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23 September, 2015  ▪  Lyubomyr Shavalyuk

Big Sale Coming Up

The government plans to reform the system of public property management and launch a wide scale sell-off. Are Ukraine’s economy and society ready?

For more than a year, Ukraine has been debating about what, how and when should be privatized. It has not yet gotten as far as organizing actual tenders to sell large state-owned enterprises, but preparations for privatization are underway. This generates various rumors and myths that distort public opinion on privatization.

The process is more important than the result

More than a year ago, Prime Minister Arseniy Yatsenyuk announced "the largest privatization in 23 years." Nothing much happened over this year: privatization proceeds amounted to mere USD 467 million. Still, the process has been launched, and even advanced from empty talks to practical steps. In the recent months, the government went as far as organizing privatization tenders.

The government has done a lot in this time. The Ministry of Economic Development and Trade (MEDT) prepared Ukraine’s Top-100 State-Owned Enterprises, a review report compiled jointly with PriceWaterhouseCoopers, Dragon Capital, the Soros Foundation and the Government of the United Kingdom, that is likely to catch investors’ attention. This is the first report of the kind providing comprehensive analysis of the position and growth prospects for a hundred largest state-owned companies (accounting for over 90% of total income of all state-owned enterprises in Ukraine). The Ministry plans to publish such reports quarterly and annually, following the practices of more advanced countries. The report also looks at the best practices in public property management in member-states of the Organisation for Economic Co-operation and Development (OECD). Guided by international experience, the report announces the reform of state-owned enterprises. The ultimate goal is to increase their efficiency and make them more competitive on the market.

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Public property reform suggests a number of interesting initiatives. One is to increase transparency in the operation of state-owned enterprises through a mandatory requirement to prepare their financial statements in accordance with international standards and to do audits by independent international agencies. In addition to that, the focus of state-owned enterprises is expected to shift to generating profit. This will be done through segregation of business operation and other functions – social or political – state-owned enterprises often carried out earlier. An example is Ukrzalisnytsia, Ukrainian state railway carrier that provides discounts for some social categories. The same goes for the separation of powers in ministries: they are currently both regulators and owners of the enterprises. This leads to a conflict of interests and distorts incentives that could otherwise come from the markets.

Finally, the crucial component of the reform is mandatory establishment of independent supervisory boards. They will appoint members of management boards and decide on business development strategies.

Previously, state-owned enterprises operated in two ways. One was for oligarchs, being minority shareholder de jure, to control managers. Thanks to good contacts in the government they preserved that status quo for years, while channeling company cash flows to their accounts (Ukrnafta, Ukraine’s biggest state-owned oil extraction company operating on local oil fields, is the most recent example, but there are dozens more). The other scenario was for the managers to deliver suitcases full of cash to those at the helm, and in case of a power shift, to those "newly-elected". This would grant them a carte blanche to leave some cash for themselves (Ukrspyrt, the monopolist producer of alcohol further used in the production of alcoholic beverages, is probably the most well-known case). Under any of these “business models” state enterprises brought to the budget – and to Ukrainian taxpayers – mere pennies or, worse, losses, while the parasites rushed to grab as much as possible before a new change in government. This is bound to change after the current reform. Every state-owned enterprise will have its own supervisory board comprised of government representatives as well as independent experts (who may even outnumber the officials). This will stop excessive government meddling and the practice of being run by oligarchs de facto. Coupled with decent financial reward for the supervisory and management board members (the Ministry of Economy proposes a wage hike), this should make the operations of state-owned companies more efficient in the near future. They will then show improved cash flows which will guarantee real market price in privatization. For natural monopolies or strategic enterprises, privatization should not be an option.

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Besides the report, the government has completed a lot of organizational work. Most importantly, Ihor Bilous was appointed head of the State Property Fund of Ukraine (SPF), filling the post that remained vacant for almost a year. The Cabinet decided to put up for privatization in 2015 a list of over 300 state-owned enterprises (majority and smaller stakes), including many large ones. The 2015 budget expects USD 17bn in privatization proceeds. All these principles of transformations and mechanisms to implement them have become part of the public property reform strategy and the relevant legislation amendments.

A list of a dozen companies that are top priorities for privatization is being compiled; the action plan on five of them is already in place and waits to be approved by the end of September. An inter-agency work group is to be set up to monitor and eliminate embezzlement at state enterprises. It is also expected to conduct independent audits of at least 100 largest enterprises, propose amendments to the legislation in order to increase wages for the managers, and develop a plan to restructure companies that pose the biggest risks of losses to be covered from the national budget.

Obviously, the preparations for large-scale privatization are well under way in compliance with the best international standards. There is political will for privatization, and it seems to be supported from the overseas. Actually, this will is so overwhelming that some believe the only significant function of Yatsenyuk as Premier to be "selling everything that has not been sold." According to Mr. Bilous, the first facility, Odessa Port Plant (OPP), will be set for an auction in November or December. Rumor has it that Norwegian, American, Arab and Ukrainian investors have already expressed their interest. It is yet to be seen whether no efforts are taken to restrict access to the auctions for bidders, and whether this interests translates into a decent price for the OPP.

