RESEARCHI PAPER SIERIES E 8 1
INDUSTRIAL REFORM AND PRODUCTIVITY IN CHINESE ENTERPRISES
ENTERPRISE BEHAVIOR AND EcoNoMIC REFORMS:
A COMPARATIVE STUDY IN CENTRAL AND EASTERN EUROPE
RESEARCH PROJECTS OF THE WORLD BANK
POLICY BRIEF
EE-PB 10
February 1994
ENTERPRISE REFORM AND RESTRUCTURING
IN TRANSITION ECONOMIES
by
lnderjit Singh and Alan Gelb
Transition Economics Division
Policy Research Department
The World Bank
TRANSITION EcoNoMics DivisioN
Tl EIPoicY RESEARCH DEPARTMENT
THE WORLD BANK
ACKNOWLEDGEMENT
The research projects on "Enterprise Behavior and Economic Reforms: A Comparative Study in Central and Eastem
Europe," and "Industrial Reforms and Productivity in Chinese Enterprises" are research initiatives of the Transition
Economics Division (PRDTE) of the World Bank's Policy Research Department and managed by I.J. Singh, Lead
Economist.
These projects are being undertaken in collaboration with the following institutions: for the project in China, The
Institute of Economics of the Chinese Academy of Social Sciences (IE of CASS), The Research Center for Rural
Development of the State Council (RCRD), and The Economic Systems Reform Institute (ESRI), all in Beijing, and
for the projects in Central and Eastern Europe The London Business School (LBS); Reforme et Ouvertures des
Systemes Economiques (post) Socialistes (ROSES) at the University of Paris; Centro de Estudos Aplicados da
Universidade Cat6lica Portuguesa (UCP) in Lisbon; The Czech Management Center (CMC) at Celakovice, Czech
Republic; The Research Institute of Industrial Economics of the Janus Pannonius University, Pecs (RIIE) in Budapest,
Hungary; and the Department of Economics at the University of L6di, in Poland; and the National Center for
Development Studies, Australian National University, Canberra, Australia.
The research projects are supported with funds generously provided by: The World Bank Research Committee;
The Japanese Grant Facility; The Portuguese Ministry of Industry and Energy; The Ministry of Research and Space;
The Ministry of Industry and Foreign Trade, and General Office of Planning in France; and the United States Agency
for International Development.
The Research Paper Series disseminates preliminary findings of work in progress and promotes the exchange of
ideas among researchers and others interested in the area. The papers contain the views, conclusions, and
interpretations of the author(s) and should not be attributed to the World Bank, its Board of Directors, its management
or any of its member countries, or the sponsoring institutions or their affiliated agencies. Due to the informality of
this series and to make the publication available with the least possible delay, the papers have not been fully edited,
and the World Bank accepts no responsibility for errors.
For additional copies, please send your written request to:
Transition Economics Division
The World Bank
1818 "H" Street, N.W.
Room N 11-029x
Washington, D.C. 20433
Attention: Mr. Christopher Rollison
or FAX your request to (202) 522-1152
CONTENTS
Acknowledgment ...................................................................................................... i
1. Introduction ..................................................................................................... 1
2. W hat is Different about PE Reform in Transitional Economies? ................................... 2
3. PE Reform Strategies, Transition Patterns, and Country Characteristics....................... 3
4. The Public Enterprise "Problem ................................................................................. 9
5. Enterprise Reforms in China: The Gradualist Approach ............................................. 13
5.1 Crisis and the Dynamics of Reform.................................................................. 13
5.2 Reforming the M arket Enviro n ent................................................................. 15
5.3 Permitting New Entry: The Growth of the Nonstate Sector............................. 16
5.4 Reforming and Restructuring SOEs................................................................. 18
5.5 Exit Policy ................................................................................................... 20
6. The Impact of Ciina's Reforms on Performance........................................................ 22
7. Two Radical Reformers: Poland and the Czech Republic ........................................... 28
7.1 Two Radical Reformers: Poland and the Czech Republic................................. 28
7.2 Creating the Institutional Framework for PE Reforms...................................... 29
7.3 Restructuring and Partial Privatization............................................................. 31
7.4 Privatization and Exit ...................................................................................... 35
7.5 Private Sector Development............................................................................ 39
8. Enterprise Adjustment in Eastern Europe: What do We Know? ................................. 41
9. Conclusion ................................................................................................... 51
Bibliography ................................................................................................... 55
ii
LIST OF TABLES AND FIGURES
TABLE 4. 1 Country Indicators, 1991........................................................................... 10
TABLE 4.2: Structure of Economy, 1991...................................................................... 10
TABLE 4.3: The State Enterprise Sector, 1991............................................................. 11
TABLE 4.4: GDP and Shares by the Private Sector....................................................... 11
TABLE 4.5: China: Non-State Sector Shares of GDP.................................................... 12
TABLE 4.6: China: Share of Employment by Sector and Ownership ............................. 12
TABLE 5. 1: China: Ratio of Market Prices to State Prices............................................ 16
TABLE 7. 1: CZ: Methods of Privatization by Sector..................................................... 37
TABLE 7.2: The First Wave of Mass Privatization........................................................ 38
TABLE 8. 1: Changes in Output and Employment in Poland and CSFR.......................... 42
TABLE 8.2: Changes in Direction of Trade: CMEA and Market Economies ................. 47
Figure 3.1: Broad PE Reform Strategies.......................................................................... 4
Figure 5. 1: China: Losses of State Owned Enterprises................................................... 21
Figure 6. 1: Growth Rates by Ownership Types.............................................................. 22
Figure 6.2: Non-State Industry and Efficiency of the State Sector in 1991..................... 26
iii
1. INTRODUCTION
This paper examines the problems of reforming public enterprises (PEs) in transitional economies-that is,
previously centrally planned socialist economies that are in the process of changing to market based systems. It
focuses on the experience with PE reforms in three countries-China, Poland and the Czech Republic. These
have been selected to highlight the central reform issues and bring out some of the sharp contrasts in initial
conditions, reform experiences and reform outcomes to date that characterize transition economies. However, it
should be emphasized that these three countries do not span the full range of transition experience.
While there are many parallels, the problem of PE reform in transitional economies is a much broader one
than in market economies, because it is part of a fundamental liberalization of the economic system and a
watershed change in the role of the state. Distinctive features are noted briefly in Section 2. Section 3 provides
an analytical framework for the country discussion. It sets out the broad range of strategies for shrinking the
weight of the PE sector in the economy, and outlines the phases of the two models of reform, the radical
"European" model and the gradualist "China" model. Before proceeding to the country discussions, Section 4
provides some comparative information on the size and characteristics of the PE sectors and of the countries.
The paper then goes on to the country cases. Sections 5 and 6 summarizes the policy experience of China
and the outcomes; Sections 7 and 8 do the same for the two European countries. The main conclusions are
summarized in Section 9.
Before proceeding further, two caveats are in order. First, all of the countries are still in the throes of
transition. While the outcomes of certain policy choices are becoming more apparent, there are still large
unknowns-in particular, concerning the impact of privatization for medium and larger firms. Second, the paper
focusses on the treatment of medium and large industrial firms, as being at the cutting edge of the reform debate
in the TEs. This is not to say that other areas of enterprise reform, such as the restructuring of collective farms
or the commercial real estate sector, are not important. Indeed, the industrial capital stock is typically only a
modest part of total assets in a market economy.' It was felt, however, that a wide focus on reform would render
the paper less compatible with those for other countries.
' At some 37% of GDP, industrial assets were barely 12% of reproducible assets in West Germany in 1988 for example,
and only about one third of the value of land.
1
2 Research Paper Series: Policy Brief
2. WHAT IS DIFFERENT ABOUT PE REFORM IN TRANSITIONAL ECONOMIES?
Several distinctive features make the problems of transitional PE reform different in nature and scope from that
in market economies:
(i) The starting point for reform is the dominance of state ownership in practically all sectors of the
economy-especially in the industrial sector. The core issue in the more advanced TEs is therefore the reform of
this (overgrown) sector, together with the financial sector, rather than the regulation or privatization of service,
infrastructure or utility companies. In the countries of Eastern Europe (EE), industrial PEs accounted for some
60% of GDP before the collapse of central planning.
(ii) Nevertheless, reorganization is not really a PE but an economy-wide issue. It involves broad sectors,
sometimes entire regions, whose economic base is potentially unviable in a market system, and a fundamental
change in mechanisms of social protection to complement enterprise reform.
(iii) The links between macro-stabilization and the micro incentive structures under which PEs operate are
crucial. Support for loss-making PEs is typically the major cause of quasi-fiscal deficits and inflation.' Without
changing the incentives for SOEs,' macro-stability is elusive, and this, in turn, may make the problem of
improving enterprise performance reform even less tractable.' Changes in the policy environment in which PEs
operate (including relative price shifts as subsidies and controls are removed) are usually dramatic and often far
more rapid than in market economies. Particularly in EE and the FSU, enormous economic, social and political
pressures combine with macroeconomic instability and uncertainty to define the environment in which PEs must
to continue to operate and be reformed.
(iv) The legal and institutional framework for markets and property rights is essentially missing, and takes
time to reconstruct. Even the state does not have clear "ownership" of its property, in the sense understood in
market economies. Therefore, privatization is both a problem of creating property rights and reassigning
rights to private agents.
(v) The supply of private domestic buyers and domestic savings is very small, relative to public assets. This
limits the -potential for normal direct sales, at prices reflecting the long run value of assets and has led to a
search for more innovative ways to privatize.
2 With transition, much of the support for PEs has shifted away from the budget and towards the financial system.
Typically, support for the PE sector is reflected in large Central Bank losses (Romania) or massive transfers from
holders of financial assets (Russia) through severely negative real yields. Budgetary deficits, on the other hand, often
result from falling tax receipts and rising social expenditures.
' PEs are commonly referred to as state-owned enterprises (SOEs) in transition economies. We have used these two
terms interchangeably throughout this paper.
SMacro-stability is clearly not essential for initiating enterprise reform. But whether or not it is essential for successful
enterprise reforms is another issue. Russia is managing to privatize its PE sector rapidly in the midst of macro-
instability. However, it is not clear how the privatized firms are expected to perform in the severely destabilized
environment.
Enterprise Reform and Restructuring in Transition Economies 3
(vi) Lacking real "owners", and with weak institutions,, a whole variety of active agents of change emerge in
the course of PE reforms. These include: governments at various levels, each with an "ownership stake;" banks,
most of which remain government-owned, "new owners," including mutual funds or holding companies; foreign
investors, seeking to gain a hold through joint ventures; and managers and employees of firms who usually
perceive themselves to have a strong direct stake in their enterprises. In the transition from a system of state to
private ownership, many putative "owners" with their own "rights" emerge. One clear danger is therefore that
the process of change may become muddy and ever-more complex.'
(vii) PE reform involves the distribution of major economic assets, and decisions on this are naturally affected
by initial and changing political conditions. Ownership has become the center of debate in most transition
economies-Poland, Czechoslovakia and China being no exceptions-and the PEs are seen as a central point in
this nexus.
Most of these issues also arise in market economies. Some experience political upheaval, others have
weak market institutions or a shortage of "suitable" owners (particularly in Africa), and so on. But the
difference in degree is so large as to make the substance of reform-both the opportunities for change and the
constraints--qualitatively different for the economies in transition.
3. PE REFORM STRATEGIES,
TRANSITION PATTERNS AND COUNTRY CHARACTERISTICS
Reform Strategies. All countries seeking to raise growth by reducing the burden of the PE sector have three
potential analytically distinct or "pure" strategies. Specific country strategies may continue these three "pure"
options:
1) "Grow out of' the PE sector, and so reduce its weight in the economy. This is easiest if the PE sector is
not too large initially and with rapid growth.
2) Restructure the PE sector to raise efficiency. This has two aspects:
a) change the environment of the Pes: liberalize product markets, harden budget constraints,
eliminate subsidies, etc. The aim is to encourage a decentralized process of enterprise-level restructuring;
and
b) change the corporate governance of the PEs: introduce management contracts and incentives,
corporatize, restructure the PEs from above, using the state's ownership prerogative, etc.
3) Effect exit from the PE sector, through privatization and/or liquidation.
Transitional countries face the same broad range of options. Figure 3.1 shows the emphasis of the PE
reforms in the three countries, focusing on the strategic industrial sector. There are both important differences
and some deep underlying similarities between the countries.
5 The dizzying complexification of ownership rights in Hungary, for example, is documented by Frydman,
Rapaczyinski and Earle (1993).
FIGURE 3.1:
Broad PE Reform Strategies
CHINA POLAND CZECH REPUBLIC
1. Very important component of overall Very important component of As for Pbland.
Restructuring the economic restructuring. overall restructuring, but
economy, by growing carried out in the context of a
out of the Carried out in a long phase of rapid phase of stabilization and
PE Sector growth and high savings rates. economic contraction
2a. Gradual change since 1978, but still Radical change from January From January 1991, as for
Change the PE important elements of control over 1990. Markets, distribution Pbland, but less extreme
environment: product markets as well as and trade freed; dramatically macroeconomic pressures due
liberalize internal (increasingly less effective) factor tighter credit, high tax burden to more favorable economic
markets and foreign market controls. Fiscal pressure on (profit, payroll, dividend, conditions before reform.
trade and enterprise sector slackens with excess wage taxes) on PEs.
distribution; harden decentralization. Financial sector Open entry.
tighten fiscal and constraints may not have tightened
financial market much, due to rapidly expanding
budget constraints. deposits in the banking system.
"Open door" policy for foreign
investors, 1978; entry for
"nonstate" sector from 1984.
2b. Major urban reforms and new Formal introduction of new From January 199 1, as for
Corporatize, contracting systems were initiated management incentives was Poland, but less extreme
introduce in 1984 to increase the autonomy not important. Decentralized macroeconomic pressures due
management of managers and improve incentives. incentives created by to more favorable economic
contracts etc. prospective privatization conditions before reform.
to restructure the combined with market
PEs "squeeze. "
3. Essentially no formal exit and High rate of small Small-scale privatization
Formal Exit: liquidation: a few experimental privatization, sometimes essentially complete;
privatization cases reported in 1993. through liquidation, essentially restitution important.
and liquidation. complete.
First wave of privatization
Limited progress on larger- complete: 2,300 firms, book
scale privatization, due to value equal to GDP; multiple
slow passage of the - methods, including vouchers.
Privatization Law. Large-scale Substantial foreign
liquidation limited by creditor investment.
passivity. Measures to resolve
problem debts in process. Privatization-based strategy
Limited foreign investment. shrinks PE restructuring
phase. So far, little liquidation,
exit.
4. *Agriculture: 1975 *Radical comprehensive *Radical comprehensive
Timing of Major reform program launched: reform program launched:
Reforms. *Industry (first phase): 1978 1990. 1991.
*Trade liberalization *Voucher privatization: 1993
(open door policy): 1979
*Industry (accelerated): 1984
Enterprise Reform and Restructuring in Transition Economies 5
Transition Patterns. Figure I also indicates some of the most important differences between the radical
"European" and gradualist "Chinese" patterns of transition.6 These do not reflect a choice of strategies so much
as the huge differences in initial conditions (including on the macroeconomic front) and political evolution.' The
main differences between the models are:
(i) In the radical reformers, the first phase involved a phase of contractionary macrostabilization because of
the initial instability, which has had to be sustained through a period of adverse external shocks. In gradualist
China which has not faced adverse external shocks, however, mild bouts of macroinstability followed the
process of partial liberalization and decentralization, and largely resulted from this. To date, stabilization has
barely interrupted the record of growth at a remarkable rate.
(ii) Price and trade liberalization was far more decisive and rapid in the radical reformers. It therefore
necessarily preceded deeper institutional reforms, for example, in the reallocation of property rights. In the
gradual, experimental, reform process, institutional reforms and liberalization proceeded in tandem, with some
aspects of the former (such as de facto privatization in agriculture) leading the latter, and vice versa.
(iii) Nevertheless, the two radical reformers are now well ahead of China in terms of both market liberalization
and establishing private property rights (except in agriculture)--even if their economies have not adapted fully
to these new conditions.
The Dynamic Interaction of Systemic Transition and PE Reform. Because so much of PE reform in the
transitional countries involves relatively rapid changes in their enabling environment, it is useful to further
sketch some "stylized processes," to elaborate the impact of these changes on the sector prior to full
privatization. The stylized processes are neither distinct nor mutually exclusive, and in practice they overlap
considerably. But they allow us to further develop the conceptual framework for understanding the changes
under way in the PE sector.
The first phase in the radical European model, macroeconomic stabilization and liberalization, involves:
a price liberalization, an end to state orders and to input rationing, steep devaluation of the official exchange
rate to eliminate parallel markets and achieve current convertibility;
" severe tightening of real credit volumes, and increases in nominal interest rates, to reach real positive
levels;
a sharp reduction of directed credits or state subsidies to cover investments or working capital requirements
of firms, together with a shift away from state profit retention and towards uniform (and heavy) taxation;
6 Following Leszek Balcerowicz, the term "radical" is used to describe a reform strategy which aims to reform all
aspects of the economy as fast as possible. This is preferred to the "big bang" terminology, as the latter implies that all
aspects of the economy can be transformed immediately, which is clearly not the case.
' For more extensive discussion of the phasing of the radical and gradualist models respectively, see Gelb and Gray
(1992) and Gelb, Jefferson and Singh (1993). EBRD (1993) provides a useful summary of the progress of reform across
Eastern Europe and the FSU.
6 Research Paper Series: Policy Brief
a an opening to international trade and foreign investment combined with currency convertibility, and
* typically, tax-based wage controls, to reduce the potential for labor to decapitalize firms prior to
privatization.
Liberalization, whether carried out gradually and in a context of growth as in the case of China, or very
rapidly, and in a context of stabilization as in the case of Poland and Czechoslovakia, radically transforms the
economic and policy environment in which PEs as well as private enterprise have to start to operate. Budget
constraints of enterprises are tightened; the enabling environment moves towards competitive markets.
Enterprises therefore come under increasing financial stress. The "squeeze" (together with the prospect of
privatization) creates pressures for a phase of restructuring initiatives plus asset transfers to the private sector
at the enterprise level, unless, of course, large-scale privatization plans are immediately implemented. This
trend is strengthened by a (further) shift in corporate control, away from traditional ministries, towards
enterprise managers (or more broadly, in some cases, employees), who are granted autonomy (in varying
degrees) to run their enterprises.
