Entrepreneurship and Privatization in Central Europe: The Tenuous Balance Between Destruction and Creation

by

Andrew Spicer, Gerry McDermott and Bruce Kogut

WP 99-04

A Working Paper of the Reginald H. Jones Center

The Wharton School University of Pennsylvania

Entrepreneurship and Privatization in Central Europe: The Tenuous Balance Between Destruction and Creation

Andrew Spicer*, Gerry McDermott**, and Bruce Kogut***

August 1999

*Andrew Spicer, A. Gary Anderson Graduate School of Management, University of California at Riverside, Riverside, CA 92521; (909) 787-3909; andrew.spicer@ucr.edu. **Gerald McDermott, Wharton School, University of Pennsylvania, Philadelphia, PA 19104; mcdermott@wharton.upenn.edu. ***Bruce Kogut, Wharton School, University of Pennsylvania, Philadelphia, PA 19104; kogut@wharton.upenn.edu.

Abstract

What is the best set of privatization policies to release entrepreneurial endeavors in transition economies? Policies of mass privatization in Central Europe were predicated on the belief that private ownership through securitization of property rights would provide powerful incentives for efficient restructuring. In retrospect, the more radical privatization programs not only failed to achieve the expected restructuring, but also have hindered the development of entrepreneurial activities. This article argues that, in fact, entrepreneurship is better fostered in a gradualist environment permitting negotiated solutions to restructuring as opposed to market-driven reforms.

The collapse of communism in the socialist bloc posed a fundamental problem: how should the assets and liabilities of the state-owned enterprises be restructured in the context of rapid reform to market capitalism? The initial policy consensus was that a policy of rapid mass privatization was needed to revitalize the state sector. In Russia, over 15,000 large and medium companies were privatized in a period of only two years. In the Czech Republic, over 1,800 companies were privatized in less than four years. Between 1991 and 1996, 14 countries adopted mass privatization programs, leading to a combined total of over 30,000 medium and large size companies privatized through this manner (Lieberman, 1997). Mass privatization policies have led to one of the most revolutionary transfers of public property to private hands in modern times. Despite the initial enthusiasm for mass privatization policies, a new discussion over the efficacy of such a radical program of institutional reform has emerged. The new debate arises because mass privatization has not lead to the economic outcomes that advocates initially predicted (Nellis, 1998,1999). A number of authors have called for a renewed examination of the theoretical underpinnings of policies of rapid mass privatization (Ellerman, 1998; Pistor and Spicer, 1997; Stiglitz, 1999). This paper contributes to the growing debate over the efficacy of mass privatization programs by examining the institutional foundations of privatization theories. A working assumption in most research into privatization is that relatively stable economic and political institutions exist to define, monitor and enforce market-based property rights. Yet, this assumption proves untenable in the context of post-socialist economies. Privatization in these countries is as much an experiment over the way in which new public-private boundaries will be formed at the level of the regional network and institutional environment,

as it is an experiment in the transformation of ownership incentives at the level of a single firm. The first part of the paper reviews theories of privatization in post-socialist economies from an institutional perspective. Underlying different perspectives on privatization are contrasting visions of how market entrepreneurship leads to the formation of new institutions. Mass privatization adopts a view of entrepreneurship similar to Kirzner (1973) that relates entrepreneurial activities to the identification and exploitation of opportunities for market exchange and arbitrage. From this perspective, advocates of rapid, mass privatization argue that the depoliticized market will quickly fill the void left by the rapid destruction of the planning system (Shleifer and Vishny, 1994; Boycko et.al., 1995). Once private ownership rights are delineated and the state is cut off from economic activity, market incentives will be sufficient to improve corporate governance and restructure companies. The alternative, gradualist view to rapid privatization admits the necessity of market reforms, but argues for the slower destruction of previous institutions to allow for experimentation and learning in the process of institutional creation. Placing less faith in the role of market prices to reformulate property relations, the model of what we identify as negotiated property reform allows for the reformulation of claims to property to evolve gradually through local bargaining and compromise. From this perspective, market entrepreneurship is more than the identification of opportunities for exchange. Instead, entrepreneurial activity involves the risky and uncertain task of recombining existing assets to form new innovations in production and organization (Schumpeter, 1934; Stark, 1996). Radical transformation is possible, but as incremental steps in a gradual evolution.1

These theoretical perspectives on privatization and institutional change are examined in the second part of the paper in the light of growing evidence of privatization outcomes in post-socialist countries. One of the important inferences from the history of policy advice to socialist countries is the precarious soundness of general recommendations insensitive to contextual conditions. To develop theory that speaks broadly, and yet incisively, to the privatization experiences of post-Soviet countries, we anchor our theoretical development in a concise comparative analysis of Central Europe. The Czech Republics rapid, mass privatization program acts as a counter-example to the slower, negotiated property reform implemented in Poland and Hungary. This iteration between theory and cases leads to the conclusion that the emphasis on speed and scale in mass privatization policy needs to be reexamined. As a theory of institutional destruction, mass privatization is effective in quickly dismantling the state planning apparatus. As a theory of institutional creation that posits that the structures and the relations of the planned economy can be rapidly transformed into a new economy coordinated through market price and exchange, mass privatization theory provides little insight into actual post-privatization outcomes. Mass privatization does not lead to the formation of a new system of entrepreneurship based on market arbitrage and exchange. Nor does it avoid the inherent political problems in renegotiating property rights among multiple claimants to an enterprise or network. Mass privatization transforms the old system, but does not mold it into its vision of the new. The benefit to policies of negotiated property reform is that they more closely link the process of privatization to local conditions and knowledge. Negotiated reform allows for experimentation in the reorganization of jointly held assets, which often requires a

