State‐owned firms and private debt

• Published date: 01 October 2018
• Author: Pierre M. Picard,Ridwan D. Rusli
• DOI: http://doi.org/10.1111/jpet.12297
• Date: 01 October 2018

P

672 © 2018 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jpet Journal of Public Economic Theory. 2018;20:672–702.

Received:12 May2017 Accepted:18 March 2018

DOI:10.1111/jpet.12297

ARTICLE

State-owned firms and private debt

Pierre M. Picard1Ridwan D. Rusli2

1Universityof Luxembourg, Luxembourg, and

CORE,Université Catholique de Louvain

2TechnischeHochschule Köln, Cologne, Ger-

many,and CREA, University of Luxembourg,

Luxembourg

PierreM. Picard, CREA, University of Luxem-

bourg,Luxembourg, and CORE, Université

Catholiquede Louvain, Louvain-la-Neuve, Bel-

gium(pierre.picard@uni.lu).

RidwanD. Rusli, TechnischeHochschule Köln,

Cologne,Germany, and CREA, University of

Luxembourg,Luxembourg (ridwan.rusli@th-

koeln.de ).

We study the role of private debt financing in reducing government

transfers and information costs in a state-owned firm. We show

that debt contracts allow the government to reduce socially costly

subsidies by letting underperforming state-owned firms default.

When the firm has private information, the government uses debt to

reducethe firm's information rents. The option of default and privati-

zation allows the government to stop subsidizing the firm. We iden-

tify the conditions under which information costs outweigh privati-

zation costs and a positive debt levelbenefits governments.

1INTRODUCTION

In most developed and less developed countries, a nonnegligible set of enterprises produce and sell goods or ser-

vices with partial or full public financing, and under the control of a variety of governmental institutions. The United

States hosts government-sponsored corporations, federallyowned corporations, and quasi-governmental agencies in

which governmental involvement is formalized (e.g., United States Postal Service, Tenessee Valley Authority). More

than 1,000 public hospitals are funded and controlled by state and local governments. Canada hosts para-publicorga-

nizations such as universities and Hydro-Québec. Francehas its “public establishments for industrial and commercial

purpose” (EPIC) that manage metro and train infrastructures,opera, and others. Less transparent are some for-profit

firms that nevertheless remain under the government'scontrol. For instance, Amtrak has all “preferred stocks” owned

by the U.S.Department of Transportation and its chief executiveofficer (CEO) appointed by the U.S. Congress. In China

and across the emerging world, manygovernment-linked corporations are effectively controlled by their governments,

even though theyare listed in the stock markets and financed with private equity and debt.

State-owned firms that are financed, owned, and controlled by the government are of major economic importance

in many countries. While such firms contributed between 6% and 8% of total gross domestic product (GDP) across

countries worldwide in the late nineties, public interventions in the last decade have led governmentsto own approxi-

mately one-fifth of global stock marketcapitalization (Megginson & Netter, 2001). A particular feature of state-owned

or state-controlled firms is that they hold significant levels of debt in the form of loans and bonds to the private sec-

tor,which reduce government equity injections. State-owned firms usually incur debt levels higher than a third of their

assets and are responsible for the issuance of many bonds worldwide. D'Souza and Megginson (1999) and Megginson,

Nash, and van Randenborgh (1994) observe that state-owned firms'average debt-to-asset ratio ranges from 29% to

66%, and that these ratios decreased after privatization. Borisova, Fotak, Holland, and Megginson (2012) describe no

less than 1,000 bonds issued by 215 listed state-owned firms across 43 countries in the last decade.

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Debt leverage has become a concern for many governments and regulators. For example,the recent increase in

debt leverage among public and private firms operating in regulated markets has motivated Ofwat, the U.K. water

regulator,to introduce restrictions on companies operating with high debt levels (Correia da Silva, Estache, & Jarvela,

2006;National Audit Office, 2015). Similarly,the high leverage of procurement projects has increased the probability

of financial distress and hence the frequency of renegotiation and recapitalization of public–private partnership (PPP)

contracts (Engel, Fischer,& Galetovic, 2010;Klein, 2012;Moore, Straub, & Dieter, 2014;Yescombe,2011).