The subsequent process of restructuring of the PEs has many potential aspects, just short of the
privatization and closing of existing firms, although some are designed to prepare firms for eventual
privatization. Restructuring measures short of large scale mass privatization include:
a Corporatization:' An early measure has typically been to try to separate "ownership" from the managerial
or supervisory role of government, by incorporating PEs and supervising them through an "independent"
though government appointed or approved, Board of Directors. Joint stock companies and joint ventures
also diversify ownership and may involve foreign ownership: they are typically attempts to gain market
outlets for exports, capital investments for restructuring and management skills.
" The separation of ownership from control is sometimes complemented by measures to improve the
incentives for managers and increase the level of accountability. Managerial contracting systems fall in
this category.
" Changes in Corporate Structures: Further attempts to separate PEs from government control may involve
the development of holding companies. These take two forms. Vertical holding companies usually follow
older ministerial and supervisory structures and are formed along product groupings familiar to them.
Retaining supply and customer links and sharing R & D facilities these holding companies can also lead
to vertically integrated monopolies.! In addition they may include previous state trading companies as part
of the firm-customer links and so reinforce cartel like arrangements. Horizontal holding companies are
attempts instead to enlarge and diversify ownership. Shareholders can include older ministries, central and
local governments, state and commercial banks and also other enterprises or even foreign investors in
selected cases.
* Corporatization in the context of transition economies is used in the narrow sense of creating a legal corporate entity
rather than the.entire restructuring of a public enterprise.
9 Romania is an example of the development of such holding companies; Uzbekistan is another.
Enterprise Reform and Restructuring in Transition Economies 7
m Spontaneous Privatization: Asset Restructuring typically involves splitting out the profitable parts of the
enterprises, usually by existing managers or supervisory agencies, who form new companies from parts of
the older ones. Such "insider," "spontaneous," "autonomous" or "voluntary" privatization has been going
on for some time and actually pre-dates the radical reforms in some cases."o When these "profit centers"
are separated, they leave behind the "bad debts" and other obligations in the old parent enterprises, which
become "shells" with fewer assets but all the liabilities."
* Leasing out of Assets: An alternative form of asset restructuring involves the leasing out of assets from
PEs to private firms. This leasing arrangement could also include the leasing out of an entire "profit
center" in the form of a service (hotels, transportation) or a product production line to another private or
state company.
a Financial Restructurin: this can involve direct government assistance to financially strapped firms
through budgetary allocations and investments, on a more selective basis than in the past. It can also
involve banks or other financial institutions exchanging debt into preferred shares.2 These debt for equity
swaps would be accompanied by assistance from the bank or financial institution to reorganize the firm
with outside technical assistance.3
* Top-Down Industry-wide Restructuring: This usually involves direct government intervention and
top-down restructuring at the industry level sub-sector by sub-sector. Firms may be deliberately broken up
to reduce size or market monopoly or increase market viability, or combined to allow increased economies
of scale in technologies, marketing and R&D or to reduce the number of unviable firms. Top-down
restructuring has not been a major aspect of reform in the sample countries, although some efforts have
been made. It is not clear that the countries concerned have the expertise-or the political authority-to
attempt top-down restructuring on any but a very selective basis.
The next phase of reforms involves formal exit from the PE sector, through privatization or formal
liquidation. It should be noted, however, that the processes of restructuring outlined above imply a good deal of
informal exit from the sector-and imply that at least part of the growth in the "new" private sector represents
the transfer or the use of state assets. Formal exit does not, of course, imply the end of a need for real and
financial restructuring. But these tasks are no longer part of PE reform-at least, in theory.
"o These include Hungary and Poland in the late 1980s, also Russia, where the current privatization strategy may be
seen as an extension and legitimization of the previous trend: for an analysis of the beginnings of privatization in
Russia, see Shatalov (1991).
When this happens it could be considered a form of liquidation of the old enterprise without going through a formal
liquidation procedure.
12 Such a process is underway in Poland.
' Other forms of financial restructuring include exchanging interenterprise debt for bank debt in the course of global
compensation arrangements. Romania and Russia offer examples.
8 Research Paper Series: Policy Brief
The Selected Countries
China is a huge Asian, largely agrarian, economy that has been undertaking systemic, as well as PE reforms, in
an experimental manner over a period of 15 years. These have involved the progressive introduction of markets,
the gradual opening to trade and foreign investment, and widespread liberalization of economic entry. As shown
below, much of the credit for its impressive performance has been due to this, and growth has, in turn,
facilitated the process of growing out of the PE problem-which was far smaller in China than in Europe in the
first place. But, to date, China has eschewed the most important reform-privatization-and private property is
still not formally accepted.4 It has also been relatively stable in macroeconomic terms and its reforms have
proceeded in an environment of exceptional growth. The Communist party retains power in spite of
decentralization.
Poland, in sharp contrast to China, transited to democracy and undertook a very radical transformation
program at the start of 1990 from a difficult macroeconomic situation. Successful stabilization and extensive
liberalization (including a dramatic opening to trade) has transformed the environment in which PEs operate,
creating strong incentives for spontaneous measures to restructure PEs and encouraging the rapid development
of the private sector in services, trade and small scale manufacturing. Poland has however also failed to follow
through. There has been little top-down PE restructuring, and PE exit via bankruptcy has been minimal. So has
.large-scale privatization, except for some which has taken place spontaneously (notably asset privatization) and
sales of smaller firms.
Unlike China, the problem with privatization in Poland has not been ideological objections to private
property, but political fragmentation and powerful opposition from workers with acquired "ownership
prerogatives." A major issue in the recent elections, which brought the former Communists coalition back to
power, has been the pace of reforms and their allegedly negative impact on living standards to date. Large-scale
privatization has been hostage to political conflict and instability.
The Czech Republic replicated the radical Polish stabilization and liberalization program in 1991, from a
far more favorable macroeconomic basis, and without so far experiencing severe macroeconomic instability.
Further, in contrast to Poland it has also followed through with the fastest and most extensive mass
privatization, the first phase of which has just been implemented. By moving so rapidly, the Czech Republic has
in largely by-passed an extended phase of restructuring of PEs, either through market processes or through top-
down measures. The real work is to be done by the new owners-at least in the industrial manufacturing sector.
" Private property includes a broad bundle of ownership rights, including the right to use, transform and dispose of
assets. In China, the right to buy and sell assets is still withheld, though use and transformation are substantially being
granted. It is in this sense that we argue that China has not formally accepted private ownership.
Enterprise Reform and Restructuring in Transition Economies 9
4. THE PUBLIC ENTERPRISE "PROBLEM"
The common economic factor that impelled PE reforms in the three countries was not simply a "PE problem" but the
increasingly apparent failure of their economic systems to deliver increased living standards in line with those of
"capitalist" neighbors despite high investment rates. After a rapid postwar spurt, growth in Eastern Europe slowed
markedly in the 1970s and 1980s, to only 1.0% and 2.0% for Poland and the CSFR respectively in 1980-88 despite
massive foreign borrowings and investments in the case of Poland. Decreasing relative quality of goods and services
was also increasingly apparent, and evidenced by changes in patterns of trade with Western countries. China's
(erratic) growth averaged 5% from 1955 to 1978, and was driven by massive investment programs. In this period, the
estimated growth in industrial total factor productivity was almost zero. Driven by agricultural reforms, overall
growth spurted after 1974, but the large-scale industrial SOEs, which accounted for the overwhelming bulk of
investment but only 18% of employment, remained largely unreformed until 1984.
In Poland, poor economic performance also reflected severe external and internal macroeconomic
disequilibrium." In 1989 inflation reached 640% despite shortages and continued attempts to control prices, and
external debt represented 73% of GDP. This largely reflected the chronic state of excess demand generated by the PE
sector, and increasingly difficult to contain in the process of shifting from a tightly planned to a reform socialist
economy.'6 The prevalence of "sellers' markets" undermined incentives for improving the productivity of input use,
and this was accentuated by highly distorted pricing.'7 The shift towards democratic government in Eastern Europe
potentially intensified this problem, as the new governments neither had the mandate, nor wanted, to reimpose tight
state direction of the economy, and frequently followed disastrous macroeconomic policies.
Tables 4.1 to 4.6 show some comparative country data and provide an indication of the number of SOEs and
the weight of the state enterprise sector in the three economies. The tables also provide an indication of the changing
shares of GDP and employment produced by the state and the private sectors (and the non-state sectors in China).
The greater weight of industry in the GDP of Eastern European countries stands out; so does the marked difference
ion income levels relative to China, although the latter is not nearly so poor on the basis of PPP estimates as
suggested by exchange-rate-based GDP conversions. In the face of deep economic contraction (as measured by
official statistics) the rapid growth of private sector activity in Poland and CSFR is also striking, with the latter, in
particular, starting from a very small base.
" There is little point in trying to separate out the PE accounts from those of the rest of the economy. With discretionary
taxes, government and PE revenues were indistinguishable, and PEs performed many of the functions assigned to
governments in market economies.
" The problem of "chronic shortage" and whether it is possible to maintain macroeconomic equilibrium in a reform
socialist economy has been discussed by many analysts. For an overview, see Kornai (1992).
'7 According to various estimates, PE employment was commonly about 40% above its comparator levels in market
economies. The energy intensity of output was also far higher.
TABLE 4.1:
Country Indicators, 1991
China CSFR Poland
Population (millions) 1155.8 15.6 38.2
GDP/Capita $US (GNP for China) $315 $2,254 $1,967
GDP/Capita PPP (1985) $2,472 na $4,189
Industrial Production/GDP (GNP for China) 42% 62.2% 50.4%
Industrial Employment 17% 36.7% 27.9%
Exports $48,248 $9,323 $10,063
Sources: International Financial Statistics, Dec. 1993; Summers & Heston, Quarterly Journal of
Economics, May 1991; Trends in Developing Economies Extracts, Vol. 1, Chinese National
Statistical Yearbook, 1992.
TABLE 4.2:
Structure of Economy, 1991
% of GDP % of Employment
China Poland CSFR China - Poland CSFR
Industry 42.0% 50.0% 50.0% 17.0% 36.0% 46.0%
Agriculture 27.0% 7.0% 8.0% 60.0% 26.7% 9.0%
Services 31.0% 43.0% 36.0% 23.0% 27.0% 45.0%
Sources: World Development Report, 1993; China Updating Economic Memorandum, 1993; National
Statistical Yearbook, 1992.
Table 4.3:
The State Enterprise Sector, 1991
Industrial SOEs China Poland CSFR
Number of SOEs 104,700 8,228 5,423
Number of Employees (millions) 106.7 3.26 2.67
Share of Industrial Output 53% na 93% *
Share of Industrial Employment 74% 62% 92% *
Share of Total Employment 18% 27% 34%
Note: *Figures for 1990
Source: China National Statistical Yearbook and CEM, 1993; Leila Webster, Survey
of Enterprises: CSFR & Poland, 1993; Biuletyn Statystyczny, July 1992; CS
National Statistical Yearbook, 1992.
TABLE 4.4:
GDP and Shares by the Private Sector
Poland Czechoslovakia
Annual Growth of GDP 1989 - 1992 -4.6 -5.8
Private Share in GDP 1989 (1991 or 1992) - 28.6 (47.5J- 4.1 (20.0)
Private Share in Total Employment 1989 or 1990 44.3 (57.0) 1.2 (16.4)
(1991 or 1992)
Annual Growth of Private Share in- GDP 1989-92 13.5 48.6
Annual Growth of Private Share in Total 4.9 139.1
Employment 1989-92
Annual Growth of Relative Private Labor 10.0 -37.6
Productivity 1989-92
Annual Growth of Private GDP 1989-92 8.3 40.0
Annual Growth of non-private GDP 1989-92 -9.8 -7.8
Share of Private Sector in Total Employment 44.3 (57.0) 16.7 28.4
(1991 or 1992)
Source: EBRD Annual Economic Review, September 1993.
TABLE 4.5:
China: Non-State Sector Shares of GDP (Estimates)
1985 1990 1991
1. Narrowest 1% 5% 6%
2. Narrow 8% 15% 17%
3. Broad 15% 21% 23%
Notes:
1. Narrowest = Industry (Individually-owned + other.)
2. Narrow = Narrowest + TVEs
3. Broad = Narrow + Urban Collectives
Source: China Statistical Yearbook, 1992 p. 365.
TABLE 4.6:
China: Share of Employment by Sector and Ownership
Total Labor Force (000) 436980 1637773 2160383
of which:
Agriculture 63% 60% 60%
Industry 17% 17% 17%
Employment by Ownership:
a. State Collective-Joint Ownership 70% 27% 21%
b. State-Private Joint Ownership 13% 24% 16%
c. Collective-Private Joint Ownership 2% 7% 8%
d. Joint Ventures w/Foreigners 11% 35% 36%
e. Other 3% 6% 15%
Non-State Share of Employment
1. Narrowest (d+e) 15% 42% 51%
2. Broad (c+d+e) 17% 49% 58%
3. Broadest (b+c+d+e) 30% 73% 74%
Source: China Statistical Yearbook, 1992, p. 91.
Enterprise Reform and Restructuring in Transition Economies 13
5. ENTERPRISE REFORMS IN4 CHINA: THE GRADUALIST APPROACH'S
5.1 Crisis and the Dynamics of Reforms
The main impetus for Chinese reforms came from a deepening sense of crisis and the ensuing stresses on the
economic brought about by the failures of the Maoist experiments with communal agriculture and centralized
planning in industry. These stresses started early with the anti-landlord campaigns and the forced
communalization of agriculture and rural industry. Some initial success was achieved at the extensive margin by
bringing new lands into cultivation, but at a great cost. Agricultural yields in China, already among the highest
in the world, were further raised through intensive agriculture using communal labor. By the early sixties further
gains within the communalized system had been exhausted.
The stresses in the industrial system started with the failed attempts at forced industrialization during the
Great Leap Forward in the fifties, followed by successive phases of heavy industrial development through very
high rates of industrial investments throughout the sixties. This was accompanied by increasing attempts at
industrial autarky and central planning, though the Chinese industrial system, which allowed for enormous
regional autonomy and differences, was neither as centralized or as planned as the Soviet counterpart. Over time
the higher and higher rates of investments in capital and human effort brought diminishing returns and per
capita incomes stagnated.
The pending and prolonged sense of crisis and stagnation in both agriculture and industry culminated in
the Cultural Revolution in the late sixties. This soon exploded into political chaos during which the party
apparatus and the central party bureaucracy were made the main target of attack by Maoist radicals. This
prolonged crisis, not only discredited the Maoist ideological approach to development, but also encouraged the
more pragmatic forces in the party, as represented by Deng Xiaopeng, to make a case for pragmatic reforms and
non-ideological solutions to the prolonged crisis of stagnation. Although an estimated 25-30 million people lost
their lives through famine during this great upheaval, it was not until the passing away of Mao, and the political
defeat of his heirs as represented by the Gang of Four in the middle seventies, that the pragmatists were able to
come into their own and initiate reforms to bring an end to China's political crisis and economic stagnation.
The reforms were initiated first in the provinces with agricultural reforms started in Sichuan in 1975.
These did away with the communal system and replaced it with individual fanning based on the household
responsibility system and liberalized farm prices. As these reforms generated considerable increases in
productivity and farm incomes, they spread to other provinces and were formally adopted by the central
government only after they were a proven success.Large share of the rural labor force that had been surplus and
underemployed in the rural communes - over 100 million people by one estimate -was also released for more
productive employment in rural industries. As rural incomes and demand grew they in turn generated local
' This section on China draws heavily from Singh, I.J. and Gary Jefferson, "Ownership and Industrial Performance in
China," Transition, (forthcoming); and Gary Jefferson and I.J. Singh, "China's State Owned Industrial Enterprises:
How Effective Were the Reforms of the 1980s?: A Review of the Evidence," CH-RPS #25, Transition Economics
Division, World Bank, July 1993.
14 Research Paper Series: Policy Brief
demand for consumer goods and industrial inputs. Growth in rural incomes and productivity also generated
large rural savings that were available for investment in local rural industries, that already existed as low
productivity, low skill and, low technology counterparts of the communal system. The choice was to allow large
scale urban migration of this labor force and to intermediate rural savings into investments in urban industry to
employ it or to allow the provincial governments the autonomy to put this released rural labor to work locally.
The plowing back of large rural savings into local industries to meet growing local demand provided the impetus
for the development of local township and village industries as well as their technological upgrading . Rural
industry grew rapidly and the breakthrough came in 1980-84 when coastal provinces took advantage of the open
door policy and rapidly growing opportunities for trade, to develop labor intensive industries for exports.
None of these developments were centrally directed through policy. Actually many in the central
government urged the suppression of rural industries arguing that they were inefficient, excessively polluting,
undertaking redundant investments and in any case competing for resources and markets better left for the state
sector. Credits for investments were actually denied to rural industry that had to depend on the generation of
their own surplus for investments."
The success with agricultural reforms and rural industry generated pressures in turn to undertake
industrial and urban reforms. State owned enterprises nominally under central bureau supervision were given
greater autonomy as provincial governments gained more power. As domestic markets grew there were
provincially led attempts to raise barriers to trade which soon dissipated due to growing competition and
increased desire for larger integrate domestic markets. Increasing demands for autonomy and inter-provincial
competition also led for demands for fiscal autonomy-that is a larger share of enterprise revenues which ware
the main source of government budgets. Compromises led to a system of tax farming and eventually to the
development of a system of management contracts.
Thus Chinese reforms were the outconde of a prolonged crisis; they were initiated experimentally from
below at the provincial levels and thereafter fed on success. The approach to reforms that the Chinese took was
also unique.
China's approach to reforms has been to work at the margin, trying a variety of reforms and ideas,
experimenting to see what works in practice, learning by doing, evaluating the results before trying the next
steps; reinforcing the changes that work, discarding those that fail; then slowly replacing older institutions and
ways of doing things by newer ones. Major reform initiatives, including the quasi-privatization of agriculture
and the development of "nonstate" industry, were not centrally planned, but were accepted as official policy
following regional experimentation and adoption. In this sense, it is misleading to refer to the Chinese pattern of
reform as a "strategy." The Chinese leadership continues to place great emphasis on avoiding "chaos" and large
scale unemployment, attempting wherever possible to minimize the social and economic costs of change and
displacement.
