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Privatization and regulatory reform in Mexico and Chile: a critical overview.

I. INTRODUCTION

Over the past decade the major countries of the region have embarked upon a process of radical economic reform that has dramatically reduced state ownership and control of their domestic economies. Privatization of state-owned enterprises and the liberalization of trade and finance in countries such as Argentina, Chile, and Mexico has been carried out to such an extent that it has put to an end four decades of state-led development under the strategy known as import-substitution industrialization (ISI). Deregulation of economic activity has also accompanied this process as evidenced by the removal of what are deemed to be unnecessary controls and restrictions on the allocation of scarce resources in the product and factor markets of many countries of the region, notably Chile and Mexico.

One of the consequences of the privatization and liberalization movement, in recent years, has been the transfer of public sector firms to the domestic (and foreign) private sector in highly concentrated industries, such as airlines, banking, telecommunications, petroleum exploration and refining, where usually one or two firms dominate these markets. The inherent danger of doing this is that it may lead to a situation where private monopolies just replace public ones and where powerful foreign and domestic interests exert undue control (without public accountability) over key economic decisions in strategic sectors of the economy - a state of affairs that circumscribes the host government's room to maneuver and may compromise national sovereignty; thus, unless an effective regulatory framework is in place to safeguard the public's interest against monopolistic abuses, the dominant firms in these markets may engage in both anti-competitive and anti-nationalist behavior that could eliminate some or all of the purported benefits (including positive externalities such as loans and aid from international financial institutions, lower interest rates, etc.) associated with privatization and liberalization.

This paper will focus on certain key aspects of the post-privatization environment in Mexico and Chile and offer some suggestions for improving the legal-institutional framework for conducting business, so that the efficiency gains promised by privatization enthusiasts are attained without unduly compromising the public interest. The paper is organized as follows. First, it reviews a number of important regulatory issues and problems which arise when Latin American countries decide to privatize strategic public sector firms and/or natural monopolies. Next, it focuses on the regulatory, economic, and social-political challenges and opportunities generated by the privatization of the airline and banking industries in Mexico, and with the privatization of telecommunications and energy in Chile. Last, it proposes some corrective policy guidelines designed to strengthen and improve the regulatory and legal environment in which market-oriented policies such as privatization are undertaken.

II. AN OVERVIEW OF PROBLEMS AND ISSUES SURROUNDING EFFECTIVE REGULATION

Neoliberalism, as currently practiced in Latin America, has meant the privatization of state-owned enterprises (SOEs), the deregulation of labor and financial markets, and the liberalization of trade. This is not surprising because these market-oriented reforms and policies are ostensibly complementary in nature. Privatization of SOEs, for example, diminishes the direct role of the state in the productive capacity of the economy and may lead to an increase in the rate of private investment if real interest rates decline and private agents perceive the reduction in the state's control over economic resources as creating a propitious business environment.(l) Deregulation, in turn, is intended to reduce indirectly the role of the public sector through the elimination of price and interest rate controls, barriers to entry, cumbersome licensing procedures, and more important, it often entails the weakening or non-enforcement of labor acts governing the right of labor to organize and bargain collectively, as well as ordinances stipulating the attainment of minimum labor health and safety standards. Last but not least, liberalization is supposed to increase competition (by enhancing the contestability of markets)(2) in highly concentrated and traditionally protected industries, thereby stimulating the transfer of new technology, managerial skills, and offering consumers a greater variety and quality of goods and services. The avowed economic objectives of these structural reforms and policies are to improve short-run productive (technical) and allocative efficiency, and pave the way for vigorous and sustained long-term growth in real per capita GDP.

However, the transfer of ownership to private agents in non-competitive sectors and/or industries without an effective regulatory framework and judicial system can, and has, created several problems that must be addressed and surmounted: First, it is often argued that trade liberalization per se will serve to minimize monopolistic practices and discipline the behavior of dominant firms in recently privatized industries. Yet recent efforts to liberalize trade and financial services in Latin America have not been extended to privatized industries, particularly those with a high degree of concentration (e.g., petroleum, chemicals, fertilizers and steel in Brazil and banking and financial services in Mexico).(3) Government officials defend this practice by arguing that exposing newly privatized firms to foreign competition before they have restructured their technical and managerial operation puts them in a vulnerable position. They also point to the fact that similar industries in developed countries remain highly protected. Meanwhile, the fact remains that the privatization process has generated a wave of mergers and acquisitions among the incumbent firms that often leaves the market in the control of powerful industrial and financial groups (Grupos).

Second, the new regulatory frameworks that have emerged from the region's privatization of public service sectors are plagued with administrative, financial and operational problems, and thus often find themselves in the awkward position of playing "catch up" with the speed at which the privatization process is taking place. For example, in many instances, the regulators do not have access to timely and the same information on consumer demand, the firm's costs and its degree of vertical integration, or the level of cost-reducing efforts undertaken by the newly privatized firm. Faced with asymmetric information, regulators are thus unclear as to what aspects of the firm's behavior should be regulated (e.g., rate of return regulation vs. price regulation).(4) Or in the case of vertically integrated natural monopolists, regulators may be unable to regulate the firm's ability to manipulate costs via transfer pricing and thus move profits form regulated to unregulated activities.

