International Corporate Governance |
The impact of political connections on the outcomes of the Russian privatization |
Table of contents
Since the collapse of the Soviet Union in 1991, Russia has tried to move from a centrally planned economy to a market economy country. Today, and after many levels of transformation since the destruction of the bastions of the Stalin’s system, Russia is known to be the eight largest economies in the world by nominal value and the sixth largest by purchasing power parity. Many Russian firms have succeeded after this big shift and have managed to establish themselves as world known companies in defense industry, telecoms and electronics.
But the evolution of the Russian economy was not that easy and the brutal turnaround that it has experimented in the early 90s was not that smooth. Indeed, in order to study the subject of our research which is “The impact of political connections on the outcomes of the Russian Privatization”, we have first to stress on the state of Russia before this transformation. Secondly, we have to analyze more deeply the progress and the process of the Russian privatization during the presidency of Boris Yeltsin. Thirdly, we shall look at the actual situation of private firms: Do private firms clearly depoliticized and swift from firms that seek a maximization of profits rather than the satisfaction of established politicians? Or are they still powerful connections between the political sphere and these ex-state firms?
Therefore, we choose to divide our term paper in four sections that will try to respond step by step and methodologically to the subject. In the first section, a short economical history of Russia will be summarized in order to better understand the predominant economic environment of what was called the Union of Soviet Socialist Republics (USSR). Before going through the analysis of privatization in section II, we will first try to define what a privatization means and the reasons why the previous Russian politicians decided to initiate it. In this section, we will cover the process of privatization and what were the outcomes of this privatization. In section III, we will try to know whether Russian firms are totally depoliticized of if they are on the contrary still in the State’s hands. Finally, in section IV, we will figure out about our impressions, opinions and thoughts about the subjects and argue the main results that we found all over our research.
In order to bring to successful conclusions our findings, we decides to use different sources and to go through several books and works to know what other specialists of this area think about this subject, their position and their pervious findings.
Russia before privatization:
The Soviet economic system was established after 1922 and was then spread to East and Central Europe. All the history of economy of Russia between this date and the collapse of the USSR in 1991 is based on the achievements of the Soviet Union which is an ideologically-based union. In this long period of the Russian history, all the industries, land and businesses where nationalized and put in the hand of the State. There were many kinds of collective properties in the USSR such as:
- State property
- Kolkhoz property
- Cooperative property, among them:
· Housing cooperatives
· Consumer cooperatives
· Rural consumer societies
(Source: Wikipedia, article: “Economy of the Soviet Union” *)
From the beginning of 1920s till 1991, the economy was structured according to Five-year plans and the whole Russian economy shifted from an agrarian society to the one of the larger manufacturer of “capital goods, heavy industrial products and weaponry” (Same source*).
But all these plans were pretty successful in the period going from 1930 to 1970:
- Russia was the leading producer of “oil, coal, ore and cement; manganese, gold and natural gas”.
- According to the article in Wikipedia called “Economy of the Soviet Union”*, by 1970, Soviet economy had reached its zenith and was estimated about 60 per cent the size of the USA in terms of estimated commodities.
But after 1970, the situation of the USSR began to be critical:
- Economic stagnation under Brezhnev also known to be the “Brezhnevian stagnation” that got worse because of the Afghanistan war in 1979.
- The demand increases as the economy grows but the bureaucratic system that suffered from lack response and flexibility couldn’t handle it.
- As a result, many communist politicians began to stress on the importance of more flexibility and initiative for the managers in order to better meet the increasing demand.
For Anders Aslud (1990), all the Soviet period was marked by several periods of centralization (war communism, the five-year plan, the war, the late 1950s and the 1970s) and periods of decentralization (the New Economic Policy in 1921, the mid-1930s, the immediate post-Stalin period, the second half of the 1960s and the last few years). The economy of the Soviet system was therefore unstable characterized by periods of intensive industrialization and several economic plans. The results were of this nationalized economy were quite successful but showed off signs of weakness in the end.
Indeed, in the book called “Gorbachev’s struggle for economic reform” (1990), the author (same as above), points out the fact that the Soviet Union’s economic and political structure began to disintegrate and that there were many attempts at reforms to reverse the process. In fact, the Soviet economy was deteriorating and many specialists began to question the reliability of a planned-based economy. For instance, Mikhail Gorbachev try to establish what was called the Perestroika in as an attempt to restructure the communist economy. Although this initiative enables a return of the growth in the Russian economy, the Soviet Government was still strictly opposed to market reforms.
