Chapter

4 The Fiscal Impact of Privatization, with Some Examples from Arab Countries

Editor(s):
Saíd El-Naggar
Published Date:
June 1989
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Author(s)
Peter S. Heller and Christian Schiller1

Introduction

One major factor leading governments to consider a privatization program is the belief that it may be of benefit to the government’s finances. The fiscal impact of privatizing a public enterprise, however, depends on a number of factors, including the nature and the magnitude of the financial interactions between the government and the public enterprise concerned, the effect of privatization on the financial performance of the enterprise, and the impact of other relevant policy decisions of the government, in particular those that lead to the enterprise being more exposed to the pressure of competition. The time perspective is also important, since privatization not only affects the government’s budget in the period when the sale of assets takes place, but also in subsequent periods (for example, loss of profit remittances); it is necessary to trace not only the various channels of impact but also their associated timing.

This paper reviews current thinking on the fiscal impact of privatization against the background of developments and prospects for privatization in Arab countries. The first section briefly reviews the economic rationale for privatization, and the second examines the factors influencing the fiscal impact of privatization. The next section reviews the factors underlying recent privatization initiatives in Arab countries, and the final section offers a qualitative assessment of the likely fiscal impact of these initiatives as well as some concluding thoughts.

The Economic Rationale for Privatization

Before assessing the fiscal impact of privatization, it is useful to review some of the arguments for privatization.2 Most important, privatization is seen as a way to reduce the economic inefficiencies associated with the public ownership of enterprises. Two sources of economic efficiency gain are possible. An increase in productive efficiency means that a given level of output can be produced by the enterprise with fewer inputs, that is, at a lower cost. Improvements in allocative efficiency imply that consumers attach a higher value to the quantity, quality, and other characteristics of the goods and services produced, and would therefore be prepared to pay higher prices.

Several arguments have been advanced suggesting that privatization can reduce the productive inefficiencies arising from public ownership and management.3 First, by reducing the frequently high degree of political interference in public enterprise operations, privatization can improve the quality of managerial decision making. In many countries, politicians influence the objectives of public enterprises. Commercial objectives may be subordinated to macro-economic and social objectives (for example, promotion of certain regions, creation of employment, and redistribution of income). Limiting the scope of political interference rids managers of the necessity to accommodate the wishes of politicians and thus may improve the performance of the enterprise. The pursuit of noncommercial objectives does not rule out privatization, but requires the government to provide direct subsidies to cover the added cost of meeting them.

Second, by making managers responsible to profit-seeking shareholders rather than civil servants, privatization may further improve managerial incentives. Both property rights and public choice theories suggest that the incentive structure prevailing in the public enterprise sector is not conducive to efficient production. Managers of public enterprises, it is argued, can secure better pay and more power by forming coalitions with civil servants in supervising ministries, resulting in increased budgets. Budget maximization may become an end in itself, with commercial objectives subordinated.

Third, privatization imposes the discipline of private financial markets and stimulates enterprises to operate more efficiently. Public enterprises can incur losses but cannot go bankrupt. Typically, if a public enterprise faces financial difficulties, it is bailed out by the government, either through direct financial support or through credit guarantees. This allows for continued operations despite financial difficulties. Lacking the discipline of the private sector, labor unions may pressure for higher pay than is warranted by labor productivity.

However, privatization-induced improvements in productive efficiency do not pari passu lead to significant improvements in allocative efficiency. The latter depends less on ownership and more on the structure of the market in which the enterprise is operating. Improvements in allocative efficiency can only be achieved when privatization goes hand in hand with extending the exposure of the firm to the pressure of competition, promoting improved resource allocation and financial performance. Insofar as a public enterprise is already subject to a nationally or internationally competitive environment, privatization will add little to existing incentives for the enterprise to seek out opportunities to improve allocative efficiency.

Privatization may even lead to losses in allocative efficiency. In a number of recent cases, governments have restricted the competitive environment of the public enterprise so as to enhance its potential value to the private sector.

Large gains in terms of allocative efficiency can be expected if privatization leads to monopolistic or quasi-monopolistic public enterprises being exposed to the pressure of competition and their monopoly power reduced. The resulting efficiency gains should not be attributed so much to the change from public to private ownership but more to the change in the structure of the market in which the enterprise is operating. The scope for efficiency gains is thus limited by the extent to which market barriers can or should be removed.

Public production and ownership may be the consequence of private markets failing to provide efficient results. In such cases, increasing the role of private markets may possibly lead to efficiency losses. For example, some public enterprises operate in sectors characterized by increasing returns and where only a single producer can fully exploit the economies of scale. Opening the market to competition may lead to efficiency losses. In such cases, while one might consider a transfer of ownership of a natural monopolist to the private sector, one would nevertheless require some degree of regulation in order to prevent the emergence of anticompetitive practices (for example, monopolistic pricing). The design and enforcement of such regulatory regimes have proved difficult, and in developing countries the capacity for efficient and effective regulations is often quite limited.4 There may be significant costs in terms of allocative inefficiency if a public or private sector monopoly is poorly regulated (for example, monopoly profits, overinvestment, internal production inefficiency).

In sum, privatization should be seen as one response to productive and allocative inefficiencies in the public enterprise sector. Insofar as a public enterprise is already exposed to competitive market forces, gains in economic efficiency can only be expected from increased productive efficiency. Meaningful efficiency gains can be realized if a public monopoly is privatized and exposed to competition, promoting improvements in resource allocation and economic performance. Therefore, to maximize the benefit of the shifting toward a more open, private sector-oriented economy, there is also a need for structural policies to be implemented along with privatization.

