The appropriate size of the fiscal deficit is largely determined by the overall macroeconomic objectives and fiscal sustainability. Viewed as a source of financing, akin to a bond sale, the amount of privatization proceeds generally should not itself determine the size of the deficit, and, moreover, the macroeconomic consequences are also similar to conventional bond financing. Nonetheless, privatization proceeds are distinct in certain ways. First, privatization may impact government net worth, which in turn has consequences for fiscal sustainability. Second, the privatization program might pose specific risks to macroeconomic stability—partly due to the size, lumpiness, and uncertain timing of privatization receipts—that enhance the need for monetary and fiscal policy coordination. And third, the discrete nature of privatization proceeds leads to questions regarding their appropriate use.
Privatization and Government Net Worth
The privatization of government productive assets yields immediate financial proceeds. But the receipts from privatization do not of themselves indicate that the government is better off or that its spending constraints today and over time are relaxed. Privatization has longer-term implications in terms of revenues foregone and/or expenditures that will not be made in the future, and government decisions on the use of privatization proceeds should reflect these intertemporal effects. Assessing them requires an analysis of the impact of privatization on the income flows and on government net worth.
The financial relationship between the government and public enterprises includes budgetary receipts of taxes and dividends, and other transfers from, and current or capital transfers to, public enterprises, including in the form of subsidies. In addition, there are often quasi-fiscal costs that are not recorded in the budget, such as directed and/or subsidized lending, as well as contingent liabilities associated with implicit or explicit government guarantees. The analysis of intrapublic sector financial flows should also consider any cross arrears, for instance, arrears on utility bills by the government and other public sector entities, which are common in some countries.
In a broader context, therefore, the change in government net worth due to privatization would equal the sum of the privatization proceeds and the net present value of the taxes of the privatized firm, minus the sum of the net present value of the net subsidies and transfers (including dividends) to or from the public enterprise (including quasi-fiscal costs)8 and the net present value of the lost taxes of the public enterprise.9
In the case where the rate of return on the asset in the public sector equals that of the asset in private hands, the government receives financial assets and gives up a stream of net future earnings on the assets of equal value. Privatization in this case would simply involve a change in the composition of the government’s assets without effects on its net worth, and the government’s intertemporal budget constraint would not be affected. However, the conditions for this to be true are restrictive: markets should be efficient—meaning, among other things, that informational asymmetries should not be important and that the government can privatize efficiently; the public and private sectors must use the same discount rate; the firm should be no more or less profitable after privatization; and it should face an identical external environment before and after privatization (Heller, 1990, and Hemming and Mansoor, 1987).
If the private sector is expected to run the enterprise more efficiently than would the state, government net worth would increase provided the government can privatize and tax efficiently. In such a case, the government’s intertemporal budget constraint would be loosened, and privatization would have a permanent effect on public finances. Conversely, the sale price of a public enterprise may be below the net present value of the expected flow of net earnings in private hands: the state, which may manage a firm less efficiently than would the private sector, may not be capable of selling it well either; it may choose to sell the firm at a price less than the maximum in recognition of externalities associated with the creation and development of capital markets; and the private and the public sector may value a firm differently due to different tolerances for risk, access to financial markets, and rates of time preference. Moreover, a government facing liquidity constraints may be willing to sell state assets at less than their economic value to finance higher expenditure.
Short-run Macroeconomic Effects of Privatization
Decisions on the use of privatization receipts should reflect the consequent impact on the fiscal policy stance and on macroeconomic aggregates and objectives. These implications may differ according to such factors as the source of privatization receipts (domestic or external), the degree of capital mobility, and the exchange rate regime. It is also important to consider the fiscal and monetary policy implications of the substantial capital inflows that may be linked to privatization.
Fiscal Stance
The effects of an increase in the deficit through higher spending or lower taxes that is financed by privatization proceeds would be similar to those resulting from a fiscal expansion financed by an increase in public debt (Mackenzie, 1998). It would put pressure on domestic demand with consequences for activity, inflation, and the external current account. The relative significance of these effects will depend in part on the initial macroeconomic position and the composition of the increase in spending in terms of imported and domestic goods and services.
