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Determinants of Public Enterprise Performance: Why some perform better than others

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1987
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Mahmood Ayub and Sven O. Hegstad

Why do some public industrial enterprises perform better than others? Why is it, for example, that public enterprises in Brazil achieve generally better financial and economic results than do their counterparts in Ghana or Pakistan? Within Brazil, what is it that makes the national iron ore company (CVRD) and the national petroleum company (PETROBRAS) much more successful than, say, the copper company (CARAIBA METAIS) or, at the extreme, the railroad company? Why does India’s Hindustan Machine Tools remain dynamic and well-performing, whereas other public enterprises in the same country and even in the same subsector are far less successful?

There are two possible sets of explanations. The first consists of country-specific characteristics and accounts for differences in performance of state industries from country to country. These characteristics include cultural, social, political, macroeconomic, and institutional factors. The second set includes factors that are specific to particular companies and accounts for variations in performance of state firms within the same country. These variables include the extent of domestic and foreign competition, the degree of autonomy, and the corporate and managerial culture.

The two sets of factors clearly overlap. This article, based on a study of developed and developing country public enterprises for the World Bank (see box), deals only with those influences on performance that are peculiar to public firms and can be affected by policymakers. It therefore excludes cultural factors, even though these can be critically important in determining the success of a public enterprise. Factors that affect the performance of both private and public enterprises are also beyond the scope of the discussion. Examples would be the quality of chief executive officers and other members of top management, as well as the macroeconomic and institutional environment. With respect to the macroeconomic environment, this discussion assumes that governments intent upon improving the performance of state enterprises would adopt appropriate macroeconomic policies.

To some extent, the reasons that public industrial enterprises generally do less well than their private counterparts lie in the differences inherent in their ownership. These include the fact that the directors of public enterprises have no financial stake in the business and probably take less interest in the degree of its success than they would if the reverse were so. The easy recourse to government finance that public enterprises enjoy greatly mutes the threat of bankruptcy and reorganization and potentially encourages complacency. Even when financial conditions might indicate cutting back payrolls, public enterprises usually face political opposition to such a move. Finally, decisions are a longer time in coming within public enterprises, where the decision-making process has been made circuitous to ensure public accountability. Important as these influences may be, three other variables are equally important: the competitive environment, financial autonomy and accountability, and the extent and manner in which managerial autonomy and accountability are ensured.

Degree of competition

Although it is impossible to make a rigorous statistical analysis of the correlation between competition and performance, evidence from a sampling of countries strongly indicates that those state industries that must operate within the more demanding, competitive environments tend to perform better. The biggest constraints on competition for both public and private firms are inappropriate macroeconomic, trade, and industrial policies. These include overvalued exchange rates, import quotas and bans, high tariffs, price controls, domestic content legislation (especially in automobiles and electronics), investment licensing, and regulations on entry and exit.

In addition to removing the obstacles to competition by changing such policies, governments can take specific steps to foster competition for state industries. Such competition can occur even among public enterprises that are considered “strategic.” A good example is the Heavy Mechanical Complex (HMC) in Taxila, Pakistan. The company faces competition from a privatized company, Ittefaq Foundry, in the production of road rollers and sugar mills. In the construction of cement plants it has to compete not only with imports, dutiable by 20 percent, but also with another public enterprise, Karachi Shipyard.

This article is based on a study, Public Industrial Enterprises: Determinants of Performance, published in 1986 as Volume 17 of the World Bank’s Industry and Finance series. The study drew on country case studies of such enterprises in 13 developing and developed countries.

In the manufacture of electrical towers, boilers, and overhead traveling cranes, its competition comes not only from private firms but also from the publicly owned Pakistan Engineering Company. In Brazil, the competition that the various petrochemical subsidiaries of PETROBRAS face is even more intense than that facing Pakistan’s HMC.

There is every reason to believe that Leon Festinger’s social comparison theory, which states that people evaluate their own performance by comparing themselves to others, not to absolute standards, applies to public enterprises as well. Central monitoring agencies should therefore make information on comparative performance widely available. In countries where central monitoring agencies review performance targets for all public enterprises, they could make a comparative analysis of performance available to all managers of public enterprises and also widely publicize the results. Apprehension of adverse publicity is an obstacle to this approach. This is obviously the case in Brazil and Pakistan, where many managers of public enterprises interviewed stressed their fear of unfavorable coverage in the national press.

