metadata: authors: 0: author: Galal,Rami Mikko Ahmed
count: World
docna: 0: docna: Public enterprise reform : a challenge for
            the World Bank
docty: Policy Research Working Paper
subtopic: Public Sector Economics,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,International Trade and Trade Rules,Competition Policy,Competitiveness and Competition Policy,Public Finance Decentralization and
            Poverty Reduction,Democratic Government,Economics and Finance of Public
            Institution Development,Financial Sector Policy,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Health, Nutrition and Population,Environment,Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
abstracts: cdata!: Public enterprises (PEs) earn an average
            10 percent of GDP in developing countries. Many governments
            are reexamining the role of the state, so questions about
            whether to divest PEs or make them more efficient are likely
            to intensify. The Bank will increasingly be called upon for
            advice and financial support in managing the transition
            period. The Bank should maintain its focus on rationalizing
            the size of PEs, by liquidating nonviable PEs, and
            transfering their ownership or control to the private
            sector, if that will make them more efficient. In helping
            countries improve the efficiency of PEs that remain public,
            the Bank should emphasize both policy framework and
            institutional set-up, and restructuring of individual
            enterprises. It should also extend its analysis of PEs to
            the socialist economies, explore the relationship between
            PEs and the private sector, and study how best to phase and
            sequence PE reforms. The Bank should refine PE reform
            components and tools, especially in terms of the phasing and
            sequencing of price liberalization and competition: the
            budgetary impact of PEs; and the valuation of PEs for
            divestiture. Lastly, it should learn more systematically
            from experience by analyzing the outcomes of PE reforms; the
            performance of divested PEs; the effects on efficiency of
            staff reductions; and the effectiveness of program contracts
            on enterprise efficiency.
repnme: repnme: Public enterprise reform : a challenge for
            the World Bank
display_title: Public enterprise reform : a
            challenge for the World Bank
listing_relative_url: /research/1990/04/700303/public-enterprise-reform-challenge-world-bank
topicv3: Price Controls m1326085 2107,State Owned Enterprises m1326323 721,Trade m1326924 698,Treasury m1327009 1045,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Health, Nutrition and Population,Environment,Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
origu: Policy, Research & Ect Affairs
no_of_pages: 52
author_keys: 0: author_key: 1651723
model_extractions: **Policy, Research, ad Extiemal Affairs**

**_*016 a,_** * ***ti.V**

**Public Sector Managemont and Private Sdetor Oev.opment**

- This paper a product of the Public Sector Management and Private Sector Development Division. - Country Economics Department is part of a larger effort in PRE to: (i) review past efforts in institutional development. (ii) deterrnine where these efforts have succeeded and where they have done poorlyv and (iii) suggest how the World Bank and its borrowers can better create and strengthen an appropnate institutional framework for economic development. An earlier version of this paper was presented at a conference on Institutional Development and the World Bank, held in Washinigton DC in December 1989. Copies of this paper are available free from the World Bank. 1818 H Street NW, Washington DC 20433. Please contact Gloria Orraca-Tetteh, room N9-069, extension 37646 (47 pages with tables).

Public enterprises (PEs) - state-owned or state-controlled productive entities whose output is sold mostly in the marketplace **-** earn an average 10 percent of GDP in developing countries (17 percent in African countries, 12 percent in Latin American countries, and 3 perr'ent in Asian countnies).

both policy framework and institutional set-up. and restructuring of individual enterprises.

* Extend its analysis of PEs to the socialist economies, explore the relationship between PEs and the private sector, and study how best to phase and sequence PE reforms.

Many governments are reexamining the role of the state, so questions about whether to divest PEs or make them more efficient are likely to intensify. The Bank will increasingly be called upon for advice and financial support in managing the transition period. Galal recommends that the Bank: Maintain its focus on rationalizing the size of PEs. by liquidating nonviable PEs and transfering their ownership or control to the private sector. if that wiUl make them more efficient. In helping countries improve the efficiency of PEs that remain public, the Bank should emphasize

* Refine PE reform components and tools, especially in terms of the phasing and sequencing of price liberalization and competition: the budgetary impact of PEs (their costs versus thcir revenues **-** and **here** Galal discusses the "watcrbed effect." how holding down costs in one area raises costs in another); and the valuation of PEs for divestiture.