But the first big shift was made between 1988 and 1991 and was highly criticized. This move was so called the “spontaneous privatization”. This was made by transferring stakes of property rights that were in the control of the State to employees and to the management, allowing “enterprises to withdraw from associations on their own”.
This process of privatization and its stages will be further developed in the second section of this term paper. Now that we have broadly reviewed the history of Russia before the privatization, we shall define more precisely what the privatization means, how it was initiated and the reasons of this shift. The analysis of this part of the term paper was largely based on the article of Boycko et al. (1993) called “Privatizing Russia”.
What is privatization and why privatization?
According to the site “privatization.org”**, privatization is “the transfer of assets or service delivery from the government to the private sector. Privatization runs a very broad range, sometimes leaving little government involvement, and other times creating partnerships between government and private service providers where the government is still the dominant player.”
But privatization is hard to define exactly as it is a very broad term. Nevertheless, we decide to stick to this definition as we believe that it is the closest and the best one to describe what happens in the Russian economy in the early 1990s. Before going through the aims of the Russian privatization, we shall develop the reasons for this privatization. According to Boycko et al.(1993) the principal reason is that public enterprises are not efficient. They backed up this assessment by saying that these kinds of enterprises employ “too many people produce goods that consumers do not want, locate in economically inefficient places, do not upgrade capital stock…”
Another reason, this time given by the Alternative Theory of Public Enterprises (in the paper of Boycko et al. (1993), explains that the public firms are inefficient because they are instrument whereby bureaucrats or politicians attain their particular interest, without carrying about the social welfare. In our case, we can set out that the aim of the communist politicians was to make sure to be secured against the potential internal and external threats. Thus, the latter invest massively in the military industry to make sure to be safe and thus don’t give much attention to the welfare of the society. By giving many examples of these types, Boycko et al. (1993) conclude that “a simple view of political objectives can go some way toward explaining many of the inefficiencies of the Soviet economy”.
As a result, the privatization of public firms seems to be, in the majority of case, successful. Indeed, we can oppose the objectives of private managers to the objectives of politicians. Private Managers seem to have as a goal the maximization of profit unlike the politicians that aim to achieve their personal interests. But this is only the case when there are no strong connections between the politicians and the private sector. If so, the link between the two can lead to inefficiencies (as we will see it in the case of Russia after the privatization). Thus, and as the article “Privatizing Russia” (1993) argues, there is a constant bargain between the two parties that often deal with each other and try to cooperate. As an example, managers can ask the politicians for money, blackmailing them of firing employees if they don’t fulfill their will (only of the politicians care about unemployment). Hence, the bargaining between the two parties lead to inefficiencies as the government often pay the managers of the firms (subsidies, soft budget constraints) to realize their proper goals. In parallel, managers follow the politician’s desires to be satisfied.
In the article, “How does privatization work? Evidence from the Russian shops”, Barberis et al. (1996) put a slant on the benefits of private ownership as opposed to public ownership. A study was made by Vining and Boardman (1992) and states that in each industry they analyzed (transport, railroads), the private sector performs better than the public one. Secondly, another study argues that there were great improvements after the privatization of a company (Megginson, Nash and Van Randenborgh (1994)). The third statement by Donahue (1989) said that “there were lower costs of contracting public services to private suppliers than providing it publicly”.
Another idea was developed in this article and shows that private parties manage better a business because they have equity in the firm and assume the financial consequences of their acts. But this theory of incentives is not always true in the reality and has to be verified.
There are additional theories in this meaning like the one which establishes that privatization, because it chooses the best managers and owners according to their knowledge and their background to run the company, is often successful.
But privatization is not always an efficient way to transform firm and to transform them into models of great governance and economic success. For example, the consequences of Russian privatization were not as described above but these theories will help us to better understand what went wrong and why privatization of large part of industries hasn’t lead to efficiencies.
However, these theories we have developed threw out the light on what we will study furthermore in the case of the Russian economy after the privatization. Is this link between the government and private firms exists in the Russian economy today? “What does privatizations accomplish that corporatization does not?”
