24 management and more productive use in the private sector. While the closure of<sup>SOEs canbe</sup> painful and costly (for the government, employees, creditors), it nonetheless<sup>producesbenefits</sup> for the economy and society at large as employees and other assets<sup>arebetterusedafter</sup> restructuring.

64. Privatization can lead to poor outcomes when there is slow and halting progress<sup>on hard</sup> budget constraints from the financial sector. This problem is acute and most evident<sup>in transition</sup> economies, for example, in the Czech Republic, Slovakia and countries of<sup>theformer Soviet</sup> Union, particularly in the mid-1990s. It is often argued that in these countries<sup>insider or diffused</sup> ownership resulting from the voucher method of privatization led to poor results,<sup>while transition</sup> economies such as Hungary and Poland that by contrast sold enterprises to<sup>concentratedowners</sup> did much better. Performance thus became linked to whether ownership<sup>wasconcentratedor</sup> diffused.

65. While there is indeed a close correlation between the use of voucher privatization methods and poor privatization outcomes (in the short term, at least), the underlying<sup>issueis</sup> that of the quality, pace and scope of financial sector reforms. Poor performance<sup>inthe FSU</sup> countries and others such as the Czech Republic and Slovakia resulted partly because<sup>inadequate</sup> managers/owners were handed the assets, but mainly because financial<sup>sector reformswere</sup> lacking that would have forced even bad managers to take the right steps-or leave<sup>the way clear</sup> for other owners. The Czech Republic is an illustrative case in point: through<sup>the1990s,the</sup> state dominated commercial banking, with a majority interest in half of the<sup>sector and essentially</sup> a controlling interest in all of it. Explicit and implicit pressure from government<sup>allowedbank</sup> borrowing by weak firms, led by sometimes corrupt firm managers, to continue<sup>at arapidand</sup> unsustainable rate. Much of the debt proved to be non-performing, and a<sup>fairpercentage was</sup> stolen (Cull, Matesova, and Shirley, 2001). The credit did not restructure the firms, weakened the commercial banks, and made the eventual bail-out one of the biggest<sup>ever in the region.</sup> 66. By contrast, Estonia, Hungary and Poland were far more successful in privatization precisely because they: (i) implemented their bank restructuring/privatization<sup>programsearlyin</sup> the transition; (ii) dealt with the bad debt problems faster than other countries;<sup>(iii)tackled</sup> difficult legal and institutional reforms, such as bankruptcy and protection of<sup>minority</sup> shareholders, before the others;' and (iv) received more inflows of FDI in<sup>the1990sthanthe</sup> other countries. These factors, along with their favoring of core, concentrated owners,<sup>are what</sup> produced positive privatization outcomes.

67. In short, financial sector reform and the creation of a competitive and<sup>commercially</sup> oriented banking system is important for successful privatization. Privatization of<sup>banksisitself</sup> part of the solution. The recent World Bank research report on finance and growth<sup>(World Bank,</sup> 2001) shows that the lower the income of a country, the higher the proportion of<sup>its bank assets</sup> that will be state-owned. The argument is that state owned banks will better<sup>distributecapital to</sup> more productive investments, provide greater access to credit for deserving<sup>sectionsof society,</sup> and be less prone to crises. In practice, these objectives are almost never achieved.<sup>It has proven</sup> difficult to design incentives that will guide even private sector bankers<sup>towardsefficient</sup>

> 1 lIn Poland, where voucher privatization was limited, there was far more stringent<sup>initialregulationof securitiesand</sup> there have been many fewer reports of investor dissatisfaction.