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 ----------------------------------------------------- Rapporteur's summary of the 1994 NATO Economics Colloquium Richard F. Kaufman The politics of privatization in Central and Eastern Europe are as important as its economic motivations, says Richard Kaufman. For the governments of these post-communist states, a variety of approaches to the "destatification" of key industries are possible. They include transferral of ownership to company employees or managers, selling or giving away shares to the public, or opening to bids from foreign investors. There is no "right way" to privatization, only a responsible one - which for each country depends on a different set of factors. In this report Mr. Kaufman offers an overview of all the speakers' views and experiences at the 1994 NATO Economics Colloquium. Richard F. Kaufman is a 1993-1994 Fellow of the Woodrow Wilson International Center for Scholars and Director of the Bethesda Research Institute. What is meant by "privatization" and what is the rationale for it? Although privatization can be defined in several ways, it is generally agreed that it involves the transfer of assets from state ownership and control to private ownership and control. For the change to be meaningful with respect to state-owned enterprises, production and pricing decisions must also be placed in private hands. A variety of approaches are possible,including transferring all or part of the ownership to employees and managers, selling or giving away shares to the general public, and inviting offers from domestic and foreign investors. There are political as well as economic reasons for privatizing state properties. The economic argument is that the economy functions more efficiently when production facilities are in the private sector where incentives for private gain promote innovation and higher productivity. These attributes, in turn, contribute to sustained economic growth and make possible improvements in living standards. Privatization is also a means for restructuring industries in which there is excess capacity or which are not competitive in world markets. The politics of privatization in Central and East Europe are as important as the economic motivations. The comprehensive transformations underway in the countries of this region include a reduction in many aspects of the role of the state. Thus, even where a state owned enterprise has been managed efficiently it may be deemed desirable to privatize it as part of a policy of change from the period when the state dominated economic activities. It can also be argued that privatization can achieve a more just distribution of wealth and is likely to benefit the emerging middle class. At the same time, there are often political factors that slow or prevent privatization, such as the response of governments to concerns that workers in state-owned enterprises will lose jobs or, in the case of strategic industries, that national security will be impaired. Marvin Jackson's analysis of the experiences in 14 post communist countries shows that in most of them there has been substantial progress in the privatization of state-owned enterprises. The percentages of enterprises privatized by the end of the first quarter of 1994 was nearly 60 percent in the Czech Republic, 30 percent in Russia, Lithuania and Estonia, 27 percent in Poland and Hungary, 15 percent in Belarus and Ukraine,and lesser amounts in the other countries. Although it is too soon to evaluate the actual effects of privatization on economic behavior, Jackson correlates the figures with increases in thes hare of the private sector in the gross domestic product (GDP) of each of the countries. Progress, in terms of sheer numbers, is confirmed by reports from individual countries. In Russia, for example, privatization is credited by Andrey Loginov with having brought about a revolution in property relations. Under the voucher privatization approach used there, 94.3 thousand enterprises were privatized by April 1994. Of the 19 thousand largestenterprises, 15 thousand were transformed into joint-stockcompanies, and 12 thousand had been privatized. Keith Bush concludes that since the removal of price controls in January 1992, the privatization program in Russia has been President Yeltsin's most important economic reform.. However, a closer examination reveals uncertain and uneven results in important respects. Several participants in the conference qualify the apparent progress reflected in the figures by pointing to the need to go behind the statistics. Marvin Jackson points out that there are no common statistical standards in the region for reporting privatization, and Yuri V. Andreev discusses the shortcomings in Russian official statistics generally. There is uncertainty, Andreev states, even about the number of factories in the Russian military industrial complex. In Russia and other countries official statistics are still designed to report primarily on government activities and much of the private sector is not included. What used to be the "hidden"economy, comprising what was then questionable or illegal activities because they were not sanctioned by the state, is still not visible in official statistics. As Eva Ehrlich shows, for tax avoidance and other reasons a considerable portion of private production activities are left off the books. In addition, an estimated 40 percent of registered small businesses are "dummy" organizations or "phantom firms" that are established for various reasons but never actually start operations. Thus, estimates of the private share of GDP and the economic consequences of privatization may have a wide range of uncertainty. In most countries, privatization has been more successful for small enterprises than for the larger ones. Salvatore Zecchini finds that only Russia and the Czech Republic have made substantial progress in privatizing large enterprises. In effect, heavy industries, energy, motor transport, major chemical industries banks and other financial institutions, and agricultural land (except in Poland) have been largely excluded from the process. The effects of privatization