Russian privatization and corporate governance: what went wrong?

• Author: Black, Bernard

1. INTRODUCTION

   Rapid mass privatization of state-owned enterprises in formerly centrally planned economies hasn't turned out the way its creators hoped, in Russia or elsewhere. When Russian mass privatization began in the early 1990s, its proponents (including ourselves) hoped that the Russian economy would soon bottom out and then turn upward, as the efficiency incentives unleashed by privatization took hold.(1) That didn't happen.

   Russia's mass privatization "voucher auctions" were moderately honest, but gave control to managers. This permitted insiders (managers and controlling shareholders) to engage in extensive self-dealing (transactions between insiders and the company, in which the insiders profit at the company's expense), which the government did nothing to control. Later privatization "auctions" were a giveaway of Russia's most important companies at bargain prices to a few well-connected "kleptocrats," who got the funds to buy these companies by skimming from the government and transferred their skimming talents to the enterprises they acquired.

   At the macro level, the Russian economy stumbled along through mid-1998, then collapsed again, as it had in 1991-92 prior to privatization. Russia's medium-term prospects are only so-so. The Russian ruble has plunged; the Russian government has defaulted on both its dollar- and ruble-denominated debt, most banks are bankrupt, corruption is rampant, tax collection is abysmal, capital flight is pervasive, and new investment is scarce. The Russian economy rebounded somewhat in 1999 and 2000, but from a greatly shrunken base and mostly because oil prices soared. The fundamentals of nonextractive industries haven't changed that much. It remains to be seen whether Russia's new President, Vladimir Putin, will develop a coherent economic policy--none has emerged in his first year as Prime Minister and then President.

   Russia's disappointment with mass privatization is mirrored in other former Soviet Union countries and, less severely, in the Czech Republic, which at one time seemed to be a model of the transition from central planning to a market economy. This suggests that the failure of privatization to jumpstart the Russian economy may reflect structural flaws in mass privatization as a transition mechanism, not just Russia's specific circumstances.

   This article joins an emerging literature that questions whether rapid mass privatization of large firms is an important element of the transition from central planning to a market economy.(2) We develop below a case study of what went wrong with large-firm privatization in Russia, using the Czech Republic as a comparison case study to assess the extent to which Russia's problems are generalizable. We bring to this task a reasonable mix of insiders' knowledge and outsiders' skepticism, gained through experience with privatization and capital markets reform in Russia and other countries.(3)

   We leave to others the analysis of the macroeconomic steps that Russia might have taken and focus on microeconomic steps related to privatization and capital markets development. But the two are related. Russia's macro effort to balance the budget, control inflation, and attract investment was defeated, in large measure, by the micro failures we discuss below.

   We see three main failures in the Russian privatization effort. First, mass privatization of large enterprises is likely to lead to massive insider self-dealing unless (implausibly in the initial transition from central planning to markets) a country has a good infrastructure for controlling self-dealing. The critical factor is lack of controls on self-dealing, and not the details of the privatization plan. If control is given to the current managers, as in Russian mass privatization, they often won't know how to run a company in a market economy. Some managers will loot their companies, perhaps killing an otherwise viable company. If outsiders can acquire control in the stock market, as in the Czech Republic, bad owners will often drive out good ones. A controlling stake is worth more to a dishonest owner who will extract all of a firm's value than to an honest owner who will share that value with minority shareholders.

   To prevent this outcome, development of a decent legal and enforcement infrastructure must precede or at least accompany privatization of large firms. If privatization comes first, massive theft is likely to occur before the infrastructure to control it can develop. At the same time, important parts of this infrastructure require a base of existing private firms. For example, to learn to prosecute fraud and self-dealing, regulators need some fraud and self-dealing to practice on. Thus, privatization must to some extent be staged, lest the crooks simply outrun the regulators.

