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Beyond privatization: getting the rules right in Latin America's regulatory environment.

Those of us in the economics profession who think of ourselves as part of the "mainstream" are often bounced about when the currents enter a patch of white-water. In few regions of the world has the turbulence been as great as in Latin America. Though we are the richer for it intellectually, recent economic experience there has raised a series of new issues for which our traditional approaches have only partially prepared us. Trade liberalization, exchange rate unification, and monetary and fiscal reform have been prominent elements in this change, with privatization probably at center stage in the attention of world financial markets.

The economics mainstream has long maintained the presumption that the net benefits of privatization are decidedly positive, and the new found enthusiasm of many Latin American political leaders and significant sections of their electorates for privatization has recently reinforced this traditional view. Yet it is difficult to believe that privatization is quite the magic solution to the region's problems that we may have led so many to believe. Of course there are strong theoretical reasons to maintain our presumption of the desirability of privatization. They must be tempered, however, by close empirical attention to actual experience as the privatization process unfolds in a number of Latin American economies. The emerging evidence, some of which has been presented in the papers in this collection, and which is our focus here, suggests that we must look beyond privatization to the regulatory climate in which the newly privatized Firms must operate.

In the ideal world of our models, the privatization paradigm consists of the replacement of an inefficient publicly owned firm by an efficient and competitive private one. In sectors in which the good or service is produced using factors priced in competitive markets and, even more importantly, is sold in markets in which the price can be equated with marginal cost, this paradigm is quite reasonable. Latin America provides a number of examples, ranging from privatized hotels in Mexico to steel mills in Brazil, in which the theoretical model provides a good prediction of actual experience.

But not all markets satisfy the implicit assumptions of competitive product pricing. Economists have long recognized that public utilities are activities in which either competitive markets or even results only analogous to competitive ones would be unlikely to emerge in the absence of competent public intervention. Natural monopolies are much more likely to result, due both to the nature of product itself and to the structure of the market that it serves. We must add to this the fact that both technological change and the political process may either strengthen or weaken competitiveness in the markets for the products of newly privatized firms. It is at once apparent that predicting the eventual outcomes of the many recent Latin American privatizations, especially those in activities like power generation, telecommunications and public transport, is at best a hazardous enterprise.

An examination of recent experience in privatizations in several major Latin American economies, among them Argentina, Brazil, Chile, and Mexico, suggests that there is a wide range of possible outcomes to the privatization process in the public utility sector. Mexican and Chilean experiences, the focus of Ramirez's work in the present collection, cannot be regarded as unmitigated successes, and provide clear examples of cases in which outcomes did not conform well to ex ante expectations. Chile's first attempt at privatization, that of the financial sector in the 1977-82 period, may provide the most dramatic example of failure. The lack of an adequate regulatory environment led to a sharp rise in problem loans, ending with the failures of a number of financial intermediaries and the re-nationalization of much of the system in 1983. Although Chile itself may have learned from this first experience with privatization, it is not clear if the lesson was learned by other countries.

The effects of an inadequate regulatory climate in contributing to adverse outcomes in Latin American privatizations obviously depend on the nature of the activity that is privatized. In the case of both the Chilean and Mexican financial sectors, inadequate supervision led to a decline in loan quality and a rise in financial risk. The eventual outcome of such scenarios is either a widespread rise in financial intermediary failures, or an increase in concentrations, with the attendant potential for monopoly or oligopoly, as failure is averted by the consolidation and takeover of weak banks.

In sectors such as airlines or telecommunications, potentially adverse outcomes also exist, but their nature may be quite different. Here the natural monopoly issue is dominant, and we might regard regulatory failures as those scenarios which lead to pricing and output decisions that depart from competitive levels, when such levels can be reasonably defined and measured. Again, both Chile and Mexico provide cases in which this appears to have occurred. As Ramirez notes, privatization of the Chilean ENDESA power generation, transmission, and distribution network, for example, ignored the fact that only the transmission network constituted a natural monopoly. ENDESA was permitted to maintain a dominant position in generation and distribution as well. In the Mexican airline case, the lack of adequate antitrust provisions permitted the two dominant and newly privatized carriers, Mexicana and Aeromexico, to raise the barriers to entry in specific route markets by Mexico's third carrier, TAESA.

The recognition that an inadequate regulatory climate may lead to some adverse post-privatization outcomes raises several important questions. At first sight, one might distort this into an argument against privatization itself, along the lines that if it can't be done right, don't do it. However pleasant such a message might be to the many opponents of privatization who remain in Latin America, this interpretation can be easily dispensed with, since there is ample evidence - some of it presented in the papers in this collection - that it can be done right.

