A W O R L D B A N K P O L I C Y R E S E A R C H R E P O R T BU REAUC RATS IN BUSINESSd; THE ECONOMICS AND POLITICS OF GOVERNMENTI s . .. _ ..... \~~~~L... *-t K ,L EMBARGO - Esil~~~~~~~~~~~~~~~~~~~ni 200 GM (4 p.m -- *D1),L,aqW9 _ t ? ?~ > i '. I ; i-, t _ i WiE M B A R G O Not for publication or broadcast A - ; $ aw 1< ? i i- * _ - , - -, ~~tititit 20.00 C.II(ip.ml. LDT),l) _6 t i 2tt e \2 X , 1;_ ?> ' t ^r- 3 [ i SundaYv. October 8. 1995 a k \ I ,i , t r . B.VF .-~~~~~~~~~~~~.,~-- AM*ik' t ' '' kif- A World Bank Policy Research Report Bureaucrats in Business The Economics and Politics of Government Ownership SUMMARY The World Bank Washington, D.C. A Note to the Reader This summary of Bureaucrats in Business is an expanded version of the overview that opens the report itself. Like the overview, it dis- cusses the main findings of the report. It also summarizes our data and analytical approach and presents key figures and tables from the main text. Readers wishing more detailed information should consult the full report. (C 1995 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing September 1995 ISBN 0-8213-3455-7 Cover photographs: At the top, a coal-fired power station; Hilary Wilkes (International Stock). At the bottom, a labor demonstration; Peter S. Heller. eText printed on paper that conforms to the American National Standard for Permanence of Paper for Printed Librarv Materials, Z39.48-1984 Foreword P UBLICATION OF THIS REPORT COMES AT A PROPITIOUS TIME. Throughout the developing world and in the transition countries, Y governments are striving to reform their economies. Yet in many countries, particularly the poorest, some parts of the economy have re- mained stubbornly resistant to reform. This report deals with one of the more important of these: the inefficient, loss-making state-owned enter- prises that are a significant burden on government budgets and scarce resources in many countries. These enterprises hinder growth, impede market liberalization, and thus both directly and indirectly limit efforts to reduce poverty. Drawing on a unique data base and detailed case studies, the report analyzes which types of state enterprise reform measures have worked best. It describes the formidable obstacles governments face when at- tempting to divest state-owned enterprises or otherwise improve their performance, and how successful reformers have overcome these barri- ers. It looks at company experience in depth and creatively applies in- stitutional analysis to determine how contracts between management and government can serve as tools to reform enterprises. Finallv, it sug- gests policy courses to be pursued under different country and enter- prise conditions. One central finding of the report is encouraging: some governments have indeed overcome the obstacles. Following a comprehesive reform strategy, they have divested when possible and improved performance incentives for firms remaining in government hands. Trade and invest- ment have usually followed, bringing more rapid growth and enhanced opportunities for society at large. But why haven't more governments privatized or otherwise reformed state-owned enterprises? Reform entails political costs. Because politics is integral to reform, a study of reforms in public ownership cannot ex- clude political analysis. A key finding of the report is that political ob- stacles are the main reason that state enterprise reform has made so little headway in the last decade. The report makes an innovative attempt to objectively disentangle and measure the elements that constitute the po- .i.i litical constraints on reform. While this is a significant contribution, we should also bear in mind that our analytical knowledge of political processes, though arguably older, is less complete than that of economic forces and motives. It is an area in which additional analytical work and more data will no doubt enhance our knowledge in the years to come. However, it is our belief that the thrust of the main findings of this study will hold true even with further scrutiny and more observations. We hope that the research presented in this book will give political leaders, policymakers, and the broader development community a clearer picture of the substantial benefits that could result from state- owned enterprise reform and, just as important, a better understanding of how the obstacles to reform can be overcome. Bureaucrats in Business is the fourth in a series of Policy Research Re- ports designed to bring to a wide audience the results of World Bank re- search on development policy issues. While accessible to nonspecialists, books in the series also seek to move forward the discussion among aca- demics and policymakers of the appropriate public policy objectives and instruments for developing economies. Like previous Policy Research Reports, this report is a product of the staff of the World Bank; the judg- ments made herein do not necessarily reflect the views of its Board of Directors or the governments that they represent. l/L L Michael Bruno Vice President, Development Economics, and Chief Economist The World Bank September 1995 iv Summary B UREAUCRATS ARE STILL IN BUSINESS. DESPITE A growing consensus that governments perform less well than the private sector in a host of activities, and despite more than a decade of divestiture efforts in developing countries supported by the World Bank and other devel- opment institutions, state-owned enterprises (SOEs) ac- count for nearly as large a share of economic activity in the developing world today as they did twenty years ago. Indeed, data compiled for this study show that the size of the SOE sector has significantly diminished only in the former socialist economies and a few middle-income coun- tries. In most developing countries, particularly the poorest, bureaucrats run as large a share of the economy as ever. Government employees op- erate a casino in Ghana; bake cookies in Egypt; assemble watches in India; mine salt in Mexico; make matches in Mali; and bottle cooking oil in Senegal. More important, in many developing countries that con- tinue to support large SOE sectors, the inefficiency of the state-owned firms, combined with the attendant state enterprise sector deficits, are hindering economic growth, making it more difficult for people to lift themselves out of poverty. Consider these facts: * In many developing countries, SOEs absorb large amounts of funds that could be better spent on basic social services. In Tanzania, central government subsidies to SOEs equal 72 percent of central government spending on education and 150 percent of cen- tral government spending on health. * SOEs often capture a disproportionate share of credit, squeezing out private sector borrowing. In Bangladesh, SOEs take about one- I JPCRTS IN BUSINESS fifth of domestic credit, although SOE output accounts for less than 3 percent of GDP. * State-owned factories often pollute more than privately owned factories. In Indonesia, government factories discharge about five times as much water pollution per unit of output as private facto- ries of the same size and age engaged in the same activity. * A modest improvement in state-owned enterprise efficiency would substantially reduce and in some cases eliminate the fiscal deficit in most developing countries. In Egypt, Peru, Senegal, and Turkey, a mere 5 percent reduction in SOE operating costs would reduce the fiscal deficit by about a third. Many governments have announced plans to sell state-owned enter- prises and to improve the performance of firms that remain in govern- ment hands, but only a few developing countries have made measurable progress. Our study found that * Developing countries, excluding the transition economies, are di- vesting an average of just three enterprises per year, although most governments own hundreds of firms. * Although SOE deficits have declined, they continue to be a signifi- cant burden to government finances and developing-country banking systems. * Notwithstanding the sale of some very large firms, the state- owned enterprise share of developing market economies has re- mained stubbornly high since 1980, at about 11 percent of GDP, even as it fell in the industrial countries from about 9 percent to less than 7 percent. * The SOE sector is larger and the problems associated with it are more severe in the world's poorest countries, where SOEs account for 14 percent of GDP on average. In sum, although the potential gains from privatization and other re- forms are substantial, only a few countries have reformed their SOEs suc- cessfully. Why haven't more countries reformed their SoEs? What distin- guishes the few that have from the many that have not? What are the political obstacles to reform, and how have these been overcome? How can leaders and policymakers in developing countries hasten reform and increase the likelihood of success? And finally, what is the role of foreign aid? These are the questions our report sets out to answer. 2 To do so, we examine the economic problems that arise when bureau- crats are in business-that is, when governments own and operate enter- prises that could be run as private firms-and the political obstacles to change. We do not suggest that bureaucrats are to blame for these ills. To the contrary, we find that divestiture and other state-owned enterprise re- forms cannot succeed without a sound bureaucracy. But requiring bu- reaucrats to oversee businesses better handled by private entrepreneurs places a heavy toll on developing-country bureaucracies, diverting atten- tion from problems that only governments can address. Bureaucrats typ- ically perform poorly in business not because they are incompetent (they aren't) but because they face contradictory goals and perverse incentives that can distract and discourage even very able and dedicated public ser- vants. The problem is not the people but the system, not bureaucrats per se but the situations they find themselves in as bureaucrats in business. We begin our study by measuring the size and economic impact of the SOE sector in developing countries. As noted above, we find that SOE sec- tors remain large in many developing countries and that large SOE sectors have a negative effect on growth (chapter 1). To understand the differ- ences between the few countries that reformed successfully and the many that have not, we next investigate SOE reform efforts in twelve countries representing a broad cross-section of regions and experiences. Our sam- ple includes nine developing market economies (Chile, Egypt, Ghana, India, Mexico, the Philippines, Republic of Korea, Senegal, and Turkey) and three transition economies (China, the Czech Republic, and Poland). We find that countries that improved the performance of their SOEs made the most of divestiture, competition, hard budgets, and fi- nancial sector reforms. In addition, all twelve countries tried to improve the incentive structure by changing the relationship between government and state-owned enterprises. The last measure rarely worked alone (chap- ter 2). To discover why, we go a level deeper and explore changes at the enterprise level. We find that improving the performance of SOEs or pri- vatized monopolies requires a better incentive structure; that is, it re- quires rewriting the contract between government and SOE management, or between government and the owners of a privatized, regulated mo- nopoly, so that both are motivated to improve performance (chapter 3). Taken together, this analysis shows that divestiture and other reforms can indeed improve SOE performance but that only a few governments have adopted the policies necessary to reform successfully. Why haven't more governments attempted these policies? To answer this question, we 3 investigated the politics of SOE reform in our twelve-country sample, identifying political obstacles and the ways that successful reformers overcame them (chapter 4). What can policymakers and the develop- ment community do to speed the reform process? Our final chapter draws on the findings of the previous work to construct a decision tree that reform advocates can use in deciding whether or not a country is ready for reform and how to proceed in each instance. We conclude with a note that outlines ways foreign assistance can help encourage re- form. This summary highlights the central arguments and findings of the book, explains the methodology, and presents key pieces of evidence beginning with chapter 1. Bureaucrats Are Still in Business A RE STATE-OWNED ENTERPRISES A PROBLEM? TOO OFTEN the answer depends on where a person sits on the ideological spectrum. To minimize such subjectivity, we set