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On Strategies for Disinvestment & Privatisation

Vijay L Kelkar, Chairman, Forum of Federations, Ottawa & India Develpoment Foundation and was Chairman Thirteenth Finance Commission

Since Independence, the size of the public sector has increased, and currently, there are 473 central PSUs, including banks and insurance companies at the State level there are 1,160 PSUs. While there are several profitable PSUs, particularly the oil companies such as ONGC and Oil India, the net return on the capital employed in PSUs seems to be lower than that of the India’s private corporate sector. If one includes the State level PSUs, then the private corporate sector will show significantly higher returns on the capital employed.

While the public sector or the Stateled entrepreneurship played an important role in triggering India’s industrialisation, our evolving development needs, comparatively less than satisfactory performance of the PSUs, the maturing of our private sector, a much larger social base is now available for expanding entrepreneurship. The growing institutional capabilities to enforce competition policies would suggest that the time has come to review the role of public sector, particularly the structural composition of the public sector portfolio or in other words, of the country’s “public capital assets”.

An issue that arises here is that what should the composition of the assets of the State be? The answer to this can provide an important perspective on the issue of disinvestment and privatisation. When the State chooses to own Re 1 of something, it comes at the cost of owning Re 1 of something else. In such a scenario what should the portfolio composition of the government be? What assets should be held by the State? The portfolio composition of the State is not something that should remain static at all times. Only when we have clarity about what the portfolio composition ought to be should we embark on a set of adjustments that take us to a different, and hopefully better, asset composition. At the time of independence, some of the choices the government made – in capital-intensive and technologically-complex industries like steel – had a major role to play in the growth trajectory of the country. But those compulsions are no longer with us. The landscape has changed and our thinking must change too.

So what assets should the government own and control? Most of us agree that the airline industry works quite well as a purely private affair. All over the world, governments have got out of airlines. The decades of losses and poor performance of ‘Alitalia’ is commonly held up as an example of what goes wrong when a firm is brought under public ownership. At the opposite end, most of us will agree that rural roads have to be on the balancesheet of the State. These roads typically do not have adequate traffic, and tolling will not generate adequate revenues. If the government did not own rural roads, these roads will not exist. Similarly, the public health capital in our towns and cities will need to come from the public sector.

The motivation for disinvestment or privatisation should not be narrowly seen as being only about maximising proceeds from the sale of assets. The country gains when the private sector obtains higher productivity – this happens even with mere disinvestment, but it happens more strongly with privatisation. And it gains when the government is able to build highways and canals, metro systems and railroads, which are crucial for India’s overall growth, creating assets that legitimately belong to the government’s balance sheet.

Equally, the preservation and improvement of forest cover will have to be a new priority for the public sector assets.

So there is a spectrum of assets, ranging from airlines to rural roads, where government ownership is inadvisable and where it is required. How should one decide which asset fits which category? Two broad categories that can make the story clear. The first area, where we have a good understanding, is goods and services in ordinary competitive markets. An example is steel. Now that India has near-zero tariffs on steel, it is a globally competitive market. The old argument – about capital and technology required for steel companies being out of reach for the private sector – is no longer convincing. Under these conditions, private ownership works best. This is because private ownership generates the best incentives for cost-minimisation, innovations and dynamic adjustment of corporate strategies.

The second aspect of public versus private ownership concerns the issues that arise when a company approaches bankruptcy. In the private sector, bankruptcy is taken seriously. The fear of bankruptcy generates drastic responses in terms of selling off parts of the company, modifying business strategy, etc. These are healthy responses from the viewpoint of the economy. When an unhealthy company sells its assets, the control of such assets moves into better hands.

In contrast, in the public sector, managers have a tendency to be relatively relaxed about the prospect of bankruptcy. Public sector companies are always able to access capital from the taxpayer. There is also a deeper problem here. In the market place, if a PSU operates under a “soft budget constraint” and with deep pockets, then it can adversely affect the performance and fortunes of even efficient private sector companies and such a structure will systematically misallocate resources.

The second area where private ownership is clearly desirable is in regulated industries. In India, we are now seeing numerous regulated industries, ranging from finance to infrastructure, where a government agency performs the function of regulation and multiple competing firms are located in the private sector. Here, a simple and clean solution – the government as the umpire and the private sector as the players – works best. If the private sector feels that the regulator will not be an unbiased umpire in the competitive process, because a PSU is one of the players, then this will inhibit private investment. In the eyes of the private sector, this is a political risk. To pay for higher risk, the private sector demands a higher return. As a result, fewer projects are implemented: the magnitude of investment goes down while user charges go up.

In the next 25 years, a very substantial portion of the investment in all regulated industries is going to come from the private sector. It will be myopic for the government to have a regulator in conflict. Instead, it makes more sense for the government to reorganise itself, shifting into the role of an umpire and not a player.

There are other areas where there are shades of grey or complexities. For instance, natural resource based industries, such as the upstream hydrocarbons sector. Here, there is a strategic issue as well as the issue of optimal appropriation of the underlying resources. Similarly, the role of government vis-à-vis universities is also complex. With the exception of these few, but albeit key areas, the government can confidently set about reformulating the activities of the State. In such a scenario, the State should not be producing things that can be produced in competitive markets.

The way ahead essentially involves a balance sheet adjustment. Say, If the government sells Rs 100 billion worth of shares of Air-India, a minority sale (i.e., disinvestment in the Indian jargon), and the accruals are used to build 2,000 km of highways, then certain efficiency gains are obtained. Today, empirical evidences show that the mere act of listing encourages improved productivity; listing forces increased transparency; corporate governance improves; and employees’ involvement increases as listing can make them shareholders through stock options and other instruments.