Third, these administrative and operational problems are aggravated by cash-strapped governments in the region that view the privatization process more as a mechanism for generating short-term increases in revenues, than in terms of long-term efficiency considerations.(5) The problem does not necessarily reside in the absence of an adequate system of property rights and contract law (although much remains to be done in the area of intellectual property rights and financial services) but rather, many of these systems are emerging with little or no track record, poor enforcement mechanisms, and are often under-equipped, understaffed, and their personnel are poorly paid relative to the industry that is being regulated. The net result is that cases take a long time to work their way through the legal system, monitoring costs are high, outcomes are often unpredictable, and regulators and judges may be susceptible to rent-seeking activities.

Fourth, the operational inadequacy of the regulatory systems in place in many countries of Latin America may mean that government officials are willing to trade off improved technical efficiency of a newly privatized firm for potentially deteriorated allocative efficiency; that is, when a public monopoly is transferred unregulated or poorly regulated to the private sector there is a switch from marginal cost pricing to monopoly pricing that is often worse in terms of allocative efficiency and social welfare.(6) However, regulators are in effect "gambling" that the short-run loss in allocative efficiency and social equity will be more than offset in the long run by the increased profitability, investment, and technological progress that are expected from significant economies of scale, greater managerial incentives, and shareholder monitoring (the principal-agent problem). Hence for single supplier private firms to be superior in terms of economic and social welfare, the improvement in technical (productive) efficiency should be significantly greater than the loss in allocative efficiency. Unfortunately, from the standpoint of social equity and economic efficiency this could be another version of the "trickle down" approach that has tended to dominate thought in the 1980s and 1990s.

Finally, regulatory systems and antitrust laws have tended to emerge after, rather than before, the privatization of public firms in so-called strategic sectors such as banking, mining, energy, and public utilities. Under these circumstances it is not possible for regulators to establish a track record and rectify some of the worst administrative/operational problems and abuses that are likely to emerge, e.g., under-investment, technical inefficiency, restriction of output and entry, and unfair labor practices. That is, it is far more effective to prevent the emergence of anti-competitive practices aimed at creating market power such as mergers, than it is to combat the anti-competitive practices of established monopolists, such as collusion and predatory pricing.

III. PRIVATIZATION AND REGULATORY REFORM IN MEXICO AND CHILE

To ground our discussion of privatization and regulatory reform (or the lack thereof), let us begin with the case of the Mexican airlines industry. Between 1988 and 1992, the government privatized both Aeromexico and Mexicana airlines and dismantled and restructured the regulatory framework that had been in place for the better part of four decades. It promoted competition by easing entry restrictions for domestic carriers into heavily-traveled trunk routes and increasing the number of international-Mexico City pairs that foreign carriers could serve. Foreign carriers, however, were, and are currently prohibited from serving domestic city pairs.

The initial effects of the reform were, on balance, positive for the new shareholders and the air traveling public as evidenced by the reduction in both Aeromexico's and Mexicana's overall costs and the improvement in the quality of their service (Aeromexico increased on-time arrival from 75% in 1988 to 95% in 1991, while Mexicana raised its on-time arrival from 73% in 1989 to 86% in 1991).(7) Perhaps the most important and beneficial aspect of the process of the privatization and deregulation of the airline industry was the entry of a third airlines, Taesa, into several of Mexico's major trunk routes, offering greater competition to the two incumbent airlines. Taesa's approach is to offer no-frills service, similar to the strategy of Southwest airlines in the United States. Its national market share is no more than 15%, but since 1991 the new carrier has cut into the share of the major airlines, particularly Mexicana.

A. Social Cost

This process, however, has not been without its immediate social costs, particularly from the standpoint of employment levels in the industry and workers' rights, such as the enforcement of existing contracts and the right of collective bargaining and the right to strike. Let's consider the case of Aeromexico. Before it was privatized in October of 1988, the Mexican state decided to "sanitize" the company which, at the time, was facing a major labor strike, by declaring it bankrupt, thus voiding its existing collective bargaining agreement. This allowed its new owners, Grupo Dictum - a consortium of Mexican investors - to reduce the company's workforce from 12,000 to 3,000, and hire a total of 3,000 new replacement workers from outside the firm. Mexicana airline, on the other hand, was sold as a solvent concern the following year to Grupo Xabre for $140 million.(8) Since the new owners were constrained by the existing labor contract, they were only able to reduce the workforce from 14,000 to 11,000. Still, major concessions were obtained from the company's union and labor force in the form of relaxation and/or elimination of job classification rules, seniority clauses, shop-floor representation, and paid sick leaves and vacation time.

