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Restructuring with What Success?

A Case Study of Russian Firms

By: Susan J. Linz

Working Paper Number 324

July 2000

Revised: July 2000

Restructuring with What Success?

A Case Study of Russian Firms

Susan Linz

This case study of enterprise restructuring utilizes data collected from thirty-two former state-owned firms in Taganrog, Russia, in the summer and fall of 1999. These data are used to construct three composite measures of enterprise restructuring. When defined broadly to include several dimensions of the restructuring process, the “restructuring threshold” is achieved by half of the privatized firms participating in the project. The firms achieving this threshold are distributed across all industries included in the sample. Regardless of the composite measure used, more than one-third of the former state-owned firms participating in this project attained the “active” restructuring designation. The results indicate that (1) production assortment changes appear to be ongoing among those firms engaged in restructuring activities, (2) employment changes appear to involve a mixed strategy with regard to timely wage payments, workforce size, and the benefits package; and (3) outsider ownership is more prevalent among the group of firms designated as restructuring than among those firms that failed to achieve the “restructuring threshold”. To put into perspective the economic and business environment in which these former state-owned firms operate, a comparison is made to a group of de novo firms that were surveyed under the auspices of the same project. Key Words : Russia, enterprise restructuring, privatization JEL Classification : P2, L2, L33, P

Research for this paper was supported by a grant from the International Research & Exchanges Board, with fundsprovided by the US Department of State (Title VIII Program) and the National Endowment for the Humanities. None of these organizations is responsible for the views expressed. I thank two anonymous readers for comments onan earlier draft.

data collected in numerous small-scale survey projects^2 detail a wide variety of efforts by managers to change production, employment and financing in order to ensure the ongoing operation and survival of their firm. The 20 th^ century ended with the jury still out regarding the restructuring success experienced by Russian firms. Why does it matter whether Russian firms are restructuring? If we take as the premise - Russian firms are not restructuring - then a set of policy options designed to initiate restructuring would be appropriate to consider. If we take as the premise - Russian firms are restructuring but their efforts have been impeded or the outcomes have not been accurately recorded - then a different set of policy options would be appropriate to adopt. Thus, the greater the detail provided about the operation and performance of Russian firms, the better able policy makers will be to adopt the appropriate measures to facilitate enterprise restructuring and the overall transition process, and the more informed business leaders in the global community will be in terms of investment strategies in Russia. This case study of enterprise restructuring utilizes data collected from thirty-two former state- owned firms in Taganrog,^3 Russia, in the summer and fall of 1999. These data are used to construct three composite measures of enterprise restructuring. The results illustrate the variation in

(^2) See, for example, Blasi et al (1997), Boycko et al (1995), Buck et al (1994), Commander and Mumssen (1998), Dolgopyatova (1995), Earle and Estrin (1997), Hendley(1998), Krueger (1995), Linz (1993 1997 1998), Linz and Biddle (1998), Linz and Krueger (1996 1998), Nelson et al (1997), Ickes et al (1995), Jones and Kuzes (1994), Standing (1996). (^3) Financial constraints limited the project to a single location. Previously-established connections with local officials made it possible to complete the project in Taganrog. While it is the case that Taganrog has beenidentified by Soviet and Russian researchers as the “average city” of Russia, the former Soviet Union (see, for example, Grushin (1980), Rimashevskaya (1992), and Chichiliymov (1999), among others), it is not the case thatthe thirty-two firms participating in this project were selected in such a way as to reflect the composition of former state-owned firms in all of Russia, or even Taganrog. The selection process targeted including one-thirdheavy industry, one third light/food industry, and one-third “other industry.”

restructuring activities across privatized firms, as well as identify the most commonly adopted changes. The case study also draws on a survey of 87 never state-owned ( de novo ) firms conducted in Taganrog at the same time. Where variables are comparable between the two groups of firms,^4 it is possible to identify similarities and differences among the survival strategies of these firms. Detailed and comparative information on enterprise operations is invaluable in gauging the impact of economic conditions on business operations, as well as to highlight policy options that would be most effective in stimulating improved performance. Detailed and comparative information delineating enterprise operations also puts into perspective some fraction of what is required for former state-owned firms in Russia to initiate and sustain restructuring activities. The paper is divided into five sections. The first section specifies the composite measure of enterprise restructuring. The second presents the methodology employed to evaluate the relative success of Russian firms in this regard. The third section describes the firms participating in the project. Restructuring results are presented in the fourth section. The final section offers concluding remarks.

