The Truth About Privatisation: Blog #6

In George Orwell’s Nineteen-Eighty Four written in 1948, Syme, the philologist, explains to Winston Smith that:

By 2020 –earlier probably – all real knowledge of Oldspeak will have disappeared – Chaucer, Shakespeare, Milton, Byron – they’ll exist only in Newspeak versions, not merely changed into something different, but actually changed into something contradictory to what they used to be.

Newspeak certainly seems to describe what has happened to Telecom.

Over the last decade the combined assaults of politicians using it as a political football, industry rivals seeking advantages through regulation, and some self-inflicted injuries of its own have virtually erased memories of the perceptions and achievements of the company in the first decade after privatisation.

Here’s the Oldspeak story of Telecom.

The company was privatised in 1990.  The price received by the government – $4.250 billion – stunned observers and the market.  No one talked about selling that piece of family silver too cheaply.

Already the company as an SOE had been transformed from the days of the overstaffed, lumbering, state monopoly post office, when subscribers took weeks or months just to get a telephone.  Under deregulation and privatisation there was an acceleration of cost reductions (that were passed on to consumers in lower prices), high rates of investment, vast improvements in services, the introduction of new technologies and vigorous competition from new entrants.

Perhaps the most interesting summary statistic generated by the changes is the rate of growth of productivity in the industry.  From 1990-2000 annual labour productivity growth averaged over 13% and multifactor productivity growth over 7%.

These rates were easily the highest of any industry in the measured sector to the economy.  New Zealand would have been a South Pacific Tiger if the productivity performance of other industries had come even close to matching them.

And how did the public view Telecom in those years?

Well, the independent polling company Insight did monthly surveys and Telecom’s favourability ratings were routinely in the top three companies, vying with Air New Zealand and New Zealand Post.  Remember the public’s love affair with Spot the Dog?

In the Corporate Management Top 200 awards, Telecom was judged to be Company of the Year in 1991 and to have the Best Corporate Strategy in 1994.

CEO Roderick Deane was judged the Best Executive of the Year in 1994 and Executive of the Decade in 1999.

The company grew operating earnings every year and its share price rose from around $2 at the time of listing to a peak of well over $9.  It was the country’s largest taxpayer and it invested millions into communities in New Zealand through arts, education, community and sports sponsorships. It had the largest capital investment programme in New Zealand apart from the government.

I will not go into the sad story of Telecom in the second half of the 2000s in detail here.  The 20 years since privatisation have been a game of two halves.  Starting with the Hugh Fletcher review of telecommunications regulation set up by the Labour government when it came to office, it has been a saga of ever-greater regulation, slower productivity growth, rapidly declining earnings, an immense hit to the sharemarket capitalisation of the company (more than $3 billion) when the government overruled the Telecommunications Commissioner’s advice and mandated unbundling, and now government involvement in the industry in the form of the broadband intervention.

The taxpayer is forking out $1.5 billion for an investment which shamefully has had no cost-benefit analysis conducted on it and where a regulatory regime is being proposed which one major player says will gag the Commerce Commission and stifle broadband competition.  Moreover, a major recent study was unable to find any significant additional economic benefit from moving to speeds higher than we have at present. That is not to say that we should not invest for faster broadband but it does indicate that we should only do so off the back of a full economic justification and not with the poor old taxpayer’s money again put at risk with a modern unjustified version of Muldoon’s Think Big projects.

Today Telecom looks like a crippled company on the verge of some sort of breakup, and public attitudes towards it are much less favourable than used to be the case.

Newspeak – the process of changing things “into something contradictory to what they used to be” – has done its malign work.

THE TRUTH ABOUT PRIVATISATION: BLOG # 5

In foreshadowing partial privatisation of some SOEs and Air New Zealand, the government is placing emphasis on the case for reducing debt.  There was a similar emphasis in the privatisations of the late 1980s.

