Viewpoint Note No. 123 July 1997 Privatization and Restructuring in Central and Eastern Europe Robert E. This Note reports on the first comprehensive analysis of the industrial restructuring that has Anderson, taken place since 1992 in Central and Eastern Europe. The study, covering more than 6,000 Simeon Djankoz. Gerhard Pohl, industrial firms in seven countries, looks at which government policies have been most effective anid Stijn at speeding up enterprise restructuring. The results show that privatization is the single most Claesso1 s important factor in restructuring. The method of privatization has been less important: to date management buyouts and massive giveaways of firms through voucher privatization have led to results similar to those of case-by-case sales to foreign or domestic investors. The study also shows that privatizing industrial and commercial firms is the most effective way to improve the solvency of the banking sector-more effective than bank recapitalization or debt forgiveness. The approach Slovenia. The number of firms in the sample for eachi country ranges from 700 to 1,000, and they The study compares the extent of restructuring account for 40-90 percent of employment in by firms in seven Central and Eastern European manufacturing (table 1).1 The governments in countries: Bulgaria, the Czech Republic, Hun- the seven countries have used different policies galy, Poland, Romania, the Slovak Republic, and to encourage restructuring, and comparing en- terprise performance in these countries should shed light on which have been most effective. The study tests the restructuring data for the TABLE 1 FEATURES OF THE DATABASE effect of such policies as: rapid privatization, concentrated outside ownership (for better gov- Employees as a ernance), wage growth restraint (to allow cash percentagenofatotal flow to improve and fund restructuring), finan- CouyFirs Employees mact cial discipline (a firm is more likely to restruc- Country________Firms______ 1992_____ employment_________ ture if neither the government nor banks finance Bulgaria 828 314,042 48 its losses), and maintaining debt obligations Czech Republic 706 829,312 64 (firms may have a greater incentive to restruc- ture if banks do not forgive or reduce debts). Hungary 1,044 428,645 41 The data are subjected to econometric analysis Poland 1,066 1,338,645 45 so that the impact of various government poli- Romania 1,092 Z121,102 91 cies can be separated from other factors includ- Slovak Republic 905 578,737 93 ing size, sector, and initial productivity levels. Slovenia 727 219,959 90 The measures of restructuring used in the study include profitability, proportion of firms with 0g| The World Bank Group * Finance, Private Sector, and Infrastructure Network Privatization and Restructuring in Central and Eastern Europe a positive operating cash flow, average oper- TABLE 2 PROGRESS IN PRIVATIZATION, 1995 ating cashflow as a percent of revenue, growth in labor productivity, growth in total factor productivity, and growth in exports. The data show that for each firm these measures tend Manufacturing Manufacturing firms to be highly correlated. The econometric analy- Country firms weighted by output sis focuses on the two most reliable indicators of restructuring: growth in labor productivity Bulgaria 8 7 and growth in total factor productivity.2 Czech Republic 89 93 Hungary 67 65 The study defines a "privatized" firm as one Poland 61 60 that has had more than a third of its shares Romania 15 12 transferred to private investors. It measures the extent of privatization in a country, by using Slovak Republic 79 83 both a simple count of the firms classified as Slovenia 41 41 privatized and a count weighted by output to reflect differences in size. On both measures, Source:Authors'estimates. the Czech Republic, Hungary, and the Slovak Republic come out ahead, while Bulgaria lags TABLE 3 ANNUAL LABOR PRODUCTIVITY GROWTH, 1992-95 behind, having made little progress in privat- ization (table 2). (percent) Impact of privatization Country Privatized firmsa State-owned firms All firms The data show that labor productivity grovwth Bulgaria 12.4 -1.4 -1.4 across the seven countries averaged 7.3 percent Czech Republic 8.6 -2.6 6.8 a year for privatized firms during 1992-95, but Hungary 6.0 3.2 4.8 -0.2 percent for state-owned firms (table 3). The Poland 7.5 1.4 5.4 econometric analysis indicates that privatization Romania 1.0 -0.5 0.1 accounts foralmost all this productivity growth. The only exception to the rule is Hungarv, where Slovak Republic 1.8 -4.1 5.1 state-owned firmls achieved half the productiv- Slovenia 7.2 1.8 3.6 ity gains of Drivatized