will vary depending upon the approach that is employed. Typically, a state owned enterprise is turned into a joint-stock company whose shares are owned by the state and may be privatized through sale or otherwise. The most common approach is mass privatization in which one or more entities are transferred to the general public through auction orsale, often with the aid of vouchers that are distributed to potential buyers. A second approach is to permit a buy-out by the managers or employees of the enterprise being privatized. A third approach is to seek domestic or foreign investors. Mass privatization has the advantages of rapid transfers of ownership and satisfaction of public demands for a portion of the wealth created under communism. It also gives large segments of the public a vested interest in the emerging market economy. Manager-employee buyouts have the advantage of continuity in management and work force, but that may also be a disadvantage.In Russia and other countries buyouts have been accompanied by charges of favoritism to the former nomenclatura and criminal elements. One of the weaknesses of both of these approaches is that the transfers of ownership do not produce new management,capital or expertise. Many economists prefer a third approach, "trade" sales to investors. This approach is a source of needed revenue to the government and, more importantly, is likely to be followed by infusions of capital and entrepreneurial skills into the enterprise. But trade sales require extensive preparation by the government, which may need to restructure an entity before it can be sold, and are often difficult to justify to a skeptical public. It is useful, for a number of reasons, to know how western governments have dealt with the issue of privatization generally and, in particular, with the privatization of defense enterprises and their conversion to commercial activities. The East German case is, at first glance, the most applicable as it, too, is a former communist country. With the end of communist rule, East Germans found themselves with many inefficient, non-competitive industries and arms production facilities that were excessive to the needs of national security. The decision of the German government soon after unification was to privatize or liquidate much of the former East German industrial structure. Wolfgang Vehse's paper provides a detailed account of Germany's successful privatization of East Germany. There are many lessons in the German experience worth recording. Unfortunately, most of them do not appear to be applicable in the other former communist countries. For one thing, the costs of the German approach would be prohibitive elsewhere. By mid 1994 the German government had spent 150 billion DMs and it is estimated that the full costs will be 275 billion DMs. Secondly, Vehse makes the point that the transformation of a command economy into a market economy cannot be forced. He lists the basic conditions that he believes such a transformation necessitates: (1) a consensus about the economic policy to be followed; (2) a proven and uncomplicated legal system; (3)competent and loyal government administrations at the local level; (4) a welfare system capable of absorbing moderateun employment; and (5) a well organized and trustworthy financial system and currency. It is precisely the absence of most of these conditions in the former communist countries that reforms are attempting to remedy. Presentations were made at the colloquium about recent efforts in the United Kingdom, the United States, and France to privatize, diversify, or convert their defense industries. Each has employed a somewhat different approach. In the UK, the government in 1979 began privatizing broad sectors of industry such as aerospace and most of the defense industry, shipbuildingand state owned housing. The US has not had notable success in past efforts to convert defense firms to other activities. More recently it put in place a program to cushion the industrial effects of reduced defense orders, to preserve certain technological capabilities, and to retrain defense workers. But it is expected that many defense firms will go under and that some of the larger firms will be absorbed in corporate mergers.In France a policy of diversification has been adopted for a segment of the defense industry, rather than privatization. The presence of Vehse's preconditions in these countries has facilitated the changes there. Another way of distinguishing the privatization and defense conversion problems of the West with those of the post communist countries is to point out that the western nations are liberal democracies with market systems. The western nations also have relatively balanced and advanced economies. Alexander Kennaway demonstrates that the defense industries in the western countries are a small part of the manufacturing base, and the economies can easily absorb restructuring and closures in the defense sector. Nevertheless, even in the West the adjustment process has not been without political and social difficulties. The fact that the countries of Central and East Europe do not yet possess the political and economic advantages of the West is, in part, what makes the privatization and conversion problems so much more difficult in this region. There are several types of special problems surrounding the efforts to privatize and convert or diversify defense industries. The most serious problems are in the former Soviet Union where the military establishment had grown to enormous proportions. In Russia and the newly independent states the demand for arms has been sharply curtailed domestically and in foreign markets. The defense industry no longer enjoys the privileged status that gave it the highest priorities for supplies, manpower and technology. Many defense plants were located in cities whose economies were highly dependent upon them and are now depressed areas. Large numbers of the youngest and more skilled workers have left to find other jobs. Defense production skills and equipment are often not convertible to commercial products. Moscow's attitude towards the problem of privatizing and converting