metadata: authors: 0: author: Shafik, Nemat
1: author: DEC
count: Slovak Republic,Czechia
docna: 0: docna: Making a market : mass privatization in the
            Czech and Slovak Republics
docty: Policy Research Working Paper
subtopic: Multinational & Corporate Governance,Corporate Governance,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Capital Markets and Capital Flows,Non Bank Financial Institutions,Capital Flows,International Trade and Trade Rules,Privatization,Energy Privatization,Energy and Mining,Civic Participation and Corporate Governance,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The author assesses the Czechoslovak
            mass privatization program for speed, equity, and corporate
            governance.  The program transferred claims on assets in
            1,491 enterprises - assets worth about $10.7 billion - to
            the 8.5 million citizens who participated in the scheme.
            The entire cycle of project preparation, public information,
            and nationwide simultaneous bidding took 14 months.  This
            was equivalent to privatizing more than three medium-scale
            and large-scale enterprises, on average, per day.  Equity
            objectives were achieved by transferring equal claims
            (equivalent to about $1,250 per person) to all participants
            and by putting in place a transparent and decentralized
            process. The government's role was simple to provide a
            framework and a set of rules for potential firms, managers,
            and shareholders to find each other.  The scheme's
            design - based on simultaneous sequential bidding rounds -
            worked to put information about enterprise values into the
            public domain by allowing increasingly informed bidders to
            interact.  The structure of ownership that emerged will have
            very different implications for corporate governance.
            Enterprises in the Czech Republic, and those that sold for
            high prices in the bidding rounds, are characterized by a
            greater concentration of shareholdings. Those in the Slovak
            Republic, and those that sold for lower prices, have more
            diffuse ownership structures. The mass privatization scheme
            served to quickly differentiate the enterprises with
            favorable prospects from those with unfavorable prospects
            under current conditions.  But enterprises that could have
            survived in some form, if they had been restructured before
            privatization, or enterprises that could have been viable
            but lacked effective governance, were sacrificed for the
            sake of speed and decentralization.
geo_reg_key: 517208,517190,517191
repnme: repnme: Making a market : mass privatization in the
            Czech and Slovak Republics
display_title: Making a market : mass privatization
            in the Czech and Slovak Republics
listing_relative_url: /research/1993/12/698725/making-market-mass-privatization-czech-slovak-republics
topicv3: Investment Funds m1326718 341,Trade m1326924 698,Corporate Governance m1326968 417,Privatization m1327236 1283,Iron m1503514 2931
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: UNKNOWN
no_of_pages: 62
author_keys: 0: author_key: NA
1: author_key: NA
model_extractions: **POLICY RESEARCH WORKING PAPER** 1231

# **Summary findings**

Shafik assesses the Czechoslovak mass privatization progtam for speed, equity, and corporate governance.

The program transferred claims on assets in 1,491 enterprists - assets worth about $10.7 billion - to the 8 5 million citizens who participated in the scheme. The entire cycle of project preparation, public information, and nationwide simultaneous bidding took 14 months. This was equivalent to privatizing more than three medium-scale and large-scale en:erprises, on average, per day.

Equity objectives were achieved by transferring equal claims (equivalent to about $1,250 per person) to all participants and by putting in place a transparent and decentra!ized process. The government's role was simply to provide a framework and a set of rules for potential firms, managers, and shareholders to find each other.

The schenie's design - based on simultaneous - sequential bidding rounds worked to put information about enrerprise values into the public domain bv allowing increasingly infornmed bidders to interact.

The structure of ownership that emergeJ will have very different implications for corporate governance. Enterprises in the Czech Republic, and those that sold for high prices in the bidding rounds, are chiaracterized by a greater concentration of shareholdings. T hose in the Slovak Republic, and those that sold for lower prices, have more diffuse ownership structures.

The mass privatization scheme served to quickly differentiate the enterprises with favorable prospects from those with unfavorable prospects under current conditions. But enterprises that could have survived in some form, if they had been restructured before privatization, or enterprises that could have been viable but lacked effective governance, were sacrificed for the sake of speed and decentralization.

- This paper a product of the Country Operations Division, Central Europe Department -is part of a larger effort in the department to monitor and evaluate innovative approaches to the transition from central planning to market economies. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 2043.3. Please contact Anita Correa, room HI 1-105, extension 38549 (56 pages). December 1993,

**_The_** _Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas_ **_abou_**<sup>**_7_**</sup> **_development issues. An_** _objective of the series is toget the findings_ **_out_** _quickly. even if the presentations_ **_are_** _less than fully polished._ **_The_** _papers_ **_carry the_** _names of the authors and should be used and cited accordingly. Ihe findings, interpretations, and conclusions are the authors' own and should_ **_not be_** _attributed to the World Bank, its Executive Board of Directors, or_ **_any_** _of its member countries._

Produced by the Policy Research Dissemination Center
# 'fking a Market:

Mass Privatlzation in the Czech and Slovak Republics Nemat Shafik Central Europe Department

## World Bank

Thanks are due to Richard Bues who kept me abret of developments in the coupon scheme and provided numerous insights into the process. Vladimir Rudlovalk's support for the study was invaluable. Special thankrs go to Marinela Dado for outstanding research assistance and to Zuzanna Murgasova. Encouragement from Sweder van Wijnbergen end comments from Kemal Dorvi;, Mohamed El-Erian, Ulrich Hower, Andrej Juris, Geoffroy lamb, S. Ramachandran, Dugan Tdska, AIfredo hornc and Ilbam Zurayk are also grtefully acknowledged. Anita Correa did an excellant job of putting the paper together.
Making a Market: **Mass** Privatizatlon In the Czech and Slovak- Republics

# Table of Contents

|I.|In|tro<br>d u ctio<br>n<br>........................................|1|
|---|---|---|---|
|11.|l<br>he|Coupon Scheme in Context|2|
|m.|The|Supply Side: WhatWas Sold? .........................|4|
||A.<br>|Project Preparation: Encouraging Competition ....<br>......<br>|...<br>4|
||B.<br>|The Coupon Scheme: What was on Offer? ...............<br>|6|
||D.|Characteristics of Enterprises ........................|7|
|IV.|The|Demand Side: Who Bought What? .........<br>..<br>...........|<br>12|
||A.<br>|Citizens ...........<br>..........................<br> <br>|12|
||B.<br>|InvestmentlPrivatization<br>Funds .......................<br>|13|
||C.<br>|Pricing Policy .................................<br>|14|
||D.|An Assessment of the Bidding Rounds ..................|15|
|V.|Conc|lusions<br>.....<br>...................................|19|
||A.<br>|Speed .......................................<br>|20|
||B.<br>|Equity .. .<br>...................................<br>|21|
||C.<br>|Corporate Governance .23<br>||
||D.|Concluding Remarks ...........|27|
|Ann|exes|||
||A.|Preparation of Enterprises for Privatization .30||
||B.|Data on Enterprise Characteristics<br>.34||
||C.|Bidding Dynamics .41||
|||Round 0: Power to the IPFs .41<br>||
|||Round 1: Bidding Bonanza .42||
|||Round 2: Investment Pause and Quality Focus .44||
|||<br>Round 3: Market Divergence and Unrequited<br>||
|||Bargain Hunting .46||
|||<br>Round 4: An Emerging Equilibrium .47<br>||
|||Round 5: Locking into the Market Before it<br>is Too Late .49||
# Mkln a Market:

# **MM1** Pivatizton in the Czech and Slovak Republlcs

# **I.** Intolctn

As in most post-communi **s** t ocieties, the debate about structural transformation in Czezhcslovakia was essentially between 'gradualists' and 'radicals/bi; bangers".<sup>1</sup> Gradualists advocated a slower pace of privatization to allow time for the establishment of the institutions of a market economy, to begin restructuring some enterprises and to reduce the adverse consequences for labor. The "big bangers saw ownership transformation as a necessary part of tho establishment of a market economy and therefore sought to privatize as quicldy as possible. Unlike countries like Poland where agriculture, which constituted between 12-24% of GDP during the 1980s, was already in private hands, Czechoslovakia was one of the most extreme cases of a cent ly-planned economy. As recently as 1989, about 98% of all property was in state hands and less than 1% of net material product was generated by the non-agricultural private sector.<sup>2</sup> There were about 7000 medium and large scale enterprises and 25,000-30,000 small scale enterprises in the state sector. Gradualism was also not an option for macroeconomic reasons. Household savings rates in Czechoslovakia were 4% during the 1980s, unlike the over 20% household savings rates in gradualist reformers like China. Thus there was little scope for the emerging domestic private sector to rapidly outgrow the state sector.

