FRIDAY GRAPH: PRIVATISATION

This chart comes from the presentations that Professor Bill Megginson of the University of Oklahoma gave in New Zealand this week. Megginson is arguably the leading academic expert in the field.

It shows that annual privatisation revenues have fluctuated but are currently at record levels.

The EU and US debt crises will no doubt give further impetus to privatisation.  SOEs have been effectively eliminated in the United Kingdom.

Megginson lists the lessons of privatisation research as follows.

  • Sales improve financial and operating performance

        – impact on employment less clear-cut

        – generally also yields fiscal bonus for government

  • But, privatisation does not always ‘work’

        – and governments often try to retain real control

  • Investors have benefited from privatisation

        – both short and long-term returns are positive

  • Governments should sell assets as quickly as possible, for cash, to highest bidder

        – favour SIPs (Share Issue Privatisations), allow foreign purchases when possible.

Visit www.nzbr.org.nz to view the presentation Professor Megginson gave at a New Zealand Business Roundtable CEO Forum.

THE TRUTH ABOUT PRIVATISATION # 15: PROFITS GOING OFFSHORE

Last year the Treasury provided a report to its ministers headed Should we be concerned about profits going offshore?   It is a competent analysis and very relevant to the privatisation debate.

The report begins with some important factual observations which are not well understood.  One is that New Zealand’s current account deficit is dominated by investment income and transfers because goods and services have been largely in balance over the past decade.

Another is that:

The result of a long period of current account deficits is a very high net international investment position (NIIP), at about -90% of GDP. The overall position is predominantly made up of net debt rather than net equity. That is, New Zealand’s investment position with the rest of the world is better characterised as owing a lot rather than being owned.

The report then moves on to analytical issues.  It makes a point I have made repeatedly in this series:

There are two sides to the sale of an asset: a one-off payment to the seller and an expected stream of profits to the buyer. If the price is efficient, these two sides of the transaction should be equivalent: that is, the purchase price represents the net present value of the future stream of profits (i.e. the commercial value). In general, in respect of sales of government assets the value of the business to the purchaser should exceed the commercial value of the asset if retained in Crown ownership because of the greater efficiencies likely to be achieved in private ownership. A competitive sale process should ensure that the value of those expected efficiency gains are captured by the Crown in the sale price.

As regards the effect of ‘profits going offshore’ on the balance of payments, the report states:

The fundamental drivers of the current account deficit are national saving and domestic investment. Selling an asset to foreigners will only have a significant effect on the current account deficit if it affects these fundamental drivers.

A quibble here is that I would not I would not take an identity A ≡ B and C and argue that B and C are the drivers of A.  We could as easily write that B ≡ A-C and A and C are the drivers of B.  It follows that I (investment) and S (saving) are not the drivers of CAD (the current account deficit) just because CAD ≡ I – S. All three variables are endogenous outcomes, even in a model as simple as the closed economy IS/LM model.

The report then correctly points out that:

When an asset is sold to overseas investors, these overseas investors will be required to pay for their purchase of the New Zealand asset. The impact on the current account deficit will depend on how the seller of the asset uses these funds:

  • If the funds are used to increase [consumption] spending, national saving would fall and the overall current account deficit would increase.
  • If the funds are used to invest in overseas equity, there would be no change in national saving or domestic investment and therefore no effect on the current account deficit.
  • If the funds are used to repay overseas debt, there will be a deleveraging of New Zealanders’ balance sheets. The composition of New Zealand’s NIIP would change by reducing debt owed to foreigners and increasing equity owned by foreigners. Overall this would be expected to reduce New Zealand’s vulnerability, because the vulnerabilities associated with a high NIIP are somewhat greater for debt than equity

It is also important to explain that it is not New Zealand that owes the NIIP to foreigners.   New Zealand is a place, not a person. The place owes nothing.  Foreign entities operating in New Zealand can and do borrow offshore.  So do entities operating in New Zealand that are owned by New Zealanders. New Zealanders are only liable for debts they have incurred.  They are not liable for debts foreign-owned entities have incurred.     If this is not explained, lay people (and even too many economists) are led to assume that the NIIP is a liability of New Zealanders. They then start thinking that New Zealanders are ‘not saving enough’ if national savings (which is only savings by New Zealanders) is not equal to the sum of capital formation in New Zealand by New Zealanders and by foreign-owned entities.  It is then an easy step for them to then start worrying that if gross fixed capital formation is greater than national savings then ‘we’ must be spending more than ‘we’ are producing.   This does not automatically follow.

