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The privatization of SOEs

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Date added: 17-06-26

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The privatization of SOEs has over time been a big and important issue in the development of the economy. This has lead to the development of many theories which explains the ideas behind what is expected practically expected and the principle on which privatization exercises are based. This chapter will however will discuss the relevant theoretical and empirical literatures of this study by focusing on objectives and rationale. This involves critically examining the theories that have been developed over time by different authors and how their impact privatization as regards the objectives of this study. This will also state why privatization is vital for the growth and development of some sectors and why, it will not in some other sectors within the economy. Finally, analysis on how privatization affects the performance of the industry and company in question will also be discussed.

3.2 Factors Determining Privatization

SOE were highly inefficient and grow at a very slow pace, too much bureaucratic issue that can cause no room for innovation and were also subject to constant government political intervention as well as administration change. It is also over dominated by the power of Labor Trade Union (Veljnovski 1987). However after the successful privatization of BT in 1984 by the Thatcher's administration, it became an economic policy that can be used to reduce the political pressure that exist within the SOEs such as inefficient use of financial and operational performances but could this be a means to wealth creation for investors, who through the spread and acquisition of shares ownership, restructuring and refocusing of SOEs economic objectives as well as cutting of labor Trade Unions influence and power will maximize profit. An argument that must be stressed here is that of the difficulty in interpreting the indictors of financial performance which might tell us little directly about either the performance within and outside the business environment economy. Take for example; poor financial performance may be consistent with high rate of internal efficiency if the formal is as a result of government policy of price control. However, since SOEs frequently respond to anticipated market failures, profit maximization and similar related measures might not necessary, be a reliable indicator for their poor performances over time (Ramanadham 1993). Rather this study will support that failure of SOEs, could be as a result of rapid demand for their goods and services faced by their steady but slow growth to reach maximum productivity movement rather than to totally shift production function ton scale was relative to their poor operational and financial performance. Yarrow (1986), however argued against privatization stating that competition and more forceful accountability will even be better than privatization in promoting both financial and operational efficiency but his argument has a limitation, it only focused on a small number of company within UK. Ramanadham (1993) pointed out that the objective of privatization is realized more if it becomes successful within a short period of time either by stock market price rise or increase in the level of efficiency or productivity bringing about instance economic growth and development. But when reverse is the case if it fails, which happens some time which even makes the impact of privatization becomes more undesirable. So it is best to set up a good regulatory frame work to remedy the situation when the objectives of privatization are not met in the short term to increase the firms level of efficiency through prize cap which also has its own disadvantage. In a further argument by Megginson et al (1994) whose strong support from recent theoretical and empirical perspective, that private firms will always outperform SOEs stating that privatization itself will always increase both the financial and operational efficiency of firms irrespective of the business environment. While another view by Moore (1992) who argued that the act of privatization promotes economic efficiency and public confidence (one of the major objectives of property right theory) in the system of industrial capitalism and thus SOEs should be sold off before efficiency gains can be realized. He also argued that the success of privatization transforms business attitude towards ownership, economic responsibility and towards improvement of corporate performances. It also allows government play an important role of regulation leaving the ownership of firms in the hand of investors and individuals who will perform better as there are more faced with scare resource and the market forces. It is clear now that different factors can lead to privatization especially when SOEs has underperformed both financially and operationally causing government political pressure, budget deficit and waste of scare resource and even administrative failure.

3.4 Evaluation of the theories of Privatization

Principal Agent Theory

Vickers and Yarrow (1995) points out that a problem exist in the principal agent theory as the principal interest greatly lies in profit making and so its interest might conflict with that of the agent who might pursue other objective apart from profitability. Further stating that since the formal do not have full information concerning what is happening within the SOE and cannot fully control the attitude of the agents who might be over ambitious and purse his own objectives. This will certainly create monitoring problems for the principal. This in fact creates both financial and operational problems directly or indirectly in some cases as the agents pursed objective might even be very different from the original objectives set to be achieved.

…………………………….am looking for more explanation…………………………………….

However when shareholders can influence the behaviors of agents (management) through vote as the only way to keep them in check to work at an efficient level in order to be focused on the set objective and maximize profit. On the other hand when the rate of efficiency increases, it leads to higher revenue which is mostly one of the objectives, to brings about higher income and dividend for its shareholders.

………………….needs more explanation……………………………………………………........

