Privatisation of State-Owned Enterprises - Example

Macro and micro economics ID Foundation group The Introduction The fundamental characteristic of a centrally planned economy is that all major decisions, regarding production and investment, are taken by the government. A market economy, on the contrary, is characterized by market forces of supply and demand, which is the determining factor regarding production and investment. So, it is implied that in a market economy, the government intervention is occasional. Privatization and Foreign Direct Investment are the paths followed by centrally planned economies in transition towards market economies. This is because such processes lead to the activation of private entrepreneurship and capital market. The transition of a centrally planned economy to market economy requires quick privatization of the state-owned enterprises (SOE) and gradual opening of the markets to domestic and state producers. There is an inherent risk involved in the process because privatisation of state-owned enterprises would mark the establishment of a private monopoly from a public one. This is bound to reduce the level of efficiency and competition, thereby defeating the very purpose of privatisation. This implies that, prior to privatisation; environment of the country should be regulated in such a manner that it can reap the benefits of privatisation. Economic Theory Free market economies are characterized by the freedom of private enterprises. The assumptions regarding free market economies are: The factors of production, namely land, labour and capital, are privately owned. The workers earn wages in return of labour and the enterprises earn profit. Agents in this economic system have freedom of choice regarding consumption, investment, savings and occupation. The government intervention is minimal in this economy (Ganesh, 1998). Even though the system of free market economy is widely discussed in economic theories, yet most countries hardly implement a pure, free market economy. The so-called market economies are often characterized by moderate government regulation and can be qualified best as mixed economy. The centrally planned economies, on the contrary, are dominated by an authoritarian democratic government. In centrally planned economies, means of production are owned by the government and goals of production are set by the same as well. The consumers do not have much of an authority in these types of economies (Cherunilam, 2010). It is argued that perfect competition, operating in a free market economy, will increase the level of output compared to the monopoly in centrally planned economy. This is because in perfect competition, there will be free mobility of resources, freedom to enter and exit the market and both producers and consumers, being price takers, are unable to influence the price. This can be explained in the following diagram. Figure 1: Monopoly Vs Perfect Competition (Source: Author’s Creation) The green area represents the deadweight loss under monopoly. The mainstream economists were highly surprised because of a decline in production, when the economies began their process of transition. This can be explained with the help of the following diagram. Figure 2: Producers Surplus (Source: Kazmer and Konrad, 2004) Figure 3: Consumers Surplus (Source: Kazmer and Konrad, 2004) Mainstream economists only consider the consumer’s surplus and producer’s surplus on the left of the graph. It fails to accommodate the people on the right of the curve, who are unwilling to trade at the equilibrium price. The inefficient high-cost producers are driven out of the markets and the poorest, who could not afford the price, are left out as well. The economies in transition (from centrally planned to market economies) were successful in reducing price discrimination of the centrally planned economy and then created poorly connected static markets. These transforming economies failed to create dynamic markets and continued to operate in the static ones, which resulted in the decline of output (Kazmer and Konrad, 2004). State Ownership and Privatisation in China From the experience of China in the reform period, when the economy was undergoing a transition from being state-owned to market-led policies, three major observations can be drawn (Woo, 1994): Firstly, the reforms adopted were piecemeal and the government could only raise the output marginally, but inflation grew at a faster pace during 1985-88. Secondly, level of privatisation of the state sector was very gradual and the government maintained a steady control over state-owned enterprises. Thirdly, the gradual reforms in China were more of a political strategy, rather than an economic one. China is one of those exemplary countries, which have proved that privatisation is not the only way to improve the ailing public sector of an economy. Although the country has followed the footsteps of globalization and opened up markets of the country, yet the reforms undertaken by China largely showcased an experimental strategy of the Chinese government. This bears a clear testimony to the fact that privatisation will not work, unless the environment in the economy is mature enough (Wang, 2007). The reforms in China had begun twenty years ago and initially, the aim of the contracts was to introduce incentive contract schemes for managers and workers. Later, during the 90s, Corporate Governance Law was introduced and the focus was to improve the internal governance of SOEs. This structure of corporate governance was based on the models of Western countries and had contributed greatly to improve efficiency of the inefficient, less competitive state sectors. However, the government retained the full ownership of these sectors (Aivaziana, Geb and Qiu, 