Privatization: Advantages & Disadvantages- The Great Debate

Introduction

Like so many other terms and concepts in social sciences, privatization has not any universally accepted definition. There are at least three perspectives from which privatization can be defined for analytical purposes and suggesting/taking policy decisions.

1. Economic Liberalization: In its broadest sense, privatization can refer to the economic liberalization of the entire economy by removing the barriers created by the state for the market mechanism to function optimally. The economic liberalization of theformer socialist economies in Central and Eastern Europe and the former Soviet Union is the best example of such economy-wide privatization.
2. Macro Privatization: At a macro level, privatization can refer to similar liberalization in one specific industry or sector of the economy i.e., telecommunication, energy, etc. It often involves the restructuring of a whole industry, giving the private sector the right to use or access the public domain (radio spectrum, land, right of way, etc.), defining the “public service” dimension, and licensing the private sector to deliver such services.
3. Micro Privatization: At the micro or enterprise level, privatization can refer to the disinvestment of state shares, partially or wholly, in an enterprise set up or nationalized in the past for the direct provision of goods and services to the public in any field.

Pakistan’s Privatization Commission Ordinance 2000 which provides the policy framework as well as an operational mechanism for privatization in Pakistan, defines privatization as follows.

“…. a transaction by which any property, right, interest, concession or management thereof is transferred to any person (entity) from the Federal Government, or any enterprise owned or controlled, wholly or partially, directly or indirectly, by the Federal Government”.

Need for Privatization

Generally, the state has one or more of the following objectives of privatization.

1. Strengthening of Private Sector: In the initial stage of economic development what Rostov called Pre-conditions to Take off, there is an acute dearth of private sector investors and entrepreneurs due to multiple reasons. i.e., prohibitive costs of initial investment, the uncertainty of benefits, long gestation period, low level of market demand, etc. In these circumstances, the state builds essential industries itself and then hands them over to the private sector besides providing a host of tax and non-tax incentives.
2. Improving the Efficiency and Service Delivery of the SOEs: Despite giving maximum autonomy, a State-Owned Enterprise cannot get rid of the shackles of a bureaucratic governance structure. Consequently, the efficiency and service delivery of an SOE is compromised to remove which the state privatizes its enterprises wholly or partially. By bringing in the incentive and reward mechanism of the private sector, the state hopes that the new management comprising private professional businesspeople, would inject capital, introduce technology and adopt better management practices.
3. Eliminating/reducing the huge State Subsidies: Every year state provides a huge subsidy to those SOEs which are continuously incurring losses, but they cannot be closed because of social welfare considerations or their strategic nature Here at least 26 % of the shares with management control of an SOE are given to a strategic investor who injects capital and improves the management
4. Raising funds in the local and global Capital Market: This is usually a one-off act of the state to raise funds for meeting its budgetary deficit or building reserves. i.e., by divesting shares of the profitable blue chip SOEs in the global market or locally. As this does not lead to any change in management, there is no impact on production or employment.

Although discussed separately for analytical purposes, the above-mentioned four different reasons are not mutually exclusive options. Privatization being a part and parcel of the overall economic liberation agenda of the government, all these considerations are kept in view while devising a privatization programme in the country.

Modes of Privatisation:

There are different modes of privatization depending upon the objectives of the state and the structure of the SOE to be privatized. These are;

1. Outright Sale of Assets and Business through Open Auction. Get rid of the unit, not to have any truck with business because of its better management in the private hands.
2. Strategic Sale of Shares through Public Auction or Tender. Improve the efficiency of an SOE that is making losses or earning fewer profits than its potential by handing over the management control along with the partial sale of its shares in the entity to the private sector without divesting its total ownership. Thus, the state gains in four ways-saving on subsidies, efficiency improvement, more taxes, and more profits.
3. Public Offering of Shares through a Stock Exchange: Share the profits of profitable SOEs with the public as well as the institutional investors. Besides increasing the size of the market capitalization and finding out the market price of the shares of its enterprise to sell the remaining shares, it also provides a transparent and equitable opportunity for investors and the public to build their investment portfolios.
4. Management or Employee Buyouts. An SOE is sold to its employees at slightly less than its market value but with certain terms and conditions. It solves the issue of staff disposal as well as the resistance to privatization by the employees.
5. Award of long-term leases: As the name suggests, it is a long-term lease, usually up to 49 years, for the extraction of any state-owned mineral resources
6. Management or Concession Contracts: This is the straightaway case of leasing out the state-owned assets to the private sector for a fixed-term lease normally 30 to 49 years.
7. Global Depositary Receipts (GDRs): This is simply taking loans from the investors against the collateral of the profitable SOE. Euro Bonds floated by the Government of Pakistan are the best example of this type of privatization.
8. Exchangeable/Convertible Bonds: This is also a form of taking loans from international funds against the collateral of the shares of its profitable SOEs. However, in this case, the purchasers have the right to convert the loan they have extended to the state by converting it into equity in the SOE

