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Writings & Speeches

Financial Market Reform and Privatization in Eastern Europe

by Eugene H. Rotberg
for
The National Economists Club
October 3, 1991

A long period of stagnation has left Eastern Europe and the Soviet Union few anchors or guidelines. The basic problem is that after centuries of centralized or monarchial control, there is no valuation system currently in place for an outside investor to know what something is worth. Nor do the countries, given the absence of open market pricing, know the value of what they have to offer. Most important, it is not clear who is the owner of a nation's resources.

No centrally planned economy, as yet, has ever made the transition to a market-oriented society. There are no blueprints. It basically requires that someone relinquish control over the allocation of resources and a dismantling of subsidies and support systems. It's hard enough to relinquish power. It's harder yet if it is unclear who has the power to relinquish. It is particularly difficult when there are scores to settle and the infrastructure for governance, public and private, is in the process of being remade.

A market-driven system, as we know, demands mobility of labor, open pricing, a credit system, a legal structure and property rights. That is not yet in place. Nor are there sufficient savings to cushion the wrenching transition from a planned economy, with its explicit subsidies and controls, to a market-based one. Each constituency nods approval to the benefits of a market-based economy, while seeking to retain for itself the preferred access to jobs, food or housing, and to the special privileges which might protect them during a period of unprecedented change. 

And it is difficult to change a system in bits and pieces with parts of, say, the manufacturing process set by market forces and others by fiat — either high or low, depending on who is favored or exploited.

Certainly the countries of Eastern Europe have not yet had the time to dismantle the old system, create a new one, and then slowly develop the systems which provide support during the transition: a social security system, retirement, healthcare, insurance, etc. That did not happen in the United States for almost 200 years. There is also the nagging spectre that government-designed safety nets in the past have served the few, the elite, through an unfair allocation of scarce resources. The countries of Eastern Europe, in truth, are trying to both dismantle an old system while building a new one without destroying the country in the process — and in a very competitive and market-oriented world.

A reasonably certain structure of taxation is not yet in place. Moreover, it can be expected that State subsidies will exist for some enterprises or activities and may remain side-by-side a nascent competing private sector enterprise for a long time.

There are uncertainties about repatriation of dividends and the status of capital gains because the basic concepts of return on equity, profit, credit risk and the time value of money are not yet meaningful. The accounting system is not reliable. There is no clear power in central banks to set interest rates as each constituency seeks exemption from the cost of capital. The relative standing of debt versus equity is unclear (as it is in the United States!).

In short, the basic social contract in all of its moral, practical and legal aspects between those who own, lend, manage others and labor has not been struck. Nor has it been struck with government. Fundamentally, there is no working consensus on the subtle balance of the rights and responsibilities of owners, borrowers, the work force and government. We tinker at the edge of a consensus. They have none.

Most fundamental, again, there is unsuredness as to who "owns" what, and what "ownership" means. And though some countries are more advanced than others, it remains unclear who in government has authority to strike a binding deal or grant permission or licenses — the Central government, the province, the workers, self-designated managers of the enterprise, the city cabinet minister.

There is also hostility, understandably, to absentee landlords coming in and buying commodities or services on the cheap.

The Soviet Union, in particular, has never had the social and political structure which has developed in Western Europe and elsewhere to bring about a working consensus between labor, management, owner and government in an industrialized society. That takes time — through guilds, labor/owner battles; taxation battles. They do not have the institutions in place which define and enforce that consensus in terms of the law, property rights, taxation, trade unions, etc. In that sense it is almost a pre-feudal system pre-dating mercantilism, craft guilds and credit extension. It is almost a pre-state environment. That condition has not existed in Western Europe for at least a thousand years, if ever. Kings, Dukes, Counts had to pay stone masons and farmers for a long time in Europe. It took a long time to change and evolve. No one in the Soviet Union now has, however, the power of the royalty of Europe against which everyone else could rail and battle it out.

The Union, or its parts, has two quite immediate problems which it will have to address before attracting external capital for direct investment: First, who has the right to grant licenses, ownership participations, or otherwise enter into agreements which permit the use of materials, goods or services. This is particularly complicated when, for example, a project may involve several different republics: the use of forest lands in one republic, the transport of lumber to a mill in another, the processing of the wood into paper, the distribution to suppliers, etc. Each component part of a complicated manufacturing process will have costs, and the rights and privileges will have to be negotiated with a number of entities which will claim the right to set costs, fees, etc.

The second problem, after the decision over "rights" to sell or the charges to be levied, will be how to allocate domestic equity ownership rights for a given project, what payment should be made by domestic citizens, how much and to whom, to perfect their equity interest.