B. Market Structure

From the standpoint of market structure, the single most important and troublesome development has been the merger of Aeromexico and Mexicana airlines in the beginning of 1993, when Aeromexico acquired a 55% ownership stake in Mexicana. The merger and consolidation of operations of the two carriers (although they maintain separate brand names) means that they now control more than 70% of the domestic market for air travel, and have almost complete control over the most traveled trunk routes. For example, Gordon Hanson (1994), in his study of the Mexican airlines industry in the post-privatization period, observes that "In the first half of 1993 Aeromexico-Mexicana still controlled more than 90% of air travel in six of ten markets, and more than 80% of air travel in nine of ten markets. Combined, these markets accounted for 41.2% of Mexican domestic air travel in 1991."(9) He goes on to conclude that, "Despite Taesa's rapid expansion in the domestic market, entry has not succeeded in breaking Aeromexico-Mexicana's grip on Mexico's major domestic routes."(10) In fact, the major carriers have also agreed to coordinate fares, introduce frequent flyer programs (to increase customer loyalty), share ground services and crews, and use a common computer reservation system in order to meet the competition generated by the entry of Taesa.

The merger of the two airlines escaped antitrust enforcement because Mexico's new antitrust law did not go into effect until four months after the merger had taken place. (Many industry analysts observe that the merger took place, in large measure, in order to head off passage of the impending legislation.) This means that, under present law - a rule of reason doctrine - the state must establish that the new airline is in fact exercising market power in order to regulate its anti-competitive behavior. Under the new antitrust law this is harder to accomplish than preventing a merger, because the government would only have had to establish that the merger was likely to have allowed the new airline to exercise monopoly power.

C. Lessons Learned

Several important lessons can be drawn from the privatization and deregulation of the Mexican airlines industry over the past four years.

First, regulatory reform that promotes competition (or the credible threat of competition) is the best regulator. It was only the relaxation of government-imposed entry barriers into air travel between domestic city pairs that allowed Taesa to emerge as an important competitor to the two incumbent airlines.

Second, even with deregulation, the absence of appropriate antitrust legislation and enforcement mechanisms allows recently privatized firms in concentrated markets to exercise considerable monopoly power, thus enabling them to erect formidable economic and institutional barriers to future potential entrants.

Third, any efficiency gains obtained through the "flexibilization" or "sanitization" of existing federal labor laws by using bankruptcy proceedings and/or abolishing collective labor contracts and the right to strike (replacing them with contracts between employers and individual workers), may have long-term repercussions that are costly in social, political and even economic terms (adverse impact on worker morale and productivity). That is, the negative externalities associated with higher levels of unemployment, rising inequality in the distribution of income and wealth, and labor unrest may well prove to be politically intolerable and economically unsustainable.

Finally, the length of time a firm has been in public hands is a poor predictor of how it will fare once it is privatized. Aeromexico, for example, was under public control for far longer that Mexicana (since 1959), and the latter was considered by industry analysts as the country's premier and potentially most profitable carrier. Yet, after privatization, Aeromexico outperformed and eventually displaced Mexicana as the country's dominant carrier. It increased dramatically its market share, culminating with the takeover of its former rival in February of 1993.

D. Antitrust Laws and Regulatory Agency

Sub-optimal outcomes can also be avoided in other sectors of the economy, particularly banking and finance, if appropriate antitrust laws and a strong independent regulatory agency with wide-ranging supervisory powers are in place. Unfortunately, the disastrous and painful experience of Chile with financial liberalization and privatization between 1977 and 1982 - one characterized by an almost complete lack of control exercised over the country's financial intermediaries and their lending practices, eventually culminating with the re-nationalization of the banking system in 1983 - seems to have been completely lost on other countries of the region, again, notably Mexico. The privatization and deregulation of the financial sector in that country during 1990-93, like in Chile before, has led to an unprecedented concentration of productive and financial resources in the hand of relatively few and powerful segments (Grupos) of the private sector (including a growing foreign presence).(11)

Nowhere is this trend more evident than in the re-privatization of Mexico's 18 commercial banks. Despite the finance Ministry's stated goal of distributing the country's financial power more equitably by prohibiting individual investors from owning more than 5% of a privatized bank's shares, ex-bankers and new private financiers - the latter having amassed large fortunes as a result of the stock market boom of the second half of 1980s and early 1990s - have created new financial controlling groups that can circumvent the law and obtain up to 100% of shares of the newly privatized banks. For example, in a recent study of the privatization of banks, Mexican financial specialist Carlos Elizondo observes that only 44 economic Grupos bid for the 18 nationalized banks, and the bulk of the savings of these privatized banks are now concentrated in a small number of individuals and firms. He reports that:

Deposits of 18,649 people and firms with accounts of one billion pesos or more, 0.07% of total accounts, make up 53% of total deposits. Those with accounts of 250 million or more, 96,000 firms or people, represent 0.37% of total accounts and 66% of deposits - the number of shareholders after privatization amounts to nearly 130,000 people. This implies that the most important savers may own part of the banks. Thus, privatization allows them to directly or indirectly manage their savings. (12)

Not surprisingly, some of the same families that owned and controlled the banking system before the 1982 nationalization have returned along with powerful industrialists and new private financiers. The latter are mainly owners of stock brokerage houses (Casas de Bolsa) who, according to Elizondo, "knew how to profit from the stock market much better than former bankers."(13)

