3   Reforming the communist inheritance

The goals and limits of privatization

This chapter aims to assess the likelihood that the Privatization Programme would achieve its objectives, given the economic and political context of the early 1990s in Russia. Were the goals set for the privatization reform realistic and, if so, what economic and political conditions were required for it to be successful?

The chapter begins by considering what was known about the industrial structure of Russia at the time. The reform programme, both its successes and failures, can be appreciated only in the context of understanding the economic institutions to be reformed. The chapter does not claim to do full justice to the nature of Soviet inheritance or to the state of the Russian economy in 1992. Indeed, some readers with knowledge of Soviet economics may wish to pass over the section of this chapter entitled “The command economy”. However, there were unique characteristics of the Soviet industrial inheritance which were of profound significance to the likely outcome of reform, and, for that reason, we believe it is important that these are addressed.

The chapter goes on to consider the various objectives that had been set for privatization, and to assess how far these were likely to be achieved, and what conditions would be necessary for success. It concludes that, given the nature of the institutions to be reformed, the Privatization Programme alone could not have achieved the goals that were set for it.

The command economy

Privatization in Russia and Eastern Europe was qualitatively, as well as quantitatively, different from the privatizations that had taken place in market economies. This difference had profound effects on the process of reform and its expected outcomes in both the short and the longer term. As the European Bank for Reconstruction and Development (EBRD) reported to the Russia Consultative Group on 8 June 1993,

There is no historical precedent for the process of change now underway. Prior to 1988 there was virtually no private sector in Russia or throughout the former Soviet Union. Indeed to take part in all but the most basic private sector activities was illegal. All productive assets, including land, industrial enterprises, homes and farms were in theory owned by “the people”.¹

In practice, however, the industrial assets of the country were controlled by a state bureaucracy. It was this body that provided many of the systems of distribution, which, in the West, would be provided by market mechanisms.

The privatization reforms were unique because of what they were reforming. The administrative economy, which developed gradually after the 1917 Russian Revolution and then more rapidly as a consequence of industrial transformation during the First Five-Year Plan (1929–34) and collectivization of farms in the 1930s, was “the great Soviet experiment of the twentieth century”, an attempt “to run an entire economy of a geographically and politically significant country by administrative command rather than by markets” (Gregory and Stuart 1994: 5).

For those used to a market economy which encompasses any degree of economic pluralism, it is difficult to envisage what the Soviet experiment had produced.² A useful analogy is one that likens the Soviet economy to “a single, giant, multibranch multiplant corporation, whose organisational components are, however, autonomous within certain limits as far as their operations are concerned” (Spulber 1969: 1).

In effect, the entire economy was planned as one single unit. Similar to a large company, this could change over time to include greater or lesser degrees of centralization. But, in effect, the state controlled all enterprises and employed all workers.

The role of money and prices

As a result of the way the economy was planned, money had a different significance in the USSR from in the West. In particular, transactions between Soviet enterprises did not involve money as we understand it, just as a Ford factory supplying a Ford production line would not involve money. The rouble served “as only a limited medium of exchange, since it [could] be used among autonomous state-owned enterprises only for transferring specified goods at pre-determined prices according to specific plans” (ibid.: 161). When goods were shipped, the receiving enterprise would have a few days to raise a complaint should the goods’ quality not be up to scratch. However, if no complaint was made, the receiving enterprise had an automatic deduction made from an account at the state central bank (Gosbank) and had a credit made to the supplying enterprise. But that credit could not be cashed or used at the enterprise’s discretion to buy goods or services.

There were therefore two quite separate flows of money within the Soviet economy. One was the cash paid to workers, which could be either spent or saved at the national savings bank (Sberbank).³ The other was a bookkeeping transaction between two enterprises both of which were “owned” by the government. Within this system, prices were deeply distorted compared to those that prevailed in market economies. In general, the state’s aim was to fix prices at a level that covered accounting costs and left enough aside for investment. This system could be considered similar to a cost plus transfer pricing regime at a multi-divisional company. However, such an arrangement led to considerable complications.

Administrative pricing created many anomalies. One example was the price setting for commodities, such as oil. Oil was extracted from both efficient and inefficient wells from different regions across the country. To account for the disparities among enterprises, the Soviet government introduced the concept of cost zones. The cost zones “reflected natural differences in production and transport costs in different parts of the country” (IEA 1994: 17). An average price was determined for all enterprises in a specific cost zone; however, enterprises sold their products to the state using an individual enterprise price. This scheme resulted in the state distribution system incurring losses when individual enterprise prices exceeded the average enterprise price and gaining profits when the individual enterprise price was below. The International Energy Agency (IEA) noted that “98 different cost zones for crude oil and natural gas with average enterprise prices varying by a factor of as much as 22” existed until 1967 (ibid.). Although the number of these extreme cases was later reduced, price distortions remained high. For example, in 1991, the international (export) price of crude oil from Russia was $133.73 per tonne. The IEA’s estimate of the domestic price, on the other hand, was recorded as $1.79 per tonne (ibid.: 15). Price distortions were so great, even between the USSR and other countries in the Soviet bloc, that, as we have seen in the case of oil, divergences between Russian and international prices could be colossal. In 1991 the IMF noted that “wholesale prices have been comprehensively adjusted only infrequently … the present internal structure of prices bears little relation to world market prices across products” (IMF et al. 1991: II, 3).

Table 3.1, estimated by the IMF et al. using Soviet sources, reveals the extent of price distortion.⁴

One side-effect of the existence of two “flows” of money, together with enormous price differentials, was that they created ample opportunity – for those with sufficient power – to “arbitrage” the system. An enterprise, or an individual, who could establish a mechanism by which to divert output through a company or cooperative that was not constrained in the way it used its income, or who could, for example, sell subsidized Russian output abroad, could make a huge profit. The oil industry provides an illustration, but the same sort of arbitrage would be available wherever there were price distortions. As noted above, the IEA, writing in 1991, suggests that the difference between the domestic and international price of oil amounted to more than 90 per cent of its export value. The export of one tanker, containing 250,000 tonnes of oil, purchased at Russian prices and sold at international ones could net a profit of over $30 million. In 1991, Russia exported 91 million tonnes of oil outside the former Soviet Union.⁵ One can imagine the incentives to which this sort of arbitrage gave rise.

