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III
Transforming Management, Labor, and Production



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Transforming Post-Communist Political Economies III Transforming Management, Labor, and Production

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Transforming Post-Communist Political Economies This page in the original is blank.

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Transforming Post-Communist Political Economies Restructuring Production Without Market Infrastructure Judith Thornton The aim of economic reform is to provide a framework of laws and institutions that will further freedom and prosperity. In pursuit of this aim, the reforming economies have attempted to privatize firms, liberalize markets, deregulate access to markets, and redirect the role of the government to the provision of economic and social infrastructure and the securing of individual rights. Several of the Eastern European and Baltic countries are succeeding in building a healthy private sector and reorienting economic activity to the world market. However, although Russia and many of the republics of the former Soviet Union have pursued privatization with no less vigor, a successful restructuring of production continues to elude them. In 1996, official data set the level of real gross domestic product in the Commonwealth of Independent States at only 52 percent of that in 1989 (European Bank for Reconstruction and Development, 1996:112). This essay examines the key elements of economic reform and their application in the context of the transition economies of the former Soviet Union. Why have some economies succeeded in rekindling growth while others have failed? The difference lies in the extent to which these economies have succeeded in putting in place the institutional infrastructure needed to support competitive production and investment, rather than rent seeking, subsidy seeking, or influence activities. The economies differ in the extent to which they have provided the legal, financial, and administrative infrastructure required to support a competitive nonstate market sector.

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Transforming Post-Communist Political Economies CREATION OF MARKETS What does economic reform mean? Creation of markets is a crucial first step. Central planning relied on administrative direction and sanctions to direct resources to centrally determined tasks. The widespread emergence of black or gray markets for goods signaled the costs these systems faced from the absence of legal alternatives to planned allocations. After economic reform, as the structure of domestic production adjusts to consumer preferences and world market opportunities, competitive product and factor markets must play the central role in directing resources to higher-value activities. In the absence of institutions supporting open markets, producers may construct alternatives, such as networks of closed relationships, privately enforced, but such arrangements are likely to stunt economic growth. Emergence of Private Producers Reform implies the emergence of nonstate producers who face hard budget constraints and competition. Private producers will bear risks, reap the benefits and costs of their activities, and thus have incentives to move resources to higher-value uses. In the reform economies, a population of competitive producers can emerge from the privatization of existing state producers, from the entry of new firms, and from an inflow of foreign capital and management. An opening of domestic markets to international trade will bring the discipline of market competition as well. Creation of a nonstate sector implies an end to the state's monopoly on ownership of productive resources and the emergence of private owners with the incentive to use resources productively. But establishment of private property rights requires legal, financial, and administrative infrastructure to define and enforce ownership rights. It implies a significant redefinition of the role of the state, which is no longer the owner and allocator of resources and capital, but is rather the means for providing social infrastructure and public goods. Redefinition of the Role of the State Thus, most importantly, reform implies the creation of a separate tax-based state with the capacity to supply social infrastructure and public goods. A separation of government revenue from ownership of capital provides greater transparency in both the capital market and the public sector. Government taxes and subsidies become explicit in the government budget, rather than implicit in government prices and allocations. If the central functions of the administrative state were ownership and control, then the central functions of the market-oriented state are provision of institutional infrastructure, social insurance, and public goods.

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Transforming Post-Communist Political Economies It follows that the role of the state is very different in the planned and market economies. In the prereform era, state controls supplanted much of the institutional infrastructure of a market economy, overriding contract law with administrative practice. Thus, elimination of state control involves rebuilding the rule of law and the capacity to enforce a framework of rules of the game. It involves rebuilding a capacity to manage the macro economy by means of monetary and financial policies, to establish independent financial institutions, and to provide public goods and a social safety net. Restructuring of government will involve building local governments with the capacity to provide local public goods and agencies at all levels that will provide more public services and less regulation. Structural Change, Investment, and Growth Initial reform policies—liberalization, stabilization, and privatization—have set some of the Eastern European transition economies well on the road to integration with Europe. But successful implementation of each of these policies assumes the existence of supporting institutions and minimum levels of governmental administrative capacity. Where such infrastructure is lacking—notably in the republics of the former Soviet Union—the desired policy results have been more difficult to achieve. The second stage of economic reform involves a still more difficult process, the reallocation of labor, capital, and management from subsidized state sectors to expanding export and consumer-oriented sectors. Eastern Europe has had considerable success in mobilizing domestic saving and attracting foreign investment, while Russia and the Commonwealth of Independent States continue to suffer capital flight. Initial Conditions and State Dependence The task of restructuring production is hampered by initial conditions. The Soviet Union shared with Eastern Europe a bureaucratic power structure controlled by a communist party and oriented toward the maintenance of political power. Yet the legacy of the Soviet system serves as a more serious impediment to restructuring in Russia than in Poland, Hungary, Czechoslovakia, or even Estonia. The classical Soviet system was a highly centralized bureaucratic hierarchy that produced distorted incentives, biased information, and high levels of lobbying. Its structure protected bureaucratic monopolies and allowed party leaders to pursue political objectives at the expense of economic performance. Ericson (1991) depicts a system that lacked rudimentary incentive-compatibility or market-based flexibility. This system had the following characteristics:

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Transforming Post-Communist Political Economies A hierarchical structure of authority Rigid centralized planning A commitment to maximal tautness Widespread rationing of goods and services Exhaustive price control A lack of flexibility, and in particular the lack of a true money The lack of legal alternatives to central plans Absolute and arbitrary control by superiors of plan assignments, performance evaluation, and rewards Plan-oriented incentives that ignored the economic consequences of decisions Many features of postreform Russia still reflect this Soviet legacy: the long bureaucratic channels between local and central levels, the largely uneconomic dispersal of production, a heavy military burden, and the burden of implicit subsidies provided by policymakers during the first years of reform. The poor information features of Soviet bureaucracy were particularly harmful. Good decisionmaking requires accurate information about the options available and the likely consequences of each choice—information that is best obtained directly from people on the spot who can seek out alternatives, gather evidence, and forecast consequences. But opening a decision process to participation by individuals with a stake in the outcome increases the resources devoted to lobbying, and these lobbying costs are greatest when a decision redistributes a large amount of wealth. Thus lobbying costs must be balanced against the increased information lobbying provides (see Milgrom, 1988; Milgrom and Roberts, 1990). One way to reduce rent seeking is to limit the distributional implications of decisions, a step that may also sharply reduce the bureaucracy's capacity to adjust to changed circumstances. Another is to limit communication by denying individuals in the hierarchy access to the information they would need to politic effectively, a step that reduces the accountability of top-level decision makers and reduces the information on which central decisions are based. The sheer size of the Soviet economy meant that the resources at stake in government decisions were enormous, creating significant incentives for individuals in the decision-making hierarchy to lobby and to distort the information on which decisions would be based. Local interests took advantage of long bureaucratic channels and local control of information to supply biased reports. Decentralization, attempted by Khrushchev and Gorbachev, limits influence activities by eliminating the central authority altogether, but decentralization when there are no markets leaves decentralized actors without effective means of coordination. The informal economy is a product of this need for horizontal links.

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Transforming Post-Communist Political Economies Moreover, allowing decentralization without establishing a legal framework for private ownership is likely to give managers access to rents, leading to a drain of resources from the state-controlled sector of the economy to the informal or illegal sector. Poznanski (1997:276-277) refers to this process as ''creeping capitalism": From the very beginning, a total shift of control to the centre proved to be impractical, this because of lack of information. . . . With time these informal spheres of free action have gained ground, this process, to a degree, being helped by official reforms. Those communist-era systemic reforms that delegated authority down the decision-pyramid, even if short-lived, were conducive to such expansion. Any reversals in the reform course were helpful because they brought in an element of confusion that served lower-level agents to hide their activities. Personal incentives to work outside of official directives—the central plan—increased further with a decline in the level of coercion. With the practice of subverting the system for personal gain reaching all layers of the system, including the center, interest in applying coercion has subsided. And when in use, coercion was increasingly applied for extracting personal gains as well. As the government began issuing trading concessions and production permits to members of the political elite, argues Poznanski, a system of what he calls "political capitalism" emerged in Poland. In this system, political power was used by party bosses, state officials, and the police to acquire and safeguard private wealth. The alternative to political capitalism is legal private property. The Socialist Firm The institutional features of the socialist firm were similarly perverse. The exercise of state ownership of productive assets left property rights poorly defined, difficult to measure, costly to enforce, and difficult to transfer. Control rights to assets were vested in the political elite that exercised control through an administrative bureaucracy. Cash-flow rights were assigned to the citizens, since they would bear the benefits and costs of decisions in the level of their standard of living. Officially, returns to capital and resources were supposed to be centralized in the treasury in the form of profits, taxes, and charges for resources, but in practice, administrators who enjoyed control rights could assign subsidies and impose costs by the policies they pursued. Although the institutions of the command system denied individuals legal ownership rights to most physical assets (tenancy rights to housing were allowed), they afforded the elite control rights over the vast rents generated by administrative allocation. Thus, corruption was commonplace. Sometimes, corruption can serve to circumvent bureaucratic obstacles. However, while corruption allows an allocator to "sell" market access at a shadow price re-

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Transforming Post-Communist Political Economies flected in the market for bribes, there is no legal way to enforce a bribe contract, so property rights remain insecure. Moreover, since control of access rights is a potential source of power and wealth, corruption creates incentives to increased regulation, resulting in a proliferation of regulators, each attempting to hold the producer hostage on a different margin. Governance of enterprises within the ministerial hierarchy raised agency problems on every margin. The enterprise manager, an agent, faced multiple principals (such as the party, the ministerial authorities, the treasury, and local authorities) whose incentives were likely to negate each other. These principals claimed enterprise surpluses and bailed out losses, taking on much of the risk the enterprise faced. While in theory the enterprise manager had few control rights over resources, in practice his control over information and his ability to trade off unmeasured dimensions of performance against measured performance indicators gave him substantial benefits of ownership. On the other hand, as central authority deteriorated in the 1980s and as nominal price controls created increasing excess demand, managers more and more frequently had to bribe allocators to gain access to supplies (Shleifer and Vishny, 1994; Boycko et al., 1995). In spite of extremely high levels of monitoring, the enterprise overstated costs, concealed true capacity, diverted resources to local purposes, and avoided innovation. Changing institutional arrangements to improve incentives and increase flexibility in the Soviet system was a daunting task. Restructuring of the Socialist Firm If the centralized Soviet Ministry was a feudal barony, then the enterprise subordinate to it was a principality. Kotkin's (1991:1) depiction of the Magnitogorsk Works in Steeltown, USSR, is instructive: Forty-three kilometers around, the Magnitogorsk Works, a dense mass of smokestacks, pipes, cranes, and railroad track, consists of 130 shops, many of which are as large as whole factories. "Steel plant" would be an inadequate description of the complex formed by an ore-crushing and ore-enriching plant, a coke and chemical by-products plant, 10 gigantic blast furnaces, 34 open-hearth ovens, and dozens of rolling and finishing mills. The Magnitogorsk Works produces more steel each year than Canada or Czechoslovakia and almost as much as Great Britain. The metallurgical complex dominates city life in every way. The works owns apartment buildings in the city housing two hundred thousand people, eighty-five children's institutions, several hospitals, a number of nearby resort complexes, and an entire agricultural system of state farms and greenhouses in the surrounding countryside. Ivan Romazan, the director of the Magnitogorsk Works, oversaw not only production, but also the political administration of almost all social life in the