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Today, the barriers significantly hampering the privatization process are plenty. Most importantly, the oligarchs are doing everything in their power to prevent privatization, since they stand no chance of winning transparent privatization tenders (the value of the companies for them is clearly lower than for foreign investors, because they will never manage to make them as efficient). This resistance is cited among the reasons for the dragged-out preparation of Tsentrenergo, a major supplier that generates 8% of electricity in Ukraine, for privatization. And just days before this article went to press, Premier Yatsenyuk postponed privatization of the Odesa Port Plant. The official reason – a need to change evaluation methods for state-owned facilities – caused rumors of his playing into the hands of oligarchs.

The judiciary poses another barrier. Recently, the infamous Kyiv Commercial Court deemed illegal the privatization of 25% of Dniproenergo, another major electricity supplier with Rinat Akhmetov’s DTEK as a major shareholder. This actually means re-privatization. More similar lawsuits may delay the privatization process for months.

State capitalism in the world

In theory, privatization is undoubtedly necessary, since the state cannot be an efficient business owner. In practice, the concept has its pros and cons.

On the one hand, massive waves of privatization held in most countries in 1970–1990's are evidence in its favor. Privatized companies became more efficient and more capable of growth. Still, state-owned enterprises play a major role in many economies throughout the world today. These are the countries of state capitalism.

China, and less so other Asian countries, is a model of economy with successful and effective state companies. This is due to a number of specific features. One is mentality that puts national interests before private ones and prevents state company executives from filling their own pockets. Another one is severe punishment for corruption, ranging from huge fines to death penalty. Each year, about 100,000 corruptionists are caught in China (and their criminal cases do not get stuck at the Prosecutor's Office or the courts, as is the case in Ukraine), and thousands of them are sentenced to death. The third feature is the polished legislative environment with high standards of corporate governance, preventing officials from interfering with companies' work or pocketing parts of their cash flows. Of course, China, like any other country with state capitalism, uses state-owned enterprises for more purposes than profit making alone, but even these alternative purposes focus mainly on economic growth priorities that feed the economy.

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In other countries of state capitalism, the performance of state corporations is far less impressive. Firstly, most state-owned companies there generate a much lower profit margin than their private-owned competitors. The market price of their shares always includes a discount for the low quality of their corporate governance, something that is unavoidable in a company with the state as the owner. Secondly, state-owned enterprises are reluctant to develop. Therefore they are virtually absent from most innovative industries. Thirdly, they appear in frequent corruption scandals. Facts of massive corruption related to the state gas giant Petrobras have recently surfaced in Brazil: private construction companies (and not only them) bribed government officials to get contracts from this state monopolist. The scandal involved the ruling party members, including President Dilma Rousseff. The losses of this state corporation today are estimated at USD 16bn. As long as state capitalism exists, such incidents will take place regularly.

In Russia, state capitalism has degraded further. State banks have monopolized the financial sector (which, by the way, made them a convenient target for Western sanctions), accumulating the bulk of financial resources and lending them to state companies. This environment hampers the development of either private banks or producers with limited access to financial resources. State oil and gas players squeeze private companies out of the market thanks to monopoly access to the best fields and transportation infrastructure. Add to that opportunities to seize the assets of private businesses – the swallowing of Yukos by Rosneft is one example. Heads of state corporations and corrupt officials have formed an intricate net where one hand washes another. Operating in the environment of impunity and complete lack of self-criticism, this has brought Russia to the blind alley of civilization. Its state-owned companies are focused not on doing business, but on financing Russia’s geopolitical interests, as seen by the Kremlin. Such form of state capitalism is the most vicious, and is completely at odds with business efficiency. Worst of all, state corporations in Ukraine were until recently following the Russian model. This requires drastic and radical change. If Ukraine is to embark on the path of development, it cannot afford to have state capitalism of the Russian kind.

Public property, Ukrainian style

According to the Ministry of Economy, Ukraine has 3,374 state-owned enterprises as of today. This is almost double the figures in 28 out of 34 OECD countries (except for the United States, Turkey and several small countries). Only 1,920 out of them are operating. The question is: what happened to the rest, and what were the management methods used by the state and its officials that led to this? Total assets of all state-owned enterprises were worth USD 813bn, or almost 52% of Ukraine’s GDP, as of mid-2014. Cumulatively, they generated losses even before the Maidan. In 2014, their financial performance deteriorated further.

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Total mismanagement of state corporations surfaces not only in journalist investigations that reveal corruption and abuse by state company executives, but also in mere facts and figures. Statistics give solid proof that public assets should be restructured to make them work effectively as a minimum, and privatized as a maximum. As seen by an average Ukrainian, the money the state collects (in the form of increased taxes or utility tariffs) is much more important than the money the state fails to receive because it was stolen by officials with a little help from state company managers. Yet, these losses amount to tens of billions of hryvnia. If they ended up in the budget (or were used to develop the companies and create jobs), the actual level of social benefits could be much higher than it is now.

