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Tales from two privatizations: Russia and the former East Germany.

Introduction: Microeconomic Analysis

The transition from a centrally planned to a market economy currently taking place in Eastern Europe and the former Soviet Union is complex and difficult to understand, both for individuals actively involved with the local changes and for those viewing it from the outside. The scale of the problems faced by the governments of countries in transition is often underestimated by policymakers who raise expectations of economic growth in short time periods. Statistics based on macroeconomic data often show that transition results, especially in privatization of industry, are rapidly approaching levels of Western economies. However, "hands-on" microeconomic information illustrates the persistent underlying problems of economic transition.

Macroeconomic statistics can present a picture of overall economic success while concealing failures in large segments of the economy as many individual companies continue to struggle with the transition. Macroeconomic information makes intercountry comparisons difficult for several reasons, including the limited reliability of data, both historic and current. The historical, demographic and geographic differences among the countries of Eastern Europe and the former Soviet Union are as vast as the differences among the approaches used to undertake the economic reforms. Diverse backgrounds and approaches within Russia, where the collapse of central control has spawned a large number of independent regional and local authorities, further complicates macroeconomic analysis. For these reasons, analysis of individual privatization cases can be used to identify problems of the transition and pin-point the progress of and limits to economic reform.

Almost seven years after the beginning of the Eastern European privatization, a large number of macroeconomic statistics are now being evaluated to determine the level of success of the transition from planned to market economies. Gross national product, unemployment, real wages, foreign investment and cost of living indices show a wide range of results from the various privatization programs throughout the former planned economies.

Two of the most diverse examples of privatization are Russia and the former East Germany. In both cases, macro statistics show a picture of progress towards a market economy. However, after five years of working on the microeconomic level with companies in both countries, it is apparent to me that privatization policy shortcomings overlooked by ministries in Moscow and Berlin persist in both countries.

From the following cases, four key factors for success in privatization can be identified. Two macroeconomic factors stand out from my work as playing a vital role in economic transition: 1) maintaining a stable economic and legal system and 1) patience and support from the West. However, the focus of this paper will be on the two microeconomic factors: 1) general management skills and adaptation to Western business practices as well as 2) accountability and an understanding of the importance of accurate financial information.

The Economic Transition: Macroeconomic Context

In 1989, East Germany's communist government quickly disappeared. Similar to the Wirtschaftswunder (economic miracle) in West Germany after the Second World War, the instant economic and political transition facilitated by funds of almost $700 billion occurred without significant internal resistance. (1) This high level of investment in East Germany is often neglected when comparing privatization results. Other factors were at least as important as the massive transfer of funds. Perhaps most significant of these was the adoption of a stable constitution and legal system. Federal subsidies to companies ranging from environmental clean-up to funding depleted pension accounts helped make investment palatable to Western firms. For individual companies, a clearly defined set of business rules and legal stability, from contracts to tax law, were also very important.
 Method of Privatization Characteristics

 Purchase Contract Company acquisition, often
 with investment and
 employment guarantees. Over
 10,000 successfully
 completed in East Germany.

 Management Buy-out Former East German
 management acquire the
 company, often with
 federal assistance. Almost
 3,000 privatizations.
 East
Germany Return of Expropriation Return of the actual
 company or restitution for
 expropriation by Nazi,
 Soviet, or East German
 government.

 Communalization Return to local
 communities, including
 schools, apartments and
 sports facilities.

 Liquidation The closing of over 3,000
 companies deemed not
 salvageable.

 Voucher Division of ownership
 through shares, primarily
 given to employees.

 Open Incorporation Full public ownership,
 with financial reporting
 requirements.

Russia Closed Incorporation Limited stockholder
 companies, lower foreign
 investment potential.

 Communalization Return to local
 communities, including
 schools, apartments and
 sports facilities.

 Acquisition Company acquisition by
 unofficial means.




In Russia, real economic reforms began in November 1991 with the appointment of two young economists, Yegor Gaidar and Anatoly Chubais, to President Boris Yeltsin's first cabinet. However, there was no clear support for the earlier reform efforts and no stability. This was underscored by their expectation of holding office only for a few months.(2) Over the next five years the economic transition in Russia made progress, but instability remains a major factor that only time can change. Many of the issues dealt with quickly in Germany have yet to be addressed in Russia. Two macroeconomic factors that still require attention are legal stability and foreign investment security. Most companies in Russia are at a disadvantage compared with those in Eastern Europe for a number of reasons, including a lack of geographic proximity to Western markets and a lack of previous ties to Western partners.