I. Measures of Enterprise Restructuring With what success are Russian firms restructuring? To address this question, one must first decide by what measure restructuring success will be gauged,^5 and second, how to determine whether

(^4) Top-level managers in former state-owned firms and in firms that never were state owned were asked about the ongoing operations and performance of their company. Twenty-two questions were the same in bothsurveys. Data collected from de novo firms are not applied to the composite measures of enterprise restructuring. (^5) Restructuring measures typically include: installation of new director or new management team, profits, sustained or increased production volume, change in the assortment of production (including qualityimprovements), timely wage payments, payment of above-average wages, absence of barter transactions, foreign capital investment, workforce downsizing equal to or greater than production declines, self-financed investmentexpenditures, new suppliers and/or new buyers, for example. See Blasi et al (1997), Djankov and Murrell (2000),

First, it is posited that for enterprise restructuring to be successful top-level managers of former state-owned enterprises, the red directors,^7 must be removed in order to terminate the Soviet legacy of maximizing output and employment rather than profits (see, for example, Aghion and Blanchard 1996, Claessens and Djankov 1999, Djankov 1999, Frydman, Pistor and Rapaczynski 1996, Pinto, Belka and Krajewski 1993, Roland and Sekkat 2000). Alternatively, for current managers to be successful in the transition and post-transition market-oriented environment, they must receive special training, perhaps even in the West (Dickenson, Campbell and Azarov 2000). Second, it is posited that re-organization of enterprise operations to accommodate the new economic environment where former state-owned firms must identify and satisfy clients’ demands is an integral component of enterprise restructuring (Brown and Earle 1999, Brown and Earle 2000, Brown and Brown 1999, Ickes, Rytermann and Tenev 1995, Joskow, Schmalensee and Tsukanova 1994, Linz and Krueger 1998, McDonald 1993, Shleifer 1998, Svejnar 1996). This is especially important for firms which sell the majority of their product to non-state-owned firms. Third, a growing literature examines the relationship between ownership structure - insiders (employees) versus outsiders (non-employees) - and enterprise performance, taking the position that enterprise restructuring will be most active when the ownership structure is dominated by outsiders (Aghion and Carlin 1996, Claessens and Djankov 1999a, Earle, Estrin and Leshchenko 1996, Estrin and Rosevear 1999, Frydman Gray, Hessel and Rapaczynski 1999, Jones 1998). It further is posited that if individual insiders (i.e., top-level managers) own substantial blocks of shares (10% or more), enterprise restructuring is unlikely to be “active”. To utilize management change as a measure of enterprise restructuring, data collected from (^7) Term coined by David Granick, The Red Executive (New York: Columbia University Press, 1954).

the former state-owned firms participating in this study focused on whether: (i) the director and/or production manager had been replaced since 1992; (ii) the current director received special training since 1992; (iii) outsiders own more than 25% of the company’s shares; (iv) anyone (insider or outsider) owns a 10% or more block of shares. While positive responses to these conditions cannot establish the existence of “active” restructuring at the firm, they tend to undermine support for the proposition that firms headed by red directors are continuing to operate in socialist production and employment modes. Changes in production To produce with the requisite degree of efficiency to survive in a market-oriented economy, restructuring of former state-owned enterprises will require changes in the volume and assortment of production. One simple measure of production change compares the current volume of output with that of the previous year. Frequently, however, managers offer information on the value rather than the volume of output, with little explanation of the valuation procedure. Consequently, questions targeted at capacity utilization and how it compares to the previous year are better suited to estimate changes in production. Yet, since both volume and capacity utilization may reflect demand conditions rather than restructuring efforts, neither are well-suited as single measures to evaluate enterprise restructuring. Change in production assortment frequently is viewed as the key component in enterprise restructuring measures (Blasi et al 1997, Ernst et al 1996, Krueger 1995, Linz and Krueger 1998). Identifying the nature and scope of changes in production assortment incorporates a variety of components: (i) did the firm eliminate any products or services from their assortment; (ii) were existing products improved in any way; (iii) have new products or services (transportation or

