The mixed ownership model : radical sell off or half-baked privatisation?

1. The mixed ownership model:radical sell off or half-baked privatisation? Sinclair Davidson

2. Privatisation • Privatisation can be defined as the transfer of ownership rights in State Owned Enterprise to the private sector. • Note: not necessarily control rights. • Privatisation is also associated with changes in: • Market participation (liberalisation). • Regulation (deregulation). • First modern privatisation: Volkswagen 1961 (?) • Australia sold its half share of the Commonwealth Oil Refinery to the Anglo-Iranian Oil Company in 1952. • Latest trend: British Petroleum 1977. • But the sale of State property is not new. • Much of the early privatisation trend was “denationalisation”. Economics, Finance and Marketing

3. How Mrs Thatcher saw it • First, we had to put the balances of the industries we wanted to sell in good order. • Second, I saw it as part of my purpose to have a policy which extended ownership of capital more widely. • Third, those companies which could not be floated on the stock market were sold to companies who were willing to buy them at the best possible price. • Fourth, some industries were so thoroughly outdated that they would have cost too much money to modernize. • Margaret Thatcher: Rebuilding an Enterprise Society Through Privatisation Reason Foundation Annual Privatization Report 2006 Economics, Finance and Marketing

4. 20 year history of privatisation Economics, Finance and Marketing

5. New Zealand has been an active participant • 34 Privatisations in 80s and 90s. • None in noughties. • Tranz Rail renationalised. • Air New Zealand renationalised. • Airline has survived but at huge cost • Has Air New Zealand covered cost of capital? • New Zealand government tended to privatise by means of trade sale • Sale of asset to single buyer or consortium. • Share market listings have been rare. • Share market listing has advantage of sharing benefits going forward but has potential for greater Principal-Agent problems. • Trend in Europe is away from IPO model to the trade sale model. Economics, Finance and Marketing

6. Previous New Zealand policy • No attempt to favour bidders or establish a shareholder democracy. Sold assets for the highest possible price. • Reluctance to privatise firms not in contestable markets. Competition reform preceded privatisation. • Donald Brash 1996: 37 Economics, Finance and Marketing

7. Current New Zealand policy • New Zealand government will partially privatise assets with following objectives: • freeing up capital for the Government to invest in other public assets, without having to borrow to do so • improving the pool of investments available to New Zealand investors and deepening capital markets • allowing the mixed ownership companies to access capital and grow without depending entirely on the Government • allowing for external oversight, which places sharper discipline and more transparency on a company’s performance, increasing the incentive for improved performance. • Source: Budget Policy Statement 2012 Economics, Finance and Marketing

8. SOEs, efficiency, and financial development • Jeffrey Wurgler, 2000, Financial markets and the allocation of capital, Journal of Financial Economics, 58: 187 – 214. • Financial markets improve the allocation of capital. • Across 65 countries, those with developed financial sectors increase investment more in their growing industries, and decrease investment more in their declining industries, than those with undeveloped financial sectors. • The efficiency of capital allocation is: • negatively correlated with the extent of state ownership in the economy, • positively correlated with the amount of firm-specific information in domestic stock returns, and • positively correlated with the legal protection of minority investors. Economics, Finance and Marketing

9. SOEs, efficiency and financial development • where I is gross fixed capital formation, V is value added, i indexes manufacturing industry, c indexes country, and t indexes year. • New Zealand data: 1963 – 1990. • Estimated ηc = 0.896 (ranked 3rd after Germany and Hong Kong). • Excellent result but financial market development? • not so good. Economics, Finance and Marketing

10. SOEs, efficiency and financial development Economics, Finance and Marketing

11. Why is privatisation so controversial? • Privatisation interacts with Bryan Caplan’s voter biases: • anti-market bias; a tendency to underestimate the economic benefits of the market mechanism. • anti-foreign bias; a tendency to underestimate the economic benefits of interaction with foreigners. • Make work bias; a tendency to underestimate the economic benefits of conserving labour. • pessimistic bias; a tendency to overestimate the severity of economic problems and underestimate the performance of the economy. Economics, Finance and Marketing

12. Why is privatisation so controversial? • To use Thomas Sowell’s terminology – there is a conflict of visions. • “people’s romance”. • Privatisation goes to the very core of political debate: • What is the role and function of the State? • What is the role of the State in civil society? • What is the role of the State in the economy? • For those who believe the State should have a minimal role, privatisation is (somewhat) uncontroversial. Economics, Finance and Marketing

13. Why is privatisation so controversial? • Privatisation is a jump from the YY or NY quadrant to the YN quadrant. Economics, Finance and Marketing

