Investment, Wages and Corporate Governance during the Transition: Evidence from Slovenian Firms

Janez Prasnikar and Jan Svejnar

Motivation

In the context of transition -- investment-wage issue especially important.

– Investment -- a principal indicator of strategic or deep restructuring (Grosfeld and Roland, 1997, Blanchard, 1997)

– Loosening of central controls in the absence of developed competitive markets => excessive wage increases? (e.g., Blanchard, 1991, and Burda, 1993).

Motivation (continued)

– Also, insiders (workers and managers) often seized control of firms (e.g., Hinds, 1990, Prasnikar and Svejnar, 1991, Commander and Coricelli, 1995, and Earle, Estrin and Leschenko, 1995)

– Under-investment problem in labor managed firms (Furubotn and Pejovich, 1970, Vanek, 1970, Uvalic, 1992)?

• Workers, unlike diversified capital owners, prefer to distribute surplus as labor income rather than reinvesting it

– Inability of many firms to pay wages – acute tradeoff between using value added for financing investment versus paying wages and fringe benefits

Why Slovenia ?

1. Data – can examine behavior of firms while going through transition-related restructuring but before being privatized

• Can focus on insider-outsider aspect of governance– is at the heart of theoretical modeling

• Can test whether the pre-privatization investment and wage behavior differed for firms that were approved for internal v. external privatization

Why Slovenia ? (continued)

2. Some Chief Executive Officers (CEOs) established their own private (“bypass”) companies in the early 1990s1. These CEOs -- perceived as being very capable

managers2. Did they siphon off enterprise profit and otherwise loot

(tunnel) the firms for their own benefit3. => We check if firms headed by these CEOs displayed

different investment and wage behavior and if this behavior is consistent with looting by managers.

3. Some firms were partly owned by other companies and institutions (e.g., banks and government agencies) rather than being fully socially owned1. If this previous ownership is more tangible and

connected with a potential source of financing, could affect investment and wage behavior of firms

MODEL : Investment Equation

• Tradeoff between investment and wages– internal funds (πa =profit net of best alternative labor

cost) -- may be used by firm to pay higher wages or internally finance investment

• => Bargaining between workers and management over the allocation of πa between investment and worker compensation – surplus labor costs (yL - yaL): a negative coefficient

implies that workers appropriate as wages part of internal funds that would have been used for investment

• Investment effect of output demand (R = revenue) – (neoclassical and accelerator models of investment)

MODEL : Investment Equation (continued)

I/L = 0 + (FIRM)1 + 2(πa/L) + [FIRM(πa/L)]3 + 4(y-ya) + [FIRM(y - ya)]5 + 6(R/L) + [FIRM(R/L)]7 + (YEAR)8 + (INDUSTRY)9 + 2,

where:

FIRM = is a row vector of dummy variables capturing the categories of

corporate governance: (EXTERNAL, BYPASS, PREVIOUS)

πa = internal funds (profit net of best alternative labor cost)

R = revenue

ya = reservation (best alternative) income per worker

y = actual income per worker

MODEL: Wage Equation

• based on a bargaining model

• How much surplus (R-H)/L) are workers appropriating ?

– H = cost of non-labor inputs

• Is it more difficult for workers to appropriate the depreciation funds (DEPR ) than to share in the surplus that the firm generates over and above this amount (i.e., R – H – DEPR)?

Model: Wage Equation (continued)

y = δ0 + (FIRM)δ1 + δ2ya + [FIRM(ya)]δ3 + δ4[(R – H – DEPR)/L] + [FIRM(R – H – DEPR)/L]δ5 + δ6(DEPR/L) + [FIRM(DEPR/L)]δ7 + (REGION)δ8 + (YEAR)δ9 + (INDUSTRY)δ10 + 4,

where:

DEPR = depreciation

Slovenian Transition to a Market Economy• declaring independence (1991)• rehabilitation of the commercial banking sector (1993)• newly established Ljubljana Stock Market: capital supply and

allocation was limited. • privatization Law (1993)

– 20 % to insiders (employees), – 20 % to a Development Fund that auctioned the shares to

investment funds, – 10 % to a National Pension Fund, – 10 % to a Restitution Fund. – 40 % for sale to insiders (employees) or outsiders (through a

public tender). • Based on the decision of how to allocate these remaining 40

percent of shares, we classify the firms in our sample as being eventually privatized to insiders (the internal method) or outsiders (the external method).

