International Insolvency Institute Colloquium on Privatization and Insolvency / Restructuring Lessons from Privatization Programs in Central and Eastern Europe Based on the paper written by Marko Mitrovic and Stephen S. Gray Athens, February 6, 2011 Lessons from Privatization Programs in Central and Eastern Europe Introduction Upon its emergence from socialism during the early 1990s, Central and Eastern Europe (CEE) underwent privatization programs on a previously unprecedented scale. The entire centrally planned economic system was replaced by a virtually opposite, market-based system. The importance of privatization and its success were viewed as crucial: . The region’s paramount geopolitical significance . Significant time pressure with the collapse of the socialist trading system . Potential global implications, the desirability of democracy / free market economy The region overall did well. Central European countries developed faster than their counterparts in Eastern or Southeast Europe. Privatization was important but other aspects played a significant role in overall economic development, primarily economic reform and foreign direct investment (FDI). CEE privatization experience offers useful insights for other regions and privatization programs. Slide 2 Lessons from Privatization Programs in Central and Eastern Europe Specifics of the CEE Situation As it emerged from socialism, Central and Eastern Europe faced very difficult initial conditions. Sharply declining regional trade and demand: . double digit declines in output and trade (in some cases as much as 80%) . virtually no access to or products competitive in Western markets . lack of liquidity . collection problems from former Soviet Union. Very little internal capital: . fledgling and illiquid equity markets . expensive and rarely granted debt . financially and institutionally ill-equipped governments. Slide 3 Lessons from Privatization Programs in Central and Eastern Europe Specifics of the CEE Situation (cont.) . Lack of institutions and capabilities: . little experience in modern commercial or bankruptcy legislation or practice . nonexistent commercial lending standards . undeveloped financial institutions / oversight bodies . very low managerial know-how . Positives included: . Inexpensive but qualified labor . proximity to Western Europe . substantial production capacity . good technical skills . No prior precedent . privatizations never implemented on such a large scale . long history of socialist control Slide 4 Lessons from Privatization Programs in Central and Eastern Europe Privatization Approaches Four distinct privatization approaches were used in CEE. Direct Sale (Hungary, Estonia) to predominantly Western strategic buyers; . gradual case-by-case-privatization . concerns were that the process may become too political, too slow, too costly. Public Ownership through Investment Funds (Czech Republic): also called “Free Market Model”; . immediate privatization of a large number of companies through their listing on national stock exchanges; . ownership “vouchers” distributed to the public; . fast creation of largely unregulated investment funds; the funds were supposed to compete both for “voucher” capital and for the assets of privatized companies; . favorite approach among economists for its speed, inclusiveness, and free market “spirit”. Slide 5 Lessons from Privatization Programs in Central and Eastern Europe Privatization Approaches (cont.) . Interim Management through Investment Funds (Poland): also called “Regulated Market Model” . 15 funds created by the State, and co-managed by Western investment banks . the equity of companies was placed in funds to manage / improve companies first, with a delayed distribution of shares to the public . criticized for potentially being too political and too slow . Management / Insider Buyouts: . create a domestic entrepreneurial class . concern that it would create corruption and cronyism Slide 6 Lessons from Privatization Programs in Central and Eastern Europe Comparison of the Results – A Few General Conclusions . Management / Insider Buyouts (MBOs) generally failed to create value: . corruption and cronyism; . numerous examples of asset stripping (“tunneling”) by former managers; . few examples of successful restructuring by new insider owners. “Free Market Model” better than MBOs but also did not create adequate value: . results generally mixed, long term results less favorable: labor productivity in the Czech Republic increased by 6% vs. 30% in Poland and Hungary (1989-1998); . Czech industrial production slightly lower over the same period vs. increasing by over 50% in Poland. “Regulated Market Model” and Direct Sale approach performed significantly better: . involvement of Western strategic investors (direct sale model) and investment banks (regulated market model) resulted in substantially higher performance . significantly fewer negative