In Czechoslovakia, the radicals won the debate and the government' **s** trategy placed ownership transformation at the center of its reform effort. An important element of that strategy was the mass privatizatin scheme, the first of its kind in all the transition economies. Czechoslovakia, like other formerly centrally planned economies, had been characterized by forced savings to finance extremely high investment rates, much of which was poorly allocated. Thus the deferred
-2 -

consumption of citizens was translated into fixed assets owned by the state. After the Velvet Revolution in 1989, the privatizatlon process was seen as a mechanism for compensating Czechoslovak citmzens for their sacrifices under the previous regime. Privatization, and particularly the coupon scheme, was also seen as an instrument for securing ths political irreversibility of the transformatlon to a market e.:onomy.

This paper is organized as follows: Section II analyzes the economic rationale for the coupon scheme and puts it into context. 'he preparation of enterprises for privatization, referred to as the 'supply side' in Czechoslovakia, is described in Section m, including an analysis of the characweristics of the enterprises offered through the coupon scheme and the initial distribution of shares across potential owners. The evolution of demand for shares - by citizens and investment funds -- through the various bidding rounds is assessed in Section IV. The conclusions in Section V evaluate the coupon scheme in terms of speed, equity, and corporate governance.

# I. 'Me Coupon Scheme in Context

The dual imperatives of speed and equity are what gave birth to the coupon scheme. The need for rapid ownership transformation argued for a process that involved little government role in the preparation of enterprises for privatization and quick sale, even at very low prices since revenue generation was not a priority, to the highest bidder. This would also rmirnimize the time in which enterprises would be in limbo without effective owners. But opening the process to all would have meant that foreigners would have easily outbid nationals, whose total private savings amounted to only about **Kcs** 300 billion in 1991, which was a fraction of the book value of enterprises to be privatized. Moreover, there was a danger that relatively wealthy citizens would benefit more, especially since 60% of households had savings of less than Kcs 20,000 (between $700-750). Politically, equal public participation in the process was critical for avoiding the perception that only
-3 -

the wealthy and well-connected were benefltting from the privatization of enterprises that were built through the efforts of the entire population.

The government trafered claims on state enterprise assets to the public which they could use for the sole purpose of privatization. The assets to which these claims would be attached would be determined through a bidding process. The size of the "subsidy" to citizens was purely a function of the number of people who chose to partlcipate In the scheme. Tho more people wanting a portion of the clairns for a fixed number of enterprise, the smaller the subsidy transferred to each individual. Why create such an elaborate scheme to transfer public wealth to private citizens? There are a number of possible exp.anations. The coupon scheme created a level playing field for all citizens. Everyone gets the same transfer at the start of the process and participation is vo!'ntary. Restricting monetary bids to nationals would have substantially lowered the sales price at which enterprises were privatized. This may have caused negative spillover effects on the sale price of enterprises sold through direct sales to foreign or domestic buyers. The altemrtive of allowing only citizens to bid cash would favor the wealthy. In both cases, domestic credit market imperfections would have meant that those with access to international capital markets would have been in a far better position to buy privatized assets. Therefore, it was necessary to create dual markets for privatization - one that was a true market where demand was based on real purchasing power and another market where participation was restricted to citizens who were given purchasing power by the state in the form of coupons.

Pure Ricardian equivalence would imply that no real transfer resulted from the coupon scheme since citizens would simply pay higher taxes in the future than if these enterprises had been sold using more conventional privatization methods. In a world of perfect markets, this would be true. Nevertheless, there is a real transfer where privatization will result in productivity gains, thereby increasing the expected value of the asset transferred to citizens today. Thus the size of tLe
4 potandal transfor is endogenoL's. Moreover, a key factor was that the effective transfer was very i'ifferent across citizens, depending on their ability to use market information (either directly or indirectly through IPPA). This differentiation of beneflts, depanding on bidding sklll, was an essential part oi. Introducing the principles of a market economy.

Although the coupon schome has received a great deal of attention because of ilS innovativeness, it was actually only a part of Czechoslovakia's overall approach to cwnership trasformation. What emerged was a hybrid process that rdied on a variety of privatization methods including: (1) transfer of state property to municipalities; (2) restitution to original owners; (3) trwformation of cooperatives; (4) small scale privatization through public auctions'; and (5) privatization of medluta and large scale enterprises through direct sale, joint ventures and the coupon scheme.<sup>4</sup> The Czechoslovak government did not rely very much on temporary srlutions such as leasing or contracting out to the private sector, which do not necessarily transform ownership, but can generate some efficienc gains in the interim.' Because the start of the voucher scheme required that all projects be ready at the same time, the government spent much of its time in the initial period processing projects for coupon privatization. Therefore in early 1992, the coupon scheme accounted for almost three quarters of property undergoing privatization. However, as other privatization methods, such as direct sale, grow in importance, the proportion of total assets privatized through the coupon system is likely to diminish. For example, in the second wave, the coupon scheme is expected to account for only about one-third of total book value privatized.

m. The Supply Side: What was Sold?

A. Project Preparation: Encouraging Competition A schematic of the institutions and steps associated with the coupon scheme is provided in Figure 1. The process or generating privatization proposals was driven by the desire to
create competition among potential buyers. Each enterprise selected for privatization had to submit its own basic privatization project reflecting management's views about the firm's future. But competing proposals for large scale privatization projects could be submitted by anyone to the enterprise's 'founders' or managing authorities (usually sectoral ministries) using a standard format. Information on tt r ubmission of privatization proposals was widely disseminated to encourage public participation. No preference was given to 'insiders,' either managers or employees.' Of course isiders did have access to privileged information, but officially the process was open to Rli and 'Insiders' were subject to legal punishment for not complying with Informational requests of those submitting competing proposals.<sup>7</sup> Ultimately, the review of competing projects that entered the coupon scheme was somewhat of a 'black box' with no strict criteria governing the selection of the propost that was finally included in the mass privatization scheme.