Efficiency, profitability and productivity

Another fundamental effect of price distortion was the difficulty of judging the efficiency or competitiveness of a Russian enterprise. Since both the value and, indeed, the very survival of an enterprise in a market economy depended on its competitiveness, this presented very real issues in predicting the likely outcome of privatization.

For example, in 1993, one of the authors worked on a project for Kamaz, a truck manufacturer, during a period when the company was contemplating western financing. The EBRD, which was considering financing the deal, requested a comparative calculation that would appraise the value of a Kamaz truck relative to its counterpart in the West. The analysis included a variety of comparative indicators, including the cost of the vehicle (Kamaz trucks were much cheaper), as well as its relative fuel consumption and the downtime it would suffer for maintenance, breakdowns and so on. The analysis showed that, when these factors were taken into account, a Kamaz truck, like many other Russian manufactured goods at that time, was not a competitive product. In part, this was because it had not been designed to be fuel-efficient, since fuel costs were so low.

Indeed, the lack of competitiveness of Soviet industry was revealed in the structure of its exports to non-socialist developed economies, where market forces might most strongly be in play. In the period 1980–89, around 85 per cent of the exports comprised natural resources or products from industries dependent on low-cost natural resources, such as paper or chemicals. Only 15 per cent of Russian exports during that time comprised manufactured goods or services, with half of that total dedicated to armaments (IMF et al. 1991: II, 70). Nor did this system of pricing create many incentives to economize on resources, particularly labour, since such resources were allocated as part of the state plan, and prices were adjusted accordingly. Generally, Soviet enterprises retained more workers than was required, with many of the enterprises employing “15 to 20 per cent more labour than was necessary to fulfil their production plans” (ibid.: 141–2). Moreover, Soviet statistics were likely to have underestimated the levels of over-staffing, “since decades of excess demand for labour may have fundamentally affected the perceptions of what are necessary labour requirements” (ibid.). Thus, the comparison of western-built plants in the USSR with matched plants in the West indicates that Soviet plants employed 50 to 150 per cent more workers (ibid.).

We will return later to these issues and to their implications for the Privatization Programme.

Credit and capital

Despite this apparent lack of competitiveness, the system was kept going by administered prices, and by the issuance of credits by Gosbank.⁶ Inefficient enterprises were either granted higher prices or were financed through the issuing of credits (Kornai 1986). Gregory and Stuart (1994: 160) point out:

Gosbank grants production credit for specific purposes: if a particular transaction is called for in the input plan, the firm is automatically granted credit for this specific purpose. Even if an enterprise builds up excessive balances at Gosbank, this liquidity still does not represent command over producer goods, unless they are specifically called for in the plan…. The demand for credit is determined as a byproduct of physical planning.

In 1992, almost all state enterprises required Gosbank financing. Put simply, there was no market for capital in Russia. Unlike western privatizations, this was not one where state enterprises were transferred to private ownership, a transactions financed by private capital markets. Privatization itself was to create those capital markets.

Commercial law

Because it was a centrally planned economy, Russia had no market-oriented commercial or financial law, which is essential in western advanced countries for allowing markets to function. In order for a market economy to function effectively, legal mechanisms protecting the rights of individuals and entities must exist and be enforceable. For instance, legal recourse must be available against those who fail to pay their bills, ultimately including a bankruptcy law. Rights of shareholders, the issuance of shares, rules concerning their subsequent trading, the responsibilities of directors, the nature of limited liability and related party dealing all must be understood, and to some degree enforceable. It needs a “calculable legal framework”. But as noted in Russian Economic Reform (World Bank 1992: 75), “administration in accordance with formal rules [was] missing from the framework of Russian governance… . The body of civil law which regulates the economic relationships necessary in a market economy is largely missing from the corpus of Soviet law.”⁷

The Russian commercial legal system in 1993 was still in its infancy.⁸ Gray and Hendley (1997: 151) point out that the 1988 Law on State Enterprises was a tentative step in the Gorbachev era away from command-administrative controls on firm behaviour in favour of some autonomy, but by 1990, “both Russian and Soviet legislation recognized privately owned business organizations of various types”. In the early years of the Federation, Russia’s legal framework was characterized by its lack of specialized legislation. For example, there was no comprehensive securities law. The existing legislation was mostly inadequate:

the bankruptcy law [was] an ineffective mechanism for creditors to seek redress … the conflict between laws, and the status of different laws and decrees; for example one observer has claimed that 14,000 regulations exist at oblast (regional) level, which are in direct conflict with federal legislation … and the considerable difficulty which exist[ed] in enforcing legislation.⁹

Just as the dual pricing system had facilitated arbitrage, so the lack of a commercial legal framework had served as an invitation to informal methods of enforcement. In the absence of an independent judiciary, enforcement may frequently have been closer to a protection racket than to legal recourse and due process.¹⁰

The lack of any history of private business until the late 1980s also meant that the market-based ethos and assumptions that underpin trust between actors in more advanced markets were missing in Russia.

Monopoly and transport systems

Within the Soviet system, although reform-minded governments tried to encourage it, incentives for competition were ineffective. It was largely absent since pricing and production were not subject to competitive forces. Soviet ministries coordinated production, with each industry enjoying monopolistic production.

The organization of production through ministries was monopolistic in more than one sense. Not only was there one ministry that coordinated production, often only one enterprise was responsible for the total production of a particular good. The concentration of production on a single site led to a remarkable degree of monopoly. This was the industrial structure that held up for a little over 60 years, and it had enormous institutional legacies, including failed systems of competition introduced only in its declining years as the Soviet government attempted to restore some life into productivity numbers.¹¹

Concentration ratios (i.e. the share of production in the hands of top firms) for the former USSR compared with the USA show that the market share “of the top four firms in any industrial market in the USA [was] lower than the top one firm in the USSR” (ibid.). Indeed, in most sectors, industrial production was highly concentrated in one or two enterprises (IMF et al. 1991: II, 16). As an example, the study reported that in the machine-building sector, a single supplier delivered 87 per cent of 5,885 products to the State Supply Commission (ibid.).