A more serious and interesting issue is that of timing and sequencing. As Ramirez shows, the examples of Chile and Mexico indicate that failure to have an appropriate regulatory framework in place before privatization increases the subsequent likelihood of adverse outcomes. But in the rapidly changing economic and political climate in which Latin American privatizations have occurred, it may be a mistake to insist too much on getting all the rules right first. However desirable it might be to proceed cautiously and deliberately, this simply may not be an available option. To counsel perfection in the development of the regulatory environment may be akin to urging potential cardiac patients to have their problems only in the emergency rooms of the best hospitals. The costs of delays in privatization are not trivial, and may easily exceed the costs caused by regulatory imperfections. In addition, international capital markets now deal swiftly and harshly with economies whose policies fall out of their favor. If delays in privatization due to legitimate concern with the regulatory structure are misinterpreted by foreign investors as resistance to privatization itself, a country may not have the luxury of getting all the rules right before initiating privatization. The potentially adverse outcomes from some privatizations, such as those identified by Ramirez in Chile and Mexico must be taken seriously. But they are reasons to improve the privatization process through better regulation, and not excuses to delay privatization itself.

Recent privatization experience in Brazil, particularly in its public utility sector, illustrates some of the difficulties in the transition process. As is so often the case in Brazil, there are some specific features of its environment that must be considered in extending generalizations about privatization to the rest of the world, or even to the rest of Latin America. We usually think of privatization as a simple transfer of property from the public sector to a group of private owners. In Brazil's electric power sector, however, actual "privatization" has really constituted an intermediate case, in which concessions with a finite life have been granted to private buyers willing to serve markets formerly supplied by state enterprises. In this respect, as Baer and McDonald have argued in their paper on Brazil's recent experience, there is something of a deja vu nature to the process, which one might view as returning Brazil's power sector to the situation which existed there prior to the nationalizations of the 1950s and 1960s.

Before World War II, Brazilian electric utility policy established concessionary contracts, subject to a number of restrictions. Among them were periodic revisions of tariffs and price setting based on rate of return on the historical capital base. Although such a system may function relatively well in periods of macroeconomic stability, it is apparent that it is quite vulnerable to episodes of inflation. If the private investors in the concessions are foreign, as was usually the case in pre-World War II Brazil, then exchange rate instability could also produce sharp changes in profitability.

With what may (even at this early date) be a return to a degree of price stability unknown to the majority of the Brazilian population, this kind of regulatory environment may once again be viable. If prices can once again be taken seriously, then it may be possible to develop regulatory frameworks for concessions that permit private investors a high enough return to induce them to supply the utility infrastructure and modernization that Brazil so clearly needs. Brazil still has a long way to go to develop such frameworks, and the comparatively small involvement of foreign investors in a number of the first Brazilian power sector privatizations, like that of ECELSA, for example, may be explained in part by their uncertainty about how these regulatory frameworks will develop.

Brazilian privatizations through the sale of finite-lived concessions to exploit a natural monopoly like a power distribution system raise an interesting political - or possibly even ethical - question. Like most Latin American privatizations, but in contrast to a number of Eastern European ones, Brazilian privatizations have generally reflected the fiscal pressures on the public sector. The revenues available both from the sale of the enterprise and from the future savings from elimination of a deficit-ridden enterprise from the public sector's balance sheets have been viewed as reason enough to privatize. Almost without question, these revenues have been treated as the property of the government, somewhat akin to tax revenues. At a more fundamental level, however, one can argue that even if a government is a faithful agent of its people - a proposition that many thoughtful Brazilians would have had difficulty swallowing in recent years - it is not identical to it. Though Brazilian taxpayers have not really been given the option, the appropriation by the government of revenues from the sale of a concession of a natural monopoly should not necessarily be automatic. One can envision a distribution of the proceeds through stock issues, vouchers, tax refunds, or other means in ways that reflect a much broader conception of public ownership than simply that of the current government. The fact that this issue has hardly ever been raised in the Brazilian context merely reflects the fiscal stress that drives current privatization, but it does not eliminate the issue from potential consideration.