The privatization can thus be dangerous especially when it’s a rapid mass-privatization in centrally planned economies as it was the case for Russia. As Black et al. (1999) point out in the article, “Russian privatization and Corporate Governance: What went wrong?” launching a rapid privatization in a country with a weak central government was a critical decision. We will develop in the third section what went wrong with this privatization and the self dealing that was created as a consequence of this privatization.
In this stage of our study, it is clearly obvious that the literature is divided in this subject: “was the privatization of Russia a good decision?” We have seen that many theories argue against this assumption but there are also many authors that defend the idea that privatization as a good step for Russia.
As an example, Boycko et al.(1993) defend the fact that “the transformation of the two third of Russian industry from state ownership into commercially independent corporations is a unique historical achievement”. We will discuss this idea latter in our term paper.
Russia: Analysis of privatization
After the fall of communism and during the beginning of a new era in Russia, the principal goals of the government were the price liberalization and the control of the budget to become a real free-market economy; however, to accomplish those goals it was essential to restructure companies by the process of privatization, which supposed to give the control to the private sector; however, this control was not complete, the firms were not able to work “freely” because throughout the process, and even after, there was political intervention and many other interests involved to satisfy government goals.
People in favor of this process strongly believed that privatization of large firms would take them to the competitive environment of the market economy, and to achieve productivity and efficiency was necessary to be in hands of capable managers who could develop the restructure of firms successfully without the intervention of the state.
Boycko et al. (1993) present the steps of the plan that the Russian government developed to implement privatization; this plan separated firms first, into the ones that would be sold to investors for cash and the ones that have to enter into the “mass privatization program”. Russia had many firms which were quite profitable so they would not be part of the privatization.
Changing many of the firms into private was a hard task to achieve, so on the second step was important to define the companies that must become private, the ones that required permission, and finally which were not possible to acquire. Third, determine the firms that needed to be corporatized, which meant to list them as joint stock companies.
In the case of corporatization, the management of the firm had three different options to become private:
1. Workers could own 25 percent of the shares without any cost but they would be nonvoting and top managers were able to buy 5 percent of the shares paying the nominal price.
2. Both managers and workers could possess 51 percent of voting shares.
3. Managers could purchase 40 percent of equity at low prices with the condition that they would maintain the firm competitive without going bankrupt.
After managers and workers have decided which option was the best (first and second option were the most popular, few firms chose the third one), they were supposed to establish the mechanism by how the remaining shares were going to be sold. In many cases, mass privatization was chosen by them, this consisted in selling the shares through voucher investment funds. “The enterprises that were privatized through voucher privatization were large in number, but often small in value” (Black et al. 1999).
The voucher started to be distributed since October 1992 to the population in order to make it fast the process of privatization. By giving to citizens the opportunity to buy shares and make them feel as key elements in this important event, the government was avoiding any kind of social conflicts.
Voucher “became the first liquid security in Russia” (Boycko et al., 1993) and it had a nominal value of 10,000 rubles which could be tradable. This characteristic allowed big investors to easily acquire large amounts of vouchers not only from citizens who were not interested in shares maybe because of disinterest due to lack of transparency in every program implemented by government, but also from workers (Black et al. 1999) who were ignorants or were forced by managers to give up to their shares at low prices. The consequence of this action led to a concentration of power in few people.
The reason of why some citizens were apathetic about privatization is related with culture, the social class they was part of, and also the age. People who felt they could receive a benefit from the economic reform as young people, managers and wealthy people were in favor of privatization; otherwise, those such as old people who had nothing to win, were indifferent (Desai et al. 2000).
Because of no strict law or regulation existed regarding privatization, managers or insiders were able to acquire shares for their own benefit in every possible way spending not only their own resources but also the capital of the company. The lack of regulations allowed this people to act freely.
Mass privatization was a quick way to achieve privatization but it did not accomplish neither the goal of restructuring companies nor depoliticization. The power of companies went from state’s hands to managers’ either because of that mass privatization or because of concessions to stakeholders; the latter show us that the state still had power on the firms and that corruption was involved in many of the transactions.
“Rapid privatization buys enormous political benefits and thus allows reforms to deepen” (Boycko et al. 1993) but in Russia, that did not happen because it carried out another problems which interfered with the correct restructuring of firms and lead to the concentration of control in a small group of people who had both the money and close relationships with government, they were called kleptocrats, which developed into oligarchs.