Property Right Theory

This is a set of right to control assets. It is a consequently grants of authority made to an investor or a group of investors through right of issue of share or control either public or private and acknowledged by other persons or organizations (Lindblom, 1977) De Soto (2006) argues that lack of formal property right is what has kept developing economies from been developed stating that it limits the amount of goods and services that can be exchanged in the market in order to have a sustainable long term economy growth. While Easterly (2001) opinion quite similar, to the views of Soto suggests that property right is a significant factor for long term economy growth. This is due to the fact that property right creates a very strong incentive for investors to even invest since there are certain about the ownership of such properties. As a matter of fact in most case it is true that mangers of most SOE and even privatized organizations are more concerned with their salaries, the growth and development, and reputation of the organization rather than achieving the objectives of the firms. The property right theory has an objective of promoting work incentive within SOEs solving employee's negligent attitude towards work. However, lack of competition and monopoly power contributes a major factor to why this employee's are negligent towards work which is a major fact to why most SOE perform absolutely poor and a leading factor to privatization. The major focus of this theory is the given control right to manage asset in order to achieve the set objectives which is mainly to create employment and basic amenities for its citizens for SOEs while for private firm is profit maximization. However a standard property right approach to public and private ownership acknowledges that there are agency problems in all forms of ownership, but because ownership is transferable through a competitive capital market in the private sector, a better use of resource will result. However this theory claims that managing by the shareholders would be more efficient than monitoring through political process. It further emphasizes upon the reduction of property right both where public ownership exists and explores the sequences of property right for efficiency. However property right theory can contribute to the growth and development of the nation economy through the stock market if a formal structured and transparent legal frame work or intuitional policies are adopted and established to protect property right as well as an effective regulatory body to monitor each transaction.

The Maximizing Privatization Revenue Theory

This theory sets out the assumption about the information between the government and the buyers on the true value of the firm to be privatized assuming that the investor (Buyer) do not have enough information about the firm profitability. However the theory predicts that the government sale off of existing SOEs will see to a continuous performance of the function of profit maximization of such firm. Since the SOE management reports to the relevant government ministry about its financial and operational performance, the government will be able to extract all the information it gets and obtain a reasonable sales price that will equally reflect the true value of the existing SOE before it is privatized. The bottom line is that as buyer observes the sale of the first SOE, their reaction towards investing in the second SOEs will so much depend upon what premium shareholders were able to make in the first deal.

Public Choice

This theory is concerned more directly with actual behavior in the public sector. The core argument is that politicians and state bureaucrats purse their own objectives rather than the public interest. (Downs, 1967; Niskanen, 1971; Buchanan, 1972; Blankart, 1983). Here policies are arranged to maximize politicians political own objectives such as votes to retain political power and SOE's are given extensive Budgets so that bureaucrats will benefit from better jobs and higher salaries (Migue and Belanger, 1974). Also public monitoring of spending is inhibited……………………………………………………

Benefit and Cost Theory

This theory argues that privatization will increase market share because privately owned enterprises have better incentives to produce goods and services in what quality and quantity the consumers would desire more. However in this case the companies who tend to succeed are the ones that will be able to meet consumers needs (market demand and supply forces). Also it is believed that the discipline of the capital market creates an avenue for additional resources and growth to an extent, depends on the past financial and operation performances. This theory then believes that with privatization, the consumers will dictate what their what should be produced rather than the government choosing which mostly reflects short term political pressure and problems the management of public sector capital requirement.

3.5 Empirical Evaluation of Privatization

In an the work of Boardman and Vining (1989), the 1983 empirical examination of a sample size of 500 largest mining and manufacturing firms based on sales per employee and per asset after controlling for regulation and competition within the business environment concluded that private firms are more efficient and profitable compared to SOEs. This could also be as a result of the pressure from the market environment competition and possible takeover as a result underperformance especially when the government is running at so many deficits in the firm or sector. While in another empirical study by Steven et al (1999) proved an empirical evidence on how political factor impact the offer of shares pricing, allocation. After examining a sample of 630 Share option privatization from about 53 countries, it became clear that even when government do not longer interfere with the daily administration (operating activities), to private owners in the initial share offer it still have veto powers through the golden share strategy to cancel or accepts some policy change that might occur in order to protect national interest. Megginson et al (1994), further explained that the restructuring that occurs prior to the privatization exercise takes place to motivates employees to work towards attaining efficiency by cutting cost, maximizing productivity and profitability to increase both financial and operational performances. However BT share issues as suggest by Redwood (1988) did more than just to enable Britain to establish the world's first largest scale privatization program but it also led to the intervention of part of popular capitalism in the country. The ideas of seeking a large new generation of small savers came out of immediate need of a marketing campaign to sell the world's largest ever equity offering to individuals or investors to own a direct stake of SOE's. This made the use of privatization program as a means of extending share ownership among work force of SOE's and to the public at last as it became clear that the privatization exercise is an economic policy for growth and development. However this method of privatization was used in UK, during the privatization of BT, was more than every other thing politically motivated by the Thatcher's Administration in order to retain power powers in the coming elections. However Boycko et al (2003) examined and discovered that SOE are often persistently unprofitable because their objective is to maximize employment and create quality goods and services for its local citizens rather that maximization of profit to create wealth for its shareholders. But this is also attributed to political interference by the government and the incentive subsides to SOEs managers to reduce input prices and implicit guarantees to cover operating losses and the constant demand from labor unions. Megginson et al 2003 suggest in terms of efficiency, when SOEs are privatized and then competition sets in, the government would expect a trade off. This will result into the cancellation of non economic objectives from the privatized SOEs rather a force from the new investors to employ all their resources more efficiently because when efficiency is not applied to the existing resources there would be no further improvement and therefore a failure in the financial and operating performance. However when the opposite is done there will be a positive growth level over short term and long term both in the return on capital employed and employee performances in productivity. However in term of capitals structure most articles (ref) has argued that because privatized firms have more access to public fund through the capital market, this can become a possibility to increase capital base for them to spend in the restructuring of the privatized SOEs in order to meet up with the already existing privatized firms in the industry or if it is the first privatized firm in the industry as at then, to meet up with restructuring and innovation as it might face competition soon enough. Furthermore, the now there will be pressure on the rational use of resource especially financial resources politically attractive goods and service will be cut off to produce economic goods and services that will boast return on capital employed as well as innovative new products that will expand market coverage and increase market share will be encouraged.

