Corporate Governance in the Former Soviet Union: An Overview

Journal of Comparative Economics 27, 398 – 421 (1999) Article ID jcec.1999.1603, available online at http://www.idealibrary.com on

Corporate Governance in the Former Soviet Union: An Overview 1 Saul Estrin* and Mike Wright† *London Business School, Sussex Place, Regent’s Park, London, NW1 4SA, United Kingdom; and †Centre for Management Buy-Out Research, University of Nottingham Business School, Nottingham NG7 2RD, United Kingdom E-mail: [email protected] Received April 14, 1999; revised June 7, 1999

Estrin, Saul, and Wright, Mike—Corporate Governance in the Former Soviet Union: An Overview This paper seeks to identify whether the slow progress in transition experienced by the countries of the former Soviet Union (FSU) arises from weaknesses in implementing effective corporate governance or from weaknesses in the broader economic environment. An overview of progress in transition in the FSU is presented followed by analysis of developments in enterprise ownership and governance. Problems in measuring the link between governance and performance and alternative mechanisms for enhancing the efficiency of enterprise in the FSU are discussed. The paper concludes that the problems of transition in the FSU concern delays both in introducing corporate governance mechanisms and in introducing an appropriate competitive market environment. J. Comp. Econom., September 1999, 27(3), pp. 398 – 421. London Business School, Sussex Place, Regent’s Park, London NW1 4SA, United Kingdom; and Centre for Management BuyOut Research, University of Nottingham Business School, Nottingham NG7 2RD, United Kingdom. © 1999 Academic Press Key Words: corporate governance; privatization; former Soviet Union. Journal of Economic Literature Classification Numbers: G34, L33, P11, P52.

1. INTRODUCTION While considerable attention has been given to transition in Russia (Boycko et al., 1995; Earle and Estrin, 1997; Filatotchev et al., 1996a); other republics of the former Soviet Union (FSU) have until recently been neglected. However, Russian evidence cannot be taken as a proxy for devel1

Thanks to Manuela Angelucci for research assistance and to John Bonin, Trevor Buck, Igor Filatotchev, Derek Jones, and Boris Kutzentsov for comments on an earlier draft of this paper. 0147-5967/99 $30.00 Copyright © 1999 by Academic Press All rights of reproduction in any form reserved.

398

CORPORATE GOVERNANCE IN THE FSU

399

opments elsewhere in the FSU. Although the now independent republics were all previously part of a common regime, varying paths to transition have been pursued in the context of different resource endowments and the differing political and cultural environments which have emerged following the breakup of the USSR. These differences raise questions about whether the constraints to progress in transition arise primarily in the political arena, linked to an inability to implement or sustain reform policies, or, even if such policies are introduced, in the weakness of market forces and the legal and institutional structure. The paper therefore seeks to shed light on whether the slow progress in transition experienced by the countries of the FSU arises from weaknesses in implementing effective corporate governance or from weaknesses in the broader economic environment. The structure of the paper is as follows. First, a brief overview of progress in transition in the FSU is presented. Evidence is provided on progress in transition in the FSU in comparison with Central and Eastern Europe (CEE). Second, developments in enterprise ownership and governance are analyzed. Both these sections provide a synthesis that places the emerging evidence on the general inertia of ownership configurations in enterprises in the FSU in the general context of progress in transition in the FSU. Third, the problems in measuring the link between governance and performance are discussed together with evidence on this link. Previous research shows that weaknesses in corporate governance in Russia, Belarus, and Ukraine have restricted corporate restructuring. This evidence points to the need to examine alternative mechanisms for enhancing the efficiency of enterprise in the FSU, and these are considered more fully in the fourth section, notably in respect of capital market developments, the role of banks and other outsiders, the role of financial–industrial groups (FIGs), product market developments, and entrepreneurship. Finally, some brief conclusions are drawn. 2. TRANSITION AND PRIVATIZATION IN THE FSU By the start of 1999, countries in transition could be divided into two groups. The first, mainly in Central Europe, had restored GDP and productivity growth, brought inflation more or less under control, and developed vibrant private sectors through privatization and the entry of new enterprises and through restructured trade links with the West, primarily the European Union. The second group, which includes much of the FSU, had not yet established economic growth nor controlled inflation in a sustainable way, and appeared to have done little to restructure enterprises or trade relationships. Our purpose in this section is to summarize the main elements of reform on the microeconomic side in the FSU, in order to set the scene for the subsequent analysis.

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ESTRIN AND WRIGHT TABLE 1 Methods of Privatization in the Baltic States and the CIS Primary method

Country

Direct sales

Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgyzstan Latvia Lithuania Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan

1

MEBOs

1

1 1 1

Secondary method Vouchers

Direct sales

1 1

1

1 1 1 1 1 1 1 1

1 1 1 1 1 1 1 1

MEBOs

Vouchers

1 1 1 1

1 1

Source. EBRD (1998).