out to deter- mine empirically whether and how SOEs influence the economies of de- veloping countries. Our first step was to define SOEs (see box 1). We 4 then assembled the best available evidence to estimate the size of the SOE sector in developing countries and to assess whether this has changed over time. We found that although governments are selling more and bigger enterprises, outside Eastern Europe, the former Soviet Union, and a handful of other countries, the SOE sector has remained stub- bornly large. We also found that large SOE sectors can hinder growth for a variety of reasons, in part because individual SOEs are usually less effi- cient than private firms and in part because the resulting aggregate SOE deficits are typically financed in ways that undermine macroeconomic stability. In addition, subsidies to SOEs often divert scarce funds from growth-enhancing public spending, such as education and health. Fi- nally we found that because SOE sectors tend to be larger in low-income countries, SOEs are likely to be most costly in the countries that can least afford them. Below we summarize the evidence for these findings. Some Governments Are Selling More-and More Important-Enterprises The number of countries selling state-owned enterprises increased in the 1980s, as divestiture spread from the industrial countries, notably the United Kingdom, to developing countries throughout the world. In the 1990s, many governments intensified their efforts, selling more en- terprises and shifting their attention from small firms operating in com- petitive markets to large monopolies. Mass privatization efforts were begun in Eastern Europe and the republics of the former Soviet Union. The growing number of countries undertaking divestitures and the shifting regional focus are shown in table 1. There were more than four times as many transactions in the six years from 1988-93 as in the pre- vious eight years (1980-87)i. Although most of the increase was due to the explosion of privatization activity in the transition economies of Eastern Europe and Central Asia, the number of divestitures increased more than fourfold in Latin America and more than threefold in the rest of Asia. Even Sub-Saharan Africa experienced an increase in divestitures, albeit a much more modest one that left the continent with fewer privat- izations than any other developing region. As a result of these increases, developing countries accounted for 86 percent of transactions in the sec- ond period, up from 66 percent during the first. The available information on the size and nature of divested enter- prises supports the view that divestiture was not only more common, 5 _ M INESS Table 1 Divestiture in Developing Countries, 1980-93 1980-87 1988-93a 1988-93a Value of Percentage Number of Percentage Number of Percentage transactions of worldwide Region transactions of total transactions of total ($ billions) value Africa 210 46 254 11 3.2 3 Asia 108 24 367 16 19.7 21 Latin America 136 30 561 25 55.1 57 Eastern Europe and Central Asia 2 ob 1,097 48 17.9 19 Total developing 456 100 2,279 100 96.0 100 Industrial countries 240 376 174.9 Divestitures worldwide 696 2,655 270.9 a. Figures are from Sader (1994), who excludes privatizations with a sales value less than $50,000, any divestirures where state-owned enterprises were simply shut down and the assets mothballed, and all mass voucher divestitures. The latter comprises an especially signifi- cant form of divestiture in some Eastern European and Central Asian economies such as Russia and the Czech Republic. b. Less than one percent. Source: Derived from Candoy-Sekse (1988), Sader (1993), and Gelb and Singh (1994). but also more significant during the second period. While data on the value of firms sold during the first period are not available, country evi- dence and a sectoral breakdown indicate that early sales involved rela- tively small state-owned enterprises, primarily in agribusiness, services, and light manufacturing. In 1988-93, by contrast, divestiture included the sale of large state-owned enterprises in such important sectors as electric and water utilities, transportation, and telecommunications, as well as major firms in the financial and industrial sectors (table 2). Of the $96 billion in public revenue generated by divestiture in developing countries during this period, the largest share ($32 billion) came from infrastructure. Even the $12.1 billion in sales revenue from the primary sector during this period is largely attributable to the sale of petroleum- related activities, which tend to be large scale; mines and agribusinesses account for most of the remainder. Further analysis of the data on the number and value of transactions in table 1 reveals wide regional divergence in the average size of firms. Latin America, with just one-fourth of the transactions, accounts for al- most 60 percent of the value, while Central and Eastern Europe, with al- most half of the transactions, accounts for only 19 percent of the value. This may reflect the greater experience with divestiture in Latin Ameri- can countries, enabling them to sell larger enterprises; Central and East- ern European governments, new to the process, were selling smaller en- 6 Table 2 Revenue from Divestiture in Developing Countries by Region and Sector, 1988-93 (dollars, billion) Total Region Primary Industrial Finance Infrastructure Others revenue Africa 0.7 0.5 0.3 0.1 1.6 3.2 Asia 1.8 6.4 2.6 7.4 1.5 19.7 Latin America 8.2 9.9 13.3 22.5 1.2 55.1 Eastern Europe and Central Asia 1.4 8.9 3.7 2.0 1.9 17.9 Total 12.1 25.7 19.9 32.0 6.2 95.9 Total number of divestitures 392 1,036 146 267 438 2,2t9 Total divestitures for 1980-87 126 92 35 51 152 456 Note: Figures exclude privatizations with a sales value less than $50,000, divestitures where srare-owned enterprises were simply shut down and assets mothballed, and all mass voucher divestitures. Source: Derived from Candoy-Sekse (1988) and Sader (1993). terprises, as well as giving away shares through mass privatization schemes. Asia, with 16 percent of the transactions and 21 percent of the value, is second only to Latin America in average revenue per sale. By contrast, Africa, with a slim 11 percent of transactions, accounts for an even slimmer 3 percent enterprise of value. This may reflect a smaller av- erage size of African enterprises as well as a greater reluctance by govern- ments in the region to sell off large state monopolies. Governments Are also Investing Less in SOEs Consistent with the perception that governments have reduced the role of SOEs in the economy is the decline in their share in investment over the period 1978-91 (figure 1). Although they still absorb a larger percentage of investment in developing countries than in industrial countries, the share of SOES in investment in developing countries has fallen from 22 percent in the earlv 1980s to 19 percent in the early 1990s. Again we see significant regional variation. But the Importance of the SOE Sector Worldwide Has Not Declined Sales of more, and more important, enterprises as well as the declin- ing share of SOE investment would tend to suggest that the importance of soEs has diminished in recent years. Neither trend, however, appears to have made a significant dent. First, although divestiture has grown, it 7 _;~~:9 O ~SINESS Figure 1 Share of State-Owned Enterprise Investment in Gross Domestic Investment, by Region Percentage of domestic investment 50 40 30 20 Lai _A~_ eeopn cnme Industrial economies 10 The state-owned enterprise share of gross domestic investment has been slowly declining everywhere. 0 1978 1980 1982 1984 1986 1988 1990 Source: Bureauicrats in Business statistical appenidix. is still small relative to the stock of SOEs. Dividing total transactions worldwide (3,351) by the number of divesting countries (ninety-five) over thirteen years (1980-93) yields an annual average of less than three divestitures per country per year against hundreds of enterprises that could have been divested in almost all countries.2 In fact most countries fell well short of the average, because transactions have been concen- trated in only a few countries. The small number of divestitures relative to the total number of SOEs, the concentration of sales in only a few countries, and the fact that the decline in the SOQ share of investment will only gradually reduce the size of SOE capital stock relative to the rest of the economy all suggest that the importance of the SOE sector on average has remained substantially unchanged in developing countries. The share of state-owned enterprises in developing-country GDP supports this view. Excluding the transition economies, SOE value added as a percentage of developing-country GDP has not decreased over time (figure 2). In the late 1980s it was about 11 percent, little 8 Figure 2 Share of State-Owned Enterprises in Gross Domestic Product, by Region Percentage of GDP 16 14 12 Developing economies Latin America ~. 8 --'-. ~~~~ *--. I~~~ndustrial economies 6 4 But the state-owned enterprise share 2 of gross domestic product has remained about constant, except in 0 _ the industrial economies. 1978 1980 1982 1984 1986 1988 1990 Soa oce: Bureauczars itn Buisiniess statistical appendix. changed from the beginning of the decade and higher than in the late 1970s. In contrast, SOEs share of GDP in industrial countries fell from about 9 percent in 1982 to less than 7 percent by 1988. During the 1986-91 period as a whole, setting aside the transition economies, SOEs played the biggest role in Africa, where they accounted for an average of 14 percent of GDP, followed by Latin America with 10 percent and Asia with 9 percent. The premise that state-owned enterprises continue to play an impor- tant role in developing economies is also supported by the lack of change in the SOE share of total employment (figure 3). As with other measures, however, important variations exist at the regional level. SOEs in Africa accounted for 23 percent of employment in 1991, up from 19 percent in the early 1980s (figure 3). In contrast, SOEs accounted for only about 2 percent of employment in Latin America in 1990-91, a share that has declined slightly. The SOE share of employment has re- mained steady in Asia, at a modest 3 percent. 9 _~~~~USINESS Figure 3 Share of State-Owned Enterprise Employment in Total Employment, by Region Percentage (unweighted averages) 25 20 15 Developing economies 10 . 5 Asia The state-owned enterprise share in _ total employment has shown little Latin America change over time. 0 1978 1980 1982 1984 1986 1988 1990 Source: Bureauoratf in Business statistical appenidix. SOEs Are Most Important in the Poorest Countries Generally, the evidence suggests that the poorer the country the larger the relative size of its SOE sector. During the 1980s, SOEs ac- counted for a substantially larger share of the economy in low-income countries than in middle-income countries; while the SOE share of the economy in high-income countries was the lowest of all. Moreover, in contrast to the high- and middle-income countries, where the average share of SOEs in the economy has declined, the share of SOEs in the less developed economies-higher to begin with-has held nearly constant. The charts in figure 4 show the share of SOEs in GDP, gross domestic in- vestment, and total employment for low-income and middle-income countries. In middle-income countries, the importance of SOEs in GDP, gross domestic investment, and employment peaked in the mid-1980s and has fallen since. In the low-income countries, only one measure, the I0 Figure 4 Three Measures of SOE Importance in Low-income Economies A. State-Owned Enterprise Share in Gross Domestic Product Percentage (unweighted averages) 16 14 1 40 developing economies 10 6 4 2 0 1978 1980 1982 1984 1986 1988 1990 B. State-Owned Enterprise Share in Gross Domestic Investment Percentage (unweighted averages) 35 30~~~~~I lowinome economies 30 25 2 55 developing economies 20 15 37 middle-income economIes 10 S 0 1978 1980 1982 1984 1986 1988 1990 C. State-Owned Enterprise Share in Employment Percentage (unweighted averages) 18 16 10 low-income economies 14 12 21 developing economies 8 11 middle-income economies 6 These figures show that, despite 4 divestiture efforts, SOES continue to 2 play an important role in developing 0 economies, especially the poorest. 