In Arab and other developing countries, the scope for privatization in this area, however, appears to be limited for a number of reasons. Therefore, reducing inefficiencies of public enterprises through, inter alia, rationalizing pricing policies, trade liberalization, and improving accountability will need to continue to be given a high priority.

Fiscal Implications of Privatization: Conceptual Issues

Introduction

Assessing the fiscal impact of privatizing a particular public enterprise is not simple. It requires the analyst to make a number of assumptions which are highly conjectural. Often the assessment will hinge as much on other policy decisions of the government as on the effects of the actual sale of the enterprise to the private sector. It is even more difficult to gauge the effects of a program of privatization involving a number of enterprises in different sectors. This section identifies several factors which determine the fiscal impact of privatizing a public enterprise.

For the purposes of our analysis, “fiscal impact” encompasses two aspects: (i) the net change in the income flow to the government arising from privatization; for example, the difference in the magnitude and timing of the net income stream to the government from the privatized enterprise, relative to the situation where the enterprise remained under public ownership; and (ii) the change in the net wealth position of the government; for example, changes in the government’s balance sheet.5

In the simplest case, the privatization of an enterprise involves the sale of the government’s equity in an enterprise to the private sector in exchange for liquid assets. Assume the simple case of a world without corporate income taxes, where the public enterprise had fully remitted its profits to the government and received no transfers from the government, and where all parties to the sale expect that the firm’s financial performance will remain essentially unchanged after privatization (see Table 1). Also assume that all parties have full information on prices and markets. In such a case, the sales price received by the government would be equivalent to the discounted stream of expected profit remittances that would have been received if the enterprise had remained in the public sector.

Table 1.Assumptions Underlying the Polar Case
Polar Case
1. A profit-making public enterprise
2. The sales price of the public enterprise reflects the full market value of assets
3. There is agreement between the government and private purchasers on the expected profit stream after privatization
4. No corporate income taxes
5. Full remittance of public enterprise profits to the government
6. No transfers from the government to the enterprise
7. No change in the financial performance of the enterprise after privatization
8. No change in other revenue or expenditure policies
9. Full information on prices and markets

In effect, in this simple case the sale of the enterprise only improves the government’s liquidity position, but leaves its net wealth position unchanged. The government simply substitutes a liquid asset for a physical asset, which is equal in value. In other words, the government obtains a higher level of current income at the expense of future income. Assuming no change in the government’s other revenue or expenditure policies, the authorities could invest the sales proceeds in a financial asset that could fully replicate what would have been the income stream to the government if the enterprise had not been sold.6 This leaves the government’s financial position unchanged except for the composition of its assets as between equity in the public enterprise and other financial assets. In such a case, the fiscal impact of the privatization exercise itself would be zero.7

A number of important assumptions are embedded in this simple analysis (see Table 1), which bear further analysis. Specifically,

  • What factors determine the sales price of the enterprise? Will it be more or less than the discounted stream of after-tax profits that would have been earned in the absence of privatization?

  • What is the financial relationship between the public enterprise and the government? How would it be changed by privatization? This requires analysis of the likely impact on the flow of receipts from (for example, corporate tax payments, dividend payments) and disbursements to (for example, operating subsidies and capital transfers, net lending) the enterprise as a result of privatization.

  • What changes in government policy toward the enterprise would accompany any change in ownership? Changes in the regulatory environment determining the firm’s exposure to domestic or international competition? Changes in the firm’s autonomy in decisions on the composition of output, employment levels, or pricing policy?

  • What effects would privatization have on the efficiency and profitability of the enterprise’s performance, independent of changes in government policy?

  • How are the sales proceeds used? Do they reduce the government’s net borrowing requirement? Are they spent or used to lower tax rates?

  • What are the effects of a privatization program on the domestic capital market? Is foreign investment politically acceptable?

  • Do the results differ for a chronic loss-making firm?

In what follows, we shall address the implications of these questions for the analysis.

Determining the Sales Price of the Public Enterprise

The sales proceeds of the enterprise is the major determinant of the fiscal impact of privatization in the period when the transfer of ownership takes place. Define S1 as the discounted value of the expected stream of after-tax remittances that would have been received if the enterprise had not been privatized. In principle, the government should be unwilling to accept no less than an amount equal to S1, or the liquidation value of the assets of the firm, whichever is higher.8 Any lower amount would leave the government worse off, for example, its net worth position would decline (regardless of the time period over which this flow of income is received). The maximum it could seek, Sm, would be the discounted value of the expected stream of after-tax remittances that could be realized as a result of privatization. An improvement in profit stream may reflect the effects of private management reforms or associated changes in the economic environment of the enterprise owing to government policy reforms. Alternatively, it may reflect specific actions taken by the government to enhance the market value of the enterprise (perhaps through limits on competition). In assessing the overall fiscal impact, it is important to distinguish between these cases (see below).

The private purchasers of an enterprise’s assets will inevitably form their own views on the value of the assets, reflecting their expectations of the current financial status of the enterprise, including its access to foreign exchange resources, the prospects for improved enterprise profitability, their personal discount rate and risk aversion, the likelihood of a favorable change in the policy environment, and the potential liquidation value of the firm’s land, plant, and equipment. The ultimate sales price agreed upon will reflect these differing views and other factors related to the capital market conditions (for example, its size) under which the government seeks to market the enterprise’s assets.

Governments have used different methods for selling public assets, including offers for sale and tender offers. These methods have proved difficult to use, even in countries where capital markets are well developed. They may be even more problematical in developing countries where capital markets are thin, thus limiting the possibility of offering public assets on the domestic capital market. Yet fears of foreign economic domination may lead the government to limit foreign equity holdings or the sale of public enterprises on international capital markets.

