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Lessons of privatization in developing countries.

Lessons of Privatization in Developing Countries

A decade ago the concept of privatization as a force for economic change was barely acknowledged. Today the concept enjoys full recognition with a growing number of nations, both developing and industrialized. Moreover, many countries embarking on structural adjustment programmes increasingly use privatization as an integral element. The most organized and effective resistance often comes from unionized labour, prompting governments to devise various ways of managing labour-related problems. In Malaysia, special guidelines state that all privatization schemes must ensure that employees will not lose the benefits they held-and be absorbed into divested firms under terms "no less favourable" than those they enjoyed-while working for the Government. In Chile, special efforts were made to sell shares to labour and pension funds, and special quotas were often reserved for them at public auctions and offerings of shares.

A decade ago the concept of privatization as a force for economic change was barely acknowledged. Today the concept enjoys full recognition with a growing number of nations, both developing and industrialized (including the planned economies). Moreover, many countries embarking on structural adjustment programmes increasingly use privatization as an integral element. The interventionist development policies of the 1960s, and to some extent, the 1970s, resulted in the creation of a staggering number of state-owned corporations. These entities are now widely regarded as stumbling blocks in the effort to regain the momentum of growth in the developing world.

But the record of those nations that have undertaken privatization programmes during the 1980s is quite mixed, and even for the more successful ones, no clear blueprint for success emerges. Each privatization seems to have its own history and dynamics, arguing the need to adopt a case-by-case approach rather than trying to formulate a simplified model.

Even so, there are lessons to be learned from those who have already travelled down this path, and this, despite the paucity of data on privatizations in individual countries, the difficulties of country comparisons, and the lack of data-based analyses on the economic welfare effects. Much evidence exists in the form of case-studies of countries and enterprises, providing some basis for assessing the record of privatization (i.e., its extent, methods, and complementary policy requirements). The examples of Chile, Malaysia, and Sri Lanka are noteworthy, as they highlight the possibilities-and limitations-of embracing privatization as a tool in the reform of the public enterprise sector.

Certainly Chile boasts the most extensive privatization experience in the developing world, as nearly every sector has been involved, with enterprises ranging from (previously privately owned) nationalized ones to small and very large state-owned corporations and banks. While the data are weak, it is estimated that between 1973 and the present, some 400 enterprises were privatized, representing, on average, about 0.75 per cent of GDP each year. Overall, these efforts are now judged as broadly successful, but the history has been a troubled one, characterized by government reacquisitions of previously privatized enterprises, some policy reversals, and more recently, a string of successes. The original impetus was a decision by the Government in 1974 to drastically reduce the size of the public sector, which previously had mushroomed from about 46 enterprises in 1970 to 600 at the end of 1973, accounting for almost one half of GNP.

Sri Lanka, by contrast, has accomplished very little on the privatization front, despite numerous and creative initiatives. It has one of the largest public sectors outside the centrally planned economies, with state-owned enterprises ("SOEs) numbering about 180 and accounting for about 40 per cent of gross output in manufacturing. Efforts began in earnest in 1977 to reduce the size of this sector, so as to relieve the drain on the government budget. But the economic and socio-political constraints may have made the environment for such initiatives difficult, leaving only about 11 enterprises divested and five management contracts concluded.

Malaysia fall somewhere in between the two, with the rate of successful privatization-in terms of the number of enterprises divested and the percent of equity redistributed from the Government to the private sector-far more limited than one would think from the public and media attention surrounding the undertakings (only about 14 enterprises have been divested, either totally or partially). The present efforts, which began in October 1983 with the initiation of a new policy of cooperation between the Government and the private sector, described as the concept of "Malaysia Incorporated," stem directly from disappointment with the performance of SOEs during the 1970s. Perhaps the most striking aspect of Malaysia's experience is the high level of political commitment (emanating from the Prime Minister). In fact, political will, translated into a defined institutional structure to enhance privatization, has had an important influence.

Emerging Lessons

What, then, are the lessons underlying these three bold attempts at privatization.

Tailoring the choice of instrument: All three of these countries have employed a variety of instruments, with creative combinations helping to overcome seemingly insurmountable constraints. The choice of instruments has depended on several influences, including the objectives of the government; the SOE's financial condition and performance record; and the ability to mobilize private sector resources, particularly through a domestic capital market.

The most commonly used methods of enterprise divestiture have involved public offerings of shares, private sales of shares, sales of government or enterprise assets, the reorganization of an enterprise into separate entities (or into a holding company and several subsidiaries), and management and/or employee buyouts (i.e., purchases). The terms "privatization" and "divestiture" are frequently used interchangeably, and this convention is being followed here.

