4 Privatization, Deregulation, and Macroeconomic Policies: The Case of Pakistan


Ibrahim Elwan1

Ibrahim Elwan1

The emergence of independent developing countries following World War II shifted the responsibilities for economic management from the colonial powers to the new governments. Policymakers inherited economies largely dependent on the export of primary commodities, cash crops, and semimanufactured goods. A large proportion of these exports was produced by foreign private sector enterprises. The rest was produced by subsistence farmers and small cottage industries. Infrastructure was limited to the industrial enclaves, large agricultural estates, and urban areas. Independence emphasized self–reliance and the need to decrease dependence on exports of primary goods and agricultural products by promoting industrialization. Failure by private sector enterprises to respond to the aspirations of the new governments because of entrepreneurial risks or an inability to mobilize the needed resources frustrated development plans. In response, governments consolidated their control over existing industries through expropriations and nationalization to capture rents for financing new industrial investments. As a result, private sector investment declined and foreign venture capital became scarce. This coupled with relatively low levels of domestic savings, poorly equipped capital markets unable to mobilize savings, and competition from the industrialized countries for reconstruction capital left a gap in the resources available to developing countries.

Faced with limited access to private sector capital, governments had to rely increasingly on external official grants and credits and guaranteed loans to finance their development plans. The growing demands on governments to accelerate growth by developing infrastructure—transport, telecommunications, power, water, and ports—and the industrial and agricultural sectors forced the public sector to take greater responsibility for the development of new industries and infrastructure by concentrating new investments in the state-owned enterprises (SOEs). Gradually, the number of SOEs increased and the extent of their activities broadened.

SOEs were created to achieve national development priorities, which at times paid little attention to comparative advantage, economies of scale, capital constraints, and profit generation. As a result, a large proportion of these SOEs depended from the outset on subsidies and budgetary transfers. Loans with subsidized interest rates were made available by governments to cover firms’ operating deficits and new investments. Nonperforming loans were converted to equity or changed to grants. SOEs also enjoyed protection from competition through licensing, concessions, preferential exchange rates, exemption from duties, and tax holidays. These practices undermined the incentives for efficiency and increased the SOEs’ dependence on budgetary support. According to a study by Malcom Gillis,2 SOEs’ deficits in developing countries increased from 5.5 percent of GDP in the 1970s to as much as 12 percent in the 1980s in some countries. Deficits and investment plans of SOEs were financed by governments through domestic and external borrowing. In the late 1980s, SOEs, particularly in the infrastructure sectors, accounted for more than 50 percent of domestic banking debt and as much as 40 percent of the external debt of developing countries.

The debt crisis of the mid-1980s brought with it severe limits on the access of developing countries to foreign exchange. This, in addition to the shortages of domestic resources attributable to poor pricing and taxation policies and the deteriorating efficiencies of SOEs, which imposed an increasing burden on national budgets, focused attention on the need to put the reform of SOEs at the top of the economic agenda. The pressure on governments to resume economic growth in the late 1980s and early 1990s, after more than a decade of slow growth and stagnation, called for policies to restore fiscal, monetary, and external balance. Critical to the success of these policies was the rationalization of the state-owned sector. The industrialized countries in which SOEs play a major role in the economy, such as the United Kingdom, New Zealand, and Japan, had launched earlier similar programs for the rationalization of SOEs. Their programs involved restructuring, corporatization, divestiture, and liquidation on the path to privatization. The success of these privatization programs gave confidence to developing countries that hoped to make privatization one of the main elements of their economic adjustment programs.

The purpose of this paper is to review Pakistan’s privatization strategy in the context of its current macroeconomic adjustment program. To provide a basis for this review, the paper starts with a definition of privatization and the means for its attainment. It then proceeds to discuss the general objectives for privatization and the framework linking macroeconomic policies, deregulation, and privatization. Pakistan’s privatization program is also briefly presented. Key issues likely to affect the implementation of the program are discussed in the last section.

Definition of Privatization

Privatization refers to the involvement of private sector enterprises, foreign and domestic, in the design, finance, development, ownership, and operation of facilities engaged in the production, transport, and delivery of goods and services. Privatization can be achieved by (i) developing new private sector facilities; (ii) transferring, partially or totally, the ownership of SOEs to the private sector; or (iii) contracting out or leasing a publicly owned asset to a private firm for operation and management.

Development of New Facilities

This approach involves the design, finance, construction, ownership, management, and operation of new facilities for the production of goods or delivery of services. The facilities could operate as new industries introduced for the first time in a market or they could operate in parallel with already existing facilities owned by the public sector. Privatization could also be achieved by diluting public sector ownership of SOEs. This would involve expanding the capacity of existing SOEs by allowing private sector enterprises to finance and construct the expansion. These private firms would then own part of the equity in the new larger SOEs. Success in this approach usually requires expanding the size of existing facilities of SOEs to the point where private sector enterprises acquire the majority shares and assume control over management.