To illustrate this turn of events, take first the case of BANAMEX, one of the three largest banks in Latin America and one of the oldest banks in Mexico, with assets more than $15 billion, 32,000 employees, and 720 banks throughout [TABULAR DATA FOR TABLE 1 OMITTED] the country. Table 1 reveals that it was sold in 1991 for $4.6 billion to Grupo Regional which includes the country's largest brokerage house, Acciones Y Valores de Mexico. The group is headed by Alfredo Harp Helu (kidnapped in early 1994 and later released that same year), Roberto Hernandez Ramirez, and Jose G. Aguilera Medrano. Hernandez Ramirez and Harp Helu are major partners in the Accival brokerage house, with controlling ownership of the company's equity capital of 39 and 36.23%, respectively. The brokerage house is also a major stockholder in Telmex (7%) and - as a result of its merger with Grupo Banacci - of the country's second largest bank, Bancomer (33.33%). It should also be noted that Harp Helu is the former president of the stock exchange and a close friend of (now disgraced) ex-president Carlos Salinas de Gortari.(14)

Bancomer, the country's second largest retail bank, was sold to individual investors (including Hernandez Ramirez and Harp Helu) led by Eugenio Garza Laguera, former owner of Banco Serfin and CEO of Grupo Vamsa and Visa (see Table 1). Vamsa is a leading financial firm based in Monterrey, Mexico, with investments in securities, brokerage firms, leasing, factoring and warehousing. Its principal subsidiary, Seguros de Mexico, is Mexico's largest individual life insurer. Grupo Visa, on the other hand, is one of Mexico's oldest industrial concerns and an influential member of COPARMEX - a highly conservative and powerful business umbrella organization. It is the largest beverage concern in Mexico, with significant investments and market share in beer, soft drinks, and mineral water. It is also vertically integrated in packaging, distribution, and marketing. Similar developments have taken place with the sale of the other major banks.

Table 1 shows that even the relatively smaller banks have been sold to individuals and firms belonging to powerful financial and industrial grupos. For example, multi-regional banks such as Banco Atlantico (7th largest) and Banco Promex (12 largest) were sold to group headed by Alonso de Garay Gutierres and Jorge Rohas Mota Velasco. The new owners are closely connected to Grupo Bursatil Americano, the country's second largest stock brokerage house. Banco Atlantico is the largest multi-regional bank with assets of $3.5 billion and a network of 204 branches spread throughout more than 26 of Mexico's 30 states. Finally, Banco Mercantil del Norte, the country's largest regional bank, was sold to a group of investors led by Roberto Gonzales, Juan Antonio Gonzales, and Federico Graf. These investors are closely affiliated with Grupo Industrial Maseca, Mexico's largest tortilla-flour producer (see Table 1).

The concentration of banking assets in a relatively small number of financial and industrial Grupos with strategic economic and institutional associations has given rise to legitimate public concerns about the degree of competition present in the privatized banking system. Economic theory suggests that one measure of market power is whether the industry exhibits sustained "above-normal" profits. In this connection, it is noteworthy that banks' profits, as measured by the real return on equity, rose from 18% in 1992 to 23% in 1993, and more than 26% in 1994 - even as their portfolio of nonperforming loans rose from 5.5% in 1992 to 8% in 1993, and then to over 10% by the end of 1994.(15) Another indication that the banking sector was expected to record persistent above-normal profits following privatization can be gauged from the relatively high price-to-book value paid for the banks by the new owners. According to Elizondo, "The banks were bought at 14.07 times profit and 3.07 times book value. The same figures for banks bought in the U.S. in the last five years have been on average 14 and 2.2 times."(16)

Economic theory also predicts that as competition and efficiency in the banking system are enhanced, the spread between lending and deposit rates should get progressively smaller. However, as shown in Table 2, the spreads widened significantly following the reprivatizations of the banks in 1992. For example, the table indicates that they rose from an already high 11.33-point margin in 1992 to 13.8 in 1993, and 14.63 in 1994. The high lending rates, in turn, contributed to the rapid rise in the percentage of nonperforming loans (reported above), particularly among small and medium-sized business firms and consumers, and ironically, made the banking system itself (with the exception of the three largest banks) susceptible to bankruptcy proceedings and government rescue packages as evidenced by the near collapse of the banking system following the 1994-95 Mexican peso crisis.(17) Although the rise in spreads reported above do not constitute prima facie evidence that concentration has enhanced market power in the newly privatized banking system, they also suggest that one has to look elsewhere for evidence that reprivatization has enhanced competition and efficiency in the industry.