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Transforming Post-Communist Political Economies city. Through his influence in the Moscow Ministry, he was responsible for ensuring delivery of the centrally allocated resources to everyone from the mayor to the plant managers. Through his role in the Communist Party nomenklatura, he selected these managers in a system where one's position in the bureaucracy constituted one's primary wealth. A restructuring of the Magnitogorsk Works involves more than privatizing a firm that employs 60,000 workers. It means creating an institutional framework for civil society in a city of 440,000 people. Moreover, it means creating the labor and housing markets needed to allow a considerable part of the population to leave "the largest assemblage of obsolete equipment in the country" for a city with better prospects. THE ROLE OF INSTITUTIONS What are the institutions whose absence impedes adjustment? First and foremost, they are property rights and markets, but the provision of property rights requires rule of law as a foundation. Institutions are sets of formal and informal rules that constrain behavior in society. According to North (1991:3): "Institutions reduce uncertainty by providing a structure to everyday life." Institutions provide a framework within which individuals seek to coordinate their separate activities and insure against risk. They structure incentives and constraints, define procedures for changing the rules, and delimit membership. The institutional framework of society includes both the formal and informal "rules of the game" and the resulting organizations people create and within which they interact to reach their individual and collective goals. Formal rules, such as laws and contracts, define the rules of the game and give people the rights and mechanisms to enforce the rules. Informal rules of the game depict individuals' expectations about the uncertain consequences of actions and events. They take into account the real-world costs of negotiating agreements, monitoring compliance, and enforcing sanctions. When the formal rules of the game provide incentives that are consistent with individual self-interest, actual behavior will generally conform to formal rules. But when the formal rules of the game conflict with individual self-interest, individuals will have incentives to evade the rules and, if there are penalties for evasion, to conceal their actions. The vast gulf between the formal rules and the de facto practice of the command system tells us that the perceived benefits of violating the rules were sufficiently large to outweigh significant penalties, which were enforced with high levels of monitoring. How does an economy's institutional framework influence the forms of governance of organizations? In a market system, there are few legal constraints on the form organizations adopt. Individuals will attempt to choose arrangements that reduce the costs of governance in order to minimize the sum

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Transforming Post-Communist Political Economies of production and transaction costs. They will trade off agency costs against the resource costs of preventing agency problems. In an administrative bureaucracy, where bureaucrats receive a small share of the benefits and costs of their decisions, the state will impose regulatory constraints on decisions and monitor results in order to prevent deviation from centrally set goals. In the Russian bureaucracy, both principals and agents have incentives to seek arrangements that give them control of information influencing the division of income. For example, low-cost producers will seek to conceal their true profits in order to retain a larger share, while government principals may seek to hide the true value of centralized resource rents from both enterprises and regional authorities who enjoy some de facto control rights to local resources. Since agents have incentives to divert resources from joint activities to their separate benefit, the authorities will attempt to create strong restrictions to local initiative. Moreover, if the political elite, as principals, gain security by their ability to monitor decision makers at lower levels in the hierarchy to prevent challenges to their authority, the state system will not necessarily have incentives to reduce monitoring costs, either. With collusion, there will also be costs of monitoring the monitors. So in sum, state-owned institutions burden citizens with an inefficient partitioning of property rights and deny them governance mechanisms that would allow them to contract around inefficiencies. The Role of Property Rights The success of an economic system depends on how its institutions structure the incentives to produce wealth, to capture wealth, and to protect wealth. Property rights are a key institution in this process. Property rights are rules of the game that may be defined by formal laws or administrative practices or may be codified in informal custom. They define the forms competition for resources may take in society. Consider two individuals, A (with an endowment of wine) and B (with an endowment of cheese). What institutional arrangements would allow both individuals to consume both commodities? The form of the transfers from one party to another will depend, in part, on whether each individual respects the other's property rights. If property rights were not protected, A could steal B's cheese, transferring ownership without compensation. If B has to incur high costs to protect herself from theft, then the value of her property will be much reduced. Alternatively, A could threaten B with violence. In this case, A would have transferred property rights to B's person, but he would allow B to purchase the rights back with an appropriate amount of cheese. Voluntary market exchange will occur only if each individual recognizes the other's property rights. (For systems with private