wages are being paid on time, and how the current wage payment situation compares with the previous year, as well as with earlier years reflects on the firm’s ability to succeed in Russia’s chaotic economic environment, which in turn seems to proxy successful restructuring efforts (Linz and Krueger 1998). As is evident from the discussion above, no single quantitative or qualitative variable or measure captures the full scope of restructuring efforts that must be undertaken for Russian firms to survive the transition from a planned economy to a market economy. Composite measures which include both quantitative and qualitative variables are more enlightening in terms of the nature and scope of enterprise restructuring, simply because they incorporate more dimensions of the overall undertaking. Moreover, by developing a composite measure, and a simple rule for evaluating success, it is possible to make comparisons across industries and regions. This information is easily digestible by policy makers, should they become inclined to seriously consider ways of improving the economic environment in which Russian firms operate. It is not the case, however, that composite measures are unambiguous in evaluations of the extent of “active” versus “passive” enterprise restructuring in Russia. Composite measures simply serve as a mechanism for identifying a pattern (or lack thereof) in restructuring activities across firms, industries, and regions, as well as over time. Understanding the pattern of restructuring activities makes possible identification of factors which enhance or impede successful restructuring efforts. Establishing a “restructuring threshold” makes it possible to separate former state-owned firms into “winners” and “losers” with regard to adopting changes that will enable them to produce with the requisite degree of efficiency to survive in a market-oriented economy.

II. Methodology The original research project was designed to investigate enterprise strategies for survival in Russia’s transition economy. Since former (and current) state-owned firms inherited a capital stock, workforce, and organizational structure from the Soviet economy, their initial conditions and objective functions are likely to be quite different from firms which never acted as an instrument of central planners or local authorities (Ericson 1996, Ickes and Ericson 2000). Consequently, two questionnaires were developed for the original research project: one to be given to firms that were formerly (or currently) state-owned, and one to be given to firms that had never been state-owned ( de novo firms). To keep the time requirements for completing the questionnaire to a minimum, given the number of questions included in both survey instruments, the majority of questions asked top-level managers to select “yes” or “no,” or fill in a number. Twenty-two of the 60+ questions included on each version were identical, yielding a core set of responses relating to the organization and operation of the entire set of participating firms. Data collected from the privatized firms participating in this project are used to construct the composite measures of enterprise restructuring. Where warranted, data collected from the de novo firms will be used to put the restructuring results into a broader perspective. While not strictly a control group, because the de novo firms encompass different sectors of the economy, the comparison is useful for highlighting how Russian firms in general are managing to cope with adverse economic conditions. To evaluate the nature and scope of enterprise restructuring, three composite measures are developed. For each, the “restructuring threshold” is achieved when the firm responds positively to one-third of the variables included in the composite measure. “Active” (firm-initiated) restructuring

is unequal -the number of variables related to changes in production (18) is at least double that of the variables related to changes in employment (9) and changes in management/organization (6). Thus, Restrct2 is biased in favor of firms that have been active in production changes, which may reflect changes in demand conditions rather than active restructuring efforts, and may, as described above, introduce an industry bias in the evaluation of successful restructuring. Consequently, a third composite measure of restructuring, (^) Restrct3 , imposes weights so that each category (management, production, employment) contributes equally to the outcome. In effect, introducing the weights reduces the number of variables, so Restrct3 utilizes the same threshold values as Restrct1 : the “restructuring threshold” is six; “active” restructuring requires a score of ten or more points. In what way will these composite measures be used? The first objective is to identify the distribution of scores by the privatized firms participating in this project: how many former state- owned firms achieve the “restructuring threshold;” how many fall into the category of “active” restructuring? The second objective is to identify the activities typically associated in the literature with enterprise restructuring that are not common practice among privatized firms. It is important to know, for example, whether or not the majority of privatized firms have replaced top-level managers or discontinued the free provision a wide array of social services to their employees. While a large representative sample of the population of privatized firms in Russia would be invaluable, case study information also is indispensable for evaluating patterns in restructuring activities. The third objective is to identify systematic differences between privatized and de novo firms in response to economic conditions. While de novo firms cannot act as a control group for gauging the restructuring efforts of privatized firms because they incorporate rather different initial conditions and ongoing activities, response patterns from managers of de novo firms help to

