SINCE THE 1980s, when Margaret Thatcher was elected prime minister of Great Britain and Ronald Reagan was elected president of the United States, there has been a massive change in I thinking about the role of the state. Part of this was a move towards privatization, as governments around the world decided to stop running businesses and let the private sector take over.
This was a fairly profound reversal in public policy. Until then, governments in both the developed and developing world had pursued a development strategy that emphasized heavy government participation in the economic cycle. Over the decades, governments accumulated a legacy of state assets. The Reagan/Thatcher “revolution” called for their divestiture. The main way of accomplishing this was for governments to sell the companies they owned, a process known as privatization.
All but a few countries—Cuba and North Korea are among the minority—have carried out at least some privatizations in recent years, and more are sure to follow. At this writing, there are about 110 countries involved in privatization programs. In many cases, they are driven by the promised rewards of privatization: higher economic growth, elimination of fiscally costly subsidies, and better companies that deliver cheaper and more efficient products and services to the people. But sometimes countries privatize because they are told it is a condition for loans from entities such as the World Bank and the International Monetary Fund. In other cases, countries choose to privatize because they want to raise money for the government treasury, not because the companies being sold off need to be privatized. As a reporter, it is important to look at why a privatization is taking place.
While privatization can result in greater “efficiency,” it also causes job loss, so it is important to look at whether the government has a safety net for those workers who are put out on the street. There is some question as to whether privatization really makes companies more efficient; in some cases this efficiency comes from private owners’ being able to make job cuts that governments cannot make for political reasons. Also, some studies have shown that the major gains take place before the actual privatization occurs as managers ready the companies to be sold, sometimes by putting in new business plans, or making job cuts ahead of the government sell-off. This process is referred to as “corporatization” and often means the government has to take stock of what the company’s assets and liabilities are and how profitable it is or could become. These kinds of information are necessary before a company can be restructured, whether by the government or by the entity buying the state-owned enterprise.
When covering privatizations, it is important to remember that the promised rewards do not always materialize. How privatization is carried out is at least as important as the privatization itself. For developing countries in particular, without a clear legal or regulatory framework to encourage competition in the marketplace, the dangers are acute. In Russia, for example, many companies went from being badly run government-owned enterprises to being badly run privately owned enterprises. The new private-sector companies, often still run as monopolies, were no more efficient, did not deliver better services or products, and did not cut prices or even create jobs.
To follow what can be a complicated and often politically fraught process, it is vital to know not just how companies are privatized but also why they can fail.
THE PROCESS
WHAT GETS SOLD?
A government may choose to sell 100 percent of its ownership in a firm (full divestiture) or it may choose to keep a stake (partial divestiture). A commonly used rule of thumb is that a “true privatization” entails the government selling at least 51 percent of the company and giving up managerial control. A government may choose to keep a stake to reassure the public that it is still closely monitoring the country’s strategic interests. Vietnam, for example, has sold off some of the hundreds of enterprises owned by the state, but has said it will not divest from “strategic” companies such as the national airline, telecom, and oil company. Or a country may decide that in order for its firm to compete abroad once it is sold, it is better to keep it in one piece rather than spinning off different divisions.
HOW IS IT SOLD?
Vouchers. In a mass privatization through vouchers, citizens of the country are given vouchers, which they can exchange for shares in companies when those are sold off. This method was widely used in Central and Eastern Europe in the mid-1990s, but with only limited success.Advantages: Vouchers can be a politically popular way of giving a typically alienated public a stake in the ownership of the company. The method is also seen as equitable in that it confers ownership across the board rather than restricting it to the moneyed elite. Vouchers have also been seen as a good way to develop budding stock markets by automatically turning members of the public into stockholders. Also, workers who are laid off during the privatization may feel they have benefited because they have been given a piece of the company.
Disadvantages: Vouchers cut down on the amount of money received by the government for the sale of a company. Also, because the company is effectively owned by thousands of individuals, there is a risk that old managers at the company may carry on as before, with no single investor forcing the changes needed to make the company more efficient. Issuing vouchers does not necessarily create new wealth, as it does not bring new investment into the country.