Table 3.2 gives some sense of concentration in other industries. In one sense, these statistics are astonishing, particularly since the vast size of the Russian land mass would suggest that there could be many products whose transport would be such that many suppliers would be required: cement, for example, or biscuits.

In another sense, monopoly was the natural outcome of a centralized process, and some observers anticipated that as market forces came into play, things would change. Brown et al. (1994: 7) write:

Under central planning, there was no incentive, let alone authority, for the enterprise to diversify its production. Thus, while concentration measured in terms of products will naturally appear greater than concentration measured at a more aggregated level, this disaggregation is exaggerated in the Soviet case.

Therefore Brown et al. propose that while the level of monopoly was very high under the planning system, it might well become competitive once enterprises were given the freedom to compete.

However, such a prediction was based on enterprise-level monopoly. In 1992, Soviet ministries were often replaced by “associations”, groupings of companies. Frydman et al. (1993: 23, 25) observe that the associations

usually had pre-existing links, having been under the common administration of a particular branch ministry. The formal foundation of an association among them was designed to make them largely independent of the formal administrative structure, thus also making them immune to the successive administrative decisions of the government and the ever-new restructuring attempts characteristic of the later years of the Soviet regime… . These associations accounted for 38.3% of industrial production and over 6.4 million employees. They are mostly horizontal structures and constitute extremely powerful cartels. Thus, for example, one concern (Rosneftigas) controls 99.8% of Russian oil production, while another (Gazprom) controls 93% of natural gas production … Stankoinstrument controls 88.7% of machine tools and 81.6% of forge presses.

Russia also inherited a peculiar transport system, designed to help fulfil the plan. The railway system functioned as the key freight carrier, administered by the Ministry of Railways (MPS). The MPS was “a vast monopoly” for long-distance, intercity and inter-republican freight transport, which was incidentally also responsible for half of the world’s railway freight (IMF et al. 1991; III, 61–3). The central grip over rail transport remained strong even when Russia began its privatization reforms, leading to conditions where freight had to be scheduled six months in advance (Brown et al. 1994: 34). The lack of diversified transport networks, coupled with the monopolistic tendencies inherent in the railway system, served as a further impediment to the creation of competitive markets.

Enterprise towns and the social role of enterprises

Soviet, and therefore Russian, enterprises were designed as monopoly suppliers. Often they were also significant as employers in certain towns, with almost half of Soviet cities, with around 12.2 per cent of civilian employment, featuring only one significant firm and more than three-quarters of cities having four firms or fewer (ibid.: 35). Frequently, enterprises took on social functions on behalf of their workforce that would not be undertaken by their western counterparts. These functions were often supplied to the whole community and included the provision of such benefits as housing, childcare facilities, schools, hospitals, transport infrastructure, recreational facilities, shops and sometimes farms.¹³

Labour and labour mobility

The Soviet system was designed to eliminate unemployment, with the state providing social protection by means of supplying every citizen in the country with a job (a constitutional guarantee). Open unemployment which was not associated with people changing jobs was not an acknowledged feature of the Soviet economy (Standing 1991, 1994). This is not to say that there was no unemployment. In part, it related to people changing jobs and it showed up in the informal economy.¹⁴ Perhaps there was considerable movement between jobs, with an interagency financial study noting that “official labour turnover rates in the USSR [were] not markedly out of line with those recorded in many Western countries” (IMF et al. 1991: III, 143). However, there was little physical mobility. Employees may have moved job, but they did not move house. In a regular housing market, 10 to 15 per cent of units are exchanged every year. In Soviet cities, statistics suggest this rate was 1 per cent or less (ibid.: III, 327).

One reason for this was the “propiska system”,¹⁵ or internal passport, which had been in use in Russia since Tsarist times (Matthews 1993). Propiska was used extensively in the past as an instrument of “labour discipline” and of “population distribution policy and special planning” (IMF et al. 1991: III, 143).¹⁶ In uncharacteristically robust language an IMF report (ibid.: III, 327) writes,

It is a major source of inequity and economic inefficiency, often subjecting rural residents to a form of serfdom by denying them the opportunity to move to cities. The population of favoured cities like Moscow has been stabilised through this passport system, and during the recent pervasive consumer goods shortages the propiska was often used when shopping.

A propiska was required to acquire housing and other social benefits, enormously impeding labour market adjustments. In cities and regions where the central government chose to control population numbers, employers were limited in their ability to adjust the size of their workforce (IMF et al. 1991: III, 327). Population control was therefore a major impediment to labour market adjustments in the sense that in most cities whose population was controlled according to the regional and special plans, “employers were not allowed to expand their staff freely” (ibid.: III, 327).

The maintenance of the system, in combination with the widespread existence of company towns, meant that, despite relatively normal levels of labour turnover, labour markets in Russia had exceptional rigidities.

Therefore, in 1992, as reformers contemplated privatization, they were faced with an economy characterized by a high degree of monopoly containing many firms which were uncompetitive, most were overstaffed and many were the only employer in isolated towns. Transport was poor, access to capital was limited, and the labour force was relatively immobile. The country lacked a corpus of commercial law, with what legislation there was often being contradictory and/or unenforceable. These characteristics of the Russian economy posed a challenge for the privatization process not just in terms of how policy was framed and how successfully it was implemented, but whether it would ever be likely to achieve its desired outcomes.

The goals of privatization

There have been many goals suggested for privatization. We discuss them under three headings: economic, that is creating the conditions for a more efficient economy; budgetary, that is raising money for the government or for companies; and political, that is garnering support for reform, changing who was in control of Russian enterprises, and indeed ensuring that control could not be exercised centrally. However, in reality, these objectives can tend to overlap.

For example, the 1992 Privatization Programme listed six objectives for privatization:

• to help develop a market economy;
• to increase enterprise efficiency;
• to ensure a social safety net;
• to help create financial stabilization;
• to promote competition;
• to attract foreign investment.

