2 Liberalization and Privatization: An Overview

Saíd El-Naggar
Published Date:
June 1989
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Alan Walters1

In this paper my main purpose is to examine the principles, practices, and record of the deregulation and privatization movements of the 1980s. No such survey could be comprehensive without straining the reader’s patience beyond breaking point. Consequently, I shall be selective. I shall try to choose to discuss and illustrate those issues which, I conjecture, are most instructive and applicable over a wide area. Of course, I do lean rather heavily on British experience, primarily because the United Kingdom has been, and still is, in the vanguard of this movement. (And, a not inconsiderate matter, I was directly involved in the process.) Although the U.K. economy and financial system differ very much from those of the Arab countries, the British example can be mined for many golden nuggets of advice, information, and even wisdom on the issues that arise in the Middle East. But to make the lessons more relevant, I shall discuss the experience of certain other countries, particularly Chile and on occasion Turkey, Argentina, and even Bangladesh, where the sophistication of the financial system and capital markets is perhaps more comparable to that of Arab countries.

Property Rights, Deregulation, and Privatization

The essence of deregulation and privatization is contained in a reassignment of property rights, usually from the state to the individual or family or even community. Powers that had hitherto been vested in the state are devolved to the private sector. As an example, consider the 1979 reforms in Chinese agriculture. Hitherto, the state acquired virtually all the produce of the Chinese farmers at prices that were determined unilaterally by government. From 1979 onward, the farmers were allowed to dispose of rather more than 60 percent of their output at any price they could negotiate in the free market. This reform represents a transfer of the rights to the disposal or sale of the fruits of the farmer’s labor from the state to the individual peasant.

The example of Chinese agriculture is interesting. Of course the prime fascination is the massive scale of the undertaking—surely the biggest deregulation or privatization in history—and the great success of the outcome. By 1984/85 the output had increased approximately 80 percent, and China was transformed from being always near the precipice of famine to being on average a food exporter. The effects on world history of this great transformation must be enormous, but we must leave that task for future historians to disentangle. What I am mainly concerned to illustrate is the limited form of the transfer of property rights, by Western standards. The Chinese farmer is not allowed to sell or lease his land and property to others, nor can he freely hire labor to till that land, nor can he borrow to finance investment, and so on. Yet this severely constrained privatization, although by Western standards a small, hesitant step, is a massive “leap forward” in the environment of China.2

I suspect that, since it involved the abolition of a compulsory marketing system, most people would be inclined to call the Chinese agriculture reform a case of deregulation. And since it did not involve any payment by the farmer for this new property right, it seems that most economists would not countenance this as a “privatization.” Yet the fundamental economic logic is the same. The transfer of property rights is the issue, and whether they are “paid for” or not is relevant only in the sense that the distribution of income and wealth is affected; the essence is that the change in property rights transforms and creates new incentives.3

The Macroeconomic Rationale for Privatization

Let me first make a categorical claim: for privatization to be a good policy in economic terms, the necessary condition is that it result in a marked improvement in efficiency of the enterprise(s). This efficiency criterion is, in my view, quite dominant in the economic analysis of privatization and deregulation. Of course there may be good political, social, or administrative reasons for privatization, and I shall touch on some of them later. But the economic case can only be made in terms of the efficiency concerns.

This efficiency criterion enables us to deal with one of the claims frequently made, by both promoters and opponents of privatization, namely, that privatization will help reduce the borrowing requirement of the public sector, and so help to control aggregate demand and inflation. The first point to note, however, is that the borrowing requirement will be reduced only if the asset is sold with a net positive price. In many privatizations in developing countries the assets are given away (see footnote 3) or, sometimes, it actually costs the government money (in terms of restructuring balance sheets) to dispose of them.

But even if the sale of the state-owned enterprise (SOE) to the private sector does raise considerable cash and actually reduces the borrowing requirement, the disposal is unlikely to have any substantial effect on the pressure of demand and on the rate of inflation except insofar as privatization results in substantial gains in efficiency. Under these conditions, imagine that the government sells the SOE for $100 million, so reducing its borrowing requirement by that amount; but then the capital markets would acquire the new equity and reduce their net acquisition of government bonds and bills. Government debt is reduced and the future interest payments will also be diminished; but if, as assumed, the SOE was profitable, the expected future stream of revenues from the erstwhile SOE will disappear and so balance the reduction in the future interest liabilities. In its simplest terms, with no efficiency gain, privatization means merely a transfer, with no net effects on wealth, inflation, or real output.

This explanation is, of course, too simple, but it does emphasize a fundamental truth. In general one should not look to privatization to solve problems of government finance. Privatization is no substitute for reducing public expenditure or for increasing tax revenue or for reducing the monetary expansion of the central bank. I emphasize this point largely because many people appear to believe that privatization is a way of reducing public spending. In the United States, for example, some of the reduction in spending under the Gramm-Rudman-Hollings process is achieved by disposing of federally owned assets. Such measures are accounting delusions and should be abjured.4