gradual redefinition of control rights and risk-sharing methods. Although slow, and perhaps untenable in some political environments, policies of negotiated property reform best foster the conditions for successful entrepreneurship in post-socialist economies. The Institutional Context of Privatization in Central Europe The reasons to privatize are many. States may seek revenues from the sale of assets, state ownership may no longer be viewed as legitimate, private interests may seek control, or international agencies may demand it as conditions for loans. However, it is important to recall that the evidence for the benefits of privatization is not uniformly confirmed by experiences in all countries. In an important study, Vickers and Yarrow (1988) found rather mixed evidence. Some economists, such as Stiglitz (1994), took a relatively sanguine view of state-ownership in industries where market imperfections predominate. Privatization efforts in post-socialist economies sought, as in other countries, to rid enterprises of state control and allow for market forces to pressure managers to restructure their assets and liabilities. Yet, given the importance of country effects on privatization outcomes, privatization efforts in former socialist economies need to be examined within the particular economic and institutional contexts faced in these economies (Lopez-Calva, 1998). The challenges of privatization in Central European communist economies differed from developing economies in three critical ways. First, countries in East-Central Europe were relatively industrialized, though with different paths. While regions like Bohemia and Moravia (of the Czech Republic) were already one of the leading industrial societies in central Europe by WWII, Communist Parties in Poland and Hungary had to direct much of the industrialization of their respective countries from a low initial base. Trying to utilize an economy of scale based on centralized

planning, communist leaders relied predominantly on large industrial concerns to lead industrialization efforts. Because of the failures of planning and uncertainties of shortage, concerns tended to be fully-integrated, incorporating upstream and downstream operations as well as facilities to build their own machines. Data reveal that industrial concentration in Central Europe far exceeded those in the West (Acs and Audretsch, 1993). A second salient feature of communist economies was the prevalence of informal industrial networks. Because of the chaotic environment of failed planning and shortage, de facto, if not de jure, decision-making rights over assets often devolved from the state center to stakeholders in industrial concerns. At the same time, dense horizontal socio-economic ties emerged to help managers and work teams, suppliers and customers, firms and local party members coordinate continual adaptations to the shortage environment. Informal bargaining rules were grafted onto the formal structures, often allowing concerns to act as umbrellas for networks (Kornai 1980; Stark 1989). Because of differing national histories, the patterns of network organization and identification of network members varied. In Hungary, relatively more liberal policies, particularly the legalization in 1982 of various forms of enterprises, allowed dense networks of small and medium enterprises (SMEs) to develop as semi-formal subcontractors of large state firms to become a burgeoning second economy (Stark, 1989; Gabor, 1990; Szelenyi, 1989). In Poland, the liberalization of the Crafts Code in the early 1980s fostered a private sector of SMEs, though mainly in agriculture. In Czechoslovakia, where movement toward market socialism was quashed after 1968, planning experiments allowed state branches and regional/district party councils to become directly involved in production and financial management. The result was that networks that emerged within industrial associations

(VHJs) varied in their authority structures and density of internal sub-contracting links (McDermott 1997, 1998). The third salient feature of Central Europe societies was the simultaneous collapse of both political and economic systems. The devolution of Communist power left a political void of how collective efforts of reform would be made and implemented. In Poland, initial compromise in 1989 between former Communists and Solidarity led to a compromise coalition in control of the government apparatus. In Hungary, the lack of a strong alternative social movement to replace the former Communist power led to a period of unfettered, electoral contests before new political processes to implement reform could be formed. In Czechoslovakia, the capitulation of former Communist leaders led to the quick transfer of state power to a new set of market-oriented elites.2 Institutional Change and Privatization Policy In western economies, market-based property rights are closely linked to systems of regulatory oversight, judicial enforcement and social norms (Campbell and Lindberg, 1990; North 1990). The absence of an institutional infrastructure to support private property rights in post-socialist economies complicates the implementation of a formal privatization program. The boundaries of ownership between multiple claimants to a firm must be defined before new property rights can be allocated. Moreover, these new rights need to be monitored and enforced following privatization. Given the absence of established political organizations and processes in post-socialist economies, it is unclear in these environments who has the authority or capabilities to solve these constitutive, supervisory and allocative issues inherent in the development of privatization policy.

Table 1 depicts two ideal-typical models of privatization in post-socialist economies based on their underlying approach to these institutional challenges to reform. These models differ both in their theoretical assessments of how fast the system of property relations developed in the Soviet system should be destroyed and in their theoretical arguments of how entrepreneurship will lead to the formation of new market institutions. Institutional Destruction and Privatization Theory A principal area of disagreement between the mass privatization and negotiated property right perspectives concerns the role of the state in its own demise. Mass privatization limits the state to the role of auctioneer in a massive sale of state-owned enterprises. In the negotiated reform model, the state acts as a mediator to develop negotiated agreements between multiple stakeholders to a firm. Mass privatization emphasizes the creation of market competition before the restructuring of political organization. In contrast, negotiated reform links economic and political change; experimentation in new organizational forms of deliberation and control are closely linked to the manner in which the property rights of state-owned enterprises firms are reassembled. Mass Privatization. The speed of mass privatization is achieved through avoiding the costly pre-privatization valuations of a company through traditional investment bank modeling. Privatization vouchers, which are distributed to the population at large for free or a nominal charge, act as proxies for shares in state-owned enterprises. The vouchers transform into actual ownership stakes in companies through state-controlled auctions, whereby individuals, or their agents through investment funds, invest their vouchers into specific firms. The eventual ownership shares in companies depend on a market-clearing price based on the number of individuals who invest their voucher in a particular

