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Finance & Development, December 1979
Article

Government and public enterprises–the budget link: How to improve the budgetary relationship between public enterprises and government so as to bolster the often lagging performance of these enterprises

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1979
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A. Premchand

State enterprises have grown substantially during the last three decades. Traditionally confined to public utilities, they now vary widely in the ways they are organized, and in their spheres of activity. Organized as corporations, companies, holding companies, boards, statutory authorities, special accounts, and autonomous agencies, their functions range from agricultural farms to highly sophisticated and high-risk ventures such as aerospace industries, and include the manufacturing of capital and consumer goods, mining and extractive activities, and trading and marketing. In many countries, strategic sectors such as energy, transportation, communications, and iron, steel, and coal production are completely operated by state-owned enterprises. Because of their diversity, state enterprises are hard to define, but they are generally owned and/or controlled by government and are usually autonomously organized—with the government providing the initial capital and being responsible for a continuous overview of their activities.

State-owned nonfinancial public enterprises (NPEs) (excluding such financial institutions as central banks and state-owned commercial banks) are now among the largest employers in a number of countries. NPEs now contribute about 40 per cent of gross domestic product in Bolivia, 25 per cent in Pakistan, and 16 per cent in India. In 1974, the share of these enterprises in the total invested capital in India was 45 per cent, 38 per cent in Iran, and 18 per cent in Sri Lanka.

The growth in the role of NPEs has been accompanied by an increasing concern about their financial performance, in part because many NPEs have tended to be less successful than expected. Their dependence on the government for subsidies and other forms of assistance contributed to deficits in the government budget and aggravated tendencies toward deficit financing. This phenomenon is common to both developed and developing countries and raises questions covering a wide range of structural, economic, financial, and managerial issues about the present and future role of enterprises. A recent study in the United Kingdom noted, for example, that there is “confusion” about the respective roles of government and enterprises and that the situation is “unsatisfactory and is in need of radical change.”

New functions

The effects of NPEs on the national economy can be grouped under several headings: first, on stabilization policy; second, on development programs; and third, as instruments for raising revenues. They are used, for instance, to counteract general deflationary tendencies in the economy; to help to eradicate poverty and promote regional development; and as fiscal agents operating as proxies for indirect taxation or as a medium for subsidization.

But if these enterprises are to fulfill these purposes, they must be well managed. Two factors threaten their sound financial management, and, in turn, risk causing destabilizing effects at the national level. Both these are inherent in the close and permanent relationship of NPEs with government. First, NPEs rarely run the risk of liquidation. Second, as most, if not all, of their funds are provided by government, they do not always operate under the discipline of having to be profitable. And in fact, experience with these enterprises shows that such dependence on government—often accompanied by easy access to credit, subsidized interest policies, and liberal write-off of loans—has contributed to inflationary pressures and difficulties in controlling aggregate spending in national economies, especially in those where NPEs have a large role.

NPEs thus have to fulfill two interdependent functions: to serve as a tool for government policies and to operate efficiently. Just how efficiently they should perform is a crucial question; different countries have different answers for different enterprises. Ideas on the question have evolved over the years. In the industrial countries, in the early years of nationalization after World War II, the guideline was that the enterprises should aim at recovering their total costs. In practice, this meant the adoption of a no-profit no-loss approach. This was followed by an approach that emphasized commercial behavior or profitability. (A report prepared by the United Nations in 1969 observed that the “profitability criterion has now become the official doctrine.”) However, neither the level nor the measurement of profit was clearly specified. Against the recognition of the need for allocative efficiency and to minimize distortions from subsidies, a new aim for NPEs has emerged: to obtain profits that reflect the opportunity costs of capital—that is, earning enough to cover all expenses, and, in addition, the implicit return on invested capital which could be obtained from alternative uses of capital funds.

The achievement of this goal involves, first, the task of defining appropriate policies for NPEs, and then of rendering them feasible. The policies should be based on an economic analysis of their operations that explicitly include any budgetary or social costs involved in meeting national objectives. Pricing policies, for instance, should generally be based on marginal costs that, inter alia, include the opportunity cost of capital; the costs of any services provided by NPEs at a price below defined costs—to serve social aims—should, as far as possible, be explicitly included as a subsidy item in the budget. But converting these principles into acceptable policies is difficult. The calculation involves the choice of appropriate interest rates that reflect the costs of capital, an agreed measure of profitability, and the explicit listing of all subsidies. Moreover, due consideration should be given to the investments already in place whose rate of return may be different from that of the proposed investments. Some of these aspects are not always easy to define quantitatively, and there is often a need for indirect measures.

