In 1990 March edition of the famed respectable Harvard Business Review (HBR), there is a note on the Efficiency of Privatised Former Government Enterprises.
The article is a summary of the researches to verify the claim of better efficiency from the privatisation process of formally government owned enterprises. The team involved spent 2 years going through all the available studies done according to academic research robustness standard in any language they could find.
The outcome of the study turned out to be very surprising.
Contrary to the assumption that a privatised enterprise will be more efficient than when it was under government ownership, the proof could not be obtained. Indeed, when the costs of higher charges to the users are included, the privatised entities become even less efficient than under government ownership. This is not an isolated case. Example after example, this is so in all the countries where privatisation programmes had been carried out. The conclusion is beyond all doubt that the claim of higher efficiency from privatisation process is non-sense.
I first read this article in 1993 while at the university library for some readings on finance. It had been several years since I left university with an honours in Finance. I had worked in Treasury capital market issuing bonds-debts for a bank, I had worked as share analyst and share portfolio manager for the same bank, for over 3 years I was a senior bond analyst for another bank during which I also had worked as an assistant bond option price maker. Later I worked as share analyst and portfolio manager again. My career was involved in high finance and at the coal face of capitalism.
Government ownership was something to me less than ideal. And privatisation was something logical as ‘efficiency gain’ was assured as most of us would assume.
Then this article appeared. For a while, I could not work out the logic behind it. Yes, LOGIC.
I say logic as the evidences are stark. Research Studies are not easily accepted for publications or put up for university academic research discussions. Other academics would go through the research materials, data, methodologies etc with fine comb. A small chink in the armour would be used to knock back the analysis and a paper would be in the bin and perhaps even academic career ruined along with it.
Hence with no exceptions, such conclusion that privatised enterprises actually become less efficient has to have some LOGICAL BASE. The logic has to be consistent with known and accepted Finance concepts.
There is one Financial Theory which could explain this phenomenon of less efficient privatised enterprises. I could not think of other Financial theories that could over turn this explanation. So here we go and let me explain what the logic behind this Harvard Business Review finding might be.
CAPITAL ASSET PRICING MODEL- CAPM
CAPM is a model that describes the EXPECTED RETURN OF A PROJECT.
ER = Rf + (Rm – Rf)B
ER is the Expected Return
Rf is the Risk Free Rate which is usually the government/treasury bond rate
Rm is the Market Return (market means the stock market in general)
B is Beta and represents the correlation between the project return and the market return, it is a measure of the performance of a project against the market, the higher Beta is, the higher the project’s return is vice versa. Each project, business, stock, investment etc has its own Beta.
All these parameters are time-dependent or they change with time and not constant. This is a crucial point for our discussions. We need to compare period to period. One period should not be used as the standard for all other periods.
This CAPM formula is not difficult and quite easy and we have good records for all of the factors involved especially the Rf (risk free rate or government bond rate) and Rm (market return).
While CAPM is only a model in term of the robustness of concept, it is used extensively in modern business management. From mining projects to government projects, CAPM is applied throughly to justify one project over another. The computed Expected Return from CAPM process is then used to work out the Net Present Value of a project and hence the viability of a project. In the stock market investment, CAPM and its market model (using actual market data) are used on a day to day basis for one method of investment approach.
CAPM hence is widely accepted and is a crucial tool in deciding the viability of a project and in some aspect of the investment industry.
So let us apply CAPM to the issue of Privatisation.
We have good data for the parameters for this formal except one.
Rf is the risk free rate or the government bond rate. We have such data readily available.
Rm is the market return or the stock market return data for which is also easy to obtain.
B or Beta is less well defined. It depends on the nature of the projects and the history of similar projects against the market performance. Luckily, most projects could be classified and assigned to their appropriate business-industry sector and even down to their sub-sector. We have the stock market returns of the stock of these industries and sub-sectors in general. So we could worked out the Beta for each sector-subsector and hence applicable to a project.
Let us however not focus on the Beta as it is project specific for the moment. The other two parameters are very easy to base our analysis on.
Back to the Harvard Business Review article. It was written in the early 90’s and with study subjects or privatisation processes mostly happened in the 1980’s. Now we are talking about economic history.