" For further discussion on the development of rural industries and the dynamics of reforms see Byrd and Qinsong
(1990), Singh (1992) and Rawski (1993).
Enterprise Reform and Restructuring in Transition Economies 15
China's economy is one of the fastest growing in the world: between 1978 (the year reforms were
introduced) and 1990, real GNP (gross national product measured at constant prices) grew at 8.8 percent per
year and industrial output by 10 percent. Between 1984-1990 industrial production increased at 13.5% and in
1991-1992, at a 16.5 percent rate.20 The main question addressed below is therefore the contribution of PE
reform to this performance. The analysis focusses on the performance of the industrial State Owned Enterprise
(SOE) sector (rather than, for example, agriculture) as the closest parallel to the PE sector considered in other
papers. The SOE sector accounted for 80% of industrial output at the start of the reforms. It has absorbed
about 70% of China's (large and rapidly growing) financial savings over the reform period. In this sense it has
been a major factor in the performance of the economy. However, at the start of the reforms the SOEs employed
only some 18% of China's total workforce, as compared to over 70% for much of EE and the FSU countries. In
addition, China's economy was never so centrally planned as those of EE and the FSU. These differences are
important factors in assessing the response to China's gradualist strategy relative to the radical approach
adopted in the "European" model.
5.2 Reforming the Market Environment
(i) Macroeconomic and price stability: Compared to most transition economies, China has maintained a high
degree of growth and price stability over the transitional period; between 1980 and 1992 prices have risen at
less than 8 percent annually.21 This has been aided by three factors: little initial macroeconomic imbalance, an
absence of serious external shocks, and a high savings rate that has been reflected in impressive financial
deepening. Although China's macroeconomic management has had a "cyclical" character-that is episodes of
high growth and investments followed by rapid deceleration of credit creation and direct administrative controls
to reduce aggregate demand and bring inflation under control-macroeconomic instability has followed partial
reform and to some extent is symptomatic of it, as further discussed below.
(ii) Gradual Price Reform: A two-tiered price system has been used as a transitional device towards a market
economy. Starting with a system dominated by controlled prices, the state has gradually allowed a larger share
of goods to be traded at market prices thus allowing production and consumption decisions at the margin to be
based on market prices. State prices have been allowed to slowly converge to market prices. (Table 5.1) As a
consequence of the dual pricing and gradual price reforms, price distortions persisted, rents and arbitrage in the
system were tolerated. However producers gained time to adjust, and the shock to producers and consumers,
inherent in a rapid price reform, was cushioned. Currently only six percent of state industrial production is
transacted at controlled prices; market prices now play the central role in allocating resources in the economy.
20 These growth rates of real GNP and industrial production estimated from published data are likely to be overstated,
(see Rawski 1993).
21 Inflation has however also been historically low in CSFR.
16 Research Paper Series: Policy Brief
TABLE 5.1:
China: Ratio of Market Prices to State Prices
1986 1987 1988 1989 1990 1991
Steel 148 145 146 136 122 111
Cement 122 120 127 135 119 111
Coal 145 142 192 268 205 170
Aluminum 143 143 180 168 120 108
Consumer Goods 117 116 117 111 108 105
Source: China: Internal Market Development and Regulation, Report No. 12291-CHA, November
1993, pp. 187-188
(ii) The "Open Door Policy": After 1979, China progressively liberalized its trade regime. Trading activity
was decentralized from a dozen or so Foreign Trade Corporations to over 3,500 companies (still within the
public sector). Direct foreign investments and labor intensive exports have been aggressively promoted. Here,
Hong Kong has played a critical role: in 1992 it provided 70 percent of foreign direct investment (nearly $10
billion), and purchased or transhipped 50 percent of China's exports (over $85 billion. Exporters were allowed
to keep a larger share of their foreign exchange earnings. A two-tier foreign exchange market was permitted to
develop, and aggressive devaluations of the official exchange rate shrank the parallel premium, to a low of 10%
by 1991 22 While access to inputs for exports has been liberalized, imports remain controlled and tariff rates-
though lowered-remain high for many products, providing a degree of protection to key state-owned domestic
industries. Merchandise exports have grown at 12.5 percent and imports at 9.5 percent annually in real terms
between 1980-1992, and China's total two-way trade has grown from $38 billion to $135 billion.
5.3 Permitting New Entry: The Growth of the Nonstate Sector
As indicated, there was a large and vibrant collective industrial sector in existence in the rural areas of China
before the reforms began. The spectacular growth of the township and village enterprise sector has been perhaps
the greatest achievement of China's reforms. At first resisted by central government, later tolerated, and
formally accepted as part of economic strategy only in 1975, this development was a spontaneous, local
response to the increasingly open nature of the rural labor surplus which became apparent after the breakup of
the agricultural commune system.' Township and village enterprises (TVEs) now employ over 90 million
workers, 60% in manufacturing and the rest in tertiary sectors including transport, distribution and
construction. They account for a quarter of China's total industrial output and exports; their growth rate has
exceeded 20% per annum in the past decade, easily surpassing that of the state sector.
22 Chinas official real exchange rate depreciated by 70% between 1978 and 1991. This had the remarkable effect of
LOWERING its reported (Atlas method) dollar GDP per head, from about $400 to $350, during a period where reported
growth of GDP per head was almost 8%.
* The TVE sector did, of course, build on a rural industrial base of local industry.
Enterprise Reform and Restructuring in Transition Economies 17
Largely because of this rapid growth, the share of the SOEs in total industrial output fell from 80 percent
in 1978 (it was 90% in 1966) to barely half by 1991. By that point, there were 104,700 SOEs and nearly 1.6
million nonstate enterprises not counting family businesses. The TVE's share of exports had increased from 4.8
percent in 1985 to 24 percent by 1990. State-owned enterprises that once dominated the commanding heights of
the centrally planned economy have been slowly turned into islands in a sea of thriving and dynamic non-state
enterprises.
BOX 5.1
Chinese Ownership Maze: Non-State But Not Private.
In China, non-state industrial enterprises are grouped into "urban collectives," "township and village
enterprises," "individual," and "other types" of ownership categories:
(i) Urban Collectives are enterprises affiliated with municipalities or counties ("large" collectives), or
with a district ("small" collectives) and include urban cooperatives. In 1991 about 190,00 such
enterpnses-including those jointly owned by cities and townships-accounted for about 14 percent
of total industrial output. These collectives are essentially extensions of state owned enterprises with
inferior access to capital and human resources. Many urban collectives are subsidiaries of state owned
enterprises from which they received their start-up capital and hire their surplus employees or spouses
and children. Most urban collectives suffer from bureaucratic inertia, interference, inefficiencies and
lack of clear autonomy; the same problems as the state owned enterprises.
(ii)Township and Village Enterprises (TVEs) are rural collectives affiliated with township or village
governments and include rural cooperatives. In 1991, out of nearly 1.6 million collectively owned
enterprises, over 1.39 million were township and village enterprises (TVEs) and they together
accounted for 24 percent of total industrial output. Thus among all the non-state forms of ownership,
the largest share of industrial output is accounted for by the TVEs: - -
(iii) Individual Businesses, owned by families or individuals, with a limit of seven employees,
have been allowed to operate since 1978, and account for about 5 percent of industrial output. In
1991, 92 percent of the nearly 6.3 million individual businesses in China were in rural areas. (The
number of individual businesses is closer to 17 million if one includes household and private ventures
in agriculture and in the tertiary sectors.)
(iv) The Other Types category includes private enterprises hiring more than seven employees,
foreign enterprises, and joint ventures with foreigners and other types of joint ventures (say between
state and non-state and foreign partners), and joint stock companies. Some 10,800 enterprises in this
category account for less than 5 percent of the industrial output.
China's non-state enterprises are collectively and hence publicly owned and cannot be considered
private by normal definitions of ownership. In China there is still a lack of legal protection for
property rights, and no clear commitment to private ownership.
Source: From Singh, I. and Gary Jefferson, "State Enterprises in China: Down from the Commanding
Heights," Transition, Vol. 4, No. 8, October 1993.
18 Research Paper Series: Policy Brief
5.4 Reforming and Restructuring SOEs.
Like the "environmental" reforms above, enterprise reforms were experimental and phased. Defined as "owned
by the whole people," SOEs are assigned to central, provincial, prefecture or county governments. At the start
of reform, they were supervised by vertically organized industrial ministries or bureaus at the central or
provincial levels.
Between 1978-1982, they were granted rights of self management (along the lines of the Yugoslavia
model), and the state started to share profits with them rather than simply retaining residual profits. From 1983
to 1987, the state moved from profit sharing to taxation through a series of fiscal reforms designed to assure
enterprise contributions to declining state revenues and to put all state enterprises on an equal footing. All large
and medium state owned enterprises-which constitute the bulk of the state sector-were required to pay a 55
percent share of their profits as tax. Since after-tax profits were determined through a bargaining process
between supervisory authorities and enterprises, there were large disparities in after-tax profit remittances by
enterprises. The state then levied additional adjustment taxes, to level the playing field. But since the state
remained the owner of assets and continued to interfere with key managerial decisions-mainly through its
control over planned investment credits-the differentiation between profit-sharing and taxation became
meaningless.
Expanded autonomy over investment, wages and bonuses contributed to classic market-socialist
"investment hunger," with the soft budgets inherent in the arrangement and pressure to raise wages and bonuses.
This led to endless bargaining between central and local governments and the enterprises, on profit sharing, state
investments, bank credits, prices for inputs and outputs, state deliveries of essential inputs at controlled prices
and so on. Indeed, I net central government revenues from the enterprise sector fell relentlessly, from 20% of
GDP in 1978 to only 2% by 1989 while net contribution of state enterprises to the budget declined from around
54.7 percent in 1978 to 12.4 percent in 1992.24
Decentralization did however grant managers considerable autonomy, and this has been strengthened by a
number of specific measures, since 1987, to separate ownership and management:
(i) The Contract Management Responsibility System (CMRS) specified profit targets and profit remittance
quotas, a lihk between the total wage bill and the profit remitted to the state and technological improvements in
negotiated contracts with managers, in order to provide incentives for better performance. Widely adopted from
1987, with a typical contract lasting from three to five years, the contract system improved incentives for
managers by shifting their focus away from quantitative to financial targets based on profits. It was a useful
transition measure." Most contracts specified a fixed profit quota and allowed a one hundred percent retention
rate for the enterprise. At least for well-performing firms, this acted like a lump sum tax system. However, it
was specified in nominal terms, and with inflation this contributed to the enormous decline in central revenues.
To overcome this problem, shorter one year contracts were refined (actually made more complex) and
24 Between 1978-89, profit remittances fell from 56% to 2% of budgetary revenues, while income tax revenues increased
from 4% to 21% over the same period. (See Anjali Kumar, "State Enterprises in China: Progress with Reform," China
Department, February 24, 1994.
25 See Anthony Koo, "The Contract Responsibility System: Transition from a Planned to a Market Economy,"
Economic Development and Cultural Change, Vol. 38, No.4, pp. 797-820, July 1990.
Enterprise Reform and Restructuring in Transition Economies 19
renegotiated in 1991. It was also too complicated, confused the tax and profit remittance components, and still
allowed managers to endlessly bargain over changing price and tax policies. Further, although providing some
incentives for good performance, as applied it failed to penalize poor performance.
In 1992 a second round of new management contracts between governments and enterprises was
negotiated under the "New Operating Mechanism for State Enterprises." In the absence of complete enterprise
autonomy, or more radical ownership reforms, such a complex instrument subject to constant renegotiations has
only partially been effective.26
Generally management contracts are deemed to be efficient; but they are so only as second best substitutes
to the principal agent problem. In the Chinese context they can be said to work only as second best solutions to
the principle agent problem in the absence of proper factor markets-there are no existing markets for factories,
building and land for example in China-and of lack of adequate market information. They allow monitoring on
the basis of shared information between the government and SOEs and allow a clearer statement of performance
related objectives by which SOE behavior can be evaluated. They however do not allow any radical adjustment
of assets to occur. Given the need for large scale asset restructuring required by SOEs, management contracts
cannot be relied on to perform this role effectively. This is one reason why property rights have to be more
clearly defined if SOE restructuring is to succeed in China.
(ii) Corporatization and Partial Privatization: Pending further refinements of the CMRS, the government
encouraged the development of joint-stock or share-holding companies and permitted the leasing of enterprises.
By the end of 1991, some 3220 enterprises had become share holding companies. (Shenyang province being a
leader in this regard). Most of these (80%) were in the collective (non-state) sector. These take the form of
limited liability companies in which the ownership of shares is mostly limited to the staff and employees and
sometimes local residents. The transfer of shares is also limited. Only 2% of these enterprise have issued shares
to the public. By June 1992, 363 enterprises had been transformed into corporations or limited liability
companies, and of these 34 had issued shares in the nascent stock markets in Shanghai and Shenzhen. There is
no data on leased enterprises, but field work suggests that around 10% of the SOEs are being leased to
individuals, collectives and local governments. Leased enterprises are taken out of the CMRS.
(iii) Mergers and Enterprise Groupings. Very few market-driven mergers to enhance efficiency or increase
market power have taken place. Mergers have been top-down measures, most often initiated by provincial
governments, mainly to rehabilitate loss making SOEs. By 1990, 17 regional authorities had specific provisions
for merging enterprises, each with their own preferential policies. Most involved mergers within the same
province, sector and jurisdiction (i.e., municipality or bureau authority). Very few involved merging enterprises
across different areas within a given province (131 in 1988 and only 81 in 1989); somewhat more involved
mergers or takeovers across different industries within the same province (697 in 1989 and 27% of all mergers).
Overall, the number of mergers is very small compared to the total number of SOEs."
26 See Inderjit Singh, China: Industrial Policies for an Economy in Transition, World Bank Discussion Paper, No. 143,
1992.
27 See CHINA: Internal Market Development and Regulation, (Report No. 12291-CHA), World Bank, November 24,
1993, pp. 120-123, and Gao Shangquan and Ye Sun (eds.), China Economic Systems Reform Yearbooks, 1990-91,
China Reform Publishing House, Beijing.
20 Research Paper Series: Policy Brief
Informal enterprise groupings allowing large enterprise to set up "horizontal links" with other firms tend
to be a natural outcome of the breakdown of central planning." Since 1986 they have taken on a more formal
character in China. Most groupings are initiated by administrative line bureaus which have, in the process,
sought to reassert control of companies they previously supervised. By 1993 there were 55 such large industry
wide enterprise groupings.2 These large groups have been allowed to establish their own financial companies
and been granted other preferential treatment, including export/import rights, foreign travel and independent
planning status not granted to other SOEs.
Since 1990, there has also been a dramatic increase in the number of "national level" enterprise groups
involving smaller firms, with over 1000 such groups in 1991 and over 6,000 groups by the end of 1992. The
cited benefits of these groupings include improvements in supplier and subcontracting links, efficiency
improvements, better capacity and resource utilization and the sharing of trademarks and improved technologies
as well as to enhance cross-sectoral or regional links in provincial and national markets. The most rapid
development of such groupings has been in the coastal provinces like Guangdong, Jiangsu and Shandong and
cities like Shanghai, and 65% of them have been in electronics, light industries and textiles.
5.5 Exit Policy
(i) Bankruptcy and Loss Making SOEs. Although exit is common in the nonstate sector, the bankruptcy or
liquidation of SOEs is not yet a widely accepted option. Government intends to submit them to market forces
and use profitability as an indicator for closure and restructuring. It has directed the State Council Economic
and Trade Office to close 2,000 SOEs and half of these suspended operations in the first half of 1992. But
outright bankruptcies have yet to occur. Loss making enterprises have been kept afloat either through
government subsidies or bank loans, or have been merged with better performing, enterprises at the local level.
Although SOE productivity has improved (see below), their average profitability has declined from 19.6% in
1989 to 12.7% in 1991.
While profitability in the collective and TVE sectors has also declined, it has fallen sharply for SOEs.
Total financial losses of SOEs within the central budget have doubled since 1986, but have remained fairly
constant at around 4-5% of GDP. The bulk of the losses-over two-thirds-are losses from non-industrial
SOEs-mostly grain distribution, foreign trade and commercial enterprises. Still in 1991 nearly 36% of all
SOEs were making losses. If price and accounting distortions are factored in, one estimate puts the proportion
of loss-makers at 60% of all SOEs.' The fastest growing component of the losses have been industrial
enterprises, with particularly heavy losses in the oil and coal sectors due to low state-controlled prices. Most of
these losses have been financed through the state budget and have exceeded the deficit in most years; were it not
for SOE losses (industrial and non-industrial), the state budget would have been in surplus.
28 Such groupings seem to be particularly prominent in the FSU.
29 These are akin to an administrative top-down merger of firms in similar product lines. Of these; 16 were in machine
building/electronics; 7 in energy; 6 in defence; 4 each in steel, building materials, chemicals and pharmaceuticals; 3 in
banking; and 2 each in forestry, transport and foreign trade. See China: Internal Market ....op. cit., p. 123.
' Since the performance of the managers and the total wage bill of its employees is tied to profits in the CMRS, there is
a universal incentives to inflate profits and under account for costs. The state too benefits from this profit inflation,
because profit remittances from SOEs constitute the bulk of state revenues. With reported losses of 37 billion Yuan, the
estimate is that these accounting losses add up to another 50 billion Yuan in 1991.
Enterprise Reform and Restructuring in Transition Economies 21
More recently the burden has been shifted to the banking system with budget financed losses droppmg
from 78% in 1986 to 60% of the total in 1991. This has contributed to a rising stock of bad debts. It is
estimated that these have reached somewhere in the range of 10-20% of outstanding bank loans."
Figure 5.1: China: Losses of State Owned Enterprises
1500
1000
500-
0-
1986 1987 1988 1989 1990 1991
| MAIl SOEs D Industrial SOEs
(ii) Privatization. In contrast to the rapid development of the non-state sector, most of which is collectively
owned and cannot be called private, (see above), there has been no outright privatization of SOEs to date. Nor
are there any indications that this ideological hurdle is likely to be crossed soon.32
Hwa, Erh-Cheng, "Enterprise Reform in China: A Background Note," Draft paper, World Bank Mission in Beijing,
September 1992.
32 There are some newspaper accounts of SOEs being bought out through foreign joint ventures, but there is no official
confirmation of this. Although any large scale privatization of SOEs remains an unacceptable alternative to the
Communist Party in China, there has been some partial privatization, and certain category of shares (B and H shares)
can be held by the public. There are reportedly over 130 quoted companies with public shares. But this is minuscule and
only recently allowed alternative.
