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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