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The World Bank FPD Note No. 7 May 1994

Is Privatization Necessary?
John Nellis

The answer is a decided “yes.” Privatiz- • The owner instructs management to

ation is necessary, and not simply to follow the signals provided by the
improve the performance of public market and gives it the autonomy to
enterprises—though the evidence is do so.
striking that it can and does improve • Management is rewarded and sanc-
performance. Privatization’s essential tioned on the basis of performance.
contributions are to “lock in the gains”
achieved earlier in reforming public Evidence shows that the theory does
ownership or in preparing a firm for indeed apply in practice—with two
sale, to distance the firm from the polit- crucial qualifications. First, the full set
ical process, and to inoculate it against of necessary conditions is only rarely
the recurrence of the common and met. And second, even when it is met,
deadly ailment of public enterprises: it tends to stay met for only a while;
interference by owners who have more the necessary conditions cannot be
than profit on their minds. made to endure.

Performance and ownership— Principal and agents

the debate There are a number of modern amend-
ments to neoclassical reasoning that
Market forces attempt to establish a clearer relation-
Neoclassical economic theory suggests ship between ownership and efficien-
that the relationship between owner- cy. These come mainly from public
ship and performance is tenuous; effi- choice theory and the literature on
ciency is seen mainly as a function of principal and agents. Operationally,
market and incentive structures. In this reasoning says that private owner-
theory, it makes little difference whether ship will produce superior efficiency
a firm is privately or publicly owned as outcomes because of five factors:
long as:
• Private ownership establishes a
• It operates in a competitive or con- market for managers, leading to
testable market without barriers to higher-quality management.
entry or, just as important, barriers • Capital markets subject privately
to exit. owned firms to greater scrutiny and

Private Sector Development Department

Vice Presidency for Finance and Private Sector Development
discipline than they do public enterprises. Public mutual obligations and responsibilities of the princi-
enterprises often operate on Janos Kornai’s fa- pal and the agent; or the owner could constitute and
mous “soft budget constraint.” Because of explicit empower a new and more independent board of
or implicit guarantees from the state, public enter- directors and give it explicit instructions to maximize
prises can borrow capital at less-than-market inter- commercial profitability; or the owner could name a
est rates, and they often enjoy outright subsidies powerful and independent chief executive officer,
and other concessions from the state (meaning and give him or her a free hand. The fifth factor—
that they don’t pay their taxes, their utility bills, better representation of the interests of capital—is
their accounts payable to other public enterprises, more difficult to resolve without some change in
customs duties, or the like). ownership, or at least some privatization of manage-
• Private firms are subject to exit much more often ment—through management contracts, leases, fran-
than public enterprises. Private firms are more chises, or concessions. But even here performance
subject to bankruptcy, liquidation, hostile take- agreements and other mechanisms to create surro-
over, and closure than public corporations. When gate capitalists are imaginable: for example, estab-
exit is a real possibility, there is a greater likeli- lishing a holding company or companies and
hood that owners and managers will take active, instructing them to act like private owners, or frag-
efficiency-enhancing measures to avoid it. menting ownership among several different levels of
• Politicians interfere less in the affairs of private government or state agencies and making them de-
than public firms. Political interference is a major pendent on the income generated by the enterprise.
cause of efficiency-reducing conditions in public Both institutional approaches would presumably
enterprises; it manifests itself in overstaffing, un- diminish the saliency of noncommercial objectives.
dercapitalization, inappropriate plant location,
wrong use of inputs, and many other costly acts. Tried and tested?
• Private firms are supervised by self-interested All of these theoretically applicable solutions have
board members and shareholders, rather than by indeed been tried, or are presently being tried,
disinterested bureaucrats, and are thus more likely around the world—with some highly positive re-
than public firms to use capital efficiently and to sponses. New Zealand’s “corporatization” efforts of
maintain it. the mid-1980s achieved efficiency and financial gains
in ten of eleven enterprises studied by Duncan and
Practical solutions Bollard in Corporatization and Privatization:
The problem with all five of these arguments is that Lessons from New Zealand.1 Korea’s performance
one can readily conceive of mechanisms to correct evaluation system for twenty-six of its government
the perceived deficiency—without changing owner- invested enterprises reduced, for a time, financial
ship. For example, if finding and rewarding excel- losses to zero. These financial gains were accompa-
lent managers is the issue, enterprises could recruit nied by a declining ratio of costs to sales, indicating
outside the public sector, or even internationally, efficiency gains. Korea’s reform program relied
and offer incentive packages equal to private sector heavily on a goal setting and review system—com-
scales. If the soft budget constraint is the problem, plete with rewards—and a massive change in the
governments could eliminate all guarantees and stip- boards of directors that reduced civil servant mem-
ulate that public enterprises must turn to commercial bership to a small minority.
capital markets and act, and be treated, like any
private sector borrower. If exit is the constraint, gov- The most powerful recent empirical evidence to sup-
ernments could liquidate persistently poorly per- port the thesis that reform can work without owner-
forming public enterprises. If political interference ship change comes from China. There are now about
is the difficulty, then the owner and the enterprise 1.3 million township and village enterprises employ-
could sign a performance contract specifying the ing 90 million people. They account for more than 20