Up to this point, I have assumed that there is no change in efficiency as a consequence of privatization. I do not think it is unrealistic to suppose that on average efficiency will roughly double—so that costs will be halved. (I will present evidence on this later.) What are the macroeconomic consequences then? If the same quantities of resources are employed in the newly privatized corporation, then output will double. If aggregate demand remains the same (and with the same monetary conditions there is no reason for it to change), the increase in the flow of output will give rise to some downward pressure on prices. In other words, the efficiency increase does help to contain inflationary pressures during the years that the rewards of privatization are reaped. This may extend for many decades if, in addition to the once-and-for-all structural changes caused by privatization, the rate of growth of productivity is permanently raised.5 However, one should not look to such fiscal improvements as a significant factor in fighting inflation or budgetary excesses. Even in the most propitious circumstances, the program of privatization is unlikely to be sufficiently productive to have a really large effect on the macroeconomic variables, and the effects of privatization, however beneficial, are likely to be swamped by other effects. China is again an illuminating case. One may conjecture that, since agriculture comprised about 30 percent of gross national product (GNP), the improvements there would have a dominating effect in containing inflation and solving the macro problems. In fact, China has developed a massive macroeconomic imbalance in the 1980s, in spite of the agricultural gains, and is now trying to contain a persistent (and, at least since the 1940s, new) inflationary pressure. The real output gains were subsumed in the macro maelstrom.

Privatization and the Strategy of Reform (Perestroika)

I will be forgiven, I trust, for remarking on the attitude of the various Thatcher Governments to macroeconomic reform and the role of privatization. The grand strategy was first to reduce the borrowing requirement of the public sector (in a so-called medium-term financial strategy) and the rate of growth of the money supply well before the privatization program really got going. Indeed the whole ethos of the time was that, first and foremost, the task was to achieve stabilization in the financial markets and reduce permanently the underlying rate of inflation.

I am not contending that privatization and deregulation are possible only under conditions of financial stability. Obviously, since there are many examples of modest privatization programs in inflationary environments, this is clearly not the case.6 But inflation does make privatization more difficult—partly because inflation is often associated with financial distress—large numbers of corporations (including financial institutions) insolvent, and a pressing shortage of liquidity. In practice such distress often results in the nationalization or de-privatization of many firms, as the government injects cash into insolvent firms to avoid unemployment or (in the case of banks) financial collapse. Even the Thatcher Government was induced to prop up (that is to say, buy the equity of) British Leyland to prevent its imminent bankruptcy.7

Although this evil effect of inflation (that is, the tendency to promote yet greater involvement of the public sector in industry) is important, of much more consequence is the inflationary debilitation of capital markets. With all the uncertainties and fears that inflation engenders, long- and even medium-term markets simply disappear, and real interest rates rise to levels that preclude many, perhaps most, normally profitable enterprises. Such circumstances do not entirely rule out privatization, but they do mean that the issue or sale price will have to be “low” and that there is likely to be a dearth of what the authorities would regard as suitable buyers. In some cases (Chile and Brazil) the government has felt it necessary to lend virtually all the money required at preferential rates in order to finance a sale. Obviously a climate of financial stability is much more propitious for a successful privatization.

In the United Kingdom, the main reason for the primacy of the goal of financial stability, however, was the need for the Government to demonstrate its credibility. Only when people substantially believed in the coherence and feasibility of the policy and the Government’s determination to implement it was it possible to make important progress in privatization, or indeed in the other elements of the “supply-side” reforms.

Privatization and Efficiency

Apart from political and social (that is, noneconomic) desiderata, the main case for privatization has to be on the grounds of efficiency and all that such an omnibus term implies. This may mean

  • an increase in output from existing inputs;
  • a reduction in inputs required to produce existing outputs; or
  • an improvement in quality of output, including reduced waiting lists, or some combination of all three.

The evidence on the relative efficiencies of private and public ownership is contained in a massive, sprawling literature.8 Here I can only summarize and illustrate. The main forms of evidence are

  • before-and-after privatization (or nationalization studies of particular industries);
  • cross-section comparisons of private and public corporations in the same business; and
  • studies of management and techniques.

Typical examples of the time-series approach are the studies of firms such as Jaguar Cars. As is well known, productivity has increased more than 80 percent without taking account of the quality improvements, whereas if the quality change is taken into account, the increase in productivity is probably closer to 150 percent when compared with its performance in 1979 (well before privatization was thought feasible, but a boom year). The increase in productivity was reflected both in a rise in real wages and in profits (and investment plans, etc.). One of the problems with this sort of comparison is that instead of a before-and-after comparison, what we really need is a with-and-without contrast. The question raised is “what would have happened if …?” But the effect on the performance of enterprises that are about to be privatized is even more important. As divestiture-day (D-day) approaches, in all cases I have seen, there are dramatic improvements in performance as the participants realize that they will have to measure up to the practices in the private sector. One remarkable example is the British steel industry. From 1980/81 to 1986/87, productivity (metric tons per manhour) increased fivefold to match the best in Europe. And after running an accumulated loss of more than £7 billion, the company is expected to make £400–500 million profit this year (1987/88). So it is to be offered to the public in a privatization late in 1988.9 This phenomenon, so typified in the story of British Steel, has led some observers to the view that one need not privatize, but merely run a threat of divestiture, to realize the efficiency gains of privatization.10 One need not go through with the deed. There is, perhaps, no need for me to point out the fallacy of such a position.