14. Am I being unfair to professional economists? • No – see Ronald Coase writing in 1960. • Most economists seem to be unaware of all this. When they are prevented from sleeping at night by the roar of jet planes overhead (publicly authorized and perhaps publicly operated), are unable to think (or rest) in the day because of the noise and vibration from passing trains (publicly authorized and perhaps publicly operated), find it difficult to breathe because of the odour from a local sewage farm (publicly authorized and perhaps publicly operated) and are unable to escape because their driveways are blocked by a road obstruction (without any doubt, publicly devised), their nerves frayed and mental balance disturbed, they proceed to declaim about the disadvantages of private enterprise and the need for Government regulation. • Economists, and policy-makers generally, have tended to over-estimate the advantages which come from governmental intervention. • James Buchanan makes similar points. Economics, Finance and Marketing

15. Why is privatisation so controversial? • Hayek has defined intellectuals as being rationalist. • “That is all very well in practice, but it could never work in theory.” • Why shouldn’t government ownership work just as well as private ownership? • If not better? • This takes us back to the Socialist Calculation Debate. • The calculation debate centred on two questions. • The “replication” hypothesis: • is it possible for a socialist society, with common ownership of the means of production, to use planning to replicate the performance of a capitalist society, with private ownership of these means of production? • The “improvement” hypothesis: • is it possible to do “better” than replication? • Until the late 1980s economists widely accepted that answer to both questions could be “yes”. Economics, Finance and Marketing

16. Why is privatisation so controversial? • Theoretical arguments for SOEs. • Market Failure. • Natural monopoly. • Externality (not applicable here?) • Asymmetric information. • Sappington and Stiglitz fundamental theorem of privatisation: when the market will do just as well as a benevolent government. • Beware the fallacies of nirvana economics. • The grass is greener on the other side. • There can be a free lunch. • People could be different. • If governments were benevolent, social-welfare maximisers there would be no need to privatise. Economics, Finance and Marketing

17. Why is privatisation so controversial? • Equity risk premium anomaly. • New Zealand estimates: 3% - 7% (best guess 5.6%). • Lally and Marsden 2002. • New Zealand estimates: 5.5% - 7.4%. • Lallyand Marsden 2004. • “If the equity premium is the result of imperfections in the private capital market, there is a prima facie case to suggest that the appropriate rate of discount for public-sector investments is that which would be generated by a perfect capital market, rather than the observed rate incorporating the anomalous equity premium.” • Grant and Quiggin (2003: 2). • “If there is no efficiency loss associated with public ownership, the expected marginal return to public investment … dominates the expected marginal return to private equity. … an expansion of public investment is desirable”. • Grant and Quiggin (2003: 14, emphasis added). Economics, Finance and Marketing

18. Why is privatisation so controversial? • Pursuit of Social Objectives. • Model employer. • Promote employment of minorities, women, etc. • Promote economic activity in remote areas. • Overcome Principal-Agent problems. • Shareholders have diverse interests and lack incentives to monitor. Economics, Finance and Marketing

19. Digression on Adam Smith • What Adam Smith had to say about the Principal-Agent problem • The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. • Why would we expect this issue to be resolved in a bureaucracy as opposed to a market? Economics, Finance and Marketing

20. Why is privatisation so controversial? • Theoretical arguments against SOEs. • Pursuit of Social Objectives. • Redistribution tends to lead to inefficiencies. • Picking winners. • Inadequate monitoring. • Soft budget constraints. • Weak incentives. • Mises argues that entrepreneurs only make the decisions they do because they are profit seeking and self-interested. • Bureaucratic functions work well for routine management tasks but not in dynamic economic environments. • All up theoretical arguments appear indeterminate. • It is the empirical record that is decisive. Economics, Finance and Marketing

21. Why is privatisation so controversial? • “… private ownership must be considered superior to state ownership in all but the most narrowly defined fields or under very special circumstances.” Megginson 2005: 52 • So we can accept that private firms are likely to dominate public firms in terms of performance. • But what about the privatisation process itself? • We have to believe that government is incapable of realising value when running a firm but is capable of realising value when selling that same firm. • Does this really matter? • “Almost all studies that examine post-privatization changes in output, efficiency, profitability, capital investment spending, and leverage document significant increases in the first four and significant declines in leverage.” Megginson 2005: 152 • Is that good enough for everyone? • No – detractors point to selection bias as explaining that sort of result. • Weight of evidence: Privatisation works (on average, over time). Economics, Finance and Marketing