But if the Rs 100 billion worth of shares of Air-India constitutes a majority sale (i.e., privatisation), then even bigger efficiency gains are obtained. Extensive international evidence shows that productivity goes up strongly after privatisation. The increase in India’s GDP because of a better-run, Air-India is the first gain. The second gain lies in obtaining an additional 2,000 km of highways. The 2,000 km of highways is the opportunity cost that we suffer every year owing to an investment of Rs 100 billion in Air-India.

The motivation for disinvestment or privatisation should not be narrowly seen as being only about maximising proceeds from the sale of assets. The real big gains come from the full picture. The country gains when the private sector obtains higher productivity –this happens even with mere disinvestment, but it happens more strongly with privatisation. The country gains when the private sector brings more investments in regulated industries. And it gains when the government is able to build highways, canals, metro systems and railroads, which are crucial for India’s overall growth, creating assets that legitimately belong to the government’s balance sheet.

Today, even as we talk about disinvestment, it is the end-game – privatisation – which should become our concern. How do we want to approach the ownership and governance of PSUs? The two broad approaches that can be adopted for privatisation are strategic sales (where a controlling stake is sold to one buyer) or open market sales (where the shares are sold to the public at large).

The three main arguments that favour strategic sales are:

  • The buyer brings in essential new technology or expertise;
  • The buyer can exert sound governance inputs into the firm and has incentives to do so owing to the large stake; and,
  • The buyer can decisively displace government as the controller of the firm.

What needs to be avoided in case of strategic sales is that they should not lead to reduced competition or increase the concentration of power and wealth in the hands of a few.

But there are other dimensions of the privatisation process in which strategic sales fare poorly, even though they often yield higher proceeds. And, the full impact of privatisation lies in its impact on GDP growth and not just on maximisation of proceeds. It is here that one must look at open market sales as an important instrumentality for disinvestment. Open market sales are the path to obtaining dispersed share ownership, creating widely-held, professionally managed companies, and generating widespread shareholder wealth. A disinvestment strategy based on open market sales will strengthen institutions and corporate governance.

For the government, one option is to first go in for a strategic sale and when a new management team is clearly in the saddle, it should eliminate its residual shareholding by selling in the open market. Another will be to opt for privatisation through open market sales designed to deliberately disperse share ownership, creating professionally managed, widely-held companies.

The full impact of privatisation lies in its impact on GDP growth and not just on maximisation of proceeds. It is here that one must look at open market sales as an important instrumentality for disinvestment. Open market sales are the path for obtaining dispersed share ownership, creating widely-held, professionally managed companies, and generating widespread shareholder wealth.

There is another dimension in which dispersed shareholding makes sense and that is the political economy. If the disinvestment process is designed appropriately, it can lead to dispersed share ownership amongst millions of households; sharing the benefits of disinvestment with the people of India. It will improve support for the reforms process, and improve the stake in the functioning of the country as seen by households. Dispersed ownership will also have a beneficial impact upon democracy, spreading wealth across a much larger slice of the country.

Internationally, open market sales have been widely used in all major countries, which have strong capital markets and democratic institutions. Among OECD countries as a whole, in the decade of the 1990s, two- thirds of privatisation proceeds were obtained using public offerings of shares. Against this, strategic sales have been heavily used in countries, which lack domestic capital markets, such as the erstwhile communist countries. This is not a constraint that India suffers from.

Vijay L Kelkar

An important area where the disinvestment process should seek to make continued progress lies in the domain of companies where the first listing has been achieved, and a clear secondary market benchmark price exists. In such companies, there is no impediment to establishing a steady and ongoing mechanism, enabling the government to gradually eliminate its shareholding. While there are concerns that future divestment can depress share prices, it must be remembered that once listed, most companies’ share value is determined by the market on the basis of its growth prospects. Also, while it is true that in a transaction where the government sells its shares can have a temporary impact upon market prices, this can be contained using two tools: the call auction and a sequence of preannounced small transactions.

In the first case, the buyers and sellers discover a single price which clears demand and supply. This method is very effective at clearing large blocks of supply and demand, while giving all transactions a single price (i.e., zero impact cost). In itself, this will offer the government a mechanism to steadily sell shares using the routine processes of the secondary market without incurring market impact cost.

In the second, the government can make a public announcement about a programme of future sales using the call auction, giving advance notice to prospective buyers, generating sufficient demand in the process. In almost all cases, such sales will realise a value close to the prevailing market prices. Such preannounced sales can enable the government to divest its stake in a simple, depoliticised way. Markets become volatile when they are surprised; by doing full pre-announcement of all future transactions, there will be minimal disruptive effects upon the market.

There is yet another instrumentality, particularly for partial disinvestment and this relates to the sale of under-performing or under-utilised assets of the PSUs. A prominent example of such assets is “land”. Many PSUs have large tracts of land, which have become very valuable, given the creeping urbanisation and growing reluctance to make land available to new industrial units. Such land assets can be leveraged by the PSUs.

We should recognise that disinvestment is an area of economic policy with multiple objectives. The most important objective should be that of increasing efficiency with which labour and capital is converted into GDP. In addition, other auxiliary goals include enhancing investment in the country, creating new traditions of corporate governance, catering to consumer interests by maximising competition in product markets and reducing the stock of public debt. An important positive impact of disinvestment upon our fiscal problems will flow through a higher GDP growth.

Vijay L Kelkar

Vijay L Kelkar is Chairman, Forum of Federations, Ottawa & India Develpoment Foundation and was Chairman Thirteenth Finance Commission
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