Article

The Road to Privatization

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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Privatization policies are currently being pursued all over the world. There have been massive privatization programs in the United Kingdom, Japan, and other major industrial countries, as well as in smaller economies such as New Zealand. Developing economies of all sizes, from Argentina to Grenada, have privatized some major utilities, often with the help of multinational corporations.

The size and structure of the public enterprise sector vary significantly within groups of otherwise comparable industrial and developing countries. Although different types of economies have adopted various approaches to privatization, reflecting domestic traditions and political pressures, there are certain general principles and processes that come into any decision to privatize. This article reviews some of these general processes countries have to consider when embarking on the path to privatization. The case of New Zealand, a small open economy where a program of asset sales has recently been completed, is particularly instructive for other countries contemplating such a privatization program.

See also the following articles in previous issues of Finance & Development:”Lessons of Privatization in Developing Countries,” by Helen Nankani (March 1990), “The Experience with Privatization,” by Mary Shirley (September 1988), and “Is Privatization the Answer?” by Richard Hemming and AH Mansoor (September 1988).

Aspects of privatization

The term “privatization” refers to any shift in activity from the public to the private sector. This could involve merely the introduction of private capital or management expertise into a public sector activity. But more typically, it involves the transfer of ownership of public enterprises to the private sector.

As an economic policy, privatization is based on the view that private ownership and control is more efficient in terms of resource allocation than public ownership. There is a presumption that public and private enterprises have different incentive structures and hence different efficiency outcomes. The traditional academic view has been that when the public and private sectors are compared in terms of costs of producing similar outputs, the private sector outperforms the public sector. Such results, however, should be treated with caution; recently, researchers have reached contradictory conclusions from surveys of a similar body of literature. It appears that there is not necessarily a systematic relationship between private ownership and cost effectiveness of a privatized enterprise.

As a political issue, privatization is extremely divisive, because it represents a reform that necessitates a redistribution of incomes and, usually, a change in employment patterns. Privatization does not necessarily eliminate the monopoly profits, if any, enjoyed by a public enterprise, but rather creates a marketable claim to those profits that were previously nontradable. A government seeking to privatize would need to take these redistribution effects into account, particularly to ensure that those who might oppose the reform from within the firm are convinced of the need for change.

Several issues come into play in a country’s decision to privatize certain enterprises. Both industrial and developing countries that face a heavy debt burden may consider privatization a relatively quick way to reduce public debt by disposing of loss-making enterprises. In the industrial countries, privatization has been used to improve financial return and product (service) quality. Through privatization, an enterprise can gain access to private sector financing, and private owners may bring exposure to new markets. If the sale of public sector assets can be made attractive to small investors, this will broaden share ownership and may spur the development of domestic capital markets.

The process

In what situations will privatization be most successful? Issues of regulation and competition are of foremost importance. A regulatory environment must be in place to prevent privatized concerns from exploiting a monopolistic position. If the full efficiency gains that are potentially available through privatization are to be realized, it is necessary to ensure that privatized markets are “contestable.” The standard characteristics of a contestable market are that: existing firms are vulnerable to entry by other firms; all firms (actual and potential) have access to the same production methods (and hence their cost structures are identical); and entry does not involve any sunk costs, that is, costs already incurred and irreversible, so that barriers to entry are minimized. If equilibrium exists in a contestable market, the following characteristics should appear: in any market producing differentiated goods, a wide range of goods will be produced, by single-and multiproduct firms, with no economic profits associated with the production of each good; there will be no cross-subsidization; and industry costs will tend to a minimum.

Aside from contestability, the company’s relationship with the government after privatization occurs must also be considered. A clear and binding relationship between the government and the privatized corporation is critical if investors are to be able to predict with reasonable certainty how the corporation is likely to perform. In other words, the degree of government intervention on areas such as regulation, pricing, and public service must be well defined.

… there is not necessarily a systematic relationship between private ownership and cost effectiveness of a privatized enterprise.