22. Why is privatisation so controversial? • In addition to: • Voter biases. • Conflict of vision. • There is a promoters problem. • The risk that corporate issuers sell bad securities to the public. • This is always a risk that buyers face. • These three issues inter-relate to each other in privatisation. • Some privatised firms fail. • Bad faith? • Poor process? • Poor business model? • Poor economic model? Economics, Finance and Marketing

23. What should government do? • “After the public institutions and public works necessary for the defence of the society, and for the administration of justice, …, the other works and institutions of this kind are chiefly those for facilitating the commerce of the society, and those for promoting the instruction of the people.” • Adam Smith 1776: 964 • Facilitating the commerce of society could include SOEs, but … “…those public institutions and those public works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the profit could never repay the expense to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain.” • Adam Smith 1776: 963 • Example? – Sewers. Economics, Finance and Marketing

24. What should government do? Economics, Finance and Marketing

25. What should government do? • What is the cost of public funds? • Seems to be very controversial in the literature. • Is the cost of public funds less than the cost of private funds? • Market anomalies? • Taxation? • Ethical issues? • There is a divide between welfare economists and financial economists as to the appropriate methodology to even approach this issue. • If we think that the required rate of return is a function of the risk of any project, then the public cost of capital must be equal to the private cost of capital for that project. • What about deadweight costs of taxation? Economics, Finance and Marketing

26. What should government do? Andrei Shleifer and others Trade-off: Disorder refers to the risk to individuals and their property of private expropriation in such forms as banditry, murder, theft, violation of agreements, torts, or monopoly pricing. Dictatorship refers to the risk to individuals and their property of expropriation by the state and its agents in such forms as murder, taxation, or violation of property. Economics, Finance and Marketing

27. What should government do? • LLS (2002) look at government ownership of banks. • Development Hypothesis • Alexander Gerschenkron – Bank finance is important in economies with under-developed financial systems. • Political Hypothesis. • Government controls banks to capture private benefits of control and to direct those benefits to supporters and friends. • In a sample of 92 economies LLSfind that the evidence tends to support the Political Hypothesis. • DMNS(2003) look at government ownership of media. • Public interest theory • Information is a public good. • State media ownership can expose the public to less biased, more complete, and more accurate information than it could obtain with private ownership. • Political Hypothesis. • Government-owned media outlet would distort and manipulate information to entrench the incumbent politicians. • In a sample of 97 economies DMNSfind that the evidence tends to support the public choice theory. Economics, Finance and Marketing

28. What should government do? • Rahn Curve (or Armey Curve) • Developed by Richard Rahnin 1988. • Originally had economic growth on vertical axis. • Once governments provide essential goods and services “economic growth rates will inevitably decline as the naturally expanding government adopts new spending programs with revenues absconded from over taxed income producing factors owned by private citizens”. • Richard ‘Dick’ Armey in 1995. • “[W]e need government to keep the peace, prevent anarchy, run the national parks, and maybe do the odd job here and there. To this extent government bears some resemblance to its constitutional description as promoter of the general welfare and securer of the blessings of liberty.” Economics, Finance and Marketing

29. Goals of privatisation • Raise revenue for the State. • Promote economic efficiency. • Reduce government intervention in the economy. • Promote wider share ownership. • Introduce more competition into the economy. • Subject SOEs to market discipline. Megginson (2005: 14) Economics, Finance and Marketing

30. Touting Privatisation • Increased Efficiency. • SOEs inefficient and the private sector can do better. • Government can spend proceeds more effectively in other areas. • Government could accelerate spending plans. • Government could invest in other ventures. • Public Finance. • The proceeds could reduce the budget deficit. • The proceeds could reduce the government debt. • The proceeds could reduce the interest charges on government debt. • The proceeds could assist to maintain (or improve) the government debt rating. • Sundry. • Government shouldn’t be involved in risky business. • Price will fall in future. • Other government’s have privatised already. Economics, Finance and Marketing

31. Popular views of privatisation Privatisation is said to have: extended share ownership. reduced government costs in some areas. • produced massive wealth transfers within the community. • conferred privileges on insiders. • led to the loss of services to the community. • led to loss of jobs in government. • led to spurious claims of savings to taxpayers. • risked the marginalisation of rural communities. • seen government-owned state based monopolies dismantled. • created powerful private monopolies. • contributed to environmental damage. • eroded public sector accountability. Economics, Finance and Marketing

32. Popular views of privatisation • What is going on here? What is the problem? The truth is that capitalism has not only multiplied population figures but at the same time improved the people’s standard of living in an unprecedented way. Neither economic thinking nor historical experience suggest that any other social system could be as beneficial to the masses as capitalism. The results speak for themselves. The market economy needs no apologists and propagandists. It can apply to itself the words of Sir Christopher Wren’s epitaph in St. Paul’s: Si monumentumrequiris, circumspice. Ludwig von Mises, 1949, Human Action, pg. 854. • If you seek his monument, look around. Economics, Finance and Marketing