Before concluding, it is important to mention that the reprivatization of the Mexican banking system and the 1994-95 pesos crisis has contributed to a rapidly rising foreign presence in the market. For example, the market share held by foreign banks was only 3% in 1994, and has more than doubled in each of the following years, reaching a level of 15% in 1996. It will be recalled that when NAFTA was negotiated, the Mexican government anticipated that the foreign banks' market share would rise gradually to about 10% in 1996.(18) The greater than expected foreign penetration was stimulated by the unprecedented financial difficulties of the smaller banks following the 1994 devaluation, many of which were caught in a tightening financial vice as a result of their rapidly deteriorating loan portfolio (due to the country's economic depression and the imprudent lending practices of the banks) and the huge increase in their foreign currency debt which stood at staggering $18 billion at the beginning of 1995. For example, Banco de Union, Banca Cremi and Banpais, just to name of few of the smaller banks, have been provided with public funds via the newly created Programa de Capitalizacion Temporal (Procapte), and the Mexican state has actively sought greater foreign participation in the purchase of the banks' equity shares so that they can meet their pressing financial commitments to depositors.(19) That is, we find, once again, the Mexican state "sanitizing" these private enterprises and thus effectively subsidizing the sale of their equity capital to powerful foreign and domestic interests. Only the three biggest banks - Banamex, Bancomer, and Serfin - have so far managed to avoid serious financial difficulties and significant foreign ownership of their equity capital (capital ordinario), but at the cost of a wave of mergers and acquisitions that will further concentrate the Mexican-owned portion of the banking system.
Table 2. Mexico: Real Interest Rates and Financial Margins, 1897-94

Years        Deposit Rates (CPP)    Average Lending    Rates Margins

1987                -14.61                -4.71             9.90
1988                -25.12               -14.18            10.94
1989                 20.31                33.40            13.09
1990                  8.45                19.08            10.63
1991                 -0.22                11.58            11.79
1992                  2.71                14.05            11.33
1993                  6.18                20.80            14.63
1994(*)               9.08                24.74            15.66

Note: * As of July 1994.

Source: Jose L. Calva, "El nudo macroeconomico de Mexico: La pesada
herencia de Ernesto Zedillo," Problemas del Desarrollo, vol. 26,
numero especial, enero-marzo 1995, Table 15, p. 92.


What makes the current wave of foreign takeovers and domestic mergers so worrisome, aside from the obvious equity considerations, is the poor track record exhibited by the banking regulatory agencies during the Salinas sexenio. In their zeal to establish market-friendly credentials, the agencies turned a blind eye to a number of excesses, ranging from allowing exorbitant spreads to permitting the second largest bank, Bancomer, to grant so many car loans that when the crisis hit, its foreclosure rate on these loans made it into the de facto owner of the largest automobile fleet in Mexico!(20) It remains to be seen whether the regulatory mistakes, oversights, and monopolistic abuses which have characterized the Mexican banking system can be avoided in the near future, and one can hardly blame a disinterested observer for being apprehensive about the eventual outcome.

III. THE CHILEAN EXPERIENCE WITH PRIVATIZATION

The privatization of Chilean public utilities of the so-called core sector began in the second, and most important, phase of privatization, i.e., between 1985 and 1990. During this period, around 30 state-owned enterprises were sold, including telecommunications, electricity generation and distribution, water and sanitation facilities, and the national airline, LAN-Chile. After converting the enterprises into corporations whose shares could be traded in the stock market, the Chilean state employed several institutional and market procedures in the privatization of these formerly strategic enterprises. For example, in the case of "capitalismo popular," which comprised between 5 and 10% of the outstanding shares, workers were induced to buy underpriced shares by receiving an advance of up to 50% of their severance payments. In addition, the state guaranteed the repurchase of the shares at the age of retirement at the severance payment value which meant, de facto, that there was no risk of loss for the workers.(21) Through this privatization method, the number of direct shareholders in the privatized companies rose from around 26,000 to over 200,000 in 1989, with workers comprising about 15% of the total.(22)

A. Institutional Capitalism

Although from an economic standpoint the total number of shares directly sold to workers was relatively small, it was highly important from a political perspective because it gave workers a financial stake in the profitability of the firms that they own, thus making it more difficult for future governments to reverse privatization.

Another method utilized by the Chilean government to privatize public sector firms during this phase was labeled institutional capitalism. Under this approach stock of privatized firms was sold to institutional investors in general and to privately run pension funds (AFPs), in particular. This procedure also served to promote, indirectly, a wider share of ownership among the Chilean public via the investment of their pension funds. In order to minimize the risks to the newly created pension system, the Chilean government created a SuperIntendency of AFPS that set an ownership limit for each AFP that stipulated that the shares of the privatized firms could not represent more than 5% of the their total investment portfolio. Chilean economist Patricio Meller (1993) observes that in spite of "these limitations and regulations, the AFP acquired (1990) around 25% of the shares of the privatized firms."(23)

B. Foreign Investors

In the case of international bidding, foreign investors were invited to acquire shares of the privatized firms via stock market and international open auctions. According to Meller, when employing the former method, foreign bidders were not allowed to acquire a controlling interest in the privatized firms (no more than 10% of the outstanding shares could be bought by a single buyer), while in the open auction method they could, as happened with the privatization of the large Chilean telephone company (CTC). Foreign investors were also encouraged to use external debt paper to acquire shares in the privatized firms. This process was heavily subsidized by the Chilean government because the debt paper, at the time, was trading in the secondary market at 30 to 40% of its face value, yet it could be presented to the Chilean Central Bank and redeemed at par value in local currency. Moreover, the favorable exchange rate prevailing at the time and the underpricing of shares of the traditional SOEs enhanced the effective subsidy of the debt-equity swap program. In total, between 1985 and 1991, the program accounted for about 50% of foreign investment in the shares of privatized enterprises and contributed to significantly reducing Chile's accumulated external debt.(24)

C. Regulatory Framework

Despite the relative success of the second phase of the second round of the Chilean privatization process, Meller points out that "the divestment of public firms has been so rapid that there has been no time to establish a regulatory framework within which the natural monopolies will operate."(25) This is clearly exemplified by the operational and regulatory problems associated with the privatization of the large Chilean telephone company (CTC).