substantial portions of its defense industry has been ambivalent. Defense procurement has been drastically reduced but factories have not been closed and there is much hidden defense unemployment. Although there has been recent progress in the mass voucher privatization of defense enterprises, it is not clear how this will lead to increased investment or a restructuring of the defense industry. Some of the same problems exist in the former Warsaw Pact countries where defense industrial structure and end products were determined by the former Soviet Union, where there also has been a collapse in demand for arms and equipment, and where there is now substantial excess capacity. The task for these countries is to reorient defense to their own requirements and dispose of the unneeded portions of their defense industries. The former Czechoslovakia and Poland had the largest defense industries inthe region in absolute terms and relative to the size of their economies. Consequently, the more serious adjustment problems are in those countries. Most of the defense industry in the former Czechoslovakia is located in Slovakia and the reduction in arms production and employment there has been the sharpest in the region. Cuts in arms spending have also been severe in the Czech Republic. Government efforts to assist defense firms in Slovakia and the Czech Republic to diversify and to attract foreign investment seem to have had only limited success. To the extent that defense firms have been privatized it appears to have occurred within the framework of overall privatization rather than as a result of actions directed at the defense industry. The Polish government adopted in 1992 a defense industry restructuring program prepared by the Department of Defense Affairs. Under the plan, as explained in Edward Gorczynski's paper, a certain number of defense enterprises will remain under government ownership and control. The remainder are to be converted to civilian activities and privatized, or their assets will be sold. As of mid 1994, defense employment in Poland had been reduced by 50 percent. Of course, the unemployment accompanying defense privatization and conversion is a matter of deep concern throughout the region. Franz-Lothar Altmann calls attention to the fact that the loss of jobs is caused by the downsizing of defense and the excess capacity in the defense industry rather than by privatization per se. The unemployment consequences can be eased by the privatization and conversion process. For this reason, foreign investment is preferable to voucher privatization because of the fresh capital that foreign investors can provide.Without an infusion of capital into privatized firms large layoffs are unavoidable. The subject of defense conversion in the post communist countries could not be discussed adequately without reference to the broader issues of national security and future relations with the West. In fact, these issues were raised at numerous times during the colloquium. There are several interrelated concerns. One is that although the Cold War is over, there are still security threats to all the nations in the region. Although it is recognized that self-sufficiency in arms and equipment is not practical, all express a need to retain some defense capabilities. Yuri V. Andreev argues that the part of the Russian military-industrial complex necessary for the maintenanceof national security should be identified before the rest is converted to civilian production and privatized. Some of the participants state that efforts are underway in some countries to redefine security requirements. Others, including Salvatore Zecchini, express doubt that the countries with large defense industries have drawn a demarcation line between the core defense activities to be retained for security reasons and those that can be privatized. A second issue is about relations with NATO. Secretary General Manfred Worner mentions in the opening remarks prepared for the colloquium the dynamic nature of NATOÕs cooperation with the states of the former Soviet Union and the other Central and East European countries. The Secretary General states that the aim is to use the framework of the North Atlantic Cooperation Council (NACC) to facilitate and promote work on common problems, like defense conversion. He goes on to state: "We aim to advance on practical cooperation on defense conversion and on security-related economic issues, including those related to defense budgets." Daniel George, Director of the Economics Directorate, states in his opening remarks that this colloquium itself is part of the work of the NACC. The Central and East European nations welcome the idea of international cooperation. Katarzyna Zukrowska and Leon Turcynski state in their paper that defense production cannot be left out of international economic cooperation and that the Central and East European countries need to catch up with the structures and equipment of the NATO partnership countries. They and other participants mention efforts by countries in the region to achieve standardization and interoperability with NATO weapons. Zukrowska and Turcynski conclude by noting that all the countries of the region want to become members of NATO. However, at the West's insistence the Central and East European countries"have to proceed through a transition period which resembles a quarantine during which they will restructure their defence systems" to bring them closer to NATO requirements. Finally, some of the papers presented at the colloquium broach the subject of European integration. Igor Kosir views the present transition period as a challenge not only for the postcommunist countries but for all of Europe and its integrated future. Daniel Daianu states the issue most succinctly: "In a broad political, social, economic and cultural sense, integration into Europe (into pan-European political, economic and defense structures) is an ultimate goal for the post-communist countries." Most of the participants of the colloquium appear to agree with that statement. ---------------------------------------------------------- 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.