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Article

The Experience with Privatization

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1988
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Mary Shirley

Public Enterprise Advisor, The World Bank

Privatization should be viewed not as an end in itself, but as one of many means to help governments interested in fostering a new division of labor between the public and private sectors, in order to increase the efficiency and contribution to development of both government and business. The term privatization is used here in a broad sense, including not only the sale of state assets, but also privatizing the management of state activities through contracts and leases, and the contracting out of activities that were previously done by the state (such as selling railway tickets in the Republic of Korea or managing jails in the United States).

This article examines the lessons from privatization, based on the experience of countries studied by the World Bank and of programs with direct Bank support.

Maximizing the benefits

The experience with privatization in developing countries is limited. A recent Bank survey of 37 developing countries (Elliot Berg and Mary Shirley, “Divestiture in Developing Countries,” World Bank Discussion Paper No. 11, June 1987) found that in all but two developing countries (Bangladesh and Chile), the number of enterprises sold, leased, or contracted out was fewer than 20. Moreover, the enterprises privatized usually were small in terms of assets or employment; most were in the manufacturing or services sectors and had previously been in private hands. Nevertheless, this experience—involving Bank-supported programs as well as nationally-organized efforts—offers some clear lessons on the design of privatization programs that will maximize benefits to the country and avoid errors.

A policy environment that encourages efficiency in the private sector is a precondition for successful privatization and is an integral part of the general adjustment process. In many developing countries, the policy and legal environments do not foster entrepreneurial behavior; business confidence may be lacking, compliance with the law may be low, and small market size may severely limit domestic competition.

Special privileges to buyers of state enterprises run counter to the efficiency objective and need to be strongly resisted. Protection from competition or liquidation, subsidies, special access to markets or capital, and the like, can reduce or even reverse the net benefits from selling an enterprise.

Creating or strengthening the capital market is a critical factor in making possible sales of public enterprises through public offerings of shares. Developing countries with weak or nonexistent capital markets have had to sell companies outright through private placements. This makes it harder to find buyers with sufficient capital. The sale of shares can avoid the concentration of wealth and income that can result from private placements. For example, the Chilean government sold 232 state enterprises (and returned to their owners another 250) over 1974-82, for little equity. The sales ended up strengthening the control of industrial enterprises by banks, leading to severe distortions in lending policies. The government had to intervene and is now selling some of the same enterprises again, through its newly expanded capital market.

Social costs. The immediately visible social costs of privatization, such as unemployment, closure of plants, and cutbacks in services can be severe in the short run, while the growth of benefits and increases in employment and investment do not appear until the medium term. Preparation for the negative consequences includes, among other things, severance packages for redundant employees, retraining and redeployment programs, and special lines of credit to assist laid-off workers in starting their own businesses. Gains to the state from these sales can be used in part to mitigate these adjustment costs. Also important are programs to educate the public about the process and its effects. For example, a public education program in Peru about the costs of employing redundant workers in the state-run fisheries industry and of their severance package led both the public and the workers to accept the restructuring program despite the opposition of some union leaders.

Adequate preparation of the strategy and program for privatization is essential. The program should clarify the government’s objectives and priorities and develop a preliminary list of enterprises for sale, contracts, leases, and so on. This helps focus attention on the fundamental goals of the program. For example, a government may seek to divest assets to raise capital and concentrate only on the price. Yet there may well be cases where the efficiency gains from introducing new management and competition are so large that the economy would be better off if government gave away the asset.

Administrative capacity of the governments involved in privatization requires special attention. There is a danger that the government may undervalue assets and make a poor bargain. Managing a privatization program is a complex matter. Governments seldom have the needed skills or administrative setup to handle such programs. Further, the Bank’s experience has shown that ministries are typically reluctant to pursue vigorously the privatization of their subordinate enterprises. Usually, some sort of central administrative unit is needed to promote or oversee the privatization process and keep decision-makers informed. It requires special skills, and often experts from law firms, consulting companies, and merchant banks are hired to assist in the detailed work of privatization. Thus, Bangladesh created a Divestment Board to decide on sales and a working group to value assets and recommend prices to the board; Jamaica created a Joint National Investment Commission, assisted by a Divestment Secretariat.

Transparency of the privatization process is important for its success. There is almost inevitably a public debate about the sale of state assets; the challenge is to make it an informed one. This means more and better studies explaining the problems of enterprises, the objectives of the sales, the costs of keeping enterprises public in terms of both implicit and explicit subsidies, and the prices of the enterprises being privatized.