There are a number of factors that may dampen the sales price, even to levels below S1 (in situations where the asset liquidation value is not higher than S1). Some argue that since private entrepreneurs can spread risk less readily than the government and are more risk averse, they will be unwilling to pay even S1. Private purchasers generally face a higher cost of capital than sovereign governments, and thus may discount future profits by more than the government, leading to a lower offer price. Bös (1988) notes that information asymmetries across investors and the government may also lead to underpricing of new equity issues. Finally, political factors or legal requirements may lead the government to set the issue price or offer price at a lower than desirable level for “fear of losing political support for the privatization campaign if too many shares remain unsold.”9

Based on the above analysis, one would expect that there is a risk that the sale price may be less than S1, unless one can obtain improvements in profitability sufficient to offset the negative factors discussed above. This would lead to a reduction in the government’s net worth.

Financial Interactions With and Without Privatization

The government and the public enterprise sector interact financially in a number of ways, and these may differ from the assumptions in the table above. On the one hand, the government may finance the operations of public enterprises through subsidies, capital transfers, net lending, and equity injections. On the other hand, public enterprises may contribute to budget revenues through tax, dividend, and debt service payments. The budgetary impact of privatization in the period following privatization represents the change in the net stream of these payments to and from the budget along with any changes in interest outlays or receipts stemming from the use of the sales proceeds in the sale period. Account should also be taken of indirect financial links that do not show up explicitly in the government’s budget, but which may be quantitatively significant, for example, payment arrears, government guarantees of public enterprise debts, and externality effects on other enterprises.

Corporate income taxation

The polar case assumed no corporate income taxation. If private enterprises are subject to taxation on their operating profits, the government would then receive some of its income from the privatized enterprise in the form of corporate tax payments, rather than as an upfront payment reflected in the sales price. The sales proceeds would presumably reflect the discounted stream of after-tax profits following privatization. Where tax evasion is common, and the government is unable to ascertain the “true” profit situation, the government may be the net loser from privatization by virtue of a lower sales price and lower subsequent corporate tax receipts. Where the purchaser is a foreign company, tax evasion may also imply a leakage of profits outside the domestic economy.

Profit remittances

Obviously, full privatization would lead to a shift in profit remittances from the government budget to the private shareholders. If the after-tax profits of a public enterprise are not fully remitted to the government, the presumption is that such retained earnings are used for reinvestment in the enterprise, thus leading to an increase in its net worth.10 In the event of privatization, the sales price for the enterprise would be unaffected, and would still reflect the discounted stream of expected after-tax profits. Privatization would still lead to the government receiving its revenues in the present, at the expense of a loss in such property income in the future. The only difference arising from a practice of less than full remittance would be that the loss of such future property incomes over the medium term would be less.

From a budgetary perspective it is irrelevant whether the government receives the excess of a public enterprise’s income over its costs in the form of profit transfers or tax payments. From the enterprise’s point of view, however, a profit tax exemption may lead it to believe that its operations are more profitable than is actually the case, possibly slowing its efforts to seek out new opportunities and improve efficiency.

Most governments engage in net lending operations with the public enterprise sector and this results in subsequent interest receipts to the government’s budget. The amount of interest income from public enterprises will be determined by the level of outstanding credit and the interest rate the government charges. Sometimes the government offers more lenient terms in its loans to public enterprises than those at which it borrows, resulting in a subsidy to the borrower.11 While a cost borne by the government, the subsidy will be unaffected by privatization.

Current transfers or subsidies to the public enterprise

To appraise the impact of privatization on such transfers requires an assessment of why they are made. Leaving aside the situation of the loss-making public enterprise caused by inefficiencies, such subsidies typically relate to the pursuit of government policy objectives (for example, low prices for foodstuffs or utilities, employment targets, regional development priorities) independent of the enterprise’s commercial objectives. If privatization leads to a termination of such transfers, this would most likely reflect the government’s decision to abandon using the enterprise to realize such policy goals. If the government continues to pursue the objective through other means of equal cost, privatization would yield no savings in terms of the subsidy. Similarly, if the privatized enterprise is expected to continue the pursuit of such social or other objectives, the government will still need to cover the associated costs.

Capital transfers and government net lending

Capital transfers and net lending often finance investment expenditures of the public enterprise sector. At times, the enterprise is investing on behalf of the government, sometimes for noncommercial objectives. Such loans may also reflect the government’s using its stronger credit position to borrow externally on behalf of the enterprise; generally, the enterprise will service the debt. The government may also provide funds to enterprises not creditworthy enough to borrow from commercial sources. Equity investments by the government in public enterprises are also common, being used to broaden their capital base. At times, such investments may represent a disguised form of subsidy to cover operating losses.

In principle, one would not expect privatization to lead to a significant change in capital transfers or net lending. If an investment in a public enterprise is perceived to have an adequate rate of return, the government’s motivation to support the investment after privatization would be no less. The only issue is whether the government chooses to invest on its own, or to provide loans to the now privatized enterprise. Similarly, if the purpose of the loan is to achieve noncommercial objectives, privatization would not affect such a decision. In practice, however, privatization might lead to reduced capital transfers and net lending to the privatized enterprises, if only because the political and economic linkages with the government would be lessened.

Another issue that may arise with privatization is the status of the public enterprise’s debts with the government. Such liabilities would inevitably be a factor in arriving at a sales price. As with any other liability of the enterprise which may have arisen from noncommercial decisions, the government most likely will have to absorb any loss in a lower sales price. Similarly, in many countries public enterprises have borrowed heavily in domestic and foreign credit markets, with government guarantees. Such guarantees create contingent liabilities which may affect government finances in future periods; their status would have to be clarified at the time of privatization. Most likely, the government would bear the burden of the guarantee.

