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Research Note: Introducing Private Sector Incentives when SOE Privatization is Infeasible

Updated: Feb 20, 2023

Implications of State Ownership on Firm Performance and National Development

One of the most prolific facets of developing economies is the presence, importance, and subsequent distortions from state-owned enterprises (SOEs). These enterprises are publicly owned and often managed, serving as key generates of revenue, large employers, and often serving as a financial and policy extension of governments. Such organizations, therefore, have immense potential to support a country’s development, competitiveness, and prosperity if operated as bellwethers of the private sector. SOEs thus promise to gain additional value from natural resources for citizens (mining and oil), help fund broader development goals (banks) or protect natural security interests from malign actors or influence (food, defense). However, such promise has largely failed to materialize in emerging markets and developing economies (EMDEs).

The failure of SOEs to perform in line with private-sector expectations reflects the complexity of managing social goals and remaining complex. Political involvement injects non-commercial incentives of higher employment, off-balance-sheet debt, and subsidized public services to the detriment of such firms’ sustainability and competitiveness. Meanwhile, countries with weak institutions see SOEs become easy targets of kleptocracy and useful tools of control. Such illicit and improper uses of SOEs also self-reinforce, entrenching workers’ managers’ and politicians' bias against competition and change even when necessary.

The consequences of state ownership go beyond the obvious inefficiency, corruption, and favoritism that create barriers for private competitors, disincentivizes investment in key sectors, and requires extensive government funds. First, SOEs are critical for macroeconomic stability in many resource-rich emerging markets. State funding also often yields below-market returns relative to private-sector corollaries. These SOEs then use more capital, for lower returns, in a manner that undermines the development of an independent private sector in SOE-Competing industries. A smaller private sector, barriers to reforms and dynamism, inefficient allocation of state funds, and options for corruption all undermine the potential benefit of such firms for poverty reduction and economically sustainable development.

Despite large-scale privatizations in the late 20th century, SOEs still accounted for 71 percent of the Morgan Stanley Capital International (MSCI) Emerging Market Index in utilities, 56 percent in energy, and 39 percent in the financial sector. This proxy for the significance of SOEs highlights how the government is still prolific across the largest firms that have the highest access to capital and represent large parts of government revenue. Therefore, despite the human costs of failed privatization efforts in EMDEs at the end of the 20th century, SOE ownership and performance are still deserving of conversation and novel approaches in pursuit of development.

The economic and financial evidence is clear, the state should not be an owner of private sector enterprises. SOEs have lower economic efficacy financial performance, are costly and risky through subsidies and implicit fiscal obligations, crowd out a proper private sector, serve as a hotbed of corruption, and can create negative feedback loops for reforms through public employment. Across the board, private ownership is associated with improved performance. (IEG 2020) Even in traditionally public sectors like electricity or water, SOEs underperform with the World Bank finding that governance scores and efficiency are systematically higher for private utilities. (Foster and Rana 2020) Additionally, the performance of SOEs has deteriorated in much of the world outside of China in the 21st century. (Garkhar and Phukon, 2017) The counterproductive incentives and opportunities for maleficence that come from SOEs in EMDEs clearly make private ownership better for long-term financial and economic performance.

When and How to Introduce Private Sector Incentives

Given the economic arguments, unleashing the poverty-reducing potential of the private sector might seem to necessitate the privatization of all state-owned enterprises. However, the same institutional deficiencies that lead to corruption and mismanagement of SOEs also undermine the privatization process itself. The previously cited World Bank research finds that privatization distribution utilities are rare given the likelihood for deteriorations in public services and should only be pursued in contexts with strong regulatory and legal environments. (Foster and Rana, 2020) This sentiment is reflected in the Bank’s evaluation of privatization performance, concluding that privatizations are generally unsuccessful in situations without the proper institutional frameworks in place. This also appears to be the legacy of privatizations in the post- soviet states and Africa, where ownership change from state to private hands frequently did not necessarily lead to higher performance. (IEG, 2020)

The painful nature of privatization and the political sensitivity of SOEs also have the potential to undermine any economic and financial gains. These gains often mean laying off bloated payrolls to attain long-term growth. This assumes that the national context possesses an effective framework for redistribution to placate the “losers.” In the absence of such a system, the disruptions to labor risk overwhelming any paper gains through radical politics, re- nationalization, and political punishment for pro-privatization candidates. Such occurrences have the potential to become long standing cleavages as Mexico’s energy sovereignty has led to protectionist measures securing PEMEX, meanwhile Argentina periodically nationalizes the agriculture sector and “privatizing” institutions like the IMF lose credibility.