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Transforming Post-Communist Political Economies protection and private capture, see Hirshleifer, 1995, and Grossman and Kim, 1995.) Private property rights create incentives to produce wealth by internalizing the benefits and costs of the owner's actions with the owner. Private ownership means that an owner can control the use of an asset and exclude others from using it, that one has the right to enjoy benefit or income and the right to transfer. Ownership also implies the responsibility to bear the costs of one's actions. Gaining these rights of ownership, individuals have incentives to create and maintain productive assets. When property rights to valuable income streams are not defined and enforced, individuals have an incentive to spend real resources to capture such rights. Such a competition will tend to dissipate (or, with uncertainty, more than dissipate) the value of ownership. If the private protection of property is costly, individual incentives to produce and maintain resources will be reduced. Further, some of the resources available for productive use will be diverted to attempts to capture wealth or prevent such capture. Property rights not only define the individual's rights to capital, but also define people's rights to their own skills and abilities. That is, liberty implies the right to direct oneself and to own the fruits of one's effort. The link between property rights and civil rights is demonstrated in the case of China. In prereform China, political authorities held the right to direct individuals to a place of work and to define the conditions of their employment. These control rights over labor were enforced by a rationing system that gave individuals access to rations of basic commodities at their place of employment. But as soon as agricultural reforms created a free market in food, it became much easier for workers to move from place to place in search of better work opportunities, giving them greater de facto property rights over their own human capital. As is true of all institutions, it is de facto and not de jure property rights that will determine people's incentives to act and will shape the organizations they establish. The Supply and Demand for Institutional Change Private owners who receive the gains from moving resources to higher-value uses will have incentives to create institutional arrangements supporting such transactions. Thus, resource owners have incentives to create market institutions that define and enforce property rights at lower cost. Moreover, differences in initial endowments and tastes for risk and incentives to enjoy specialization and economies of scale will lead individuals to establish institutional arrangements that allow them to partition property rights in a variety of different ways. If the institutional framework allows, an owner may choose to farm her land herself or to hire a tenant. She may lease her fields to the tenant in exchange for a fixed payment, leaving him free to select

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Transforming Post-Communist Political Economies The state-owned Russian firm produced its output in response to government demands, serving a multiplicity of goals other than profit making. Managers enjoyed considerable leverage as a result of their superior knowledge of the firm's true capability, and exercised that leverage by diverting resources in directions that served their separate interests. The main skill of a successful general director was his ability to pry scarce supplies out of the center, not knowledge of production, marketing, or finance. The legal rights of residual claimancy belonged to the state. In most markets, existing firms began reform with redundant labor, outmoded technology, and production processes selected in a protectionist environment—that is, in response to the wrong prices. Successful restructuring of the firm, then, means bringing control and cash-flow rights together through privatization. It also means eliminating political capitalism as the primary determinant of enterprise success. In the case of firms with many owners, the goal of bringing control and cash-flow rights together implies creating institutions for corporate governance and providing the legal infrastructure to support governance. The weaker is corporate governance; the more concentrated must be ownership. In practice, ownership rights in larger Russian firms are split among several groups, and the legal and financial infrastructure needed to support governance is just beginning to emerge. Restructuring of firms is inseparable from creation of input and output markets. Price liberalization and an opening of the economy to the world market present producers with new customers, domestic and foreign, and with new sources of competition. In consequence, firms face rapid changes in relative prices and in market demands. Berkowitz and DeJong (in this volume) find evidence that an integration of consumer markets is, indeed, under way, indicated by comovement of prices across Russian cities. Market integration brings changes, as well, in the relative profitability of various economic activities and in the valuation of assets used for production. Many former directions of production are unprofitable and cannot compete, but there are windfall gains and unfilled market niches elsewhere, and, in the short-run, opportunities for arbitrage between domestic and foreign markets. What must a firm do to survive in a competitive market economy? It will have to produce in response to private, rather than government, demand, supplying products that can be sold in competition with new domestic and established foreign competitors. Especially in neglected consumer sectors, opening to the foreign market brings in cheaper, better-quality foreign products, so domestic producers will need a rapid infusion of know-how and technology if they are to survive. Those firms that adapt will have managed to separate out a few productive pieces from a former industrial complex such as Magnitogorsk, shortening hierarchies and bringing information and decision making closer. They will have to sell off unneeded facilities and housing and transfer social over-