The privatization of CTC began in December of 1987 and was completed in 1990 when Telefonica de Espana acquired a controlling interest in the company. Although from a broad economic standpoint the privatization of CTC has been a success (in terms of relatively higher rates of return in the post-privatization environment, an improvement in call-completion rates and repair responses, and a decrease in the practice of subsidizing domestic rates through higher international rates), the lack of clearly defined rules regarding entry into the industry and what type of communications services it should specialize in has created confusion and diminished allocative efficiency. The problem arose when CTC, a natural monopoly supplying about 95% of local phone services, decided to enter the lucrative international long-distance market (by installing an optical fiber network and its own long-distance satellite-based operations) even though ENTEL was originally established by the Chilean government to provide long-distance service for the country. ENTEL, for its part, legally challenged CTC's decision to enter this market because the latter's dominant position in the market (arising from the fact that all long-distance operators must get approval for new connections from the local phone company), could lead CTC to discriminate in favor of its own affiliated long-distance operator.(26)

In October of 1994 the Chilean Supreme Court ruled that CTC could compete in the long-distance market along with ENTEL and four other long-distance operators, including Bellsouth, Chilesat, VTR, and Lusatel. Since the liberalization of the long-distance telephone market, the rates for calls to the U.S., Spain, and Japan have fallen by almost 75 percent. The Supreme Court's decision has also led the six companies to invest heavily in Chile's long-distance business which is projected to double from the current $500 million a year to $1 billion by the end of the decade.

However, the benefits to the consumer ensuing from the price-cutting war have come at a heavy price in terms of the balance sheets of the long-distance operators. Table 3 shows that during the first six months of 1995 the operators had jointly lost more than $52 million, with 78% accounted for by ENTEL, CTC, and Bellsouth. The intense competition that has followed the Supreme Court ruling has led the companies to drastically cut labor costs, seek additional [TABULAR DATA FOR TABLE 3 OMITTED] capital from abroad, and not surprisingly, consider merging with their rivals. Table 3 reveals that, altogether, close to 1900 jobs have been eliminated during the period in question, of which 1,100 were accounted for by ENTEL and CTC. In addition, VTR - a company belonging to Chile's Luksic group - has taken on a foreign partner, Southwestern Bell, in order to raise needed capital and offer a full range of activities such as cellular telephony and cable television.(27) There are also reports of potential mergers and "strategic alliances" among the remaining long-distance operators.

In this connection, it is important to point out that aside from its 43.6% share in CTC, Telefonica also has a minority participation in ENTEL (20%). This led to a situation in which Chilean regulators concerned about the likely exercise of monopoly power ordered the foreign company to divest from either one of the companies.(28) Telefonica initially appealed the decision to the Chilean Supreme Court, but in view of the Court's decision in October of 1994 it is almost certain now that it will divest itself of its shares in ENTEL. Again, this example serves to illustrate the fact that is it far more effective to prevent the emergence of anti-competitive practices aimed at creating market power, than it is to combat the anti-competitive practices of established domestic and foreign monopolists. Still, the question that now remains for the Chilean consumer is whether the ongoing price war and heavy losses of the long-distance operators will, in the long run, mean a more concentrated market with considerably higher rates in order to recoup heavy current losses.

Another example of regulatory failure that could lead to monopolistic abuses has arisen in the Chilean electricity industry. It is now a well-established fact that competition can be introduced in the generating and distributive operations of the industry. Only the transmission network need be a natural monopoly. However, when ENDESA was privatized, regulators allowed the company to maintain its monopolistic position in activities where competition is not only viable but should be encouraged. For example, ENDESA provides 65% of the power generation, owns the Central zone transmission grid, and its controlling company ENERSIS owns the largest distribution firm (CHILECTRA). Moreover, ENDESA owns most of the water rights for hydro-electric projects for the next twenty years.(29) Obviously, the present organizational structure creates high entry barriers that are likely to reduce competition in the industry for some time to come.

The Chilean experience clearly demonstrates that even in a country deeply committed to private property rights and the workings of markets, regulatory failure may induce delays in investment patterns, diminished allocative efficiency, conflicts of interest, discriminatory behavior, and sub-optimal patterns of development at the sectoral level.

IV. SOME RECOMMENDATIONS FOR ENHANCING THE EFFECTIVENESS OF PRIVATIZATION PROGRAMS IN THE REGION

The case studies outlined in this paper for Chile and Mexico are by no means meant to be exhaustive or entirely representative of what is occurring in the privatization and liberalization movement sweeping the region. However, they do point to actual and potential problems that have arisen when privatization and liberalization efforts have taken place without efficient and credible legal and regulatory frameworks in place. The central question then is how to specify and sustain a set of economic policies that will promote market forces in the region, without allowing them to both trample weaker economic interests and generate excessive distributional inequities.

