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.

 

 

 

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8 thoughts on “THE TRUTH ABOUT PRIVATISATION: # 14: DIVIDENDS

  1. This has been an excellent series. It’s a shame the Herald publishes rubbish like Armstrong’s columns and not lucid arguments based on proven economics. Thank you.

  2. So far as i would understand it, rather than worrying about the revenue from a govt owned company(forgetting the fact that it is rare to get market value when privatizing) the concern would be that the newly private company will be able to use its position in the private sector to gauge the public in the pursuit of profits.

    If the company were at least domestically held the extra dividends to share holders(if put back into the economy) might balance out the job loses due to streamlining operations and the increased cost to users due to the added focus on profiting from a dominant market position.

    If however those shares end up overseas even by way of being sold on by private individuals the so called efficiency gains will be made to line foreign pockets not NZ ones.

  3. That’s exactly the point though – a proper sale process WILL get market value for the shares in the relevant businesses. A buyer will pay the net present value of the optimised business. (In fact this is a relatively minor consideration because the majority of ‘value’ was added when the businesses were corporatised (which is not to say they’re run effectively at present)).

    These companies operate in competitive sectors (electricity generation etc) so if they were going to gouge customers it’s not clear why their non-SOE aren;t doing that at present.

    If you read this whole series of articles your concerns are pretty much all addressed. There may be some job losses but you’ll find these big infrastructure-intensive companies aren’t particularly labour intensive anyway.

  4. This comment by Jaimini is stuck in the back end.

    Comment by Jaimini June 21, 2011 @ 2.03

    The exact matching argument is one often put forward to demonstrate the benefits of a free market that finds the ideal level for everything.

    In the real world knowledge is unequal every investment is a best guess according to the knowledge that each party holds so huge gains(and hence losses to another party) can be made by people with more knowledge/connections/leverage.

    A privatized company can streamline, remove risk controls increasing risks and returns and sell on to less knowledgeable mom and pop investors(or greedy investment funds) in a cycle of speculation ultimately costing the taxpayer all over again when they need bailing out.

    Often the reason a company is public in the first place is because the goal of pure profit does not line up with the idea of a triple bottom line. Is a private power company going to worry as much about the environment? what if it’s foreign owned? is a prison going to worry about rehab or quality of life when re-offending is actually more profitable(but costs the tax payer in policing costs and social impact)? is a foreign owned bank in NZ for the long run or just a wee money maker on the side for foreign money?

    In an ideal world everyone would have equal knowledge we would have a small government and a free market and greed would be a forgotten word.

    In the absence of an ideal world a government needs to protect its people from the worst amongst them and in this day and age the worst from around the world too. If publicly held companies help protect us then stick with them.

    Comment by Jaimini June 21, 2011 @ 2.03

    • As perfectly knowledge is a unattainable nonsense its not worthy of wasting time on…like most leftist straw-men “arguments”.The price is what is important..and ultimately what people focus on when buying and selling.

    • Companies never need “balling out”.

      Let them fail!! at no cost to the public purse.

      The world economy would be far stronger overall if Greece, Portugal, and New Zealand were bankrupted, their bank accounts cancelled, and any remaining “assets” sold overseas for hard currency to allow the economy to restart from scratch.

  5. Roger asked…
    What sort of responsible economic journalism is that?

    Roger, we (the public) must understand that the so called journalists of today are not really journalists. A journalist is someone who is suppose to report of what they see, and not give an opinion of what they think about of what they see. Once they started giving out their (misinformed) opinions of what they see, then they’re stepping in to the territory of news manufacturing and that’s exactly what’s happening today and John Armstrong & his colleagues at the Herald are no exception.

    The most obvious thing when journalists do this (ie, manufacturing news with their misinformed opinions on a specific subject), those who are knowledgeable in that specific domain (be it economics, climate science, engineering or science, etc,…) can really see that they’re spouting bullsh*t. The thing here is that they’re unwilling to school themselves on issues. FFS, one can just get some books on a specific topic and read about it thoroughly so he/she can be very well informed.

    It appeared to me that John Armstrong & his colleagues at the Herald haven’t done that really. They haven’t schooled themselves in how an economic system evolves over time (ie, what stimulates growth, what hinders businesses, what encourages entrepreneurs to take risks, etc,…). They turned up at the Herald everyday just to publish uninformed bullsh*t opinions without taking time to learn about what they’re writing about more deeper. The result is that the public (with full of useful idiots) take what they’re reading in the newspapers seriously thinking that it is the truth, but unknown to them is what they’re consuming is all nonsense and bullsh*t.

    Had journalism being like professions as engineering or medicine (ie, candidates are required to sit regular examinations so that they’re upto date with recent developments in technologies and advances in knowledge), most journalists would fail to pass.

    Even Tapu Misa is a misinformed commentator herself, I do admire Tapu for trying to school herself on issues that she’s writing about. When she writes her regular columns, she does quote published studies (peer review) in her articles. This clearly shows that she researches her subject very well (although she only seek articles that conforms to her political ideologies).

    Herald journalists should take a leaf out of Tapu’s efforts. They should read, read, read (even peer reviewed studies), until they almost master the topic before they write their articles. But as I said above, I know that journalists are unwilling to school themselves on issues and the chance of this happening is zilch (ie, getting familiarize with the subject they write about on a deeper level) .

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