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October 10 2009 | Filed Under Banking , Business , Economics , Economy ,
Financial Theory
How do you build something from nothing? The early 1990s witnessed an
unprecedented challenge - creating free market economies in a huge geographic
region with no market culture to speak of: the former Iron Curtain countries of
Central and Eastern Europe and the former Soviet Union. Read on to examine one
of the most fascinating and controversial parts of that transition: the mass
privatization of state-run economies and the attempt to create sustainable
financial market mechanisms.
The Wall Fell - Now What?
The iconic Berlin Wall images in December 1989 were unforgettable, but they
soon gave way to concerns over what the future had in store. The Soviet
economic model operated under central planning, with an absence of organic
market mechanisms to facilitate uninhibited trade between buyers and sellers of
goods and services. Much of what is taken for granted in market economies -
prices fluctuating in response to supply and demand, capital markets
facilitating the efficient investment of national savings into profit-seeking
businesses - simply did not exist in Hungary, Russia or Uzbekistan before the
dawn of the 1990s.
The challenge was to build an investment culture - private businesses owned by
investors and financial conduits such as banks, stock exchanges and
broker-dealers to enable the flow of capital. The state - the sole shareholder
of the country's income-producing assets - was to sell off its interests into
private hands.
Two questions immediately arose. First, into whose hands? Under the socialist
system, the state was legally considered to be something like a trustee of the
national property on behalf of its citizens who, according to Marxist theory,
were to own the means of production (according to Marxist theory, the resources
and apparatus by which goods and services are created). Somehow, the transfer
of ownership had to take this notion into account.
The second question was price. What were these assets worth? Given the legacy
of central planning, any traditional valuation benchmarks - cash flow,
appraised asset value, earnings or book value multiples - were meaningless.
Moreover, this was simply appraising the value of one or two assets. Each
country had thousands of identifiably distinct economic entities, each of which
required some strategy for transferring ownership. Time was of the essence, but
so was getting it right. (Learn more on the valuation of assets in our related
article Relative Valuation: Don't Get Trapped.)
Enter the Consultants
This problem galvanized the attention of Western governments, which saw
economic viability as essential to democracy and integration into the global
community. In the early 1990s, the U.S. and Europe earmarked billions from
their federal budgets to provide technical assistance to solve the problem of
transition to market economies. The US Agency for International Development
(USAID), the World Bank, the British Know-How Fund and the European Union's
TACIS organization were prominent among the organizations providing donor
assistance. (For further reading, be sure to read What Is The World Bank?)
In a practical sense, this meant that the new Marriotts, Hiltons and Sheratons
rising up among the boxy Soviet-style offices and older historical buildings in
the region's downtown centers were soon teeming with sharply-dressed Western
consultants - experts in one or another area of finance, law and economics -
full of ideas about how to accomplish this massive transition from state
ownership to private enterprise.
Mass Privatization
While every country from Croatia to Kazakhstan had its own way of looking at
this problem, a general model emerged. This model had two basic components.
First, privatize as much as possible, as quickly as possible. Second, set up
the requisite infrastructure, again, as quickly as possible. The technical
assistance contracts awarded to large global consulting firms like KPMG, Booz
Allen Hamilton and PriceWaterhouseCoopers had eye-popping tasks and deadlines.
Privatize 4,000 companies in the next 12 months.
Create a securities market regulator and a full set of laws regulating capital
markets. Build a stock exchange. Conduct initial public offerings.
Form self-regulatory organizations for local broker-dealers, where
broker-dealers didn't even exist. (Check out our IPO Basics Tutorial for
related reading.)
Small-Scale Auctions
Before any of that could happen, though, countries and their advisors had to
wrap their arms around what actually was to be privatized, and how. Mass
privatization took into account three distinct approaches, each for a
particular type of enterprise. At the bottom were the many small shops,
services and businesses with little in the way of assets or income. These made
up the small-scale privatization program and were by and large auctioned off
for whatever consideration (financial or barter) an interested party would pay.
Strategically Important Assets
On the other end of the scale were assets deemed to have strategic importance.
Natural resources like oil and gas, energy utilities and telecommunications
companies dominated this group. In many cases, these were either not privatized
at all or the state retained a controlling interest while issuing minority
stakes to investors. Because these assets made up a relatively small number of
enterprises and because the businesses were understandable - production and
distribution of crude oil, for example, or provision of local telephone
services - the strategic privatization program, also called case-by-case
privatization, more closely resembled prevailing privatization methodologies
elsewhere in the world. Investors who bought minority stakes in, for example,
Russia's telecommunications monopoly Svyazinvest, owned their interest in the
form of traditional common shares of equity. (This structure can be very
effective, but it is also known for its abuse of power. Read Early Monopolies:
Conquest And Corruption for more information.)
