Privatization

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Privatization

Privatization (sometimes privatisation, denationalization, or disinvestment ) is the process of transferring property from public ownership to private ownership and/or transferring the management of a service or activity from the government to the private sector. Privatisation can be partial or complete. It may also carry conditions as to the change in ownership.

The reverse process is nationalization or municipalization.

The term was coined in 1948 and is thought to have been popularized by The Economist during the 1980s.

The term has also been used to describe the buyout, by the ultimate majority owner, of all outstanding listed shares of an holding company, some of whose shares are listed on a stock exchange.

Overview

Classic liberals believe that the role of the state should be restricted to income and wealth redistribution and dealing with or preventing market failure. Government ought not to have any role in running companies or businesses. It is argued that "Public Ownership" is a misnomer, as state-owned companies are owned by no-one in reality. In addition, privatisation helps to establish a competitive market, as well as foster free market competition. It is the voluntary exchange of goods and services underpinning the free market which gives better quality, greater choice at a competitive price. Privatization pushes back the frontier of the state, and is a radical reversal of the trend of many years for Governments both left and right to take companies into "Public Ownership".

Conversely, socialists argue (and fear) that entrusting private businesses with control of essential services reduces the public's control over them and leads to greater profits being achieved at the expense of quality of service, workers, and society as a whole. There are also concerns about the ownership of companies and assets passing into foreign hands. Additionally, opponents of privatization often raise concerns about the transparency of the process of awarding contracts. In some cases, the government will not put a contract up for bids but simply award it to a company of their choosing. Critics point to the potential for campaign financing to be influenced by the awarding of contracts.

In general, privatization was common during the immediate post-second World War period, but privatization became a more dominant economic trend (especially within the United States and the United Kingdom) during the 1980s and 1990s.

This latest trend of privatization has often been characterized as part of a "global wave" of policies greatly influenced by the thinking of classic liberals such as Adam Smith, Friedrich von Hayek and Milton Friedman, and adopted as policies by Ronald Reagan and Margaret Thatcher in response to the rising proportion of Gross Domestic Product in the hands of the State.

Types of privatization

There are three main methods of privatization:

share issue privatization (SIP) - selling shares on the stock market
asset sale privatization - selling the entire firm to an investor, usually by auction
voucher privatization - shares of ownership are distributed to all citizens, usually for free or at a very low price.

Share issue privatization is the most common type.

Share issue can broaden and deepen domestic capital markets, boosting liquidity and potentially economic growth, but if the capital markets are insufficiently developed it may be difficult to find enough buyers, and transaction costs (eg underpricing required) may be higher. For this reason, many some governments elect for listings in the more developed and liquid markets such as Euronext, the London, New York or Hong Kong Stock Exchanges are popular because they are highly developed and sophisticated.

As a result of higher political and currency risk deterring foreign investors, asset sales are more common in developing countries.

Voucher privatization has mainly been used in the transition economies of Central and Eastern Europe - countries such as Russia, Poland and Czechoslovakia (Czech Republic and Slovakia).