This in itself is quite a long list of objectives. But other commentators would suggest their own views of the rationale for privatization. Åslund (2007: 144ff.), for example, divides them into important political as well as economic goals. The political ones included “the breakup of hegemonic state power” and the building of “a new middle class of educated property owning people”. Economic goals included the building of a well-functioning market economy; creating “real owners” for enterprises; making companies independent; imposing hard budget constraints on companies; creating enterprise restructuring and better corporate governance; creating real capital markets; and encouraging investment.

Just combining Åslund’s goals with those of the Russian parliament, therefore, creates a number of potentially conflicting objectives, and this is a far from comprehensive list. Therefore, in the following pages, we summarize what might be considered the main aims of privatization and their rationale. We then go on to consider whether, given the conditions of the Russian economy, these aims were likely to be achievable. In Chapter 4 we discuss how the design of the programme favoured one or other of these objectives.

Economic objectives

To summarize above, there are two broad economic objectives for privatization. The first aims to establish the ownership of the country’s industrial assets. The second has the broader goal of seeking the efficiency and prosperity that market economies had achieved. This includes the restructuring of enterprises to make their operations more efficient.

The goal of ownership transformation at that time required significant institutional change, in regard to both formal rules and informal custom. In 1991 in Russia, clear asset ownership did not exist, although Gorbachev’s 1988 Law on State Enterprises had introduced a legal framework for cooperatives and contract brigades; small farmers could own land but not pass it on to their heirs. The general understanding of ownership until then was that it was shared between citizens, workers’ collectives and government agencies.¹⁷ De facto control lay in part with managers, in part with “trusts” comprised of bureaucrats and managers from old branch ministries, and in part with local and national political figures. Therefore a key aim of the reformers was to clarify ownership and to do so as quickly as possible. Indeed the privatization legislation was framed in such a way as to create adequate incentive for those who had gained de facto control to accept the new de jure legislation.

Beyond alignment of de facto and de jure rights, the aims of privatization also implied the assumption, or reason for believing, that private ownership would lead to a more efficient and prosperous economy. Eduardo Borensztein and Manmohan Kumar (1991: 300ff.) write, “The evident failure of the central planning system has created the near consensus that the move to a market economy is necessary to achieve standards of living comparable to those of the industrial economies of the West.” Efficiencies will emerge, they explain, in a competitive environment, where market prices reflect relative scarcities, and enterprises and individuals make decisions mainly in response to market signals. “Private ownership leads to the achievement of these conditions,” they argue, “because the incentives for the private owners to ensure their costs of production are minimized and … their output mix is determined in relation to market signals.”

However, while privatization may be a necessary condition for effective ownership and efficient markets, it is not a sufficient one. Foreign advisers were well aware of this at the time. Borensztein and Kumar note further that,

By this rationale privatization will, within a free competitive environment, lead to efficient allocation of resources, which will maximize the welfare of the economy as a whole. However, for this to be the case privatization … must be accompanied by other policies to promote competition if a significant turnaround in the performance of public enterprise is to be achieved.

Similarly, at a seminar of western experts on privatization organized for the Russian reformers by the EBRD/World Bank in March 1992 (prior to the passage of the 1992 Programme), a key conclusion was that

privatization is not an end in itself. It is one among a number of means which are crucial to the achievement of improved efficiency throughout the economy, in the service of economic growth and higher living standards for the people of Russia.¹⁸

The question to be asked is: If privatization was not an end in itself, what other conditions were necessary to make it work, and to what extent did they exist in Russia in 1992?

Ownership

The minimalist economic justification for privatization, then, is perhaps the establishment of basic ownership rights. The importance of ownership rights is expressed in the work of Ronald Coase, who notes that, in the absence of transaction costs, provided that asset ownership is clear, ownership rights will result in efficient outcomes (Coase 1988: 158). In 1994, “members of the team, which put [privatization] together”, Maxim Boycko, Andrey Shleifer and Robert Vishny, write that reform was based on the establishment of clear property rights, which they anticipated would be achieved. Reflecting the “Coase theorem”, they summarized their thinking as follows (Boycko et al. 1995: 19):

When property rights over a productive asset are clearly specified and the person who decides how to employ this asset bears full costs and full benefits of such employment, he puts the asset to its most productive use. This argument provides the ultimate rationale for relying on private property as the basis for an efficient organisation of economic activity.

However, as they are aware, security of ownership rights in a market economy requires protection of property and enforcement of contracts. Yet, as we noted above, the “body of civil law which regulates the economic relationships necessary in a market economy [was] largely missing from the corpus of Soviet law”. Without that corpus of law, privatization alone would be unlikely to create the conditions that those economists who focus on analysis of property rights would prescribe.

Nor is this simply a legal issue, it also has to do with the structure of ownership. Economists understand that different forms of “ownership” of companies are each likely to produce different results. For example, Adolph Bearle and Gardiner Means’s classic study, The Modern Corporation and Private Property (1932), cited in Boycko et al. (1995: 20), refers to the separation of ownership and control in a public corporation as one way of rendering it inefficient, because managers make decisions and shareholders bear the costs of those decisions. Alfred Marshall (1946: 303) in a similar analysis, notes that the success of the public corporation, where ownership and management are separated, depends on a “spirit of honesty and uprightness in commercial matters”.

It is therefore somewhat surprising that the initial privatization reforms envisaged separating the rights of owners as a group from those of the managers and workers of the enterprise. The aim of the government’s initial privatization proposals, which were reflected in the so-called Option One of the Privatization Programme, was for managers and workers to be given shares which would not carry any voting rights in order to encourage their cooperation but not their control. It was envisaged that other shareholdings would be widely distributed, as they might be in Anglo-Saxon capital markets. It was further envisaged that all shares would be tradable, leading to the creation of up to 20,000 public enterprises (more public enterprises than would be found in the whole of the rest of the world put together).

To be sure, some of the International Financial Institutions (IFIs) recognized this issue. Writing in March 1992, before the Privatization Programme was passed, the World Bank and EBRD study team note that

a voucher program that is not part of a wider mass privatization program risks diffusing ownership amongst thousands of inexperienced shareholders potentially dispersed over a vast geographic region… . The risk is that current management will be entrenched, free of shareholder discipline, and able to misallocate resources, or do nothing at all to enhance the prospects of the company.

