State-Run Economies: From Public To Private

By Katrina Lamb AAA

How do you build something from nothing? The early 1990s witnessed an unprecedented challenge - creating free market economies in a huge geographic region with no market culture to speak of: the former Iron Curtain countries of Central and Eastern Europe and the former Soviet Union. Read on to examine one of the most fascinating and controversial parts of that transition: the mass privatization of state-run economies and the attempt to create sustainable financial market mechanisms.

The Wall Fell - Now What?
The iconic Berlin Wall images in December 1989 were unforgettable, but they soon gave way to concerns over what the future had in store. The Soviet economic model operated under central planning, with an absence of organic market mechanisms to facilitate uninhibited trade between buyers and sellers of goods and services. Much of what is taken for granted in market economies - prices fluctuating in response to supply and demand, capital markets facilitating the efficient investment of national savings into profit-seeking businesses - simply did not exist in Hungary, Russia or Uzbekistan before the dawn of the 1990s.

The challenge was to build an investment culture - private businesses owned by investors and financial conduits such as banks, stock exchanges and broker-dealers to enable the flow of capital. The state - the sole shareholder of the country's income-producing assets - was to sell off its interests into private hands.

Two questions immediately arose. First, into whose hands? Under the socialist system, the state was legally considered to be something like a trustee of the national property on behalf of its citizens who, according to Marxist theory, were to own the means of production (according to Marxist theory, the resources and apparatus by which goods and services are created). Somehow, the transfer of ownership had to take this notion into account.

The second question was price. What were these assets worth? Given the legacy of central planning, any traditional valuation benchmarks - cash flow, appraised asset value, earnings or book value multiples - were meaningless. Moreover, this was simply appraising the value of one or two assets. Each country had thousands of identifiably distinct economic entities, each of which required some strategy for transferring ownership. Time was of the essence, but so was getting it right. (Learn more on the valuation of assets in our related article Relative Valuation: Don't Get Trapped.)

Enter the Consultants
This problem galvanized the attention of Western governments, which saw economic viability as essential to democracy and integration into the global community. In the early 1990s, the U.S. and Europeearmarked billions from their federal budgets to provide technical assistance to solve the problem of transition to market economies. The US Agency for International Development (USAID), the World Bank, the British Know-How Fund and the European Union's TACIS organization were prominent among the organizations providing donor assistance. (For further reading, be sure to read What Is The World Bank?)

In a practical sense, this meant that the new Marriotts, Hiltons and Sheratons rising up among the boxy Soviet-style offices and older historical buildings in the region's downtown centers were soon teeming with sharply-dressed Western consultants - experts in one or another area of finance, law and economics - full of ideas about how to accomplish this massive transition from state ownership to private enterprise.

Mass Privatization
While every country from Croatia to Kazakhstan had its own way of looking at this problem, a general model emerged. This model had two basic components. First, privatize as much as possible, as quickly as possible. Second, set up the requisite infrastructure, again, as quickly as possible. The technical assistance contracts awarded to large global consulting firms like KPMG, Booz Allen Hamilton and PriceWaterhouseCoopers had eye-popping tasks and deadlines.

Small-Scale Auctions
Before any of that could happen, though, countries and their advisors had to wrap their arms around what actually was to be privatized, and how. Mass privatization took into account three distinct approaches, each for a particular type of enterprise. At the bottom were the many small shops, services and businesses with little in the way of assets or income. These made up the small-scale privatization program and were by and large auctioned off for whatever consideration (financial or barter) an interested party would pay.

Strategically Important Assets
On the other end of the scale were assets deemed to have strategic importance. Natural resources like oil and gas, energy utilities and telecommunications companies dominated this group. In many cases, these were either not privatized at all or the state retained a controlling interest while issuing minority stakes to investors. Because these assets made up a relatively small number of enterprises and because the businesses were understandable - production and distribution of crude oil, for example, or provision of local telephone services - the strategic privatization program, also called case-by-case privatization, more closely resembled prevailing privatization methodologies elsewhere in the world. Investors who bought minority stakes in, for example, Russia's telecommunications monopoly Svyazinvest, owned their interest in the form of traditional common shares of equity. (This structure can be very effective, but it is also known for its abuse of power. Read Early Monopolies: Conquest And Corruption for more information.)