The use of external debt bystate-owned companies is striking for two reasons. On the one hand, governments gen-

erally access credit marketsat better conditions than private agents. Because governments hold diversified portfolios

ofpublic projects, have recourse to taxation, and face no bankruptcy risk, government bonds are considered as risk-free

and offer the lowest interest rates in most modern economies. As a consequence, public projects should be internally

funded from the treasury rather than externally with private creditors. On the other hand, the use of external debt

contracts introduces the possibility of bankruptcy when state-owned firms are unable to meet their debt obligations.

The government must then face the difficult decision of whether to refinance and bail out state-owned firms, or to let

them default and relinquish control to private creditors.

A number of state-owned firms haveindeed defaulted in the past and are still undergoing default procedures today.

Creditors acquired (temporary) control of defaulting firms during the Asian crisis in the late 1990s. Many European

public airline companies went bankrupt and/or were privatized in the past decades. Post companies like the U.K.

Royal Mail are set in the process of privatization because their debts became a subject of intense political concern. In

China, thousands of smaller Chinese central and regional state-owned companies have gone bankrupt overthe years.

Between 1975 and 2008, many financially distressed public hospitals in the United States were unable to service their

debts because of insufficient revenues resulting from excess capacity and increasing number of uninsured patients.

Due to deteriorating public finances, many local governments refused to inject new funds and decided to privatize

them (Ramamonjiarivelo et al., 2015).

Such cases of default and subsequent privatization of state-owned firms necessitate governments'commitment

to—immediately or eventually—stop subsidizing the firm and face the risk of operational disruption and employees'

and citizens'discontent.1These examples takeplace under crisis conditions and in complex multiyear processes, often

involving interim subsidies. Nevertheless, they highlight the fact that debt contracts maytrigger governments'disin-

vestment in nonperforming state-owned firms. In many instances, bankruptcy is not a necessary step for privatization.

Numerous money-losing state-owned enterprises have placed themselvesunder pressure of their creditors before fil-

ing for bankruptcy. They have been privatized and sold to consortia of private investorswho often included former

creditors. Hence, the broader question that we explore in this paper is whether the debt policy and the subsequent

pressure from creditors can be used by governments as instruments to discipline state-owned firms'managements.

The objectiveof this paper is to highlight the role of debt leverage when state-owned firms benefit from information

advantages. We show that the governmenthas incentives to induce the state-owned firms to take a debt contract with

private creditors because the possibility of not bailing out the firm reduces information rents.2

Tohighlight this mechanism, we revisit the natural monopoly regulation setup with adverse selection presented in

Baron and Myerson (1982) and Laffont and Tirole (1993). A utilitarian and benevolent government monitors a state-

owned firm operating in a natural monopoly market,such as transport, water, energy, waste, and health.3The govern-

ment faces an information asymmetry because the firm's management has private knowledge about the firm's cost

(or demand parameter). The government faces a budget constraint that is summarized by its “shadow” cost of public

1Inthis paper, we define liquidation as the government's act of defaulting and subsequently privatizing the state-owned firm to private creditors or investors.

2Default provisionsof typical loan agreements and bond prospectuses often exclude government guarantee clauses;they thus convey an implicit no-bailout

commitment.

3Many state-owned companies are local natural monopolies like in water supply in poor countries and hospital care in sparsely populated rural America

(Alexander,D'Aunno, & Succi, 1996;Auriol & Blanc, 2009;Langabeer, 2006). Before 2002, EU national airlines could benefit from an artificial monopoly posi-

tion under countries'air transportbilateral agreements. Our analysis of monopoly can be generalized to oligopolistic markets as in Auriol and Laffont (1992)

andAuriol and Picard (2008).