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Transforming Post-Communist Political Economies head capital to private firms and the municipal government. They will employ a substantially smaller labor force than they used in the past and be producing a new mix of products. Only when such a substantial restructuring appears probable will outside investors be willing to risk capital in the privatized firm to accomplish the necessary renovation. These changes, again, require market-supporting infrastructure and a market-oriented state. Only when the institutional base supporting property rights is stronger will inside managers be willing to direct profits to long-run investment. Major restructuring is likely to require the replacement of the Soviet-era general director and his deputies with new managers who have a radically different mix of skills and face different incentives, including the long-run incentives of ownership. Kuznetsov (in this volume), says the new managers must be turn-around specialists who can chart new directions and introduce new technologies. They are unlikely to succeed without links to the world market. However, in Russia, there are information problems in both the market for management and the market for equity that may raise the search costs of finding a new manager. Brown (1997) captures key features of the Russian market for managers. With poor disclosure of the financial condition of firms, firms do not receive a signal of the ability of outside managers. Firms can eliminate the adverse selection problem by offering managers a performance-based contract that screens out low-ability managers, but managers require a large risk premium for a performance-based contract since they, in turn, do not know the true financial condition of the firm offering the contract. Stronger incentives and better managers are complementary changes. Johnson et al. (in this volume) suggest they might be so strongly complementary that neither change would yield results alone. Case studies of enterprise restructuring in Poland indicate that an infusion of new management skills is crucial to restructuring (Johnson and Loveman, 1995). Blasi et al. (1997) report that 33 percent of large and mid-sized firms in their sample had replaced their general director between 1992 and 1995. They observe that the larger was the share of outside ownership, the higher was the probability that a firm would have replaced its top manager. Many firms will not survive. Some may continue to produce in the short run if they cover variable costs, but their owners will not reinvest net revenues. In an environment with high political and economic risk, it may be in the interest of some asset holders to strip the existing firm of its assets, to harvest its resource stocks rapidly, and to move the portfolio offshore to an environment with lower risk and more secure property rights. Until legal and financial infrastructure are in place, a conservative portfolio manager may well wait to exercise an option to invest in the Russian economy.

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Transforming Post-Communist Political Economies The Demand for Financial Institutions The underdevelopment of the Russian financial market is a major constraint on the restructuring of existing firms and on the emergence of a new private sector. Private lenders provide vital discipline in Western financial markets, where banks, lenders, and trade creditors have the ability to monitor performance, establish restrictions on the policies of borrowers, and, ultimately, obtain control of the assets of an insolvent borrower. But in Russia, the legal and administrative foundations for well-functioning financial markets are still incomplete. Private property rights to land are missing or incomplete, it is difficult to use property as collateral for lending, bankruptcy laws are in their infancy, and the legal infrastructure for enforcing contracts is weak and subject to political influence. There are major information problems in assessing the performance of firms and banks. As a result of these shortcomings, savers lack confidence in domestic financial institutions, and financial institutions, such as banks and stock markets, play a limited role in mediating between savers and investors. With more than 60 stock exchanges and over 2,500 banks, 90 percent of stock trading is done over the counter and settled offshore. A well-functioning financial system is essential to the process of restructuring. Trade liberalization leads to the collapse of noncompetitive activities, but without an infusion of management know-how, new investment, and new technology, new competitive sectors are slow to emerge. A well-functioning financial system would mobilize savings and direct investment to activities with the best prospects for profitability. In the past 8 years, in spite of weak infrastructure, Russia has seen the rapid appearance of financial institutions, some of which have quickly developed the capacity to become participants in Western-style financial markets. These include more than 2,500 commercial banks, over 600 investment funds, over 1,000 licensed insurance companies, and more than 60 stock exchanges (down from 109 in 1993). In contrast to the privatization program, which was initiated from the center, the development of capital markets was initiated by private actors. After the first commercial banks were established in late 1988, other financial institutions appeared rapidly. In December 1989, the Soviet Ministry of Finance issued its first treasury bills, and the USSR Bank of Industry and Construction introduced promissory notes, vekselya, opening a market in government debt. In 1990, when the Russian government gave state-owned firms the right to sell over-contract production privately, networks of trading companies and commodity markets sprang up. The first of these was the Russian Commodity and Raw Materials Exchange, founded in 1990 by Konstantin Borovoi. Numerous stock and currency exchanges and brokerages were formed in 1991,

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Transforming Post-Communist Political Economies sometimes as branches of existing commodity exchanges. In July 1991, the Russian Republic legalized investment funds and provided for their regulation. At the same time, foreign investors were granted the right to buy Russian equities. Liberalization of prices in January 1992 eliminated the need for most commodity exchanges, so many of these exchanges moved into voucher trading. As privatization accelerated in 1993, most began to make markets in the shares of privatized enterprises. Along with the exchanges, numerous brokerages and voucher investment funds were established. Although exchanges have proliferated, to date there has been little self-regulation of exchanges, and popular mistrust of many exchanges is widespread. In consequence, the exchanges account for a small share of trade in equities. Most trades are conducted through the over-the-counter market. An interregional system of currency exchanges with branches in Moscow, Novosibirsk, Rostov, St. Petersburg, Ekaterinburg, and Vladivostok, established with support from the Russian Central Bank, plays the largest role in interbank trading of government securities, bank securities, municipal bonds, and corporate securities. About one-third of the daily trades of equity take place through the Russian Trading System, an electronic system that is expanding to link more than 20 regions. Most trades in that system involve a core group of large conglomerates, the ''Russia 100" companies. These represent a few sectors of the economy-—oil and gas, 43 percent; electric utilities, 21 percent; metals, 13 percent; telecommunications, 1 1 percent; and others, 12 percent (Blasi et al., 1997). Another two-thirds of trades take place over the counter. However, much remains to be done before Russia's stock markets will bring borrowers and investors together in a transparent and orderly process. First, legal infrastructure must allow property rights to be defined clearly, enforced at reasonable cost, and transferable. This requires that market participants agree to a set of rules guiding procedures for reporting of price, trading, clearing, and settlement in order to reduce the risk of fraud and of insider trading. Clearance and settlement procedures must be established to minimize the risk of default and provide timely transfer of funds. Procedures for issuance, listing, and pricing of additional shares should be agreed upon. Most important, the compliance of market participants with the rules must be monitored by a trustworthy coalition of market representatives and government authorities and enforced by the courts. The changes necessary to support an equity market are under way, but Russian apprehension about foreign participation in the domestic financial market restricts the role of international firms. Governance remains a problem. The low prices at which Russian assets trade reflects the apprehension of outside owners that inside managers are in a position to transfer most of the benefits of production to insiders. Russian capital markets have little or no transparency. This lack of transparency