Transfer of Ownership to Private Sector

This approach to privatization involves the partial or total sale of SOEs to the private sector. The transfer could be achieved by selling the controlling shares to private firms through private offers. The purpose of such a sale is usually to provide an opportunity for private enterprises to introduce their know-how in terms of management and operations with a view to improving the efficiency and financial performance of SOEs. Alternatively, the transfer of ownership could be achieved through public offerings, involving the sale of shares in national and international capital markets. The shares could be sold in one block or a series of blocks, depending on the industry, the absorptive capacity of domestic capital markets, and the assessment of risk and financial returns by international financial markets. The two approaches to the transfer of ownership, through private offers and public offers, can be combined. This would involve the sale of part of the equity of SOEs through a private offer to attract the technical, managerial, and financial know-how of private enterprises and the placement of the rest of the equity in the form of shares in trust until the SOEs are restructured and their performance improved. Thereafter, the shares held would be disposed of, usually at better prices, through a public offer.

Contracting Out or Leasing

This approach involves the leasing of SOEs to private sector companies for operation and management; the ownership and financing of the assets would remain in public sector hands. Similarly, private enterprises could be contracted to deliver services previously undertaken by the public sector. Under the contracting out and leasing arrangements, private firms agree on efficiency criteria and remuneration for services, which would cover costs and provide a fair return, dictated solely by the private firm’s ability to achieve the level of efficiency agreed.

The first two approaches to privatization—the development of new facilities and the transfer of ownership—involve the assumption of control over SOEs and hence the right to exploit, expand, contract, or dispose of assets. The third approach, contracting out and leasing, provides only for the right of exploitation. All three approaches share the expectation that the private sector would bear the financial consequences of all of its decisions.

Objectives of Privatization

Governments pursue privatization to achieve at least one of the following objectives: (i) improve the efficiency of SOEs; (ii) mobilize resources from the sale of assets; and (iii) tap the private sector’s technical know-how and markets.

Improvement of Efficiency

A number of comprehensive studies to assess the performance of SOEs have provided strong evidence that, on average, the productive efficiency of SOEs is lower than that of private sector enterprises engaged in the same activities. SOEs in developing countries operate in a highly controlled environment, in which the owner is the state and the management is essentially the agent. However, for all practical purposes, managers carry out their responsibilities as owners of the assets. The absence of a system for monitoring their performance, financial discipline, and achievement of social objectives provides few incentives to managers to improve efficiency.

The inefficiency of SOEs is attributable to their lack of autonomy in setting targets and prices for output, in recruitment and employment of workers, in compensation and rewards, in acquisitions and retirement of assets, and in access to needed foreign exchange. Privatization contributes to the improvement of efficiency in that it redefines the owner-agent relationship and allows the latter to exercise full control over SOEs in order to achieve well-defined objectives, usually the maximization of profits. This also prevails in cases of contracting out and leasing where the facilities are owned by the public sector but the private sector performs as an independent agent with an agreed objective. The emphasis on profits explains how the contracting out and leasing approach to privatization has succeeded in improving the productive efficiency of enterprises previously requiring budgetary support.

Managers’ incentives under the system of SOEs are rarely linked to profitability but are tied to output quotas, sales turnover, maintenance of employment, and other performance measures. On the other hand, managers’ incentives in the private sector are linked to profit, and there rests the basis for improved efficiency once SOEs are privatized. Privatization coupled with deregulation, promotion of competition, and reliance on market forces achieves allocative efficiency. Private sector managers compete by considering the prices of all inputs and outputs when determining the level of output that would maximize profits.

Resource Mobilization

The burden of SOEs on the national budget, in terms of investment needs and transfers to cover the shortfalls in operating revenues, was financed during the 1970s and early 1980s by external and domestic borrowing. This contributed to the fiscal deficit and increased the external and internal public sector debt. Privatization was seen as a way to mobilize resources through the proceeds of the SOE sale, which would allow governments to capture domestic and foreign savings. The mobilization of the resources for privatization has had two aspects. The first covers the short term, where the transfer of ownership brings in sale proceeds to the government, which can be applied to priorities such as debt reduction, contribution to fiscal resources, and new investments. The second is long term, in that it frees resources that would have otherwise been allocated to support the SOEs.

Private Sector Know-How and Access to Markets

Implicit in privatization activities is a recognition of private sector expertise, both technological and managerial, in terms of project development, project finance, and enterprise operation and management. In addition, the private sector’s ability to capture the economies associated with comparative advantage and to penetrate new and existing world markets is key to developing countries’ attempts to improve economic performance. Access to markets covers several fronts. The private sector could provide privatized firms with access to domestic and international capital markets in the mobilization of equity and long-term debt financing. Confidence in reputable private sector firms with proven track records reduces the extent of commercial risk associated with the operations of privatized SOEs and hence improves their access to resources. The private sector could also provide the privatized SOEs with access to international markets by integrating them vertically into global multicountry production processes that would ensure demand for their output and secure returns earned internationally. Technological improvements of SOE operations and better training of personnel could also take place with privatization.

