 rubles inJanuary 1993, to 42,529 committees and associations that descended rubles in September 1993-an increase of from the former sectoral ministries. 350 percent. Thus, the ratio of average Just under 60 perceni of managers said salaries of skilled and unskilled workers that production had been stable or had in- changed from 1 to 2.2 to 1 to 2.6 in the first creased over the last few months. Sectoral 9 months of 1993. Moreover, almost all en- differences were prominent: 60 percent of terprises (89 percent) offered social ser- firms producing textiles and clothing and vices to their employees, typically a mix of 50 percent of construction firms reported housing and associated utilities, health and declining production, whereas 78 percent child care facilities, vacation locations, of furniture manufacturers and 73 percent transportation, and farming plots. of transportation firms reported increasing Provision of housing represented by far volumes. Over half of mass privatization the most critical and knottv problem in the firms reported declines in production com- area of social services. Eighty-seven percent pared with a third of PLC firms.

176 RUSSIA: CREATING PRmVATEENIERPRISES AND E'FFICIENT MARKETS

Just under 60 percent of firms con- tion. Specifically, half sold most output on firmed orders for only the following three national markets, just under 40 percent months, but a third had orders that would sold locally and in nearby towns, and about keep them busv for the next six. Large in- 10 percent sold elsewhere in Central dustrial firms producing metal and plastic Europe. Only 2 percent of managers re- products more frequently had long-term ported that thev faced any regulations con- orders; small firms making consumer goods cerning distribution. were likely to have short-term work plans. A quarter of managers said they had Again, mass privatization firms were less no competitors in their main markets; 40 likely to have confirmed orders for the fu- percent had fewer than ten. The slow de- ture than were PLC firms. velopment of competitive markets was a Most enterprises had easy access to in- bit surprising given that most firms were termediate inputs. Access was maintained, producing basic consumer and intermedi- The main barrier to in most cases, by the continued presence of ate goods where competition typically is enterin export the former network of suppliers (many now greatest. The highest levels of competi- privatized), although some managers com- tion were reported by managers in trans- markets was lack of plained that markets had become chaotic port and furniture companies. Among information about -with former suppliers changing product firms that did have competitors, the main potential trading lines and charging monopoly prices. One source of competition was other large, producer described a situation where a mo- private firms-again confirming the de- partners, the nopolv scrap metal supplier cut off all degree to which the economy had been pri- structure of liveries for a month to increase prices. vatized. The fact that only 11 percent of demand in foreign Of the 20 percent of managers who had managers cited state enterprises as their problems obtaining needed inputs, three- main competitors dispels notions that the markets, and quarters relied mainly on suppLiers in other existing state sector is crowding out pri- required product CIS countries. These firms typically tied up vate firms or at least the newly privatized large amounts of scarce working capital for sector. The almost nonexistent level of long periods as they waited for slow and er- foreign penetration was evident in that packaging. ratic deliveries. They described chronic dif- only 2 percent of managers said that their ficulties in dealing with bureaucratic and main competitors were imports, and none unpredictable cross-republic quotas, cus- named joint ventures or foreign firms as toms regulations, pavment systems, and competitors. transport arrangements. Just under half of firms were exporting Just under two-thirds of managers cited some production (20 percent on average). other private (mainly privatized) firms as Two-thirds of those who exported sold di- their main customers. State enterprises and rectly to buyers; the remaining third sold to newlv-privatized state companies offered intermediaries. Most exports were sold in large contracts and the built-in advantages Ukraine and Belarus, with only a few firms of an existing personal network, but they selLing in foreign markets outside of CIS were much slower to pay for goods and ser- countries. vices. Private firms paid their bills faster, The main barrier to entering export but orders were too small to sustain sample markets was lack of information about po- producers, and large orders were increas- tential trading partners, the structure of de- ingly hard to come by Enterprises likely to mand in foreign markets, and required sell mainly to other private firms tended to product quality and packaging. Many felt be smaller, produce consumer goods (such that locating a foreign partner who could as clothing and furniture), and to be former inject capital and link the firm with appro- leaseholds. Those who relied on state en- priate markets was a prerequisite for suc- terprises as their main customers were of- cessful exporting. Managers also described ten large, mass privatization firms that formidable logistical problems, including manufactured industrial inputs. payments problems, high export taxes, dif- Firms' primary markets were in Russia ficulties with export licenses, and excessive and there were few problems with distribu- paperwork and fees. Without capital to up-

NEMXIi-PR1VA-nZED ENTFRI'RThES: A SuRvTE 177

grade equipment and thereby improve since privatization.Many managerssponta- product quality, most felt unable to com- neouslyrevised this question by savingthat pete in foreign markets. Others com- recent changes in their firms resulted more plained about the share of profits taken by from the economic crisis in Russia-most trading companies that could market their notably the recession that is under way- products abroad. One manager said that than from the shift in ownership. Even so, the overvalued ruble meant that he could the most important changes were: get better prices on the domestic market; On average, 90 percent of enterprise another cited quotas and tariffs in foreign ownership had been transferred to pri- markets. vate hands through privatization pro- Almostall managersequated the state of grams (either MPP or legal buyouts by their technology with the state of equip- leaseholds); Forty-seven percent ment. Virtuallynone showed an awareness * Ninety-five percent of firms owned all of firms huad of technology issues such as information their buildings and equipment, and al- svstemsand the organizationof production. most 40 percent sold off some redun- changed their mix Rather, they focused on the need for better dant equipment; of products in the equipment that would produce higher qual- * Fiftv-five of the ninety-two firms sur- past 12 months, itytoutput. Some production equipment ap- veyed laid off employees (on average, peared adequate, but much appeared 10 percent of their current labor force), typically starting up outdated and run down. Furniture makers and fourteen hired new employees (on production of new needed higher precision machines and bet- average, 8 percent of their labor force); products, upgrading ter quality finishing equipment. Textile pro- * Forty-seven percent of firms had quality.ducers needed new knitting and weaving changed their mix of products in the p roduct quality, machines. Plastics manufacturers were past 12 months, typicallv starting up and introducing aware that their production equipment was production of new products, upgrading trade and service inadequate to produce higher-tech plastics. product qualitv, and introducing trade MNlostmanagers seemed fully aware of and serviceactivities; activities... environmental concerns associated with Seventy-sevenpercent took (and pre- their factories, but actions to ameliorate sumablvrepaid) short-term loansin the problems were seldom seen. Many report- previous 12 months, almost all from ed that they were subject to environmental commercial banks at going interest inspections by government officials. The rates of 180 to 220 percent a year; most frequentlyobserved problem was tox- * Fifty-seven percent of managers ic fumes that affected workers. Some man- changed the waysthey motivateand re- agers said they had improvedventilation in wvardworkers-typically linkingperfor- their factories, but most admitted that mea- mance with payment and differentiating sures had been insufficient. A number of more between skilled and unskilled managers said that officialsroutinely mea- workers; sure the level of pollutants in nearby water Forty-fivepercent o(firms made invest- sources and fine them if levels are too high, ments in other firms; almost 20 percent but most said they could not afford to build invested in three or more other firms; reclamation or water purification plants to Fiftv-eightpercent of firmsrelied on oth- solvethe problem.The impressionwas that er private firms (some privatizedformer environmental assessmentsprobably would customersand somenew) as primarycus- reveal fairly serious problems with pollu- tomers rather than on the state sector. tion and worker safety in many firms. Despite the magnitude of aggregate changes undertaken over the previous 12 Strategies for the future months, firm-levelresponse was highlyhet- erogeneous. Firms fall into three groups- Firni-levelchAnge those who resisted making changes, those who made marginal changes, and those Entrepreneurs were asked to identify \vho embraced the new environment and changes that had taken place in their firms reshaped enterprises as quicklvas possible.

178 RUsSIA: CREA1iNG PRIVATI ENIERPRISES AND EFFICIENI NLMRKETS

The first group (25 to 30 percent of except to other workers and then only with firms) was clinging to the status quo, pro- permission of the coHective. In another 46 ducing the same products for the same cus- percent of firms, shareholders were free to tomers, and struggling to hold on to their sell shares but none had done so. Share- labor force in the face of falling orders and holders sold shares in only 20 percent of increasingly inadequate working capital. firms, and most reportedly sold few. Except for firms with monopoly power, Boards of directors had been established these firms were among the weakest firms in in most firms, but were dominated by man- the sample. The second group (50 to 60 per- agers. Formal membership typically was still cent of firms) typically made small changes the one prescribed in the corporatization in their product mix in the direction of con- legislation-that is, one representative each sumer demand, laid off small numbers of from managers, workers, the property fund, workers, ventured into new markets on a and the municipal government. New corpo- Boards met once or limited basis, and began to think about di- rate charters, to which enterprises were en- twice a year to versification. The third group (15 to 25 per- tided following privatization, had not been .nd cent) were headed by the most competent drawn up. Boards met once or twice a year consider questions managers in the sample, and they typically to consider questions concerning issuance concerning issuiance started up new product lines, downsized, of dividends and management of social as- of dividends and and introduced flexible production. sets, but they appeared to have litde or no involvement in decisions affecting firms' management of Corporategovernance operations. social assets, but

Without question, corporate governance of Strategiesfor the future they appearedto enterprises was in the hands of managers. have little or no W'hen queried about how the new ownership Managers' priorities. Managers were involvement in structure was affecting the decisionmaking asked to describe their strategies and pri- decisions affecting process, most managers exhibited no qualms orities for the near term. A common an- about stating they were fully in charge. swer was "to survive." When pressed, a firms' operations. Indeed, an implicit bargain wherein workers' third said that investment in new equip- rights to participate in a selected, narrow ment and a quarter said that finding new range of decisions and to receive dividends in markets was their first priority. More for- exchange for managers' taking responsibility ward-looking managers in the sample also for keeping as many people employed as pos- tended to include improving financial sible had been acknowledged. Maintenance management and marketing skills and en- of the labor force and delivery of social ser- tering export markets. vices was felt as an ethical and weighty re- Managers' emphasis on procurement of sponsibility by most managers. new equipment was difficult to evaluate. Most managers fulfilled the formal re- Most managers showed little awareness that quirements regarding governance that they could bring about substantial improve- came with privatization. Almost 90 percent ments in production other than through held shareholders meetings (usually sched- new equipment. Indeed, strategies for in- uled annually), and over 90 percent had creasing production efficiency using current shareholder registers. Many managers re- capital stock were seldom raised. Strategies ported that shareholders made important such as improving the lay-out of production, decisions at the shareholders' meetings, inventory management, product design, most focusing on the disposition of social and workers' skills took a back seat to ac- assets. Only about a third issued share cer- quisition of new equipment. On the other tificates and paid dividends; most reported hand, some enterprises were at a competi- they would soon do both. tive disadvantage using outdated machin- Few shares had been traded. In a third ery, and their ability to compete depended of firms-almost all leaseholds that con- critically on acquiring new equipment. verted to closed joint stock companies- Mlanagers' emphasis on developing new workers were not allowed to sell shares products and finding new markets reflect-

NEWLY-PRRI'AIZEDENTERPRISES: A SURVEY 179

ed falling orders from established cus- foreign exchange risk, and most managers tomers. This was the first priority for large seemed to understand what was involved. firms as they struggled to maintain working Many managers said that thev would have capital and labor forces in the face of falling an interest in such loans, but would have to orders from their old customers. But as understand the terms thoroughly before seen elsewhere in Eastern and Central making a commitment. European enterprises, managers often were stymied without the necessary market Technicalassistance. Some managers said information or marketing skills. they had no need for technical assistance (TA). Most were unclear about what kinds Externdl financing. When asked how of options might be available. The first pri- they planned to finance future investment, ority among those who acknowledged TA ... managers stressed 43 percent of managers said that they needs was for assistance with marketing, that most useful would use business profits; 25 percent said followed by technology and financial man- thev would take long-term loans from agement. Many explained that they had assistance avoids banks when available; and 21 percent said never before needed to market products conceptual realms that they would rely on equity from foreign and that the services used in effective mar- and focuses on investors. The fact that most managers as- keting (advertising, telecommunications, sumed they would be able to finance in- marketing firms, and so on) were totally conveying practical, vestment costs from business profits lacking in Russia. Assistance in financial how-to information reflected their doubts about accessing ex- management also seemed to be a priority. in key areas of ternal finance and an optimism about the Survival of many enterprises depended on future of the Russian economy and of their their ability to diversify and in the view of busilness enterprises. Most managers felt their busi- researchers, manv could have used assis- management. nesses would perform better once the econ- tance in strategic planning before invest- omy stabilized. Many spoke readily about ments in new product areas were made. the desirability of locating a foreign partner Managers were divided as to the best and preference for equity financing, but format for technical assistance. A third few had made tangible steps mainly be- each thought that TA programs should be cause they did not know how to proceed. packaged as short-term consultancies, Demand for external finance was diffi- study tours abroad, and short courses. cult to assess. Managers clearlv had access Almost all who wanted consultants wanted to and made use of short-term, ruble cred- foreign consultants, with few requests for its from commercial banks. When queried Russian experts. Views were mixed on the about potential demand for long-term subject of study tours. Some managers loans, most managers indicated they would were clear that they would benefit greatly have numerous uses for investment credits from actually seeing foreign firms in sirni- but, with few exceptions, thev were unwill- lar industries at work, gnd others dismissed ing to take on the risks associated with long- this approach by saying that conditions in term loans in rubles at current domestic Russia were sufficiently different to render interest rates (even if available). The gener- visits abroad irrelevant. al impression was that most managers were There was little disagreement about the risk averse as regards taking on debt-even level at which technical assistance should be though debt to equitv ratios were low and delivered or about the kinds of people man- ownership of buildings and equipment pro- agers felt were best-suited to deliver. vided enterprises with collateral. Without exception, managers stressed that The single credit package in which man- most useful assistance avoids conceptual agers did express an interest was mid-term realms and focuses on conveving practical, (2 to 3 years) hard-currency loans. Many in- how-to information in key areas of business quired about potential interest rates of management. Along these lines, managers hard-currency loans and how the foreign recommended that those who deliver TA exchange risk might be handled. Inter- programs should be drawn from the ranks viewers explained the basics of assuming of private, international consultants, prefer-

I C) RussiA: CREATINGPRIATE ENAERPRISES AND EFFICIENTMARKETS

ably people with personal backgrounds in had a few yvearsheadstart as partially private firms with like activities. Many thought that businesses. Lack of investment capital and international assistance organizations and chronic difficulties reading an unstable mar- the Russian government should take re- ket xvere their primarv constraints. sponsibiitv for the organization of such pro- A quarter of firms are likely to fail, bar- grams-but not the actual delivery ring substantial restructuring and large infu- When asked whether thev would be sions of capital. They were operating at a willing to pay part of the costs of technical loss-unable to find solvent customers, cut assistance for their firms, most managers costs, downsize, and reorient their product responded affirmativelv. Most, however, lines toward profitable markets. Of the medi- said that they would only do so if they felt um-size and large firms that came through the price was reasonable and the assistance the mass privatization program, most were was of the highest quality. This qualification associated with heavy industry and almost all Staying afloat will reflected a general wariness among many were highlv dependent on the declining state depend critically on managers about the true value of consul- sector for their sales. Notable exceptions to tancies and training programs. this characterization were found among a series of factors, some large firms that were able to exploit mo- such as firms' Conclusions nopolv positions and inelasticities of demand ability to maintain for their products. Performance By implication, the most fruitful strategy adequate working might be to focus assistance efforts on the capital; managers Prospects for enterprises included in this large numbers of firms that are "surviving," skills in making survev were mixed. About half of the enter- under the assumption that the strongest en- prises were "surviving," struggling to find terprises will achieve success without assis- strategically correct solvent customers and to cover their oper- tance and in spite of extemal difficulties, and choices abouit pro- ating costs. Staving afloat will depend criti- the weakest firms are unlikely to survive ducts and markets; callv on a series of factors, such as firms' even with assistance. the degree of free- abilitv to maintain adequate working capital; managers' skills in making strategically Restructuring dom managers can correct choices about products and mar- exercise in down- kets; the degree of freedom managerscan Seriousrestructuring had yetto beginin most exercisein downsizingin areas such as labor firms,despite the relativelyhigh percentages sizing In areas such and social assets; the speed with which ex- of enterprises that laid off workers and as labor and social temal competition strikes; and in the longer changed their mix of products. Most of these assets; the speed term, the availabilityof capital for restruc- changeswere marginaland probablvare in- turing. Underpinning all of these factors is sufficient for the mid- to long-term. Obvious with which external the rate at which the economy as a whole needs for restructuring to reduce expendi- competition strikes; stabilizes. Each step deeper into recession tures included downsizing of operations, and in the longer diminishes these firms' chances of survival adoption of cost-cutting measures, and elim- as does each percentage point of inflation. ination of nonviable activities in favor of term, the avail- About a quarter of firms showed promising ones. Restructuring for competi- ability of capital for promise and were easy to spot. All were cov- tiveness will call for strategic re-orientation in restructuring. ering their costs and many were operating at the direction of consumer demand, develop- a profit. Their managers were making strate- ment of marketing capabilities, and attention gic shifts in their operations, cutting back on to environmental pollution problems. When loss-making activities and expanding into foreign competition enters the marketplace, profitable private-sector markets where most enterprises will be faced with the addi- they were less dogged by payments prob- tional necessity of modernizing their plants, lems. These firms mainly produced goods including upgrading technologies. and services for consumers, and their man- Some enterprises can and will restruc- agers were focusing on improving product ture on their own as the market settles and qualitv These better firms were found more capital becomes available. Others will need frequently among leasehold companies that incentives and financial and technical sup-

NFEWLY-PIVAMZEDENTERPRISES: A St R\mE 181

port. A third group should be allowed to fail nominal rates were exorbitant and that without attempts to resuscitate them. The commitment to long-term debt payment challengefor those involvedin deliveringre- was untenable given the uncertain future. structuring services will be to distinguish The exception might be medium-term clearlybetween the three tvpes of enterpris- loans (2 to 3 years) denominated in foreign es. Asnoted in this report, researchers locat- currency Managers were interested in ed largenumbers of managerswho appeared loans of this sort because interest rates well-qualifiedfor their jobs and receptive to would be fixed(even though they would as- new approaches-a finding that bodes well sume the foreign exchange risk) and be- for implementationof assistance programs. cause the term is long enough to finance some capitalinvestments but not so long as Labor to incur unacceptablerisk. Over time, markets i.n eniterprise shares A significantnew increasein unemployment Governance is coming, not onlv from business failure w'ill develop, and attrition, but also from financially- Private corporate behavior is beginning, corporate takeovers induced workforce reductions. Forty per- but true shareholdercontrol is still nascent. and strategic invest- cent of firmssaw themselves as overstaffed, Shareholder meetings had been initiated on average by 17 percent. Thirty-fiveper- and boards of directors constituted, but it ments will ensue, cent of managersreported they were unable was clear that managers exercised control board management to cover their operating costs, a large share over almost all aspects of enterprises. The will chanige,and of which goes for salaries. Pressures to re- few areas where managers may not have structure and establish firm-level viability dominated included the disposition of so- managerial willengender tremendous conflict for the cial assetsand payment of dividends-both behavior tvill manymanagers who have a strong sense of left for workers to decide in many firms. It respond to share- responsibilityfor their employees. Creating will take time for shareholders to begin to job opportunitiesfor those laid off may be exercisetheir power and see the connection holder pressure. central to successful restructuring efforts, between corporate performance and divi- giventhe strong obligationmanagers feel to dend payment. Over time, markets in en- their employees. terprise shares will develop, corporate A fledglinglabor market was observed takeoversand strategicinvestments will en- in the growing discrimination between sue, board management will change, and skilled and unskilled workers, and in re- managerialbehavior willrespond to share- ported movementof the most skilledwork- holder pressure. ers to private firms of their own. Linked with these developments, greater social Socialassets tension can be expected as less-skilled workers lose jobs and skilled workers' Socialservices, includipg housing and asso- salaries increasinglylag. Social safety nets ciated utilities,medical and educational ser- and measure to facilitate labor mobilityare vices, and vacationfacilities were provided crucial,and some firmsmay need assistance by most firms to significant numbers of in labor restructuring. workers.Continued provisionof social services,mainly housing and utilities,became a Investment large financialburden for many managers, but few alternativeswere apparent. In some MIanagerswere anxious to obtain financing cases, ownership of some social assets re- for new investment, but few were willingto verted to municipalgovernments at the time take the risk under current conditions. of privatization,but enterprises generally Moosthad taken short-term loans to cover continuedto pay large sums for utilitiesand working capital shortfalls, but few had tak- maintenancecosts, particularlyfor housing. en or would take long-term loans (which A smallnumber of enterprises found so- were not available in any case). Despite lutions to some problems associated with negative interest rates, managers felt that socialassets, such as privatizingsome hous-

IS2 RussiA:CREAnNG PRIVATEENTERPRISES AND EFFICIENT MARKETS ing and instituting worker-ownedkinder- all expressed doubts as to its usefulness. gartens. Most need assistance sorting Areas where assistance was requested in- through the knotty social and financial cluded marketing, general management, problems associatedwith divestiture of so- financial management, and technology. cial assets. Improvements in housing and The preference, voiced by virtually all who labor markets could have positiveeffects in requested technical assistance, was for ex- this area. perienced Westerners with product-specific knowledge and a practical, "how-to" Technicalassistance approach. Most were willingto pay part of the costs so long as the assistance offered Most managers needed and wanted tech- was of high quality and useful for their nical assistance. At the same time, almost purposes.

NEWLY-PRIVATIZEDENTERPRISES: A SURVEY 183

PartFour

THE EMERGING PRIVATESECTOR: CONSTRAINTSAND REGULATIONS

CI-L4PTPER14

Constraints to Private Enterprise in the FSU: Approach and Application to Russia Marie Sheppard

The purpose of this paper is to describe the compliance if conditions continue to make constraints that restrict the formation and it more rational for entrepreneurs to renege growth of private enterprise in Russia and on commitments and renegotiate at every to suggest an approach for alleviatingthem. step in the process. Such laws are only ef- When designing a strategy for private-sec- fective if accompanied by other conditions, tor development (PSD), a prerequisite is to (such as penalties, enforcement practicesor identify binding constraints. A PSD strate- ethical codes of conduct) that render com- gy also requires some method for deciding pliance to a rational business decision. which constraints to target and what types of remedial programs are likelyto be most Propertyand ownership cost-effective. This paper is organized into four sec- Vague owvnership and property rights in tions. The first reviews the recent develop- Russia increase risk, impede investment, ment of private business in Russia. The next and limit economic growth in both the pri- section proposes a typology of business con- vate and public sectors. During the Imperial straints. The third section focuses on the period, the tsar or tsarina owned everything most binding constraints to Russian busi- and his or her approval was required for all nesses. The final section describes an ap- contracts. Proper-tv rights began to develop proach for alleviating constraints to business before the revolution, but following it, pri- development and applies this approach to vate property was virtuallv abolished. This some binding constraints in Russia. did not, however, equate to making enterprises property of the state. State enterpris- The context es were legal entities that controlled assets, but the right to dispose of these assets and Count Witte, a Russian Imperial Prime other concrete resources was never clearly Minister at the end of the last centurv, wrote defined. This left enterprise directors in a that his country was different from the rest difficult position; even actions that clearly of the world. Russians had "no sense of increased efficiency could be used by a high- propertv or legality " While the uncertainty er political authoritv as an example of mis- regarding property rights is pre-revolution- use of state property Hence, enterprise ary, the Soviet period reinforced it by abol- directors had a disincentive to make re- ishing most forms of private propertv. source-related decisions that might result in Despite the collapse of the Party ownership productivity gains. and property rights remain ambiguous and To answer this dilemma and increase there is still no market infrastructure and productivity, perestroika introduced the few incentives (or penalties) which encour- first non-state enterprises. Until 1987, the age market-oriented behavior. only legal forms of economic activity were Simply importing missing elements of a state enterprises, collective farms, and agri- market system will have limited effect if cultural production on family plots (usually there is no institutional infrastructure to less than 1 hectare). Gorbachev introduced support them. A sound body of contract law, two new management systems-coopera- for instance, will not lead to contractual tives (in 1988) and leases. Cooperatives

CONS IRMNTS To PRIVAII ENTrERImISEIN IIE FSU: APPROACH AND APPI.(.ATION TO RuSSLR 187

were the firstlegal non-state enterprise, and cial forces intertwined into a stable state all kinds of entrepreneurs flocked to regis- system that looked after each member of ter their businessesas "cooperatives". the society and provided a strong sense of The legal foundation for the current en- security. terprise structures was essentiallv complet- The collapse of this system invokes ed by 1990, when it became possible to have ambivalent reactions. NIarket reforms have a 100 percent privately owned business.' created countless opportunities for entrepre- During this same period, market liberaliza- neurs who are providing services and better tion began. Thus Perestroika increased the quality goods. They are quick to capitalize on autonomy of the public sector as well as op- opportunities created bv the transition portunities for the private sector. process. Exploiting temporary features such Reforms, however, focused more on as gaps between state and market prices Tellingly, Russians ownership than on property rights. So far, (complemented by the fluid legal and regu- often refer to the while propertv can be owned, it can seldom latory environment) creates huge arbitrage be considered secure. Most enterprises rents and enables business people to gener- private sector as the (stateor private) possess property titles that ate vast profits in very short periods of time.2 nonstate sector. are less than absolute. On the other hand, market-driven Uncertainty surrounding property forces cannot immediately fill gaps left by rights is exacerbated by the political situa- the retreat of the state system. Individuals tion. The collapse of the Soviet and com- fear an immediate worsening of livng con- munist systems created a power vacuum ditions, and not being able to afford the that has largely been filled by local govern- most important services (housing, health, ments. The distribution of power varies and education). It is not surprising that widely across and within oblasts, and this most of the population continues to depend lavering of jurisdictions (often with over- on the old system for jobs, along with the lapping mandates) creates confusion, am- package of housing, goods, and services. biguity, and opportunism amongst both Most Russian families have ties to both officials and entrepreneurs. the state and nonstate sectors, with at least While private enterprises appear more one member moonlighting or engaged in autonomous with regard to property than nonstate economic activity.Official jobs are state enterprises, there is ample opportuni- kept to secure housing, goods, and services, tv for outsiders to meddle in their opera- but many people earn more money in the tions. Leasing arrangements (primarily of non-state sector. Thus an engineer paints premises) and continuing control over apartments on weekends, a research scien- sources of supply (despite some apparent tist dabbles in a small travel company, and monetarization) guarantee that the direc- an accountant at a state enterprise keeps Table14.1 Russianprivate tive features of the Soviet system continue the books for small companies. Because enterprisein mid-1993 to function. Indeed, business people con- these peoplekeeptheir jobs in the state sec- Number of tinue to depend on it, and this reinforces tor, employment figures are relatively sta- Ownership structure companies the poNverof the old system. Entrepreneurs ble. But the bulk of their income may be Partnerships 440,000 will not be wiling to break these links until generated from private activity. Individualprivate there is an alternative svstem for resource enterprise 220,000 allocation-one in which property rights The private sector Cooperatives 165,000 Jointstock companies 110,000 are clearly defined and enforced. Associations,consortia 15,000 As of mid-1993, the official non-state sec- Total 950,000 Institutions and attitzudes tor accounted for roughly a tenth of the Note,These figures nclude those com- economy tn resources and production. panies that have been privatized. Tellingly,Russians often refer to the private Roughly 950,000 new enterprises had been partnerssoandtndvldual privateenter- sector as the nonstate sector. From the registered (table 14.1). Though imprecise, nies) reflect independent start-ups and 1920s to the 1980s, important resources these figures indicate some growth in pri- small-scaleprivatization Joint stock companiesinclude firms privat zed under (food, housing, health, education, and vate economic activity and this reflects the the masscrivatization program. work) were allocated through top-down de- impact of privatization. But, the pace of 1993 cisionmaking. Economic, political, and so- change is not enough to avoid the threat of