Voucher Privatization
In between these two methods was the heart of mass privatization: mid-sized and larger companies that were too big for the small-scale program but not sufficiently important for case-by-case privatization. The most common method for this, variations of which took place in the CzechRepublic, Romania, Russia, Ukraine, Kazakhstan and elsewhere, was the so-called voucher or coupon program. All national citizens could participate by purchasing, for a notional sum, a book of coupons entitling the bearer to participate in mass privatization tenders. Voucher holders would tender their coupons for ownership interests in the companies being offered. A government agency created specifically for the purpose of mass privatization would organize and conduct the tender with assistance of the Sheraton-dwelling Western consultants from the international donor programs.

The reasoning behind the voucher program was to build the foundations of an investor society, in which citizens quickly learn the ropes of free market economics because they themselves are invested. Developers of these programs also saw vouchers as a neat way to solve the valuation problem. Values simply derived from the notional value of the vouchers. Once the objects were in the hands of these private investors, the thinking went, the invisible hand of the market would work and the new "owners" of any enterprise could freely buy and sell among each other, allowing for value and price discovery along the way. (To learn more of free-market economics, be sure to check out our Economics Basics tutorial.)

Challenges and Controversies
Problems surfaced as the voucher programs commenced in the early 1990s. A major one was the lack of supporting infrastructure. Another was that people who had spent their entire careers working for the state, living in government-provided apartments, not understanding private savings, were not ideally positioned to become effective owners of profit-seeking assets. A third was that this absence of effective infrastructure or stewardship opened the door for fraud and exploitation.

To address the first two of these problems, promoters encouraged the formation of financial intermediaries, giving rise to what were known as investment privatization funds (IPFs). In theory IPFs were to act as asset aggregators similar to mutual funds. IPFs could purchase vouchers from the citizen holders, offering a return above whatever notional face value they had. Fresh from their investment training programs led by the Western consultants, IPF professionals could potentially help spur price discovery by actively bidding on interests in the newly privatized companies. Observers believed that once the various pieces of the financial and regulatory infrastructure were in place, these organizations would eventually evolve into fully-fledged securities organizations with broker-dealer, investment banking and asset management capabilities.

Although the theory behind the IPFs and voucher privatization was compelling, it seemed to pay little attention to the practicalities of implementation. In reality, the citizenry of the socialist economies had little to do with the running of anything outside a small group of politically-connected individuals known as the nomenklatura. Contrary to the original goal of privatization in getting assets out of state control as soon as possible, the real faces of the old state - the nomenklatura - reappeared through control of the IPFs, the privatization agencies and other parties directly related to the process. In the absence of effective monitoring systems and their detailed understanding of real power structures, these groups were able to profit from these programs in ways that the original planners had not fully foreseen.

Muddling Through
For all the problems, though, these countries managed to muddle through their first decade as market economies. Despite chronic inflation, the 1998 Russian debt default, political fragility and endemic corruption, the region emerged into the global economy. Accession to the European Union began in 2004 and now includes 10 former Warsaw Pact countries: Bulgaria, CzechRepublic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. Ukraine has an active corporate bond market. In May 2007 investment manager Van Eck Global launched New Vectors Russia, a NYSE-traded exchange traded fund (ETF). Clearly, the market has come a long way in a relatively short time.

Conclusions
The mass privatization of Eastern Europe and the former Soviet Unions is a unique and fascinating economic case study. The task - to create market economies where none existed in the shortest time possible - was unprecedented and fraught with challenge in the translation from theory to practice. Despite the difficulties, the region has emerged as an integral part of the global economy, albeit one with its own local color and characteristics that will likely be around for some time to come.

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