Cross-section studies comparing firms in public ownership with those in the private sector in the same industry have generally confirmed the results of the before-and-after studies. Yet I think cross-section results are more persuasive because they compare performance in exactly the same environment of economic conditions, regulation, distortions, etc. An illuminating example is the study of publicly owned and privately owned bus concerns.11 Around the world several cities have, for a variety of reasons, both publicly owned and privately owned buses operating on similar routes. An analysis of their cost, fares, and revenues showed that private buses operated at about half the cost, on average, of the publicly owned buses. Subsequent analysis of the United Kingdom tended to confirm these results (although the authors were more cautious in claiming only a reduction of about one third in costs). Similar studies have been carried out for manufacturing industries, particularly textiles, with somewhat similar results. These cross-section analyses are limited, however, by the rather rare availability of situations in which both private and public firms produce side by side. Nevertheless the general result—that private costs are substantially below public costs—seems to be ubiquitous. Indeed I have yet to see a counter example.

Management studies are rather rare, and this is much to be regretted. In all privatizations the main changes appear to be in management. This may, and often does, mean a change of management, and as we shall see, this is best carried out well before the privatization is accomplished. But there may be no change of management (as in the case of management buyouts). (Perhaps the most dramatic example of privatization with no change in management is the National Freight Corporation in the United Kingdom; the story is told in Annex B.) The essential feature, however, is the change in the incentives of management, which is often but not always associated with a dramatic change in the structure and form of management responsibilities. I shall return to this subject below.

Priorities in Privatization

These studies of privatization have had an important by-product. They indicate where the greatest gains are to be made in transferring industries from the public to the private sector.12 First, the gains will be the more impressive, the greater the degree of competition introduced by the privatization. There are many subtleties here that we must perforce skim over. One, however, deserves attention. It may be claimed that the United Kingdom SOEs face considerable competition in their product markets. For example, the nationalized car firms of Western Europe (British Leyland and Renault in France) face fierce competition from domestic competitors but above all from imports and in exports to third markets. How can privatization help produce greater efficiency? The answer lies in the fact that such nationalized concerns do not face what Janos Kornai has called the “hard budget constraint.”13 They know that while the state underwrites their balance sheets, they can incur costs and tolerate practices that private sector competitors cannot afford. In Kornai’s useful terminology, the nationalized concerns have a “soft budget constraint,” and consequently miss that urgency for change and efficiency that is characteristic of the competitive private sector. Again, an interesting example from the motor industry is the Jaguar concern. There is no doubt that the privatization (and before that the prospect of privatization) achieved its wonders through the new appreciation that they were on their own with a hard budget constraint.

Another priority for privatization is a situation where there is, either currently or in prospect, considerable technological change. The record of the public sector in industries that have been subject to sharp changes in technology has been either indifferent or notoriously bad. The information technology and microbiotic industries, for example, are ill suited to public ownership. Similarly powerful arguments exist for privatizing telecommunications and all the associated subindustries.

Finally, priority should be accorded to privatizations that break up monopolies, and particularly where the monopolies are in the public sector. In some cases privatization is essential, at least in political terms, in eroding the power of monopoly trade unions in the public sector. In many developing countries such unions, particularly in the sensitive public utilities, have accumulated enormous power, which is exercised primarily through overmanning rules, occasionally through high wages and benefits, and through all sorts of restrictive practices. Similarly, when the monopoly is in the product market, privatization is likely to be a necessary, if not sufficient, condition for efficiency. (Normally one would need to reduce regulations and trade barriers as well.)

These considerations enable us to specify a sequential policy of reform. Before the actual process of privatization, it is best to reduce regulations and allow free entry into the industry. Many SOEs are protected from domestic competition by restraints on entry into the industry. (Such restraints may take all sorts of forms, although, apart from legal prohibitions and regulatory restrictions, the main ones are credit rationing and labor restrictions.) Then a phased reduction in trade protection should take place—first by replacing quotas with tariffs and then by reducing the tariffs as the concerns are privatized.

Enterprises, Utilities, and the Regulatory Problem

With any privatization program it is easy to see the concerns that should obviously be in the private sector. To take an absurd example, during the course of its acquisitions the Government of the United Kingdom became the owner of several public houses or pubs. The (Labour) Government had argued that the nationalization program was meant to enable the state to occupy the “commanding heights” of the economy, the better to manage full employment, growth, welfare, etc. The pubs were clearly not on the commanding heights—more like the lower vaults—of the economy. The state, often in periods of financial distress or sometimes in association with a major acquisition, nationalizes concerns which, given the ideological position of the government, do not belong in the public sector. In general, firms in the manufacturing and distribution industries—which, if not protected, are normally highly competitive—should be considered prime cases for privatization. If launched into competitive markets, special regulation or protection is not needed; they should be treated as ordinary members of the competitive private sector, subject to the normal oversight to prevent monopoly and restrictive practices.

With the privatization of utilities, however, one cannot be so cavalier. Although much of the utility may be launched into a competitive environment, virtually all utilities have sectors where there is a natural monopoly. In telecommunications, for example, there is a natural monopoly in the link from the telephone to the first switching station—which implies that there is a monopoly in local calls but not in the long-distance component of communications. For most utilities, the local distribution system has some of the characteristics of a natural monopoly. (It is worth noting, however, that what appears to be a natural monopoly may well be subject to considerable growth in competition as time goes by, unless that competition is prohibited by government. For example, the local telephone connection is being challenged by cable and television, by VHF radio, and by citizens band connections.)