Another interesting issue that is highlighted by the Brazilian experience arises from the finite life of the concessions sold. In principle, at the end of the concession period, there must be an open competition for the new concession. Since the expected value of a concession is clearly affected by the possible loss of the concession to a higher bidder at the time of renewal, it is obviously in the interest of the successful bidder for the current concession to prevent this future outcome. One way to interpret this problem is to recast it in terms of "limit pricing," or in other words, the optimal strategy to serve a monopolized market threatened by the future entry of a potential competitor. Barring outright "capture" of the regulatory agency or the concession granting authority, the successful bidder must avoid future entry by competitors by making the prospect of entry sufficiently unprofitable to discourage such a move. This may be done by keeping current prices sufficiently low and quality of the service high, but this may reduce the present value of the concession. An optimal pricing strategy must therefore trade future income off against present income, setting prices and services at a level which ensures a current profit but does not jeopardize future profits by drawing in a competitor and losing the concession. There is thus a fundamental tension between Brazilian regulatory authorities, whose interest is served by the threat of non-renewal of the concession, and that of the successful current bidder, which seeks to ensure renewal. Whether or not such strategic behavior will emerge in the newly-privatized Brazilian power industry remains to be seen, but the way in which the privatization has been structured clearly sets the stage for this kind of outcome.

Recent Argentine experience with privatization provides a different perspective on potential outcomes, when viewed from a macroeconomic perspective. This is the focus of two separate papers, by Lopez and Urbiztondo respectively. Both raise related questions about how recent "neo-liberal" reforms and their privatization component may be judged. Much more than was the case in any other Latin American country, Argentina since 1991 has relied on a fixed exchange rate policy as the centerpiece of its macroeconomic stabilization policy, with a credible parity between the peso and the U.S. dollar guaranteeing the alignment of those goods and services which may be traded. The essential element for such a policy to work over the long run is that the exchange rate peg be credible to market participants. A gauge of this credibility is provided by the difference between domestic and external interest rates: if all believe that the peso will be forever worth a dollar, and financial capital may freely flow in and out of Argentina, then one would expect little or no divergence between world and Argentine interest rates. Experience since 1991 shows that this is not the case, and even though the rate has been held, it is clear that the credibility battle is not yet won.

In a scenario like the Argentine one, maintenance of the fixed exchange rate and avoidance of speculative attacks on it depend in part on the capacity of the government to attract a sufficiently large inflow of capital. It is here that Argentine privatization may have played one of its most important macroeconomic supporting roles in the short and intermediate run, whatever may be the microeconomic efficiency and political arguments for it in the long run. For privatization-induced foreign capital inflows to support a fixed (and possibly overvalued) exchange rate, however, there must be both a reasonable prospect that (1) real exchange rate overvaluation will eventually be overcome without a nominal devaluation, and that (2) the policy regime governing the privatized enterprises will not change abruptly. Lopez characterizes the current Argentine policy regime as "neo-liberal," and associates the external payments constraints that it faces with this neo-liberal "model." This characterization is unquestionably correct. Yet the constraints which a fixed-exchange rate, financially open economy face are as much technical economic limitations on what Argentina may or may not do as they are the consequences of any particular "neo-liberal" ideology. There is no question that ideology, and particularly sharp political differences in Argentina's recent history have heightened the uncertainty and undermined the credibility that attaches to the current Argentine "neo-liberal" policies. Successful stabilization in such a context is costly, and it is clear that a reduction in uncertainty about future policies is critical to it, given the past record of political and economic stop and go policies and about-faces.

This focus on the uncertainty attaching to the "rules of the games" - both for investors in newly privatized enterprises and in a larger macroeconomic context for Argentines themselves - raises an important question. As Lopez notes, recent Argentine policy making has been characterized by an extraordinary concentration of decision making power in the executive branch of the government, with both the legislative and the judicial branches relegated to distant second or third places. One may ask whether or not this contributes to the reduction of policy uncertainty. A superficial examination would suggest that it does, since there are fewer cooks to spoil the neo-liberal technocrats' broth. But this is far too simple a view. Credible reforms - which a society like Argentina badly needed after years of erosion of government credibility - must have deep roots. Those roots are strongest when a broad consensus has produced them. Even if both are initiated by the executive branch, a law which has been debated and scrutinized by the legislature and possibly tested and reaffirmed by an independent judiciary is far more likely to constitute a "credible" policy than does a decree or "provisional measure" promulgated by the executive. Lopez's focus on this feature of current Argentine policy making is fruitful, since it suggests that not only must we look at what the policies say, but who said them and how seriously the society is likely to take them. In the context of privatization, such a focus is fundamental.