illuminate the economic environment in which Russian firms operate. When designing or adopting policies to improve business conditions, it is important to know, for example, whether response patterns differ significantly between the two types of firms for any given variable influenced by the economic environment. If so, the policy outcome will vary depending upon the relative share of privatized and de novo firms in the community. III. Sample Characteristics Of the 35 former state-owned firms contacted in the June and October 1999 to participate in this project,^8 32 completed at least three-quarters of the designated questionnaire, for a response rate of 91%. The ownership distribution of privatized firms participating in this project includes: 22 registered as joint stock companies (of which 6 were “closed”), 4 registered as privately-owned, and 6 registered as partnership. The industry distribution of these firms includes: 3 in transportation, 4 in construction and construction materials, 10 in heavy industry, 3 in light industry, 6 in food processing, and the remainder in utilities, R&D, and services.^9 Workforce size among the participating privatized firms ranged from under 20 employees to over 10,000 employees. Of the twenty-seven firms responding to questions about capacity utilization,^10 nine reported capacity utilization at 50% or less for the current month; eighteen top-level managers reported capacity utilization exceeding 60% at the time they completed the questionnaire. In comparison to capacity

(^8) The population of former state-owned firms in Taganrog was, for the first time in the city’s history, available in a telephone directory. About half of the firms were contacted initially by phone; the balance involvedan initial contact by person. Assistance with this project was provided by colleagues at Taganrog State University for Radio Engineering. (^9) All but one of the former state-owned “service” companies participating in this project are engaged in activities related to Taganrog’s sea port. (^10) One question asked the respondent to report the percent of total capacity used by the firm during the current month. A second question asked the respondent to compare the percent of capacity used during thecurrent month with the same month in the previous year.

new office equipment (including computers). About 40% discontinued production of at least one product (STOP92, STOP95). A similar percentage reported adding new suppliers since 1992 (NEWSUP92), although these firms were significantly more likely to have added new suppliers since 1995 (NEWSUP95). Fourteen of sixteen firms responding reported outsourcing their former activities (OURSOURC); that is, buying materials or components from other firms that it used to produce itself. Nearly half of the privatized firms participating in this project obtained new production equipment since 1995 (NEWMCH95). In terms of management/organizational change, about half of the privatized firms experienced turnover in the top-level management positions (NEWBOSS, NEWMGR). One quarter of the managers completing the questionnaire reported receiving specialized training since 1992 for their management position (TRAIN). In more than half of the privatized firms participating in this project, there is at least one block holder (person owning at least 10% of the company’s shares). Fifteen of 18 firms responding reported outsiders (non- employees) owning shares in the company (OUTSIDER). In terms of changes related to employment, three-quarters of the firms did not expect to release workers in 1999 (RELEASE), nor did they expect to hire additional workers (HIREMORE). Just over 40% reported labor productivity improvements since 1995. Former state-owned firms provided the data for the restructuring measures used in this paper, but the research project also involved a survey of 87 de novo firms conducted at the same time in Taganrog.^12 While not strictly a control group,^13 data collected from the de novo firms will be used

(^12) Contacts were made by colleagues at Taganrog State University for Radio Engineering, as well as one official from the city administration. I do not know how manyin the project, thus I have no concrete information about the response rate. de novo firms were contacted about participating (^13) For example, the privatized firms in this sample, in comparison to the de novo firms: (i) were less likely to be in services/trade; (ii) employed significantly more workers; (iii) reported that a significantly lower

where warranted to illuminate economic conditions facing Russian firms, as well as to put into perspective the restructuring activities undertaken by former state-owned firms. The industry distribution of the de novo firms participating in the project includes: 6 in construction,^14 7 in light industry, 5 in food processing, 55 in retail and other services, and the remainder in R&D. The ownership distribution includes 27 firms registered as privately-owned, 51 firms registered as partnerships, and 7 firms registered as joint stock companies (of which 4 were “closed”). Of the eighty-six firms responding, 63 reported a workforce size of 20 or fewer employees, only three reported a workforce size in excess of 100 employees.