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Transforming Post-Communist Political Economies reflects the economic interest of market participants, inside managers, and outside stockholders who are competing for control of enterprise assets. After privatization, most share activity was characterized by a one-way transfer of shares from initial small holders to managers and other closely related insiders. During the post-privatization period, not only managers of firms, but also large outside investors and financial intermediaries themselves have entered the market to acquire small stock holdings at advantageous prices. Where a control battle between insiders and outsiders was likely, secrecy was also important to stock buyers. In a recent World Bank report, Morgenstern (1995:89-101) characterizes the Russian securities markets as a "one-way control market" where the brokers' principal customers, and often the brokers themselves, have little economic interest in transparency and liquidity. Since there is little two-way trading that would benefit from self-regulation and institutional support, brokers see control of the economic environment as a higher priority than liquidity. Brokers often view their principal customers as the issuers, not the investors. In the wake of privatization, stock exchanges functioned like a vacuum cleaner, vacuuming up securities from workers on behalf of inside mangers and strategic investors. While much remains to be done to create genuine two-way trading in a stock market, a bank-centered closed market for ownership has emerged instead. Large outside blockholders are gradually consolidating control of a core group of large enterprises, initiating market-oriented changes, but the high degree of centralization of Russia's top-tier banks and their dependence on political relationships makes it uncertain whether they will be able to provide bank-based enterprise governance that is oriented to long-run efficiency. Banks and Financial Industrial Groupings A study of bank privatization by Abarbanell and Meyendorff (in press) shows that an emerging demand for financial institutions led to the commercialization and privatization of state-owned banks more rapidly and irreversibly than in other reforming economies. Over half of all Russian banks operating today originated in the private sector, with over 75 percent of banking assets under the control of private investors. During the past 8 years, the Russian banking sector has undergone an impressive change. A top tier of about a dozen banks has emerged that provides a wide variety of corporate and personal banking services. The top ten banks in this group account for more than half of total assets in the banking sector. While the Russian state still has majority ownership in the two largest banks, six of the top ten banks are new commercial firms, and they tend to dominate the market for new services. Outside of the top tier of banks, there is a large pool of small regional

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Transforming Post-Communist Political Economies banks that emerged early in reform, many of these established on the basis of regional branches of state banks. Often these banks served to direct regional savings into local investment and to channel central bank credits to regional enterprises. They have familiarity with local clients and rely on a relationship system to enforce contracts, but they are frequently undercapitalized and lacking in the professional skills needed to compete with larger centralized banks in the long run. Can the privatization of a top tier of strong banks provide the institutional framework for bank-led governance of Russian industrial firms in the style of Germany or the Japanese keiretsu? The evidence is ambiguous. Looking at the case of one successful bank, Abarbanell and Meyendorff (in press) find that rapid bank privatization contributed to elimination of the government's role in the corporate governance of Mosbusinessbank. Effective as the Russian approach was in privatization, it was ineffective in the transfer of genuine control rights to the nominal owners of the bank. Inadequate governance, monitoring, and voting rights mechanisms lead to a passive, diffuse ownership structure that perpetuates managerial control and agency problems. An incumbent management that enjoyed strong relationships with prospective stakeholders of the bank gave Mosbusinessbank an initial franchise value, the maintenance of which provided incentives to direct credit in efficient directions. "On the other hand, the tendency for these managers to engage in non-market driven transactions, to respond slowly to new opportunities, and to make restructuring decisions on the basis of criteria other than profit maximization suggests that the franchise value of the bank will continue to decline in an increasingly competitive market" (Abarbanell and Meyendorff, in press). The authors also observe that intense competition by new domestically owned private banks brings product market discipline to the credit market, motivating improvement in preexisting banks. In the case of bank credit, Abarbanell and Meyendorff observe that the initial franchise value of Mosbusinessbank was based on the strength of management's relations with ministries and local government officials, and find a large number of cross-holdings and cross-governance relationships in the bank's ownership structure and investment portfolio. Profitable bank operations in the period 1992-1995 were at least partly linked to the federal government's policy of funneling directed credits to troubled enterprises through the banks, using central bank loans for leverage. Initially, government-directed loans were profitable for the banks, but recently, government delayed payments have imposed losses on banks. The emergence of large conglomerates with extensive cross-holding among banks and enterprises and the consolidation of these relationships into more than 30 financial-industrial groups (FIGs) provides evidence that infrastructure for open financial markets is still missing and that "political capitalism" continues to be an important source of wealth. However, these FIGs