The government did not attempt to restructure enterprises before privatization - ths would only slow down the process and would be too remLniscent of the central planning view that the state knew better than the privatm sector how production should best be organized. Restructuring proposals could be submitted in the context of privatization proposals by interested buyers, but were not initiated by the govermment. The most frequent type of restructuring proposed and approved was breaking up of large enterprises into smaller units. This was approved as long as the firm's overall value was not reduced as a result of the splitting of assets. There was no real effort to restructure firms financially, to change management, or to shed labor prior to privatization. There were two loan consolidation operations in 1991 and 1992, but these were intended to address the banks' portfolio problems, not the financial restructuring needs of the enterprise sector. The agency and control problems that might result from diffuse ownership were not a serious concern. The government also did not emphasize the revenue generation aspect of privatization - price was only used as the most efficient mechanism for distinguishing the degree to which potential buyers valued the firm.
-6-

# EIg.w1: Schanatic of the Coupon Scheme

## Supply Side

<!-- Start of picture text --> ComWotirkg|<br>proposals<br>s1 "Ic All proposals R*pubblic<br>Privatization with Ninfstry's Ninistry Chosen<br>Enterprise Proposal t 1 try reommncstbtlon of Prvatiz2ntfon Proposal<br>> _ - _ + ond Ar' *monopo _y<br>Offic X<br>*jp6 ilc lCnter fJr<br>National Coupon Privatiuation<br>Property te"orary Fedoral Ministry<br>Fund ownership of Finance<br>(awnership<br>trust+") L shares _<br>r----, ~~~~~~dataeo<br>I LocatJ Pufl - P Co puter enterprises<br>'Rogistration Copet1ng Citens Infor tfn Cnter nd prices<br>IC ntors Bfdos<br><!-- End of picture text -->

bidding inforastion Demand Side

## B. Ihe Couron Scheme: What was on Offer?

The Center for Coupon Privatization published a list of 1491 companies with a book value of Kcs 300 billion (about $10.6 billion) on May 13, 1992 which would be included in the coupon scheme (out of a total of 2744 enterprise **s** lated for privatization in the first wave). This publication included the following information for each enterprise: name, address, business activity, identificatio **n** umber, shares offered, book value, value of other enterprise assets, debts, output in 1989-91, book profit in 1989-91, number of employees in 1989-91, allocation of non-coupon shares (foreign investors, domestic investors, restitution, National Property Fund, state, or sale of shares through some third party such as a bank). Since the government's transformation program, including
**-7-**

price and trwade liberalization, had begun in 1990, the data on entwrprist performance in 1950 and 1991 had some relevance. Howaver, the publication also included a warning that much of the data were of dubious qtlity and may not be relevant in a rapidly changing economic situation.

Of the 491 enterprices included in the first wave of coupon prlvatization, 943 with a book value of **Kcs** 206.4 billion were from tIe Czech Republic, 487 enterprises with a book value of **Kcs** 90.1 billion were from the Slovak Reriblic and 61 enterprises with a book value of Kcs 2.9 billion wete enterprises operating at the Federal level. The ratio of assets offered for voucher prlva?'zatlon across Republics was 2.29: 1, which corresponded to the ratio of voucher holders in the Czech Republic relative to those in the Slovak Republic. Within the group of 1491 enterprises in the coupon scheme, some shares were set aside for foreign ot domestic investors, restitution, the National Pronerty Fund, banks, and transfers to municipalities (able 1).

In both Republics

|the vast majority of shares were|Table 1: Coupon Scheme Dist|ributionof S|hares|
|---|---|---|---|
|available for citizens to bid under|I Foreign Invesors|1.6%|0.8%|
|the coupon scheme. In Slovakia,|DomstInvestors|3.8%|2.3%|
|the proportion of total shares offered|Restiution|0.4%|0.02%|
||NationalProperty Fund (temporary)|7.0%|2.8%|
|to citizenSwas much higZher at|National Property Fund (permanent)|O1.%|2.0%|
|92. 1% compared to that in the|Banks|1.5%|0%|
|Czech Republic. In both Republics,||Municipalities|1.2%|0%|
||Ciizn|84.3%|92.1%|
|thosesmall proportions of shares||<br>8-||

that were set a'4e for other purposes tended to be concentrated in a very small number of enterprises.'
# C. Creriatics of Enterpss

Data on the eharacterigtics of the enterprises included in the first wave of coupon privatization are presented in Tables 2 and 3.1 Given the large number of firms included in the coupon scheme, it is not surprising that the sectoral composition mirrored that of the entire Czechoslovak economy. The largest number of firts were in the engineering and building and civil engineering sectors - which aceounted for **_458_** enterpries or about one-third of all enterprises in the coupon scheme. The food industry, with 148 enuerprises was the next most common sector. In general, firms included in the first wave were in productive sectors like manufacturing and services and not public utilities, whose privatizition raised complex isWas of regulation which were postponed tc the second wave. lhe largest enterprises in terms of book value tended to be !r b tinking, electric power, iron and steel, metallurgy, chemicals, pulp and paper, clothing and insurance.

Based on the data on past performance provided to the public, the most profitable sectors were the foreign trade companies, banks and insurance companies. The average profit/equity ratio in 1991 for the entire sample was 17.6, while these sectors had ratios four to seven times that level. Thus it is nct surprising that foreign trade, banking and insurance would emerge as some of the most popular shares in the bidding rounds. Factor shares, as reflected in capital/output and capital/labcr ratios, tended to vary as might be expected across economic activities. Sectors with high ratios of capital tended to be water supply; glass, china and stoneware; foreign trade and banking. Labor-intensive sectors tended to be design, research and development, clothing, security and services.

One of the most striking characteristics of the enterprises is their relatively low indebtedness, as evidenced by the low average debt/equity ratios. The most indebted firms tended to be in the financial sectors (banking and foreign trade), which is normal given the nature of these activities. Thereafter, the firms providing infrastructure and services tended to have some of the
-9 -

highest debt/equity ratios -- building and civil engineering, engineering, mining, communication, domestic trade, retail sales, publishing, and other services. These are sectors that may<sup>have been</sup> forced to provide their output at subsidized prices and as a consequence incurred substantial debts in their operations. However, the average debt/equity ratio for the entire sample is well<sup>below a</sup> "normal" rate in most market economies (of course the 'normal' rate varies by the nature and riskiness of the enterprise's activities). The explanation for this may lie in the direct budgetary s"bsidies that these enterprises once received in the form of equity. As loss making enterprises increasing relied on banks, rather than the government budget, for financial support, these enterprises' debt levels may have risen dramatically since this data from 1991.

The sectoral distribution of Czech and Slovak enterprises was broadly similar as were debt/equity ratios. However, in terms of other characteristics, there were some najor differences. Czech enterprises tended to have higher book values on average and tended to be more capitalintensive in terms of book value (as evidenced by the capital/output and capital/labor ratios). Labor productivity was also higher on average in the Czech Republic. The major differencs was profitabiity. Profitability (as measured by profit/equity or profit/output) was on average over twice as high in the Czech Republic than in Slovakia.
- 10 -

