PRIVATIZATION IN NACC COUNTRIES Defence Industry Experiences and Policies and Related Experiences in Other Fields COLLOQUIUM 1994 ********* COLLOQUE 1994 PRIVATISATION DANS LES PAYS DU CCNA Experiences et politiques des industries de defense et experiences comparables dans d'autres secteurs Colloquium 29-30 June, 1 July 1994 Brussels -------------------------------------------------------- THE ROLE OF FOREIGN INVESTMENT IN DEFENCE PRIVATIZATION: THE RUSSIAN CASE Sven Hegstad and Thierry Malleret There are many theories about what should and should not be done to privatize the Russian defence complex, and Sven Hegstad and Thierry Malleret offer an interesting external perspective. According to these experts, if you look beyond today's immediate crisis situation, the Russian case offers great possibilities. The long term prospects here are something of an economist's dream: the absorption potential of the Russian internal market is huge, while the entry cost is virtually zero. Sven Hegstad is Director, and Dr. Thierry Malleret a member, of the Privatization and Restructuring Team at the European Bank for Reconstruction and Development. This paper describes the principles that determine the way in which the European Bank operates in the area of defence industry privatisation. The EBRD has been created to support the transition process to the market economy. Therefore, every single transaction concluded by the Bank, whatever the sector, is ultimately aimed at developing the private economic activity. Defence conversion is no exception to that rule, although we recognise that the defence industry constitutes an unusual case because it represents one of the few sectors where the state governance may be maintained for reasons of national sovereignty. However, one may assume that this justification ceases de facto to be relevant when the facility is converted. How do we tackle the conversion issue? We will not elaborate on the titanic difficulties the conversion process is currently facing in the former Soviet Union. We will just highlight a very simple but crucial fact which illustrates why the process - if only for this reason - is worthwhile: in the long run, the conversion from defence to civilian production will be very profitable because the absorption capacity of the internal market is huge, while the cost of entry is virtually nil. This is why we support defence conversion. We would like also to point out that we use the word conversion, but what we really mean is diversification. Conversion per se is extremely difficult to realise and examples abound all around the world of conversion failures. By contrast, diversification allows expansion of the civilian core business in a military enterprise which may devote only 10-20% of its total production to the military activity. This is the case today in Russia. The conversion needs in the Bank's 25 countries of operation are so considerable that the resources of one or even several institutions would not be sufficient to meet them. Even if the European Bank were to devote all its resources to foster the conversion process in the former Soviet Union only, this would represent in the end an infinitesimal contribution (to make a comparison, President Clinton decided to allocate in the next few years US$ 20 billion - twice the capital of the EBRD - for conversion in the United States). Therefore, the most sensible way to proceed is to create a critical mass of replicable conversion cases. In other words, the aim is to register a few "success stories" which could then exercise a snowball effect on the conversion process itself, with a spin-off effect on the business environment. In that respect, attracting and gaining the support of foreign joint venture partners constitutes the cornerstone of the Bank's conversion policy. In effect, joint ventures offer many advantages: they enable us to carve out a fraction of the production facilities which can then be privatised; they provide the expertise and the know-how, they train the local workforce along Western lines and improve managerial methods; they establish in the local economy some development poles; they help in de-monopolizing the economy; and finally, they accelerate the transition process. Obviously, domestic investment opportunities for conversion abound, but most of them are beyond the current means of the Bank because of its commitment to sound banking principles and the constraints on its equity investment portfolio. In particular, principles approved by the Board require the Bank to equity invest only when it: (1) invests under terms it considers fair; (2) perceives clear potential exit strategies; (3) projects an acceptable internal rate of return. You may notice that immediate privatisation does not constitute an absolute prerequisite. Obviously, the Bank favours those projects which offer a clear prospect of privatisation, but will not systematically exclude state-owned companies. In the field of defence conversion, one cannot afford to be too demanding because bankable opportunities are very limited indeed. Therefore, conditions which should be met before a project is seriously considered derive from common sense rather than "religious dogma". However, defence enterprises in the former Soviet Union do not - or very rarely - meet these criteria since many of them are currently in danger of further deterioration and collapse. In fact, none of them is yet in a position to borrow money on commercial or any other terms from an international bank. Why? To put it in a nutshell, any bankable