The Treasury report concludes:

In sum, we think focussing on ‘profits going offshore’ has a weak economic basis because it focuses on only part of the picture. So we do not think it makes sense to be concerned about ‘profits going offshore’ per se. The more important places to focus from a macroeconomic perspective are the overall saving and investment balance and New Zealand’s overall external vulnerability. 

In the final analysis, a concern about ‘profits going offshore’ applies to all foreign direct investment.  Particularly in an era of globalisation it is hard to make a general argument that foreign investment is bad for New Zealand.

 

 

 

THE TRUTH ABOUT PRIVATISATION: # 14: DIVIDENDS

New Zealand Herald political commentator John Armstrong was dispensing advice to the Labour Party on privatisation issues in his column last Saturday (June 11).

First, he wrote:

Labour needs to make merry hell with the foreign ownership bogie – perhaps to a point bordering on xenophobia.

What sort of responsible economic journalism is that?  I dealt with the foreign ownership ‘bogie’ in TAP # 7.  First, selling shares in SOEs to foreigners does not increase net claims on the New Zealand economy.  Second, for a given current account balance, restricting foreign ownership of SOEs is likely to mean higher foreign ownership of other companies.  Does that make any sense?  Third, FDI in SOEs may bring the same benefits as FDI generally: why, on economic grounds, would you want to apply different rules to SOEs?

Mr Armstrong goes on to write:

Labour knows it must also win the pivotal argument surrounding the permanent loss to the Crown of dividends from a one-off sale of up to 49 percent of the shares in each state-owned enterprise.

Labour cannot win that argument because it is false.  I discussed it in TAP # 11.

Let’s first look at the factual situation.  The Crown would lose the future dividend stream and up to 49 percent of the SOE’s retained earnings if a minority interest in an SOE were sold.  Retained earnings of SOEs that are attributable to the Crown and dividends paid to the Crown are included in the Total Crown operating balance. 

On this basis it is easy to demonstrate that Mr Armstrong’s argument is false because there is no net financial loss from a sale.  For a given fiscal deficit or surplus, the proceeds from selling one asset must be used to reduce debt or to invest elsewhere.  That is an accounting identity.  If all transactions are at market values and the buyer can effect no improvement in the SOE’s earnings, the value of the reduced interest payments on debt or on the increased dividends from the replacement investments will fully compensate taxpayers for the sale of the SOEs.  Expected cash flows to the Crown will rise or fall depending on whether the replacement investments are more or less risky than the SOE investment, but risk-adjusted they will be the same.  In other words, the Crown can’t lose from selling an asset at its market value.  Such a sale does not change the market value of Crown net worth.  Nor does it alter the net income stream that can be generated from that net worth.

A similar conclusion is evident from examining the way in which shares and bonds are valued in simple models.   Essentially what I was saying on TAP #11 was that if an SOE distributed its entire net cash flow each year, the present value of the future dividends would, assuming the distribution policy had no adverse effect on the efficiency of the firm’s operations and given the appropriate discount rate, equal the value of the enterprise.  On this static assumption, and assuming away different assessments about risk and uncertainty, a rational investor would be indifferent between selling the asset for its net present value now and retaining it and receiving the future dividend stream because they are of equal value. There is no loss if the share is sold for its market value.

In fact an alternative owner and a different incentive structure arising from a change in ownership may improve efficiency.  In this dynamic situation, the value of the enterprise on its sale may be more than the present value of future cash flows under the existing incentive structure.  Given a competitive sale process, the Crown is likely to end up better off from a financial perspective because bidders would tend to pay what the enterpise is worth to them, taking account of the scope to increase efficiency. This is a key economic and financial argument for privatisation.