22 Research Paper Series: Policy Brief
6. THE IMPACT OF CHINA'S REFORMS ON PERFORMANCE 3
Recent research using firm-level data provides considerable evidence on the response of the SOE sector to
reforms and the comparative performance of the SOEs and the NSEs.
State versus Nonstate Sectors. Between 1980-1990, Chinese total industrial output grew in real terms at
12.6% per annum. During the same period, SOE sector grew at 7.7%, the urban collectives grew at 10.7% and
TVEs grew at 18.7%. The growth was even higher for very small household/individual enterprises-from a low
base they have grown at over 100% per annum. "Other" enterprises (other private, individual joint ventures and
joint stock companies) saw output grow at 43% per annum.' The acceleration of SOE reforms has had a
positive impact on SOE growth performance, but the differences in growth between SOE and urban collectives
on one hand and TVEs on the other has increased. The smaller nonstate sector has accounted for most of
industrial growth, in particular the TVEs.
Figure 6.1: Growth Rates by Ownership Types
70
60-
50
40
30 FISOEs
20 J MCollectives
101 NTVEs
10
0
1979-84 1984-90 1991-92 1992-93
Source: China Statistical Yearbooks, World Bank, Economic Unit, September 1993.
(Note: Data for 1992-93 are provisional and in nominal terms)
* This section draws heavily from Singh, I.J. and Gary Jefferson, "Ownership and Industrial Performance in China,"
Transition, (Forthcoming).
* T Rawski, "An Overview of Chinese Industry in the 1980s," CH-RPS #18, Transition Economics Division, World
Bank, February 1993, Table 2.
Enterprise Reform and Restructuring in Transition Economies 23
BOX 6.1
What is Different about TVEs?
Township and Village Enterprises (TVEs) are the most significant and rapidly growing component of the non-state
sector in China (see box). Compared to traditional state owned enterprises, the operations of the TVEs have been
characterized by:
" Better Governance. TVEs are better able to overcome many of the principal (owner)-agent (manager) problems
because they are locally owned, supervised and managed, instead of being supervised by far off central bureaus and
ministries. Since local budgets are highly dependent on enterprise revenues, local governments have a direct stake
in the performance of enterprises under their control.
" Greater Autonomy: Because TVEs are closer to the market, they are more market responsive. By changing resource
and product mix, adapting to new technologies and market opportunities, and increasing investments (from own
earnings) or deposing of fixed assets, they have demonstrated an impressive awareness of market realities.
Compared to SOEs, TVEs are more free to hire and fire labor, link wages to performance, rent and buy land locally,
construct, and transact business with buyers and sellers, of their own choice;
a Clear-Cut Incentives: The major incentive for the local governments that own TVEs is to maximize post-tax returns
to their capital investments, while taking care of their "own" labor force (as distinct from migrant casual labor).
The state owned enterprises have no such clear and simple optimizing goals;
m Hard Budget Constraint: TVEs rely mostly on capital generated from their own earnings, or local and household
resources. (Only eight percent of all banking loans go to TVEs, while state owned enterprises capture at least 80
percent). TVEs do not receive subsidized bank credits, or centrally allocated materials, similarly to state owned
enterprises. They buy and sell inputs and outputs at market prices, and generally operate under hard budget
- constraints. But most critically local government budgets are tied to enterprise surpluses. As much as 90-95% of the
local revenues come from the enterprises. As local budgets as well as the incomes, perks and de-facto pay of local
officials come from these revenues, there is in effect a hard budget constraint at the local level.
" Less Regulations and Social Obligations: Unlike state owned enterprises, TVEs are not obligated to provide a
plethora of social services including housing, health care, education and life time employment and pensions to their
employees and their dependents. They are thus free from the "iron rice bowl" that reduces factor mobility and
compromises work incentives; and
a Greater Competition: Their number and smaller average size, coupled with the growth of domestic demand and
reduction of barriers to internal trade, ensures growing and ever fiercer domestic competition. Each year thousands
of new TVEs enter the market, while thousands of old and failing ones exit from it. The greater concentration of
TVEs in coastal provinces (though by no means confined to them) and the strong links to investors from Hong
Kong and Taiwan-assiduously cultivated by Chinese local and provincial officials, even in inland provinces-have
enhanced competitive factors by bringing in new technologies, management methods, markets for exports and a
"kindred model" to emulate. Being very competitive, TVEs have actually increased the pressures on state owned
enterprises for better performance.
In short TVEs operate in a highly competitive environment in which managers, local workers and local officials
appear to behave as shareholders with consistent objectives
Source: From Singh, I.J. and Gary Jefferson, "State Enterprises in China: Down from the Commanding Heights,"
Transition, Vol. 4, No. 8, October 1993.
24 Research Paper Series: Policy Brief
Regional factors: The Open Door. Location also seems to have been an important factor in explaining
growth. Between 1978 and 1990 the average growth rate of the coastal provinces was about 3.7% per annum
higher (it was 5.4% higher in Guangdong and Fujian) than output in the inland provinces between 1982-90. But
coastal provinces also tend to have a higher concentration of TVEs and among them Guangdong and Fujian
with their proximity to Hong Kong and Taiwan have been the major sources of foreign investment and outlets
for TVE export growth. Coastal provinces with close proximity to Hong Kong and Taiwan have achieved
higher growth than the inland provinces, attesting the efficacy of the "kindred" model these island economies
have exerted on the mainland."
Productivity. Output growth has been accompanied by growth in total factor productivity. There is clear
evidence that productivity in the non-state sector has grown faster than in the SOEs." Studies of productivity
growth within China's industrial sector during the first decade of reforms (1980-1990). indicate that
productivity in the SOEs grew in the range of 2-5% per annum; comparative estimates suggest that
productivity in the non-state sector grew at between 1.5 and 2 times the rate in the SOEs." Even when
allowances are made for size, type of industry and institutional factors, TVEs have had a significant advantage
in productivity growth over SOEs.'
The surprise is perhaps not that TVEs had higher rates of TFP growth than SOEs. Rather it is that the
SOEs have also experienced productivity growth. This goes counter to the received wisdom from the phase of
European reform-socialism that SOEs cannot perform reasonably well in terms of productivity during
transition.. The evidence does affirm the notion that the non-state sector, with greater degrees of freedom from
" See Singh, Ratha and Xiao, op.cit. and Chen Kang, Gary Jefferson and I.J. Singh, "Lessons From China's Economic
Reform." Journal of Comparative Economics 16: pp. 201-225, 1992.
There is a vigorous ongoing debate regarding how much productivity has improved in the state sector or whether any
productivity gains have occurred in the state sector at all. For an alternative view see Woo et. al. (1993). Others argue
that productivity in the collective sector has not grown faster than in the state sector. See Rawski (1993).
3 Jefferson, Rawski and Zheng (1991), using data for 1980-88 shows that total factor productivity in the collective
sector, of which TVEs are the largest part, rose at an annual rate of 4.6 percent; surprisingly the comparable rate for the
state sector was 2.4 percent! A second study by Xiao (1990) using a smaller sample for 1980-85, shows that TFP growth
for the SOEs was nearly 4% while for the TVEs it was 8.8%. Nor were these differences due to the fact that TVEs were
starting from a lower TFP base, as at the start of the decade they had a virtual parity with SOEs; by the end of the
decade TVEs were substantially outperforming SOEs in terms of productivity growth. See Jefferson and Rawski (1992).
' Jefferson (1993) finds that even if we control for such factors as the provision of housing and social services by SOEs
and the degree of market exposure as measured by the higher share of goods sold at plan prices by SOEs, which would
tend to lower SOE productivity growth, TVEs tend out perform SOEs. Zou (1992), using more detailed price data on
shares of both inputs and outputs sold and market prices and the spread between market and plan prices for SOEs
reaches similar results and concludes that in effect the underlying performance of China's industrial enterprises has
been "market driven rather than ownership driven"-it is the market exposure and market conditions under which
TVEs operate, that explain productivity differences, rather than the SOE/TVE dichotomy. See Geng Xiao, "What is
Special About China's Reforms," PRDTE, November 1991, G. Jefferson, "Are China's Rural Enterprises Outperforming
State Owned Enterprises," PRDTE, July 1993, and Gang Zou, "Enterprise Behavior Under the Two-Tier Plan/Market
System," Draft, PRDTE, September 1992.
Enterprise Reform and Restructuring in Transition Economies 25
government control and quasi-private incentives and characteristics peiforms much better. Indeed, it appears
from micro-level estimates that the level of total factor productivity in the nonstate sector now exceeds that in
the SOEs, despite (or perhaps because of?) the privileged access of the latter to resources.
An important point to understand is how hard budget constraints operate in township and village
industries. This occurs because local budgets are tied to enterprise surpluses. In fact most of the revenues for
local governments- between 90 95 percent-come from the surpluses of enterprises which they "own" and
supervise. All the budgetary outlays of local township and village governments, for housing, social safety nets,
education, welfare and most important of all for the salaries and perks of local officials have to be met from
these surpluses generated by enterprises. Local governments have a direct interest in making sure that
enterprises remain profitable, yield a surplus over and above operating costs and do not become a burden on
local resources; local managers whose da-facto pay is linked to the financial performance of their enterprise also
have a direct incentive to make sure that the enterprises yield a surplus. In addition these surpluses have to be
large enough to generate most of the funds for further investments. Thus even though a hard budget constraint is
not imposed on each enterprise, there is an enormous incentive on the part of both managers and local
governments to make sure assure that enterprises operate at a profit. The hard budget constraint at the local
level in effect translates into a hard budget constraint for the local enterprises also."
Such hard budget constraints at the local level are usual throughout China because of the long tradition of
local autonomy, self reliance and responsibility for meeting local needs from locally generated resources. Local
autarky and autonomy is jealously preserved. There is no tradition of provincial or central government bail outs
for local governments and their enterprises and the central government has restricted subventions to local
governments. Thus there is a natural local hard budget constraint.
There is also evidence that the emergence and rapid growth of the non-state sector has itself done much to
change the market environment in which all enterprises operate. More intense competition has had a salutary
effect on the performance of not only the TVE sector, but of the SOEs as well.' This is confirmed by (i)
convergenfce between factor returns between SOEs and TVEs, (ii) declining profit rates in the collective, TVE
and SOE sector, (iii) micro-level evidence that productivity changes have been greatest in those SOEs most
exposed to market competition, and (iv) a direct and positive relationship between productivity in the SOEs and
the share of the non-state sector.41
' For a detailed analysis of the dependence of local budgets on enterprise surpluses see Byrd and Gelb (1990).
4 This has also happened in Eastern Europe. For a comparison with Poland see Section 8 below.
"' See Singh, Ratha and Xiao op. cit; G. Jefferson, "Growth, Efficiency and Convergence in China's State and
Collective Industry," PRDTE, July 1992; G. Jefferson and I.J. Singh, "China's State Owned Industrial Enterprises: How
Effective Were the Reforms of the 1980?," PRDTE, July 1993, G. Jefferson, "Are China's Rural Enterprises
Outperforming State-Owned Enterprises?," PRDTE, June 1993; and G. Jefferson and I.J. Singh, "Ownership and
Industrial Performance in China's Industries," PRDTE Outreach Draft, November 1993.
26 Research Paper Series: Policy Brief
Figure 6.2: Non-State Industry and Efficiency
of the State Sector in 1990
100a
U_U
90 a a
07
85-
5- 75--
0
x U
70-70
60
65 --
10 20 30 40 50 60 70
Non-State Sector Share of Industrial Output (%)
The Legacy of Partial Reforms
So far there has been no widespread change in formal ownership rights within China's state sector. SOEs
continue to be publicly owned-by either central, provincial or county authorities. Widespread privatization is
still ideologically taboo at present, even though "public ownership" is elastic enough to allow considerable
ownership diversification-including joint ventures with private foreign investors and ownership of shares by
other publicly owned mutual and pension funds and insurance companies. Clearly it is hard to argue against
China's success in terms of its past growth performance. Nevertheless, many problems remain as a legacy of
partial reforms of the Chinese enterprise system.
(i) Continuing SOE losses: Although concentrated in specific sectors, many SOEs continue to show losses;
these losses are supported by state subsidies which are a serious fiscal drain on declining central budgets; it
would have been even more in relative terms if not for the rapid growth of the non-state sector. Meanwhile,
unclear tax obligations with unresolved rules for demarcating central, provincial and local fiscal tax authorities,
undermines the effectiveness of fiscal policy as a macroeconomic instrument and erodes central revenues. A
major tax reform designed to clarify central, provincial and local tax rights and obligations (and including the
right to tax enterprises) has been initiated, but has yet to be implemented.
Enterprise Reform and Restructuring in Transition Economies 27
(ii) Life Time Employment and Lack of Exit Policy: Despite the spreading of a "contract" system, SOEs still
provide life time employment. This severely limits labor and factor mobility because social benefits come tied to
the enterprise. There is no exit policy and very few bankruptcies have been allowed; nor can permanent labor be
fired. Loss makers continue to be bailed out and not closed.42
(iii) Burden of Social Services and Pensions: SOEs carry a heavy burden of housing, education, health
benefits and pension provisions that they are required to provide by law to employees and their dependents. This
burden of services and pensions and benefits are being slowly shed by enterprises, reformed and assumed by
local governments. Little progress has been made in this area thus far.
(iv) Subsidized and Mis-Allocated Credits: SOEs still continue to receive the lion's share of bank credit, much
of which (especially investment credits) is subsidized and not allocated in any clear relation to performance. In
the first half of 1993, industrial investments grew 71 percent. The SOEs accounted for 62 percent of these
investments-a clear case of investment credits not going to the most productive sectors of the economy.
(v) Poorly developed, non-independent banking sector: With poor links between credit allocation and
performance, administrative credit allocations, a plethora of non-market and negative interest rates, dependent
banks and an ineffective central bank, financial sector reform lags severely behind the progress on the "real"
side of the economy;
(vi) Poorly Defined Property Rights: While industrial progress has been possible without formal private
ownership in China,43 the need for clearly and well defined property rights-whether public, collective or
private-and the autonomy and obligations that go with them, clearly remains a serious problem. Both the
SOEs and the nonstate sector require clear formalization of property rights and the ability to enforce them
through an independent system of laws and contracts.
(vi) Recurring Macro Instability: The boom-brake cycles of inflation with growth and contraction that China
has experienced-first in 1987-88 and then again in 1992-93-are symptomatic of the lack of controls over the
"investment hunger" that characterizes, particularly, the SOEs. This is a symptom of a partially reformed
economy. The danger for China is that such cycles will cease to be buffered by abnormally high savings and
financial deepening, and that far more serious macroinstability could ensue. This could, in turn, have a seriously
adverse effect on growth.
China's dominant strategy so far has been to grow out of the PE sector through rapid growth of the non-
state sector. This shrinking of the state sector has been a viable strategy, both because of the tremendous
potential for growth of rural industries and the repression of the service and trade sectors. The approach has
succeeded not by discouraging the growth of state industry and contracting its output, but rather by allowing
and encouraging entry and competition from the non-state sector and thus reducing the share of the state sector
in the economy.
42 A figure of between 60400 bankruptcies is cited. The form of bankruptcy is old in that it does not involve managerial
change. The largest case is of Chongging textiles whose manager has actually produced a booklet on how he declared
his enterprise bankrupt. The Corporate laws of December 1993 has a large section on the implementation of bankruptcy.
(We are indebted to Anjali Kumar for this information.)
a See T. Rawski, "Progress Without Privatization: The Reform of China's State Industries," PRDTE, October 1992.
28 Research Paper Series: Policy Brief
The question arises as to the limits of such a strategy. Can PEs just wither away? At present the limits
have not been reached. Even as the state sector continues to grow, its share would continue to decline. Even if
real industrial growth was halved over the next decade, there would still be enormous potential for growth of the
non-state sector. But at the end of the process the core of state-owned industry would still remain and it would
be very hard to shrink this away. The hard core PE problem in China will then center around the need to further
reform and restructure (i) key industries deemed strategic, (ii) defence industries, (iii) key heavy and resource
based industries (iv) utilities, (v) key infrastructural sector and (vi) industries in special locations-all of which
can be expected to be retained in the state sector. Huge cuts in the labor force of SOEs in these sectors will be
needed even if closure and privatization are not chosen as alternative paths for exit. Of course, many financial,
managerial and even utility and infrastructural services can be bought by SOEs and governments from the
private sector, as shown by the experience in Taiwan and Hong Kong, but at present there is little evidence that
this path will be followed in China.
7. Two RADICAL REFORMERS: POLAND AND THE CZECH REPUBLIC
Poland and the Czech Republic (CZ hereafter) are examples of very radical reform attempts to move the system
towards a market economy. We treat them together because their stabilization and liberalization programs that
have so dramatically altered the PE environment have been very similar. They differ in two major respects:
(i) Both are small, and now open, economies, that have seen very large declines in reported output in the last
three years following the initiation of reforms. These declines cannot be attributed to the reforms, but were
largely the result of the break up of the CMEA trading system and the collapse of the FSU." But initial
macroeconomic imbalances were far more severe in Poland, and the degree to which enterprises have been
forced to adjust to date is correspondingly greater. In both countries, macroeconomic policies and external
constraints are far tighter than in China.
(ii) Poland has been stymied in its attempts to carry out large scale program for the privatization of state
enterprises, but CZ has initiated mass privatization using a voucher scheme, whose first phase was implemented
in June 1993. CZ offers the only case where rapid stabilization and price liberalization has been shortly
followed by mass privatization.'
7.1 Reforming the Market Environment: Stabilization and Liberalization
The very aggressive, and rapidly implemented programs of stabilization and market reforms initiated in Poland
in January 1990 and CZ one year later included:
(i) Price liberalization: In 1989, food prices were liberalized in Poland and by the end of that year about 50%
of the turnover was at market prices. By the middle of that year hyper-inflationary conditions prevailed. In
' See J. Brada and A.E. King, "Sequencing Measures for the Transformation of Socialist Economies to Capitalism: Is
there a J-Curve for Economic Reforms?," EE-RPS #3, Transition Economics Division, World Bank, June 1991.
" Slovakia shared in the privatization program of the Czech and Slovak Federal Republic. For convenience, this paper
concentrates on the Czech Republic.