With all state monopolies some regulatory arrangements decide pricing levels, availability, and conditions of supply. Usually the regulatory system is internalized in a department and is rarely explicit. Often there is considerable political influence exercised not only over broad policy issues but also in the detailed management of the utilities. It is possible, but hardly likely, that government may decide that privatization can take place without any explicit regulatory system to replace the existing arrangements. With sufficient contestability of the utilities’ “monopoly,” this may well be the best arrangement. But it is more likely that there will be a case for containing the exercise of privatized monopoly power so that customers are not “gouged” with high prices and poor service.14

So the regulatory system will be a critical element in the process of disposal. When the issue takes place the public should be informed of the nature of the regulatory process and how it is to be implemented. This disclosure in the tender document acts as a sort of contract between the government and the purchaser of the equity. Incidentally, it ensures that the regulatory system is then stable, explicit, and open, rather than erratic and politicized.

Although this is clearly not the place to discuss the many ramifications of alternative regulatory systems, it is useful to summarize the two broad options:

  • (a) Government can regulate to ensure that the utilities do not earn unduly large profits. This is the system practiced widely in the United States—and we may call it the American maximum rate of return regulatory system. This system is similar to those in continental Europe where the basic approach is to ensure that prices are based on cost.
  • (b) Government can impose a ceiling on prices of the products in the sector where there is monopoly power. This method is commonly practiced in the privatized utilities in the United Kingdom; it allows the firms to increase prices: for example, in British Telecom by the percentage increase in the retail price index minus 3 percent over quinquennial periods. We might call it the British maximum price increase regulatory system.

The main problem with the maximum rate of return system has been well argued and documented. It gives incentives to waste and has, in fact, delivered considerable overcapacity and inefficiency. System (b) is relatively new and was only introduced in the British Telecom privatization, so we have less basis on which to judge its efficacy. It is clearly designed to avoid the wastes inherent in the (a) system, since the management will have incentives to cut costs and not to overinvest. A preliminary judgment is that system (b) has achieved much of its promise. Indeed the U.S. Federal Communications Commission has suggested that the United States switch over to a(b) form of regulation precisely because of the manifest advantages of incentives that promote efficiency rather than waste.15

As always, there remains the vexed question of control exercised in the interests of “national security” or perhaps just the “national interest.” Such arguments are sometimes cover for special interests, but, particularly with critical utilities, there are good cases for some government control to prevent takeovers or indeed some undesirable developments in share ownership patterns or in policies of the company. In the United Kingdom we devised the “golden share,” which the Government holds, and which, according to the articles, can block certain types of decision—particularly those related to takeovers. Since this is the Gulf, it seems relevant to talk about a recent case. It occurred this year when the U.K. Government blocked a substantial increase in a foreign government interest in British Petroleum (BP). The Government of Kuwait was in 1987 and 1988 gradually acquiring a substantial stake in BP, and by the time the U.K. Government was alerted, Kuwait had acquired 22 percent (which it still held in June 1988). There is no objection per se to foreign ownership of assets in the corporations of the United Kingdom, provided there is no chance of increases in monopoly power and restrictions of output and increases in price associated with the exercise of that power. But Kuwait’s acquisition of any degree of control would have significantly affected the U.K. free market competitive oil industry. Clearly the Kuwait Government, as a member of the Organization of the Petroleum Exporting Countries (OPEC), could then extend the control of OPEC over a considerable part of the U.K. oil industry. The United Kingdom never objects to foreign money buying British assets providing that competition (and modest national security interests) are secured.16 The U.K. Government rightly did not want to turn over the privatized BP to a foreign, or indeed any domestic, controlled cartel. (As of June 1988, the matter was sub judice.)

Preparation for Selling an SOE

There are certain aspects of selling an SOE which I will not discuss in this paper. But what I want to cover are the parts of the process that are often neglected and which, in my experience, are essential for success. First, there is the preparation of an SOE for privatization. This may involve many steps of considerable magnitude and difficulty. Some SOEs are structured as self-standing public corporations but many are not. Often the first stage in the preparation is—as the New Zealand Government calls it—corporatization. An important illustration is the telecommunications authorities which, in most developing countries, have been a part of a government department (usually the Post Office).

Telecommunications either in post offices or other government departments have had an administrative structure similar to any other entity in the civil service. The lines of responsibility were largely functional—for example, the engineering staff would be organized in a strictly professional hierarchy with chains of responsibility stretching upward from the linesman engineer to the chief engineer. In Annex A will be found a description of the British telecommunications management before it was reorganized for privatization. What is suitable for a government department administering a government program, however, is clearly quite unsuitable for a dynamic business in a high-technology market with rapid changes in competitive conditions and technology. It needed a structure that would enable it to be positively managed rather than passively administered. It needed all the freedoms that are normally associated with private business, rather than the bureaucratic rules and restrictions so common in government agencies.

It is most important to achieve most of these management changes while the enterprise is still in the public sector. This will then enable the SOE to be sold to the private sector as a concern that, with only relatively small structural changes, can make its way into the competitive market. The legal, labor, and administrative problems of the reform will then be behind it when the issue is made. To achieve this transformation, it is of the utmost importance to appoint a suitable chief executive officer of the SOE, at least a year or two before the prospective date of privatization, who has the ability, drive, and incentive to carry through the reforms and launch the SOE on the market. It is only a modest exaggeration to claim that the success of a privatization is largely determined by the quality of the management (and in particular the chief executive officer) that was in charge for the years covering the date of privatization. For example, I would claim that the great successes of Jaguar and Cable and Wireless are very largely due to Sir John Egan and Sir Eric Sharp, respectively. They became chief executive officers of their SOEs with the clear intention, fully backed by the Government, of taking them into the private sector and of remaining in command of the corporation that they had reshaped and prepared for the more rewarding and exciting life as they shed the constraints and supervision imposed by Treasury and other departments of state. The liberated management could make its own investment decisions and its own judgment about acquisitions, strategy, management structure, and plans.

