The Heritage Foundation

Backgrounder #859 on Russia

October 11, 1991

October 11, 1991 | Backgrounder on Russia

The Former Soviet Republics Confront Privatization: A RussianAnalysis

(Archived document, may contain errors)

859 October 11; 1991 THE F'ORMEX SOVIET REPUBLICS CONFRONT PRIVATIZATION A RUSSIAN ANALYSIS Leonid Grigoriev EL. Wie gand Fellow INTRODUCTION one of the most urgent tasks for the republics of the fanner Soviet Union is to dis mantle their inefficient, statedomjnated economies and to turn over to private owner ship virtually all state-owned agricultm, businesses, housing , industry, and land. This transition from a communist command economy to a market economy-commonly known as privatization-must be undertaken with unprecedented speed, because the Soviet economy is collapsing, and only a growing, robust private sector can s ave it ucts, increased wages and decreased costs to government. Of course, privatizatita is not a panacea for all that ails the republic economies. To be effective, privatization must be accompanied by other refoxms such as price and trade liberalization, tight con trol of the money supply to avoid inflation, deregulation, tax reform, and budget cuts Formidable Obstacles. Recent experience with privatization in Eastern Europe demonstrates that the republic policy makers face foxmidable obstacles. Foremost a mong these is the sheer size of the undertaking. By some counts there are approxi mately 46,000 large state enterprises and 750,000 stae-owned shops on the territory of the former Soviet Union. In addition to finding methods for turning these entities ove r Privatizing the state sector will result in haeases in efficiency, higher quality prod This is the first of aseries onprivahthnin the former Sovietrepublics.'lhe ppose ofthis study is to provide m ovemiew of some of the problems the republics face in uyi n g to privatize their economies. Subsequent parts will offer xecommendattons dGtailing the options available to republic policy malrers to ovemhe the obstacles to privatizatiOn After complethg his tam as The Heritage Foundation's EL Wiegand Fellow. Leaid G rigoriev has returned to the In sta~tute of World Economy and Intenratiosral Rl?latirmP, Msoyuznaya Slr 23. MOSCOW, 1174

18. U.S.SR., FAX private ownership, the 50 percent of the housing stock still in government hands and the bulk of agricultural land also need to be privatized. Privatization on such a mass scale has never been attempted.

Technical and economic obstacles to privatization in the republics include the lack of savings, an absence of capital markets and banking institutions, and a currency that cannot be converted into Western hard currencies needed for international transac tions. Agricultural privatization is a particularly difficult task. Furthermore, the hatie nality of Soviet prices, which have been set arbitrarily by the stat e rather than market farces, makes it nearly impossible to correctly value the state enterprises to be privat ized As if these problems were not enough, political and social obstacles to privatiza tion are sure to arise, including opposition from local off i cials and the nornenkdutwa the Soviet Unions entrenched bureaucracy-new problems of envy, the need to privat ize in an equitable way, and control over part of the underpund economy by the So viet Unions own mafia of organized crime republics are formidabl e , they are by no means insurmountable. Most of these prob lems have been encounted in privatization efforts in other parts of the world, and have been overcome by economically sound and politically savvy policies. The lack of capital markets and domestic s avings and the problem of how to value enterprises can be overcome by giving away state assets, rather than selling them. The opposition of workem, factory managers, and local officials can be tumed around by giving them a stake in promoting the developme nt of a market economy. Some of the giant apindustry state farms can be privatized by turning them into joint-stock compa nies and giving workers shares in the enterprise.

Finally, the republics should be expected to rely on internal financing and private foreign investment for privatization, not Western government handouts. Foreign fms are already very active in the republics. In the near future, there should be much greater foreign interest in purchasing stakes in the more profitable enterprises. Repub l ics should encourage greater foreign participation in the privatization process because it brings in needed capital and managerial expertise.