percent of China’s industrial production and are That leaves a variance to explain—and ownership is
growing far more rapidly than the traditional state- a strong candidate for a good part of the explana-
owned enterprise (SOE) sector. Their financial and tion.
economic performance surpasses that of the tradi-
tional SOEs by two or even three times. They are a Empirical work
stunning example of how positive performance can The second strand of the argument is empirical. It is
be achieved by firms that are not privately owned— based on several recent and rigorous studies that
but that are made to act as if they were. have looked at firms before and after privatization.
These recent studies show generally, and impres-
Added to these positive cases are the findings of a sively, improved performance after sale. A Journal of
fairly extensive literature, most of it dating from the Finance article2—by Megginson, Nash, and van Ran-
early 1980s, that tried to measure public versus pri- denborgh—compares the pre- and postprivatization
vate performance. This was done basically on a financial and operating performance of sixty-one
“with and without” basis; that is, comparisons were companies from eighteen countries in thirty-two
between roughly similar public and private enter- industrial sectors. The study shows strong postsale
prises in operation. The conclusions reached were performance—increased real sales, greater profitabil-
by no means unanimous, but more often than not ity, increased investment spending, improvements in
the literature suggested that, after correcting for mar- operating efficiency, and, most surprising, a slight
ket structure, there are no real differences between increase in work forces.
public and private ownership. The policy implica-
tion is that perceived deficiencies of public enter- A second study, on the welfare consequences of
prise performance can be corrected by changes in selling public enterprises,3 was conducted by the
policy, incentives, and institutions, and that owner- World Bank in collaboration with Boston University
ship change is not necessary. economists. This study looked at pre- and postsale
performance in profitability and productivity in
In light of all this, how can one still reasonably con- twelve firms in four countries. It went on to construct
tend that ownership matters? an elaborate counterfactual, to determine what
would have happened had the enterprises not been
Why ownership matters privatized. The authors then were able to say “here
is what was actually happening before sale, here is
Probability what actually happened after the sale, here is what
The first strand of the case is probabilistic in nature. we reason would have happened under continued
While private firms do not always outperform pub- government ownership.” In constructing this scenar-
lic enterprises, the evidence shows that they usually io, they did their best to isolate and neutralize the
do. For example, over the years, the World Bank gains and losses due to factors other than divesti-
has noted that rates of return on equity invested in ture. They then subtracted the hypothetical from the
industrial or commercial public enterprises often historical, and thus derived a measure of the gains
are about a third of those in the country’s industrial due to ownership change. This study quantifies the
private sector. The overall contention is that there welfare gains and losses of the various actors in the
are two spectra of performance from good to bad— process; that is, the costs and benefits to the selling
one for public enterprises, one for private firms. governments, purchasers—domestic and foreign—
There is a fair degree of overlap between the two. workers, consumers, and competitors. The results
But the private sector performance spectrum ex- are as follows: in eleven of twelve cases studied,
tends somewhat to the right of the public enterprise there were positive welfare effects for society be-
performance spectrum—and mean performance for cause of the sale, and improved performance at the
private enterprises is also somewhere to the right. level of the firm.4