Another way to subject public enterprises to competitive pressures is to encourage them to export. Of course, no amount of encouragement or cajoling can make them export if a country’s macroeconomic framework is biased strongly the other way. So long as the framework is appropriate, even a small amount of exporting can make a big difference. The outstanding performance of Hindustan Machine Tools in India can be largely explained by the fact that, since the recession of 1966–69, it has placed greater emphasis on exporting, marketing, and profitability. While it exports only about 8 percent of its sales, this seems to be enough to give the company access to new management techniques and new technologies.

In industries in which economies of scale are not important, competition can be enhanced by breaking up monolithic holding companies or large enterprises. The break-up of Sweden’s Statsforetag into smaller sectoral holding companies definitely increased competition and made public enterprises more mindful of efficiency. The present Bolivian government’s efforts to break up the Bolivian Mining Corporation into several competing companies could be a useful experiment. Occasionally, breaking up large enterprises does not necessarily produce better performance. For example, the break-up of the Fertilizer Corporation of India in the early 1970s made only a limited difference, mainly because the new smaller companies were hampered by the same inhospitable regulations under which the large former parent company labored. This underscores the importance of the regulatory and policy environment as companies try to improve their performance.

Financial autonomy, accountability

One of the main reasons that public industry runs into financial and economic problems stems from the fact that management and operations are not clearly separated from political and strategic considerations. In many cases, such blurred separation results in diffuse and conflicting objectives, a loss of the managerial autonomy needed for efficient commercial operations, and a civil service culture where chief executives are administrators rather than enterprising businessmen. In such an environment, employment, investment, and pricing decisions are often made without due consideration for their financial consequences.

A prerequisite for improving the performance of state industries is to delegate more decisionmaking to their managers. The managers interviewed in the study on which this article is based cherished financial autonomy above all, in the sense of being substantially free of the need to rely on treasury financing. The two French steel companies, Usinor and Sacilor, have been chronic loss-makers and, as a result, all major decisions require prior approval by their sponsoring ministry. By contrast, the essentially profitable companies of Saint-Gobain (now privatized) and Roussell have enjoyed the greatest possible managerial autonomy. Similarly, in Sweden, the profitable tobacco company has had significantly more freedom than the loss-making steel company, even though both are subsidiaries of the same holding company, Statsforetag. Profitability also largely explains the greater autonomy of Brazil’s petroleum company and iron ore company as compared with its steel companies and the railroad company.

There are various requirements for financial autonomy. They are greater market discipline, sound financial objectives, clear social objectives, appropriate capital structure, and greater discipline in financial relations.

Greater market discipline. A combination of more autonomy in financial matters and greater exposure to markets normally creates among public enterprise managers a stronger sense of responsibility and a deeper interest in the financial health of their company. In countries with robust private banking institutions and few implicit or explicit government guarantees, one way of institutionalizing financial discipline is to give state industries access to capital markets. Independent bankers scrutinize investment and financing decisions before they provide any loans.

Financial objectives and dividend policies. Sound financial management involves specifying a company’s financial objectives, monitoring progress toward them, and holding managers accountable for the outcome. The main measures of performance include return on assets or capital used, return on equity, dividend pay-out ratio, debt-to-equity ratio, and a specified level of internal financing of large investment projects. In Sweden, officials of the agency that oversees state industries argued that the establishment of broad financial objectives and enforcement of a clear dividend policy are even more essential in state enterprises than in private firms. They stressed that even though the dividends paid by state companies are often small, the principle of paying them matters more than the amount paid.

Clear social objectives. Public enterprises are often expected to pursue social objectives as diverse as redistributing income, subsidizing particular regions of a country, and creating or maintaining employment. The problem is not in the fulfillment of these objectives, which can often be desirable. The problem is that multiple objectives, together with the absence of a sense of priorities, allow social goals to become an excuse for poor performance. When using state industries for social purposes, governments need to consider two questions. Are the social objectives being fulfilled? Are there no better ways of achieving them?

There is evidence that using public enterprises to pursue social objectives can produce perverse results. One example can be found in Zambia, where strict price controls were imposed on refined oil and fats produced by Zambia’s publicly owned agro-based industries, which produce mostly vegetable oil products, detergents, and soap. These controls were recently lifted, but not before they had precipitated large financial losses, severely undercut staff morale, and shifted the product mix away from oil and fats. This result was precisely the opposite of the government’s social priorities.