Without doubt, the peoples of the former Soviet Union will encounter political and technical difficulties in the p rocess of privatization. However, they have no alternative but to embark immediately on this task. The longer they wait, the mare difficult it will prove Sound and Sawy Policies. While the obstacles to privatization in the former Soviet POLITICS AND PRIVA T IZATION The new political situation after August 19s failed coup has resolved the issue of what to do with what is known as all-union property. Virtually any enterprises or other assets owned by the Soviet central government, or center, it is widely ackno w l edged, now will belong to the republics. It also is clear that privatization will be almost entirely the responsibility of the republican governments rather than what remains of the center. While some republics unwisely may choose to go slowly, republic a n con trol of privatization on balance should accelerate the pn>cess, as has been demonstrated with privatization efforts around the world 2 HOUSING The main danger is that some republics may try to exclude outsiders from bidding on enterprises within the i r territory. Such a restriction of capital flows would be self defeating because it would decrease the amount of capital available for purchasing and subsequently modernizing the enterprises, thereby slowing the process. These and other resmctions on capi t al flows and free trade-such as restricting exports-explic itly should be rejected by the republic governments. Any program of privatization also will require tailored approaches. Policy makers, for instance, face much different politi cal and technical o b stacles in privatizing housing than they do in privatizing large in dustry Problem of Restitution. Eastern Europes recent experience with privatization demonstrates that the issue of restitution-returning land and buildings nationalized by communist gover nments to their former owners-can slow privatization signifi cantly.

This is because competing claims on properties can result in prolonged legal battles and uncertainty regarding title to properties. It also discourages foreign invest ors, who may fear th at their investment will be lost in the event of a claim by a previ ous owner. Restitution currently is a real issue only in the Baltics, which already m committed to returning land taken from private owners by the Soviet government after World War II.

In the rest of the former Soviet Union, restitution primarily affects those who emi grated around the time of the 1917 revolution and ensuing civil war. This is because only those living outside the Soviet Union managed to hold onto the legal papers to thei r estates; within the Soviet Union, possession of such documents could have meant a death sentence during the Stalin era. Up to now, this issue was seldom discussed pub licly in Russia or most of the republics. But if restitution to emigrants becomes an is s ue it could be an extremely controversial one, especially since the land of many for mer countryside estates is now part of heavily industrialized cities Housing is one of the most politically sensitive sectors of the economy and needs to be privatized ra p idly. Only one half of the housing in the Soviet Union currently is pri vately owned. These are primarily houses in small towns and villages, as well as some condominiums in large cities. The average Russian citizen has 160 square feet of living space, or about the size of a kitchen in an American home. Most housing is heavily subsidized by the state and therefore very inexpensive, equalling only 5 percent to 10 percent of an average individuals salary. Yet this system had tremendous costs to the average c itizen. Thexe is a dire shortage of housing in the Soviet Union. Some families wait ten to fifteen years for housing. And some never get their own apartments and are crammed in with relatives or housemates, particularly in the cities.

The process of assign ing apartments is a bmaucratic nightmare; there axt innumera ble waiting lists for all categories of people, including veterans, families, singles, and others. Assigning housing is one of the most important, and lucrative, activities of local authorities. Corruption is rampant. As a matter of course, bribes to local officials are required to obtain apartments. Once apartments are obtained, residents come to con sider the apartments their own, even though technically owned by the state, shce it is 3 virtual l y impossible to lose an apartment even if the rent is not paid. This will make privatization of housing a contentious political issue, since those who want to keep their homes will have to start paying for them, and because local opposition will arise if individuals from outside the community begin to move into local housing, displac ing current residents.

Between 1986 and 1988, there was considerable growth in housing construction.

However, since 1989 the rate of construction has dropped by one-fourth. The absence of private land and restrictions on entrepreneurial activity are preventing any improve ment in the situation.

Recent Reforms. A law passed in early August by the Russian parliament gives all Russians the right to own their own homes. Existing living quarters will be transferred to current residents if they want to become owners. The first approximately 200 square feet of space per family member will be transfed free of charge. If the total ami of the apartment exceeds this, then the resident w i ll have to pay the state for the extra space. price will be determined by quality and location of the apartments. Those who choose not to assume ownership of their apartments can continue to pay rent instead but the rent will go up significantly based on market factors. A similar program of housing privatization is being undertaken in Lithuania.

One problem with the Russian law is that it is not clear who will own the buildings the newly-privatized apartments are in, and who will be responsible for maintenance of common areas, connections with public utilities, landscaping, and other tasks. Plans are for the state to retain responsibility for maintenance, but there is no reason to be lieve that the state will do any better than the poor job it is doing today.

Ultimately, the critical need is to encourage the new construction of private housing.

