Chapter

XX. Privatization

Editor(s):
Ke-young Chu, and Richard Hemming
Published Date:
September 1991
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How does privatization affect economic efficiency? Does it result in goods and services being produced at lower cost? Is the private sector more responsive to consumer demand?

Is the impact of privatization different in competitive and monopolistic markets? Should public monopolists be privatized, exposed to competition, or both?

What forms can privatization take? Are there limits to the size and scope of a privatization program?

Does privatization have beneficial consequences for public finances?

Privatization is a term used to describe a wide range of policies designed to effect a transfer of activity from the public sector to the private sector. However, its most notable manifestation is the sale of public enterprises to private buyers, and in particular the sale programs undertaken in France and the United Kingdom, and now planned on an ambitious scale throughout Eastern Europe. However, privatization does not necessarily require total divestiture; franchising, contracting out and leasing, whereby public sector activities are undertaken by the private sector, are widespread forms of privatization.

The note is organized as follows. In the first section the link between privatization and efficiency is outlined. To a significant degree, this depends upon whether privatization is associated with increased exposure to competition. Therefore the relationship between privatization and competition is also discussed. After a description of some of the practical constraints facing successful privatization, the fiscal impact of privatization is considered. An attempt is made to distinguish between the characteristics and implications of asset sales as compared to less drastic forms of privatization.

Privatization and Economic Efficiency

There are two possible sources of increased economic efficiency that can be derived from privatization: gains in productive efficiency, when a given level of output can be produced at a lower cost; and gains in allocative efficiency, when resources can be reallocated to better meet economic and social objectives—see the note on Public Expenditure Productivity for further discussion of these efficiency concepts.

Productive efficiency

Proponents of privatization argue that it will reduce productive inefficiencies arising from public ownership and management. First, by limiting the scope for political interference, privatization will result in higher-quality managerial decision making. Second, the number of objectives that the public sector usually pursues will be reduced. Often these multiple objectives are inconsistent with one another, and this reduces the ability of managers to minimize costs. Third, privatization can impose the discipline of private financial markets, which leads to more rational managerial decisions. Fourth, privatization may improve managerial incentives by making managers responsible to profit-seeking shareholders rather than to civil servants.

The merits of the above arguments need to be examined closely. Privatization may indeed improve productive efficiency under certain circumstances, but this need not be the case universally and privatization may not necessarily be the best method of securing such improvements. For example, reducing political interference in the operations of a public enterprise could also be accomplished by creating a political structure that discourages interference. Substituting the single goal of profit maximization for multiple objectives can also be achieved without privatization. However, the central issue is whether the noneconomic objectives pursued by the government are compelling. Certainly some simplification of goals will often be desirable and feasible. But it is inevitable that efficiency will have to be judged relative to objectives that are wider than those in the private sector. As regards the discipline of the financial marketplace, a government can itself impose greater financial discipline on public agencies, making them compete with other firms on equal footing for scarce financial resources. This would force public enterprises to rationalize their operations along commercial lines. Finally, the argument that privatization will improve managerial incentives depends critically on whether or not privatization in fact increases the accountability of managers. The type of bureaucratic failures that give rise to principal-agent problems—where the principals (governments) cannot provide effective incentives or adequate monitoring to guarantee that their agents (managers) pursue the principals’, as opposed to their own, interests—may also arise in the private sector.

Allocative efficiency

Improvements in allocative efficiency will in general only be achieved when privatization goes hand in hand with extending the exposure of firms to competition. Under such circumstances, increases in allocative efficiency can be expected to the extent that the monopolistic or quasi-monopolistic position of public agencies and enterprises is weakened. It is the discipline imposed by the product market—which determines profits—and the capital market—which determines whether sufficient profit is made to stay in business—that promotes allocative efficiency. However, since gains in allocative efficiency reflect mainly a change in the competitive environment, they can potentially emerge without any change in ownership structure. In the case of a public enterprise that is a natural monopoly (see the note on Public Expenditure and Resource Allocation for further discussion of natural monopoly) privatization can worsen allocative efficiency to the extent that the resultant private firm takes greater advantage of opportunities to restrict output and raise prices than the public enterprise. In such an instance, it may be necessary to regulate the newly privatized firm in order to maintain allocative efficiency. The issue then turns on whether public ownership is a more effective form of regulation than other alternatives.