Let’s come at the issue from another angle and consider the analogy of a bond.  Suppose I had a risk-free bond of $100 yielding 5%.  The risk free rate of interest is thus 5%.  The present value of the interest stream to infinity (assuming a constant risk-free discount rate) is $5/i=$5/0.05=$100.  In this case the entire interest is paid to the bond holder.  The net present value of the interest stream is equal to the value of the bond.  As a bond holder I am indifferent as to whether to hold or sell the bond.  If the government were the bond holder, no one could sensibly object to a decision to sell it.

The situation is the same with a holder of equity.  Suppose I have a $100 share in a firm that is fully equity-financed and, for argument’s sake, is regarded as risk-free, and it pays out 100% of its profits at a dividend rate of 5%.  I am in the same position as I would be as a bond holder:  I am indifferent as to whether I receive the future cash flows as dividends or take them out up front by selling the share.  Thus if the government were the holder of equity (say, in an SOE) no one could sensibly argue that it would lose financially from a sale.

Of course, dividend rates may be higher but only because of greater risk.  Adjusting for risk and other factors like liquidity, investors should again be indifferent between the two cash flows. Moreover, as noted above, if a share is sold at market value while holding the government’s deficit or surplus constant, taxpayers will be fully compensated for the dividend stream and retained earnings forgone.

The bottom line is that taxpayers are unlikely to be worse off financially from SOE sales and are likely to be better off because of the efficiency gains from a competitive commercial environment. 

Having said all this, the fiscal effects of privatisation are a second-level issue.  The more important efficiency gains from privatisation could also be achieved if the government simply gave away shares to citizens.  It is community welfare, not the Crown’s financial position, that counts and that is where the debate should be focused.  Debate over fiscal effects doesn’t go to the heart of the matter.

Labour would be unwise to follow Mr Armstrong’s advice.

 

 

 

THE TRUTH ABOUT PRIVATISATION #13: GOVERNMENT FINANCES BENEFIT FROM PRIVATISATION

Another example of misunderstanding, this time by Vernon Small in yesterday’s Dominion Post (2 June 2011).

First, he asks:

How does it make sense to sell shares in safe, well-performed assets earning good profit, such as the state generators, to lower debt that costs much less to borrow than the earnings stream you are flicking off?

Simple intuition should have made Mr Small pause before asking this question. If the proposition were true, the government should be borrowing even more heavily than it is today in order to invest in global sharemarkets (maybe taking over the New Zealand private sector along the way) on the grounds that equity returns are higher than returns on debt. Indeed it could finance all its spending that way.

Those who chased higher returns from finance company deposits have learnt a lesson that has apparently escaped Mr Small – that higher returns come at the cost of greater risk.  Governments that gear up, buying $1 million of risky assets for every $1 million of government bonds that they issue, do not create any wealth for taxpayers. Rather, they expose taxpayers to greater risks.  This is particularly likely to harm those in the community who are least able to protect themselves against the risk of government cutbacks when government investments turn sour.

This is not an academic point.  Back in the 1980s Sir Roger Douglas found that taxpayers had lost around $7 billion in dollars of the day from previous governments’ investments and guarantees relating to energy projects.  That was when GDP was around $47 billion.  The addition to the net public debt represented around 15 percent of GDP.  That burden makes the projected cost of the Christchurch earthquakes look quite small.  

Another fundamental point is that ‘good profits’ are not an enduring feature of state-owned businesses.New Zealand’ s economic history is littered with examples of losses rather than profits from state-run commercial activities, and of the failures of such companies to achieve their cost of capital (see earlier posts on Air New Zealand).  Politicians commonly have many non-commercial objectives, and few commercial skills.  Political imperatives will out. (Currently the Labour Party is saying state electricity generators should not have to pay commercial dividends.)

A further point is that even if it were true that the investments were as safe as government bonds, contrary to Mr Small’s assertion, the costs of the debt that could be retired if the asset were sold would exactly match “the earnings stream you are flicking off”.  Suppose, for example, that the investment returns $12 million a year safely and the cost of servicing each $100 million of government bonds is $6 million a year.  Any investor who pays $1 for a 6 cent return will accept having to pay $2 in order to get a 12 cent return.  It follows that the sale of the asset will fetch $200 million under these assumptions.  The public debt could be reduced by $200 million, reducing debt servicing costs by $12 million a year.  This exactly matches the return forgone by selling the asset.

