So Far...Could Be Better

Though we say so far so good with regard to privatization ("So Far So Good? A Privatization Update," by John Nellis, Transition, November-December 1996, p. 6), we should recognize certain problems.

First, privatization has been accompanied by serious corruption; it is, in fact, by far the most important area of corruption in most transition countries. Second, and related, crony privatization has skewed the wealth distribution in favor of the haves in a way that will last for a hundred years. Furthermore, most of the haves are former communist functionaries. Third, and again related, it has been accompanied by asset stripping, by shell companies being left with liabilities they could not pay, which in turn bankrupted banks. And last, in the mind of the public, it has been accompanied by the collapse of once-great companies, by increased unemployment, by a decline in the social services provided by enterprises, and so on. One can argue that the last has little to do with privatization, but that is not how it is perceived by many local people.

Privatization has brought a social and economic transformation of mammoth proportions. There is no way it could have been done without creating large-scale problems. We must not close our eyes to those problems.

World Bank Budapest Regional Office

The Ethics of Privatization

Every single thing Mr. Long says about the pitfalls and costs of privatization in transition countries is true. But the sad reality is that in those countries that have avoided, postponed, or tried to conduct slow privatization in order to evade these problems, the outcomes have been even worse. I cite the cases of Belarus, Bulgaria, and, until recently, Ukraine. In Bulgaria the lack of privatization over five years has resulted in the near-total destruction of the industrial base. It is awful for assets to be stolen and for the nomenklatura to become the bourgeoisie, I agree; but it is worse when the asset base is degraded to the point of being worthless. Mismanagement under incompetent state ownership can mean that there is little left to privatize.

Some thus conclude that it is wrong and indeed counterproductive to wring one’s hands over the legality or injustices of privatization; the important thing is to get the property into the hands of those capable of putting it to good use, those with the incentives to watch over the longer-run health of the capital. Foreigners, if you can find them, but there won’t be many, so you have to look inward—and all you will find are the former managers, the former elites, the nomenklatura.

But claiming that one should ignore the injustices for the sake of restructuring and efficiency gains, ignoring the political-economy issues, can be dangerously naive. It is possible and indeed likely (as democratic processes become more the norm) that electorates in transition countries, fed up with the fraud and excesses of the divestiture process, will vote in populists or leftists who will delay and modify, if not reverse, reform. It really hasn’t happened yet (showing the strength of the public’s revulsion toward many aspects of the old system), but it could.

What does this mean for us in the Bank? We should espouse privatization but we should equally espouse that it be done right—that standards of transparency are promulgated and maintained, that mechanisms exist for the wide distribution of shares outside the elites; that safeguards are enforced for minority shareholders; that regulatory systems are in place before the sale of an infrastructure monopoly, and so on. Will our insistence on these measures always work? No, but we should continue to do it anyway, and uphold the correct standards even when it is unpopular. We are not a private bank, interested only in the financial return. Our job is not simply to push for privatization; it is to push for privatization being done in a manner that is mutually beneficial to the buyer and the seller—and has a reasonable chance of adding to consumer welfare as well.

John Nellis, Private Sector Development Department, World Bank

Millard Long

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Are Currency Boards Helpful? Consider Bulgaria and Bosnia

Professor Steve H. Hanke is thrilled because the IMF has changed its [formerly hostile] attitude toward the currency board and has been forcing Bosnians and Bulgarians to accede to pressures to use this exotic measure ("New Currency Boards Come to the Balkans," Transition, February 1997, p. 8). Unlike Professor Hanke, I am afraid that the currency board will be seen as a panacea—but will fail to confront realities in the Balkans.

Estonia’s experiences with a currency board are, at least in part, relevant for Bulgaria and Bosnia and Herzegovina, too. (The experiences of Hong Kong and Singapore, usually cited as successful cases by advocates of the currency board arrangement, are less relevant.) Estonia has had a currency board with a fixed exchange rate (8 Estonian kroon = 1 deutsche mark) since June 1992; inflation nonetheless runs at 25 to 30 percent annually, and the trade deficit has been increasing, from $100 million in 1993 to $700 million in 1995 to $900 million in 1996—and is expected to reach $1,200 million in 1997. The current account deficit was $185 million in 1995, increased to $250 million in 1996, and is expected to reach $400 million in 1997. The inflow of direct or portfolio investments, however, is sufficient to conceal the problem. Thus inflation and a current account deficit can coexist with a currency board.

(Slovenia, with a normal central bank and a flexible exchange rate system, reduced an annual inflation rate of 1,000 percent—as measured in October 1991, when the new Slovene currency was introduced—to single-digit levels by 1995 and 1996. The country has no current account deficit, and the foreign exchange reserves, which started from scratch as the new monetary system was established in 1991, are now twice as much as the M1 money supply.) Bosnia and Herzegovina and Bulgaria are among those former socialist countries that would have suffered severely from transition, even without the devastation of war (Bosnia) and prolonged financial crisis (Bulgaria).