This article will examine ways in which the annual budget review can be used to improve financial management within NPEs. The improvements obviously only relate to issues covered by the budget process—establishing optimum rates of return, transferring funds in the appropriate form, determining workable levels for self-financing and borrowing by enterprises. Many issues remain outside the budget’s purview (not all NPEs are dependent on the government, for instance). Moreover, the feasibility of implementing improvements in those elements that the budget can affect is dependent on external factors that vary from country to country. Nevertheless, improving the budget process would lead to a more systematic and coordinated approach to enterprises, and this alone could have beneficial effects on the general effectiveness of government. Both experience and analysis point to the necessity of (1) evolving clearer and better coordinated national policies regarding NPEs, and (2) improving the budgetary process itself. (The chart illustrates the structural relationships between government and enterprise budgets.)

Budgetary relationships

The budgets of governments and those of NPEs are linked in three ways: (1) through national budgets which either include those of enterprises or which have only a thin dividing line between the two (as in Somalia and the Yemen Arab Republic); (2) through government direction, review, and approval of enterprise budgets which are, however, not included in the government budget (as in India, Sudan, and Tanzania); and (3) through government review of only specific aspects of budgets—such as capital expenditures financed by national plan allocations or subsidies (as in Kenya, the Philippines, and Saudi Arabia). In this last method, the enterprises function generally within the overall policies of government but have a substantial degree of operational freedom. As a result, the relationships between enterprise and government budgets may often have an ad hoc character.

Not all NPEs earn a profit: for example, some are under price restraints imposed by governments and others are instructed to operate to achieve specific national social aims. However, good financial management requires that the enterprises operate according to explicit objectives which specify the overall role of the enterprises (including their financial and social welfare functions), the returns expected on the government’s investment in the enterprises, and the period over which such returns should be made. In order to formulate such a framework, the government needs to undertake a comprehensive examination of the enterprise’s capacity to earn and to determine the share of earnings to be retained and the share to be transferred to government. In turn, there must be an annual assessment of how profitable the enterprises can and should be; such an analysis must consider exogenous factors like the size and nature of markets, the policy goals of government, existing levels of technology, and the availability and utilization of skills.

In practice, however, a large number of countries, including those where budgets of enterprises are fully integrated with the government budget, seem to set only ad hoc operational goals for enterprises. This has naturally led to numerous problems that could have been avoided. In some countries (Sri Lanka is an example) where there was no obligation for the enterprises to make any contributions at all, new legislation had to be introduced to ensure the transfer of operating surpluses to government. In others, lack of forward budgeting and advance corporate strategies meant that the size of contributions tended to be fixed arbitrarily. Elsewhere (as in Somalia and Sri Lanka) enterprises had to borrow funds from the banking system—and in some cases from the government itself—to meet their obligations. Variations of these experiences are so common that they underline the paramount need for a framework of national economic and financial objectives within which detailed planning of the enterprise activities and their contributions to government can be made.

Transfers

There are four main issues that arise when a government considers transferring funds to an enterprise: (1) whether the capital transfer fits into national priorities; (2) the form it should take—grant, equity, loan, or subsidy; (3) how much investment should be self-financed; and (4) how much the NPE should borrow.

Capital transfers—the initial capital for enterprises and the additional funding for takeovers or for extensions of installed capacities—are generally provided for as a part of national development plans. In principle, such provision requires an appraisal of the economic aspects of investment, including identification of the social costs, and the specification of the link between the proposed investment, its rate of return, and the necessary pricing policies. The investment programs—including those that are financed by enterprises from their own resources—need to be coordinated at a central level. Autonomous functioning can work against national priorities—experience with NPEs in Yugoslavia, for instance, illustrates how extensive self-management can work against central fiscal and monetary policies. Moreover, given the close relationship between industries, whether private or public, coordinated appraisal of investment plans makes good economic sense.

