Privatisation: problems

In the comments to a previous post PaulL asked

During your research for this, were there any counter-studies that you haven't mentioned here, or would you say this is a reasonable sample of the literature?

I think it is an reasonable quick look at the evidence but obviously there have been a number of privatisations that have not worked out. The question is Why?

When discussing privatisation in Latin America, Alberto Chong and Florencio Lopez-de-Silanes write,

Overall, the empirical record shows that privatization leads not only to higher profitability but also to large output and productivity growth, fiscal benefits, and even quality improvements and better access for the poor. Instances of failure exist, but in light of the overwhelming evidence, these failures should not be turned into an argument to stop privatization. The analysis in this chapter suggests that privatization failures can be understood in a political economy framework. Their roots can be traced to substantial state participation in opaque processes, poor contract design, inadequate reregulation, and insufficient deregulation and corporate governance reform that increase the cost of capital and limit firm restructuring in a competitive environment. (Chong and Lopez-de-Silanes 2005: 2)

The basic points they make are true of a wider range of privatisation programmes. A badly formulated and run programme will give bad results.

An major example of these problems is given by the early privatisation programme in Chile. Ronald Fischer, Rodrigo Gutierrez and Pablo Serra explain:

Most financial firms, as well as several banks that had been privatized from 1975 to 1979, were taken over by the state during the economic crisis of 1981-83. Beginning in 1981 several banks became effectively insolvent because they could not recover loans from troubled companies, many of them related firms, which were either bankrupt or had suffered severe losses. The government took over four banks in November 1981 and two more the following year, all of which were later closed. In January 1983 the government had to take over eight additional banks that had failed to repay international loans (three of these banks were later closed down). Ironically, most of the financial institutions that had been privatized during 1975 and 1976-representing 55 percent of all financial assets-were again being run by the state in the early 1980s (Rosende and Reinstein 1986).

By December 1984 the accumulated losses of the financial sector represented more than 200 percent of the sector's equity and reserves and 18 percent of GDP (Valenzuela 1989). To continue to have access to international credit markets, the government had to guarantee all foreign loans of the banks that it had taken over while rescuing local depositors. The government also took over many nonfinancial companies, as well as the private pension funds (Administradoras de Fondos de Pensiones [AFPs]) that were linked to the troubled banks, either because they had unpaid loans from the banks or because they were owned by the same economic conglomerates (Rosende and Reinstein 1986). Between 40 and 90 firms were taken over by the state, giving rise to the so-called a'rea ram ("gray sector"). Hence in the 1982 crisis, the state once more became the controller of many previously privatized firms. This new period of state control was fairly short-lived, and firms were not considered to be truly state-owned.

The trigger of the crisis may have been international in origin (a large rise in the prime lending rate in 1981 plus a moderate fall in the terms of trade), but the impact was amplified by mistakes in economic policy, some of which were related to the privatization process. The Chilean financial system was sufficiently fragile that the rise in interest rates, coupled with the stoppage in capital inflows, weakened the new conglomerates, most of which had high debt-to-asset ratios. The mechanisms used for privatization in the 1970s led to concentrated property holdings and gave rise to conglomerates that were highly leveraged (Sanfuentes 1984). In many cases, the buyers of banks used bank deposits to pay the loans incurred in acquiring the banks. When nonfinancial firms were privatized in 1976-77, the new owners of banks also used their clients' deposits or loans from other financial institutions to buy the firms. As mentioned, the buyers were required to put up collateral for 150 percent of the loan used to buy state-owned firms, but shares in the firm could be used as collateral. In this way, large and highly indebted conglomerates were formed.

The lack of regulation in the banking system made it easy for the banks to lend money to related firms, and even when restrictions were imposed on related lending, they were easily eluded. In the case of the two main banks, 71 nprcent and 50 Dercent of all loans went to conglomerate members. Bank regulators did not keep track of the quality of the loan portfolios, Ideology played its part in the lack of regulation, since government economists argued that if the banks were receiving deposits, private investors must have decided that the projects to which the banks were loaning money were profitable, and regulation was unnecessary. However, the regulators failed to realize the effect of implicit deposit insurance on their assumptions. In 1976 depositors in a failing newly privatized bank had been protected from losses, which created the perception among depositors of the existence of implicit state insurance. Moreover, investors in the conglomerates believed that they were too large to fail (Vergara 1996). Regulatory changes to monitor the quality and supervise the concentration of bank loans were put in place only in 1982; a stringent new banking law was not introduced until 1986.

In addition to the financial resources from their affiliated banks, the two largest conglomerates managed mutual funds (82 percent), insurance companies (53 percent), and pension funds (68 percent) that granted them even more control over the economy (Sanfuentes 1984). These institutions bought shares of firms in the conglomerate, thus raising share prices. The indebtedness of the conglomerates resulted in part from the level of real interest rates in the 1975-81 period, which was high because of the excessive demands for credit from the conglomerates to buy even more privatized firms. The high real rates were compensated by capital gains in the stock market. In 1981 the government allowed banks to contract loans abroad, which led to a rapid increase in indebtedness. Firms that had access to international loans obtained credit at much lower rates than could smaller firms with no access. In less than two years foreign debt doubled, with the two largest groups holding 52 percent of the debt.

Starting in 1985 the banks that had been taken over began to be privatized once again. Preferred shares representing 70 percent of equity were sold to new buyers. The banks sold their bad loans to the central bank and were recapitalized. In return, the central bank became a claimant on future profits of the banksg When selling the two major banks, the government strove to create a broad-based class of shareholders for two reasons: to provide stability and to make it more difficult to reverse the privatization process. The mechanism was so-called "popular capitalism": buyers were required to put only 5 percent down, while CORFO gave them a 15-year loan for the remainder. There was a 1-year grace period at a zero real interest rate, a 30 percent discount for timely repayment of the loan, and generous tax benefits. The number of shares per buyer was limited (and limits were enforced). Three additional banks were sold to groups of investors.

The two main conglomerates had been the owners of the larger AFPs (Provida, Santa Maria, San Cristbbal, and Alameda), which held 68 percent of workers' pension funds. The two largest (Provida and Santa Maria) were sold under the popular capitalism scheme (without the tax benefits). Aetna, which owned 49 percent of AFP Santa Maria, bought enough shares to get control, while the rest went to small buyers. Banker's Trust bought 40 percent of the shares in Provida, with the remaining shares going to small buyers. The other two AFPs were merged and auctioned under the name of AFP Union.

After their recapitalization, the government also auctioned the other firms it had taken over. In most cases, a controlling package was auctioned, but in contrast to the procedures of the 1970s, the government required that payment be up-front. Local conglomerates in association with foreign investors bought the major companies. To make the auctions more attractive to foreigners, they were allowed to pay with Chilean bonds that were selling in the market at 60 percent of par value. Unfortunately, little information is available about the details of the transactions of that period, as there seem to be no clear records. (Fischer, Gutierrez and Serra 2005: 207-10)

So as argued above if you implement a privatisation programme badly you are most likely to bad results, just like any other policy programme.

• Alberto Chong and Florencio Lopez-de-Silanes (2005). 'The Truth about Privatization in Latin America'. In Alberto Chong and Florencio Lopez-de-Silanes (eds.) "Privatization in Latin America: Myths and Reality", Washington: World Bank.
• Ronald Fischer, Rodrigo Gutierrez and Pablo Serra (2005). 'The Effects of Privatization on Firms: The Chilean Case'. In Alberto Chong and Florencio Lopez-de-Silanes (eds.) "Privatization in Latin America: Myths and Reality", Washington: World Bank.