Of these instruments, the single most popular-excluding liquidation-has been the private sale of shares or assets to single buyers, as borne out in a recent Bank survey of about 530 recorded privatization transactions in some 90 countries. This held true not only in Sub-Saharan Africa, which lacks developed capital markets, but also in countries such as Brazil, Italy, and Spain. The reasons are many: such sales often serve as the only alternative in the absence of equity markets; they frequently present the only alternative for weak-performing enterprises, or for those too small to justify a public offering; they provide an opportunity to evaluate new owners; and they offer flexibility in negotiating the operating rules that the purchaser brings to the divested SOE.

With respect to the privatization of management, the most commonly used methods have been leases and management contracts. Moreover, these instruments have often served as the first step toward complete divestiture, largely because they are the least contentious approach politically. They do not involve a sale of assets, at least in the initial period, and they enjoy a relatively clear legal framework, because of the well-defined contractual relationship between the SOE and the management group.

From the very start, Chile has employed a variety of instruments, but the initial phases of privatization were so inadequately managed that many enterprises were sold to buyers with neither the management expertise nor the financial capital to successfully run them, leading, along with macro-economic instability, to bankruptcies and re-possessions. The next set of privatizations, however, were more carefully planned, and far more successful. The basic instrument used was the public sale of shares, with the emphasis on attaining a widespread distribution of ownership, a sharp contrast to the earlier private sales of shares to a few large conglomerates. Thus, the privatization of Banco de Chile, one of the nation's two major commercial banks, was largely through "popular capitalism" (the sale of shares to small investors), while the privatization of ECOM, the government-owned computer firm that controlled over 50 per cent of the market, was through "labour capitalism" (the sale of shares to employees).

In Malaysia, given the Government's overt policy of privatization, there has been relative freedom to use a variety of instruments, although it is not clear that this has resulted in the most desirable method being chosen, from the point of view of achieving an efficient sub-sector over the medium term. In the divestiture of Malaysian Airlines Systems (MAS), an offer for the sale of existing shares and an offer for subscription of new shares were handled at the same time. The privatization of the container terminal at Port Kelang was a combination of an outright sale of movable assets, the leasing of immovable assets, and a management contract, to be followed after a two-year period by a sale of shares to the Malaysian public.

The Sri Lankan authorities, however, have been most careful in their choice of instruments, responding creatively to a multitude of environmental constraints. Methods used have included complete and partial transfers of ownership, joint ventures, and management contracts, with a concentration on the latter. An interesting example is the break up of the Co-operative Wholesale Establishment (CWE) into four subsidiaries, and their subsequent privatization. This procedure was adopted to take advantage of the limited liability of subsidiaries, which unlike the parent company, escape Ministry of Finance supervision.

Choosing complementary macro-economic and sectoral policies: It has been imperative for governments to ensure that privatization occurs in an economic environment-macro-economic and sectoral-in which competitive forces, both domestic and international, are allowed to lead to efficient production, and hence to improving the prospects for growth (see "The Experience with Privatization," by Mary Shirley, Finance and Development, September 1988). For example, the outlook for undertaking privatization in an environment characterized by high and uncertain inflation is poor, for the same reasons that private sector investment tends, under such circumstances, to be dormant-prices lose their ability to transmit signals that improve the allocation of resources.

Moreover, the longer-term gains can only be unleashed if the mix of sectoral policies is appropriate. This means that for potentially competitive sectors, deregulation would be necessary to allow for freer entry of domestic and/or foreign firms, and where applicable, trade sufficiently liberalized to permit imports of like commodities. But for sectors that are likely to remain monopolies (for economic or technical reasons), such as utilities, deregulation would involve autonomy for the enterprise within a framework of transparent regulatory oversight by the public sector.

The experience of Chile is instructive in this regard. The first phase of privatization was undertaken rapidly, in a period of macro-economic instability and without complementary measures to improve the incentive structure in the relevant sectors. When stabilization, deregulation, and trade liberalization were subsequently pursued, many of the privatized enterprises went bankrupt because they were not capable of surviving in the more competitive environment which, in principle, provides the true justification for privatization. In many cases, the firms that had been privatized earlier may instead have been better candidates for liquidation rather than privatization, but this had not been obvious because privatization had preceded the reforms aimed at adjusting the macro-economic and sectoral policy context through stabilization, deregulation, and liberalization. While policy sequencing issues are very difficult to generalize about, it seems safe to suggest that privatization efforts are likely to run into difficulties and not to yield their potential longer-term benefits unless preceded by needed macro-economic and sectoral policy reforms such as stabilization, deregulation, and liberalization.