* Leam more systematically from expenencc by analyzing the outcomes of PE reforms: the performance of divested PEs; the effects on cFliciency of staff reductions; and the effectiveness of program contracts on enterprise efficiency.

**Tlhe PRE Working Paper Series disseminates the rirdings of work** under **way in the Bank's Policy, Resereh. and Extcrnai** Affa.rs Complex. An objective **of the senes** is to get **these** rindings out quickly. even if presentations **are** less than fully polished. **The** findings. interpreutons. and conclusions **in** these **papas** do not necessarily represent **official** Bank pohc>

Produced **at** Lhe PRE Dissemination **Center**
# PUBLIC ENTERPRISE REFORM AND THE WORLD BANK: Aproach, Practices and Challenzes

# Ahmed Galal

# TABLE OF CONTENTS

||Paze|
|---|---|
|INTRO|DUCTION/EXECUTIVE SUMMARY<br>..|
|I.|THE WORLD BANK's APPROACH TO PE REFORM .<br>3|
||A.Evolution.<br>3|
||B. Theoretical Foundation of Approach.<br>3|
||C. Components of Approach.<br>6|
|II.|REFORM EXPERIENCE<br>..<br>11|
||A. Documentation of Reform .<br>11|
||B. Reform Out..ome ..<br>12|
||C. Prerequisites for and Constraints to Better|
||Implementation .18|
|III.|CHALLENGES AHEAD .19|
||A. Overview .19|
||B. Conceptual Challenges .19|
||C. Reform Components and Tools .22|
||D. Learning from Experience .24|

# CONCLUDING OBSERVATIONS .26

|REFERENCES .28|
|---|
|STATISTICAL ANNEX .31|

This paper was presented at the World Bank's Conference on Institutional Development, Washington, D.C., December 14-15 1989. I am grateful to Mary Shirley, John Nellie, Leroy Jones, Bela Balassa, Robert Lacey, Arturo Israel, Robert Taylor, Bernard Drum, Brian Levy, Barbara Lee, Henry Laurant and Peter Wright for helpful comments, to Polly Means for research assistance and to Gloria Orraca-Tetteh for secretarial assistance.
INTRODUCTIQN/XECU'T:VL SE (ARY

1. Public Enterprises (PEs) are productive entities which are owned and/or controllei by the state and the bulk of whose output is sold in the market place (Jones, 1975). As a sector, PEs play a significant role in mixed economies, averaging 10% of GDP in developing countries worldwide, with PEs in African countries higher than the average (17%), Asian countries at the lower end of the scale (3%), and Latin American countries somewhere in between (12%). (Swanson and Wolde-Semait, 1989). They dominate important sectors in most countries (e.g. infrastructure, heavy industries, etc). Furthermore, PEs are major borrowers in domesric and international markets; they draw extensively on government budgets, and often employ a large segment of the labor force. Therefore, attempts to improve their performance are critical co the macroeconomic performance of most countries.

2. In recognition of the importance of PEs. and their generally unsatisfactory past performance record, the World Bank has devoted attenJion to assist its borrower countries in their efforts to improve the operating and allocative efficiency of PEs. To this end. progress has been made on two fronts. First, the Bank. has developed and disseminated a sector-wide approach to PE reform. In this approach, PEs are viewed, as the name implies, as enterprises whose managers are supposed to respond to market signals, and as public entities whose managers are supposed to respond to their governments as the owner and regulator. Therefore, measures to increase the effective functioning of markets have been treated as a necessary condition to irmprove the operating and allocative efficiency of PEs. Reforming PEs' institutional set-up, to supplement and compensate for deficiencies in ilarket conditions and to persuade managers to respond to correct market signals, has been treated, together with market-related reforms, as a sufficient condition without which the desired supply response may not be forthcoming. More recently, divestiture has increasingly been utilized as a tool of public policy to rationalize the size of the sector in such a way as to maximize the benefits from government intervention to correct for market failure, and to minimize the costs of such intervention resulting from bureaucratic or organizational failure. The rehabilitation and restructuring of individual PEs have continued throughout to constitute an integral part of the Bank's approach to PE reform.

