Karl Marx Adam Smith

Transition Recession GDP declinegreater than in US

during Great Depression

Russia 50% Ukraine 60% Uzbekistan 20%Georgia 77% Belarus 37% Kazakhstan 39Moldova 69%Lithuania 46% Latvia 39% Estonia 36%CEE avg 22%

Country New CurrencyRuble Exchange Rate

Introduced

Armenia Dram 200 1993

Azerbaijan Manat 10 1992Belarus Ruble 10 1992Estonia Kroon 10 1992Georgia Lari 1 1993Kazakhstan Tenge 500 1993Kyrgyzstan Som 200 1993Latvia Rublis 1 1992Lithuania Talonas 1 1991Moldova Cupon 1 1992Tajikistan Ruble 100 1995Turkmenista

nManat 500 1993

Ukraine Karbovanets 1 1992

Uzbekistan Som 1 1992

Structural Legacies of Socialism• Dictatorial state

• No private property• No entrepreneurship• Quantity output planning • Soft budget constraint • Heavy industry• Large enterprises• Outdated technology• Militarization • No commercial banks• Distorted prices– Raw materials too cheap– Value-subtracting production• Shortages• Inefficient agriculture• No support for innovation

• Inefficiently allocated capital• Uncompetitive output• Poor transportation

infrastructure • State monopoly in internat’l

trade, inconvertible currencies• Large foreign debt in CEE • Suppressed human rights

• NEED RESTRUCTURING• NEED PRIVATIZATION• NEED Price liberalization• NEED to create monetary and fiscal policies for

MACRO STABILIZATION

Need Institutional Reform

• Tax system• Social safety net

–To cushion impact of structural transformation

–Unemployment benefits–Retirement benefits–Public health care

• Property law – income from property–transferability - sell, rent,

bequeath

• Contract law–framework within which parties

can legally enter into contractual relationships

–remedies for breach–protection of vulnerable parties

(consumers, tenants)

• Bankruptcy law–how businesses can close

down, distribute assets, pay liabilities

• Anti-monopoly laws–anti-competitive practices

•monopolization of markets•collusion, price fixing

• Securities law–regulates sale of stocks and

bonds to public–prevent fraud and ensure full

disclosure

• Intellectual property law–patents, trademarks, copyrights

• Labor laws–rights and obligations of

employers and employees

Transition Debate: Sequencing and Speed

• Where to begin? what order of reforms?– “changing the engines of a plane while it keeps flying” (Roland)

1. Big bang shock therapy (Poland, Russia)– Shut down central planning, let market determine prices– All at once, painful, sharp economic collapse– “Washington consensus”, IMF/World Bank loan condition

• Based on belief individuals have “rational expectations”• Individuals are able to accurately predict the future of economy• Economy will instantaneously move to the new equilibrium• Quick privatization• Tight fiscal policy, low spending for low budget deficit• Market prices + tight monetary policy against inflation• Fixed exchange rate

2. Gradual, slow and steady (China, Hungary)– Avoids collapse but takes longer– Market requires enormous legal, political and physical

infrastructure

Russian Shock Therapy, 1992

•Price liberalization– Most prices freed

• except energy, medicines, necessities, public utilities– Average price increase of 245% in January 1992

•New tax system and better tax collection– 28% value-added tax on most transactions– Progressive income and profit tax– New taxes on domestic energy use

•Lift restrictions on foreign trade and investment•New import and export tariffs

– tax on oil and natural gas exports•New constitution, 1993

– Parliamentary system– President, appoints Premier (head of government),

ministers, judges •Bicameral legislature

– Federation Council (upper house) - members appointed by top executive and legislative officials of federal administrative units

– State Duma (lower house) - members popularly elected

Yeltsin 1992-99

Hyperinflation, 1992-94 • Removal of price and wage controls• Monetary deficit financing

– Tax revenues down in recession– Government spending up: 181 billion rubles (US$1.1 billion) gov’t

credits to insolvent enterprises – issuing credit = printing money

Crisis: 1992-94• Consequences of hyperinflation

– Higher inequality • Ruble savings accounts wiped out• Poverty among retired on fixed income

– More shortages• soap, eggs, sugar, vodka, etc - rationed

– Dollarization– Economic inefficiencies:

• Time spent in unproductive activities (changing rubles into dollars)• Buying jewelry and durable goods• 80% of private savings held in cash dollars, not invested

• Anti-crisis program, 1993 • Control inflation through tight monetary and fiscal policies

– RCB increased interest rates on credits (1990s: 20-250%)– Restrict subsidies to state enterprises – Close inefficient state enterprises– Limit wage increases for state enterprises– Establish quarterly budget deficit targets– Issue government bonds to finance budget deficit– Providing social safety net for unemployed and pensioners

GaidarGaidar

1. Capital Constraint• No private wealth under socialism• Foreign capital limited

– international capital market restrictions– aversion to foreign capital– exchange rate risks– lack of information– uncertainty of institutions of a transition economy

2. Administrative • Defining ownership titles of state assets• Valuing state assets • Finding potential buyers • Registering transfer of ownership3. Political • Insiders (workers and managers) favor transfer of ownership to them• Outsiders want to obtain as much as possible, and free if possible, of state assets4. Informational constraint• How can privatization agency know who is the best buyer?5. Fiscal challenge to balance budget • After privatization, government revenues = taxes