In Pakistan, all these modes have been adopted in different periods depending upon the SOE to be privatized and the objectives of the state for its privatization. Thus, in the 1990s wholesale privatization of SOEs was the preferred mode because of the large number of business units available in the public sector, a legacy of the 1970s’nationalisation policies. However, from 2000 onwards privatization through strategic sale was a preferred mode but other modes were also adopted for privatization.

Privatization-The Great Debate

Whatever the reason for the privatization of a State-Owned Enterprise, there are always some benefits as well as disadvantages to doing so. In this section, we will try to discuss all the arguments given for or against privatization since the process started more than half a century ago

Potential Benefits of Privatization

Some of the arguments for the privatization of State-Owned Enterprises are as follows.

1. Efficiency Gains: Driven by the profit incentive, the argument runs, the private sector puts in its best efforts to cut costs and be more efficient. Not restrained by the crippling constraints of an SOE, a private firm is interested in making a profit by cutting costs and improving quality. Pressure from shareholders to perform efficiently is another reason for improving its efficiency and resulting profitability
2. Improved Competitive Environment: Part and parcel of a government philosophy of overall deregulation and liberalization of the economy, the entry of previous SOEs as private sector entities with new management structures and governance styles results in improving the competitive environment of the economy. Not only old firms are forced to increase their efficiency, but new firms also enter the market with new ideas and practices in the market and increase competitiveness of the market.
3. Increased Governmental Revenues: Selling state-owned enterprises can increase public revenues in three ways. Firstly, transaction proceeds will bring in one-time substantial revenue depending upon the quantum of shares sold. Secondly, improved profitability of the privatized SOE will increase the tax revenue of the state from various sources. Thirdly, in the case of strategic sales where a government has sold only 26% of shares of an SOE with management control, it will get 74% of the net profits of the firm in the future.
4. Reduced Corruption: The main source of corruption in government is red tape. If you privatize, then there is less scope for government involvement and therefore, less corruption. Market forces and competition ensure that the private sector delivers higher quality service at a lower cost than the public sector. Privatization influences overall standards of governance. It reduces the scope for misuse of public funds, corruption, and patronage by removing politicians and bureaucrats from the business.
5. Increased Rational Investment: Political governments usually make decisions in terms of the political mileage they could get from making investments. This not only reduces their timeframe to five years or less but also prompts them to go for grandiose projects without following strict cost-benefit analysis. Lack of proper accountability and easy access to state subsidies blurs their long-term vision and short-term decision-making. Once privatized, the firm will utilize its scarce resources in the most rational way and terms of its long-term survival and growth.

Disadvantages of Privatization

On the other side of the fence are those who oppose privatization in its entirety or at least object to some of its aspects. Their arguments normally center around the following;