3. Second, the Bank has increasingly provided financial support to its member countries embarking on PE reform programs. Increasing Bank support is evident from the growing number of adjustment lending operations focusing exclusively on PE reform (often referred to as PELs), or operations in which PE reform constitutes a major componert, i.e. structural adjustment loans (SALs), sectoral adjustment loans (SEtALs), or technical assistance loans (TALs). By June 1989, the total number of operations in which PE reform was a major component was 147, of which 24 operations were approved by the Board in the last year alone (July 88-June 89) 4. Systematic empirical evidence regarding the impact of reforms on the performance of PEs has been relatively scarce; in part because of the short time horizon during which PE reforms have been attempted on a sectoral
basis (the 1980s). More recent.; however, preliminary Bank analysis suggests that the overall effect of these reforms, where they have been implemented, is moderatel: ' posi:i'.'e. First, there are indications that the size of the ?E sector has declined (or has been curtaiLed), for example, in the Philippines, Mexico, Jamaica, Togo and Guinea, thus implying greater room for private sector initiatives. Second, the profitability of PEs has improved in countries such as Thailand and Turkev. 'n other countrias (e.g. Mauritius, Niger, Mali) PEs' consolidated losses, excluding subsidies and taxes, have declined. Profitability improvements and/or reduction in losses partially reflect output price increases, but they also reflect better allocation and use of resources. Third, available empirical evidence regarding the budgetary impact of ?Es (wnich is broadly defined as the difference between the flowi of funds from the Treasury to PEs minus the flow of funds from PEs to the Treasury) suggests that profitability improvements and/or reduction in losses have largely meant less dependency on the government's budget for financing (e.g. Mauritius, Thailand). PEs' budgetary burden worsened in other cases (e.g. Senegal, Malawi). Where the effectiveness of reforms to reduce PEs' budgetary burden has been limited, attempted measures have been inadequate and/or unaccompanied by the liquidation of non-viable PEs, the divestiture of those better run by the private sector, and the restructuring of viable PEs. Even in these cases, however, it could be argued that the budgetary burden could have been worse in the absence of reforms.

5. Notwithstanding this progress, new challenges are emerging. At the conceptual level, recent developments in socialist economies --in particular as some of these economies are moving toward greater decentralization and reliance on market forces-- suggest the need to extend the Bank's approach to PE reform to socialist countries. The increasing emphasis on the private sector as an important engine of growth--yet its dependency on PEs--suggests that the analytical approach to PE reform should consider their crowding out and crowding in effects on the private sector. Thirdly, to maximize the effectiveness and sustainability of PE reform, attention should be given to the question of phasing and sequencing of these reforms. At the operational level, the feedback from experience suggests the need to sharpen the tools of PE reform, refine its components, and systematically consolidate the process of learning from experience. The most pressing issues in this regard concern: the phasing of price reform and competition, the budgetary impact of PEs, enterprise valuation for divestiture, outcomes of PE reforms, the efficiency consequences of staff reduction, the effectiveness of performance contracts at the micro level, and the ex-post performance of divested firms.

6. The need to address these challenges is gaining urgency given that many governments around the world are increasingly reexamining the role of the state. As a result of this reexamination, it is expected that questions of divesting PEs and attempts to improve the efficiency of those remaining in the public domain are likely to intensify, rather than diminish, in the near future. In the process, the Bank will increasingly be called upon for advice and support in managing the transition period. To meet the expected demand, concerted effort is necessary. Within the Bank, this requires collaboration between the Policy, Research & External Affairs (PRE) complex and the four operational regions. PRE is well positioned to provide an inter-regional perspective. Operations (i.e., the Technical and Country Departments of
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different regions) can provide regional patterns, country-specific experiences, and operational direction for the needed research. In addition, valuable insights can be gained from the acalemi_ communit'y and other development institucions.