In short, no value is created for taxpayers from issuing $200 million of low-risk bonds and using the proceeds to buy $200 million of either a safe or a risky investment.  Sure, the riskier the investment, the higher the expected net return for taxpayers, but this is offset by the greater risk.  Mr Small tries to avoid this problem by referring to the investment as ‘safe’, but in doing so he contradicts his assumption of a higher return. 

He is trying to have it both ways, but either way the argument is fallacious.

In any case, the reality is, as I have pointed out in this series, that the government is likely to be better off financially from SOE privatisations because, on average and over time, private owners run the businesses more efficiently and the government will capture some of the efficiency gains in competitive sales.

The article goes on to argue that privatisation:

 … does not address the central issue driving the country’s indebtedness – the mountain of private debt accumulated to buy houses and farms.

In fact it is relevant to this issue too. The foreign liabilities are the outcome of the large current account deficits under the previous government which were due in part to the loss of international competitiveness. By increasing efficiency in the non-traded goods sector of the economy, privatisation can contribute to improving the competitiveness of our traded goods industries.

Finally the article states:

Selling state assets to reduce debt is irrelevant to the debt problem in the eyes of overseas lenders and rating agencies. 

Tell that to the Greek government, which is currently under huge pressure to step up its privatisation programme to try to avoid further bailouts or debt restructuring!   

 

THE TRUTH ABOUT PRIVATISATION BLOG # 12: POWER PRICES LOWER WITH PRIVATISATION

‘Prices will go up if SOEs are privatised because they will have to make profits.’ What is wrong with this claim?

First, SOEs are supposed to make normal profits now: to operate as efficiently as successful private businesses. If they don’t meet their cost of capital (achieve normal profits), this is an indication that they are not being managed efficiently or that capital should be reallocated elsewhere in the economy.

Dispensing with the role of profits as a resource allocation mechanism was a socialist illusion that contributed to the collapse of the centrally planned economies.

 It follows that there is no reason to expect prices to rise more with privatisation than under public ownership (unless they have previously been suppressed for political reasons under state ownership). To the contrary, other things being equal, prices should fall or rise more slowly with greater private sector efficiency.

Australia is often a useful economic laboratory given the different jurisdictions of its states and territories. A recent study looked into trends in electricity prices in four Australian states and compared the performance of the private and state-owned electricity distributors. The five distributors in Victoria and South Australia are privately owned whereas those in New South Wales and Queensland are owned by the state governments.

The results of the comparisons are striking:

Figure 3 compares the revenue per connection from government owned and privately owned distributors. The government owned distributor curve is the weighted (by connection number) results for the distributors operating in NSW and QLD, while the privately owned is the weighted result for distributors operating in Vic and SA. The figure shows the clear divergence, particularly from 2009 onwards, in revenue per connection for government and privately owned distributors.

The study also employs a more sophisticated analysis to benchmark the efficiency of the distributors. The results of that analysis are that: 

… the average performance of the privately owned distributors is at the upper-quartile of all distributors. By comparison, the average government owned distributor is around half as efficient as the average private distributor (i.e. they incur more than twice as much expenditure to deliver the same level of output as the average privately owned distributors).

The consequence is that:

  • Government owned distributors currently charge almost twice as much as privately owned distributors. The gap has been getting bigger since 2001 and will increase even further until at least the middle of this decade;

 The lower charges are not at the expense of service quality:

These results show that on average government owned distributors provide slightly lower levels of service (more frequent and longer outages) than their privately owned peers.

 It goes on to report that:

  • Privately owned distributors are on average twice as efficient as government owned distributors; and
  • the efficiency gap between private and government owned distributors has grown significantly over time.

 The report’s first recommendation is:

 Privatise

The compelling evidence that privately owned networks in Victoria and South Australia have delivered superior outcomes for electricity users in those states should be considered carefully. Private ownership of the distributors in New South Wales and Queensland coupled with effective regulation will strengthen efficiency incentives and eliminate distortions attributable to these governments’ financial interest in their distributors. The best interest of consumers should take precedence over ideology.