Enterprise Reform and Restructuring in Transition Economies 29
January 1990, the remaining price controls were lifted and 90% of all prices were liberalized. Both consumer
and producer prices increased fifteen-fold in Poland between the first quarter of 1989 and the first quarter of
1990. The stabilization program slowed these price increases dramatically, but prices have continued to rise at
around 3% per month. Consumer prices rose faster than producer prices.' In the Czech Republic prices
remained fairly stable in 1990, jumped in the first quarter of 1991 after liberalization, but stabilized by the end
of that year. There was no significant wedge between consumer and producer prices.
(ii) Devaluation and total current convertibility. The exchange rate was first fixed and then followed a
crawling peg in Poland and is pegged to a basket of currencies in CZ (with special clearing provisions for the
Slovak Republic). Capital controls remain in place in both countries.47 Open trade with very low average tariffs
(average around 18% in Poland and 5% in CZ) and no quantitative restrictions on either exports or imports in
Poland and a very few quantitative restrictions on agricultural imports only and a few restrictions on exports m
CZ. Removal of most restrictions on direct foreign investments.
(iii) Sharp credit squeeze, and high interest rates.'
(iv) Tight fiscal regime, elimination of most subsidies and sharp reduction in the rest. A change in the tax
regime, with a shift away from profit remittances by enterprises to high levels of corporate tax and payroll
taxes.49
(v) Strict control over wages in both countries with a high excess wage tax (popiwek in Poland) on
enterprises;"
7.2 Creating the Institutional Framework for PE Reforms
(i) Reasserting Control Over Ownership. The first problem in reforming SOEs in many transitional
economies has been the problem of reasserting state ownership control over the enterprises. This is a paradox. If
the eventual aim is to devolve ownership, why should the state reassert ownership? The answer is that in many
cases, prior to reforms the state had decentralized control and supervision over PEs to local or enterprise level
' This is characteristic of most of the reforming countries in EE, particularly as real exchange rates appreciate. One
consequence is divergent movements in the "real" or deflated wage and the product wage.
4 These are kept in place primarily to manage balance of payments crises and prevent capital outflows from
destabilizing the reforms.
' In Poland, Pinto et. al. (1991-92) found from firm level interviews that nominal interest rates on working capital
were in the range of 50-72% per month by the end of January 1990, one month after the reforms,
' These included in Poland a single payroll tax (of 46% paid by the employer) and a corporate income tax of 40%; in
the Czech Republic these included an employer payroll tax of 46% with an additional employee payroll tax of 16% and
a corporate income tax of 35% in CZ an employer payroll tax was with payment of dividends to the government as
owner. See EBRD (1993).
" The excess wage tax in Poland (called the 'popiwek' or PPWW in Polish) was a steep and progressive tax on wages
paid above norm wages determined by a fractional indexation of base wages in September 1989. The highest marginal
rates reached 500 percent (lowered later to 400 and then 300 percent).
30 Research Paper Series: Policy Brief
authorities through a system of self management. At the same time "collectives" with varying degrees of state
and local participation were also allowed to develop. But in all instances, "since all property had a socialist
character," property rights and ownership were left ill defined and fuzzy. Thus a number of agents-the
treasury, the supervising ministries, local governments, but above all the managers and workers, obtained a
strong sense of property rights, at least over the enterprises they worked in. This multiplicity of agents with a
vested sense of property rights has been one of the legacies of "reform socialism," and self-management, which
preceded the radical reforms started in 1990. This response to the "ownership vacuum" made it much more
problematic to undertake SOE reforms."
This legacy was particularly powerful in Poland, where workers' councils have played a major role in
running enterprises and have a strong sense of defacto property rights in their enterprises. Poland's labor unions
have been and remain politically very powerful and the role of Solidarity has been central in all elections except
the last one. No mass privatization program can progress without a major say from workers about who gets the
shares in their enterprises.
Nevertheless in 1990 Poland passed legislation that gave the government the authority to privatize
industrial enterprises. This legislation defined five forms of ownership: (1) treasury property including SOEs
and state budgetary entities such as schools and hospital; (2) municipal property including municipal-owned
enterprises and budgetary entities; (3) property owned by cooperatives and state farms; (4) joint stock
companies owned by the state and other SOEs; and (5) private and semi-private property including joint
ventures between SOEs and private foreign or domestic owners.52 But despite this legislation, ownership and
control remains ill-defined for most enterprises. Management had served at the pleasure of the workers councils,
and many managers were former council members or trade union activists." Over time managers have however
acquired more power relative to the worker's councils.
These problems have been far less acute in CZ because the system of self management had been in
operation only very briefly, and was soon repealed when market reforms were introduced. The state had clear
ownership rights in SOEs and other state property. This made it easier to carry out a program of mass
privatization. But even so, the issue of closure of SOEs and the growing unemployment in Slovakia which had a
larger share of heavy and large SOEs, were major factors of contentions both in the 1992 elections and the
subsequent dissolution up of the country.
In both Poland and CZ, corporatization has been used mainly as a transitional device to prepare for
further privatization. In Poland all state assets and enterprises are legally owned by the State Treasury, but in
practice its ownership rights have been delegated largely to Workers' Councils and in part to various ministries.
The Ministry of Privatization (MOP) is exercises the state ownership rights in "commercialized" companies
slated for privatization
* In China, the ownership vacuum has been less pronounced and to the extent that it has occurred it has been filled by
local and provincial governments.
52 See Kochacv and Sood, op. cit., page 17.
* Workers Councils appointed their own managers immediately after the reforms in 1990; most of them belonged to
Solidarity. See Alan Gelb, Erika Jorgensen, and Inderjit Singh, "Life After the Polish 'Big Bang': Episodes of
Preprivatization Enterprise Behavior," in Ayre Hillman and Branko Milanovic (eds.) The Transition from Socialism in
Eastern Europe, World Bank, 1992.
Enterprise Reform and Restructuring in Transition Economies 31
(ii) Creating the Legal and Institutional Framework for Privatization. The legal framework for a market
economy and the institutions to implement it must be rebuilt in transition economies. Corporate law contract
law, property law, bankruptcy law, company law, commercial codes, anti-trust regulations-have only recently
been legislated and are now becoming effective. No well functioning institutions exist for their implementation
there are few recent precedents to build on. In a market economy the legal framework must define property
rights, set a framework for exchanging them, set rules for entry and exit from economic activity and regulate
markets. Though much remains to be done, the basic legal and regulatory framework to cover the essential laws
has been put in place, and a start has been made in developing courts and regulatory agencies to enforce them.5'
Nevertheless, implementation capacity remains a major problem, and entire professions must be recreated."
7.3 Restructuring and Partial Privatization56
(i) Poland. The state sector in Poland at the start of reforms in 1989 included some 8,500 enterprises
accounting for 30% of GDP, 19% of employment, 85% of exports and 60% of fiscal revenues.17 Polish industry
is dominated by both heavy and state-owned enterprises; it is concentrated and monopolized. State-owned
enterprises and joint stock companies account for over 83% of industrial sales and 92% percent of industrial
employment. Further nearly 44% of industrial sales and over 58% of industrial employment are concentrated in
heavy industries. Much of the heavy and state-owned industry is also geographically concentrated, making the
problem of SOE reform and privatization more politically sensitive.
Poland has adopted a multi-track approach to privatization and has an ambitious program for transferring
state owned assets to private owners. It allows for a variety of alternative methods of partial privatization:
(a) "commercialization" (corporatization) of SOEs by transforming them into State Treasury
Corporations (joint stock or limited liability share companies).' The shares can then be sold to private investors
' See C. Gray et.al., "The Legal Framework for Private Sector Development in a Transitional Economy : The Case of
Poland," Policy Research Department, WPS #800, November 1991; and C. Gray, "The legal Framework for Private
Sector Activity in the Czech and Slovak Federal Republics," Policy Research Department, WPS #1051, November 1992.
" For a more complete and extensive discussion of the evolving legal issues and framework in Central and Eastern
European economies and the problems of implementation, see Cheryl Gray and Associates, Evolving Legal Framework
for Private Sector Development in Central and Eastern Europe, World Bank Discussion Paper, No. 209, 1993.
56 By partial privatization we mean a wide range of measures and methods taken to change the structure of the firm or
the way it operates short of outright and large scale changes in the formal ownership of state assets. Partial privatization
can be seen as half way or transitional measures pending mass privatization or preparing for it and include
corporatization (or "commercialization") and improved corporate governance for SOEs; "spontaneous" privatization
through leasing of assets of SOEs to private firms or management buy-outs; creation of intermediaries such holding
companies and mutual funds (some government owned) as an interim holders of assets before privatization and other
schemes for the diversification of ownership including providing the provision of shares to other state firms, banks or
mutual funds. Under restructuring we include both enterprise level as sectoral restructuring.
1 Pinto et. al, (1992).
" Commercialization is different from privatization. Commercialization consists of an SOEs conversion to a joint-stock
company fully owned by the Treasury-the actual transfer of the share capital to new owners occurs only later via "mass
privatization" or other methods of transfer. Under liquidation all or some of the assets are transferred via sale or lease,
32 Research Paper Series: Policy Brief
through direct sales or public offerings. This method of transferring assets is called capital privatization or
privatization through transformation, and is aimed mainly at large and financially viable companies.
Commercialization starts with an SOE expressing an interest and undertaking a feasibility study (usually
through a consulting firm) to determine the number of shares, their value and employee share ownership (up to a
maximum value of 20% of total share value or average workers salary in the state sector multiplied by the
number of workers in the enterprise). Once approved by the managers, the Workers' Council and the founding
body (e.g., ministry of industry)" the plans are submitted to the Ministry of Privatization (MOP). If approved,
the SOE becomes a State Treasury corporation with a Board of Directors-selected by MOP and chosen by
employees. The last stage involves developing a strategy to determine which method will be used to privatize the
state corporation---direct sales, public offerings, or management buy-out. All three options must include an
employee share scheme.
Data are hard to come by, but latest available figures show that some 92 large enterprises have gone
through "capital privatization" or "privatization through transformation" in Poland.'
(b) Spontaneous privatization and "privatization through liquidation" of SOEs, with the subsequent
. sale of the business into an existing company, or its leasing, completely or partly, to an existing company. This
option is aimed at small and medium size enterprises. It usually involves sales initiated by enterprises "from
below" and has the advantage of being decentralized and enjoying the full participation of managers and
workers. Spontaneous-privatization was ongoing in Poland even before the recent radical reforms."1 It usually
involves the leasing of SOE assets by their managers to private firms owned by themselves or their associates.
This form of privatization accelerated after the Privatization Law of 1990 allowed management buy-outs after
approval by the Ministry of Privatization (MOP). The Law requires that enterprises being bought out by
managers first go through a formal process of legal "liquidation"-hence the term "privatization through
liquidation."
Once initiated by the SOE and Workers' Council and approved by the MOP, privatization through
liquidation can take four forms: i) sale of the whole or part of the enterprise following the liquidation procedures
set out in law; ii) "fast track" privatization through auctions, by-passing the usual liquidation procedure; iii)
transfer to a joint venture (most often involving a foreign investor) with the State Treasury as partner, of all or
part of the shares of an enterprise to other investors (including institutional investors such as banks); and iv)
leasing of assets or part of the business to other firms (MOP policy has been to confine this to Polish investors).
from the SOE to a new private company or owners without an intermediary owner. In the case of liquidation, the
remaining "shell-SOE" still remains on the books, thereby inflating the total number of SOEs still in existence.
" "Founding bodies" of SOEs include ministries, provincial and local authorities, control and supervise enterprise and
are the representatives of the State Treasury that has formal ownership.
0 Out of 8,441 enterprises registered in 1990, 2,385 have been included in the privatization process. Of these,
approximately 28 in 1991, 22 in 1992, and 42 through October 1993 providing revenue of some 10,000 billion Zl.
Commitments of additional investments of some 20,000 billion ZIs over these years. See "Country Privatization Report:
1993," paper presented at the Fourth Conference of the Central and Eastern European Network (CEEPN), Ljubljana,
December 3-4, 1993, p. 16.
1 Prior to reforms it was called "nomenklatura" privatization, a termed now dropped.
Enterprise Reform and Restructuring in Transition Economies 33
Apart from liquidation, auctions have been used to expedite privatization of small and medium size
enterprises without the formal valuation of assets, and are also closed to foreigners, the other forms have to
follow set liquidation procedures.62
Through October 1993, a total of around 852 small and medium enterprises have been privatized through
the "liquidation" procedure in Poland. Of these 117 have been through direct sales, 39 have been joint ventures
with foreign investors, 633 have been leased out to employees or the management of enterprises and 63 fall in
the category of some mixture of the above methods. Some 71 additional enterprises have been sold through
auctions. Most liquidated firms have been small, with 60% having less than 200 workers, and the firms usually
are considered to be sound ones. In contrast, firms that are in poor financial conditions are usually liquidated
through sales of part or all of their assets (see below)."
(c) Bankruptcy privatization: This process allows the sale of assets of a bankrupt SOE.' It is
estimated that some 1,013 such cases of bankruptcy of SOEs have occurred. Bankruptcy liquidation has been
dominated by firms in industrial manufacturing and agriculture."
(d) Sectoral privatization involves whole branches of industry and has been introduced by MOP with
the objective of accelerating the process of privatization. This sectoral-wide approach requires the government
to identify the sectors to be privatized by this method on the basis of such criteria as economic potential of the
sector, investor interest and pressure of firms eager to privatize. The sector is then assigned a "lead adviser"
selected by competitive tender, who undertakes a complete sectoral analysis, and an analysis of each company in
the sector. At the same time he contacts potential investors to gauge their interest and requirements, and presents
a sectoral strategy along with plans for privatization and/or restructuring of enterprises. After evaluation and
approval by government the plans are implemented. Implementation usually involves the same methods as
liquidation-public offerings and direct sales-or the sector becomes a candidate for the mass privatization
program. Some 14 sectors have been identified for this approach.' The results cannot be separated from the
other programs, because they depend on the method chosen for privatization.
Altogether, it is estimated that of the 8,441 SOEs registered in Poland in 1990, 2,385, or 28 percent, have
been included in some form of partial or complete privatization using the various approaches outlined above."
As set out in article 37 of the Law on Privatization. For details see CEEPN (1993), op. cit. The process works as
follows: the worker-manager group wishing to buy makes an up front payment of about 20% of the value of a firm
(based on a quick outside evaluation of assets based usually on book value) with the rest purchased with a loan from the
government amortized over several years.
63 See Dabrowski, Janusz, M. Federowicz and Jan Schomburg, "Privatization of Polish State-Owned Enterprises,"
Economic Transformation Report No. 29, The Gdansk Institute for Market Economics, Gdansk-Warsaw, 1992.
* Under article 19 of the State Enterprise Act.
b5 Dabrowski, et. al., (1992).
* Including ball bearings, breweries, cables and wires, cement and lime, confectionery, construction, electric motors,
furniture, glass, machine tools, automotive components, pulp and paper, telecommunications and tire and rubber
products.
6 CEEEN (1993), p. 16.
34 Research Paper Series: Policy Brief
(e) Privatization through Restructuring (PTR): In order to accelerate the privatization of SOEs the
MOP developed a new program in 1992, as an alternative path for those enterprises that required a transition
period to prepare for full privatization. In general the enterprises selected for this program are already in the
midst of organizational and other improvements and require additional resources to complete this process. The
program calls for both restructuring and privatization to be carried out by highly qualified management teams
(called "management groups"). It starts with the preparation of business profiles by the MOP of companies
chosen for this program. Then these management groups are invited to "bid" for a particular company and
submit business plans that will prepare the company for privatization. The "bid" should reflect their estimate of
the company's worth. They are solicited through competitive tenders from management groups, which can be
Polish or foreign. The winning group gets to implement the restructuring and privatization plan for the company
(after making a 5% security deposit on the tender value which can be used for restructuring).
The management group is expected to bring "appropriate" inputs to the firm, including capital, new
technology, improved organizational designs, access to new markets, and production and marketing skills for
restructuring. The management groups are offered significant incentives to improve the value of the firm. When
the group realizes the sale of 51 percent of the equity in a given firm, they become entitled to receive 70% of the
real capital gains realized on the sale.' The remaining 30% is awarded to the employees and the supervisory
board. In both cases the capital gains are payable in shares.
Privatization through restructuring may be seen as a form of management contract which includes
financial and other contributions to a restructuring program supervised by the MOP and encourages the
management groups to have a long term strategic interest and to increase their ownership stakes. In these
respects they differ from conventional management contracts to run firms for a direct fixed or performance
based fee. By the end of 1993 some 10 pilot management contracts had been signed. It is too early to evaluate
the results.
(f) Restructuring of residual strategic industries: The MOP has a special program for enterprises
considered to be in the strategic branches of industry such as defence, coal mining and steel industries. The
objective here is not to sell off state property, but to restructure through reorganization and rationalization. This
restructuring is being handled by the Industrial development Agency with funding from the Polish Development
Bank.
(ii) CZ. Some, though relatively little, spontaneous privatization also took place in CZ prior to radical
reforms." SOE assets were frozen by law so that managers and former "nomenklatura" could not take
advantage of an ownership vacuum to privatize property to themselves.70 In CZ, the radical reforms included a
a The real capital gain is the difference between the sale price and the tender price adjusted for inflation.
69 Jan Mladek, "The different Paths to Privatization: Czechoslovakia, 1990-?," in John S. Earle, R. Frydman and A.
Rapaczyncki (eds.), Privatization in the Transition to a Market Economy. Studies of Preconditions and Policies in
Eastern Europe, London: Pinter Publishers, 1993.
70 What little there was prior to the reforms took the form SOE directors establishing a private firm and using their
connections to use idle capacity, obtain resources or use capital assets and labor resources of SOEs to fill profitable state
orders. Leasing was minimal and informal at best. There was also transfer of capital assets from state firms to private
companies, despite the fact that it is forbidden. There are no hard numbers on how extensive this activity was since it
was unlawful.
Enterprise Reform and Restructuring in Transition Economies 35
clear intention to privatize the state sector as quickly as possible through a program of mass privatization. It
took the view that newly created private owners should restructure, not the government, and it also ignored
advice that its agencies should attempt to increase the efficiency of SOEs before it subjected them to
privatization. There was therefore no extended period of spontaneous and partial privatization or restructuring
of SOEs before mass privatization."