1978 1980 1982 1984 1986 1988 1990 Source: Bureaucrats in Business statistical appendix. II _|S0IN E ~SINSS state-owned enterprise share of investment, has fallen since the mid- 1980s; even that began to climb again in 1990. These measures clearly indicate that, despite divestiture efforts, state- owned enterprises continue to play an important role in developing economies, especially in the poorest countries. Whether or not this is a problem depends upon the impact of SOEs on the economy. If that impact is negative, then reform is vital, especially in least developed economies. How SOEs Affect Economic Performance W H HAT IS THE IMPACT OF STATE-OWNED ENTEPRISES ON the economy? Although a handful of SOES undoubtedly perform very well, there is a wealth of anecdotal evidence suggesting that many more do not. Consider the following examples: * In Turkey, Turkiye Taskorumu Kurmu, a state-owned coal mining company, lost the equivalent of about $6.4 billion between 1986 and 1990. Losses in 1992 worked out to about $12,000 per worker, six times the average national income. Yet health and safety conditions in the mine were so poor that a miners' life ex- pectancy was forty-six years, eleven years below the national aver- age. In short, the miners and the government would have been better off if the government had imported coal and paid the miners to stay home. * In the Philippines, the performance of the National Power Corpo- ration steadily deteriorated from 1985 until the early 1990s. In 1990 the capital region alone lost an estimated $2.4 billion in eco- nomic output due to power outages. By 1992-93, electricity was shut off about seven hours a day in many parts of the country. * In Bangladesh in 1992, the state sugar milling monopoly had twice as many office workers as it needed, or about 8,000 extra employees. Farmers near the outmoded state mills were required to sell their sugar cane to the government at below market prices, with the result that many planted other crops, causing a shortage of cane. Mean- while sugar cost twice as much in Bangladesh as it did internationally. * In Tanzania, the state-owned Morogoro shoe factory, built in the 1970s with a World Bank loan, never manufactured more than 12 about 4 percent of its supposed annual capacity. Designed to turn out four million pairs of shoes a year, four times the international norm, the factory planned to export three-quarters of its produc- tion to Europe, even though Tanzania lacked high quality leather, experienced designers, and shoe assembly-line workers. Ill-suited to Tanzania's tropical heat, with steel pillars, aluminum walls, and no ventilation system, the plant deteriorated quickly after it was commissioned. Production ceased in 1990. Of course such anecdotal evidence, no matter how disturbing, does not constitute a convincing argument for or against state ownership, nor does it enable us to quantify the impact on the economy and wel- fare of large SOE sectors. Chapter 1 of the full report presents a detailed assessment of this crucial issue. It begins by presenting arguments and empirical evidence at the microeconomic level. It finds that, on bal- ance, private firms are more efficient than SOEs in markets that are competitive or potentially competitive and that, under certain circum- stances, the same is true in monopoly markets as well. Included in this analysis is an assessment of the welfare consequences of privatizing SOEs and recent findings about the negative impact of SOEs on the environ- ment. It then turns to the way that SOE sectors in the aggregate finance their operation and expansion, given that their finances may under- mine fiscal stability and fuel inflation. Finally, the analysis draws on the microeconomic and finance discussions to consider the impact of large SOE sectors on growth. Here we summarize the evidence on the financ- ing of aggregate SOE sector deficits and the overall impact of SOEs on growth. The Impact of Financing Aggregate SOE Deficits State-owned enterprise sectors are often unable to generate the re- sources to finance their operation and expansion and service their debt. The resulting shortfall is the state-owned enterprise savings-investment deficit (or SOE S-i deficit), defined as the difference between the SOE sec- tor's current surplus and investment. This deficit is filled by government transfers, domestic private savings, foreign borrowing, or a mix of all three. Evidence presented in the report suggests that large and continu- ous s-i deficits typically indicate poor enterprise performance and can hurt economic growth in a variety of ways. 13 _ i N E S~`kij NSS Our data suggest that the SOE S-i deficit has narrowed somewhat in developing countries overall; however, improvements are concentrated in middle-income countries while in the poorer countries the problem remains acute. Figure 5 shows trends in SOE savings minus investment as a percentage of GDP for the forty-six developing countries for which data were available. For the entire group, the annual average s-i deficit went from 2.2 percent of GDP during 1978-85 to 0.8 percent during 1986-91. However, the figure also reveals a worrying divergence of trends in the SOE S-l deficit in middle-income countries, on one hand, and the low-income countries, on the other. From 1978 until the mid- 1980s, the average ratio of the s-i deficit to GDP narrowed for both groups. After 1985, the SOE S-t deficit in the twenty-nine middle- income countries in the sample continued to narrow, to the point where SOEs in these countries showed a surplus in 1990. But the seventeen poor countries in the overall sample lost ground, so that their SOE S-I deficit fell back to an average of 1.7 percent of GDP during 1986-91. Figure 5 State-Owned Enterprise Savings Minus Investment Percentage of GDP (unweighted averages) 29 middle-income economies -2 17 low-income economies The soE savings-investment deficit improved in most countries until the mid-1980s. Since then it has deterio- rated in the poorest countries. -4 1978 1980 1982 1984 1986 1988 1990 Source: Bureaucrats in Business statistical appendix. 14 Assessing the Impact of State Ownership on Growth The generally poor performance of SOEs at the microeconomic level described in the report and the SOE s-i deficit at the aggregate level sum- marized here suggest that a large SOE sector is likely to have a negative impact on growth in a variety of ways. At the microeconomic level, the inefficiency of individual SOEs would be expected, in the aggregate, to exert a drag on growth, so that, other things being equal, the larger a country's SOE sector, the lower its growth rates. Moreover, the more ex- tensive government ownership in an economy, the greater the likelihood that bureaucrats, facing perverse incentives and contradictory demands, are running businesses in which private entrepreneurs, facing clear-cut incentives for profit maximization in competitive markets, would be more efficient. Furthermore, at the aggregate level, the financial burden of SOE deficits can crowd out expenditure on growth-enhancing social services, such as basic health and education. Figure 6 shows the percent- age that governments could increase spending on education and health if they eliminated direct SOE subsidies. Diverting SOE operating subsi- dies to basic education, for example, would increase education expendi- tures by 50 percent in Mexico, 74 percent in Tanzania, 160 percent in Tunisia, and 550 percent in India. The other cost to growth of SOE deficits, the impact on fiscal stability and inflation, is harder to quantify but perhaps ultimately more impor- tant, given the abundant evidence of the importance of macroeconomic stability to long-term growth.3 A large SOE s-i deficit can be financed in a variety of ways, all of which have a potentially negative impact on growth. For example, a government may resort to central bank financ- ing, effectively printing money to pay SOE bills, with the attendant in- flationary pressures. Alternatively, the government may direct the bank- ing system to loan money to financially strapped SOES, diverting credit that would otherwise have gone to the private sector. Finally, govern- ments may borrow abroad to finance SOE deficits, contributing to a bal- ance of payments deficit and hence the current account deficit, and ex- erting downward pressure on the real exchange rate. Our data strongly support the premise that the larger the SOE sector's overall deficit, the larger the fiscal and current account deficits. The average annual SOE s-i deficit for thirty-eight developing countries from 1978 to 1991 moves closely in tandem with their fiscal and current account deficits (figure 7), and the SOE deficit is also correlated with both deficits. That the '5 _EFSI0NE$tNSS Figure 6 Explicit Operating Subsidies to State-Owned Enterprises A. Transfers to SOEs as a Percentage of Central Government Education Budget India _ Tunisia Tanzania Mexico Turkey Senegal Egypt Morocco Kenya Colombia Peru Guatemala Thailand 0 20 40 60 80 100 120 140 160 550 Percent B. Transfers to SOEs as a Percentage of Central Government Health Budget India Mexico Tunisia Turkey Tanzania Senegal Egypt Morocco Kenya Colombia Peru Subsidies to SOES consume scarce Guatemala government funds that could better be spent on education and health. Thailand 0 50 100 150 300 350 400 450 500 550 600 Percent Source: IMI-; statistical appendix. I6 Figure 7 Indicators of State-Owned Enterprise Performance in Thirty- Eight Developing Countries Percentage of GDP (unweighted averages) 2 0 -2 4 > 5. P -¢- C > ~~~~~~~~~Government fiscal deficit A ' -6 ionaf current account deficit The SOE savings-investment deficit National cunrent account deficit moves closely in tandem with fiscal -8 and current account deficits. 1978 1980 1982 1984 1986 1988 1990 Source: Statistical appendix. SOE s-i deficit is important for fiscal stability is further evidenced by the fact that it averaged 35 percent of the fiscal deficit in the same thirty-eight countries (measured by the ratio of the means of both variables). In sum, then, the evidence supports the premise that large SOE sectors can hinder grozvth. Moreover, because soE sectors tend to be larger in low- income countries, state-owned enterprises are likely to be most costly in the countries that can least afford them. What Makes for Success in State-Owned Enterprise Reform? M OOST DEVELOPING COUNTRIES FACE THE STATE-OWNED enterprise problems described above, and many have an- nounced their intention to reform. Yet few have made mea- '7 surable progress. What differences in policy distinguish the few success- ful countries from the many that have failed? To find out we first as- sessed the impact of SOE reform in twelve countries, then analyzed the differences in policy. Table 3 shows the key characteristics of the coun- tries in our sample, which includes nine developing market economies and three former socialist economies in transition. Although the sample is small and nonrandom, it covers a mix of regions, income levels, and reform strategies. Neither our sample nor any of our indicators are per- fect. Even so, they reveal patterns that help us to understand the main components of successful SOE reform. To measure success objectively, we selected five quantifiable indica- tors: two measures of state-owned enterprise financial returns, two of state-owned enterprise productivity, and the state-owned enterprise savings-investment deficit. Using these indicators, we find that Chile, Korea, and Mexico achieved the best results; their SOE sectors performed better than the other countries and they were able to improve on their Table 3 Twelve Countries Undertaking State-Owned Enterprise Reform Country characteristics Public enterprise characteristics Average per Average size Beginning of capita GNmJ of SOEs to GDP' SOE reform (dollars, (percent, (year, Country 1978-91) Rankb 1978-91) approximately) Chile 1,784 85 13.8 1974, 1985 China 315 28 53.Oc 1984 Czech Republic 2,254 83 95.9 1991 Egypt 594 46 34.1 1991 Ghana 384 36 7.0 1983 India 286 18 12.1 1985 Republic of Korea 2,872 106 9.9 1983 Mexico 2,324 99 11.6 1983, 1988 Philippines 639 27 1.9 1986 Poland 1,967 76 71.4 1990 Senegal 519 48 7.7 1986 Turkey 1,324 80 7.5 1983 a. For the transition economies, average per capita GNI is for year 1991; average size of SOEs to (,DP is for 1989 except for China, which is for industrial state enterprises in 1990. b. Rank is relative to 132 countries. c. Share of industrial (GDP. Source: World DevelopmentReport (1994); Bureaucrats in Business table Al in statistical appendix; Gelb and Singh (1994). already good performance. Egypt, Ghana, and the Philippines had mixed results; and India, Senegal, and Turkey had the poorest results. Although we lacked comparable data for ranking the three transition economies, partial indicators suggest that China, the Czech Republic, and Poland show mixed to good results. What explains these differences? To find out, we considered