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Why disinvest when profits are booming?
R Nagaraj
There is need to revisit the arguments for disinvestment and ask whether the PSEs’ recent performance calls for a sale of public sector equity.
Disinvestment is back. Policy-makers believe that there is no reason to oppose it, since at least 51 per cent of the equity holding in the public sector enterprises (PSEs) would continue to remain with the government, which would retain their managerial control. However, this calls for revisiting the arguments for disinvestment, and asking whether the PSEs’ recent performance calls for a sale of public sector equity.
Dilution of public ownership is meant to bring down the fiscal deficit, thus potentially reducing the adverse inflation and balance of payment effects. Growing fiscal deficit could also lead to downgrading of the nation’s credit rating, raising the cost of international borrowing. Disinvestment is also expected to impart stock market-based discipline on enterprises’ performance, and reducing their losses.
Such reasoning assumes that the economy is currently in “full employment,” that is, any additional deficit would only translate into higher inflation, additional imports and deterioration in the external balance. But what if there are large underutilised resources, as in a labour surplus economy like ours with 56 per cent of the labour force still subsisting on agriculture? If deficits are productively used, they could yield additional output; hence the ratio of the fiscal deficit to GDP may not rise. So, in principle, what matters is not the deficit per se, but what is done with it.
Empirically, the relationship between the fiscal deficit, inflation and balance of payments is far from robust, denting the validity of the widely advocated policy to maintain a low deficit at all times. It, however, does not mean that the fiscal deficit can be ignored. They do matter in specific situations, depending on the state of the economy, the composition of debt, how it is financed and what they are used for.
A firm’s efficiency depends on the market structure: competitive markets, in principle, yield the desirable outcomes. But the bulk of public investments, almost by definition, are in industries that display decreasing costs or have considerable externalities – inviting public regulation to correct for market failures. Often these industries also have strategic value to the nation. Such market failures are most acute in networked industries like electricity (for that matter most infrastructure), which is why, the dividing line between regulated private industries (as in the U.S.) or public monopolies often gets blurred. In such situations, it is hard to argue that form of ownership makes a difference to performance.
However, it is finance theorists who argue the superiority of private ownership, based on the disciplining function that the secondary stock markets impart on a firm’s performance, via the threat of takeover or bankruptcy. Is the threat credible? No, not for the PSEs, as only a small fraction of their equity is sold and traded in the market. Evidence suggests that stock market based discipline on a firm’s performance has rarely worked to improve corporate efficiency even in the advanced economies. One only has to recall the recent experience to realise how, given the information imperfections in financial markets, corporate managers (or, promoters in Indian parlance) in the U.S. enriched themselves at the expense of their stakeholders and the economy (one only has to read Joseph Stiglitz’s The Roaring Nineties for evidence of this).
So, even in principle, disinvestment is unlikely to enhance efficiency. If, however, the objective is to raise revenue to reduce fiscal deficit (as seems to be the case now), its contribution is likely to be minuscule. For instance, during the 13 years since 1991-92 when disinvestment began, the cumulative proceeds of disinvestment was Rs. 29, 520 crores — amounting to less than 1 per cent of the cumulative fiscal deficit. Is it then cost effective? No, because it is a much costlier source of finance than debt; the average yield on equity is distinctly higher than the average interest rate on government bond. As the risk of default on government bond is zero, it would be cheaper to issue bonds than sell shares. Moreover, transaction costs of public issues (listing, underwriting, advertising and so on) are often too high. But, won’t debt increase the future burden of its repayment? It will not, if used productively. Perhaps the only robust rule one could think of is that as long as the national output grows at a faster rate than the interest rate (in nominal or real terms), there is little danger of explosive debt growth and national insolvency. Perhaps it is worth quoting Evsey Domar’s celebrated passage written in 1952, “… the problem of the debt burden is essentially a problem of achieving a growing national income. A rising income is of course desired on general grounds, but in addition to its many other advantages it also solves the most important aspect of the problem of debt. The faster the income grows, the lighter will be the burden of debt”.
Disinvestment also means forgoing the future stream of dividends from public investment. Why should the government forgo them, especially now that the PSEs profits are booming? (See my “Public Sector Performance since 1950: A Fresh Look”, Economic and Political Weekly, June 24, 2006). Central PSEs’ profitability – as measured by gross profits to capital employed – has almost doubled from 10.9 to 20.3, between 1990-91 and 2007-08. This is commendable by any yardstick considering that the petroleum companies had to bear the brunt of the administered prices of oil during the recent boom. Since 2003-04, the sustained improvement in profits (along with a turnaround in tax-GDP ratio) has wiped out government dis-saving, boosting the domestic saving rate to 37.7 per cent of GDP in 2007-08; a level close to what the fast growing East Asian nations have achieved. Over a longer period of the last 25 years, in the aggregate, capital-output ratio has steadily declined implying an undeniable rise in public sector efficiency. This is also evident in perceptible decline in employment, contributing to the improved financial returns.
Surely, many problems remain. The crux of the public sector financial losses lay with the utilities and transport. For instance, despite a steady raise in the physical efficiency of power generation for over the last quarter century (as measured by the plant load factor for thermal power plants), the state electricity boards incur huge losses because they cannot raise prices or enforce collection of user charges, as these are outside the enterprises’ purview; government is responsible for these policy decisions. Instead of squarely facing these hard questions of pricing of public services, the government is resorting to the softer option of selling shares of PSEs’, which are yielding improved returns year after year.
This is not to suggest that all is well with the PSEs. Surely there is an enormous need and scope for securing better returns on these investments, and to achieve their strategic objectives (wherever applicable). Despite the disinvestment, the owner’s (politicians and bureaucrats) dysfunctional interference in PSEs’ would persist, as they have little to fear from the market; the procedural audit of CAG would also continue. So if one is serious about improving public sector efficiency, then one should bother about changing the relationship between the government (the owner) and the enterprises — that is, reforming the corporate governance; an issue nowhere on the policy horizon.
As stock market-based discipline seems unworkable, what then is the alternative? We suggest a bank centric governance structure, patterned after the Japanese form of Kereitsu. Disinvest PSEs’ shares among interdependent PSEs and tying them around a large public sector bank (the main bank). As government holding in the PSEs falls below 51 per cent, direct interference from the government, and the parliament will get reduced, and the CAG audit will cease. Compared to stock market, banks, in principle, are better at screening investment projects, and monitoring fund utilisation to safeguard their reputational capital. As performance of a particular enterprise would depend on the other firms in the Kereitsu, there would be peer monitoring and better coordination by the main bank. To safeguard their loans, banks would be in a better position to appoint managers offering them long-term contracts with suitable incentives (for details see my paper, “Disinvestment and Privatization in India: Assessment and Options”, in Trade Policy, Industrial Performance and Private Sector Development in India, Oxford University Press, for the Asian Development Bank).
Surely this will not solve the problem of monitoring the monitors (the banks in this case), as government remains the ultimate owner. But with delegated monitoring and with multiple monitors like other regulators in place, there is a distinct possibility of greater professionalism and minimisation of dysfunctional interference.
In sum, disinvestment is unlikely to impart the expected efficiency gains; resources thus mobilised are costly and their quantum, as a proportion of the fiscal deficit, will be minuscule. The infrastructure deficit is perhaps a far greater danger than the fiscal deficit. So as long as the public debt is used for productive investment that yields additional output, extinguishing the additional debt burden would not pose a threat. Moreover, selling shares when the profits are booming makes little economic sense.
(R. Nagaraj is a professor with the Indira Gandhi Institute of Development Research, Mumbai; email: nagaraj@igidr.ac.in )
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