DAVID LIPTON World Institutefor Development Economics Research JEFFREY SACHS Harvard University Privatization in Eastern Europe: The Case of Poland THE TRANSFORMATIONof the Eastern Europeaneconomies into market economies requires comprehensive action on three fronts: macroeco- nomicstabilization, liberalization of economicactivity, andprivatization of state-owned enterprises.' Each of these is a monumental task. Nonetheless, privatizationstands out as the most difficultand novel of the three, both conceptually and politically. There are enormous chal- lenges in transferringstate-owned property-which constitutes around 90 percent of industrialcapital in EasternEurope-to privatehands in a mannerthat is rapid,equitable, and fiscally sound, andthat accomplishes two fundamentalgoals: the efficient operation of the resultingprivate enterprisesand the developmentof efficientcapital markets. The task of privatizationin EasternEurope is not widely understood in the West, partly because misleading analogies have been made to This paperdraws heavily upon the policy debatein Polandin recent monthsregarding strategiesof privatization.As such, it has benefitedenormously from extensive discussion with variousofficials and advisers of the Polish government,including Finance Minister Leszek Balcerowicz,former Minister of OwnershipTransformation Waldemar Kuczyn- ski, Stefan Kawalec, Jerzy Kozminski,Jacek Rostowski, MatthewOlex, AndrewBerg, Homi Kharas, and Joseph Bell. Of course, the views expressed here are strictly our own, and not those of the governmentof Poland. We also thank Janos Kornai and LawrenceSummers for very helpful discussions. Our work is supportedby a project on economicreform in EasternEurope at the WorldInstitute for DevelopmentEconomics Research(WIDER), of the United Nations University, Helsinki, Finland. 1. For a discussionof the authors'preferred strategy for makingthe transitionto the marketeconomy in EasternEurope, see Liptonand Sachs (1990). For two otherdiscussions of a comprehensivestrategy for transitionto the marketeconomy in EasternEurope, see BlueRibbon Commission: Project Hungary (1990), and Kornai(1990). 293 294 Brookings Papers on Economic Activity, 2:1990 privatizationin other parts of the world.2In a typical country that has recently "privatized"some state enterprises,only a handfulof firms- perhapsup to a few dozen-have been sold by the governmentto the private sector. These sales may have made an important economic difference in some sectors, but they have not involved a fundamental transformationof the economy. The amount of capital transformed through privatizationhas generally been a small proportion of total business capital and nationalincome, and the economies typically had large, privateindustrial and financialsectors before the privatizations. In Eastern Europe, privatizationis a very different task, involving nothingless thanthe completeredefinition of propertyrights for literally thousands of enterprises. Privatizationmeans creating anew the basic institutionsof a marketfinancial system, includingcorporate governance of managers,equity ownership, stock exchanges, and a varietyof finan- cial,intermediaries,such as pensionfunds, mutualfunds, andinvestment trusts. The importanceof such financialintermediaries can be gauged from the fact that institutionalinvestors now hold more than half the value of sharesin the United Kingdom,Italy, and Japan,as well as more than half the value of the New York Stock Exchange.3The economic challenge,then, is to combinethe redefinitionof propertyrights with the creation of vital financialmarket institutions. The political challenge is also awesome:to designa mechanismfor creatingprivate property rights that can win broad,lasting social approval(and prevent special interests from paralyzingthe process througha fightfor the spoils). Ironically,the rush of investmentbankers and Westernexperts who have been proposingprivatization strategies in EasternEurope have not addressedthe real needs of the privatizationprocess. Not surprisingly, the bankers have focused almost exclusively on afirm-by-firm strategy not unlike the programsin which they have participatedin other parts of the world. In EasternEurope, however, this customized approachis likely to bog down for political, economic, and financialreasons well before a significantportion of state firmsare actuallyprivatized. 2. Thereare, of course, exceptions.Trenchant recent analyses may be foundin Kornai (1990)and Milanovic(1990). For an excellent overview of the privatizationexperience throughoutthe world, see WorldBank (1988). 