These are essentially socio-political problems and very difficult ones. Moreover, for a country to make economic sense, it must have a product or products that an outsider wants — natural gas, oil, perhaps some other commodities — which it can export at competitive prices, earn hard currency, and buy goods and services which they need to increase productivity. That is not easy to do going into the 21st Century. It is not like the 19th Century where a major European power or the United States had to compete with relatively few countries, mainly amongst each other, whose products were, for the most part, different from each other. Nor is it an environment where European powers controlled, through colonies, cheap labor or raw materials or controlled the markets into which they sold. Now Eastern Europe will find itself competing not only with those industrialized countries, but with Singapore, Taiwan, Indonesia and, of course, very inexpensive labor forces in China and India — all the while while trade barriers are dropped, communication links are increasing and management expertise and manufacturing facilities are distributed widely throughout the world. It is not even easy for Switzerland.

It is in that context that I find the movement to use people like me to set up stock exchanges, or capital markets, as well as lawyers, financial market specialists, consultants, economists, ludicrous. They should put that stuff on the back burner. Stock exchanges and capital markets come much later. They are the icing on the cake. The cake must be made first. Why?

1. The investment does not go to the company/productive sector. Exchanges only facilitate trading amongst people who wish to shift their accumulated financial assets from one asset to another.
2. It attracts talented and productive people into an unproductive enterprise — being a middleman in the transfer of assets — with no impact on a country's growth or GNP.
3. It puts icing on a cake before the cake is made.
4. It will be manipulated for the benefit of insiders or the intermediaries.
5. Savings are better deployed elsewhere.
6. It will concentrate wealth upwards, even more than now.
7. It will leave a bad taste in the mouths of lower socio-economic classes who cannot participate. Nonetheless, expectations for quick wealth will rise quickly with accompanying political disillusionment.
8. It is unnecessary. Liquidity of assets will come slowly and naturally after productive enterprises are developed.
9. The legal regulatory and disclosure structure is not in place for informed investment.
10. Most industrialized countries developed with hardly any equity markets. It was done with private equity and bank credit. Even Ford Motor Company did not become public until the 1950's or 1960's.
11. It is dangerous to have stock exchanges before there are accummulated savings in the hands of institutions such as insurance companies, pension funds, etc.
12. In developing countries, stock exchanges are, typically, vehicles for insiders to bail out.
13. Stock exchanges do not create wealth or savings; they reflect wealth once it has been accumulated.
14. It will come soon enough.
15. Middle class capitalism develops when individuals feel a commitment to the work that they are doing in their own company for their own enterprise, as employees or owners, not from owning pieces of paper reflecting an intangible interest in someone else's company over which they have no control.

What do I recommend should be done? First, stay away from investment bankers, commercial bankers, lawyers, accountants, consultants, academics and economists — all of us who are expert in writing papers on financial reform and privatization. We do not know the most efficient way to pump and transport oil. Second, stay away from financial intermediaries, except perhaps to arrange introductions.

I would recommend the following for the Soviet Union, after they resolve (a) who has the power to grant access, and (b) how to distribute domestic private ownership rights and at what cost. Outsiders cannot do that for them.

First, focus on the corporate sectors throughout the world in each industry for potential joint venture operations — for direct private investment. That external corporate partner will have the responsibility to send strategic planning people (engineers, marketing) to the domestic entity authorized to strike the deal. Businessmen are interested in resolving 5-6 matters. I would recommend the following:

1. Permit foreign ownership of controlling equity interests — virtually without restriction.
2. Define exactly what is meant by "profit" in accounting terms. For example, if electricity, rail transportation, land, the "right" to extract oil or gas, etc. is provided, then, up front, the attributed dollar cost of such goods or services must be explicitly identified and quantified by someone having the power to set it. In other words, a notional balance sheet and P&L statement must be created where each cost, ex ante, is explicitly quantified and charged in dollar terms. These will be negotiated between the foreign corporation and the entities which have the power to grant the "license" or provide the needed goods and services.
3. An explicit understanding must set forth dividend policy and the distribution of excess cash flow over costs. That policy would make clear how much of the "profit" is returned to the business, how much can be taken out of the country in the form of return on equity, and how much distributed to domestic owners.
4. The owners will want to hire, fire, set wages for managers and workers as they see fit.
5. An explicit agreement has to be set out on taxation of "profit."
6. An explicit agreement should permit the foreign or domestic owners to sell their interest at any price they want, to whomever they want to sell, in or outside the country.

Certainly, the above format does not guarantee success. Processes never do. It, indeed, may be that the social/political stresses during the period of transition will be such as to tear the countries of Eastern Europe and the Soviet Union apart, either because of internal stress, corruption, or simply the failure to strike an acceptable consensus between those who own, manage and labor. Or, it may be that it is simply too late now to embark in the business of producing a better or less costly product or service the rest of the world wants in competition with those who have had a 50-year head start. It is arguable that there is no value-added given the availability of increasingly sophisticated technical skills all over the world, low wages and, perhaps most important, the transferability or replicability of even the most sophisticated technical processes virtually anywhere in the world. My point, however, is that there is room at this juncture in Eastern Europe and in the Soviet Union for substantial value-added breakthroughs, but I am afraid there will likely have to be a period of exploitation and a concentration of wealth until various national constituencies can fight it out for a fairer allocation. I am afraid they may have to go through a "robber baron" period first.

© 2012-2024 Gene Rotberg