188 RussiA: CREATINGPRIVATE ENTERPRISES AND EFFICIENT NMARKETS

serious social disruption should mass un- ing and margins are squeezed. The other is emplovment materialize. Nor is it sufficient the rent seeking opportunist, cashing in on to compensate for the drop in productivity connections and making a quick ruble while in the state sector. the opportunity lasts; once "rents" are no WYhilean increasing number of Russian longer there to be captured, many of these businesses are wholly private, their daily traders will disappear. operations seldom reflect this.' Commer- The second group is equally quick to cial enterprises are dependent on state en- pounce on cash-rich opportunities, but titles as customers and suppliers, but that these entrepreneurs are using cash-flow dependence varies bv ownership type and from trading to build an asset base. Manu- by line of business. Purely private compa- facturing profits are volatile and are driven nies (26 percent) depend less on the state by value added and by imbalances in prices than do other types of companies (47 per- of input/output markets. The latter is a While an increasing cent). The greatest dependence is among transitionary feature that creates both ob- share of Russian manufacturers; 60 percent declared them- stacles and opportunities for manufactur- selves "largely dependent" for supplies. ers. Valuable assets can be obtained from businesses is wholly The state sector wields tight control state enterprises and used to build manu- private, their daily over rubles, resources, and information. facturing capacity for the future. operations seldom Allocation of these resources is highly de- For instance, a common phenomenon is tis centralized, but depends on individuals an imbalance between the cost of raw mate- reflect this. scattered throughout government and rials-world market-and the price for across state-owned enterprises. which finished goods can be sold-local lev- As the old system crumbles, opportuni- el-that makes manufacturing seem like a ties to capture value abound. In fact, a losing proposition. Many entrepreneurs in- unique feature of the transition period is novate around this constraint by adopting that these opportunities (usuallv in trading) complicated resource reallocation schemes far outnumber those for value creation. with state enterprises. In essence, the private There is a tendencv amongst Russians enterprise purchases inputs from state en- to lump this "army of speculators" into a terprises at subsidized prices, some portion single category that can then be castigated of which is in cash. The subsidies received by for reaping benefits from Russia's hardship. state enterprises are only in credit, and be- In reality, many of these entrepreneurs are cause state-owned enterprises (SOEs) can- providing a useful function in commerce, not survive without cash, the SOE forgoes manufacturing or both. These business the potential profit it could theoretically people share one trait that is common make (by selling at a market price) in order amongst entrepreneurs worldwide: a desire to receive cash. The private trader then col- for independence. Strategies for achieving lects the difference between the subsidized that independence fall into two general cat- price and the market price. If the company egories: entrepreneurs for whom trading is uses these inputs to manufacture a product, their end business and entrepreneurs that their margin might be squeezed, but they use trade as a means to accumulate capital, will be able to produce goods-something market knowledge and other resources the company without access to the subsi- needed to build a sustainable production or dized inputs cannot do at all. service-oriented business. A/lost companies, no matter the size, en- Entrepreneurs in both categories are gage in several activities simultaneously One quick to exploit business opportunities cre- characteristic of the transitional environ- ated by the transition; the difference lies in ment is the speed with which business op- their long term strategies. While both groups portunities emerge and evaporate. A use trade to generate cash-flow, for one common coping strategy is diversification. group, this is enough. Within this first group Most companies perform a combination of of traders, there are two subcategories. One manufacturing, services and trading. By is learning commerce and will continue to maintaining a flexible strategy, entrepre- trade long after the market starts function- neurs try to keep enough of a presence to

CoUN\RAI,NTS TO PRWRAkTLENTERPRISE IN THE FSU: APPROACH AND APPLICATION TO RUssLu 189

build on shouldan opportunityopen up and most start up businessesdo) or through fi- minimize exposure to anv single activity. nancial institutions (common for estab- W'hilethis flexiblestrategy helps firmsto sur- lished companies) depends on both the vive,it also inhibits investment and growth. state of the financial markets and on the There are no black and white distinctions manager's tenacity and performance. betweenthe state and private sectors.There A business can innovate around svs- are degreesof "stateness"and "privateness" temic constraints, but it cannot change in allventures. The task is to encouragebusi- them. For example,entrepreneurs can ex- nessesand individualsto behave increasing- ploit tax loopholes, and so, reduce taxes lv in a market-orientedmanner. To do this, payable, but government is the entitv re- conditionsmust be created and supported sponsible for setting rates and rules. where market behasior is possibleand ratio- In environmentssuch as Russia's,where nal-bv removing constraints, creating in- systemicrisks abound, entrepreneurs tend centives,and providingmeans. to increase the range of business activities (and reduce the depth) to manage expo- Systemic versus operational constraints sure. In many market economies, governments strive to improve the business Constraintsinhibit economic activityby in- environment bv targeting systemic con- creasing (perceived)costs of starting or op- straints; the underlvingpremise being that erating a company.They heighten business less systemicrisk will enable entrepreneurs risk and are a disincentive to entrepreneur- to take on more operational risk, which ship and investment. The greater the con- yields higher returns. Twocommon strate- straints, the slower the rate of enterprise gies are to reduce the real cost (lower infla- formation, investment, and growth. tion, streamlinedregistration, efficient and There are two broad types of con- equitable arbitration mechanisms and so straints-systemic and operational.The en- on), and to maintain a constant legal, regu- trepreneur has no control over systemic latory,and macro environment. constraints,but has some capacity to control operating constraints. Product quality Constraints to Russian enterprise can be improved through management decisions,such as better inputs or processing Of all the problems faced by Russian busi- techniques.The constraints can be thought nesses, systemic constraints are the most of as a continuum, with systemicconstraints acute. Foremostis the volatilepolitical and at one end and operational constraints at economic environment, particularlv infla- the other. While some constraints can be tion (figure 14.1). A businessman from clearlv positioned at either end, others can Perm encapsulated the general sentiment, be a little of both. Obtaining capital, "Inflation, ruble instability, and unpre- whether through savings and friends (as dictable price rises all lead to the absence of any idea of whattomorrow brings and an in- Figure14.1 Constraintsto privatesector abilitvto plan for the future." development(a continuum) Regulator- constraints also rank high and the most costlvis tax~ation.Others are sources of commercial property, access to information, dispute resolution, and business registration. Interestingly, few entrepreneurs consider lack of management Ei g0 skills a constraint. 2 a 3 - 17 c c What follows is a brief description of iA p} .X o E the priority constraints as perceived by o 0o cl E .n E 0 Russian entrepreneurs. These constraints v=G X .- E v o cJ include taxation, sources of finance, com- _a cz su m c E - mercial propertv,information, dispute res- 4ii 11111 mm Einiiiiniiiini IE olution and business registration.

190 RussLA: CREATING PRIVATEENTRPRISES AND EFFICIENT MARKETS

Taxation November 1, 1992. Although it was not enacted until February 1, 1993, the authorities Russia's tax system is a major impediment required that companies pay the tax from to business growth and to transparency of November 1. Those companies that pro- the private sector. Problems are recog- tested were fined until they conformed. nized by both the private and public sec- The second example is the mechanism tors. For businesses, the cost of the tax used to collect overdue taxes across the system includes rubles paid for taxes and countrv. At the tax inspector's request, fines for "services" rendered to appease tax au- for late payment are automatically with- thorities; time taken to understand the drawn from a company's bank account complex system; and the uncertainty gen- without even informing the company. This erated by constantly changing laws and in- not only allows the government to impinge consistent administration. Tax authorities on property rights, but encourages ex- The average Russian themselves are overwhelmed by the com- ploitative behavior of government officials. company must plexity of the system. Government receives only a fraction of its dues because of am- Informationgaps. Most businesses lack comply with biguities in the regulations and increased the information they need to comply with fourteen federal, informal activitv. the tax regulations. So do some tax author- four oblast and ities. For example, when some business Tax legislation.Tax regulations are cum- people from Tomsk asked for clarification up to twenty-two bersome and confusing. The average Russian on how to comply with a recent change in local taxes. company must comply with fourteen federal, tax codes, local authorities were at a loss to four oblast, and up to twentv-two local taxes. provide answers. While admitting that they The number of taxes is constandv changing, did not understand the new tax regulation, many new taxes are applied retroactively and the tax authorities insisted that businesses reporting procedures are seldom standard- comply and fined those that refused. ized. This can also result in duplication. There is no streamlined communica- Witness the profits tax (at 32 percent) and tion between the federal, oblast, and mu- the recendy recommended enterprise in- nicipal tax authorities or between the come tax. Indeed, taxes add up to more than authorities and businesses. Due to the two-thirds of profits. complexity and malleability of the tax code, it is often impossible for businesses Tax administration. The driving forces to independently ascertain whether they behind the tax administration, which is in- are complying with the law. Many respon- efficient and frequently regarded as preda- dents claimed that tax authorities monop- torv, seem to be the numerous and varied olize what information they have, and this locations of tax authorities and the control enables them to interpret ambiguities to systems that undermine those authorities. their own advantage. No public body is ac- Tax authorities lack accountability and cre- countable for providing taxation informa- dibility. Few have training and most do not tion to businesses on a timely basis, and possess the information needed to admin- while some tax consultants are taking on ister taxes according to the law. The wide- this role, few businesses are willing or able spread complaints of incompetent officials to purchase their services. and lack of integrity simply underlines this broader problem. Impact. The dilemma facing the Russian Tax authorities, moreover, are perceived government is how to increase tax revenue as having broad discretionary powers, which and simultaneously encourage investment. they frequently use. It is necessarv however To a large extent, it seems that Russia has to distinguish between sheer exploitative adopted a short-term strategy of generating behavior of individuals and the blunt in- revenue by hiking up tax rates. While there struments the system requires them to use. have been some attempts to use tax policy Take two examples, tax inspectors in Tomsk to stimulate sectoral development, most of expected a Federal tax to be introduced on the tax breaks have been clumsy, conflict-

CONSTRAINTS 10 PRnIAIT EN-ERPRIbE IN ITHEFSU: APPROACHf \ND A]''LU AnION T( RuSSiA 191

ing, and unattractive. Just when it is critical Sourcesof nance to take a long-term strategv that encourages business formation, fosters investment, Entrepreneurs across the board were quick and broadens the tax base, the government to articulate their financingconstraints, and appears to be choking business develop- the list of finance related problems was ex- ment through high tax rates, a complicated tensive-ranging from the cost of credit, to code, and abusive enforcement. corrupt bankers. However, when ranked The net effect is that the tax base is against other constraints, finance was not eroded and fraud is rampant. Many enter- the highest priority. prises evade taxes or remain informal. Whereas most western start-ups are fi- Some "companies"do not register, have no nanced from personal savings,in Russiain- official bank account, and conduct all flation has eroded this option. The transactions in cash. This is not limited to dominant source of funds is trading activity, the kiosk traders or government stores which generated more than 60 percent of which now have "commercial sections" total financing (figure 14.2).As the market running similar operations. Other "compa- develops and marginsare squeezed,howev- nies" appear and disappear quickly,usually er, this will become less viable. bv agreement with the authorities that are supposed to control them. This has given The banking system. From slow pay- rise to the cliche, "Paying taxes is stupid, ments to poor administration,the banking but paying bribes is vital." system is rife with problems. In fact, care- Most companiesuse legaland semi-legal fully selecting a bank seems to be the most means to avoid taxes. Some also inform on efficient way firmscan alleviatebank-relat- competitorsto tax authorities.Avoidance ex- ed constraints and sourcingcredit. The pri- tends right through the economy "Under- mary reason for this is institutional. ground" production companies have been Government uses banks to control private operating for years. Most started to become businesses. The 1992 decree, for instance, legal.but were driven back underground by obliges all enterprises to deposit money at the tax regime. Now, they employ various a bank and use that bank for all transac- means to evade taxes, includingcreating un- tions (unless previously agreed with the profitable subsidiaries and false charitable bank). Government can also withdraw tax funds. Government experts estimatethe un- fines from a company's bank account and delivered revenues at more than a trillion restrict the use of deposits when the client rubles, hamstringing investment programs is considered behind on accounts payable. and fuelinginflation. Because bank managershave much discretion over these matters, the most important criteria in choosing a bank is the Figure14.2 Sourcesof finance:average per firm entrepreneur's relation,hip with bank management and staff.Given the importanceof - Foreign investment(1 %) good banking connections,it is not surpris- Loansfrom friends (11%) ing that entrepreneurs using bank credit /___ /\Bank (1 5%) were more likelyto have been managersof state-owned enterprises (46 percent) and less likely to be women (35 percent). Partner (2%) Promfit(62%) Other (not specified)(4%) Bank finance. Compared to past prac- Suppliercredit (2%) tices (for example, restrictions on multiple Family means (3%) bank accounts), it now seems relatively easy Customercredit (5%) for entrepreneurs to open bank accounts. Personalcapital (5%) Those companies that wanted bank credit appeared able to get it, roughly 41 percent of enterprises in the survey had used bank Based on a 1992 suIvey of eight oblass credit, of these, 34 percent have outstand-

192 RUssIA: CREAI1NG PRIVATEENTFRPRISES AND EFFICIENT MIARKETS

ing loans. Bank credit does not, however,fi- are used as flats instead of shops and shops nance investments in new equipment. are located outside of pedestrian traffic ar- Roughly 24 percent of loan recipients re- eas). Russia's property markets (such as ported up-to-date equipment, less than the thev are) are dominated by the state as 26 percent overall. owner and regulator. As "owners." SOEs Bank financingaverages 15 percent of and local governments are reluctant to sell total financing. Although complaints of property and seem to have little incentive short terms (averaging2 to 3 months) and to do so. Leasing is more common, partic- exorbitant rates (150 to 200 percent) lose ularlyinformal lease arrangementsbetween their force because rates are negativein re- acquaintances. al terms, credit terms are clearly unattractive to most entrepreneurs. Those most Legislation.Current (and lack of) laws interested in credit were existing bank bor- make it difficult for entrepreneurs to find, rowers; 57 percent of bank borrowers plan secure, and use the property they require. to finance expansion with bank credit, As yet, there is no law on private property whereas only 17 percent of non-users do. or land and little economic stimulusfor the So, what type of financeis there demand state to release these rapidly appreciating for? Equity would seem a better fit for the assets. Even where ownership has been average Russian entrepreneur. Cash-flow clarified, control is fragmented. As the would remain untouched, bank red tape chairman of Novosibirsk's property fund avoided, and inflation-related uncertainty says, "the property fund owns the property, reduced. but districts will not provide information about the vacant premises. If any of them Equitv finance. Because relationships become vacant, nobody will let us know, are so crucial to Russian businesses, equity and if an organization collapses, they will partners and cross shareholdings would not get out of the premises they used to seem a natural next step. Russia has no tra- rent." It is hardly surprising that many dition of the independent entrepreneur. premises are underutilized. Most businesses are jointly owned by three to five partners. Entrepreneurs should, Lessors.Landlords range fromoblast and therefore, be more amenable to taking on municipal GKIs and MKIs to technical in- another partner. Formal equitv financing, stitutes and SOEs. The incentives to rent however, is discouraged in the present en- vary among landlords.Some are keen on fa- vironment. There is no established means cilitating "socially valuable" businesses, for investmentin (or exit from) the market. whereas others are only after a kickback. Concerns with contractual performance Landlords across the board saw "no reason limit the potential for mutually acceptable for advertising."Demand for premisesover- partnerships. Not surprisingly,capital mar- whelmsaccessible supply, and no body (pub- kets are underdeveloped, and there are no lic or private) disseminatedinformation on venture capital or investment banks. availablepremises. Instead, this information (spottv though it is) is passed on to the ever Commercialpremises growing circle of "friends" of the property fund; roughly 90 percent of the entrepre- Finding appropriate commercial property neurs found their premisesthrough person- and obtaining secure tenure is "the prob- al connections. Of these, half spent more lem of all problems" for many Russian en- than a year searching. trepreneurs. This reflects the lack of a Rent also varies depending on the goals functioning commercial real estate market, of the landlord and the extent to which as well as legislativeand administrativesup- landlords seek to control the use of their port for it. There is a shortageof retail space property Official agencies, such as the exacerbated by a rigid svstem of property NIKIsand GKIs use similar formulasto de- administration that often misallocates ex- termine rent. Their weightings, however, isting space. (For example, ground floors vary across (and within) oblasts.There is al-

(CONYIA,I.NTS10 PRUVATLENmERPRISE IN THE FSU:APPROACH AND APPLICATE)NTO RUSSIA 193

so a usage fee, which allows landlords to and those that own property have pur- promote or penalize various activities. For chased it through auctions.The only means example, in June 1993 the Voronezh MIM of locatingpremises is through informalre- charged 2,000 rubles per square meter for lationships with officials. One small con- "sociallyvalued" uses (such as retail clothes sulting company has two offices: one at a or manufacturing food) but 3,000-5,000 friend's travelagency and the other at a citv rubles for other purposes (such as retail cig- government building.Another companv is arettes or producing vodka). hidden in a state-owned enterpnrse,using Many government and commercial or- premises (and equipment) in exchange for ganizationssublet property to private firms, channelingfunds (and resources)to the en- and 50 percent of the renters' revenue is terprise's director. While the arrangements taxed by the mayor's office. Businesses vary,the denominators are common-high renting from non-government organiza- cost and low security. tions pay a flat fee, plus goods, services,or a percentage of the firms' revenues. Hotel Information rooms are attractive as offices for two reasons-space and utilities(most importantly, The lack of accessible,accurate information a telephone). The telephones in most hotel is a serious constraint.It increasesthe cost rooms have direct outside lines, and given and uncertaintvof startinga businessor ex- the state of telecommunications,thev are a panding an existing one. Effective collec- valuable service.The tenants' rent includes tion and disseminationdoes not exist. The a fixed ruble rent plus an in-kind compo- cause of this informationgap is deep root- nent (linens, mattresses, or other furniture ed. Under communism, the information as required by the hotel managers). collected was a function of administrative, not market needs, and there were powerful Leases.Rent agreements, whether with incentivesto distort it. The Party sought to government,state-owned enterprises, or pri- regulate and channelinformation, making it vate firms, are usuallyfor one year, but full- availableonlv to a select audience. term tenancy is seldom secure. "Although guaranteesexist on paper,practically they are Informationneeds. Identifving profitable meaningless.Everyone who rents can find business opportunities depends on infor- themselves out of doors at anv moment." mation-knowledge of existing laws and And while arbitration courts exist, they, too, regulations,sources of credit and other in- are "effectivelvuseless." Businesses leasing puts, and markets for outputs as well as premisesand small "privatized"enterprises commercialknow-how. Businesses lack the are also burdened by profile restrictionson most basic information (telephone books the type or volume of goods to be sold or and transportationschedules) and more ad- manufactured,as well as minimumemploy- vanced data (on standards,competitors, po- ment. For each municipality,there is usually tential buyers,and so on). There is no credit a departmentof financeand tax policywhich rating serviceand no reliableway to check controlsthe legitimacyof rightson premises. the history of a potential partner, buyer, or Sanctionsare strict,and, if the propertyis not supplier. Ironically,while a few computer- used for the purposesdesignated, the lessors ized databanks have emerged (on legisla- must pay the citya share of profits. tion and enterprise directories), these are Accordingto the Voronezhoblast MKI, beyond the meansof most private business- many enterprises continue to operate on a es. In most markets,the best source of com- leasehold basis, under which lessees have mercial information is other businesses.In generous buy-out options at the end of the Russia, businesses are so fragmented and lease. Most intend to exercise this right in informationso precious,that such networks the near future. are not functioning. The information gap is also costly to Impact on lessees.Niost private compa- government. Without accurate data on the nies hold one year leasesfor their premises, private sector, governmentcannot monitor

194 RussiA: CREAIING PRivATE ENTERPRISES AND EFFICIENT NLMRUKETS

private economic activity, and this impedes drives up transaction costs, and the out- their capacity to develop and adjust policies come is uncertain-therebv driving up risk. accordingly, as well as collect taxes. Despite the dearth of information on Business registration the private sector, enterprises are required to present mountains of data to various For tenacious entrepreneurs, registration is state agencies. Russian companies resent more of a nuisance than a binding con- providing statistical data, because little is straint. Tortuous registration, however, returned to them in a useful form and it is sends a strong signal to would-be entrepre- often costly. neurs and to the population. While register- As in the West, information collection is ing a business is significantly less difficult decentralized. Every firm must provide da- than in 1991, roughly 50 percent of the busi- ta to the bureau of statistics, tax authorities, nesses surveyed had trouble registering. ... roughly 50 pension funds, employment funds, regis- The process varies widely amongst regions, percent of the tration bodies, and banks. Not only is this but in many,registration is complicated and time consuming, but widespread disclosure time-consuming. btcsinessessurveyed of proprietary information increases the de- had trouble mands for bribes and the probability of Process. Mlost requirements are left- registering. racketeering. All information is regarded as overs from the previous regime (certificates a commercial secret. As corruption and of property ownership, legal addresses, and mafia-related activities increase, there is permission from the police for use of a growing secrecy in company operations and seal ). Requirements such as these slow reg- a tendency to provide inaccurate data. This istration, increase cost, and seem to serve fuels the information shortage and prevents no good purpose. the development of an information indus- Many municipal authorities recognize try, the most effective way of meeting com- that the registration process is badlv orga- panies' information needs. nized and too complicated. When the law on entrepreneurship was adopted, it was as- Dispute resolution sumed there would be one state register for all registered and liquidated companies. Lack of efficient, reliable ways to resolve This did not happen, and municipal author- commercial disputes substantiallv increases ities developed their own registers. Registra- the risk of doing business. Russian business tion procedures often differ, even amongst people have two options when trving to re- districts. In Stavropol, for example, not on- solve a dispute-formal and informal. Iy does the list of required signatures vary, Most entrepreneurs prefer to resolve dif- but it tends to be too manv. Entrepreneurs ferences amongst themselves than bring often spend days racing around in search of cases to court for arbitration. a sanitary-epidemiological station, environ- Arbitration courts are overloaded ment protection committee, lawyer, tax of- (queues average one and a half years) and ficial, fire-control inspector, and finance plaintiffs pav an advance equivalent to 10 inspector to find the necessary signatures. percent of the suit. Even if the case is won, Few of these organizations bear responsibil- legislation makes no provision for compen- itv for the activity of the enterprise, and sation of damages (contractual sanctions even if they do, few carry- it out. Instead, for state enterprises cannot exceed 8 per- most documents are signed shortly after cent of the claim's value) and settlements bribes have been paid. are not indexed for inflation. Most entrepreneurs adopted a matter- Impact. The cost and time required to of-fact approach: "trv and sort out the prob- register a business varies across districts. lem and, if this fads, never do business with Total costs include time spent preparing the the person again." Although considered less application, registration fee (and bribes), expensive than arbitration, the informal and cost of the delay. In Novosibirsk, for route is costly It limits contractual options, example, 45 percent of the respondents

CONSTRAINTSTO Pi.wxTE ENTERPRISE IN THE FSU: APPROACH AND APPLICATION TORussLA 195

took 2 weeks to register, 45 percent, 2 to 3 The most costly.The first step is to iden- months, and 10percent, 6 months. Most of tifvthose obstaclesthat are absolutelybind- these firms paid between 2,000-4,000 ing or are the most costly for the average rubles, except businesses in retail trade or entrepreneur to overcome. Cost refers to joint ventures, which paid 15,000 rubles the ruble, time, and/oropportunity cost to a and 40,000 rubles, respectively, firm. For example,to send freight bv rail in Manyorganizations have been formed to the Central Black Soil region, entrepre- help business registration.Most companies neurs have to pay a standard fee plus a per- are associatedwith the local executivecom- centage of their revenue (or goods) to the mittee (responsiblefor registration)or other local manager of the state owned rail com- government agencies. For example, one pany.Likewise, a tailor in St. Petersburg is such company in St. Petersburg cooperates only able to register after he promised free closelywith the Mayor's department for the clothes to a local officialand his family for promotion of entrepreneurial activity.The an indefinite period. Quantifying cost is firm provides the entrepreneur with a legal subjective. So the key is to determine address, opens a bank account, prepares whether the cost is a nuisance or a serious seals,and completesrequired documents. In impediment to profitability.To the extent mid-1992, the cost of a complete package that the most cosdy constraints hold con- (includingapproval from the executivecom- stant across firms, interventions that ad- mittee) was 25,000-70,000 rubles; services dress these constraints should have the that did not requirenetworking were less ex- most impact on privatesector development. pensive (2,000 rubles for preparing statutory documents). Entrepreneurs that filed Potentialto alleviate.The second step is documents independentlyusually faced de- to determine whether the given constraint laysof up to 6 months. alleviated can be eradicated or overcome. Either way,that requires identifyingthe po- Targetingconstraints tential alleviatorsof a constraint and evaluating their potential to alleviate. Which constraintsto target? The universe of potential agents is broad and should include those able to Given the breadth of problems, the difficul- have a direct and an indirect effect. These tv of tackling them, and the importance of parties might include different lavers of makingsubstantive and speedyprogress, the government, domestic business associa- approachto reducingconstraints must be se- tions, educational institutes or private lective.This section provides a simpleframe- providers of businessservices, or aid agen- work for selectingthe constraints to target. cies. The evaluativedimension of the analysis should focus on the incentives,capacity, and authoritv that eac, agent has to allevi- Figure14.3 Targetingconstraints ate the constraint. While alleviationneed not imply direct intervention,the more in- Government'spotential to influenceconstraints direct the delivery(or distanceda given Low High agency is from responsibility for a constraint), the more dependent that agency becomes on thosedownstream or upstream Labor Registration in the process. For example,donor condi- U Low regulations complexity tionalitymight spur a change in regulation, but the donor cannot control the regulation nor how it is enforced.