the extent to which each country in our sample used five components of reform that economic theorists and reform practitioners widely recommend- divestiture, competition, hard budgets, financial sector reform, and changes in the institutional relationship between SOEs and government. Wefound that the more successful reformers made the most of allfive com- ponents. Indeed, they used them not as separate options but as mutually supportive components of an overall strategy. Other countries in our sample achieved less in individual reform elements and followed a less comprehensive strategy overall. The successful reformers both divested more (especially where the state-owned enterprise sector of the economy was more than 10 percent of GDP, table 4) and reformed remaining SOEs the most, and they pur- sued reform more comprehensively. Thus they introduced more compe- tition by liberalizing trade, easing restrictions on entry, and unbundling large enterprises. Then they divested many of their SOEs in competitive sectors, reducing the risk that government, under political pressure, sub- sidizes SOEs to help them cope with private competition. Competitive pressures only improve performance if SOEs face hard budgets. So suc- cessful reformers also hardened budgets by reducing or eliminating di- rect subsidies, putting access to credit on a more commercial basis, strengthening regulation of SOE monopoly prices, and reducing or clim- inating hidden subsidies (see box 2). To ensure that SOEs could not get easy access to credit, successful SOE reformers also reformed the financial sector. They strengthened supervision and regulation, relaxed controls over interest rates, and re- duced directed credit. They also relaxed entry restrictions and privat- ized banks once SOE reform and supervisory and regulatory reform were well under way. Although the less successful reformers have in- troduced some financial reforms, they have not yet been able to over- come a history of underdeveloped financial systems, subservient to state direction. Surprisingly, successful and unsuccessful reformers alike tried to im- prove the incentive structure by changing the relationship between SOE I9 Table 4 Successful Reformers Divested More SOE value added as percentage of GDP Revenue from Before divestiture After divestiture sale as Country Year Size (percent) Year Size (percent) of 1990 GDP Better performers Chile 1973 39.0 1991 8.0 9.4 Republic of Korea 1980 10.4 1990 10.2 1.0 Mexico 1983 17.2 1991 8.4 8.7 Mixed peiformers Egypt 1982 38.9 1991 32.8 0.0 Ghana 1986 10.6 1991 10.7 1.2 Philippines 1983 1.7 1989 3.0 0.9 Poor performers India 1983 11.1 1989 13.8 0.1 Senegal 1984 10.3 1989 - 0.9 Turkey 1983 7.3 1991 7.2 1.1 Transition economies' China 1978 80 Ob 1991 53*0b 0.9 Czech Republic 1989 95.9 1992 80.0 8.1 Poland 1989 71.4 1992 52.5 2.2 - Not available. a. Estimated. b. Share of industrial GDP. Source: Privatization Yearbook (1992); Hachette and Liiders (1993); Sader (1994); Tandon (1992); Morin (1993); European Bank for Reconstruction and Development (1993); State Statistical Bureau (1992, 365); Gelb and Singh (1994). managers and the government. Countries at the top and bottom of our performance ratings introduced new oversight bodies, increased man- agerial autonomy, and signed explicit performance agreements. Why did the apparently similar efforts to change institutions produce different results? Partly, such institutional reforms only work in con- junction with the other reforms just described. In addition, there may be differences in the ways that countries designed and implemented these changes that would show up only at the microeconomic level, in detailed company level analysis. To find out, we analyzed the ways that governments rewrote their contracts with managers of state-owned en- terprises, with private managers contracted to run government firms, and with the owners of privatized, regulated monopolies. 20 Contracting: What Works, What Doesn't, and Why EACH RELATIONSHIP BETWEEN A GOVERNMENT AND THE MAN- ager of a state-owned enterprise, between the government and private managers of stare assets, or between a government and the owner of a regulated, private monopoly, can be seen as a contract, that is, an agreement between the government and the other parry based on shared expectations. Such written contracts have been estab- lished for only a small proportion of the state-owned enterprises worldwide, but their use is growing. Countries often use contracts for their most important and problematic activities, such as infrastructure monopolies (electricity, water, telecoms), and major exporters and rev- enue earners (tea in Sri Lanka, gold in Ghana, and hotels in Egypt). Yet little is known about whether such contracts work, what distin- guishes the successful contracts, or which type of contract works best in which circumstances. Chapter 3 of our study focused on three types of contracts: 21 _ N E S~~~~~~~~~ES m performance contracts, which define the relationship between a government and public employees managing a state-owned enterprise m management contracts, which define the relationship between a government and a private firm contracted to manage an SOE * regulatory contracts, which define the relationship between a gov- ernment and the owners of a private, regulated monopoly. For each type of contract, we first examined a sample of firms to de- termine whether in each instance the contract improved performance as reflected in such indicators as return on assets, labor productivity, and total factor productivity. Comparing performance before and after implementation of the contract, we found that performance contracts worked least well. Management contracts worked better, but only in the specific circumstances described below. Regulatory contracts worked well for enterprises in monopoly markets, provided that they were properly designed and implemented. Overall, then, the greater the participation ofprivate agents in ownership and management, the better enterprise performance. To better understand the differences between successful and unsuc- cessful contracts, we analyzed how each contract handled three types of problems: information asymmetry, rewards and penalties, and commit- ment. Information problems arise because contracting agents (govern- ment on the one hand and public or private managers or owners of a monopoly, on the other) have different sets of information; thus each side can use the information it holds exclusively to improve its position at the expense of the other. At the same time, because future events are unknown it is impossible to design a contract that will cover all even- tualities. To alleviate the information problems and contract imperfec- tions, contracts usually include promises of rewards andpenalties to in- duce the contracting parties to reveal information and comply with contract provisions. But promises of rewards and penalties alone are not enough. Each party needs to be convinced of the commitment of the other to actually deliver. Like a chain with three strong links, contracts that include mechanisms to handle problems of information, rewards and penalties, and commitment are best suited to attaining the desired outcome-improved enterprise performance. We summarize our findings about each type of contract below. 22 Performance Contracts Rarely Improve Incentives and May Do More Harm than Good Performance contracts were used in twenty-eight developing coun- tries in the mid-1990s, mostly in Asia and Africa. Our analysis of a sam- ple of twelve companies in six countries (listed in table 5) gives little sup- port to the premise that these contracts help improve SOE performance. As figure 8 shows, only three of the twelve case study companies showed a turnaround or acceleration in total factor productivity (TFP) after con- tracts were introduced (Ghana Water, Mexico Electricity, and Senegal Telecoms), six continued their past trends, while three performed sub- Table 5 Case Study Enterprises First contract Country (contract type) Enterprse name: NAME USED IN TEXT Contract duration year Ghana (performance contract) Electricity Corporation of Ghana (ECG): Yearly 1989 GHANA ELECTRICITY Ghana Water and Sewerage Corporation (GWSC): 1989 GHANA WATER Ghana Posts and Telecommunications (GP&T): 1990 GHANA TELECOMS India (memorandum of National Thermal Power Corporation (NTPC): Yearly 1987 understanding) INDIA ELECTRICITY (published) Oil and Natural Gas Commission (ONGC): INDIA OIL Korea (performance evaluation Korea Electric Power Corporation (KEPCO): List of yearly 1984 and measurement system) KOREA ELECTRICITY targets Korea Telecommunications Authority (KTA): KOREA TELECOMS Mexico (convenio de Comisi6n Federal de Electricidad (CFE): 3 years 1986 rehabilitaci6n financiera) MEXICO ELECTRICITY Philippines (performance Metropolitan Water and Sewerage System List of yearly 1989 monitoring and evaluation (MWSS): PHILIPPINES WATER targets system) National Power Corporation (NPC): PHILIPPINES ELECTRICITY Senegal (contrat plan) Societe Nationale d'Electricite (SENELEC): 3 years 1987 SENEGAL ELECTRICITY Societe Nationale des Telecommunications du 1986 Senegal (SONATEL): SENEGAL TELECOMS Source: World Bank data. 23 _USINESS Figure 8 Pre- and Postcontract Performance: Total Factor Productivity (indexed to base year) A. SOEs Showing Turnaround or Accelerating Improvement 4 3- 2 1 0 -2 Base year 2 4 6 B. SOEs Showing Deterioration 1.5 1.0 0.5 Performance contracts were followed Philippines Water by improved trends in total factor / productivity (TFP) in three of the /India Electricity seven cases for which data were available. TFP trends in three cases deteriorated. o -5 -3 -1 Base year 1 3 5 Source: Company data and World Bank estimates. 24 stantially worse under contracts than before. The trends in rates of re- turn on assets deteriorated for three firms; the rest show little change. Only two firms show a kink in their trends in labor productivity. Why did performance contracts have so little impact on performance? We found that these contracts did not improve, and in some cases exac- erbated, the poor incentive structures facing government managers. In- deed, performance contracts failed to address all three contracting prob- lems. They did not reduce the managers' information advantage; instead managers were able to use their knowledge of the firm to negotiate mul- tiple soft targets that were easy for them to reach. Similarly, performance contracts rarely included rewards and penalties that could motivate man- agers and staff to exert more effort: where cash bonuses were offered they had little effect because they were not linked to better performance; other promised incentives, such as greater managerial autonomy, were often not delivered; and penalties for poor performance, such as firing or de- motion, were seldom applied. Finally, governments demonstrated little commitment to the terms of the contracts, frequently reneging on key promises. This increased managers' incentive to use their information ad- vantage to negotiate soft targets. Each of these problems can be seen with the performance contract governing Senegal Electricity. The contract included twenty-two criteria for judging performance, but no rewards if managers attained them; moreover, government regulators lacked the power to enforce penalties reliably. Finally, although the government promised to take actions that would make it possible for the firm to meet its targets, such as forcing other SOEs to pay their electricity bills, these promises were often bro- ken. The company has suffered declining productivity. Indeed, as with several other enterprises in our sample, it appears that the contract may have actually worsened incentives and performance. Management Contracts Work but Only in Some Situations Management contracts are not widely used but have generally been successful when they were attempted. Our worldwide search using a rel- atively broad definition found only about 200 management contracts: forty-four involved hotels managed by major international chains; the rest were concentrated in agriculture and water. Our analysis of manage- ment contracts governing twenty firms in eleven countries (see table 6) found that profitability and productivity improved in two-thirds of the 25 ->V NE ~AJNSS Table 6 Sample of Management Contracts Enterprise Country Contractor Sector Successful Manila Terminal Philippines ISTSI (domestic) Ports Mumias Sugar Kenya Booker Tate (UK) Sugar Hino-Pak Pakistan Consortium (UAE, Japan) Auto/truck assembly Domestic Appliances Pakistan Al-Futtain (uAs) Electrical appliance assembly Guyana Sugar Corp. Guyana Booker Tate (UK) Sugar SONEG Guinea SEEG (Guinea and France) Water SNE Central African Republic SAUR (France) Hotel Shepheard's Hotel Egypt Helnan (Denmark) Hotel Cairo Sheraton Egypt Sheraton (USA) Hotel Nile Hilton Egypt Hilton (USA) Hotel Sofia Sheraton Bulgaria Sheraton (USA) Hotel Hotel Stadt Germany InterContinental (USA) Hotel Sri Lanka plantations Sri Lanka Domestic contractors Tea, rubber Borderline Linmine Guyana Guyana Minprod (Australia) Bauxite mining Mount Kenya Textiles Kenya AMSCO (Netherlands) Textiles Naga Power Plant Philippines Ontario Hydro (Canada) Electricity State Gold Mining Co. Ghana Canada-Guyana Mining (Canada) Gold mining Light Rail (LRTA) Philippines Meralco (domestic) Transport Failures Nzoia Sugar Kenya Arkel (USA) Sugar Sanata Textile Limited Guyana SOE (China) Textiles Source: Shaikh and Minovi (1994). cases, and results were mixed for most of the remainder. Only two of the contracts were rated as failures on both counts. What were the characteristics of the successful management con- tracts? And, since they are often successful, why aren't they used more often? Analysis of the ways that the successful contracts addressed the problems of information, rewards and penalties, and commitment an- swers both questions. Where management contracts succeeded, governments used compe- tition to reduce management's information advantage. Of the thirteen successful contracts, ten involved SOEs in competitive markets; the other three involved competitive bidding for monopoly enterprises (two water companies and a container port). Successful contracts also established meaningful rewards and penalties, usually by limiting (or eliminating) 26 fixed fees and linking the contractor's fee to the firm's performance. Fi- nally, successful contracts were set up in ways that elicited a strong com- mitment from both parties. For example, they were for longer periods with the possibility of renewal and provisions for arbitration of disputes. Why aren't they more widely used? We concluded that the costs to the government of obtaining the information needed to negotiate, mon- itor, and enforce a management contract are one reason that they are largely confined to hotels, agriculture, and water. Information is more easily available, and contract transaction costs thus lower, in such sectors as these. They tend to be sectors where technology is not changing rapidly, and output is a single, homogeneous product (as with water or sugar); or where the private contractor has an international reputation to protect, the market is competitive, and quality is easily compared (as with hotels). Moreover, under the conditions where management con- tracts can work, privatization will often provide governments with higher benefits (the selling price) and lower costs (no need to monitor, enforce, and renegotiate the contract). Regulatory Contracts Work but Require Careful Design Nearly all privatized firms providing infrastructure services operate in monopoly markets where government regulation is needed to pre- vent firms from abusing their market power. These regulations and other divestiture provisions constitute a regulatory contract, that is, an agreement-sometimes implicit-between the government and the company owners about how the firm would be rewarded and the con- ditions under which it should operate. Devising effective regulatory contracts has become increasingly important as developing countries privatize a growing number of former state monopolies in telecommu- ntcations, power, water, railroads, roads, ports, and gas. The value of government sales of firms in these sectors exploded from a mere $431 million in 1988 to nearly $6.5 billion in 1992. To evaluate these contracts, we analyzed the experience in the seven developing countries where the basic telephone network is privately owned and government regulated (table 7). Although the sample is small and not random, its diversity in terms of economic development, rate of economic growth, initial telecoms development, the pace and timing of the regulatory reform, and the extent of divestiture enables us to analyze different aspects of regulatory design under a wide variety of circum- 27 Table 7 Sample of Countries with Private Sector Participation in Telecommunications Year of Percent of Real dollar GDP Years of regulatory sector per capita growth waiting time for Teledensity Country refornn privateb GNP, 1981 ratec pboned in 1981e Argentina 1990 100 3,442 1.4 4.1 7.7 Chile 1987 100 1,995 4.5 5.7 3.4 Jamaica 1988 100 1,242 1.9 9.0 2.6 Malaysia 1987 25 2,096 6.3 1.6 3.6 Mexico 1990 100 2,510 1.4 4.9 4.4 Philippines 1986 100 669 1.2 14.7 0.9 Venezuela 1991 40 3,647 2.5 2.5 5.6 a. Prior reforms were undertaken in Chile (1978, 1982) and Jamaica (1982); some additional reforms to facilitate partial privatization were undertaken in Malaysia in 1990. With the exception of Malaysia, and the Philippines, where the telecom sector has been privately owned for decades, the year of reform is also the year of privatization. b. As of 1993. c. Average real GDP growth rates over rhe period 1981-92. d. As of 1987 for Argentina and 1986 for Jamaica; calculated as a ratio of the number of applications on the waiting list to the average number of main lines added over the last three years. e. Phone lines per 100 people. Source: Galal and Nauriyal (1995). stances. Except in the Philippines, where the telecoms company has been privately owned for decades, and in Mexico, where privatization occurred earlier, regulatory reform coincided with privatization. We found that regulatory contracts usually improved performance, resulting in more rapid network expansion, increased labor productivity, and higher re- turns on net worth. Not all regulatory contracts are successful, however (figure 9). Chile, where the results were positive, and the Philippines, where the results were negative, represent the two extremes. Countries with successful contracts addressed all three contracting issues-information, rewards and penalties, and commitment. In Chile the government reduced its information disadvantage by selling the franchise for local telephone service through competitive bidding and by injecting other elements of competition into the contract wherever possible. Price regulations were designed to reward improved perfor- mance and penalize failure to improve. Chile's benchmark pricing is based on a fair rate of return to a hypothetical efficient firm and is re- viewed only once every five years. This encourages the company to im- prove efficiency, since it reaps the benefits until prices are adjusted, at which point the savings are passed on to the consumer. Finally, the Chilean government demonstrated its commitment to abide by the con- z8 Figure 9 Telecommunications Reform: Impact on Network Expansion, Labor Productivity, and Returns Network Expansion Labor Productivity Growth rate of main lines Lines per worker Prereform Postreform Prereform Postreform 5.3 9.4 Argentina 58 96 7.5 14.3 Chile 48 81 6.2 18.8 Jamaica 35 26 17.6 12.3 Malaysia 26 54 7.0 12.8 Mexico 95 122 7.2 4.9 Philippines 35 36 6.5 11.8 Venezuela 68 83 -50 0 50 100 150 200 250 -40 0 40 80 120 Percentage change Percentage change Returns on Net Worth 1985-88 *Prereform Argentina 1991-93 Postreform 1983-86 Chile 1987-91 Jamaica 1982-87 Malaysiaa 1982-86 ovailable mexicob 1982--89 1990-93 Regulatory contracts usually resulted in Philippines 1982-85 more rapid network 1986-92 expansion, improved Venezuela 1990-939 labor productivity, and Venezuela 1986-89 higher returns on net 1990-93 worth. -15 -10 -5 0 5 10 15 20 25 30 Percent annual change a. Postreform profit before taxes over net worth for 1990 only. b. Postreform data is an estimate based on World Banik projections of revenues and expenses for I ELNIEX. Note: The prereform/postreform periods for which dara are reported are Argentina: 1981-90/1991-92; Chile: 1981-86/1987-92; Jamaica: 1981-87/1988-92; Malaysia: 1981-86/1987-92; Mexico: 1981-89/1990-92; Philippines: 1980-85/1986-92; and Venezuela: 1981-90/1991-93. Sourrce: Hill and Abdala (1995); Galal (1 994): Spiller and Sampson (11993); World Bank ( 993, 1990); Wellenius and others (1994): Esfahani (1994); Clemente (19943; International Telecommunications Union (various years; 1994). 29 _ IA~~~~~ESS tract to investors in many ways; for example, the legislature passed laws defining procedures for arbitration and appeal of disputes. In contrast, the Philippine government did not use competition or other mecha- nisms to reduce its information disadvantage. Nor did the Philippine government use pricing structure to reward improved performance and penalize failure to improve; instead it left pricing at the regulator's dis- cretion, merely putting a ceiling on the operator's returns. Finally, be- cause the regulatory contract itself is unclear, the Philippine government has not been able to demonstrate its commitment. Although there is an explicit procedure for the firm to appeal regulatory and tariff decisions to the Supreme Court, because the rules themselves are unclear the basis for appeals, and their outcomes, are uncertain. The poor regulatory en- vironment in the Philippines has been costly for consumers: although the Philippine telephone company scores poorly in terms of network ex- pansion and labor productivity, it enjoys the highest rate of return on net worth in our sample. The overall evidence from our sample suggests that divestiture of state-owned enterprises in noncompetitive markets, accompanied by appropriate regulation, usually does result in greater efficiency, ex- panded service, and overall improved welfare. But only a small propor- tion of the countries with large government monopolies in noncompet- itive sectors have attempted regulatory contracts. Indeed, as we have seen, despite the potentially large economic benefits of divestiture and other types of SOE reform, relatively few countries have made a system- atic, determined attempt to reform their SOEs. To find out why, we stud- ied the politics of state-owned enterprise reform. The Politics of Reforming SOEs T HE REFORM OF SOES ALMOST INVARIABLY INVOLVES ELIMI- nating jobs and cutting long established subsidies-actions that can cost a government its support base. Consequently, politi- cians who rely on SOE support carefully weigh any change in SOE poli- cies, preferring policies that benefit their constituencies and help them remain in office over policies that undermine support and may cause them to be turned out of office. While some exceptional leaders may be able to change their support base and mobilize new constituents in favor 30 of reform, most are inherently responsive to the supporters who put them in office. How have the countries that reformed successfully over- come the political obstacles to SOE reform? What can other countries learn from their example to hasten the reform process? In considering these questions, we found that there are three necessary conditions for successful reform: * Reform must be politically desirable to the leadership and its con- stituencies; the political benefits outweigh the political costs. Re- form usually becomes desirable with a change in regime or a coali- tion shift in which those opposing reform lose power. It may also happen when an economic crisis makes SOE subsidies so costly that reform becomes preferable to the status quo. * Reform must be politicallyfeasible. Leaders must have the means to enact reforms and overcome opposition, either by compensat- ing the losers, thus winning their support, or by compelling them to comply despite their losses. * Promises central to state-owned enterprise reform must be credi- ble. Investors must believe that the government will not renation- alize privatized firms; SOE employees and others who fear that they may lose out in reform must believe that the government will de- liver on any promises of future compensation. Chapter 4 investigates these conditions in detail, drawing on the findings from the twelve country case studies of successful and unsuc- cessful reform presented in chapter 2. In this summary, we will illustrate each condition with brief examples. Our analysis is not a judgment about the countries or their govern- ments. Rather, it assesses obstacles that may prevent even the most effective and selfless leaders from undertaking SOE reform. In conducting this as- sessment, we use a consistent methodology with three important charac- teristics: first, our measures of desirability, feasibility, and credibility and the conclusions that we reach are transparent and easily checked for accuracy and consistency; second, we use measures that could be observed indepen- dent from and prior to