firms. in Bulgaria and Romania, where privatization has been insig- Average 7.3 -0.2 3.6 nificant, productivity in state-owned firms is de- clining, pulling down labor productivitv for the a. Firms privatized by 1995. Source.:Authors'estimates. manufacturing sector as a whole. Results are similar for the productivity of all factors of production. The cumulative gains in (percent, cumulative) total factor productivity for privatized firms far 15 exceed those f'or state-owned firms in the sample (figure 1). The analysis shows that pri- 12 vatization has increased total factor productiv- ity growth by about 4 percentage points a year. 9 r vatizedirms The data also show that even a credible threat 6 of privatization promotes restructuring. For ex- 3 _ ample, in Polancl, where the government's com- State-owned firms mitment to privatization was perceived as 0 credible, the firms included in the mass privat- 0 1 2 3 ization program began to show rapid improve- Years since privatization ment in profitability in 1994 and 1995-long Source: Authors' estimates. before they were formally privatized in Novem- ber 1995. One possible explanation for this is that managers, expecting to be held account- able by the future new owners, improved their FIGURE 2 ANNUAL GROWTH IN LABOR PRODUCTIVITY performance. Government plans for large-scale AND REAL WAGES FOR PRIVATIZED AND privatization programs appear to boost produc- STATE-OWNED FIRMS, 1992-95 tivity in state-owned firms, probably because (percent) of similar anticipation and signaling effects. 15 Labor productivity * Privatized firms State-owned firms Method of privatization 12 Bulgaria - Manv foreign advisers to the governments of Slovak Republic Czech Republic transition economies initially believed that mass 6 Hungary * privatization and insider buyouts would lead to 3 Hungary weak pressures to restructure and that the pre- a Romania Slovenia Poland Real ferred strategy should be sale to strategic inves- Bulgaria . cR nia wages tors. But the study finds no significant differences -3 Czech Republic Slovak Republic in the effectiveness of privatization methods. -64 Productivity growth for privatized firms iss -4 -2 0 2 4 6 8 10 lar in the Czech and Slovak Republics, which Source:Authors estimates. chose mass privatization, and in Hungary and Poland, which have relied more on case-by-case TABLE 4 AVERAGE ANNUAL INVESTMENT PER WORKER, privatization (table 3). Also in the Czech Re- 1992-95 public, where data on the results of different (U.S. dollars, purchasing power parity) privatization methods are available for a suffi- cientlv long period, the studv finds only minor Country Privatizedfirms State-ownedfirms differences among the methods. But it finds strong effects of ownership concentration on Bulgaria the speed of restructuring (Viewpoint 111). 2390 90 Czech Republic 3,290 470 The role of wage restraint Hungary 2,990 460 Poland 1,880 410 Restructuring is likely to be encouraged if the Romania 590 110 workforce does not initially absorb all the pro- Slovak Republic 3,340 230 ductivity gains through higher wages. Firms must finance much of their investment with Slovenia 1,690 310 retained earnings from current cash flow espe- Source:Authors'estimates. cially when the financial system is weak. But this demands new habits. While firms in in- FIGURE 3 SHARE OF NONPERFORMING LOANS TO dustrial countries have relied mostly on inter- INDUSTRIAL FIRMS, 1992 AND 1995 nal cash flow to finance working capital or new investment, firms in the formerlv socialist Bulgaria 1992 economies have relied heavily on loans from CzechRepublic state-owned banks. Hungary The study finds that privatized firms have re- tained most of the large productivity gains from Poland privatization to finance productivity-enhancing Romania investments. Labor productivity has grown faster than real wages in privatized firms in all Slovak Republic countries (above the diagonal in figure 2). That does not mean that real wages in privatized Slovenia firms did not also grow rapidly. But since the _ firms maintained a large margin between labor 0 10 20 30 40 50 60 70 productivity and wages, they were able to sus- Percent tain high levels of investment per worker (table Source: Aathors' estimates. 