IFC Discussion Paper Number 31
Trends in Private Investment in Developing Countries
Statistics for 1970-95

International Finance Corporations

Lawrence Bouton
Mariusz A. Sumlinski
December 1996
February 1997 (revised)

Privatization and Private Investment
The Dimensions of Privatization, 1988-95
Privatization and FDI
Privatization and Investment Commitments
The Impact of Privatization on Private Investment
The Empirical Literature
The Econometric Evidence

Privatization and Private Investment

Over the last decade there has been a widespread change of opinion about the role of state and private enterprises in promoting economic growth. A strong consensus has emerged that the achievement of more dynamic economic growth requires a greater role for the private sector. Underlying this consensus is the belief that resources will be used more productively if they are transferred to the private sector. A key element of this new market orthodoxy has been the privatization of state-owned enterprises (SOEs).

Although the growing empirical literature on privatization has almost invariably found that the transfer of assets from public to private hands yields both efficiency and welfare gains, there has been a surprising lack of research on the macroeconomic consequences of privatization. This chapter addresses that issue, albeit briefly, exploring the impact of privatization on private fixed investment. As a starting point, the dimensions of the privatization revolution are summarized with special emphasis on the contribution made by foreign investors. Data on investment commitments stemming from privatization are also presented. The final section offers some econometric insight into the importance of privatization as a determinant of private investment in developing countries.

The Dimensions of Privatization, 1988-95

The dimensions of the privatization revolution have been huge, and recent years have seen a major and continuing trend towards private ownership. While privatization has become a global phenomenon, the distribution and intensity of privatization activities continues to be geographically uneven. The most profound changes, of course, have been experienced by the countries in Eastern Europe and the former Soviet Union.

Between 1988 and 1995 (the latest year with complete privatization data), developing country governments earned more than $132 billion from the sale of state-owned assets. (1) This reflects the transfer of control of over 3800 entities from public to private hands. The number of developing countries undertaking privatizations has grown continuously from 14 in 1988 to over 60 in 1995. Revenues from the sale of SOEs in developing countries has grown from only $2.6 billion in 1988 to over $21 billion in 1995, having peaked at over $26 billion in 1992. The majority (51 percent) of privatization revenues have been earned in Latin America followed by East Asia (21 percent) and Europe and Central Asia (18 percent). Relatively little privatization has taken place in the Middle East, North Africa or in Sub-Saharan Africa. While South Asia has also experienced only modest amounts of privatization over this period, sales (primarily in Pakistan and India) have been increasing in recent years.

On a sectoral basis, infrastructure has accounted for the bulk of transactions, comprising some 39 percent of total realized privatization revenues. The privatization of infrastructure, including telecommunications, energy, water and transportation, has played a particularly important role in Latin America as well as in East Asia. On the other hand, in Eastern Europe and Central Asia, industrial enterprises, such as steel and chemical concerns, have accounted for more than half of all sales. The limited sales in Sub-Saharan Africa have been largely in the primary sectors of petroleum and mining. Of these, the sale of two assets - Nigeria’s NNPC oil field and Ghana’s Ashanti Goldfields - have accounted for nearly 40 percent of total African privatization revenues.

During 1995, the financial crisis triggered by the devaluation of the Mexican peso made the conditions for privatization in many developing countries, especially in Latin America, less favorable. Nonetheless, major privatizations continued to be carried out in 1995. Among the largest transaction was Indonesia’s privatization of PT Telekomunikasi for $1.6 billion. The Czech Republic also undertook a large privatization selling a 27 percent share in its state telecommunications company, Spt Telecom, for $1.3 billion. Malaysia obtained $1.1 billion through the privatization of Petronas Gas while Bolivia granted a six year monopoly and a 40 year concession on the $610 million “capitalization” of Entel, Bolivia’s international and national long-distance telecommunications monopoly.

Privatization and FDI

Although the bulk of private investment continues to be financed by domestic savings, increased access to foreign savings has played an important role in mobilizing resources for the private sector in developing countries. In recent years, not only has the private sector in these countries enjoyed renewed access to international bank lending and international debt markets, it also have increased its ability to raise funds in the international equity markets. (2)

Privatization in developing countries has attracted considerable amounts of attention from foreign investors. These investors can participate in privatization either through foreign direct investment (FDI) or portfolio equity investment. The distinction between the two types of investment depends, in part, on the extent of the investor’s ownership involvement in the privatized company. Generally, portfolio equity investment is a purely financial investment with the foreign investor’s share in equity not exceeding 10 percent of the recipient company’s total equity capita. FDI, on the other hand, normally involves management control.

