It depends what you mean by privatization

Privatization has been one of the strongest oars rowing the boat of global economic liberalization.

In the last two years alone, the privatization sale of assets reached $53 billion in Europe, over $5 billion in the Americas and nearly $9 billion in Asia. In eastern Europe privatization helped push the transition from communism to capitalism. As output from the non-state sector soared to 55% of GDP, assets with an estimated economic value of $200 billion were returned to the people.

Worldwide, in most countries where state-owned enterprises (SOEs) had played a significant role, selling them off added between 0.5% and 3% to equity market capitalization, on average amounting to 0.7% of GDP.

In restructuring and emerging economies such as Hungary, Indonesia and Poland, as well as in developed European countries such as Denmark, France and Italy, where the state had been a big producer, the ratios were even higher. But these figures don’t convey the real economic significance of privatization. That lies in its role as a catalyst for greater economic efficiency. And, as I’ll argue, it is greater economic efficiency that is the long-term argument for creating investor wealth too.

But to understand that, first let’s analyze the economic role of SOEs before privatization. Anybody who has visited a supermarket, a post office and a railway station must draw one conclusion: bureaucrats and politicians are not cut out to run corporations, while supermarket managers are. The more of an economy the state owns, the less productive that economy will be. Transferring ownership to the private sector of most of the things you and I can invest in can only be a good thing if done properly.

Two things stand out. The first is that the regions of the world where SOEs are biggest in terms of their share of total output are those with the poorest track record of economic success. In Africa, SOEs account for 18% of output compared with 5% in industrialized countries. In low-income developing countries, the ratio is 13% and in Asia (including non-Tiger economies like India and Pakistan) it’s 10%. Low growth and big state ownership tend to go together.

The second message is that SOEs don’t only have an impact on the markets they supply, where they are undoubtedly poor performers, but also on the markets which supply them. In Africa, for example, SOEs account for 28% of all capital formation and use 17% of the total credit available in the economy to do it. They also employ 16% of the labour force. In middle-income developing economies, which include the Asian Tigers, SOEs still play an important investment role, accounting for 21% of total investment. But they use only 10% of national credit and 3% of the labour force to do it.

Economic distortions

In China, SOEs are even more dominant in their use of national savings and labour, respectively 60% and 70%. Worse, we estimate that the SOEs’ marginal output is less than half that of foreign direct investment and the TVEs (profit motive-based township and village enterprises). In other words, as China wastes its own resources, it is overly dependent on those of others to maintain growth. And the distortions that SOEs cause are at the epicentre of the country’s structural economic problems, jerky economic cycles and growing regional wealth differentials. It is this too more than anything else that is responsible for the awful returns investors have made on their China B and H shares. China would do much better to privatize its SOEs and increase the efficiency with which it uses domestic labour and capital.

The interesting point here is that despite all this there is a role for SOEs to play in successfully emerging economies. The proportion of investment and output they represent in many east Asian Tigers is twice that of rich industrialized countries. But the efficiency of east Asian SOEs sets them apart from those in industrialized countries and in less-successful developing countries. SOEs in low-income countries, particularly in Africa, use proportionately much more of the national savings rate and available labour to do the job of economic development. In the main, the rule still holds that as economies get richer, SOEs should be privatized if economic growth is to be maintained.

Privatization is a means to gain economic productivity, but it is not a palliative. Above all, it doesn’t work in isolation. Five conditions have to be fulfilled. On a micro-scale, the enterprise has to be sold off, and management control and ownership have to be firmly rooted in the private sector. Privatization works best if it is carried out in a competitive environment so that the SOE has to cope with liberalized markets – where barriers to entry are minimized – for its products. State subsidies and policy loans should be eliminated. SOE monopoly prices have to be regulated with a clear pricing formula that keeps pressure on management to improve efficiency.

The markets that surround SOEs on the output and input sides must be liberalized at the same time. That means deregulating banks so that the SOE has to compete for capital at market prices. It means freeing up labour so that SOEs compete for talent and no longer provide jobs for the boys. The same goes for markets – no more cushy contracts with the government and, yes please, lots of competition from imports and new domestic entrants to the marketplace where possible.