Improvement in the Financial Performance of the Enterprise

A positive and durable fiscal impact requires improvements in productive and allocative efficiency. As noted in the previous section, these are important objectives of any privatization program, even in regard to current profit-making firms not receiving any operating subsidies from the government. Several factors underlying weak financial performance by a public enterprise may be distinguished: (i) poor internal management, such that under private management the firm’s operations could be reorganized to achieve higher productivity; (ii) external interference in the firm’s operations (for instance, in its pricing, employment, or output decisions); (iii) lack of comparative advantage, such that the firm would not be profitable under any market test (see below); and (iv) market structure, for example, insulation from the pressure of competition.

By itself, privatization is only likely to address the issue of internal management. The fiscal impact of improved management may be reflected in the sales price of the firm and in the level of corporate tax receipts. If the government believes the firm will be more profitable after privatization, it may seek some of these gains in a sales price closer to Sm. If the government realizes a higher price, privatization will have yielded some additional fiscal benefit in the form of greater short-term revenues from the sales proceeds. In addition, the government will benefit from higher subsequent corporate tax receipts from the privatized enterprise.

One of the most important determinants of efficiency is the macro-economic policy environment within which the enterprise operates. In many developing countries, fundamental structural reforms in the policy environment are essential for improving the efficiency and profitability of privatized firms. When the government accompanies privatization with a relaxation of controls on the enterprise’s operations, or by exposing it more fully to competition, the benefits arise not from privatization but from the act of removing these controls or the more competitive environment. Since the government could, in principle, realize the full value of such improvements in the public enterprise’s financial performance without privatization, it would be misleading to associate these benefits with privatization. If the government were willing to relax such controls, reduce such interference, enhance exposure to competition, and force greater financial autonomy (such as removal of government financing of operating losses), it would obviously make sense for the government to take such actions prior to or as part of the privatization effort, so as to obtain the rents from such action in the form of a higher sales price.

When the government accompanies privatization with restrictions on trade to promote private demand for the enterprise’s assets, one might observe higher profitability after privatization. However, such gains would be at the expense of lower allocative efficiency in the economy as a whole. The fiscal gains from privatizing the enterprise are likely to be offset by the lower productivity and output in other sectors of the economy.

For an enterprise that is essentially not competitive under free market conditions, privatization will not remedy the situation. In such circumstances, no significant fiscal benefit from privatization is likely. Whatever subsidies have been required to operate the public enterprise in the past will still be necessary after privatization, though to a lesser extent. The possibility of closure of the enterprise should be considered.

The Loss-Making Enterprise

It is essential to determine the source of losses. The government would need to assess the prospects for improved performance in determining the financial conditions for sale. In situations where the enterprise cannot be made competitive without substantial subsidies, closure might be considered, with the government selling off the physical assets of the enterprise and settling with the firm’s creditors (including its employees). Often the liquidation value of the firm’s assets (land, equipment, and plant) may be sufficiently high for the purchase of the firm still to be an attractive option to private investors. Such enterprises have effectively shut their doors with the assets dismantled and sold and with the employees receiving some severance pay (often financed by restructuring loans from external sources). Typically, the budget is relieved of subsidies in subsequent years.

When the sources of inefficiency reflect conscious government policy decisions, we have noted that privatization will not change the situation. In the case of an enterprise sustaining operational losses which are financed by direct government transfers, privatization would entail the government continuing to provide such operational subsidies. Alternatively, the government might seek to sell the enterprise for its net liquidation value, for example, the liquidation value of the assets of the firm less any outstanding liabilities (inclusive of severance pay obligations to employees or pension liabilities).

The Use of the Sales Proceeds

In principle, the sales proceeds can be applied either to reduce (increase) the size of the government’s deficit (surplus) (by acquiring financial assets or reducing its debt) or to finance tax cuts or expenditure increases. In the former, there is a substitution of increased interest income (or reduced interest costs) for the property income stream previously derived from the enterprise. Accordingly, there is no net change in the fiscal position of the government over the medium term. The sales proceeds would reduce the deficit in the initial period;12 in subsequent periods, revenues would remain as they were before privatization.

In initially reducing the government’s deficit, privatization may give rise to the perception of a shift in the government’s macro-economic posture. This may mask the true extent of the fiscal imbalances since the initially reduced deficit does not in fact correspond to any change in the underlying fiscal position, but simply a change in the composition of the government’s asset holdings. If the funds are neither spent nor used to cut taxes, the underlying fiscal policy stance would be unchanged, both in the period of sale and in subsequent periods.13

However, political pressures often lead authorities to use the proceeds of privatization either to increase expenditure or to limit taxation, rather than to reduce the deficit. Such a policy would be at the expense of a higher deficit in subsequent periods, relative to the pre-privatization position.14

Payment Arrears15

Delays in the payment of taxes, profit transfers, and debt service to the government by public enterprises have occurred in a number of Arab countries. Such arrears often result from the government not meeting its own financial obligations. In such cases, observed financial flows between the government and the public enterprise sector understate the appropriate level of financial transactions between the two sectors. Payment arrears obviously occur in the private sector as well; indeed, tax arrears of private enterprises have been sizable in many countries. However, if privatization results in an improvement in the financial performance of enterprises, tax arrears are less likely to emerge. As above, any net balance in arrears must be considered in setting the sales price of the enterprise.

Other Fiscal Effects

There may be some indirect budgetary consequences from privatization. Since it adds to the supply of physical assets available in the private market, the price level of existing physical assets must decline in order for markets to clear. On the other hand, in financial markets there will be an exchange of financial assets as the government obtains resources from the private sector, and under the assumptions above, either reinvests the funds or borrows less. While the ultimate impact on interest rates is difficult to judge, any changes will affect both private investment demand and the government’s cost of borrowing.16

Significant indirect effects may also arise from the way in which privatization is implemented. Without other policy reforms, the gains in productivity are likely to be limited in size and narrowly confined to the enterprise. When accompanied by liberalization of trade and reduced controls, the positive effects on the enterprise and the economy are more significant, and this will be reflected in commensurate fiscal gains. Conversely, privatization associated with tightened controls may yield fiscal gains to the budget and the privatized enterprise, but at the expense of possibly greater losses elsewhere in the economy.

