Nafziger Economic Development (4th ed)

696Part Five. Development Strategies

Why is India’s Hindustan Machine Tools dynamic when most other Indian public enterprises are far less successful?

1.State enterprises perform better with competition; no investment licensing; no price, entry, nor exit controls; and liberal trade policies (low tariffs, no import quotas, and exchange rates close to market prices). In Pakistan, the highly profitable parastatal Heavy Mechanical Complex faces competition from the privatized Ittefaq Foundry in road rollers and sugar mills’ output; with imports and another public enterprise (Karachi Shipyard) in constructing cement plants; and with SOE Pakistan Engineering Company in manufacturing electrical towers, boilers, and overhead traveling cranes. Since 1969, India’s Hindustan has learned much about remaining competitive from exporting, which has exposed the company to new technologies and management approaches. When economies of scale are not important, breaking up large enterprises, such as the Bolivian Mining Corporation and Sweden’s Statsforetag (a holding company), can increase competition.

2.Successful performing SOEs, such as those in Japan, Singapore, Sweden, Brazil, and post-1983 South Korea, have greater managerial autonomy and accountability than others do (Kohli and Sood 1987:34–36). Excessive interference in investment, product mix, pricing, hiring and firing workers, setting wages, and procurement by government suffocates managerial initiative and contributes to operational inefficiencies. Government should demarcate its role (as owner), the board of directors’ role (setting broad policy), and the enterprise management role (day-to-day operations). Central or local government rarely has the information or the skills essential for detailed control over parastatal operations. South Korea’s 1983 reform is a good example of increasing managerial autonomy and reducing government interference.

Good management usually requires decentralizing power in favor of a professionally skilled board of directors and judging managers by enterprise viability and a limited number of performance indicators. In Sweden the cabinet (the formal owner of the limited liability SOE stock corporation) delegates ownership responsibility to a staff of eight professionals in the Ministry of Industry, which oversees 90,000 people in state industries. These professionals do not overpower the board with their ownership role except in times of crisis or when state financial support is required. Korea’s reforms also increased decentralization and evaluation by enterprise performance.

Until the mid-1980s, managers of SOEs, which comprised 60 percent of Ghana’s industrial output, had poor performance and little autonomy. In practice a Ministry of Finance and Economic Planning board set prices and approved wage contracts; the Ministry of Labor authorized worker dismissal; the Ministries of Trade and Finance allocated import licenses; the Bank of Ghana approved import licenses; and the Ghana Investment Center and the Ministry of Interior approved foreign staff quotas.

Although many LDCs suffer from the Ghanaian problem of too much interference and unclear, fragmented lines of authority, other LDCs lack any effective control, creating uncertainty, misunderstanding, and distrust, with reactions sometimes swinging to the other pole, excessive control.

Financial autonomy is a major factor contributing to SOE managerial effectiveness. Two French steel parastatals, Usinor and Sacilor, which acquired funds for expansion from their government ministry, have had chronic losses. But public firms scrutinized by independent bankers before getting investment funds usually perform better. Excellent financial management involves specifying financial objectives, monitoring their progress, and holding managers accountable. Government should set SOE noneconomic goals clearly and evaluate whether the firm is using the most cost-effective way of achieving the goal, so that SOE managers do not use these same goals as an excuse for poor performance. In the mid-1980s, Zambia imposed price controls on refined oil and fats use for vegetable oil products and soaps. The controls resulted in large losses and poor staff morale and shifted output away from oil and fats, the opposite of the government’s social priorities. Finally, government should not allow substantial transfers between SOEs and government to undermine firms’ ability to acquire “true” financial results.

3.Government reduces (or keeps) the size of the public sector commensurate with technical and managerial skills. Beginning in 1983, South Korea privatized a number of SOEs to improve the effectiveness of government oversight (Park 1987:25–27).

Privatization

Privatization refers to a range of policies including (1) changing at least part of an enterprise’s ownership from the public to the private sector (through equity sales to the public or sale of the complete enterprise when capital markets are poorly developed), (2) liberalization of entry into activities previously restricted to the public sector, and (3) franchising or contracting public services or leasing public assets to the private sector. Government needs improved competition policy in the private sector if denationalization is to result in gains in allocative efficiency. A government selling a public enterprise faces a tradeoff between the higher sale price when a privatized firm is offered market protection and the greater economic efficiency when the firm operates under competitive market conditions (Cook and Kirkpatrick 1988:3–44).