Paymento Accessto Targeting.How should a local govern- High systemdelays commercialcmeca ment in Russia decide where to intervene? property Governmentwill be mosteffective if it tries E______.______to alleviate high cost constraints that gov-

196 RussIA: CREATINGPRIVAIE ENTERPRISES AND EFFICIENTM'IARKETS emnment is in a strong position to influence panies either formally (through markets) or (figure 14.3). Hence, in this example a pri- informally (through networks). Either way, oritv for local government is access to real the private sector is the most effective deliv- estate. erv mechanism for active interventions, such Government should exhaust their po- as financial and advisory services. Certainly, tential to intervene in the high-cost/high- evidence of government's use of active in- impact quadrant before considering others. tervention seems to confirm this argument. If, having addressed all the constraints in Such interventions are seldom cost effective this quadrant, government has some spare in developing a sustainable private sector. capacity, they should then consider the oth- The reasons are more complicated than er quadrants. At this stage, government those proposed above. should weigh the trade-offs between the First, government has multiple, con- cost of a constraint and government's abil- flicting objectives. For example, it's interest Government ity to alleviate it. In most cases, government in short-term employment creation is often should exhaust should target those constraints it can con- at odds with long-term growth of value- trol, even if these are less binding to firms adding enterprises. Second, the structure their potential to than others might be. Thus, having ad- of the intervention is often poorly designed intervene in the dressed the priority quadrant, government and delivered, usually due to government's high-cost/high- might turn to business registration or other involvement past the initiation stage (ex- constraints in the high-potential/low-cost tending to design or delivery of the service). impact quadrant quadrant. Finally, the strategy of the intervention is before considering The mapping process also identifies seldom consistent with the principles of a others. constraints that an organization should not market economy. Active interventions target. If the constraint is not costly and the should encourage, not displace, markets agency is unlikely to alleviate it, it makes lit- and should work within (or minimize dis- tle sense to try. In this example, government tortion of) market principles. should not focus on labor regulations. Unfortunately, many active interventions MNIappingout constraints should be are often delivered by agents that lack ap- completed on an iterative basis. Not only propriate incentive systems and cost- will the environment change, but as bottle- effective operations. These interventions necks ease, new constraints will emerge. often provide direct subsidies to enterprises, Likewise, the capacity of organizations to and this leads to distortions, rationing, and intervene will also change. rent-seeking. Such mechanisms tend to send the wrong signals to private providers of ser- Alleviating constraints vices and their clients, thereby stifling the industrv. Customers receive variable service, Having chosen where to intervene and who which is often taken for granted as subsidies should intervene, the question then becomes continue. Poor performers are rewarded and what to do. Quite often these three questions potential competitors are crowded out. are blurred or one ends up driving the oth- None of this means, however, that gov- ers. It might be assumed that government emrnent should keep clear of all active in- should only intervene to alleviate systemic terventions. Even if this were desirable, it is constraints-or that systemic constraints can not particularly useful for the simple reason onlv be alleviated by government. Based on that governments worldwide have and will this assumption, government should focus continue to engage in active interventions. on creating an enabling business environ- To the extent that these initiatives go for- ment. Hence, tools to intervene should be ward, it makes sense to optimize them and limited to passive interventions, including to avoid the costly mistakes made elsewhere. policy, regulatory, and investment decisions Government should not be limited to that promote entry and competition without passive interventions, nor the private sector targeting specific activities or enterprises. to active ones. Instead, interventions should Conversely, it could be argued that oper- be viewed in three phases-initiation, de- ating constraints are best alleviated by com- sign, and implementation. Different players

CON\TRArNTS TO PRrvATE ENTERPRISE IN THE FSU: APPROA.H A.ND APPLICA11ON TO RussL\ 197

can take responsibilityfor different stages. government; these include the tax system, Government might be the catalyst for an ac- commercialproperty, and information. tive intervention, such as a directed credit program (figure 14.4). Government, how- 'Taxation ever, could sub-contract the program's design and implementation to private Costs incurred by the current tax system companiesthat would operate the program stem from the content of the law,the waythis cost effectively.In this example, govern- informationis disseminated,and how taxes ment is the catalyst for an active interven- are administered.Together thev amount to a tion, but the private sector is the major constraint to business operations; implementing agent. Another example, is whileefforts to alleviateit are predominant- self regulation.In this case, the private sec- ly passive,thev are not exclusivelyso. tor might initiate and design the intervention, but this will require government Taxlaw. Content includes the tax base, approval. the number of taxes, and the rates. While In Russia,the capacity of both the pub- businessesworldwide complain of high tax lic and private sectors to pursue passiveand rates, Russian businesses can pay up to 65 active measures is limited. Government is percent revenue in taxes. Of almost equal highlydecentralized and, to a large extent, importance is the complexityand change- lacks the resources and incentives to allevi- abilitv of tax regulation. Business people ate business constraints of any kind. It spend many hours a dav poring over news- might be argued that government should papers to learn the latest changes in tax focus on its comparative advantage and not policy. get embroiled in active measures. But the While tax rates shouldbe determined by private sector also lacks capacity to initiate fiscaland other considerations,there are five activemeasures on its own. Bv default, fed- principlesof tax reform,which would great- eral and regionalgovernments are initiating lv alleviatethe constraints that taxation sys- measures to alleviate operational con- tems impose on Russian businesses. First, straints, and it makes sense to optimize simplifvtaxes-reduce the number of taxes, these efforts. the ambiguit; and the contradictions that A practical application of these ideas is currentlv enable disparate interpretations. the most effectivemeans of explainingthem. Second.provide stabilitv-keep changes to The following section illustrates what the a minimum,prohibit retroactiveapplication role of government might be in alleviating of laws,and establishfixed buffer terms for three constraints.This section assumes that corrections to laws or instructions. Third, the mappingprocess described in figure 14.3 give priorityto rules that preempt adminis- has identified three priority constraints for trative decision making and minimize discretionary options by tax officials. Fourth, reduce the amount of information required financefigurce14.4p per firmfourcermoAverage by taxation bodies and provide guarantees for the secrecvof commercialinformation. Passivemeasures Active measures Finallv developaccounting definitions for taxation that consistentlyencourage investment instead of relyingon tax holidaysand Private Self- Consulting other distortionarvor discretionary invest- sector regulation services ment promotion schemes. Dissemination of tax legislation is slow, often spotty, and frequently inaccurate. The lack of information keeps administra- Public Infrastructure Directed tors from enforcing the law and businesses sector credit from complying. Government should ensure that businesses have access to timely, l______accurate information. Given its resources,

198 RussiA:CREATING PRIvATE ENTERPRISES AND EFFICIENT 191ARKETS the size of the country,and growing levelof marketable real estate tend to be state- decentralization, government might fran- owned enterprises or else the firmsonly re- chise this service with business associations cently privatized. Most of these entities or private firms that would distribute infor- have not faced hard budget constraints and mation on a user pays basis. Some private other incentives that could othervise force firms have already sprung up, but the accu- them to restructure and divest assets. racy of their material is questionable and Hence, the propertv markets now tend to the cost of their service prohibitively high. be dominated by public agencies, and ef- These problems are often exacerbated by forts to develop them are largely subject to tax administrators, who also lack information the explicit policies and operating practices but insist on enforcing the "law"- even of these bodies. when the law is unknown, misunderstood, or Thus, development of a commercial re- misconstrued. Tax administration is ineffi- al estate market requires both passive and Access to real cient and frequentlv corrupt. There are too active measures. Passive measures are estate is a critical manv offices to be Visited and redundant largely legislative (including enforcement) forms to be filled out. Tax inspectors are of- Laws on land and private property should bottleneck to ten untrained and motivated by their broad be enacted, and an appropriate public business formation discretionary powers as opposed to enforcing propertv administration policv should be and growth the tax law Inspectors possess the power to established in all relevant jurisdictions. set penalties that are automatically enforced. Profile restrictions on leased/sold business- Improving the quality of the tax inspec- es should be eliminated. torate would be easier if the first twvorec- A complicating factor is that there are ommendations had been enforced, but this often several jurisdictions with a role in should not be a prerequisite for addressing propertv management policy-federal, re- administration. In fact, because most taxes gional, and local government. This makes it are enforced bv oblast and municipal gov- difficult to define a framework for proper- ernments, tax administration (on a pilot ba- ty administration regionally. Therefore, it is sis) is an attractive and urgent target. The tax necessary to understand the existing com- inspectorate should be reorganized, control position of assets held bv state and local systems imposed, and equipment updated. government entities and the reasons for Tax administrators should be trained and in- this allocation. Different public-sector centive (and penaltv) systems introduced; property-management policy mav be fol- non-performers should be dismissed after lowed by each public sector "ovner." While appropriate warnings. A streamlined appeal the challenges of addressing this complex mechanism should be established, where structure are daunting, substantive work complaints are resolved before the collec- has been done in this area. tion of fines. City and oblast governments have the legal authority to allocate property within a Commercialproperty given region, but it seems that none have pursued it to its full potential. The accent so Access to real estate is a critical bottleneck far has been on privatization of enterprises to business formation and orowth. Because as going concerns, with distribution of commercial property is essentially under shares to workers and management and control of the state, it is a clear case where voucher auctions being the predominant the public sector must initiate passive and forms of privatization. This has tended to active measures to encourage a commercial re-orient the demand for fixed assets property market. Either the assets are un- around sales of shares of enterprises. The der de jure control of bodies of state ad- chairman of the Voronezh Oblast ministration, or they are de facto subject to Committee for State Property Management the control of public property administra- articulated an increasingly common belief, tion policy because of the way ownership that as the initial stage of privatization nears distribution has been determined. Other completion, the emphasis will shift towards than government agencies, entities with bankruptcy, and asset sales in liquidation

C( )N5TRUNI'S TO PRI\-L E.\'l .RI'R1IN l\IlL. FSU: APPROA(:i A.NDAPPLICAITION 1O RussL\ 199

could facilitate the emergence of property that struggle to secure and maintain rental markets. Under law,the managementof the agreements. The centers would also en- asset liquidation would be a prerogativeof courage the development of a commercial the arbitration court and the MEk. real estate market by rewarding the release Most of these agencies have missed op- of under-utilized buildings, demonstrating portunities. Property administrators have a that real estate transactions can be con- vested interest in maintaining the current ducted transparently,and providing an op- system in which property (or information portunity for private firms to be active in on property) is passed onto colleagues. the real estate market. Transparency has a high price, particularly when the officialsinvolved do not see a vi- Information able alternative and will soon lose their jus- tification for existence (as privatization The goal here is to shift from information winds down). One approach, in the grey rationing to information markets, in which area between active and passive measures, information is accurate, delivery transpar- is to help these administrators transform in- ent, and organizationsgenerate and access to brokerages for commercial property. data at minimum cost. Achieving this de- Agencies could provide an information pends on both the public and private sec- clearinghousefor buyers and sellers,lessors tors, as each will play an important role in and lessees. This activity could increaseac- the collection, analysis,and dissemination cessibilityof real estate to "unconnected" of different types of data. business people, encourage state-owned The most costly information-related enterprises to spin off assets, and shift the constraints to businesses fall into two cate- profitable part of the MKI and GK['s prop- gories: description of current legislation ertv management functions to the private and information on private firms sector, thereby reducing their resistance to (input/output markets and competitors). change. Such brokerages could facilitate Similarly,government needs solid informa- the development of a transparent, price-de- tion on which to base policiesthat affectthe termined market for commercial property. private sector. Activemeasures that promote a leasing In many countries, government is re- industry might also be effective. Private sponsible for collectingand disseminating property management companies could various typesof information-ranging from lease a building from a state-owned enter- data on private businesses to updates on prise or local authority, refit the building as regulationand schedulesfor publicservices. appropriate, and on-lease the office, manu- The Russian government has traditionally facturing or retail sites to local businesses collected copious information but was not on a for-profit basis. The concept is similar inclined to disseminate it. Hence, the first to executive leasingservices used through- step is for governmentto recognizethe val- out the west, and some additional services, ue of open information policies. Targeting such as utilities or secretarial support, first that which is most useful to businesses might also be included in the package. and to government,it should focus its data- Representatives of the state sector gatheringefforts and process the ensuingin- seemed attracted by this proposal because formation in an accessibleway. they would maintain ownership over the property and receive rental fees, adjusted Informaton on legislation.The informa- for inflation, for a fixed term. In exchange, tion most needed by entrepreneurs is they would relinquish all control over use of accurate descriptions of regulation. Dis- the propertv.An agreement on the type of semination is haphazard and largelydepen- construction to be undertaken (which dent on the press, whose information is would increase the value of the property) incomplete, and often, inaccurate.Agencies would also be required. responsible for formulating laws and regu- Leasing centers would provide a direct lationswill not suddenlystart disseminating benefit to the numerous private businesses them widely-nor would such a step be cost

200 RuSSIA: CRFEAING PRIVATEE.NTERPRISES AND EFFICIENT MARKETS

efficient. A possible solution? To adopt the should review its current collection practices practice (used in many countries) where leg- and consolidate them as appropriate, given islation is not effective until it has been pub- the trade-off between the value of inforrna- lished in a gazette. Hence, at the origin, tion and the cost of collection, compliance, there is no gap between information and analysis and dissemination. legislation. The gazette should be widely ac- Government might reduce the number cessible to individuals, private firms, and of collection agencies and encourage coor- public agencies who interpret and use it dination amongst those that survive accordinglv. (Goskomstat and the Ministry of Finance In a functioning market economy, it are in the process of being linked), mini- might be argued that dissemination of in- mize the number of forms and the fre- formation should be left to private firms quency of collection (some forms are who could do it efficiently, profitably, and at required on a monthly basis), and simplify a cost reasonable to clients. In Russia, this forms and cull repetitive questions. will take a long time to emerge, meanwhile Efforts to improve collection will not be the cost of waiting is also high. So, why not effective until the risk of disclosing infor- a compromise that will stimulate an information is reduced. Most businesses are mation industry and deliver useful infor- penalized for being visible and need en- mation to companies? couragement as well as prodding to change One active measure could be to con- their behavior. Confidentiality must be re- tract out regional business information spected, and administrators that violate this clearinghouses, that would collect, codify, ethos should be punished. Publicizing these archive, and disseminate information on a transgressions and the penalties imposed is fee basis. The clearinghouses would priori- one wav for authorities to demonstrate that tize information most valued by customers they value confidentiality. If effective, the and then target this for collection and dis- perceived risk of information disclosure will bursement. Information gaps will close as wane, and there will be less resistance to di- the information industry evolves. Govern- vulging "commercial secrets." Clearly, this ment subsidies would be weaned over time, idea will be difficult to implement, particu- until the clearinghouses become self-suffi- larly given the resources of most local cient. Granted, establishing a network of governments. BICs would be a resource intensive task, An altemative is the carrot. After collect- and, given that it is unproven, a pilot pro- ing and analyzing the data, administrators gram might be appropriate. Because of could ensure that some of the results are de- Russia's size and its unreliable postal sys- livered to those firms that complied. For ex- tem, an oblast network might be the place ample, given how desperate businesses are to start. One oblast clearinghouse would for the most basic types of information, a serve as the hub for local clearinghouses general profile of local companies or open (which would act as libraries) or clearing- access to registration information would be house vans (which would make a circuit invaluable. It would also demonstrate that throughout the oblast, disseminating mate- the information disclosed is actually put to rial directly). good use. Another idea might be to Link up As the private sector develops, some information collection with the aforemen- clearinghouses would target specialized tioned clearinghouses. Companies that dis- niches and others would continue to focus close requested material might receive a on more general material. Such a program fixed credit at the local clearinghouses. could provide a jump start to the emerging information industrv Notes

Informationon theprzvatesector.IC'ith gen- This paper is a condensedversion of an Internal eral data on the private sector, the federal DiscussionPaper, published by the Europe and government is in the strongest position to Lm- CentralAsia Region of the World Bank. The pa- prove the qualitv and flow. Government per owes much to Mr. E. Rveda-Sabater,Mr. S.

(C2ATRAINTS IO PRIP,II ENTERPRISE IN THE FSU: APPROACH A.ND APPLICATION TO RUSSIA 201

Vasiliev, Mr. V Shironin, Ms. I. Boeva, Ms. L. lieve that businesses profit from working the sys- McCuaig, and to a number of other colleagues, tem-as opposed to hard work. A poll undertak- both within and outside the Bank, but it does not en by Russia's Public Opinion Center in Autumn reflect their views. In particular, the paper bene- of 1992 indicated that roughly two-thirds of the fitted from interviews with numerous Russian en- respondents believed that a business' success was trepreneurs and from the collaboration with a result of swindling, fraud, and crime, 14 percent officials from the Russian government, whose attributed this to luck, and 13 percent to persis- ideas and energy were the key to driving this work tence and hard work. (Source: The Public forward Opinion Center of the Russian Federation, 1. Thiss,stem provides for the following legal February 1993.) forms: state, municipal, and individual enterpris- 3. This information was generated from a sures, full and mixed partnerships, limited liability vey of 180 companies covering eight oblasts. The (closed stock), and open stock companies, associ- survey was conducted in 1992. Throughout this ated, subsidiary,and leasing enterprises paper, any detailed information (such as percent- 2. Rent-seeking behavior has dangerous attitu- age of firms responding) or reference to a survey dinal implications. It seems that may Russians be- refers to this one.

202 RUSSIA: CREATING PRIVATEENIERPRISES AND EFFICIENT MIARKETS

CHAPTER 15

Private Sector Manufacturing in St. Petersburg LeilaWebster and Joshua Charap

A survev of ninety-nine firms implemented chose to leave, often taking with them in St. Petersburg in November 1992 docu- skilled workers, equipment, and technical mented the characteristics and problems of know-how. Although many began their pri- Those entrepreneurs private-sector manufacturers. In doing so, it vate activities by selling much of their pro- who had held produced a historical record of the status of duction back to the military industrial positions as private manufacturing im a major Russian complex, the trend was toward sales to non- citvin the early stages of Russian reform. The defense state enterprises and private managers in state research had three specific objectives: to customers. enterprises... develop a profile of manufacturers and their Those entrepreneurs who had held posi- rted out firms, to identify and analyze constraints to tions as managers in state enterprises (about growth, and to reach some conclusions half) started out with substantial advantages substantial about how private-sector manufacturing is in both assets and personal connections, advantages in both developing, and how it might best be They were able to transfer real estate leases assets and personal supported. and production equipment to themselves on Firms were drawn randomly from the preferential terms from the state sector. connections. population of registered, majority privately Despite unequal start-up positions, however, and domestically owned manufacturers manv entrepreneurs from nonmanagerial with seven or more employees. Self-em- backgrounds also had good prospects: they ploved people, trade and service firms, and dominated among exporters, and they ac- joint ventures were excluded. counted for three quarters of the most promising firms in the survev. The entrepreneurs Many entrepreneurs expressed confidence in their knowledge of production, less Russian entrepreneurs were almost all mid- so about how best to organize their busi- dle-aged men with solid technical educa- nesses. Specifically,entrepreneurs wanted to tions and previous emplovment in the state know more about management (financial sector. More than 60 percent had universi- planning, accounting, inventory control, ty degrees and an additional 21 percent had quality control and technology applications); post-university education. Almost all fit one marketing (market research, advertising); of four professional profiles: just under half and export markets (requirements for entry, were highly skilled professionals, many with criteria for success). Most felt that would-be engineering backgrounds; just under a trainers should come with first-hand knowl- quarter were former research scientists; edge of industrial production in market about 15 percent were former bureaucrats economies. Regardless of the sponsor of from state enterprises; and 10 percent were training programs, entrepreneurs repeatedly novices without relevant backgrounds. stressed the importance of recruiting experi- Almost one third of entrepreneurs had enced practitioners rather than theoreti- an research and development or manufac- cians. Many expressed frustration with the turing background in the military industri- lack of adequate basic information such as al complex. The most frequent pattern was economic forecasts, business directories, de- that two or more colleagues in a research in- tails on available assistance programs, and stitute or military industrial state enterprise foreign business in general.

PRIVArE SE(TOR NkNUEACLThRIN(, IN ST. PETERSBURG 203

The firms sponded to the onset of spontaneous privatization and the enactment of privatization Twenty-ninepercent of sample firms were lawsallowing managers and workers to con- limitedliability companies, 25 percent joint vert state enterprisesto joint stock compa- stock, 19 percent cooperatives,and 16 per- nies and to buy majorityshares. cent private small enterprises. Half of sur- In general,prospects appeared strongest vevedfirms had operated previouslyin other for privatized firms and new start-ups and legal forms, some private and some state- weakest for cooperatives. Privatized firms owned.As privately-ownedenterprises, the were substantiallylarger, with a larger assets medianfirm age was 22 months, with the old- base than most new private entrants. The est private firm dating from NIay 1985. The strength of many new entrants stemmed averagefirm was larger than might be ex- from their flexibility.Similar to the earliest Almost all firms pected in terms of workers (sixty-threefull- Polish entrepreneurs. lack of fixed invest- traced their genesis time workers) but smaller in monthly sales ment, small size, and sharp noses for prof- ($14,810). Entrepreneurs manufactured a itable niches mav be the Russian to one of three wide range of products that can be loosely entrepreneur's keys to survival.Prospects sources. Either classifiedinto three groups-low-tech con- for cooperativesthat operated independent- they were fully sumer goods, such as books and cigarettes lyof state enterprisesappeared equal to oth- (33 percent of firms); low-techindustrial in- er typesof firms,but those that maintained private since start- puts such as construction materials and spare physical location within state enterprises up, they began as parts (40 percent);and high-techgoods such generallywerepoorlv positioned for success. quasi-private as precision testing equipment and optical Two-thirds of entrepreneurs used their devices(26 percent). own savingsfor start-up capital.Almost 40 enterprises- Production arrangements were unique- percent of new firms also relied initially on cooperatives anld 1. Russian and transitional. Thev varied advance payments from customers. leaseholds-mostly equally among firms that were entirely free- Commercial bank credit played a less im- the lae 1980s, standing, entrepreneurs who functioned portant, albeit significant,role during the in t1e ate primarilyas brokers (obtaining orders from first six months of operations with 22 per- or they were one state enterprise and contracting with cent of entrepreneurs receiving loans. The privatized units of workers in another state enterprise for pro- majority of transactions were in rubles, and duction), and enterprises that were embed- most went through the banking system. state enterprises ded within the state sector. Entrepreneurs said that there were no bar- Almost all firms traced their genesis to riers to legallyobtaining foreign exchange, one of three sources. Either they were fully but onlyabout a quarter reported that they private since start-up (38 percent of firms), used foreign exchange in their businesses they began as quasi-private enterprises- and most used small amounts. cooperativesand leaseholds-mostly in the Entrepreneurs used few financial ser- late 1980s(37 percent), or they were priva- vices, usually restricted.to obligatorv cur- tized units of state enterprises (25 percent). rent-account transactions and short-term The types of business established and their credit. Many complained about the poor timing almost perfectlv mirrored the qualityof servicesfrom banks. Fortv-seven opportunities that came with each liberal- percent of sample entrepreneurs had re- ization of private enterprise regulations. ceived loans. of which 42 percent were Cooperativesand leaseholds started up in short-term and 5 percent were long-term. 1988 and 1989 when these forms of enter- Thirty-five percent of loans came from prisewere first permitted; most small enter- banks,22 percent from nonfinancialinstitu- prises were established from 1990 onward tions,and 8 percent from both. The consen- when they were first permitted; and limited sus was that short-termcredit was available liabilityand joint stock companies, allowed at nominalannual interest rates of between in 1990, were registered in large numbers 100 and 200 percent, but most entrepre- from 1991. The jump in registration of pri- neurswere unwillingto borrowat suchrates. vatized state firmsas joint stock and limited Long-termcredit was said to be virtuallyim- liabilitycompanies in 1991 and 1992 corre- possibleto obtain.

204 RussiA: CREATINGPRivATE ENTERPRI.SESA.ND EFFI(IENT NLMRETS

Entrepreneurs generallyhad ready ac- they could bid up their wageswhen private ,ss to capitalequipment throughpurchase entrepreneurs appeared with contracts in jr lease, virtuallvall from the state sector. hand. State managerswere holding on to as The 20 percent of entrepreneurs who re- many workers as possiblein hopes of future ported access problems typicallvneeded subsidies, social payments, or policy rever- equipment that was produced exclusively sals in the direction of maintaining out- in one of the other republicsof the former put-that is, anticipating a link between Soviet Union. Inside deals with the state allocationsof state funds and the size of the sectorwere obvious.Almost a third of those labor force. Mlany private entrepreneurs who purchased equipment cited the state avoided carrying the overhead and commit- enterprise where they worked previouslyas ment associatedwith in-house labor and in- the source. Similarly,almost half of entre- stead, maintained their flexibilitv by preneurs who leased their equipment cited subcontracting to workers in state firms. ... three issues their former state employer as the lessor. Onlv twelve entrepreneurs had been underlie problems Entrepreneurs indicatedthat there were no able to purchase factorybuildings. The main input ma regulations blockingequipment sales from jority leased their business space-roughly rkets: state enterprises, but that the opportunity two-thirds with multi-year leases and one- the loss of suppliers to purchase depended heavilyon personal third with annual leases.Virtually all real es- from other connections and substantialbribes. tate was owned by state enterprises,the city IMostproduction equipment appeared government, and a handful of other gov- republics of the to be old, energy-inefficient,polluting, and einment institutions. The consensus was former Soviet often dangerous. The averageage of equip- that production space was available but Union, the ment was 10 to 20 years. and manvfirms re- leases typicallywere insecure and increas- i built and jerry-riggeddecrepit equipment. ingly expensive. informality of input By comparison with firms surveyed in State enterprises were the primarv markets, and the Central Europe, production equipment in source of raw materials and intermediate high transaction St. Petersburg firms appeared much older inputs. Entrepreneurs reported that one and far more dangerous. could find any input or raw material need- Costs associated It was difficultto measure preciselythe ed (if willing to pay the price) and yet, ac- with souircingraw sizeof an enterprises'labor force,due main- cess problems were sufficientlyserious that materials. ly to the widespreadpractice of subcontract- almost half said that they had problems get- ing workers in state firms. The average ting the domestic inputs they needed. number of full-timeworkers in samplefirms Survey data suggest that three issues un- wassixty-three; the numberof part-timeem- derlie problems in input markets: the loss ployeesaveraged twenty-three. The fact that of suppliers from other republicsof the for- twenty-eightfirms had more contract work- mer Soviet Union, the informalityof input ers than full-timeemployees underscores the markets, and the high transaction costs as- extent to which entrepreneursreLied on tem- sociated with sourcing raw materials. porary, subcontracted labor. In November Over half of the entrepreneurssaid state 1992, averagemonthly salarieswere 12,000 enterprises were their major customers. rubles l$30) for skiLledworkers and 5,300 Some said that orders from state enterprises rubles ($13) for unskilledworkers. had fallen sharply,but others said that such Labor markets were best characterized enterprises had becometheir best customers as provisional. Because future develop- since government injections of cash re- ments were so uncertain, the principalplay- sumed the previous summer. Competition ers-workers, state managers, and private was minimal but growing:almost a third of entrepreneurs-were hedging their bets. entrepreneurs said that they had no com- Althoughlarge-scale transformation of state petitors in their main markets, and another enterprises into joint stock companies ap- third said they had fewerthan ten competi- peared well underway,there was no evi- tors. Over 90 percent of entrepreneurs re- dence that state workers were sufficiently ported no problems with distribution. concerned about potential lay-offsto seek Exports accounted for less than 3 per- jobs in private companies, particularly as cent of total sales within the sample. Only

PRIVArT SEC:OR %M-ANULFA,TURINGIN ST. PEIERSBURG 205

elevenfirms exported for hard currency, vith workable contracts, and obt . the remaining exports selling to other re- In contrast, managers in the xx c publicsof the former Soviet Union. Barriers had chosen products unwisely to export were significant.Exporters were marketingproblems for which the required to obtain export licenses that re- equipped. portedlyinvolved bribes, long delaysand de- Strong and weak firms also diffe. tailed restrictions. Transaction costs were their basic characteristics.Strong firms high. Entrepreneurs had to pay substantial erally enjoyed revenues more than twei fees to change currencies, take an addition- times as great, while providingemplovmen al exchange loss when surrendering the re- for more than four times as many individu- quired50 percent of hard currency earnings, als, at wages nearly twice as high. Further- and pay a higher rate of profit tax on export more, the replacement cost of enterprise Problems cited most earnings. capital stock was more than fivetimes larg- frequgently were er than in weak firms, and more than one exessiveandlwerStrong firmsversus weak firms quarter of capital stock was new,compared excessiveand to less than one percent of new capital in frequently changing Groups of strong and weak firms were weak firms. taxes, inflation, and identified and compared to help clarifyfac- In all weak firms, entrepreneurs had tors associated with success. Firms were used their own savings as start-up capital, an ineffective classifiedaccording to three criteria: and only one had received a bank loan at banking system. * How production had changed in the the outset. In contrast, almost halfof strong previous months; firms had received an initial bank loan. In * Txendsin profitability; the whole sample, only 25 percent of en- * Rankings given each firm bv interview trepreneurs said they used hard currencyin teams. their business.Almost half of strong firms Survey teams ranked firms' prospects used hard currency (many only for bribes), based on having listened to their owners but no weak firms used hard currency.The and managers,viewed their facilities,exam- most frequently cited problem among ined the trends in their businesses, and strong firms was "taxes" which they felt compared firmsin the same sectors. If firms were draining their profits. In contrast, en- received positive rankings, profits were in- trepreneurs in weak firms complained first creasing and production was rising, firms of poor demand which perhaps reflected were classifiedas strong. Similarlv,if rank- their inability to choose their products ings were negative, profits were falling and wiselyand market well. production was falling,firms were classified Relationswith the state sector were an- as weak. Using this criteria, twelve firms other important factor. All weak firms sold were classified as strong and seven were mainly to state enterprises, whereas some classified as weak, with the remainder in strong firms sold directly to private retail- between. ers. Since pavment delays were frequent, The numbers of strong and weak firms particularlyin the state sector, the inability were too small to yield definitiveresults, but to collect accounts receivable adverselyaf- an in-depth look at each group of firmspro- fected weak firms. Again, effectiveness of vides some insight into factors associated management in locating new, solvent cus- with success. The most pronounced differ- tomers was a decisive factor in success. ence between the two groups of firms was the competence of their managers. Regard- Major constraints less of their origins, size, or sector, strong firms were led bv strong managers-indi- Entrepreneurs were asked to identifytheir viduals who were sav!v about how to navi- three largest problems in order of impor- gate in the difficult business environment tance. Problems cited most frequentlvwere they faced. They knew how to spot prof- excessiveand frequentlychanging taxes, in- itable niches, forge needed connections, as- tlation, and an ineffectivebanking system. semble the factors of production, create Other problems included unclear and un-

206 RuSSiA:CREAIING PRIV.i, ENTERPRISES AND EFFICIENT MNAR`TS

stable regulationsand policies,poor internal to the national pension fund. Entrepre- managementskills, weak demand, and high neurs had to provide their banks with nominal interest rates. evidence of tax compliance before banks would permit wage payments. Taxes *Inport and ex%porttaxes were paid by those involvedwith foreigntrade. Import tariff High rates of tax and frequently changing rates were increased for all categoriesof tax regulationswere cited by 36 percent of goods, and the general rate rose from 5 entrepreneurs as being among their top percent to 15 percent from September 1, three problems. The prevailing view was 1992.In addition,a 0.15percent customs that the government was robbing private processingfee was applied.Export taxes entrepreneurs through excessivelyhigh tax- differed accordingto product. Raw ma- ation. In addition, many had trouble getting terial export taxes were designedto cap- accurate information about the numerous ture 30 to 40 percent of the salesprice of tax regulations.Entrepreneurs complained taxed exports outside the CIS, but eva- that modificationsin taxes commonlywere sion appears widespread. Some manu- enacted retroactively,making planning and factured exports were not taxed; others compliance difficult. The number of new were taxed at 10 percent. taxes reportedlywas increasingmonthly. In addition, entrepreneurs were subject Primary taxes are: to a multiplicityof other small taxes, each VValue added tax (28 percent) is collected with a different timetable and basis. The on sales. Several entrepreneurs de- most common included: a hard currency scribed difficulties obtaining credit for tax (10 percent of gross hard currency rev- VAT paid on inputs. Although widely enues): a road use tax (0.4 percent of gross resented, most businesses appeared to sales, payable monthly); an advertising tax complv with VAT.On January 1, 1993, (0.5 percent of expenditure); apropertytax the standard rate for VATin Russiawas on all assets includinginventories and bank lowered to 20 percent. accounts-excluding liabilities but after • Corporateprofit tax was said to vary ac- depreciation (one percent of gross based cording to activitv. lMostentrepreneurs on repriced value); a police tax; and a car in the sample were liable for 32 per- tax (based on horsepower). Payment cent.Wagesin excess of four times the schedules and procedures varied by type of minimum wage were taxed as profits at tax, and entrepreneurs relied heavily on 32 percent. Entrepreneurs complained bookkeepers and attorneys to maintain that some expenditures, such as invest- their compliance. ment in new equipment, could not be Compliance with tax regulations was expended against profits tax liability. difficult to evaluate. Many entrepreneurs Interest on bank loans was deductible seemed to be making extensive efforts to only when the proceeds of the loans meet their obligations. Without question, were used for operating expenses, and regulations mandating companies to make then only to the extent that the rate of payments via the banking system limnited interest did not exceed by more than the scope for evasion. High penalties on three points the rates set by the Central delinquent payments, reportedly one per- Bank. Thus, interest on bank loans used cent per day,also were an incentive.Tax of- to acquire fixed or intangible assets was ficials apparently were active in monitoring not deductible. Nor was interest on enterprises' books, auditing them once nonbank loans. every three years, and making frequent, * Payrolltax(39 percent) includespension random spot checks. Severalentrepreneurs (28.0 percent), social insurance (5.4 complained that tax officesimposed penal- percent), unemployment (2.0 percent), ties without juridicalprocess, and that they and medical insurance(3.6 percent). An were powerless to contest these decisions. additional one percent of wvageswas Local tax offices were said to have an un- withheld by employersfor contribution officialcollection target of 25 percent of en-

