Methods of privatization.

• Author: Berg, Andrew
• Position: Privatization: Political and Economic Challenges

Privatization has been in fashion for more than 15 years, if we date its recent flowering from Margaret Thatcher's initiatives in the late 1970s. Shrinking the state's economic presence became part of the economic reform programs that characterized economic policy throughout much of the world in the 1980s. The collapse of communism in Eastern Europe and the former Soviet Union (FSU) moved privatization issues onto a much larger stage in the 1990s.

Privatization in the broadest sense means giving private actors a greater role in decisions about what, where, and how to produce goods and services. A great deal of experience has now accumulated regarding this process. Some of it shows the great potential that privatization has for increasing productivity, income and welfare.(1)

However, it also reveals the complexity and difficulty of effective privatization. Privatization even in the narrower sense of "divestiture"--the sale of state-owned enterprises (SOEs)--has presented greater challenges than its early advocates envisaged.

Relatively few countries account for most of the divestiture activity in recent years. Thus, of the roughly $300 billion in divestitures between 1988 and 1994, two-thirds occurred in industrial countries. (This excludes sales of small enterprises and give-aways such as "mass privatization" programs.) The five biggest privatizations--among them Japanese Railways, British Telecom, and Deutsche Telekom--account for some $60 billion in proceeds. Of the $100 billion in developing country privatizations, more than half took place in Latin America.(2)

In developing countries, macroeconomic impacts of privatization activity have been small in most cases. Despite the widespread privatization rhetoric and many formal structural adjustment programs under World Bank sponsorship, the average public enterprise sector share in gross domestic product for 40 low- and medium-income developing countries between the late 1970s and the early 1990s remained unchanged, as did the sector's share in wage employment.(3)

In the low-income developing countries (those with average per capita incomes below $600 a year) the pace of privatization has been particularly slow. In sub-Saharan Africa, for example, only 1800 (mostly small) divestiture transactions took place between 1980 and 1995, with a sale value of about $2 billion. In only six countries (Benin, Ghana, Guinea, Mozambique, Nigeria, South Africa and Uganda) did total sales through 1995 amount to more than $50 million, which suggests insignificant reductions in the relative size of the public enterprise sectors in most of the continent. Ghana, Nigeria and South Africa account for almost 70 percent of the total sales value of African privatizations.(4)

Overall progress has been much faster in Eastern Europe and the FSU. Most of these countries have succeeded in moving from almost complete domination by the state sector to predominantly private economies.(5) However, only a few of these countries have been able to divest many state enterprises to new managers, and the problem of using former state assets more efficiently remains problematic in much of the region.

Many factors enter into the explanation of these patterns of privatization. In this paper, we focus on only one of these: the relationship between methods or techniques of privatization and the objectives that governments seek to attain through privatization. This has two related dimensions: the fit between method and objectives, and the incompatibilities between various objectives.

The main objectives, explicit or implicit in most privatization programs, are: fiscal relief by cutting government subsidies to money-losing SOEs and/or by generating new revenues from their sale; increased enterprise efficiency; increased efficiency of the entire economy through more competitive markets and better allocation of resources across firms and sectors; increased political support and broadened institutional underpinnings for a market-based economy or further liberalization; stronger financial markets; increased investment and the stimulation of entrepreneurship.

The main methods to be reviewed here fall into five broad categories: sales of shares or assets; capital dilution; management-employee buy-outs (MEBOs); broad-based or mass privatization; and indirect or partial privatizations via management contracts, leases or service contracts. These categories are convenient but not entirely mutually exclusive: MEBOs are a type of sale, while mass privatization involves some combination of the other methods with some type of free distribution of shares or vouchers.

Before we turn to a discussion of these techniques, we should note that we are leaving out a number of privatization instruments, the most important being privatization through liberalization.(6) The creation and growth of new private firms, along with a withering of state enterprises, has been even more important in many of the transition countries than privatization in terms of the reduction of the state's ownership share.

Consider two otherwise dissimilar examples: Poland and China. Poland's private sector has grown from 29 percent of gross domestic product (GDP) in 1989, largely in agriculture, to 56 percent in 1994. Though classification and data problems make the calculation difficult, most private sector growth in Poland appears to have come from the creation and growth of new firms, not from privatization of existing firms.(7) The workers and, in some cases, the assets for these private firms presumably originated in the state sector, but these were pushed out by economic pressures on state enterprises or pulled out by the attraction of high profits in the private sector. China is perhaps an even more dramatic example, though definitional and measurement issues are even more difficult. The share of the non-state sector, including so-called township-and-village enterprises (TVEs), in gross industrial output rose from 24 percent in 1980 to 57 percent in 1994, solely through differential growth rates following liberalization.(8)

This is clearly privatization in the broadest sense, but a full discussion of this method lies outside the scope of this paper. Suffice it to say that macroeconomic stability, price and trade liberalization, elimination of restrictions on start-up firms and a real hardening of the budget constraints facing state enterprises appear to be required to allow fast privatization, as well, perhaps, as a tolerance for the methods by which assets find themselves in private hands.(9)

Turning now to privatization itself, we consider each of the five methods in turn. We describe each briefly, provide relevant examples, indicate prevalence, summarize strengths and weaknesses and show how various methods entail trade-offs between government objectives.

Sale of Shares or Assets

The classic type of privatization is the sale of full or partial ownership of a state enterprise by public offering on stock exchanges, by competitive bidding for shares or assets or by non-competitive placement of shares.

Public Flotation of Shares

Under this method, the state sells to the general public through the stock market and other financial institutions all or a substantial part of the stock it holds in a going concern. The initial public offering (IPO) is often combined with other methods, such as the sale of shares to employees on favorable terms.

The public flotation is politically appealing and has great revenue-raising potential. It allows broad ownership, which is always more popular than a sale to powerful domestic or foreign buyers. Wider stock ownership is a common objective in most privatization programs, as it was for example in the United Kingdom, Jamaica, Chile and more recently in Germany. It also has the effect of locking in privatization actions. Most observers believe, for example, that renationalization of Chile's telecom SOE is unlikely because, as a result of mandated preferences for small investors, one-third of the shares of the major telecommunications company has passed to the general public.

Public flotation is also flexible. It allows targeting of particular groups to meet political objectives or social purposes. Thus, in some Jamaican privatizations, as in Chile and elsewhere, small buyers were given preference. In the sale of the Jamaican National Commercial Bank, for example, no investor was allowed to own more than 7.5 percent of the outstanding shares.(10) Sale via public flotations can also contribute strongly to the development of local capital markets, as in Jamaica, where the initial privatizations increased the capitalization of traded shares by 40 percent.

Public offerings are also more transparent than other methods. Prices are set by the market for all to see, and for anyone to buy. Since one of the main obstacles to privatization is widespread public concern about corruption and cronyism, this is no small advantage. Sale through the stock market can be accompanied by private placements--to pension funds, to disadvantaged groups or to employees, thereby increasing the equity of the transaction.

In addition, public offerings allow gradual approaches. Sales can be organized in tranches, with first tranche prices and conditions being designed to win acceptance, and later tranches set at higher prices to benefit from improved enterprise performance and better knowledge in the market about the privatized firm.

The characteristics of IPOs that make them attractive also make them hard to implement, especially if speed is an objective. Their clarity and transparency bring tremendous transaction costs--such as preparation for sale, valuations and managing the offer. As a result, only larger SOEs or large government holdings are usually appropriate. Moreover, firms have to be readied for sale. They must be made attractive to buyers. At the same time, the diffuse ownership that tends to result means management will...