7.4 Privatization and Exit
(i) Restitution and Reprivatization. Both CZ and Poland have programs for the restitution and reprivatization
of enterprises. The 1992 Restitution Law in CZ provided for the return of all property confiscated by the former
Communist government to former owners or their heirs who had until September 1991 to file their claims. Some
80,000 people have applied; property with an estimated total value of 300 billion Krona (about US$10 billion,
or 10% of all state owned property) is expected to be returned. Restitution is expected to be voluntary and
former owners are expected to pay for any improvements in value and then obtain the whole property or can
take compensation instead. Cash compensation is limited to US$1,000 with the rest to be paid in bonds or
vouchers that can be exchanged for shares in newly privatized SOEs.'
In Poland restitution is far more limited and is to be made only where previous nationalization was
deemed "abusive" or inadequately compensated. Small properties, those nationalized in 1946, small farms and
some real estate were approved for restitution. Except for specific cases, the general principle is that former
owners will be compensated rather than have their properties returned. Although the extent of reprivatization is
yet to be determined, by the end of 1991 some 1,200 applications for compensations had been received.
(ii) Small Scale Privatization. The fastest area of privatization has been the transfer of small business to the
private sector. This has taken place mostly in retail, trade and services, but has not been confined to these
sectors. In Poland, some 60,000 shops were leased or sold in 1990 and early 1991. By the end of 1991 some
80% of retail outlets and small services had been transferred to private owners; by 1993, most if not all retail
trade and services are private hands in Poland. In CZ, the Small Privatization Law was approved only in
November 1990. By the end of 1991 about 120,000 retail shops, restaurants, service businesses and kiosks had
been sold by auctions or leased, in addition to the 80,000 to 100,000 businesses that had been returned to their
former owners. It is estimated that 92% of the retail and wholesale distribution sector and 78% of construction
are private. Some 21,000 small manufacturing enterprises were also sold by auctions in 1992 for total proceeds
of Kcs 25.5 million ($860 ml), with two thirds of the sales being in the Czech Republic. The funds were
deposited in the Funds of National Property in each republic.
" Jan Mladek, "The different Paths to Privatization: Czechoslovakia, 1990-?," in John S. Earle, R. Frydman and A.
Rapaczyncki (eds.), Privatization in the Transition to a Market Economy, Studies of Preconditions and Policies in
Eastern Europe, London: Pinter Publishers, 1993. What little there was prior to the reforms took the form SOE directors
establishing a private firm and using their connections to use idle capacity, obtain resources or use capital assets and
labor resources of SOEs to fill profitable state orders. Leasing was minimal and informal at best. There was also transfer
of capital assets from state firms to private companies, despite the fact that it is forbidden. There are no hard numbers
on how extensive this activity was since it was unlawful.
* The law excludes property legally nationalized before and after 1948 by the state and postpones the settlement of
church lands. See Kochav and Sood, op. cit., p. 20.
36 Research Paper Series: Policy Brief
The importance of this transformation to the quality of life cannot be underestimated. Not only did it
transform the structures of these economies, by allowing services and trade-long repressed sectors accounting
for an insignificant share of output and employment in socialist economies-to grow very rapidly and provide a
growing share of incomes and employment. But the hustle and bustle of such businesses, carried out in the open
and in shops and streets of all major towns has transformed the grey socialist drabness visibly, and in an
astonishingly short time.
(iii) Large Scale or Mass Privatization Programs (MPP). Both Poland and CZ envisaged mass privatization
programs with voucher schemes, and set up agencies to take charge of the process. But voucher privatization
plans in these two countries differed in important respects. In CZ vouchers were given to the population at large,
and were redeemable for shares in specific enterprises. Individuals bid directly for shares in the company or
assigned an Investment Privatization Fund (IPF) to bid and manage their holdings. In Poland, individuals are to
receive shares in specific financial intermediaries (initially Holding Companies, now National Investment
Funds), which will own shares of the enterprises to be privatized.
(a) The Polish Mass Privatization Program (MPP). The Polish MPP was designed to partially
privatize several hundred large SOEs that have already undergone the process of "commercialization," through
indirect distribution of shares at a low nominal price. The enterprises are first transformed into joint stock
companies, and 60% of their shares are distributed to specially created financial intermediaries called National
Investment Funds (NIF). These are to become legal owners of the shares, monitor the performance of the firms
in their portfolio, and then later restructure or sell them either wholly or in part. The shares in each company
would be divided in fixed proportions-33% for the "lead fund," 27% equally across the other funds and 10%
for the employees,' with the state retaining 30% non-voting shares ("except in emergency!"). Shares in the
funds will then be distributed to Polish citizens over 18 years old (some 27 million people) at a nominal price to
cover the administrative costs. The program was supposed to be implemented in two waves, with the first wave
of some 200 firms in 1992. A second wave was to follow a year later.74 The latest incarnation of the scheme
involves the establishment of 20 National Investment Funds (NIF) to manage 400-600 commercialized state
enterprises. Each adult will receive one share of each investment fund after paying 10% of their monthly wage.
Workers in the affected enterprises will receivr 10% of the shares in their own enterprise free of charge.
Although the mass privatization program (MPP) was first proposed in 1990, it has been a subject of
major political controversy and debate, and the Law on Mass Privatization on which it was to be based, was
adopted only in June 1993. Little real progress can be reported. The current timetable calls for selection of
companies and the creation of NIFs by the end of 1993; the appointment of fund management firms, allocation
of lead shareholding NIFs and distribution of share certificates by the end of 1994, and the listing of NIFs on
the Warsaw stock exchange by 1995.
(b) The Czech and Slovak Voucher Privatization. It is important to note that CZs scheme for voucher
privatization is only one of the ways in which privatization of state owned assets is being undertaken.
' This differs from the provisions in the other types of privatization that allows workers to buy up to 20% of the shares
at a 50.5 discount, with the subsidy limited to one years salary.
" Frydman, R., A.Rapaczyncki and J. Earle et. al., The Privatization Process in Central Europe, London: Central
European University Press, 1993.
Enterprise Reform and Restructuring in Transition Economies 37
Large scale privatization may be carried out through one (or a combination) of methods, although voucher
privatization is probably the most significant and far reaching."
Successful though the voucher program has been as far as the distribution of property rights is concerned,
it should be noted that vouchers constitute less than 50% of the total sales of large-scale enterprises in 1992.
Government policy has generally favored direct sale (26%) or public auction/tender, for mainly smaller firms
while commercialization (joint-stock) or unpaid transfer (27%) to a municipality or local organ is used for other
types of firms. Unpaid transfers has been most prevalent in sectors such as utilities and natural resources.
Partial privatization has been most prevalent in those sectors where large companies are found, and the
majority of firms choosing this method have dedicated at least a part of their shares to the voucher scheme.
Surprisingly, standard methods are being used in sectors where there are larger firms as well: Paper Plants
(51%), Printers (64%), and Cultural Facilities (54%). It is most likely that parts of the firms have been broken
off or that suitable partners have been sought for these firms.
TABLE 7.1:
CZ: Methods of Privatization by Sector
Commercialization % Direct Sale or Public Auction/Tender %
Banks & Insurance Companies 86 Community Services 68
Publishers 80 Leather Goods 62
Transportation Companies 61 Trade Services 60
Agricultural Distributors 50 Domestic Trade 57
Forestry 43 Wood Processing 55
Fuel Production 41 Research & Development 54
Machine Tools 41 Health Care Facilities 52
Chemicals & Plastics 39 Tourism 52
Agriculture 38 Production of Construction Materials 50
Energy 34 Processed Food Products 47
Construction 46
Electronics 43
Source: Privatization Newsletter of Czechoslovakia, February 1993, No. 13
Other methods include i) the transformation of a state-owned enterprise into a joint-stock company and a transfer of
shares (e.g., through voucher privatization), direct sale to a predetermined buyer, public auction or public tender, free
(of charge) trahsfer to municipal ownership, free (of charge) transfer to social security, health insurance and other
publicly beneficial institutions.
38 Research Paper Series: Policy Brief
Breaking firms apart can also explain the high proportion of unpaid transfers in industries such as Glass
and Ceramics (56%), Metallurgy (40%) and textiles and clothing production (36%) to municipalities. Such
units usually comprised housing and social facilities, not actual factories or workplaces. Nonetheless the overall
method of privatization is now shifting away from commercialization to more standard methods.
Mass privatization sought to "privatize the privatization process." Anyone could submit a plan for
privatization of a company (multiple plans could be and were submitted)."6 The Czech and Slovak Ministries of
Privatization then reviewed the projects and submitted those approved for voucher privatization to the Finance
Ministry, which was in charge of coordinating the voucher scheme. Each resident could purchase vouchers to
bid for firms directly or through intermediaries. Privatization was to be two waves, the first with about 15,000
and the second with 3,500 SOEs.
TABLE 7.2
The First Wave of Mass Privatization
1st wave 2nd wave
Number of firms offered for sale 1491 3500
Total book value $ 10.78 bn
Total voucher bood holders 8.53 mn
Total voucher points to invest 8.53 bn
Ton Ten Investment Funds
Czech Savings Bank 9.3
Harvard Capital and Consulting 7.5
Creditanstalt (Austria) 3
Remaining seven /Fs 20.5
Remaining Holders of Voucher Points
Smaller IFs 31.6
Individual investors 28. 1
Source: CERGE Newsletter, 1993
" In the first wave, privatization projects per firm averaged 3.8 with some enterprises receiving as many as twenty
proposals.
7 Each citizen above 18 years was eligible to purchase a voucher booklet for Kcs 35 ($1.20) and could register it for
Kcs 1000. This voucher was divisible into 1000 points and these points could be used to bid for companies directly or
through intermediaries. In the first round all shares had the same price in points calculated by dividing the book value
of a firm by total number of points bid. If there was an excess demand or supply in the number of points bid for a firm,
the share price was readjusted and a second round of bids ensued. The final price was arrived at through a process of
discrete time tatonment. For further details see Frydman, Rapaczyncski and earle et. al. (1993).
Enterprise Reform and Restructuring in Transition Economies 39
Most of the bids came through intermediaries-called Investment Privatization Funds (IPFs)-to whom
individuals had assigned their vouchers. The IPFs have played an exceptionally significant role in the first wave
of voucher privatization that was completed in June 1993. The liberal approach of letting private (not
government-controlled) funds participate in voucher privatization resulted in no less than 264 IPFs in the Czech
Republic participating in the first wave. IPFs were set up by domestic banks, private consulting companies and
some privatized enterprises. The result was that 72% of all investment points were placed in the hands of the
IPFs, and half of this was in the hands of the ten largest funds. Among the ten largest funds, 7 were established
by domestic banks, I by a subsidiary of a foreign bank and 2 by companies created by private agents for this
purpose.' The outcome of the Czech program is therefore that the banks, a number of which themselves are
privatized, have effective control over much of the economy. Voucher privatization has turned more than 75%
of Czech adults into share holders. Each of them now owns shares either in 1,500 privatized companies or the
IPFs. This has laid the basis for the development of a private secondary market in securities and the birth of a
capital market. Two security exchanges have already emerged-a traditional stock exchange established mainly
by banks (the Prague Stock Exchange) and a non-traditional electronic RM-S market that can be accessed by
anyone-professional brokers or private individuals-as long as they olbey the trading rules. The largest IPFs
have become members of the stock exchange and also trade on the RM-S, and have their own shares listed on
the stock exchange. The volume of trading is already high and there is significant competition between these
exchanges.' One concern is the quality of prudential regulation.
The Czech experience provides two important lessons: (i) it is possible to reconcile a program of equitable
and large scale diversified ownership with the degree of concentration of ownership needed for effective control
without imposing the form of intermediation; and (ii) such a scheme can quickly lead to the development of
securities and capital markets.
It is yet unclear whether voucher privatization in itself will create profit maximizing owners, able to
develop appropriate products, marketing strategies and management capacity awcessary to compete in a global
economy. How fast the capitalist mentality spontaneously develops in the new owners remains to be seen
Voucher privatization also does not assure enterprises of access to funds needed for restructuring. It is too early
to assess its impact. Voucher funds, though some are managed by banks, are separate from their loan portfolios,
and do not have deposits as liabilities; they just have shares. This makes it less likely that the involvement of the
banking system in the investment funds will lead to financial instability
7.5 Private Sector Development
The rapid development of the private sector, with the entry of new firms along with small privatization, has been
one of the bright spots in the otherwise difficult adjustment process in CEE. Allowing private property and
private firms the right of entry and providing the legal and institutional framework for establishment, contracts
and exit are necessary preconditions for the development of the private sector and have been largely set in place.
This has led to a very rapid growth of the private sector, mainly in services, construction, retail and wholesale
' Triska, Dusan, "Investment Privatization Funds on Securities market in the Czech Republic," paper from the fourth
CEEPN Annual Conference on Privatization in Central and Eastern Europe, Ljubljana, December 3-4, 1993.
' For example in one month "redemption scheme" of just one IPF, some 150,000 share-holders of that fund sold their
shares through the electronic exchange. Triska (1993) op. cit.
40 Research Paper Series: Policy Brief
trading and small manufacturing. The growth in the number of small firms (fewer than 5-7 employees) in
service industries is phenomenal. Growth of small manufacturing is more muted and dependent on generation of
savings and capital in the private sector, that is usually difficult to come by.
Poland already had a largely private agricultural sector, but the urban private sector was small, being
confined to very small or sole proprietorships mainly in the service sector." In late 1988, Poland passed the
"Law on Economic Activity," which allowed for large-scale entry of private entrepreneurs, removing restrictions
on type of activity and number of employees. The resurrection of the 1934 Company Law also provided for
limited and joint stock companies. The response was immediate. It is estimated that by the end of 1989 over
800,000 sole proprietorships had been established and 16,000 new companies registered. New private entrants
have continued to grow--commercial law partnerships" have grown from around 17,000 to 54,000 (among
which private firms grew from 11,600 to 45,000 and joint ventures from 429 to 4796), sole proprietorships
from around 800,000 to 1.42 million and cooperatives from 15,000 to 17,000 between 1989 and 1991. It is
estimated that the share of GDP contributed by new private firms (excluding agriculture and cooperatives), rose
from 11% to 19% and the share of total employment rose from 13% to 26% between 1989 and 1991.82
A sectoral breakdown shows that much of the overall private sector growth was in wholesale and retail
trade. However when the registered companies in the incorporated sector (which grew in number by 52% during
1991 alone) are examined, it is seen that while trading firms grew by 92%, the number of industrial firms grew
by a very healthy 35%, in addition to sole proprietorships which were evenly divided among industrial and
trading activities. Joint industrial ventures increased sharply from 853 to 2,697 in one year between 1990 and
1991. Most of the new manufacturing firms are small," but official data show a 48.6% increase in private
industrial production in 1991.
This dramatic shift in ownership structure in Poland in the short span of four years (1989-93) has been
mhainly due to new start ups. More than 1.5 million out of the 1.8 million businesses were initiated in the last
four years. However partial privatization and small scale privatization have also contributed to this
development, and the squeeze on the SOE sector has encouraged the release of assets for private sector use. By
the end of 1993 over half of the labor force in manufacturing will be in the private sector, despite of the stalling
of mass privatization. Poland is now a mixed economy."
Czech Republic. Following the passage of the Entrepreneurial Law in 1990, new companies registered
grew rapidly. By the end of 1991 nearly I million sole proprietorships (many inactive) and some 40,000
'0 It is estimated that the share of the private sector was around 15% of GDP in Poland in the mid-eighties before the
reforms. See J. Charap, "Entrepreneurship and the SMEs in the EBRDs Countries of Operations," E.B.RD. (Draft),
London, March, 1992.
" These are limited liability and joint stock companies and include, treasury-owned, private firms and joint ventures
and other law partnerships.
' See Leila Webster, Private Sector Manufacturing in Poland: A Survey of Firms Industry and Energy Department
Working Paper, Industry Series Paper No. 66, December 1992.
8A survey of private limited liability companies carried out in 1991 showed that 60 % of these firms had fewer than 20
employees and almost 75% of them reported sales of less than US$50,000. See Webster (1992) op. cit.
* CEEP (1993), and Jacek Rostowski (1993).
Enterprise Reform and Restructuring in Transition Economies 41
companies were registered. Small firms were privatized via some 25,000 auction sales and some 50,000 original
owners had been given their properties back through a program of restitution. It is estimated that between 1990
and 1991, the share of the private sector in GDP rose from 2% to 8% and the share of private sector
employment from 1% to 16%. Surveys of new manufacturing firms showed that most of them were small as in
Poland." Recent estimates on the share of GDP produced in the private sector are shown in Table 4.4.
In 1992 the private sector accounted for 20% of the GDP and 16.4% of the employment in CZ and 47%
of the GDP and 51% of the employment in Poland. Further while GDP fell in both Poland and CZ between
1989-92, the private share of the GDP as well as the share of employment grew because the private sectors
grew so rapidly. Private sector output has grown at 40% per annum in CZ and at 8% per annum in Poland
between 1989-92. The large declines in output and employment from the state-owned sectors (noted earlier) has
been partly offset by increasing output and employment in the private sector-but not totally as overall
unemployment has also been growing apace and now stand at 13% in Poland and 3% in CZ. The larger the
private sector, the smaller the impact of a given reduction in the state sector and the larger the impact of a given
growth in the private sector. Poland, with a large private sector share of GDP and employment in 1992, and
with continuing high rates of growth in the private sector, will show even faster overall recovery. Predicting the
impact of private sector growth in the future for CZ is more difficult, because the mass privatization program
has just started to transform the ownership patterns radically.
8. ENTERPRISE ADJUSTMENT IN EASTERN EUROPE:
WHAT Do WE KNow?
Proponents of rapid privatization of SOEs in transition economies have argued that even when freed from
supervising agencies, ownerless SOEs will: (i) grant employees large wage increases; (ii) not lay off redundant
workers; (iii) decapitalize themselves; (iv) fail to rationalize resource use and become profit-motivated; (v)
continue to demand soft budgets, and be unaccountable for losses; and (vi) fail to renew vigorous growth.' An
alternative view is that much can be done to change the behavior and exert pressures for improved performance
of SOEs through macroeconomic reforms and market pressures-even if changes in ownership and governance
lag behind. Extensive large scale privatization has yet to occur in Poland, and has only just been initiated in
CSFR, so that there is still little evidence of the impact of changes in property rights. But what can we say
about the behavior of the firms which are still mainly SOEs during the past 3 years?