PRIVATE SECTOR NIANUFACIURING IN S I. PE.TERSBURG 207

terprise gross revenues, irrespective of en- to be paid on inflation in the value of inven- terprise costs. tones which increased the tax burden. For At the same time, there were numerous example,one entrepreneur noted that prior instances of tax evasion.Discounts for cash to introductionof VAT,it was advantageous pavments were common, as were efforts to to maintain high inventories as a hedge avoid reporting activities.The shortage of againstinflation. But under present circum- cash rubles and the poor qualityof banking stances, the real levelof inventories had to servicesfacilitated tax evasionby increasing be understated for tax purposes. Manysam- the incentives for cash transactions.Entre- ple entrepreneurswere payingfor trainingof preneurs activelyengaged in paper transac- company accountants, reflecting both the tions to limit tax liabilities.For example,one importancethey attached to complianceand profitable company underpriced its prod- their desire to lowertaxes legally. ucts, sold to a loss-makingcompany, and re- purchased them at a higher price, thereby Inflation decreasing reported profits and value- added. The inflationaryenvironment also fa- Severe macroeconomic instabilitvcompli- cilitatedthese transactions,since prices were cates business decision-making because changing rapidly and paper transactions relative prices are constantly changingand could occur at different dates than the real future interest rates and exchange rates are exchanges.Other methods of tax avoidance unpredictable.Average prices were increas- included provision of in-kind goods to em- ing by about 25 percent a month (almost ploveesand understatementof the numbers 1,400 percent annually).Virtually all entre- of workers and hours worked. In January preneurs were acutely aware of the impact 1993, the tax code was changedand in-kind inflation was having on the cost of inputs payments are now taxed as regularincome and salaries of workers,and of the necessi- along with the value of trainingprovided to ty to reflect increased input costs in the workers. price of products. But most felt unable to Taxes created disincentivesto building raise prices to cover fully increased costs a business.For example,one entrepreneur because, in their view,consumers could not observed that 80 percent of his gross rev- afford to pay more. In fact, weak demand enue was taken away by taxes, whereas was cited by 14 percent entrepreneurs as continued employment in the state sector one of their top three problems. In most would have guaranteed a modest income. cases, however, demand seemed to con- Moreover, high taxes do not necessarily strain expansion rather than endanger sur- correspond to high levels of government vival. In some cases, complaints of falling revenue because of exemptions, frequently demand may have been camouflage for to the benefit of state enterprise. For ex- poor marketing. ample, in 1992 export taxes were expected Entrepreneurs blamed inflation for in- to raise revenue of 17 percent of GDP creasing the cost of short-term loans. Actualcollections were 2.7 percent of GDP, Annual interest rates offered by banks (100 primarily because of exemptions and eva- to 180 percent) were seen as unfairlyhigh. sion. Furthermore, the abilityof an enter- Few understood concepts such as value of prise to extract tax concessionsor subsidies money, and compound and real interest. is linked to its size, importance, and Many entrepreneurs suggested that they connections, all of which tend to be less sig- were prepared to accept loans at annual in- nificant for private businesses. terest rates of no more than 40 to 50 per- Inflation had a mixed impact on entre- cent. Only one person said that he thought preneurs' tax liability:it eroded the real bur- a loan at the prevailinginterest rate consti- den of some taxes, but the absence of tuted "a good deal given inflation." indexationin the tax law made businessesli- Strategies to cope with inflation included able for increasesin nominalvalues. Accord- stockpiling raw materials; repricing prod- ingly,delays in the payment of profit tax ucts based on raw materials costs; diversi- could decreasethe realburden, but VAThad fyingproducts; using the index of inflation

208 RUSSIA: CREATING PRIvATEENTERPRISES AND EFFICIENT LARKETS to revalue inventories; and indexing con- salaries or purchase raw materials, forcing tracts. Rising,input costs also increased in- them to cut back production or lose orders. centives to seek out "under the table" Apparently,it was not uncommon for banks contracts at reduced prices. to misplace documents needed to process Movements in the exchange rate are payments. linked to current and expected inflation, Problems with inter-republic transfers and one entrepreneur producing knitwear were particularly severe, although it was gave an example of how exchange rate de- sometimesdifficult to distinguish between preciation affected his business. His pro- slow processingby commercial banks, and duction process required large needles for delaysdue to problems between the respec- weavingpolvester and fine needles for cot- tive central banks. Some entrepreneurs re- ton. Large needles were available from ported that they routinely traveled to collect Russian manufacturers, but fine needles payments directly from customers in other Russia's banking had to be imported from Germany or Japan republics. sector appeared at 0.80 Germanmarks. Given the current Given the lack of information and exchange rate and low quality of Russian transparency in the svstem, it was often dif- inefficient and ill- cotton (whichconsumed the needles rapid- ficult for an entrepreneur to know where equipped to handle lv), it was unprofitable for the entrepreneur the problem with payments lav. The lack of the requirementsof to purchase imported fine needles for cot- electronic banking and clearance systems ton production. Instead, he focused on meant that transactions were largely de- a rapidly expanding polvester weaving, and a valuable piece of pendent on the slow Russian postal svstem. private sector. German equipment sat idle. In somecases, delayscould be attributed to delinquent payments by customers. Mlany IneffectiVebanks entrepreneurs also maintained that banks intentionally delayed payments to earn in- Entrepreneurs reserved particularly harsh terest on captive deposits. Two firms re- criticism for the Russian banking sector, ported that banks had been instructed by ranking problems with banks third on their the Central Bank to delay payments by up list of most serious problems. Despite in- to two weeks.The end result for virtuallyall troduction of reforms in state banking and enterprises was massive forward and back- the appearance of numerous private banks, ward payments arrears. Russia's banking sector appeared ineffi- Short-term credits were widelv avail- cient and ill-equipped to handle the re- able if one were willingto pay the costs as- quirements of a rapidly expanding private sociated with obtaining a loan-that is, sector. In general, entrepreneurs described current interest rates, bribes, and costly their relations with banks as adversarialor, guarantee fees. Mlost entrepreneurs were if positive, based on personal connections unwilling to do so. Claiming that banks and quid pro quo. Mlanycomplained that discriminated against private manufac- banks were not interested in their clients turers, thev alleged that state enterprises re- and treated even large and profitable pri- ceived preferential treatment, including vate companiespoorlv. ready accessto cheap credits that they were The most serious problem, long delays not expected to repay. in processingcurrent-account transactions, There was much variation in interest was due to nationwidegridlock in payments rates charged by banks. Some rates were clearance.Entrepreneurs reported delaysas "fixed,"particularly cheap long-termcredits, long as four or five months between differ- but it was doubtful that fixed or flexiblehad ent cities in the RussianFederation. In sev- true meaning. Banks appeared to act spo- eral cases, payments initiated in the first radically,doubling or tripling rates wvhenev- quarter of 1992 had not cleared by er they saw fit. Even the expensive rates of November 1992. One firm's electricitywas 200 percent were highlv negative in real cut off because its bank held up payment to terms. One puzzled entrepreneur pondered the state utilitv. Delays frequently meant whybanks chargeextortionate rates but con- that entrepreneurs were unable to pay tinuallyclaim that "we are all goingbroke."

PRIVATESFA-TOR MANUFACTURING IN ST. PETERSBURG 209

The lack of transparency in what con- which increased the overall anti-export bias. stituted creditworthiness was a particular For example, one firm ended up paying a to- problem. One producer had a large order tal of 12 percent in paperwork fees for a for- from the Soviet Chief of Police in his hands, eign exchange transaction that was shuttled but his bank refused to lend him the mon- between Moscow and St. Petersburg four ey needed to purchase machinerv. The lack times, a 3 percent fee charged per transac- of collateral was acute, since most entre- tion. Frequently bank practices encouraged preneurs leased building space and owned the cash economy that Moscow was trying no land. Fixed assets such as equipment, to discourage. One entrepreneur retumed when not leased, tended to be antiquated to paying workers with cash after his bank and of little value as securitv. The usual col- instituted a 2 percent commission on direct lateral requirements were not in excess of transfers to their accounts. ... the role taken by what is seen in other countries-that is, as- Banks appeared to exercise inordinate the banks some- sets with a book value of 100 to 150 per- power over enterprise activities. Indeed, the bappearomed cent of the loan. But even companies with the role taken by the banks sometimes ap- times appeared to viable collateral had book values eroded by peared to have more to do with controlling have more to do inflation. The common response to inade- enterprises than delivering financial ser- with controlling quate collateral was to obtain often costly vices. Examples include: guarantees from SOEs, state trust compa- * Entrepreneurs must show evidence of enterprises than nies, and insurance companies. having opened a current account with a delivering financial Informal credit markets, a familiar phe- bank before their registration can be services. nomena in countries with inefficient formal completed. And banks reportedly ex- banking sectors, were present in many tracted high payments in return for forms. The common practice among state opening accounts. enterprises of extending credit to one an- According to Central Bank regulations, other at low or zero interest also was ob- all inter-company payments must be ef- served among private manufacturers. Some fected via the current account. Thus, state enterprises gave loans to private en- banks effectively function as bookkeep- trepreneurs who leased plants and equip- ers and overseers of enterprise accounts. ment from them. In several cases involving In principle, entrepreneurs are required former cooperatives and units of SOEs, to notify banks as to their forthcoming new spin-off firms were able to secure large, current-account transactions at the below-interest loans from the parent company ginning of each quarter, and are limited Denial of financial services and high to what has been requested. fees for such services were additional prob- To an important extent, banks control lems. Bank officials reportedly discouraged the amount of cash that enterprises can entrepreneurs from opening accounts, hold. By regulation, the maximum cash claiming that they did not want more clients withdrawal, aside from that needed to and they did not like doing business with payworkers'wages,was 1,000rublesper private manufacturers, preferring "more month until October 1992 (increasing to creditworthy" traders or state enterprises. 5,000 rubles by the time of this survey). Entrepreneurs reported that banks rou- Firms complained that banks frequendy tinelv charged fees of 40,000 rubles (3100) charged high fees for withdrawals or or more to open accounts, creating a "dev- claimed they had run out of cash. il you know" situation where competition in * Some banks reportedlv froze accounts the banking sector was stifled by the high without warning or explanation, made cost of switching banks. Many entrepre- payments to other firms without per- neurs preferred to remain with state-owned mission, and denied firms access to banks rather than risk their money with a their money private bank. Researchers also observed other critical According to entrepreneurs, banks re- issues in the business environment that un- quired high fee, multiple transactions for dermined entrepreneurs' abilities to oper- foreign exchange transactions, a practice ate their businesses effectively. The most

210 RussLA:CREATIN(G PRiVATE ENTERPRISESANID EFFICIENT 1MARKETS important appeared to be lawlessness, cor- tracts and real estate markets, and rein- ruption, and isolation. forcing, the power of personal contacts in securing resources. In instances of viola- Law,lessness tion, mechanisms for contract enforcement were unclear, and entrepreneurs seemed to In addition to frequent, retroactive changes have limited legal recourse. Some entre- in tax structure, almost one in five entrepre- preneurs recounted stories of successful neurs cited ambiguous or unstable govern- lawsuits for breach of contract, but settlement regulations among their top three ment amounts were significantly below the problems. There appeared to be no defini- level of economic damage. Generally, the tive source for information on government judicial system appeared undeveloped, and regulations. Nor was there effective legal re- compliance with contracts appeared close- course for entrepreneurs who considered ly linked to the ability to enforce. Sample themselves unfairly treated. Entrepreneurs Ambiguous property rights, particularlv entrepreneurs with a commitment to comphlance were with respect to the assets of state-owned forced to constantly check official and infor- enterprises, also created strong incentives described the mal sources for details of new regulations. To for all levels of society to expropriate state deficiencies of a a signficant extent, business decisions relied property with few mechanisms to prevent business climate on speculation and rumor about future gov- them from doing so. State enterprise man- emrnent poLicies.Presidential decrees were agers seldom sold assets outright, but they lacking the basics of issued frequentlu Some published, some ig- appeared fully able to use them for person- a modern nored, some implemented, and some con- al gain bv leasing them informally to the pri- economy-business tradictorv. Enforcement reportedly was at vate sector. the discretion of local officials who mav Sample entrepreneurs described the de- ethics, codes of selectively enforce regulations in pursuit of ficiencies of a business climate lacking the conduict, and self-enrichment. basics of a modern economv-business reputtion Fewer than one in ten entrepreneurs ethics, codes of conduct, and reputation. considered start-up regulations, licensing, Given the degree of uncertaintv in the econ- and permits to be one of their three main omy, it is rational for most entrepreneurs to problems: most had acquired their start-up focus on quick profits which obviates the Licensesand permits in three months or less. need to develop a reputation. A pervasive Fewer than 25 percent said thev had any lack of trust impedes the development of problems obtaining other licenses and per- sophisticated business relationships and mits thev needed, although many admitted narrows the scope of private activitv.At pre- to smoothing the process via the distribu- sent, entrepreneurs must either have close tion of side payments. The number of firms control over business activities, or find di- offering "expediting services" was said to be rect means of enforcement or redress for increasing, and competition led to lower breach of contract which do not rely on the prices and faster services. Overall, the re- effectiveness of state authorities. Inevitablv, searchers formed the impression that most development of these basics will proceed regulations were not major obstacles for en- slowly, "from above" with effective law entrepreneurs even though compliance was forcement by the state, and "from below" far from straightfor-vard. The problems with respect for and adherence to law. with regulations wverelinked to the rate at which they changed and the ambiguity of Corruptzon their content. The lack of clear and enforceable con- Corruption and illegal practices were ram- tracts and property rights appeared to be a pant and costly Even so, entrepreneurs critical factor slowing and distorting pri- rarelv identified corruption as a major ob- vate-sector growth. The lack of such rights stacle in business. Rather, practices that greatly increased uncertainty in the busi- would raise legal and ethical questions in ness environment, tostering a provisional the Vest were frequently framed as "good quality in leases, purchasing and sales con- connections" and widely cited as keys to

PRrv.\Ti- Su: I()R \L\NI' It RIN(; IN ST. PETERSBURG 211

success. The exchange of favors of signifi- timber or exportingraw materials, involved cant commercial value, including interest- substantial side payments. One entrepre- free loans and steep discounts on products, neur said: "Exportingis too expensive;you was normal practice even between private have to pay too many people." Similarly, businessmen. some public utilities were rationed and Access to almost all resources required bribery was said to expedite service. For ex- payoffs. Bribes reportedly were required to ample, the going rate for telephone installa- obtain leases, lower raw material prices, and tion was reported at $200. lock in contracts. Apparently, bribery was Although entrepreneurs were quick to requisite to obtain bank loans: the going rate admit that pervasive corruption was costly was said to be a 5 percent cash payment. to them, the researchers noted a high lev- Payments could expedite bank transactions el of acceptance of practices judged illegal The government that might otherw,ise take months. Due to and unethical in the West. For the most racket" was a term price liberalization, factors of production part, corruption appeared as the inevitable generally were available for purchase on the legacy of an economic system based on used to refer to open market. But side payments could low- administrative allocation, that was further corruption within er the prices of most resources. Formerly, exacerbated by unclear property rights. local administra- bribery was said to account for about 25 per- The extent to which corruption would con- cent of raw materials prices, but had de- strain the growth of the private sector was tions and bribe- clined to less than 5 percent for most ambiguous because the economic burden seeking behavior of entrepreneurs. Purchase of some types of it imposed was unclear. Some incidents officials at all levels, equipment still required bribery, but most described by sample entrepreneurs could was reportedly available on the "legal mar- be considered as a market mechanism ket for stolen parts." repricing goods and services. In this light, Organized crime, the "mafia," was said one might regard aspects of official cor- to be interested primarily in trading com- ruption as nothing more than efficient panies, not manufacturing, since profits allocation of scarce government services to from trade are higher. The reportedlv high the highest bidder. A potentially serious payments required to obtain valuable, cen- concern, however, is the degree to which trally-located retail space were avoided by patterns of behavior from the old system manufacturers who could locate their pro- become the norm for the new economy, duction space far more cheaply on the out- and the economic burden this may impose. skirts of the city. Those who did lease retail The extent to which corrupt elements be- space in the city claimed that one could come organized will influence their chose freely between purchasing requisite longevity, and the numerous references to protection services from the police or from organized crime by sample entrepreneurs organized crime. One highly successful en- may mean that this behavior has already trepreneur said that he realized it was nec- become entrenched. essarv to approach the mafia once his company became sufficientlv large. Isolation The "government racket" was a term used to refer to corruption within local Researchers formed the impression that administrations and bribe-seeking behavior most entrepreneurs were isolated from of officials at all levels. NMid-levellocal offi- each other, from the state sector, and from cials were said to offer paid "consulting the outside world. Entrepreneurs tended to services" to businesses for expediting paper- conceal their physical location and limit work that might otherwise take months. their contacts with each other out of con- One entrepreneur stated that administra- cern for physical security and suspicion of tion officials were afraid to accept bribes contacts originating from outside their net- from capable professionals but were quick works. Isolation from the state sector was to spot the inexperienced. Apparently, li- more common in new ventures than among censes for certain activities, such as cutting privatized units of state enterprises, but

212 RIusst,: CREATING PRIVATEENTERPRISES AND EFFICIENT MNLRKETS even the latter tended to have links only to Conclusions their state parent rather than to a larger business communitv. Prospects There are, for instance, two relatively large, private businesses (each employing The vitality of Russian entrepreneurship about 200 people) located acrossthe street was evident in St. Petersburg, both among from each other, but unawareof the other. sample entrepreneurs drawn from the ap- When an intervieweroffered to put them proximately 30,000 private enterprises reg- in contact, the response wasnot only favor- istered in mid- 1992 and in the burgeoning able, but led the entrepreneur to explain informal sector visible in the streets. This his view that such contacts were essential first wave of private manufacturers tended for the survival of the private sector. to be highly educated, technicallvskilled, Nevertheless, horizontal links between en- and adept at survival and growth in the tur- Close connections trepreneurs were virtuallynonexistent, and bulent Russian business environment. If with the state sector there seemed to be no lobby groups for the rate of market entrv remains high and their interests. As a result, the influence of the privatization program continues at a were critical for private enterprise in government circles is fast pace, the private manufacturingsector many firms. likelyto remain marginalcompared to larg- should grow rapidly. er state enterprises with greater political The plaving field in private manufactur- leverage. ing, however, was far from level. Opportu- Close connectionswith the state sector nities were unequal because individuals were criticalfor manyfirms. Those entrepre- with closerlinks to the state sectorwere bet- neurs with close and favorablelinks reaped ter situated to gain preferential accessto re- significantbenefits, whereas others were out sources. Half of the entrepreneurs sampled of touchwith the complicatedyet crucialsys- were former managers from state enterpris- tem of connections.Connections were based es. Demonstrating a strong spirit of entre- on prior employmentin the state sector,fam- preneurship withinwhat was once the state ilv links, or straightforwardbribery, but the sector, many former managers had used net resultseemed to be the same-improved their positions to obtain factory space and accessto input and output markets. production equipment at below-market The population of the former Soviet rates, giving them significant advantages Union was generallycut off from the rest of over others from nonmanagerial back- the world for decades, and many entrepre- grounds. Until markets normalize and a neurs had not yet overcome this legacy of substantial portion of state assets are priva- isolation. Most had little knowledge about tized, such inequalitv of opportunity is like- business in the West including tastes, stan- ly to continue. Despite their headstart, dards, preferences, and codes of conduct. however, prospects for former managers did Many said they would like a Westem busi- not appear better and, in some cases, were ness partner, but none had anv idea how to worse than other entrepreneurs. A primarv locate one. Some portrayed a more insular difficulty faced by some former managers attitude, pronouncing: "We are here, why who took over units of state enterprises was doesn't a Westerner come and find us?" the need to restructure, usually without ac- Others had the view that since they were cess to investment financing and sometimes doing "well enough," there was no need to with restrictions on deployment of capital actively seek new markets or new partners. assets and labor. The degree of isolation from the West, ob- The Russian business environment was served among entrepreneurs in St. particularly uncertain and risky High infla- Petersburg, was far greater than observed tion, continually changing relative prices, and among their Central European counter- unpredictable interest rates and exchange parts who were quick to break down barri- rates, all obscured the economic signals nec- ers with the West, in part by simply crossing essary for properlv functioning markets. over the borders. Capital and labor markets functioned poorly

PRIATE SE:TOR MANUFACTURINGIN ST PETERSBURG 213

and were frequentlyintluenced through per- stantial businesses,despite the difficulties sonal connections. Liberalization had im- presentedbh the environment.At the same proved access to most resources, but critical time, uncertainty and lack of transparency distortions remained, including pnrce-fixing distracted them from core activities, and in energy and raw materials and subsidies for limited their willingness to invest. Despite the state sector. The legal and regulatory such difficulties, most entrepreneurs framework (particularlv taxes) was chaotic, seemed prepared to make significant in- constantly shifting and poorlv administered; vestments once the business environment and corruption, lawlessness, and isolation improves. wvereper-vasive. The inadequacy of the bank- Second, the ways in which privatization ing sector made many routine transactions is taking place in Russia contain both posi- time-consuming and costlv There were nu- tive and negative aspects. Allowing managers The mTioststiccessful merous systemic biases against exports. At to move some of the best state assets into enltrepreneulrs the same time, chaos created significant op- companies they own or control through sp- portunities that capable entrepreneurs had ontaneous privatization is inherently unfair. secuired orders, turned to their advantage. Returns accrue to the individual rather than obtained supplies of NMostentrepreneurs responded to their the state. Formal privatization facilitates a rawv mnaterials, environment rationally by attempting to process that is crucial to the development of minimize risk and maximize flexibility to the Russian economy, but the Russian mod- arrLanzgedfor use of protect against possible unfavorable devel- el gives workers and managers an unfair ad- equipmenit through opments. The focus clearly was on short- vantage in acquiring property-perhaps long-term or term profits, and the extent to which further exacerbating appearances of unfair- entrepreneurs made long-term commit- ness and leading to a social backlash against temporary leases, ments varied widely depending on expecta- reform. At the same time, it is reasonable to employed or tions. Entrepreneurs sought to hedge bets. assume that the new private owners will ex- conitracted workers Some had set up free-standing businesses. tract higher returns from these assets than Others worked primarilv as brokers with was the case when the state owned them, and to prodtuce the few, if amn,fixed investments. Yet others re- will do so far faster than if these assets are order, and netted mained embedded inside state enterprises. held back for a more equitable approach to profits of 30 Those entrepreneurs with the possibility of privatization. Moreover, the government is purchasing factorv space and production unlikelv to be able to impede this process percent or more. equipment frequently chose to do so without adversely affecting the momentum (predominantly at below-market rates), but of economic reform. Inequities in opportuni- some preferred the greater flexibilitv of leas- ties to acquire resources mav be an inevitable ing. Other entrepreneurs leased because price of rapid privatization, providing that they had no choice. Some businesses had society can absorb the injustice. Ultimately, taken on full-time labor forces, whereas oth- the appropriate (economic) yardstick by ers used a mix of their own workers and which to judge privatization is the effective- subcontracted labor from state enterprises ness with which new ow,ners deploy the reas needed. Although almost half of the sources they control. entrepreneurs had short-term credits, the demand for credit was notably lowvat going Winnersand losers interest rates. This can partially be explained bh a reluctance to make financial There were four major players in the commitments, even as short as six months microeconomv of private manufacturing in into the future. St. Petersburg-private entrepreneurs, W'hat are the implications of economic managers in state enterprises, workers in transition for private sector development? state enterprises, and the state (that is, the First, Russian entrepreneurs showed them- national government). Analysis of the rela- selves capable of responding rapidly and ef- tive positions held by each group of play- fectively to opportunities. There appeared ers provides insight into the dynamics of to be no shortage of entrepreneurs in St. their relationships. and helps identifv win- Petersburg. Indeed, many had built sub- ners and losers.