What happened in the 1974 and 1982 and hence the interest rate for this period?
We had first oil shock in 1974. We had second oil shock in 1982. These two major events gave the world high inflation rates that not seen in most economies since the 1920~1930’s. Well, the inflation rate levels in the 1920’s~1930’s were much higher than that in the 1970’s~1980’s.
With this high level of inflation rate, the interest rate was also high. The government bond rate used as the risk free rate in CAPM determination hence would be high.
And how about the stock market return or the Market Return for CAPM for the same period? Well, the return while not excellent was positive and certainly not negative.
CAPM formula for this period of the 1980’s would be high.
The Rm-Rf may be negative as the Rf was very high. But the difference is low, so the net result is that the ER is high even if the Rm is lower than Rf depending on the period chosen.
That is the ER for this period is high. Or in another word, any project would have high return expected due to the high bond rate at the time. If a project has very high Beta or its sector performed much better than the market as a whole, such expected return (ER) would be even higher. Or when the market return is low or negative, it would be higher or positive.
This high ER level of course would have been translated into higher profitability for any privatised enterprises.
But how is this compared with the RF under government ownership?
Well, in general, while the governments do use CAPM for some projects, the computed rate is often not used as there are other benefits that could not be quantified. These could be social benefits such as lower unemployments, better skill base for the economy, better health level, higher productivity, lower crime rate etc which could not be assigned a number easily. As a result, the adjusted CAPM ER would be lowered under government ownership.
That is, under the government ownership, ER for the same enterprise would be lower than under the private ownership.
This is just logical. If an enterprise is not making decent enough return, no one would ever invest in it in the private world. So a privatised enterprise has to have higher return than under government ownership which does not expect high monetary return as other non-monetary benefits compensate any low monetary returns.
Now how about the experiences in the 1990’s and first decade of the 21st century?
Well, while inflation rate has been benign in most of economies, the market return or the stock market performance has been brilliant to say the least till 2008. We had almost 2 decades of un-broken bull run.
So applying CAPM for the period of 1990s’ and 2000′ to 2010, of course we are going to have high ER again.
Hence, without considering Beta, in the last 3 decades, ER for any privatised formerly government enterprises would have to be high. Compared to the return under government ownership, these ER’s levels have been very high.
Let us look at Beta.
No business CEO would tell anyone that their business would under perform the general market as it would be a sign of incompetence. Regardless of the fact, no CEO would be that honest as the CEO would be out of the job immediate. This simply implies that these CEO’s would work out high CAPM ER. Then they would adjust their business practices which include higher charges to achieve these high levels of ER.
This CAPM based analysis is hence the logic behind Harvard Business Review’s findings on privatisation- privatised enterprises cost the whole economy more with higher charger to the users in general. I have a feeling this analysis has also at work for the privatisation outcomes around the world in the last 20 years. That is the HRB analysis outcome would be repeated had it applied to those in 1990’s to 2000’s.
In Finance, the economic term of efficiency is only looked at narrowly. There are no analyses of other efficiency gains such as lower workforce, higher productivity and better management plus higher investments as claimed by those supporting privatisations. However, I am not economist, and I have no data or any research that any or combination of the above considerations have been met by the privatisation. That is, the perception is non-supportive.
The HRB article authors see efficiency level in term of the charges to the users. They seem to say that higher chargers to the users are sign of lower efficiency. This does make sense. If a business privatised to become more efficient, such efficiency gains could be passed as lower costs to the users. When such higher gains are not passed down as lower charge but in contrast higher chargers are imposed, of course this would be seen as the outcome of lower efficiency. (I hope some economist could explain to me the definition of efficiency in business sense.)
Benefits of Privatisation to Government
Some will argue that the benefits for the privatisation process should not be enterprise centric or in another word, there are other benefits other than to the business itself. Eg, Some say that the government uses the proceeds to finance other projects and other enterprises. Some say that by using parts of the proceeds to pay back government debts, that is a good thing too. Let us look at the facts.
First let us examine the claim that the proceeds of the privatisation could be used to finance other projects or enterprises within the government. This is an interesting point not from the new project or new enterprise point of view. The focus should be on the amount of the proceeds or to be precise the valuation set for sale to the private sector- share market listing or direct sales to the private sector without going to the stock market.