7. The rest of this paper will: (1) briefly summarize the 3ark's approach to and experience in reforming PEs; (2) identify more concrecely some of the challenges lying ahead; and (3) suggest, on the basis of findings, an agenda for future work on PE issues. Before proceeding further, howerer, one remark is order. This paper is written for the Bank's conference on institutional development. Yet, it addresses PE reforms in general, of which institutional reforms constitute but one component. The wider focus was favored because it emphasizes that institutional reforms should be treated a. an integral component, but not a substitute for, policy reforms in PE reform programs.

# I. THE WORLD BANK's APPRGACH TO PE REFORM

# A. **Evolution**

8.

8. The World Bank's approach to PE reform has evolved over time. Until the late seventies, in the context of its project work, the Bank focused on the creation, strengthening, and re_tructuring of individual PEs. Since then, the Bank has increasingly moved toward a sector-wide approach to PE reform. In part, the shift reflects the fact that PEs in diverse activities (e.g. infrastructure, industry, agriculture) share common problems, many of which are the product of public ownership. To solve these problems, a common framework is required. In part, the shift mirrors the Bank's increasing emphasis on the role of the overall policy and " titutional environments in the adjustment process at the macro level. When .is emphasis is translated to PEs, it implies that the root cause of their poor performance lies to a large extent in their distorted and rigid incentive structure, inappropriate institutional set-up, and over-extended role in economic activities.

9. Increasing Bank emphasis on a sector-wide approach to PE reform has not meant that the rehabilitation, strengthening or rescructuring of individual PEs is no longer necessary Rather, it has meant that restructuring was to supplement the sector-wide approach, focusing in particular on PEs whose performance is critical to the success or failure of other actors in the economy. It has also meant that greater emphasis is now placed on the liquidation of non-viable PEs, the sale of those better run by the private sector, and the rehabilitation of the others.

# B. Theoretical Foundation of ARproach

10. The theoretical folndation for the Bank's sector-wide approach to PE reform is succinctly summarized in the following quotation:

- M the efficiency of an enterprise - public or private - is highest when the enterprise strives to maximize profits in a competitive
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market, under managers with the .tonomy, capacitv, and mocivation te respond to competition, and when enterprises that cannot compete go bankrupc" . (Shirley, 1989.) Since PEs seldom face such conditions, largely for reasons of public ownership, the Bank's approach to their reform is focused on assisting its member countries in providing a more efficiency inducing set of condicions.

II. The origin of this framework cannot be found in neo-classical microeconomic theory, in which ownership is seldom discussed.1/ Rather, it finds its ori.gin in extensions to PEs of the arguments developed by property rights, public choice and X-efficiency schools (e.g. Alchian, 1965, Williamson, 1975, Leibenstein, 1970). The basic argument of this literature, which presumes extended or selective rationality instead of the presumed rationality in the standard theory of the firm, can be stated as follows: In large private corporations, ownership is divorced from management, thus a wedge is creaced between the principals (the owners) and their agent (the managers).2/ Depending on the room for discretion, which increases in sheltered (uncompetitive) markets, managers of these corporations are likely to maximize objectives differing from, and often incompatible with, profit maximization. Monitoring managers and replacing them is costly. Therefore, the principals are often ready to accommodate a tolerable level of managerial discrecionary behavior, with adverse effects on efficiency. When managers, or individuals within the firm, choose to devote less than maximum effort (for reasons of inertia and limited incentives), X-efficiency theory argues that the resulting output will be less tharn optimal for a given input mix.