214 RUTSSA:CREATING PmIVAnTENTERPRISES AND EFFICIENT NARKETS

Mianv private entrepreneurs were earn- some instances, the "state enterprise man- ing high profits, based on keen perceptions ager" and "private entrepreneur" were the of market niches and strong skills as bro- same person-with the manager running kers. Most had engineered subcontracting both businesses from the same office with- arrangements with state enterprises. The out oCficialsanctions against his clear con- most successfulentrepreneurs secured or- tlict of interest. ders, obtained supplies of raw materials, At the same time, state managers faced arranged for use of equipment through urgent problems stemming generally from long-term or temporaryleases, employed or the transformation and specificallv from contracted workers to produce the order, conditions in the enterprisesthev managed. and netted profits of 30 percent or more. Regardless of the outcome of the political But in exchange for profits, most entre- struggle over the scope and speed of the preneurs tolerated significant constraints Russian economic transformation,the hey- and undertook large risks. In all cases, day of the large state enterprises seems to entrepreneurs were trying to make plans in have passed and managersface monumen- a highly unstable economy while facing a tal changes. Although state managers con- maze of regulations that absorbed their trol assets, the profitabilityof those assets is time, cut into revenues, and threatened often questionable due to outdated and in- high penalties for lack of compliance. All efficient production equipment and to operated businesseswith little or no access sharplv contracting markets. Manv state to basic financialservices considered indis- managers are saddled with large, often un- pensable in the West.All were forced to co- productive workforcesto whom they are at exist with the dominant state sector whose least partiallvaccountable. The researchers managers effectivelycontrolled most in- encountered some dynamicstate managers, dustrial assets in St. Petersburg. Most particularlyin smaller enterprises, who al- leased factoryspace from the city and from ready wveretransforming units into joint state enterprises where officialsand man- stock companies and seeking means of en- agers offered escalating rents and change- hancing competitiveness. But the general able terms to those without ironclad impression was that there are many more connections. Most had no opportunity to managers who bear the burden of main- purchase real estate due to obstacles to taining or dismembering dinosaurs-with clearing titles and the unavailabilityof term little assistance from anyone. financing. Manycharacterized popular and Workers in state enterprises-particu- official attitudes toward them as hostile. larlyskilled workers-were key to manypri- Mlanagersin state enterprises enjoyed vate entrepreneurs' abilities to generate the considerable advantage of controlling high profits. The competitiveedge in man- almost ail assets needed by private manu- ufacturing rested almost entirely on entre- facturers, including real estate, production preneurs' abilities to deliver high-quality equipment, stocks of raw materials-and products quickly This abilitydepended, in most workers. Their abilitvto maintain con- many cases, on contracting with skilled trol over these assetswas enhanced by gov- workerson an "as-needed" basis to produce ernment subsidies in the second half of orders. Some entrepreneurs had large or- 1992, which allowed them to continue pay- ders for mass-produced goods that made ing workers and provided them with a fi- use of short-term contracts with crews of nancial cushion. A wide spectrum of unskilled workers. In both cases, workers interaction was observed betwveenstate were able to use their leveragewith private managers and private entrepreneurs- entrepreneurs to bid up their wages by 10- from those who wveretaking frilladvantage 20 percent and to secure valuableovertime of their positions to extract considerable work. Most workers were reportedlyunwill- rents from private entrepreneurs in ex- ing to give up the securitv of state employ- change for real estate leases and sales of ment, but many were able to supplement raw materials, to those who lost money (in their declining incomes by extracting rela- real terms) in deals with private firms. In tively higher wages from private entrepre-

PwP: ATE SE(IT()R .NIANiIA, [l RI\l IN SI. PETERSBURG 215

neurs-a practice which may have enabled sector, ridding the state of its liabilities some to hang on to their secure, albeit low- enhancingeconomic efficiency. paying, state jobs. Despite their capacity to extract high Cross-country comparisons wages from private entrepreneurs in the short run, most workers in state enterprises Russian entrepreneurs and firms can be face structural changes that are unlikelyto compared with their counterparts in favor them. Vhen the inevitablelayoffs be- Poland, Hungary and the former CSFR in gin, some workersw,ill find niches in the pri- three key areas-entrepreneurship, con- vate sector,but most risk findingthemselves straints, and relationswith the state sector.' unemployed and without marketable skills. Entrepreneurs in St. Petersburg presented Older workers, particularly those with less unique accounts of their businessesand the The entrepreneurial flexibleskills, will be more vulnerable.Real environmentin whichthey operate,but sim- skills that mattered wages have declined, despite injections ilar themes have surfaced across countries. from private entrepreneurs, and many re- Entrepreneurs were remarkablysimilar most... were the portedly have faced periods when wage pay- across all three countries: well-educated abilities to choose ments were delayed or suspended. men in their fortieswith solidtechnical skills producsts,.. In this provisional status quo, the state, and indefatigable ambition to succeed in as owner of the assets in state enterprises, their new businesses.The majorityof the assemble factories,. . . would appear to be the loser on all counts. Central Europeanswere engineers,whereas motivate workers,... To an unknown extent, the assets of state the Russian sample included many research and sell the output... enterprises have been moved into private scientists. Almost all came from high-level firms by managers who purchased them, positions in the state sector. In all cases, presumablyat below-marketprices without those who came from the highest positions facing a competitive process. Despite for- in the state sector started out with consider- mal ownership of most assets, the state ap- ably more advantagesthan did newcomers. peared to receive almost no returns on The entrepreneurial skills that mattered them. Entrepreneurs leased production most in all countries were the abilities to equipment belonging to state enterprises, choose products for which demand was but rents reportedlywent directlyinto man- strong and competitionweak; assemblefac- agers' pockets. Entrepreneurs purchased tories by buying or leasingspace and equip- raw materialsmainly from state enterprises ment piecemeal; motivate workers to that bought in bulk, but mark-ups were of- upgrade qualityand learn newskills; and sell ten pocketed by managers. Enterprises as- the output in markets that typicallywere sumed the overhead for workers, and contracting. Exceptionallycompetent indi- private entrepreneurs merely paid wages. viduals could be identifiedas the key factor WNorkerswere able to use their positions in in almostall successfulfirms in each country. state firmsto postpone making their wayin- Constraints varied across each survey to the private sector. At the same time, location accordingto the particularsof the many of these same state enterprises were respective business environments. The making losses,which tend to be financed by importanceof a stable macroeconomicenvi- the state-a root cause of inflation. ronment can not be overstated. Entrepre- At present, the state is unable to effec- neurs' businesseswere negativelyaffected by tivelyown or manage most of its assets,but inflationin St. Petersburgand by recessionin is politicallytoo weak to avoid stemmingthe Poland and Hungary.Only in the formerCS- losses on those assets. In such an environ- FR were entrepreneursnot criticallyaffected ment, the productivecapacity of state assets by macroeconomicproblems. Issues of fi- is siphoned off by managersand workers,in nance arose in all cases, but problemswith conjunctionwith or as part of the privatesec- accesswere not universalas isoften assumed. tor, whileliabilities and costs are transferred Entrepreneurs had relativelygood accessto back to state budgets. Privatizationmust ef- short-term credit in St. Petersburg and fectivelytransfer both the rightsand respon- Poland,but somewhatless so in Hungaryand sibilitiesfor the use of assets to the private the former CSFR. Long-term finance was

216 RusSLA:CREATING PRVATE ENTERPRISES AND EFFICIENT MARKETS

available onl in the former CSFR. The need data are inconclusive, but several points for capital infusions was universal, but in all can be made. First, private entrepreneurs locations except the former CSFR, demand must have access to productive equipment for credit was constrained by entrepreneurs' and labor held in state enterprises. Private- refusal to borrow at prevailing nominal inter- sector grow-th can not wait for a lengthy est rates which were considered too high. process of formal privatization. Interim Financial services were dismal in all coun- arrangements, such as leasing, piecemeal tries. Unstable and unclear regulations- sales, and subcontracting from state to pri- particularly surrounding taxes-negatively vate sectors, are crucial in order to grant affected each group of entrepreneurs. fast access to needed resources in the state One approach to analyzing the rela- sector. At the same time, soft boundaries tionship between the dominant state sector that facilitate these arrangements have and the fledgling private sector in these opened the door to widespread corruption econories is to look at the firmness of and raised serious equity questions. boundaries between them and assess the Second, it can be hypothesized that a extent to which people and assets flow from high level of integration of the state and pri- one to the other. Two patterns were ob- vate sectors may ultimately retard private served across the four countries. In the first, sector growth. Entrepreneurs desperately observed in Poland and the former CSFR, need the assets held in state enterprises, but boundaries between private and state firms when assets are shared in a way that causes were well-defined with relativelv little in- the sectors to become interdependent, pri- teraction beyond state enterprise sales of vate firms become vulnerable to inevitable inputs and some purchasing of outputs. downturns in the state sector. Examples in- Leasing of assets, sharing of work forces, cluded spin-offs from state companies cre- and mixing of enterprise ownership were ated only to supply the parent company, and relatively rare. In essence, the state sector equity arrangements that combine private in these countries remained intact awaiting and state interests and pit them against the formal privatization processes, and the changes in the status quo. In such cases, private sector pried loose what it could in widely observed in St. Petersburg and the way of cast-off equipment and workers Hungary, a downtum in the state sector willing to make the leap to private sector brings a downturn in the private sector. In employment. contrast, when entrepreneurs are given ac- In St. Petersburg and Hungary, bound- cess to assets without restrictions, they are aries between state and private sectors were more able to deploy them flexibly to exploit blurred and integration was relatively high. available opportunities-the pattern seen This pattern may have developed as a result more often in Poland and the former C SFR. of early reform programs that introduced Third, personal connections-strong quasi-private enterprise forms into the determinants of access to resources in all state sector-leaseholds and cooperatives post-socialist econorrues-were particularly in Russia and economic work groups in important where state and private sectors Hungary Many enterprises became fully were highy integrated, in effect the glue that private as new laws were passed, but they held together cross-sector networks. Access continued to maintain strong ties with the to resources in St. Petersburg and Hungary state sector. Production equipment was depended to a large degree on having the shared, primarily through leasing, and per- right personal connections which, in effect, vasive subcontracting effectively bridged ensured the flow of goods and services as labor forces. Ownership was mixed, most formal allocation systems broke down and often seen as state enterprises taking equi- markets had not yet replaced them. But al- ty in private companies. Capital was shared locating resources based on personal con- in the form of suppliers' credits and other nections instead of the formal marketplace inter-enterprise pavments networks, has the highly negative effect of freezing out Which set of relationships most effec- newcomers. The researchers observed many tively furthered private-sector growth? The instances, in both locations, of newcomers

PRIVATESECTOR iANL\UFACTU'RINGIN ST. PETERSBURG 217

whosechances for successwere significantlv and deconcentrationof the economy.It may diminished because they were effectively be desirable to maintain most newlv-priva- outsiders. tized enterprises as going concerns as restructuring takes place. But, from the Jlnplicationzslorassisting perspective of small business development, entrepreneurs need the opportunitv to pur- Despite an urgent search for a magical for- chase only those assets appropriatefor their mula to promote the Russianprivate sector, businesses,without restrictionsand obliga- there is no quick and easy route. Evidence tions to maintain production and labor from this survey,however, suggests efforts forces. Since smallerbusinesses are likelyto on t-wofronts-improvement in the busi- acquireassets fromlarger companies, piece- ness environment and direct assistance to meal sales of assets should be encouraged entrepreneurs. where feasible. A number of measurescould significant- Almost 30 percent of sample entrepre- lvimprove the businessenvironment. An im- neurs came from the military/industrial portant step would be to ensure that private complex. This sector possesses an abun- sectordevelopment is given a key role in the dance of technical knowledge and skills. formulationof the national agenda in both Somedepartments and unitswithin military words and deeds. Decisionmakersat all lev- enterprisesare activelyinvolved in cornmer- els must recognizethe importance of private cializing technology,and this spontaneous sectordevelopment-its potential contribu- development should be nurtured and en- tion to GDP employment,and the growthof hanced by facilitatingtechnology transfer competition and markets. Experience in and spin-off companiesfrom the military/ Poland, the former Czechoslovakia, and industrial complex. Particular attention Hungaryindicates that decisionmakersoften should be givento the effectivenessof "bot- do not understand the role of small business tom up" initiativesin bringingnew products in developed economies,and hence do not to market. focus on its development.Thorough analysis High prioritiesfor regulatoryreform are: of the impact of legislation,policies, and reg- Propertyand contractlZWs and regula- ulation on the smaLlbusinesses is necessary. tions. The focus should be on the for- Formationof private-sectoradvisory groups mulation of an appropriate legal and that include representativesof government regulatoryframework for private sector and privatebusiness might be a useful forum development and on strengthening the for reaching consensuson the changes that enforcement of laws and regulations. are needed. Private ownership of land should be In terms of general policies, the impor- clarified to provide property to the pri- tance of macroeconomicstability as a pre- vate sector. condition for private investment can not be * Reassessmentof the tu.i-systemin terms of overstated. Removingremaining price con- its effects on private business. In par- trols, especiallythose on raw materials and ticular, a reviewshould concentrate on e gnerg;would enable markets to operate easing administrativeburdens by creat- wvithfewer distortions and entrepreneurs to ing a clear,logical basis for taxes, which better plan for their businesses.Elimination may include realigningthe tax basis to of systemicbiases againstexports would in- facilitatetransparency and compliance. crease foreign trade, introduce stable mar- * Export proceduresincluding licensing, kets, and generate benefits associated with hard-currency transactions and cus- exposure to competitive marketplaces. As toms, environmental regulations, and noted above, rapid progressin privatization intellectual property rights. is critical for a varietv of reasons. Similarly, reform of the banking sector is Because of the high degree of monopo- critical to improve the efficiencv of private- lization in Russian industry, the privatization sector operations. Banks must be redefined process should strive to break up larger en- as facilitators of transactions rather than in- terprises and facilitate demonopolization struments of state control. At present,

218 RussIA: CREATINGPRRVATE ENTERPISES AND EFFICIENT MIARKETS

Russian banks are generallv ineffectivein programs could send Russianentrepreneurs taking deposits, giving account balances, abroad on study tours. Such a program collecting on payments, and transferring could be organized according to sector or money:Improvements of pavmentssvstems function, and participants could includeen- should be a high priority,perhaps furthered trepreneurs as well as individualsfrom pri- by installationof efficientfinancial informa- vate and government agencies. Programs tion systemsand trainingof bank personnel. would need to be tailored to specificneeds. Trainingprograms that increasehuman cap- Particular attention would need to be paid ital in the banking sector could be a signifi- to participant selection, choosing people cant step towards providing effective based on aptitude and abilityto use and dis- banking services. seminate education, rather than on an indi- Effectiveimplementation of policyand vidual's informal Linksto those responsible regulatoryreforms depends on institutional for local management of the program. capacity.Improvements are needed in local In some Central Europeancountries, re- government offices,tax offices, and banks. gional centers for small business support Foreign assistancecould be of help in this have been established where activeand po- area. Strategies for assistance depend on tential entrepreneurs can go to for informa- whether the aim is to improve an entire or- tion, referral, and support in developing ganization or to carve out an "island of business plans. Although the provision of efficiency"within an institution. Usefulap- general information and counsellingon how proaches might include technicalassistance to start, run, and grow a business may not in governance(the rights and responsibilities constitute a viable opportunity for private of different levelsof government);civil ser- business,these servicescan be providedby vice reform; and an assessment of the in- public-privatepartnerships that are financed centive structures in governmentoffices. by fees and by subsidies.And privateprovi- In direct assistance, entrepreneurs sion of services,perhaps as subcontractors, spoke clearlyabout their desire for help in should be sought wherever possible. management, marketing, and exporting, Accessto credit was not cited by entre- and for an increased understanding of preneurs as one of their major problems. Western business practices. They empha- Short-term loans were said to be widely sized that training programs should avoid available, but demand was low primarily the theoretical and focus on the practical. due to entrepreneurs' perceptions that Lack of access to specific information on nominal interest rates were unacceptably domestic markets (suppliers, customers) high. If the economy stabilizesand inflation and export markets (opportunities,require- falls, demand for credit mav increase al- ments) was a big handicap. While both ar- though the high real interest rates that typ- eas represent potential market niches for icallyaccompany stabilization are likelyto Russian entrepreneurs, foreign support limit credit demand. In the long term, how- could facilitateentrepreneurs'contacts with ever, entrepreneurs will probablv seek to the West, a servicerequested by almost all make significant capital investments to re- entrepreneurs. structure and upgrade equipment. A discussion about the design of assistance programs is bevond the scope of this Note study, but some implications arise from this survev A critical question is how to educate 1 These comparisons are based on comparable surveys carried out in Poland. Hungary, and the entrepreneurs while taking the Russian con- former Czechoslovakia in 1991-92. Reports on text into account. The answeris probably a these survevs are available from Leila Webster, partnership between Russian and Western Private Sector Development Department, World professionals. Reverse technical assistance Bank.

PRIVATE SE(TOR 19L:NU1FA(:JU'RNGIN ST. PEIERSBURG 219

C[IAPTER 16

CompetitionLaw and Policy R. Shyam Khemani

One of the few areas of at leastapproximate the command-control economic planning confluence between the Neoclassicaland system, and in part due to the need to guard Marxistschools of economicthought relates against monopolistic practices, the Russian to the problem of monopoly.For neoclassi- government has also enacted an anti- cists, monopolyis a problem becauseit gives monopoly law. rise to prices and profits that are above The purpose clause of the law states those that would prevail under competitive that it "...shall determine the organization- conditions, and an inefficientlevel of out- al and legal foundations for the prevention, put is produced. The principalconcerns are limitation, and suppression of monopolistic that consumer welfareis not maximizedand activities and unfair competition and is di- a misallocationof resources takes place. In rected towards ensuring the conditions for mild contrast, the focus of attention of the creation and effective functioning of Marxisteconomists is on the high pricesand goods markets" (article 1). profits earned by monopolies.Concerns are The purpose clause suggests that the expressed regarding the income distribu- law will apply to existing or emerginganti- tion and economicand politicalpower con- competitive situations, and that it will also sequences of monopoly pro-actively foster an economic environ- These perspectives have also been his- ment in which competitive markets can torically reflected in the policies proposed properly function. Russia's anti-monopoly to resolve the monopoly problem. The neo- law has not been effectively applied. More- classical approach is to foster market con- over, the Russian State and Regional Anti- ditions by reducing barriers to entry, to monopoly Committees (the administrative enact government antitrust policy, or both bodies that enforce the law) have been in order to erode the position of monopo- overly preoccupied with the possibility that lies. Where this strategy is not feasible, such the privatization process will simply trans- as in the case of natural monopolies, regu- fer state-owned monopolies into private lations may be imposed. The Marxist ap- hands, resulting in monopolistic exploita- proach has been to institute government tion. Until recently, the committees have ownership and direct control over prices, not played an active role in the privatization profits and output. process, nor have they attempted to reduce In the transition from a centrally various centrally determined barriers to en- planned economy to a mixed-enterprise try, in order to address these concerns. free-market system, the monopoly problem Instead, they have adopted a regulatory ap- has re-emerged as a central issue in Russia. proach by maintaining a list of enterprises In connection with instituting market-ori- which are deemed to be dominant in their ented reforms, the Russian government has sphere of economic activity and have sub- recognized the need for privatization of pre- jected them to profit margin and output viously state-owned enterprises, in order to controls. These controls distort the price- provide the necessarv economic incentives profit signals and the flow of resources from for increased efficiency and output. lower to higher valued uses. Such controls However, in part because of the high levels also tend to adversely effect markets and of industrial concentrationt inherited from the structural adjustment process.

(NIPLI11T0.N L.\xwAND POLICY 221

Russia has framed a reasonable compe- mote economic efficiency and consumer tition law. Hovever, the implementation of welfare. The principles of competition law this law and the role and capabilities of the should be integrated into the formulation State and Regional Anti-monopolv Com- and implementation of government poli- mittees need to be enhanced to promote cies; otherwise they may adversely impact efficient enterprise and industrial restruc- the prevailing state of competition in the turing and to foster market-oriented economy This implies a larger role for com- processes. petition authorities. Not only should these authorities attack existing or emerging an- Dimensions of competition law and ti-competitive situations, but they should competition policy also play a role in economic policymaking as advocates for competition. In particular, ... particularly [for] Broadly defined, the term competition poll- competition authorities should be pro-ac- Russia, fostering cy encompasses the area commonly known tive in reducing government-induced barri- tS .as antitrust (in Russia anti-monopolv) law, as ers to entry. competitive markets weLIas various micro-industrial policies af- This paper's primary focus is on Russian represents a low fecting the market svstem and the allocation competition law and not on the range of cost method of of resources by firms and other economic other government policies that also affect agents. Examples of such policies would be competition. efficiently allocating foreign investment, intemational trade, in- resources... tellectual property, industrial policy, and reg- Competition law in an emerging market ulation of natural monopolies and specific economy economic sectors. Competition policy,when properlv designed and implemented, cor- The proper implementation of competition rects market failures and distortions that law hinges on clearly distinguishing between arise from monopolistic business practices those business practices and arrangements and extensive government ownership and that substantially lessen or prevent compe- regulation of economic activitv It enhances tition and those that are legitimately pur- the mobility of resources and facilitates sued to respond to changing market adaptation, flexibility, dynamic change, and conditions. A zealous application of the law efficiency in the economv. In the face of fis- may dampen legitimate competitive strate- cal deficits and severe budget constraints gies of firms, whereas an overly lax approach confronted by governments in many coun- mav give rise to a new, or entrench an exist- tries, particularly Russia, fostering competi- ing, monopolistic market structure. Either tive markets represents a low-cost method of approach will impede the development of efficientlv allocating resources that avoids the market mechanism. In the context of the administrative and bureaucratic costs as- emerging market economies such as sociated with direct government oversight. Russia's, the risks of this occurring are par- Additional reasons for having an effec- ticularly high, for two important reasons: tive competition policy arise from the nu- The distinction between the types of merous benefits of a well functioning business practices that are legitimate competitive market svstem-namelv the and those that are anti-competitive is entry of new and innovative firms, greater particularly difficult to define in highly- varietv and choice of products, lower prices concentrated economies. and price stability, increased consumer and Identifying actual or potential anti- total economic welfare, diffusion of tech- competitive situations is not a trivial ex- nology and information, and reduced scope ercise. It requires legal and economic for rent seeking behavior bv special interest expertise that is generally lacking in for- groups (a factor of particular saliency in mer centrally-planned economies, and present-day Russia). that takes considerable time to develop. Competition law is a framework policy This suggests that the law must be se- which seeks to strengthen the market lectively appled, perhaps only in blatant mechanism as the primarv vehicle to pro- anti-competitive situations (such as collu-

222 RussIA:CREAINC, PRIVArn ENTERPRISES AND EFFICIENT NIARKETS

,ye agreements to divide markets or fix polistic Activity in Goods Mlarket" on prices or abuse of a dominant market posi- NMarch22, 1991 (amended July 15, 1992). tion that blocks the entry or expansion of Subsequently, the State Committee on firms). Highest priority should be attached Anti-monopolyPolicy and the Promotion of to easingconditions for entry of new firms, New Economic Structures (SCAP) was es- foreign investment, and import competi- tablished to administerand enforce the law. tion. Not only do these measures positive- In addition to the State Committee, eighty- ly influencethe economic environment,but two regionaland localcommittees were cre- they also avoid the risks of inducing other ated, with a staff of approximately 2,400 economic distortionsthrough the misappli- officials, to implement the law across the cation of competition law. In emerging whole country.This makes Russia's compe- economies such as Russia's, most firms, tition agencies the largest in the world. The particularly those dominant in specific in- law contains a conventionalset of provisions ... the law must dustrial sectors, have come about because to address the followingtypes of competi- be selectively of central planningand administrative fiat. tion related matters: In these cases, should an active deconcen- * Abuse of dominant market position applied, perhaps tration policyof breaking up large firms be (AOD or monopolization)-article 5. only in blatant pursued in order to create the structural ba- The provision prevents practices such anti-competitive sis for increasedcompetition? If so, willthis as monopolistic pricing, impeding en- Si encounter the risks of incurring losses in try, discriminatoryor extortionary con- tuations economic efficiency?The likely answer is tractual terms and violations of pricing that such risks are low.In other words, the procedures in other Acts. State and Regional Anti-monopoly Com- Price-fixingand othertypesofcollusive be- mittees in Russia may have the luxury of havior-article 6. The article is aimed at adopting more structurally-oriented solu- agreements and concerted actions by tions toward competition problems (stem- competitors to fix prices, rebates, and ming from existing large, dominant firms), mark-ups, divide markets and cus- than their counterparts in Western indus- tomers, refuse to sell, and impede mar- trialized countries. ket access. However, there is no ban To promote competition and economic against price-fixing or other collusive efficiency, competition authorities need to agreements per se. In exceptional cases be given a larger role in government policy these agreements can be reviewed and formulation and econormic decisionmaking. registered, especially when markets are This is not the prime issue of concern in the saturated or involve exports. context of Russia. The Russian State Com- * Restrictive business practice (RBP)-arti- mittee for Anti-monopoly Policy and the cles 7 and 8. These articles extend to dis- Promotion of New Economic Structures has criminatory sales and conditions, price a wide formal mandate-perhaps too and nonprice predation, exclusive deal- wide-relating to competition, consumer ing, and geographic market restrictions. protection, export promotion, privatization, * Mergers,acquisitions, corporatereorganiza- and small and medium-sized enterprise de- tions, and liquidations (M&A)-articles velopment. If the agency is to realize its po- 17 and 18. These provisions are particu- tential of having a major influence on the larly directed to keep business entities economic climate, organizational structure from establishing dominant market posi- and market performance of Russian indus- tion through mergers, acquisitions, affil- try for years to come, the committee must iations, associations, and various other adopt a more pro-activ'e role. means. Extensive registration requirements and approval procedures are put The application of competition law into place to prevent such business con- in Russia solidation and order divestitures. * Divestitures-articles 1 9 and 21. Russia's Supreme Soviet adopted the "Law - R;ght of accessto inftrtnation (for investi- on Competition and Limitation of Miono- gatorYpurposes)-articles 13 and 14.

COMPEnMINLWx' AND PO L .. 223

In addition, the State and Regional The number of queries and Anti-monopoly Committees can impose dled by the State and Regional . penalties and issue various types of orders nopoly Committees seems to be lai to address different competition concerns. to date there have been only a few ca. Failure to comply with the committees' igated before the Arbitrage Court- measures are backed by legal sanctions, in- body that adjudicates differences betwL cluding prison sentences. the views of the Anti-monopoly Committi There is a lack of accurate statistics on and business entities. The majority of thest the activities of the State and Regional matters have been resolved through nego- Committees, and at times conflicting infor- tiations or rulings of the State and Regional mation is provided by different senior offi- Anti-monopoly Committees. cials. One source states that as of summer Russian observers suggest that the time 1993-since the passage of the law-over and resources expended by the committees 4,000 queries and individual cases have does not correspond to the distribution of been examined by the State and Regional queries and complaints indicated above, Committees. A rough estimate of the and that as much as 55 percent of the com- breakdown of these queries is as follows: mittees resources is devoted to reviewing formation of new businesses, joint stock Articles Percent- Subject companies, and enterprise reorganizations. 5 30 AOD Apparently, new and restructured business 17 26 M&As entities can only be formally registered af- 19 and 21 11 Divestitures, ter the Anti-monopoly Committee has ex- corporate amined and reviewed their formation and reorganizations organizational structure from a competi- 6, 7, and 8 10 Collusion-RBPs tion viewpoint. This procedure imposes an 13 and 14 6 Information unnecessary regulatory burden on compa- requirements nies and delays the entry of new firms and Others 17 the restructuring of enterprises. The State Anti-monopoly Committee Another source states that in the first has been preoccupied with formulating quarter of 1993 alone, nearly 3,000 com- new rules, regulations, and procedures on plaints were received by these committees, the interpretation and implementation of and of the nearly 800 cases initiated, 64 the law. This may be justified to foster con- percent pertain to article 5 and 22 percent sistency in the application of the law across to article 7 of the law. If this is the case, the the Russian Federation, given that there are level of enforcement activitv in Russia far eighty-two separate Regional Committees. exceeds that of many OECD countries. At the initiative of the Anti-Monopoly Given the high level of industrial con- Committee, a memor4ndum of under- centration prevailing in Russia, and the large standing has been agreed between Russia, amount of privatization, a higher incidence the CIS countries, and some Baltic re- of cases and queries relating to abuse of publics on exchange of information and dominant market position and restrictive mutual cooperation and assistance to pre- business practices is to be expected. More- vent anti-competitive practices by enter- over, the lower incidence of price fixing and prises located in different jurisdictions. other collusive arrangements may be due to These measures are also aimed at main- the high levels of inflation and the changing taining the production and supply linkages market environment. In such an environ- that existed between enterprises in the for- ment, stable inter-firm anti-competitive mer Soviet Union, thus facilitating trans- arrangements are difficult to monitor and border transactions (which may otherwise maintain. Also, with increased privatization have been restricted by artificial and unfair one may expect a fair number of cases in the restraints to trade). areas of mergers and acquisitions and cor- These measures, as well as amendments porate reorganizations. to the law currently under review, suggest

224 RussIA:CRxAnING PRivATE ENIERPRISES AND EFFICIENT MARKETS

that the legal infrastructure is in place for a maintain supplies, withdraw subsidies, much more vigorousapplication of the law. force enterprise restructuring, and require However, they also implv that the State and contributions to the state reserve funds Regional Anti-monopoly Committees may from the sale of output at regulated prices. be even more prone than the State Com- The decrees and resolutions relating to mittee toward a regulatory approach to im- the register reflect difficulties encountered plementing the law Nowhere is this more in directly controlling prices and the behav- evident than in the maintenance of a ior of enterprises, and represent an example "Register of Dominant Firms." of incremental regulation. Initially the de- According to the Russian Anti-monopoly crees concerned the pricing policies and Law, a dominant firm is one which has 35 other business practices of dominant firms percent of the relevant market. However, that had abused their market power. Then because statistics are not available to delin- they related to control of prices of specific eate the relevant market, the State and industrial and consumer products consid- Regional Anti-monopoly Committees have ered to be important or vital. Subsequently, relied primarilv on census production data measures were instituted to control the compiled by the State Committee for prices of dominant firms engaged in the pro- Statistics (Goskomstat). Once an enterprise duction of these products. When it was has been deemed to be in a dominant posi- found difficult to directly monitor and con- tion, it is listed on a register and subjected to trol prices of these enterprises-in part be- profit-margin, price, and output controls. cause of high rates of inflation, decline in The register is also material to the privatiza- output, and deterioration in general eco- tion process, as the State Committee for nomic conditions-profit margin ceilings Mlanagement of State Property (GKI) uses were established for dominant firms pro- it to select the order of enterprises to be pri- ducing specific products. All these policy vatized. Because being listed on the register changes took place over a span of five introduces constraints on operational free- months. (The profit-margin ceilings and dom as well as on restructuring and privati- other controls do not apply to nondominant zation, managers have initiated legal enterprises producing the same products.) challenges and applications to the Anti- Constantly changing government poli- monopolv Committees to have their enter- cies introduce additional business risk and prises delisted. The register is updated uncertainty. It has been well established in monthly and the exact number of listed en- the economic literature that price, profit, terprises varies by region and over time. The and output controls give rise to distortions register was instituted in Februarv 1992, and in the allocation of resources. These mea- at that time contained approximately 2,000 sures also act as impediments to efficient enterprises at the state and regional levels. enterprise restructuring. In several situa- While precise data is not available, it is ap- tions, existing product lines could not be al- parent that the designated list of dominant tered in response to changing market enterprises on the register has been shrink- demands. In addition, enterprises have en- ing during the past year. gaged in regulatory avoidance by inflating The Dominant Enterprise Register is costs to obtain price increases while keep- maintained in an effort to prevent monop- ing within the established profit-margin olistic exploitation bv state-owned and ceilings. newly-privatized enterprises in the wake of Establishment and maintenance of the price liberalization. Initially various de- register has changed the role of the Anti- crees and resolutions were introduced dur- monopoly Committee from that of an ing the 1991-92 winter, to control the agency that encourage competition and pricing behavior and business practices of corrects market failures arising from mo- enterprises which had abused their market nopolistic practices, to that of a regulatory power. To deter and counteract these abus- agency that further distorts price-profit sig- es the committee was empowered to take nals and the efficient resource allocation measures to restore contractual terms, process. Firms on the register must not only