2.1. Privatization Commencing with privatization, the countries of the FSU shared a commonality of approach up to the breakup of the country in 1991. Principally, under the provisions of the 1989 legislation, enterprises could exercise their option to buy out (Filatotchev et al., 1992). These enterprises were generally even more heavily dominated by insiders than those privatized under the later, country-specific programs. Following the dissolution of the Soviet Union, the newly independent republics pursued different approaches to privatization, and at different speeds. The main methods employed are summarized in Table 1. Every country has used a mixture of methods, but the dominant approach has been to imitate Russia in the application of privatization through vouchers, with direct sales as the secondary method. Only a handful of countries, including Belarus and Ukraine, have eschewed the use of direct sales entirely. In practice, however, Russian-type privatization has favored insiders (Boycko et al., 1995). Hence, the distinction between privatization plans based on vouchers and management employee buyouts (MEBOs), although clear formally, is probably of limited practical significance. Only Estonia has pursued a policy primarily focused on direct sales, and therefore likely to encourage widespread outsider ownership. This is in sharp contrast to the countries of Central Europe, where direct sales or voucher

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TABLE 2 Private Sector Share in GDP in the Baltic States and the CIS, 1991–1998 Country

1991

1992

1993

1994

1995

1996

1997

Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgyzstan Latvia Lithuania Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan

24.2** — 6.8* 17.7* — 12.2* — — 15.4* — 10.1* — — 7.8 —

36.7** — 8.1* 22.0* — — — — 20.0* — 14.0 — — 5.6 —

— — — 50.6** — — — — — — 21.0 — — 7.5 —

40 20 15 58** 20 20.2 30 55 50 20 50 15 15 30 20

45 25 15 65 30 25 40 60 55 30 55 15 15 34 30

50 25 15 70 50 40 50 60 65 40 60 20 20 40 40

55 40 20 70 55 55 60 60 70 45 70 20 25 50 45

Source. EBRD (1995, 1998). Note. Values marked with an asterisk were taken from the EBRD (1995), where recent official numbers were unavailable. Numbers reflect pure private sector share, except for numbers marked with a double asterisk, which are non-state sector shares.

privatizations, often in favor of outside owners, have predominated (Estrin, 1994; European Bank for Reconstruction and Development (EBRD), 1998). Although privatization methods may have tended to favor insiders more than is desirable for successful transition (Frydman et al., 1996a; Blanchard and Aghion, 1996; Hanson, 1997; Smith et al., 1997; Leshchenko and Revenko, 1999), Table 2 reveals that significant private sectors had been established in most countries of the FSU by 1997. From a very low base in 1991, typically less than 15% of GDP, we find that 3 countries, i.e., Estonia, Lithuania, and Russia, had attained private sector shares in officially reported output of 70% by 1998, and that 9 of the 15 new republics had private sector shares in excess of 50%. Three countries clearly lag in their progress with privatization. In Belarus, Tajikistan, and Turkmenistan, private sector shares had risen only moderately since independence, with most of that increase coming from small-scale privatization of shops, farms, and housing rather than from within the industrial sector. 2.2. Foreign Direct Investment In addition to funding investment in excess of domestic savings, foreign direct investment (FDI) is a source of management know-how, technology, and skills

402

ESTRIN AND WRIGHT TABLE 3 FDI in the Baltic States and the CIS (Millions of Dollars) Per capita inflows b

Country

Inward stock 1996

Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgyzstan Latvia Lithuania Moldova Russia Tajikistan Turkmenistan Ukraine

26 787 114 799 59 3505 191 864 296 131 8093 55 365 1345 156

Uzbekistan

a

Inflows 1997

a

1994

1995

1996

1997

43 1051 192 262 203 2106 75 418 355 60 6241 4e 121 e 623

2.13 c 2.96 c 0.87 150 c 1.48 30.71 e — 84 c 8.33 c 2.75 c 4.32 c 2.09 c 25.5 3.06 c

— 20.70 c 1.45 308.78 1.11 — 21.26 c 71.57 c 19.65 c 14.71 c 13.64 2.2 14.3 5.20 c

4.86 78.7 7.09 468.5 7.4 — — 152.8 41 c 5.6 16.8 2.17 23.2 10.15

11.6 138.84 18.82 713.1 37.6 134.38 c,d 16.16 c 167.2 96 14 42.4 — — 12.24 —

85 e

3.27 c

21.05

2.16

a From United Nations/Economic Commission for Europe Secretariat (1998), except values marked otherwise. b FDI values are from the United Nations, Economic Commission for Europe Secretariat (1998). c Population values from the United Nations, Economic Commission for Europe Secretariat (1998). d Population values from the United Nations, Statistical Office (1998). e From United Nations (1998).

for enterprises in transition economies and has been an important element in the more successful transformations of CEE (Meyer, 1998). We report, in Table 3, three alternative indicators of FDI that give a picture of emerging patterns for the countries of the FSU. The natural-resource-rich republics, notably Azerbaijan and Kazakhstan, have experienced the highest FDI as a percentage of GDP. Kazakhstan, Russia, and Ukraine have relatively large stocks of FDI, in excess of $1 billion, accumulated by 1997, while Azerbaijan, Russia, and Kazakhstan all received significant inflows, also in excess of $1 billion, in 1997. However, once we scale for the size of the economy by using per capita inflows, it becomes clear that outside the resource-rich republics only Estonia has received significant FDI flows. In the other two Baltic countries, per capita FDI flows are modest, and in the remainder of the FSU, they are extremely low. Only in Estonia does FDI represent a sustained significant element in gross fixed capital formation, between 17 and 41% in the period 1992 to 1997. In no other country does FDI exceed 5% of gross fixed capital formation in this period (World Bank, 1996; United Nations, 1998).