Language and cultural understanding also play an important but less tangible role in successful privatizations and the transition to develop market-driven companies. Less than 10 percent of the 12,000 companies that the German Federal Privatization Agency (Treuhandanstalt) sold went to foreign investors. Of those, Swiss and Austrian companies were among the leaders in the number of former East German state-owned companies purchased. Having Western partners (and potential investors) with language and cultural similarities is another advantage not shared by Russia.

The clean break with socialism, the planned economy and the Communist Party facilitated a relatively smooth transition in East Germany. Germany's Partei der Demokratischen Sozialismus (PDS), the new name of the Communist Party, now only receives an average of 15 percent of votes in elections in the 5 former East German states. In the remaining 11 states, the PDS has practically no presence and, at the national level, only 29 of the 673 seats in Congress (4 percent).(3)

The situation is different in other former communist countries. Russia (and the remainder of Eastern Europe) has to deal with the transformation to a market economy while carrying the ideological baggage of former Communist Party bureaucrats. In the Russian Duma, the Communists remain the strongest party and often block economic reform efforts. Programs of assistance are often derailed by the opposition parties, sending mixed signals to the West. In general, economic goals remain less focused than in the former East Germany and the advantages of a market economy are still often fiercely debated in Russia.

Case Studies: Understanding the Basics and Realizing Stability

Management is an evolutionary process that has been finetuned in the West. Modern business skills in finance, marketing, personnel and manufacturing are required for survival in the competitive world market. Western managers have modified these skills over decades while their counterparts in planned economies have developed a completely different set of survival skills, which are primarily political connections. The following East German and Russian case studies illustrate the difficulty of adjusting to modern business practices.

Struggling to Adjust at the Kashira Moebel Kombinat(4)

The Kashira Moebel Kombinat in the Moscow Region provides an example of the problems resulting from a lack of basic business skills. Founded in 1922, the furniture factory grew to a peak in 1975, becoming one of the largest wooden chair manufacturers in the Moscow Region. However, like many Russian consumer goods manufacturers facing outside competition for the first time, Kashira is in serious trouble. Central plans no longer ensure raw material delivery and distribution channels of the past have broken down. Suppliers of raw materials now demand payment upon delivery or in advance, often in Western currency. Long-established fabric producers have vanished and expensive imports remain the only option. The once secure flow of customers to purchase everything the factory produced without question has now vanished. Decisions regarding purchases might have had serious cost consequences for the company, but individual directors never assumed responsibility for these management decisions. As a result, the workforce has dropped from over 500 to 160 and the factory's current production estimate of 50 percent of capacity is optimistic. The abandoned shell of an unfinished five-level manufacturing building provides a visible sign of the harsh changes.

While crime and taxes are serious problems for companies everywhere, the scale of the problem is much greater in Russia and threatens Kashira's existence. Organized protection groups and local tax authorities keep a watchful eye on production companies and can extort a large portion of their income. To avoid the possibility of appearing profitable, many companies keep their records secret. But this is often an exercise in futility; for example, tax authorities and most criminal groups are well aware of any large transactions, such as furniture purchases for housing projects, long before the production company is informed. Vital company information is hidden or forged for various reasons and inhibits sound management decisions. It is telling that even Kashira's own director is unsure of most of the company's key financial information, including profitability.

Since privatization in 1992, the general director, who served as "comrade director" in the 1980s, has attempted some reforms. Unfortunately, Kashira does not possess the managerial expertise to make the transition to a market-driven company. Much day-to-day business is accomplished through the same network of connections that drove the planned economy. The economic evolution proceeds slowly while political instability in the Kremlin often rekindles hopes among many managers for a return to the old business methods.

During my group's work with Kashira and other consumer goods manufacturers, we discussed many relatively obvious problems with management. For example, when the inventory of one particular model of chair increased, production continued. We asked Kashira managers whether the company planned to correct the problem through sales or marketing efforts, and made concrete suggestions, such as low-cost advertising in the regional newspaper. These recommendations received a cool response. The director explained that production would continue and marketing efforts would not be made' reasoning that if the products were of good quality, they would be sold as they always had been. "Only second-class products need to be advertised," he argued.

Explaining new concepts and making suggestions help to some degree, but the transition will take time. Some companies will adapt faster than others, and the process of natural selection will determine which companies survive in the new market economy While the old economic system is disappearing fast, lack of understanding or trust still persists among a whole generation of ax-communist managers still in control of much of Russian production. For example, the functionless central planning office for furniture distribution still exists, and Kashira's director still maintains contact with the administrators who, in the past, accepted each piece of furniture produced to meet each year's plan.