12. In PZs, ownership is also divorced from management. Therefore, PE managers could be expected to maximize objectives differing from profit maximization, or to simply lead a tranquil life. And indeed several authors have suggested alternative objective functions for PE managers (e.g. Niskanen, 1971, Aharoni, 1981, Baldwin, 1975, Galal, 1986, Levy, 1987).3/ Details aside, the basic point of this literature is that PE managers are likely to deviate from profit ma.cimization to a greater extent than their private counterparts for several reasons. First, from an ,nstitutional point of view, politicians 1/ To be sure, a textbook theory of the firm suggests a role for the government to play in order to compensate for incidents of market failure (e.g. exter,ialities, public good, increasing returns, asymmetrical information, future markets etc.). This theory leaves, however, the form of government intervention open to include direct ownership of resources, regulation, and subsidy and tax schemes.

2/ Extended rationality refers to situations in which managers maximize ob,ectives other than profits, e.g. their utility. Selective rationality or X- efficiency theory questions whether individuals maximize at all.

3/ Niskanen suggests that PE managers maximize their budgets; Aharoni suggests they maximize their autonomy; Baldwin, Galal and Levy suggest that thev maximize their utility with different arguments in their utility functions and different political and bureaucratic constraints.
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tend to use PEs to achieve policical<sup>ends, e.g. appointing loyalists to</sup> managerial positic-is (a.g. party members,<sup>generals). setting prices to satisfy</sup> certain incerest groups (including<sup>gaining votes for the party in power in a</sup> aemocracy, Boneo, 1981), and using<sup>PEs for employment generation, or regional</sup> development.'/ The mulciplicity of and<sup>conflict between objectives often mean</sup> che satisfactorv achievement of<sup>none; failure to achieve one objective is</sup> often blamed on attempts to achieve the<sup>rest.5/ Even more, efficiencv losses</sup> tend to persist, largely because<sup>politicians are rarely voted out of office</sup> for reasons of poorly performing<sup>PEs.</sup> 13. Second, the problem of multiple objectives<sup>is exacerbated even</sup> further by the problem of "plural<sup>principals". The latter problem refers to</sup> the observation thae the ownership<sup>of PEs is either diffused or ill allocated.</sup> Unlike private shareholders who<sup>can trade their shares and claim dividends,</sup> shareholders of PEs are not usually<sup>well specified.6 / Hence, many government</sup> agencies/ministries attempt to<sup>perform the ownership function.</sup> 7 / They place conflicting demands on PEs and<sup>interfere in their operations to the point</sup> where they become an extended<sup>part of the government bureaucracy, rather than</sup> commercial entities.