3. Cited in Milanovic(1990, p. 45). For evidence on the rise of institutionalinvestors in the United Kingdomand Japan,see Cosh, Hughes, and Singh(1989). They reportthat in the United Kingdom,for example, financialinstitutions held 58.9 percentof the value of listed securitiesin 1985,up from44.8 percentin 1976(table 6, p. 16). David Lipton and Jeffrey Sachs 295 In this paper,we review the enormousscope of the privatizationtask, and suggest meansfor a rapid,efficient, and equitabletransformation of state propertyinto privateproperty. Our focus will be Poland,where we serve as economic advisers. Some of the problemsthat we discuss are more urgentthere than elsewhere. Particularlyproblematic for Poland is the fact that workers' councils are powerfully organized in many enterprises, and are fightingfor worker self-managementand against privatization. Nonetheless, most of the analysis of privatization in Polandapplies throughoutEastern Europe. We should offer one disclaimerat the outset. Even thoughwe favor rapidprivatization, we doubtthat privatizationwill produceimmediate, large increases in productivityor managerialefficiency. The real gains from private ownership will take years to manifest themselves-the length of time needed for managersto be upgraded,supervisory boards to gain experience, stock marketsto improvethe qualityof valuationof enterprises,and real economic restructuringto take place. Nonetheless, we believe that in order to enjoy those enormouslong-term gains, it is necessary to proceed rapidly and comprehensivelyon creating a pri- vately owned, corporate-basedeconomy in EasternEurope. Since privatization is such a vast topic, and cannot be treated comprehensivelyin a single paper, it is importantto spell out what we will not discuss here. We do not discuss the problems of the "small- scale" privatizationof retail shops and smaller industrialenterprises.4 We will not touch on the socially complex question of restitution of property(or reprivatizationas it is called in Eastern Europe) that was nationalizedfrom the 1940sthrough the 1960s. We will not discuss the ground-updevelopment of the private sector in Eastern Europe, which is at least as important,and in JanosKornai' s view, even moreimportant, thanthe privatizationof state enterprises.SFinally, we will say relatively 4. Small-scaleprivatization is movingforward in Poland.Approximately 17,000 retail outlets had been privatizedthrough September 1990. It is still not clear, however, if the governmentwill be able to achieve its target of privatizingroughly two-thirds of retail establishmentsduring 1990. 5. The availableevidence in Polandsuggests a surgeof privatesector activity during 1990,with highrates of returnand the rapidestablishment of new enterprises.According to the officialdata, approximately360,000 new privateenterprises had been established duringJanuary-November 1990. However, the data are subject to many biases. Many establishmentsare not registeredin orderto avoid taxes; other establishmentsare simply shell organizationscreated to reducetaxes for otherrelated businesses. 296 Brookings Papers on Economic Activity, 2:1990 little about the crucialquestion of managerialcompensation, which can provide a vital link between the interests of managersand the interests of the owners of the enterprises. The Debate over the Pace of Privatization Perhaps the central debate about privatizationin Eastern Europe concerns the feasible pace of an effective privatizationstrategy. Some authorsbelieve thatthe potentialefficiency gains from private ownership and private capital marketsare so overwhelmingthat the process must be speeded up as much as possible. Advocates of rapidprivatization are typically confident that even if quick privatizationinitially leads to an inappropriatedistribution of ownership with, for example, too diffuse ownership, or firms in the wrong hands, then the capital markets will encourage a reshufflingof ownershipthrough takeovers, mergers, and buyouts so thatthere is a propermatching of owners andfirms. For these analysts, privatizationshould be undertakenas rapidlyas possible, to reap the full benefitsof privateownership. Many authorswho take this point of view have recently called for the free distributionof the enterprisesinto privatehands as a way to speed privatization.6In Poland, the landmarkstudy callingfor a free distribu- tion of shares in orderto speed privatizationis by Janusz Lewandowski and Jan Szomburg. In Czechoslovakia,the ministerof finance, Vaclav Klaus, and his deputy, Dusan Triska, have been outspoken advocates of rapidprivatization through the sale of enterpriseshares for vouchers. In Hungary, Tibor Liska has been an outspoken advocate of the free distributionof shares to the population.Other important and influential pieces are those by Manuel Hinds and Roman Frydmanand Andrzej Rapaczynski.AOther researchers advocating rapid privatization through the free distributionof shares include