A related aspect is how to establish arrangements that are acceptable to potential investors, but which at the same time will prevent the corporation from acting against the public interest. If markets are clearly contestable, this problem may be minimized. In smaller developing countries, the government may choose to maintain a majority ownership interest in a firm being privatized. In larger countries, the government may retain a single (largely passive) “golden” share with special voting rights that can be used in well-defined circumstances to protect the public interest.

A final consideration is the manner in which the enterprise is actually sold and the role of overseas and retail markets. At the core of many privatizations is the sale of equity or shares. A distinguishing feature of most privatizations is that the sale will often greatly exceed the size of typical private sector equity offers. Another feature is the political setting of privatization—decisions about the percentage of shares offered to domestic versus foreign buyers, the timing of the share sale, and budgetary impacts of the sale must be made on the basis of the unique characteristics of each enterprise.

Public finance considerations

Assessing the budgetary impact of privatizing a particular enterprise requires several considerations. The objectives of the privatization program will influence the type of privatization adopted, the method of implementation, and the associated policies toward deregulation and financial restructuring. These considerations will impinge on the market value of an enterprise as perceived by potential buyers.

The budgetary impact of a sale encompasses both the net change in the income flow to the government arising from privatization and the change in the net wealth position of the government. In the period when the transfer of ownership occurs, the immediate fiscal impact will reflect the proceeds received from the sale. The market perception of the value of an enterprise will be influenced by prior performance (especially if the firm already has been operated along quasi-commercial lines), prospects for improved profitability, the perceived value of the firm’s land, plant and equipment, and the perceived policy environment in which the firm will operate. Frequently, however, political or budgetary pressure cause sales to occur at below-fair-market prices.

The transactions costs of selling public assets are fairly high, even in countries where capital markets are well developed. These costs tend to be even higher in developing countries where capital markets are less so-phisticated, thus limiting the possibility of offering public assets on the domestic capital market. But fears of foreign economic dominance may cause the government to limit foreign equity holdings or the sale of public enterprises on international capital markets. In most cases the government, particularly in less developed countries, can benefit from the potential buyers, whose staffs are often much better equipped to investigate the possible worth of the asset. However, heavy costs can occur at the stage of underwriting a share issue. In many respects, the government may be in a better position to absorb the risk of underwriting than the private sector, because it does not face the cash flow constraint of a private underwriting firm.

Once the sale has occurred, the cash flow position of the government vis-â-vis the enterprise may shift for several reasons. If private enterprises are subject to taxation on their operating profits, the government would then receive some of its income from the privatized enterprise in the form of corporate tax payments. The sales price presumably reflects the discounted stream of after-tax profits following privatization. In principle, full privatization would lead to a shift in profit remittances from the government budget to the private shareholders, net of any retained earnings used for reinvestment.

After privatization, the government would in most cases be able to suspend current transfers or subsidies that had been made to the enterprise, unless the government had specific policy objectives (e.g., low utility prices, employment targets, and development priorities). Capital transfers and government net lending to the enterprise may be more difficult to terminate, especially where the government had guaranteed the original loans. Clearly, the status of government guarantees on loans received by public enterprises must be clarified at the time of privatization.

The use of the sale proceeds from a privatization program may be used either to reduce the government’s deficit by reducing its debt, or perhaps less favorably, to finance tax cuts or expenditure increases. Political pressure, however, often leads to decisions to use the proceeds for increased expenditure or tax reduction, rather than for deficit reduction.

New Zealand’s experience

New Zealand is a good case study of many of the issues mentioned above facing a small open economy embarking on a privatization program. In the mid-1980s, public sector involvement in marketable activities in New Zealand amounted to about 12 percent of GDP. Since 1984, the Government has tried to extricate itself from several commercial activities, with the objective of improving cost efficiency. Prudently, the main fiscal goal of the privatization program was to reduce the large public debt, rather than to use the proceeds for increased expenditure or tax reduction.

A first step in the process was to put the state-owned enterprises (SOEs) on a commercial basis, while still retaining government ownership—a process called “corporatization.” This was done to identify the financial position of the enterprises to facilitate improved efficiency and to make them marketable. As discussed above, and typical of an industrial country, the aim was to improve both the financial and service performance of the enterprises. And performance did improve: financial reports for 1988 showed that eight of the nine SOEs were operating profitably, although the rates of return on capital were still below those in the private sector.