SOE reform attempts; this makes these measures use- ful for prediction; finaHly, we look at every indicator in every country. This marks a break with much previous analysis, in which different criteria have been applied to different countries, making generalization difficult. Nevertheless, our analysis still has significant limitations. Like all be- havioral sciences, the study of political decisionmaking is complex. Vari- 31 ables, such as the intensity of supporters' opinions, can change out- comes but are difficult to measure and to use in a consistent, generaliz- able fashion. Political analyses that depend on such variables cannot therefore be easily tested to see if they are true or false or if they have pre- dictive power. Compared to such analyses, the approach pursued here focuses on variables that can be measured consistently and ex ante. De- spite these advantages, however, the analysis, given its present state of development, will not always lead to unambiguous conclusions and predictions. Our data and analysis provide no support for the frequently voiced opinion that SOE reform is more likely in authoritarian regimes than in democratic ones. In our sample, authoritarian governments exhibit both good and bad performance in the SOE sector. Chile under General Augusto Pinochet pursued SOE reforms that helped to lay the founda- tion for future rapid growth; the Philippines under President Ferdinand Marcos went in the opposite direction, nationalizing private firms and putting up barriers to competition that contributed to economic stag- nation and deeper poverty. Nor is there any clear link between democ- racy and SOE reform. During the period we examine, reform was slow in India but rapid in Poland and the Czech Republic. These mixed results are to be expected. While reforms may be more feasible in authoritarian regimes, where the leadership need not establish a consensus before act- ing, the institutions that require consensus-building in democracies in- crease the credibility of the resulting policies, as we discuss below. Condition 1: Political Desirability Reforms can become desirable to the leadership and its supporters in two complementary ways. The first involves changes in the leadership's constituencies such that those who oppose SOE reform are no longer a significant part of the leadership's support base. These changes may be the result of an outright regime shift (as in Chile in 1973 or the velvet revolution in Czechoslovakia in 1989) or a shift within the governing coalition (as in Mexico in 1988). The second involves an economic crisis (for example, a drop in GDP or a sharp fall in net foreign assistance) that makes it increasingly difficult for the government to continue subsidizing SOEs (as, for example, in Ghana and Mexico). The size of the economic crisis needed to make reform desirable depends on how much the leader- ship relies on the support of those who benefit from the SOE status quo. 32 The more successful reformers in our sample met the political desir- ability conditions, but most of the six countries with mixed or poor SOE reform records did not. Most of the mixed and poor performers expe- rienced either a significant regime shift or economic problems that could have created an opening for reform. Yet the continued impor- tance of the soE, sector in the government's support base meant reform did not become politically desirable. In Turkey, for example, a regime change in 1980 resulted in numerous economic reforms. However, these efforts stopped short of privatizing or otherwise reforming state- owned enterprises because SOE employees were crucial to the new gov- ernment's support base. Condition II: Political Feasibility Reform is politically feasible when the leadership can secure the ap- proval and support of other government entities whose cooperation is critical to success-legislatures, bureaucracies, and the state or provin- cial governments that are responsible for formulating policy or carrying out the reform. In addition, the leadership must be able to withstand opposition to reform from those who stand to lose, such as SOE employ- ees, especially when these groups are organized, numerous, and ready to engage in demonstrations, work stoppages in strategic industries, and other actions that might be costly to the government. The likelihood of opposition is greatest when the enterprise has many extra employees- in some SOEs up to 90 percent of employees may not be needed. In such instances, workers, rightly worried that reform may lead to layoffs, have a strong incentive to resist. In all the successful reformers in our sample, the leadership con- trolled the policymaking and implementation apparatus when reform began; moreover, in each country the leadership offered compensation and sometimes used compulsion sufficient to overcome resistance out- side normal political channels. Compulsion can have high social costs, and the reforms enacted through coercion are often not sustainable. No government relied solely upon compulsion to overcome opposition. In Chile, for example. the military government employed often harsh mea- sures to curb union powers but also offered handsome severance pay to port employees who might otherwise have engaged in job actions that could have disrupted the economy. In the 1980s, the government dis- tributed SOE shares to the general public and SOE employees under vari- 33 _I$ N E S~jNSS ous generous financing alternatives. Neither Poland nor the Czech Re- public used compulsion but instead satisfied reform opponents with dif- ferent distributions of enterprise shares. Ghana, which we rank as partially meeting Condition II, illustrates the difficulties that less successful reformers faced in overcoming oppo- sition to reform. Throughout most of the 1980s and into the 1990s, the executive controlled policymaking. In 1985, to overcome substantial re- sistance to SOE reform, the government tried a mix of compulsion and compensation. On the one hand, it reduced the power of the state- owned enterprise union, detaining labor leaders critical of the reform; on the other, it began to give fired state-owned enterprise workers more generous severance payments. With the approach of district elections in 1988, however, the government became increasingly reluctant to com- pel compliance with decisions about layoffs. Severance payments be- came so expensive that the government had to abandon efforts to cut SOE employment. Condition III: Credibility The third and final condition for successful state-owned enterprise reform is government credibility. We identified three ways to judge a government's credibility. First, credible governments have a reputation for keeping promises; for example, because they announced and imple- mented overall economic reforms or have not previously expropriated private firms. Second, they face domestic restraints on policy reversal, such as constitutional restrictions that make it hard to overturn legisla- tion or widely distributed shares in privatized SOES that can create a large, proreform constituency. Third, they submit to international re- straints, such as trade treaties or loan covenants, which make it costly to reverse reforms. Some mechanisms are more powerful than others. A government with a solid reputation, or strong domestic restraints, may enjoy sufficient credibility whether or not it accedes to international treaties. The reverse is not true, however: international restraints are usually too weak to confer credibility where other conditions are absent. The range of abilities that countries exhibit to credibly commit to re- form can be seen by looking at two less successful reformers, India and Egypt, and two more successful reformers, the Czech Republic and Poland. Although India did not meet the first two conditions of reform, any reforms that it might have undertaken would have enjoyed substan- 34 tial credibility. India had significant domestic restraints on policy rever- sal and was regarded by investor risk services as a relatively safe place to commit resources. In contrast, Egypt in the 1980s had a low confidence score with foreign investors and few domestic restraints to protect re- forms from being overturned. The experience of the Czech Republic and Poland illustrates how decisive moves to implement macroeco- nomic reform while at the same time putting in place domestic re- straints that make policy reversal difficult can enable a country to build credibility in remarkably little time. Predicting Reform Readiness Would knowing whether or not a country satisfies these three neces- sary conditions for successful reform-desirability, feasibility, and credibility-help us to predict reform outcomes? Political behavior is in- herently complex and dynamic, making prediction difficult. Neverthe- less, the methodology developed in the report enables us to set forth ob- jective and transparent indicators that can be known prior to reform, tested for accuracy and consistency, and applied systematically to our entire sample. Table 8 shows which countries in our sample failed to meet one or more of the three necessary conditions according to these measures. Countries that did not meet any one of the three conditions were less successful reformers. Thus, unready countries privatized less and failed to implement nondivestiture reforms effectively. This illus- trates a keyfinding of our analysis: reform cannot succeed until countriesful- fill each and every one of the three readiness conditions. What Can Be Done to Spur Reforms and Improve Outcomes? T HE EVIDENCE MAKES IT ABUNDANTLY CLEAR THAT REDUCING the role of bureaucrats in business and improving the perfor- mance of the remaining SOEs can bring a country substantial economic gains. Yet reform has been slow and seldom successful. We conclude our study by suggesting ways that leaders and policymakers in developing countries can foster more rapid and successful state-owned enterprise reform and ways foreign aid can assist them more effectively. 35 _ I N E S 5~~NES Table 8 Unmet Conditions in Less Than Successful SOE Reformers Condition I Condition II Condition III Country Desirability Feasibility Credibility Egypt 0 Ghana 0 Philippines 0 India 0 0 Senegal 1983-88 0 1988- 0 Turkey 1983-91 0 1991-92 0 * Does not meet the condition. Condition 1: Met if coalition change or exogenous crisis and SOE reform losers outside government's support base; not met if reform losers in the government's support base. Condition II: Met if reformers can secure approval and design sufficient compensation packages to defuse opposition; not met otherwise. Condition III: Met if government known for keeping promises, faces domestic interna- tional restraint on policy reversal. Note that by OECD standards, in which countries score much higher in ICRG (Switzerland with thirty, for example) and receive scores of seven on constraints on the executive, none of the sample countries would be judged to meet fully Condition III. For the purposes of this table, Chile, Korea, and the Czech Republic were used as benchmarks against which the remaining countries in the sample were compared. In general, countries that did worse on two dimensions and no better than on others were judged not to meet the condition. Source: See text. A Decision Tree for Reform of SOEs State-owned enterprise reform involves a multitude of choices, each with its own set of problems and opportunities. The choices made will in- evitably vary from country to country; but to lead to successful outcomes, they must be made in a logical order. It might seem obvious, for example, that countries will not reform successfully until the leadership perceives re- form as desirable. Yet, perhaps precisely because the economic gains of re- form are substantial, well-intentioned outsiders, including the World Bank, have sometimes attempted to prod developing countries that are not ready for reform into acting. Similarly, developing-country leaders and policymakers, persuaded of the benefits of reforming SOES, have sometimes attempted to do so, only to choose an option that meets with failure. How can those who rightly favor reform organize the multitude of choices they face in a way that will increase the likelihood of success? 