Privatization has been one of the forces behind the substantial rise in direct foreign investment (DFI) in Argentina in the 1990s. Urbiztondo's examination of the trends in DFI tells a story parallel to that of a number of the major Latin American economies in the same period. Even more than the other Latin American economies, however, Argentina suffered from a reputation for opportunism in its treatment of foreign investors. Sunk capital owned by private investors, many of them foreign, was often regarded as an attractive target for expropriation under populist governments in the post-World War II period. Against this historical backdrop, Argentina's recent successes in attracting foreign investment in newly privatized enterprises is all the more remarkable. Although one might argue that the increase in foreign investment in Argentina in the 1990s simply reflects the fact that a rising tide lifts all boats, including the Argentine one, it would not have lifted one with gaping holes in its hull. Clearly there has been a shift in investor perceptions of the rules of the game in Argentina, which as Urbiztondo notes, "gives plenty of room for optimism."

A game-theoretic model for this shift, which is sketched briefly by Urbiztondo, provides an appealing explanation for this sea change in the investment climate. In the "opportunistic" equilibrium, local agents find it worthwhile to expropriate the sunk capital of foreign investors, without concern for the long-run consequences of the regulatory uncertainty and credibility problem which results. In the equilibrium which he characterizes as "rule" based, cooperation results when the public learns the costs of erratic changes in the investment and regulatory climate on capital formation. Successful privatization may thus be a "virtuous circle," in which an increase in foreign investment reinforces this learning process. Although the use of such a model to explain recent changes in Argentina is still speculative, it is a productive approach. The distinction between single period and repeated games, and between those which explicitly model the reputations of different players and those which implicitly ignore them, are all elements that need to be considered in the further development of the game-theoretic approach suggested by Urbiztondo.

One of the hopes of the supporters of privatization in Latin America has been that much greater microeconomic efficiency sill result from the elimination of state monopoly and the reduction of barriers to entry. The telecommunications industry, which is examined by Braga and Ziegler, provides a useful case study in which to discern such potential trends, even though it may be too early to draw strong conclusions. In contrast to some other sectors which have been or are being privatized, such as the steel industry or airlines, higher rates of technical change in the telecommunications sector raise additional problems of regulation.

In the traditional view, technology creates particular market structures. A hard-wired telephone system, for example, is usually viewed as a natural monopoly within a given service area, since it would be economically inefficient to have a group of competitors attempting to deliver telephone service in the same street or district. In this paradigm, easily identified natural monopolies should then be regulated by authorities in such a way as to eliminate monopoly pricing through the restriction of output.

In many sectors, however, technical change may create or eliminate monopolies more rapidly than governments can develop regulatory structures to deal with them. Recent trends in the telecommunications industry suggest that this may be the case in this sector. Cellular service, for example, permits competition even at the individual user level in a narrow geographical area. At the international level, satellite links permit competition among long-distance carriers. In the language of international trade theory, technical change may convert "non-tradeable" services into "tradeable" ones, imposing the price competition of international markets on providers who might once have enjoyed a natural monopoly.

Such developments may be all to the good from the point of view of consumers. But it is clear that if regulation lags behind the changes in market structure induced by technical change, these potential gains to consumers may not be realized. Whether or not technical change weakens or strengthens natural monopolies is of course an empirical question. Braga and Ziegler's examination of the telecommunications sector suggests that in this particular case, recent developments have weakened monopolies and increased the potential for competition.

Their characterization of competitiveness in this sector as a series of stages on a continuum, ranging from monopoly through "fringe competitive" and "benchmark competitive" is useful, since it provides a kind of yardstick for measuring the success of privatizations. By their measure, Chile is the most competitive, with the larger Latin American economies (Brazil, Mexico, and Argentina) lagging some considerable distance behind. Yet privatization, which is also an interval on a continuum and not a single condition or point, does not automatically lead to full competition, as defined by Braga and Ziegler. There is a positive correlation between the degree of privatization, however, and the level of competition attained, with Chile in the lead by both measures.

"Getting the rules right" in Latin American privatization is clearly an art, and not a science. The evidence which is coming in as privatizations proceed does not show that privatization can always deliver all that its proponents have promised. But the occasional failures can be understood and explained. We already have a much stronger empirical basis for the theoretical presumption that privatization of many activities formerly in the public sector in Latin America can make a positive contribution to the economic welfare of the region.


* Direct all Correspondence to: Donald V. Coes, R.O. Anderson Graduate School of Management, University of New Mexico, Albuquerque, NM 87131. <>.
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Title Annotation:The Changing Role of International Capital in Latin America
Author:Coes, Donald V.
Publication:Quarterly Review of Economics and Finance
Date:Sep 22, 1998
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