2005). The experience of China is the biggest witness that corporatization of SOEs was a successful venture, which was undertaken by the government, as opposed to not full-fledged privatisation. In a research conducted by Aivazian, Ge, Qiu (2005), it has been seen that economies that are in transition can improve the performance of their SOEs without massive privatisation. The alternative strategy that can be employed by countries, in restructuring their public sector, is through corporatization. Views presented by the research of Holz (2002) had pointed out that the ailing SOEs can improve their performance by privatisation, but it is not a necessary condition to achieve growth. State Ownership and Privatisation in Russia The privatisation of Russia began in 1992, when the communist government had launched a program to transform the economy from centrally planned to market oriented one. The picture presented was crystal clear, in terms of promoting efficiency of market forces of the state-owned corporations by decreasing their reliance on the government. After disintegration of Soviet Union, privatisation, which was followed by Russia, was quite different from that followed by other European Union members (Sachs, 1992). The economic rationale behind privatisation was that the country was facing huge fall in its level of production and output, which required a massive push to get it out of the situation. The answer rested in privatisation. The situation had worsened after the fall of Soviet Union, which provided them with no time for proper planning of privatisation. The resulting privatisation was haphazard and lacked a logical pattern (Sanguinetty and Mastrapa, n.d.). The disorganized privatisation followed a structure of political loot, rather than a proper process of the same. Consequently, the initial results of privatisation were extremely poor (McFaul, 1995). The unstable political and economic environment of the country led to asset stripping and frauds, thereby resulting in a significant capital flight from the country. The privatisation in Russia was marked by a lot of adversities like, economic stagnation, low levels of employment, greater monopoly and poorer economic development. This is perhaps the biggest proof that haphazard privatisation cannot bring positive growth to a country, unless a proper environment for it is created. The biggest problem with the Russian government was that in the initial years, privatisation, as was planned, was not carried out in reality. The state was unable to enforce hard budget-cuts and the much-required actions to stimulate the market by creating legal codes and corporate governance. The main idea behind rationale privatisation was the allocation of property rights, according to the market forces. In Russia, there was not even remote achievement of this principle. The government began to confiscate private property of the rich. Yet, it could not effectively reallocate these resources. The following points summarize the results of inefficient privatisation: Firstly, the economic output stopped growing and level of unemployment began to rise, which undermined economic performance of the country. Secondly, standard of living of the country had deteriorated and there was growing incidence of inequality. Finally, it had led to an environment infested with crime and corruption. Conclusion This study has focused on the privatisation of state-owned enterprises as the economy embarks on the transition path from a centrally planned economy to a market economy. The first section of the essay has focused on characteristics of both of these economies to highlight the chief attributes of them. The rationale of privatisation was that it will improve efficiency and productivity of the SOEs. However, it has been found that the level of output, in case of transition economies, tends to fall as the mainstream economics exclude the inefficient producers and consumers, driving them out of the markets. From the experience of China and Russia, a clear picture has emerged regarding privatisation. The experience of China has shown that privatization is not the only way by which productivity of the private sector can be improved. The experience of Russia had shown that failure of a proper institutional structure and privatisation under such conditions can have disastrous effects on performance of an economy. This implies that to allow privatization to achieve maximum growth, the country must have proper institutional structure. Reference List Aivaziana, V. A., Geb, Y. and Qiu, J., 2005. Can corporatization improve the performance of state-owned enterprises even without privatization? Journal of Corporate Finance, 11, pp. 791-798. Cherunilam, F., 2010. International Business: Text And Cases. New Delhi: PHI Learning Pvt. Ltd. Ganesh, G., 1998. Privatisation experience around the world. New Delhi: Mittal Publications. Kazmer, D. R. and Konrad, M., 2004. Economic lessons from the transition: the basic theory re-examined. New York: M.E. Sharpe. McFaul, M., 1995. State Power, Institutional Change and the Politics of Privatisation in Russia. World Politics, 47(2), pp. 210-215. Sachs, J., 1992. Privatisation in Russia: Some Lessons from Eastern Europe. The American Economic Review, 82(2), pp. 43-47. Sanguinetty, J. A. and Mastrapa, T., n.d. Lessons Learned From 20 Years Of Privatization: Albania, Estonia And Russia. [pdf] Association for the Study of the Cuban Economy. Available at: [Accessed 23 January 2014]. Wang, L., 2007. An Alternative to Privatization of Transition Economy State-Owned Enterprises: The Case of China. [pdf] Old Dominion University. Available at: [Accessed 23 January 2014]. Woo, W. T., 1994. The Art of Reforming China, Poland and Russia. Journal of Comparative Economics, 18, pp. 276-300. Read More