The effects of a fiscal expansion financed with privatization proceeds will, in many developing countries, depend on the source of the proceeds, though this need not be the case with perfect capital mobility.10 If the receipts are from abroad, the effects would be similar to a foreign-financed increase in the fiscal deficit and are likely to include pressure toward the real appreciation of the currency. For domestic receipts, the impact on aggregate demand would be similar to that of an expansion financed with domestic bond placements. In this case, the need for the buyer to finance the purchase could put upward pressure on interest rates, and the effect on aggregate demand may be more limited.11
The government may use privatization proceeds to reduce its net indebtedness by retiring external or domestic debt, settling domestic or external arrears (if any), building up financial assets at home or abroad, or depositing the proceeds with the central bank. These operations would generally be associated with reductions in the country’s risk premium. An automatic sterilization of foreign privatization receipts is achieved by parallel reductions in the net public external debt, including domestic currency debt held by nonresidents and external arrears. The external current account benefits from such operations and the reduction of country risk through lower net public interest payments. This, however, will be offset, at least in part, by remittances of profits and dividends to foreign investors holding shares in privatized firms.
In some countries, privatization proceeds may, in part, be used to repay domestic debt, particularly when this debt is expensive and the external debt is mainly on concessional terms. Consideration needs to be given, however, to the effects on domestic liquidity and interest rates of a net redemption of government domestic debt, including foreign currency debt held by residents and domestic arrears, under conditions of less-than-perfect capital mobility. This could be expansionary, including through the associated reduction in interest rates, and might imply the need for offsetting monetary policy measures.
Privatization and Capital Inflows
Large-scale privatization programs have sometimes been associated with capital inflows that have created complications for macroeconomic policy. Such inflows can pose challenges to financial policies if the government spends them or repays domestic debt. There is a direct link between privatization and capital inflows when asset sales are financed through foreign direct investment.12 Additional capital inflows may occur in the form of foreign direct investment if the new owners of privatized enterprises decide to finance investment programs with foreign capital, as illustrated by the case of Hungary (see Box 1).13 Substantial privatization programs may also signal favorable changes in the policy regime and in growth prospects that trigger exogenous capital inflows not directly related to the privatized enterprises. In Argentina, for example, the rapid and large-scale privatization program of the early 1990s and the use of part of the receipts to reduce public debt conveyed a signal to markets about the new policy regime that contributed to concerted flows.
Sterilization of Privatization Revenues in Hungary
The Hungarian privatization process generated significant revenues in the years 1991–98, when gross privatization proceeds averaged 4 percent of GDP a year, largely from abroad. In the early 1990s, Hungary followed a fixed, but frequently adjusted, exchange rate, and in early 1995 the government switched to a crawling peg system. Under both regimes, the spending by the government of part of the privatization revenues, as well as capital flows associated with privatization, posed challenges to monetary policy. Capital inflows led to increases in the money supply, thereby potentially compromising the objectives for inflation (to the extent that the liquidity injection exceeded the growth in base money demand), and the real exchange rate. At various times, the authorities attempted to sterilize the effect of capital flows on monetary aggregates.
The challenges for monetary policy posed by privatization-related capital inflows, and government deficits partly financed with privatization receipts, first appeared in 1991, when significant foreign direct investment was received, while a decline of real GDP by more than 10 percent reduced money demand. This created pressure for the National Bank of Hungary to remove liquidity from the system through sterilization. In the next three years, as foreign direct investment flows continued—most of them related to privatization—while output remained subdued and inflation remained high, some sterilization took place through the issuance of interest-bearing debt. At the same time, the National Bank of Hungary used changes in reserve requirements to influence liquidity.
In 1995, in the aftermath of financial turmoil triggered by concerns over Hungary’s capacity to service its foreign debt, the privatization process was speeded up as part of a stabilization package. The new government made the reduction of the foreign debt a cornerstone of the economic strategy. Consequently, the bulk of the privatization revenues from abroad was used directly to reduce the foreign debt and, hence, did not need to be sterilized. Of the US$3.8 billion in privatization revenue received in 1995 (out of a total of US$4.4 billion in foreign direct investment), some US$3 billion was used to repay foreign debt. In later years, a similarly high share of privatization revenues was used to repay foreign debt, and although the absolute amounts became more modest, privatization revenues allowed for a substantial improvement in Hungary’s foreign debt position.