Nevertheless, in practice very few countries appear to undertake such comprehensive evaluation of investments in NPEs. More frequently, appraisals are undertaken to support a decision already taken rather than to weigh the alternatives. Moreover, these appraisals tend to be limited to selected individual projects rather than to the investment program of the sector as a whole. It is also evident that governments have too often tended to set investment levels intuitively rather than relying on actual market tests or on realistic estimates of market conditions. Frequently the lack of coordination between government investment plans and the self-financed plans of enterprises have led to situations where government-owned holding companies acquired units in lower-priority areas. Capital transfers should, therefore, be made to enterprises within the framework of a coordinated national program.

The second major issue relating to the budgetary review of transfers is the form these should take—whether as a grant, or equity, or a loan. Grants have two obvious disadvantages from an economic point of view: since they are made available free, they may not induce any financial discipline in the enterprise; second, the cost of a grant to the government is borne by the taxpayers and not by the recipients of the services of the NPEs.

Financing, then, should be provided to NPEs either in the form of a loan or as equity capital. Although from an economic angle these two have to earn a return, they have different implications and effects. Equity represents risk capital on which a dividend is declared at the management’s discretion; NPEs generally prefer to be provided with equity rather than loans. A loan implies the payment of interest—which is a cost to the enterprise and, in turn, affects the prices of its products. If an enterprise relies heavily on borrowing, this results in upward pressures on prices; if prices are then controlled—as they often are for a variety of reasons—the cash flow and profit position of NPEs would be seriously weakened. Loans can adversely affect an enterprise that has a long gestation period; the fixed interest charged by government can be onerous; and extensive capitalization may adversely affect the ability of enterprises to win new business. Governments prefer their financing to be in the form of loans for two reasons: their own funds are largely borrowed and when interest on government loans to the NPEs is not charged at the rate at which the government had originally borrowed, the burden would be shifted to the taxpayer.

Budgetary relationships between government and public enterprises

There are other practices relating to government lending to enterprises which lead to inefficiencies. Not only do governments provide NPEs with financing without systematically evaluating alternative sources of funds, but they also lend without any careful analysis of the terms and conditions. Short-term and longer-term loans are made without specific provision for amortization, and often at interest rates that are substantially below market rates. This has led, at one extreme, to an excessive volume of government loans and consequent capitalization in the financial structure of enterprises; at the other extreme, government funds have often become the easy financing option. Governments have also extended loans to enterprises not only to cover capital needs but also to cover accumulated operating deficits. Under certain conditions, this can be an acceptable practice, and is done frequently in the private commercial world; but efficient budgetary control requires that governments should not cover the losses of NPEs automatically. Instead, the causes contributing to losses should be studied—cyclical factors, managerial inefficiency, and technological obsolescence. Alternatives to simply meeting the losses should be examined. It may be appropriate, as a means of reducing costs, for instance, to decide to write off the loan, or to reduce the firm’s capital base. The financial implications of these alternatives need to be considered both in terms of the government budget and in terms of the capital costs of the enterprise.

A major form of transferring funds to NPEs, which has been and continues to be a subject of debate, is the granting of subsidies. These, by their very nature, require a clear policy on what to subsidize and at what level. Such clear policies have rarely been established. Experience with subsidies has varied widely. In some cases, indirect subsidies—such as reduced interest rates or preferential treatment for government procurement of goods—may not be identifiable in the budget. In others, no initial provision is made in the budget for the cost of subsidies, and the operational losses of enterprises are routinely covered at the end of the year by transfers from government.

With a view to reducing the rate of inflation, governments have often imposed price restraints on the products of NPEs. Such restraints may reduce the rate of inflation initially, but as the government budget usually compensated the enterprises for any losses caused by the restraints, they also generated inflationary pressures. Frequent revision of prices is also resisted by governments on the grounds that it might have a disruptive influence on consumer confidence. This approach had a twofold effect: price restraint prevented the enterprises from achieving a prescribed positive rate of return, and subsidies became open-ended as inflation increased. The combination of an absence of clear policies on subsidization and on price restraints has led enterprises to resort to perverse escape mechanisms, such as using capital allocations or other finance to cover operating expenses.

