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Privatization in the former Soviet Union - one year later.

IN THE FALL of 1991, the old Soviet Union broke apart, leaving the former member republics to find their own way to economic reform. Most have chosen to move in the general direction of private business economies. This is a step most are ill prepared to take, however. Many important prerequisites for the transition from communism to capitalism are lacking in that region. Especially important are the attitudes and commitments of the leadership and the public for such a change. Most of the countries of Eastern Europe, on the other hand, have a considerable segment of the population that can vividly remember what their countries were like before the communist takeover after World War II. In addition, the process of economic reform in the Soviet area has been frequently interrupted by outbreaks of ethnic or nationalistic violence. Consequently, after a year of hesitating progress, the success of many programs seems in doubt.

Nevertheless, impressive progress in the role played by private business in the former Soviet Union was registered during the first twelve months since the breakup. Business enterprises enjoy substantial independence of operation, businessmen are free to start and develop private firms, and the prices businessmen charge for most commodities have been decontrolled. In addition, a unified exchange rate has been established in Russia for the ruble, making international business more possible. Western style advertising is finding the Russian public receptive rather than hostile. The lines at McDonalds are longer than those at Lenin's tomb, and western firms are encountering more and more success in negotiating contracts to supply technology and services. Witness the recent deal calling for Hughes Aircraft to equip remote Tatarstan with cellular and satellite telecommunications.

Enormous problems remain, however. In 1992, Russia's foreign trade fell a precipitous 27 percent from a year earlier, while industrial production dropped off 14 percent. At the same time, decontrol left consumer prices almost 10 fold higher than they were a year previously. Investment in early 1992 was only 56 percent of what it was in 1991. An unprecedented peacetime decline in public health has taken place. In addition, the birth rate has dropped precipitously and now is below the death rate.

As a result of these many factors, political opposition from groups like the "Civic Union," an alliance of old state-owned industry managers and leaders of former communist trade unions and the Party of Economic Freedom, which represents Russia's new businessmen, was being felt. The first group believed that only the existing managers can run the large industries, while the libertarians felt that Yeltsin's plans leave government with too much control. Although temporarily in opposition to the government, it was encouraging that private business interests had gained sufficient strength to be a meaningful political force.

Conditions were sufficiently favorable so that the Yeltsin government had not given up its plans for drastic reform of the economy. Although threatened by unwise central bank policy, the budget deficit was down from 20 percent of GDP in 1991 to 5 percent in mid-1992. The inflation rate had fallen to 10 percent per month from much higher previous numbers. Against this background, a voucher plan for privatizing state-owned ventures was started on October 1, 1992. A change of emphasis by the Yeltsin regime had taken place, however. The new approach stressed attempts to build consensus step by step rather than by executive degree. In addition, the very stringent credit policy had been moderated to ease social tensions.

Russia, a year after the breakup, was ahead of the other former Soviet Republics in its movement toward private business but they too were going through a similar process and were moving in the same favorable direction.


Under Russia's privatization plan, part of the ownership in business ventures is being given to employees and management. The balance will be sold for a combination of vouchers that will be given to every citizen and cash. The vouchers, it is hoped, will achieve the objective of speed, while the cash component is expected to promote market efficiency and make setting prices easier. Use of cash also is expected to provide local governments, which in most instances control the enterprises in question, with an incentive to support the program, because up to 65 percent of the sale proceeds (mostly the cash) will go to them.

An attempt to change the way many enterprises are controlled is planned before the privatization effort itself is undertaken. Firms with over 1000 workers and over 50 million rubles in capital will be expected to turn supervision over to a board of directors that includes management, workers, local governments and the area privatization agency. This step is called "corporatization." These boards will be encouraged to reorganize or break up the firms; if needed, to make them more attractive before they are sold. Hopefully, in this way 100,000 small firms and 2,000 large and medium-sized firms will be privatized in 1993. By the end of 1994, 40,000 large firms are expected to pass from public to private ownership using this type of mechanism.


It is not surprising that industry managers are skeptical and are attempting to thwart or delay the process. They have vested interest in the old system and are seeking to retain as much power as they can for as long as possible. In addition, in many cases they are the only ones with the skill and experience to manage many firms. This group has enjoyed some success thus far, because Boris Yeltsin as well as the Russian parliament have been reluctant to end their favored position or face up to the problem of management. Although the central planning process has largely been abandoned, much of the control apparatus still exists and plays a role in many business decisions. Many cumbersome rules are still enforced as a matter of routine. This problem is compounded by the numerous layers of administration by which directives are formulated and enforced.