– tax system and collection mechanism needed• Government no longer finances privatized firms, but faces other expenditures:

– Unemployment benefits– Infrastructure investment – roads, hospitals, schools, telecommunications

Privatization: ChallengesPrivatization: Challenges

Russian privatization Stage Zero 1988-91: Spontaneous Privatization

• 10,000 enterprises, 1988-91• 1988: State Enterprise Act during Perestroika

– “commercialization of the state sector” – cooperatives, joint-stock companies and partnerships set up – work collectives took out leases on state enterprises with or without buyout

• Asset stripping– transfer of state enterprise property and communist party money to the

balance sheet of cooperatives, joint-stock companies, partnerships– “privatization of profit”

• Berezovsky’s scheme to move profits from state to private sector:– Avtovaz (SOE) produced cars at average cost $4,700– Cars sold to dealership (private) at $3,500 each– Dealership sold to customers at $7,000– Loss-making enterprise cheap to privatize

• Other schemes:– Director of a state enterprise sells highly valuable raw materials at throw

away prices to his own private company– Manager buys absolutely useless goods at exorbitant prices from another

manager and shares the profit– No breach of law - impossible to prove there was a bribe

Russian Privatization Stage One 1992-94 : Mass Voucher Privatization

• 70% of Russia's large and medium-sized enterprises • 90% of small enterprises privatized• 1991: State Committee for Management of State Property,

Federal Property Fund created • Every citizen (144 million) given a voucher

– worth 10,000Rb(US$63)• Vouchers could be

– Sold for cash– Put in investment fund that purchases shares of enterprises in auctions– Sold for shares in medium-sized and large enterprises chosen for auction– Hundreds of voucher funds and investment agencies sprung up – Many bogus – collect vouchers, declare losses, disappear – Lack of state supervision

• “Insider privatization": assets given to managers and workers of SOEs – Implication for corporate governance:– New owners have little interest in restructuring– who wants to lose jobs?– Did not bring new capital or management expertise– few firms experienced management turnover

Russian Privatizaton Stage Two, 1994-95: Cash Auctions (loans for shares)

• Sales at ridiculously low prices to former elite– Oligarchs-run banks awarded loans to state firms in return for shares– Auctions with chosen few participants invited– Foreign entities not permitted to participate

• “Oligarch privatization“: shifted control of most profitable enterprises to groups of individuals with inside connections in government / mafia

– Uneximbank of Moscow received a 38% interest in giant Noril'sk Nickel Joint-Stock Company at half of a competing bid

• Government raised less than expected revenue, $12 billion

Russian Privatization Stage Three, 1996: Case-By-Case Sales

• Sold several large state enterprises– joint-stock company of Unified Electric Power System of Russia – Russian State Insurance Company (Rosgosstrakh)– St. Petersburg Maritime Port– Communications Investment Joint-Stock Company (Svyazinvest)

• Open to foreigners• Expert advising on timing and method of sale and valuation

Comparison of share prices of two major enterprises

0

100

200

300

400

500

600

NORILSK NICKEL LUKOIL

starting price of 1%(million USD) in1995

starting price of 1%(million USD) in2008

Criticism of Privatization• Much less open and transparent than

privatization in Central Europe• High interest rates

– "non-insiders" left incapable of borrowing capital to invest in Russian enterprises, leaving privatized industries starved of cash

• Opening of the capital markets capital flight – $2- $3 billion of capital per month– US$65 billion have left the country in 1992-97

• Stiglitz: "Anyone smart enough to be a winner in the privatization

sweepstakes would be smart enough to put their money in the booming U.S. stock market, or into the safe haven of secretive offshore bank accounts. It was not even a close call; and not surprisingly, billions poured out of the country."

• Russia followed bad advice to pursue rapid reforms…. Gradual approach with focus on building institutions would be better.

Joseph Stiglitz, 2001 Nobel Prize in Economics

Eastern EuropeEastern EuropeCzech Republic• Mass Voucher Privatization to Outsiders• Restitution - Return of nationalized property • Auctions – Sale of small enterprises to highest bidder

Hungary• Most property sold thru bids to foreign investors• Restitution• Some buyouts by managers and workersPoland • Public offerings• Sealed bids- sale to private investors including foreigners• Leasing• Vouchers- free distribution of shares• Liquidation of assets • Revenues from privatization far below expected:

– Under 13% of GDP• Sales to outsiders brought modest revenues because

– outdated plants (and machines) offered for sale– partial asset stripping– various schemes of noncash payments– fears of investors about reversal of reforms

Demonetization: 1992-98

• How can enterprises survive?– Interest rates too high to borrow– Subsidies cut– No money to pay suppliers for materials– SOEs are not paid for own output– No money to pay taxes

• Barter and offsets in 1998– >80% of tax payments were non-monetary (“in-kind”) – 70% of all transactions among enterprises non-monetary

• Barter at fictitious “virtual” prices (Ickes and Gaddy)• Overpriced output delivered in lieu of payments• Recorded prices and transactions not the same as actual terms of trade• Actual market price of output below cost of inputs

– Wages paid “in-kind”• Massive increase in inter-enterprise debt • Wage and pension arrears within state enterprises

– Wages delayed for several months for 65-67 million workers, 1996