This case is valid but it is a secondary argument.  The main argument is about economic efficiency: that on average and over time, privately owned enterprises out-perform publicly owned ones (and hence contribute more to national income).

For some years the most commonly cited meta-study in support of this view was a 2001 Journal of Economic Literature (JEL) article by Megginson and Netter.  The JEL is the leading economic journal for survey articles of this kind.  As summarised by Phil Barry in his report for the Business Roundtable, the paper found that:

1. of the ten studies examining the relative efficiency of private and public enterprises operating in the same industry, eight studies found the private sector firms performed better, while two found no significant difference between the privately and publicly owned firms. None of the studies found the public sector was more efficient;
2. of the 22 studies that examined the effects of privatisation in developed countries, all but one found privatisation was associated with improvements in the operating and financial performance of the divested firms; and
3. of the 16 different studies of the effects of privatisation in transition economies, the studies documented “consistent and significant” evidence that private ownership was associated with better firm-level performance than was the case with continued state ownership. Further, foreign ownership was associated with greater performance improvement than for firms where ownership was limited to domestic investors.

Phil Barry also cited OECD and World Bank surveys that reached similar conclusions.

One would not expect all studies of privatisation to find that private ownership is superior:  SOEs can perform well for periods of time.  Some individual case studies have found public sector superiority.  The key point is the “on average and over time” finding.  Governments should not gamble against known odds with taxpayers’ money.

Since the three studies mentioned above, the only comprehensive survey article I’m aware of is this paper by Saul Estrin et al, published by the World Bank and also in the JEL in September 2009.

The Estrin et al survey examines the effects of privatisation in post-communist economies and in China. Their findings parallel those of the three earlier surveys noted above. In particular Estrin et al find:

• ownership matters but it is not the only thing that matters;
• on average and over time privatisation leads to improved firm performance and improved economic performance (the CIS seems to be an exception to the latter); and
• allowing foreign ownership significantly increases the positive effects of privatisation.

Thus the government would appear to be on firm ground in citing the empirical evidence in support of full privatisation.  The evidence on partial privatisation may well be more mixed.

THE TRUTH ABOUT PRIVATISATION: BLOG # 4

I blogged about Air New Zealand on 1 February.  My main point was that although Air New Zealand has been innovative operationally, it is not meeting its cost of capital (and it did not do so in at least some earlier years) and is hence a drag on the economy (GDP and GDP/head).

The Treasury has recently posted an interesting short paper on Air New Zealand on its website.

It is dated but nevertheless still relevant.  The author, experienced former Treasury official John Wilson, suggests the following lessons from the Air New Zealand experience:

It was private investors, rather than the government, who lost money as a result of Air New Zealand’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.

A New Zealand government is likely to find itself the only potential source of new capital in the event of financial failure of a New Zealand-based international airline.

One comment on my earlier post was that (some) other airlines are not making money either.  This is true.  John Wilson comments that “the record of airlines as investments is poor”.  Noted investor Warren Buffett once said that if someone had shot down The Flyer when the Wright brothers put it into the air at Kitty Hawk they would have done investors a favour.  The moral of the story is that governments should be wary of committing taxpayers’ money to such investments.

THE TRUTH ABOUT PRIVATISATION: BLOG # 3

Last Sunday’s Sunday Star-Times editorialised against the government’s privatisation plans (‘Asset sales road littered with disasters and fiascos,’ 30 January).

Among other things, it said that government-owned companies “can be efficient as well as profitable. Kiwibank has been a brilliant success …”

The first part of this statement is certainly correct. Not all SOEs are poor performers and not all privately owned businesses perform well. But the unequivocal findings of economic research are that on average and over time, privately owned businesses outperform publicly owned ones (see here for relevant references). What matters for policy is this general result. Government should not bet against the odds with taxpayers’ money.

What about the claim that Kiwibank has been a “brilliant” financial success. I have never seen evidence to support this claim. Two points are relevant:

As I understand it, the original Cameron Partners advice to the government was that Kiwibank would ultimately earn profits but that these would not be sufficient on an NPV basis to warrant the investment, and

Many argue that Kiwibank has been cross-subsidised by the postal business of New Zealand Post.