External debt reduction has important cost advantages as an instrument to offset the domestic impact of privatization receipts from abroad. Sterilization implies a cost to the central bank proportional to the differential between the interest rate on the debt issued and the return on foreign assets. External debt reduction does not imply such costs, and it reduces the debt-related risk premium. In the case of Hungary, however, the very success of the privatization program, and the use of the receipts for debt reduction, triggered other capital inflows and the consequent need for sterilization.
In late 1995 and early 1996, the National Bank of Hungary intervened heavily in the foreign exchange market to keep the forint from appreciating, and in the first half of 1996 sterilization took place through reverse repo operations and the sale of government bonds. As international confidence increased, and with substantial foreign investment from 1995 to mid-1998, the forint has typically been at the most appreciated edge of the band, requiring sustained foreign exchange purchases by the National Bank of Hungary and therefore sterilization operations. From March 1995 to end-1997, the liabilities of the National Bank of Hungary arising from sterilization surged from Ft 18 billion to Ft 681 billion (more than currency in the hands of the public).
Sustained capital inflows of the type discussed in the previous paragraph will contribute to the appreciation of the real effective exchange rate. Under a flexible exchange rate regime, they would result in an appreciation of the exchange rate and a reduction of inflationary pressures. Under a fixed exchange rate, or managed float, and in the absence of sterilization, such inflows would cause an expansion of base money through the increase in foreign exchange reserves, as well as inflationary pressures.
Several policy responses are available to deal with the potential destabilizing effects of concerted privatization-related capital inflows (Ariyoshi and others, 2000). Some sterilization may be necessary to smooth out and limit the effects on liquidity; however, depending on interest rate differentials, the quasi-fiscal costs of sterilization could be significant and, in any case, must be taken fully into account when formulating policies. Real effective exchange rate appreciation may take place, depending on the exchange rate regime, through combinations of nominal exchange rate appreciation and increases in the prices of nontradables, but the use of exchange rate appreciation may be constrained by competitive considerations. Fiscal policy may need to be tightened, particularly to contain inflation and prevent an excessive appreciation of the real effective exchange rate, and especially if the flows are large relative to the absorptive capacity of the economy.
Use of Privatization Proceeds in Case Study Countries
Proceeds from equity sales in the capitalization scheme were effectively reinvested in the firms divested.
Vouchers, including for restitution purposes, were used for most assets divested in the early period.
Vouchers were used for restitution.
Vouchers were used.
Some of the proceeds were earmarked for social spending.
Privatization certificates were issued.
The remaining proceeds have been held in a special account by the Ministry of Finance as reserves.
Use of Privatization Proceeds in Case Study Countries
| Country | Use of Proceeds |
|---|---|
| Argentina | Partly debt retirement, partly unearmarked budget financing. |
| Bolivia | Off-budget part was fully earmarked for reinvestment in the privatized public enterprises; on-budget part was unearmarked.1 |
| Cóte d’Ivoire | Unearmarked. |
| Czech Republic | Of the proceeds received by the budget part was used for debt reduction.2 |
| Egypt | During 1996-98. about one-fourth of gross proceeds went to severance pay and one-third to financial restructuring of the enterprises. The remainder was used for debt reduction. |
| Estonia | Initially to cover costs of currency reform (1992–93); then restitution, privatization costs, enterprise restructuring, and several extra budgetary funds.3 |
| Hungary | The on-budget share was partly used for debt retirement, while the off-budget share was used for restitution (compensation coupons), overhead of the privatization process, capital transfers to firms unrelated to the privatization process, and financing of extrabudgetary funds. |
| Kazakhstan | Mostly unearmarked.4,5 |
| Mexico | Proceeds kept off budget were used to finance a contingency fund for debt retirement. |
| Mongolia | Unearmarked.4 |
| Morocco | Unearmarked.6 |
| Mozambique | Although most of the proceeds were used to settle the liabilities of the divested firms, in 1996 a special fund to support small-scale entrepreneurs using these resources was established. |
| Peru | The on-budget share was used for social spending, while the off-budget part was used to recapitalize the public pension system.7 |
| Philippines | Some proceeds have been earmarked. |
| Russia | Unearmarked.4 |
| Uganda | Severance pay to workers retrenched in the process, settlement of debts and costs of the public enterprises before sale, and promotion of entrepreneurship. |
| Ukraine | Unearmarked.6 |
| Vietnam | The limited proceeds received so far have been reinvested in the divested firms. |
Proceeds from equity sales in the capitalization scheme were effectively reinvested in the firms divested.