Russian government believed that making privatization fast would result in benefits for everyone, as Boycko et al. (1993) stated, but due to the country did not have any kind of regulations and laws related with the concentration of power, it was impossible to develop an organized system on the firms. The government could not attract foreign investors because they were aware of the lack of protection for investors so the only action government could accomplish was to give to “reputedly honest managers” (Black et al. 1999) the firms.
Not only foreign investors knew about the lack of protection for shareholders, but also the government so the creation of laws would be implemented gradually to avoid problems such as “self-dealing”.
Self-dealing was the principal problem of privatization because managers suddenly had in their hands the power of the firm and instead of following the principles of the free-market economy which state the efficiency in the production to could afford the competition with other firms, kleptocrats just took the wealth of them because it was easier to loot firm’s value than to make them competitive (competition was difficult to achieve due to their few managerial skills). These people theft firm’s value and although some firms in the moment of the acquisition were running quite well, their lack of skills and their greed led them to bankrupt.
Kleptocrats were known to be the owners not only of firms but also of the media, they had in their control both newspapers and television stations which published manipulated information that was very useful in the career of politicians. But not just the latter were benefited with that relationship, after 1995 kleptocrats were becoming more powerful with the help of the corruption of the government by a mechanism known as “loans-for-shares” which consisted basically in selling the largest firms for a minimum fee that had nothing to do with their real value. Any kind of privatization was involved with corruption, “the bigger the stakes, the dirtier the deal” (Black et al. 1999).
“Loans-for-shares” started by auctions managed by banks, but it is important to state that these auctions were fake because they were already planned to give the shares to someone in particular. It is possible to mention this because in some cases there was someone willing to bid for a firm and that person just could not won because of any pretext.
Because of the state was the owner of the firms during many years, the process of privatization could not avoid political intervention, as we already stated, every single transaction had something to do with corruption. However, not all the transactions were the same and it is important to know if this connection still exists and how it affects the development of the firms.
The different connection between Russian government and private companies:
With privatization, the state has abandoned most of its total ownership in order to improve the corporate performance. Currently, the state owns only 7% of the Russian industrial enterprises even if these 7% represent 30% of the Russian GDP. Indeed, the State’s ownership remains important in the biggest enterprise.
At the beginning, this private ownership was represented nearly only by insiders. This is the normal consequence of the privatization program that, as we already mentioned, consisted to give a large shares of a company to employees and managers. That is a way for the government to keep a state ownership. However, this trend is now inversed and the ownerships of outsiders become progressively bigger than the insiders ‘ownerships. On the other hand, the foreign ownership remains to be very low in Russia. (Väätänen, 2008)
It is important to state that the consequences of this privatization are not as good as we could think. First of all, even if the state deletes nearly all its ownership, it always has a big influence in the management of a great part of the Russian companies. Indeed, “In Russia, connected firms represent 86.75% of the market capitalization” (Faccio, 2006). This percentage has to be compared with the world average of connected firms, 8%! “A company is identified as being connected with a politician if at least one of its large shareholders (anyone controlling at least 1% of voting shares) or one of its top officers is a member of parliament, a minister or is closely related to a top politician or party.” (Faccio, 2006).
Therefore even if, in the theory, companies are privatized, most of them remain connected to the state. Russia is the country with the highest percentage of connected firms in the world. In the majority of the countries, there are restrictions in the law to avoid this connection. For instance, minister or parliament member cannot sit on a board of a company or to have their own company. But it is not the case in Russia; nothing prevents this connection between the government and the company.
A second bad consequence of the privatization is that it has increased the gap between the rich and the poor. Indeed, when people received shares of company during the privatization, most of them had not any idea of what to do with it. Only few people, who had knowledge in finance and economy, took advantage of these shares, often also by taking advantage of public relationships. They bought other people’s shares for a lower price and today, these people own a lot of shares in big companies, as we already described.
The most famous of that people are the “seven oligarchs “of the privatization; Berezovsky, Gusinsky, Khodorkovsky, Smolensky, Potanin, Vinogradov and Friedman. They build an incredible fortune during the process privatization and became extremely powerful. “The terms “oligarch” denotes a businessman who controls sufficient resource to influence national politics.” (Rachinsky, A. and Guriev, S., 2005)
An interesting point is to analyse the link between these seven Oligarchs and the government. Indeed, they all have strong links with the government. Berezovsky built a joint venture in Switzerland for the communist government. That allows to Berezovsky to have strong relationships in the government and he used them to change the manager of one of the biggest plane company of Russia.