36 In thinking about the prerequisites of reform, and the conditions that are necessary for the success of various reform options, we have found it useful to draw a decision tree (figure 10), At each juncture we ask a question, the answer to which sends us in one of two directions, where we encounter another juncture and another question or a sug- gested policy approach. Chapter 5 describes that decision tree, offering checklists that reform advocates can use in deciding how to proceed in a particular country or with a particular enterprise in order to avoid the potential pitfalls along the way. We conclude with a summary of the main decision points. The first question is whether the country is ready for reform. The an- The decision tree helps to organize swer will be determined by whether or not a country meets each of the the multitude of choices involved in three readiness conditions described above. In the borderline cases, of SOE reforn. To use it, begin with the three r n cfirst question at left. Each answer which there may be many, up-front actions, such as trimming an over- leads to another question or a sized SOE work force or selling or liquidating a large firm, can be a good recommended policy course. Figure 10 A Decision Tree for State-Owned Enterprise Reforn Introduce competition in markets yes >Ensure transparency and competitive bidding Other implementation details in text - Management contracts preferable where yes - Is divestiture possible? yes technology and taste do not change rapidly - auction the contract use performance-based fees provide commitment mechanisms Are soss potentially Are contractual arrangements yes competitive? n with the private sector possible? Is country ready Are natural monopolies no for SOE reform? to be divested? Unbundle large firms, Increase competition In markets Restrict soft credit, end subsidies and transfers Ensure managerial autonomy to respond to competition Use performance contracts selectively no yes Enhance readiness Ensure adequate regulations are In place for SOE reform urnbundle large firms implement other reforms - aiction the franchise - reduce worker opposition - establish appropriate pricing regimes improve reputation, boost credibility - provide commitment mechanisms Source: See texr in summary. 37 _I4 BUI INESS signal of readiness to proceed with a broader program of SOE reform. Depending on the answer, the course of action is radically different. We first describe the course of action to be pursued in countries that are not ready to reform, then turn to the policies that can help reform-ready countries to maximize the benefits. Because foreign aid can have an im- portant influence on the timing of SOE reform and how it is pursued, we suggest ways to enhance its effectiveness in supporting SOE reform at the end of the book. They are summarized here in box 3. 38 What to Do in Countries Not Ready to Reform SOEs Failed reform attempts can be very costly. Money spent to restruc- ture state-owned enterprises and pay off their bad debts is wasted if the enterprises fail to improve or, having been privatized, collapse back into the government's arms. More difficult to quantify, but no less impor- tant, are the costs in wasted human and political capital. Policymakers who spend months or years designing SOE reform programs when the 39 prerequisites for success are lacking could devote their scarce skills to other issues where success is more likely. Similarly, developing-country leaders and donors who push SOE reforms with a very scant or nonexis- tent chance of success draw down their political capital without achiev- ing any significant returns. Are we suggesting that nothing be done in such situations? Certainly not. Rather, policymakers can pursue other reforms that are beneficial in their own right and also help to make reform of state-owned enterprises more desirable, feasible, and credible. Important reforms that do not target state-owned enterprises are often possible in environments where the three conditions for successful SOE reform do not yet exist, because different types of reform affect different constituencies. Many macro- economic reforms, for example, do not directly threaten the interests of SOE supporters but nonetheless help to generate pressure and support for future SOE reform, thus making reform more desirable. To help make SOE reform more politically desirable policymakers could: * Reduce fiscal deficits. Fiscal and monetary reforms that bring rev- enues and expenditures into line increase pressure for SOE reform by making the burden of SOE deficits explicit. u Ease trade restrictions. Liberalizing trade restrictions gives exporters a stronger position in the economy, and exporters can become an important constituency for SOE reform, demanding more efficient provision of goods and services that SOEs supply. • Remove barriers to entry. Removing barriers to entry increases the number of voices calling for SOE reform. New entrants who must rely on state-owned enterprise services or compete with subsidized SOE products help enlarge the constituency for reform. * Initiate financial sector reform. Governments not ready to reform SOEs may still be prepared to develop their financial system by im- proving supervisory and regulatory capacity, reducing directed credit and direct government control over financial intermedi- aries, and easing some interest rate controls. Similarly, governments can make SOE reform more feasible by reducing the opposition to reform by workers and others dependent on state- owned enterprises. Policymakers could do the following to help: * Eliminate obstacles to pri'vate job creation. One reason state-owned enterprise workers typically oppose reform is that while over- 40 staffing makes layoffs likely, appealing alternative employment is often lacking. Policymakers can thus ease the way for SOE reform by improving private employment opportunities. Steps include eliminating interest rate subsidies (these encourage employers to substitute capital for labor) and complex employment regulations (which have been shown to inhibit private job growth). * Uncouple soE jobs and social services. State workers who receive many goods and social services through their jobs are especially fearful of being fired. In most transition economies, for example, state firms traditionally provided housing, health care, transport, educational assistance, and other benefits. Creating alternatives to enterprise benefits, such as a commercial housing market or public health care, enables SOEs to stop providing these services and offer offsetting higher pay instead. This gives workers greater mobility and reduces their resistance to reforms that may threaten their jobs. Finally, to enhance their credibility governments can take actions: • Improve their reputation. By announcing reform programs, such as the macroeconomic reforms mentioned above, in advance and ad- hering to the program scrupulously, governments can enhance their reputation with potential reform supporters. * Establish domestic and international constraints. Enacting and ad- hering to constitutional provisions guaranteeing the right to prop- erty can help reassure investors that the government will honor its commitments. Trade treaties and multilateral agreements raise the cost of reversing future SOE reforms and help enhance credibility. Policymakers who pursue this agenda will eventually find themselves on the opposite branch of the decision tree, among countries that are ready to reform state-owned enterprises. What to Do in Countries Ready to Reform SOEs A country that meets the three readiness conditions for successful SOE reform faces a multitude of choices about how to handle each enterprise, the answers to which will depend on the nature of the market, the firm, and the country's capacity to divest and, in the case of monopoly mar- kets, to regulate. Returning to our decision tree, we see that it asks policy- makers in countries ready to reform to classify SOEs into two types: 41 * Those operating in competitive or potentially competitive mar- kets (all manufacturing and most services) * Those operating in natural monopoly markets where regula- tion is necessary to protect consumers (some utilities and most infrastructure). Enterprises in competitive or potentially competitive markets should be divested, provided that competition is enhanced and arrangements for the sale can be made transparent and competitive or at least open to the possibility of competitive bidding. Enterprises in natural monopoly markets can also be divested, provided that the sale is transparent and open to competitive bidding and that a credible regulatory structure can be put in place. These two outcomes correspond to the two outermost branches of our decision tree. For both types of enterprises, policymakers undertaking divestiture face many questions that have different answers depending on country conditions and in some instances on the size and condition of the en- terprise being sold. Questions that policymakers will want to consider when designing a divestiture strategy include: * Is it better to begin with small enterprises or big enterprises? Selling big firms first produces bigger welfare gains: the bigger the firm, the bigger the potential benefits. It also signals that the govern- ment is serious about reform and, properly done, can create new proreform constituencies. On the other hand, starting with small firms and gaining experience before tackling the large firms makes sense if bureaucratic capacity is the limiting factor. * Should the government financially restructure firms before selling them? While some financial restructuring may be necessary, new investments are seldom recovered in the sale price. Even so, gov- ernment assumption of SOE debt is sometimes the only feasible way to unload a company whose debt exceeds the sales value of its assets. * Should the government lay off workers before selling an enterprise? Countries as diverse as Argentina, Japan, Mexico, and Tunisia have sometimes had to fire SOE employees prior to privatization. This is sometimes necessary because investors will not buy a firm where acrimonious labor disputes seem likely. Moreover, govern- ments are usually better able than private investors to alleviate ad- 42 verse social impacts of mass layoffs. Severance pay can reduce the risks facing SOE workers. Selling monopolies is more complex than selling firms in competitive or potentially competitive markets. Even so, as long as the sale is com- petitive and transparent and a credible regulatory contract can be de- vised and implemented, divesting monopolies can produce major wel- fare gains. Policymakers who decide their country is ready to divest state-owned monopolies will want to incorporate the following findings in their divestiture plans: * Regulatory contracts work better when governments reduce thefirms in- formation advantage througlh competition. In addition to competitive bidding for the contract itself, competition can be increased by splitting competitive activities from natural monopolies and break- ing national monopolies into regional monopolies. In markets that still remain monopolies, the government could require the winning bidder to meet specified targets or lose the concession. * Price regulation is more effective when it allows firms to retain some of the benefits of improved performance while passing part to consumers in the form of lower prices. Basing prices on information from sources other than the firm or independent of the firm's cost can eliminate the firm's incentive to inflate costs. Revising prices infre- quently gives firms an incentive to cut costs between adjustments. * Credible regulatory contracts lower costs to the consumer. Govern- ments that credibly commit to meeting their end of the regulatory contract can drive a harder bargain with investors. When the reg- ulatory contract is based only on a presidential decree or lacks pro- visions for impartial adjudication of conflicts, investors demand higher returns or greater monopoly powers to compensate for higher risk. When such costs are very high, policymakers may wish to improve credibility before divesting. Alternatively, they nmay seek external guarantees (see box 4). Even in countries where the leadership is committed to rapid and ex- tensive privatization, some SOEs are likely to remain in government hands for a long time, for political if not for economic reasons. What to do with these enterprises is the final question on the decision tree; it asks: are contractual arrangements with the private sector possible? 43 Management contracts with the private sector are the preferred course; however, as we have shown above, these are useful only in a limited number of circumstances where the enterprises technology changes slowly and output is primarily a single homogeneous product (such as water and sugar) or where qualitv is easily monitored (such as hotels). 