Public Disclosure Authorized Enterprise Reform In Eastern .

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Public Disclosure AuthorizedPolicy Rerarch W01RKING lAsiaDepartmentTheWorldBankJanuary 12Enterprise Reformin Eastern EuropeSwedervan WijnbergenPublic Disclosure AuthorizedPublic Disclosure Authorized/993Public Disclosure AuthorizedWPS1068ApplyingWesterntextbook solutionsto the problemsof enterprisereformin EasternEuropeis likelyto be counterproductive.Policydesignmustbe imaginativeandexplicitlyincorporatethepolitical constraints and incentive problems specific to theregion, leading to rew approaches to enterprise and indingsofworkinuand eniu ciniTuncpapuu,disnbdo imactationsr andconfusionstheauthots own.oeyshouIdiseonlytidrvibeandwtb Wdoldab ndiedccordingy.efindininsnot be muntud sothe WodldBw&.its BoWrof Dismo its managemalnat any of its menbercounuies.

PollcyResearch TransitionandMEacro-Adjustment WPS 1068This paper - a productof the Europe and Central Asia Department- is part of a larger effort in thedepartmentto assist the process of enterprisereformin EasternEurope.Parts of this paper draw on vanWijnbergen(1992), which appeared in the 1992 Marjolin essay competition volume sponsored byAmericanExpressBank.Copiesof thispaperare availablefreefrom the WorldBank, 1818H StreetNW,Washington,DC sion37033(January1993,36 pages).Enterprisereformis emergingas the coreeconomicproblemin EasternEurope.As privatizationhas beendelayed,a new problemhasemerged,largelyunanticipatedby outsideadvisers:It is probablypossibleto run a clear-cutstate enterpriseefficiently,and it is certainlypossible to get efficientperfonnancefrom aprivateenterprise.But it is utterly impossibletoget anythinglike efficiencyfrom an enterprisefor which the currentand futureownershipstatusare in limbo. Whathas happenedin Poland,where reformstartedearlierthan elsewhere,isprobablya harbingerof things to come.Two years afterthe crumblingof centralauthoritythat used to exerciseboth ownershipand control,ownershipof ntnte-ownedenterprises remainsineffectiveand controldiffuse.Lackingsharplydefinedcontrolrights, variousgroups(workers,incumbentmanagers,and localauthorities)oftenhad no other way of demonstratingtheir clout thanby disruptingthe enterprise. And with changesin ownershipannouncedbut not implemented,managersand workerscouncilsalike have everyincentivetodecapitalizethe enterpriseand increaseits debts.EasternEuropeis not well served withstraighttextbookadvice.The commonwisdomon privatizadtionfailsto addresstheproblemscreatedby diffuse ownershipand conflictsovercontrolthat exist beforeprivatization.Regularcash auctionsmay fail to match managersandcapitalstock efficientlybecauseof pervasivewealthconstraints.Standardadviceon enterpriserestructuringdoes not allowfor the sheer scale oftheproblemor the specialreasons why,inEasternEurope,currentprofits are a poor guideto potentialprofitability.Simply applyingWestembankruptcyproceduresbased on currentdata bias toward liquidationand delay.And, argues van rance,although it would lower the social costs of unemployment,could also contributeto its indefiniteextension.Van Wijnbergensketcheshow these problemscan be addressedby incorporatingall theincentiveproblemsspecificto Eastem Europeintothe design of the policies to be implemented.Sometimesthe advicethat results is novel and asyet untried; sometimesexamplesexist of itssuccessfulimplementation.But the altemativeisa long periodof decliningincomesand, presumably,increasingsocialunrest as the consensusunderlyingthe reformprogramsbegins to erode.The ngs of workunderway inthe Bank.Anobjectiveof theseriesis to get these findingsout quickly, even if presentationsare less than fully polished.The findings,interpretations,andconclusionsin these papersdo not necessarilyrepresentofficialBank policy.Producedby the PolicyResearchDisseminationCenter