They go on to advocate that no project should be approved if “it fails to provide for ownership of a control block of shares by a strategic investor group”.¹⁹

That recommendation creates a Catch-22. Either shares were to be widely dispersed, in which case management acquired de facto power, or they were to be sold to a strategic investor. The problem, which we describe in greater detail in Chapter 4, lay in the fact that there were few candidates who could become strategic investors, save those who had had the capacity to protect the value of their savings by holding cash abroad. Such investors tended either to be foreign investors, Russian individuals and institutions who held cash abroad, possibly illegitimately, or enterprises which were to be privatized in the first place.

The problem was in part “solved” when parliament passed the Privatization Programme, including a new option, negotiated by Chubais, that allowed workers and managers to subscribe for full voting shares. This legislative change was opposed by some of the reformers. Indeed, some years later, at a lecture in Moscow, Yegor Gaidar observed that the concession to grant workers and managers control of the enterprises was a mistake.²⁰ The critics of privatization noted that the option of granting shares to managers and workers gave rise to factory directors gaining “control and effective ownership of most of the country’s factories at minimal cost to themselves, as well as minimal benefit to the public at large” (Goldman 2004: 81).

It is paradoxical that this option, opposed by both some of the reformers and their critics, may in fact have been necessary to achieve one of the fundamental goals of privatization – a greater unification of de facto and de jure ownership rights. Put simply, the ownership of a company share, and the control rights it confers, cannot be divorced from the structure, the culture and the modus operandi of the economic system within which those legal rights are conferred. The reformers generally opposed allowing control rights to pass to the managers and workers of the enterprises to be privatized. Yet, in the absence of enforceable laws, it was only through this device that the reformers’ key goal, that is clarifying the ownership of the enterprise, was likely to be established.

Creating a market economy

The clarification of ownership rights was a necessary goal of privatization. However, the economic objectives of the programme went much further than that.

“The foremost aim of privatisation”, writes Anders Åslund (2007: 146), “was to build the foundation of a well functioning market economy… . It was this which lay behind the economic imperative for the reform programmes in Eastern Europe.”

The World Bank, the group of advisers hired by the World Bank/EBRD to assist the Privatization Ministry (the Consortium) and other advisory groups were equally clear. Braxton Associates and Deloitte write: “Privatization is not an end in itself. Privatization is part of a package of measures designed to bring about economic growth and higher living standards for the people of Russia.”²¹

The assertions that privatization would yield economic benefits were underpinned by over 200 years of economic thinking. By this model, it is price that is the arbiter of whether a transaction takes place. Competition ensures that those who produce goods offer them for sale at close to their cost of production. If a supplier charges too much, other producers will offer lower prices and customers will go elsewhere. There is therefore a high incentive for producers to keep pushing down costs, and push up the value delivered to customers, in order to maximize profit. This in turn creates the productivity that is the driver to economic growth. However, the model requires that prices are free to move to equate the supply and demand for goods at their “natural price”.

We underscore, as economists cited above did at the time, that Russia in the early 1990s was unlikely to provide such a foundation for prices to move freely. Let us revisit some of these issues.

Monopoly

The classical model will only produce “efficient” solutions when certain conditions are met. First, it requires that there is competition. Monopolists will restrict output and create higher prices in order to maximize profits. Adam Smith writes on competition:

the monopolists by keeping the market constantly under stocked … sell their commodities much above the natural price. The price of monopoly is upon every occasion the highest that can be got. The natural price, or the price of free competition … is the lowest which the sellers can commonly afford to take, and at the same time continue their business.

(Smith [1776])

The degree of monopolization in Russia presented a dilemma. Monopoly existed at two levels, as noted above: the enterprise trusts, or “associations” which had replaced branch ministries; and at the level of the enterprises themselves. To some extent, the Privatization Programme could aim to weaken the trusts, or associations, as was advised: “the implementation of a privatization program must be designed carefully to ensure that existing administratively created monopolies are not merely transferred into private hands in a form that would hinder the long term efficiency of the economy.”²²

However, at the enterprise level, it could prove impossible to break up monopoly producers. “Given the large number of monopoly structures and the weak government control over the SOE’s (State Owned Enterprises),” the appraisal continues, “it may not always be possible for the Government to split up the monopolies before they are privatized”.

Furthermore, traditional responses to monopoly problems would only lead to ineffective policies, since they often involve price controls. Central to a successful market economy is the need for prices to be freely determined. Indeed, it is “price signals” that encourage new entrants to a market. So, by controlling prices, regulators would stifle the very market forces that privatization sought to promote.

Russia’s competition policy was therefore threatened by over-intervention by the state in price regulation, with the GKAP (the Russian State Committee for Anti-Monopoly Policy and Promotion of New Economic Structures) monitoring an official register of over 2,000 enterprises, which comprise 80 per cent of industrial production and supplied over 6,000 goods and obliged enterprises to register any price increase.²³ The prevalence of overlapping laws and weak information systems in 1992 meant that even when policies were revised by the government, they did not always become effective. As an indication of the legislative difficulties that prevailed in 1992, although a Memorandum of Economic Policy issued by the government in early March determined that such price regulation (along with maximum rates of profitability) would be discontinued as of 1 July 1992, even the City of Moscow Anti-Monopoly Committee was not aware of this decision one month later.²⁴

Given the degree of monopoly, price liberalization and privatization policies were likely to have unpredictable consequences, which might not, in the medium term, conform to the efficient markets that reformers sought. Indeed, as Adam Smith notes, privatized monopolies will raise prices and reduce output. This was the reverse of the reformers’ intentions.

Just as the market for goods needs to be competitive, so does the market for capital and labour. As regards labour, in an efficient economy, workers need to be able to decide which job to take; they need to be able to move to a preferred employer should they choose to do so. Yet, as we have seen, the propiska system constrained labour mobility, particularly the sort of mass mobility that might occur should the sole enterprise in a factory town be forced to close.