(GA)PLTflh()NLA\X AND POLICY 225

respect the established profit-margin cell- An area of particular importance is ings, but also declare and receive approval wholesale and retail trade distribution (infor anv price increases.Failure to do so car- cluding warehousing).Regulatory impedi. ries fines that are equal to twice the addi- ments, high concentration,restrictions on tional income earned between the private ownership of land and real estate, difference of the previous and subsequent and increased market segmentationdue to price levels. According to one informed the breakdown in transportation systems source, violationsof this policv have led to have all contributedto heighteningthe bar- fines of 2.7 billion rubles. In one oblast riers to entry in this area.As a consequence, (Kurgan) over fiftv dominant enterprises the flowof goodsand the marketadjustment failedto register price increases and had to process have been adverselyaffected. Local return (were fined) 220 million rubles. and regionalmonopolies are widespread. Fostering effective In addition to maintaining the "Domi- All in all, in order to foster competition competition is as nant Enterprise Register," the committees in the Russian economy, the Anti-monopoly have the right to veto a privatization pro- Committee should be a much more active much a vigorous posal. This powerful instrument can, in advocate of competitionrather than simply application of theory, be applied to accelerate the break- a regulator of suspected abuse. It must: competition law as up or divestiture of integrated monopolis- Promote the break up of large integrat- tic firms.However, this policv lever has not ed enterprises (demonopolization)dur- it is promoting a been effectively utilized, especially at the ing the process of privatization; liberalized state level. As a consequence, large inte- * Attackvarious licensing regulations, ad- economic grated firns in highly-concentrated indus- ministrativeobstacles, and procedures tries have been privatized as single entities, that impede the entry and restructuring environment. missingthe opportunitv of demonopoliza- of enterprises;and tion and increased competition. * Pro-actively encourage pro-competi- In severalcases where privatization has tion governmentpolicies, such as in the taken place and a number of independent areas of private ownership of land and business entities have emerged, there has real estate, financialmarkets, foreign in- been a tendencv to re-establish previous vestment, and trade. horizontaland verticallinkages through the Fostering effective competition is as establishment of holding companies and much a vigorousapplication of competition associations.In some situations these link- law as it is a promotion of a liberalizedeco- agesrepresent legitimate attempts to main- nomic environment.A complementaryand tain vital technological linkages, realize reinforcingset of actions need to be taken certain efficiencies,and reduce the risks as- on multiple fronts. sociatedwith variousinter-firm contractual Information on the operations and pri- relationships. However, it is more likely orities of the Anti-monopoly Committee that they will act to limit competition must be made availableand public aware- through price-fixing and other anti-com- ness of the importanceof the law and competitive practices. Given the highlv concen- petition policvneeds to be increased.These trated nature of Russian industry, the actionswould contribute toward creating a committee must be particularlv vigilant of broad base of support for competition in these developments. It should develop the Russian economy.At present the com- strict rules for mergersand acquisitions and mittee has a lowprofile both insideand out- the formation of holding companies. The side the government.This has led to the burden of proof that efficiencies are likely view that it is not a significantplaver in the to be generated and that competition will economic transition process. not be significantlyimpaired should rest with the firms. Wherever possible, inter- firm rivalryshould be encouraged to pre- Conclusion vent managers from gravitating to the comfortable relationships central planning Much needs to be done to effectivelyim- had previouslyestablished. plement Russia's competition (anti-mo-

226 RUSsIA: CREATING PRiv,%T ENIERPRISES AND EFFI(CIENT IMARKETS nopolv) law and to foster a competitiveen- * Trainand develop staff in Russiaand pro- vironment to facilitate enterprise reform vide internships in established competi- and structural adjustment. The law has not tion agenciesin industrializedcountries. been vigorouslyapplied by the Anti-mo- Undertake legal and economic studies nopolv Committee, in part because of the to further improve the application and lack of institutionalcapabilitv, trained per- development of competition law and sonnel, and financial and other resources. policv in Russia. In addition, the committee has tended to be regulatorvin its approach bv maintain- Notes ing the dominant enterprise register and imposingprofit-margins, output, and other Withoutimplication, this paper has benefitted controlswhich overlv constrain the opera from exchangeof viewsand informationwrith CharlesBlitzer and Irina Starodubrovskava,The tions of these enterprises. The register and WXorldW BankB ResidentRsdnmsi. mission, i91oscowv;M VlaclimirV related regulations need to be abolished. Capelik,Vlorking Centre for EconomicReforms, Concerns regarding monopolv pricing by Moscow;and variousofficials in the State and the dominant enterprises are best ad- RegionalAnti-monopoly Committees. dressed bv reducing barriers to entry- 1. There are differingviews on the degreeto most of which have been created bv ahich industrialconcentration can be character- government policy itself. The existing law izedas highin Russia.Brown et al (1993)found contains sufficientinstruments to remedy that verylarge firmsare more prevalentin the other anti-competitivepra s whc UnitedStates, and there is littleaggregate or in- other anti-competitive practices wvhich dustrvconcentration at thenational level in Russia. these enterprises may engage in. However.they find that barriersto competition A number of other recommendations highlysegment product markets in Russia, suggest- have been made in the this chapter. To re- ingthat industnrconcentration at regionaland lo- capitulate, the Anti-MonopolyCommittee cal levelsis muchhigher. One problemwith the must: dataset used in theiranalysis is that it doesnot in- * Formulate strict rules for mergers, ac- clude the productionof civiliangoods by enter- .ui.ition., and holding companieswith prisesin the defensesector, which, depending on quisitions, and holding companieswith theirrelative size and number. can significantly bias the burden being on the enterprises to the measuresof concentration. For other xiews on prove that efficiencieswill be generated industrialconcentration in Russia,see citations in and that competition wvillnot be signif- Brownet al and in Starodubrovskava( 1994). icantlv reduced. * Increase the scrutiny and break-up of Selected references large integratedenterprises and industrial associations,particularly those seeking Brown,A.N., B. Ickes and R.Ryterman. 1993. "The to re-establish traditionalconcentrated- Mythof Monopoly:A NewvView of Industrial monopo-stclinkaesfoteredbvStructure in Russia." The %Xbrld Bank. Draft. Capelik,V 1993."Antimonopolv Policx in Russia." plannmng. PrincetonUniversitv, New Jersev Draft. * Initiate competition in the wholesale Joskow,PL., R. Schmalenseeand N. Tsukanova. and retail trade distribution and trans- 1994."Competition Policy in RussiaDuring and portation sectors. After Privatization,"Discussion Paper, The To effect these changes, the institution- BrookingsInstitute, Woshington, D.C. al capabilities and resources of the Anti- Petrov,A. 1993."Privatization and Antimonopolv monopolytCommittee must be enhanced. Policy" in Ruissias Emnergin.gMarket, RFE/RL Technical assistance is needed to: ResearchReport2 30X:i9-'2 Provideandresidentexpertadvisiting Starodubrovskaya,1.1994. "The Nature of Mono- * Provide visiting and resident expert ad- polyand Barriersto Entrvin Russia,"Commza- visorsin the fieldof industrialorganiza- nist Economies and EconornicTransfomnation tion and competition policy: 6i ):3-18.

C0'.:-':I-.ln()NL. X AND V )1.1' 227

Synopsisof ConferenceProceedings Privatization and the Emerging Private Sector in Russia June 20-21, 1994

OnJune 20-21, 1994, the World Bank held JUNE 20 - DAY ONE a conference in Washington, D.C., on the subject of "Privatization and the Emerging An Overview of Russian Mass Private Sector in Russia." Those making Privatization presentations included: Maxim Boycko, RutssianPrivatization * Anatolv Chubais, Russian Deputy Prime Center Minister * Naxim Boycko, President of the Russian The principal goals of the Russian Mass Privatization Center Privatization Program (MPP) were to - Peter Filppov, Head of the Department transfer state-owned enterprises (SOEs) to of Information in the Administration of the private sector. The intention was to re- the President of the Russian Federation move firms from the control of politicians, * AndreiVolgin, Director of the Derzhava and create a constituency for a market Investment Fund, Moscow economv. The Russian MPP has been very * Andrei Shleifer of Harvard University, successful in achieving these goals. The Advisor to the GKI speed of transfer of so large a volume of as- * Jonathan Hay. Advisor to the GKI sets is without precedent. * Charbel Ackerman, Advisor to the GIM The implementation phase of the MPP * Joseph Blasi of Rutgers University, started in December 1992, with the sale of Advisor to the GM and Russian Privati- eighteen enterprises. Since then, between zation Center 12,000 and 13,000 large and medium-size * LerovJones of Boston University, Advi- enterprises have been privatized, across all sor to the GM sectors, increasingly even including some in * Sven Hegstad of the European Bank the defense industrv. Russia has gone much for Reconstruction and Development farther than manv countries in choosing to * Mark St. Giles of Cadogan Intema- quickly privatize infrastructure firms, includ- tional, London ing electricity, telecommunications, and gas. * Walter Coles of USAID The view sometimes expressed that large en- * John M14oranof USAID terprises have not been privatized is incor- * Alexandra Vacroux of Harvard Univer- rect-one-third of all divested assets are in sitv, Advisor to the GMI companies vith over 10,000 employees. * Thirteen staff members of the World Two-thirds of total industrial employment Bank and IFC, all of whom have worked will be already privatized bvJuly 1, 1994, with on the privatization process in Russia. the average privatized companv employing Attendance at the two-dav meeting var- 1,100 people. ied from 50 to 200 persons, depending on Privatization has catalyzed a number of the session. What follows is a svnopsis of important reforms elsewhere in the econo- the verbal presentations made in the course my. One example pertains to the develop- of the conference, both by presenters and ment of capital markets. In 1992, onlv a few discussants. companies were publicly traded. Since the

SvN,ulI,1 (F CONFERENCEPROCEEDINGS 229

inception of the MIPPE16,000 companies Fuirtherdeaelopcapitalmarkets. Effective have issued shares and more than 600 in- regulation and efficient support systems vestment funds have been created. in capital markets will have an impor- Vouchers have been activelv traded, at a tant impact on enterprises' ability to volume which sometimes reached 400,000 raise capital. Transparent transactions to 600,000 per dav. There are now more and liquid markets must be assured if shareholders in Russia than in the United the capital markets are to be a vehicle States and United Kingdom combined. for enterprise reform. The ownership structure in most com- Implement land and real estate reform. In panies is dominated by insiders, holding an Western economies, nearly one-half of average of 60 percent of the shares of each total tangible wealth is in land and real privatized firm. But the negative effects of estate assets. In Russia, these assets are ... the negative insider domination are less than anticipat- today controlled by the local govern- effects of insider ed, and secondarv trades are beginning to ments. A clean and transparent system take place. Verv often, for example, compa- for real estate registration must be es- domination are less nies in need of cash solcit outside investors, tablished. Further privatization of land than anticipated, including foreign investors. Workers and and clear property rights will also allow and secondary managers own shares on an individual basis, enterprises to attract capital for restruc- not in a collective manner, and in many cas- turing, by permitting them to mortgage trades are beginning es they are selling shares to outsiders. their realIestate holdings. Measures such to take place. Information from a survev conducted by as development of a mortgage finance Leila Webster of the World Bank showed institution should also be considered. that 60 percent of newly-privatized enter- * Facilitate spin-off of social assets. Only prises have introduced new products, and limited progress has been made in sep- 40 percent have laid off workers. Data from arating social assets (such as housing, three regions show that large outside in- childcare, and healthcare) from enter- vestors have successfullv appointed new prises. The maintenance of these assets managers to privatized companies; and an- poses a high financial burden on firms, other studv indicated that managers have diverts scarce management resources been replaced in 10 percent of all firms ex- from restructuring, and makes an en- amined. Thus, insiders have not been able terprise unattractive to investors. Even to totallv block restructuring, and outsider more importantly, enterprises use these ownership continues to increase, mitigating assets as hostages and pressure the gov- the potential problems of concentrated in- ernment for funding, predicting social sider ownership. catastrophe if the flow of subsidies is The next phase of reform must focus on cut off thereby ruining any hopes of de- attracting foreign investment into the politicizing the new enterprises. Russia Russian private sector. The critical mea- has proposed that the World Bank fund sures required to achieve this goal are: a pilot program for divesting social as- Implement a 'classical" prnvatizationpro- sets, and awaits its decision. In this area, gra. The 10,000 or more companies not a great deal of foreign aid and technical included in the MPP, and the remaining assistance is needed. (minority) state-owned shares in MPP The MPP has led Russia through in- companies, should all be sold using clas- credible reforms in record time. The array sical privatization methods-auctions, of accomplishments would have been trade sales, tenders, and so on-thus fi- unimaginable wvithout the MPP Mlost im- nalizing the separation between the state portantly, the MPP has made market re- and enterprise. This program would also forms irreversible. generate cash, of vhich about 50 percent The discussant for the Boycko presenta- wvouldbe returned to the enterprise for tion was Walter Coles of USAID, who pre- use in restructunng. Both investors and sented five elements that contributed to the the existing insider-owners should find success of the MPP First, consolidation of this prospect attractive. donor resources led to quick and concerted

230 RuSSIA:CREATING PRIVATE ENTERPRISES AND EFFICIENT NIARKETS action. Second. flexibility and speed were enterprises sometimes closed temporarily to emphasized over rigid strategies. Third, in- enable labor collectives to develop business dependent advisors wvereused, instead of a strategies. prime contractor with implementation re- The regional large-scale privatization sponsibilitv Generallxv a sole contractor program was a multi-step process. First, the tended to become closely aligned with one enterprises were transformed into joint government institution, and its own inter- stock companies. Employees in most enter- ests might have conflicted with the best in- prises chose the second of available options, terests of the program. Fourth, Russian in which 51 percent of the shares get trans- managers were trained and appointed early ferred to insiders. The voucher auction in the process, and therefore enterprises did process then distributed all but 20 percent not have to continually relv on long-term of the shares of each enterprise, with this re- foreign consultants. Lastly; clear and trans- mainder held bv the regional property fund. Enterprises formed parent systems were developed to avoid re- Enterprises were sold in waves of forty to a basically liance on case by case approaches. Through fifty every two months. By the third quarter application of these principles, both the of 1993, Primorskv was one of the top fif defensive structure Russian privatization team and the donor teen Russian regions in the number of en- called the PAKT to community avoided problems common to terprises sold. Thus, it was a shock when the aid-supported operations. local administrationeffectively banned further auctions in August 1993. from outside A Regional View of Privatization- An analysis of the interaction between investors. Primorsky Krai the four groups of active participants in the Alexandra Uacrotcv,GKI privatization process illustrates why such a decision was taken. The participants were Primorskv krai lies seven time zones from local government, federal government, en- Moscow. Until the last few vears its center terprises, and entrepreneurs. was a closed militarv citv with a population The local GKI and local property funds of 2.3 million. Over 1.0 million people are were most influential in deciding the order part of the military industry, which com- in which enterprises were to be privatized. prises 25 percent of the regional economy. The Central GKI and Central Propertv The region has many natural resources, Fund struggled with each other as well as such as ore and mineral deposits, timber, with the local agencies. The state remained and marine products. It has the advantages dependent on enterprises for tax revenues of geographic location with three ice-free and the provision of social services. The en- ports, natural resources, and a highly- trepreneurs found privatization profitable, trained labor force. and wanted it to continue. (A potential fifth The region had 1,800 small-scale enter- group, labor leaders and local politicians, prises, of which 51 percent have been pri- were found to be generally inactive in this vatized since the spring of 1993. Mlvostwere region.) privatized through competitive tenders, Enterprises formed a basically defen- with restrictions forbidding the new owner sive structure called the PAKT to protect to change the line of business for a period themselves from outside investors. This or- of five years. Both the enterprises and the ganization sought to transform the eco- local government responded quickly to the nomic power of industrial enterprises into cash incentives presented by small-scale pri- political power. In Miay 1993, the governor vatization. Problems which surfaced includ- of the krai appointed members of the ed disputes between regional and municipal PAKT to his administration. The enterprise governments regarding -whoactually owned managers wanted to maintain control of what, and complaints that private enterpris- their firms, and they used the power of the es were "reprofling" or closing, thus failing PAKT and the local administration to chal- to provide necessary services. In reality, the lenge and halt privatization. Ultimatelv nonprivatized enterprises were the ones re- pressure from Anatolv Chubais, the Deputy profiling and driving up prices. Privatized Prime Mlinister, and the entrepreneurs

SVNOPSIS ()I (OFPCOTRENCE PROtEEDWINUS 231

forced the local administration to reverse of shares, so they already,presumably, have its decision. the same objectivesas shareholders. The struggle in the relationship between the central and regional agencies Land Privatizationin Nizhny Novgorod continues to evolve. The central govern- GretchenWilson, IFC ment wants to maintain a supervisory role over the localgovernment. The central gov- The International Finance Corporation ernment had a particular interest in started working with the GKI in December Primorskykrai because of the wealth of the 1991, to complete privatization transac- region. On the other hand, the natural re- tions which would put the new laws and ap- sources and wealth in Primorsky krai rein- proaches into concrete action. Nizhny forced a local perception that it did not Novgorod was chosen as the experimental need the assistance and interference of the site because it wasRussia's third largest city, central govemment. was a leading industrial area, and had a The discussant, Igor Artemniev,of the mayorand a govemorcommitted to reform World Bank, noted that this type of politi- in general and privatizationin particular. cal maneuvering,which caused Primorsky The IFC's approach was decidedly grass krai to fall from its position as one of the roots, meaning it sent staff to live in the leaders in privatization, has been quite field, and gain the knowledgeand trust nec- common in Russia. He presented some essary to develop open, rapid, and fair sales likelyfuture problems concerning the role processes-with the further hope that they and authority of local governments. The be transferred to other regions.In collabo- conflictover distribution of proceeds from ration with the regional authorities and privatizationwill become more intense as with central GKI, IFC concentrated on more cash auctions take place. The battle four areas of privatization: small scale, for the proceeds of privatization among the trucking, large scale, and land reform. The central government, the regions, and the first three have been described in other enterprises wvillescalate. He predicted that seminars; Ms. Wilson concentrated on the regional authorities will become more re- last, less known program. sistant to the privatization of land and real The IFC initiated the land reform pro- estate because that is their last area of con- gram in January 1993, at the request of the trol. The regional authorities also want a local authorities. There are 700 state col- role in corporate governance,and they seek lective farmsin Nizhny Novgorod, with an control over a percentage of the state average size of 3,000-4,000 hectares. An shares. Lastly,regional authorities will seek average of 600 people live on each farm, a role in holding companies and industrial one-half of whom are pensioners. groups that are being created. The objective of the program was to In the ensuing general discussion, transfer land and property to private own- Maxim Boyckopointed out that Primorsky ership. The design of the program adhered krai was an exception in the degree of to five basic principles: participation was prominence and power of the PAKT. Mr. voluntary; participantschose the structure Bovckoalso made a comparison with China of ownership for the new units which were regardingthe relationship between central created; assets were transformed into fam- and local government and the role of com- ily farms, partnerships, or companies; dis- petition in incentivizing managers. The cussion of all contracts and agreements was Chinese government has a straightforward an open public process; and information relationshipwith all local govemments, but was widely disseminated.Six farms volun- this is not the case in Russia,wvhere the fight teered to participatein the pilot program. for authority takes place in individual nego- Actual reforms were implemented in tiations with regions. In China, managers' five stages. The preparationstage involved compensationneeded to be alignedwith the assessingthe land and preparing an mven- shareholders' interests in order to provide torv of property.The description and char- incentives.In Russia.managers hold blocks acteristics of the farm were verified, its

232 RussiA:CR.c.sTING PRIVATEENTERPRISES AND EFFICIENT MARK-ETS balance sheet revalued, and the qualifying cessfulbecause of the high levelof commit- individuals were confirmed. In the first ment, voluntary participation, and foreign stage, entitlement certificateswere distrib- assistance in initiation stages. uted to all qualifyingindividuals, specifying John Nellis of the World Bank praised the number of hectares of their entitle- the IFC's commitment and the active,res- ment. The public information programwas idential, hands-on implementation role it also initiated at this time to educate people has taken in this and all its activities in about the program. Russia.He asked whether land allocations In the second stage, contracts creating were adjusted for differences in land qual- new enterprises were finalized.Individuals ity, and asked about the time and estimat- were presented samplecontracts for differed cost of implementing this type of ent types of entities-private familyfarms, program on a widespread basis, noting that partnerships,and companies-and the rights a major effort was required to privatizejust and obligationsof each type of entitywas ex- six farms. Ms. Wllson responded to the first plained. Individualsthen chose the type of issue by citing the widely accepted Russian entities theywanted to form.Pensioners who method for rating land quality Hectarage is did not wish to farm could lease or gift their simply adjusted by this rating. This pilot hectarage. program privatized six farms over eighteen Stage three was the auction process. months at a cost of $2.5 million, but once Land was divided into the smallestunits, so the systems and procedures are developed, that private farms could apply for individ- the cost and time requirements should de- ual fields. Each entity applied for the land cline dramaticallv.The next six months of and property it wanted, indicating the the program willconcentrate on trainingof- amount of land entitlement certificates ficials from other regions, so they can im- they were willing to bid. In practice, the plement the program themselves. land and property have already been divided between the participants through their VoucherInvestment Funds in Russia own negotiations. Only in a small number Andrei ,olgin,Derzhava Investment Fund of cases did conflicts arise over the same property,in which case it went to the high- In 1992, there were less than 100 smallin- est bidder. In the finalstage, land and prop- vestment funds in Russia; now, there are ertv were transferred, and titling was over 640 funds. There are four types of completed. Both the World Bank and US- funds: funds created by banks; funds creat- AID have been working to develop the tied by financial institutions, such as broker- tling system in Nizhny Novgorod. ages or investment consultants; "amateur Between November 1993 and May funds" created by regional authorities, or 1994, all six test farms were privatized.This solely to purchase a single company; and process created sixty new private entities, fraudulent funds. The recent exposure of a rangingfrom an individualwho now owns a fund with a million shareholders,which lost truck and provides trucking services, to one-third of its assets due to fraudulent be- small familieswith their own farms, to com- havior, has focused attention on preventing panies operating a large farm with hundreds phony funds.' of owners. Prime Minister Chernomyrdin The size of a fund is generallv depen- endorsed this program as a model for other dent on the geographic scope of its invest- regions in a conferencewith governorsfrom ments. Some of the most popular funds are eighty-eight regions held in March 1994. small regional funds with 1,000 to 10,000 Workhas just begun with two other regions shareholders and less than $1.0 million in in implementinga similarprogram and fifty assets under management. However, ap- more farms have volunteered to be priva- proximately30 percent of these funds can- tized. The process generates new issues not cover their operating costs, and are which need to be addressed, such as mar- seeking mergers with other funds. The in- keting, infrastructure,and access to credit terregional funds generally invest in fiveto and supplies. Nizhny Novgorod was suc- thirty regions and manage $1.0 million to

SYNOPSISOF CONFERENCEPROCEEDINGS 233

S 10.0 million in assets. The largest funds, Other funds combine the focus on new ven- the national funds managing asset bases of tures with an emphasis on long-term portfo- S25 million to $50 million, are held bv 1.0 lio investments. Generally, in companies million to 3.0 million shareholders. wvhichare held for long-term investments, The government sponsored advertising two to three funds each control up to 25 per- campaigns to encourage people to invest cent of the shares, and work together to push their vouchers, rather than sell them. Most restructuring quickly Lastly, there are diver- people had no experience in investments or sified funds, which hold shares in 70 to 240 investment funds, and responded to adver- enterprises, and funds that specialize in par- tising and promises of high returns. The ticular sectors. funds had no time to build their reputation, and had to rely on advertising and promis- Emerging Capital Markets in Russia The popular es to attract investors. The largest funds Clatdia Morgenstern,IFC perception of spent 3 percent to 10 percent of their assets in advertising. This created unachievable The development of efficient capital mar- investment funds is expectations, and funds faced great diffi- kets is a critical part of the Russian trans- currently at a very cultv in the first quarter of 1994 explaining formation for two reasons: capital markets low level. their low performance. The popular per- serve to allocate funds needed to restruc- ception of investment funds is currently at ture enterprises and thev provide a source a very low level. of discipline and incentives for enterprises. IMvlostfunds had difficulties developing Capital markets regulate a company's ac- their back office svstems for colLecting cess to, and cost of, capital. Shareholders vouchers and recording shareholders. can discipline poorly performing managers Funds contracted with Sberbank (the through their voting rights or through exit Russian national savings bank, with offices in the secondary market. Neither of these throughout the country) and the post office functions can be provided solelv by banks. for collection of vouchers. Most funds is- The Russian market is currentlv very sued certificates indicating shares in the in- fragmented. There are more than eighty li- vestment fund in exchange for vouchers; censed exchanges, but most of the trading only a few funds had a book entry system occurs outside the market. The exchanges for recording this information. The largest account for no more than 10 percent of to- funds have not vet completed the work of tal trading volume. Foreign portfolio man- recording all shareholders. agers are extremelv active in the market. Russian equity markets are not very liq- Two recent presidential decrees seek to uid and suffer from poor trading systems. establish minimum standards for reliable in- Fund managers prefer to trade directly with formation in the capital markets, including each other rather than through an ex- the investment funds. The first decree spec- change. Systems for trading, information ifies truth in advertising standards, the oth- depository services, and clearing are being er establishes standards for distribution of developed. The problem of enforcing fulL new securities issues and financial reporting. disclosure regulations must still be ad- The perceptions and objectives of the dressed in order to create efficient markets. participants are the main impediments to There are only a few funds with a pro- the emergence of efficient markets in nounced investment strategy that is strictly Russia. First, brokers and their customer are followed. One such strategy is the specula- not concerned with transparency or effi- tive approach, whereby funds purchase ciency; thev wvant to manipulate prices. shares of companies in special situations Second, many brokers were permitted into with the intention of selling them quickly. the market without any regulation, and Often, these are companies in wvhich the without much concern toward the broker's managers and outsiders are quickly purchas- stabilitv.This will need to be better regulating shares in order to gain control. Another ed as the secondarv market develops and strategy combines the speculative approach brokers have to provide counter-party trans- with a focus on new venture investments. actions. Third, investors are concerned not

234 RIISSLA:CRrAT;NG PRi\'I-n ENT1RPRI.IES AND EFIICIENT NAR}nTS with the pricing mechanism which an effi- example, USAID is involved with one cient exchange provides, but with promises fund which focuses on small and medium- of return. Investors tend to think of stocks sized enterprises with fewer than 2,500 more as fixed income instruments. Fourth, employees, and another fund which fo- brokers see control over their economic en- cuses on larger companies, in two regions. vironment as a higher priority than efficien- These funds take equity positions and pro- cy, and are suspicious of any collective vide technical assistance to companies in institutions for centralized clearing and set- which they invest. tlement. Lastly, brokers see only the issuers as their clients, and aim to monopolize trad- Private Sector Development in Russia ing in a particular issue, rather than to serve Leila W't'bsterand Marie Sheppard, Wvorld the investors. Bank The first two areas of regulation for the Securities and Exchange Commission in Leila Webster presented the results of a sur- the United States were the registration and vey she conducted to identify the types of deposit of securities. Nearly all new securi- people in the emerging Russian private sec- ties in Russia have been issued in the form tor, their operating strategies, and the im- of bearer certificates. Manv investors, in- plications for future assistance programs. cluding investment funds, want certificated The survey, undertaken in November 1993, shares so they can be traded immediately. shows a private sector that is very hetero- Tlhe development of a reliable registration geneous, composed of new firms, newly- system is the only solution to persuade in- privatized state-owned enterprises, and vestors to switch from share certificates. firms which have been operating in a quasi- Russia's capital markets have a strong private mode since the Perestroika reforms regional bias due to the size and geograph- of the late 1980s. ical diversity of the country The regional emphasis is somewhat beneficial, because Who are the managers?The managers of officials in a region will have the best and private firms are overwhelmingly male, with most current information on companies in university degrees, between the ages of that region. But the current situation-a forty-five and fifty. Thev are either former large number of exchanges with high fixed managers of SOEs or have technical back- investments and low trade volume-can- grounds. These are educated, skilled people not be maintained. who have gaps of knowvledgein a number of A substantial number of existing insti- specific areas related to operating a private tutions are not motivated financially to business. work through collective institutions. A shift in economic incentives, so that brokers How do they maxunzte profits) The new view the investors as their primary clients, firms generallv have a short-term outlook, wvillbe an important turning point toward seeking to capitalize on a few niche oppor- rationalizing markets. tunities, while the privatized firms have a Mlark St. Giles, of Cadogan Interna- longer-term outlook. Many new firms gen- tional, commented on the presentations bv erate profits by supplying import substitu- Volgin and Morgenstern, noting that the tion goods, which they can monopolize for reason investment funds devote so much a short period. They are flexible and can re- energy to control is because there are no react quickly to serve the market, taking ad- liable support systems. Once the market vantage of the inefficiencies of the former and the infrastructure develop, and brokers SOEs. The privatized companies provide develop more trust in these svstems, the ob- greater assurance of delivery for large or- session with control will decline. ders, and continue to work with other for- John IMvloranof USAID described mer SOEs. They are making small changes some equity funds in Russia, which to enhance productivity and responsive- USAID has taken a role in establishing, in ness, as well as to minimize the burden of conjunction with OPIC and EBRD. For social assets.