ENTERPRISEREFORM IN EASTERN EUROPEbySweder van WijnbergenSenior Advisor, Central Europe Department, World BankIINTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . .1IIOBJECTIVESOF A SOUND RESTRUCTURINGPLAN3IIIPRIVATIZING PROFITABLE INDUSTRIES . . . . . . . . . . . . . .IVENTERPRISERESTRUCTURINGAND PRIVATIZATION. . .IV.l Core Issues in Debt Restructuring . . . . . . .IV.2 Two Practical Proposals . . . . . . . . . . . .IV.3 Dealing with Large EnterRrises . . . . . . . .V.7. . . . . . .10. . . . . .11. . . . . . . . . . . . .1419COMMERCIALBANKREGULATIONAND INCENTIVES . . . . . . . . . . . . .V.1Regulation. . . . . . . . . . . . . . . . . . . . . . . . .V.2Enforcement of PrudentialRegulation. . . . . . . . . . .232324AV.3VI. . . .Issues in the design of enforcement mechanismsBRecapitalizingbanks . . . . . . . . . . . . . . . . .Establish a Proper Incentive Structure for CommercialBanks .EMPLOYMENT CONSEQUENCES:WHICH POLICIES CANVI.l Diagnosis . . . . . . . . . . . . . .VI.2 What Can the Governmentdo? . . . . .ATraining programs .BCapital Market Interventions .CVII. . . . . . . . . . . . .HELP?. . . . . . . . . . . . . . . . . . . . . . .Public Investment Programs and Regional Targeting . . .CONCLUSIONS .24252828283030313233I thank without implicationPhilippeAghion of the EBRD, Marie ReneeBakker, Kemal Dervis, Olivier Godron, S. Ramachandran and Lawrence Summers ofthe World Bank, and Stefan Kawalec and Slavomir Sikora of the Ministry ofFinance in Poland for helpful discussions.Parts of this paper draw on vanWijnbergen (1992), which has appeared in the 1992 Mariolin essay competitionvolume sponsored by American Express Bank.

1IINTRODUCTIONPrice decontrol has eliminated queues in Eastern Europe within a matterof weeks. What it has not done is lead the place much closer to efficientresource use. Moreover, the reforms that most economists agree are necessaryto introduce production side efficiencyhave been surprizingly difficult tointroduce.Privatizationdrives, after init.al successes in selling off shops,restaurants and so on, have stalled, with none of the grandiose distributionschemes anywhere near implementation(Czecho-Slovakia'svoucher experimentmayprovide the first exception after almost two years of delays). In the meantime, output in State Owned Enterprises (SOEs) has collapsed across the beard,almost independentof sectors and country of location. As a consequence,eventhe success stories Czecho-Slovakiaand Hungary have seen GDP decline bydouble digit numbers in the first year central planning was abandoned.The collapse of the SOE sector all over Eastern Europe has alsodramatically increased the difficulty of macroeconomicmanagement. Governmentsrelied mostly on SOE profits as a source of revenue; with the decline of SOEprofitabilitythe tax base is rapidly eroding. Since introductionof efficientsystems of taxation is turning out to be more time consuming than manythought, governments now face the difficult choice between cutting expenditurein line with falling taxes, the deepening recession notwithstanding,orreignite inflation through increasingreliance on the inflation tax. Moreoverthe widespread fear of massive unemploymentonce privatizationproceeds inearnest is developing as a major deterrent to privatization.This problem ismore acute in a recession because fired workers would have difficulty findingalternativeemployment while the economy is already in a slump.

2Thus enterprise reform is emerging as the core economic problem inEastern Europe. Moreover, as implementationof the privatizationplans raninto delays, a new problem emerged, largely unanticipatedby outside advisers.It is probably possible to run a clear cut state enterpriseefficiently, andit is certainly possible to get efficient performance from a privateenterprise. What is turning out to be utterly impossible is to get anythinglike efficien:y from an enterprise whose current and future ownership statusare in limbo. The Polish example is iikely to prove a harbinger of things tocome elsewhere, as Poland's reform program started earlier than those in therest of Central Europe and the CIS states.Two years after the crumbling of central authority that used to exerciseboth ownership and control, ownership of SOEs remains ineffectiveand controldiffuse. In the absence of sharply defined control rights, various groups(workers,incumbent managers, local authorities)often had no other way ofdemonstratingtheir clout than disrupting the enterprise.Moreover, withchanges in ownership announced but not implemented,managers and workerscouncils alike have every incentive to decapitalisethe enterprise andincrease its debts. Thus wage claims have acceleratedwell beyond productivityincreases,and two years after hyperinflationwiped out all nominal debts,2000 out of Poland's 8000 major enterprisesyet to be privatized findthemselves once again unable to service their rapidly accumulating debts.There is little doubt that this number would grow if interest capitalizationon bank debt would stop.The debt overhang problem that has been created in the past two yearspretty much prevents straight privatizationthrough auctioning. Outsiders haveno way of knowing whether the firm's distress situation is due to inefficient