Table 2

|S<br>Subsector|ector and_Sik_<br>C<br> <br>Number of<br>Enterpri|_of_Entwprise<br>S F R<br>Average Book<br>Value<br>(MiUllon<br>Kca)|Offered in th<br>CZEC<br> <br>Number of<br>Enterpriea|e Fit Wave(1<br>H REPUBLIC<br>Average Book<br>Value<br>(Million Kcs)|991)<br>SLOV<br>Number of<br>Enterprie|AK REPUBLIC<br>Average Book<br> <br>Value<br>(Milloan Kca)|
|---|---|---|---|---|---|---|
|ASriculture|61|165.9|55|<br>170.0|6|128.4|
|Baking|6|5,629.0|4|6421.3|2|4,044.4|
|BuUding and civil engineerIg|224|115.6|132|<br>141.0|92|<br>79.2|
|Buildig**materials**industy|61|254.6|35|319.6|26|<br>167.0|
|Chemical and rubber industries|27|1,198.5|20|804.0|7|2,325.8|
|Clothing iJustry|2|378.5|1|1.0|-|721.4|
|_Communication_|4|16S.0|4|165.0|-|-|
|Caisucti<br>activity|I|S11.2|I|S11.2|-|-|
|CooliS, ho spring and tobacco indus|<br>8|140.5|3|193.1|_5_|08.9|
|Cultul service|4|40.3|3|36.8|1|50.8|
|Desp Activity|87|S5.S|38|88.0|49,|<br>30.7|
|Domeatle trade|60|136.1|47|140.7|13|119.5|
|Ecotchnical<br>indusuy|52|327.0|38|300.2|14|<br>399.7|
|<br>Engineering|234|482.2|174|540.7|60|312.3|
|Food Indutry|148|216.2|87|275.9|61|131.0|
|Foripgntrade|34|1,121.1|31|1,180.2|3|S10.9|
|Forestry|2|93.5|I|26.7|1|160.3|
|Fuel indwtzy|IS|876.4|14|673.0|1|3,723.3|
|Fundamentalscience|2|146.9|2|146.9|-|-|
|Gologcal activity|30|66.6|14|88.2|16|47.7|
|Gla, china and stoneare industries|18|614.2|16|667.9|2|184.4|
|Hotelindustry|4|56.2|4|56.2|-|-|
|Houding|2|127.2|2|127.2|-|-|
|Iurance|1|1,841.9|1|1,841.9|-|-|
|Iron nd sted industi|11|3,499.6|7|2,234.2|4|S,714.1|
|Leather, boot-and-shoe and furrier lad|<br>7|315.9|6|223.8|1|868.4|
|Modial and other halth seIc|2S|134.0|2S|134.0|-|-|
|Melworking indu-try|21|S97.6|5|1,134.9|16|429.7|
|Non-ferrous metallurgy|4|1,72S..1|3|217.5|1|6,248.2|
|Other industrial tvies|8|193.6|S|277.0|3|54.7|
|Other producion activity|5|228.8|5|228.8|-|-|
|Other sevices|29|124.1|_15_|149.1|14|97.4|
|Personal ervic|9|62.6|9|62.6|-|-|
|Printing industry|9|181.1|8|152.7|1|408.2|
|Productlo of eloctric powwr ad hea|17|3,836.2|17|3,836.2|-|-|
|Publising activiUes|S|73.4|2|83.6|3|66.6|
|PulpandpaperIndustry|14|1,187.1|8|1,481.2|6|794.9|
|RocreoalS srvices|7|224.3|S|288.6|2|63.6|
|Rsarch and science ervices|2|47.S|2|47.S|-|-|
|Resatch &dovlopaientnbabllindus|2S|84.9|9|77.1|16|89.4|
|Rsarch & developmeant<br>In building|7|26.0|2|?3.3|5|7.1|
|Reearch & developmet in commercie|<br>2|23.5|1|45.2|1|1.5|
|Resarc A developmnat In cosumer|7|142.0|1|3.5|6|16S.1|
- 11 -

# Table 2 (Cnntinued)

||Seor and Size o|f Enterprim|. Offered in th|e Firas Wavo (1|991)||
|---|---|---|---|---|---|---|
|Subecor|CSF R<br> <br>Number of<br>Enwrprlae|<br>Avewage<br>Boo<br>Value<br>Millio Kca|CZEC<br>k<br>Numbar of<br>Enterprlc|H REPUBLI<br>Averag Book<br>Value<br>(Milion KlC)|SLOVA<br> <br>Number of<br>Enterprieu|K REPUBLIC<br>Average Book<br> <br>Valuo<br>(Milion K¢J)|
|S;curAiy and nationd dfence||18.3|4|15.4|1|<br>32.1|
|Suyply ndeas of goods|4|274.6|1|614.4|3|<br>161.3|
|_Suplyof_agriculturalg od|43|146.2|14|167.0|29|<br>136.2|
|Teotleinduatry|42|293.1|36|272.2|6|<br>418.1|
|Tranport|39|2S2.1|33|288.5|6|<br>52.0|
|Watsraupy|6|83S.9|6|83S.9|-|-|
|WoodworIn4g ladunry|S1|<br>233.2|34|190.9|17|<br>317.8|
|Total|84182|<br>381.3|57595|<br>433.9|33S12|<br>277.5|

Table 3 Chracteuatl of Enterprise Offered in te Firt 'Wave (1991) (Total)

||Number of<br>Enteprls.|Average<br>Book Value<br>(Mlion K¢s)|Average<br>Equity/<br>Out|Avorugo<br>Equity/<br>Emnploymn|Average<br>Profit/<br>Ouput (S)|Average<br>_PtofW_<br>Equity(%)|Averago<br>Employmm±<br>Output (%)|Averge<br>/<br>Debt/<br>Equiy (%)|
|---|---|---|---|---|---|---|---|---|
|CSFR|1491|<br>381.3|1.22|<br>519.43|6.29|17.59|<br>0.41|<br>140.-|
|Czech Republc|990|433.9|1.24|<br>632.27|7.96|21.49|<br>0.37|<br>139.7|
|SlovakRepubl|ic<br>S01|<br>277.5|1.18|<br>296.44|2.99|9.87|<br>0.51|<br>141.4,|
# - 12 -

## IV. ano,e _mD_ de: W0o Bought What?

## A. CitZ

All Czechoslovak citizens eighteen years or older were eligible to participate in the coupon scheme. Participation required purchase aid registration of a coupon book at one of the 648 registration centers around the country by February 28, 1992.10 Coupon books were sold for a nominal fee of Kcs 1000 plus a rngistration fee of Kcs _35,_ equivalen **t** o about $35, or one week of the averge wage. The Kcs 1000 **fee was** used to cover the costs of runniue q . *upon scheme. For bidding purposes, the Kcs 1000 were equivalen **t** o 1000 points." The coup , .re r..x tradable in the prinary market' in which the initial distribution of shares would occur, ' were fully tradable In the secondary market. bis initial non-tradabiity of coupons is similar to Lithuania wnd Mongolia. In contrast, Russia allowed immediate tradability of coupons under its privatization scheme. A total of 300 million shares were being offered, i.e. each share was equivalen **t** o Kcs 1000 In book value of the total of Kcs 300 billion of book value to be privatized in the coupon scheme. In the initial bidding round, three shares in an enterprise were equivalent to 100 points.

The initial response to the coupon scheme was fairly limited, with only 2 million coupon booklets sold by January 10, 1992, despite the government's extensive public information campaign. This participation rate was well below the government's target of 4-5 million booklets. The most important factor in increasing public interest in the scheme was the advertisements of the Investment Privatization Funds (IPFs), which were similar to mutual funds, some of whom promised returns of up to tenfold or more on coupon books if citizens allowed them to manage their shares. Ihese promise were not that unroalistic given that the average book value on offer was equivalen **t** o about Kcs 150,000 for each of the 2 million owners of voucher booklets (or 150 times the amount the individuals had actually paid for the coupons). As the deadline for registration approached, participation increased dramatically. Ultimately, _8.5_ million people registered out of an eligible
- 13 -

population of about 10.5 million. Despite this increased participation, there remained a large transfer element to the coupon scheme because the book value alone of the enterprises exceeded the value of coupons sold by 35 times. Thus, each Czechoslovak citizen was transferred claims on the equivalent of Kcs 35,300 in book value terms (which is about $1250, or about one-half of average per capita income).

# B. Invstment Privatization Funds

At the start of the process, 429 Investment privatization funds (IPF) were registered to participate in the coupon scheme, 264 of which wore based in the Czech Republic and 165 in Slovakia. The largest IPFs were run by commercial banks, saving banks and insurance companies, which had credibility and reputations to preserve. In Czechoslovakia, these funds emerged independently, unlike in other countries such as Pcland, Kazakhstan or Romania where funds to manage enterprise shares are created by the state.