Arguments for and against

See also: public ownership and welfare state

For

Performance. The government may only be motivated to improve a company when that poor performance becomes politically sensitive.
Improvements. Conversely, the government may put off improvements due to political sensitivity — even in cases of companies that are run well.
Corruption. The company may become prone to corruption; decisions may be made for political reasons, personal gain of the decision-maker (i.e. "graft"), rather than business ones.
Accountability. Managers of privately owned companies are accountable to their owners/shareholders.
Civil Liberty concerns. A company controlled by the State may have access to information or assets which may be used against dissidents or individuals who disagree with their policies.
Goals. The government may seek to run a company for goals other than business ones.
Capital. Privately-held companies can more easily raise investment capital in the financial markets, investment decisions are governed by market interest rates. State-owned ones have to compete with demands from other government departments.
Security. Governments have had the tendency to "bail out" poorly run businesses when, economically, it may be better to let the business fold, often due to the sensitivity of job losses.
Lack of market discipline. Poorly managed state companies are insulated from the same discipline as private companies, which could go bankrupt, have their management removed, or be taken over by competitors.
Natural monopolies. These exist also in the private sector, and Governments can enact or are armed with anti-trust legislation and bodies to deal with anti-competitive behaviour of all companies public or private.
Concentration of wealth. Ownership of and profits from successful enterprises are dispersed and diversified. The availability of more investment vehicles stimulates to capital markets and promotes job creation.
Political influence. Nationalized industries are prone to interference from politicians for political or populist reasons. Examples include making an industry buy supplies from local producers (when that may be more expensive than buying from abroad), forcing an industry to freeze its prices/fares to satisfy the electorate or control inflation, increasing its staffing to reduce unemployment, or moving its operations to marginal constituencies.
Profits. Private companies make a profit by enticing consumers to buy their products in preference to their competitors'. Private corporations exist to serve exactly the needs of their clients; their clients' propensity to pay is usually correlated with how well they serve the needs. Corporations of different sizes may target different market niches in order to focus on marginal groups and satisfy their demand.

The basic economic argument given for privatization is that governments have few incentives to ensure that the enterprises they own are well run. Governments have the de facto monopoly to raise money by taxation should revenues be insufficient. As Governments may borrow money more cheaply from the debt markets than private enterprises, they will squeeze out more efficient private companies through this misallocation of resources.

Where Governments lack it, it is said that private owners do have profit motive. The theory holds that, not only will the enterprise's clients see benefits, but as the privatized enterprise becomes more efficient, the whole economy will benefit. Ideally, privatization propels the establishment of social, organizational and legal infrastructures and institutions that are essential for an effective market economy.

Privatizing a non-profitable (or severe loss-making) company which was state-owned would shift the burden of financing off taxpayers, as well as freeing some national budget resources which may be subsequently used for something else. Especially, proponents of the laissez-faire capitalism will argue, that it is both unethical and inefficient for the state to force taxpayers to fund the business that it can't make work for itself. Also, they hold that the privatized entity would have to adapt to market forces or be penalised if it fails to adapt to the market reality by offering goods and/or services which are preferred by the customers.

The main political argument for privatization is that of civil liberties and privacy. A very substantial benefit to share or asset sale privatizations is that bidders compete to offer the state the highest price, creating revenues for the state to redistribute. Voucher privatisations, on the other hand, would be a genuine return of the assets into the hands of the general population, and create a real sense of participation and inclusion. Vouchers, like all other private property, could then be sold on if preferred.

Against

Opponents of privatization dispute the claims concerning the alleged lack of incentive for governments to ensure that the enterprises they own are well run, on the basis of the idea that governments are proxy owners answerable to the people. It is argued that a government which runs nationalized enterprises poorly will lose public support and votes, while a government which runs those enterprises well will gain public support and votes. Thus, democratic governments do have an incentive to maximize efficiency in nationalized companies, due to the pressure of future elections.

Furthermore, opponents of privatization argue that it is undesirable to transfer state-owned assets into private hands for the following reasons:

Performance. A democratically elected government is accountable to the people through Parliament, and is motivated to safeguarding the assets of the nation. The profit motive may be subordinated to social objectives.
Improvements. the government is motivated to performance improvements as well run businesses contribute to the State's revenues.
Corruption. Government ministers and Civil servants are bound to uphold the highest ethical standards, and standards of probity are guaranteed through codes of conduct and declarations of interest. However, the selling process could lack transparency, allowing the purchaser and civil servants controlling the sale to gain personally.
Accountability. The public does not have any control or oversight of private companies.
Civil Liberty concerns. A democratically elected government is accountable to the people through Parliament, and will intervene when civil liberties are threatened.
Goals. The government may seek use state companies as instruments to further social goals for the benefit of the nation as a whole.
Capital. Governments can raise money in the financial markets most cheaply to re-lend to State-owned enterprises.
Lack of market discipline. Governments have chosen to keep certain companies/industries under public ownership because of their strategic importance or sensitive nature.
Cuts in essential services. If a government-owned company providing an essential service (such as water supply) to all citizens is privatized, its new owner(s) could lead to the abandoning of the social obligation to those who are less able to pay, or to regions where this service is unprofitable.
Natural monopolies. Privatization will not result in true competition if a natural monopoly exists.
Concentration of wealth. Profits from successful enterprises end up in private, often foreign, hands instead of being available for the common good.
Political influence. Governments may more easily exert pressure on state-owned firms to help implementing Government policy.
Downsizing. Private companies often face a conflict between profitability and service levels, and could over-react to short-term events. A state-owned company would have a longer-term view, and be less likely to cut back on maintenance or staff costs, training etc, to stem short term losses.
Profiteering. Private companies do not have any goal other than to maximize profits. A private company will serve the needs of those who are most willing (and able) to pay, as opposed to the needs of the majority, and are thus anti-democratic.

Obstacles to privatisation

In practical terms, there are many pitfalls to be overcome when countries try to privatise and it is highly intertwined with political concerns, especially in post-communist economies or in developing nations where corruption is endemic. Even in nations with advanced market economies like Britain, where privatization has been popular with governments (if not all of the public) since the Thatcher era, privatization programs arouse many emotions, and raise many legitimate political debates. Controversial issues are, for example, valuations in the absence of well developed markets; balancing fiscal objectives with democratising ones - choice of share sale vs voucher; the level of worker or management participation in the sale; the extent of foreign ownership of privatized enterprises; the level of government which can privatize, and types of assets and thresholds. Nevertheless, there seems to be a shift in the climate compared to when privatization in the 1980s. It now seems more generally accepted that certain companies, such as BT, British Airways, belong in the private sector.

Privatization can potentially cause tremendous shocks in the short-term as the countries adjust to the abandonment of the command economy. Social fractures and upheavals have occurred, as privatizations often lead to mass redundancies, or sharp changes to consumer prices as price controls were lifted. This may lead to widespread despair and civil unrest. For example, in the Soviet Union, many state industries were not profitable under the new system, with the cost of inputs exceeding the cost of outputs, and have closed down. Privatization has been blamed for sixteen percent of the workforce becoming unemployed in both East Germany and Poland. Critics contend that it has impoverished millions to little social benefit in many post-Communist countries. On the other hand, proponents claim that Poland's and East Germany's economies will fare better in the long term, with positive social consequences that one can already see in those countries. In the process, the Russian government of Vladimir Putin has given over large chunks of Soviet industry to a small number of people named "the oligarchs" and who in turn support President Putin, and has gone from having one of the world's most equal distributions of wealth in the Soviet era to one of the least today. There has been a dearth of large-scale investment to modernize Soviet industries and businesses still trade with each other by means of barter.

Undeniably, the economies in the former Soviet bloc countries have been transformed by more liberal economic policies, and not just by privatization alone. The opening of the markets to imports has benefitted consumers by giving them higher quality, lower prices and better choices compared with the old national industries. However, one must take into account the specifics of the regime prevalent in those countries and the timescale to judge the success of privatisation. It was possibly the cumulative effects of mismanagement, the inattention to the market realities, lack of investment and innovation and the obsolescence of companies' assets that lead to fatal consequences.

Privatization, in the absence of a transparent market system, may lead to assets being transferred to a few very wealthy or influential people at the expense of the general population. This has occurred notably in Russia, Mexico, and Brazil, and discredits the process of economic reform in the opinion of the public and outside observers.

Moreover, in former planned economies where free-market policies are rapidly imposed, the bureaucratic tools necessary to regulate it may be underdeveloped or non-existent. This has been a pertinent problem in Russia and in many South American countries, although some other Central European countries, such as Poland and the Czech Republic, fared better in this respect, partly through the support of the European Union. Paradoxically, while Britain has long had a market economy, it also faced this issue after it privatized utilities in the Thatcher era; British utilities’ regulators have been criticized as being ineffective or "lacking in teeth".