3management, due to very efficient management responding to perverse incentivesor due to the fact that the firm has no prospects at its current capitalstructure even under the best of management practices. This means thatenterprise restructuringhas become unavoidable in spite of widespreadagreement in the profession that this is best left to new private owners.An additional problem concerns the financial sector's role in all this.Western loan classificationpractices would show most of the banks recentlysplit off from the central bank to be insolvent, in most cases because of thevery debt servicing problems in the SOE sector I just highlighted.But banksare the major creditors of SOEs and claims on SOEs dominate the assetportfolios of the banks. These two facts make separate treatment of enterprisedebt and bank recapitalizationimpossible.Thus a successfulrestructuringplan needs to address both problems jointly. The current note identifies themain outstanding issues and proposes ways of addressing them within thegeneral framework and the current legal structure concerning privatizationanddebt restructuringin Eastern Europe.IIOBJECTIVES OF A SOUND RESTRUCTURINGPLANThe core objective is to restore efficient employment of industrialassets, both capital and labor. The more narrow objective of solving the debtoverhang of enterprisesand the portfolio quality problem in banks is aprerequisite for the wider objective.However, common sense and experienceelsewhere (for example Morocco's public enterprise restructuringin 1987)suggest that that is not enough. The debt problems arose for a reason; if thatroot cause is not addressed,the problems will most likely reoccur a few years

4from now, as they did in Morocco. Thus any sound restructuringplan will haveto include safeguardsagainst reoccurrence.Experience to date in Eastern Europe has shown clearly that it is maybepossible to run a clear-cut state enterprise efficientlyand that it iscertainly possible for a private enterprise to function efficiently.What isclearly not possible is, to run an enterpriseefficiently whose ownership andcontrol structure are in limbo. Thus a clarificationof medium term ownershipstructure should be the starting point of any plan. Similarly,clearassignment of control rights over the corporation,not in the medium term butright now, is essential to stop the destructive fights over control and thedecapitalizationthat are currently plaguing-mostenterprises.The first deci3ion necessary to achieve clarificationof ownershipstatus is whether the firm is to be privatized or even in the long run shouldremain in state hands. If state, the company should arguably be transferred toa separate agency that will deal with enterprises that are to remain in stateownership;'/the state as senior creditor and owner can take separate actionand afterwards establish an effective governance scheme. Incentive problems inpermanent state enterprisesare entirely different from those faced inenterprises about to be privatized; there is no obvious merit in combiningtheir control in one agency.For those enterprises that are not to remain in the state sector,reestablishingcentral control on an interim basis is unlikely to beeffective. No governancescheme can be effective if privatizationwill takeplace "somewhere" in the future, since managers in that case always have1 See Dervis and Condon (1992) for a defense of this approach, which wasfollowed in Hungary.

5incentivesto decapitalisethe firm and buy off worker unrest throughexcessive wage increases.This suggests that all firms not permanently putunder state ownership should be transformed into joint-stock companiesimmediately,with the intention to transfer these stocks to an effective ownerin the near future. The only proper safeguard against reoccurrenceof the debtproblems is a substantial accelerationof the privatizationeffort.For firms that currently succeed in servicing their debts, one of themany proposed privatizationschemes can be considered; a positive cash flowafter debt service means that a positive price is feasible through auction orpossibly bilateral negotiation. Such a sale does not necessarilyhave toinvolve cash up front; a strong case can be made to also seriously considernon-cash mechanisms, such as bank funded managementbuy outs. Otherwise wealthconstraintsmight limit the set of potential bidders too much, leaving outpotentially better entrepreneursbecause of ineffective capital markets.However auctioningoff enterpriseswith a heavy debt burden will mostlikely fail; under present management practice most of them are insolvent,which precludes straight auctioning off since a cash auction, for incentivereasons, will require a positive price. To see this, note what the effect ofa negative price at a cash auction would be: a transfer to a "buyer" of a lumpsum payment plus a negative net worth company (otherwisethe cash paymentwould not be necessary to begin with). Clearly the optimal thing to do for thebuyer is to simply take the money and walk away from the company; this would,with the state or state owned banks being the main creditors,once again meanstate ownership.The net result would then be a cash transferbut noprivatization.Problems with auctions are exacerbated if many firms are offered at the