Russia's current business school graduates provide hope for the transition, but they face intimidating obstacles upon entering the job market in a society that places high value on age and experience. With few exceptions, the only available management positions for aspiring young business graduates are with the limited number of foreign companies in Russia. The remaining alternative for the most qualified is to leave Russia. The resulting "brain drain" slows Russia's transition to a market economy.

A large number of successful Russian business men are Russian emigres from the 1970s and 1980s who returned with Western business skills and retained their Russian language and cultural skills. This group also plays a role in the Russia's transition. However, unlike the West German managers who flooded East Germany in 1990, returning Russian emigres tend to be more interested in taking short-term gains and exploiting unchecked areas of the Russian economy.(5) This could be due primarily to the fears of instability and a return to the old system.

In contrast to the examples of management skill deficits in Russia, the Treuhandanstalt is full of examples that highlight how quickly many in the former East German management class recognized the opportunities of the transition to the market. These individuals participated in 2,983 management buy-outs (MBOs) of the companies in which they had worked throughout the period of communism.(6) Though the government encouraged local entrepreneurs through support funding, the primary motivation for most MBOs came from within the former management.

Continued Focus on Production: The Yegorsk Shoe Factory(7)

Problems at the Yegorsk Shoe Factory result from a Sovietera focus on production rather than on reducing costs, meeting market demand, distribution, marketing and sales. One of the Moscow region's largest shoe manufacturers, Yegorsk continued producing lightweight textile shoes in high volume without questioning the costs or potential market demand for its product. After a tour of its modern production plant, the director proudly explained to us how production figures had steadily increased over the last two years in spite of overwhelming difficulties in obtaining raw materials. Yegorsk's manager saw this as a tribute to his managerial skills--meaning his industry connections with plastics and textile suppliers.

Furthermore, the manager was confident that the company would produce over 6,000 pairs of shoes in the following month. Only after further examination of the factory grounds did we discover the warehouse, which held over 20,000 pairs of the same shoes being produced at record levels. The distribution system that supplied shoes from Yegorsk throughout the Soviet Union had collapsed. Marketing and sales were never functions left to the production companies, but they must now be rapidly acquired.

Resistance to Change: The Dolgoprudnie Candy Factory(8)

Difficulties at the Dolgoprudnie Candy Factory further illustrate a lack of business understanding and the fairly widespread illusion among small and mid-sized Russian companies that foreign investors are saviors. This case also highlights the lack of the required managerial skills and the Soviet characteristic of placing hope on a larger source beyond control of the company.

From an aging factory on the outskirts of Moscow, Dolgoprudnie manufactures popular soft caramels, primarily for Moscow and the surrounding areas. The director has worked for the company for more than 10 years but is nervous about addressing the changes of the past 5 years. Only with a high degree of reluctance were Westerners allowed to work with the company. However, it quickly became obvious that in the opinion of the director, the only thing Russian firms can use from the West is money. Management of the small factory continues much as it has over the last 20 years, with little regard for the new economic system. This includes a wide range of "non-core" business activities such as providing childcare and vacation housing for its employers. The fact that declining sales and increasing costs result in a large deficit is secondary. The company hopes to survive through connections and barter until the system returns to "normal."

The director made it clear that she had no intention of changing to so-called dishonest capitalist business practices, though she indicated that she would be interested in talking to any Western investors we knew. Further questioning revealed her definition of a Western investor: a company from a capitalist country with too much money. In her eyes, investment in Dolgoprudnie would simply entail a rich investor giving money. While this view may not represent the majority of Russian firms, it shows a large gap in the understanding of basic market principles in many smaller firms and illustrates the problems of an entire generation in dealing with economic transition.

In contrast to the poor understanding of basic market principles throughout many Russian companies is the success of individual privatizations in the former East Germany. Two strong historic arguments explain the ease of the transition to a market economy. First, the states of former East Germany have a long entrepreneurial tradition, especially the state of Saxon, where industrialists in Dresden and Leipzig were among the strongest of pre-Second World War Germany. Second, the East German socialist and planned economy lasted only 45 years, not 75, as in Russia. Together, these two factors are difficult to quantify but their impact is clearly evident in discussions with managers over a wide range of industries throughout the new German states.