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2.3. Enterprise Restructuring and Governance A panel of EBRD transition indices is used in Table 4 to capture progress in key aspects of microeconomic reform across the FSU, using one of the leading transition economies, Hungary, as a reference. Commencing with indicators of restructuring, and corporate governance of firms, on a scale from 1 to 5, Hungary sets a strong standard, attaining a 3 in 1994 and moving to 31 by 1998. No country in the FSU matches and sustains Hungary’s 1994 level by 1998 except Estonia. The typical level of attainment in FSU countries in 1994 is very much lower, with a majority of countries being ranked at the lowest level of attainment. We observe some modest improvement by 1998 in the worst performing countries, e.g., Ukraine, Azerbaijan, and Kazakhstan. However, the countries that start slightly better in 1994, for example, Russia and Moldava, display no palpable improvement in corporate governance during the period 1994 to 1998, and one country, Belarus, is considered by EBRD to have gone backward. 2.4. Financial Markets Table 4 also reports on indicators of progress in financial markets, referring to banking reform and securities markets, respectively. With the exception of Estonia, and to a lesser extent the other Baltic states, the situation in these areas is even more worrisome than in the enterprise sector. In the FSU in 1995, only the three Baltic states had moved to bank solvency, although most countries had started to liberalize interest rates and credit allocation. The EBRD indicators suggest no real progress in bank reform in any of the four countries covered in the symposium between 1995 and 1998, with some deterioration again in Belarus. In the entire FSU, only four countries, i.e., the three Baltic countries and Kyrgyzstan, moved to bank solvency by 1998; there is no effective bank supervision and little or no lending by financial institutions to the private sector. This situation contrasts with that in Hungary (Schaffer, 1998), where a better ranking had already been achieved in 1995 than for any country in the FSU except Estonia. Hungary further improved its position between 1995 and 1998. 2.5. Legal Infrastructure Given widespread reports of weak legal infrastructure and corruption in the FSU, it is important to consider the spread of attainment in this area. Using the 1995 EBRD classification, we find that most countries in the FSU had a reasonably full set of laws in place to address commercial and financial issues, e.g., investment, security over assets, and repatriation of profits. The important exceptions are Azerbaijan, Tajikistan, and Turkmenistan. The formal legal situation improved further in most countries in 1998, so that in nine countries of the 15, the EBRD (1998) reports that legal rules do not impose major obstacles to

3 1 1 2 3 1 1 2 2 2 2 2 1 1 1 1

Hungary Armenia Azerbaijan Belarus Estonia Georgia Kazakhstan Kyrgyzstan Latvia Lithuania Moldova Russia Tajikistan Turkmenistan Ukraine Uzbekistan

3 2 2 2 3 2 1 2 2 2 3 2 1 1 2 2

1995

3 2 2 2 3 2 2 2 3 3 2 2 1 1 2 2

1996 3 2 2 1 3 2 2 2 32 32 2 2 1 22 2 2

1997 31 2 2 1 3 2 2 2 32 32 2 2 22 22 2 2

1998 3 2 2 2 3 2 2 2 3 3 2 2 1 1 2 2

1995 4 21 2 1 31 21 21 32 32 3 21 2 1 1 2 22

1998 3 1 1 2 2 1 2 2 2 2 2 2 1 1 2 2

1995 31 2 22 2 3 1 2 2 21 21 2 22 1 1 2 2

1998

Financial institutions: securities markets and non-bank financial institutions

3 2 1 1 4 1 1 2 2 2 3 1 1 1 2 1

1995

4 3 2 2 41 2 2 2 3 2 2 2 2 1 4 2

1996

4 3 1 2 4 2 2 2 3 3 3 3 na na 2 2

1997

2 3 na 2 2

4 3 2 2 4 3 2 2 2 3

1998

Legal indicators: effectiveness

Source. EBRD (1995 to 1998). Note. The classification system is as follows. Governance and enterprise restructuring: (1) Soft budget constraints; few other reforms to promote corporate governance. (2) Moderately tight credit and subsidy policy but weak enforcement of bankruptcy legislation and little action taken to strengthen competition and corporate governance. (3) Significant and substantial actions to harden budget constraints and to promote corporate governance effectively. (4) Substantial improvement in corporate governance, forexample, on account of an active corporate control market, significant new investment at the enterprise level. (41)

1994

Country

Enterprises: governance and enterprise restructuring

Financial institutions: banking reform and interest rate liberalization

Progress in Transition in the Baltic States and the CIS

TABLE 4

404 ESTRIN AND WRIGHT

Standards and performance typical of industrial economies; effective corporate control exercised through domestic financial institutions and markets, fostering market-driven restructuring. Banking reform and interest rate liberalisation: (1) Little progress beyond establishment of a two-tier system. (2) Significant liberalization of interest rates and credit allocation, limited use of directed credit or interest rate liberalization ceilings. (3) Substantial progress in establishment of bank solvency and of a framework for prudential supervision and regulation; full interest rate liberalization with little preferential access to cheap refinancing; significant lending to private enterprises and significant presence of private banks. (4) Significant movements of banking laws and regulations towards BIS standards; well-functioning banking competition and effective prudential supervision; significant term lending to private enterprises; substantial financial deepening. (41) Standards and performance norms of advanced industrial economies; full convergence of banking laws and regulations with BIS standards; provision of full set of competitive banking services. Securities markets and non-bank financial institutions: (1) Little progress. (2) Formation of securities exchanges, market-makers, and brokers; some trading in government papers and/or securities; rudimentary legal and regulatory framework for the issuance and trading of securities. (3) Substantial issuance of securities by private enterprises; establishment of independent share registries, secure clearance and settlement procedures, and some protection of minority shareholders; emergence of non-bank financial institutions and associated regulatory framework. (4) Securities laws and regulations approaching IOSCO standards; substantial market liquidity and capitalization; well-functioning non-bank financial institutions and effective regulation. (41) Standards and performance norms of advanced industrial economies; full convergence of securities laws and regulations with IOSCO standards; fully developed non-bank intermediation. Effectiveness (1995 classification): (1) Legal rules are usually very unclear and often contradictory and the availability of independent legal advice is very limited. The administration of the law is substantially deficient (e.g., little confidence in the ability and independence of the courts, no or poorly organized security and land registers). (2) Legal rules are usually unclear and sometimes contradictory. Legal advice is often difficult to obtain. The administration and judicial support of the law is rudimentary. (3) While legal rules are reasonably clear and ascertainable through legal advice, administrative and judicial support is often inadequate (e.g., substantial discretion in the administration of laws, few up-to-date registers). (4) The law is usually clear and legal advice is readily available. Investment laws are usually well administered and supported judicially, although that support is sometimes patchy.