As I remarked above, the essential condition is to change the incentives of management—the appropriate structure will then follow. I have emphasized the need to change the structure of responsibility and management before the date of divestiture. Indeed, one can see that it is only then that the private investor can make an assessment of the prospects of the enterprise in the private sector. But, as always with propositions on privatization, there are exceptions. Indeed, management and worker buy-outs are the odd men out. Then all that is required is the change in incentives, and they can sort out the management issue. One need not be concerned about the investors’ knowledge of the enterprise! An outstanding example of a management-worker buy-out is the National Freight Corporation; there, neither management nor workers changed very much, but incentives certainly were transformed with “miracle” results. (See Annex B for a brief account.)

Capital Market Constraint

There are many ways of transferring the ownership of an SOE.17 But there are also severe constraints, especially in countries where there is only a vestigial capital market and the financial markets are fairly thin. Finding buyers of SOEs is much more difficult in, say, Ghana than in the United Kingdom. Although the Arab countries do not have any broad sophisticated capital and financial markets like the Western countries or indeed like those growing financial centers in the Pacific Basin (such as Hong Kong and Singapore), some financial centers have developed. Until 1975 Beirut was an important banking and financial center, and its place has been taken by Kuwait and Bahrain.18 The rapidity of financial transactions now makes the Middle East particularly attractive as an intermediate time zone between London and the Far East, and one would expect there to be considerable opportunities for international intermediation. All these financial contacts and institutions would tend to foster capital markets granted a suitable governmental environment. With appropriate government supervision and encouragement, one can therefore expect that Kuwait and Bahrain will develop further as the most important regional capital markets. By Western standards, however, they will remain thin and underdeveloped for many years to come.

It is often asserted that no substantial privatization can take place without thriving and thick capital markets. Although there is no doubt that a capital market makes privatization much easier, administratively and politically, it is not a necessary condition. The most striking counter example is that of Chile. The Chilean capital and financial markets had been shattered first by the great inflation and dislocations of the early 1970s and second by the financial distress occasioned by the solvency crisis of 1982–83. Yet the Government has carried out the most extensive and successful privatization policy—almost comparable to that of the United Kingdom—and it proposes to continue with an ambitious program.

The success of the Chilean policy was undoubtedly helped by the fairly rapid development of capital markets, especially in the period after 1985.19 The growth of capital markets was much assisted by (a) the reduction in the deficit of the public sector so there was little crowding out; (b) the reduction in inflation to levels which, by Latin American standards, are low (and stable); (c) the development of debt-equity swaps to reduce external indebtedness and encourage foreign participation in acquiring Chilean equity;20 and (d) the privatization of the employee social security system. Perhaps the most interesting feature is the last—the conversion of a bankrupt state social security system into a number of privately managed and competitive funds. These funds are allowed to acquire the equity of an approved list of Chilean corporations and are likely to contribute very important and stable growth to the development of the markets.

I must emphasize that one should not regard the Chilean experience as a model for ready-made application to other developing countries. The indebtedness and financial distress were undoubted elements that drove the authorities toward the development of a capital market. But it remains a most instructive example of the rapid growth of such markets when the ambience becomes even moderately favorable.

Finally, I would stress that capital markets are much more adaptable and more resilient than even the most experienced investment and merchant bankers think. The British Telecom float was the biggest issue in history on any market. The experts were alarmed that the market “could not absorb” such a large issue. Steps were taken first to sell only 51 percent of the stock and, second, to string out payments (through the “partly paid” form) over a considerable period. In the event, the experts fears were quite unjustified. Indeed, the market digested the stock without a murmur, and later an even larger issue—British Gas—was easily absorbed with no detectable effect on the structure of prices and yields. The lesson is that the “experts” are not very reliable guides when they project their expertise far beyond their limited experience.

Methods of Sale

I now turn, very briefly, to consider the problem of the marketing of the equity (or quasi-equity and subordinated debt) of SOEs. First, one must note a burden borne by all those who dispose of government-owned assets: privatizers will always be accused of “giving away” the assets at prices well below their real value. I can think of no single exception to this rule (except perhaps the BP shares that the U.K. Government disposed of last October!). Claims of massive giveaways have been made in the United Kingdom, France, Chile, and many other countries with more modest records of privatization. One need not spend time wondering why there are no accusations of selling at prices above the real value; no one in his right mind would make such a purchase. So the only deviation from real value must be negative. It is a sure bet.

The natural way to ensure that the issue fetches the highest price is to auction the shares. This has been practiced in several of the British issues and has been used rather more rarely in other countries. The main disadvantage of the auction system is that it is virtually certain to exclude the small investor, and in particular it will inhibit the workers of the SOE from participating in ownership. In auctions, the purchasers are usually the institutions with their professional portfolio managers competing with one another. In most privatization movements, however, it is the authorities desire to use the process to spread ownership, and in particular to get worker participation.