company.3 At the end of the mass privatization process, firms are joint-stock companies whose new shareholders hold legal rights to engage in active corporate governance and to receive a portion of the firms profits through dividends.4 The speed and scale of voucher mass privatization, which is sometimes identified as the privatization of privatization, arises from the minimalist role of the state. The government does not become directly involved in choices of who should own what, but instead acts as the auctioneer of the voucher privatization process. To achieve this goal, the government needs to develop and distribute privatization vouchers as well as supervise an auction mechanism by which these vouchers can be transformed into actual shares of companies. An important political benefit to the speed of voucher mass privatization is that it allows market reformers to introduce radical privatization rapidly before potential opposition to such a program can be organized. The supervision of voucher auctions can often be implemented within new, and temporary, state bureaucracies that owe allegiance to the market reformers advocating mass privatization. This allows reformers to bypass obvious opposition from other parts of the government that oppose the devolution of state control. The limited and technical nature of the auction process also lends itself to targeted foreign aid to support mass privatization programs.5 Negotiated Property Reform. In contrast to the well documented debate over mass privatization policies, what we identify as negotiated property reform is an attempt to identify underlying similarities in property reform that have taken place in post-socialist countries that have foregone the rapid policies of mass privatization. In China, a gradual reform process through which local actors negotiate rights to the use and income of

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community assets has led to radical changes in property relations even in the absence of mass privatization programs (Nee, 1992; Walder, 1994). In Hungary, the gradual transformation of property relations during the early 1990s involved the restructuring of collective assets and liabilities inherent in the networks of relations developed during the socialist era (Stark, 1996). In Poland, bank-led restructuring and enterprise leasing programs have brought about a recombination of the existing assets of the socialist system into new forms of property relations (Levitas, 1994; Gray and Holle, 1996). Policies of negotiated property reform treat property rights as negotiated claims, not as tradable securities as in the mass privatization model. These claims become renegotiated on a local basis, leading to new forms of governance and coordination that often do not correspond to western conceptions of market or hierarchy (See Nee, 1992; Stark, 1996). The state often retains an initial share in these new organizational forms, although rarely takes an active role in the management of the new concern. Instead, the state plays an important role in mediating between multiple stakeholders so that new collective agreements over how a firm will compete in a new market environment and how profits will be divided can be reached and enforced. The logic of governance in negotiated property reform is based upon a growing literature on the prevalence of network forms of coordination and exchange in market economies. Embedded relationships based on personal ties and informal agreements lead to information transfer that is more proprietary and tacit than the price and quantity date in market exchanges and to economic exchange that is based more on trust and personal relations than explicit market contracts (Granovetter, 1985; Uzzi, 1997). Moreover, mutual monitoring mechanisms of on-going negotiation allow for parities with local knowledge of

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the activities of a firm or network to monitor the behavior of other interdependent actors (Sabel, 1994). Given the lack of established legal systems, the thinness of strategic factor markets, and the unstable political structures in formerly planned economies, Peng and Heath (1996) posit that these types of personal connections and informal agreements are particularly important in post-socialist economies. Applied to issues of property reform, this theory points to the role that multiple stakeholders to a firm have in monitoring each others behavior. Investors, suppliers, buyers, managers, workers and state officials have an incentive to ensure that others provide credible information and follow negotiated agreements. The danger of negotiated reform is that the inclusion of multiple interests into the negotiation process may simply lead to deadlock with no action at all, or that political considerations will outweigh economic ones. Moreover, in the absence of an explicit program of privatization, managers or state officials separately or acting together may appropriate an enterprises valued assets for their own personal gain in what is identified as spontaneous privatization (see Boycko et. al., 1995; Kaufman and Siegelbaum, 1997). The challenge for the state in the implementation of negotiated property reform is to develop an institutional mechanism that limits the ability of any single stakeholder, including its own bureaucrats, to appropriate assets without deliberation with other potential stakeholders. Institutional Creation and Privatization Theory Advocates of rapid privatization argue that the informal property relations that defined the post-Soviet economic landscape should be rapidly reconfigured into formal claims to ownership based on western conceptions of property rights. In contrast, proponents of negotiated reform suggest that policies of reform must be built within the

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ruins of socialism (Stark, 1996). Informal relations and local knowledge become the starting points for new entrepreneurial activities to emerge from the dismantling of the Soviet system. Mass Privatization. As a policy of institutional destruction, the implementation of mass privatization before political restructuring allows for the rapid introduction of radical reform. As a policy of institutional creation, however, this rapid destruction of the old institutional system leads to the problem of how new private actors will operate in an environment with little political consensus or organization. Mass privatization creates hundreds, if not thousands, of newly privatized firms before complementary market institutions are formed or tested. A core aspect of the economic theory of mass privatization is the hypothesis that market entrepreneurship in the absence of established market institutions will provide the impetus for economic restructuring and growth. In describing the ability of the market itself to redefine the property relations between the multiple claimants to state-owned enterprises, Shleifer and Vishny (1994:139) write that [mass] privatization is a way to define the property rights between these various claimants so that efficient bargains could subsequently be struck. Their argument is that the market opportunities for efficient bargains that mass privatization creates will lead to the eventual consolidation of shares in strategic investors willing to engage in enterprise restructuring. Arbitrage thus is not only a means by which markets are perfected, but it should also lead to the consolidation of shares in the hands of owners who place the highest value on shares. This avenue of argument relies, however incompletely, upon entrepreneurship as exploiting opportunity. Kirzners (1973) definition of entrepreneurship as the exploitation

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of the information that prices convey fits the underlying logic of the market perspective present in mass privatization. Kirzner (1973:41) posits that entrepreneurs discover where buyers have been paying too much and where sellers have been receiving too little and bridge the gap by offering to buy for a little more and to sell for a little less. This perspective has a current echo in the resource-based view of the firm. Firms converge to common (and better) capabilities to the extent that information regarding the value of assets is public and strategic factors (e.g. management) can be purchased in the market (Barney, 1986). Mass privatization reforms endorse this observation as an operative principle of market capitalism. It is through information regarding value, the incentivized effort of managers, and prices that economic development is initiated. Negotiated Property Rights. In contrast to the vision of entrepreneur as trader in mass privatization theory, the logic of entrepreneurship in negotiated property reform is based on two ideas associated with Schumpeter. The first idea is Schumpeters conception of entrepreneurial innovation as the recombination of existing assets (Schumpeter, 1934). The second is the insight that radical innovation involves an act of creative destruction (Schumpeter, 1942). Schumpeters emphasis on entrepreneurship as the recombination of existing assets highlights the importance of evolutionary paths of economic development in post-socialist economies. Inherited technical and financial links between firms constrain the ability of any single firm to restructure its activities in isolation from others. Strategies of growth often require the coordination of resources across a number of interconnected firms (Peng and Heath, 1996). The formation of new organizational forms often derive from existing relations of trust and interdependence developed in the socialist era (Stark, 1996). From this