14. Third, one consequence of the multiplicity of obiectives<sup>and</sup> plurality of principals is that<sup>public agents tend to be unable, and at times</sup> reluctant, to devise and implement<sup>efficient monitoring and incentive</sup> mechanisms. The limitations of public<sup>agents to devise such mechanisms stem,</sup> in addition, from their complicated<sup>hierarchical arrangements, information</sup> asymmetry (whereby managers are<sup>the ones who know the most about their PE5)</sup> and the nature of managemenc within<sup>the civil service. In particular, civil</sup> servants tend to be procedures rather<sup>than outcomes oriented,</sup> -erventionist (in the day-to-day operational decision-making<sup>of PEs), and toj.ssess skills</sup> less suited for promoting business-like<sup>behavior. The reluctance on the part</sup> of bureaucrats to devise efficient<sup>monitoring and incentive systems is</sup> believed to arise in principle from their desire<sup>to maintain ambiguity so that</sup> chey can retain control, evade accountability<sup>and possiblv form coalitions</sup> with PE managers to secure better pay,<sup>power and prestige.</sup> 15. Fourth, from a market o^oint of view,<sup>FE managers are likely to</sup> deviate from profit maximization to<sup>a greater extent than their private</sup> i4/ Boneo (1981) observed, for example,<sup>that upward price revisions of the</sup> output of PEs in Argentina systematically<sup>followed elections.</sup> 5/ Jones (1985) has shown, in Egypt<sup>and elsewhere, that attempts to control</sup> PE prices in order to benefit the<sup>poor turned out to benefit the rich.</sup> 6/ At one extreme, ownership is allocated<sup>to "society" (e.g. YugDslavia).</sup> At best, it is allocated to a holding<sup>company (e.g. Italy).</sup> 7/ Typically, the Ministry of Finance<sup>attempts .o maximize revenue form PE</sup> operations; the Ministry of Labor attempts<sup>to maximize employment; the Technical</sup> Ministries attempt to increase their<sup>power and prestige through the expansion</sup> of PEs under their domain.
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counterparts because PEs tend to<sup>operate, by and large, in sheltered markets</sup> (which are either natural --<sup>decreasing cost industries-- or policy induced--</sup> protection and the like).<sup>They usually escape the disciplineof</sup> financial markets; p.rticularlv because they have access to government<sup>funds and credit</sup> from the banking svstem and<sup>abroad, often at preferential termi. Moreover,</sup> they operate behir.d barriers to exit; that is, they<sup>are seldom liquidated even</sup> when thev prove to be costly<sup>tosociety.</sup> 16. The implication of this literature<sup>is straightforward:</sup> ownership matters; it has consequences<sup>for enterprise efficiency. Public ownership and</sup> management of resources of<sup>enterprises producing tradable commodities and</sup> operating in relatively competitive<sup>or potentially competitive markets entail</sup> costs associated with bureaucratic<sup>failure that go largely uncompensated for</sup> by any gains from reductions<sup>in market imperfections.</sup> Therefore, private ownership of such activities<sup>shoull usually be prcferred. The same conclusion</sup> does not strictly apply, however,<sup>to non-competitive</sup> firms, i.e. firms which may be in a position to exercise<sup>some monopoly power. For this subset of PEs,</sup> the net benefits from and feasibility<sup>of regulating private monopolies have to</sup> be weighted against the net benefits<sup>from and feasibility of retaining them in</sup> the public domain and reforming<sup>thiem.</sup> Assuming that a decision is made<sup>in</sup> favor of retaining this subset<sup>of PEs in the public domain, this literature</sup> suggests, in order to reduce<sup>the room for managerial discretionary behavior</sup> and reduce political interference,<sup>that: PEs should pursue commercial</sup> objectives; their managers should<sup>be appropriately</sup> selected and induced to pursue these objectives; and<sup>they should have the autonomy to respond to</sup> market signals, in return for<sup>which they should be held accountable for</sup> outcomes and rewarded or penalized<sup>accordingly.</sup> PEs should, in addition, face greater competitive pressure and<sup>financial discipline. Non-viable PEs should</sup> be closed down.<sup>8</sup> /

## 9

# C. Components of AoDroach

17. The Bank's sector-wide approach<sup>and best practice solutions to PE</sup> reform correspond to the above recommendations. In its endeavor to assist its borrower countries to improve the<sup>efficiency of their PEs, the Bank suppor-s</sup> reforms to: (1) rationalize the<sup>sector's size, (2) improve the PE market-</sup> related environment, (3) streamline<sup>the institutional set-up governing the</sup>

**8/** Theoretical assertions apart,<sup>similar conclusions are reached by a</sup> number of country studies and inter-country comparisons. One such study, which focuses on the determinants of performance<sup>of PEs in a sample of ..3 developed</sup> and developing countries, concluded<sup>that the most important determinants of the</sup> performance of PEs were: competition,<sup>managerial and financial autonomy, and</sup> accountability. The countries covered by the study<sup>are: Austria, Brazil, France,</sup> Ghana, India, Israel, Italy, Norway,<sup>Pakistan, Portugal, Sweden, Tunisia, and</sup> Zambia. For details, see: Ayub and<sup>Hegstad, 1986.</sup>