Macroeconomic Framework

Governments can be involved in economic activities in three ways: as suppliers of commodities and services; as setters of output and prices; and as regulators. As suppliers, governments can be directly involved through ownership of the means of production, either through ministries or through SOEs. In setting prices, governments can subsidize the prices of goods and services either explicitly or implicitly by (i) pricing factors of production below their opportunity cost, or market-determined price, (ii) extending interest rate subsidies directly to specific sectors, and (iii) converting public sector loans into equity to reduce SOE debt-service burdens. As for regulation, governments’ involvement can, at one extreme, leave market forces to operate unhindered, limiting involvement to the setting of standards for output, in terms of quality and safety, and developing strong regulatory and legal systems to enforce these standards and provide recourse to public agencies, producers, and consumers. At the other extreme, governments can fully control the day-to-day operations of sectors and SOEs by setting input and output prices, employment levels, performance criteria, and production levels.

Governments are involved in their economies in all three ways. Movement toward economic liberalization and deregulation requires a withdrawal of the government from the supply of goods and services and the setting of prices and output quotas. It also necessitates a strengthening of their regulatory functions and the promotion of competition. Ideally, governments should concentrate on creating an enabling environment for private sector firms. In terms of economic policy, a greater role for the private sector requires, in the absence of unlimited resources, the rationalization of the public sector as a producer. Theoretically, rationalization of the public sector implies that it produce those goods and services that, if otherwise produced by the private sector, would involve higher economic and social costs. Public sector productive activities should be limited to the provision of goods and services whose consumption would yield net social benefits, provided both costs and benefits reflect the true cost of the resources to the economy.

The mix between the public and private sector is determined by comparing for each activity the cost and benefit that, if summed across all goods and services, would maximize the benefits to the economy. The optimal mix of public and private sector participation in an economy rests to a large extent on the willingness of policymakers to rely on market-determined prices for evaluating the options. Subjective assignment of costs and benefits on national grounds of independence, self-reliance, and security would introduce distortions into the evaluation and lead to a suboptimal mix in the productive activities of the two sectors.

The private and public sectors will achieve the optimal mix in their economic activities only if both face the same market signals for factor inputs and outputs. This requires the elimination of all subsidies and the pricing of tradable commodities at their market-determined level. Governments should refrain from setting interest rates and allocating credit through quotas. Market forces should be relied on for setting the value of domestic currencies relative to foreign currencies. Moreover, import restrictions should be abandoned in favor of an environment conducive to competition, leading, in turn, to optimal resource allocation by both private and public sectors. The reliance on market prices would also require governments to address taxation policies and collection practices with a view to redesigning taxes, duties, and levies to improve resource mobilization, while imposing the least possible distortion on relative prices.

The process of liberalization and privatization requires the creation of regulatory institutions to establish the pricing, entry, and competition pertaining to each sector. Governments also need to put in place strong, sound legal frameworks to support producers, consumers, and government entities in resolving conflicts and seeking recourse in an orderly, expeditious, and efficient manner. Regulators for the various sectors should be independent of government agencies, with regulatory bodies staffed by experts.

Finally, one has to be concerned with the social impact of the structural changes in the economy. The restructuring of various sectors to realign the responsibilities of the public and private sectors involves decisions on the use of factors of production that will inevitably result in labor redundancies. Policies to mitigate these negative social effects should constitute any program for liberalization, deregulation, and privatization.

Pakistan’s Privatization Program

Pakistan is currently in the process of implementing a privatization program representing the logical continuation of the economic reforms initiated in 1985. These reforms covered several key sectors of the economy: energy, transportation, industry, agriculture, and finance. The structural reforms have been introduced while sustaining a relatively healthy level of growth. This growth, however, was accompanied by increased budgetary deficits and, at times, upward pressure on the general price level. The fiscal deficit, which increased from 2 percent of GDP in fiscal year 1979 (FY79) to 9 percent of GDP in FY88, was due to (i) increased public sector expenditures; (ii) the inadequacy of revenue generation attributable to the underpricing of most public sector services, such as natural gas, electricity, fertilizers, wheat, cooking oils and fats, and transport; (iii) inadequate tax levies and collection, particularly in the agricultural and household sectors; and (iv) sustained increases in economic and financial transfers to SOEs. The fiscal deficit was financed by public sector borrowing and by tapping household and institutional savings. Subsidies to SOEs between 1981 and 1992 amounted to PRs 32,048 million, or $1,302 million. The distribution of these subsidies among the major SOEs are presented in Table 1.

Table 1.

Subsidies to SOEs, July 1981-June 1992

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The increased fiscal deficit and the historical levels of public sector expenditure and borrowing were virtually impossible to sustain while attempting to restore balance and maintain growth. As a result, public expenditure and borrowing were rationalized, and the shortfall in the investment required to sustain economic growth was earmarked for the private sector. The increased reliance on the private sector has focused attention on the need to deregulate the economy in order to provide an attractive environment for venture capital.