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perspective, the formation of new entrepreneurial activities is necessarily an incremental process involving negotiation and deliberation. The high uncertainty of return to joint restructuring efforts makes it difficult for a single party to provide the necessary guarantees to other parties or outside funders to develop clear and enforceable market contracts.6 The institutional embeddedness of entreprenurial action suggests that the paths of economic development are highly dependent on initial conditions and therefore difficult to reshape according to predetermined plans. At the level of the firm, this viewpoint is predicated upon notions of relatively inert resources that explain why firms are slow to change (Nelson and Winter, 1982). Since firms develop through a recombination of their existing capabilities (Kogut and Zander, 1992), change is an incremental process involving negotiation and deliberation. At the level of the institutional environment, gradual change is predicated on the embeddedness of everyday action in a broader system of regulatory laws, normative beliefs and cognitive understandings (Scott, 1995). Instead of institutions converging on an idealized set of market-efficient practices, they develop upon pathdependent paths that reflect differences in local environments (North, 1990). A number of theorists have stressed the importance of evolutionary processes of change to argue that policy makers in post-socialist economies should not follow western blueprints of reform but should instead incorporate processes of experimentation and local learning into policy design (Murrell, 1992; Kogut, 1996). From this perspective, an important benefit of negotiated property rights is that it permits entrepreneurs to experiment with different organizational forms and production methods. This experimentation process often prohibits a priori clarification of control and cash flow rights because of the high uncertainties of return and the necessity of economic actors to cooperate for common or

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overlapping assets, such as common testing labs, production facilities, and subcontracting relations. Negotiated reform allows processes of creative destruction to reside not only over individual firms, but also over the eventual successes, or failures, of different types of reform efforts. Public agencies themselves experiment with institutional forms that directly and indirectly provide financial cushions and mechanisms of collective negotiation for private actors. Public agencies not only learn how to be a credible mediator of conflict among multiple parties during the privatization process, but also how to define their future role once these property rights are transferred to private parties. Assessing Institutional Outcomes of Privatization in Central Europe Debate over methods of privatization in post-socialist reform has been based on theoretical beliefs about how private property will interact with country conditions to produce entrepreneurial outcomes. The next step in the comparative analysis of EastCentral European countries is to relate theory to practice. However, the limited number of countries that have implemented the different types of privatization models makes it difficult to examine the link between policy process and economic outcome. An example of this small-n problem in examining privatization outcomes is the growing debate over the explanation of China success in economic growth and Russias failure. A number of authors have argued that Chinese evolutionary policies of property reform has contributed to Chinas economic success, while Russias policy of radical mass privatization has contributed to its decline (Burawoy, 1996; Stiglitz, 1999). Others posit that large differences in political and economic conditions in Russia and China make the comparison a poor test of the efficacy of policy choices (Sachs and Woo, 1997).

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Although important differences exist between the Czech Republic, Hungary and Poland, they represent a closer set of comparisons than Russia and China. Moreover, Czech Republics mass privatization program is often considered a model of successful implementation, lacking the insider ownership component of Russias privatization program.7 A comparison of these Central European countries therefore provides an important set of cases by which to examine the effects of different privatization strategies. An examination of macro-economic performance of the Czech Republic, Hungary and Poland shows relatively similar performance of GDP growth and industrial output in the first half of the 1990s. However, Hungary and Poland have been performing better on a number of variables in the late 1990s. As illustrated in Figure 1, industrial restructuring in the Czech Republic has barely risen over time, as of yet not reaching the previous levels of 1990. The Czech Republics failure to restructure is particularly striking compared to the steady growth of industrial output in both Poland and Hungary since 1995 (OECD, 1999). These large differences in the pace of industrial restructuring have recently become reflected in GDP growth. In 1998 GDP in the Czech Republic contracted by 3%, in contrast to a 5% expansion in Poland and Hungary (Business Central Europe, 1999). Although these numbers are consistent with the argument that evolutionary reform leads to better-long restructuring, it is difficult to identify a direct linkage between privatization policy and long-term economic growth both solely on an analysis of macroeconomic variables (UNCTAD, 1995: Chapter 7). In the following section, we supplement the broader macro-comparisons to build more grounded theory of why mass privatization has not led to the entrepreneurial outcomes initially predicted. Comparative case analysis

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becomes an important mechanism to directly examine processes of change that are difficult to evaluate in any other manner (Ragin, 1987). Mass Privatization in the Czech Republic Mass privatization in the Czech Republic consisted of two waves held between 1992 to 1995. Citizens could buy vouchers for prices representing about 25% of their monthly income. The bidding for shares was conducted through an electronic trading system, the RM-System, with terminals located throughout the country. Through several iterations, prices were adjusted with ad hoc intervention to clear the market. Overall, 8.5 million citizens, or 80% of the entire population, became equity shareholders in the over 1,800 medium-to-large companies auctioned through the Czech mass privatization program. Investment privatization funds (IPFs) emerged as large owners in the Czech program, as over 550 funds collected close to 70% of all privatization points throughout the two waves of mass privatization (Coffee, 1996). The capitalization of the listed Czech stock market reached $14 billion in 1995, which far exceeded the market capitalization in any other post-Soviet economy (Pohl, Jedrzejczak and Anderson, 1995). Moreover, hundreds of new investment funds and financial companies had developed to participate in the newly-created financial markets. In short, the conditions for post-privatization arbitrage and exchange had been developed exactly according to the theoretical statements involved in mass privatization theory. Yet, based on an analysis of post-privatization outcomes in the Czech Republic, we argue below that mass privatizations theory of market-driven institutional creation provides little explanatory power in the description of entrepreneurial outcomes in the Czech Republics post-privatization economy. The secondary exchange of property rights into the