In these circumstances, it is understandable why workers might have had particular concerns about their prospects. This was perhaps one reason why enterprises went for Option Two for privatization (which granted control to workers and managers), despite that fact that in theory workers and managers would have been better off financially if they chose a different privatization option.

Restructuring

The lack of readily available capital created a further problem. The aim of moving to a “capitalist” model of production was that capital would be given to efficient enterprises that showed a high return and were profitable, and withdrawn from those which were unprofitable. All companies should be subject to a “hard budget” constraint, that is, one where capital is only made available to projects and enterprises that will generate an adequate return for the risk taken.

However, given the level of monopoly and the distortion in prices, it was difficult to determine which enterprises were efficient and which were not. On 1 January 1992, some Russian prices were liberalized. But some were not. So, while many enterprises may have seemed profitable, this was only because the price of their sales was inflated, or other inputs deflated. Other loss-making enterprises might have been profitable had they been able to trade at world prices. Furthermore, the enterprises that were to be privatized had not been run to make a profit. Indeed, they often had explicit responsibility for running the schools, transport and housing of the town in which they were located. Until these and other issues had been dealt with, enterprises would find it difficult to determine their costs, even if Russia had had a market pricing regime.

As we have seen, in Russia in 1992, the only supply of firm credit came from the Central Bank of the Russian Federation (CB, 1990–, formerly Gosbank), or from suppliers. There were no effective alternative financing systems. Indeed, the Privatization Programme aimed to develop such a system by encouraging the creation of investment funds. However, in the meantime, a hard budget constraint would only prevail if the CB could be persuaded to enforce it. Without that constraint, all enterprises would request funds from the CB. If the CB acceded to that request, it would create “moral hazard”, that is, a situation in which companies were encouraged to find ways to generate credit from the state rather than to compete in the marketplace. If the CB refused, it risked dislocating the economy. Because Russian enterprises often reflected monopolistic divisional suppliers within larger company networks, the effect on the supply chain could be significant if they were to close.

In the event, following the liberalization of prices in January 1992, no effective plan was made for how the CB was or was not to fund enterprises. As a result, enterprises essentially funded each other. Companies continued to supply one another to allow the buildup of inter-company debt. In order to overcome this problem, which itself threatened to undermine the privatization process, the CB ultimately issued credits to allow for debt to be paid. However, in doing so, it breached the purpose of privatization, which was to wean companies onto a hard budget.

Discussion

It was unlikely that the privatization reforms alone could lead to the creation in the medium term of the efficient markets to which the reformers aspired. As the above discussion argues, advisers to the Russian government were well aware of this problem. As the World Bank and EBRD privatization group note in March 1992 as their first “key point”, privatization needed to be seen as an instrument to generate economic growth and higher living standards and that “When options within the privatization programme are being considered, they should therefore be tested according to these criteria. The options that contribute to economic efficiency should be preferred ahead of those that impede its achievement.”²⁵

If privatization did create new owners, then it might nevertheless have been expected to bring about a restructuring, whatever the form of industry. If the new owners of the company sought to maximize its profits, they would have little reason to keep open unprofitable operations, to accept overstaffing, or indeed to support the various social activities that companies were involved in providing.

However, this created another difficulty for the Russian government, as we shall discuss when we look at the social and political goals of privatization. If privatization was successful, and enterprises were managed efficiently, this would cause dramatic social consequences, for which Russia was unprepared. If, however, there was to be little restructuring, then the goal of economic efficiency and improved living standards was unlikely to be realized.

In retrospect, it is difficult to make the case that in Russian conditions privatization could have led quickly to efficiency or higher living standards. This was not because of a failure of understanding by either the Russian government or its advisers of the difficulties presented by the need for institutional change prior to privatization. Rather, it was that the Mass Privatization Programme needed to be coordinated within a sequencing of reforms and of investments to restructure and liberalize Russia’s economy. These included abolishing price and wage controls, creating competition, establishing rouble convertibility, creating a comprehensive and enforceable legal framework, and implementing numerous other reforms in labour, goods and financial markets. Given the structure of the Russian economy, the coordination and linkage among all these reforms would be of particular importance to the overall success of each. As we will discuss in the next chapter, such coordination did not happen in Russia in 1992.

Budgetary/investment objectives

Government budget

When the Privatization Programme was passed, it was envisaged that it would make a significant contribution to the government budget. Indeed the programme itself stated that one of the six aims was to provide the finance to create a “social safety net”, where receipts from privatization could raise enough to help pay for pension, unemployment and other benefits. Indeed, receipts from privatization were envisaged as a possible sponge for the “monetary overhang” which had built up over previous years, and hence the programme was seen as a contributor in helping to “create financial stabilisation” and “an effective way to reduce the monetary overhang” (IMF et al. 1991: II, 394).

However, the introduction of vouchers meant that the state gave up its right to the proceeds of privatization to the voucher holders. In the June 1992 Programme, it was envisaged that this would relate only to the 35 per cent of the proceeds of large-scale privatization that were due to the federal government. However, in October, vouchers were applied to the whole programme, and all state authorities therefore received little or nothing from it as a consequence. As Goldman (2004: 93) notes critically:

Another shortcoming in the first round of privatization was that it generated very little in the way of revenue, either to the government or the firm’s balance sheet and capital. Based on my unofficial estimates the state collected a mere $160 million during the first three years of privatization.

This was, of course, a necessary consequence of choosing a voucher programme. Later, in 1995, the government moved on to monetary privatization, where objectives changed. According to one of the architects of monetary privatization, its goals were “totally different from the voucher period, [when] we had been selling off companies really for symbolic prices” (Kokh 1998: 47). During the monetary privatization, the government worked, he writes, “to sell prime companies at top prices; attract investment; maximise revenues from sales; and encourage greater participation from the West”.