There are better ways of making social changes. A country could achieve regionally balanced economic growth, for example, through investment encouragement schemes that consist of income and corporate tax credits and other measures. A large portion of the industrial growth of the economically depressed northeast region of Brazil over the past two decades was achieved with hardly any direct public investment. Often it is more effective to allow public enterprises to operate on commercial, profit-seeking lines and then use their profits to achieve such goals as income distribution and employment creation.

Appropriate capital structure policies. Several major benefits arise from using a proper mix of debt and equity, as opposed to using mostly or only debt in financing public enterprises. A mixture of debt and equity increases an enterprise’s eligibility to borrow in financial markets, serves as a check against overexpansion, stimulates a keener awareness of profit, and strengthens a company’s ability to survive recessions.

Greater discipline and transparency in financial relations. The accounts of the major public enterprises in the study sample contained a complicated maze of transfers between them and their central governments. To improve financial discipline and to be able to record “true” financial results, governments should demand tax, duty, interest, dividend, and amortization payments from public enterprises, just as they do from private companies. Losses and negative cash flow would then have to be financed in a more transparent way through new equity loans, or other means.

If governments are to require financial discipline from their public enterprises, they must demonstrate the same quality in their own financial management. They can do so in various ways. First, a government commitment to pay in new equity capital as part of a large investment project should consider the risks involved and the government’s own capacity to afford the capital. Second, when government payments to public enterprises have been approved by the appropriate ministries, they should not be delayed and questioned by other ministries. Finally, surpluses from public enterprises should not be used to finance government deficits. Instead, viable enterprises should be allowed to decide how to use their surpluses, once an agreed upon dividend payment has been made to the government as the major shareholder. Managers who have made the profits are normally better placed to decide upon their productive use than are bureaucrats more distant from the marketplace.

Managerial issues

The third crucial factor that distinguishes successful public enterprises from poorly performing ones is a higher degree of managerial autonomy and accountability in the top performers. Experience has shown that excessive control of and interference with the operational decisions of public managers (in investment, product mix, pricing, hiring and firing staff, wage-setting, and procurement policies) by the government unit with oversight can suffocate managerial initiative and result in a loss of accountability and costly operational inefficiencies. The problem of excessive control over operations is not only that the process is time-consuming for a bureaucracy already stretched to the limit, but also that government officials lack the necessary information, business perspective, and confidence to make correct and expeditious decisions.

Excessive political interference in the operational matters of public enterprises can be reduced by demarcating clearly the roles and responsibilities of the government (ownership role), the board of directors (strategic role), and the management of enterprises (operational role). Further benefits will accrue by appointing professional directors with experience relevant to their tasks and by decentralizing appropriate powers to the board of directors. Additional steps include introducing a management philosophy that is less control-oriented and procedure-bound, and more concerned with judging managers on the basis of enterprise viability and a limited set of indicators of performance.

The countries included in this study represent a wide spectrum of organizational structures. The most decentralized are those in Sweden and Norway. Intermediate ones are in Austria, Brazil, France, Israel, Italy, and Portugal, while highly centralized structures are found in Ghana, India, Pakistan, and Tunisia. A comparison of the two polar cases—Sweden and Norway on the one hand and Ghana on the other—is instructive. In Sweden, the Cabinet, the formal owner of public enterprises, has delegated this responsibility to the Ministry of Industry. Within the Ministry, an operational unit, the Unit for State Participations (Unit 5), which is staffed by eight professionals, actually executes the ownership role for the state industries, which employ 90,000 people. In Norway, where state industries employ 50,000 people, a staff about the same size as Unit 5’s in Sweden performs the ownership responsibilities. The Unit does not involve itself in the boards’ decision making and does not maintain a data bank of financial or operational data. The Unit does not keep a roster of management candidates, nor does it perform any management services. Executives of Unit 5 are directors on only a limited number of boards. They stress that in their role as board members, they should not overpower the board with their ownership role. Only in times of crisis and when state financial support is required does Unit 5 increase its involvement in decision making. Most public enterprises in both countries are organized as limited liability stock corporations and are regulated by corporate law. Where a firm also has private shareholders, the board reflects the fact.