The principal conclusion of the preceding discussion is that privatization cannot guarantee a priori an increase in economic efficiency. Increased competition is not only the key to improved allocative efficiency—which is generally independent of which sector undertakes an activity—but it may also provide the strongest incentive to seek improvements in productive efficiency by introducing the risk of bankruptcy or takeover. The questions that then arise are: (i) whether privatization makes it easier to increase exposure to market forces; and (ii) whether a government pursuing such a policy option will be in a position to complement it with a judicious choice of other policies, most notably liberalization to promote competition and regulation to prevent anticompetitive practices.

Privatization and Competition

Privatization is unlikely to result in increased efficiency unless it is accompanied by a dismantling of protective barriers that restrict competition. However, for a variety of reasons—such as the need to generate maximum revenue or to secure the compliance of management and workers—it may be thought appropriate to restrict competition at the time of privatization. Not only does this call into question the motives of a privatization program, it also makes it difficult to believe that liberalization will ever take place. The maximum efficiency gain will result from privatization accompanied by liberalization. Efficiency considerations also suggest that where conflict is likely to emerge, liberalization should precede privatization.

To the extent that public ownership reflects circumstances in which markets do not work well or produce outcomes that are considered socially or politically undesirable, removing barriers to competition would be insufficient or inappropriate. Natural monopoly, for example, is a market outcome; to introduce competition in a natural monopoly setting, the market has to be redefined. One solution is to make the right to run a natural monopoly the object of competition, by auctioning franchises to the private sector. This approach has been most widely adopted in the areas of local broadcasting and transportation. Also, some activities associated with natural monopoly, such as maintenance, are likely to be contestable, and these can be contracted out to the private sector. Contracting out has been successfully employed in a wide range of public services, such as street cleaning and garbage collection. Although extensive in the private sector, leasing is an option that is only now beginning to be explored in the public sector.

Certain social objectives may also be left unmet in a private market. The public sector can support loss-making activities of social value through cross subsidization by profit-making activities; in a liberalized market, the private sector will undertake only profitable activities (so-called cream skimming) and leave social needs to be met by the public sector. Certainly, the private sector can be induced, for example through the payment of subsidies, to provide essential services to sparsely populated areas and to employ people even when it is unprofitable to do so. The issue should then be one of cost-effectiveness of different types of intervention. In all likelihood, however, a wide range of priority social objectives will remain the responsibility of the public sector.

Constraints on Privatization

In designing a privatization program, especially for a developing country, a number of practical constraints will have a bearing on the type of program that can be introduced and, in the limit, on whether privatization is feasible or desirable. Of considerable importance is a policy environment and an administrative (especially legal) framework that is conducive to private initiative. If trade and industry are heavily regulated—through administered access to foreign exchange, quantitative import restrictions, entry and exit barriers, labor market controls, etc.—the scope for increased competition will be severely limited. This in turn will reduce the likelihood that privatization will be associated with increased efficiency.

To the extent that privatization involves the sale of public sector assets, the weak or nonexistent capital markets in many developing countries will restrict this option. On the other hand, some modest sales could be instrumental in expanding a fledgling capital market, and pave the way for more extensive privatization at a later date. The government must also have the administrative capacity to manage a privatization program, especially if asset sales are involved. Many ambitious privatization programs have failed to get off the ground because of the lack of specialist skills to implement them.

There may also be a resource constraint to privatization, particularly in the short term. Clearly there will be initial start up cost; consultants must be hired, government employees need to be trained, the public must be educated, and the privatization program needs to be administered. There may also arise a need to restructure public enterprises prior to sale, although this is probably best left to the new private owners. Afterwards, if privatization leads to the anticipated efficiency benefits, there may be a need to compensate for social costs such as increased unemployment, plant closures, and reduced services. Only in the medium term is privatization likely to yield the financial benefits to offset these initial costs. And even if there are the resources to get enterprises onto the selling block, there may not be sufficient domestic savings available to buy them and resistance to purchases by foreigners. The above constraints all provide reason to believe that privatization should not be embarked upon lightly. However, overriding all these considerations is the importance that must be attached to political commitment. Without it, none of these obstacles can be overcome and privatization is unlikely to work.