CORPORATE GOVERNANCE IN THE FSU 405

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business. However, in Belarus and Ukraine of our sample countries, the legal rules themselves are considered to be significant constraints. The final columns of Table 4 refer to the effectiveness of laws. Apart from in Estonia, the situation is unsatisfactory throughout the FSU, particularly in comparison with Hungary. The attained levels of legal effectiveness were extremely low in 1995; in a majority of FSU countries the law relating to commerce is described as usually very unclear and often contradictory, with the administration of the law being substantially deficient. We find some modest progress in most countries from the lowest possible to the next lowest category by 1998, but only in six countries are legal rules considered by the EBRD to be clear. Of our sample countries, only Estonia reaches a Hungarian standard in legal effectiveness. In summary, most countries of the FSU have applied privatization policies successfully, and some have achieved private sector shares comparable to the Central European economies, although there is a wide range from Estonia to Belarus. Performance in establishing other key elements of a market economy, i.e., restructuring and corporate governance, the development of capital markets, and the establishment of a legal system to support the market economy, is much less satisfactory and lags behind the CEE everywhere except in Estonia. In most countries, the problems stem as much from a lack of success in implementing policies and laws as from an unwillingness to introduce them. Among our sample countries, Russia exemplifies this situation. However, in a few countries of the FSU, governments have been unwilling even to implement reform strategies, Ukraine and Belarus notably. 3. DEVELOPMENT IN ENTERPRISE OWNERSHIP AND GOVERNANCE IN THE FSU In this section, we use survey evidence to consider in greater detail the evolution of ownership in the four countries covered by this symposium. We first summarize the main conceptual arguments on the relationship between enterprise performance and ownership. 3.1. Ownership, Performance, and Governance Early studies of the relationship between ownership and performance in the Western literature concentrated upon analysis of the differences between private and state-owned enterprises (Vickers and Yarrow, 1988). Privatization was expected to encourage effective enterprise restructuring and improve performance via two causal routes. First, with the introduction of a financial stake for the new owners, some of whom may be incumbent managers, incentives are sharpened and monitoring of enterprise performance increases. Second, passing cash flow and control rights from the state to private owners would sever the umbilical chord of the state, so hardening budget constraints and reducing

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407

managerial discretion to pursue non-profit maximizing goals (Estrin and Perotin, 1991). Managers are expected to comply with the interests of the external owners of the private enterprise; however, given information asymmetries, it is difficult for owners to ensure that managers do so. Ideally, managers and equity investors would enter into a binding contrast (Shleifer and Vishny, 1997), but it is difficult to specify contracts ex ante that accommodate all possible future contingencies. Therefore, should unforeseen circumstances arise, managers assume contingent control rights that provide them with the potential to operate against investors’ best interests. Asymmetric information between managers and external investors serves to increase the costs of monitoring and, therefore, enables managers to pursue their own goals rather than those of the equity investor. The potential for increasing monitoring costs is particularly pertinent if there are a large number of dispersed external investors, creating a free-rider problem. This problem can be minimized if ownership is concentrated in the hands of large block holders who will be more likely to utilize their voting power to influence managerial behavior. However, as Shleifer and Vishny (1997) note, this will require a robust legal system in order to protect voting rights. 2 Finally, in the transition context, it may not be enough for outside owners to give managers the right incentives for good performance. Rather, there may need to be replacement of managers ill-suited to the new economic milieu (Barberis et al., 1996). The second causal route considers that improvements in enterprise performance result from reductions in the influence of the state upon the privatized firm. Such a hypothesis implies reduced intervention and control by politicians over privatized firms. By transferring control and cash flow rights from politicians to private owners and managers, privatization requires the politician to compensate the firm for foregone profits if the firm is to increase employment beyond its efficient level. Boycko et al. (1995) suggest that this is less likely to occur as it would require an actual payment to be made, and thus privatization is likely to lead to restructuring and improved performance. Furthermore, privatization is likely to be more effective if ownership and control is exercised by outside owners rather than managers, as they are more likely to be concerned with the profits of the firm. As noted above, a large number of privatizations in the FSU have included a significant element of mass privatization or management-employee buy-out. Such equity was established at the cost of highly dispersed initial ownership, potentially limiting the monitoring of enterprise activity. Mechanisms for trading share vouchers have sometimes emerged, but the problems of dispersed owner2 This leads to the proposition that large block holders will exercise more effective corporate governance, a finding which has been supported by a host of studies in developed market economies, e.g., Kaplan and Minton (1994) and Kang and Shivdasani (1995).