Broad Trends. There are serious statistical problems and biases in measuring both industrial outputs and
employment in both Poland and CSFR.'
" See Leila Webster, "Private Sector Manufacturing in Czech and Slovak Federal Republic: A Survey of Firms,"
Industry and Energy Department Working Paper, Industry Series Paper No. 68, December, 1992.
8 M. Hinds, "Issues in the Introduction of Market Forces in Eastern European Socialist Economies," World Bank,
March 1990 and D. Lipton and Jefferey Sachs, "Creating a Market Economy in Eastern Europe: The Case of Poland,"
Brooking Papers on Economic Activity, 1: 1990, pp. 75-133; and also "Privatization in Eastern Europe: The Case of
Poland," BPEA, 1: 1990, pp. 293-333 and were early proponents of this view.
87 See Jacek Rostowski (1993) for an extensive discussion on Polish data.
42 Research Paper Series: Policy Brief
Aggregate industry and sub-sectoral evidence is relatively well known. There have been large declines n
industrial output and employment in both Poland and CSFR, with employment declining after a lag. Unit labor
costs have risen and labor productivity has generally fallen. The output decline occurred in all sectors,
especially in those heavily dependent on CMEA trade." This decline in output, though not employment, has only
recently been reversed in Poland. It is too early to tell whether it can be sustained. The upturn has yet to come in
CSFR: it is possible that some adjustments have been postponed while preparing for voucher privatization.
TABLE 8.1:
Changes in Output and Employment in Poland and CSFR
Level Level
Output Growth (% p.a.) 1988= 100 Employment Growth (% p.a.) 1988 = 100
CSFR 1989 1990 1991 1991 1989 1990 1991 1991
Total 0.7 -3.5 -24.7 73.2 -0.6 -3.2 -12.1 84.6
Industry by Branch:
Fuel & Pbwer -0.3 -4.1 -5.7 90.2 -0.4 -3.8 -7.5 88.7
Metals 0.5 -1.8 -26.0 73.0 -0.9 -3.0 -10.1 96.4
Electro-engineering 0.8 -3.4 -32.4 65.8 -0.8 -5.5 -13.5 91.1
Chemicals 0.7 -8.7 -22.7 71.1 0.0 -2.2 -9.4 88.6
Minerals 2.2 -3.7 -30.3 68.6 0.0 -4.5 -12.6 83.5
Wood & Paper 0.9 -0.8 -22.4 77.7 -1.2 -3.1 -11.1 85.2
Light Industry 1.1 -1.1 -36.0 64.1 -1.0 -2.9 -14.6 82.1
Food Processing 2.5 -2.0 -16.4 84.0 0.5 -1.4 -10.3 88.9
POLAND
Total -0.5 -24.2 -11.9 66.4 0.3 -4.9 -7.3 88.4
Industry by Branch:
Fuel & Pbwer -2.4 -22.1 -8.4 69.6 0.8 -8.2 -6.4 86.6
Metals -4.8 -19.7 -22.4 59.3 -3.8 -4.6 -8.1 84.3
Electro-engineering 0.7 -22.0 -22.4 61.0 -1.4 -4.8 -11.0 83.5
Chemicals 2.6 -24.6 -13.5 66.9 2.1 -6.4 -6.4 89.4
Minerals 5.5 -21.5 -2.6 80.7 0.1 1.1 -3.1 98.1
Wood & Paper 6.9 -24.9 -1.4 79.2 4.0 -2.2 4.6 106.4
Light Industry 3.3 -33.8 -13.0 59.5 2.7 -5.4 -13.1 84.4
Food Processing -5.9 -23.7 -0.9 71.2 -0.4 -0.2 5.0 104.4
Source: Estrin, Schaffer and Singh (ESS), extended to include data through 1992.
* See Saul Estrin, Mark Schaffer and Inderjit Singh, "Enterprise Adjustments in Transition Economies:
Czechoslovakia, Hungary and Poland," in M. Blejer, G.A. Calvo, F. Coricelli and A. Gelb (eds.), Eastern Europe in
Transition: From Recession to Growth?, World Bank Discussion Paper No. 196, 1993, pp. 111-136.
Enterprise Reform and Restructuring in Transition Economies 43
These declines cannot be attributed entirely to the stabilization and liberalization programs, but partly
reflects exogenous shocks to the balance of trade, investment and autonomous consumption.' One study
estimates that the impact of the collapse of Soviet and CMEA trade alone was in the range of 8.5%, 8% and
6.3% of GDP in CSFR, Hungary and Poland respectively."o 9 (See Table below).
Very large changes in the output and employment shares of agriculture, industry and services have taken
place in favor of the latter, and there has also been a very large shift from state to private activity. These have
already been noted and represent significant changes that have structurally transformed these economies.
There is more debate on the extent to which subsectoral shifts within industry signify a "transformational
recession." Those expecting such shifts depart from the view that market forces should force sharp
specialization along sectoral and branch lines of comparative advantage. But in practice, most industrialized
countries are sectorally rather diverse, and competition forces a great deal of specialization within the various
branches of industry, and firms succeed by occupying particular product and market niches. Even branch level
data tend to obscure such a process of adjustment that occurs at a far more microeconomic level.
Recent microeconomic evidence from Eastern Europe suggests that there is indeed a growing
differentiation between more and less successful firms within given industrial branches of industry. Firms are
making factor and output adjustments and changing behavior as they respond to a severe squeeze from
stabilization, liberalization and external shocks-and as they look forward to privatization. The discussion
below draws on very recent enterprise level studies and field surveys to describe this process. Data are richer on
Poland the for the CSFR, but many elements of the process seem to be similar.92
89 See Josef Brada and Arthur E. King, "Sequencing Measures for the Transformation of Socialist Economies to
Capitalism: Is There a J-curve for Economic Reforms?," EE-RPS #3, Transitions Economics Division, June 1991.
90 See Dariusz K. Rosati, "The Impact of the Soviet Trade Shock on Output Levels in Central and Eastern Europe
Economies," paper presented at the Conference on Output Declines in Eastern Europe: Prospect for Recovery?, IIASA,
Austria, 18-20 November, 1993.
9' That the declines in outputs need not be due to liberalization and are not the only likely outcome is obvious from the
experience of China. Much depends on changes in and the composition of aggregate demand. If private and government
investments are growing, as private demand is increasing due to increases in incomes and exports are growing, the
normal response to liberalization is an increase in output. If instead, as in Central and Eastern Europe, government
demand and investments have been declining, export demand has collapsed due to the breakdown of the CMEA, and
private demand has declined due to a drop in incomes, and there is a tight squeeze on credits and fiscal subsidies; a
decline in outcome is to be expected.
92 The evidence is mainly from Poland and is taken from the following studies: 1) Jorgensen, Gelb and Singh (1992); 2)
Estrin, Schaffer and Singh (1992); 3) Pinto, Belka and Krajewski (1992 and 1993); 4) Dabrowski, Federowicz and
Szomberg (1992); 5) Gora (1993); 6) Schaffer (1993); 7) Gomulka (1993); 8) Dittus (1993); 9) Estrin, Gelb and Singh
(1993); and 10) Brada, King and Ma (1993).
44 Research Paper Series: Policy Brief
Profits: A Pattern of Growing Interfirm Differentiation
In 1990 reported enterprise profits (and taxes) were much higher than anticipated in Poland. As Schaffer (1993)
has shown, these were "paper profits" due to the use of historical cost accounting to value inventories. One year
later profitability in the enterprise sector collapsed-from 23% of sales in 1990 to 7% in 1991. However, firm-
level data shows that there was growing differentiation between firms. Some were not only surviving but doing
well and showing higher profits. In Poland some differentiation occurred immediately after the reforms, with
firms that were oriented towards Western exports doing very well compared to others." Recent surveys by Pinto
et. a! (PBK 1992 and 1993) and Dabrowski et. al (DFS 1992) confirm that in each sector successful and less
successful firms were emerging." Using profitability as a measure of financial performance and a sign of the
degree of adjustment, PBK (1992) that by 1992 65% of their sample (AAA firms) had positive retained
earnings (net profits after meeting all tax obligations), another 39% (AA firms) had positive gross but negative
after-tax net profits, while the remaining 12% (A firms) actually had negative gross profits." All three kinds of
firms existed in all sectors.
DFS (1992) reported that while profits continued to decline for all firms in their sample, the smallest
declines (from 36% to 15% between 1990-92) occurred in firns that had been privatized through sales, auctions
or public offerings." These firms (16% of their sample) were the "plums" in Poland. They had high quality
products, strong foreign market links and more modern equipment." Among firms that had gone through partial
privatization through liquidation, profits fell more sharply (36% to 2%). SOEs that had been corporatized, but
had been retained by the Treasury had very high profits in 1990 (50%), but continued to show profits (10%)
even in 1992! Some firms, that underwent liquidation through bankruptcy had relatively high profits in 1990
" Schaffer attributes about half of this drop to a decrease in the inflation rate and hence the decrease in the inflation as
in profits resulting from the use of historical cost accounting and most of the rest to higher labor unit cost and higher
amortizations. The drop in profits led to a sharp decline in government revenues and a budget deficit of 3-4% of GDP-
very large swing of about 7% of GDP leading to a fiscal crisis in Poland in 1991. See Mark Schaffer, "The Enterprise
Sector and the Emergence of the Polish Fiscal Crisis: 1990-91," Policy Research Department, WPS #1195, September
1993.
See Gelb. Jorgensen and Singh (1992).
Pinto. Belka and Krajewski (1991, 1992 and PBK hereafter) report on a sample of 75 large SOEs surveyed from five
different manufacturing sectors in the summer of 1991 and a follow up resurvey of 64 of the same firms in September
1992. Of these 37 remained SOEs, 24 had been "commercialized" and 3 had been privatized by various methods.
Dabrowski, Federovicz and Szomberg (1992, and DFS hereafter) report on a survey of 55 firms in the middle of 1992
focusing on different methods of privatization pursued by firms in Poland.
9 Net profits were retained earnings after paying corporate income tax, the dividend (actually a state asset tax paid to
the government) and the excess wage tax. Gross profits were pretax profits.
* Their sample of 55 firms and findings are reported by four category of firms. Category 1: those that had been
privatized via public offerings, sales or management buy-outs (16%); Category II: those partially privatized through
various methods of liquidation including sales of assets, contribution to equity, or leasing of assets (44%); Category III:
those partially privatized through bankruptcy liquidation (using the same methods as in II but firms in extreme financial
distress) (23%); and Category IV- those that had been "commercialized" (i.e., corporatized with workers' councils
replaced by supervisory boards), but retained under Treasury ownership (16%).
* Their method of privatization via sales, auctions and public offerings is clearly a matter of self selection.
Enterprise Reform and Restructuring in Transition Economies 45
(31%), but were very hard hit by "shock therapy" and did not have the financial reserves to slow down their fall
They were in dire financial straits by mid-1992 with heavy losses (negative profits of -40%). Detailed case
studies provide further evidence of this progressive divergence in the fortunes of firms, which has been masked
until recently by the severity of aggregate contraction.
Credit Markets and Budget Constraints
Financial Markets. Schaffer (1990) and others have documented how government policies (including ex_post
firm-specific subsidies, bank credits, and tax breaks) softened budget constraints for the Polish Lista 500 firms
before 1990."1 After 1990 in Poland and 1991 in CSFR budgetary enterprise subsidies were almost eliminated.
With price liberalization, unexpectedly high initial inflation, tax, power and utility hikes, the demand for
working capital credits increased sharply However, real interest rates were kept positive and nominal credit
volumes were constrained, while growing import competition made it progressively harder to raise output
prices. Subjected to both a profit and a severe credit squeeze, firms ran early on into a liquidity crises,
cushioned only by undervalued inventories and foreign bank balances.' Firms responded in a number of ways.
Immediately after the reforms there was a sharp rise in payables and receivables among Polish firms;"'
supplier's credits were an early buffer in the system, allowing firms a margin of time to adjust. Ratios of inter-
firm credits to sales soon declined, however, for the best performing firms and worsened for the worst ones.
Clearly signalling that the reforms were felt to be credible, better firms became reluctant to extend credits to
weaker ones.,'2
Several factors contributed to the credibility of the governments policies: (i) the old system has been
totally discredited making it possible to undertake radical measures; (ii) there was a widespread recognition that
reforms were needed making these measures politically and socially acceptable; (iii) all parties recognized that a
window of opportunity existed for a radical break away from the Soviet dominated economic system that was
seen as alien; and (iv) the government reinforced these perceptions by an unequivocal adherence to a set of
consistent and restrictive macroeconomic measures from which it did not veer. A consistent willingness to pay
the political cost of taking strong measures reinforced this credibility.
Taking into account interest charges, Dittus (1993) shows that the overall resource transfer from the
banking to- the enterprise sector was negative over the reform period in Poland, Hungary and CSFR. After
99 Schaffer, Mark, "Taxation, Subsidization and Regulation of State Owned Enterprises in Poland," in European
Economy: Transformations in Hungary and Poland. Brussels: Commission of the European Communities, 1990.
"0 Schaffer (1990) has documented extensively how in Poland, firm-specific subsidies and tax rebates, and the
undervaluation of inventories using historical cost accounting methods, led to soft budget constraints for the Lista 500
firms.
'0 GJS (1992) reported that in state owned firms in late 1990 inter-enterprise credits stood at between 17 weeks of the
total sales.
102 The ratio of receivable to payables declined for all firms to near unity except for those in dire financial standing
(bankruptcy liquidation) where they have deteriorated (to about half). They are high for commercialized SOEs (where
they are about 2) suggesting that such firms are still providing extensive credits to their customers, perhaps as a way to
move their stocks of finished goods. The containment of interenterprise debt in Poland and CSFR, in contrast to
Romania and Russia, is a good indicator that reforms were considered to be credible. Also see Rostowski (1993).
46 Research Paper Series: Policy Brief
rising from 1989 to mid-1991, the ratio of working capital loans/operating costs rose for all Polish firms. But it
fell thereafter in all but the most poorly performing firms'o3 Faced with high real interest rates, good firms
retreated from borrowing, and debt concentrated increasingly towards the more problematic firms. By the end of
1992, "weak" firms accounting for only some 12% of sales were responsible for much of the net debt of the
banking system, and estimates of banking portfolio losses ranged from 30% to 40%. Dittus (1993), Golmulka
(1993). Banks had not acted as active agents to force enterprise bankruptcy, but tight financial policy and a
credible program had caused a self-selection process as viable enterprises sought to become debt-free.''
Following macroeconomic stabilization reforms, inter-enterprise credits were contained and actually
shrank relative to bank credits in Poland. In contrast, they have exploded in Russia and Romania because the
macroeconomic stabilization programs were never seen as credible. This is only one of the examples of the
critical links between various reforms-macroeconomic and enterprise reforms in this case-that makes it
difficult to undertake one set of measures without making credible progress on others.
Taxes. Tax arrears on the other hand have risen for all firms, but they remain very small (4%) for the best
performing firms with positive net profit. In contrast they have grown substantially for categories of firms with
positive gross profits and the poorest firms with negative gross profits. The latter have no profits to tax, so that
these arrears are due to non-payment of dividend and excess wage taxes. Not only is the collection of the state
dividend not enforced, but lax local tax chambers have been persuaded by many firms not to act on the 3 month
tax arrears rule that would trigger bankruptcy proceedings. Real bankruptcy is not seen as a credible option as
yet. Arrears to utility companies have also risen.
On the basis of interviews, PBK (1992) report that by the end of 1992 managers felt that the budget
constraint at the firm-level had hardened and was now credible. But the evidence on hardening budget
constraints is still somewhat mixed, especially at the low end of the performance spectrum. Working capital
loans have continued to rise, and, although direct subsidies have been eliminated, there is still some
subsidization of poorly performing firms. There have been extensive labor layoffs but few firms have yet been
forced to exit.
Product Composition
Both successful and failing firms showed declining output between 1990-92. This was a rational response, one
would expected even in a market economy.' The composition of outputs provides one indicator of
(considerable) adjustment to new market conditions. Firms began to change their product lines as early as 1990
(GJS 1992) and have continued to do so. DFS (1993) report that two thirds of the firms in their survey had
either introduced at least one new product, modified an old product to better suit their customers needs, or
103 Investment loans also rose the fastest for the,both the best performing firms and the worst performing firms-but in
the latter they were used to roll over interest payments on earlier loans and finance a growing stock of inventories.
104 In late 1991, nine independent state-owned commercial banks were spun off from the Bank of Poland. With increased
competition for a limited number of good customers, banks have become more conscious of their net worth and
portfolios. Supervisory boards with strict monitoring by the Ministry of Finance (including a freeze of lending to 2,000
suspect firms) has helped tight credit policies to become credible.
'S All firm level studies confirmed this. See GJS (1992), PBK (1992-93) and DBS (1992).
Enterprise Reform and Restructuring in Transition Economies 47
diversified their production lines to respond to changes in market demand. Only a third had responded passively
to declining demand by decreasing their outputs. Nearly 20% had developed new products. Most of these were
in consumer goods, which faced the most intensive import competition when markets were opened and had to
upgrade quality-especially in the food processing industry. Firms that did this were able to retain or increase
their shares in export markets.
The most active firms were those that had been privatized through sales and auctions or firms that had
leased state assets and used this excess capacity to produce new products. About two third of leasing firms
modified their products and production lines or developed new products. SOEs recently commercialized tended
to be the least active and made only some changes in product lines. This could partly be explained by the fact
that they are large firms that require considerable amounts of investments for product and production line
modifications. Firms leased by old "nomenklatura" managers were also not very active.
Exports. The break up of the CMEA has resulted in a large changes in trade patterns and a remarkable
growth in hard currency exports: see Table 8.2. Poland's hard currency exports took off grew by 40% in 1990
even as industrial sales fell by 23%. In Poland, even as firms continued to rely on state trading agencies to
export their products at the start of reforms, they realized that exports to the West would be a central part of
their strategy for survival, and that penetrating Western markets would require major quality upgrading from
CMEA standards. The firms best able to adjust have been those with a preexisting orientation towards hard
currency markets and foreign market connections."'o
TABLE 8.2:
Changes in Direction of Trade: CMEA and Market Economies
(percentage changes in 1970 US$ amounts)
Socialist Market
1970-79 1979-89 - 1989-92 1970-79 1979-89 1989-92
Poland 19.2 -33. 1 -59.5 172.8 -21.5 48.8
CSFR 6.3 -27.2 -47.2 60.7 2.0 62.1
Source: Annual Economic Review, EBRD, September 1993, p.68.