The opposite of an auction is a fixed-price issue. Experience shows that the small investor will much more readily bid for an “allocation” of shares at a fixed price. But of course the problem is to estimate the level of price at which all the shares can be sold. The temptation is that—to ensure the success of the issue—the valuation will err on the downside. This is the characteristic feature of all new issues, whether made by established private corporations or by the governmental privatization process.

By much trial and many an error, the United Kingdom was able to evolve an issue system that can be fairly represented as getting the best out of both methods. It takes the form of a mixed fixed-price and auction method. First, a fraction of the shares are offered in “allocations” to employees and small investors on a fixed-price basis. The price is deliberately chosen to be attractive, since one of the main objectives of government is to foster a popular capitalism—or, in Mrs. Thatcher’s memorable phrase, “to give industry back to the people.” One of the dangers is that small savers will bid for the shares and then immediately sell them at a profit as soon as the market opens. To induce people to hold on to shares, it was arranged that after so many years (usually five) the original owner, if still the owner of the shares, would be entitled gratis to a bonus issue (of say one in ten). This is a sort of loyalty bonus and was used with considerable success in the British Telecom and British Gas issues. Some measure of the success is to be found in the fact that ownership of shares increased from 2.7 million to more than 9 million over the period 1980–86. (And, if I may anticipate an obvious question, there has been no sign of any diminution since October 19, 1987.) Second, the remaining shares were auctioned to the large shareholders, mainly the institutions, with no limit on ownership (except for some restrictions on foreign holdings). In all cases the auction price considerably exceeded the fixed price paid by small shareholders.

Virtually everyone has argued that this is a giveaway, a bribe to the electorate, the union members, and the petty capitalists. But, on the contrary, I believe that the Government was engaged in a most sophisticated process of maximizing the proceeds of the sale. Let me put the argument. One of the major inhibitions in buying privatization issues is the fear that a future government may nationalize the concern without adequate compensation. (Until very recently this was a normal threat of the opposition Labour party.) But if a substantial number of shares are held by small shareholders, and particularly the workers and trade union members, it is much less likely that there will be any threat of expropriation. Thus, piggybacking on the workers, etc., the large holders will be much more sure of the continuation of the firm in the private sector, and so will be induced to bid a considerably higher price in the auction for the residual issue. It is easy to see that there is a nice trade-off between the giveaways to the workers and the true value of the shares, so that, by a suitable choice, the government may well claim that it is certainly getting more revenue by this two-stage process than if it sold all the shares in one grand auction. But not only does the two-stage process maximize the proceeds for the treasury, it also helps create the “property owning democracy” that has been such a source of stability in Western society, and, of course, shareholders are unlikely material for socialist revolutions.21

Some Political Implications

Had I written this paper in May, instead of June 1988, I would have claimed that privatization has been a great success politically in all the countries in which it has been steadfastly pursued. It has been a factor in the re-elections (a record) of Mrs. Thatcher, and in the Lange Government of New Zealand, and, so far as one can detect, it has been politically popular even in the authoritarian regime in Chile. Even the modest programs of privatization in Spain and Turkey, for example, appear to have struck a popular political chord. But now we have an exception—albeit an equivalent exception—in France. The Chirac Government pursued a brave program of deregulation and privatization; but M. Chirac was rejected by the voters in favor of the more ambiguous M. Mitterand. Certainly the French vote was not for the 1981–83 policies of M. Mitterand, but more for the pragmatic liberalizations pursued in the period, ending with the “cohabitation” with M. Chirac. I doubt if there will be any move back toward renationalization in France, and I suspect that liberalization and privatization will proceed, if at a somewhat reduced pace. (Recently France has embraced the European Community program of liberalizing capital markets by 1990, so the signs are promising.)

In the United Kingdom the deregulation and privatization movements have had profound political effects. Perhaps the major effect was associated with the privatization of housing. Approximately 38 percent of housing was owned by the state and local governments, and was rented to tenants at rents that were below, sometimes substantially below, what they would command on the market. From 1981, Mrs. Thatcher gave the tenants the right to buy their dwellings at a discount below what the house would fetch on the free market. Approximately a million houses have been sold to the people who live in them. This massive expansion in owner-occupiers has undoubtedly changed the political landscape, and has given a very different set of incentives to the electorate. But the most important consequence is ironical. The Labour party in the 1970s and up to 1983/84 bitterly opposed the selling of these state-owned houses, and indeed it threatened to renationalize on varieties of unfavorable terms. The political popularity of the privatization, however, was so overwhelming that the Labour party first said it would not renationalize; and by the election of 1987, the party formally embraced the principle of giving the tenants the right to buy their houses. Indeed, through a 180-degree turn, the Labour party embraced the Government’s policy.

Similar changes have taken place in the general attitude of the parties to privatization and indeed economic policy generally. The agenda has moved and is still moving. I believe that this is broadly the case, if less dramatic, in most countries. If I am correct, this is a major turning point in history.

Table 1.United Kingdom: Privatization of Major Public Enterprises, February 1981–January 1987
Date1EnterpriseProceeds (millions of pounds sterling)
February 1981British Aerospace43
October 1981Cable and Wireless181
November 19832Britoil627
December 1983Cable and Wireless263
June 1984Enterprise Oil382
July 1984Jaguar Cars297
November 19843British Telecom4,090
May 1985British Aerospace346
August 1985Britoil426
December 1985Cable and Wireless571
December 19864British Gas1,796
January 19875British Airways415
Source: Richard Hemming and Ali M. Mansoor, Privatization and Public Enterprises, Occasional Paper No. 56 (Washington: International Monetary Fund, January 1988), p. 7.

