The Politics of Privatization, Quality of Governance, and Financial Development in Eastern Europe

ABSTRACT

This paper provides theoretical justification and empirical evidence linking the mode of privatization of state assets in banks and industries to the quality of institutions of legal and financial governance that underpin financial development. The evidence from twenty-five states of Eastern Europe suggests that allowing foreigners to assume the role of strategic investors in banks and industries via direct sale methods of divestiture of state assets contributes to legal and institutional development, particularly a stronger and more impartial legal system, better quality of bureaucratic governance, and stronger legal protection of creditors, while insider privatization schemes, such as voucher privatization or management–employee buyouts, do not fulfill the same role. The empirical results are robust to instrumental variable analysis and to the inclusion of numerous economic and political controls for alternative explanations.

Acknowledgments

I am grateful to Dorothee Bohle, Valerie Bunce, Marcelle Chauvet, Barry Eichengreen, Alexandru Grigorescu, Indridi Indridason, Juliet Johnson, Ethan Kaplan, Peter Katzenstein, Jonathan Kirshner, Matthew Mathutga, Peter Rosendorff, Beate Sissenich, Christopher Way, conference participants at the annual meetings of the American Political Science Association, International Studies Association, and European Union Studies Association, and three anonymous referees for helpful comments on earlier versions of this paper. I thank Dennis Quinn and James Vreeland for graciously sharing their data with me. I also want to express my gratitude to the Research Department of the National Bank of Slovakia and its Director Martin Šuster hosting me as a visiting research fellow and for providing a hospitable and stimulating environment.

Disclosure Statement

No potential conflict of interest was reported by the author.

Notes

1. In their critical review of the literature on finance and inequality Demirgüç-Kunt and Levine (2009, 312) conclude that “The results of cross-country, firm-level, and industry-level studies, policy experiments, as well as general equilibrium model estimations all suggest that there is a strong beneficial effect of financial development on the poor and that poor households and smaller firms benefit more from this development compared with rich individuals and larger firms.” However, there might be some cross-regional differences. Using data from Argentina, Berger, Klapper, and Udell (2001) found that large and foreign-owned banks are more inclined to lend to large firms with foreign owners rather than to small firms. By contrast, a more recent study by Giannetti and Ongena (2012) exploring the effect of financial integration of East European countries shows that not only firms have the same access to loans whether or not they borrow from a foreign bank but that foreign loans indirectly benefit all firms.

2. The East Asian state-led model of development that featured government-mandated credit allocation at low interest rates to strategic industries was considered successful until the 1997 Asian financial crisis. Scholars argued that the crisis was the outcome of excessive gambling and stealing by weakly regulated banks protected from entry barriers to competition from outside banks. The crisis thus showed the inadequacies of financial repression. Whereas the allocation of credit brought some benefits in the initial stages of development, such policies led to overinvestment and excessive risk taking, particularly in real estate. See, e.g., Krugman (1998), and Kruger (2011).

3. The “development” view of financial development associated with Gerschenkron advocates a key role for the state in the banking sector and government ownership of firms in the strategic economic sectors. By contrast, proponents of the “political” view of government participation in finance argue that governments acquire control of firms and banks in order to provide employment, subsidies, and other benefits to supporters, who return the favor in the form of votes, political contributions, and bribes (see La Porta, Lopez‐De‐Silanes, and Shleifer 2002).

4. Stock markets in EE developed from literarally non-existent in the early 1990s to capitalization ratios peaking in 2007 at 35 percent in the Czech Republic and Hungary, at 43 percent in Poland, and at 47 percent in Slovenia. But EE countries still have to do a substantial catching up when compared to countries with well-developed capital markets, such as Australia, Canada, the United States, and the United Kingdom, with stock market capitalization levels at over 140 percent in 2007. These data come from Beck, Demirgüç-Kunt, and Levine (2009). It is worth noting that a developed banking system is a precondition for stock market development (Chinn and Ito 2006).

5. For the evolution and diversity of financial systems in EE, see, e.g., Neumann and Egan (1999), Johnson (2000), Berglof and Bolton (2002), McDermott (2007), and Denizer, Desai, and Gueorguiev (2006).

6. Only Russia had a brief, but unsuccessful, experiment with a common-law approach to corporate law (Berglof and Bolton 2002, 90).

7. See Pistor, Raiser, and Gelfer (2000).

8. Braun and Raddatz (2008) show that trade liberalization changes the relative strength of promoters and opponents of financial development in various industrial sectors. Chinn and Ito (2006) explore the link between capital account liberalization, legal and institutional development, and financial development.