Sri Lanka provides a good example of the use of complementary sectoral policies in the case of a public monopoly, even though at the expense of the momentum of privatization. Complex preparations are preceding the proposed commercialization of the telecommunications department. Initial efforts involve formulation of a telecommunications policy framework, formation of a new legal entity, and design of a carefully crafted regulatory oversight body. Only much later will the private sector be introduced.

Further, in many instances, even a sub-sectoral perspective is mandatory. The privatization of Malaysian Airlines Systems (MAS), although significant in terms of a reduction in government ownership-from 90 to 42 per cent - did not result in increased competition or significant changes in the operations of the company, because the Government's aviation policy and role in the enterprise-thanks to the golden share that gave the Government veto power-were left largely intact. Similarly, the divestiture of Malaysia's container terminal at Port Kelang could have been better handled. By divesting the container terminal first, the Government sold the most profitable part of the port facilities and may have made it more difficult to divest the rest of the port, which except for a public deregulatory role, need not remain in public hands. The privatization of the terminal draws attention to the need for a careful redrawing of boundaries between public and private ownership within the context of a carefully designed sectoral policy framework. Policies of unrestrained privatization could end up being counterproductive, often leading to the transformation of a public monopoly to a private one.

Properly weighing costs and benefits: The arguments in favour of privatization are almost always couched in financial terms shrinking the budget, mobilizing financial and managerial resources, and improving the management and efficiency of public enterprises. There are also frequent references to the economic benefits. The greater role of the private sector, it is argued, would provide for a more efficient use of the country's productive resources, improve the level of the nation's savings and the allocation of its investment resources, and hence improve growth performance.

But these financial and economic consequences are difficult to measure and quantity. For example, quantification of long-term cash flow effects, efficiency effects, and aggregate resource effects depend critically on the underlying assumptions (e.g., subsidy levels) and vary considerably from one case to the next. Moreover, most developing nations, already strapped for cash, cannot ignore the sometimes burdensome short- and medium - term transaction costs, which involve financial restructuring or partial physical rehabilitation of the enterprises; redundancy and severance payments; restructuring or transfer of the firm's debts to the government and/or the private sector; advisory services; and the time of busy government executives.

Overall, therefore, the weight of political considerations is bound to be heavy, and in practice, political constraints have frequently obstructed the implementation of economic and financial policies designed to improve, through increased competition, the efficient performance of the sectors in which privatization is being sought. The principal issues in the politics of privatization center on the relative strength of proponents and opponents; the public's perception of potential effects, particularly on employment; and the issue of "foreign" ownership.

Privatization has many enemies, and together, they pose a formidable challenge to the typical supporters (planning and finance ministers, donor countries, and international development agencies). Employed labour opposes divestiture for fear of job loss. Government officials may resent it because their jurisdiction becomes restricted. And the intellectual community may oppose it because privatization tends to be perceived as primarily benefiting the rich and the privileged.

The most organized and effective resistance often comes from unionized labour, prompting governments to devise various ways of managing labour-related problems. In Malaysia, special guidelines state that all privatization schemes must ensure that employees will not lose the benefits they held-and be absorbed into divested firms underterms "no less favourable" than those they enjoyed-while working for the Government. In Chile, special efforts were made to sell shares to labour and pension funds, and special quotas were often reserved for them at public auctions and offerings of shares.

The ethnic composition of ownership issues has also needed to be tackled, particularly in multiracial/ethnic societies, such as Malaysia, and to some extent, Sri Lanka. In Sri Lanka, the privatization programme actually came to a standstill partly because the Government was determined to reach a peaceful constitutional settlement of ethnic issues and thus unwilling to embark on policies that were domestically contentious.


The case for privatization, therefore, frequently rests less on fine-tuning the net benefits and more on a vision of changes in the roles of the public and private sectors, as well as in the particular sector in which the enterprise selected for privatization operates. For this to occur, privatization must take place within a macro-economic and sectoral policy framework that induces greater competition, both domestic and international. In this overall context, the process of mediating between the losers and the gainers, and of steering the programme through the various political constraints imposed, for example, by ethnic or nationalistic considerations, calls for a persistent and decisive effort-hence, the critical role of political will. In the final analysis, privatization is just one facet of the larger policy issue of private sector development. Its contribution should be seen as helping to further this development, as countries attempt to adjust toward more efficient and growth-oriented economies for the 1990s.
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Author:Nankani, Helen B.
Publication:Economic Review
Date:Mar 1, 1991
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