In April 1987, nine large government departments were transformed into SOEs as public corporations, and by December, a formal announcement was made that these enterprises would be sold to reduce public debt. The corporations for sale were engaged in sectors such as steel, oil, insurance, airlines, hotels, computing services, forestry, banking, and telecommunications. Recognizing the diverse nature and size of these enterprises in the Government* s portfolio, the managers of the program assessed the method and timing of sales individually, while seeking to maximize economic efficiency. Creating a regulatory regime that would promote contestable markets was a clear goal of the program.

Various methods of privatization were tried, with varying degrees of success: partial as well as full sales of equity; combinations of strategic stake sales; share floats on both the domestic and international sharemarkets; full sales to single buyers and to consortia; and sales of rights, as in the case of cutting rights to state forests. Considerations as to the percentage of shares offered to domestic versus foreign buyers, as well as the timing and budgetary impacts of the sales, were the most problematic and were unique in the case of each enterprise sold.

In New Zealand… prudently, the main fiscal goal of the privatization program was to reduce the large public debt, rather than to use the proceeds for increased expenditure or tax reduction.

Several lessons emerged in the course of the enterprise sales. First, full privatization was more successful than partial privatization. Although partial privatization was politically more feasible, it raised long-term problems. The partial sale of shares in Petrocorp, New Zealand’s largest oil and gas company, illustrated some of these difficulties. For instance, it was found that private sector minority shareholders were in a good position to “capture” management and thus influence future share sales in a direction contrary to the public sector goals or interests at the time. Private interests led the business to take higher risks than the government would take on its own. Partial ownership also made it difficult to change the regulatory environment due to conflicting private and public interests.

Second, open bids for purchase of an enterprise were found to be superior to share market sales. As discussed earlier, for a small country like New Zealand, the size of public enterprises for sale often surpassed the scale of typical private market sales, and the capital market was not deep enough to absorb significant amounts of shares. In order to get the best value for the taxpayer, it was necessary to ensure that foreign bidders were attracted into the sales process. Selling an asset with an open bid also removed the pricing of individual blocks of shares from the pressure of the political process and eliminated underwriting problems for the Government.

These lessons proved instructive in the sale of New Zealand Telecom. The enterprise was sold to a consortium (including two New Zealand and two US companies) on September 12, 1990, and was by far the biggest transaction in New Zealand’s history. Despite the large size of Telecom, the Government had learned that the best method of sale was to fully privatize the enterprise and to avoid a direct share market sale. The consortium purchased 100 percent of the Telecom assets, with payments spread over six months. This deferred payment structure was devised to minimize disruption to money markets.

Under the terms of the sale, the two New Zealand partners would purchase 10 percent of the shares over three years. The two US partners would each own just under 25 percent of the shares, so jointly they would own just less than half the shares, to ensure a minority interest. The board of directors comprised a majority of New Zealanders. To avoid overwhelming markets with the Telecom shares, the remaining 40 percent of the shares would be floated in two or more tranches on the New Zealand share market, as well as in international markets when favorable market conditions prevailed.

The Telecom sale proceeded very smoothly for several reasons. First, as mentioned previously, the sale benefited from extensive research by the consortium partners on the financial worth and potential of the enterprise. Second, the existing staff within Telecom were supportive of the sale. Third, firm agreements were reached on the details of the sale prior to its announcement.

The actual sales price for Telecom was far higher than financial market expectations. Because of this windfall, the Government was tempted to use a portion of the proceeds for public capital expenditure, despite the original goal of debt reduction. Nonetheless, with this single sale, the Government was able to reduce public debt by nearly 12 percent and conclude its asset sales program begun in 1987. A total of NZ$ 9 billion (US$ 5.6 billion) in assets were sold, and public debt was reduced from 80 percent of GDP in 1987 to an estimated 53 percent in 1990.

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