The “right” answer of privatization thus fails to survive execution in deeply the imperfect intuitional contexts of EMDEs. The political pressures of full employment, national security interests, and historical legacies then mean that SOEs will continue to be a large source of public sending, government revenue, hard revenue, and key service provision in EMDEs. Therefore, the state will continue to own enterprises, but they should limit these to the socially crucial and management with the inherent risks of sector mixing in mind.

In some industries, more direct ownership – through controlling shares, more aggressive regulation, or intervention is occasionally warranted in natural monopolies, firms with key social utilities that would generate large displacements in privatization, and strategic industries like defense and a food base that come with large tail risk from foreign influence or extreme situations. All others should face some degree of privatization. Full privatization is unlikely to be beneficial in EMDEs, though with the World Bank identifying corruption and competition as most strongly associated with SOE reform outcomes. (IEG, 2020) Such criteria mean that many SOEs in countries from Brazil to Burkina Faso are better served by staying under state ownership than undergoing flawed privatization. In such cases, the goal should be to mimic successful SOEs by neutralizing the impact of political ownership through selling voting shares, insulating operations from government influence, and ensuring disciple by requiring commercial financing.

Partial privatization by offering a majority of SOE shares to investors has been a particularly effective way of introducing commercial pressures, governance changes, and reducing political exposure without the same degree that directly selling the firm would. Such shareholder-driven changes partially absolve the government of political pressures while allowing the state to still keep a portion of the company under control. Additionally, the state also benefits from improved financial performance without needing to adjust taxation. Minority ownership has been particularly attractive and largely successful for China, Malaysia, Singapore, and France. However, as seen in the recent retrenchment of SOEs in China, the government’s controlling stake still offers the means to renationalize. In corrupt or authoritarian governments then, minority stakeholders are at risk of tunneling and government intervention. Even though distributing ownership through established stock markets creates strong disincentives for the same degree of political interference that fully owned SOEs face and is thus an attractive option for more successfully introducing private incentives to increase societal returns.

Even outside of the minority shareholder model, ensuring that SOEs raise funds through private capital markets is critical for minimizing risk to the public while instilling market discipline. This can be achieved through statute, rulemaking, or out of necessity which binds government agencies from using any funds to support the SOE. Like all SOE reforms, it is worth noting that some degree of political support is present for such efforts. While such rules against direct Treasury support could always be overturned, creating self-sustaining reforms that are harder than a direct sale by nature to undue are ideal for policymakers in constrained national contexts. One example of this is isolating management from political obstruction and aligning their incentives with the performance of the firm. This can be accomplished through the government retaining non-voting shares, compensation packages being tied to financial performance, and deregulating sectors to force competitive evolution. Creating a constituency of managers whose incentives align with the financial performance of the firm can begin to entrench reforms such as in Singapore and Malaysia.

The appropriateness of privatization is first and foremost a reflection of any country’s capacity to manage the process’ complexity in a fair and sustainable way. Therefore, privatization as a general solution should be approached cautiously by policymakers and evaluated in the context of each country’s capacity to minimize corruption and ensure competition.

Unfit for Sale: Comparing Privatization Success in Argentina and Singapore

The determining power of a country’s political and institutional context on a privatizations’ outcomes are often opaque rarely clear. The extreme political and institutional circumstances of Argentina and Singapore highlight the role such variables play though in an astounding fashion. Singapore is arguably one of the most successful cases of state-led development along with South Korea and China. The single-party-led country has pragmatic and expert-led politics in a country with very little corruption and robust legal, regulatory, and economic institutions. Meanwhile, Argentina has an endemic level of grand corruption for an upper middle income which goes alongside unstable regulatory and economic institutions in an extremely sensitive political content.

