Why do states own quoted stock?

1. Why do states own quoted stock? Roland de Bruijn (CPB), Paul Grout (CMPO), and Gijsbert Zwart (CPB, TILEC) Partnerships between Government and the Private Sector EBRD, London, 22-23 February 2007

2. Active area of research + Large economic interest • Privatisation/ ownership literature • Megginson, Nash and van Randenborgh (JoF ‘94) • Jones, Megginson, Nash and Netter (JFE ‘99) • Megginson and Netter (JEL ’01) • Dewenter and Malatesta (AER ’01) • La Porta, Lopez-de-Silanes and Shleifer (JoF ’99), … • (Non-transitory) Government ownership over equity • Biais and Perotti (AER ‘02) • Faccio and Lang (JFE ‘02) • La Porta, Lopez-de-Silanes and Shleifer (JoF ‘02) • Gupta (JoF 05) • Faccio (AER ‘06) • Faccio, Masulis and McConnel (JoF forthcoming) Megginson (2005): Privatisations account for 18.2% of the global stock market value and 38.6% of the non-US total stock market value Bortolotti and Faccio (‘04): 2000: Government either the largest shareholders or held special control rights in 62% of all privatisations.

3. Outline • Simple theoretical model that gives an explanation what might be the benefits of (permanent) partial state ownership • Empirical verification of one of the implications of this model • Focus on equity risk in airline industry

4. A simple model • Two conflicting factors causing inefficiency • Fully private firm: The Stiglitz-Weiss effect • Fully state-owned firm: Soft-budget constraint Can partial state-ownership be the efficient compromise?

5. Stiglitz-Weiss: private investors choose higher risk projects prob. density A Project A has higher expected return and lower variance than B But B has higher probability of high returns B return

6. Stiglitz-Weiss: private investors choose higher risk projects prob. density A Debt Project A has higher expected return and lower variance than B But B has higher probability of high returns B return Given debt D: private investor maximises Expected value of max(RA,B- D, 0) (cf option value) Tendency for high risk projects, since part of the downside risk is borne by the creditors • This implies that • Private investors tend to prefer project B over efficient project A • Anticipating this, debt-holders may ration the amount of debt, so that project may not go ahead at all

7. Why is Government different? • We assume that, at least for some sectors, government has different pay-off than private investors in particular: government incurs loss L when firm is terminated prematurely • externalities on rest of economy, • unemployment, • … • Government, if majority shareholder, will opt for lower risk project

8. Adverse consequence:Soft budget constraint Two-period model: t=1 t=2 t=0 t=0: project choice (safe for government); management effort t=1: observe first period success or failure; decide on refinancing to complete project at t=2. government cannot commit to non-refinancing (Soft-budget-constraint): creates moral hazard in manager: low effort Unprofitable projects are continued. If debt-holders stand to lose from such projects, they can step in and force termination?

9. The debt-holders... • ...have no direct information on whether project is in good or bad shape (shareholders have) • ...can step in and force termination in bad state, but at monitoring costs M • Monitoring costs and legal bills to prove in court • If probability of good outcome without manager effort sufficiently likely: debt holder will not monitor • factors in likelihood of failure in the interest rate • soft-budget constraint not resolved

10. How can trade of (minority) shares help? • Government still chooses safe project (majority shareholder) • Minority shareholders: conflicting interest • Bad outcome (low effort): shareholders observe and exit Objective information (‘signal’) on state of the firm conveyed to debt-holders from stock market • If signal sufficiently large: • Debtholders can credibly spend M to put firm in bankruptcy and receive termination value • But in equilibrium: will bargain with government to avoid costs M and receive compensation

11. Liquidity traders: noisy signal Signal probability distribution in good state Probability distribution in bad state; shift proportional to minority share quantity Signal distribution Generally, manager, bank and government play mixed strategies probability of effort increases with size of minority share

12. When is mixed ownership optimal? • Loss L should not be too large • Project will be continued independent of bank’s intervention • Loss L not too low either • Budget constraint sufficiently tight that there is no difference between state and private (and state chooses risky project)

13. Implications • Majority government owned quoted companies will be less risky than privately owned quoted companies. • Cost shocks (since they reduce equity value) should have more impact on the risk of private quoted companies than majority government ownedcompanies • ( exacerbates Stiglitz Weiss effect).

14. A Case Study

15. Needed for case study • Industry with good mix of private and majority government owned companies • Companies with thickly traded stock • Relatively homogeneous product/service • A shock to sector that is significant, unanticipated and global • Not price or capital regulated

17. 26 quoted, well-traded airlines around the world • Daily share prices from Datastream • sample: 1999-2004 (“symmetric” window around 9-11 shock)

18. Measure risk as CAPM beta World market GARCH estimation (common on financial data) Focus on difference: compare portfolio of (majority) state-owned shares with privately owned ones (filters out company specific and airline sector noise)

19. Kalman filtered beta for differences (plus 95% confidence interval)

20. Basic regressions State-owned portfolio lower beta With 9/11 dummy

21. Sensitivity checks • Concern: time mismatch (end of day Asia vs. US) • leads and lags of returns • More general country effects • Regressions by continent (narrows down sample considerably)

22. Far East Europe

23. Further sensitivities • Higher moments (corrections on CAPM) • Exchange rates • Gearing Overall conclusions on empirics: Robust result: not in conflict with theoretical model