Compromise and backsliding cial over noncommercial aims, the results are, as we
The third and final strand of the argument for pri- have seen in China, very good. But they tend not to
vate ownership is political and organizational in last. In most instances there is pronounced backslid-
character. The idea is twofold. First, as noted, most ing. The common story is that bad times make for
governments find it difficult if not impossible to good policies—in crises governments do establish
apply the entire package of qualifying conditions the precedence of commercial objectives, they do
that are essential for reforms short of ownership impose a harder budget constraint, and they do give
change to work. The landscape, particularly in autonomy to public enterprise managers to achieve
developing countries, and now in ex-socialist coun- commercial aims. But again and again, when the
tries as well, is littered with partial attempts to im- crisis fades, or when the regime changes, or when
pose reform where the government owners hadn’t some major political claim arises, commitment to the
the will or the fortitude or the knowledge or the priority of commercial aims and to noninterference
capacity or the luck to impose the whole of the in day-to-day management of the firm fades with it.
reform package—and the results were minimal, Examples of backsliding include the New Zealand
modest, or nonexistent. Post Office, the Japanese National Railway, Pakistan
public industrial enterprises, and some of the
There are innumerable examples in which govern- Korean government invested enterprises.
ment owners kept prices for the products of suppos-
edly reformed public enterprises too low to cover Conclusion
costs, out of fear of the political consequences of Based on this reasoning and evidence, it is clear that
price increases. Governments may shut off direct ownership matters—that it is a significant determinant
budget flows to public enterprises, but few then go of the profitability and productivity of an enterprise.
on to block concessionary transfers from the bank- Political and organizational factors are fundamental to
ing system. Governments grant operational autono- the reason why. Ultimately, as Oliver Williamson is
my to managers, but not with regard to hiring and fond of saying, “politics trumps economics.”
firing, or plant location, or from whom to obtain
inputs. Technically innocuous board of director re- 1
Ian Duncan and Alan Bollard, Corporatization and Privatization:
forms have been halted in Kenya, Morocco, and Lessons from New Zealand (Auckland: Oxford University Press, 1992).
William L. Megginson, Robert C. Nash, and Matthias von Randenborgh,
elsewhere because board membership is a lucrative
“The Financial and Operating Performance of Newly Privatized Firms:
core part of the patronage system. The list is end- An International Empirical Analysis,” Journal of Finance 49(2): 403–52
less, and the point is obvious: most governments (1994).
have noneconomic objectives for their public enter- Ahmed Galal, Leroy Jones, Pankaj Tandon, and Ingo Vogelsang,
Welfare Consequences of Selling Public Enterprises: An Empirical
prise systems. While they want them to be profitable Analysis (New York: Oxford University Press, 1994).
and productive, they are most often unwilling or 4
There is much else that is striking in this study. For example, it shows
incapable of allowing these commercial aims to take clearly that policy matters as well as ownership, that macroeconomic
liberalization in conjunction with privatization is a powerful combina-
clear precedence over the noncommercial. Thus, tion, and that effective regulation must accompany (preferably pre-
their reform efforts tend to be partial. cede) the privatization of infrastructure firms if divestiture is to yield its
full potential.
Second, in the few cases in which governments do
establish and maintain the precedence of commer- John Nellis, Manager, Private Sector Development

This series is published to share ideas and invite discussion. It covers financial and private sector development as well as
industry and energy. The views expressed are those of the authors and are not intended to represent an official statement of
Bank policy or strategy. Printed on recycled paper.
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