Law number 248 regulating the behavior of the investment funds and corporations was passed on April 28, 1992, well after the IPFs had started operations. This law restricts ownership of any IPF to 20% of the shares of any individual enterprise, limits any single enterprise to 10% of the IPF's total assets. Because many IPPs are grouped into "investment companies" there is an additional restriction that no investment company, including all its constituent fimds, can hold more than 40% of the shares in any individual enterprise. These restrictions are intended to reduce the risks for individuals who buy shares in IPFs. The law also specified reporting requirements and disclosure rules for IPF operations, and limits the funds' fees to 3% of the assets they manage and a one-time fee of 2% to cover initial costs.
-14-

# C. Pricing Policy

The pricing rules adopted by the Price Committee based in the Federal Ministry of Finance were fairly pragmatic and sought to clear the market for shares as soon as possible. Unlike a normal market where equilibrium is reached through infinite bidding rounds, the price comnmittee had to insure ccnvergence within a finite number of rounds. There was a consistent attemp **t** o undervalue shares to ensure that oidders would not be left with unused points. Instead, the National Property Fund would be left with shares that were not bought, even though almost all points would have been used. The pricing policy was based on the following guidelines: P erfe qtuilibrium In the hypothetical case where demand by citizens and funds was exactly equal to supply, all enterprise shares would be sold in that round."1 Undersubscriptio Where a firm's shares were undersubscribed, those that bid receive shares at that price and remaining shares are offered in the next bidding round at a lower price. This rule enables the National Property Fund to capture the "consumer surplus" associated with some bidders valuing shares in a particular enterprise more than the eventual market clearing price.

Oversuscription by less than 25% Where there is excess demand for shares that is less than 25% of the shares on offer, individual citizens were given priority. The demand of the investment funds is reduced however much is necessary to clear the market at that price.

Oversubscription by more than 25% Where the excess demand is large, all shares are offered again in the next bidding round at a higher price. The magnitude of the price adjustment is a function of relative demand. For example, where demand for an enterprise was twice as much as the supply of shares, the price would be adjusted from 3 shares for 100 points to 3 shares for 200 points. In some cases described
- **15** -

below, there was "manual adjustment' of prices by the price committee to reduce market volatility.

What were the economic consequences of these pricing rules that governed the auctioning of shares? The reduction in the demand of investment funds in cases where there was oversubscription by less than _25%_ was a clear effort to bias the outcome in favor of individual citizens. Tis served to help relatively "uninformed' buyers in the name of "popular capitalism". The price discrimination rule that operated for shares that were undersubscribed meant that the size of the actual transfer received by individual bidders varied In book value terms. The size of the aconsumer surplus" or revenue appropriated by the state may have been greater under a nondisaiminatory pricing rule. Tbis would result when the demand curve is lower in a price discriminating auction because bidders fear "overpaying" for shares (the so-called "winner's curse"). Hypothetically, revenues could be higher if the Cemand curve shifts out when the "winner's curse" problem is eliminated through a non-price discriminating auction. In the case of Czechoslovakia, where revenue generation was not a priority, the discriminatory price rule seems to have served the objective of speed (by clearing the market quickly) at the expense of equity (although not necessarily utility).

# D. An Assessment of the Bidding Rounds"

There were ultimately five bidding rounds from March 1 to December 22, 1992. In the early rounds when price divergence across enterprises was small, bidders focused on high quality, high price companies. In the second and third rounds, it was still possible to buy shares in an expensive company for the modest price of 3/100 to 1/400. By the third round when price divergence increased, there was a massive shift in market demand to low price firms, some of which had been priced very low because of the excess supply of their shares in earlier rounds. Because of
- 16 -

this pattern of bidding, equilibrium was reached more quickly in the market for high price shares, whereas the low price share market was more volatile in the early rounds.

The IPFs started with almost three-quarters of all voucher points (72%) and ended with about two-thirds (66%) of the book value offered in the first wave of the coupon scheme. The largest shareholders were the same IPFs that began the process with t..e most points - the Czech savings bank (6.9% of shares), and the largest Czech and Slovak commercial banks (2.9% and 2.6% respectively). The ten largest IPFs controlled 23.6% of all shares at the end of the coupon scheme. The distribution of **TP** shareholdings was fairly normal and ranged from the smallest IPF with 164 shares to the largest with 19,120,802 shares. IPFs bids constituted a declining share of total bids with each round (from a peak of **_75%_** after the first round to about 50% in the later rounds). In contrast, individuals tended to bid more aggressively in later rounds as they gathering more information. Nevertheless, IPF participation rates and success at securing shares in each round (with the exception of round 4) tended to exceed those of individuals. This differential performance may be attributed to the IPFs' better organization and better information.

Enterprises Characterstics and Prices. What characteristics determined the final price at which enterprises were sold? Table 4 categorizes firms into those that sold at low, medium and high final prices and provides data on average characteristics of these enterprises. The characteristics that were associated with different selling prices are discussed below.
- 17 -

Table 4: Charactsics of Enterprises by Share Price (1991)

||**Avege**Book<br>**Value**<br>**(Milion**Kos)|**Aveag**Equity/<br>Output|**AvarapEquity/**<br>**EmploYmnt**|**Average**<br>Profit/<br>**Output (%)**|**Aveoge**Prorit/<br>Equity (%)|**Avenge Employ-**<br>en/Output (%)|**Average**<br>**Dcbi/**<br>Equity (*)|
|---|---|---|---|---|---|---|---|
|**Hish P,i. Eatmprise**|272.72|o."|339.62|13.55|35.94|0.38|173.32|
|Medium**Price**Euterprime|383.03|**1.16**|**643.64**|**6.25**|14.92|0.44|145.93|
|**Price Entepris**|441.75|1.41|405.07|0.71|7.28|**f.39**|102.54|

-- **in ound in ebich bidding wvu ompted: pi" etepriuua: Sbarwfa/vestmen Point** < - 0.015 **or** 3 _sbar_ **_per_** 200 **point** ;us **pice anterprise: Shaneinlveiment Poibts** < 0.06 or **shades p_r** 100 **poins ad** _>_ 0.015 or 3 **wbat** per 200 **points .&W** price **eteprises: SbarueIvessme** Poina > - 0.08 **ort** sham pt 100 **poins**

Profitability. Perhaps the most prominent characteristic of enterprises that sold for high prices was their very high profitability. Profits as a share of equity were five times greater and profit/output ratios were 19 times greater thaa those of low price firms. Despite government warnings to the contrary, investors did use past profitability as an indicator of future performance.

=. Scale was clearly important since high price enterprises tended to be small and low price enterprises tended to have the highest average book value. The size of the enterprise was not very important for individual citizens, whose shares were actually distributed in favor of large enterprises (Table 5). Individual investors were simply too small to have a serious hope of influencing management. Instead, they seemed to focus on large, well-known enterprises. In contrast, the IPFs, particularly the small and medium ones, focused on smaller firms where they could hope to have greater management control." Small IPFs acquired shares in only 9 large enterprises. Medium sized IPFs also focused on smaller enterprises, but also bought shares in 380 medium sized enterprises, such as food-related industries. In contrast, the large IPFs had a wider distribution of shareholdings which included larger enterprises. Because
-1l8-

of the rule limiting their holdings in any individual enterprise to 20% of total shares, the large IPFs had little choice but to diversify their bids across companies of all sizes. lhese size preferences of bidders were clearly reflected in the sales price of firms with investors getting more shares per investment points in larger enterprises.