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Transforming Post-Communist Political Economies could provide an alternative governance structure in which long-term relationships and implicit contracts sustain cooperative behavior. FIGs are large, diversified conglomerates that can play the role of a blockholder in restructuring the enterprises they control. Freinkman (1995:57) writes: In general, the characteristic feature of many existing FIGs is extreme diversification and confusion of their internal structure, in which, as a rule, a great number of small and auxiliary subsidiaries are created. These subsidiaries have a very complicated cross ownership structure and stable high volume of mutual payments. This results from the aim of maximizing accounting confusion and minimizing tax payments on this basis, as well as evading state regulation requirements, including limits on investment activity. Blasi et al. (1997:155-157) see FIGs as an attempt to create a kind of closed capital market in which enterprise managers can deal with people they know rather than with the anonymous market. They differentiate "capitalist politburo" FIGs, attempting to reestablish old management systems, and merchant bank FIGs that function as a concentrated shareholder: The merchant bank does not have to worry about stock market, share registries, struggles with managers, or halfhearted commitment to restructuring plans. . . .This conglomerate is performing all the functions of a concentrated blockholder while skirting many of the barriers smaller blockholders confront. In sum, banks, investment trusts, and brokers have designed successful strategies for operating in a market with missing institutions, but their ability to function as a source of market-led discipline will depend on continued improvement in financial market infrastructure. Russia's merchant banks are undercapitalized themselves and need to establish credibility in the international market. The participation of foreign banks in the Russian market is limited. Rapid institutional innovation in financial markets could either support an active open capital market or serve the closed capital market of Russian financial industrial groups. Product Market Discipline To date, a competitive product market provides a stronger source of market discipline in Russia than does a competitive financial market. Rapid domestic price liberalization and more gradual trade liberalization force firms to compete with both import and export alternatives. However, most large and medium-sized firms are spin-offs from former state organizations. Genuine new market entrants are small and have little access to the capital market. Blasi et al. (1997:189) report that of 917,937 firms privatized between 1991

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Transforming Post-Communist Political Economies and 1995, over 900,000 were small firms; of these, 794,889 were small startups. The size of the informal economy suggests that official statistics understate the entry of private entrepreneurs into trade, services, and construction. But in the product market, as well as in the financial market, missing institutional infrastructure impedes the ability of small private firms to compete. Small private firms are vulnerable to extortion from racketeers and to arbitrary and changing tax liabilities from all levels of government. In consequence, many small businesses contrive to operate in the cash economy without a fixed place of business. Firms that come to the attention of a local "mafia" frequently close down, sometimes reopening inconspicuously in a different location at a later date. New entrants are extremely important to the restructuring of Russia's markets. They fill market niches that were underserved in the planned economy, supply food and consumer goods, provide employment, and mobilize saving. Their success generates information for prospective future entrants to the market. McMillan (1995) points out that entry of new firms reduces the control of bureaucrats over the economy. Because it reduces the profits of former state firms, it can force those firms to improve their performance as well. Operating with Weak Legal Infrastructure In the absence of a legal framework to structure relationships, resolve disputes, and enforce contracts, Russian enterprises seek strategies for operating without using law and legal institutions. Hendley et al. (1997) find that Russian enterprises make little use of law and legal institutions in structuring their relationships. Some of the firms' business strategies, such as requiring prepayment for goods, implied relatively little ability to develop substitutes for legal enforcement of contracts, while other strategies, such as extensive, multilateral barter, indicated that the firms were able to develop informal relationship institutions in place of laws. In August 1995, Kevin Block, General Director of the Pacific Law Center in Vladivostok, met with business researchers from the University of Washington to discuss how firms there use Russian law in structuring business practice. Block said Western investors misunderstood Russian legal institutions. Some assumed Russian law creates a binding framework of rules to which all parties must adhere and provides penalties and sanctions if they do not. Others assumed Russian law was "telephone law"—all problems could be resolved by telephone calls to a friendly official. But in his experience, the truth lay somewhere between these two views: "Russia doesn't have rule of law, but there are a multitude of laws and there are consequences for breaking them."

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Transforming Post-Communist Political Economies Block said businesses found themselves operating in three separate spheres of law: relationship law, substantive law, and bureaucratic law. Russia is still a relationship society, where whom you know is more important than what the rules say. The term "relationship law" refers to the fact that it is generally so costly for a contracting party to enforce the content of a contract that the rules set forth in agreements should merely be viewed as a statement of the parties' intent to work together to achieve a common goal. The sphere of "substantive law" refers to the new body of Western-style laws that are being written to support market reforms. Modern commercial codes, laws on foreign investment, and tax laws are examples. These laws are clear, rational, available, and subject to interpretation, not unlike legal norms in the United States. But to support a rule-of-law society, laws must be enforced by "mechanisms that work and sanctions that hurt." In Block's view, tax and customs laws could be considered substantive; others were not as yet. Finally, said Block, the largest sphere of law was "bureaucratic." Russian bureaucracy is like bureaucracy elsewhere. Its primary mission is to regulate. For business, bureaucratic law has some unique features. One is its sheer volume and intrusiveness. Second, it is produced by people with no interest in business and "often contradicts sound business practice." Third, regulations are enforced arbitrarily, corruptly, or not at all. Fourth, regulations often contradict the law they are supposed to implement. Fifth, it is difficult to find out about regulations, especially at the local level, because they are not published in a consistent manner. In this environment, said Block, businesses use law mainly to structure arrangements to avoid future problems. Contracts between parties are set up to provide some counterleverage at each step in a relationship. Another recent study of business strategy in an environment with missing infrastructure finds that Russian firms set up links with foreign firms in order to gain access to the institutional infrastructure of the world market (Thornton and Mikheeva, in press). The authors find that Russian firms rely on their Western partners to supply investment and credit or to borrow and post collateral on the world market. They use a foreign partner or subsidiary to collect receipts and disperse payments. A Western partner with a reputation for strict monitoring of quality may vouch for the quality of a Russian firm's performance, allowing it to gain access to the world market before its track record is known. Within the Russian economy, Russian enterprises make use of familiar relationship and reputation mechanisms to enforce agreements within business networks. They attempt to design self-enforcing arrangements to support agreements in the absence of third-party enforcement and to reduce the incentives to engage in short-run opportunistic behavior. A high franchise value of business opportunities within the relationship system and private enforcement of contracts together provide positive and negative incentives to live up to agreements.