First, as mentioned above, regulatory systems and enforceable antitrust laws need to be in place well before the privatization and deregulation of a given industry. At a minimum it would be wise to avoid the simultaneous privatization of several public service sectors which have newly emerging regulatory systems and where administrative and operational flaws are likely to be discovered only after privatization. Otherwise, one may end up with a situation which emerged in the Mexican airline industry or the Chilean electricity industry where, in the presence of lax regulatory supervision and the absence of anti-trust laws, the privatized firms were able to quickly consolidate and exercise considerable monopoly power.

Second, in order to avoid becoming "captured agencies" of the industries they are supposed to regulate and monitor, regulatory agencies should be strong and financially independent institutions that have their board appointments staggered through the political cycle. The financial strength and relative independence of these agencies could be insured by legally requiring industry members with gross revenues above some minimum threshold to pay a flat rate (say, 2-3% of revenues) into a state fund specifically earmarked for the regulatory agencies' general maintenance, hiring of personnel, and administrative and technical training. Although by no means the only (or best) funding option, this institutional mechanism is used by a number of U.S. regulatory agencies (e.g., the Department of Public Utility Control in Connecticut) in the public services sector (e.g., gas, water and electricity).

Third, regulatory personnel should be technically qualified, very well paid relative to the industry that is being regulated, provided with promotional and training opportunities, and prohibited from working in the regulated industry for a specified period of time after their board appointments are terminated.

Fourth, to avoid moral hazard problems on the part of private owners - namely engaging in excessively risky behavior that calls forth government intervention to socialize losses, particularly in industries such as banking and finance where bank failures are usually amplified, given the high degree of interdependence among these institutions (as happened in Mexico following the 1994 peso devaluation and in Chile in 1982-83) - the state should consider regulating the privatized firms more comprehensively than is traditionally the case, including their lending practices, debt accumulation, diversification of assets, investment policies, and merger activity.

Fifth, privatized firms in the telecommunications and airline industries should have the scope and duration of their monopoly privileges reduced (not like in Mexico where TELMEX was granted a 50-year guaranteed monopoly) and competition should be allowed immediately in non-basic operations such as cellular telephony, data transmission, cable television, ground services, computerized reservation systems, etc. In addition, regulatory systems must be flexible in the face of fast changing technological developments taking place in these sectors.

Sixth, regulatory systems should be transparent in the sense that they are based on impersonal rules that are clearly defined and technically consistent with the administrative skills of the country's regulators, and comprehensible to not only owners and management, but also to consumers and the public at large.

Finally, although effective regulation may initially lower the present discounted value of the firms about to be privatized when compared to those that are granted extensive monopoly power - thus undermining the objective of generating immediate revenues for financially-strapped governments of the region - the tradeoff may not be significant because rational agents will discount the effects of excessively permissive regulatory frameworks that in all likelihood will be subject to thoroughgoing restructuring at a later date.

Acknowledgment: The author wishes to thank Professors Werner Baer and Donald Goes for their valuable comments and criticisms on an earlier draft of this paper.

NOTES

* Direct all correspondence to: Miguel D. Ramirez, Department of Economics Trinity College, Hartford, CT 06106-3100.

1. The decision to privatize a SOE can be formalized by appealing to the following expression:

W = (E + L + tV) - (T + V) (1)

where W is the net gain to the state from privatizing the firm; E denotes the expected net value of externalities generated by the firm when it is privatized. The E variable may have a positive or negative sign. L refers to the lump-sum payment that the state expects to receive when privatizing the firm, while tV is the net present value of the future stream of profit taxes, where t denotes the tax rate and V represents the present value of the firm's future stream of revenues. Finally, T refers to the transaction costs associated with the privatizing the SOE (e.g., finding buyers, assessing the "true value" of the firm's assets or "sanitizing" the firm before sale).

Equation 1 above suggests that the state should choose to privatize the SOE if it anticipates high positive externalities, a high sales price, low transaction costs, a high revenue flow, and a low present value of the firm. For further details see Cantor (1996, pp. 96-111).

2. For example, William Baumol (1982) suggests that high concentration per se need not constitute a problem provided that the market in question is contestable in the sense that entry barriers are not insurmountable so that the threat of competition is perceived as credible by the incumbent firms.

3. See Ayres (1996, pp. 303-324) for a detailed and insightful analysis of the rising level of concentration and collusion in the privatization of the Brazilian steel, petrochemical, and fertilizer industries.

4. See Armstrong (1994, pp. 14-15).

5. In terms of equation (1) above, the lump-sum payment, L, received by the state may be offset by the long-term loss in government revenues if the tax rate t is reduced significantly or eliminated. Moreover, the deficit-reducing effects of privatization may be offset completely if one includes the transaction costs, T, associated with "sanitizing" the enterprises in order to render them more saleable to domestic and foreign buyers. For further details see Birch and Braga (1993, pp. 119-133). See also Baer and Birch (1992, pp. 1-25).