Dates shown indicate initial offering.

Of which £334 million in 1982/83 and £293 million in 1983/84.

Of which £1,352 million in 1984/85, £1,246 million in 1985/86, and £1,084 million in 1986/87. Also included is £408 million generated by the sale of British Telecom stock and preference shares.

Total estimated proceeds are £5,090 million, with the second installment having been due in June 1987 and the third in April 1988. In addition, £750 million of British Gas debt was redeemed in May 1987.

Total estimated proceeds are £825 million, with the second installment paid in August 1987.

Source: Richard Hemming and Ali M. Mansoor, Privatization and Public Enterprises, Occasional Paper No. 56 (Washington: International Monetary Fund, January 1988), p. 7.

Dates shown indicate initial offering.

Of which £334 million in 1982/83 and £293 million in 1983/84.

Of which £1,352 million in 1984/85, £1,246 million in 1985/86, and £1,084 million in 1986/87. Also included is £408 million generated by the sale of British Telecom stock and preference shares.

Total estimated proceeds are £5,090 million, with the second installment having been due in June 1987 and the third in April 1988. In addition, £750 million of British Gas debt was redeemed in May 1987.

Total estimated proceeds are £825 million, with the second installment paid in August 1987.

Annex A British Telecom

The British Telecom (BT) sale was not only the largest ever (until British Gas) and the most successful public flotation in the world, it also has led to a revolution in the development of telecommunications in Britain. In addition to opening the market to increased competition, there is now an explicit regulatory environment in the form of a licensing system with the powers of the Director General’s Office of Telecommunications (OFTEL), the Monopolies and Mergers Commission, and the courts to police it.

But perhaps the most interesting changes are in the management structure and attitudes of BT itself. As Sir George Jefferson describes it (in the 1985 Quilter Goodison lecture), before privatization BT was an administration, a branch of government, rather than a business. Its staff were effectively district commissioners administering a government-controlled service through a board consisting principally of part-timers who tried to take detailed decisions on most issues centrally. By 1980, despite a turnover of about $8 billion, it had only one profit center. The accounts, which had been qualified for years, were of the simple civil service cash-book variety. The Government wished to break up the nationalized concern into regional companies before disposition. It was strongly argued, however, that to sort out the accounting complexities of any such division would delay the privatization for at least two years. This sounds like an excuse—but, alas, there was ample evidence that it was true.

Staffing arrangements were typically of the civil service form—owing more to hierarchy and ease of negotiations. It is quite remarkable that one trade union covered all workers in the nationalized concern right up to board level. Departmental compartmentalization with vertical hierarchies emphasized that the organization was meant to serve internal interests rather than the customer. The commercial development of the business was centered on engineering concepts rather than market and commercial needs. The customers, although they frequently called BT to complain, did not call the tune. In fact, it was rather difficult for any new subscribers to call anyone, since they normally could not get the standard telephone on demand and had to join a waiting list usually for a shared party line.

Much has changed. The old vertical hierarchies are being broken down. Instead of the civil service procedure of “passing the buck,” managers are now being encouraged to manage. Promotions and appointments now depend more on suitability and success rather than on seniority and status. There is, however, no wholesale change of personnel. On the contrary, as Sir George Jefferson emphasized, the existing personnel were as good as one could obtain in private business. State ownership had shackled them and never allowed them to develop more than a small fraction of their potential. In sum, the “culture” of BT has changed.

One would expect that these changes would be reflected gradually in the profits of BT and, owing to competition, in the prices and growth of privatization as BT began to adapt to the new environment. So they did. And this has continued with an increase of 22 percent in profits for 1985/86 compared with 1984/85. OFTEL reported in November 1986 that BT’s prices have fallen 89.5 percent over the last three years, and that unit costs had fallen by 5 percent a year in the last two years. A massive investment program (costing about $3 billion a year) is under way, spreading digital technology and optical fibers throughout the system.

Annex B National Freight Corporation

The National Freight Corporation (NFC), a trucking firm with storage and travel businesses, was launched into the private sector in February 1982. The state-owned company had made losses year in and year out, and the Government found it very difficult to find anyone interested in paying anything for such a moribund group. The management and workers, however, perceived their opportunity. After securing some institutional backing in the City (at present 17 percent of the shares are owned by institutions), they proposed a management-worker buyout, for a sum of £6.5 million (or about $10 million). In 1987, at the company meeting, the value of the company was put at 35 times that amount, namely, £240 million ($370 million). The original shares, for which the employee or manager paid £1, were in 1987 worth in excess of £70.

It is not hard to envisage the change in attitudes that privatization engendered. Now NFC is engaged in a massive investment program that envisages considerable expansion both at home and overseas.