Voucher Privatization
In between these two methods was the heart of mass privatization: mid-sized and
larger companies that were too big for the small-scale program but not
sufficiently important for case-by-case privatization. The most common method
for this, variations of which took place in the Czech Republic, Romania,
Russia, Ukraine, Kazakhstan and elsewhere, was the so-called voucher or coupon
program. All national citizens could participate by purchasing, for a notional
sum, a book of coupons entitling the bearer to participate in mass
privatization tenders. Voucher holders would tender their coupons for ownership
interests in the companies being offered. A government agency created
specifically for the purpose of mass privatization would organize and conduct
the tender with assistance of the Sheraton-dwelling Western consultants from
the international donor programs.
The reasoning behind the voucher program was to build the foundations of an
investor society, in which citizens quickly learn the ropes of free market
economics because they themselves are invested. Developers of these programs
also saw vouchers as a neat way to solve the valuation problem. Values simply
derived from the notional value of the vouchers. Once the objects were in the
hands of these private investors, the thinking went, the invisible hand of the
market would work and the new "owners" of any enterprise could freely buy and
sell among each other, allowing for value and price discovery along the way.
(To learn more of free-market economics, be sure to check out our Economics
Basics tutorial.)
Challenges and Controversies
Problems surfaced as the voucher programs commenced in the early 1990s. A major
one was the lack of supporting infrastructure. Another was that people who had
spent their entire careers working for the state, living in government-provided
apartments, not understanding private savings, were not ideally positioned to
become effective owners of profit-seeking assets. A third was that this absence
of effective infrastructure or stewardship opened the door for fraud and
exploitation.
To address the first two of these problems, promoters encouraged the formation
of financial intermediaries, giving rise to what were known as investment
privatization funds (IPFs). In theory IPFs were to act as asset aggregators
similar to mutual funds. IPFs could purchase vouchers from the citizen holders,
offering a return above whatever notional face value they had. Fresh from their
investment training programs led by the Western consultants, IPF professionals
could potentially help spur price discovery by actively bidding on interests in
the newly privatized companies. Observers believed that once the various pieces
of the financial and regulatory infrastructure were in place, these
organizations would eventually evolve into fully-fledged securities
organizations with broker-dealer, investment banking and asset management
capabilities.
Although the theory behind the IPFs and voucher privatization was compelling,
it seemed to pay little attention to the practicalities of implementation. In
reality, the citizenry of the socialist economies had little to do with the
running of anything outside a small group of politically-connected individuals
known as the nomenklatura. Contrary to the original goal of privatization in
getting assets out of state control as soon as possible, the real faces of the
old state - the nomenklatura - reappeared through control of the IPFs, the
privatization agencies and other parties directly related to the process. In
the absence of effective monitoring systems and their detailed understanding of
real power structures, these groups were able to profit from these programs in
ways that the original planners had not fully foreseen.
Muddling Through
For all the problems, though, these countries managed to muddle through their
first decade as market economies. Despite chronic inflation, the 1998 Russian
debt default, political fragility and endemic corruption, the region emerged
into the global economy. Accession to the European Union began in 2004 and now
includes 10 former Warsaw Pact countries: Bulgaria, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia. Ukraine has
an active corporate bond market. In May 2007 investment manager Van Eck Global
launched New Vectors Russia, a NYSE-traded exchange traded fund (ETF). Clearly,
the market has come a long way in a relatively short time.
Conclusions
The mass privatization of Eastern Europe and the former Soviet Unions is a
unique and fascinating economic case study. The task - to create market
economies where none existed in the shortest time possible - was unprecedented
and fraught with challenge in the translation from theory to practice. Despite
the difficulties, the region has emerged as an integral part of the global
economy, albeit one with its own local color and characteristics that will
likely be around for some time to come.
by Katrina Lamb
Katrina Lamb is an investment analyst based in Washington, DC, where she
researches and advises on portfolio strategies employing a wide range of asset
classes and means of investment exposure. Katrina has spent more than 15 years
in the investment profession including a great deal time of living and working
overseas in markets such as Japan, Southeast Asia, Central and Eastern Europe
and the former Soviet Union. She is fluent in several languages including
Russian and Japanese.