From 1988-95, foreign investors accounted for about 43 percent of the total proceeds from privatization. Of this, FDI accounted for four-fifths of foreign investment generated from privatization with the remainder coming from portfolio equity investment. However, FDI from privatization, like total FDI, has been uneven across regions. Latin America (principally Argentina, Peru and Mexico) has accounted for the largest share of global FDI from privatization, followed by Europe and Central Asia (primarily in Hungary). Given their small shares of total privatization revenues, Sub-Saharan Africa, the Middle East & North Africa and South Asia have also received only a minor share of FDI from privatization.

FDI from privatization, as a share of total FDI, has been much more important in Europe and Central Asia than in Latin America. As shown in Table 2.1, over the period 1988-95, some 40 percent of total FDI in Europe and Central Asia came from privatization. In Hungary, for example, some 63 percent of all FDI has been made as a result of the privatization program. While this figure was around 21 percent for Latin America as a whole, certain countries within this region are very dependent on their privatization programs. Over 70 percent of all FDI in Peru, for example, has come through privatization. Privatization in Brazil, on the other hand, accounts for only 12 percent of total FDI. The countries of East and South Asia have been much less dependent on their privatization programs to attract FDI, with only about 5 and 14 percent respectively of FDI entering these regions as a result of the privatization programs.

Privatization and Investment Commitments

Privatization programs also are an important vehicle for attracting additional domestic and foreign investment flows above and beyond those related directly to the sale of SOEs. (3) One reason is that privatization acts as a signal of government commitment to the private sector. That is, in parallel with privatization programs, governments often embark on simultaneous macroeconomic and structural adjustment reforms - such as reducing the fiscal deficit and generally cutting back the extent of government intervention in the economy - that improve the country’s investment climate and increase the credibility of government efforts to encourage private sector development.

In addition, privatized companies often require significant new investment to refurbish and modernize existing assets. In some cases the government imposes the requirement that purchasers of state-owned assets must pledge additional investment resources at a latter date. In Peru, for example, the privatization program has integrated the sale of state assets with required commitments to future investments. From 1991 to 1995, proceeds from Peru’s privatization program amounted to $4.4 billion while investment commitments stemming from these privatizations was on the order of $4.6 billion.

Although data on follow-on investment have not been collected in any systematic fashion it appears that these additional investments - whether required by the state or voluntary - are considerable. An indication of the size of follow-on investment is given by limited data collected on investment commitments made at the time of privatization. (4) Over the 1988-1994 period, investment commitments made during the course of privatization amounted to over $19 billion. These commitments far exceed the $6 billion in privatization revenues obtained from the sale of the corresponding state assets. If one uses the same three-to-one ratio found in this limited sample to extrapolate total follow-on investment from all privatizations, the result would exceed $300 billion.

The Impact of Privatization on Private Investment
Who Invests More, SOEs or Private Firms?

It is argued that SOEs are established (nationalized) partly to provide governments with a vehicle for investment or because SOEs have the borrowing power and resources of the government supporting them. Further, governments might be willing and able to subsidize inefficient investment by SOEs in order to attain other socially desirable goals, such as, employment.

The empirical literature suggests that SOEs have rarely over-invested relative to their private sector counterparts. In fact, the low levels of profitability or, in many instances, the large operating losses incurred by SOEs precluded them from funding capital investments with internally generated cash flows. Further, SOEs have generally found it difficult to obtain additional government resources to undertake investments because governments already face large borrowing requirements stemming from their own fiscal deficits. Indeed, profitable SOEs have often been used as a source of revenues to help finance government fiscal deficits.