Pakistan’s privatization program was initiated under the Seventh Five-Year Plan (1989-93), concentrating primarily on the energy sector. The sector was in adjustment for the last three years of the Sixth Five-Year Plan (1984-88), following the realization at the end of the first two years of the plan that the investment targets for the sector were greater than the external and domestic resources available. A process of rationalizing expenditures was initiated to match the outlays and the available financing. This process brought to the fore two essential issues. The first was that after correcting for the distortions in energy prices, by setting them equal to economic costs, the available financial resources were substantially less than those required to ensure the optimal development of the sector. The second issue was that bottlenecks in the supply of energy were attributable in part to the inadequate implementation capabilities of SOEs in the sector. This led the government to develop a Core Investment Program (CIP), which represented the minimum investment needed by SOEs. The CIP comprised ongoing and new investments needed to minimize the shortfall in achieving the output targets and ensure a smooth transition to the seventh plan. The implementation of CIP was successful and provided the basis for the formulation of the seventh plan by identifying at the outset the investments and financing needed to achieve the plan targets.

The identification of the output targets for energy supplies showed that the SOEs would not be able to achieve them. The difference between the required investments for the seventh plan and the investment sanctioned for the SOEs was earmarked for the private sector. As a result, CIP for the seventh plan was the first program to include investment plans by both SOEs and private sector firms. Policies for enhancing the role of private sector firms in the exploration and development of oil and gas were followed and new higher producer prices were declared with a view to providing better incentives for private sector activity. Some gas and oil fields were allocated for sole exploration by private firms; others were earmarked for joint venture with an SOE, namely the Oil and Gas Development Corporation (OGDC); and the rest were earmarked for OGDC alone. In the power subsector, amendments to the laws were introduced to allow private firms to design, finance, construct, own, and operate power generation units to supply the national SOEs, the Water and Power Development Authority (WAPDA), and the Karachi Electricity Supply Company (KESC).

Unprecedented activities by the private sector were seen in both the petroleum and power sectors. And so far, Pakistan has been able to exceed the plan targets for oil and gas. Further investments in the power sector have been identified; however, their implementation has been delayed. In addition, the privatization of the largest gas distribution company in Pakistan, Sui Northern Gas Pipeline Limited (SNGPL), was initiated through a process of private placement with an internationally reputable gas company. The competitive bidding process aimed at bringing the technical know-how of a large gas corporation to SNGPL and boosting public confidence in the future prospects of the company. The rest of the shares were to be sold through a public offer. The process of divestiture would reduce government ownership of the company from 98 percent to 26 percent as a first step. The next step would see government involvement phased out, limited in its ownership to a goldenshare. The government has also divested of 10 percent of its ownership in Pakistan International Airline.

The present government has continued the process of privatization. The objectives of the privatization program are as follows:

  • —provide opportunities for private sector firms in activities previously reserved for the public sector, such as power generation, airlines, ports, shipping, highways, and telecommunications;

  • —deregulate the financial sector to operate in accordance with market forces, privatize the banks nationalized in 1974, and encourage new private sector commercial banks; and

  • —privatize 115 SOEs.

The deregulation and privatization of the telecommunications sector and the power sector were later added to the list.

The government has created an independent privatization commission that reports to the cabinet. The commission has identified the industries to be privatized in consultation with the appropriate ministries and with the approval of the cabinet (Annex 1). The cabinet has sanctioned the divestiture of 102 SOEs, excluding those in the power and telecommunications sectors. Table 2 summarizes the SOEs offered for sale by type of industry.

Table 2.

SOEs Approved for Divestiture

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Source: Government of Pakistan

Of the 102 SOEs offered for sale, 48 are in the food processing sector. So far, agreements on sales have been reached in connection with the divestiture of 36 SOEs, which are expected to provide proceeds of about PRs 6,786 million ($277 million). However, when examining the transfer of ownership from the public to the private sector, only 25 SOEs have been effectively privatized, with expected proceeds of about PRs 2,599 million ($105.6 million). As for the remaining 11 SOEs, agreements on their sale prices have been reached but the actual transfer of ownership has not taken place, as payments to the government by the private sector have not been made. Moreover, of those firms where ownership has been transferred, the government has received PRs 1,106.4 million ($44.9 million) and the remaining balance, secured by bank guarantees amounting to PRs 1,493 million ($60.7 million), would be paid on an agreed timetable. Table 3 summarizes the breakdown of the proceeds from the expected divestiture of the 36 SOEs.

Table 3.

Proceeds Expected from the Sale of 36 SOEs

(In millions of rupees and dollars)1

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The exchange rate used is 24.6 rupees to the U.S. dollar.

