Bureaucrats in Business—New World Bank Study on Headaches in Reforming State-owned Enterprises

Bureaucrats who run state-owned enterprises (SOEs) should not be blamed for the ills of these companies: they are not necessarily incompetent, but rather, they have to deal with contradictory goals and perverse incentives, a new World Bank study points out. Drawing on an extensive new data base, the report finds that, despite more than a decade of privatization, state-owned enterprises account for nearly as large a share of developing market economies—11 percent on average—as they did fifteen years ago. (In industrial countries the state sector's share dropped to 7 percent from 9 percent in 1980. Transition economies are now privatizing in much greater volumes than developing economies, but they started out with a much larger stock.)

Comparing state-owned enterprises' financial returns, productivity, and deficits, the report finds that Chile, Mexico, and the Republic of Korea were the more successful reformers among nine developing market economies (also including Egypt, Ghana, India, the Philippines, Senegal, and Turkey). Although comparable data were not available for the transition economies, partial information suggests that the Czech Republic and Poland had good results, and China mixed results, among the transition economies investigated.

Successful reformers in both transition and market economies followed similar strategies: increased competition, liberalized trade, lifted price controls, eased barriers to entry, and, simultaneously, hardened budgets, through reducing or eliminating subsidies to SOEs. Both the Czech Republic and Poland reformed their financial systems, improved regulation and supervision, and ended directed credit. Poland introduced legislation that entrusted banks with initiating bankruptcy at poor-performing firms. This decentralized approach can propel troubled firms to restructure and privatize more rapidly, and push inviable firms to liquidate, early signs indicate.

Reformers (successful and unsuccessful alike) tried to improve the incentive structure by changing the relationship between state enterprise managers and the government. They introduced new oversight bodies and increased managerial autonomy and accountability. Results are mixed. Looking for answers, the report considers contracts between government and state enterprise managers, between government and private managers, and between government and owners of newly privatized monopolies.

Performance contracts between government and state enterprise managers. These contracts were common under central planning and are still widely used in China under the contract responsibility system. Some transition governments have considered introducing a variant of these to improve SOE performance. In the developing countries, performance contracts failed to improve profitability or total factor productivity, and in some cases even produced worsening performance. Managers were able to use their information advantage to negotiate multiple, soft targets; the contracts failed to give management an incentive to improve performance; and governments were not committed to the process and frequently reneged on key promises. Thus, these contracts should be used only if they convey clear reform signals and provide rewards for improved performance, as well as curb government's tendency to renege.

Management contracts between government and private managers. These arrangements were not widely used; however, they proved generally successful in transition economies, such as Poland and Romania. In two-thirds of the cases studied they improved profitability and productivity. They work best when they are competitively bid, when the contractors' fee is linked to firm performance, and when government commitment to the contract is signaled by, for example, providing for contract renewal and arbitration of disputes. They are largely confined to a few sectors—namely, hotels, agriculture, and water. The cost to the government of obtaining the information needed to negotiate, monitor, and enforce a management contract is one reason. Information is more easily available, and contract transactions costs thus lower, in sectors where technology is not changing rapidly and output is a single, homogeneous product (as with water or sugar); or where the private contractor has an international reputation to protect, the market is competitive, and quality is easily compared (as with hotels). Moreover, under the conditions where management contracts can work, especially in competitive sectors, privatization will often offer governments higher benefits (revenue from the sale) and lower costs (no need to monitor, enforce, and negotiate the contract).

Regulatory contacts between the government and private owners of a monopoly (mainly in infrastructure). In most cases these contracts improved performance. However, at this time only a few countries were ready to privatize their monopolies in infrastructure. [Hungary just recently escalated the process, privatizing electricity, gas, and oil production and distribution. The editor.] Regulatory contracts work best if governments separate the competitive parts of a firm (such as separating cellular telephones from the state's telecommunications monopoly) and initiate competitive bidding for the rest (such as for basic telephone service); if price regulation is designed to reward improved performance; and if the government demonstrates its commitment to the contract—for example, by designating clear procedures to resolve disputes.

In most countries the reform of state-owned enterprises was rather disappointing; governments—aware that reforms almost invariably involve eliminating jobs and cutting long-established subsidies—were reluctant to sacrifice their support base. Governments that were more successful in reforming their state enterprises can be characterized as follows:

• Mobilizing wide support. In the Czech Republic and Poland the political transition away from the communist regime constituted a fundamental rejection of totalitarian government and state control of daily life.
• Controlling the levers of power and having the means to overcome opposition. The Czech Republic's strategy of universal share distribution increased popular support for privatization, and also overcame the objections of managers who expected to be able to retain control over their privatized enterprise if the ownership shares remained diffuse.
• Having credible reform policy—for example, compensating state employees who lost their jobs, as promised. The Czech government followed through on its promises and, consequently, was able to push through its program of sweeping macroeconomic reforms.

If any one of these conditions is not met, divestiture and other measures to improve the efficiency of state enterprises cannot succeed.

In principle, developing market economies, in comparison with transition economies, have an easier job reforming and divesting their state-owned enterprises:

• The state-owned sector has a much smaller share in the economy; thus, resistance to reform should be correspondingly less.
• The domestic private sector is a potential buyer or competitor for the state firm, and should help spur the process.
• The habits and apparatus (such as stock exchanges) of markets are already in place, making it easier to carry out reforms.
• The market economy is not simultaneously trying to reorder or recreate its trading system, political system, financial institutions, judicial structures, and other key institutions of society, making change less wrenching.

But in a sample of twelve countries, the three transition economies were among the more successful state enterprise reformers, suggesting that being in transition may be an advantage. Politically charged reforms may be easier to push through in the context of widespread, sweeping change than when they are part of a more routine incremental reform process.

Bureaucrats in Business: The Economics and Politics of Government Ownership, World Bank Policy Research Report, Oxford University Press, 1995, 346 p. To order: World Bank, P.O. Box 7247-8619, Philadelphia, PA 19170, USA, tel. (202) 473-1155, fax. (202) 676-0581; or visit the World Bank bookstores, in the United States, 701-18th Street, N.W., Washington, D.C. or in France, 66 avenue d'Iena,75116, Paris, (Email: books@world bank.org) (Internet: http://www.world bank.org/)