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.

FRIDAY GRAPH: PRIVATISATION HITS NEW RECORDS

According to FT.com, privatisation is again sweeping the world:

…with governments hauling in a record $213bn in revenues last year in a massive sale of everything from ports to phones and gambling companies to gas groups.

The trend looks set to continue globally this year with another $150bn on the block so far, suggesting that revenues from privatisation will near the 2010 figure, the highest achieved since governments began offloading assets three decades ago.

Large deals on the table include the $6.3bn auction of Polkomtel, the Polish mobile phone operator, and Mongolia’s 30 per cent IPO of a stake in the mining company Erdenes Tavan Tolgoi, expected to raise as much as $2bn.

The figures have been bolstered by the offloading of stakes acquired in government rescues throughout the financial crisis.

The biggest privatisation this year is expected to be the US Treasury’s estimated $15bn sale of shares in Ally Financial, General Motors’ financial arm, bought when the car manufacturer was bailed out in 2009.

Although revenues from asset sales were technically higher in 2009 than in 2010, almost two-thirds of those sales involved bank repurchases of mostly preferred stock that were acquired through government bail-outs during the financial crisis, according to William Megginson, professor at the University of Oklahoma.

Last year, governments sought to devolve responsibility for infrastructure and assets in almost every political system and country.

Significant deals included Agricultural Bank of China’s $22.1bn IPO, the largest stock offering in history.

The 27 EU nations have traditionally been slow to privatise but with sell-offs a condition of bail-outs, Spain, Poland, Portugal and Greece are set to unleash a wave of asset sales.

There were several big infrastructure sales last year but many of the deals involved the sale of long-term contracts rather than entire assets. For example, the Queensland state government auctioned the right to operate the Port of Brisbane for 99 years.

The Chinese, Indian and Polish governments were involved in a number of sell-offs, partly aimed at promoting their capital markets. But the government retains a controlling stake in deals such as AgBank’s.

New Zealand governments have stood out from these worldwide trends for over a decade.  In this they were joined only by a handful of countries like North Korea and Myanmar.  I know of no other centre-left party that has adopted the anti-privatisation polices of New Zealand Labour.  It is pleasing that the government is seeking a mandate to resume a privatisation programme at the forthcoming election.

Professor William Megginson, a leading authority on privatisation, will be presenting on the subject at a CEO Forum to be held at the Business Roundtable’s offices at 5.30 pm on 8 August.  Expressions of interest are welcome.

“SENDING PROFITS ABROAD IS A GOOD THING”

Here is a nice little piece by Oliver Hartwich, a highly talented researcher at the Centre for Independent Studies in Australia.

As he notes, it’s amazing how easily Australians are persuaded by the claim that every time someone buys products of a foreign-owned company, the profits will somehow disappear and harm Australia’s prosperity.

In New Zealand, we also hear the ‘sending profits abroad’ argument in the context of the privatisation debate.

Leaving aside the likelihood that some significant part of the profits of a multinational may be reinvested in the host country, the article notes:

If the parent company however decided to transfer the profits from its Australian branch to America, it would soon find out that Australian dollars are pretty useless outside Australia and change them into US dollars.

And then it gets to the nub of the issue:

But what happens to the Australian dollars? Since Australian dollars don’t buy anything abroad, they will return to Australia to buy Australian goods and services. Maybe a US company will use them to buy Australian minerals. Perhaps US tourists will come here to spend their holidays. Or the US might import Australian-made cars.

In any case, Australian dollar profits transferred abroad return to Australia sooner rather than later because outside Australia, our dollars are just printed paper that will not get you a cup of coffee.

So the conclusion is:

This is where the ‘Australian-owned’ argument falls to pieces. For Australia’s wealth and prosperity, it does not matter where the profits from Australian businesses end up. All that matters for the Australian economy is that Australia remains a place where business transactions take place – irrespective of who owns the business.

Would that more New Zealand journalists and commentators exposed the fallacy of the ‘sending profits abroad’ argument.

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