Vouchers, including for restitution purposes, were used for most assets divested in the early period.
Vouchers were used for restitution.
Vouchers were used.
Some of the proceeds were earmarked for social spending.
Privatization certificates were issued.
The remaining proceeds have been held in a special account by the Ministry of Finance as reserves.
Use of Privatization Proceeds in Case Study Countries
| Country | Use of Proceeds |
|---|---|
| Argentina | Partly debt retirement, partly unearmarked budget financing. |
| Bolivia | Off-budget part was fully earmarked for reinvestment in the privatized public enterprises; on-budget part was unearmarked.1 |
| Cóte d’Ivoire | Unearmarked. |
| Czech Republic | Of the proceeds received by the budget part was used for debt reduction.2 |
| Egypt | During 1996-98. about one-fourth of gross proceeds went to severance pay and one-third to financial restructuring of the enterprises. The remainder was used for debt reduction. |
| Estonia | Initially to cover costs of currency reform (1992–93); then restitution, privatization costs, enterprise restructuring, and several extra budgetary funds.3 |
| Hungary | The on-budget share was partly used for debt retirement, while the off-budget share was used for restitution (compensation coupons), overhead of the privatization process, capital transfers to firms unrelated to the privatization process, and financing of extrabudgetary funds. |
| Kazakhstan | Mostly unearmarked.4,5 |
| Mexico | Proceeds kept off budget were used to finance a contingency fund for debt retirement. |
| Mongolia | Unearmarked.4 |
| Morocco | Unearmarked.6 |
| Mozambique | Although most of the proceeds were used to settle the liabilities of the divested firms, in 1996 a special fund to support small-scale entrepreneurs using these resources was established. |
| Peru | The on-budget share was used for social spending, while the off-budget part was used to recapitalize the public pension system.7 |
| Philippines | Some proceeds have been earmarked. |
| Russia | Unearmarked.4 |
| Uganda | Severance pay to workers retrenched in the process, settlement of debts and costs of the public enterprises before sale, and promotion of entrepreneurship. |
| Ukraine | Unearmarked.6 |
| Vietnam | The limited proceeds received so far have been reinvested in the divested firms. |
Proceeds from equity sales in the capitalization scheme were effectively reinvested in the firms divested.
Vouchers, including for restitution purposes, were used for most assets divested in the early period.
Vouchers were used for restitution.
Vouchers were used.
Some of the proceeds were earmarked for social spending.
Privatization certificates were issued.
The remaining proceeds have been held in a special account by the Ministry of Finance as reserves.
Use of Privatization Proceeds: Choices and Experience
Countries have indicated their intentions to allocate privatization proceeds to a wide variety of uses (see Table 4).14 Below are some of the fiscal factors to be taken into account when considering the possible uses of privatization receipts.
Fiscal Expansion
A fiscal expansion financed through privatization receipts would generally tighten the intertemporal budget constraint. The more specific implications of higher expenditure would, however, depend on the type of spending increases that might be considered.15
The temporary and uncertain nature of privatization receipts suggests caution in relying on them as a source of financing of increases in current expenditure. Such increases are often difficult to reverse at some later point, and therefore there is a danger that spending may become entrenched at levels not consistent with the revenue-raising capacity of the government. If increases in current spending are nonetheless considered, their likely quality would need to be carefully evaluated.