Voucher privatization critics like Goldman are right to point out that the programme stopped the Russian government from achieving any budgetary goal. The decision to abjure cash sales was a point upon which the government found a consensus with international advisers, however, in particular the Deloitte Consortium. They note that, unless the timing of privatization was slowed, it was difficult to see where legitimate investment monies would be found to finance the privatization. Reporting on the situation in August of the following year, the Consortium reiterated the point:

In its original conception [the Mass Privatisation Programme] envisaged 65% of the equity of Russian companies being sold for cash. Although it is difficult to measure the value of this equity, this could well be equal to 15–30% of Russian Gross National Product, based on preliminary estimates. Raising such a sum of money from within the country could well be difficult, given the estimates of savings and other internal sources of liquid assets.²⁶

The Consortium went on to welcome the extension in October 1992 of the voucher programme, which addressed this problem, and it also noted that cash sales would be likely to encourage the formation of holding companies.

It is likely that many companies will choose their customers and suppliers as strategic investors. This will result in interlocking holding companies being formed in Russia, with significant monopolistic power. The privatization programme offers little protection against this outcome… . At this stage we have few fool proof solutions to the holding company problem. However, the following suggestions may make them more difficult to create: (a) Extend the voucher programme … (b) lengthen the timetable of the Mass Privatization Programme (c) encourage worker control under Option Two.

Vasiliev, the Deputy Privatization Minister, made the same point:

Price liberalization had destroyed everyone’s savings, there was no money any more. That realisation led us to the conclusion that cash privatisation would lead to a cataclysm. A very narrow group would buy the whole economy. That would provoke the deep seated envy of the Russian people and could spark a social upheaval.²⁷

Therefore there was a clear trade-off made in the MPP, between the raising of revenues, the practicality of trying to do so, and the future industrial structure that cash privatization would create. In 1992, the choice was made, and endorsed by western advisers to the Privatization Ministry: for both practical and policy reasons, the future structure should take precedence.²⁸

In sum, therefore, during the MPP, the budgetary objective of raising cash for the government was abandoned in voucher privatization, for reasons of practicality and economics, and to protect the legitimacy and integrity of the process.

Investment by enterprises

This, of course, left open the question of where the cash would come from to re-equip companies. A potential source of capital could come from the repatriation of Russian foreign currency, held legally and illegally,²⁹ estimated to be worth many billions of dollars. There was, however, the danger that this would raise political issues if enterprises were sold to those whose source of funds was illegitimate; or if companies were to use their own foreign currency deposits, this would result in the holding company structures that the reforms sought to avoid.

Another possible source of new funds was foreign investors. They were in a position to provide Russia not only with much needed investment, but also with access to technology and experienced management.³⁰

However, the Privatization Programme attracted little interest from foreigners. In the summer of 1992, for the State Committee on Foreign Investment, Goldman Sachs surveyed 300 companies considered likely to invest in Russia. The survey concluded that while there existed the possibility for one to three “megadeals”, they were unlikely to materialize; 20 to 30 deals, ranging between $20 million and $50 million, as well as several technical exchanges, were anticipated at most.³¹ As such, the likelihood of foreign investment during the first phase of privatization was small and, indeed, this proved to be so. This was not just because of limited interest by western companies, but because there was “little political support for foreign investment in tenders”, since “Directors [were] concerned that direct foreign investment would mean potential loss of control”, and would “prefer to JV [joint venture] in a new enterprise”.

So, while in theory the Privatization Programme created structures and securities that could be used by privatizing companies to raise finance in the future, there was limited prospect in the medium term that it would achieve the goal of raising finance either for the state or for the newly privatized companies.

After 1994, as policy moved towards monetary privatization, budgetary issues came to the fore, and the issue of who was put in control of the privatized companies was set aside. We have already noted (p. 67) Vasiliev’s early concern that monetary privatization would mean that a very narrow group would own the whole economy. Yet Appel, writing in 2004, cites Vasiliev as having ultimately “made explicit his preference for using sales over free transfers, arguing that property would only be valued if it were exchanged at a cost to the new owners”. He went on to say of the later monetary privatization that “Our aim is to form a layer of effective owners. This is privatisation in favour of a very small circle of people” (Appel 2004: 82, 93).

It is therefore paradoxical that much of the criticism of voucher privatization is levelled at its creation of corruption and oligarchy. In fact, its aim was to stop this happening. To some extent, the MPP was implemented with a degree of bad practice, and we discuss this in the following two chapters. Nevertheless, few companies that were to have been privatized in the original 1992 Programme can be identified as major vehicles for corruption or platforms for oligarchs (Gazprom and Lukoil, initially entered in 1994, were not part of the original programme). In part, this may be because the larger companies were not part of the Mass Privatization Programme, since enterprises in the field of natural resources, aluminium and banking were excluded from it. The oligarchs’ direct involvement in privatization were in the main the creation of a later era, when the ability to raise substantial financial assets became a necessary condition for participation in privatization, and the benefits skewed towards a very small circle of people (Treisman 2010).

In summary, then, the voucher privatization was never likely, in the medium term, to achieve what we have termed “budgetary goals”. It is the nature of vouchers that they do not raise money.

Social and political objectives

In Russia, privatization was not just an economic policy. It also had social and political aims.

Generating popular support

First, the aim, as in voucher privatization in the Czech Republic, was in part to create political support; privatization would generate a give-away. For this to succeed, however, the benefit to be received by citizens had to outweigh the costs in terms of the pain of restructuring. The Russian government had to persuade its citizens that, despite forthcoming reductions in income and redundancies, the privatization would deliver a “dividend” to them (Kikeri et al. 1994: 11). In this context, the popularity of the programme rested on the financial rewards available to citizens in the short and long term, as well as on its overall fairness towards everyone in the country. It was imperative to demonstrate early successes in privatizing large strategic enterprises in order to secure popular support.³²

In the event, large strategic enterprises were not included in the privatization. As a result, the value of the assets to be sold via MPP was not high. Additionally, in the absence of a functioning commercial law system, the rights of the new owners were also difficult to determine. So the market price of vouchers remained below their 10,000 rouble face price until the summer of 1993; in dollars their value was between $4 (in May 1993) and $20 (in November 1992) (Åslund 1994: 105). Consequently, the Privatization Programme paid little dividend to the budget. As a result, if anything, the low value of the voucher led to stories of what might have been thought of as a birthright inheritance being exchanged for a bottle of vodka.