project encounters the following general problems (setting aside the economic and political difficulties): uncertain legal framework, no audited financial statements, liquidity crisis, uncertainty about ownership rights, and lack of knowledge in preparing business proposals. Furthermore, and this is particularly relevant to the defence industry, the transformation of these big conglomerates into stock companies and their subsidiaries into companies with limited liabilities proves to be a nightmare, exactly as it was in East Germany when the Treuhand found that for most companies, total liabilities exceeded the realisable value of their assets. These "kombinates" would be due for liquidation if normal economic rules were applied. However, some of them possess a strong potential for surviving and prospering if they are given the proper assistance (both financial and technical). Therefore, the privatisation-restructuring team concentrates on: - Stabilising enterprises currently in a critical condition, but potentially viable, so that they might be able to operate profitably in a market economy. - Attracting, and sharing the financial risk with local and foreign corporate investors who would otherwise have scaled down or cancelled their investment plans. For the time being, the European Bank has about 20 conversion projects in the pipeline. The majority of these are at an exploratory stage while a few are more advanced. They cover several countries (with a strong emphasis on Russia) and a wide range of industrial products from satellite launching rockets and integrated circuits to refitting of railway cars, forklifts and furniture production. Twenty is simultaneously very few and very many. Very few in the light of what needs to be done, but many when one considers the constraints faced when tackling conversion. To give an order of magnitude, at the end of 1992, about 220 joint-ventures were directly involved in conversion and diversification in the former Soviet Union, of which 180 were for Russia alone. However, the role played by the European Bank cannot be measured in terms of figures alone. As a direct result of its policy to stabilise, restructure and privatise certain companies, the Bank, in reality, is making a contribution to a positive and irreversible transformation of these economies. We understand that we are just putting a drop in the ocean, but this may be a drop of ink which might colour the sea. If I have time, or if you should have questions, I would be happy to expand on a few projects already launched by the Bank in some very large enterprises such as Lomo or Perm or entire sectors such as the Air-Traffic Control. Before concluding, I would like to stress a methodological point. The main problems associated with the state governance of enterprises are well known: ex-ante control (leading to meddling) rather than ex-post (that is to say, judging results), multiple objectives (i.e. non-commercial objectives such as employment combined with profit maximisation), multiple principals, and lack of competition. However, privatisation works efficiently only when it modifies the behaviour of the firm. In that respect, one could redefine the role of the state and its articulation with free initiative. When the cold war came to an end, we heard about the end of history proclaimed by Francis Fukuyama, which was to be followed by the natural emergence of the market and democracy. Clearly, the creation of a proper entrepreneurial climate relies upon the promotion of entrepreneurs, in other words upon the creation of a situation where individuals shoulder their own responsibilities. However, the state also has a number of crucial responsibilities, since there are many areas such as the creation of a legal framework, a viable and fair taxation system, an effective competition policy, a decent social security system, an efficient education system, the acceptance of public order, etc. where the state has a fundamental role to play. To put it very simply, the market and democracy will only thrive where and when the state has the means to protect them. In the end, there is no miracle or quick solution. This reminds me of an apt metaphor used by Vaclav Havel when he was welcomed by the AcadŽmie des Sciences Morales et Politiques in Paris last October. Referring to Beckett's famous play "Waiting for Godot" and analyzing the phenomenon of waiting in post-communist societies, he noted that people should not wait for Godot. Godot will not come because he does not exist. -------------------------------------------------------- Copyright 1994 NATO All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic tape, mechanical, photocopying, recording or otherwise, without permission in writing from the copyright holders. Authorization may be requested for redistribution of the text on a non commercial base by research and educational services. Requests should be addressed to the Economics Directorate, NATO, via e-mail 'scheurweghs@hq.nato.int'. First edition 1994 ISBN 92-845-0079-6 This is the latest in a series bringing together papers presented at the NATO colloquia organised by the NATO Economics Directorate and Office of Information and Press on economic issues in the former USSR and Central and East European countries. For further information please write to the Director, Office of Information and Press, 1110 Brussels, Belgium. The articles contained in this volume represent the views of the authors and do not necessarily reflect the official opinion or policy of member governments or NATO.