T his can be done by slashing complex and burdensome government regulations gov erning construction-regulations that were set up for the precise purpose of discourag ing private construction. This will facilitate free entry into the housing market. The re s u lt could be a housing boom that would be a driving force behind economic expan sion by increasing the demand for lumber and other construction materials, wiring plumbing, and other goods needed for homebuilding TRADE, SHOPS, AND RESTAURANTS The experience in Eastern Europe demonstrates that privatizing retail trade and food services can be relatively easy. In Poland for instance, over 60,OOO such establish ments were privatized in a little over one year. Armenia, the Baltics, Georgia, and pos sibly Ukraine also will be able to rapidly privatize shops and restaurants. However small-scale privatization may go more slowly in the other republics, including Russia.

There are several reasons for this. For one thing, there still exist strong prejudices against pri vate trade, ingrained by years of exposure to official ideology; Many peo ple misguidedly consider trade a farm of pmfiteering that benefits small groups at the expense of honest members of society. Such anti-market attitudes, while probably not that wide s pread, could be an impediment to refarm in some localities 4 For another thing, in many parts ofthe former Soviet Union the so-called'tnder ground economy largely controls the regional supply of goods. All attempts by the government to uproot this suppnss e d farm of market economy have failed.To be sue the undagroundeconamy has its advantages. With the breakdown of the state distribu tion system, the underpund economy has become the only reliable source of supplies for retail shops. On the negative side, a s egment of the underground economy is am trolled by organized crime, which is engaged in exdon, rackekering, protection, and drug pushing. In many areas, the local crime ODganizatian is iq collusion with the nomedazuru. which is bribed to protect criminal m onopolies. A signifhut percent age ofcoopemives axe conmlled in this way, resulting in much higher prices for goods that axe ofthe same dismal quality as those which would be found in state stores, if they had anything on the shelves. It will be extremely difficult fix the govern ment to sepanue the beneficial and the uiminal elements of the undergmmd economy.

The greatest danger is that the nomdeuwill use the need io break up the uimi nals as an excuse to crack down on legitimate business activity.

Anoth er obstacle toprivahg shops andrestaurants throughout the former Soviet Union is that ncBilcrs often must still rely on the inefficient state distribution system for supplies. New private.businesses could fail due to the heflickmy ofthe state distri butio n and wholesale system. To avoid this, policy makers should privatize the whole selling off the shops and leaving the lest of the ccollomic chain anitrolled by the state.

Inmically, there me examples of enmpmeurism in the wholesale sector developing al rea dy hm the Komsomol-the young Cammunist league. hyiously, Komsomol members qmsented diffemt enterprises in their districts, and thedore had a good working knowledge ofavailable resources. Recently many have put this knowledge to work in the private wholesa l e trade, using their personal connections with the 1 de, distribution, and retail lev& of the ec~namy simulmly,,rak than Simply nome~atoe~thatsuppliesreach~.tiaders AGRICULTURALLAND Due to the amendous inefiiciency of collectivized agriculture, fd regions that once were agricultural exporkm, such as the Baltics and Ukraine, now must often cope with food sholtages oftheir own. Privatizing agricultural land will rapidly increase the productivity of farms in all the republics and ens= that =liable supplies of staples mch hungry citizens. In some republics, agricultural privatization is pmhg relatively easy..Exampk Armenia already has privatized 70 percent to 80'peicent of its agricul tural land.This was possible because the agricultural plots in Armenia not ve ry large, and therefore could easily be turned over to the peasants who worked the land.

In some other Iepublics, particularly Russia, quick agricultural printhation faces sig nificant obstacles The huge Size of Russia's state farms, known as hkbzes, is no t in iW In China. beginning in 1978 huge state farms similar to Russia's were privatized quickly by simply dividing up the land and distributing it to peasants. But on many large Russian collective farms then scalemachinery.Suchmachinerycannoteasilybedivi d edupamongthew~af One problem is the scale of Russia's is the adArAfgCtOD, notpxesent in aim ofwidepadlelhce on sopaisticatedlarge 5 I I Fixed Assets in the USSR at the End of 1988 by Industry I I I Houslna I524.8I I I I I I I Cultureand Arts I 20.3 I 47.5 I 22.1 I 4.63 I 4.65 I I Gloss Total Not Baltic Republics P Estonia, Lativa, Lithuania; Caucasus Republics Armenia, Azerbeijan, Georgia I Data compiled by Leoni Grigoriev. I these enterprises in private hands in a relatively short period of time will not be an easy task. In Britain, it took nearly ten years to privatize about two dozen large state owned enterprises.