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ship have been made more acute by thinness of capital markets. In practice, share trading has been rare in the early stages of transition so there were few possibilities for concentrating shareholdings (EBRD, 1998). Furthermore, the true disciplinary device is takeover rather than monitoring. The potential for takeover has been greatly diminished by the difficulty of purchasing shares and the inability of potential predators to raise sufficient capital to support a bid. Most analysts argue that the introduction of outside owners would have a positive influence upon enterprise performance and restructuring (Earle and Estrin, 1997). This influence is expected to occur through improved monitoring and the possibility for foreign owners to introduce new capital and Western experience. In contrast, worker ownership may be associated with reluctance to shed labor, slower restructuring, lower levels of investment, and difficulties in obtaining access to capital. If managers hold large stakes in their firms, managerial risk-aversion can lead to excessively cautious firm behavior and entrench management in the absence of a managerial labor market. Evidence from Russia indicates significant entrenchment by management in terms of purchasing shares from employees, resistance to takeover by outsiders, and size of managerial equity stake (Bleaney et al., 1999). Finally one of the stylized facts of transition has been the strong performance of the ab initio private sector (Konings et al., 1996; Bilsen and Konings, 1998; Richter and Schaffer, 1996). Being privately owned, these firms are likely to have strong corporate governance arrangements. Often either one owner or a small number of owners are able to monitor the management closely, and in many cases the management will themselves be the owners. More generally, while state-owned and privatized firms have inherited their sectoral and locational characteristics, entrepreneurs starting new private firms are able to choose the sectors and locations in which they operate and may be expected to choose the more promising ones. To achieve enhanced economic performance there is, therefore, a need to promote entrepreneurial skills as well as good corporate governance. 3.2. Trends in Ownership Structures Although, as we have seen, private sector shares in GDP were relatively high in much of the FSU by 1997, the methods of privatization and surveys of Russian firms (Filatotchev et al., 1996b; Hanson, 1997) suggest that insider ownership is predominant. Our aim in this section is to investigate the evolution of Russian ownership structures and the situation in other countries of the FSU. One of the key issues in effective corporate governance is the centralization of ownership in outside hands, and we also explore the evidence on this below. The evolution of ownership structure in Russian privatized enterprises is reported in Table 5. Ownership distribution varies somewhat between sur-

66 19 47 14 11 3 20

171

69 21 48 20 — — 11

214

Buck et al. b (%) (1994)

142

13

65 25 40 21

Blasi et al. c (%) (1994)

322

55 16 39 32 23 9 13

Blasi et al. c (%) (1995)

357

58 18 40 32 26 6 9

Blasi et al. c (%) (1996)

111

59 13 46 27 15 12 14

Jones d (%) (1996)

314

59 12 47 31 23 8 10

Wright et al. e (%) (1996)

105

55 16 39 39 26 13 6

Buck et al. f (%) (1997)

139

52 15 37 39 25 14 7

Aukutsionek et al. g (%) (1997)

Note. Years in brackets refer to year of survey. Note also that a small sample of 36 Russian privatized firms surveyed in 1992/93 by Pistor (1995) found insider ownership of 62%, outsiders 19%, and the state 19%. Webster et al. (1994) surveyed 92 firms privatized through the State Privatization Program and through leasing in two oblasts of Russia in October 1993 and found inside ownership averaged 61% (of which managers 17%). a Earle et al. (1996). b Buck et al. (1996). Includes enterprises privatized through State Privatization Program and lease buy-outs. c Blasi and Shleifer (1996) and Blasi et al. (1997). Figures do not sum to 100 in original due to rounding errors and missing data. Includes enterprises privatized through State Privatization Program. d Jones (1998). e Wright et al. (1998a, 1998b). Includes enterprises privatized through State Privatization Program and lease buy-outs. f Buck et al. (1999). g Aukutsionek et al. (1998).

Insiders Managers Employees Outsiders Large Small State Sample (no. of firms)

Owners

Earle et al. a (%) (1994)

Equity Ownership in Privatized Russian Firms, 1993–1997: A Comparison

TABLE 5

CORPORATE GOVERNANCE IN THE FSU 409

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ESTRIN AND WRIGHT

veys, primarily because of differences in sample coverage and the problems in obtaining representative samples. 3 Some studies incorporate all forms of privatization, including those enterprises disposed of through voucher programs and the leasing option (Filatotchev et al., 1996a; Earle et al., 1996), while others omit privatization through the leasing option (Blasi et al., 1997). Despite these methodological issues, it is clear that, on average, insiders are majority owners in Russian privatized enterprises, with managers alone owning around a fifth of shares. The extent of insider ownership in privatized firms in Ukraine and Belarus is generally higher than in Russia, as shown by Buck et al. (1999). In contrast, reflecting an approach to privatization where insiders were not favored, evidence from Estonia reported by Jones and Mygind (1999) shows that 16.6% of a sample of all established firms were majority owned by managers and 9.8% by employees. Table 5 also suggests that insider ownership in Russia is falling over time, albeit slowly, and that among insiders there is a shift in equity-holding from employees to managers. There is, however, little direct evidence about changes in share ownership from longitudinal studies. Such comparative evidence as there is from panels of firms over time have found mixed evidence of the extent of the decline in insider ownership, but the panels are consistent in noting a shift in the balance toward managers (Jones, 1998; Aukutsionek et al., 1998). These studies also show a sharp fall in state holdings in companies and a notable increase in outsiders’ holdings. 4 There is also important evidence about changes in dominant ownership. With respect to Russia, Jones (1998) finds heterogeneity in the development of dominant owners; at the time of privatization none of the 111 firms in his sample had dominant nonstate outsiders, but by 1996 some 29 enterprises were in this position. The importance of managers and nonmanagerial workers as dominant owners had also grown, but less dramatically; employees had become more important where the state had previously held a dominant position on privatization but had become less important in other cases. Aukutsionek et al. (1998) find a growth in the importance of dominant managerial shareholders in Russia 3 Goskomstat publishes statistics on the industrial, size, and regional distribution of all Russian enterprises taken together, but comparisons with samples of privatized enterprises need to be treated with caution since the shares of privatized and de novo firms varies between sectors. Since privatization was decentralized with no national body collecting aggregate statistics, there is no publicly available list of privatized firms in Russia, although it is possible to obtain access to sampling frames including all established firms. 4 It needs to be borne in mind that these findings may be influenced by a potential selection bias in that the reduced number of enterprises responding a second time may be those where the share distribution has changed least, those where it has changed most perhaps having ceased to be independent or being reluctant to disclose it. Similarly, taking a sample of enterprises in a later year and looking backward at changes in ownership over time may also involve a selection bias.