<!-- Start of picture text --> Table 5: Number of Eneprim by Individual<br>and IPF Shares by Size and Pac*<br>Sim oJnf f,2dmls<br>S.aiI Modium Large<br>Individuual 751 527 213<br>(13%) (30%) (57%)<br>IPF by Sizel<br>Small 335 126 9<br>(71%) (27%) (2%)<br>Medium 470 380 99<br>(50%) (40%) (10%)<br>Large 291 368 16S<br>(35%) (45%) (30%;<br>High Price 220 88 36<br>Modium Price 340 254 97<br>Low Price 138 142 59<br>Shares/nvest- 0.054 0.078 0.086<br><!-- End of picture text --> Produtivi. For high price firms, capital/output and capital/labo **r** atios tended to be low. This implied that high price enterprises were not capital-intensive and had relatively small, but highly productive labor fbrces (as evidenced by the low labor/output ratios in Table 3). Relatively small labor forces also meant fewer problems associated with the redeployment of labor often associated with
-19-

restructuring. Since it Is usually easier to hire than to fire labor, physical assets and small but productive labor forces tended to be v.'ued more highly. Past indebtedness did not deter investors and high priced firms had the highest average debt/equity ratios. This average may have been biased upv rds by the banks, trading and insurance companies which, by the nature of their activities, are highly leveraged." Foreign Investor. Foreign investor participation was also an important indicator of ultimate selling price. In the group of enterprises that sold for high prices, foreigners were likely to have shareholdings that were over nine times greater on average than in enterprises that sold for low ptices. The average foreign investor shareholding for the 340 firms that sold at low prices was 0.21%; whereas it was 1.87% for the 341 enterprises that sold for high prices. Although average foreign investor shareholdings look small, they are actually concentrated in a handful of firms. Thus, foreign investor Interest was considered a good signal of enterprise prospects, in part because there would be a major shareholder with controlling interest.

Rgublic. Slovak firms so:d at prices that were 40% less than Czech firms on average. Czech bidders focused almost exclusively on shares in the Czech Republic, with less than 5% of their bids going to Slovak firms. Individual Slovak investors did show some interest in Czech firms, with about 15% of bids placed for firms based in the Czech Republic. In contrast, Slovak IPFs bid about 40% of their points on Czech firms in the various bidding rounds.

# V. Conclusions

How successful was Czechoslovakia's approach to mass privatization? One's conclusion depends crucially on the criteria used to evaluate success. In terms of the government's
-20 -

own stated objectives - to transform ownership through a process that was fast and fair - the coupon scheme was successful. The fairly narrow objective of Czechoslovakia's privatization program - ownership transformation -wu driven by the conviction that 'ownership mattcrs". Thus any assessment of the coupon scheme's success hinges on whether one believes that simply transferring ownership from the state to the private sector will result In eventual productivity gains. This Is an issue that has been much debated and only recently has there has been some empirical evidence on the wefare consequences of privatization." In detailed case studies of twelve enterprises by Galal et al, productivlty increased in seven firms after privatization and remained constant in five. Domestic welfare, which includes benefits to consumers, govrnment, workers and competitors, improved in ten out of the twelve cases. All of these case studies which have found that ownership matters have been in market economies where privatization was part of an incremental, rather than a fundamental, effort to achieve efficiency gains. Therefore, any economic assessment for a transition economy must also consider the possible consequences for corporate governance. The conclusions that follow evaluate the scheme in greater detail In terms of speed, equity, and corporate governance.

# A. Sped

In terms of speed, the coupon scheme was successful. ITe inventory of all state enterprises for privatization took much of 1991 with a full list of 2744 medium and large scale enterprises selected for the first wave published in November 1991. Six months elapsed for the supply side of the coupon scheme to be prepared, privatizatdon projects to be selected', and a list of the 1491 enterprises included was published in May 1992. The endre bidding process took eight months - from May to December of 1992; Thus the cycle of project preparation, public information, and bidding for almost 1500 enterprises took a total of 14 months - an average of over 3 medium and large scale enterprises privatized per day. The economic gains from speed are more rapid
-21 -

restructuring and less scope for **asset** stripping and 'spontaneous privatization" In the transition period.

The major sources of delay wor asociated with the supply side, particularly with project preparation and review as well **as** with restitution claims. Once privatization projects were identified, the demand side proceeded very quickly. Although enterprisos have been in a period of management and ownership limbo, that undairable state has been relatively shorter than in other transition economies. Thi time savings can in part be attributed to the government's decision<sup>not to</sup> restructure in any substantial way prior wo privatization. Thero was an additional delay in transferring ownership to the now shareholdors afker the bidding was completed which was caused to a large extent by the break-up of the Federation. This was resolved and shares were iued and began tmding in the summer of 1993. The IPFs are beginning to meet with enterprise management to review balance sheets and to define a business strategy. This is particularly so with the "plums' in the IPFs' portfolios, but there may still be a iargo number of enterprises that continue to have no effective owner.

# B. Eguiix

The objective of equity was achieved by establishing a process that was largely transparent and created a level playing field for all potential buyers of shares thr(ugh the coupon scheme. There was no systematic bias in share allocations in favor of "insiders" (either<sup>management</sup> or workers), in contrast to the mass privatization scheme in Russia, Poland, Kazakhstan and Lithuania. The government provided information about enterprises to the public and allowed the market to interpret the data. Thus the govermment did not have to address the difficult issues of valuation of enterprises in a transition economy; those judgements were left to the collective wisdom of coupon holders. In general, the process of generating information was highly decentralized,
- 22 -

although market clearing was centralized becau it had to be simultaneous. Information was also provided to those interested in submitting privatization proposals and in managing enterprisa. Information was also provided to the public and to the IPPs (who wer, also decentralized and emerged endogenously) who would bid for shares in these enterprises. The f -vernment's role **was** simply one of providing a framework and a set of rules in which these potential managers, firms and shareholders could find each other.'9 The results of the bidding rounds Indicate the degree to which the public used the information provided by the government. Popular firms did tend to have high profits i" the past **and** a typgraphical error in the data was enough to swing market bids dramatically (such as case a of a hotel in t'ie firb: iddilug round). But informal sources of information did play a role, as evidenced by the diversiL, if enterprises that sold for either high or low prices. There was a large element of share price determination that could not be explained by published information alone. The fact that some people did have 'insider information" about the true value of some enterprises was not considered a systemic bias, particularly since such privileged information would often be revealed in the bidding process.

The elements of the privatization process that were the most criticized for unfairness were precisely those elements that were the least transparent. In particular, the review of competing privatization proposals on the supply side had a large subjectiv **e** lement which left scope for favoritism. The requirtment that proposals chosen for inclusion in the privatization program be reviewed by both the founding Ministry and the Ministry of Privatization did provide one, albeit imperfect, check against croonyism. The only other process that lacked full transparency was the workings of the price committee which set new prices after each bidding round. The working of this committee was sometimes criticized, but there were never any serious allegations made. Other issues such as the discriminatory pricing rule and the fact that some people were left with unused and
- 23 -

worthless points at the end of the process, could be considered 'unfair" outcomes that emerged from a **"fair** process. In general, the transparency of the process was critical for insuring broad-based public support for the privatization process.

The privatization of insolvent enterprises also raises a number of equity issues. Enterprises were required to proceed with privatization, regardless of declared insolvency, to avoid maagement using financial distress as an excuse for avoiding privatization. The consequence is that som. individuals and IPFs hold worthless shares and (conceivably) potential liabilities. Although the _actual_ losses incurred by shareholders are likely to be small, since they paid only a nominal fee, political support for the privatization program will be adversely affected. The situation is more complex in cases where insolvent bsnlks have been privatized. In general, bank shares sold for high prices, despite knowledge of substantial bad loan portfolios, possibly reflecting expectations of an eventual government bail out. However, any such bail out would result in either windfalls to existing shareholders or 're-nationalization' of the banks. Because of this clear trade-off between equity and credibility of the privatization program, firms that were known for certain to be insolvent should probsbly have been excluded from the voucher scheme. Instead, the government could have reorganized these firms to privatize the viable parts and liquidated any remaining assets.