Another problem was seen when the Czech Republic used vouchers in a mass privatization program from 1992 through 1995. Investment funds bought up many of the vouchers. Large, domestic, government-owned banks controlled those funds. Those same banks often held debt owed by the privatized companies, too. In effect, the bank became the ultimate owner of the company. As a result, the funds would not punish a badly run company by pulling out because then the bank would have to write off the loans it had extended to the company. Of course, this problem, while important, is not restricted to the voucher method. Banks could, and often do, become owners of enterprises in other ways as well.
Direct Sales. The government sells the company directly to large investors. These strategic investors, usually a private company or group of companies, bid against each other to buy the firm. They may bid in an open process with the highest offer accepted, or the government may choose to review potential buyers on a case-by-case basis. This process was used to privatize Kenya Airways in 1996. The government sold 77 percent of its shares in the airline in a series of competitive auctions. KLM Royal Dutch Airlines bought 26 percent of the carrier; local investors bought the remainder.
Advantages: Competitive bidding is likely to bring the government the most revenue from the sale. In addition, the method typically brings along a “strategic investor” who, in addition to capital, provides technological and managerial expertise. Direct sale is also cheaper than offering the company for sale on the stock exchange, which often involves marketing and other costs.
SIDEBAR
At two minutes before noon on 16 June 2000, a heavily armed police assault team stormed the Prague headquarters of Investicni a Postovni Banka, the Czech Republic’s third-largest bank. Within minutes they had corralled the bank’s top managers and seized control of the building, handing it over to government-appointed administrators. A run on the bank had emptied its coffers, threatening the Czech banking system—and, regulators feared, the entire Czech economy—with collapse. IPB’s largest shareholder, a Netherlands-based firm controlled by the Japanese bank Nomura, cried foul. Within days, IPB had been sold to KBC Bank of Belgium, the owners of IPB’s local rival, Ceskoslovenska Obchodni Banka, and the government agreed to swallow most of IPB’s bad loans. The final bill is not yet in, but the IPB debacle is expected to cost Czech taxpayers as much as $5 billion, or about $500—more than a month’s average wage—for every man, woman, and child in the land.
IPB was at the heart of the entire Czech economy, and its path from state-owned banking giant to an apparently empty shell is a microcosm of the problems the Czechs had privatizing not just their banking sector but the entire economy. Czech banks were among the last businesses privatized after the fall of communism, and, as the country’s chief source of investment capital, they held extraordinary power over the Czechs’ newly privatized industry. The managers of the state-owned banks were nearly all political appointees, and they opened the cash taps to political parties and well-connected firms.
The postcommunist government, believing in the magic of the market, barely regulated the banks or the stock market, and a vicious circle quickly developed. Banks loaned money to companies that were in turn owned by investment funds controlled by the banks. The firms lost money, but the loans kept flowing as companies borrowed just to cover the interest on outstanding loans. As long as no one looked too closely, the whole house of cards stayed up.
As economists Edward Snyder and Roger Kormendi pointed out in the case of IPB’s state-owned rival Komercni Banka, “the opportunity to privatize a strong bank and harden enterprise-level budget constraints quickly was foregone, or at least postponed, in favor of creating a protected bank that would deal more leniently with [the bank’s] politically-vested commercial clients.”1
At IPB, as economist Zdenek Kudrna of Prague’s Charles University noted in a comprehensive study of IPB that was sponsored by CSOB, before Nomura took control of the bank, management quietly bought control of the bank at the shareholders’ expense. Through a series of sophisticated and highly opaque transactions, using tax havens like the Cayman Islands and a web of friends and firms allied to IPB, the management dug into IPB’s deposits to effectively lend itself the money to buy shares in the bank.
By 1997, bad loans and insider deals had left the Czech banking system in crisis. A dozen small- and medium-sized banks had collapsed, and IPB, like the other large Czech banks, was in a liquidity squeeze. Police investigators had already jailed IPB’s top managers, Jiri Tesar and Libor Prochzka, in a fraud investigation, later abandoning the probe.