For Paul Cook and Colin Kirkpatrick (2003:213–214), the case for privatization is based on the adverse effect of an “overextended” public sector on economic growth. As William Megginson and Jeffrey Netter (2003:33) state: “Privatization arose [historically] not because of ideas but because government ownership and management of firms did not work.” The survey by Cook and Kirkpatrick (2003:209–219) indicates no significant relationship between SOE size and economic growth. According to them, the literature suggests that fiscal discipline, price and

698Part Five. Development Strategies

trade liberalization, and privatization help determine LDC growth; however, taken individually, each variable is limited in its effect.7

What are the objectives of privatization? In addition to improving economic performance, other objectives include reducing subsidies to SOEs, raising revenues from SOE sales, and increasing the private sector’s output share (Cook and Kirkpatrick 2003:211).8

Some Pitfalls of Privatization

The transition from centrally managed state enterprises to a liberal, privatized economy is politically and technically difficult. Prices masked by controls inevitably rise. Forcing inefficient firms to close is likely to be unacceptable where labor is not mobile, as in Africa, or unions are well-organized, as in India. Skilled people are usually lacking. Moreover, government may require parastatals to achieve social objectives, such as setting quality standards, investing in infrastructure, producing social goods (especially for low-income earners), controlling sectors vital for national security, wresting control from foreign owners or minority ethnic communities, rescuing bankrupt firms in key sectors, avoiding private oligopolistic concentration, raising capital essential for overcoming indivisibilities, producing vital inputs cheaply for the domestic market, capturing gains from technological learning, and creating other external economies that private firms would overlook. To illustrate, Nigeria’s abolition of the government Cocoa Marketing Board and licenses for marketing cocoa in 1987 resulted in poor quality control and fraudulent trading practices, which adversely affected the reputation of Nigeria’s cocoa exports. The government subsequently incurred substantial costs reintroducing inspection procedures and marketing licenses (Hackett 1990:776).

Joseph Stiglitz (2002b:157) indicates that “In a World Bank review of the ten-year history of transition economies, it became apparent that privatization, in the absence of the institutional infrastructure (like corporate governance), had no positive effect on growth. The Washington Consensus had again gotten it wrong.”

The effectiveness of creating market incentives and deregulating state controls presupposes a class able and willing to respond by innovating, bearing risk, and mobilizing capital. Although significant groups of indigenous entrepreneurs have

7Studies assessing LDC privatization also include Jalian and Weiss (1997:877–895); Aziz and Wescott (1997); Short (1983:30–36); Heller and Tait (1983:44–47); Stein (1998); Baer (2003:220–234); Chai (2003:235–261); Schwella (2003:291–309); Bennell (2003:310–321); Saal (2003:560–582); Saal and Parker (2003); Millward (1988:143–161); Aussenegg and Jelic (2002); Kocenda and Svejnar (2003); Nellis (2003); Park (1987:25–27); Shirley and Walsh (2000); Siniscalo, Bortolotti, and Fantini (2001); Birdsall and Nellis (2003:1617–1633); and Cook and Kirkpatrick (1988).

8On this, Ramirez (2003:263) argues that Mexico and Chile privatized to attain a “functionally neutral and minimalist state.” On the first – economic performance – India’s disinvestment minister Arun Shourie was motivated by his shock from inefficiency and scandal involving SOEs. According to Solomon and Slater (2004:A1), from 2000 to 2003, Shourie used a confrontational approach in privatizing 34 SOEs, a larger number than in the previous three decades. He not only resisted ministers, party officials, and bureaucrats, who received patronage from SOEs, but also striking workers and their supporters, some of whom threatened Gandhian civil disobedience.

700Part Five. Development Strategies

private middlemen and women and enlarged the patronage base for state officials, but did little to develop Nigerian administrative and technological skills for subsequent industrialization. Kenya, Tanzania, Zaire, Malawi, and Coteˆ d’Ivoire made even less progress than Nigeria in using public enterprises to reduce dependence on MNCs (Nafziger 1988:53). Tropical African countries have been less successful than Argentina, Brazil, Mexico, Peru, Venezuela, South Korea, Taiwan, India, and Indonesia in using MNC technology transfer to improve their own industrial capabilities.