I. Argentina

In the early 1990s, SOEs composed around half of all economic activity and operated in every industry. Facing high budget deficits, a stagnating economy, and international pressure, President Menem rapidly privatized state enterprises. Utilizing decentralized sales committees rather than the traditional privatization ministry or team with the finance ministry, the government could move forward with multiple sales simultaneously. Argentina’s speed and scale of privatization and use of funds for social programs initially gained the program plaudits as an exemplar of efficiency and social consciousness. Debt decreased, efficiency improved, and there was a rush of international investment. However, after the initial sugar rush of public spending wore off, the government was left with uncompetitive terms, increases to unemployment, insufficient regulatory capacity, and higher spending, which contributed to the 2001 default. With a broad political backlash against Menem’s “neoliberal” agenda towards SOEs, many enterprises either experienced re-nationalization, creeping expropriate, or corrupt/anti-competitive activities in the absence of strong regulations.

II. Singapore

Beginning independence with a relatively low level of SOEs as a percentage of GDP, Singapore’s survival-driven growth saw an infant industry approach that leverages state backing to grow like other newly independent emerging markets. Privatization has often been carried out due to fiscal and efficiency considerations (Kikeri, Nellis, and Shirley, 1994). Singapore has been atypical in this regard. During the 80s, progress through SOEs towards economic development goals, international influence, and strategies to become a finance hub led to large- scale privatization with the full backing and cooperation of multiple ministries and agencies. However, privatization meant reducing direct involvement in business to prepare SOEs for global competition. As such, the state remained a majority or minority shareholder in most companies while giving managers autonomy to face commercial finance and adaption constraints. This meant letting key firms struggle during the Asian financial crisis unassisted but also reaping the rewards of a stronger management tier and more competitive firms. Meanwhile, its unique autonomous holding company, Temasek, entered globally competitive markets and succeeded to the point where the share of SOEs in Singapore’s GDP actually grew from around 5% to over 25% after privatization. Over this time, the share price of privatized government- linked companies in Singapore significantly outperformed non-government-linked companies after privatization (Tan, Yeo, and Kuok, 1993).

III. Lessons

Argentina and Singapore’s divergent experience with privatization reflects highlights the World Bank’s view that “privatization of both competitive and noncompetitive SOEs is easier to launch and more likely to yield financial and economic benefits in countries that encourage entry and free trade, offer a stable climate for investment, and have a relatively well-developed regulatory and institutional capacity” (Kikeri, Nellis and Shirley, 1994). According to this view, the Argentine’s tight fiscal position forced the speed which ensured that the Menem government could not ensure competition or effective regulation. Meanwhile, beginning from a position of economic strength allowed Singapore to conduct proper due diligence, involve all relevant stakeholders in a centralized process, and ensure strong regulation. Further, they retained a substantial percentage of the upside which helped fuel longer-lasting social spending than the Argentine sugar rush. Singapore’s gradual introduction of market pressures, restrain indirect funding, and minority share approach allowed longer-term success where the short-termism and complete privatization of an unprepared Argentina helped fuel a disastrous economic collapse and perspective on privatization that continue to impact SOE policy in the country.


Once the dust had settled from the rush of privatizations that closed out the 20th century, the issue of SOEs has nearly become one of religious adherence to one economic school or another. With many detractors and proponents alike entertaining little nuance in their positions about their benefits. The lessons learned from successes and failures alike present the necessity of private incentives for SOEs to fulfill their developmental potential. With low corruption, strong competition, and a stable macroeconomic outlook often necessary for privatization successes, challenging the competitiveness and approach the undergirds private sector growth must come through measures other than wholesale auction for many governments. While such measures are numerous, successful and failed privatizations alike support the minority ownership model, requirements for competitive funding, and measures to protect management from political pressure.

Such methods are stopgap measures to allow the fundamental corruption, competitiveness, and fiscal reforms to execute a well-timed, sustainable, and clean privatization. In many cases, though, fiscal pressures amid political constraints drive fire sales. Additional research should therefore focus on asset stripping amid crisis-driven privatization, use of SOE collateral to the IMF for over-allotment funding, and how transferable the government-linked companies’ model of Temasek is to different political economies. Policymakers should also consider more novel mechanisms to insulate SOE management from political exposure like central bank possession of state-held shares and carving out a subsidiary of utilities to support non-viable customers. It is through such continued experimentation or incredible patience by policymakers to pursue foundational reforms that will then finally allow privatization to fulfill its promise in poverty reduction, national competitiveness, and economic development at large.


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