Alternative Approaches to Privatization

Privatization does not necessarily imply the transfer of ownership of a firm. In a number of Arab countries, privatization through leasing and management contracts has proved both politically acceptable and commercially successful as a means of enhancing the efficiency of an enterprise while retaining public ownership (for example, in the hotel industry in Egypt and Sudan). Under a management contract, the contractor is paid by the government for its management services, but does not directly benefit from the enterprise’s financial performance. In principle, this should allow the government to benefit directly from any improvement in efficiency derived from the strengthened management. The typical difficulty that emerges with such contracts is that they tend to be on a cost-plus basis, without any of the penalties or awards associated with a change in the enterprise’s performance. This frees the manager from any incentives to obtain increased efficiency.

Under a lease arrangement, a private operator leases an asset or facility owned by the government and uses it to conduct business on its own account. A leasing agreement yields rental income rather than property income to the government. While this may afford a financial incentive for improved performance to the lessor, it may not lead to any greater revenue for the government.

Some countries (for example, Morocco) are contemplating or have introduced debt-equity swap programs. Typically, a foreign bank will sell, at a discount, an outstanding loan made to a domestic public sector agency to an investor, most often a multinational company seeking an equity position in the indebted country. The investor presents the loan to the central bank of the indebted country, which will redeem the loan in domestic currency at the prevailing market exchange rate, as long as the investor uses the proceeds to acquire a domestic equity interest. Insofar as these loans have been guaranteed by the government, such a swap increases the private equity position and reduces the government’s external debt burden without drawing on scarce foreign exchange resources.17

Factors Underlying Recent Privatization Initiatives in Arab Countries

An analysis of the fiscal impact of privatization policies in any country requires an assessment of the likely change in the financial status of the firms to be privatized, their relative importance in the economy, their financial interactions with the government budget, and the likely direction of changes in other government policies relating to the privatized enterprises. The availability of data is obviously important for any such analysis.

For a number of reasons, an empirical assessment of the fiscal impact of privatization in Arab countries is beyond the scope of this paper. The unavailability of data on specific enterprises is perhaps the most critical bottleneck. Also, the scope of privatization efforts has not been fully resolved in most countries, with the specific enterprises to be privatized often not yet identified. This suggests the more limited objective of a qualitative assessment of the likely fiscal impact, based on our conceptual analysis and whatever country-specific evidence is available. To place the discussion in this section in context, the following subsection provides a brief survey of the role of the public enterprise sector in the Arab countries. Since weak financial performance is often a key motivation for privatization initiatives, the relevance of this issue in these countries is then examined, followed by an identification of the focus and content of the privatization strategies adopted in a number of Arab countries, thus narrowing the scope for our analysis of fiscal impact. References to country examples are limited by the data available on privatization initiatives.

Background on the Public Enterprise Sector

In most Arab countries, a significant public enterprise sector coexists with the private enterprise sector.18 In some countries, the public enterprise sector is obviously dominated by the oil sector, reflecting past efforts to secure public control over this vital sector. Government participation in the non-oil sector has also been significant, reflecting economic, political, and ideological factors. Chief among them has been the wish to develop rapidly through the expansion of such strategic industries as steel, fertilizers, and basic chemicals. Such sectors were regarded as beyond the capacity of the private domestic sector because of their high capital intensity. Employment objectives have been central in a number of countries. Public ownership has also been supported by the desire to limit foreign ownership and control. A few illustrative examples may be cited, chosen largely on the basis of availability of data.

In Egypt, the public sector accounts for about 50 percent of gross domestic product (GDP), 70 percent of total investments, and 80 percent of manufactured exports. It covers a wide range of sectors and subsectors in industry, banking and insurance, foreign trade, construction, and transport. In agriculture, the marketing of the principal agricultural crops and the supply of essential agricultural inputs are largely under public sector auspices.19

In Mauritania, the size of the parastatal sector expanded rapidly throughout the 1970s, and now generates about one fifth of GDP and accounts for one fourth of formal employment. In the Syrian Arab Republic, all large-scale utilities, mining, manufacturing, and construction enterprises are publicly owned. Public enterprises also play an important role in domestic and foreign trade. In Djibouti, the public enterprise sector occupies a monopolistic or dominant position in a number of industries in the water, energy, transportation, and communications sectors. Total public enterprise activity is equivalent to about 25 percent of GDP.

In Morocco, the public enterprise sector accounts for approximately 20 percent of GDP, 30 percent of investment, and 50 percent of exports, and operates in such sectors as utilities, mining, transport, wholesale trade, and tourism. The Government fully owns more than 200 enterprises, is the major shareholder in another 270 enterprises, and has a minority interest in 130 enterprises.

Financial Performance of the Public Enterprise Sector

Weak financial performance has been a primary factor underlying the interest of many Arab countries in privatization. Profit rates have been low, government subsidies high, and payment arrears common. Extensive protection from domestic and foreign competition exists, as well as frequent government guarantees for public enterprise borrowing. The following may illustrate the problems that privatization is seen to address.

In Egypt, the limited data available suggest that many public enterprises are not commercially viable. In 1986/87, the authorities sought to collect profit transfers from public enterprises equivalent to a return of 2.6 percent on the Government’s investment. Even this low target was not achieved. Most firms are not able to make any financial contributions to the budget. Most profit transfers are from the oil sector, the Suez Canal Authority, and the Central Bank. Major factors responsible for this poor performance are government intervention in pricing, employment, wage and investment decisions, poor enterprise management, and excessive protection against competitive imports provided by the customs tariff. Interlocking arrears have also been a problem in Egypt.