In the short run, privatization can result in job losses and wage cuts for workers and, in those cases where price subsidies are removed, higher prices for consumers. When designing expenditure policies in a setting of large-scale privatization, it is important to address these concerns through policies to cushion the short-term social impact of privatization (see Section IV). Such policies can also increase public support for the reform process.
The fiscal stance may also be loosened through increases in domestic public investment. Particularly in countries with pressing infrastructure needs, a case could be made for implementing high-quality investment programs. Such an investment policy could aim at enhancing competitiveness by focusing on the development of infrastructure and human capital, thereby leading to higher growth. The implications of additional investment for recurrent government spending would need to be taken into account.
Government net worth would not decline as a result of capital spending if the expected return to the government on the new assets were comparable to that on financial assets. However, the conditions for this to hold are restrictive: even if public investment were to have a high return, the government would still need to capture the additional returns from the investment for it to be self-sustaining (Fischer and Easterly, 1990). Just as important, experience shows that in policy settings characterized by institutional weaknesses and constraints there is a risk that public sector projects will be poorly conceived and implemented, and that many low-return projects will end up being incorporated in investment programs.
Reduction of the Net Public Debt
The government may use privatization proceeds to reduce the net public debt by retiring debt or settling arrears, or building up financial assets, including official reserves. This occurred in several of the case study countries, including Argentina, Egypt, Hungary, Mexico, and Peru, with the debt retired being predominantly external. A reduction in the net public debt permanently lowers the fiscal deficit through a decline in net interest payments and may help reduce the exposure of the fiscal position to changes in market sentiment. In addition, the improvement in fiscal sustainability, signaled by the saving of the proceeds, could contribute to fostering market confidence and lead to reductions in the rate of interest on the public debt. The choice of whether to reduce gross indebtedness or build financial assets, and how to effect it, are debt-management issues that require appropriate consideration of relative yields; risk; the currency composition of budgetary flows, assets, and liabilities: and liquidity preference.
Some countries, including Bolivia, Estonia, and Hungary, have explicitly linked the use of privatization proceeds to the transition costs associated with a pension reform. In effect, this recognizes the implicit pension debt of the government and makes provisions for it with assets held by the state. If a government is also making efforts at maintaining or improving fiscal sustainability, the recognition of pension debt could lend credibility and help garner political support for privatization.16
Earmarking of Privatization Proceeds
A number of countries have formally earmarked privatization revenues (see Table 5). To some extent, the earmarking of privatization receipts may be seen as an attempt to deal explicitly with the temporary nature of privatization receipts. Under certain circumstances, such treatment of the receipts might help avoid permanent increases in spending. An element of earmarking may also be put forward to make privatization more politically acceptable, as was the case in the early stages of the Peruvian privatization process. The impact of earmarking is, however, uncertain insofar as budgetary resources are fungible.
Earmarking of Privatization Receipts in Selected Countries
In Vietnam, equitization is a form of partial privatization of nonstrategic small- and medium-sized public enterprises. Although the mechanism was introduced in 1992. the scope and depth of equitization to date remain limited.
Earmarking of Privatization Receipts in Selected Countries
| Country | Form of Earmarking |
|---|---|
| Bolivia | Under the capitalization system, the proceeds remain in the privatized enterprises and are pledged for investment. |
| El Salvador | Early in 1999, legislation was passed establishing a fund to manage the proceeds obtained from the privatization of the state telephone company, under which only the interest generated by these proceeds may he spent and only in the social sectors and for the development of information centers at the local level. |
| Estonia | After settling debt obligations and tax arrears that were accepted by the successful bidders, some 45-50 percent of the remaining privatization proceeds were transferred to the Compensation Fund to cover its liabilities (bonds that were issued in exchange for privatization vouchers), while the remainder was earmarked to compensate previous owners of real estate. |
| Kazakhstan | Some of the cash proceeds from the auction of small enterprises were earmarked for social safety net purposes. |
| Peru | During the early stages of the privatization process, the government earmarked part of the receipts from privatization for social expenditure and structural reform programs designed in cooperation with the World Bank and the Inter-American Development Bank; inter alia, to foster public support for the privatization and reform process. |
| Uganda | By law. privatization proceeds are to be used to settle enterprise debts, finance retrenchment programs, meet any other costs of enterprises prior to divestiture, and promote entrepreneurs hip. |
| Vietnam | Revenues from equitization may only be used for enterprise and labor force development1 |
In Vietnam, equitization is a form of partial privatization of nonstrategic small- and medium-sized public enterprises. Although the mechanism was introduced in 1992. the scope and depth of equitization to date remain limited.