CORPORATE GOVERNANCE IN THE FSU

411

TABLE 6 Equity Ownership in Privatized Ukrainian Firms, 1995–1997: A Comparison

Owners

Buck et al. a (%) (Privatn)

Buck et al. a (%) (1995)

Estrin and Rosevear b (%) (1997)

Buck et al. c (%) (1997)

Insiders Managers Employees Outsiders Large Small State Sample (no. of firms)

81 14 67 16 12 4 3 100

80 15 65 17 13 4 3 100

51 8 43 38 22 16 11 123

70 12 58 25 13 12 5 100

Note. Years in brackets refer to date of survey. a Buck et al. (1996). Dates of privatization of enterprises in sample vary. b Estrin and Rosevear, this volume. c Buck et al., this volume.

between 1995 and 1997, with managers forecasting that they will become more dominant by 1999. In discussing trends in employee ownership it is important to recognize, however, the difference between ownership and control. Evidence suggests that although employees may have significant equity stakes, their involvement in boards of directors and other control mechanisms is generally very low (Filatotchev et al., 1996b). In Estonia, Jones and Mygind (1999) establish that between 1995 and 1997 majority ownership did not change in 75% of firms. However, where employees held more than half of the shares, majority ownership in privatized enterprises more frequently switched to another group. A similar shift occurred in a quarter of cases where managers were majority owners. These ownership changes relate to risk aversion and liquidity; capital intensive and large firms are found to be more likely to be owned by outsiders initially and to remain as such. There is also evidence that foreign investors have an interest in building up ownership in certain sectors, with minority ownership by domestic outside investors being a prelude to attempts to secure majority ownership. Economic performance is not found to be influence ownership structures or their dynamics. The limited evidence concerning the shift in ownership distributions in Ukraine is reported in Table 6, based on studies conducted at different points in time by Buck et al. (1996, 1999) and Estrin and Rosevear (1999). This suggests that the change was initially very slow, although by 1997, a noticeable fall in insider ownership had occurred.

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4. THE EFFECTS OF GOVERNANCE The measurement of the effects of governance on performance is particularly problematical in the FSU. 5 Unsurprisingly, studies to date relating to postprivatization in Russia generally find insignificant relationships between governance variables and financial performance (Earle et al., 1996; Filatotchev et al., 1996a; Filatotchev et al., 1996b), although Earle and Estrin (1997) did report some performance effects from outsider ownership once controls for selection were included. These findings may have a variety of causes. First, although the relevant accounting legislation has been enacted, there are clear shortcomings in its enforcement for financial reporting purposes. Comparisons of financial performance over time are also problematical because of substantial inflation and devaluation of local currencies. These problems apply to both listed and nonlisted enterprises, but are especially acute in private firms, where there are widespread attempts to hide profits both from the state and from organized crime (EBRD, 1998, p. 15), where the practice of tunneling can mean that assets are transferred out of companies by dominant owners without other owners being aware (Harris, 1997), where reported asset values can be quite fictitious (Shama and Merrell, 1997), and where it may be necessary to obtain a board seat to gain access to reliable information (Wright et al., 1998a). Problems also exist in listed companies where listing requirements may be expected to lead to greater transparency. An examination of the accounts of listed companies in Russia shows that comparisons over time and between enterprises may be difficult because of the lack of standardization of usage of either the less stringent Russian Accounting System or the more robust International Accounting System (Shama and Merrel, 1997). Many listed enterprises switch from one system to the other and back again from one year to the next. There is no simple systematic mechanism for converting figures between systems. Second, the relatively short period of time since privatization in most countries of the FSU, coupled with the problems relating to the reliability of financial data, may mean that the effects of governance on performance have yet to manifest themselves. Given massive shifts in demand, it is also important to separate changes that are exogenous from those relating to the effects of corporate governance. It may thus be more appropriate to examine the link between governance and strategic actions rather than financial performance. Strategic actions underpin restructuring activity and can be measured, and they can provide a forwardlooking indicator of future performance. With respect to strategic actions, dis-

5

See Goergen (1998) and Jones et al. (1998) for a summary of problems concerning the endogeneity of ownership and other estimation difficulties regarding enterprises in transition.