6. For further details see Vickers and Yarrow (1988, pp. 35-39).

7. See Hanson (1994, pp. 199-216).

8. Ibid., p. 204.

9. Ibid., p. 206.

10. Ibid.

11. To compound matters, the OECD reports that the distribution of household income in Mexico during the 1989-92 period has become more skewed. For example, the top quintile increased its share of household income from 53.5% in 1989 to 54.2% in 1992. At the same time, the remaining bottom deciles - with the exception of the third and fourth lowest (where their respective shares remained unchanged) - recorded a drop in their shares of household income. Not surprisingly, the OECD also finds that the Gini coefficient for Mexico rose from .46 in 1989 to .48 in 1992. For further details, see OECD Economic Surveys: Mexico, 1995. Paris: OECD Publications, 1995, p. 101, Table 23. Undoubtedly, the rapid and unprecendented concentration of banking assets in relatively few industrial and financial Grupos that accompanied the privatization of the Mexican banking system aggravated this unwelcome trend in income (and wealth) inequality in Mexican society.

12. Elizondo (1993, p. 11).

13. Ibid., p. 15.

14. See Mexico Business Monthly, October 1991, pp. 6-7.

15. For a radical perspective on the Mexican banking crisis, see Cypher (1996, pp. 455-456).

16. Elizondo, op. cit., p. 12.

17. See Peiro, "Cambios en la Actividad Empresarial del Estado Mexicano," in Giron and Roldan, eds. (1996, pp. 127-147). For further details see Ramirez (1995, pp. 104-109).

18. The growing participation of foreign capital is by no means confined to Mexico. Latin American Weekly Report (LAWR) reports that between 1993 and 1995 the share foreign capital in government revenues from privatization in Latin America rose from 37.6% in 1993 to 61.8% in 1996. For further detail see LAWR, July 29, 1997, pp. 354355.

19. See Latin American Economy and Business, April 1995, No. 4, for further details.

20. Ibid.

21. For an informative assessment of Chile's privatization process between 1974 and 1990, see Luders (1991, pp. 1-19).

22. See Christian Larroulet, "The Impacts of Privatization on Distributional Equity: the Chilean Case, 1985-89," in Ramanadham (1995, p. 237). In this connection, Hachette and Luders (1993, p. 103) estimate that if share holdings through the AFPs are taken into account, then the number of shareholders rises to over 3 million.

23. See Meller (1993, pp. 95-112). See also Hachette & Luders, op. cit., pp. 106-107.

24. See Luders, op. cit., Table 5, p. 17.

25. Meller, op. cit., p. 107.

26. Bitran and Serra (1994, pp. 179-197).

27. Latin American Weekly Report, August 31, 1995, WR-95-33, p. 389. the LAWR also reported that a group of commercial banks from Europe, Japan, and the U.S. has granted CTC a loan for $200 million to help finance the company's investment plans for 1995 and 1996.

28. See Birch and Braga, op. cit., p. 127.

29. See Bitran and Serra, p. 184.

REFERENCES

Armstrong, Mark. 1994. Regulatory Reform: Economic Analysis and the British Experience. Cambridge: MIT Press.

Ayres, Ron. 1996. "The Economics of Privatization and Regulation: The Brazilian Experience, 1990-94." Journal of Political Economy, 8(3): 303-324.

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Baumol, William. 1982. Contestable Markets and the Theory of Industry Structure. New York: Harcourt Brace and Jovanovich.

Birch, Melissa and C. A. Primo Braga. 1993. "Regulation in Latin America: Prospects for the 1990s.," The Quarterly Review of Economics and Finance, 33(Special Issue): 119-133.

Bitran, Eduardo and Pablo Serra. 1994. "Regulatory Issues in the Privatization of Public Utilities: The Chilean Experience." The Quarterly Review of Economics and Finance, 34(Summer): 179-198.

Cantor, Paul. 1996. "To Privatize or Not to Privatize." Review of Radical Political Economics, 28(1): 96-111.

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Elizondo, Carlos. 1993. "The Making of a New Alliance: The Privatization of the Banks in Mexico." CIDE 5 (Documentos de Trabajo): 1-20.

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Hanson, Gordon H. 1994. "Antitrust in Post-Privatization Latin America: An Analysis of the Mexican Airlines Industry." The Quarterly Review of Economics and Finance, 34(Summer): 199-216.

Larroulet, Christian. 1995. "The Impact of Privatization on Distributional Equity: The Chilean Case, 1985-1989." In Privatization and Equity, edited by V. V. Ramanadham. London: Routledge.

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Peiro, Isabel R. 1996. "Cambios en la Actividad Empresarial del Estado Mexicano." In Mexico: Pasado, Presente y Future, edited by Alicia Giron and Genoveva Roldan. Mexico City: Siglo XXI Editores.

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Vickers, John and George Yarrow. 1988. Privatization: An Economic Analysis. Cambridge: MIT Press.
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Title Annotation:The Changing Role of International Capital in Latin America
Author:Ramirez, Miguel D.
Publication:Quarterly Review of Economics and Finance
Date:Sep 22, 1998
Words:7868
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