1. Privatization may not result in Improved Efficiency: Improved efficiency through privatization depends not only on the management skills and experience of the new private strategic investor but also on the market environment and the presence of effective regulatory mechanisms. Left to itself privatization is no guarantee of improving the efficiency of the once state-owned entity
2. Creation of Private Monopoly instead of State Monopoly: It is strictly not a case against privatization, but rather a precautionary note. For example, the power sector is an ideal case of this type of monopoly occurring. It has very substantial initial fixed costs, precluding any scope for having competition amongst several firms, particularly in a developing country. Therefore, in this case, privatization would just create a private monopoly that might seek to set higher prices that exploit consumers.
3. Public Interest Argument: In any state, many state-owned enterprises perform an extremely important role in providing social goods and services such as health care, education, public transport, etc. The state provides these services without caring about their economic profitability or financial viability. For example, in the case of health care, privatizing health care may result in the private sector paying a greater priority to profit rather than patient care.
4. Government Loss: Not all State-Owned Enterprises in a country incur losses; many of them are quite profitable. Selling them to the private sector results in two types of loss for the state-once privatized, these will not pay as much tax as they were paying as a state entity. Secondly, the dividends of the shares sold are now going into the private shareholders which would have come into state coffers.
5. Divided Responsibility: Many State-Owned Enterprises operate under a unified sectoral framework; breaking them into bundles and privatizing each bundle separately may lead to unnecessary and even uneconomic fragmentation. Rail Network is a typical example of such a case. Its privatization is impossible without first breaking up the rail network into infrastructure and train operating companies. This may lead to ambiguity about the sphere of influence and responsibility which can seriously jeopardize the overall safety of train operations if it was unclear who had responsibility for track maintenance.
6. The short-Termism of the Private Sector: Not only is the government motivated by short-term pressures but private firms are also known for resorting to short-term decision-making at the cost of the long-term framework. For example, in their efforts to increase short-term profits, they may try to make use of existing plants rather than invest in new ones.
7. Poor Service Delivery: Private companies, in their zeal to reward their shareholders in the form of higher profits, may end up cutting corners, or even under-investing in public services. For example, water utilities when privatized may ignore leaks instead of investing in infrastructure resulting in a supply of substandard water to the households.
8. Higher Prices: A private company not only has to make a profit for its shareholders, but it must also pay more to hire/retain the top executives. This can come from improved efficiency or cutting the corners. But it may also force them to charge higher prices for the services delivered.
9. Lack of Public Accountability: Unlike a public-sector entity, a private company is not democratically accountable to public representatives. That makes it harder for the public to lodge complaints against their poor service delivery or prohibitive costs of services. Lack of transparency, manipulation of contracts by suppliers and cumbersome procedures to sack underperforming providers further compound this erosion of public voice.
10. Employee Welfare is Compromised: Even the ardent supporters of privatization would agree that privatization ultimately adversely affects the previous employees despite all the lock-in clauses inserted by the state to protect their post-privatization interest. Once privatized, the new management tries to cut corners to save costs and employees are the obvious target. The private sector knows where it will be cost-effective to employ a new worker or retain the old one. Secondly, historically speaking, the introduction of modern technology has always brought increased efficiency at the cost of the labour force.
11. Irreversibility of Privatisation/Loss of Expertise: Except in exceptional circumstances such as a national emergency of economic severe economic recession (i.e.2007/8 crises) a state-owned enterprise, once privatized, cannot be re-nationalized. It means the state loses the pool of knowledge, skills, and experience that public sector workers have acquired over many years. This also adversely affects the integration both within and across different public services.

Evaluation of Privatization

After reading all the arguments for and against privatization, one is naturally curious to know the what is the final verdict in this great debate. Well, like so many other debates, the final evaluation of privatization depends upon several factors

1. Firstly, it depends on the motive of the state to privatize a state-owned enterprise in the first place. For example, if it privatized a unit to reduce the burden of state subsidy, then all the budgetary savings because of its sell-off is a net gain for the state. However, the resultant impact on consumer welfare or employees’ interest may be positive, negative, or neutral. Similarly, if a state unit has been privatized to improve its efficiency and service delivery, then a careful post-privatization study can reveal whether the induction of new management has resulted in positive or negative results of this measure.
2. Secondly, it depends on the industry in question. In some industries, such as fast-moving consumer goods, energy, telecom, etc., the incentive of profit can help increase efficiency even at the cost of increased prices for the consumers. However, if you apply it to social service industries like education, health care, or public transport, efficiency measured in terms of profitability will be a disaster for the public welfare.
3. Thirdly, and most importantly, it depends on the quality of post-privatization regulation by putting in place a robust and comprehensive post-privatization legal/regulatory framework backed by appropriate institutional mechanisms and judiciously implemented. If the state regulators make the privatized firms meet certain standards of service and keep prices low, then the privatization is beneficial, and so on. In the absence of the above, privatization will be at the mercy of market conditions which may or may not help in realizing the objectives of privatization
4. Fourthly, it depends on the overall market conditions and the extent of competition. In a contestable and competitive market, privatization will not only result in improved service delivery but also reduced prices for consumers. However, if privatization has just resulted in the creation of a private monopoly instead of a state monopoly, then it is a perfect example of privatization gone astray.

Conclusion

Despite all the good intentions and safeguards, vesting ownership of SOEs in private hands through a process of privatization does not necessarily guarantee the outcomes which are considered desirable or hoped for. The historical experience of privatization is testimony to this law of the unintended consequences. While privatization in the UK is considered to be a resounding success, the result of privatizing state-owned enterprise in several Latin American countries and former socialist countries have not been so beneficial. In most of cases, these resulted in the creation of oligarchs and private monopolies but failed to serve the citizens at large.