Other forms of privatization should also be pursued. For example, the contracting out of activities previously handled within the government may provoke less opposition than the sale of assets and yield equal or greater returns. Indonesia, for example, has contracted a Swiss firm to run its customs administration. Thailand has contracted private companies to operate some of the passenger lines on the state-owned railroad.

Improving the performance of enterprises that remain in the public sector is only prudent. Thus far, privatization has had only limited impact on the quite dominant economic role of the state-owned business sector in developing countries. For example, Brazil has a list of some 65 enterprises destined to be privatized; they represent only 5 percent of total assets in the state-owned productive sector. Chile reduced the value-added produced by state enterprises from 39 percent of GDP in 1972 to about 24 percent in 1981 (the comparable average in OECD countries excluding the United States is 10 percent).

Bank and IFC support

The Bank’s efforts to support member countries’ privatization schemes are not conceived with a focus on the ownership of enterprises as such but as part of broader programs designed (within the context of national priorities) to foster growth, economic efficiency, and sound enterprise management.

The success of privatization should be judged not in terms of the sale or contract itself, or the price paid to government, or even the survival or expansion of the enterprise sold. Rather, the test is whether there are net benefits to the economy as a whole. Since privatization is a relatively new and experimental activity for most governments of developing countries and since developing economies may not have all the necessary conditions for success, these benefits are by no means assured. The Bank’s efforts aim to help interested governments create the necessary conditions and to structure their privatization programs so as to maximize efficiency and minimize social cost.

About 30 Bank-financed projects are designed to assist governments in privatizing state enterprises through sales, leases, or management contracts. An example of this support can be found in Togo, where the government has had an active program of privatization since 1983. Prior to privatization, Togo had 72 state enterprises. As of December 1987, Togo had sold five state enterprises outright (including textile and oil producers), leased four (steel machinery, oil storage, and milk production), and sold majority shares in another two (building materials and plastics). In addition, 11 enterprises were closed and are in the process of being liquidated. The Bank financed the provision of technical assistance to help the Togolese government develop a strategy and the necessary capacity to formulate its privatization program, perform operational and financial audits of enterprises, and set up an organizational structure to manage the program and develop and negotiate deals.

Even more important, Bank projects support privatization by helping create the necessary conditions for an efficient and vibrant private sector. In Turkey, for example, the Bank assisted the government’s program to develop the capital market by improving regulation, providing tax incentives to offer and hold equity, encouraging the development of new instruments to mobilize savings, and so on. Competition has been expanded both through trade liberalization, the removal of price controls and state monopolies, and antitrust measures (limits are being introduced on interlocking ownership between banks and industrial conglomerates, for example).

The Bank has also worked to reduce the adverse social consequences of privatization, not only through parallel projects to improve health, education, urban services, and the like, but also through direct support to laid-off workers. For example, in Benin the Bank helped to finance retraining and redeployment programs as well as productive investments by laid-off workers starting their own small businesses.

The International Finance Corporation, the Bank’s affiliate which helps develop the private sector, is actively involved in privatization as well. In the narrower sense of divestiture, IFC advises governments on specific deals and may take an equity position in an enterprise up for sale. IFC recently approved seven equity investments with privatization components that have total transaction values of about $178 million and IFC participation of $22 million. Thus, in Rwanda IFC formed a joint venture with a private international group to take over and modernize a previously government-owned match factory; it assisted the Government of Malaysia to review the operations of Sabah Forestry Industry with a view to eventually privatizing it; similar privatization initiatives are being undertaken in, for example, Bangladesh, Nepal, and Sri Lanka. IFC helped the government of Togo evaluate bids and invested directly in one of the privatized enterprises. IFC is also active in the broader sense to help prepare the ground for successful privatization. It provides advice and assistance to governments in fostering capital markets, attracting private investment and transferring technology, and improving the regulatory and level environment.

Overview

Under the appropriate circumstances, privatization can be a potentially useful means to promote efficiency and growth. As the preceding discussion makes clear, it should be treated as one part of a broader effort to increase market forces, decentralize decision making, strengthen managerial capabilities and incentives, and improve the allocation of resources. Paradoxically, a critical part of successful privatization is to improve public sector management. Government must be capable of managing divestiture, providing a suitable environment for private sector development, promoting competition, regulating monopolies, providing the necessary infrastructure and delivering efficient services, and in general managing well the enterprises and activities that remain in the public domain.

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