# C. Co=orate Governanea

What was the distribution of ownership that resulted from the coupon scheme and what are the implications for corporate governance? Table 6 provides the average distribution of shares between individuals and IPFs that resulted jOrom the coupon scheme. For the entire sample, shares are split almost evenly between individuals and investment funds. The average firm in the sample has about 3 investment funds involved as shareholders. However, in the Czech Republic, the Investment funds tend to have controlling interest whereas in Slovakia, it is individual citizens who
- 24 -

are in the majority. There is also an extreme polarization based on the final selling price of the firm - with the investment funds having clear majorities in medium and high price firms and individuals dominating in low price firms. This pattern would seem to reinforce the greater likelihood of success of enterprises that sold for relatively higher prices. Non-coupon shareholders in the 1491 enterprises are also distributed very unevenly across Republics and

|Table 6: Governance: Average Di<br>of Enterprise Ownership<br>in the Coupon Schene<br>Coupon Sche<br>Individuals|stribution<br> <br>me<br>IPFs|
|---|---|
|Total<br>48.6|51.4|
|Czech<br>453|547|
|<br>.<br>Slovak<br>55.1<br> <br>|.<br>44.9|
|Low Price<br>56.6|43.4|
|Medium Price<br>42.7|57.3|
|high Price<br>47.7|**_52.3_**|

across enterprises of different prices. On average, Czech firms have much larger shareholdings by foreign and domestic investors, restitution claims, bank and local authorities. In contrast, governance in Slovak firms is far more diffuse on average. In fact, such diffuse ownership by individual coupon holders may result in de facto management control, more along the lines of so-called 'spontaneous privatization" in other countries. Similarly, high price firms also have a greater proportion of their shares held by significant noncoupon interests relative to low price firms. Thus the initial prospects for corporate governance are far more favorable in Czech firms and in firms that sold for higher prices.

In many countries, there is a strong tendency for share ownership to quickly become concentrated after the initial dispersion of ownership caused by mass privatization.' It is not surprising that many individuals participate in the process to take advantage of the transfer element, which they are keen to convert into a cash transfer as soon as possible. Thus those that are interested in actually managing the firm tend to buy 'out those who participated in order to take advantage of the public transfer. However, in Czechoslovakia, this process of concentration has
- 25 -

been partially thwarted in part by the law restricting IPFs' shares to 20% in any enterprise, which is intended to protect shareholders in the IPFs. Nevertheless, one can expect cash-poor shareholders to sell shares to cash-rich investors, in effect simulating direct sales through the secondary market.

Nevertheless, the key players will be the IPFs, who control most of the shares and are likely to be at the forefront of financial deepening and enterprise restructuring. The behavior of these IPFs is not yet known. The evidence from the bidding process indicates that there was an effort by IPFs to focus on firms where they could have controlling interests. Early anecdotal evidence cf IPFs taking an activist role in enterprise management is encouraging. There are also cases of individual investors forming shareholder associations. But the IPFs will also be under enormous pressure to distribute dividends to shareholders (to whom they made promises of substantial quick returns), which may result in decisions inconsistent with restructuring for the long term. The interests of minority shareholders may also be jeopardized . It is also not yet clear from where the capital for restructuring will come. Since coupon privatization does not bring new money into the firm, owners will have to rely on retained profits, new investors, or the banks for investment. Without modifications to the regulatory framework for investment funds, some protection for minority shareholders, and some clarification of the relationship between banks and investment funds, the process of restructuring after privatization is likely to be more costly than necessary and fraught with moral hazard and agency problems.

It is possible to thiak of four possible outcomes depending on the competitiveness of enterprises and the eventual character of corporate governance (Figure 2). In those cases where enterprises prove to be viable under current competitive conditions and have effective governance either through a major shareholder or through associations among IPFs or individuals), pr-luctivity gains from privatization will result. These will be the success stories of mass privatization. Another possibility are enterprises that are not viable. Those in the fourth quadrant of figure 2 would move to
- 26 -

bankruptcy proceeings, assuming implementation of Czechoslovakla's stated commitment to avoiding continued subsidies to nonv.able enterprise. Because of the speed of the process, the advantage of mass privatization is that these frm would start bankruptcy procedures relatively sooner, thereby .educing the costs to society of keeping then afloat. ITose firms in the third quadrant would adlo move to bankruptcy. But had there been some effort at restructuring prior to privatization. some parts may have been viable and productive. The fourth possibility are enterprises that are viable, but for whateve **r** easons lack effective governance. This last group can be considered the seal **'casualtl** of mass privatization' - firms that might have made productivity gains if a different method of privatization had been used.

# **Eg=** _2:_ Outcome from Privatizadon: The Role of Competidon and Govemance

<!-- Start of picture text --> Governance<br>effective ineffective<br>1 2<br>viable success stories casualties<br>of mass<br>privaizaton<br>Comnpetitiveness<br>3 4<br>non- bankruptcy, but smaller bankruptcy<br>viable loss with restructuring and<br>before privatization? liquidation<br><!-- End of picture text --> The likely success of a mass privatization scheme depends to a large extent on the distribution of enterprises across these quadrants in Figure 2. The differences across the Czech and Slovak Republics illustrate the point. In fact, the privatization program was almost like a controlled experiment with the same policy applied to two different economies. In the Czech Republic, where the structure of industry was more competitive, the mass privatization scheme seems to have worked
- 27 -

far better. There was genuine competition on the supply side with the average Czech firm sought after by over 17 different privatization proposals. A greater portion of shares were brought by foreign or domestic investors who sought controlling interests. The higher prices at which Czech firms sold in the bidding rounds was an indicator of the market's assessment of the greater viability and profitability of Czech enterprises. There seems to be more evidence of shareholder and particularly IPF management activism In the Czech Republic. Thus a better initial position (more enterprises in the first quadrant) at the start of privatization resulted in a better initial position for restructuring.

In contrast, in Slovakia, with a less competitive enterprise sector, there were far fewer privatization proposals (2.9 for each enterprise on average) and no real competition among potential buyers (more firms in quadrants 3 and 4). Ninety-two percent of enterprise shares were sold through vouchers directly to citizens with no other investors with significant controlling interests. Thus the initial shareholding structure in Slovakia is more diffuse than that in the Czech Republic with more firms in quadrants 2 and 4. Also, because both the banks and the IPFs are very oligopolistic in Slovakia, there seems to be little pressure on them to initiate enterprise restructuring. It is almost trivial to say that privatization is more difficult in economies characterized by heavy industries that were artificially established through central planning. But the choice among different approaches to privatization depends crucially on the trade-off between losses associated with the time taken to :structure enterprises prior to privatization versus losses from potentially viable enterprises that emerge with poor governance under a mass privatization scheme.