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Transforming Post-Communist Political Economies CONCLUSIONS The aim of economic reform is to provide a framework of laws and institutions that can channel investment and production in competitive directions and support economic growth. Liberalization of markets, stabilization of the macro economy, and privatization of firms in Russia are vital steps in providing the incentives, information, and market discipline needed for improved economic performance. But until Russia extends property rights in land and acquires the administrative capacity to provide essential market-supporting institutions, newly privatized firms will not have the incentive to provide greater transparency or face the discipline of competitive markets. Investment, structural change, and renewed economic growth will emerge if self-interested owners and investors are able to design self-enforcing institutions of corporate governance, build the legal institutions required to enforce contracts, and provide secure and transparent capital markets. The experience of Eastern European countries shows that a major redefinition of the role of the state and a minimum level of state capacity (to provide market infrastructure) are necessary to support market reform. Alternatively, in the absence of market-supporting infrastructure, the Russian state itself could be "privatized" as the major source of economic rent. In this case, future Russian economic growth could be based on an interlocking network of large, well-connected conglomerates at the center and an insecure and rapidly changing periphery of small service firms. The resulting inequality of ownership and access would generate social discord and a high level of political uncertainty. Thus, if the state is unable to provide market-supporting legal, financial, and administrative infrastructure, the economic result is likely to become not market competition, but a system of "political capitalism." REFERENCES Abarbanell, J., and A. Meyendorff in press Bank privatization in post-communist Russia: The case of Zhilsotsbank. Journal of Comparative Economics. Blasi, J., M. Kroumova, and D. Kruse 1997 Kremlin Capitalism: Privatizing the Russian Economy. Ithaca, NY: Cornell University Press. Boycko, M., A. Shleifer, and R. Vishny 1995 Privatizing Russia Cambridge, MA: MIT Press. Brown, J.D. 1997 Asymmetric Information and Managerial Labor Market Inefficiency in Transition Economies. Paper presented at the Annual Convention of ASSA, January 4-6, New Orleans, LA. Ericson, R. 1991 The classical Soviet-type economy: Nature of the system and implications for reform. Journal of Economic Perspectives 5(4): 11-27.

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Transforming Post-Communist Political Economies European Bank for Reconstruction and Development 1996 Transition Report 1996. London, England: European Bank for Reconstruction and Development. Freinkman, L. 1995 Financial-industrial groups in Russia: Emergence of large diversified private companies. Communist Economies and Economic Transformation 7(1):51-66. Grossman, H., and M. Kim 1995 Swords or plowshares? A theory of the security of claims to property. Journal of Political Economy 103(6):1275-1288. Hendley, K., B. Ickes, P. Murrell, and R. Ryterman 1997 Observations on the Use of Law by Russian Enterprises. Paper presented at the Annual Convention of ASSA, January 4-6, New Orleans, LA. Hirshleifer, J. 1995 Anarchy and its breakdown. Journal of Political Economy 103(1):26-52. Johnson, S., and G. Loveman 1995 Starting Over in Eastern Europe: Entrepreneurship and Economic Renewal. Boston: Harvard Business School Press. Kotkin, S. 1991 Steeltown, USSR: Soviet Society in the Gorbachev Era. Berkeley, CA: University of California Press. McMillan, J. 1995 Markets in Transition. Symposium address at the Seventh World Congress of the Econometric Society, August, Tokyo. Department of Economics, University of California at San Diego. Milgrom, P. 1988 Employment contracts, influence activities and efficient organization design. Journal of Political Economy 96:42-60. Milgrom, P., and J. Roberts 1990 Bargaining and influence costs and the organization of economic activity. Pp. 57-89 in J.A. Alt and K.A. Shepsle, eds., Perspectives on Positive Political Economy. Cambridge, England: Cambridge University Press. Morgenstern, C. 1995 Capital markets development and financing Russia's transformation. Pp. 89-109 in Ira Lieberman et al., Russia: Creating Private Enterprises and Efficient Markets. Washington, DC: World Bank. North, D.C. 1991 Institutions, Institutional Change and Economic Performance. Cambridge, England: Cambridge University Press. Poznanski, K. 1997 Poland's Protracted Transition. Cambridge, England: Cambridge University Press. Shleifer, A., and R. Vishny 1994 Corruption. Quarterly Journal of Economics 108(3):599-618. Thornton, J., and N. Mikheeva in press The strategies of foreign and foreign-assisted firms in the Russian Far East: Alternatives to missing infrastructure. Comparative Economic Studies.