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Jan Svejnar
  Jan Svejnar

Privatization Laboratory

10/16/2009 --

Freed markets in Central and Eastern Europe show foreign firms make good owners for former state-run companies.

ANN ARBOR, Mich. — Physicists often wish they could go back and observe the Big Bang, since it would help resolve some of the most confounding mysteries about our universe.

Economists studying transition economies have been fortunate to witness their own version of the Big Bang: the fall of communism and rise of capitalism in Eastern and Central Europe in the late 1980s and early 1990s. Those same economists have had enough time now to form meaningful conclusions and debunk some longstanding theories.

New research by Ross professor Jan Svejnar examines the performance of former state-owned enterprises after privatization. Results vary, depending on ownership and other external factors, according to the data. But Svejnar discovered some widely held assumptions — such as the fear that employment levels sink under foreign ownership — do not hold up.

In fact, one of the main themes of Svejnar's "Effects of Privatization and Ownership in Transition Economies" is that companies sold to foreign owners perform markedly better than ones sold off to domestic owners. Svejnar is the Everett E. Berg Professor of Business Administration at Ross. He also is a professor business economics and public policy.

The research can serve as a guide for future policymakers in centrally planned countries should they open their markets, Svejnar says. In addition, U.S. lawmakers shaping healthcare reform can draw lessons from the research, which also studied the results of companies that retain state ownership but operate in an open market.

Overall, privatization usually has a positive effect on a country's output and economic growth, especially when accompanied by other reforms, such as building a robust legal system. But Svejnar's research showed more nuanced results at the company level to suggest that privatization alone isn't a guarantee of improved performance. Better financial results are tied to ownership structure, internal and external politics, and the makeup of shareholders.

"One shouldn't automatically assume that privatizing is going to improve the performance of firms," Svejnar says. "We found the results are very diverse, and depend on a number of factors. So privatization is not a panacea."

In Central and Eastern Europe, companies that privatized with foreign owners performed much better than ones sold to domestic owners. In some cases, selling to domestic owners had a negative effect.

There are a number of reasons for that phenomenon. Foreign ownership brings wider access to global markets and, just as important, wider access to capital. That better access leads to more careful restructuring and the ability to fund new products and systems. Foreign-owned companies also typically operate by their home country's legal and ethical frameworks. So it matters less whether the legal system in a transition economy is set yet.

By contrast, firms sold to domestic owners in Central and Eastern Europe didn't fare as well because they didn't enjoy those advantages. And in some cases the new owners stripped the firm of assets for immediate gain, since they were able to take advantage of an undeveloped legal system.

"Opening a market, liberalizing prices: things like that happen overnight," Svejnar says. "Establishing a good, functioning legal framework takes a long time. You can establish it on paper relatively fast, but it takes longer to enforce, so the functionality takes longer."

External factors also can dictate how fast an effective legal code may shape up. Several of the former communist states in Central and Eastern Europe sought European Union membership, so they moved faster than Russia — which doesn't want to join the EU — in creating a well-enforced legal system, Svejnar says.

Another factor that seems to affect the performance of firms is the makeup of the shareholder base. Companies with one or two holders owning large blocks of shares perform better than firms with more dispersed ownership.

"You want supervision of the managers by some block holders who have a strong interest because of their concentrated ownership," Svejnar says.

The ability to study about 20 years' worth of data from these transitions also sheds light on a bigger issue: Is it better to privatize faster or slower?

From his observations, Svejnar says it's probably best to first establish the rules of the game and build a strong legal system, make sure government oversight departments work, and then "let go, and let go fast on all fronts, because these reforms are very complementary."

But that's not always possible. Poland and Russia, for example, suffered from hyperinflation when they transitioned, so they had to move faster and make more spontaneous decisions. Poland stabilized and emerged in a relatively strong position. While Russia enjoyed economic growth, its transition was marked by the rise of oligarchs, the result of an internal political phenomenon, Svejnar says. Boris Yeltsin's government, seeking cash, auctioned off huge chunks of former state properties such as factories, oil fields, and precious metal mines.

Svejnar's research also debunks some assumptions from earlier studies. Previously, it was feared that allowing insiders, such as management or worker co-ops, to own a former state-owned enterprise would degrade performance. But based on more and longer studies, he found that wasn't the case.

Another assumption: A foreign owner in a takeover would be more apt to cut jobs than a domestic owner. State-owned companies were known for having more workers than they really needed. And indeed, many of these companies did restructure under foreign owners, resulting in initial job loss. But subsequent growth balanced out job cuts.

"They had to double and triple production in some cases because the operation was no longer serving just the local market; it was serving a multinational company's global needs," Svejnar says. "So these firms did not reduce total employment."

Based on the research, Svejnar says it will be interesting to watch the emerging economies of China and India. China has moved cautiously, opening up its economy in stages without changing its political system. While China has limited outright foreign ownership, joint ventures involving foreign companies are commonplace. India has always been a democracy and an open market, but has more state-owned firms than other free markets and it has limited foreign ownership. But it has been privatizing and allowing more foreign activity recently. Svejnar says his research shows there's not much to fear from foreign ownership or privatization, when done correctly.

There are takeaways for mature economies in the research, particularly for the United States regarding the current healthcare debate. One option being discussed for healthcare reform would have a public entity providing health insurance and competing with private insurers. Svejnar's research shows that companies that keep state ownership and operate in a newly free market "actually do quite well."

But the key is that the market remains competitive. Propping up the public entity with constant subsidies defeats the purpose.

"By keeping the system open to external competition, any company — state-owned or not — has to shape up because they are all subject to the same market pressures," he says. "So the lesson here is that if a government-run insurer is not subsidized going forward and has to compete with the market head-on, it could be quite efficient. So some of these findings can be a lesson for mature economies as well."

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847,