The experiences of privatisation process, as far as stock market sale, is concerned has been a pitiful one from the government point of view. Almost all such privatisation valuations have been set at such low levels, that the proceeds to the government are low compared to the value of the enterprises in the stock market within a short period after privatisation.
In the stock market investment, there is a un-spoken rule that a newly issued stock has to be priced at ATTRACTIVE LEVEL for the stag to occur. The stag means the initial subscribers to the sales of the shares fist ever come to the market expect some comfortable return. That is, it must be a gift to the initial subscribers as it were. Otherwise the market wisdom would say that very few would participate in such initial sales and the sale may be aborted. That is why there is always an underwriter to such initial sales. The underwriter would take the losses. But underwriters always try to palm off such risks to others no matter what.
The stag is a very short period of time. It is usually less than 3 months. At say 10% return in less than 3 months, it is analysed equivalent is more than 40%- compounding effect. I can assure you that 10% is not high for most initial offering stags.
That is, automatically, the proceeds from any privatisation would not justify the true value of the enterprise. So how is that the government benefits from it using the proceeds to finance the other projects? Would it not mean the new investments would be lacking in finance already everything else being equal? Would it not also mean that the government has to divert resources from another means to cover the short fall? Or out another way, automatically the NET WORTH of the government is lowered. Net worth being the total sum of values of projects, enterprises and assets owned by the government. The assets also include cash such as the proceeds from the privatisation process. With one day, the Net Worth for the government is lower by the profits of the stag.
Secondly, let us look at the use of the proceeds to pay back government debts as the obvious benefit of selling government assets and enterprises.
Gee, let us go back to the 1970’s and 1980’s. The government bond rates were rather high. However it is well known that for 15 years to 1985, the average bond rate (long term bond rates) was 1% less than the inflation rate for the same period. (this was the figures in US and not dissimilar for other western economies.). That is the inflation rate was so high, government was better off to borrow at its favoured rate. So what was the sense of selling assets-enterprises to pay down government debts in these years? Indeed, most governments of the day did not bother as it was not wise at all. But there were some just would not take this into considerations.
How about the period since mid 1980? Well, up to mid 1990’s or for 10 years, the inflation rate was still relatively high but at the same period the government bond rates went lower with the inflation rate. The real rate of bond rate was just above negative for the 15 years period.
It was not till from 1996, have we seen consistent real positive government bond rare or the bond rate has been higher than the inflation rate. So intuitively one would say that paying government debts by selling government assets and government owned enterprises would be appropriate.
But there is an irony here.
Since mid 1990’s, the general interest rate level has been very low against the recent history as inflation has been benign. In the last 10 years and since the GFC, they are at historically low level.
Back to Finance 101. There is this more or less truism which says that when the general interest rate leave is low and at the same time when the market return is relatively high, one should borrow and invest the borrowed amount in the market at higher return. That is, one should not repay debt by selling any investment, asset or enterprise in such environment.
And we all know about the market return since the early 1990’s. There was a bull run longer than any other periods in history till late 2007.
Privatisation and using the proceeds of privatisation to pay back government debts since mid 1990’s would be against this Finance 101 law. It is anti-logic to sell high performance asset to pay low interest rate debts. Instead one should borrow more to finance more high return assets.
DOUBLE WHAMMIES
Hence the privatisation since the 1990’s would have been in general have 2 adverse impacts.
First, the governments have sold assets-enterprises at low valuation level making the finance of next projects more expensive. Or the government uses the proceeds to pay debts though the government bond rate has been low when the assets could have returned more. These 2 are the government side of the equation making government less efficient.
Second, the owners and the management of the newly privatised enterprises would, using CAPM against the high RM and high Beta, charge higher fees to use the same services to achieve high CAPM determined rate of return.
That is, not only the average users of the privatised enterprises pay more to use the same services, the government’s finance actually have got worse.
While the average users have no control over charges in most cases, the government certainly has different stance in privatisation.
CAPM and Debt Return vs Investment Return are two major concepts in Finance. It seems from the above analysis, privatisation processes have been conducted against the logics of these two most fundamental concepts in finance.
jiaberg 
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