Rapid Transition: The Privatization of the Kabelwerk Oberspree (KWO)(9)

The privatization of KWO, the cornerstone of the former East German cable production conglomerate, illustrates how a privatization can quickly overcome obstacles and provide benefits for risk-taking investors.

Prior to the privatization of KWO, foreign cable manufacturers attempted to enter the lucrative German market for electrical cables for years without success. As with each privatization, the German government had several goals for the company. The first was to retain as many jobs as practical at the factory, which is located in an industrial section of East Berlin. The second goal was to modernize the factory's aging 30 year-old machinery. The third goal was to break the near-monopoly status which West German cable manufacturers enjoyed in a practically closed market.

Privatization proceeded with relative ease and the goals of both investors and managers were met. The level of integration of the former management was an unexpected cost savings for the investor. The new owners initially replaced in key officers, but many of the mid-level managers remained at the company. After evaluation and training, the new "imported" managers determined that several key positions could be best filled by former managers, who were eager to learn new management skills and who quickly adapted to new market practices.

In summary, the individual cases of privatization show deficits in several areas of basic business skills. In Russia this problem has a historic base. However, over time it can be overcome with training, as long as the prerequisites of stability and security are present. West Germany contributed billions of dollars to facilitate East German transition, but even more valuable was an immediate assurance of future stability through a constitution and laws. Additional German advantages include the instant conversion to western systems and accountability. A large number of systems, contracts and business methods were quickly adapted to the companies of the former East Germany. These tools, as well as the management "invasion" from West Germany, are still missing in Russia.

Case Studies: Accountability

The history of management information in Russian companies is deeply rooted in secrecy. Russian accounting has its own detailed set of rules and exceptions which served its purpose in the planned economic system. This system has been maintained to a large degree during the recent transition period although it is fairly incompatible with the General Agreement on Tariffs and Trade accounting methods. An additional complication for recent accounting is the period of rapid devaluation of the ruble from the fixed non-convertible value of over one U.S. dollar per ruble to its current relatively stable rate of over 5000 rubles to one U.S. dollar. There is the additional problem with the lack of reliable information within Russian companies. Almost every figure, from annual sales to assets, can vary significantly in most firms. This is often a result of the historic need to fulfill annual production plans and cover various former Soviet interests. Attempts by Western investors or consultants to audit Russian companies typically result in a large degree of guess work and frustration.

Accounting Secrecy and Multiple Records: The Obukova Carpet Factory(10)

The Obukova Carpet Factory illustrates both the secrecy of information and the general mistrust of foreigners and authorities. Initially, it appears to be a modern Russian company operating sophisticated spinning and weaving machines and running at near capacity. Only upon discussions with the chief accountant and the general director does one learn of Obukova's problems. After our third visit and many requests, a manager informed us that the financial statements which we were shown were based on the production projections from 1990. Further investigation revealed that the planning department maintains two sets of accounting books; neither set, however, reflected the actual costs, income, and assets of the company.

Alhough this information was useless, the planning department was not allowed access to the alleged actual figures from the finance department. The finance department maintains still another, separate set of books. Questions and simple analysis reveal that this set was also not a true reflection of the company's business. Further questioning led to the discovery that only the general director knew the accurate information; and he was not willing to divulge even the least sensitive portions. Interest in working with the West is obviously low and could involve only a "no questions asked" capital investment.

In several Russian companies there is high interest in understanding Western financial management. However, there are at least an equal number of companies such as Obukova that survive in a world of secrecy and intentionally-limited transparency of basic company data.

Eroeffnungsbilanzen: Financial Statements for East German Companies(11)

There was no question of the level of information on privatized companies with the 13,815 companies held by the German Federal Privatization Agency. An army of accountants immediately set upon the work of developing what was called an Eroeffnungsbilanz, or opening balance sheet, for each of the companies. This monumental task was the basis for valuation of the entire economy of the former East Germany. These companies employed over 4 million workers and estimates put over 30 percent of the companies in legal bankruptcy. Only 10 percent were estimated to be able to reach profitability after the collapse of the planned economy. An initial credit of $20 billion was issued by the government in October 1990 and the political and economic debate over the cost of transformation began.

German federal laws required each company to produce detailed audit reports which included costs of environmental clean-up, personnel reduction plans and costs of restructuring. Committees of industry experts, accountants and consultants solved the accounting problems as quickly as possible. On 31 December 1994, the Privatization Agency closed its doors after finishing the successful transition from a planned to market economy, in just over five years.