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tinctions need to be made between short-term cost reduction strategies and longer term deep restructuring (EBRD, 1995). 6 Using qualitative restructuring indices, Estrin and Rosevear (1999) find that in Ukraine ownership is not related to performance, consistent with Russian studies. They also show that outsider ownership never leads to greater restructuring but that dominant ownership by insiders sometimes does. Buck et al. (1999) find in privatized enterprises in the Russia, Ukraine, and Belarus that institutional outside investors have had a significant positive influence on retrenchment strategies but that severe product market conditions are more important in influencing retrenchment strategies. 5. ENHANCING GOVERNANCE AND PERFORMANCE The evidence of little involvement by outsiders and the absence of strong support for a link between governance and performance raises the question of how governance and performance might be enhanced. In this section potential mechanisms for enhancing governance in the FSU are discussed. 5.1. Capital Markets The development of capital markets provides the basis for the role of the takeover mechanism. In developed market economies, there is considerable debate about the effectiveness of the market for corporate control. Takeovers may be costly mechanisms subject to free-rider problems and may only be effective as a last resort mechanism. However, there is also recognition of an important complementarity between the presence of the takeover threat and other internal corporate governance mechanisms (Hart, 1995). To be effective, however, there is a need for capital markets to be very liquid and effective. It has also been argued that the development of the governance by exit option would reduce the incentives of investors to monitor or replace managers and may also encourage managers to adopt short-term perspectives. There were some capital market developments in the FSU up to 1997; the ratio of stock market capitalization (EBRD, 1998) was 25.2% in Estonia, 29.4% in Russia, and 6.1% in Ukraine (figures for Belarus are not available, though certainly they were very low). This ratio of stock market capitalization is low compared both to developed market economies and to the major countries of Central Europe (EBRD, 1998, Chart 5.5). Similarly, the liquidity of stock markets, as measured by the ratio of stock-market turnover to market capitalization, was also lower in FSU countries than in developed markets with similar levels of income and in Central European markets (EBRD, 1998, Chart 5.6). The 6 It should be noted that local governments may have an important role to play in preventing deep restructuring because of fears about the effects on local employment. This point may be especially applicable in company towns.

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problems of July and August 1998 seem to have had a major adverse impact on stock markets in the FSU and indicate that the progress was not sustainable. For example, the main and OTC (Over-the-Counter) Russian stock markets have seen the number of actively traded stocks fall from 300 in July 1998 to 15 by January 1999. In addition, although it has been suggested that shares should be traded anonymously and that registration of firms should be done outside the firm (Blanchard and Aghion, 1996), a major problem arises in the enforcement of such regulations. In unlisted privatized firms, managers may attempt to secure insider control even with free tradability of shares (Bleaney et al., 1999). The role of the market for corporate control in effecting ownership change in enterprises with majority insider ownership is also questionable. Hence, it seems unrealistic to expect that the takeover mechanism will play an important role in corporate governance in the FSU in the foreseeable future. Moreover, the threat of takeover may have a negative role as the fear of being taken over may prevent managers from being willing to admit any new finance from outside sources into their firms (Bleaney et al., 1999). 5.2. Banks The vast majority of newly privatized companies in the FSU do not have a significant representation of outside financial institutions in either ownership or formal board-level control (Frydman et al., 1996a, 1996b; Wright et al., 1998a). In the minority of cases where banks and investment funds are active monitors of enterprises (Kochevrin et al., 1994; Wright et al., 1998a) their role focuses on reviewing financial performance rather than on more strategic matters. In a situation where the bankruptcy law is difficult to enforce and loan collateral difficult to secure, banks use debt covenants, develop a portfolio of shares in companies from a particular sector, and nominate key people in client companies. A first barrier faced by banks and investment funds in obtaining a greater involvement in enterprise monitoring arises from the reluctance of insiders to cede control to outsiders. There are implications here for enhancing the transparency of share tradability (EBRD, 1998). A second barrier is that banks and other outsiders may face difficulties in accessing information to engage in effective monitoring, even where they have board seats (Wright et al., 1998a). This problem is exacerbated by poor procedures, low transparency, and weak standards. A third set of barriers relates to the need for appropriate capitalization, regulation, and governance of banks (Sabi, 1996; Baer and Gray, 1996; Van Wijnbergen, 1997; EBRD, 1998; Abarbanell and Meyendorff, 1997). These factors have implications for the promotion of competitive market entry (Bonin and Leven, 1996), the restriction of imprudent or fraudulent lending (Meyendorff and Snyder, 1997), and the sending of signals that the government will not intervene to bail out failing banks (Berglof and Roland, 1998).

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These issues have a particular resonance from mid-1998 onward, with the onset of the crisis in the Russian economy. Although banks were making some progress in Russia in the monitoring of clients, the turmoil of late 1998 undermined their ability to intervene. Many banks became technically insolvent and some lost their licenses, including banks such as Inkombank that were actively involved in monitoring enterprises (Wright et al., 1998a; Thornhill, 1998). The hardening of budget constraints on enterprises may, in principle, help the banks’ financial position as well as place pressure on enterprises, but the feasibility of this option in the current environment is unclear. The problem of nonperforming loans varies throughout the FSU, being less severe in Estonia and Russia than in Belarus, Ukraine, and Kazakhstan (EBRD, 1998, Table 8.1). 5.3. Financial–Industrial Groups (FIGs) The development of financial–industrial groups (FIGs) represents a governance device peculiar to the FSU and Russia in particular (Gorbatova, 1995). In 1997, there were over 70 formally registered FIGs in Russia, plus a number of other networks. FIGs may be either bank-dominated or looser industrial associations; some may be regionally based and coordinated by local governments (Johnson, 1997; Perotti and Gelfer, 1998). FIGs have arisen in an environment where property rights are not well established and contract enforcement is problematical. In principle, FIGs provide a mechanism by which finance providers can undertake monitoring, enforce payment systems, and enforce contracts without the need to go to court. In the absence of developed capital markets, finance generated internally to the group can also be used for investment (Perotti and Gelfer, 1998). To some extent, however, the development of FIGs represents a formalization of late Soviet-era networks to enable them to survive during transition. The consequent problems of collusion between banks and enterprises may be exacerbated where government exerts pressure to maintain enterprises that are too big to fail. There is some evidence (Wright et al., 1998a) that FIGs have been created where banks have used trading problems to put pressure on their client enterprises to sell their shares to them. Von Hirschhausen (1998) notes that FIGS in Ukraine have typically been created under political pressure based on a logic of state planning with profitable enterprises being forced to finance unprofitable ones. Because of this continuation of soft budget constraints, directors of FIGS may have a reduced incentive to enhance efficiency. The impact of the turmoil in Russia in late 1998 has exposed the fragility of FIGS. However, in an environment such as the FSU, where there are problems in enforcing legal contracts, there would appear to be a need for some form of network (Modigliani and Perotti, 1997). Hence, although the initial form of FIGs may be breaking down, it is expected that new forms of networks will emerge.