The privatization of the 36 SOEs was carried out through a bidding process in which each bid was made open to the public on the announced date for evaluation. Of the 36 SOEs privatized thus far, 16 are in the food processing industry, ranging in bid prices from PRs 152 million ($6.2 million) for Associated Industries, a producer of edible fats (vegetable ghee), to PRs 1.6 million ($65,000) for Bahawalpur bakery factory (roti plant). The remaining 20 SOEs privatized are in the automotive, cement, chemicals, and engineering industries, ranging in bid prices from PRs 1,799 million ($73.5 million) for D.G. Khan cement plant to PRs 16.9 million ($690,000) for Pioneer Steel Mills Ltd. (See Annex 1 for details.)

The present government has blamed labor union resistance for the difficulties experienced in 1989, when the previous government first introduced the privatization program. As a result, its privatization program provides a social safety net for cushioning the labor force of SOEs from the full adverse effect of divestiture. Under the present privatization program, the welfare of the labor force employed in the SOEs to be divested is protected through the following provisions:

  • —employees of privatized SOEs cannot be declared redundant during the first 12 months of private ownership;

  • —employees can acquire up to 10 percent of the shares of the privatized SOE;

  • —employees declared redundant are given priority in receiving permits for employment overseas and credits on easy terms should they elect to become self-employed;

  • —employees declared redundant are given priority in employment elsewhere and until they are employed receive unemployment benefits of PRs 1,000 a month ($40), representing two-thirds of the official minimum wage, for a maximum of two years. In addition, grants for children’s education and marriage are made available.

  • —employees opting for early retirement are entitled to grants (a golden handshake) of one month’s salary and benefits for each year of service and four months’ basic salary for each year of service;

  • —employees declared redundant are entitled to a training program to enhance their chances of securing new employment; and

  • —employees are entitled to arrange independent financing to bid for “employee buyouts” of their SOEs.

The provisions of the safety net are fairly comprehensive and could provide opportunities to enhance the future earnings of the affected labor force through training and self-employment. It is, however, too early to determine whether this program is effective. Its success will undoubtedly depend on the extent and speed with which the provisions are made available.

Issues and Constraints

Sequencing of Privatization

As mentioned, Pakistan’s privatization program started in 1989 in the energy sector, which was undergoing a comprehensive program of structural adjustment launched in 1985. This adjustment program had a broad focus, covering the formulation of a national development strategy for the exploitation of energy resources, the identification of investment priorities, the rationalization of energy prices, and the strengthening of the sector’s regulation. In this respect, the deregulation of the sector and the creation of a regulatory framework preceded the process of privatization and divestiture. The concentration of the energy sector in relatively few SOEs contributed to the government’s ability to prepare for their corporatization as a first step toward privatization. In addition, the sector has always involved the coexistence of SOEs and private sector enterprises. In the petroleum subsector, OGDC, the predominant SOE responsible for the exploration of oil and gas, has relied on foreign expertise to assist in exploration activities and the development of new fields through joint venture arrangements, farming out of gas and oil areas, and leasing. The petroleum refining sector has also been characterized by the coexistence of private and public enterprises. These attributes have facilitated the process of privatization and contributed significantly to the speed and success of the divestiture program. The privatization of SNGFL, the corporatization of OGDC and the divestiture of some of its holding to the private sector, and private sector expansion of refining capacity have all been accomplished. Significant achievements with respect to the refining sector have been the new Hydrocracker plant, to be implemented shortly by a private sector joint venture, the National Crescent Petroleum Corporation, with an investment of about $450 million, and the development of four million tons of petroleum refining capacity by PARCO.

It is noteworthy that within the energy sector privatization has been much slower in the power subsector, which is under the control of two SOEs: the Water and Power Development Authority and the Karachi Electric Supply Company. Resistance by these SOEs to the privatization of the sector has been strong. WAPDA has taken substantial time to change its attitude toward private sector generation. Only after its own investment program was curtailed did it accept the prospects of having private firms supply about 2,000 megawatts of power to the system.

The privatization of the energy sector and the accelerated pace at which economic liberalization has taken place over the past two years have provided the basis for the initiation of the second phase of the privatization program. The second phase involves the privatization of 101 SOEs, whose divestiture is currently under way. The blueprint for the privatization of WAPDA is currently under preparation. The government has also changed the Telegraph and Telephone Department of the Ministry of Communications into a corporation, Pakistan Telecommunications Corporation (PTC). The deregulation of this sector is motivated by a desire for more competition. Consultants are being recruited to formulate the strategy for the privatization of PTC. Several other major state-owned railways, ports, and other facilities are currently being prepared for privatization.

The success of the second phase of privatization in Pakistan has been commendable given the span of time during which it has been implemented. In the energy sector, privatization progressed in an orderly manner, moving from deregulation on the sectoral level to divestiture at the enterprise level. By contrast, the privatization of WAPDA, telecommunications, ports, highways, and railways is progressing in tandem with deregulation. This is likely to hinder the effectiveness by which their privatization is achieved. Potential buyers will be asked to bid for the SOEs while not being fully aware of the regulatory framework under which they will operate, the extent of competition they would face, and the basis they will use for pricing, compensation, and repatriation of profits. These uncertainties would lead the private sector to hedge its bids and offer lower prices for the assets than would be the case if the risks did not exist. Privatization of the major infrastructure is largely dependent on the enabling environment and the regulatory framework as well as on the availability of foreign and local resources needed to acquire the assets. Given these issues, the speed with which privatization of the 36 enterprises has taken place is encouraging. However, the same speed would not be possible in the case of the large SOEs, such as WAPDA, PTC, railways, and ports, which will require substantial effort and resources to transfer ownership.