Many of the first steps undertaken in Germany have not yet begun in Russia's privatization. Concepts quickly agreed upon and set in practice in Berlin are still being discussed in Moscow. These are macro-level issues which must then be implemented case-by-case in each company throughout the entire country and will require patience of both Russians and foreigners.

Conclusions: Russian Problems and Lessons from the Former East Germany

Develop Management Skills

A long-term management education process is needed for privatization progress in Russia. Currently, the large number of Western assistance efforts remain fairly uncoordinated because of competing political interests, both among aid donors and within the various Russian ministries. Coordinating existing management education programs would be more effective than additional random efforts by individual groups.

Another key to successful training would be the development of management skills based on proven practices in the West and adapted to the Russian economy. This would involve integrating existing Russian market characteristics and adapting management programs in marketing, finance, organization and personnel to meet current needs. Simply copying Western programs that are often poorly suited to dealing with the current transition problems in Russia is inadequate.

Improve Accountability

Accurate financial information and accounting standards will not only facilitate foreign investment but will also promote more efficient internal company management. An initial attempt at transplanting American and European systems to selected Russian companies resulted in confusion and duplication of accounting efforts. Before individual companies can make the transition to western accounting and management practices, stable government requirements such as tax regulations must be established. As with management skills, accounting and financial standards involve a long-term education process that should be supported by western countries. Attempts to simply impose a Western system on Russian companies without improving accounting standards are not likely to succeed.

Promote Macroeconomic and Legal System Stability

Legal and economic stability is a key factor to a successful transition for companies struggling to adapt to market needs. Based on case evaluation, this stability has not yet been achieved in Russia. The nature of the political and economic transition in Russia will, unfortunately, prohibit the immediate development of stable systems similar to those in Germany and other Eastern European countries. For this reason, Western agencies assisting in the financing of Russia's transition must continue to support efforts toward stability in Russia.

Continue Western Patience and Support

A better understanding of the scope of economic transition will help both Russians and foreigners to set realistic expectations. However, this process will require patience and steady assistance from the West over the coming decades. Steady progress towards the goal of a market economy in Russia should be supported on all levels. Education efforts in Russia and further study of individual privatization successes will correct earlier transition mistakes and help ensure economic stability. Ultimately, the transition will succeed by rebuilding the Russian economy step-by-step, as with each of the cases examined above. The resulting transformation of Russia into a strong economic partner will benefit the world economy in the long run. (1) World Bank, From Plan to Market, World Development Report 1996 (Washington DC: World Bank, 1996) p. 10.

(2) Maxim Boycko, Andrei Schleifer and Robert Vishny, Privatizing Russia (Cambridge, MA: Massachusetts Institute of Technology Press, 1995) p. 1.

(3) Sigrid Dillman, "German Election Results - Bundestagwahl 1994," Congressional Information Service (Berlin: 1995).

(4) Andrei Sacharov and Scott Thomas, "Treuhandostberatung--Project Summary Report," paper delivered to the Moscow Oblast Privatization Commission (Moscow: December 1995) pp. 32-39.

(5) Tuemen Regional Ministry of Commerce, The Current State of Business in Western Siberia (Tuemen: Tuemen Regional Ministry of Commerce, April 1996) p. 3.

(6) Treuhandanstalt, Abschlussstatistik der Treuhandanstalt per 31.12. 1994 - Statistical Report (Berlin: Treuhandanstalt, June 1995) p. 2.

(7) Karl-Heinz Dubner and Scott Thomas, "Treuhandostberatung - Project Summary Report," paper delivered to the Moscow Oblast Privatization Commission, (Moscow: December, 1995) pp. 14-21.

(8) Irene Voloroisch and Scott Thomas, "Treuhandostberatung - Project Summary Report," paper delivered to the Moscow Oblast Privatization Commission, (Moscow: December, 1995) pp. 46-47. (9) Treuhandanstalt, Daten und Fakten zur Aufgabenerfullung, Summary Articles (Berlin: Treuhandanstalt, 1995) p. 2.

(10) Andrei Sacharov, "Gesellschaft fur Technische Zusammenarbeit," paper delivered to the Moscow Oblast Privatization Commission (Moscow: April 1996) p. 3.

(11) Treuhandanstalt, Daten und Fakten zur Aufgabenerfullung--Annual Report, Summary (Berlin: Treuhandanstalt, 1995) p. 18.
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Title Annotation:Privatization: Political and Economic Challenges
Author:Thomas, Scott
Publication:Journal of International Affairs
Date:Jan 1, 1997
Words:4382
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