In light of these events, public support did not last. The main objective of privatization, in other words, as Kikeri et al. (1992: 11) put it, “to transfer the property rights to owners who have incentives for defending the interests of the capital they own”, was not achieved, or at least not in terms of creating a popular demand for restructuring where private owners supported with their votes “the painful steps for transiting fully to a market economy”, including the restructuring of industry.

However, that very restructuring was likely to have social consequences which could create profound problems. These might include, if there was a radical restructuring, significant unemployment in the wake of reform.

For some reformers, a key economic benefit of privatization was to limit political control of enterprises, because politicians were arguably, ipso facto, inefficient owners; therefore, removal of their influence from economic life was expected to reduce inefficiency, as privatization would prevent politicians from allocating goods (Boycko et al. 1994: 20ff.). This, of course, tends to simplify the question of what should be the relationship between the state and the market. It also begs the question of how the social consequences would be managed if restructuring were to remake Russian companies. The consequences would include high unemployment and the companies’ abandonment of the social services they previously provided to the community.

From 1989 to 1992, the Russian GDP dropped further than comparable GDP figures for the USA and Germany in the 1930s.³³ Labour figures reflected high “overemployment”, as well as employment at uneconomic plants.³⁴ Projections suggested that the unemployment consequences of privatization could be dramatic, particularly on a local level, if the incentives for enhanced efficiency were to take effect more rapidly than could be absorbed by production and market growth.³⁵

However, by summer 1992, the drop in GDP had resulted in hardly any unemployment. Furthermore, the governance structures that would come about as the result of Option Two (the option in the Privatization Programme that gave power to the management and workers) would have the effect both of stifling restructuring and of reducing unemployment, which was “a source of opposition to privatisation”. This conservative attitude to restructuring was evident in the summer of 1992. A survey by the GKI asked enterprise directors about their plans for the future of their “social assets”, such as housing, healthcare, education and recreational facilities. Most enterprises “did not wish to divest themselves of social assets, reflecting the fact that social, personal and political motivations, as well as classical economic motivations, will continue to play a significant part in the conduct of privatised companies”.³⁶

So, while the distribution of vouchers might gain some modest popularity for privatization, particularly if major enterprises such as telecoms companies were included, the value of these was likely easily to be outweighed by the initial negative economic consequences of the programme. It was another Catch-22. Either the programme brought about restructuring, its economic goal, and created a political backlash, or it avoided the political backlash but at the cost of failing to achieve its economic goal. As we shall see, the problem was resolved by the granting of ownership rights to those with the greatest interest in the preservation of the status quo: the workers and managers of the enterprises themselves.

Changing attitudes

There were two other “political” goals that cannot be ignored. The first was the aim of creating a change in attitudes. This was not an explicit goal, particularly of the economic advisers. But it was the primary positive outcome of reform that Yeltsin noted in his memoirs (Yeltsin 1994: 18). He reflects on whether the Gaidar reforms have helped cure the “sick” Russian economy, and concludes that there has been improvement. He goes on:

I draw this conclusion not on the basis of economic indicators; they are objectively poor… . Rather I am making this analysis based on the fact that people with an entirely new psychology have emerged in our country. They have the psychology of the muzhik, the sturdy Russian peasant who does not expect anyone to help him and doesn’t rely on anyone – not the government, the parliament or Yeltsin … normal people – the kind of people who used to be crushed by the state – have begun to appear in our country.

It is beyond the scope of this book to assess whether Yeltsin’s goal was realistic, or indeed whether it was achieved.

The end of the command-administrative economy

But there was one other important political goal of privatization on the Russian side. It sets the reform in its historical context at the end of perestroika in Russia and the emergence of independent states in Central and Eastern Europe. The powers of the command-administrative economy had been underpinned by a communist ideology, which had shown its resilience over many decades. Marshall Goldman (2004: 21) comments:

those in charge, such as Yegor Gaidar and Anatoly Chubais, rationalise what they did by insisting that in 1992 the fate of the reform movement, even the rejection of communism, was in doubt. Therefore they felt it was essential to adopt a strategy that would reinforce the public’s determination … to reject the communist system. Whenever challenged, Chubais insists that, whatever the consequences of the ill fated reform process, preventing the communists from regaining power was justification enough.

And indeed the feeling of the end of an era was palpable.

We began this chapter by emphasizing the experimental nature of the Soviet economy and, then, its accumulation of power and institutional stability. By the end of the 1990s observers were pointing to the emergence of oligarchs who had taken over Russian companies without due process. However, in 1992, the threat was less the emergence of a group of oligarchs; rather, it was, on the one hand, a descent into anarchy, and, on the other, the re-emergence of a centralized system of control. Depending on how privatization progressed, it could influence the degree to which Russia emerged as either a pluralist or a centralized and controlled economy. However, this political goal, like the economic goals, would not be determined by privatization alone, but also by the broad interplay of political forces in post-Soviet Russia.

Summary

In this chapter we have reviewed the various goals of the Russian Privatization Programme. Few of these could be achieved by privatization alone. Rather, their achievement depended on a series of reforms: the creation of a commercial legal code; the freeing of prices; the establishment of a commercial banking system; the transition from monopoly production; the transfer of responsibility for employment and social protection. Privatization, or at least the clarification of “ownership rights”, may have been a necessary condition for the achievement of these goals. But for most of them, it was not a sufficient one.

The one area of reform where privatization could be particularly important was the establishment of legal title to ownership of enterprise assets. Provided that it granted these rights to those who already had some de facto claim to the assets, it could nudge ownership in the direction of one group or another, and help marry law with practice. This had knock-on effects on the degree of power granted to enterprise workers and managers, on the one hand, or to the “associations”, on the other. Granting rights to insiders also had knock-on effects for the speed with which the restructuring process would begin.

Table 3.3 summarizes the various objectives for the Privatization Programme. What is immediately apparent is that, even with a comprehensive reform programme, most of the goals would be difficult to achieve in the medium term. Even over the longer term, they would all require corollary reforms in laws and their implementation and a radical change to the economic structures of the country.