6same time. In that case the informationproblem for potential bidders becomesalmost impossible to solve. However, the problems with negative price cashauctions do not mean tha. heavily indebted firms should not be privatized,butthat their debts need to be reduced prior to privatization.Liquidation,which is often proposed for enterprises that do notgenerate enough cash flow to service their debts, is both infeasible inpractice and likely to be excessively destructive;poor performance in manycases reflects as much distorted management incentivesas real insolvencyassuming sensible management incentives.A much more efficient way of debtrestructuringwould use the opportunity to introduce effective ownership intothe process. This suggests that conversion of some of the debt into equityshould be the main focal point of the restructuringexercise, rather than debtwrite downs and full collection of what remains. Debt equity conversion offersa more promising way towards efficient use of the assets controlled by theenterprises than liquidation into a thin capital market and a depressedeconomy does.Privatizationis in fact most efficiently done within the context of thedebt restructuringplan. After all, debt restructuringand work outs willinvolve changes in the modus operandi of the firm; to make such decisionswithout involving the ultimate owners is likely to be inefficient in that italmost guarantees the need for further reorganizationsonce new owners takeover. Thus there is a high priority to devising ways of bringing privatizationinto any debt restructuringscheme.The situation is different for commercialbanks. While there is littledoubt that they need to be privatized eventually if they are to operateefficiently,the combination of de facto if not de jure deposit insurance and

7informationasymmetriesmakes this industry exceptionallyvulnerable to fraud.There is now widespread consensus in the economics profession that the fastestway towards a socializedbanking system is complete liberalizationwithouteffective regulation.Chile's banking collapse in 1982 after a no holds barredliberalizationeffort is only the best known of many such crises. On thesegrounds, actual privatizationof the commercialbanks may be best delayeduntil an effective regulation framework and mechanisms for enforcement ofprudential rules are in place.This also means that working towards establishingsuch mechanisms is ofthe utmost importance;a really efficient banking system cannot be expected tocome in operation until that time. In the mean time, half way solutions can beimplemented,following the Mexican example in financial sector reform: run thebanks, while still state owned, on an "arm's length" basis until regulation isin place, at which time they can be privatized. This makes the provision ofproper incentives to bank managers a particularly thorny problem. Since muchof what will be proposed below hinges criticallyon the banks exercisingeffective control over their onsets, such reforms are also critical for thesuccess of the enterprise reforms.IIIPRIVATIZING PROFITABLE INDUSTRIESThere is widespread agreement that privatizationis the ultimate answerto Eastern Europe's problems, and that it should be done fast. Neverthelessnot a single country has been able to implement privatizationat a significantscale beyond simple single establishmentservice sector firms. Everywheremassprivatizationschemes have either been abandoned or are stalled; even Czecho-

8Slovakia'svouchers scheme has been delayed by almost two years. So what is itthat the initial advice overlooked?Why is privatizationso much moredifficult than initially thought?The initial discussions focused mostly on how to promote widespreadshare ownershipwithout diluting corporate control and on whether thegovernment should also pursue revenue objectives (Tirole (1991)). For smallestablishmentsthere is only one owner so the effective control issue does notarise. In most mass privatlzationschemes the effective control objective ispursued through establishmentof intermediaries(investmentfunds). Themonitoringof the funds themselvesis an unresolved issue. Since most of theprivate sector emerged from communism completelydecapitalized,Mexican or UKstyle auctioningwould have been impossible;a serious stock-flowproblem(financingthe purchase of the capital stock out of the flow of currentsavings) precludes prices anywhere near discountedfuture earnings. Thus bothPoland and Czecho-Slovakiasettled for give away schemes at nominal fees.Exceptionswere made where dominant investors could be found, usuallyforeigners;in that case firms were to be kept out of the mass privatizationschemes.All this sounds well thought through and workable; so why has n't itworked? With hindsight three major issues were overlooked, each importantenough in itself to block serious progress. The first issue derives from themost striking differencebetween SOEs in Eastern Europe and say Mexico and theUK: in the latter two countries state enterprises,by the time privatizationcame under consideration,were tightly controlledby an effective centralauthority. The situation was the same in Eastern Europe until the earlyei

Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized . Bakker, Kemal Dervis, Olivier Godron, S. Ramachandran and Lawrence Summers of the World Bank, and Stefan Kawalec and Slavomir Sikora of the Ministry of . 1 See Dervis and Condon (1992) for a defense of this approach, which was

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