Crisis in Bulgaria

The crisis in Bulgaria was not caused by the national bank’s financing of the budget deficit. Rather, it began with the so- called consolidation of the banking sector, which triggered a vicious circle in which interest payments have absorbed a rapidly growing share of budget revenues. This share equaled 17 percent of budget revenues in 1992, 66 percent in 1996, and 88 percent in the last quarter of 1996. Meanwhile, the shares of public revenues in GDP (ranging from 38.8 percent in 1992 to 30 percent in 1996) and of noninterest expenditures (ranging from 38.8 percent in 1993 to 21.2 percent in 1996) have been much lower than in other transition economies. The primary budget surplus reached an astonishing 9 percent of GDP in both 1995 and 1996.

It is a matter of theoretical debate whether Bulgaria should target a balanced budget or a noninflationary financing of the budget deficit. Fiscal revenues are, and will remain, insufficient as long as economic activity is squeezed, particularly in the former state sector, where a predominant part of tax revenues was generated and collected. An increase in tax rates would simply further compress the tax base and lessen, rather than increase, tax revenues. The social distress, meanwhile, requires enormous social transfers—a large part of the population is starving. The pros and cons for more or less restrictive fiscal policies are irrelevant because there are no sources to finance the deficit.

The IMF, which has acknowledged that Bulgaria faces a fiscal deficit this year, is ready to provide financing before the creation of a currency board through a "drawing fund." It seems that no new sources of revenue will be available to bridge the fiscal gap. Consolidating the cash balances of other extrabudgetary funds and cashing in additional privatization revenues can bring in only marginal revenues. Thus external borrowing appears the only available way to bridge the gap. Will the drawing fund of this highly indebted country increase the confidence of foreign investors? I doubt it.

Prospects for Bosnia and Herzegovina

The creation of a currency board, envisaged in the Dayton-Paris Agreement for Bosnia and Herzegovina, is supposed to create stable money and promote gradual economic reintegration of the country. As in Bulgaria, however, setting up a currency board in Bosnia and Herzegovina can hardly solve the most acute problems. If it is not clear who is collecting taxes and who is paying teachers, it makes no sense to argue whether the fiscal policy should be more restrictive or not, or whether the government should run a budget deficit or not. Fiscal revenues remain very low because of the destroyed tax base and weak tax collection. War victims, pensioners, and the unemployed require enormous social transfers. The government(s) of Bosnia and Herzegovina cannot afford to run budget deficits because there is no one to finance them.

As to the functioning of a currency board, another question emerges: What are the prospects of generating surplus in the current account? The economy is performing at only 10 percent of its 1991 level and cannot count on surpluses in trade or services. Individuals receive remittances from abroad, but most of this foreign currency is held, not traded in for domestic currency. The deutsche mark, which serves as an accounting unit, is also used for transactions, especially in the informal sector, and with this alternative available, only a small portion of remittances is likely to be converted into the new domestic currency. Also slowing currency conversion will be the likely parallel circulation of Yugoslav dinars in Republika Srpska and of Croat kunas in the parts of the Federation that will remain controlled by Croats. Administrative measures—to increase the current account—say, by placing restrictions on the inflow or holding of foreign currency—would fuel resentment in the population. Finally, large foreign private capital flows into such a high-risk economy cannot be expected. Thus, official financial assistance might be the only way to achieve a surplus on current account, the only source of the reserve currency that is a prerequisite for a functioning currency board.

Profile for a Currency Board?

What will the currency boards in these countries look like? What will be the initial currency reserves required? Who will provide the reserves and under what conditions? The starting reserve can be quite modest. For example, in Bulgaria, on the basis of the current exchange rate of 2,000 lev = 1 U.S. dollar, less than $100 million would suffice for establishing a currency board. However, at such an exchange rate last year’s GDP is calculated as a mere $1 billion, consistent with a $10 monthly average wage. (On the basis of the 1996 average exchange rate, the 1996 GDP rises to $3.6 billion, and the required reserve currency to $300 million; on the basis of the leva’s average exchange rate in 1991-94, more than $700 million is needed.)

Currency boards cannot solve the problems in these two countries. The problems can only be solved by foreign assistance focused on building production, creating employment, preserving subsistence agricultural production, controlling public expenditures, protecting domestic production, and imposing long-lasting administrative price controls on many nontradable goods. These might all be considered as steps in the wrong direction, away from a market economy and world economic trends. They are, however, also steps away from an economy where a dinner for one foreign expert costs the equivalent of a worker’s monthly wage.