Most of Mauritania’s public enterprises suffered financial losses in the first half of the 1980s. These were largely financed through increasing tax and debt-service arrears with the Government. In turn, government arrears were accumulated because water, electricity, and post and telecommunication services were systematically under-budgeted.20 Mauritania’s public enterprise sector has also been hampered by weak management, poor planning, overstaffing, and inadequate pricing policies.

The financial performance of Somalia’s public enterprise sector has been poor in recent years, with many enterprises operating well below capacity. Contributing factors have included a lack of technical expertise, shortages of spare parts, management deficiencies, excessive taxation, and inadequate labor productivity. Many public enterprises have fallen behind in their tax liabilities, and contributions to government revenue have been limited. Only a few enterprises regularly pay dividends to the Treasury. Only about one fourth of the public enterprises made any contributions to the budget during 1980–84.

With the exception of the enterprises responsible for the procurement and sale of essential commodities, public enterprises are expected to be profitable in the Syrian Arab Republic. In practice, however, a number of enterprises have incurred losses owing to restrictions on price increases and an inability to control costs. Losses have been covered either by direct budgetary transfers or by borrowing from the banking system. On a number of occasions since 1980, the Central Government has taken over the accumulated bank liabilities of certain public enterprises.

In Tunisia, the financial performance of the public enterprise sector has been mixed at best. By the early 1980s, its burden on public resources was substantial. In part, this was attributable to external factors, in particular unfavorable world prices and declining world demand. Endogenous factors included excessive emphasis on production and employment (rather than on profit maximization), lax financial control by the Government, an insufficient capital base,21 and an excessively regulated pricing policy which did not allow for full cost recovery. Total government financial support to the public enterprise sector has ranged from 5–7 percent of GDP in the period 1983–86. These transfers included subsidies to cover operating deficits (10–20 percent of the total), capital transfers for investment and debt repayment (20–40 percent), and new capital injections in the form of equity participation and lending (30–50 percent).

In Morocco, the performance of the public enterprise sector has deteriorated markedly since the mid-1970s, when relatively easy access to government transfers and bank credit accommodated lax public enterprise financial behavior. In the early 1980s, access to external sources was curtailed and budgetary resources became increasingly scarce, subjecting many public enterprises to liquidity difficulties. With delays in government payments, public enterprises began to accumulate substantial reciprocal claims and debts, complicating financial management, and disrupting financial and operational relationships among enterprises. Some public enterprises were unable to meet debt-service obligations or remunerate shareholders, with the result that much of the public enterprise debt to external creditors had to be rescheduled along with that of the Government. At present, only a limited number of public enterprises transfer funds to the Treasury, either in profits or taxes.

Recent Privatization Experience in the Arab World

Privatization must be seen as only one of a number of strategies of Arab countries in their quest to increase the efficiency of the public enterprise sector and ameliorate its large fiscal imbalances. Public enterprise reform has also focused on rationalizing pricing policies, improving accountability, limiting government subsidies, and controlling public enterprise borrowing and spending. The following survey of privatization initiatives is not comprehensive, but will give some sense of the scale of privatization initiatives contemplated.

In Mauritania, under a 1983 reform program, no new public enterprises were to be established unless economically justified; existing public enterprises were to be reviewed and nominated for liquidation, privatization, or rehabilitation. Privatization through private sales, management contracts, liquidation, and employee buy-outs have occurred in the cinema, sugar, and pharmaceutical distribution sectors. Further sales of assets are planned for enterprises in the hotel, textile, and state farm sectors.22

In Somalia, the Government is committed to closing financially unviable public enterprises, particularly those whose services are not essential. In 1981, three such public enterprises were phased out of operation. The Government also sold a 60 percent interest in the state-owned National Banana Board to a private entrepreneur. An Inter-Ministerial Commission to study the public enterprise sector was established in 1982, with one of its objectives the streamlining of the size of the public enterprise sector. Steps were taken in 1984 to transfer to workers’ cooperatives a number of enterprises, including the petroleum distribution agency, a brick factory, and a fruit processing factory. In agriculture, land administered by government agencies has been passed on to participating farmers. The Government is now in the process of classifying public enterprises according to whether they should be liquidated, privatized, or left in the public sector.

In Sudan, action has already been initiated for the divestiture of a number of public enterprises, including some banks and hotels. The Government is expected to identify soon additional public enterprises to be included in a program of rehabilitation, divestiture, and/or liquidation. Diagnostic studies have already been launched for a number of firms.

In Tunisia, the authorities have begun a public enterprise reform program to (a) cut by more than half the number of public enterprises under the direct control of the Government; (b) take measures to facilitate government divestiture from enterprises in sectors where competitive private firms can operate profitably; and (c) develop action plans for the economic and financial rationalization of enterprises which, because of their strategic nature, the size of the investment involved, or their position as natural monopolies, should remain in the public sector.

In July 1985, the Government passed a law limiting direct government control to 164 parent companies, and defining 137 subsidiaries that will be controlled by the parent companies. A National Commission for the Rationalization and Restructuring of the Public Enterprise Sector was formed in 1986 to assess which enterprises are to be privatized, liquidated, or rationalized. Thus far, of the 35 enterprises examined by the National Commission for Restructuring of Public Enterprises, 2 enterprises have already been privatized and decisions have been made to privatize 9 others and liquidate 3; the remainder will be rehabilitated. In August 1987, the Government passed legislation to speed up the privatization process, and introduced a number of specific measures to attract private domestic and foreign investors. The scope for privatization is limited by the size of the Tunisian stock market.