Adjustment and Liberalization in Eastern Europe, the Former Soviet Union, and China

The model of internal and external balances above clarifies the need for macroeconomic stabilization to adjust to external deficits and debts and stagnation or collapse of the domestic economy, and structural (or supply-side) adjustments, including economic liberalization and reform, for long-term remediation of LDCs. From the perspective of the IMF, World Bank, and the European Bank for Reconstruction and Development (EBRD), a development bank based in London, which loans funds to governments of Eastern Europe and the former Soviet Union, virtually every developing and transitional country needs to adjust and reform. As IMF Managing Director Jacques de Larosiere asserted in 1987: “Adjustment is now virtually universal [among LDCs]. . . . Never before has there been such an extensive yet convergent adjustment effort” (IMF Survey, February 23, 1987, p. 50). Since the collapse of communism, the IMF would add transitional countries to other LDCs.

The remainder of this chapter shows some concrete problems in undertaking reform and adjustment in transitional economies. This discussion focuses more attention on China, Russia, other states in the former Soviet Union, and Eastern Europe, because their experiences demonstrate in starkest fashion some of the prospects and problems from economic liberalization and reform. To be sure, the developing countries of Africa, Asia, and Latin America have undergone painful institutional and structural adjustments to reform their economies, but these changes have been less abrupt and the consequences less astounding than in Russia and Eastern Europe.

In 1960, a confident Soviet Premier Nikita Khrushchev, when at a summit meeting with President Dwight D. Eisenhower in the United States, boasted that “we will bury you” and predicted that Soviets would be more prosperous than Americans by 1980. However, the Soviet Union suffered through stagnation during the 1970s and early 1980s, so that, according to Harvard’s Abram Bergson (1991:29–44), in 1985, when Communist Party leader Mikhail Gorbachev came to power, consumption per capita in the Soviet Union was only about 29 percent of that in the United States (see Chapter 3).

Socialism collapsed in Eastern Europe about 1989 and in the Soviet Union in 1991. All these countries faced painful transitions to a market economy, with falling real GDP, high unemployment, high inflation, and increased poverty and inequality in initial years of transition, before eventually attaining positive growth and improvement

FIGURE 19-2. Real GDP Percentage Change Index (1989 = base). Source: Svejnar 2002:9.

in other variables. Indeed the transition is like a valley between the two hills of communism and capitalism. Figure 19-2 shows the sequence of inflection (turning) points by transitional countries: Poland, the first, in 1991, Slovenia 1992, Hungary 1992–94, Czech Republic 1992–94 (forming a “W” with later growth reversal), and Slovakia 1993, the only ones to recover pre-1989 GDP levels by 2001. Russia did not attain its turning point until 1998. Several others (but not Ukraine) turned around between 1993 and 1998, albeit in some instances only growing temporarily (Svejnar 2002:9).

By 2004, Russia’s GDP was only 80 percent of its 1990 level (Figure 19-2). The IMF (1995d:20) estimates that, if you adjust for “black market” or unmeasured sales, 1994 real GDP for Russia may have been 40 percent higher (an index of real GDP, with 1990 = 100, of 67 not 48), thus falling only one-third from 1989 to 1994 (Table 19-1). Still, average living standards probably fell less than one-third to 1994 because of investment declines, a fall in the production of goods not desired by consumers, a reduction in searching and queuing costs due to the charging of market prices resulting from liberalization, and the cutback in waste and other inefficient resource use with the demise of central planning. Ukraine and Kazakhstan’s GDP understatement was probably of a similar relative magnitude to that of Russia (ibid.).10

10Andrei Schleifer, an economic advisor to Russia’s President Boris Yeltsin, 1991–97, and Daniel Treisman (2004:20–38) see Russia as a “normal” middle-income country. They argue, that because of the rapid growth of Russia’s unofficial economy and an overstatement of pre-1991 GDP, Russia’s GDP fell less than the IMF and Svejnar indicate. Moreover, according to Schleifer and Treisman, living standards, which fell even less than GDP, almost recovered their 1990 level in 2001.