Earmarking of Privatization Receipts in Selected Countries
| Country | Form of Earmarking |
|---|---|
| Bolivia | Under the capitalization system, the proceeds remain in the privatized enterprises and are pledged for investment. |
| El Salvador | Early in 1999, legislation was passed establishing a fund to manage the proceeds obtained from the privatization of the state telephone company, under which only the interest generated by these proceeds may he spent and only in the social sectors and for the development of information centers at the local level. |
| Estonia | After settling debt obligations and tax arrears that were accepted by the successful bidders, some 45-50 percent of the remaining privatization proceeds were transferred to the Compensation Fund to cover its liabilities (bonds that were issued in exchange for privatization vouchers), while the remainder was earmarked to compensate previous owners of real estate. |
| Kazakhstan | Some of the cash proceeds from the auction of small enterprises were earmarked for social safety net purposes. |
| Peru | During the early stages of the privatization process, the government earmarked part of the receipts from privatization for social expenditure and structural reform programs designed in cooperation with the World Bank and the Inter-American Development Bank; inter alia, to foster public support for the privatization and reform process. |
| Uganda | By law. privatization proceeds are to be used to settle enterprise debts, finance retrenchment programs, meet any other costs of enterprises prior to divestiture, and promote entrepreneurs hip. |
| Vietnam | Revenues from equitization may only be used for enterprise and labor force development1 |
In Vietnam, equitization is a form of partial privatization of nonstrategic small- and medium-sized public enterprises. Although the mechanism was introduced in 1992. the scope and depth of equitization to date remain limited.
As a result of earmarking, budgetary resources, whose size ex ante may be quite difficult to predict, are placed outside the allocative budget process. Also, earmarking complicates fiscal management and makes it more difficult to reallocate spending in response to changes in circumstances or priorities, potentially forcing governments to devote more resources to an activity than they would otherwise do. Conversely, necessary spending may be constrained by shortfalls in privatization receipts. If, in addition, privatization revenues accrue to off-bud get agencies and are partly disposed of outside the budget, these problems may be compounded by a reduction in fiscal control and transparency. Therefore, in general, the earmarking of privatization revenues for specific uses is not an efficient spending allocation mechanism.
Privatization, Fiscal Pressure, and Liquidity Constraints
Fiscal pressures may lead a government to privatize partly with a view to relaxing a financing constraint so as to achieve a certain level of public spending. Privatization in this case is viewed as another source of revenue—it is regarded as a windfall, and the proceeds are consumed immediately or over a longer period. This has been advanced as a hypothesis to explain privatization activity, with countries more likely to sell stakes in public enterprises if they face higher borrowing costs (Yarrow, 1999).17
There have been recent cases where privatization programs appear to have been accelerated—involving in some cases high-quality assets—because of the perceived need to finance deficits and support current spending in the face of financing restrictions. In Kazakhstan, the significant increase in the general government deficit in recent years—to 8 percent of GDP in 1998—was financed to an important extent from privatization receipts, which rose to more than 4 percent of GDP that year, boosted by privatization activity in the energy sector. Similarly, the fiscal policy stance in Lithuania was loosened considerably in 1998. The fiscal deficit rose by 4 percentage points to close to 6 percent of GDP, reflecting the largely off-budget spending of a surge in privatization receipts equivalent to 5 percentage points of GDP, of which the bulk was generated by the sale of the telecommunications company.
In cases where governments embarking on adjustment and reform programs initially face financing constraints, some limited use of privatization receipts may perform a useful role. They can provide some financial cushion and fill short-term financing gaps while fiscal consolidation is effected and reforms take hold, and until confidence is restored and market access is reestablished. In the absence of an effective program of fiscal consolidation, however, such a strategy will not be sustainable.