In Morocco since the early 1980s, the Government has pursued a policy of divesting to the private sector those public enterprise activities not considered of strategic importance. For example, hotels belonging to the Moroccan National Tourist Office were leased to private concerns. Three subsidiaries of the National Fishing Office were sold to private groups and fishing boats were leased to Moroccan and Spanish private shipowners. The state has sold the bulk of its holdings in certain sugar factories. Responsibility for the marketing of processed food products and the monopoly on exports of fresh fruits and vegetables was removed from the Office de Commercialisation des Exportations. The Government has also relinquished its monopoly of cargo handling to an enterprise which functions in accordance with commercial principles.

Recently, Morocco has intensified its privatization efforts. An inventory is under preparation which will characterize each public enterprise by its strategic importance, economic and financial situation, type and sector of activity, and the impact on the budget through subsidies and dividends. The inventory will also provide a general assessment of the potential of particular enterprises for privatization through complete divestiture, sale of shares, or leasing. The Government also intends to limit the scope of intervention of public enterprises to strategic sectors, public services, and sectoral management and development activities, and to disengage progressively from activities in the fisheries, sugar, transportation, and tourism sectors. The Government also plans to transfer to the private sector its direct or indirect minority participation in various companies, particularly when this participation does not allow the Government to control efficiently the policy of the companies or to offer any specific strategic advantage.

Less comprehensive privatization programs have been initiated by Qatar and Saudi Arabia. In Qatar, the Qatar Fertilizer Company was partially privatized in 1984 with a European company becoming a minority partner with an exclusive management and marketing contract. In Saudi Arabia, the Government is currently implementing a small privatization program, whereby some shares of a public enterprise principally operating in the petrochemical sector have been sold to the public. Further sales of shares in this enterprise are planned. However, these sales represent a minority of outstanding shares in the enterprise concerned.

In Egypt, two publicly owned hotels have recently been put under private management contract and plans are under way for other hotels to be sold, leased, or put under management contract. In Iraq, there have been some sales of supermarkets, petrol stations, and car maintenance centers to the private sector, and some sales of state farms are reportedly under way. There are also plans to sell approximately half of the shares of Iraqi Airlines to the private sector. In Jordan, there are plans to privatize various subsidiaries of Alia, the Royal Jordanian Airline, with shares sold gradually to private investors over the next few years. There are also plans for privatization initiatives in the telecommunications and the public transport sectors. In Oman, privatization through a public offering of shares for a flour mill, cement company, and refinery have been completed. Finally, in the Gulf Cooperation Council (GCC) countries, the sale of 49 percent of the equity of Gulf Air to the nationals of Bahrain, Oman, Qatar, and the United Arab Emirates has been discussed.23

In summary, privatization efforts are under way in several Arab countries. However, substantial sales of public enterprises have not yet occurred, and those enterprises privatized have tended to be small in terms of output and employment.

Thoughts on the Fiscal Impact of Privatization in Arab Countries

From the limited information available for the different Arab countries, what can be said about the likely fiscal impact of their privatization programs? First, the scale of privatization that is contemplated for the public enterprise sector in most Arab countries is quite limited. Wholesale divestiture of the public enterprise sector is hardly being contemplated in most countries. Certainly in the oil producing states, the oil sector is not a candidate. This immediately suggests that the magnitude of budgetary resources likely to be obtained from the sales proceeds of any divestiture program is not likely to be quantitatively large as a share of total government revenues in any year. The thinness of capital markets in many Arab countries and the limits often placed on foreign ownership also imply that the oft-observed tendency for undervaluation of enterprise assets may also occur in this region.

Second, the revenue flow to the budget from the enterprises likely to be candidates for privatization is probably small. While it is true that property income to the government budget from the public enterprise sector is a very high proportion of budget receipts in a number of Arab countries, this primarily reflects the importance of oil income, and in some countries enterprises not likely to be candidates for privatization (for example, in Egypt, the Suez Canal Authority, or in Jordan and Tunisia, the Central Bank).24 It is likely that the property income actually received from many of the candidates for privatization is small. The low rate of return cited above for Egyptian public enterprises is suggestive in this regard. This implies that the loss in future property income to the government after privatization may not be that great.

Third, how large are the possible savings in subsidies and transfers that would emerge if many public enterprises were privatized? To answer this question, one would need to isolate statistically not only the magnitude of subsidies to the public enterprise sector, but also the amount of subsidies arising from operating losses distinguished from the implementation of specific policy objectives. In most Arab countries, the share of total current subsidies to public enterprises is 2–5 percent of total government expenditure (for example, 2 percent in Morocco and Tunisia; about 4 percent in the Syrian Arab Republic).25,26 In a number of countries, capital transfers, government lending, and equity investments from the central government to the public enterprise sector have been fairly significant in budgetary terms. In Morocco, capital transfers were about double current transfers in recent years. Capital transfers and net lending by the Government to the public enterprise sector have also been quite significant in Tunisia in the early 1980s.27

Again, the available data are highly aggregative and do not reveal whether such transfers are significant for the particular candidates for privatization or whether such transfers, current or capital, would cease after privatization. Our discussion above on capital transfers and government net lending suggests that many of the subsidies, capital transfers, and net lending might continue. Yet the presumption must be that privatization will lessen the pressure for such transfers. Closure of some of the more unprofitable enterprises will also lead to further savings, though there may be initial costs associated with the liquidation of unprofitable enterprises.

For many of the loss-making or low-profit public enterprises, the government may nevertheless be able to derive significant revenue from the sale of their assets. In some cases, this reflects the potential benefits that may stem from rationalization of management, and a shedding of wasteful and unproductive practices (although the government may not be able to appropriate fully the benefits of managerial improvements). In other cases, the intrinsic value of the assets of the enterprises, particularly the site value of industrial plants and commercial and retail facilities, may be sufficient to make their purchase attractive to private investors.