702 Part Five. Development Strategies

TABLE 19-1. Russia: Index of Real GDP, 1990–2004

Sources: IMF, World Economic Outlook, various years.

Russians and other peoples of the Soviet Union often failed to analyze the reasons for their economic decline. Dudrick et al.’s (2003:220) characterization of many from Georgia, a former Soviet republic facing greater decline than Russia, is also true of many Russians:

The fact that the . . . economy collapsed after the actual political breakup of the Soviet Union led [many people] to attribute their pauperization to the demise of the Soviet state . . . rather than its inherent economic weaknesses. They continued to associate the Soviet Union with economic stability.

Economists debate whether the transition to the market should be gradual or abrupt. Columbia’s Jeffrey Sachs (1993), an advisor to the governments of Solidarity leader Lech Walesa in Poland and later Boris Yeltsin in Russia in their transitions to the market, argues in favor of “shock therapy,” an abrupt transition to adjustment and the market. The critic Vladamir Popov (2001:35) contends that shock therapists put a heavy emphasis on “introducing the whole reform package at once to ensure that it became too late and too costly to reverse the reforms.”

Howard Wachtel (1992:46–48), an evolutionist who emphasizes the gradual building of institutions, contends that shock therapy downplays the creation of a smallscale private sector, small independent banks, market reforms in agriculture, and funds for a “safety net” for social programs and full employment for the population. Kazimierz Poznanski (1996:xix), who stresses that institutions form at a relatively slow pace, contends that attempts to radically remake institutions are potentially destabilizing and costly. Replacing an established institution with an untested project is dangerous. Indeed, by the mid-1990s, electorates in Poland, Russia, and Hungary, disillusioned with market reforms, voted the former Communist Party, often

TABLE 19-2. Inflation in Russia, 1990–2004

Index of consumer prices

Average of 105.5% increase annually over the period.

Sources: IMF, World Economic Outlook, various years.

refashioned as social democrats or democratic socialists, to a parliamentary plurality in place of the party of economic reform.

In response to critics of shock therapy, Sachs (1994:14–18) argues correctly that production in the Soviet Union was in decline, inflation rates were surging, and the black-market value of the ruble was falling in the immediate years before President Yeltsin’s transitional government came into power in late 1991. Moreover, Sachs charges that United States and IMF aid to Russia was disbursed too slowly, and that shock therapy could not have failed because it was never tried.

Popov (1996:1) describes Russian reform as inconsistent shock therapy. Russian reformers introduced a Polish-type shock therapy by deregulating prices instantly in January 1992, but failed in macroeconomic stabilization, eliminating subsidies, and shutting down loss-making enterprises. The pressure of interest groups and the lack of consensus between center and regions, between the parliament and government, and within the government itself, were at the heart of the failure of shock therapy. As is frequently true in Latin America, Russia had little choice but to tolerate a high rate of inflation in the early 1990s (see Table 19-2), inflation that reflected the lack of political consensus (Popov 1996:20). But this inflation was costly for those on fixed income, as a Ukraine woman indicated: “When I retired, I had 20,000 rubles in my savings account. . . . But what the government did with it – the government we trusted with our money! They’ve indexed savings so that inflation ate it! That money is now not enough for bread and water” (World Bank 2001i:53).

Reddaway and Glinski, Market Bolshevism: The Tragedy of Russia’s Reforms

(1999), are the most critical of shock therapy. They accuse President Boris Yeltsin,

704Part Five. Development Strategies

his domestic advisers, U.S. government officials and scholars, and “functionaries of the IMF” of promoting shock therapy in late 1991 as part of a “Russian historical pattern of “revolutions from above.” In doing so, they resisted any “civic democratic” opposition to the encrusted Soviet party and state leadership, the nomenklatura.

The Collapse of State Socialism and Problems with Subsequent Economic Reform in Russia

After the late 1980s, state socialism fell apart before our eyes. The Soviet Union measured income as net material product (NMP), that is, gross domestic product minus nonmaterial services, depreciation, and rent. From 1981 to 1990, income fell by 3 percent and collapsed in the early to mid-1990s.