Many have argued that the strategy of privatization in Russia differed from those seen in, for example, Hungary and Poland. The defects of the process in Russia, combined with capital market liberalization and failure to establish institutional infrastructure, have led to incentives for capital flight, contributing to economic contraction in Russia after the fall of the Iron Curtain in November 1989.

Large-scale programs of privatization can be associated with high unemployment, as was the case in Argentina. Formerly, the state was the largest employer in Argentina and average lay-offs by newly-privatized firms of close to 40% contributed to the drastic increase in unemployment during the 1990's.

Privatization can also have a ripple effect on local economies. State-owned enterprises are often required by law to patronize national or local suppliers. Privatized companies, in general, do not have that restriction, and hence will source their purchases from the cheapest supplier. It is also possible that local and national economies may be affected by increases in prices resulting from privatization - especially with services fundamental to business, such as postal, public transport and utility services, without which they cannot survive. Bolivia underwent a rigorous privatization program in the mid 1990s, with disastrous impact on the local economy in the short term.

The Wall Street Journal has reported that the World Bank, historically a supporter of denationalization in developing countries, has also begun to voice concerns over privatization. It no longer believes that privatization should be recommended in all cases. Mexico's President Vicente Fox has come under criticism for his plans to privatize Mexico's electrical power generating industry.

Finally, it has been argued that the Chinese economic reform has illustrated that economic reform can take place in the absence of large-scale privatization, though the Chinese government has been tenderly following limited forms of privatisation since the 1990's.

The above arguments have centered on whether or not it is practical to apply privatization in the real world, but some reject the profit incentive, the theoretical basis for privatization, itself. Some opponents of privatization argue that because the driving motive of a private company is profit, not public service, the public welfare may be sacrificed to the demands of profitability. There is no definitive answer, but it is very often argued that essential services, such as water, electricity, health, primary education, and so forth, should be left in public hands. This argument, of course, relies on the view on the obligations of the state, regarding what it should or should not be obliged to do. What is seen as desirable by a socialist may not be by a supporter of capitalism, and vice versa.

Obstacles to renationalisation

In reversing the trend of State ownership and central planning, economic power has undoubtedly shifted as a result of privatisation, and privatized enterprises cannot be renationalized so easily.

There is strong pressure exerted by international lending agencies, namely the International Monetary Fund, to maintain the pace of privatization.

Many entities have become hugely profitable since privatisation, making valuations and cash outlay more costly for Governments to renationalise.

Where share ownership of a company has become widespread, renationalisation would create a great number of potential losers, thus lost votes

As always, there will always be huge resistance from investors on grounds of property rights violations by the Government. Investors may take flight from the country concerned, fearing that any business they start could also potentially be taken from them.

Successes and failures

Most economists agree that consumers may be worse off if a natural monopoly is privatized without being subject to a strong and effective regulation, otherwise it will be prone to serious market failures when in private hands. This seems to have been the case with rail privatization in the UK and in telecommunications in Mexico; in both countries, public disaffection has led to government intervention.

Privatization has been notably successful in telecommunications in Europe because genuine competition has arisen: the former state-owned enterprises lost their monopolies due to legislation and technological change, competitors entered the market, and prices for broadband access and telephone calls fell dramatically.

British Rail is an example of privatization program that has been deemed a failure and largely abandoned. The track-owning company has been effectively repossessed by the British government, and many of the train-running companies are at risk of having their concession removed on the grounds that they fail to provide adequate services. One of them, Connex, actually had its franchise cut short in June 2003 by the government for what the Strategic Rail Authority called "poor financial management." In this case, one of the causes for the necessary renationalization was the incomplete nature of the privatization, not leaving enough incentive for the firm to make capital investments.