If the experience in privatization, gained from transactions with foreign companies and in the domestic oil and gas sector, are to be taken into consideration, then the government’s privatization program should proceed with the divestiture of the 102 SOEs already sanctioned, provided the sectors in which they operate are deregulated. As for the major regulated industries, the first step should be their corporatization: the delinking of SOEs from budgetary support and the severing of the control of civil servants over their daily operation and management. In addition, financial performance criteria, preferably expressed in terms of net operating revenue and return on assets, should be agreed. Totally independent management teams with proven track records in their field of expertise should be appointed to manage the SOEs with mandates to prepare them for divestiture. The second step, which can be implemented in parallel with the first, would involve the creation of a regulatory framework, deregulation of the sectors, and identification of the sequence in which SOEs would be privatized.

The final step would cover the privatization of the SOEs over a longer time horizon. It is extremely difficult, if not impossible, for the capital market and private sector investors to cope with the divestiture of major SOEs simultaneously. The declared objectives of the government to privatize all major SOEs within a period of 18 months is unattainable and if pursued would undermine the process of divestiture. There is a need to note not only the successes achieved elsewhere in terms of privatization but also the extensive preparatory work involved in identifying the priorities and in sequencing the SOEs to be privatized. It is not accidental that the first SOEs privatized in several countries have been those with potential for foreign exchange earnings—telecoms in Mexico, Argentina, Malaysia, Chile, Venezuela, United Kingdom, and Japan; airlines in Venezuela and Brazil. If these experiences are to influence the privatization strategy of Pakistan, the telecommunications sector, PTC, and the petroleum subsector should be given the highest priority, followed by ports and airways and gradually power and railways.

Adequacy of Financial Resources for Privatization

The success and pace of privatization are closely linked to the availability of financial resources to provide the equity and possibly to refinance the debt for private firms to acquire SOEs. The success of the privatization program in the United Kingdom, New Zealand, France, and Japan was due to the government’s ability to rank the SOEs in terms of sequencing and pacing of privatization and to ensure the availability of domestic and external financing. In developing countries, the potential for mobilizing domestic financing through the capital market is limited and hence the reliance on external sources for financing privatization is greater. In Pakistan, the need for domestic financing through the capital market, to the extent needed for the privatization of the major SOEs (WAPDA, KESC, and PTC), is far greater than the equity market could meet. In 1992, the largest transaction in terms of local equity to be underwritten by a financial institution in Pakistan is expected to be for the Hub Complex, a 1,292 megawatts power plant to be designed, financed, constructed, owned, and operated privately, in the amount of PRs 2,460 million ($100 million). This represents a sevenfold increase over the largest equity ever raised through a public offer. As the economy of Pakistan moves toward greater reliance on the private sector for developing capital-intensive projects—refineries, power plants, port terminals, airports, telecommunications facilities, cement, and fertilizer plants, all of which are under preparation at present—the equity demands on the domestic capital market would eventually be impossible to meet.

Pakistan’s capital market is far weaker than should be the case. In 1991, the Karachi Stock Exchange had about 398 companies listed with a total equity capitalization of only PRs 59,688 million ($2,426 million). Of these, 352 companies are private and 46 are SOEs. Most of the SOEs listed on the stock market are those whose financial performances have been weak. Despite their performance, several continue to declare dividends, mainly because of the government’s willingness to forgive debt service for sovereignly guaranteed loans. To illustrate, consider KESC, which is listed on the Karachi exchange. In 1990, it declared a dividend despite a financial rate of return on revalued assets of less than 4 percent. This was possible by deferring interest payments on outstanding loans and postponing tax payments. KESC has been in default on its financial obligations for the past ten years, and a quick review of its projected financial performance shows that it is likely to default for the next five years. The value of KESC’s shares, including the bonuses, has increased by 300 percent since 1980 despite its poor performance. The appreciation in the value of KESC’s shares took place while the company was receiving a subsidy from the government amounting to PRs 6,295 million ($256 million), representing 19.5 percent of the total subsidies extended to SOEs between 1981 and 1991.

KESC illustrates the effects of government intervention in the operations of SOEs and the cost it bears as a result of subsidies, forgone tax revenues, and rescheduled debt. KESC also provides a glimpse at why the general public doubts the reliability of information provided by the Karachi stock market. As is the case with KESC, the share values of a number of SOEs do not accurately reflect their financial performance because of government intervention. Discrepancies between the financial performance of companies listed on the stock market and the value of their shares undermines the confidence of investors in the ability of the market to ration capital.