S', NOISIS OFCONFERENCE PROCEEDIN(,S 235

H(11od( they mi nz rzsk)Managersof subsidies to alleviate the constraint), and new tirms hesitate to make large invest- poorly-designed and -delivered programs. ments and generally rely on leased equip- For these reasons, many people believe that ment and space. They avoid hiring full-time the government should only provide passive employees and taking on long-term financ- intervention, and should leave the active ing. They rely on short-term loans and cus- measures to the private sector. Government tomer advances for working capital. The can play a role by identifying the appropriate managers of privatized firms are not laying organizations to work on various compo- off workers, either because they do not want nents of an assistance program. to be caught with insufficient labor when a In Russia, finding and securing com- large order appears or so they can use the mercial property is a severe constraint. workers as "hostages" to negotiate subsi- There is a shortage of retail space, but there There is little import dies. They too tend to avoid long-term debt. is an excess of manufacturing space. competition now, so Property use is misallocated, creating areas Howv can we help?There is little import where street level space is reserved for we (the World Bank competition now, so we (the World Bank housing, so that retailers must be located and external aid and external aid agencies) need to encour- far from residential areas. agencies) need to age trade liberalization. We need to respect One passive solution to this problem is the people we are assisting; thev are compe- the lifting of profile restrictions for priva- encourage trade tent. We need to listen to what they need, tized companies, so they could provide liberalization. and provide practical training, not theories. whatever services the area market needed. WX'eneed to encourage more activities along Secondly, effective mechanisms for dispute the lines of a recent project which establish- resolution would allow contracts for space es a 2 to 3 year financing mechanism for en- to be enforced. A gray area is provision of terprises. And we must prove our worth by information on available properties, for- providing top qualitv assistance. merly available only through the GKI. This Marie Sheppard dealt with alleviating information could be provided by the pri- constraints to businesses. She discussed how vate sector to allow businesses easier access. to identify the most important constraints An active measure that addresses this prob- and to examine the potential to alleviate the lem is the creation of semi-permanent street constraint, using the shortage of commercial markets. The government could regulate propertv in Russia as an example. The first these markets and contract out the mainte- step in alleviating constraints is to determine nance to a private firm. This solution would whether a perceived constraint is a serious provide a stable location for the sellers, ac- impediment, or merely a nuisance. Con- cess to the buyers, and revenues for the gov- straints which have the greatest commonali- ernment, and might even provide business tv should be addressed first. The resources people with some relief from the "mafia" and participants must be examined in light of that interferes in real estate and other busi- their potential to alleViate the constraint. ness operations. Another solution might be Thus, one should target constraints that are the development of leasing centers which most costly to the greatest number of firms, would renovate underutilized space for re- and that one has the abilitv to alleviate. tail and manufacturing use. This option, The mode of intervention can be passive however, requires financing to renovate or active. Passive intervention includes ad- space and development of contracts which dressing policy or regulatory issues, while ac- provide the legal assurances necessary for tive intervention involves actually providing making large investments. services to firms that would alleviate the con- Commenting on these presentations, straint. It is rare to find active government in- Michael Gould, of the World Bank, pre- ter-ventions which are cost-effective and sented a broader view of Russia's passive target the appropriate people. Governments and active measures for developing the pri- tend to have multiple, conflicting goals (em- vate sector. Over the last few months, ployment and efficiency), strategies that are Russia has shown some signs of increasing inconsistent wxitha market economy (provide macroeconomic stability, which should ale-

236 RUSSIA:CREAnNG PF;v.;nEENTERPRISES AND EFFIC1ENT M%LARKETS

v-iate some of the most pressing constraints been financed directly from a supposedly on the private sector. In addition, however, infinite state budget. Today, it competes Russia needs to develop laws defining and against Siemens and must be much more regulating commercial operations, institu- cost-conscious. While this company seems tions to enforce these laws, and a support- to have made a smooth transition, one of ive public opinion toward not only these the directors, who controls 40 percent of laws, but also toward the concepts on which the enterprise, continues to financially sup- they are based. On the micro level, exten- port the Communist Party and openly wish- sive training of entrepreneurs, providing es for a return to the times of SDI. knowledge of modern technologv, markets, This shows that significant resources and operations is extremely important. must be dedicated to media and public relations campaigns. One of the main obsta- View of the Private Sector and cles to reform is the mentality of the people, Eight out of ten Entrepreneurship in Russia Today which can onlv be changed through effec- Russians today Peter Filzppov.Adminzistration oftthe tive advertising and education programs. President's Office, Moscow The average Russian is still quite ignorant cannot explain why of the reasons for reform. Eight out of ten a market economy The extent of misleading information and Russians today cannot explain why a mar- is more efficient fraud in the private sector has surfaced as a ket economy is more efficient than a com- real problem. Private companies and in- munist system. Shareholders realize that than a communist vestment funds are making promises they they are owners of the countrv's assets, but system. cannot keep to investors, and there are they still feel subordinated to the national fraudulent companies and funds which rob and local bureaucracies. Many people still investors of money and enterprises of as- believe the president determines prices and sets. Recent decrees have been enacted to evervthing else in the economv. Life in protect investors' interests and ensure truth Russia has turned out to be more difficult in advertising, but these decrees will take than expected, driving people to turn to ex- time to implement, and thev cannot at once tremists who promise quick solutions to all create a mentality for ethical behavior. the problems. Cash payments account for 50 percent The future of Russian privatization and to 70 percent of trade turnover, creating reformnmight colide with traditional Russian easy opportunities for those in control to psvchology. It is our task to steer, and shift defraud shareholders and avoid tax collec- this psychology so that a fatal collision does tors. Individuals who know of such rob- not occur. beries usually cannot report it because there is insufficient documentation. Share- JUNE21 - DAY Two holders have little alternative but to turn to the mafia to punish these crimes and re- Privatization in Russia-After the dress their grievances. In the newspapers Voucher Program there are dailv reports of explosions which Anatoly Chubais, Deputy Prime Minister of kill or wound managers and directors of Russia companies and banks. There have also been cases where mafia figures have inves- The Russian economy is currently in a deep tigated cases of tax evasion in order to use recession, experiencing an average decline in such information to blackmail an enter- output of 25 percent (overlast vear's alreadv prise-and the enterprise pays the mafia depressed figures). Official unemployment because it is cheaper than paving taxes. remains very low at 2.3 percent, but it is in- Often, enterprises show signs of reform creasing at a rate of 8 percent per month. on the surface, but in fact have little com- The three main reasons for this decline are mitment to the new system. For example, a the process of financial stabilization, work- manufacturer of voltage converters, which ers' strikes, and cutbacks in the military in- had worked on the Strategic Defense dustrv. On the other hand, macroeconomic Initiative (Star Wars) some years ago, had conditions are improving-inflation has sta-

SY (\uPSI>, )I CONI1TRENCE PROCELDIM-, 237

bilized at less than 10 percent per monthand Mr. Chubais addressed a variety of is- is declining,savings have increased,and the sues during the question period: Central Bank interest rate has declined * He defended the role of insider prefer- moderatelysince the end of 1993.Time lost ence in the IsLPPas absolutelvnecessary to strikes has declined substantiallyin the for political reasons. Shares held by last two years. However, the consolidation of workers and mangers are now being re- the military industry, which accounts for distributed in the secondary market. In one-half the decline in output, has yet to be the next phase of cash privatization, priv- addressed. ileges for employees will be cut sharply, The mass privatization program has reducing both the percentage of shares produced manv important results and has and the price discount they can receive. achieved its primary objectives. Approxi- * He elaborated on the need to privatize Many companies mately 80,000 retail shops and restaurants, and develop the urban land and real es- haveseen their or 72 percent of small scale enterprises, tate market, and to establish firm prop- have seen their have been privatized. Bv the end of this erty rights. Privatization of urban land stock values year, approximately 85 percent will be pri- will lead to more efficient use and allow multiply as a result vatized. The program distributed vouchers enterprises to sell or lease extra land in of restructuring to 99 percent of the population, and over order to support restructuring. 50 percent of the GDP has been privatized. He did not have manv details on the efforts, so there are The program also created 40 million share- forthcoming sectors targeted for priva- high potential holders and 640 investment funds. It has tization, nor on the speed of the cash returns in the created an environment in which the pri- privatization program. Approximately vate sector can survive and grow. 70 percent of Russian industry has been market. The primary objective-making market privatized; another 10 percent will like- reform irreversible-has clearly been ly be held by the state indefinitely, in- achieved. A new administration will not be cluding sectors such as steel and nuclear able to demand the return of equity assets materials; the remaining 20 percent, in- from 40 million shareholders. The most cluding much in the military-industrial convincing sign of stability is that even af- complex, will be privatized in this next ter the first group of reformers left the gov- stage of reform. ernment, the reforms continued. * Regarding laws for joint stock companies In the next stage of reform, the critical and securities regulation, there are cur- issues are attracting capital for the restruc- rendy drafts under consideration by the turing process and resolving the problems Duma. It will create a significantproblem that the privatization process highlighted. if they are not enacted by September; if Capital is needed to support enterprises in this is the case, these laws may need to be their restructuring efforts, and conversely, enacted through presidential decree. restructuring must occur in order to attract foreign and domestic capital. Many strate- The Next Stages of Reform in Russia gic investors have invested in Russia, in- Andrei Shleilfer,Harvard UniversitY cluding PepsiCo, Phillip Morris, Siemens, and United Technologies. Institutional in- The principle achievement of the mass pri- vestors are only beginning to enter the mar- vatization program has been putting into ket, having invested S1.0 billion between motion the wheels of reform. A tremen- MIarch and Mav 1994. IMany companies dous amount of restructuring is already un- have seen their stock values multiplv as a re- der way. Enterprises are changing product sult of restructuring efforts, so there are lines, shutting down bad operations, and high potential returns in the market. In ad- searching for new markets. The military in- dition to attracting capital, other issues to dustrv has lost 20 percent of its employ- be addressed include the regulation of the ment, yet most of these workers have been securities market. privatization of land and absorbed into the private sector. real estate, and the restructuring of social Manv lobbving groups have been creat- assets. ed to accelerate and deepen the reform

238 RusSiA: CREATING PRFVATEENTERPRISI:S AND EFFICIENT MARKETS

process. The privatesector would like more tration of these assets also diverts valuable focus on developing property rights laws management time which needs to be de- and curtailingthe power of organizedcrime voted to restructuring. and the local governments.This is a time to Mr. Shleifer also addressed the topic of speed up reforms and to capitalizeon the governance pressures from commercial accomplishmentsof the MPP banks and capital markets. He predicted The success of the reforms to-date was that an active stock market will be estab- partly dependent on agreement, in 1993, lished in the next 3to 4 months, based on by all in the donor community that rapid, self-regulation,but it willneed to be trans- genuine reforms were achievableif imple- formed into a liquid, organized market. mented quickl: It was not the amount of Commercialbanks, on the other hand, are aid that was vital, but the quality of aid and lobbyingto delaythis, proposingways to mo- the consensus on promoting reform. nopolize the process of financialintermedi- Even laws that Recent confusion in the West over the next ation. Nonbank institutions, given further people support in priorities for reform h'asled to a reduction development of stock market's infrastruc- in aid, and even more importantly, a de- ture, may become more active in corporate principle are often cline in the quality of aid. Foreignfunding governancethan commercialbanks. unenforceable and technical assistance must continue to In response to a question about the lack becausepeople do be focused on programs that promote a of standardized accounting principles, Mr. market economy, reduce political interfer- Shleifer reiterated a basic concept govern- not turn to the state ence in evervdaylife, and expand the pri- ing future reforms in Russia: Russian com- for enforcement. vate sector. panies will not initiate changes because of There are six priority areas for future recommendations from Western advisors; reforms. they willmake changes because it is in their .Mlove to cash privatization to attract best financial interests. Thus, as securities capital and create core investors; markets develop and firms find it useful to * Implementation of legal reforms, par- attract private domestic and foreign in- ticularlyin commerciallaw, to allowlaw vestors, they will develop standardized ac- and government to replace the mafia; counting principles because of investors' • Privatization and registration of land demands. and urban real estate; * Further development of corporate gov- Legal and RegulatoryReform in ernance functions; Russia-The Next Steps * Development of securities markets, so JonathanHay, GKI shareholderscan exercisetheir most ba- sicgovernance power-exit rights:and, The written law in Russia today does not * Development of a social safety net, to have much significance. There is wide- prevent enterprises from using social spread use of private law-enforcement assets as an excuse to extract govern- mechanisms.The private sector would pre- ment subsidies. fer the state enforce laws, because private During the discussion, Mr. Shleifer law enforcement is costlyand risky.But, un- elaborated on the social safety net issue. til the state issueslaws that the people want The main areas of concern are unemploy- enforced, the Russians will continue to ment, housing, and childcare. An unem- avoid and evade the law. ployment system must be developed to Even laws that people support in princi- accommodate layoffs which occur during ple are often unenforceable because people restructuring. Housing and childcare must do not turn to the state for enforcement. To be addressed because they account for 85 illustrate, private entities do not bring con- percent of the total costs of social services tract or property rights disputes before the provided by enterprises, according to a state, preferring to use private enforcement V;borldBank estimate. Social assets provide mechanisms. The main reason is that once an excuse for subsidies from the govern- an entity comes before the state for law en- ment. Ira Lieberman added that adminis- forcement in some area, it exposes itself to

SYNOPSISOF CONFERENCFPROCEEDINGS 239

liabilities in other areas of the law which it nancial intermediation and recently uncov- wants to avoid. For example, the tax law is ered scandals should produce quick action so burdensome, few people abide by it; but in this area. But a potential problem in the people then hesitate to bring contract dis- development of the capital market is that putes before the state because it may lead to the lawmaking process is captured by small exposure of their tax [iabilitv. In another interest groups. For example, a proposal case, a shareholder asked the state to setde that all trading be done on the M91oscowex- an issue over registration of a trade; the change could later be turned into a device state investigated and concluded that the for rent-seeking. It is important to maintain shareholder might not legally be entitled to competition between various markets to hold any shares. Thus, there are high risks in prevent such a situation. Other examples of involving the state. rules that do not serve all interest groups in- A second problem is that the state does clude proposals that all financial intermedi- not create laws or rules that people want to aries have a banking license, or that all follow because the process of lawvmakingis share registries are controlled by the local controlled by special interest groups. These government. There is a high risk of the cre- groups capture the limited resources avail- ation of laws which only serve the interests able to devise and enforce laws that are in of a small group. their own interests. As a result, most private There is no organization that is respon- activities are outside of the law, and most of sible for regulating capital markets in the private sector is uninterested in laws. Russia. A newly created Securities and The creation of laws that people have an in- Exchange Commission should try to win le- terest in following is essential if we want gitimacy by issuing rules that people want them to be law-abiding and involved in the enforced. This organization should main- lawmaking process. tain independence from the day-to-day pol- In contrast, the privatization law-and itics of the govemment. The organization by implication the program-was success- would create rules and delegate enforce- ful because it gave incentives to all inter- ment, such aslicensing of participants or re- ested parties. The rules for privatization view of prospectuses, to private market were extremely simple and made violations institutions. easily visible. The rules resolved differences Both funding and moral support from between stakeholders and united them in the West are very important to further legal favor of privatization. Also, the GEI was a and regulatory reforms in Russia. New re- new bureaucracy, and old bureaucrats forms should create rules that the market played a limited role. Before privatization, requires to function, not bureaucratize pro- managers and bureaucrats diverted assets cedures that are currently functioning. from SOEs. Organized crime has become Andrew Vorkink of the World Bank pre- established in the past few years as a result sented his observation,s on the legal system of people turning to private enforcement of and the Constitution in Russia. There are ownership rights. But, while privatization many gaps in the legal system yet to be re- clarified ownership, the laws on actual solved including civil code, joint stock com- rights associated with ownership are so pany act, securities law, property rights, and poor that people again are forced to turn to bankruptcy law. There are two areas of the private enforcement. Constitution which require further clarifi- Russian capital markets are now in need cation: the lawmaking role between the ex- of efficient, enforceable rules. The creation ecutive and legislative branches, and the of an efficient capital market would lower relationship between the central and local the cost of capital to private enterprises by governments. The next steps toward ad- promoting competition between financial dressing these issues include creating a le- intermediaries and distinguishing the rep- gal information system to keep people utable players from others. Russia has made informed, training people to enforce the progress in this area, but the market is still new laws, and furthering coordination unstable. The huge potential profits in fi- among different authorities.

240 RussIA:CREATIN(, PRiVATE ENTERPRISES AND EFFICIENT MAL\RKETS

Competition Policy in Russia portant to the state. Firms in the register are R SbhYamKhemani, VbrlJ Bank subject to profit margin ceilings and other controls, that are not applied to nondomi- There is a fundamental difference between nant firms producing the same products. the neoclassicaland Marxian approaches Steps are being taken to abolish the register, toward competition. The neoclassicalview but it has alreadyhad manydamaging effects is that monopoly gives rise to high prices in preventingrestructuring. and profits, lowers output, and misallocates During the discussion period, many resources. The Marxian view sees the mo- participants reiterated the conclusion that nopolist as an exploiter of the masses. competition policy in Russia should focus Since 1990, Russian competition policy on enabling free entry rather than prevent- has been modeled after the European ap- ing monopoly. Russian firms tend to be very proach, rather than the North American. concentrated at the oblast level due to reg- Russia has the The competition law is more anti-monop- ulatory and institutional barriers preventing largest competition oly than pro-competition In orientation. contestability from firms in other regions. The Anti-Mlonopoly Committee has not Competition advocacy is needed to en- bureaucracy in the played a large role in formulating decon- courage enterprise restructuring. world, with over 80 centration policiesfor newlyprivatized monopolies. There is a pervasive view that Restructuring Newly Privatized reg2onal offices and competition law is not necessary, as long as Enterprises 0 s trade policies allow import competition. Charbel Ackerman, GKI But it is unlikely that Russian markets can become competitive quickly without a law The great majority of privatized enterprises to promote competitiveness. are large and medium-size enterprises, with The Russian anti-monopoly law is based 80 percent of the enterprises employing on a model derived from OECD advice. It over 1,000 people. Management and work- includes a clause which addresses abuse of ers own 59 to 60 percent of the shares on dominant power, but without firm guide- average. When blockholders exist, they lines for defining the appropriate market. hold an average of 18 percent of the shares. Price fixing behavior is also deemed illegal Based on a survey conducted by Leila if it has a substantial effect on the market. Webster, privatized enterprises have taken Other clauses cover vertical constraints and measures to increase efficiency: mergers and acquisitions. * 60 percent of the firms laid off an aver- There is little public education on the age of 10 percent of their workforce; subject, and private actions in protest of * 57 percent changed their incentive system; monopolistic behavior are seldom taken. * 15 percent hired new labor; What few private inquiries do occur cite * 40 percent sold redundant equipment abuse of dominant market position, exis- or leased-out excess space; tence of vertical constraints, inquiries into * 47 percent made changes to their prod- divestitures, and price fixing. uct line; and Russia has the largest competition bu- * 60 percent now have privatized compa- reaucracy in the world, with over 80 regional nies as clients. offices and 2,400 staff. The Russian law de- Privatized enterprises have also improved termines the legal foundation for suppres- their use of working capital, as illustrated by sion of monopoly and can be applied to this example of a shoe manufacturer. Prior existing and emerging monopoly situations. to privatization, the enterprise produced The anti-monopoly authorities do not apply shoes for all seasons year-round, maintain- the law, however, but instead spend most of ing a set level of stock in all styles. After pri- their resources creating distortions worse vatization, it immediately changed its than those under monopoly, through the operations so that it produces its shoes just dominant firm register. This register was cre- in time for the appropriate season. It has ated to highlight dominant firms that raise tightened its working capital and maintains pnces, with a focus on products that are im- only a one-month supply of production.

S \'N( )PSIS OF CONFEREN(CE PROCEEDINGS 241

The basic issues involved in enterprise tablished financial intermediaries in the restructuringare change in organization and form of venture capital funds, which pro- management, choice of product markets, vide funds to upgrade enterprises to a developmentof marketing and distribution credit-worthystatus. On the retail level, it capabilities,reduction of staff, and manage- has made direct investments in individual ment of social assets. The presentation fo- enterprises and has assisted in the identifi- cused on the first and last issues. cation of foreignpartners. Organizationalchanges are required in large Russian corporations mainly because GovernanceIssues in Newly Privatized the existing structure is overly centralized Enterprises and does not permit analysisof the perfor- JosephBlast, Rutgers University mance of any singleproduct line. Functions ... while insiders such as accounting, finance, research and A study of ownership structure based on a hold the majority of development, and marketing are generally sample of 200 enterprises in 33 regions re- centralized for up to 200 to 300 product vealed that whileinsiders hold the majority shares, top manage- lines. There are almost no incentives in this of shares, top management's share is rela- ment's share is type of structure because performance can- tivelylow at 8.6 percent on average. Where relatively low at 8.6 not be determined. The structure must be blockholdersexist, their holdings rarely ex- changedso that it is more decentralized and ceed 20 percent of the shares. Overall, percent on average. a manager can be held accountable for the blockholders hold only 11 percent of all businessunit. This change willalso allowthe sharessold to date. In the next reform phase enterprise to determine which business the remaining state ownership should be lines are worth additional investment and sold to other investors-including block- which must be divested or shut down. The holders-who would, it is hoped, take an main themes to consider in programs to activerole in corporate governance. train new managers are restructuring busi- In the firmssurveyed, top management ness units, managing cash flow,finding do- was very frustrated with the MPP, feeling mestic and foreignpartners, reducing costs, that they got an unfairly small share of the analyzing product profitability, organizing enterprises.General directors of enterpris- foreign marketing, performing marketing es were asked to state the ideal ownership research, and establishing distribution structure of an enterprise. The common re- channels. sponse wasthat insidersshould own 72 per- As noted bv previous speakers, socialas- cent, with top management owning 40 sets are a severefinancial drain on enterpris- percent. Of the share held by top manage- es. On average social assets' costs are 5 ment, they responded that 31 percent percent of sales, but there are examples of should be held personallyby the general di- enterpriseswhere they total over 20 percent. rector. They also responded that the state Most enterpriseswant to divest social assets should not maintain any residual owner- to stop the drain on funds as weLlas to con- ship. The general directors' responses are servevaluable management resources. not encouragingbecause there is no vision Sven Hegstad, of the EBRD, stressed of the firm as an open, public companv with how important it was for the government to a varietyof blockholders.General directors focus on macro issues that willcreate an at- want a closely-heldfirm that they can dom- tractive environment for foreign investors inate and control. But, this may be a transi- in Russia. Foreign investors are the best- tional issue because general directors will qualified restructurers of Russian firms. come to realizethat the companies need to The government's role is to provide incen- raise capital, which is only available from tives and support for foreign investors, sup- outsiders. port the economy with equity capital, and The general directors exert control un- delivertraining and technical assistance. der the current ownershipstructure in many The EBRD has heen actively support- ways.In most cases, they informallycontrol ing restructuring both on a wholesale and the employee block. Generally,80 percent retaillevel. On the wholesale level,it has es- to 90 percent of the employees give their

242 RL:SSL-\:CREAnNG PRIV.T ENTFRPRISES.IND EFFICIENI IIARIUTS proxies to a smallgroup of managers.More One should consider the low percent- formally,general directors can control the age of shares owned by management as a employees through a trust that holds the victory.The majorityinsider ownership has shares owned by employees. Use of trusts not hindered restructuring, as the workhas not been widespreadbecause it is un- force and unions have been fairly passive. necessary; informal control has worked Although general directorswant more con- well-though there have been casesof gen- trol. they do not have sufficient cash to eral directors making illegalchanges to the make this a reality.There is a cryingneed to corporatecharter in order to limitoutsiders. better educate general directors, showing Lastly, general directors have also pur- them the practices of chief executives in chased shares either from employeesor in- Western firms, who hold very little equity, vestment funds. yet control the company and are well-paid. In January 1994, President Yeltsin is- Cheryl Gray, of the World Bank, pre- sued a mandate requiring that enterprises sented a more pessimisticview of the gov- implement cumulative voting for board ernance issue in Russia. She highlighted seats and limit insiders to one-third of the examples which showed that managersand seats on the board of directors.Only three workers are still lacking the mentality and out of forty firms questioned on this matter values to create a real market economy. had implemented the decree or planned to Workers are exerting little control because implement it at the next board meeting. they do not know their rights as sharehold- Outsider stakes in these three firmswere 37 ers. Managers want control, not as a way to percent to 48 percent. Of the firmsthat did further restructuring, but as a means to not implement cumulative voting, 33 per- maintain control of their former empire. cent had outsiders on the board. Of these Unfortunately, there is growingmanagerial firms, average outsider ownership was 32 control through control of insider shares, percent, with 26.5 percent held by block- prevention of employee sales to outsiders, holders. Other firmsthat did not implement purchases of shares from investmentfunds, the decree either had no blockholders, and solicitation of friendlyinvestors. friendly outsiders, or widelydispersed out- Managers do not know which business sider shareholders. Overall, the decree did lines are profitable and worth continuing. influence the behavior of firms. Their ideas of the amount of capital need- Managerswant to increasetheir owner- ed for restructuring are wildlyexaggerated. ship, but they lack cash to buy shares.Sixty There is no focus on profitably, only on percent of the managers surveyed oppose growth of the empire. Managers are look- having a dominant outsiderwho wouldpro- ing to expand wildly at a time when they vide capital needs. This opposition is de- should focus on divesting assets. cining over time-as resources from the There are two big risks in the current sit- state decline and financialneeds grow more uation in Russia: slow death of enterprises acute, but there is stilla conflictbetween the and pressure for bailout once there is need for control and the need for capital.As macrostability If outsiders are successfully a hypotheticalexercise, the expected insid- kept out, entrenched insiders winlmanage er ownership was calculated based on the the firms into decline. The other risk is that current insider ownership and the general once firms are faced with real financialcon- directors' estimates of market value and straints, they will pressure the government capital requirements. In all cases, top man- for bailout funds. Should this become the agement's share would drop dramaticallyif case, functional bankruptcy procedures there were a capital infusionby outside in- and not a government bailout would be vestors. In one-third of the firms,the insid- necessary. er stake becomes minuscule;10 percent of Leroy Jones, of Boston University, the firms would still maintain majority in- raised two questions to be used as the cri- sider ownership;and 20 percentof the firms teria for judging whether the MPP has in- would maintain significant, but minority deed been a success. Are people actually ownership. better off after the firmsare privatized than

SYNOPSISOF CONFERENCE PROCEEDINGS 243

before? And, how quickly are enterprises been voluntary.Thus, it is not yet clear to changing their behavior? We know that what extent the MPP drove changes. eventually enterprises will have to change Mlr. Blasi responded that while some their behavior, but we must assess whether managers may still be vying for control, the MPP has been an effective catalyst for there is evidence of declining management change. ownership and attempts to shed labor. The The most basic change that is required issue of entrenchment and whether current is new management. New managers will managers should be allowed to accumulate have a much greater impact than any addi- larger shares is an honest policy debate. It tional capital. Further, capital will not be has not been established that managers found until there are good managers in cannot drive reform as well as outsiders. place. There is some evidence of this change-10 percent of boards changed Note their managers in the first board meeting. There arear alsoals examplesexmpe ofofod,, old managersagr ThisNellisoftheWorldBank'sPrivateSectorDevelop-synopsis was w-ritten by Grace Lao and John retiring and ceding the way to younger, ment Department. market-orientedmanagers. Another basic 1. Mr.Volgin was not referringto the MMM change is a reduction in the workforce. Fund,which ran a classicpyramid scheme and col- Almostall employee reductions so far have lapsedat the end of July 1994.