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hands of true owners who intend to restructure firms has moved much slower than imagined. Moreover, market-based, mass privatization policy offers little support in resolving problems of joint-ownership or control over critical assets, such as common suppliers and development funds. Our case analysis suggests that mass privatization policies have damaged the evolutionary development of entrepreneurial activities in the Czech Republic through eroding credible claims to property and disrupting network ties. Mass Privatization and the Secondary Exchange of Property Rights . A recent Organization for Economic Cooperation and Development (1998) report states that the ownership structures developed through the Czech mass privatization program impeded efficient corporate governance and restructuring. Other reviews of post-privatization outcomes in the Czech Republic have remarked that the secondary exchange of property rights into the hands of consolidated ownership with strong interests in firm restructuring has moved slower than initially expected (World Bank, 1999; Coffee, 1998). A number of factors have contributed to the slow development of secondary market exchange. First, the crosscutting mechanisms of ownership developed through mass privatization created a labyrinth of inter-enterprise ownership with large shares continuing to be held through the state. Investment privatization funds (IPFs) were often owned by other investment funds and banks. In turn, the largest banks in the country were owned mostly by other banks and IPFs. Moreover, the Czech government held shares in the banks, therefore leading to indirect control of the state over IPFs and enterprises. Instead of solving the problems of unclear boundaries of ownership developed during the socialist era, mass privatization in the Czech Republic only created a new series of inter-enterprise

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ownership patterns that made corporate governance and secondary trading difficult to implement. A second factor in the lack of secondary trading of shares is growing evidence that the managers of investment privatization funds have taken advantage of the lack of market regulation to extract personal gains at the expense of shareholders (Coffee, 1998; World Bank, 1999). Many fund managers have found it more profitable to tunnel the most valuable assets of firms to friendly parties than to invest in the difficult task of firm restructuring (Ellerman, 1998; Kogut and Spicer, 1998). Between 1994 and 1996, the shares of closed ended privatization investment funds traded at an average discount over net asset evaluation of 75-85% (Czech Securities Exchange Commission, reported in World Bank, 1999). The fear that investors placed in investment fund securities is illustrated through the example of Harvard Consulting Company, which controlled many of the largest funds from the privatization process. In 1996 the Harvard Consulting Company announced that they were merging their multiple funds into a single holding company, therefore adding another layer of non-transparency into the already closely-held company. The price of some Harvard funds declined 22% in one week, allowing the owners of the Harvard Fund to buy back many of their shares at a greatly reduced price. The new holding company, Daventree Ltd., is based in Cyprus and effectively outside the control of the Czech authorities (Coffee, 1998). Other investment companies followed Harvard Companys example and transformed into non-transparent holding companies. Eventually, new regulations were passed that forbid this type of legal maneuvering.

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A third difficulty in the consolidation of ownership following mass privatization has been that most trading has taken place outside formal stock markets, therefore making it difficult to judge firm values or prices through listed prices (Kogut and Spicer, 1998). A new Securities and Exchange Commission has been developed to place stricter regulation over the market, and strong state control has been placed over the activities of investment funds. Market capitalization has steadily decreased following mass privatization through the de-listing of stocks from formal exchanges due to illiquidity and lack of public information (Prague Stock Exchange, 1997). Total market capitalization of the Prague stock exchange by the middle of 1998 was less than the total capitalization of the Budapest stock market, despite the distinct capital market strategy of the Czechs mass privatization program (FAME Information Services, 1998). An explanation of the challenges of encouraging restructuring through market mechanisms can be developed through an analogy with the difficulty of using markets prices to resolve bankruptcy issues. US bankruptcy law under Chapter XI is designed to allow those firms with the potential to restructure to attempt to do so. The question open for judgement is whether the firms failure is based on short-term fluctuations in markets and credits, and therefore could be restructured to repay current obligations, or whether the bankrupt firm should be immediately liquidated and its assets distributed under Chapter 7 of the bankruptcy law. Bankruptcy procedures are negotiated in court, and not placed in the open market, because the very uncertainty of the firms future income stream makes it difficult for market prices alone to determine the manner in which the firm will be restructured.

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From this perspective, the many accounts of asset stripping in the Czech Republic can be attributed to the particular entrepreneurial conditions created in the aftermath of mass privatization. A profit-maximizing investor, or investment fund manager, may decide to bypass restructuring a firm, which remains a long-term and highly-uncertain endeavor, for the more immediate gains realized through liquidating the most profitable assets of a firm to friendly partners. The lack of regulation and transparent market prices in the Czech Republic makes the tunnelling of assets for personal gain at the expense of shareholders difficult to detect or prosecute (Kogut and Spicer, 1998). Mass Privatization and Network Ties. The difficulties of market mechanisms of exchange can be illustrated not only through an examination of post-privatization capital market formation, but also through an examination of the effects of mass privatization on network ties. The lack of bankruptcies, the exorbitant growth of insolvency and interenterprise and bank debt, and the poor performance of industrial spin-offs in the Czech Republic suggest that firms and banks independently lack the capital, resources, and knowhow to find market-based solutions to network problems.8 An example of the importance, and challenges, of maintaining network ties in an uncertain environment is illustrated through an effect on mass privatization of the Machine Tool Industry in the Czech Republic.9 During communism, the Czech machine tool industry was one of the premier suppliers of machine tools to the CMEA and was largely organized within the industrial association, TST. TST was home to over 20 member firms, approximately 30,000 employees, and a very broad production profile. In 1990, one would have imagined that these firms would become dynamic entrepreneurial firms. Virtually all member firms had over 60 years of experience in the industry. Its organizational and