With the fall of the center-right Klaus government in November 1997, the new cabinet moved swiftly to sell IPB. Rushing to show he was serious about privatization, finance minister Ivan Pilip sold IPB in March 1998 for half of what the government had originally hoped to net. Nomura, which had already acquired a 10 percent stake in IPB, bought the government’s remaining 36 percent share for about 3.03 billion crowns, or $80 million in cash, and the promise to inject another $160 million.
Nomura said it aimed to restructure IPB, clean up its loan portfolios, and reorganize the bank’s commercial-, retail-, and postal-banking operations. Then it would sell IPB to a larger but more cautious commercial bank. Under Nomura’s ownership, IPB hired teams of consultants and became one of the country’s most consumer-friendly banks.
Nomura’s interest in IPB was not limited to consumer banking. As an investment bank, it already had several business arrangements with IPB, some involving shares controlled by IPB and its investment funds in key industries, including world-renowned Czech breweries. IPB also knew how to play its political cards. The bank itself had loans outstanding to the top two private television networks and to Mr. Klaus’s party and its chief rival, the Social Democrats.
Despite its large stake in IPB and its promises to turn the bank around, Nomura kept its distance from IPB’s banking operations. Tesar and Prochazka were kept on during Nomura’s ownership, even as an on-site inspection by regulators from the Czech National Bank, at the end of 1999, provisionally concluded that IPB, by then 46 percent owned by Nomura, “was not proceeding prudently and was conducting its affairs in a manner which harmed the interests of its investors and threatened the security and stability of the bank.”2 The regulators provisionally concluded IPB would need to create a further 40 billion crowns of reserves, but Nomura disagreed.
IPB’s troubles had begun long before Nomura entered the picture, but even under Nomura, IPB ignored the growing holes in its reserves, many of them caused by poor loans made under Tesar and Prochazka to firms linked with the bank. Analysts say the reason was a tacit agreement between IPB’s Czech management and Nomura. IPB, wrote Kudrna, provided Nomura with shares in the highly lucrative Czech beer industry, while Nomura would offer IPB a cloak of credibility as Tesar and Prochazka continued to consolidate their ownership of IPB using the bank’s own deposits.3
In one key transaction, a Nomura-owned firm, Ceske Pivo, bought IPB’s stakes in Plzensky Pivovary maker of the world-famous Pilsner Urquell beer, and several smaller breweries for an estimated $250 million. The brewery was merged with Pivovar Radegast, the second-largest brewery in the Czech Republic, and the merged group was sold for $629 million to South African Breweries in 1999. The deal was a profitable one for Nomura, which booked the profits through a series of subsidiaries. Minority shareholders in IPB and shareholders in the IPB-run funds that sold their shares to Nomura’s Ceske Pivo, say they never received fair market value for their brewery shares.
Meanwhile, IPB’s banking business continued to worsen. By early 2000, IPB was beginning to bend under the weight of bad loans. Auditors estimated them at $1.1 billion, nearly a third of IPB’s portfolio. A string of newspaper stories detailing the depth of IPB’s troubles sent depositors scrambling to empty their accounts. Nearly $1.5 billion, a quarter of IPB’s deposits, were withdrawn in less than a week. Nomura proposed refinancing the bank, but the government was under pressure from public opinion to move quickly. Talks between the government and Nomura fialed to produce results, and on that fateful Friday, Czech regulators sent in the police. Three days later, IPB was a paper shell, its banking operations in the hands of Belgian bank KBC and its Czech subsidiary, CSOB.
“Machine guns and taxpayers’ money were used to expropriate IPB and make CSOB the dominant Czech bank,” Randall Dillard, Nomura’s point man on the IPB transactions, told Newsweek in 2000. “When the smoke clears and the mirrors no longer dazzle, we will see a familiar tale of corruption, cronyism and politics.”4 Dillard is probably right. Nomura is now suing the Czech government for about $1 billion and says it was unfairly denied the bailout some state-owned banks received. The European Union scolded the Czechs for subsidizing their banking sector, but the Czech government says it will pay Nomura nothing and is countersulng for the hundreds of millions of dollars it says were lost in the beer deal. The gist of the government’s argument: the smoke and mirrors were all manipulated by Nomura and its political patrons.