   In a mythical thick market for corporate control, good owners could buy companies from bad owners if a company was worth more if run honestly than if run to maximize short-run skimming. But in fact, good owners don't exist in Russia in significant numbers or with the capital to buy large enterprises. If they existed, they wouldn't pay a bad owner anything close to fair value, because they couldn't verify what shape the business was in. Moreover, the business might be worth more to the bad owner, who has a comparative advantage in the important tasks of self-dealing, evading taxes, obtaining favors from the government, not paying workers, and using effective albeit unofficial means (read: the Mafia) to enforce contracts and scare off competitors. In contrast, an honest owner risks having the government expropriate his investment.

   Second, the profit incentives to restructure privatized enterprises (instead of looting them), and to create new businesses that could draw workers from shrinking enterprises, can be swamped by a hostile business environment. In Russia, that environment includes a punitive tax system, official corruption, organized crime, an unfriendly bureaucracy, and a business culture in which skirting the law is seen as normal, even necessary behavior.

   Third, corrupt privatization of large firms can compromise future reforms. In Russia, self-dealing was widespread before privatization began, and would have continued if large enterprises were privatized more slowly. But privatization can make self-dealing easier. In a vicious circle, dirty privatization also reinforces corruption and organized crime, as the new owners (some already with Mafia ties) turn their new wealth to the task of buying judges and government officials. Corrupt officials and company insiders join forces to resist future reforms, while the public comes to see privatization (and, by inference, other market reforms) as connected with self-dealing, corruption, and organized crime.

   To be sure, Russia's economic problems weren't caused by privatization. Ukraine offers a sobering example. It hasn't privatized large firms, but is as corrupt as Russia and has done even worse economically. Comparing Russia with Ukraine suggests that if government is bad enough--badly enough corrupted, incapable of sustaining sensible policy--mass privatization won't affect economic performance very much, for better or worse. The assets of state-owned enterprises will be stolen whether they are privatized or not.

   Our concerns here are with mass privatization of large enterprises, not with the other elements of the "shock therapy" prescription dispensed by Western advisors. There is much to be said, in the transition to a market economy, for the government rapidly selling or giving away small shops and businesses to the people who work there, and apartments and land to the people who live there. These steps don't entail the separation of ownership and control that encourage self-dealing by controllers of large enterprises. But we believe that a concerted effort to control self-dealing is central to successful large firm privatization.(4)

   An important piece of the overall puzzle: The largest Russian companies were sold in massively corrupt fashion to a handful of well-connected men, soon dubbed "kleptocrats" by the Russian press (Russian: [RUSSIAN TEXT NOT REPRODUCIBLE IN ASCII]), who made their first centimillions or billions through sweetheart deals with or outright theft from the government, and then leveraged that wealth by buying major companies from the government for astonishingly low prices. The "reformers" who promoted privatization regretted the corruption, but claimed that any private owner was better than state ownership. Even if the new owners got their ownership in unfortunate ways, they would have incentives to increase company value. Many foreign advisors bought this story, viewed dirty privatization as better than no privatization, and supported Russia's privatization czar, Anatoli Chubais, as he pursued privatization by any available means.

   Left unnoticed was that the new owners had two ways to make money-increase the company's value, or steal what value already existed. The first was difficult, perhaps beyond their ability, and uncertain in outcome. The second was easy; they were expert at it; and it was sure to produce a handsome profit that could be tucked away overseas, beyond the reach of a future Russian government. Most of the kleptocrats chose the second, easy approach.

   An example: Bank Menatep (controlled by kleptocrat Mikhail Khodorkovski) acquired Yukos, a major Russian oil holding company, in 1995. For 1996, Yukos' financial statements show revenue of $8.60 per barrel of oil--about $4 per barrel less than it should have been.(5) Khodorkovski skimmed over 30 cents per dollar of revenue while stiffing his workers on wages, defaulting on tax payments, destroying the value of minority shares in Yukos and its production subsidiaries, and not reinvesting in Yukos' oil fields.

   It's doubtful that running Yukos honestly could have earned Khodorkovski a fraction of what he earned by skimming revenue...