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network structure was relatively decentralized. Member firms each had numerous plants, retained considerable decision-making powers and independent financial accounts, and developed direct links to regional bank branches and district councils, which were sources of countervailing bargaining power vis--vis the TST directorate and the state ministries. A TST firm typically produced over 80% of their inputs in-house, with parts like hydraulics, pneumatics, ball bearings, and certain metal casting coming from other members and electronics (domestic and foreign) purchased jointly from other industrial associations via the TST directorate. Indeed, when Czechoslovakia dissolved the industrial association system, TST members (including many plants) chose to become legally independent state firms. With the advent of mass privatization in 1990-91, TST members took two major steps to utilize the new ownership regime to balance individual and common interests. First, the firms chose to enter privatization individually (mostly via vouchers with some MBOs) and allowed many of their plants to do the same. Second, members sought to use equity links to help manage areas in which they lacked individual resources and know-how, such as foreign trade, critical supplies, vocational training, and large development loans. Members converted the former directorate to an association-support headquarters, SST, in which each was an owner. SST, in turn, used its historical ties to actors in the trade and financial sectors to take a 30-40% equity stake in one of the major trade houses, Strojimport, and build an alliance with members of the foreign trade financial group FINOP and the Czech Republics main trade bank, CSOB. With FINOP and CSOP, SST participated in the creation of a new private bank, Banka Bohemia, and an equity investment company, ISB, whose engineering fund would buy strategic stakes in SST member firms and important

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suppliers/customers.10 The result of this elaborate equity and financial alliance can be seen in Figure 2. While member firms owned SST, SST ran the board of Strojimport and the engineering fund. The use of equity links to supplant the previous network had three objectives. Strong control over Strojimport would give members direct access and control over trade financing and global trade links. The links to CSOB and Banka Bohemia gave SST potential access to much needed restructuring financing. The combination of its industry informational advantages and the strategic equity stakes via ISB in member firms and critical supplier/customers could help SST influence the development of the industry and protect firms from shortsighted new owners. During 1991-1996, these objectives failed and the industry fragmented into insolvency for two main reasons. First, the uncertainties of new production experiments undermined the cooperation between member firms. As each firm began to experiment with new products or alterations of existing ones, they turned to one another for the development or sub-contracting of certain components and the cost sharing of exporting and importing. Since these experiments were highly uncertain and often conflicted with one another, no firm could give the guarantees to the others to forego their own plans and invest in those of the solicitor. For instance, with the collapse of trade in the CMEA and the domestic recession, SST firms sought new market niches based on short production runs. These runs were often too short to instill confidence in other members to prioritize their own component production for the given project. Moreover, the short runs forced members to solicit the joint import of minimum volumes of certain CNC electronics. Yet the specifications often meant that solicited

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members were to alter their own designs, which they refused. A similar fate met the vocational training system, which severely hurt the ability of member firms to retain existing craftsmen and train new ones.11 At the same time, distrust and isolation grew among members as they began to encroach on one anothers product niches in a desperate attempt to seek export earnings. Secondly, the supporting equity alliances failed to provide needed financing to overcome the hold-up problems among members. As one of the big-five Czech banks, CSOB was the critical financial link in the alliance. Yet the combination of the collapse of CMEA trade, new creditor rules, and government enforcement of hard budget constraints, left CSOB and Strojimport with a large stock of non-performing credits and weak capital bases. CSOB, in turn, refused to initiate the restructuring of Strojimport and provide credit lines to Banka Bohemia and SST firms. With the other big Czech banks equally constrained to lead bankruptcies or finance restructuring, SST firms languished. Indeed, in 1994, four of the five largest de novo banks, including Banka Bohemia, were seized by regulators and closed. The fragmentation of socio-economic relationships among SST members and the lack of public institutions to support various aspects of SMEs became fertile grounds for certain members to take highly risky, semi-legal steps acquire needed financial resources and survive. Unable to acquire needed financing from the big five Czech banks or the dominant investment funds, one SST member, ZPS, allied itself with a group of local entrepreneurs, most of whom were former ZPS and big bank employees. Together they constructed an elaborate network of new small banks and investment funds to channel financing from a poorly monitored state insurance company to ZPS. They utilized the funds

25

to manipulate share prices and take over several of the fledgling SST member firms. This scheme came crashing down in 1996 when two of their small banks went insolvent and regulators seized the insurance company. The history of this network points to the problem of seeking to view property rights as vested in the ownership of individual firms. Instead of leading to the eventual restructuring of the interdependent firms in the machine tool industry, the eventual outcome of mass privatization resulted in the collapse of the broader social network that had supported the Czech machine tool industry in the past. In turn, individual firms were unable to restructure to compete in the new market environment. The irony of reforms is that adoption of mass privatization reforms did not obviate the importance of negotiated property rights. These negotiations are sometimes private ordered insofar that only private parties claim the assets. But these claims are adjudicated in the context of legal statutes and policies that have evolved in response to the post-privatization situation. The state remains very much an important force in the Czech economy. Negotiated Property Reform in Hungary and Poland An extensive analysis of property reform in Hungary and Poland is beyond the scope of this paper. Examples of fraud and corruption, as in the Czech Republic, similarly marred the process of property reform in each of these countries. Yet, the essentials of these cases raise the important issue that the lack of speed in mass privatization does not represent the absence of reform. Both Polish and Hungarian officials have implemented a series of policy reforms designed to create new private owners. While inevitably some of these reforms have failed, these gradual steps toward private ownership have lead to the formation of new market institutions that are sustainable in their local environments. These long-term