This article includes some changes made at the request of Nomura International PLC to avoid lengthy disputes under the restrictive free speech and expansive libel laws of the United Kingdom, which are far stricter than the laws of the United States.
Disadvantages: Direct sales may be politically unpopular since the general public has no opportunity to get a stake in the company. In addition, focusing attention on one buyer tends to raise complaints that the government is selling the country’s jewels, often to foreigners. And since shares are not issued or sold, this method does nothing to help develop the stock market.
Public offerings. Where the company is sold to the public on the stock exchange through an initial public offering of shares.
Advantages: A direct sale helps to develop the stock market. It is also easier to make this a transparent process, where the public can see exactly who buys what and for how much. It is also used to phase in a sale with a first tranche (a bond series issued for sale in a foreign country) used for “price discovery” purposes before launching a more comprehensive public offering. And it prevents a single politically powerful investor from snapping up all the shares. For these reasons, this process is also more likely to attract foreign investors.
Disadvantages: Public offerings have shortcomings similar to those of the voucher approach. They also involve a diffuse shareholdership that amkes owner control over management more difficult. Advantages accruing from technology and management-technique transfers typically associated with “anchor investors” tend to be absent when privatization is done through public offerings.
Mixed Sales. This is a mix of a direct sale to strategic investors followed by a public offering, often held six to twelve months later. In the 1990 privatization of Telmex, the Mexican government sold 20 percent of the company’s shares to a “strategic” investor, then sold another 31 percent through public offerings in 1991 and 1992.
Advantages: The “anchor” investors can carry out the changes needed to make the company more efficient and profitable by the time it is offered publicly. This often raises significantly the company’s value, benefiting both the government and the new partial owner. Chances of a successful public offering increase when a company has first been run by a strategic investor.
Disadvantages: There is a cost to carrying out one type of sale and then another type, including fees to the investment banks that help organize the sales and so on. Because of this, this method is normally used on large companies that are attractive to investors. The approach can also be politically sensitive since the original (“anchor”) investors typically buy shares at a cheaper price than the price eventually prevailing when the company goes public.
Concessions. Citing “strategic reasons,” governments sometimes decide not to give up ownership of companies in certain sectors, particularly in the case of natural monopolies such as water, electricity, or infrastructure development. Owning an asset, though, does not mean that the government needs to manage it. As such, governments will sell the rights to operate the company for a specific period of time. This method aims to give the investors the freedom they need to make money, while still protecting consumers from exorbitant price increases. It can also be seen as a way of keeping ownership of a vital national asset. In 1997, Gabon used this method to privatize its water and electricity company, Socièté d’Energie et d’Eau du Gabon (SEEG). Interested companies bid by offering the biggest cut in water and electricity rates that they could implement if they won the concession. France’s Vivendi, in a consortium with the Electricity Supply Board of Ireland, won with a proposed cut of 17.25 percent and an investment requirement of at least $200 million. A successful IPO was carried out afterwards.
WHAT SHOULD HAPPEN NEXT?
Ideally, after privatization the company should become more competitive and productive. Ultimately, if it is successful, it should create more jobs and deliver better goods and services to the people of the country at a cheaper price. In addition, the government should be able to save the money it previously used to subsidize an inefficient company and instead spend it on things the country needs, such as health care, education, or roads.
To figure out if this will happen, reporters should ask these questions:
Who bought the company?
What are they doing to make it work better?
Is the government doing what it must to create the right kind of economic environment for the company to succeed?
Even before the privatization has been held, reporters should be asking, What has the government done to prepare for this?
The government will likely continue to play a role even after a company is sold. They will likely perform a regulatory role and may need to set up a regulatory agency in order to do this. New legislation may need to be passed. Government officials may even serve on the board of the privatized agency.