Statistics dispel the myth about preserving the status quo as the best strategy for public property management. Firstly, what good are the assets that generate no cash flow? Secondly, what happened to the companies that went out of operation? The answer is simple: their equipment was used as scrap metal, stolen or taken away, and the buildings were rented out for kickbacks. All of this happens with the consent of the officials who transfer part of their income from this "up the chain." The longer the companies remain state-owned without reform and restructuring, the more they will be pilfered, increasing the burden on the budget. It is obvious that civil society should in no way tolerate this status quo.

Enchained by preconceptions

There are many other widespread myths related to privatization. The government should take seriously the issue of dispelling them by commenting on the process and on its outcomes.

The main myth is that after the privatization, companies will work worse. The best case to the contrary is ArcelorMittal Kryviy Rih (former Kryvorizhstal). In 2005, when the company was privatized following an open tender that remains unique to this day, it had 55,400 employees earning an average of 1,522 hryvnia per month, which was 89% higher than the average salary in Ukraine. Its net income was UAH11 bn, or USD 2.15bn. 10 years after the privatization, in 2014, the company had 28,800 employees (the ones that were laid off received huge compensations) with the average monthly salary of UAH 6,661, which is 91% more than the national average. Its net income increased by half to UAH 36.7bn, or USD 3.09bn. At the same time, over the 10 years from 2005 to 2014, the company invested USD 12bn, increasing almost six times its average annual investment from less than UAH 200mn before the privatization to UAH 1.2bn thereafter.

ArcelorMittal Kryviy Rih is a typical example of a successfully and transparently privatized company that improves its efficiency and increases production, while reducing staff and paying higher wages. The salaries of the company's employees could well have been higher, but that would hardly be a feasible option for the owners in a situation where there are armies of the unemployed willing to work for less.

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Companies privatized non-transparently have fewer reasons to be proud. Ukrtelecom, the nationwide fixed line operator, faced a "grabitization" in early 2011. In 2011–2014, it reduced its staff by 31%, and payroll by 12%. In this way, the average salary increased by 29% compared to a 55% increase nationwide. Its net income fell 4% even in UAH terms. Annual investment dropped by several times, from UAH 0.7–1.7bn before privatization to UAH 0.15–0.65bn thereafter.

DTEK Zakhidenergo PJSC, grabitized by Rinat Akhmetov in the late 2011, is in a slightly better situation. In 2012–2014, its staff was reduced by 23% and payroll by 2%; however, its net revenue in hryvnia terms increased by 58%, and annual investment grew by several times, from UAH 100–150mn to UAH 400mn.

Quite often, state-owned enterprises begin to perform more poorly after falling into the hands of oligarchs through privatization. The workforce is hit the hardest: the only thing that the oligarchs manage to do under any circumstances is to lay off staff, and reduce salaries to get more benefit for themselves.  Development and justified profitable investment are above their head. Therefore, those who believe that state-owned enterprises should not be privatized because they will work worse are right to a certain extent. However, the cause of possible deterioration is not privatization as such, but privatization that is obscure and noncompetitive, inaccessible to efficient private bidders. With a competitive and transparent tender, the result will be quite the opposite. The lone example of ArcelorMittal Kryviy Rih is the proof.

Another common misconception is that when a company is state-owned, it "feeds" many employees, who now and then sell stolen goods, spare parts etc. After the privatization, however, the new owner will quickly stop this petty trade by its personnel, thus impoverishing the population. There are several aspects to this. First of all, Ukrainians got used to stealing state property (at collective farms, state farms, and factories) back in the Soviet days. But back then, we fleeced a foreign country, while now it is our own. Therefore, this habit should be thoroughly eradicated. If privatization can remedy this, then it should be done as quickly and fully as possible. A state where theft and corruption are a social convention cannot develop. This has been taught by the greatest minds of the mankind since ancient times, and has been confirmed by practice.

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Secondly, privatization does deprive many people of opportunities to make money, and therefore – to survive, even if illegally, in the Ukrainian economy (in addition to hordes of petty traders of stolen goods, privatization will generate another horde of laid-off workers, as well as officials who lose their shadow income). Therefore, comprehensive economic reform should be carried out in parallel with privatization in order to improve business climate and foster new businesses that could absorb vacant workforce and give people the opportunity to make money. Only in this case will privatization be socially effective and contribute to the country's development. Otherwise, its only noticeable implication for society will be increased unemployment, social tensions, and emigration. Ukrainians have had enough of all these problems.

A careful analysis of the advantages and disadvantages of privatization on the basis of theory, international practices and local specifics shows that Ukraine really needs one. The phase of restructuring state-owned enterprises and preparing them for tenders is especially important. Coupled with the fact that, in times of war, the sale of state corporations is one of the few available sources of budget replenishment and foreign exchange earnings through FDI, it shows the dire need for privatization. Whether the current government manages to get the message across to the public and avoid social tensions caused by privatization by improving the business climate remains to be seen.

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