4). By contrast, real wage growth in state- Privatization and Restructuring in Central and Eastern Europe owned enterprises has exceeded labor produc- tion in the banks unnecessary. By contrast, in tivity gains, eroding internal financing. countries that have done little or no privatiza- tion, firms' financial conditions did not improve The analysis shows that privatization has had and the banks' bad-loan problems are worse a greater effect on wage restraint than govern- than the pessimists expected (figure 3). The ment wage policies. Most of the seven coun- speed of privatization of the industrial and com- tries had a policy of limiting wage increases mercial sectors has proved to be the most im- (though by 1995, all countries had market- portant policy issue for the financial sector. determined wages). For example, the Czech Republic, Hungary, and Poland each introduced Conclusion an excess wage tax during 1991-94. But even though government-led wage restraint applied One of the most important policy questions in primarily (or exclusively) to state-owned firms, the transition economies is what governments wages grew faster in the state sector than in can do to speed the restructuring of firms and the private sector in both Hungary and Poland. thus hasten the transition to a mature market And in Bulgaria and the Slovak Republic, which economy. The study provides some answers. pursued more vigorous wage restraint in the Rapid and comprehensive privatization lead- state sector, real wages still outstripped pro- ing to concentrated ownership encourages ductivity in state-owned firms-but not in the restructuring. Privatization also promotes re- private sector. structuring because privatized firms are more Viewpoint is an openlieytasae-w d forum intended to likely than state-owned enterprises to exercise encourage dissemina- Financial restructuring and the role of wage restraint-and wage restraint is vital to tionl of and debate oni banks free up internal finance. Policies that increase ideas, innovations, and best practices for bank lending to firms, such as debt forgive- expanding the private What actions, if any, should governments in the ness and recapitalization, may do more harm sector The views region take to encourage the financial restruc- than good. The safest course is to recapitalize published are those of the autbors and should turing of over-indebted firms. In industrial coun- banks only as part of privatization and to en- not be attributed to the tries, most financial restructuring takes place courage negotiations for financial restructur- World Bank or any.of its through private negotiations between private ing onlv after the banks are privatized. affiliated organizations. Nor do any of the con- lenders (mostly banks) and private firms. But in oSlasions represent transition economies most of the banks and This Note is based on a paper by the atihors of the same title (World Bank Technical tPaper 368, WXashington. D.C., 1997). Official policy of the manxv firms are still tinder state ownership, so To ensure comparability, the studv adjusted the data to reflect World Bank or of its Executive Directors the incentives to negotiate are different. Many differences in accounting standards both over time and among or the countries they banks in the region inherited large portfolios of ntries an exclue u tlpa t es.a king, and agficultura firms and represent. nonperforming loans when state enterprises, sUbsectcars-mostlv food, textiles, chemicals, metals, machinery, To order additional suddenly exposed to competition, started run- and transport eqLlipment-is similar across the countries. copies please call ning big losses. Atidits done in accordance with 2 Labor productivity (value added per man-houLr) does not take into accoLunt deprecidion, debt service, anti taxes, which are more 202-458-1111 or contact international accounting standards showed that likely to cliffer from country to ccuntrsy because of hiistorical cir- Suzanne Smith, editor, Room F6P-188, up to 60 percent of the banks' loans were con- cumstances, differences in tax laws, or accounting standards. The World Bank, sidered irrecoverable. The usual advice at this 1818 H Street, NW, point was for the government to take over the Robert E. Anderson (anderson9@&worldbank. WashIngtonDC 20433, bad loans and recapitalize the banks (usually org), Senior Private Sector Specialist, Simeon ssmith7@worldbank.org. through an asset swap). Djankov (.sdjankov@ worldbank.org), Financial The series is also Economist, and Gerbard Pohl (gpohl@ available on-line (www.worldbank.org/ The study's analysis shows that this course was worldbank.org), M1anager, Europe and Central ltml/fpd/notes/ premature. In countries that pursued large and Asia, and Middle East and Aborth Africa Tech ni- notelist.html). rapid privatization programs, privatized firms cal Department, and Stijn Claessens (claessens@ ® Printed on recycled have improved their profitability much more worldbank.org), Principal Economist, EastAsia paper. than expected, making government interven- and Pacific V7ice-Presidency