Read the Energy Users Association of Australia’s full report: Australia’s Rising Electricity Prices and Declining Productivity: the Contribution of its Electricity Distributors

THE TRUTH ABOUT PRIVATISATION: BLOG # 11

One of the difficulties of debunking myths about privatisation is that some people do not get basic factual or economic points even when they are clearly explained.

Thus in a recent letter to the Dominion Post, investment analyst Garth Ireland wrote:

Labour leader Phil Goff says that, under Labour, there will be no asset sales (May 2). He says: “It is economic madness. The power companies return $700 million in dividends every year – that is lost forever”. But is it?

Surely the sale price received today is equivalent to the future expected dividends? Nothing is lost. Dividends of $700m a year at a rate of return of, say, 10 per cent are equivalent to $7 billion today.

Mr Goff claims that the dividends “pay for 10,300 teachers, 12,600 new police officers or 33,000 hip replacements”. He can still spend the $7b sale proceeds or the $700m each year forever. They are equivalent.

This drew the following comment on the Dominion Post website:

“Surely the sale price received today is equivalent to the future expected dividends?” I think you sir may in fact not get it. “The future expected dividend” is infinite. Inflation happens, and so does increasing dividend.

If we sell it for 7 billion, that is ALL we ever get and it will end up like kiwi rail, run down by the owners to maximise profit. The 7 Billion will become worth less and less. And we will become asset poor.

If we keep it, the value will increase, dividends will increase as electricity becomes our primary fuel source (Oil crisis), and because we (the NZ government, and by default the NZ people) will invest in it, it will not become run down.

Would you sell your kidney for short term profit? I think you would. Think long term, thinking short term led to the current problems.

The future expected dividend may indeed be infinite (if the SOE performs well). But what Garth Ireland was pointing out is that to compare the value of the asset to the Crown if it remained in public ownership with the value to the Crown of a sale, you have to discount the future (infinite) dividend stream to express it in net present value terms. People value a dollar today more than they value a dollar in 100 years’ time.

On that basis, the Crown’s financial position is no worse as a result of the sale. In fact Garth Ireland could have made a stronger point: because the new private owners of the business are likely, on average, to operate it more efficiently, the Crown is likely to be better off financially (relative to keeping the asset) because in a competitive sale process it will capture some of the likely efficiency gains.

THE TRUTH ABOUT PRIVATISATION: BLOG # 10

Recently the Treasury released a December 2010 paper Short History of Post-Privatisation in New Zealand, written by John Wilson, an experienced former Treasury official.

It records in a balanced and objective way the history of nine major privatisations by central and local governments.  The companies surveyed are Ports of Auckland, Bank of New Zealand, Air New Zealand, Auckland International Airport, Telecom, Tranz Rail, Trustpower, Contact Energy and the Forestry Corporation.

The paper notes that

The selection of companies was intended to illustrate the issues that have arisen from privatisation. The list of companies is not comprehensive, nor is it necessarily a sufficiently robustly drawn sample to draw strong aggregate conclusions about privatisation in New Zealand. The strongest general conclusions about the merits of private rather than government ownership can be drawn from global studies with much bigger samples.

Not covered are many of the other 20 plus privatisations that would generally be regarded as successful, such as NZ Steel, Petrocorp, Postbank, Rural Bank, State Insurance, Works Development Services and Capital Property Services.

The paper notes the range of objectives of privatisation of governments around the world:

  • Putting businesses under the full pressures of private capital markets, and thus making them more efficient.
  • Reducing the exposure of the government balance sheet to risky debt financed assets.
  • Removing the capacity of the businesses to seek government aid in bad times, thus both promoting better business management (to avoid that risk) and reducing risks to government fiscal outcomes.
  • Promoting the development of local capital markets, and/or encouraging a broad ownership of shares in the community.
  • Using the sale proceeds for higher priorities, typically to reduce government debt.

All of these objectives have been relevant at different times in New Zealand.

On methods of privatisation, the paper comments:

Typically, in an asset sale, the best price is obtained by selling a controlling shareholding to a single entity that can control the destiny of the business (a trade sale). A float generally gets a lower price.

New Zealand governments mainly employed trade sales, with some floats or sell-downs.  Privatisation was not ‘done the wrong way’, as some critics allege.