Taxes are always a major problem confronting private business. The tax system can also be a serious barrier to privatization programs. To begin with, in Russia business is burdened by a value-added tax of 28 percent. Unfortunately, because of an odd mixture of local and central government jurisdictions, this tax can be levied at several stages of the productive process and the total can come to over 80 percent. Social insurance taxes also run from 28 to 37 percent, and the personal income surtaxes reach 60 percent at relatively low income levels. Although there are the obvious advantages to cutting or eliminating many of these taxes, to do so now would invite the wrath of external creditors and the I.M.F. The best that private business in Russia can realistically hope is a gradual reduction of taxes as subsidies are scaled back. A similar situation is found in the tax system of the other former Soviet republics.


Prior to the recent meltdown, leaders of the old Soviet Union were obsessed with the belief that enormous economies of scale could be realized in agriculture. Production therefore was concentrated on 26,000 huge publicly owned farms. So-called state farms averaged 42,730 acres, while collective farms usually encompassed 16,300 acres. These monsters occupied 97 percent of Russia's farm land space, while 38 million private garden-type plots were on the remaining 3 percent. At least 500 workers were usually found on these farms, along with huge tractors and other equipment adapted only to very large-scale operations. Their commitment to size went far beyond large scale agribusiness in this country. Production was by their standards highly capital intensive.

Former Soviet agriculture was exceedingly inefficient, producing far less corn, minor crops and vegetables than we do with similar resources. In wheat production outputs were comparable to those in the U.S. With this crop, they achieved 83 percent of the production possible with the land and capital available. Output suffered not only from the excessive size of the production unit and equipment but from contamination of much available land. Farming was also beset by upstream and downstream failures with 25 to 30 percent of crops lost through improper storage.

A change of agricultural ownership today is proceeding very rapidly. There are now 70,000 private family farms, and the amount of land under private ownership is expanding rapidly every day. Russian farmers have been voting on the disposition of state-owned farms. Over half have elected either family farms or farm associations where land is owned and managed individually but, because of its huge size, farm machinery is shared. Another 40 percent have elected to remain temporarily as large units operating as private cooperatives, while 10 percent have opted to continue as state farms. The cooperatives could easily be broken up into family farms in the future.

Although more has been accomplished with agriculture than many others sectors, serious difficulties must be overcome. Agricultural labor lacks the sophisticated skills needed to utilize modern farming methods. In addition, a large proportion of the farm work force is old and not receptive to new techniques. The channels of supply of seed, fertilizer and equipment to the farm community must be made much more efficient, as must the distribution, storage, and processing of farm products. New and adequate private grain exchanges are needed. Banking institutions must supply needed credit at strategic times and those manufacturing farm equipment need to adapt to a much smaller scale of operations than in the past. The pricing mechanism requires further liberalization. Another concern is that Soviet agriculture, which has been preoccupied with huge size in the past, will turn too far in the other

direction and concentrate most production on fifty or hundred acre plots. This problem is especially acute because of the prospective influence of biotechnology and genetic engineering in the not-too-remote future. A compromise on efficiently sized farms is needed.


The nations of the former Soviet Union as a group were the largest producers in the world of many metals. Together with South Africa, they turn out over 90 percent of the world's rhodium, palladium, and platinum, over 70 percent of the vanadium and two-thirds of the chrome. They also account for about half of the manganese and 40 percent of the gold. This means that without any joint action, the members of the old Soviet Union occupy a dominant position in the metals market. With South Africa, should some reciprocity arrangement be worked out, their position would be dominant.

Lester Thurow pointed out that there are no stockholders to claim a return on their investment in metal producing plants. As a result, the capital of the metal smelters of the old communist nations is a gift from the past and available at its maintenance costs. In addition, the dollar cost of former Soviet labor is very low, thus making their metal industries the lowest cost producers in the world. At the same time, domestic demand has fallen off considerably, leaving Soviet metal producers a much larger proportion of the output available for export. They will almost certainly exploit their favorable position to the fullest. Already many barter deals have been made, with western importers receiving metals from the former Soviet Union in return for various needed supplies. Organized efforts are also being made to collect and export scrap, of which the former Soviet Union has ample supplies. Another source of valuable metals in the former Soviet Union is enriched uranium from dismantled nuclear weapons. This could amount to as much as 500 metric tons, which would be a meaningful increase in world supplies. As a result, nuclear energy cost could be reduced worldwide. On September 10, 1992, Russia's nuclear energy minister announced a plan for such sales. The metals industries are an area where the prospects for private business are bright indeed.