Government affects the operation of the capital market in Pakistan in two ways. The first involves the issuance of sovereignly guaranteed bonds for the major SOEs to mobilize local financing with relatively high assured yields. These instruments have in the past crowded out the private sector. The second involves the financing of SOEs’ investment through guaranteed five-year rolling bonds whose maturity is shorter than required for long-lead investments such as power generation, telecommunications, and ports. The success in the past of selling the bonds of SOEs has been largely due to the government’s directives to the banking and insurance enterprises in the public sector to pick up whatever financing was not acquired by the general public. Continued guarantees for the financing instruments issued by large SOEs undermine government plans to put them on a purely commercial footing. This interference in the financial market erodes its effectiveness and its ability to mobilize equity.

Privatization in all of its forms requires long-term financing. This is expected to be one of the major impediments to privatization in Pakistan. So far, the available financing has a maturity of about five to seven years, including a two-year grace period. The government should consider allocating substantial resources to the development of the long-term financial market, possibly by guaranteeing, initially and until the market is established, payments for the end years and hence extend the available instruments of 5- or 7-year maturities to 10 and 12 years by guaranteeing the last five years.

The capital market in Pakistan would need to be deregulated and credit ceilings removed. The regulatory framework for the operations of the financial sector should be established and an independent regulatory body appointed to privatize gradually the sector and to foster competition. The regulation of the stock market should also be strengthened, and laws governing financial reporting and audits of companies should be enforced. Financial performance indicators for companies listed on the stock market should be set and applied to both public and private enterprises. SOEs’ financial performance should be declared and adherence to internationally accepted standards for financial practices should be enforced. These measures would enhance the confidence of investors in the accuracy of the stock market’s valuation of companies. In addition, loss-making SOEs would be easily identified and corrective measures taken to restore their financial position if possible. Failure to restore financial health would make the SOEs suitable for liquidation.

As for the mobilization of foreign equity to support the privatization program in Pakistan, concerns over the transfer risks are the principal constraints to the flow of direct investment. The level of foreign reserves continues to be the benchmark for the assessment of the risks of foreign exchange availability. Reserves in September 1991, about $415 million, do not provide the confidence required by the private sector to assume the transfer risks. It is expected that the liberalization of the economy, particularly the financial market, would improve Pakistan’s foreign reserves. However, during the time horizon for the implementation of the privatization program, the government would need to allow slightly higher returns than normal to compensate private sector investors for transfer risks. Direct foreign investment in 1989 amounted to only $120 million, which is significantly lower than would be required to sustain the privatization of the large SOEs, such as WAPDA, with paid-up share capital and accumulated profits of about PRs 44 billion ($1,400 million) and the National Fertilizer Corporation, with paid-up capital and reserves of about PRs 4.2 billion ($170 million). The scarcity of direct foreign investment should be taken into consideration in sequencing the privatization of SOEs and timing the placement and flotation of shares to the private sector.

Higher returns are expected to be more effective in attracting equity financing than debt financing. Equity would follow the returns, provided they are competitive with alternative investments internationally. On the other hand, debt financing would be difficult to attract in the amounts and maturities needed for privatization in Pakistan because of considerations regarding foreign exchange availability, debt burden, and deficits. The use of foreign debt financing for privatization in Pakistan should be selective and limited, allocated primarily to the foreign exchange-earning SOEs and new private sector enterprises. Gradually, this can be relaxed as the international financial community gains confidence in the stability of the economy with the improvement of its foreign exchange potential. So far Pakistan has not been able to mobilize foreign commercial bank financing, except for a maximum of $100 million per year with one-year maturities. The use of enhancements—that is, guarantees from multilaterals and export credit agencies—would increase the size of the loans and lengthen the maturities and grace periods. Government should consider the use of these enhancements for select key projects and privatization transactions, with a plan to phase out these supports as confidence in the credit market builds through the acquisition and successful retirement of long-term commercial bank financing.


The views expressed in this paper are those of the author and should not be taken to represent the views of the World Bank.


Gillis (1989).


Gillis, Malcolm T., “Taxes and Sub-Rosa Subsidies Through State-Owned Enterprises,” paper prepared for Sequoia Conference Series, Washington, May 1989.

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Annex 1. List of 102 SOEs Offered for Sale: Status of Privatization and Proceeds

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Balwanth Reddy

In current debates on economic development, there is a great temptation to start an argument with the implicit, uncontrovertible axiom that the public sector is inherently inefficient and the private sector is the sole engine of efficiency. Yet a bit of historical analysis makes evident those circumstances that have previously led governments, even in countries that strongly believe in private initiative and enterprise, to intervene across a broad spectrum of economic activities—from setting up regulatory regimes (including price regulation) to participating in the direct production of goods and services. The interventions have generally been unavoidable when larger public interests conflicted with narrow private ones and when response-adjustment time in a totally private regime took too long. Indeed, even in large organizations, whether public or private, significant allocative decisions are often taken outside the market framework and its associated pecuniary incentives, which constitute the principal arguments supporting privatization.