There are numerous impediments to privatizing state enterprises in the republics.

These include a lack of capital markets, the near impossibility of correctly valuing the enterprises, high inflation-which makes investment inherently more risky-and a shortage of household savings to use to purchase shares in enterprises.

Most of the savings in the former Soviet Union are concentrated in the han ds of a small percentage of the population. Those who could be classified as rich-usually private businessmen or black marketeers-possess more than half of all personal sav ings. For the bulk of citizens, household savings m not great enough for major inv e st ments. Even among the relatively well-off segment of the general population, those with annual incomes in the 300-400 ruble range per capita, average savings are suffb cient only to buy one or two major items, such as a car. The majority of the populat i on possesses only enough savings to buy ordinary consumer durables, meet run-of-the mill unforeseen expenses, and supplement state pension funds for retirement. Such in 7 dividuals, with their limited resources, cannot be expected to play a major role in the purchase of state assets.

Another potential problem in selling state enterprises to outside investors would be opposition from the managers of the enterprises. Many managers consider themselves the de facto owners of the enterprises that employ them, a nd would strongly resist the loss of control. The failure of the August coup reduced the power and size of the exist ing nomenkluturu, but many still will attempt to assert control over enterprises and profit from their privatization.

An often-proposed solution to overcoming all the obstacles to rapid privatization of state enterprises in the republics is to issue vouchers fhe of charge to every citizen.

The vouchers in turn could be used to purchase shares in state enterprises. The Russian parliament approved an initial voucher system on July 3,1991.These vouchers have been termed "privatization accounts and can be used by Russian citizens to acquire sha r es in state and municipal enterprises from local or republic authorities. The voucher system has much to recommend it, yet distributing the vouchers to hundreds of millions of citizens entails enormous administrative problems. Moreover, with little availa b le accurate published information about individual enterprises, the average Rus sian citizen-in fact, even many financial analysts-will have no idea which enter prises might be good investments, or what their real value should be. The process will more cl o sely resemble a lottery than a market-oriented approach to investment based on potential profitability. Lastly, such an approach would mean that in the short run ownership of enterprises will be broad and diffuse. Without the presence of suong core owners , the enterprises may continue to operate as inefficiently as they did in the state sector vouchers would be to assign large state enterprises to "investment funds The invest ment funds would first turn the state enterprises into limited liability, joint-s tock com panies. The investment funds would be charged with selling or distributing stock in the new joint-stock companies and appointing Boards of Directors to head the companies.

The investment funds would be required to sell off their portfolio of state enterprises within a given time period, perhaps ten years A better alternative than having citizens invest directly in state enterprises with CONCLUSI0.N The failed coup has opened the door for dramatic political and economic change in the republics of t he former Soviet Union. One of the most urgent reforms for the new governments is privatization. Housing, land, agriculm, industry, stms, restaurants and services all need to be transferred rapidly to the private sector.

While the need for massive privatiz ation is generally acknowledged by most of the new leaders in the republics, privatization faces daunting obstacles that may discour age many leaders from launching an ambitious program. For instance, the lack of a capital market, which allows savings to b e transferred efficiently to investment, con strains privatization. Other obstacles are the absence of market institutions, high infla tion, a worthless and non-convertible currency, opposition from the nornenklurnu, and the sheer size of the task in the s tate-run economy 8 Surmountable Problems. To develop appropriate policies, policy makers need to have a clear understanding of the numerous political and economic obstacles to privatization. They must recognize that though the obstacles 8~e fannidable, th e y are not insurmountable. Instead of selling state assets and running into major problems with valuation, for instance, state assets can be given away. Problems with agricultural privatization can be overcome in a number of ways, including turning large a g mindustrial complexes into joint stock companies and giving away shares in the new enterprise to the workers The experience around the world with privatization--from Britain to Chile to Kenya demonstrates that heavy political apposition and serious techni c al difficulties to privatization can be surmounted through creative strategies. The republics of the far mer Soviet Union can draw important lessons from the success and failures of the worldwide privatization movement and the =cent experience in Eastern Europe. Al though the course will be a difficult one, privatization in the republics ultimately will be the critical fmt step to building prosperous economies in the republics of the former Soviet Union 9

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