9. For Rajan and Zingales (2003), when a country is open to foreign trade, incumbent industries cannot charge monopoly prices. Similarly, when a country is open to global financial flows, enterprises are not limited to funds supplied by incumbent banks.

10. On financial repression, see McKinnon (1991).

11. See, e.g., Haber, North, and Weingast (2008), Pinto, Weymouth, and Gourevitch (2010), Becerra, Cavallo, and Scartascini (2012), and Calomirs and Haber (2014).

12. In his seminal work, The Rise and Decline of Nations, Olson (1982) argued that politically stable countries suffer from “institutional sclerosis” caused by the growing political influence of distributional coalitions.

13. See, e.g., Kornai (1995), King and Hamm (2005), Bennett, Estrin, and Urga (2007), Brown, Earle, and Gehlbach (2009), and Bjørnskov and Potrafke (2011). For a comprehensive survey of the literature on the implications of privatization in EE countries, see Estrin et al. (2009). The bulk of this literature relied on firm-level surveys and explored the effects of privatization on firm performance.

14. Boubakri, Cosset, and Smaoui (2009) examine the effect of privatization on the quality of legal institutions of governance but exclude EE countries. For the impact of privatization on the development of capital markets, see Boutchkova and Megginson (2000).

15. Pierson (1993) writes that policy feedback is likely to be consequential for EE countries in which interest group activity was not well established in the initial years of transition.

16. For the factors determining the design of privatization and privatization methods, see, e.g., Bjørnskov and Potrafke (2011), Boubakri et al. (2016), and Weiss (2020).

17. The main attractiveness of the voucher privatization program was the speed of divestment of state property and the relatively egalitarian distribution of shares to the population.

18. As Hellman (1998) famously argued, “the most common obstacles to economic reform in post-communist transitions have come from enterprise insiders who have become new owners only to strip their firms’ assets; from commercial bankers who have opposed macroeconomic stabilization to preserve their enormously profitable arbitrage opportunities in distorted financial markets.”

19. Author’s interview with Tomáš Ježek, former Czech minister of privatization, June 2006, Prague.

20. Citizens became owners of the worst-performing privatized assets, while the best companies have come under insider control, and asset-stripping has become widespread (Megginson and Netter 2001, 346).

21. Privatization by sale (in the form of the acquisition of concentrated holdings) in EE countries was undertaken predominantly to foreign owners due to underdeveloped capital markets and the lack of domestic entrepreneurs with the appropriate set of skills and collateral to become “good” owners of state assets.

22. Foreign entry through acquisition of domestic banks is likely to have a greater impact on institutional development than de novo entry (greenfield investments), because the former breaks the existing bank-firm-state networks that impede financial development and decreases the number of state banks and firms. I thank an anonymous reviewer for this suggestion.

23. It is possible that foreign owners can also be “extractive” and collude. However, in principle, they should favor strong institutions of governance in host countries that would protect their investment and property rights and minimize the risk of expropriation of assets as well as unfair treatment with respect to local firms and banks. I thank Peter Rosendorff for this remark.

24. I have an unbalanced panel dataset with some observations missing at random.

25. Privatization is not a discrete one-time event but rather a gradual process; thus an event study methodology is not appropriate.

26. See, e.g., Chinn and Ito (2006), Boubakri, Cosset, and Smaoui (2009), and Bruno and Claessens (2010).

27. The advantage of the ICRG variables is that they are collected on an annual basis. The disadvantage is that the data on legal-institutional development change slowly and do not vary a lot over time because institutions tend to be sticky. However, EE states, experiencing radical political and economic transformation since the collapse of communism, display a relatively high variation in institutional quality both over time and across countries. For instance, the law-and-order dimension of the institutional index improved in Poland from 4 to a maximum 6 already in 1994, which compares favorably with developed countries, such as the United States, Germany, or France, where the ICRG institutional indices range between 5 and 6 points. By contrast, Russia’s -law-and-order index decreased after the start of its voucher privatization program.

28. The most common form of corruption is financial corruption in the form of demands for bribes for loans.

29. The creditor rights index comes from Djankov, McLiesh, and Shleifer (2007). The index captures de jure regulation; it does not measure the level of regulatory enforcement.

30. I focus on creditor rights rather than legal protection of minority shareholders because banks remain the main providers of outside finance in EE.

31. My sample is limited to the years 1990–2004 because the EBRD does not systematically report data on privatization methods after 2004. I also wanted to avoid the skewing effect of the 2008 crisis. Financial crises are associated with contagion effects and require different modeling techniques.