On these issues, developing countries may eventually be able to learn from the experience of countries in Eastern Europe, which plan rapid and extensive privatization. The intention in Poland, for example, is to privatize about a half of state industry, which dominates the economy, in as little as three years. While the political commitment to privatization as a means of effecting the transformation from a planned to a market economy is not in doubt, the institutional obstacles are immense. There are no capital markets, adminsitrative capacity is weak, the legal infrastructure hardly recognizes private property, price distortions make valuation difficult, and domestic savings are a small fraction of enterprise worth. To resolve the conflict between bold ambition and weak implementation capacity, a combination of every available privatization technique is being adopted, including mass privatization based upon the free disposal of shares to the population. At the same time, privatization is being supported by wide-ranging price and trade liberalization, appropriate competition policy, and fiscal and monetary reform.

Fiscal Impact of Privatization

Privatization is often ascribed objectives that extend beyond efficiency improvements. Diluting the strength of public sector trade unions and achieving wider share ownership are sometimes mentioned. However, it is in connection with reducing public sector deficits that privatization is most frequently associated. This is especially so where the sale of public sector assets, mainly public enterprises, is concerned.

Privatization and fiscal stance

As recommended in the Fund’s Manual on Government Finance Statistics, proceeds from enterprise sales are treated as capital revenue or a loan repayment in the government accounts, which will lead to a once-and-for-all reduction in the fiscal deficit, assuming that the sale price obtained is greater than the net income generated for the government by the enterprise in the year of the sale. The change in the deficit, however, may not necessarily reflect a fundamental change in the fiscal policy stance. To gauge such a change, an analysis of the income flows and changes in the government’s net worth arising from privatization is necessary.

Assume that a public enterprise is sold to a private buyer at a price equal to the present value of the stream of after-tax earnings of the enterprise. Moreover, assume that the public and private sectors face the same taxes, are equally efficient, and discount future income at the same rate. Then the reduction in the fiscal deficit in the year of the sale will be counterbalanced by larger deficits in all future years, reflecting the government’s loss of revenue in the form of remitted profits. These larger future deficits, however, can be exactly offset if the government uses the sale proceeds to purchase financial or physical assets, or to retire a portion of its own debt. Under such a scenario, the government and private sector have simply exchanged assets, and this should not affect the demand for real resources at the time of the sale, or in the future. However, if the government uses the sale proceeds to finance an expansion of current expenditure or a reduction in taxation (or both), the deficit in the year of the sale would be unaffected, while future deficits will be larger. In such a case, the fiscal policy stance is affected by the sale. The resulting fall in government net worth signals the expansionary impact of the transaction, and the possible need for subsequent contraction to reastablish a sustainable fiscal stance. Thus, while privatization receipts may be formally treated as revenue, their economic impact is the same as financing.

The above line of reasoning holds for a loss-making enterprise, too. In such a case, the government may have to pay an up-front lump-sum subsidy. As such, a larger initial deficit in the year in which the public enterprise is transferred to the private sector will be counterbalanced by lower fiscal deficits in the future as a result of the government shedding its responsibility for future losses of the now-private operation. However, the service on debt accumulated to finance the initially higher deficit will return future deficits to their higher original level. Again, the public and private sectors have simply exchanged assets, and the fiscal stance will not be affected. This example also illustrates that a permanent improvement in fiscal performance will not necessarily be brought about simply by selling enterprises that are heavily subsidized; interest payments on debt accumulated to pay the private sector to take over the operations will offset any apparent fiscal gains.

Privatization can permanently improve fiscal performance only if large efficiency gains, both productive and allocative, result from the transfer of ownership from the public to the private sector. In such a case, the government will benefit from privatization to the extent that it can capture part of the expected efficiency gains in its sale price and/or additional taxes. Thus, in examining the fiscal impact of privatization, it is necessary to distinguish between cases in which privatization is likely to have a significant impact on productive and allocative efficiency and those in which such an outcome is unlikely. From the budgetary perspective, cases in which large efficiency gains can be expected should be the focus of a privatization exercise.