26

outcomes of institutional experimentation in Poland and Hungary stand in marked contrast to the continued difficulties that the Czech Republic has faced in building new economic and political institutions following mass privatization. Poland. Property right reform in Poland has its foundations in two critical policies toward state firms and banks. First, the stop-and-go privatization of large Polish firms allowed for the development of insider-led buy-outs. Second, the Polish government initiated in 1993 a bank-led restructuring of large state-owned enterprises. Together, these two policies created conditions for entrepreneurs to negotiate the restructuring of network assets with other firmlevel and public actors while allowing for an injection of public resources to cushion the uncertainties of reorganization. Although many observers of Poland have noted how worker council veto powers effectively blocked mass privatization, few have noted how the very 1990 law which legalized those veto powers enabled employee councils to legally dissolve their firms and rent, lease or sell the assets to a new corporation (Levitas 1994). The evolution of this law has produced arguably the most important channels (termed direct privatization and liquidation) of privatization in Poland. As mass privatization languished, by the end of 1995 these two channels had initiated over 2507 transfers in ownership (of which 1450 were completed) or over two-thirds of two ownership transfers in Poland (OECD 1998). These two channels were critical for the development of industrial networks in Poland since they forced network members attached to large state firms to negotiate with other stakeholders (other firm managers and work groups, banks, and the ministry) over the method of property reform. Indeed, neither channel was very rapid. For instance, liquidation required approval of the employee council, management board and the ministry.

27

More than two-thirds of direct privatization took place through leases, again requiring approval from the various parties to the assets. The negotiation mechanisms denied clean break off but allowed actors to gradually gain autonomy for certain assets while maintaining consideration of the strategic interests of other network members. Indeed, one could argue that such a process allowed new production strategies to be grafted onto existing firmspecific sub-contracting programs, thus facilitating a continued flow of know-how, financing and access to R&D and training facilities. The 1993 government policy on bank-led workouts mirrored this more micro-level development and provided a broader mechanism for the disciplined flow of resources to the transforming state firms without abrupt changes in ownership. The policy, namely the bank conciliation procedure, provided a framework for state owned banks to lead workouts of the largest debtors. While the relative success and details of the bank policy have been thoroughly examined elsewhere (Van Wijnbergen, 1997; Gray and Holle, 1996), two aspects are critical for our purposes. First, the government provided a one-time capital injection of banks based on certain criteria about loans made prior to 1991. This step is, of course, not unique, as the Hungarians entered into repeated bank-bailouts and the Czechs conducted a one-time purchase of certain old debts and a capital injection in 1991-92. What is unique in the Polish case is the second aspect of the policy: the creation of clear rules to stimulate and monitor bank-led restructuring of firms. This is significant considering that the Czech banks viewed capital injections and other financial incentives as insufficient to overcome their interdependency with industrial firms and lead restructuring or bankruptcy. This framework essentially provided specific application of the philosophy behind US Chapter XI assigning clear responsibilities and rights to the lead senior

28

creditors, relief-attached-to-restructuring criteria for debtors, and government representatives (as senior creditors and owners themselves) to monitor deliberations and mediate disputes. Together the two policies of privatization and bank-led restructuring illustrate how quasi-institutional structures combined public-private risk sharing with multi-party restructuring cum negotiation. These mechanisms loosened the constraints on economic actors but provided them the means by which to learn to govern their joint-claims on property. Numerous new firms were created but within the context of a transforming industrial network. Hungary. Starks (1996) analysis of Hungarian enterprises illustrates the manner in which pre-exising industrial ties greatly influenced the formation of new industrial networks in Hungary during the early 1990s. Former socialist enterprises used the new political environment surrounding property rights reform to create corporate satellites independent from the larger, state-owned enterprise. These corporate spins-offs had separate legal identities with their own directors and separate balance sheets, but remained tightly linked to the broader network. Therefore, while nominally private, these new incorporated enterprises remain closely linked to large, state-owned enterprises. Stark (1996) argues that the resulting ambiguity of property rights in Hungary allowed actors to experiment with a variety of organizational forms and production strategies critical for survival in highly turbulent markets such as those in Central Europe. Moreover, the combination of ties between partially private banks, large firms, and the satellite firms allow new enterprises to create sub-contracting sources of cash-flow and innovation as well as gain access to resources vital for new, small firms: R&D, training, and credit.

29

Over time, the recombination of domestic networks into new organizational forms became closely tied to a growing objective of Hungarian privatization to raise capital through foreign investment. At first, the newly created State Privatization Agency attempted to develop public offerings of large firms through state-initiated open tenders. Yet, open sales of large firms failed to attract bidders as foreign investors were unwilling to enter competition by submitting tenders (Csaki and Macher, 1997). The new strategy of the SPA was to further decentralize the privatization process so that management-initiated privatization plans could be submitted to the SPA for approval and oversight. This new decentralized mechanism now allowed potential investors to negotiate directly with managers before the submission of new bids. Yet, any potential alliance of managers with potential foreign investors was placed in a negotiated position with the SPA, which had clear aims of ensuring a high price for the company and judging the realism of the overall restructuring plan (Antal-Moskos, 1998). By 1995, foreign participation in privatization contributed over 80% of the revenue generated during that year (Csaki and Macher, 1997). However, unlike the initial public offerings based on competitive bidding that the SPA had initially planned, even the sales of companies to foreign investors involved informal negotiation among multiple stakeholders (Antal-Mokos, 1998). The lack of mass privatization has not stopped the transformation of public to private property in Hungary. In fact, by 1998 over 80% of Hungarian GDP now resides in the private sector (EBRD, 1998). While some commentators have remarked that the lack of uniformity of Hungarian privatization makes it difficult to provide general statements about the policies undertaken, others have suggested that it is precisely the consistent emphasis on