Cutting Costs: Employment, Wages and Material Inputs
The three major relative input price shifts have been for labor (product wages have declined), energy (prices
have risen greatly) and capital (real cost of capital has gone up). Adjustment towards more labor and less
capital and energy-intensive production might be expected.
106 See GJS, p. 201.
48 Research Paper Series: Policy Brief
Changes in the employment levels reflect to some degree the initial conditions in most SOEs. Labor use
was excessive, and there was little correlation between pay scales and performance. There was some fear that
worker dominated SOEs would lack the will to shed labor to improve efficiency. These fears have been
unfounded.
Declining demand (as well as high social security and excess wage taxes) has forced firms to cut labor use
and total wage bills. As noted above, Polish firms entered the "big bang" with relatively large financial cushions
and cut employment very slowly at first-through attrition, retirement, voluntary layoffs and later through
involuntary layoffs. Workers approaching pensionable age and casual workers were laid off first.'"
Both growing and contracting sub-sectors as well as the most and least successful firms have shed labor.
But for different reasons, successful firms to raise their efficiency, cut labor costs and reduce their wage bill and
the poor performers due to inability to meet their wage bill when sales are declining."os Substantial labor
shedding has occurred despite the presence of workers' councils. An overall decline of over 20% in industrial
employment in four years in Poland and slightly less in CSFR is strong evidence of adjustments in factor
proportions.
In contrast to the somewhat perverse response of financial markets at the low end of profitability, labor
reallocation at firm level appears to be following the pattern of sales and profitability. Firms (and sectors) where
output has contracted most have seen a rise in unit labor costs relative to firms with better performance, as
labor adjustment has lagged output decreases. But these firms have also tended to reduce their labor forces more
rapidly.o' Problem firms are therefore being "hollowed out."
In addition, the combination of enterprise breakups, new entry and attrition is resulting in a marked
change in the size distribution of employment in Poland. Relative to 1989, employment in firms with more than
5,boo workers fell by 36%; .in firms with 2,000-5 000 by 29% and so on: meanwhile employment tripled in firms
with 50-100 workers, and it rose by 31% in firms with 101-200 workers."0 This suggests that Polish industry is
moving away from Soviet-style concentration patterns and towards a size distribution characteristic of market
economies with astonishing speed.
There is also some evidence for CSFR that wage-setting has begun to respond to local unemployment
conditions, layoffs have occurred and that wages are diverging according to productivity. Svejnar (1994).
It is normally assumed that privatization will increase labor shedding. DFZ (1992) report just the opposite
for Poland-labor shedding among genuinely privatized firms has been the smallest; commercialized SOEs and
enterprises liquidated through bankruptcy have shed the most. Average wages have actually increased in
107 See Alan Gelb, Erika Jorgensen and Inderjit Singh, "Life After the Polish 'Big Bang': Episodes of Preprivatization
Enterprise Behavior," in Ayre Hillman and Branko Milanovic, The Transition from Socialism in Eastern Europe, World
Bank, 1992. (Hereafter GJS).
o' See Gora (1992), Pinto et. al. (1992) and DFS (1992).
'" PBK (199), Gora (1993); also case study evidence in Estrin, Gelb and Singh (1994).
"o Gora (1993) Table 2.
Enterprise Reform and Restructuring in Transition Economies 49
privatized firms compared to SOEs and partially privatized firms. Wage structures have been simplified, made
more dependent on profits and increasingly under the discretion of supervising managers."'
There is also evidence that firms have become more cost conscious and have improved the efficiency of
energy and material use. The "big bang" brought a huge (3-fold) increase in energy and material prices. The
ratio of material and energy costs to sales rose through mid- 1991 as firms adjusted, and then began to decline,
suggesting significant increases in the efficiency of energy and materials use. This increase occurred across the
board, in both successful and poorly performing firms, falling the faster in the latter."2
The Internal Restructuring of Enterprises
Pre-reform SOEs in planned communist countries were essentially factories. Marketing was unnecessary with
state orders; distribution and sales were carried out by large monopolistic state trading organizations (for
domestic markets) or foreign trading corporations (FTCs) (for foreign markets) organized along product or
ministerial lines. Prices and accounting were notional; finance adjusted passively to the needs of the plan. There
was little need to assess the production costs or returns on product lines. Firms had no experience dealing
directly with small customers and after-sales services were non existent. Most of these features persisted even in
reform socialism.
In both Poland and CSFR firms responded almost immediately to the opening of markets by creating sales
departments, setting up distributorships, and searching for foreign partners to provide marketing expertise."'
Purchasing and marketing divisions with internal sales personnel, along with cost accounting and management
information systems began to be created. New distribution channels have been set up very quickly, and direct
customer contacts with final consumers or retailers have totally replaced state controlled ones and are the
norm. 4
Firms have installed cash management and reporting systems. Cost accounting along modern lines has
been introduced to assist managerial decisions. Profit centers have been established in multi-product firms to
establish responsibility and measure performance. Financial management has become a major priority in many
firms.
Indeed, PBK (1992) suggest that what sets successful, profitable, firms apart from their failing
counterparts has been the quality of their management. Good managers have been able to take hard decisions to
shed labor, cut costs, restrain wages and borrowing, keep a tight eye on cash flow and develop new products
and markets. They also take a longer term strategic view of the firms prospects. In Poland, this has been in large
part due to the changes mainly in the market environment and partly in corporate governance brought about by
partial privatization. In such firms, management boards or supervisory boards have replaced previous managers
under the control of workers councils, which had generally fired old managers and appointed new ones in the
" DFS (1992).
See Pinto et. al. (1992).
" See GLS op. cit. and Estrin, Gelb and Singh (1993).
" PBK reports that 80% of all sales are to final customers.
50 Research Paper Series: Policy Brief
first year after reform."' DFS (1992) report that over half of the managers have again been replaced. The newx
managers appointed by supervisory boards are younger, better educated, more industrious and not beholden to
workers' councils. They have started to earn higher salaries which are now linked to performance of the firm.
Even in SOEs, boards with more authority and independence and greater long-term strategic interest have
replaced older, more political and less competent boards. One of the major benefits of even partial privatization
has been the domination of such boards by strategic investors.
An Assessment of Enterprise Behavior
In 1990 the combination of shocks, reforms and credit crunch left firm managers in Poland reeling and
overwhelmed. Firms adopted short run survivalist strategies as their only option. With the focus on cash flow,
the coping mechanism was to make the most urgent payments first and delay others as much as possible. In
most cases these were wages followed by taxes--deferring payments to other firms and debt service. Foreign
investors or joint ventures are seen as "saviors" to paralyzed firms."'
The studies cited above suggest that even the SOEs are emerging from these short run coping strategies
and changing their behavior to focus on becoming financially viable. They are now going beyond coping to
preparing for growth. The radical reforms have forced firms to change behavior in a number of ways. They are
relying on their own initiative to find products, customers, markets and funds. Even the limited number of
liquidations has reinforced the idea that there will be no bail out. The prospect of privatization and the
knowledge that better performing firms are likely to be stronger candidates (with potential benefits to the
managers) has reenforced the need to pay attention to the bottom line."'
This is reflected most clearly in the changed attitude of Polish mangers reported in the field studies.
Without exception, they now favor hard budgets and stress the importance of not returning to the old system of
subsidies and bailouts by the government. They accept that some enterprises will have to fail. They realize the
need to control deficits and inflation which make long term planning impossible, stress the importance of
consistency if government policies are to remain credible, and decry the "stop and go" approach to privatization
taken by the government that has left them in confusion. Of greatest importance is their changed attitude to the
government. They now think that they cannot rely on it for their survival.
In most cases the initiatives towards privatization have come from managers who recognized that the more
successful companies would be the best candidates for privatization and that they would stand to gain by it.
They see this as an incentive to improve the performance of their own firms. There is no evidence that
employees or trade unions want to block privatization, but they see it mainly as a way of reducing their tax
burden and the excess wage tax that kept their wages in line."' More than half the privatizations reported by
DFS (1992) were initiated by workers' councils.
"' See GJS (1992).
"' See Estrin, Gelb and Singh (1993), and Estrin and Richet (1991).
"' See PBK (1992), DFS (1992), and Estrin, Gelb and Singh (1993).
11 Because privatized firms are not subject to the state asset tax and the still high "popiwek."
Enterprise Reform and Restructuring in Transition Economies 51
Another change in behavior of firms has been the willingness to shed social assets attached to the firm
(vacation homes, kindergartens, housing, etc.), which though not a large financial burden, were a heavy
managerial burden. These assets are being taken over by local communities, or bought out by small and medium
size private firms, or by ventures set up by former employees. Management of social assets (especially housing)
remains a serious problem, but these measures have lightened the burden on management considerably.
A Summing Up of Micro-level Evidence
Though it is early days, some overall conclusions stand out from enterprise-level evidence:
(i) Considerable adjustment and restructuring is ongoing within branches of industry and firms, even prior to
privatization. Different types of firms have adjusted in different degrees and this has resulted in considerable
differentiation in performance. A process of market selection is tending to concentrate poor performers, and
these are seeing the sharpest shrinkage in their labor forces. Private activity has been most dynamic, and even
partial privatization has led to considerable restructuring. It is not possible to yet assess the impact of large-
scale privatization.
(ii) Budget constraints have become more credible, but are not yet completely hard, especially for firms at the
low end of the performance spectrum, which have been cushioned by bank credits. Nevertheless, hardened
budgets combined with import competition have been critical to sustained restructuring of firms-and there is
some parallel here with the experience of China. The impact of credible macropolicies and marketization has
been diluted considerably by confusion about privatization in Poland.
(iii) Changes in corporate governance has brought in more motivated managers, but there is little evidence of a
major impact on firm performance in isolation from other factors. Better management incentives have largely
come through anticipated gains from privatization perceived by managers.
9. CONCLUSIONS
The process of reducing the weight of the PE sector and improving its performance in transitional countries is
part of a fundamental systemic sea-change, especially in the East European countries. While poor PE
performance, as manifested in low growth despite high investment and in some cases macroeconomic
imbalances, was a factor motivating reform, the impulse goes far beyond this, especially in those countries
which have thrown off communist dictatorships. In economic terms, reforming enterprises is only part of the
problem; the larger problem is the restructuring of the entire economy including the industrial sector, due to the
legacy of central planning.
There are some striking parallels between the countries, but also some big differences in initial
conditions:
a) Whether economic reform follows a political transition (China versus EE);
b) The initial relative size of the PE sector (far smaller in China than in EE), and the larger share of the
agricultural sector in China;
52 Research Paper Series: Policy Brief
c) Whether PE reforms are undertaken in a growth or a severely macro-contractionary context (China vs EE
and within EE, Czech Republic versus Poland); and
d) Whether a period of reform socialism, with self management and independent labor unions created
widespread vested interests which cannot be bypassed in undertaking SOE reforms or mass privatization (far
more pronounced in Poland than in CSFR). "'
Such differences have caused the broad strategies of PE reform to diverge considerably across the
countries, as between restructuring the economy via new entry (growing out of the PE sector), restructuring the
PEs, either spontaneously or "top down," or exit from the PE sector via privatization and liquidation. How have
these strategies played out?
New Entry. In all the countries, much of the growth following reforms has come through rapid expansion
of previously repressed sectors. In China, these included agriculture, trade, services and small "nonstate"
manufacturing; in EE it mainly included services but also some private manufacturing. New activities allowed
previously underutilized resources (redundant labor in communes and PEs in China and in over-manned PEs in
CEE) to be redeployed and has also allowed the more efficient use of investible resources. The growth of
private and quasi-private activity through entry of new private firms (and also small scale privatization in
CEE) has led to remarkably fast changes in the structure of production and employment. Poland in particular
is now a mixed economy; China is also in a sense a mixed economy but with the division (within the industrial
sector) being between state and "nonstate" rather than private. The nonstate sector in China has been the main
engine of industrial growth in the reform period, in Europe, the private and service sectors have played this role.
Restructuring. Top-down restructuring (e.g., on a sectoral basis) has been limited in all of the three
countries, and there is good reason to doubt the capacity of the government to manage such a process on a wide
scale. However, starting from initial conditions of inefficient enterprises and enormously distorted and restricted
environments, micro-evidence shows that it is possible to have significant gains through price and trade
liberalization of the economy, correction of price distortions and tightening budget constraints, even without
major privatization:
(i) Enterprise-level evidence from China shows that increased autonomy, better performance incentives.
openness and proper price signals can induce efficiency-enhancing responses even in the state sector.
Relative to the pre-reform period of extensive growth, productivity increase in the SOEs has accelerated, though
it has lagged the nonstate sector.
(ii) Enterprise-level studies in Poland show that market liberalization combined with a severe resource
squeeze is forcing rational adjustments on the PEs, including in their use of labor. Market forces are resulting
in increasingly divergent performance at enterprise level, changes in the size distribution of firms towards
market profiles, changes in factor and product mix, and internal reorganization. What this suggests is that
getting prices and incentives right is a central element in any reform strategy with a high payoff.
(iii) As a broad generalization, labor markets are working better than financial markets in the transition. In
Poland, labor shedding appears to be fastest where output has contracted the most, evidence towards cost-
minimizing behavior. The major emerging issue-both in EE and in China-concerns the buildup of bad PE
"' Formally, labor's political clout is muted in China but it is in fact powerful in the SOEs.
Enterprise Reform and Restructuring in Transition Economies 53
debt in the banking sector and the implied need to accelerate exit mechanisms. It is notable that the debt
problem has arisen both under very tight and very expansive credit conditions. Enterprise and banking sector
reforms are inextricably intertwined in all three countries.
Two important links are apparent between the process of PE reform and the rise of the private and/or
nonstate sectors:
(i) Increasing the weight of the latter intensifies the development of competition (together with trade
liberalization, and removes the PEs from their "commanding heights;" this is essential for productivity gains.
Without such a competitive environment, reforms of management incentives alone are unlikely to be fruitful.
(ii) The rapid rise in the private sector is aided by asset privatization by a PE sector under financial stress,
even without formal privatization or exit. A lot can happen spontaneously without direct policy interventions;
for example, Polish enterprises sold off a large number of trucks in 1990-91, establishing the basis for a private
distribution and trading system.
Privatization. The problem for transitional economies is as much to create property rights as to reassign
them. This creates a set of problems that are less tractable than in market economies, because the legal and
institutional framework is missing or weak.
Small-scale privatization can proceed rapidly, despite legal tangles over restitution. The privatization of
larger enterprises takes longer, and is necessarily slow using conventional methods because potential buyers lack
wealth. Large-firm privatization in Poland has been slow, but the limited evidence available supports its role in
accelerating restructuring. The prospect of privatization can also increase the interest of managers in improving
the position of their firms in the interim. It is too early to assess the impact of the CSFR's privatization program
on the productivity and behavior of firms, but the Czech experience offers several important lessons for
implementing mass schemes:
(i) the PE restructuring phase can be short-circuited if the political will to go for implementing a program of
mass privatization exists-but in the interint, mass privatization plans can place a damper on spontaneous
restructurings;
(ii) it is possible to reconcile an initially equitable distribution of shares with concentrated control through
intermediaries (IPFs) to enable potentially better supervision and monitoring of performance of privatized firms;
(iii) it is not necessary to rely on a top-down government-created intermediary structure for this;
(iv) it is also possible to substantially "privatize privatization" through inviting competing plans for
enterprises, and this focusses attention on possibilities of restructuring;
(v) widening private ownership can quickly lead to the emergence of capital markets. This may be a mixed
blessing in the absence of adequate regulation; but on the other hand, without the development of capital
markets, most restructuring would be much slower.
. That gains are possible before privatization is not a valid argument against privatization. Little direct
micro-level evidence exists yet on the impact of privatization in Eastern Europe. But the evidence from China
(as well as from the generally dynamic growth of private activity in Eastern Europe) suggests that ownership
54 Research Paper Series: Policy Brief
reforms and creating clear private property rights are vital for further productivity gains. The question is not
whether or not to privatize, but when and how fast. Further gains from PE reforms-through contract
management systems or improved incentives for PE performance--exist even for SOEs. But without changes in
corporate governance and increased competition from the private sector or imports, the gains from these
changes alone may be small. As PEs will endure even where privatization is rapid, the issue of how to improve
their performance will be on governments' agendas for a long time. Infrastructure, utilities and key strategic
sectors have not been addressed in this paper. But the standard argument that there can be no progress
possible without privatization is clearly wrong.
The Phasing of Reform. In the sequencing of reforms, it is not so much that stabilization and liberalization
must come before PE reform, but that macro stabilization issues are very much related to micro incentives faced
by economic agents including industrial firms. Macrostabilization requires fundamental PE reform, while PE
reforms cannot be productive without successful macro stabilization. Partial reforms present their own set of
problems. PE reforms without extensive liberalization and privatization create opportunities for corruption and
recurring problems for stabilization, as seen in China; liberalization without macroeconomic control creates
chaos. A credible macrostabilization program is very important in changing the PE environment and promoting
micro-level reform, as shown by CSFR and Poland.
However, as shown by the three countries, PE reforms are a highly politicized process.120 In China,
privatization has been minimal because of the fear of loss of political control by the CP, but the PEs have had to
cope with steadily increasing competition. In practice, much reform has been initiated from below and
sometimes reluctantly accepted on top. The speed and nature of reforms are central to all the debates of the CP.
.All CP factions are now reformers (who can argue with success?); but the reforms are used as a proxy for
political struggle and succession. In Poland, partly due to a sense of vested rights and the political power of
labor, workers have been able to retain a central role in the partial privatization process and have, in a sense,
been able to block mass privatization. Five separate cabinets have come and gone since Poland's reforms began,
and the nature and impact of reform have been important political issues. In the meantime, PEs have been
subject to competition and a dramatic resource squeeze, that has forced decentralized restructuring and some
liquidation. In .CSFR, the political will of one party (indeed, to some extent one leader?) has caused an extended
PE restructuring phase to be circumvented in favor of liberalization and radical privatization. This may have
contributed to the split into two republics, since Slovakia has a larger concentration of heavy industry and a less
developed service sector to take up the slack.
120 The political economy of reforms is a subject that needs a separate and more complete treatment due to its
importance.
Enterprise Reform and Restructuring in Transition Economies 55
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