DEVELOPMENT BRIE Number 38 The World Bank August 1994 1990s followed the decision of the Property right..... s matt er Gorbachev government to refuse to protect these rights. As a result, the Poorly defined property rights cause two problems: rights were effectively grabbed by inefficient structures of control rights over assets and the managers, not peacefully turned poor contract enforcement. Well-defined property over. rights solve both Privatization reallocates I n the transition from a com- from the central ministries to sev- rights mand to a market economy, eral other stakeholders. A workable privatization program property rights are poorly * The enterprise managers got had to combine political reallocation defined, with the excessive control substantial control over invest- of control rights away from the cen- rights of the politicians and bureau- ment, employment, product devel- tral bureaucracy to private share- crats as the leading example. The opment, and many other decisions holders with awards of equity and most obvious way of getting previously controlled by central other benefits to the stakeholders around political control is corrup- ministries. who would support the program. tion, but this strategy has many The Russian large-scale privatiza- problems beyond breaking the law, tion program explicitly rejected including the limited enforceability Privatization "nomenklatura privatization," of corruption contracts. which would offer equity to existing At the Bank's sixth Annual Con- transfers control bureaucrats, since the political im- ference on Development Econom- perative dictated that they should ics, Andrei Shleifer suggested three rights from the be marginalized rather than em- alternative strategies for establish- powered. Even under this con- ing property rights in transition bureaucrats straint, the Russian privatization economies: giving equity to the bu- program showed how a small politi- reaucrats (and other parties that * The workers (unlike those in cal mandate could be built into a have control), reforming the civil Poland) did not have much control successful reform. service, and politically removing over decisions in the firm. But they The Russian program combined bureaucratic control rights did have, through their allies in the the elements of political redistribu- (privatization).* Looking at Russia, Parliament, effective veto power tion of control rights (using manag- he shows how privatization-com- over any change in the legal owner- ers, the public, and the local bined with equity incentives for en- ship structure of the enterprise. governments to undermine the terprise insiders-transfers control * The local governments wanted power of Moscow bureaucrats) with rights from the bureaucrats and enterprises to maintain employ- equity awards to parties that al- stimulates political and economic ment and provide social services ready had control rights (managers pressures for the genuine protection for the local residents-and they and workers). As a mechanism of of private property rights. controlled the supply of water, transferring control rights from electricity, and other services to politicians, the program was very Managers grab rights firms. successful. In 1993 alone, almost In the early 1990s, after the collapse * The central ministries retained 10,000 industrial enterprises, with of communism, control over the some control over firms in part be- 40% of industrial workers, were Russian industrial enterprises went cause they could coordinate supply privatized. By July 1, 1994, when the 'Formoredetails,seeAndreiShleifer, "EstablishingProperty and distribution much better than program was scheduled to end, Rights," in Michael Bruno and Boris Pleskovic, eds., Proceed- enterprise managers. more than 15,000 industrial enter- ings of the World Bank Annual Conference on Development Eco- T d nomcs 1994 (Washington, DC: World Bank, forthcoring in The devoluton of control rights prises, with almost two-thirds of in- 1995). Mr. Shleifer is a professor at Harvard University. from the ministries in the early dustrial workers, were to be private. This success is clearly the conse- cases, these outside shareholders be improved through a combina- quence of the program's reliance on ally themselves with the workers to tion of allocating cash flow rights to a politically viable approach to dismiss incompetent managers and parties with control rights and po- transferring control rights. replace them with outsiders or more litical transfer of control rights, competent insiders. even under a very weak govern- Now, the hard part Even more important, outside in- ment. To do that, the reformers But the transfer of control from vestors, including investment must build a political coalition politicians is only a first step in es- funds, have begun lobbying the strong enough to counter the bu- tablishing property rights. Indeed, government for regulations that reaucratic opposition to loss of con- the Russian managers (but prob- protect their control rights, includ- trol. The Russian privatization also ably not the workers) have ing independent share registrars, shows that genuine establishment emerged from privatization with laws protecting investor rights, se- of property rights comes after the quite enormous control rights, in- cret corporate voting, and so on. transfer of control rights from the cluding the ability not only to make These investors have also lobbied politicians, as private investors be- most corporate decisions, but also for the creation of a securities and gin to use their economic and politi- to select directors, to control share- exchange commission that will have cal resources to protect their rights. holder votes, and often even to con- the mandate to enforce unrestricted At the same time, the Russian ex- trol the trading of shares through trading of shares. Toward the end perience shows how difficult it is to physical control over share regis- destroy political control. The ters. While Russian management privatization of shops in Russia has teams on average own about 15% . r . worked much less well than that in of the shares of their companies, Outside investors Eastern Europe because local gov- through their influence on the have begun ernments continued to control busi- workers and on the government nesses through leases and property funds that still own some lobbying the regulations. Land reform has been shares many managers almost fully similarly stymied by government control their firms. Control by man- government agencies committed to controlling agers is probably better than con- all land transactions. Even with trol by politicians. While managers of 1993, these investors began to large-scale privatization, proposals are interested in empire-building succeed politically, and the govern- for consolidating firms into indus- and preserving their jobs, their wel- ment adopted a variety of regula- trial groups and other quasi- fare is more closely tied to the prof- tions protecting shareholder rights. governmental structures continue its of the firm than is that of the In this way, privatization, while not to resurface even after most firms politicians, particularly when man- establishing full property rights by have been privatized. Moreover, agers have an equity stake. Still, to itself, has stimulated policies in- credit policy has served as a con- establish property rights in these creasing the protection of these tinually effective instrument of po- enterprises, managerial control rights. litical control of privatized firms. must be curtailed and that of out- As property rights become estab- Last, it is plausible that politicians side investors increased. lished, the restructuring of the Rus- have delayed the protection of pri- As a result of privatization, many sian enterprises begins. Even before vate property rights in Russia-and Russian companies have ended up privatization, as managers got control perhaps even condoned crime, with large outside investors- rights but before they received cash since fear of the mafia often brings investment funds, wealthy Russian flow rights, the employment in state entrepreneurs to seek political pro- entrepreneurs, or even foreigners. enterprises in Russia began to fall. tection, an action that of course only These investors, interested prima- Most firms continue to consider gives the bureaucrats more control rily in profits, use whatever control themselves substantially overstaffed. over firms. If nothing else, the Rus- rights they have (votes at share- sian experience reveals the many holders' meetings, jawboning the Some useful lessons difficulties of escaping the political managers) to demand value- The Russian privatization shows control of firms. maximizing strategies. In a few that allocations of control rights can Deelopment Briefs are issued by the World Bank to inform the media, business, academic, and govemment policy communities about development policy analyses and results from the Bank's research activities. They are drawn from the work of individual Bank researchers and do not necessarily represent the views of the World Bank and its member countres-and should not therefore be attributed to the World Bank or its affiliates. Briefs are issued periodically by the Research Advisory Staff, Development Economics Vice Presidency, The World Bank, 1818 H Street, NW, Washington, DC 20433. Tel: (202)473-3984, Fax: (202)477-0955. Briefs are not copyrighted amd may be reproduced with the appropriate attribution.