33. How to privatise? Trade Sales. IPO (share issue privatisation). Advantages. Revenue. Promotes stock market development. Transparent. Disadvantages. Costly and slow. Does not promote FDI. • Advantages. • Speed. • Revenue (?). • Increased FDI. • Disadvantages. • Do not promote stock market development. • Reduce liquidity. • Non-transparent. • Possibility of corruption. Economics, Finance and Marketing

34. How to privatise? • Choice between trade sale and IPO. • Market considerations. • IPO is more likely: • the less developed capital markets are. • the greater the level of income equality. • Firm-specific considerations. • IPO is more likely: • for larger SOEs. • for more profitable SOEs. • Political considerations. • Trade sales more likely in those economies with strong property right protections. Economics, Finance and Marketing

35. Why do government’s privatise? • Privatisation is associated with: • high levels of public debt. • fiscal imbalances lead to privatisation. • A well-functioning domestic stock market. • “hot” IPO markets can be used to time floats. • right-wing political parties. • diffusing the benefits of capitalism. • Money and ideology. Economics, Finance and Marketing

36. Assessment • Increased efficiency. • Hard to see any downside here. • Some privatised firms may not survive over time. • “The main argument is about economic efficiency: that on average and over time, privately owned enterprises out-perform publicly owned ones (and hence contribute more to national income)”. • Roger Kerr February 25, 2011. • “In my view, the main issue is transferring the business from public to private ownership to reap the efficiency gains”. • Roger Kerr April 14, 2011. • In this view what matters is that the ownership transfer occurs. How it occurs and what happens to the proceeds is of lesser importance. • Should privatisation occur via voucher schemes? Economics, Finance and Marketing

37. Assessment • Privatising to pay off public debt? • “This case is valid but it is a secondary argument”. • Roger Kerr February 25, 2011. • Most western economies have public spending problems. • Massive increases in debt and deficit. • Sale of public assets validates past expenditure. • Problem is that public assets are finite while capacity for debt and deficit is infinite. Economics, Finance and Marketing

38. Privatising to pay off public debt? • Australian Financial Review June 4, 2013 (pg. 10) Economics, Finance and Marketing

39. Privatising to pay off public debt? • Selling public assets to pay for irresponsible spending sprees may get economies out of debt and deficit holes now, but without a fiscal constitution that restrains future debt and deficit the underlying problem remains. • Using privatisation proceeds to validate past consumption is a case of eating seed capital. • Privatising to pay off the national equivalent of “wine, women, and song” doesn’t address the spending problem. Economics, Finance and Marketing

40. Fiscal constitution • Informal fiscal constitution – a widely-shared and broadly-measurable consensus about how collective goods and services are to be spent. • Buchanan and Wagner call this the “old time fiscal religion”. • “Frugality, not profligacy, was the cardinal virtue, and this norm assumed practical shape in the widely shared principle that public budgets should be in balance, if not in surplus, and that deficits were to be tolerated only in extraordinary circumstances.” • That informal consensus has broken down. • Not everywhere – Australian voters still believe in the old-time religion. • New Zealand? • Majority rule is not a sufficient constraint on excessive expenditure, taxation, and borrowing. • Need for explicit constraints. Economics, Finance and Marketing

41. Conclusions • Mixed ownership model is a pathway to full-privatisation. • Privatisation “works” – by itself. • Privatisation works better when embedded in a reform program. • Past privatisation wave was associated with liberalisation and deregulation. • Very radical at the time • A coming privatisation wave? • What is the reform agenda? • Proposal • Link privatisation with need for on-going fiscal reform. • How to restrain Leviathan? • New Zealand’s privatisation is not radical enough. Economics, Finance and Marketing

42. Select Bibliography • Bernardo Bortolotti, Marcella Fantini, Domenico Siniscalco, 2003, Privatisation around the world: evidence from panel data, Journal of Public Economics88: 305 – 332. • James Buchanan and Richard Wagner, 1977, Democracy in Deficit: The Political Legacy of Lord Keynes, Liberty Fund. • William Megginson, 2005, The financial economics of privatization, Oxford University Press. • William Megginson, Robert Nash, Jeffry Netter and Annette Poulsen, 2004, The Choice of Private versus Public Capital Markets: Evidence from Privatizations, The Journal of Finance, 59(6): 2835 – 2870. • Bob Walker and Betty Walker, 2000, Privatisation: Selloff of sell out?, ABC Books. Economics, Finance and Marketing