• general collective agreement regarding the wage setting

DATA AND SUMMARY STATISTICS Entire Sample Internal

Privatization External Privatization

Bypass Firm Previous Owner

No. of Workers 301 252

397

206 411

Value Added 50957

36876

78482

36408

80373

Labor Cost 38491

30058

54977

26242

56013

Profit 566

1016

-313

2406

2431

Revenue 205362

142609

328033

149627

332074

Investment 11822

6333

22553

9439

25292

Capital 140066

69441

278126

120619

268407

Alternative Wage 94.377

94.384

94.365

94.627

93.466

Profit+Labor Cost 39057

31074

54664

28649

58444

Profit / Value Added 0.111

0.027

-0.004

0.066

0.030

Labor Cost / Worker 127.47

119.00

138.47

126.86

136.26

Value Added / Worker 168.75

146.00

197.67

176.00

195.51

Profit / Worker 1.875

4.023

-0.788

11.634

5.913

Revenue / Worker 680.10

564.62

826.20

723.30

807.79

Investment / Worker 39.15

25.07

56.80

45.63

61.53

Capital / Worker 463.86

274.93

700.51

583.07

652.92

No. of Workers / Capital 0.002

0.003

0.001

0.001

0.001

Value Added / Capital 0.363

0.531

0.282

0.301

0.299

Labor Cost / Capital 0.274

0.432

0.197

0.217

0.208

Profit / Capital 0.004

0.014

-0.001

0.019

0.009

Revenue / Capital 1.466

2.053 1.179

1.240

1.237

Investment / Capital 0.084

0.091

0.081

0.078

0.094

No. of Firms 458 303 155 82 108 No. of Observations 2290 1515 775 410 540

DATA AND SUMMARY STATICTICS

• Firms privatized to insiders

– on average smaller and less capital-intensive and more profitable than firms whose residual shares sold to outsiders

• Enterprises run by CEOs with bypass firms

– on average small and relatively capital-intensive and high value added, profit and profit/value added ratio

– high rates of investment per worker but low investment per unit of capital

• Firms with previous owners

– on average larger than the other types of firms

– relatively capital intensive, positive profit, high rate of investment in relation to the size of capital as well as labor

RESULTS : Investment EquationTable 1.2: Determinants of Investment/Worker

Model: IV Lagged Levels

Variable:

OLS Lagged Levels

IV Levels

IV First Difference

πa/L 0.399a

0.602a

0.934a

0.285a

y - ya -0.383a

-0.600a

-0.995a

-0.324b

(πa/L)* External -0.319a

-0.508a

-0.734a

-0.281a

(y - ya)* External 0.516a

0.574a

0.615a

0.353c

(πa/L)* Previous 0.350a

0.560a

0.214b

0.411a

(y - ya)* Previous 0.172c

-0.346c

0.507a

-0.329

(πa/L)* Bypass -0.182a

-0.388a

-0.827a

-0.037

(y - ya)* Bypass 0.346a

0.761a

1.271a

-0.027

External Dummy -10.287

7.666

40.144a

-

Previous Dummy -19.587b

-37.868b

-80.165a

-

Bypass Dummy -12.382

-39.144b

-27.327

-

Constant -2.486

3.765

9.160

1.859

Year Dummies Yes Yes Yes Yes

Industry Dummies Yes Yes Yes No

Adjusted R-squared 0.198 0.255 0.114 0.007

No. of Observations 2290 1832 1832 1832

RESULTS: Investment Equation (continued)

Investment principally determined by availability of internal funds (i.e., supply side factors) rather than by demand side considerations (as implied by the neoclassical and accelerator models). – Coefficient on R/L is very small and insignificant

(excluded)

INTERNAL PRIVATIZATION• Availability of internal funds (credit rationing) -- important

determinant of investment in firms slated for insider privatization (positive coefficient on augmented profit) .

• Trade-off between worker compensation and the amount of investment in firms slated for insider privatization (negative coefficients on surplus labor cost per worker)

RESULTS: Investment Equation (continued)

EXTERNAL PRIVATIZATION

• Investment behavior virtually unrelated to firm’s internal funds and to the ability of workers to obtain higher wages

FIRMS WHOSE CEOs HAVE BYPASS FIRMS

• Have a weak or nonexistent link between both internal funds and investment and surplus labor cost and investment.

• Able to secure external investment funds and thus weaken or eliminate any positive link between investment and internal funds.