If privatization is to produce the economic benefits synonymous with creating investor wealth in the long term, it’s no easy option. I believe that the motivation that drives governments to privatize tells us if the conditions for success will be met.

So, let’s look at the state’s motives for privatizing. There are three types.

The first type is that of the former communist countries. They want to return what was stolen from the people to the people. In doing so, they hit a number of goals. One is to create a property-owning middle class (real estate is privatized too). That rolls back communism forever, though not ex-communist parties when it comes to politics. In microeconomic and macroeconomic terms, the benefits are to increase the efficiency of corporate management and thus raise the productive potential of the economy.

The second type is exemplified by Margaret Thatcher’s UK. As in eastern Europe, Mrs Thatcher wanted to change irreversibly the political systemas much as the economic system. Hers was a moral vision. Privatization was, as in eastern Europe, a step towards greater social equity. It was a part of the process of “responsibilizing” the individual, be he or she a manager of a (previously) state-owned enterprise or the buyer of a council flat. None of this was disinterested – outside the tales of the martyrs, few great historical acts are. It worked nicely in favour of her own and her party’s fortune by shifting the UK political spectrum to the right.

The third type of privatization is that of what I call the Southern Comfort Countries (SCC). These are the highly indebted European states. They share few of the Thatcherite tenets of economic liberalization. They have a simpler motive: they are bankrupt. Privatization is a means of grappling with the problem of empty state coffers, no more and no less. When the SCCs privatize, they are doing something close to what Harold Macmillan thought Mrs Thatcher was doing, namely selling off the “family silver”.

And there are privatizations that fall somewhere between the moral vision of the UK or eastern Europe and the opportunistic motives of SCCs. Latin America went for privatization because it went bust. But because it went bust it wished to change its economic model. In Argentina and Chile, privatization was part and parcel of a profound commitment to market liberalization on a broad front.

Market liberalization

The closer a country is to the “moral” vision of eastern Europe or Thatcherite Britain, the more likely it is that the five major conditions for successful privatization will be satisfied. Argentina, Chile and the UK all created the market conditions for privatizations to work because they were matched by a firm commitment to enact broader measures to liberalize markets and the economy.

In eastern Europe this is true too. But the process has not been good to shareholders for two reasons: the financial markets and local participants are unseasoned and the process of mass privatization has impeded the concentrated share ownership that would force proper management of companies. This is particularly important given the need to restructure them. In my view, this is about to change in the Czech Republic, Hungary, Poland and Russia. So I would invest selectively there.

In the SCCs, the deep commitment to market liberalization upon which successful privatization depends is simply lacking. It is far more likely in these markets than elsewhere that the investor will be screwed by the powerful combination of state interest and mendacious investment banks.

Much of continental Europe is close to this model. So too, alas, is much of Asia, where one mentality applies when it comes to the economy and another when it comes to selling state assets and then letting them operate as private-sector corporations.

The performance of privatized shares bears this out. UK privatizations have outperformed those of Italy and France. The reason, I believe, is clear. UK privatization was part of a broad thrust of economic liberalization, continental Europe’s was not.

Nevertheless, many investors are cynical about the notion that what’s good for the economy is good for the investor. They believe that buying into a privatized utility that preserves its natural monopoly and has no price formula may make them more money than buying into a privatized company which is being opened up to competition. The former corporation, so they argue, will continue to earn monopoly profits. This is true – particularly if the utility is priced cheaply at the outset. But it’s a dangerous game to follow this investment instinct and not one that I recommend.

Rather, I strongly believe that over the longer haul truly competitive and dynamic corporations do better for investors than monopolists. There are several reasons for this. A monopolist is normally inefficient and may just turn excess prices into excess costs and kickbacks rather than shareholder returns. I’d prefer to own something that earns an honest and competitive return on capital.

Also, a privatized corporation with which the state maintains a close and influential relationship will be asked to “pay” for any benefits it gets. Furthermore, in an economy that is globalizing everything from electricity to telecoms equipment, the cosseted privatized producer will lag in terms of technology and efficiency. Eventually markets will be prised open and profitability will collapse. So the conditions that make privatization an economic success are the same as those that make them successful investments.

1994-95 privatization issues to market capitalization (%) for selected countries

1994-95 privatization issues by region

David Roche is president of Independent Strategy, a London-based research firm.