IMPORTANT INDICATORS
Large amounts of debt. Few investors will want to take over a government company that is deeply in debt. The government must usually assume the company’s debt and promise to pay it off separately, in order to sell the company free of debt. The alternative is to sell the company at a very low price to tempt investors to take on the debt, too.
Competition policies. Turning a government-owned telecommunications monopoly over to a private investor may simply replace one monopoly (that of the government) with another (that of the new private owner). Monopolies are not known for bringing down prices. This would require a new competitive environment. Has the government issued licenses to anyone else who wants to start up similar companies? Is there a watchdog agency that makes sure the new owner’s activities mimic those of a firm working in a competitive environment? The latter could include forcing the firm to allow newly emerging competitors to use its infrastructure for a reasonable fee and ensure that consumers in rural areas where there is no competition are charged reasonable rates.
Property rights. There must be a functioning system of legal property rights. There will be no buyers for a company if the ownership of the land or assets it owns is in dispute. Are there any hidden disputes over ownership before the sale? Are the country’s courts strong enough to enforce contracts if there is a dispute after the sale?
A weak financial and economic environment. The success of a privatization is linked to the health of the overall macroeconomy—including the health of the banking sector. Once the company is privatized, are interest rates too high for it to borrow the money? Is there a viable stock market or bond market where the company can raise money? Is the banking system strong, or is it carrying a lot of bad debt? It is also important to look at whether the new owner’s plans for financing are credible and well planned. The new owners will need to restructure the company in the short term, while in the medium to long term they will hopefully want to expand. It will be difficult to do either if the new owners do not have the access to the funding they need.
Next, after the privatization, reporters should ask: What is the government doing to make sure the transition is as smooth and beneficial as possible?
Layoffs. In the short to medium term, there are likely to be job losses both before and after a company is privatized. Governments often use state-owned companies as employment-generating machines, rendering the firms overstaffed, inefficient, and unprofitable. Jobs may have to be cut before the sell-off as the new owners will not want a company with excessive employees. Often, the new owners will find that they have too many clerical and administrative workers. Laying off large numbers of white-collar workers may be necessary for the company, but it could have harmful effects for the country’s economy and political stability. Is the government making plans to soften the blow? Did the government take into account the new owners’ layoff plans when it negotiated the sale? Some countries (Benin, Zambia) insert five-year “no layoff” clauses into their sale contracts. Others, (Pakistan, Madagascar) require the buyer to provide severance packages to the workers it lays off. In many cases, the country receives low-interest loans from the international development agencies for this purpose. These severance packages, varying from a few months’ to more than a year’s salary, give the worker support while looking for a new job or provide seed capital for a new business.
Shortages of skilled workers. While there are often too many administrative workers at a state-owned company, there may also be too few skilled technical employees available in the workforce. Has the government set up any education and training programs to make sure the country is producing enough skilled workers? Has the new owner developed and implemented a training program? What about new hiring?
Benefits. Many government companies include housing, education, and health and child care as part of their employees’ package. Has the government set up any safety net of benefits to replace the ones these workers will lose? This issue, particularly acute in the former Soviet Union, extends beyond the divestiture of the enterprise and involves myriad issues of fiscal decentralization and institutional building of local governments. The fiscal implications of these programs are extremely important and need to be carefully examined.
Poor tax collection and big budget deficits. When a government privatizes a company it receives a big influx of cash. But that is just a onetime effect. Over the long run, the government will be losing out on the profits the company may have been earning while it was state owned. To make up for that lost revenue, tax reform is often needed to introduce market-based systems that replace old-style transfers with corporate taxation of the newly privatized company. The absence of such a tax system in post-privatization Russia caused a dramatic collapse in government revenues, eventually contributing to the crisis of 1998.
Government interference. In cases where the government has given up management control of the company, it should not interfere with the running of the firm. Independent regulatory boards should be the ones to monitor price and competition policy.
THE NEW OWNERS
The government is not the only party to watch. The new owners are now responsible for the running of the company. Will they make it a healthy part of the economy and create jobs for the country?