3.6 Impacts of Privatization on Company's Performance

The impact of privatization is a direct result that is linked to the method of privatization. The problem identified with it is that in some cases it is hard to identify such result differently from the result which may be associated from other economic circumstances like a more liberal regulatory policies, change in management policies or sudden use of idle capacities that may have contributed to improved performance rather than the privatization exercise itself. However this study focuses on only the circumstances induced as a result of the privatization exercise which in some cases are almost immediate and other case may take a longer time. For instance this could be from lay off of labor forces to increase in share prices or restructuring of the existing management style. The best way to examine the impact of privatization could be to divide it into two aspects, one from the inside angle (how this has changed the financial and operational performance) and the other the outside angle (how this has changed the company's performance in relation to other firms in the sector and the economy at large)


Privatization can affect the performance of a company based on an assumption that once a firm start existing in a private setting it will be subject to strong, constant and challenging pressure to performance efficiently because it is now faced with a rapid, changing and very competitive business environment where it has tom struggle for resource and market share to survive. Privatization can be an effective way to bring about fundamental structural change by formalizing and establishing property right which directly creates strong individual incentives (Filipovic 2005). The processes of privatization that involves sale of shares to employees, labor unions, local investors make this investor to work more efficiently to cut cost and make more profit which will reflect in dividends or share prices. However privatization will promote competition and increase efficiency especially in situation where the government relevant regulatory authorities cap the pricing of a service of product. Little Child……… However economist like Vickers and Yarrow (1998), suggest that privatization may not increase efficiency without competition. But some privatized industries like the telecoms, are usually now oligopolistic, rather than going into price wars that will increase their levels of efficiency will rather agree to fix price within them. They argue that cost reduction may be too small to outweigh the benefits of competition. Moreover Martin and Parker (1997), believes that being exposed to competition does not necessary make privatization in the UK more successful. However another issue that leads to privatization is the response to the failures associated with SOEs (Parker and Saal, 2003). Megginson and Netter (2001), outlined some of the theoretical arguments on the advantage of private ownerships compared to SOEs stating first that contracting ability affects the efficiency of SOE's, then there is an advantage to the goal of shareholders wealth maximization and it provides a well defined goal that guides a firm policy. On the other side government has many objectives other than profit. These objectives can change from one administration to another hence the inability of government to be committed credibly can significantly reduce the efficiency of SOE's operations and administrations. In addition the government goals can be inconsistent with efficiency, maximizing social welfare or even malicious. However Littlechild (?) in his argument believes that they could be a danger associated with identifying what objectives should be achieved in this new business environment (Post Privatization) clearly focusing on defined objectives. He further went ahead to induce a price cap method that can encourage efficiency by putting a cap on profit margin to encourage minimization of production cost and increase in efficiency in order to make more profit. This was going to be reviewed from time to time to ensure that go with economic situation within the business environment. The weakness associated with this was that there were no incentives for the manager to work more efficiently as ……………..The impact of privatization on a firm can also range from productive efficiency, competition allocative efficiency (Kay et al 1986). Manne (1965) argues that the incentive for productive efficiency comes with the aim to maximize profit and stay in business within the strong hold of competition in the business environment and corporate control. After much analyzes and this study can argue that in most cases one can believe that it might be that privatize firm will not perform better than SOE expect for the fact that due to the competition created as a result of privatization that leads to market pressure, private firms will then strive to survive within the market environment in order not to be takeover and bankrupted or even die off (Pryke 1982) However the performance of company as a result of privatization can be affected either by the controlling share the new investor have because some vital sectors been privatized by the government cab not be totally left in the hands of private investors because the vital role it might play in the economy. In this situation, both parties most agree to a set objective or any policy change that can lead to improving the financial or operational performance of a firm. Thus the distinguishing feature of the different methods and objectives of privatization, in comparison with a firms performance post privatization will determine to a greater extend the performance of a said firm. For instance the full or partial privatization of a firm through share option method, can see different investors or group investors with different objective to invest which in some case can lead failure depending on what percentage each investor has or the lobby power or even voting right one investor or groups of investor can have to bring about a policy change through restructuring the production resources or reduction of work force. This is the more reason why in most privatization exercise the government tries and owns the majority share in order to still be in control of deciding what objectives to achieve. However the problem with this is that it become too political as government will only vote for policies that will only serve their own purpose without considering the investor entrepreneur skill and objectives of wealth maximization
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