Does the Sunday Star-Times have evidence on these points to justify the “brilliant success” claim?  I think we ought to be told.

THE TRUTH ABOUT PRIVATISATION: BLOG # 2

Veteran anti-market critic Frank Macskasy writes (Letters, Dominion Post, 31 January), “why should Kiwi mum and dad investors buy something that they already own?”

Taxpayers are indeed the true owners of SOEs (and other government assets).  A perfectly viable approach would be for the government to simply give shares in SOEs to them.  This is not necessarily the best approach but it would yield benefits because of the disciplines of private ownership.

A variant would be for the government to give shares to taxpayers but to set up a trust into which shareholders could gift their shares if they valued collective ownership.

Would Mr Macskasy be happy with either of these approaches, I wonder?

But if the government simply sold shares, Kiwi investors wouldn’t just be buying what they already own (or, rather, buying more shares than they currently indirectly own).  Those investors who bought shares would be paying fair value for them to all taxpayers (including themselves).  All that would be happening is that the asset portfolio of taxpayers would be rearranged (so that the government had less investment in risky commercial enterprises and more in, say, roads, hospitals, schools etc.  This is an argument prime minister John Key has been making.  Why would this be a bad thing?

THE TRUTH ABOUT PRIVATISATION: BLOG # 1

I am starting a blog series exposing myths in the privatisation debate.  It could become a lengthy exercise.

This one is on Air New Zealand.

Since Air New Zealand was effectively nationalised by the Labour government (I’ll leave aside here arguments about that controversial decision) it has often been regarded as a success story. Thus Finlay MacDonald in the Sunday Star-Times of 30 January described it as “a glamour product” and a letter in Friday’s Herald said “Air New Zealand is a classic example of a government/private partnership working well.” The government has also referred to Air New Zealand as a model of partial privatisation.

Under Ralph Norris and subsequently Rob Fyfe, I think it is fair to say that the airline has been innovative and performed well operationally. But the bottom line for any commercial business is just that: its bottom line. How has Air New Zealand performed for investors, the majority of whom are taxpayers?

The answer is, not well. 

One source of information is the Treasury’s Crown Ownership Monitoring Unit which published the 2010 Annual Portfolio Report in December last year. It tells us that for 2009 and 2010 Air New Zealand’s return on equity was 1.3% and 5.2% respectively.  While this period includes the recession, total shareholder returns in three of the last five years have been negative.  Air New Zealand’s total market capitalisation has more than halved since 2007 – from $2,776 million to $1,152 million in 2010.

Air New Zealand itself has reported in the past that it has not met its cost of capital. It appears that again in 2010 it failed to do so by at least 2%. Given the most favourable WACC of 8.4% and the operating return of 6.3%, the shortfall is 2.1% and equivalent to close to $100 million (NOPAT). 

A private firm that persistently under-achieves its cost of capital eventually gets restructured (like Fletcher Challenge in the late 1990s) or goes out of business.

What does a failure of a firm to meet its cost of capital mean?

First, it means that resources have been misallocated – scarce capital could have been employed where it yielded higher returns.

Second – which is saying the same thing – the poor profitability of a firm means that it contributes less to national value added or GDP (profits are a component of GDP). In other words, material living standards are lower than otherwise.

Third, a lack of profitability means that competition (with other airlines and transport modes in Air New Zealand’s case) may be distorted, reducing potential national income further.

Fourth, in the case of a taxpayer-owned business, taxes (or borrowing) will have to be higher, other things being equal, to make up the profit shortfall.

Some people may be happy to see governments owning unprofitable airlines, rail businesses or other enterprises out of nostalgia and for other reasons.

But they should recognise that investing in socially unprofitable activities (like Think Big) has been an important part of New Zealand’s economic problems and will hold back economic growth and increases in living standards.