As Ibrahim Elwan points out in his paper, the principal reason for the current well-orchestrated advocacy of privatization from the international lending agencies, the potential borrowing governments, and the associated elites is the large budget deficits in many developing countries, to which the losses of public enterprises make no mean contribution. Privatization would reduce the deficit partly because the losses would no longer be debited to the public sector account. But the main reason it would reduce the deficit is because the proceeds from the sale of public assets would make a handsome contribution to reducing the public debt and the interest liability on it. Incidentally, privatization can also make it easier to circulate the large amounts of income that escape the income tax net.

In this budgetary context, considerations of efficiency become secondary. Yet ailing industries are not unique to the public sector; their incidence is substantial in the private sector, too, though perhaps not as great. And without understanding the underlying causes for industrial malaise, whether in the public or private sector, privatization as an article of faith will not assure efficiency, though it may meet immediate budgetary needs. Some causes of industrial infirmity are common to both the public and private sectors, while others are specific to one or the other.

In addition to the question of efficiency, no developing economy can afford to ignore the major related issue of income distribution, which is intimately connected with the manner in which wealth in a country is distributed. Privatization, irrespective of the way it is carried out, will have a great effect on the distribution of private wealth.

A critical analysis of privatization is important and urgent because even the residual activities left with the public sector, whether they cover only administrative issues, public order, and defense, or extend to regulatory institutions and infrastructural components of the economy, must be operated efficiently in terms of costs. Such an analysis may also shed considerable light on those activities that would enjoy greater efficiency if left to the private sector. These may include, at one extreme, repair services, restaurants, and the like, and, at the other extreme, research and development activities, which have considerable externalities and pose all the problems associated with appropriability. In these latter areas, even with the protection conferred by patent legislation and allied measures, the private sector may not deliver the goods without substantial support from the public domain, as evident from the experience of privately owned large industries in the United States and Japan.

One can spell out the proximate criteria by which to judge the success of privatization programs, but in the ultimate analysis success must be reckoned in terms of its effect on the rate of economic growth and the income distribution within a country. Elwan would have done well to examine these issues in his paper.

There are many conditions common to both the public and private sectors in terms of efficiency and effect on the economy. For a privatization program to succeed, it must take these conditions into account. The first and most important condition is the design of a rational and effective price structure, covering not only principal inputs but also labor and the exchange rate. The structure must be rational in the sense that it recognizes market forces—the responses of households and enterprises—and the implications of increasing returns, externalities, asymmetric distribution of information among the participants in various markets, transaction costs, and the obstacles to creating markets where they do not exist. Clearly, this price structure differs from one determined exclusively by market forces, as envisaged by Elwan. It is not enough to call for the correction brought about by market–determined prices. What is more important and difficult to create is an institutional mechanism that can generate these prices for principal inputs and outputs and can shape the necessary fiscal instruments to make them operationally effective. To expect a rational price system to emerge as an automatic response to privatization is unrealistic.

The second condition common to both the public and private domain relates to the pace at which technology in various sectors of the economy is likely to improve. Profitability and efficiency in both domains depend on easy access to efficient technologies and their continuous improvement. Given the nature of research and development activities and the diffusion and absorption of improved technologies, the private sector, especially in developing countries, can play only a limited role. How imaginatively and effectively the public authorities marshall and direct the resources of a country to promote technological improvement will be crucial to the long-term success of privatization.

The third common condition is connected with the control of enterprises and their accountability, especially the concurrent accountability of management to the community at large and to the owners in particular. One of the principal reasons why in most countries public enterprises incur significant losses is the diffused nature of controls and accountability. This is perhaps an inevitable consequence of the manner in which boards of management are constituted, chief executives are selected, and bureaucrats and politicians intervene in management. In this respect, the private sector is not significantly different from the public domain. In the past, shareholders have been marginalized in private enterprises, and the effective power has been exercised by the managerial elite and the plutocrats, with an uneven distribution of “information” between them and the shareholders. This development has not been easy to avoid. Openness, especially easy access to information and the ability to use this information, is a sine qua non for enhancing accountability.

The incentive structure within the enterprise, at all levels of its hierarchy, is the fourth condition common to both sectors. The incentives need not always be pecuniary, though these are the dominant ones. It is widely believed that privately managed enterprises, governed by pecuniary incentives, operate more efficiently than public enterprises, which are guided by inadequately designed incentives. The question of incentives also raises larger issues with implications extending beyond the working of the enterprises, though I do not have the space to detail them here.

The short-term gain from privatization in terms of its effect on budgets is not difficult to see. Gains from the additional “savings” from accounted and unaccounted incomes are also easy to visualize. But these are not the long-term goals of privatization. Success in this respect, as I have argued, will depend on the foregoing conditions, which must flow from public policy and the Government of Pakistan’s commitment to privatization.