1The World Bank does not accept responsibility for the views expressed herein, which are those of the author and should not be attributed to the World Bank or its affiliated organizations.
2In the Eastern bloc, some countries (notably Hungary and Poland) have made some progress in the privatization of their economies, and particularly in agriculture. See Tamas Bauer, “Economic Reforms Within and Beyond the State Sector,” American Economic Review, Papers and Proceedings (Nashville, Tennessee), Vol. 78 (May 1988), pp. 452–56.
3The idea that privatization involves rights for which a payment is extracted is common but most misleading. Many of the privatizations in Chile during the first stages (1975) took the form of disposing of firms, often back to their original owners, at zero prices. Similarly the Canadian province of British Columbia disposed of its holdings of state-owned corporations by issuing shares gratis to all the residents. We may regard the payment issue as entirely a secondary matter in terms of fundamentals; but, as we shall see, it is of considerable importance as far as fairness and equity issues are concerned. It also has implications for the development of capital markets.
4Some commentators, particularly academics, claim that the disposal process is a major conjuring trick in the macroeconomic policy of the United Kingdom. For all I know, some people may well have been fooled, but since I was intimately involved in policy formulation from 1980 to 1984, I can certainly testify that neither I nor my close associates were under any such illusions.
5Here I should record that I do not entirely share the views put forward by Richard Hemming and Ali M. Mansoor in their Privatization and Public Enterprises, Occasional Paper No. 56 (Washington: International Monetary Fund, January 1988). They say, “When efficiency gains are judged to be feasible only under private ownership, government and public sector finances will benefit to the extent that the government can share in these gains by setting asset prices to reflect at least part of the improvement in performance and by taxing the higher profits that result. Indeed, in budgetary terms, this should be the whole point of the privatization exercise.” (p. 18). Apart from the omission of proceeds from the value-added tax on the new output, the argument does not take into account the fact that the newly expanded stream of output will, with unchanged monetary and fiscal stance, reduce the rate of inflation and so have an effect on the desired fiscal/monetary balance. The fiscal/monetary problem should be seen in terms of the deviation of the actual from the desired fiscal/monetary balance, and the issue of policy is to find a suitable path from the former to the latter.
6Outstanding recent examples are the privatizations in Turkey and Chile. The modest privatizations in Argentina during the 1970s were also achieved in the ambience of substantial inflation.
7I was opposed to the bailout of British Leyland, and my general view was accurately described by the chief executive, Michael Edwardes, in his book.
8A good example of the literature is Richard Pryke, The Nationalised Industries: Policies and Performance Since 1968 (Oxford: Martin Robertson, 1981).
9See Financial Times (London), June 10, 1988, p. 12.
10See John Vickers and George Yarrow, Privatization: An Economic Analysis (Cambridge, Massachusetts: MIT Press, 1988).
11A.A. Walters, “Ownership and Efficiency in Urban Buses,” in Prospects for Privatization, ed. by Steven Hanke, The Academy of Political Science, Proceedings, Vol. 36, No. 3 (1987), pp. 83–103. This paper is a shortened version of a research report for the World Bank that was completed in 1979.
12See Michael Beesley and Stephen Littlechild, “Privatization: Principles, Problems and Priorities,” Lloyds Bank Review (London), No. 149 (July 1983), pp. 1–20.
13Janos Kornai, “The Hungarian Reform Process: Visions, Hopes and Reality,” Journal of Economic Literature (Nashville, Tennessee), Vol. 24 (December 1986), pp. 1687–737.
14It should be observed that the history of government regulation in the field of transportation, which was once thought to be a natural monopoly of the railroads, should give one pause before recommending such regulation as an antidote to monopolistic exploitation. See Gilbert Walker, Road and Rail (London: Allen and Unwin, 1948) and A. A. Walters, “Transport” entry in Vol. 4, The New Palgrave: A Dictionary of Economics, ed. by John Eatwell, Murray Milgate, and Peter Newman (London: Macmillan, 1987).
15Dieter Helm and George Yarrow, in “Assessment: The Regulation of Utilities,” Oxford Review of Economic Policy, Vol. 4 (Summer 1988), pp. i–xxxi, have argued that there is essentially no difference between the two forms of regulation. If that is the case, it is difficult to see why so sophisticated a body as the U.S. Federal Communications Commission is spending considerable capital and reputation on trying to change over from (a) to (b).
16For example, the Rowntree takeover was not opposed although (a) it is a large fraction of the industry—but the industry remains competitive, and (b) the Swiss Government would undoubtedly block any similar takeover of their leading chocolate and confectionery firms.
17Madsen Pirie, in his Dismantling the State: The Theory and Practice of Privatization (Dallas, Texas: National Center for Policy Analysis, 1985), has illustrated more than 20 methods of disposal.
18The remarkably successful activities of the Bahrain concern, Investcorp, especially in its European acquisitions, have demonstrated that Bahrain is a significant base for international capital operations.
19The most interesting account is contained in Rolf Luders, “Latin American Contrasts: Capital Markets and Development in Chile and Argentina,” a paper delivered at the Sequoia Institute Conference, “Capital Markets and Development,” June 3, 1988, Washington.
20The success of the debt-equity swap is illustrated by the fact that Chile had converted about 22 percent of its long-term debt into equity. Among all the heavily indebted countries, Chile was the only country to reduce its indebtedness over the period 1985–87.
21Although I put these arguments in the course of the discussions about the British Telecom privatization during 1982 and 1983, I did not have occasion to put them on paper until 1986, when I prepared a paper for the Fifth Annual Convention of the Association of Argentine Banks (ADEBA) held in Buenos Aires, March 1987. Apparently no one else had thought about the change in the probability of renationalization having an effect on the value of the shares at issue. See, for example, Hemming and Mansoor (1988) and Vickers and Yarrow (1988) (cited in fns. 5 and 10, respectively). At least in the British context, I am sure that the point is of great importance.

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