# D. Concludini Remarks

# Political Visin. Perhaps the most important element in Czechoslovakia's mass

privatization prograrn was the clear political commitment to a bottom-up process. Without such a
-28 -

vision, and an administrative infrastructure with integrity to implement it, the scope for political infighting and corruption to thwart privatization are enormous. 'This is perhaps the most difficult thing to replicate In other countries. The other key factor was that privatization was n= asked to achieve too many objectives beyond ownership transformation. Too often, the privatization process is expected to address regional development, unemployment, and fiscal shortfalls. None of these were objectives of Czechoslovakia's mass privatizaon program. While there was some attempt to evaluate the quality of business plans submitted by competing privatization proposals, there was no attempt to systematically favor proposals that promised to invest in cortain regions or to preserve jobs. From a budgetary point of view, the coupon scheme **was** irrelevant. The Kcs 1000 paid by each of the _8.5_ million individuals participating in the procoss **was set** to cover the expenses of running the scheme. In fact, because of the desire to transfer **assets** to the public, the scheme actually had adverse budgetary consequences in the short run if the counterfactual is privatization through direct sales to domestic and foreign buyers.<sup>21</sup> In the long run, however, a more profitable privatized enterprise sector is likely to mean enhanced tax revenues for the government.

Dealing with the Information Problem. Privatization in transition economies is essentially an information problem. The process tends to stall on issues such as valuation of enterprise assets and the viability of a firm under a completely different set of relative prices. The major achievement of the Czech and Slovak approach was in creating a process that generates information and treats it like a public good. Markets that are information-intensive are often imperfect, especially where there are large fixed costs associated with being informed. In Czechoslovakia, these 'fixed costs' were shared by all citizens participating in the scheme and the resulting process of centralized bidding by decentralized actors generated the best available information to increase the competitiveness and efficiency of the market.
-29 -

The special role of information bocomes apparent when the sequential rounds **and** simultaneous bidding used in Czechoslovakia are compared to some alternatives. For example, a single simultaneous bidding round that allows agents to make multiple bids (thereby revealing their demand curve) could have been used, but would have favored those who had access to privileged Information and gonerated no intermediary information for other bidders. Similarly, an auction that was not simultaneous, but was conducted individually for each enterprise (similar to that occufring in Russia) would not have generated the relative price information that facilitated the emergence of a market equilibrium. The particular advantage of the Czechoslovak approach was that the bidding rounds themselve **s** erved to put information about enterprise values in the public domain by allowing increaingly informed bidders to interact. Thus there were clear positive externalities for uninformed bidders.
**-30-**

ANNEXES

# Annex A: Preparation of Enterprises for Privatizatlon

An inventory of all state property was conducted in 1991 and information **wa** published to solicit privatization proposals. Enterprisa were divided into two 'waves depending on their rediness for privatization and a small third category consisted of fim that would remain In stoa hands. Many of the more complex privatizations -such **as** onrgy, health services and qrlculture - were postponed to the second wave. The inventory of enterprises for the first wave of lae scale privatization, consisting of 2744 enterprises, was published on November 20, 1991 with a deadline for submitting projects of January 20, 1992. Tbe list of enterprises for the second wave was published on April 16, 1992 with a deadline for submissions of June 16, 1992.

Privatization projects included proposals on what proportion of shares would be sold through which means, but founding ministries also made recommendations about the use of different methods of privatization. In general, there was a strong preference for competitive processes - **such** as public auctions, tendors, or vouchers - over direct sales to predetermined buyers.> In the **case** of privatization by direct sale, the decision also had to be approved by the Economic Council of the government, to insure transparency and then implemented by the National Property Fund, the executing agency for privatization. In the vast majority of cases, domestic and foreign buyers were treated identically. All privatization projects also had to insure that all restitution claims have been met or that resources have been set aside to meet future restitution claims. Three percent of the shar of all joint stock companies undergoing privadzation were set aside in a National Restitution Fund. Where restitudon claims were clear, the property was returned to the original owner and resulted in one of the quickest forms of privatization. But resdtution claims also slowed down the
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privatization process in many cases where there were legal complications surrounding claims. In **cases** where the state itself could not document its own ownership, and therefore its right to privatize an enterprise, delays resulted.

Review of competing proposals was conducted by the sectoral or "founding" ministries initially who passed on their recommendations to the Ministries of Privatization in the Czech and Slovak Republics. In the early stages, there was an emphasis on the quality of privatizatlon proposals and in particular the business plan and investment commitnent presented by **the** buyer. **After** criticism that these criteria were too subjective and time-consuming, the new govermment began to rely more heavily on price as a criteria for selecting buyers where direct sales wore involved.' lhere was also some divergence in views between the Federal Ministry of Finance which originally preferred voucher privatization and the Republic-level Founding Ministries and Ministries of Privatization which generally preferred direct sales. The Federal Ministry of Finance saw the governrment's role as simply one of processing projects (most of which were expected to be basic projects proposed by enterprise management) and insuring that issues such as restitution and foreign investment were managed according to the law. The Ministries 3f Privatization wanted to take a more active role in evaluating the quality of altemative proposals and tended to prefer direct sales over methods that would result in more diffuse ownership.

Nevertheless, the review by the Republic-level Ministry of Privatization was an important check to insure that the process was not biased in favor of existing management and did not simply reinforce old power structures. This final review function concentrated a great deal of power in the hands of the M.nistries of Privatization, which in some cases did overturn the recommendation of the founding ministry. In order to accelerate the process and protect it from excessive lobbying, the final approvals of projects by Ministry of Privatization officials were conducted in isolated locations outside of Prague and Bratislava. In an intensive month, those projects that would be
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included in the voucher scheme were reviewed and selected. Those responsible for alternative projects were summoned to give additional information as needed to sequestered government officials. The major delays in the large privatization process occurred because of problems on the supply side. The original target for basic project submissions was October 31, 1991 and November 30, 1991 for competing projects, which would have allowed the bidding process to begin In January 1992. However, the Ministries of Privatization extended the deadline for project submissions by two months to allow for more competitive proposals. The result was that about threequarters of all proposals were competitive projects and only one-quarter originated from the enterprise. Because this enabled additional proposals to be submitted, the time required to review alternative privatization projects was greater, causing further delays. Ultimately, rather than begin in January 1992, the bidding process began in May 1992. This was still before the June 1992 parliamentary elections, which was an important deadline for the government which wanted to show quick results and to create stakeholders in privatization among the electorate. Although this delay was a great source of tension within the government, five months is a relatively short time considering the setbacks to privatization experienced in other countries.

# Outcome on the Supply Side of the First Wave: Divergence Across Republics

A total of 18,106 privatization projects were submitted in the first wave, of which 16,609 were submitted in the Czech Republic, 1,436 in the Slovak Republic, and 61 at the Federal level.21 Of these projects in the Czech Republic, 3638 were basic projects submitted by enterprise management and 12,971 were competing projects. This implies that in the Czech Republic, the average enterprise had 17.6 projects submitted, 13.8 of which were submitted by competing "outsiders.' In contrast, in the Slovak Republic, the average enterprise had only 2.9 projects submitted, 1.4 of which were from competing "outsiders." Of course the number of projects
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submitted varied enormously across enterprises. But it is clear that in the Czech Republic the supply aide was far more competitive than in Slovakia, where rmore proposals were submitted by insiders than outsiders and where there were fewer interested parties for any given enterprise.

The projects submitted in the first wave varied across the spectrum of privatization methods, but the distribution varied signiflcantly across the Czech and Slovak Republics. Relatively more Czech enterprises were privatized through direct sale whereas more Slovak firms were sold through the coupon scheme. In the Czech Republic, about _45%_ of the proposals were for direct sales, 22% for commercialization toa joint stock company which was a precondition to voucher privatization, 11% were for public auction, 8% for public tendor, 8% were for unpaid transfer to municipalities or financial institutions, and 4% were for privatization of a stateowned joint-stock company.27 In the Slovak Republic, _55%_ of total book value privatized was sold through the coupon scheme and only 8% was sold through standard method **s** uch as direct sale. The remaining shares were placed in the National Property Fund or were set aside for restitution claims.