32. I also estimated models coding primary and secondary methods of privatization. The results remain unchanged.

33. Bennett, Estrin, and Urga (2007) create three time-specific dummy variables for asset sales, vouchers, and management–employee buyouts. Megginson et al. (2004) use a dummy variable, which equals one if the privatization is through a share issue privatization and zero if the government used an asset sale.

34. Several EE governments changed their privatization strategies in the course of the transition. For example, after initially using voucher privatization, both Bulgaria and Kazakhstan implemented the direct sales method in 1997 and Lithuania in 1998. The theory proposed here can explain reversals in institutional governance.

35. This measure may conflate sales to foreigners and sales to domestic outsiders but it was not until foreign banks were allowed to acquire strategic stakes in the domestic banking sectors that private ownership took a firm hold in EE (Berglof and Bolton 2002, 85).

36. Chinn and Ito (2006) found that a higher degree of financial openness fosters financial market development—but only if a threshold of legal development has been attained.

37. There is some evidence that capital account liberalization and domestic financial sector liberalization may precipitate the banking and financial crisis (see, e.g., Cetorelli and Goldberg 2011; Stiglitz 2000).

38. This measure is based on Stulz and Williamson (2003) and the CIA Factbook, which report religions by adherents (the fraction of the population adhering to a particular religion).

39. See Acemoglu and Johnson (2005), Weymouth (2011), and Denizer, Desai, and Gueorguiev (2006).

40. The variable years under socialism captures the heterogeneity within the EE region between former Soviet republics and East Central European states that came under communist control after World War II. Compared to regional dummies, this variable allows us to differentiate between the Baltic states, with less time under communism, and other post-Soviet states.

41. There are some plausible explanations for this result. The ICRG index of corruption assesses corruption within the political system but it does not explore financial or corporate corruption. The index is determined by a network of correspondents with country-specific expertise rather than by surveys of firms or households that contain multiple questions pertaining to narrower aspects of corruption.

42. Eastern Orthodoxy is the primary religion in a number of post-Soviet republics.

43. This is compatible with the findings of Stulz and Williamson (2003).

44. The indicator is available for 1996, 1998, 2000, and annually from 2004.

45. I use the the Heritage Foundation’s index of property rights protection (with higher scores indicating better legal protection of property rights) as another alternative dependent variable. I find that it has a positive and statistically significant correlation with the quality of legal institutions of governance (estimates not reported).

46. I thank James Vreeland for graciously sharing the data with me.

47. I also probe the robustness of my findings by including the lagged value of the dependent variable on the right-hand side of the equation. Results are available from the author.

48. Megginson et al. (2004) show that governments able to commit to property rights protection are more likely to privatize via direct sales.

49. Note that the number of observations drops substantially because of the data availability for the GINI coefficient.

50. Viktor Orban’s government in Hungary, which took office in 2010, implemented hostile policies toward foreign banks in an effort to increase the role of the state in the banking sector, but ended them in 2015. Foreign bank presence has proven to be valuable to Hungary. Rating agency Moody’s identified foreign bank penetration as “a major stabilizing factor” for the Hungarian banking system during the 2008 crisis. Parent banks of foreign subsidiaries pledged to ensure a “prudent capitalization of their subsidiaries” in Hungary and to maintain at least 95 percent of their exposure (De Haas et al. 2012, 8).

51. Some countries have reversed bank privatization in recent years. The right-wing ruling Law and Justice Party in Poland has promoted a “repolonization” in the banking sector, which is a form of renationalization with state-controlled firms buying stakes back from foreign investors. Similarly, the Orban government in Hungary has pursued a “center-right nationalism, using its supermajority to adopt unorthodox financial policies aimed at increasing Hungary’s monetary sovereignty and privileging national insiders,” while identifying foreign-owned banks as “outsiders,” a label that had a strong connotation of “anti-Semitism” (Johnson and Barnes 2015, 544). However, the foreign bank presence has proven to be “a major stabilizing factor” for the Hungarian banking system, particularly during the 2008 crisis, according to the rating agency Moody. The Orban government ended its hostile policy toward foreign banks by signing a Memorandum of Understanding with the EBRD in 2015, in which it committed to reduce bank taxes and “refrain from implementing [unilateral] new laws or measures that may have a negative impact on the profitability of the banking sector.” See: https://www.ebrd.com/news/2015/hungary-ebrd-and-erste-group-join-forces-to-strengthen-financial-sector-and-bolster-economic-growth.html.

Additional information

Funding

Funding for data collection and research assistance was provided by the Austrian Marshall Plan Foundation and the Center for Transatlantic Relations at the Paul H. Nitze School of Advanced International Studies, Johns Hopkins University.