The Soviet Union, before its dissolution, produced over 12 million barrels of oil a day, making it the world's leader. Although by 1991 the total had fallen to 10.3 million barrels, it still exceeded the 8.5 million by Saudi Arabia and 7.2 million by the U.S. The fall in output has been caused mainly by shortages of cash and equipment. In the Tyumen fields in Siberia alone, 16,000 wells are out of production for this reason. The decline in production was exacerbated by the low official price, which had been artificially set at 450 rubles a metric ton. In September 1992, the Russian government announced an oil price increase and stated that it would allow the price to reach world levels by the end of 1993. It is hoped this will stimulate an inflow of dollars and encourage investment.

Although large scale privatization has not yet hit the oil fields, joint ventures where private oil companies join with local governments are showing great promise. Exxon and Mobil have recently agreed to search jointly for very large oil fields in Western Siberia. They seek fields with a minimum of 300 to 500 million barrels in reserves. Under an accord reached in May 1992, Chevron acquired a 50 percent interest in a joint venture with the government of Kazakhstan for a $20 billion development of the Tengiz and Korolev fields believed to be twice the size of Prudhoe Bay. This project anticipates peak outputs of 700,000 barrels daily and is expected to have a 40-year life. A 1500 square-mile area also will be explored for oil under this agreement. Other such agreements are in the making that could point the way to a resurgence of the oil industry in the former Soviet Union. Groups led by Amaco and British Petroleum seek to develop fields in Azerbaijan, and another consortium of which Marathon is a member won in bidding for drilling rights off Sakhalin Island.

Another development that bodes well for the future of Soviet oil production was the formation of a consortium that will build a pipeline from the Tengiz field to deep-water terminal facilities. Initially the governments of Kazakhstan and Oman will each own 50 percent of the shares of the venture. Others may be brought in later. Terminal sites could include the Black Sea, Persian Gulf and the Mediterranean. Other pipelines serving a much larger area might ultimately be added.


Before the cutbacks occasioned by the end of the cold war, defense industries in Russia employed 7.5 million workers. By August 1992, over 350,000 of them had been laid off. This is only the start of labor force reductions; military procurement orders were down 60 percent compared with a year earlier. Included prominently among those who have lost or will lose their jobs are some of Russia's best technicians and scientists.

The possibilities of large scale conversion of most defense industries seem quite limited. True, the Krunichev arms plant, which formerly produced Bison bombers, intercontinental missiles, and Proton rocket boosters, is now turning out ski poles and children's bicycles. This, however, hardly utilizes its former capacity. In late 1922, the Boeing Co. announced plans to place some jetliner parts production in the former Soviet Union. Russian officials had also been conducting talks with aerospace producers such as Honeywell, Lockheed, and Rockwell. Russian sources also could supply Proton rocket boosters to American communications companies at prices well below U.S. competitors. To date, American competitors are vigorously resisting such a move.

Unfortunately many of the firms of the old military industrial complex are dinosaurs that ultimately will have to go out of business. Although they provide employment for millions of workers, most do not possess the high technology needed today. As a result, they are not attractive candidates for privatization or foreign investment. The ultimate resolution of this situation will be long and painful.


The progress of Russia and rest of the old Soviet Union toward a free private business economy has been quite uneven. Substantial gains have been registered in some areas while little movement can be discerned in others. The problem of devising new institutions where none have exited before is formidable. Meaningful political parties in the modern democratic sense have not yet emerged. The task of uprooting the old bureaucracy entrenched for three-quarters of a century is by no means easy. Central governments often lack adequate control over local conditions and industries.

But new businesses are springing up, new enterprises are functioning effectively and western methods and attitudes are increasingly encountered. Joint ventures with Western companies hold great promise in many areas. New Soviet businesses, some very high tech, are gaining a foothold in certain markets. Remarkably, despite the difficulties and hardships felt by many, thus far very little organized resistance has been encountered. If a coup or military uprising can be avoided, prospects of achieving a private business economy are brightening materially. However, the cost will be high. It is estimated that over the next few years up to $500 billion of new risk capital, most from private sources, will be required for privatization to succeed. The western business world, however, has an enormous stake in a favorable outcome.

Robert H. Wessel is Emeritus Professor of Economics, University of Cincinnati, Cincinnati, OH. This paper was adopted from one presented at the 34th Annual Meeting of the National Association of Business Economists, September 13-16, 1992, Dallas, TX.
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Author:Wessel, Robert H.
Publication:Business Economics
Date:Jan 1, 1993
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