The paper makes a key point on how to judge privatisation:

The outcomes for the individual companies dealt with here vary a great deal. Some have prospered and greatly rewarded their shareholders; others have gone into financial distress and some of those have required government finance again. It is probably unfair to see both of these ends of the spectrum as indicative of failed privatisation. In any group of companies over two decades, some will prosper and some will fail. That is in the nature of a competitive economy.

Interesting points made on the nine privatised companies are as follows:

Ports of Auckland

Partial privatisation achieved significant efficiency gains.  “For example between 1988 and 1993 staff numbers fell from 1393 to 504, and average turnaround times fell from 38.4 to 15.7 hours.”  The point is not made that after renationalisation the financial performance of POA fell away and the partially listed company Port of Tauranga has outstripped POA in terms of productivity gains.

Bank of New Zealand

The main takeaway here is a cautionary note about partial privatisation: “the period of mixed ownership of the BNZ was not a success.”

Air New Zealand

The paper records the lessons of Air New Zealand as follows:

It was private investors, rather than the government, who lost money as a result of Air NewZealand’s financial failure.

The Ansett purchase was a major strategic failure. It does not disprove the general principle that private ownership is more commercially adept than government ownership. But it reminds us it is a general principle rather than an iron law.

The paper is wrong to state that since (partial) renationalisation “the commercial performance of Air New Zealand has been good.”  As noted in an earlier blog (1 February 2011), Air New Zealand has not systematically met its cost of capital.

Auckland International Airport

There has been little controversy about this privatisation (other than the previous government’s misguided intervention in an overseas bid for a stake in the company).  As the paper notes, “AIA has become one of the major and respected companies on the NZX, and it retains a wide shareholding.”

Telecom

The paper states:

Telecom’s post-privatisation performance divides, on the face of it, into two periods. For the first five years or so the value of the company rose quickly, as reflected in its share price, and although that led to some critics arguing that it had been sold too cheaply, the public  also appreciated both Telecom’s improved service compared to the memory of the Post Office, and the new competition from Bell South and Clear.  Subsequently, as Telecom’s share price has fallen back to near the original float level, criticism of the original sale price has dissipated.

It does not go into the previous government’s politically motivated unbundling of Telecom, contrary to the advice of the Telecommunications Commissioner.  This was an unprincipled regulatory taking without compensation to Telecom shareholders which crippled the company and has led inexorably to further intervention, in particular taxpayer investment in broadband.

Tranz Rail

The key points here are that under private ownership cost reductions occurred and returns on capital improved, but the business was still not financially viable in the face of continuing declines in competing freight costs.  Rail is a very difficult business in New Zealand.  The paper notes:

Nonetheless, privatisation meant that for 10 years from 1993 to 2003 the Crown did not have to fund the rail freight system. That is quite likely the only such decade since rail came under central government control in the 19th century.

and:

As an integrated commercial asset rail is probably worthless now, though elements of it (for example the ferries; the West Coast coal route) would still have value in a break-up. The price paid by the government in 2008 reflected essentially a non-commercial transaction.

In other words, the Labour government paid an exorbitant price to buy back rail for political reasons, and taxpayers are now saddled with a business that loses “at least $100 million a year”.  Bill English has rightly described this as the price of nostalgia.

Trustpower and Contact Energy

Both have been success stories since partial and full privatisation respectively.

Forestry Corporation

The paper notes:

The FCNZ sale was a success, but not for reasons that were expected at the time. It shifted the write-down of forest assets as a result of the 1998 Asian crisis from the Crown to Fletcher Challenge and its consortium partners. Clearly in this case the price received for the asset was, with hindsight, excellent.

Contrary to claims that ‘family silver’ was sold too cheaply, Fletcher Challenge clearly paid too much for this business.

Conclusion

Three final points in the paper are worth noting:

  • The privatised companies have followed very different paths, and the level of commercial success they have achieved has varied greatly. That should not surprise us. That is how an economy made up of competing private businesses functions.
  • Five of the companies under discussion that remain listed on the NZX (Auckland Airport, Air New Zealand, Contact, Telecom, Trustpower) make up over a third of the market capitalisation of the NZX50.
  • The privatisation programme of the 1980s and 1990s is one of the factors behind New Zealand entering the recent financial turmoil with a relatively modest level of government debt.