30

bargaining and negotiation that characterizes the Hungarian experiment (Frydman et.al., 1993; Antal-Mokos, 1998). Conclusion The initial debate over privatization methods in post-socialist economies often emphasized the importance of speed in property reform. The underlying assumption was that the market itself would lead to beneficial post-privatization outcomes. Yet, a comparative examination of privatization outcomes in the Czech Republic, Hungary and Poland demonstrates that the choice is not plan or market. The absence of rapid mass privatization programs in Hungary and Poland did not lead to the continuation of the planning economy. Markets and private ownership have developed, albeit in a slower, more evolutionary manner. The argument between mass privatization and negotiated reform is, above all, a dispute between different visions of the entrepreneurial act. The belief that entrepreneurship is essentially an act of arbitrage assumes that markets exist outside of local environments and relations. Yet, as the events in the Czech Republic demonstrate, markets remain closely linked to local contexts even following radical, market reform. The rough information embedded in market prices have not proven capable of facilitating the types of proprietory information exchange and joint governance mechanisms necessary for the uncertain and complex challenge of restructuring state-owned enterprises. The contrary vision to mass privatization is the proposal that economic progress rides upon the negotiated claims to restructure among interested parties, including the state. The entanglement of liabilities and assets leads to a cat-and-mouse game in which new owners seek assets, while laying off the liabilities on other parties, be it banks, other firms,

31

or the state. Mass privatization postpones this fundamental restructuring while it weakens dramatically the power of the state to reach settlement. Negotiation, though unquestionably vague in the a priori determination of property rights, permits negotiated outcomes in the presence of strong state representation. The crux of the difference between mass privatization and negotiation is that transition economies require institutional and organizational experimentation. Auctioning off ownership assigns a uniformity of corporate governance over assets that, in fact, cannot be supported by incipient and weak markets. In its micro operations, gradualism is a process of experimentation in which not only ownership is adjudicated, but also institutional solutions fail or succeed by trial and observation. Whereas mass privatization is strong in destruction of the prior regime, it is weak in its support for the creation of a new institutional order. It is this balance between creation and destruction that is maintained through a recognition of existing industrial networks and the role of the state in negotiating property claims and yet allowing the emergence of new forms of market entrepreneurship.

32

Table 1: Models of Privatization

Voucher Mass Privatization Theory of Institutional Destruction Voucher Auctions Role of the State Theory of Institutional Creation Theory of Post-Privatization Enrepreneurship Auctioneer Revolutionary Kiznerian Market Arbitrage and Exchange Negotiated Agreements Mediator Evolutionary Schumpeterian Recombination Negotiated Property Reform

33

Figure 1: Industrial Production in the Czech Republic, Hungary and Poland

160
Index of Industrial Production 1990 = 100

140 120 100 80 60 40 1990 1991 1992 1993 1994 1995 1996 1997 1998
Year

Poland Hungary Czech Republic

Source: OECD 1999

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Figure 2: Network Ties in the Czech Machine Tool Industry Trading House (Strojimport )
Large Debts to CSOB 3040 % SST Firms together own 30-40 % of Strojimport. SST manages these shares. SST President is Chair. Of 10.7% Board of Strojimport.

CNB,FNM,MoF
Trading Bank (CSOB) Financial Group (FINOP) Private Bank (Banka Bohemia)

20 %

Investment Company (ISB)

11 %

Industry Association (SST)

Member Own SST

Investment Fund (1st Engineering)

ISB & Fund own 5-20% of SST Firms

SST Firms
Note: - Percentages connote ownership share. - Direction of arrow connotes direction of ownership Adapted from McDermott (1998)
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Endnotes
1

For early expositions of evolutionary approaches on reform, see Nee (1992) for a discussion of China, Murrell (1992) on evolutionary policies, and McDermott and Mejstrik (1992) on small firms. See also Grabher and Stark (1997) for an evolutionary approach to business organization via inherited networks in post-socialist countries.
2

See Stark (1992) and Stark and Bruzst (1998) for a description of how different paths of political compromise over the devolution of Communist power in Central Europe influenced the political opportunities for reform in the post-Soviet era.
3

An analogy can be made to the system used in some business schools for the allocation of space in elective courses and interviews. Students are given a certain number of points which they can bid in differing degrees for certain desired spots. Final allocation is based on market-clearing outcomes based on the total number of points bid.
4

The ideal-typical model of voucher mass privatization described here is what Pistor and Spicer (1997) identify as free-market mass privatization. The allocation of ownership shares takes place through open voucher auctions of firms in which private citizens have multiple choices of how to invest their vouchers. This type of voucher privatization program allows for the speed and scale of implementation that is the focus of this paper. The free-market approach differs from the slower, more regulated mass privatization programs in Poland and Uzbekistan.
5

See Boycko et. al. (1995) for an extended discussion of the political benefits to mass privatization in overcoming state opposition to reform. See Schwartz and Nelson (1994) for the role that foreign assistance can play in the implementation and supervision of voucher auction systems.
6

See Hayri and McDermott (1998) for a detailed discussion of the problem in the Czech Republic of using market prices and contracts to solve network coordination problems .
7

Russias mass privatization allocated a controlling share of state-owned enterprises to insider management and workers (See Frydman and Rapaczynski, 1994: Chapter 6).
8

For a detailed discussion of these problems, see Hayri and McDermott (1998). Lizal, Singer, and Svejnar (1995) show through econometric analysis that the large majority of spin-offs performed worse than their mother firm.
9 10

This section draws heavily on Chapter 5 of McDermott (1998).

Given the shareholding regulations and dispersion of ownership in the Czech Republic, the 3-20% equity stakes acquired by ISB enabled SST, on behalf of ISB to gain a seat on the management or supervisory board of the respective firms.
11

Vlacil et al. (1996) show that the combination of the government policy to make training centers self-finaning and the liquidity constraints of machine tool firms led to the virtual collapse of vocational training in the industry.

42