Outcomes

Nellis and Kikeri have shown that in competitive industries with well-informed consumers, privatization consistently improves efficiency. Such efficiency gains mean a one-off increase in GDP, but through improved incentives to innovate and reduce costs also tend to raise the rate of economic growth. The type of industries to which this generally applies include manufacturing and retailing. Although typically there are social costs associated with these efficiency gains, many economists argue that these can be dealt with by appropriate government support through redistribution and perhaps retraining.

In sectors that are natural monopolies or public services, the results of privatization are much more mixed, as a private monopoly behaves much the same as a public one in liberal economic theory. In general, if the performance of an existing public sector operation is sufficiently bad, privatization (or threat thereof) has been known to improve matters. Indeed, Megginson & Netter showed that the greatest gains from privatization are achieved in the pre-privatization period as reforms are made to prepare for the transfer to private hands. Changes may include, inter alia, the imposition of related reforms such as greater transparency and accountability of management, improved internal controls, regulatory systems, and better financing, rather than privatization itself.

Alternatives to privatization

Sub-contracting

It is possible that national services may sub-contract or out-source functions to private enterprises. A notable example of this is in the United Kingdom, where many municipalities have contracted out their rubbish collection or administration of parking fines by tender to private companies.

In addition, the British government is debating the possibility of involving the private sector more in the workings of the NHS, principally by referring patients to private surgeries to ease the load on existing NHS human resources, and covering the cost of this.

Part ownership

An enterprise may be privatized, with a number of shares in the company being retained by the state. This is a particularly notable phenomenon in Germany, where the state owns around a third of Deutsche Telekom. As of 2005, the state of North Rhine-Westphalia is also planning to buy shares in the energy company E.ON in an attempt to control spiraling costs.

Whilst partial privatization could be an alternative, it is more often a stepping stone to full privatization. It can offer the business a smoother transition period during which it can gradually adjust to market competition. Some state-owned companies are so large that there is the risk of sucking liquidity from the rest of the market, even in the most liquid marketplaces, and thus must be sold off bit by bit. The first tranche of a multi-step privatization would also in the first instance establish a valuation for the enterprise to mitigate complaints of under-pricing.

Notable privatizations

See also: List of privatizations

Privatization programmes have been undertaken in many countries across the world, falling into three major groups. The first is privatization programmes conducted by transition economies in Central and Eastern Europe after 1989 in the process of instituting a market economy. The second is privatization programmes carried out in developing countries under the influence of international financial institutions such as the World Bank and IMF. The third is privatization programmes carried out by developed country governments, the most comprehensive probably being those of New Zealand and the United Kingdom in the 1980s and 1990s.

Anti-privatization campaigns

Privatization proposals in key public service sectors such as water and electricity are in many cases strongly opposed by opposition political parties and civil society groups. Usually campaigns involve demonstrations and political means; sometimes they may become violent (eg Cochabamba Riots of 2000 in Bolivia; Arequipa, Peru, June 2002). Opposition is often strongly supported by trade unions. Opposition is usually strongest to water privatization - as well as Cochabamba (2000), recent examples include Ghana and Uruguay (2004). In the latter case a civil-society-initiated referendum banning water privatization was passed in October 2004.

References

unindexed

Clarke, Thomas (ed.) (1994) "International Privatisation: Strategies and Practices" Berlin and New York: Walter de Gruyter, ISBN 3110135698
Clarke, Thomas and Pitelis, Christos (eds.) (1995) "The Political Economy of Privatization" London and New York: Routledge, ISBN 041512705X
Juliet D’Souza, William L. Megginson (1999), "The Financial and Operating Performance of Privatized Firms during the 1990s", Journal of Finance August 1999
von Hayek, Friedrich, (1960) "The Constitution of Liberty"
Smith, Adam (1994) "The Wealth of Nations"
Stiglitz, Joseph Globalization and its Discontents

External links

Privatization Database - World Bank data on privatization in developing countries (1988 to 2003).
Stop Privatization
Cato Institute
Privatization.org (pro-privatization)
Privatization page on the NCPA website
Privatization of Social Security The original 1983 Cato/Heritage plan—now almost complete.
TheVanguard.Org

Macroeconomics

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