On the other hand, Gusinsky was very active in the communist youth league, had strong links with the communist party and had a good working relationship with the major of Moscow. For this reason, when Gusinsky created a bank, this bank became the privileged economic partner of Moscow.
Khodorkovsky became the assistant chief of the communist youth league for his educational institute and was the economic adviser for the prime minister just before the collapse of the Soviet Union. That permitted to his bank to be used by the government when it needs credit.
Potanin came from a family very well placed in the communist hierarchy and worked in the ministry of foreign trade as well as his father. In 1989, he started a trade company with the help and the economic support of the ministry for foreign trade. After that, he started two banks and a lot of state companies placed their money in these banks. Later Potanin seems to have good relationships with Boris Yeltsin.
We do not have many information about Smolensky. However, we know that his company went in bankruptcy in 1998, during the depression in Russia. The only two among the seven that seem to succeed without strong ties with the government are Vinogradov and Friedman. Friedman had strong relationships with the mafia and big oil companies and it seems that Vinogradov was simply particularly brilliant. All the others Oligarchs succeed thanks to their strong relationships. (The information for the description of the Oligarchs come from the website; http://www.sjsu.edu/faculty/watkins/oligarchs.htm)
The third bad consequence of the privatization is the failure of the Russian economy and the pervasive corruption in the transaction. In 1997, the Russian economy reached its lowest performance, the GNP decrease by more than 50% in comparison with 1991 and the main cause of this, was the privatization. Indeed, suddenly, people receive shares of company but they never learn how to deal with it or to deal with the liberalization of price. That also involved a huge rate of corruption; “According to estimates by the Ministry of the Interior, 70 - 80 per cent of privatized and private firms and commercial banks are obliged to make payments to criminal gangs, corrupt officials or racketeers”. (Prokopenko, 2000).
Moreover corporate governance is nearly inexistent, most of the companies do not respect the shareholders ‘rights at all and this observation is even worse if the shareholders are foreigners. That partly explains the very low rate of foreign investors in Russia while these foreign investors could have brought the experience and the funds necessary to improve the Russian economy.
“The comparative analysis of productivity shows that foreign firms are more productive than Russian ones. This finding confirms the hypothesis that foreign-owned firms have advantage over domestic ones in terms of access to technologies and better management. (...) Russia can benefit a lot if it succeeds in attracting a substantial inflow of FDI. We also show that bad policies can not only prevent foreign firms from investing in Russia, but also negatively affect the quality of investment” (Yudaeva, K., Kozlov, N., Melentieva, N., Ponomareva, N. 2000)
Conclusion: The suggested solutions to eliminate the existed connections
From our study, it is possible to affirm that there are several connections between firms and Russian government; probably they are not as strong as them used to be but they are still present somehow in the firms’ behavior. This kind of connection between them affects the development of the firms not only on their commercial activity but also on the way they are managed. For this reason, we know that some rules of corporate governance need to be improved to enhance firms’ management; therefore we have thoughts about some solutions for this issue.
First of all, it is necessary to enforce regulations regarding protection of minority shareholders due to the threat of expropriation of their capital; we strongly believe that these regulations will attract both domestic and foreign investment.
Besides, to make possible foreign investment it is important that transparency and disclosure are present in every transaction. If every transaction becomes clearer, the corruption will decrease. With less corruption and as told above, foreign investors will have more trust in Russian transactions and thus, it will be easier to attract them.
We have also noticed that the power of oligarchs is quite strong in Russia and that they have a lot of influence over politicians. Consequently, we believe that some mechanisms can be implemented to prevent these links between the economic and political fields. For instance, laws that force every company to have a powerful and efficient board that controls the transparency of every transaction or other laws that prevent politicians (prime minister, influential MP) from having high position in the company or in the board are needed in order to avoid conflict of interests or influence on the behavior and development of the firms.
To put it in a nutshell, there are many rooms for improvement in Russia in the field of corporate governance. But we notice that some efforts were already made as the current situation is better than it was. Although Oligarchs have a big concentration of power and ownership, they play a role in this improvement and are still key actors in the Russian economy.
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