IV. Restructuring with What Success? Three composite measures are used here to gauge the relative success of Russian firms in restructuring their operations. The first gives equal weight to 18 variables associated with changes in production assortment (see Restrct1 in Table 1). Using this measure, twenty privatized firms achieved the “restructuring threshold” (positive response to at least 6 questions). This represents over 60% of the privatized firms participating in the project, and includes: 8 heavy industry firms, 5 food processing firms, 1 light industry firm, 2 construction and construction materials firms, and 3 firms in services. The anticipated industry bias - favoring firms with lower capital intensity - is not evident in Restrct1 : all but two of the firms in heavy industry and two of the four firms in

proportion of their workforce showed up regularly for work; (iv) were less likely to be considering hiringadditional workers in the coming year; (v) were less likely to pay wages on time; (vi) reported paying a significantly lower percentage of sales revenues to tax authorities; (vii) were more likely to be involved in exportactivities; (viii) were more likely to have a marketing department; (ix) were more likely to be involved in barter transactions, (x) were headed by significantly older managers; and (xi) were significantly more likely to beadding new products or services. However, there were no significant differences between privatized and de novo firms in terms of recent changes in the volume of activities, or the purchase of new equipment. (^14) None of the de novo firms manufactured construction materials.

managerial change. With regard to the restructuring variables, all three report acquiring new production machinery since 1995, yet they still report the need to renovate between 25% and 60% of their capital stock. Despite having vehicles, none of these firms added transportation services since 1992. Differences between these firms arise with regard to outsourcing (2 of 3 do not), discontinuing a product line since 1995 (2 of 3 did not), and receiving management training outside of Russia (2 of 3 did not). In contrast to other privatized firms participating in this project, these three were less likely to be selling to new buyers or buying from new suppliers. Regarding changes in production assortment, what is not being done by the thirty-two privatized firms who participated in this project? Given that these firms report needing to renovate on average over 50% of their capital stock, it is not surprising that less than half of the firms report any change in their main assortment of production; three-quarters report not changing or improving the quality or characteristics of any product in their assortment. Approximately three-quarters of the firms did not eliminate any products from their assortment, although 60% report adding new buyers. Less than half of the firms reported the acquisition of new production machinery.^17 None spent money on research and development in the previous year. Rather surprisingly because of its revenue-generating potential, only two of the thirty-two privatized firms participating in this project reported adding transportation services.^18 The second composite measure, Restrct2 , incorporates changes in production, management,

Italian technology, and production of consumer goods, including televisions, for example. (^17) While the correlation coefficient between NEWMCH95 and ELIMPROD is rather low (0.22), there is a stronger correlation (0.46) between the acquisition of new production machinery and improvements in productquality (IMPROVE). (^18) This stands in marked contrast to the de novo firms participating in this project –36% of these firms added transportation services in the last two years.

and employment, giving equal weight to the thirty-three variables associated with enterprise restructuring (see Table 1). Fourteen of the privatized firms participating in this project achieved the “restructuring threshold” of 11 points. Not surprisingly, given the dominance of production assortment variables and the equal weights assigned to each variable in Restrct2 , of the fourteen that achieved the “restructuring threshold” in terms of this broader measure, seven were part of the “active” restructuring group using (^) Restrct1. The newcomers include two companies engaged in activities related to the sea port (ship loading, ship repair), one firm in construction materials, one machine tool firm, one bakery, one firm making electronic devices, and a firm that leases equipment and other materials. All of these firms report at least one block holder; all but two report outsiders owning shares -between 15% and 55%. All replaced the production manager at least once since 1992; all but one experienced a change in the director since 1992. The majority of these firms have introduced new products, improved the quality of existing products, found new buyers and suppliers, acquired new production machinery and established a marketing department. The majority report timely wage payments. The majority have reduced expenditures on benefits/social services, in part by reducing the range of benefits offered and in part by reducing the number of workers employed to provide these services. 19 Seven firms achieved the “active” restructuring designation using Restrct2. These include three firms in heavy industry, one construction and construction materials firm, one food processing firm, and one firm in services. If these data do reflect the broader population of privatized firms in Russia, the result that less than 25% of the former state-owned enterprises are actively engaged in restructuring activities does not bode well for the future. Nearly a decade after Russia initiated its

(^19) The majority of these firms, like the other privatized firms participating in this project, have not transferred benefits to municipal authorities.