Public enterprise managers in Ghana, by contrast, have had little autonomy until recently. Their companies were responsible for about 60 percent of total industrial production in the country in 1975–81, but their performance has generally been poor. The Ghana Industrial Holding Company was established in 1967. A central government body, the State Enterprise Commission, with varying responsibilities for development and control of public enterprises, has been established and re-established three times, in 1965, 1976, and 1981. In its current incarnation, its roles are to advise the government on issues involving performance, strategy, finance, and personnel, and to monitor and evaluate performance. The ownership role is vested in the sectoral minister. The lines of responsibility are then supposed to flow through the holding company’s board and management down to the board and management of the operating companies.

In practice, most control remains in the ministries, with the sectoral ministers holding the key positions. For example, the Prices and Incomes Board, which is a unit under the Ministry of Finance and Economic Planning, sets prices. The dismissal of five or more workers must be authorized by the Ministry of Labor (except in cases of proven criminal offenses). Import licenses are allocated by the Ministries of Trade and Finance, while letters of credit for approved import license are the responsibility of the Bank of Ghana and the commercial banks. Approval of immigrant quotas for foreign staff is handled by the Ghana Investment Center and the Ministry of Interior. Wage contracts need the recommendation of the Prices and Incomes Board and the approval of the Ministry of Finance.

It has been shown in state industries as well as in large private enterprises that the worst repercussions of a poor organizational structure can be avoided by scrupulously adhering to the following principles:

• The roles and responsibilities of the government, the board of directors, and the managers of public enterprises should be clearly demarcated.

• Authority should be fully delegated within the designated lines of responsibility.

• Professional directors and managers with experience directly related to their tasks should be hired.

• A management philosophy should be introduced that judges managers on the basis of financial viability and a limited set of other indicators.

Coordination within government

Once the government has decided how much decision-making authority to delegate, the next question is how to organize its own ministries and specialized agencies to ensure that decision making is effective. The multiplicity of government bodies involved in public enterprises has frequently led to confusion, duplication, and excessive control. Superimposed on this diffusion of responsibility is the tendency for public enterprises to suffer the extremes of political interference whenever the government changes.

One way to coordinate decision making and to prevent excessive political interference is by establishing supervisory agencies of some sort. Some among such bodies perform the full ownership role; the function of others is more limited. Responsibilities of focal points performing the full ownership role include establishing and amending the enterprise’s charter; hiring and firing the board of directors; approving annual accounts and dividend payments; hiring auditors; and monitoring performance. Responsibilities of such agencies whose role is only supervisory or advisory include defining financial and operational objectives; reviewing multi-annual plans and budgets; monitoring performance on a monthly or quarterly basis; and providing technical assistance and training.

While it is true that one main characteristic of state industry management is excessive government interference, it is equally common to find a lack of effective control—a situation that creates uncertainty, misunder-standing, and sometimes distrust, and that frequently ends up in excessive interference. The dual purpose of supervisory agencies is therefore both to protect the directors and management from undue political maneuvering and also to exercise effective control over a limited number of variables.

It is generally desirable to give supervisory agencies some elements of the ownership role together with their supervisory functions. This is done in Austria, Italy, Norway, and Sweden. In Brazil, the success of the Special Secretariat for the Control of State Enterprises (within the Ministry of Planning) depends partly on the fact that it has been granted several powers that normally belong to the ownership role. There are strong reasons for requiring a supervisory agency to report to more than one ministry. The agency might be responsible to an intersectoral committee, for example, or operate as a quasi-governmental unit, or be attached to the office of the prime minister or president. Such arrangements give the agency greater status and ensure that it does not become beholden to the narrow views of a single ministry.

Establishing an institutional and policy framework that is conducive to good performance by state industries is a challenging task. Because this is a relatively new area of economic inquiry, and because institutional issues loom so large, it is difficult to apply standard economic analysis. Prescriptions for the problems of public enterprises vary among countries, depending on factors such as the level of economic development, the availability of free markets, and the political philosophy. In essence, however, this article has proposed a framework that stresses the decentralization of decision making to the directors and management, and the strengthening of their capabilities. It has not attempted to quantify the benefits of this approach. It has provided compelling examples of how the performance of state industries varies widely, with the variations often being attributable to the way the industries are organized and run.

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