44 ' CiaratT,,he guarani.es might .04 rather iba speed, priatisation. Since * Becen rwe&d One advntage ofrrvatiza. governents cannot credibly commit to ser- tion is that iftpat'rhe eifiiencies genrerated by vicing a growing supply of guarantees and incentives associated with private profitmak- loans, then to some extent, taking a guarantee * ipg. Bu5 if guarantees cover most or al of the displaces a loan. (Indeed, it would be worri- .risks, pivae `inivestoms will have little incentve some if this did not occur, as it would stuggest to run the enteprise barer than buteauciats thiat the authorities were taking on contingent * did before privatizarion. liabilities without any restraint.) If the govern- * Re dif5ul 0 price., The guarantor will want to tnent believes that the countryrs ability to gen- charge a fee for the guarantee. to cover its costs erate foreign exchange earnings is limited, and (inclucding sorneof the risk of holding acontin- if demands for foreign loans in the country for gent liability) and to signal investrs that their other prpjects is high, then the government reduced risk is not'Nvwthout a price. The proW' might be inclined to wait for those to whoem lem is th,at there is no dcear rarket for such reg- guarantces are not necessary, thereby delaying ulatory risk, and even if there were, guarantees. the privatization effort. like oc,her assets, can be mispriced. Also, a fee In sum, guarantees appear to be usefl when a trucrure that did not vary according to differ- government is committed to reform but the couII- ent levels of coverage or risk or, more generally, try's history makes it difficult for the government to a vague guarantee that did not precisely delimit commit credibly, thus raising the return that in- the exposure for the guarantor, the authorities, vestors demand or making it difficult to attract in- and private participants might send incorrect vesrors at any price, However, guarantees are not signals to financiers. In pairicular, it might lead without drawbacks and should not be used as a sub- them to demand more coverage than was opti- stitute for necessary reforms. Authorities should keep mal for the country. Although guarantees can in mind thar the first step in attracting domestic or lower the rate of return investors demand, they foreign investment should be to improve the under- are nor free to the consumer, since comnpanies lying economic environment. Perhaps the best gen- usualy pass on the cost of the guarantee in the eral guidance concerning guarantees is that they form of higher prics, should only be employed when there are dear advan- * Reduce, rather than enhance, credibility. If other tages beyond merely enabling privatizarion to pro- private investors mistakenly take the guarantee ceed. These might be additional investment or in- as a sigrnal that the country is likely to renege, vestors' acceptance of lower rates of return that result it could lead to ckedibiliry, problems in interns- in tangible benefits to the public. tional markets. For firms that cannot be divested but are unsuitable for management contracts, policymakers have no choice but to attempt improvements within the existing ownership and management arrangements. Specific measures that miust be implemented include introducing competition, cutting government subsidies, reforming financial arrangements to 45 _'4 IN USINE SS eliminate soft credits, and holding managers responsible for results while giving them the freedom to make necessary changes. The perfor- mance of SOEs which are not divested can be improved through these ac- tions, but getting the details right is tough because each reform relies on the successful implementation of others. Policymakers will want to keep in mind the following: * Foster competition wherever possible to create incentives for improved performance. State-owned enterprise managers will only exert the effort needed to improve performance when they are pushed by competition. * End subsidies and transfers. Fostering competition is fundamental to improving the performance of SOEs in potentially competitive markets. But competition can only be effective if government transfers and subsidies are eliminated. * Eliminate access to soft credit. Cutting subsidies and transfers only results in hard budgets if access to soft credit is also eliminated. • Give managers the autonomy to respond to competition and hokl them accountable for results. Managers must have the power to lay off workers, seek lower-cost suppliers, end unprofitable activities, and pursue new markets. And they must be held accountable for results. Lacking autonomy and responsibility, managers may respond to the increasing number of constraints in ways that hurt the enterprise, such as cutting spending on maintenance, marketing, even supplies. * Only use performance contracts when they address underlying p rob- lems. Performance contracts only work if they convey clear signals for reform, provide rewards for improved performance, and curb governments' tendency to renege. Writing a sound performance contract can seem simple; as we have seen, however, these con- tracts have usually failed to address the problems of information, rewards and penalties, and commitment. In general, the effort that goes into such contracts could be better spent pursuing the mea- sures for unready countries described above, in particular putting in place the conditions for divestiture. * * . In sum, we have shown in the report that large and inefficient state- owned enterprise sectors have high costs for developing economies, es- pecially the poorest. Yet reform is possible and offers potentially large 46 benefits, including more goods and services of better quality at lower prices; increased availability of resources for health, education, and other social spending; and improved fiscal stability, all of which contribute to more rapid economic growth. Reforming SOEs isn't easy, however, and reforms often entail political costs. Indeed, we found that political ob- stacles are the main reason that state-owned enterprise reform has made so little headway in the last decade. Nevertheless, this study documents that countries in very different economic and political circumstances have overcome these barriers and successfully reformed. Notes 1. The two periods come from different data sets and 1993; Easterly, Rodriguez, and Schmidt-Hebbel 1995). It may not be strictly comparable. No data are available on has also been shown that large fiscal deficits are a leading value of transactions for the earlier period. Data for the later cause of high inflation, which in turn undermines eco- period exclude East Germany and the voucher sales and nomic growth (see, for example, Wijnbergen 1991; privatization of small-scale enterprises in Eastern Europe. Bruno and others 1991; Edwards and Tabellini 1991). A negative relationship between inflation and growth has 2. If we had included the recent voucher privatization also been documented by de Gregorio (1993), Gvlfason in Eastern Europe and former Soviet Union, it would have (1991), and Fischer (1993). More recently, Bruno and increased our total number of privatizations severalfold, Easterly (1994) report a significant negative association but it would also have added many thousands of SOES to between high inflation episodes and growth, more specif- the stock of enterprises that could have been divested. ically where inflation exceeds 40 percent. Accordingly, to the extent that SOE savings-investment deficits are 3. Several studies have shown that large fiscal deficits strongly correlated with fiscal imbalance, we can conclude negatively correlate with growth (see, for example, Fischer that SOEs adversely affect economic growth. 47 Contents of the Report Foreword The Report Team Acknowledgments Definitions Introduction and Overview What Makes for Success in State Enterprise Reform? Contracting: What Works, What Doesn't, and Why The Politics of Reforming State-Owned Enterprises What Can Be Done to Spur Reforms and Improve Outcomes? 1 Bureaucrats Are Still in Business State-Owned Enterprise Sector Remains Large Despite Increasing Divestiture How SOEs Affect Economic Performance Conclusion Notes 2 Success and Failure in SOE Reform Measuring Success and Failure What Reform Characteristics Distinguish Successful Reformers? Divestiture and SOE Reform Outgrowing State-Owned Enterprises: An Alternative to Divestiture? Divestiture Alone Is Seldom Enough Improving SOE Performance through Competition Hard Budgets Financial Sector Reform Changing the Relationship betveen Governments and SOE Managers Conclusion 49 _ S Wffjk IN BUSINESS Appendix 2.1: Reforms to Open SOE Markets to Competition and Introduce Hard Budget Constraints Appendix 2.2: Financial Sector Reform Notes 3 Contracting: What Works, What Doesn't, and Why How Incentive Factors Interact to Influence Outcomes Performance Contracts: With Public Managers Management Contracts: With Private Managers Regulatory Contracts: With Private Owners Conclusion Notes 4 The Politics of SOE Reform Assessing Condition I: Political Desirability Assessing Condition II: The Political Feasibility of SOE Reform Assessing Condition III: The Credibility of State-Owned Enterprise Reform Explaining and Predicting Reform Success Conclusion Appendix 4.1: The Politics of State-Owned Enterprise Reform: Additional Evidence Notes 5 How to Spur Reforms and Improve Outcomes How to Tell Whether a Country Is Ready to Reform What to Do in Countries Not Ready for SOE Reform What to Do in Countries Ready for SOE Reform W hat to Do with SOEs That Cannot Be Divested Conclusion Notes Implicationsfor Foreign Assistance Statistical Appendix References Index 50 LWorld Bank Publications Order Coupon CUSTOMERS IN THE UNITED STATES: CUSTOMERS OUTSIDE THE UNITED STATES: Complete this coupon and return to Contact your local World Bank Publications The World Bank distributor for information on prices in local currency Box 7247-8619 and payment terms. 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Despite more than a decade of privatization. state- owned enterprises account for nearly as large a share of developing countries' economies today as tven- ty years ago 'I'hese enterprises are often inefficient, and the resulting losses to the economy hinder growth, making it harder for people to escape poverty The book of which this is a summary draws on extensive data and detailed case studies to show how divestiture and other reforms can improve eco- nomic performance, why politics often impedes reform, and how reforming countries have overcome these obstacles. Why have so few countries reformed? Bureanucrats in Butsiniess explains that fewv countries have the three conditions necessary for success: first, that their leaders perceive reform as politically desirable (that is, they perceive that their supporters favor reform); second, that reform is politically feasible (that is, the leaders are able to overcome opposition); and third, that reform is credible (that is, the leaders' promises to protect investors' property rights and compensate fired employees are believable). To demonstrate why some countries succeed in reform and some do not, the book compares poli- cies for state-owned enterprises in twelve countries. Successful countries have made the most of divestiture, competition, hard budgets, and financial sector reforms. And all twelve countries have tried to change the relationship between the government and state-owned firms through the use of contracts. The book documents the importance of three types of contracts for reform: performance contracts (between the government and public managers), management contracts (between the government and the private managers of a government firm), and regulatory contracts (between a government and the owners of a privatized, regulated monopoly). Using a wealth of company experience, it analyzes how performance contracts, widely promoted by development institutions, including the World Bank, have not improved company performance; how management contracts have worked better (but only in par- ticular situations); and how regulatory contracts have usually worked well, provided that the govern- ment is able to design and implement effective regulations. The book is rigorous in approach and lucid in presentation. It presents detailed recommendations for the reform of state-owned enterprises and will appeal to specialists and nonspecialists alike. Buireauicrats in Business is the fourth in a series of Policy Research Reports that bring to a broad audience the results of World Bank research on important policy issues. Previous volumes are The East Asian Mfiracle, Adjustment in Afica, and Averting the 01(1 Age Cr isis. 13455 DEV 080 0-8213-3455.7 5 3UREAUCRATS IN BUSINESS: ISBN 0-8213-3455-7 COVER DESIGN BY BRIAN NOYES THE MAGAZINE GROUP