In sum, there is likely to be some small net gain to the budget in the period of privatization, a limited loss in forgone property income, and the potential for savings in budget outlays in support of public enterprises. While the net impact on the budget may not be a substantial portion of GDP, privatization may nevertheless offer some positive yield. As privatization programs proceed, the possibility of cumulative gains is significant. However, such gains can only be realized if privatization is seen as an integral element of a structural adjustment reform effort involving trade liberalization, relaxation of price controls, corporate tax simplification, reduced interference in public and private enterprise operational decisions, and increased exposure to foreign investment and trade. In the absence of such essential macroeconomic policy reforms, the potential gains for allocative efficiency for the enterprise, for the economy, and, a fortiori, for the budget will be limited indeed.

Moreover, it is important to guard against the temptation to maximize the fiscal gains from privatization of an enterprise by restrictions on trade or by granting the firm a preferential position in domestic markets. The losses in allocative efficiency in the rest of the economy will be reflected in reduced output and forgone revenues to the budget which may, in the long run, prove even more costly.

References

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    WattleworthMichael“Credit Subsidies in Budgetary Lending: Computation Effects and Fiscal Implications” in Measurement of Fiscal Impact: Methodological Issuesed. by Mario I.Blejer and Ke-YoungChuOccasional Paper No. 59 (Washington: International Monetary FundJune1988) pp. 5770.

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The authors have benefited from comments by colleagues in the Fund, but are solely responsible for the views expressed in this paper. Any views expressed should not be interpreted as official Fund views.

This section draws extensively from Hemming and Mansoor (1988).

In this discussion, we assume that public ownership is associated with public management. In situations where the management of the enterprise is in private hands and insulated from public political pressures, these inefficiencies are less likely to be apparent.

See Yarrow (1986) and “Pricing the Privatized” (1988), for approaches to regulating prices in such an environment.

These two aspects are, of course, interrelated because the government’s net wealth position is identical to the discounted value of the government’s net income stream.

Alternatively, the funds could reduce outstanding borrowing, with equivalent effect.

It is however possible that the asset shift could have an impact on the economy, with some corresponding fiscal effects.

This is based on the assumption that privatization is not accompanied by a change in the tax regime that, for example, would result in the privatized company paying higher corporate profit tax rates. In this case, the government might be willing to accept a reduction in the sales price up to the discounted value of the expected stream of additional profit tax remittances.

Bös (1988), p. 14.

This assumption is not always valid. When the public enterprise is a monopoly under regulation, it may have an incentive to overinvest; by expanding its capital base (on which the rate of return is based) it may increase absolute profits. The investment may then not lead to a commensurate increase in net worth.

See Wattleworth (1988) for the role of subsidies in government lending programs.

A Manual on Government Finance Statistics by the International Monetary Fund suggests that sales proceeds should be reflected above the line in a reduction in “government net lending” (for example, lending minus repayments), since the budget category of repayments includes any receipts arising from equities sold (International Monetary Fund, 1986). In terms of the government’s balance sheet, and assuming no change in other revenue or expenditure, the government’s holding of financial assets increases (or its debt decreases) and its holding of equity in the enterprise falls.

It may be more appropriate for the evaluation of macroeconomic policies to consider the sale of an enterprise as akin to the sale of government bonds, and regard the sales proceeds as inflows financing the government deficit rather than reducing it. Alternatively, the overall budget deficit could be supplemented by other indicators, such as the net wealth of the government. See Heller, Haas, and Mansur (1986).

The only exception would conceivably be if the proceeds financed higher productive expenditures or tax cuts that offered reasonable certainty of a future fiscal benefit.

For a general discussion of arrears, see Diamond and Schiller (1988).

For a more extensive analysis of government activities in a portfolio framework, see Schiller (1983).

For a review of recent developments in debt-equity swaps, see Blackwell and Nocera (1988).

For a concise survey of recent economic developments and policy issues in Arab countries see El-Naggar (1987).

Since 1985, the Government has substantially increased its budgetary allocations for these services and eliminated these arrears.

This forced enterprises to borrow heavily on a short-term basis and at increasing costs.

Details on the privatization initiatives in Iraq, Egypt, Jordan, Oman, and the GCC countries may be found in Candoy-Sekse (1988).

In Bahrain, Oman, and Kuwait, nontax revenue from public enterprises amounts to 30–70 percent of total government revenue (with most derived from the oil sector in Oman and Kuwait). Egypt, Jordan, and Tunisia obtain 10–30 percent of budget revenues from nontax revenues from public enterprises. In Egypt, about 40 percent of the combined total of profit transfers and profit tax payments is accounted for by the Suez Canal Authority and the petroleum authorities. In Jordan, the main contributor to nontax revenue from public enterprises is the Central Bank. In Tunisia, Central Bank profits and oil receipts explain more than three fourths of total nontax revenue from public enterprises. In the Yemen Arab Republic, Sudan, and Morocco, the share of total revenues derived from nontax income from public enterprises is below 10 percent. In Yemen, more than half of this amount derives from the banking sector. In Sudan, the main contributing factor is a surplus of sales of foodstuffs.

In Lebanon, aggregate subsidies were 20 percent of total government expenditure in recent years, which primarily reflect policy objectives rather than inefficiencies of public enterprises.

Such statistics take account only of explicit subsidies through the budget. Implicit subsidies, such as may be connected with foreign exchange allocations at less than market rates, cannot be easily measured.

In Tunisia, total financial support to public enterprises ranged from 13–17 percent of total government expenditure in 1983–86.

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