• These CEOs also appear to be able to resist wage increases at the expense of investment.

• Findings consistent with other types of behavior, including the view that the elite CEOs siphon off (loot) investment funds that they prevent the workers from appropriating

RESULTS: Investment Equation (continued)

PREVIOUS OWNERSHIP BY AN EXTERNAL INSTITUTION• strengthens rather than reduces the dependence of

investment on the availability of internal funds• Effect on surplus labor cost-investment relationship --

sensitive to model selection

RESULTS : Wage EquationTable 1.3: Determinants of Labor Cost/Worker

Model: Variable:

OLS Lagged Levels

IV Levels

IV Lagged Levels

IV First Difference

ya 0.475a

0.332

0.691a

-0.063

(R - H - DEPR) / L 0.676a

0.854a

0.696a

0.766a

DEPR / L 0.083

0.011

0.107

-0.141

ya . External 0.216

0.523a

0.193

1.511a

[(R - H - DEPR) / L] . External -0.334a

-0.435a

-0.312a

-0.429a

(DEPR / L) . External 0.476a

0.575a

0.471a

0.592a

ya . Previous 0.029

0.189

0.158

0.855b

[(R - H - DEPR) / L] . Previous 0.028

-0.024

0.009

-0.246a

(DEPR / L) . Previous -0.321a

-0.234a

-0.311a

-0.063

ya . Bypass 0.163

0.502a

0.251

1.085a

[(R - H - DEPR) / L] . Bypass -0.320a

-0.363a

-0.499a

-0.101

(DEPR / L) . Bypass 0.160

0.263c

0.203

0.248

External Dummy 6.802

-4.614

5.968

-

Previous Dummy 5.206

-3.542

-3.549

-

Bypass Dummy 16.483

-1.044

28.324

-

Constant -53.213a (

-0.137

8.335

2.231

Regional Dummies Yes Yes Yes No

Year Dummies Yes Yes Yes Yes

Industry Dummies Yes Yes Yes No

Adjusted R-squared 0.534 0.863 0.520 0.571

No. of Observations 2290 1832 1832 1832

RESULTS : Wage Equation (continued)

INTERNAL PRIVATIZATION• workers appropriate a significant part of their firm’s

surplus (coefficients on surplus per worker is positive)• coefficients on the alternative wage is between 0 and 1• null hypothesis of the bargaining model cannot be rejected in

almost any specification• workers appropriate part of the funds allocated by law for

depreciation investment • hypothesis that workers appropriate depreciation funds as

easily as surplus rejected => workers appropriate surplus much more readily than depreciation funds

RESULTS : Wage Equation (continued)

EXTERNAL PRIVATIZATION• wages more related to the alternative wage

• workers boost their wages by appropriating depreciation funds and by not sharing in losses

• wage setting hence driven by the available alternatives • deficiency in corporate governance manifested by workers’

– resistance to share in firm’s losses– ability to appropriate depreciation funds

RESULTS : Wage Equation (continued)

FIRMS WHOSE CEOs HAVE BYPASS FIRMS• own wage tied more to the alternative wage and less to the

surplus generated by the firm • very limited and weak evidence that workers able to

increase wages at the expense of the depreciation funds

PREVIOUS OWNERSHIP BY AN EXTERNAL INSTITUTION• coefficients on both the alternative wage and surplus per

worker are significant and in the [0, 1] interval in all specifications

• lower ability of workers to appropriate depreciation funds as wages

CONCLUSION1. FIRMS SLATED FOR INTERNAL PRIVATIZATION

– small and do not have powerful relationship with suppliers and banks.

– appropriate part of the surplus (but not depreciation funds) and do so at the expense of investment

2. FIRMS SLATED FOR EXTERNAL PRIVATIZATION– large and have strong ties to suppliers willing to provide credit

or tolerate arrears and have more assets (especially land) that can be used as collateral to obtain bank loans

– workers appropriate part of the depreciation funds but this behavior is unrelated to firms’ investment decisions

3. CEOs with bypass firms are able to resist workers’ demands for surplus sharing, while previous ownership by an external institution has the opposite effect

CONCLUSION: (continued)

• Theory and policy -- underestimated the power of elite (and highly self-interested) managers to restrain wage demands and overestimated such powers on the part of external owners

• Policy makers should assign priority to establishing a proper legal and institutional framework as they relax or lose control over firms. Insiders behave rationally and exploit legal and institutional opportunities, and appropriate part of rents