Self-financing, borrowing

How much of the investment made by an enterprise should be self-financed? Again, the economic implications should be examined. Self-financing affects the consumer as it leads to higher prices to cover costs or to increased profits. It may also raise the problem of present consumers paying the cost of increased investment for what may benefit only future generations.

Experience with self-financing shows that levels are often set arbitrarily by the government and have unintended consequences. These levels are frequently not attained and this contributes to a slackening in the expected rate of growth of the firm. In other cases, the absence of well-coordinated investment plans has led either to enterprises being flush with liquid funds, or to their building up excess capacity as a result of this liquidity. More significantly, the effects of investments by enterprises have often tended to be perverse: frequently such investments have been made at a time when they added to general inflationary pressures and withheld when financing was needed to counteract recessionary tendencies.

Borrowing is another important issue that arises out of the budgetary relationship between government and NPEs. Public enterprises have become major borrowers on their own account, both in domestic and in external markets. Borrowing by NPEs accounted for nearly a fourth of the total borrowing in international markets in recent years; in 1977 about half of this borrowing was accounted for by the NPEs from developing countries. Domestically, however, enterprises borrow more from government than they raise from the market.

Substantial foreign borrowing can be a potential problem at a national level, by contributing, for example, to debt servicing problems. When foreign and domestic borrowing is uncoordinated, this dual borrowing can work against government policies.

It is important, therefore, to clarify the borrowing activities of both government and enterprises. Borrowing independently could lead to a greater diversification of the sources of borrowing, while including such borrowing in the government borrowing program could be helpful for economic management. It appears that more is to be gained by including the enterprise’s needs in the borrowing requirements of the public sector as a whole, so as to minimize any adverse impact on the national economy from the timing and magnitude of borrowing.

Some limitations

In theory, then, better financial management of enterprises should result if issues such as profit margins, capital transfers, self-financing, and borrowing are systematically and comprehensively assessed as part of the annual budgetary review of the relationship between government and NPEs. The existing budgetary process in each country would be the most appropriate means of reviewing all the aspects of this relationship, but the process has a number of limitations. First, the formulation of appropriate fiscal policies requires comprehensive coverage of the financing and pricing activities of enterprises. Such a review has tended to be restricted to financing items appearing in the government budget and to the activities of those NPEs that are financially dependent on the government. More significantly, the operations of many subsidiaries of the government-owned holding companies, which have been growing substantially, appear to be outside the direct purview of the government review process (as confirmed by experience in France, Indonesia, and the United Kingdom). Further, there are no well developed financial reporting systems in the government on the activities of NPEs.

Second, budgets of government and public enterprises cover only a year and are based on annual operations that do not disclose longer-term corporate strategies. This has resulted in ad hoc decisions and annual changes that introduced distortions in the working of NPEs. Other factors—such as outdated procedures and lack of skilled manpower—have seriously weakened the capacity of the government to make comprehensive and systematic analyses. Moreover, the separation of planning and finance within the government has resulted in the adoption of dual approaches toward NPEs, which has, in turn, contributed to a situation where many vital decisions seem to fall between the two.

If these problems are to be avoided, a first step is to determine the realistic frontiers of what can and cannot be done by the government. Admittedly, the need is not for an Argus-eyed control by government, but for a well-coordinated program for the NPEs, a clearer allocation of their responsibility, and the institution of necessary arrangements for ensuring that they carry out the agreed policies. Both analysis and general experience indicate the need for improvement in two major areas: in overall policy and in the budgetary process. More efforts need to be made to evolve a framework of objectives and expectations of the government regarding NPEs. Such a framework implies an agreed strategy within which operational and managerial functions would be performed by NPEs. The framework, in order to serve as a basis for evaluation, should be specific and indicate the rate of return expected, the pricing policies to be followed, the extent and direction of subsidies, and any other social policies to be served by enterprises. These policies should recognize the characteristics of each industry and should also have some stability so that enterprises can plan their operations over a period of years.

Once such a framework is available, budgeting would become more rational and would essentially be concerned with the determination of the annual segments of the longer-term framework. It would also free agencies to install monitoring and evaluation systems that would permit a continuous assessment of the financial working of the enterprises. Care needs to be taken, however, to ensure that these systems do not take away from NPE management its decision-making responsibilities nor make enterprises too dependent on government responses. It is imperative that more attention should be paid to these matters now.

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