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Ukraine Needs to Privatize Its State-Owned Companies — But Rushing It Would Repeat the Mistakes of the Past

Posted on the 20 April 2016 by Center For International Private Enterprise @CIPEglobal
Storied aviation company Antonov, makers of the world's largest cargo plane, is in no position to be privatized.

Storied aviation company Antonov, makers of the world’s largest cargo plane, is in no position to be privatized.

The stakes for reforming Ukraine’s state-owned companies are high: these companies are the lifeblood of a corrupt, sclerotic crony capitalist system that scares away potential investors, drives off international donors, and robs the Ukrainian government of legitimacy. But  privatizing them as quickly as possible is not the solution.

Even after mass privatization in Ukraine in the 1990s, the government still owns a large portfolio of companies in a variety of sectors – from heavy industry to banking — that employ over 900,000 employees, far more than any private firm.  Reforming these state-owned enterprises (SOEs) has been a slow process and remains incomplete due to weak corporate governance, unmotivated management, and a near-total lack of transparency. None of these problems will be solved by simply speeding up the process.

The demand for rapid privatization is a familiar tune. Western “expert” advice in the early 1990s led to a huge transfer of wealth from the former Soviet Union to a handful of connected insiders, particularly in Russia: first through voucher privatization and later through the disastrously corrupt loans-for-shares schemes in the run-up to Russia’s 1996 election.

To get an idea of the scale involved, a 1993 paper by several Western economists who worked directly on the voucher privatization program estimated that most of the Russian Federation’s civilian industrial base – nearly every plant, factory, and mine in the country – was effectively sold off to insiders for between $5 and $10 billion, less than it would have cost to buy a single mid-sized Fortune 500 company (and roughly equal to the market capitalization of Whole Foods today). Still, at the time they regarded this program as a great success.

Unfortunately, the corrupt and predatory “oligarch” elite, created practically overnight, proved to be more interested in asset-stripping than in transforming their new firms into firms that could compete on world markets. What followed was the largest peacetime economic collapse of any country in recorded history. The sheer volume of banditry surrounding state assets during the 1990s led many average citizens in post-Soviet countries to believe that lower standards of living and a complete lack of justice were a natural part of living under democracy.

While Ukraine at first underwent a similar process, leading to a similarly entrenched oligarchic elite, there are still significant state assets yet to be privatized. Additionally, given Ukraine’s relatively dynamic political process and strong civil society, there is an opportunity to privatize remaining SOEs in a way that will eliminate the vestiges of crony capitalism, reduce corruption, and maybe even earn a small return to the state.  With so few firms left to privatize — around 2,000 operating enterprises are still in state hands, as compared to about 250,000 in post-Soviet Russia — there is nothing preventing Ukraine from establishing an orderly way for the state to exit from many of these enterprises.

With the situation as it exists, I am shocked that experts from the West and their Ukrainian counterparts are again pushing hard for rapid privatization of these state companies (which a cynic may say will lead to sales of companies to insiders for kopecks on the dollar). A snapshot of what happens when a firm with poor governance is hastily put up for sale comes in a 2012 report from the OECD on the famous airplane manufacturer Antonov. The report found that, at the time, there was no share capital and  no clear ownership of underlying assets; no board of directors to act as an intermediary between ownership and management; a governance structure that raised significant challenges, with the primary enterprise lacking control over the operations of the constituent companies; and a lack of independent directors.

Such deficiencies represent enormous gaps in governance and control, and the Antonov case is not an outlier. Without an orderly and accurate accounting of state-owned firms’ assets, liabilities, and ownership — just to start — the current push for rapid privatization seems not just premature, but potentially disastrous.

One key to transforming SOEs from a drag on Ukraine’s progress into engines of change is to improve their corporate governance, so that they are accountable to their owners (the Ukrainian taxpayers) and not corrupt inside operators. So far, this isn’t happening. The facts are overwhelming. According to a report from/ the Ministry of Economic Development and Trade (MoEDT), as of September 30, 2014, only 29 out of the top 100 SOEs had a board of directors in place composed solely of public servants, and fewer than 40 percent of the TOP-100 SOEs were audited, with only a handful of those audits being performed by internationally recognized audit firms.

According to that same report, as of September 30, 2014, Ukraine owned 1,833 operating businesses, with the largest 100 accounting for approximately 80 percent of the revenue and 90 percent of the assets.  During the first nine months of 2014 the largest 100 SOEs reported a combined net loss of UAH 74.7bn (about $6 billion at 2014 exchange rates), with UAH 62.5bn ($5 billion) of the losses from Naftogaz of Ukraine alone.

So, in summary, Ukraine has a massive number of SOEs working in an opaque governance environment and they are losing money, placing a burden on the state budget.

The problem is not only an economic one. It is widely recognized that SOEs in Ukraine act as personal piggy banks for well-connected members of parliament. In order to tackle endemic corruption among the elite political class, these enterprises need to be privatized.  Perhaps a current plan to sell 342 companies is a bit too ambitious a goal.

With all due respect to Adomas Audickas, a Lithuanian who works for Ukraine’s economics minister on privatization programs and is quoted in a Wall Street Journal article on privatization,  the situation is Ukraine is definitively not like “having a private-equity fund with 2,000 companies.” In a private-equity fund an investment committee has performed meticulous due diligence on each firm, run stress tests on financials, put management under a microscope and then bargained for the best deal for the private equity firm.  What Ukraine has is a giant black hole of nearly 2,000 companies it inherited at the collapse of the Soviet Union 25 years ago.  A full generation has passed and these companies are now deeply embedded in an opaque network of crony capitalism.

Nobody asked me for my advice in the Ukraine privatization process, but I will give it regardless: first, be systemic in privatization – have a concrete plan laid out and stick to milestones. Second, be meticulous and methodical in the preparation of investment packets for each company, working with as many private sector actors as possible in an open data environment, with detailed and audited financials going back (at least) five years. Third, be innovative, as the Ukrainian government has shown it is able to be with the online Prozorro public procurement process.

Finally, perhaps most importantly, start with improving corporate governance at the SOEs – or indeed just implementing any corporate governance at all.  By targeting corporate governance as a first step towards privatization Ukraine can begin to understand what exactly is inside these SOEs and how it may best be able to return them to private productive enterprises, and be accountable to taxpayers for selling the companies at a market value.

Ultimately, effective corporate governance is a vital step toward breaking the upside-down loyalties of lawmakers and government officials who, too often, thwart reforms in order to enrich themselves.

Eric Hontz is a Program Officer for Eastern Europe & Eurasia at CIPE.

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