Corruption in Privatization in the Public Utility Sector and Growth in South-East Europe: Contracts and Regulations in Telecommunication



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Corruption in Privatization in the Public Utility Sector

and Growth in South-East Europe:

Contracts and Regulations in Telecommunication
By
Emi Velkova

(Harvard University, Government Department)



(March 12, 2007)

(Please do not site or quote without author’s permission)

Abstract
This article explores the doubtful impact of foreign direct investment (FDI) on growth in economies with high corruption and weak property rights systems. Corruption in the privatization of the public utility sector prevents FDI from promoting growth in South-East European (SEE) countries because of the legal provisions concerning creation of commercial contracts related to privatization.

Corruption in privatization contracts in the public utility sector, as a form of non-equal bargaining contracts, puts the state in a very weak and vulnerable position and puts into question to the beneficial effect of investment. Further, the state is obliged to pay damages resulting from such contractual agreements while at the same time those agreements distort market competition by creating monopolies and thus preventing growth.

In this paper I focus on international experience in the regulation and creation of contracts in the telecommunication sector in designing an appropriate contract and regulation model that would promote growth in South-East Europe towards their EU integration.

Introduction

In early 2000 many SEE advisers advocated fast privatization of public utility companies in South-East European (SEE) states under the assumption that privatization promotes quality and efficiency of firms, and lowers the need for government subsidies for public sector areas opened up to competition. They were influenced by the prevailing academic preference for quick privatization.1 Some authors (Blanchard, 1991)2 believed that privatization should be “urgent and must take place long before firms are restructured” Others, such as Ronald (1994),3 believed that it should be gradual and deal with political problems and potential backlash. Summers (1994) emphasized the attention to the rule of law and other institutional issues, while Newberry (1991)4 emphasized braking monopolies before privatization.5

In general, the prevailing view in SEE countries was that privatization of the public utility sector should be key to reform in order to foster growth and development. Privatization advisors and SEE experts were influenced by the ‘big push theory” for rapid industrialization for promoting development and, relying on textbooks written for developed economies, ignored the lack of adequate regulatory framework and the state of development of market institutions6 in SEE countries.

Privatization of the public utility sector did not promote the desired sustainable growth because the privatization was rapid, lacked transparency, lacked rule of law meaning well defined and enforced property rights7 and adequate participation as a result of lack of democracy. It lead to high corruption in companies privatization by concluding the contractual agreements, unfavorable for state interests and growth.

Privatization procedures in the public utility sector breed corruption in South-East European (SEE) states, because establishing the real value of a company or asset is difficult when there is no efficient stock market and no real benchmark to compute the value of monopolies or duopolies. Governments sold public utilities in the absence of independent regulatory authorities and judicial institutions that would enforce corrupt activities. So the privatization did not promote growth by fostering competition, instead it created large private monopolies.

The contracts in the public utility sector have some specific features. They are often incomplete characterized by long-tem arrangements, higher uncertainty at the negotiation stage about future consequences of present acts and the investment of the resources unique to the transaction. This implies that parties should accommodate each other’s needs during the time of performance, without any explicit arrangement.

The need for high investments in infrastructure in the public utility sector

ex. pipelines, cable landing, makes it difficult for the parties to exit from the relationship even when things go better for the one party than expected for the other.

In the case of contract breach, damages are enormous and are rarely fully compensatory on both sides because of the nature of the long term contract.

Further, the existence of developed market institutions is especially important in infrastructure utilities because the incumbent can be a significant barrier to competition.8 For example, in telecommunications it is very hard for a new entrant to succeed in the market if the incumbent does not allow interconnection. Without the proper regulatory framework and adequate institutions to enforce regulations, the privatized company has no incentive to allow competition.


I argue that corruption in the privatization of the public utility sector prevents FDI from promoting growth in SEE countries because of the legal provisions concerning creation of commercial contracts related to privatization. Corruption influences governments to conclude long-term concession contracts with the pricing method that does not allow flexibility over time. At the same time those agreements distort market competition by creating monopolies and thus preventing growth. Thus, the type of the contract and the pricing method should depend on the ability of the country to commit.

I begin my analyses with several corruption cases concerning creation of contracts in the public utility sector related to privatization. In the second part, I describe the problem of corruption, weak property rights in SEE countries, their impact on growth, investment and on contract creation. I then present comparative analyses of contracts and telecommunication regulations in an effort to devise an appropriate contract and regulation that would foster growth in SEE countries towards their European Union integration. I conclude by proposing hybrid form short –term contracts, that are complete with the pricing method that allows flexibility and adjustments over time and commissioners instead of regulators to reduce corruption opportunities.


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