Other than being freed from government funding needs, there are many reasons why privatized firms might increase capital spending. First, because of various social goals, SOEs tend to be excessively employee rich and capital poor. Restructuring following privatization tends to reverse this imbalance. In addition to restructuring their capital and labor inputs, the privatization of SOEs can also lead to restructuring of outputs. Under government control, SOEs are subject to a variety of incentives to over-produce goods that may be politically attractive but economically wasteful. SOEs often charge below market prices for their output with a subpar quality good or service produced. By restructuring production, privatized firms can reallocate resources to higher valued uses. This in turn can stimulate additional investment. Second, because these newly privatized firms are more profitable, they generally have better access to private debt and equity markets and hence are better able to finance their investment needs. Third, privatization is usually accompanied by deregulation and market opening that exposes these firms to new competitive pressures. In the face of this increased competition, these newly privatized firms can have very large investment needs. Further, many SOEs fall behind on routine maintenance because of lack of budgetary resources. Newly privatized firms can face substantial investment needs as a result of years of deferred routine maintenance.

The Empirical Literature

The bulk of the empirical literature on the effects of privatization has focused on performance gains measured at the enterprise level.(5) The most commonly used yardsticks of performance are economic efficiency and financial profitability. Studies investigating the relative technical efficiency and profitability of SOEs and private enterprises generally support the proposition that private sector performance is superior. This conclusion is also reached in the literature comparing the performance of firms before and after privatization. For example, a World Bank study follows the performance of twelve such firms and concludes that in nearly every case, performance as measured by a broad range of indicators improved with privatization.(6) This study also found that investment increased following privatization.

One of the most comprehensive privatization studies examined the pre and post privatization financial and operating performance of 61 companies from 18 countries and 32 industries.(7) The study found that following privatization, firms increased their levels of investment. On average, firms included in the sample increased the ratio of capital expenditures to sales from 11.7 percent of sales before divestiture to 16.9 percent, with over 67 percent of the firms in the sample increasing this ratio following privatization.

The Econometric Evidence

Empirical studies on the determinants of investment have generally associated increased levels of investment with a macroeconomic environment characterized by high growth and stable prices. Low external indebtedness and fiscal deficits have also been positively correlated with high levels of investment.(8) Neither the investment literature nor the privatization literature, however, have investigated the consequences of privatization on the overall level of private investment.

In order to gain some insight into the impact of privatization on private investment, an empirical model was used to estimate the importance of privatization as a determinant of investment in developing countries. The results, are consistent with the view that privatization of SOEs is likely to have a fixed investment multiplier effect and is, therefore, a very important ingredient of governments’ efforts to improve the business climate and to step up the pace of development.

Footnotes

1. The source of these data is the World Bank Privatization Database which includes all sales of public assets to private entities through public offers, direct sale, contracting out of government services through concessions or licensing agreements, and joint venture arrangements. It excludes voucher sales and divestitures and mothballing of state-owned enterprises. Small-scale privatizations with a sales value of less than US$50,000 are also not included nor are voucher based mass privatization. The database does not account for private firms entering into activities previously reserved for state monopolies. For more details, see World Bank, World Debt Tables 1996, Volume 1, Appendix 8.
2. The increased access of developing countries to international capital markets is explored more fully in F. Jaspersen, A. Aylward and M. Sumlinski , “Trends in Private Investment in Developing countries: Statistics for 1970-94”, IFC Discussion Paper No. 28, December 1995.
3. See Frank Sader (1995), “Privatizing Public Enterprises and Foreign Investment in Developing Countries, 1988-93”, Foreign Investment Advisory Service, Occasional Paper 5, World Bank.
4. The commitments data collected in the World Bank’s Privatization database are not comprehensive. Out of the 3041 privatization transaction only 412 have information available on investment commitments. The absence of information about investment commitments should not, therefore, be interpreted as lack of investment. Further, in some instances, investment commitments made during privatization have later been reneged.
5. The theoretical and empirical literature on privatization is reviewed in a paper by Stephen Yeaple and Warren Moskowitz, “The Literature on Privatization”, Research Paper No. 9514, Federal Reserve Bank of New York, June 1995.
6. Ahmed Galal et al, Welfare Consequences of Selling Public Enterprises: An Empirical Analysis, World Bank, Washington, DC, 1994.
7. William L. Meggison, Robert C. Nash and Matthias Van Randenborgh, “The Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis”, The Journal of Finance, Vol. 49, No. 2, June 1994.
8. See, for example, Joshua Greene and Delano Villanueva, “Private Investment in Developing Countries: An Empirical Analysis”, IMF Staff Papers, Vol. 38, No. 1, March 1991.