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5.4. Product Markets Enhancing attempts to stimulate product market competition as a governance device (Hart, 1983) may provide an external pressure to improve performance. Recent evidence from across Central and Eastern Europe emphasizes the policy importance of linking competition and financial discipline with effective corporate governance and the rule of law. Compared to countries such as Hungary, Poland, and the Czech Republic, Russia and other countries of the FSU such as Belarus and Ukraine show major shortcomings in this respect (EBRD, 1998). Buck et al. (1999) show a significant effect of changes in industrial output in certain sectors as a proxy for the level of product market competition. The impact of product market competition as a corporate governance device may be constrained in the FSU by the widespread existence of entrenched and incompetent management, continuing soft budget constraints, and an unwillingness on the part of governments to promote competition. 5.5. Enterprise and Entrepreneurship We observed earlier that there may be a need to replace underperforming and incompetent management in order to effect major performance improvements. However, there are problems with this approach to installing entrepreneurial managers. This issue arises in both existing and de novo firms. Indeed, the extent of new firm entry into markets has been considerably less in the FSU than is the case elsewhere in CEE; there were less than one million officially registered new firms in Russia in 1997 (EBRD, 1997). The managerial labor market is weak, and it may be difficult to find good managers to replace existing ones. Managers in the FSU may be hostile toward outside investors if they are perceived to be only concerned with shallow restructuring, including the replacement of the managers themselves, rather than longer term deep restructuring. Evidence from the West suggests that entrepreneurial action inside existing corporations, such as the creation of new products and entering new markets, is positively associated with long-term institutional share ownership but that many institutions possess only the skills and access to information to effect short-term monitoring (Baysinger and Hoskisson, 1990; Zahra, 1996). Survey evidence from Russia suggests that managers of privatized enterprises perceive banks, investment funds, and other financial institutions to be primarily short-term portfolio speculators (Wright et al., 1998b). Absent their replacement, there is some debate about the extent to which managers in privatized enterprises are able to effect entrepreneurial actions (Kreuger, 1995) or, possessing only routine functional skills, entrench themselves in control of their enterprises (Linz, 1997). It should be borne in mind that even under the central planning system entrepreneurs existed outside the minis-

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tries, either in the shadow economy or as tolkachi employed by factories to identify scarce material inputs (Filatotchev et al., 1992). Moreover, the managerial cadre in privatized enterprises in the FSU includes both the old nomenklatura and those who have the capabilities to turn their enterprises into viable businesses. Perverse incentives and inappropriate legal infrastructures may, however, mean that entrepreneurship in the FSU is unproductive or even destructive (Baumol, 1990; Blasi et al., 1997), as in the case, for example, of organized crime. The encouragement of enterprise in the FSU depends, therefore, partly on the development of legal infrastructures that will be effective in creating the conditions for positive entrepreneurship. It also depends on the development and encouragement of entrepreneurial skills (Filatotchev et al., 1996b). 6. CONCLUSIONS At the start of this paper, we posed the question of whether the slow progress in transition experienced by the countries of the FSU arises from weaknesses in implementing effective corporate governance or weaknesses in the rest of the environment. Our review of progress in transition suggests that the problem lies in both areas. The countries of the FSU have lagged behind the countries of Central Europe in introducing effective corporate governance mechanisms. This overview has presented new evidence on the reduction in insider ownership. However, insiders in FSU countries where vouchers have been the primary mechanism of privatization remain entrenched and outside investors typically have a limited role. While there would appear to be greater benefits from adopting privatization methods where insiders are not favored, as in Estonia, privatization involves the balancing of potentially conflicting policy objectives. An approach which fails to favor insiders may be limited in contexts where political constraints emphasize the need to obtain insider support for reform, as was argued to be crucial in Russia (Boycko et al., 1995). There has been a recent trend away from voucher and MEBO approaches to privatization toward greater use of sales to outsiders in parts of the FSU such as Georgia, Kazakhastan, Lithuania, and Ukraine, but these auctions have often been slowed by lack of domestic liquidity and unrealistic price expectations (EBRD, 1998). Factors other than governance mechanisms may be important in enhancing the efficiency of enterprises in transition economies. Notably, the evidence presented in this paper suggests that there is a need in the FSU to develop more effective legal infrastructures and enhance product market competition. The discussion of alternative mechanisms offered few obvious solutions to the governance problem unless these two aspects were strengthened. There is also a need to enhance the entrepreneurial skills of management, although this too may require the establishment of an effective legal infrastructure.

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