What brought the Soviet Union down? Here is the answer of Mikhail Gorbachev (2003:30), Soviet leader, 1985 to 1991:

What happened to the Soviet Union happened mainly for domestic reasons. It was a failure of the model based on a command economy and dictatorship. The rejection of freedom and democracy, the decisionmaking monopoly of one party, and the monopoly of one ideology all had a chilling effect on the country. That model turned out to be incapable of making structural changes. It did not open up ways for initiative and was overly centralized.

The following elaborates on Gorbachev’s analysis of failure, examining the reasons for the collapse of state socialism in Russia and its problems during the first decade of reform, two interrelated phenomena. Gerard Roland (2002:47) is correct in emphasizing the failure of Russia’s institutional transformation: inadequate creation of “the executive, legislative and judicial branches of government; a free press; new social norms and values; an openness to private organizations and to entrepreneurship; a network of regulators; and a new network of contractual relationships.” Our discussion of this case and subsequently Poland and China provides insight into the political economy of liberalization and adjustment in developing countries, even though their collapses and transitions were less dramatic than Russia’s.

DISTORTED INCENTIVES AND PRICE SIGNALS

Under Soviet central planning, firms produced low-quality output, with incorrect assortments, avoiding preshrunk fabrics or reducing the impurities of metals, as bonuses depended on the quantity of output. To maximize output, managers were tempted to reduce quality and disregard the composition of demand. If the rewards for nail output is gauged in tons, only giant nails will get produced, whereas if the output plan is stated in numbers of nails, firms will make only the tiniest ones (Kohler 1992:5–14).

Soviet planning involved material balance planning, the detailed allocation by central administration of the supply and demand for basic industrial commodities. The material balance system was slow, cumbersome, lacked clarity, and distorted incentives. The Soviets used the previous year’s production as the target for the next

year. Enterprises worked for part of the year without knowing what their targets were. Toward the end of the month or year, they may have “stormed” to reach the target, or deliberately slowed down operations so as not to increase targets too much for the subsequent period. The enterprise management’s motivation was to hide the true capabilities of the plant from planners.

Administered input prices do not show where the firm can best use resources, thus providing false signals to firms. These establishments overorder and hoard labor and raw materials since they do not bear the cost of excess inputs needed to meet quotas or as insurance against future shortages (Kohler 1992:12).

Incentive schemes reward managers for maximizing variables such as output rather than profit or efficiency. But even profits are poor guides to enterprise behavior when prices are set without reference to supply and demand. These prices give the wrong signal, spurring enterprises to produce too little of what is short and too much of what is in surplus. Moreover, the weak link between domestic and international prices erodes the government’s response in identifying and closing inefficient enterprises (Kaminski 1992:41).

THE PARTY AND STATE MONOPOLY

The Communist Party, with its interlocking and overlapping authority over the Soviet government, an institution with highly embedded interests, had a monopoly over political power, which also meant a monopoly over economic power. “Redness” or political correctness was a more important criterion than expertness in making decisions.

The party, as controller of the state, bore the full burden of economic management. Party leadership gained from concentration and limiting competition, as managers and workers received rewards for increased enterprise profits and revenues. Dissatisfaction with economic performance became a direct challenge to the political order. Discussion, intellectual ferment, and technical innovation threatened the position and authority of party leaders and enterprise managers.

Even reforms that encouraged entrepreneurial activity suffered from the Communist Old Guard’s advantages in obtaining permits and access to funds. Under reform, managers, bureaucrats, and party apparatchiks gained control of the more viable socialist enterprises through privatization. In other cases, government officials looted the enterprises, either controlling the newly privatized firms or leaving no assets for others. After 1988, managers (and other shareholders, including sometimes workers and local governments) gained autonomy at the expense of departments (ministries), who no longer could appoint them (Kaminski 1992:25; Weisskopf 1992:28–37; Blanchard, Boycko, Dabrowski, Dornbusch, Layard, and Shleifer 1993:42–44). Much of privatization involved large-scale give-aways to insiders; mass voucher privatization had only limited effect. Liberals had little credibility in leading market reforms. In Russian privatization, the reformers encouraged workers and mangers in enterprises to defy central ministries (Shliefer 2002:17–19).

The Soviet leadership fused the state with the economy, creating a built-in bias against change. State socialism had evolved after Stalin’s period, and had become