244 RussiA: CREATING PRIvATEENTERPRISES AND EFFICIENT MIARKETS

Glossary

ADINUNISTRATION(authorities, government): CIDA (Canada)-Canadian International Federaladministration-responsible for pri- Development Agency vatization of federal properties; Krai administration-responsible for priva- COOPERATIVE-form of an entity permit- tization of krai's properties; ted from 1988, often a subcontractor or Municipal administration-responsible for spin-off from a state enterprise; often set small-scale privatization program; up to exploit privileged access to scarce Oblast (Regional, Local) administration- goods. oblast property committees and funds; they carry out the practical tasks of pri- CORPORATIZATION-firststep in the mass vatization at the oblast level along with privatization program; a process by the approval of the GKI or the Federal which an enterprise becomes an open Property Fund before proceeding with joint-stock company with a legal identity. privatization. The enterprise is no longer an adjunct to a branch ministry. It has its own charter ALL-RussLAAuCTION CENTER-see iNational (rights and obligations of shareholders) Auction Center and a board of directors that has the right (in theory) to appoint and dismiss man- ANTI-MONOPOLYCOM.MlTTEE-responsible agement, and operates under the same for antitrust or pro-competition policy in commercial law as the private sector. All Russia, in principle, all enterprises with 35 large-scale enterprises, except those for percent or more market share. which privatization is forbidden, must be corporatized prior to privatization. ASD (U.S.)-Association of Securities' Dealers. COUNCIL OF PEOPLESDEPUTIES-see Soviet.

ASSOCLATION OF INVESTMENT FUNDS- DEPOSITARY (of an investment fund)- a voluntarv trade association represent- holds all the assets and cash of the fund; ing the interests of the managers of receives all the interest, dividends and voucher funds. other income; executes transactions in securities and for cash on instructions AUCTION-in small-scale privatization, the from the manager; applies money to the enterprise is sold to the highest bidder, payment of dividends according to the with no special conditions attached. All decision of directors; maintains ac- potential bidders have to pre-register, de- counts of the capital and income of the posit 10 percent of the price as a sign of fund and of expenses for statutory, reg- good faith, and bid in person. In mass pri- ulatory, and shareholder information vatization, regional voucher auctions were purposes. the primary means of privatization. All- Russian or national auctions were estab- EESF-Enterprise Emplovees' Shareholding lished for the largest companies. Fund (see Penonalprivatization accounts).

GL( )SSARY 245

FEDERAL-meaning at the state, central INVESTMENTFUND: government level. Nonvoucher investment fund-licensed and regulated by the Ministry of Finance. FUNDS MONITORINGUNIT-a Mloscow- Can subscribe for cash. based agency that collects information on Voucher znvestment fuind (VIF)-a part of developments in the industry from oblast the mass privatization program. Russian MIs, analyzes financial statements of individuals and firms (but not state enter- funds, and initiates action against unli- prises) are free to start up voucher funds censed funds and other illegal behavior. that can accumulate vouchers and bid for enterprises, subject to minimal criteria. GM (Goskomimushchestvo)-The State Voucher funds are licensed and regulated Committee for the Management of State by the GMI, and can subscribe for cash. Property, formally responsible for man- Voucher funds are closed-ended-they aging the property of the state. GM have a fixed number of shares per issue. serves as the driving force behind the pri- An investor subscribes capital during spe- vatization program. cific offer periods, and once the fund is set up, the investor recoups investment by GKI (K): selling voucher fund shares on the sec- Federal (Central) GKI-is responsible ondary market. Unlike in open-ended for formulating and implementing pri- funds, investors in a closed-ended fund vatization policy, for drafting annual cannot subscribe more capital or ask the privatization programs, drafting privati- fund to redeem shares. zation laws and decrees, distributing vouchers, licensing investment funds, IPO-initial public offering, the flotation and enforcing privatization legislation. of a company's shares on the capital It is supported by local and municipal market; used as a privatization tech- subsidiaries (MIs). nique in Czech and Slovak Republics Munictpal KI (MKI)-a municipal proper- and Poland. ty committee, subsidiary of the Federal GMI, attached to administration of the KRAI-an administrative area which is not municipality. The head of each municipal an ethnic unit but may contain ethnic I is appointed by the local city mayor. units (autonomous oblasts) within it- The municipal M ensures that each state self. Often translated to English as re- enterprise sets up a privatization com- gion, thus having the same meaning as mission, produces a privatization plan, oblast. and is later corporatized. Oblast (Regional, Local) KI-an oblast LEAGUE OF INVESTMIENTMANAGERS-a property committee, subsidiary of the voluntary trade association representing Federal GMI, attached to administration the interests of the'managers of voucher of the localitv. The head of each oblast M funds. It has a self-regulatory status with is nominated by the governor of the the GE and the Ministry of Finance; it oblast subject to approval by the central was modeled after the ASD in the United GKI. The oblast MC ensures that each States and the CIDA in Canada. state enterprise sets up a privatization commission, produces a privatization LEASEHOLD (leaseholding) COMPANY- plan, and is later corporatized. form of an entity permitted from 1988, usually a sub-unit of big state enterprise. GOSPLAN-State Planning Agencv. Groups of workers would often lease space and equipment from their state en- GoSSN.AB-Committee of Deliveries and terprise; the leasehold is free to accumu- Supplies, which distributed product late new assets through retained earnings groups in the economy of the former or bank loans, with these assets becom- Soviet Union. ing the property of the leaseholders.

246 RUSSIA:CREATING PRivATE ENTERUP'RSES AND EFFICIENT NLARKETS

NMAssPRA\TIZATION PRO

NATION.ALAUCTION CENTER-established PRPVATIZATION-sale of the assets of state- in March 1993, based in Moscow.Allows owned enterprises the equity of an enterpriseto be soldcon- Small-scaleprivatization-is under controlof currendv through a large number of municipalauthorities. Small enterprises are oblasts.The center is almostexclusively re- not to be corporatized and are to be sold served for the very largest enterprises,al- for cash through one of the two methods- most all of which are federally owned an auctionor commercialtender. Smallen- properties. terprises are usuallyretail establishments, restaurantsand other serviceorganizations. NAV-net asset valuation, value. "Spontaneous"privatization-the term refers to settingup of cooperativesand leaseholds NMP-net material product. and outright confiscation by well-placed managersin order to divert profits and as- NATIONALNE-Ix'ORK CENTER-see National sets in the late 1980s and early 1990s. Auction Center PRIVATIZATIONvOUCHERs-were put on sale OBLAST-region. Oblasts are merely ad- on October 1, 1992, valid from December ministrative divisions with no titular eth- 1, 1992, to Julv 1, 1994. Each Russian citi- nic group. They are named most often for zen regardless of age, residence, workplace, the largest city within them, which also or income, was eligible to receive one serves as the oblast center. voucher denominated at 10,000 rubles for 25 rubles. Vouchers were accepted by pri- OPEN JOINT STOCK CONPmAN-a company vatization agencies anywhere in the Russian whose shares can be bought and sold by Federation for the sale of state assets. Once third parties. received by the agency, vouchers expire. Vouchers are bearer documents and can be OPIC (U.S. )-Overseas Private Investment used to buv shares of the enterprise in which Corporation. the voucherholder works, in the auction of any other enterprise in the Russian Federa- PAKT-the Primorskv Manufacturers Share- tion, or in a commercial or investment ten- holders Corporation der, exchanged for shares of a voucher investment fund, sold for cash, or used to PERSONAL PRIRA-TzATIONACCOUNTS-are pay for housing and small-scale property. part of an enterprise's social fund. A social fund is composed of such items as a hous- PRODUCTION UNIT (PTK)-production ing fund, wage fund, bonus payments, technical complex. and, more recently, privatization accounts. Each year part of the enterprise's net in- PROPERT'-a series of laws passed by come is allocated to the social fund. Parliament in 1991-92 categorized state Employees can use these privatization ac- propertv as federal, local (oblast), or mu-

GLOSSARY 247

nicipal and allocated responsibility for SHARE FUNDFOR EMPLOYEESOF THE EN- privatization to property committees and TERPRISE(FARP)-allows certain groups propertv funds at the appropriate levels. of employees to subscribe for up to 5 percent of the enterprise's capital after the PROPERTYFUND-assumes the state's stake in closed subscription and the voucher auc- an enterprise from the GKI or KI (as rele- tion. FARP applies to those who could not vant) after corporatization of the enterprise. participate in the closed subscription, Federal (National) Property Fund-a rival such as former or retired employees. agency to the GKI, created by the Russian Parliament. The Fund reports di- STATE-OWNED ENTERPRISE (SOE)-until rectly to the Parliament. Responsible for 1985 there were some 47,000 state en- sale of the enterprises' shares. terprises in the USSR industrial sector. Oblast (Regional, Local) property fund-its Including energy and large service firms, head was appointed by and reported to the total rises to 55,000. oblast soviet until the latter was abol- Large-scaleSOEs-a category established for ished in October 1993, following the privatization purposes, includes a state en- failed coup. The fund exercises owner- terprise with more than 1,000 employees ship rights on behalf of the state and is re- or assets over 50 million rubles as of sponsible for the management and January 1,1992. dispersal of the state's remaining stake, Medium-size SOEs-neither large nor such as publishing the legal notice an- small, defined by exclusion. nouncing an auction and distributing Small-scale SOEs-a category established property titles. for privatization purposes, includes a state enterprise with less than 200 em- ROSKOMZENI-State Committee on Land ployees or assets less than 1 million rubles Management. as of January 1, 1992. They follow a different privatization procedure than large RSFSR-Russian SoViet Federative Socialist enterprises. All small-scale enterprises Republic, the name used in the former (such as retail shops, catering facilities, Soviet Union, presendy Russian Federa- and consumer services) are under munic- tion. The Russian Federation consists of ipal authorities. eighty-nine subjects, including twenty-one republics, six krais, forty-nine oblasts, ten SUBSCRION: autonomous okrugs, and the cities of Closed equity subscription-the first step in Moscow and St. Petersburg. corporatization. Closed subscription allows employees of an enterprise to pur- RUSSIAN-A.MERICANENTERPRISE FUND- chase its assets. It gives Russian managers established by the U.S. government as a and workers a right to secure big (often venture capital fund to invest in Russian majority) shareholdings before equity is enterprises post-privatization. put up for general sale. Employees have three different options available to them. RFCSE-Russian Federation Commission Open subscrzption-part of the mass priva- on Securities and Exchanges. tization program, sale of the equity remaining after the closed subscription. RPC-Russian Privatization Center, estab- Three options were available: a voucher lished as a not-for-profit institution to auction, a voucher auction combined assist GKI in implementing the privatiza- with commercial tender, and a voucher tion program. It has become a recipient of auction combined with investment ten- G-7 (donor) funds to assist in post-priva- der. Each of these options could also be tization efforts as well. followed by a sale of shares for cash.

SBERBANK-the state savings bank with SOVIET-at the federal level, Supreme 42,000 local branches. Soviet, Soviet Union's Parliament; at the

248 RusSIA: CREArTNGPRIVATE ENTERPRISES AND EFFICIENT NIARKETS

local level, local Soviet (Council of auctions include local(regional), national, Peoples' Deputies). and inter-oblast. In a ty,picalregional auction, the shares of between five and twen- TENDER: tv enterprises are sold at the same time. Commercialtender-in small-scaleprivatiza- Bidders must report physicallyto the tion can include post-privatizationcondi- voucher auction center or to a satellitebid tions for potentialbidders, and the highest center within a specified period-normal- bidder satisfyingthese conditionswill ac- ly two to six weeks. Voucherholdershave quire the enterprise.Restrictions can cov- two choices. They can submit any number er emplovment, investment, change of of vouchers, not specify the number of business profile, the financing of social shares they expect, and accept the strike programs,and the preservationof histori- price that clears the auction. Or they can cal buildings. Bidding can be open or submit any number of vouchers with a closed. Commercial tenders have been specificmaximum price (that is, the max- used for most sales.In large-scaleprivati- imum number of shares per voucher). zation the enterpriseis sold (in an auction Those who bid at or above the strikeprice room or by a sealed bid) to the highestbid- are then allocated shares. Those who bid der acceptingspecific conditions. below the strike price do not receiveany Investmenttender-suitable for large enter- shares and have their vouchers returned prises. The evaluation criteria are not re- for use in a future auction. stricted solely to price, but may also include investment, emplovmentguaran- VOUCHER DEPOSIT.ARYNETWORK-estab- tees, and other provisions. Investment lished in 1993, it consistsof thirty centers tender is very rare. around the countrv; it allows voucherholders to deposit vouchers at one of the TORc-a huge retail, wholesale,or distrib- centers in exchange for a receipt. The re- ution monopoly, sometimes comprising ceipt is used to bid at a voucher auction up to 100 different stores. held in other oblasts. At that voucher auction, the authorities verifythe receipt TRADE SALES-sale to an investor group, by checking through the depositary net- usuallythrough some form of competitive work to see that vouchers had indeed process; privatization technique used in been deposited at the point of issue of Czech and SlovakRepublics and Poland. the receipt, and that thev had not been used in another auction. On verification, VOUCHER AUCTION-part of the masspriva- the voucherholder's account is debited. tization program, an effectiveway to dis- perse outside share ownership and, as a Note consequence, limit and dilute the influence of outsiders.A minimumof 29 per- Thisglossary was preparedby EnnaKarlova of the cent of the total equitvof an enterprisehas World Bank's Private Sector Development to be sold in a voucher auction.Types of Department.

GLOSSARY 249

Contributors

Ira Liebermanis a manager in the World Tanzania,Kenya, and Tunisia.He is a prin- Bank's PrivateSector Development Depart- cipal author of two WorldBank policy doc- ment where he is activelyengaged in shap- uments-Public EnterpritseReform and ing the World Bank's approach toward Privatization:The Lessonsof Experience.Dr. privatizationand restructuring.Over the last Nellis has authored some thirty-fiveother year and a half, his primary focus has been publications on the issues of privatization, on Russia.He has assisted the Russiangov- public enterprise reform, civil service re- ernment in conceptualizingand implement- form, fiscaland administrativedecentraliza- ing its Mass PrivatizationProgram. He has tion, and institutional development. worked on the G-7 process for Russiaand presendy serves as advisor to the Russian Enna Karlovais on the staff of the Private Privatization Center on post-privatization Sector Development Department of the restructuring. In addition to his work on World Bank. She is currendy working on Russia,Dr. Lieberman has advised several corporate governance issues related to governments on their privatizationand re- China. She has worked on privatizationand structuring programs includingthe govern- private sector development issuesin Russia ments of Argentina, Bolivia, Colombia, and Kazakhstan and has provided exten- Kazakhstan,Malavsia, Mexico, and Poland. sive support to the variousWorld Bank mis- He is currendyin chargeof the WorldBank's sions to these countries. Ms. Karlova has effort to assist the new administration of co-authored articles on Russian privatiza- Turkey,headed by Prime iMinisterCiller, in tion. She received her MBA in Intema- launching its privatization program. Dr. tional Finance in 1994, and a BS in 1992 Lieberman is also the author of numerous from Lehigh University Prior to that she papers on privatizationand restructuring. studied International Economic Relations at the Moscow State Institute of Inter- John NeUlis is a senior manager in the national Relations. World Bank's Private Sector Development Department. Since joining the IBRD in Joyita Mukherjee is part of the enterprise 1984, he has led and taken part in W\orld restructuring and development team at the Bank operations on privatizationand pub- Private Sector Development Department lic sector reform worldwide, the transition of the World Bank. She is presently work- from socialistto market economies,private ing on privatization, emerging capital mar- sector development, administrativeand in- kets, and small and medium-sizeenterprise stitutional reform, and improving gover- development. Ms. Mukherjee has co- nance in developing and ex-socialist authored a forthcoming publication from countries. Prior to joiningthe XborldBank, the World Bank on Comparative Mass he held facultv positions at Carleton Privatization in Russia, Poland, Lithuania, Universitvin Ottawa, Canada, and at the and the Czech and Slovak Republics. She MaxwelISchool, SvracuseUniversitv. With organized and managed a conference on the Ford Foundation, he conducted re- Russia held by the World Bank whose pro- search and administered aid programsdur- ceedings have resulted in the production of ing extended periods of residence in this compendium. Prior to joining the

CCJN1TUBL -IORS 251

Bank, Ms. Nlukherjeeworked for the Inter- fund managers in severalcou. American Development Bank and for a Giles was educated at Winche. Washington-basedconsulting firm. England and later receivedhis NI. degree from Cambridge Universitr Suhail Rahuia is currently a research asso- ciate in the Private Sector Development Sally Buxton is director of C. Department of the World Bank. Over the Financial,a companythat works with t last year, he has been wvorkingXVith the set management industry and its inve: Russian Privatization Center on capital throughout the world. She spends a ma market development in Russia.Before join- portion of her time working on investmei ing the World Bank, Mr. Rahuja was with fund projects with clients in the formei Credit-Suisse First Boston and participat- Soviet Union. This includestechnical assis- ed in privatization transactions in Eastern tance to the State Property Commnitteeof Europe. the Russian Republic (GM) and the Ministry of Finance in Estonia, in addition AlexandraVacroux is a doctoral candidate to projects undertaken in Kazakhstan and in the Department of Government at the KyrghyzRepublic on behalf of the World Harvard University She is currently com- Bank. Ms. Buxton has been working as an pletingher dissertation,a comparativestudy advisor to the Russian GE on the develop- of how industrial privatization has been ment of investment fund regulations and completed in the Russian regions.Her con- practices since 1992. tribution to this compendium representsthe first of six case studies. MIs.Vacroux was an Andrei Volgin is Manager of Derzhava advisorto the State Proper-tvCommittee of Investment Fund, one of the largestvouch- the RussianRepublic (GM) untilNovember er investment funds in Russia.His articleis 1993. Her responsibilitiesincluded prepar- based on his professional experience. ing voucher auctions, coordinating foreign assistancein support of the privatizationin- Yuri Milner is presently working with the formationcampaign, and developinga man- World Bank. He is activelyengaged in fi- ual for local privatization officials and nancial sector reform in Russia. Currently, foreign investors. he is working with the State Property Com- mittee of the Russian Republic (GM[) on Mark Valentine St. Giles is Chairman of developing a private real estate sector and InternationalFinancial Strategy, a consultan- Russian capital markets. cv and conferencebusiness which specializes in investmentfunds and asset management Jeff Schwartzis a seniormanager with Price worldwideand of Frarnlington Group plc, Waterhouse's International Privatization the international asset management sub- Group, specializing in strategic manage- sidiarvof Credit Commercialde France.Mr. ment, including privatization and financial St. Gileshas worked in Eastern Europe and institutions restructuring. He has directed the Former SovietUnion since 1991.He has projects and worked as a team leader for sig- advised Slovakia'slargest commercialbank nificant corporate and donor-funded en- on the development of its investment fund gagementsin the United States,the former and asset management business, the State Soviet Union, Africa,Europe, and Asia. He Committee on Propertv of the Russian took a leave of absence fromthe firm to help Republic on the development of legislation start the first Peace Corps program in and regulationfor-voucher investment funds, Russia.Previouslv he wasa directorwith the and the State Comnittee on Propertyof the firm's consultingdivision in East Africa.He Republic of Kazakhstan and the State began his career as a banker with Chemical Cornmittee of Property for the Kyrghyz Bank in New York. Republicon investmentfunds in the privatization process. He has also participatedin a Zoanne Nelson is currently a senior con- number of trainingprograms for investment sultant with Price Waterhouse in Moscow,

252 Russi,A: CREATINGPRiATE ENTERPRISESAND EFFICIENT MNARKETS specializing in the management of the priva- (IFC). Beginning with the IFC's assistance tization program in Russia. Prior to this, Ms. in the implementation of Russia's Mass Nelson was a professor of entrepreneurship Privatization Program in December 1992, and small-business management mn a Mis.Morgenstern has coordinated IFC's ad- Moscow-based graduate business school. visorv support to the Russian government She has participated, as well, in various oth- on capital market development. Prior to er projects in Russia and the former Soviet joining the IFC, she was with the Inter- Union. These include providing business ex- American Development Bank, where she pertise to a Russian democratic newspaper, was active in expanding the capital markets and the implementation of humanitarian aid technical assistance capacity of the IDB shipments from the United States to Group, focusing principally on a broad cap- Moscow. Ms. Nelson began her career as a ital market reform program for Chile. Ms. senior accountant with J. P Morgan. NMorgenstemis a graduate of Smith College, Harvard Law School, and the School of Andrei Shleifer is a Professor of Advanced International Studies of Johns Economics at Harvard University and the Hopkins Universitv. editor of the Quarterly Journal of Economics. He was educated at Harvard Roger Leeds is a partner in the Policy University and the Massachusetts Institute Economics Group of KPMG Peat Marwick. of Technology and previously held faculty He heads the Privatization and Enterprise positions at Princeton University and the Restructuring Group that advises govern- University of Chicago. He is widely pub- ments on a broad range of issues regarding lished in the areas of financial economics, the preparation and implementation of pri- economic growth, privatization, and the vatization transactions and the design and problems of transition from socialism. evaluation of public policies affecting pri- Currentlxe he serves as senior foreign advi- vate sector development and financial mar- sor to the Russian privatization effort. In kets. Dr. Leeds is considered one of the 1989, Dr. Shleifer received the Presidential leading authorities in the field of privatiza- Young InvestigatormAward in Economics. tion and private-sector development, and has worked in more than fifty countries. In Maxim Boycko is Chief Executive Officer addition to his work at KPMG, Dr. Leeds is of the Russian Privatization Center (RPC), an adjunct professor at the School of a newly created institution in charge of co- Advanced International Studies at Johns ordinating privatization-related foreign aid Hopkins University, and also a faculty mem- in Russia. In 1993, the RPC managed $75 ber at Wharton School of Business, million in technical assistance programs. University of Pennsylvania. He has pub- Dr. Bovcko is also the Chief Economic lished several articles in leading journals and Advisor to the Chairman of the State contributed to books on economic develop- Committee of the Russian Federation on ment and international finance. Management of State Property, and has had a principal role in the design and im- Michael Harman is currently with the plementation of the Russian Mass Policy Economics Group of KPMG Peat Privatization Program. Several articles by Marwick and has been actively involved in him on Russian privatization have been the firm's practice in the former Soviet published in leading academic joumals. He Union. Recently, he participated in the received his doctorate in Economics in group's Share Registry and Clearing and 1985 and in 1991-92 was a visiting fellow Settlement project in loscow and St. at the National Bureau of Economic Petersburg. The project is comanaged by the Research in Cambridge, Massachusetts. State Property Committee of the Russian Republic (GKI) to assess the current condi- Claudia Morgenstern is Senior Invest- tion of Russian capital markets and to de- ment Officer, Capital MIarkets Division at velop and implement recommendations to the International Finance Corporation foster growth of the secondary market. Mr.

C0)NFRmiL:rORS 253

Harman holds both an MA and an MBA mittee of Russia since November 1993. This from the Universitv of Pennsylvania and assignment includes ongoing policy advice worked as a senior consultant in the finan- on restructuring and competition policy, as cial services division at Anderson Consulting well as the coordination of a number of pro- prior to joining KPMIG. jects implemented for the Anti-Monopoly Committee by the Harvard Institute of Joseph Blasi is a Professor of Labor- International Development and the Russian MIanagement Relations at the Institute of Privatization Center. Ms. Tsukanova will re- Labor Mvlanagement Relations, Rutgers ceive her PhD in Economics and Inter- University. In addition to his academic com- national Organization from the Institute of mitments he also serves as advisor to the World Economv and International Relations GKI and the Russian Privatization Center and Moscow State Universitv in 1994. She on the issues of employee and management has previously been a visiting scholar at the ownership, economic reform, and privatiza- Russian Research Center at Harvard Uni- tion. Mr. Blasi has worked closely with the versitv and has worked at the Harvard U.S. Congress on employee ownership leg- Institute for International Development. islation. He is a member of various com- She has co-authored a number of articles on mittees such as the U.S. Congress corporate governance, structure of the Competitiveness Policy Council and Sub Russian markets, and anti-monopoly issues. Council on Corporate Governance and Financial Markets, and the Journal of HAkan Wilson is currently a private sector Employee Ownership Law and Finance, development specialist in the World Bank's among others. He has authored several ar- Private Sector Development Department. ticles and books on the subject of employee In this capacity, he participated in develop- ownership and has previously held facultv ing a comprehensive proposal of how to as- positions at Harvard Universitv and sist post-privatization restructuring of large California Polytechnic State University. Russian enterprises. He is also developing the privatization component for an ongoing Leroy Jones is a Professor of Economics World Bank operation in Ghana. Prior to and Director of the new Master of joining the World Bank, Mr. Wilson was in a Economic Policy Program at Boston management consulting firm, during which Universitv. He has extensive experience and time he was part of a team that conducted a numerous publications in the field of priva- complete review of a large Russian military- tization. Dr. Jones has co-authored roughly industrial enterprise and made recommen- five books in this area, two of the most re- dations for its restructuring. NIr. Wilson cent being, The Economics of'Divestiture: A graduated from the Woodrow Wilson Cost/Benefit Approach and Who Wins and School of Public and International Affairs in WV'hoLoses from Divestiture? Case Stutdies Princeton University ii, 1988. from Chile, Mlalaysia,Mexico, and the Unizted Kingdom. He has advised and trained gov- Leila Webster is currently a private sector emnment officials from several countries on development specialist in the World Bank's the concepts, issues, and the implementa- Private Sector Development Department. tion of privatization. In 1992, he prepared In recent years, she has focused her work two reports on monopoly and corporate gov- on issues affecting the private sector with emance for the State Property Committee an emphasis on small and medium-sized of the Russian Republic (GKI). Prior to join- enterprises. Ms. Webster has assessed the ing Boston University, and after receiving his World Bank's portfolio of lending to small PhD from Harvard Universitv in 1973, he and medium-sized enterprises. She has car- was a research fellow with the Harvard ried out a number of surveys of private sec- Institute for International Development. tor manufacturing and has published extensivelv. Mvis.Webster holds Mlasters de- Natalia Tsukanova has been an advisor to grees in Social Work and International the Chairman of the Anti-Monopoly Com- Relations from the Universitv of North

254 RissiA: CREATINGPR[vArE ENTERPRISES.NlD EFFICIENT NLARxeTS

Carolina and from Johns Hopkins Univer- Joshua Charap is a staff member at the sity respectivelv. International Mlonetarv Fund. In his previous assignment wvith the European Bank Juergen Franz is in the Agriculture, Industry, for Reconstruction and Development, he and Finance Division in the Eastem Europe and Ms. Webster conducted the research and Central Asia Regional Office in the and survey on private sector manufactur- World Bank. He was active in formulating a ing in St. Petersburg that appears in this loan to support Russian privatization. More compendium. recenth; he developed a loan to provide credit to privatized Russian enterpnses. R. Shyam Khemani is Senior Industrial Economist in the Private Sector Develop- Igor Artemiev is a private sector development Department of the World Bank. He ment specialist in the Private Sector has been involved in the formulation and Development Department in the World implementation of competition law and Bank. He is activelv involved in the privati- policy in several countries including zation and commercialization of the Russia, where he serves as a member of the Russian oil industrv. Prior to joining the Advisory Council to the Anti-Monopoly Bank, NMr.Artemiev was with Deloitte and Committee of Russia. Dr. Khemani has Touche and had worked on the Russian published several articles and edited mass privatization program. books on competition policy, economic regulation, corporate concentration, and Harold Wackman is manager of the Energy entry and exit of firms. Before joining the Sector Team in the Technical Department World Bank, Dr. Khemani was a faculty for Eastern Europe, Central Asia, Middle member at the Universitv of British East, and North Africa Country Depart- Columbia. He has held several senior po- ment. He did extensive field work on the sitions including Director of Economics survey of recently privatized enterprises in and International Affairs, and Senior Russia that appears in this compendium. Policv Advisor at the Canadian Bureau of Competition Policv. Marie Sheppard is currently a staff member in the World Bank. In one of her early as- Grace Lao is on the staff of the Private signments, she was involved with the World Sector Development Department of the Bank's initial work on private enterprise in %Xbrld Bank. She manages and dissemi- Russia. In particular, she was responsible for nates information on experiences and best designing measures to alleviate constraints practices in private-sector development, in- to private Russian businesses. Before joining cluding a series of notes summarizing the Bank in 1992, Ms. Sheppard worked to Bank-sponsored seminars. Prior to joining establish a venture capital fund in New the World Bank, she worked for a New Zealand. Her previous experience was in the York-based asset management firm and a private sector, first in exposure management consulting firm in Washington. She re- for a commercial bank, and later as a busi- ceived her B.S. in Finance and Multi- ness consultant. Ms. Sheppard is a graduate national Management from the Wharton of WIXlliamSmith College and Harvard School. Business School.

C(NTRIPITORS 255