Czech Republic's experience

Russia's experience

Russia's privatization experience illustrates the problems. The mass privatization program of 1992–94 transferred ownership of more than 15,000 firms through a distribution of ownership vouchers. A worrisome result of this program was that "insiders"—managers and workers combined—gained control of an average of about two-thirds of the shares of privatized firms. Still, by the fall of 1994, hopes were modestly high that privatization would lead the way toward rapid transition to a market economy. Financial discipline would, it was anticipated, start to force secondary trading in shares of insider-dominated companies and introduce outside ownership, and transparent and sound methods would be used to privatize the half or more of industries still in state hands.

This, by and large, did not happen. First, insiders—particularly the workers in the newly privatized firms—deeply feared outside ownership and a loss of control (and jobs). Second, because the financial and physical conditions of many firms were unattractive, not many outsiders were interested in acquiring their shares. Third, there was an acute lack of defined property rights, institutional underpinnings, and safeguards for transparent secondary trading; this further discouraged outside investors. Fourth, various Russian governments failed to put in place supporting policies and institutions—such as hard budget constraints, reasonable taxes and services, and mechanisms to permit and encourage new business entrants—that might have channeled enterprise activity to productive ends.

Worse was to come: a donor-led effort to persuade the Russian government to sell at least a few large firms using transparent and credible "case-by-case" methods produced few results. Much of the second wave of privatization that did take place—in particular, the "loans-for-shares" scheme, in which major Russian banks obtained shares in firms with strong potential as collateral for loans to the state—turned into a fraudulent shambles, which drew criticism from many, including supporters of the first, mass phase of Russian privatization.

Others concluded that not just the second phase of privatization but the whole approach was wrong; that it should have been preceded (not accompanied) by institution building; and that the proper way forward would be to concentrate on strengthening the structures of the state, especially mechanisms to manage public firms.

Czech Republic's experience

By 1995, the Czech government had divested more than 1,800 firms in two waves of voucher issuance, sold a group of high-potential firms to strategic investors, and transferred a mass of other assets to previous owners or municipalities. In 1996, then prime minister Vaclav Klaus claimed that transition had been more or less completed and that henceforth the Czech Republic should be viewed as an ordinary European country undergoing ordinary economic and political problems. At the time, almost all economic indicators supported this judgment.

In 1998, however, GDP contracted by more than 2.5 percent. The Czech economy is in recession—in contrast to 4–5 percent annual expansion in neighboring countries. There are many reasons for the slide, but much of the blame is placed on the way privatization was carried out.

An Organization for Economic Cooperation and Development (1998) report states that the Czech voucher approach to privatization produced ownership structures that "impeded efficient corporate governance and restructuring." The problem was that insufficiently regulated privatization investment funds ended up owning large or controlling stakes in many firms privatized through vouchers, as citizens sought to limit their risk by transferring their vouchers into these funds in exchange for shares in the latter. But many of the largest funds were owned by the major domestic banks, in which the Czech state retained a controlling or majority stake. The results, say the critics, were predictable.

• Investment funds did not pull the plug on poorly performing firms, because that would have forced the funds' bank owners to write down the loans they had made to these firms. The state-influenced, weakly managed, and inexperienced banks tended to extend credit to high-risk, unpromising privatized firms (whether or not they were owned by subsidiary funds) and to persistently roll over credits rather than push firms into bankruptcy.
• The bankruptcy framework was weak and the process lengthy, further diminishing financial market discipline.
• The lack of prudential regulation and enforcement mechanisms in the capital markets opened the door to a variety of highly dubious and some overtly illegal actions that enriched fund managers at the expense of minority shareholders and harmed firms' financial health.

While the most visible reasons for inadequate enterprise restructuring are weaknesses in capital and financial markets, the voucher privatization method itself—with its emphasis on speed, postponement of consideration of many aspects of the legal/institutional framework, and initial atomization of ownership—is seen as the underlying cause.