There are generally three types of new owners:
Foreigners. Foreign investors pay for companies with foreign exchange. This is attractive for governments, who can use that money to pay off their foreign debt. Foreigners also bring in expertise and technology. In poorer nations, there may not be a local investor with enough money to buy the company. Foreign investors, in addition, tend to have access to capital that local investors may lack. A committed foreign owner will reinvest profits in the company to ensure its long-term prosperity. Reporters should watch for foreign owners who whisk future profits out of the country instead of reinvesting them. This will spur political opposition to the whole privatization process.
Insiders. Inside owners are generally the managers and employees already at the firm. On the one hand, these kinds of owners could be seen as having the most experience at running the particular company and having the most interest in seeing it succeed. On the other hand, though, selling a company to existing managers risks their continuing with the same inefficient practices behind the initial problems. “Asset stripping”—the practice of siphoning off company assets in the guise of losses—is not unknown in companies sold to insiders. Reporters should watch for inside owners who are reluctant to make any change in the way the company is run or who keep relying on the government for financial support and bailouts.
Outsiders. These owners tend to be local entrepreneurs and businessmen. In their favor, they will have a good understanding of the domestic marketplace, sufficient capital for expansion and technological improvements, and proven track records in business. Reporters should watch for outside owners with political influence who force the government to protect the company from competition.
WHAT SHOULD THE NEW OWNERS BE DOING?
Incentives and training for workers. In the short term, the new owners may have to bring in executives from their old businesses with the experience they need. But are they spotting workers with managerial talent and developing those employees? They will need to do this if they want to ensure stability and profits in the long run.
Strategy. Are the new owners identifying and terminating products or services that the company provided for purely political reasons? Are they focusing on improving those areas where the company does have a competitive advantage? Are they updating technology and labor skills? If the company is not making money in the beginning, how will it gain access to short-term cash flow? Can it sell bonds or borrow from the banks? Does the new owner have the cash to invest in the company?
Reporting requirements. Is the newly privatized company transparent—is there reasonable public access to information regarding the financial health of the firm? If it is listed on the stock exchange, is it filing reports in line with international accounting standards with the securities regulator? If it is a monopoly, is it submitting accounting reports to the government or a watchdog body? Is the company training its managers and accountants in the new accounting procedures?
Profitability and efficiency. The company should tell reporters not just what profit it made but also give some measure of its efficiency. A commonly used measure of profitability is earnings before interest and net earnings. Also important is the rate of return on assets and equity. Reporters should inquire about the level of debt both in absolute terms and relative to assets (leverage). Profit statements should be checked against cash flow—some companies hide losses by exaggerating depreciation charges and other accounting gimmickry. Do the indicators improve or worsen in the first year following privatization?
LINKS FOR MORE INFORMATION
1. The Reason Public Policy Institute publishes research papers and commentaries and maintains a database on privatization issues. www.privatization.org.
2. This Web page maintained by Universiti Putra Malaysia provides many links to online resources on issues pertaining to privatization. www.lib.upm.edu.my/iispri.htm.
4. The World Bank’s Rapid Response Unit is also a good source of resources on privatization issues. http://rru.worldbank.org.
5. Padma Desai, a professor at Columbia University, is an expert on Russian privatization and a number of her papers are available on her Web site. www.columbia.edu/~pd5.
6. Professor Ann Harrison at the University of California at Berkeley has written about privatization and her papers are published on her Web site. http://are.berkeley.edu/~harrison.
7. The Center for Competitive Government at Temple University publishes research studies on privatization issues. http://www.temple.edu/prc.
9. The Development Gateway Web site also has useful information on many issues around privatization, such as laws, costs and benefits, and labor impact. http://www.developmentgateway.org.
10. “Bank Privatization in Argentina: A Model of Political Constraints and a Different Outcome,” a paper written by George Clarke and Robert Cull of the World Bank, July 1999. http://ideas.repec.org.
NOTES
3. Bauer et al., The Rise and Fall of Investicni a Postovni Banka.
4. “Meltdown in Prague,” Business Week, 7 August 2000.