incentives than in MBOs and “Free Market Model” Slide 7 Lessons from Privatization Programs in Central and Eastern Europe Role of Entrepreneurial Responsibility In CEE mass privatizations, relative success of failure of the individual approaches was not due to their intrinsic elements. It centered on whether they fostered or decreased the level of entrepreneurial responsibility. Entrepreneurial responsibility – an important corollary of private ownership . Only two mechanisms to develop entrepreneurial responsibility . fair price paid for the asset (direct) . control of financial and other institutions (indirect) . In CEE during the 1990s, the MBO and the Free Market Model did not meet either criterion . Without entrepreneurial responsibility, negative incentives took over, either through . direct asset stripping (MBO) or . negative aspects of separation of ownership and control (Free Market Model) . Regulated Market Model and Direct Sale performed better due to . fair price paid (Direct Sale) . higher institutional control (Regulated Market Model) . better governance (both) Slide 8 Lessons from Privatization Programs in Central and Eastern Europe Role of Reforms and FDI – Slovakia In Slovakia, reforms and FDI proved more important than privatization itself. A country with few initial comparative advantages ascended to a regional economic leader: . 1998: ten years after socialism and after most companies were privatized, Slovakia was significantly behind its peers: . GDP per capita 15% was lower than in Hungary and 30% lower than in Czech R. numerous instances of asset stripping and several pyramidal banks . politically drifting away from the EU . exports mostly consisted of low value-added products . per capita FDI considerably lower than other CE countries . 2008: Slovakia caught up with other regional countries and entered EU in 2004; . reformed political and economic system (tax, pension, and healthcare reform) . FDI tripled to nearly Eur 3 billion per year on average . competitiveness and exports increased, the latter by nearly 170% compared to 1998 and comprised 80% of GDP . value added manufacturing significantly increased (automotive and electronics) Strategic investors (predominantly Western) brought what was needed the most at the outset – new markets, management expertise, and capital. Slide 9 Lessons from Privatization Programs in Central and Eastern Europe Role of Reforms and FDI – Other CE Countries Reforms and FDI have the highest correlation to GDP growth throughout the region 1995-1999 2000-2004 2005-2008 Czech Republic Average annual FDI - $ billion 3,067 5,237 8,503 Average annual GDP growth 0.8% 2.6% 4.0% Hungary Average annual FDI - $ billion 3,807 3,221 6,397 Average annual GDP growth 2.8% 3.5% 1.3% Poland Average annual FDI - $ billion 5,340 7,346 17,037 Average annual GDP growth 5.0% 2.5% 4.8% . Czech Republic: low growth between ’95 and ’99 in part due to its unsuccessful privatization approach. As reforms took place earlier last decade and the average annual FDI increased, so did the average annual GDP growth. Hungary: initial stronger growth due to direct sale model and highest per capital FDI in the region. Lack of reforms over the past decade – especially in tax and pension systems – were a major reason for slower growth over the past five years. Other regional countries became a lot more attractive, despite government concessions given to prospective green-field investments. Poland: lower but still clear correlation; ‘95-’99 highest growth in the region due to both a comparably lower starting point and successful privatization model; from second period to third period much faster growth due to higher FDI Slide 10 Lessons from Privatization Programs in Central and Eastern Europe Conclusions Properly executed, privatizations can provide significantly more benefit than the value to the state from the enterprise sales. Private ownership without entrepreneurial responsibility did not result in meaningfully better performance, as negative incentives for both insiders and unregulated intermediaries outweighed distant future benefits. Fair price paid (directly) and control of the institutions (indirectly) are the main instruments which can ensure entrepreneurial responsibility and significantly impact the prospects for success. Especially for smaller and/or less developed countries, strategic foreign investors add to future growth by providing a higher level of management expertise, governance, access to new markets, as well as capital. Rather than enticing them with tailored, special incentives, meaningful economic and governmental reform has in CEE proven to be far superior in attracting such investment. Chance for success of individual privatization models is higher if it addresses the initial needs of the country, minimizes negative incentives, and creates conditions which can unlock value inherent in private ownership. Slide 11.