Privatization and financial policy

The design of financial policy is increasingly having to address the issue of the treatment of uncertain privatization proceeds when the price of enterprises and the timing of sales cannot be predicted. In principle, this uncertainty should not be a problem. The appropriateness of a government’s fiscal stance is determined by financing needs. Therefore, if one starts from a budget that assumes no privatization revenue, fiscal stance will be unaffected if privatization revenue is forthcoming (from either domestic or foreign sources) and net credit to government is correspondingly reduced. Less obviously, if the budget makes allowance for privatization revenue that does not materialize, a compensating increase in net credit to government does not affect fiscal stance. In particular, there is no additional inflationary pressure owing to the increased money supply, which is matched by increased money demand because, contrary to initial expectations, privatized assets are not substituted for money in individual portfolios.

The usual practice is to assume no privatization revenue and to reduce net credit to government by the amount of actual receipts. In some cases, part or all of privatization revenue is earmarked to investment, especially if high-quality programs are pre-specified. A more cautious approach should perhaps be adopted when privatization revenue is assumed in the budget. If there is a shortfall, an offsetting increase in net credit to government is generally judged to be too risky because money demand cannot be tied down with any degree of precision. Instead, revenue has to be raised in its place or spending has to be reigned in. However, this approach can result in bad taxes being levied and fairly arbitrary expenditure cuts, with damaging consequences for efficiency. Hence the preference for assuming no privatization revenue in financial policy design.

Country Experiences

Problems with divestiture in Ghana and Sierra Leone

Past employment practices in Ghana led to significant overstaffing in the public enterprise sector. At the same time, collective bargaining agreements granted extremely generous severance pay arrangements. In an attempt to maximize proceeds from the eventual sales, pre-privatization efforts have focused on rationalizing manpower levels at many of the firms to be divested. However, in the absence of a political will or desire to repudiate past ill-conceived policies, part of Ghana’s privatization program has been hindered and delayed by a lack of budgetary resources to cover the contingent liabilities of the firms to be divested, and in particular severance pay.

Public choice theory suggests that since the benefits of privatization will be spread out over a large number of people—but the costs will be borne by a small number, especially civil servants and public managers—the small group may voice strong opposition to the reform effort. In the case of Sierra Leone, however, members of the civil administration were the most interested prospective buyers of assets under a World Bank coordinated privatization program. Because of limits on foreign ownership as well as a weak private sector and poor financial intermediation, it appeared that the government might end up receiving less than a fair price for privatized enterprises. As a result, the privatization program is currently being restructured, with a view to raising the income the government derives from privatization and improving the government’s fiscal position.

Experience with other forms of privatization

Franchising

In Thailand, the Bangkok Metropolitan Mass Transit Organization (BMMTO) began franchising bus routes in the late 1970s. The results have been mostly positive, as the BMMTO was able to increase the number of buses on crowded routes and was able to sell off many of its used buses at attractive prices. However, some evidence exists that the franchises were underpriced, and that the BMMTO did not maximize its financial gain.

Contracting out

In Australia, the government, in an effort to improve road sealing, town sweeping, and other activities at the city council level, decided to contract out these various functions. Contract specifications and conditions with built-in safety clauses to maintain the quality of service were developed. Regular review procedures and monitoring systems were also introduced. Competitive tendering resulted in a reduction in costs and an improvement in services offered.

Bibliography

    Hemming Richard and Ali M. Mansoor “Privatization and Public Enterprises,” Occasional Paper No. 56 (Washington: International Monetary Fund1988).

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    Mansoor Ali. M. “The Budgetary Impact of Privatization” in Measurement of Fiscal Impact: Methodological IssuesOccasional Paper No. 59ed. by Mario I. Blejer and Ke-young Chu (WashingtonInternational Monetary Fund) October 1987.

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    Shirley Mary “The Experience with Privatization,” Finance and Development (Washington: International Monetary Fund1989).

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