9/ For a detailed review of the<sup>Bank's approach to PE reform, reform</sup> components, best practice solutions,<sup>and examples, .ee Shirley, 1989a.</sup>
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relationship of ?Es with their governments<sup>as the owner and regulator, and(4)</sup> assist in the rehabi:Lzatiun/'restructuring programs of viable PEs. These issues are brie!"I elaborated below.<sup>°.</sup> 18. Rationalizing The Sector's Size: Excessive<sup>gover-ment intervention</sup> in the form of direct ownership of<sup>resources implies that the efficiency of</sup> PEs will suffer for two basic reasons.<sup>First, the government's scarce</sup> administrative capacity will be spread<sup>too thinly across too many activities,</sup> which, in turn, diminishes the government's<sup>capacity to perform its ownership</sup> function efficiently. Second, PEs will<sup>exist in activities in which society is</sup> likely to better-off, for reasons given<sup>below, if they are left to the private</sup> sector (e.g. tradable commodities in<sup>general). /</sup> 19. To rationalize the size of the sector,<sup>the Bank supports</sup> divestiture (in the form of liquidation,<sup>sale of assets, contracting-out the</sup> delivery of public services to the<sup>private sector or franchising) when such an</sup> action is expected to promote efficiency.1<sup>2 / Efficiency gains are expected</sup> when divested firms operate, or are<sup>made to operate, in competitive or</sup> contestable markets. The presumption<sup>is that the transfer of ownership will</sup> enable private entrepreneurs to operate<sup>freely from problems inherent to PEs;</sup> political interference, multiplicity<sup>of and conflict between objectives,</sup> plurality of principals, and rigid<sup>and inappropriate control structures. The</sup> new owners will, in addition, face<sup>the threat of merger and bankruptcy, and</sup> will have to borrow on their own merit.<sup>In short, divestiture will internalize</sup> the costs of and benefits from ownership.<sup>As a result, self-motivated private</sup> entrepreneurs will exert greater effort<sup>to improve efficiency at the</sup> enterprise level. In the case of<sup>divesting non-competitive PEs, the Bank</sup> supports such an action when it is<sup>accompanied or preceded by the enactment of</sup> an effective regulatcry system.<sup>Short of instituting such a system, it is</sup> feared that private monopolists may<sup>exploit the consumers without necessarily</sup> lo/ In implementation, it is possibLe<sup>to find deviations</sup><sup>_from_the</sup> recommended approach. The implementation<sup>experi.-n:e is reviewed in section II</sup> below.

l/ Activities in which the costs of<sup>bureaucratic failure are likely to be</sup> large have the characteristics of:<sup>being small relative to the product and factor</sup> markets, requiring decentralization<sup>of establishments and decision-making,</sup> involving the production of non-standardized<sup>goods, not requiring lunpv capital,</sup> and being relatively labor-intenrive.<sup>For further details on these issues, see</sup> Jones and Mason, 1982.

12/ Governments may pursue divestiture<sup>for reasons other than or in addition</sup> to increasing efficiency; for example:<sup>capital market development, promoting</sup> competition, resource mobilization,<sup>distribution of ownership, diffusing the</sup> strength of trade unions and the like.<sup>These objectives are important in their</sup> own right. Yet, they are viewed as positive<sup>byproducts from divestiture when they</sup> occur. Moreover, it should be emphasized<sup>that they could, perhaps more</sup> effectively, be achieved via alternative<sup>instruments; e.g. financial sector</sup> refornm, deregulation, trade liberalization,<sup>and subsidies and tax schemes.</sup>
--

attaining anv gains in efficiency.<sup>13</sup> / But even then, the costs and feasibility of instituting regulatory mechanisms have to be weighted against the ~:osts and feasibility of retanirng PEs in the public hard and rer;rming them.

20. Increasinl Competition and Financial Discipl.ne: Even after measures have been taken to rationalize the size of the sector, the likelihood is hLgh that some PEs (especiall'; natural monopolies producing non-tradable commodities and possibly ochers) will remain public. As noted, the efficiency of those is likely tc suffer when government policies diminish or preclude competition in the product, input, factor or financial markets. Competition reducing policies include: barriers to entry of new firms ar,d exit of inefficient ones, widespread monopoly rights, excessive protection, price control, uneconomic investment decisions, rigid !.abor and wage policies, and economically unjustified access to the banking sector, government funds and foreign credit.

21. To reduce the adverse effects of such policies on the efficiency of PEs, the Bank supports measures to promote competition and reduce the antior-pro PE bias. 14/ To promote foreign competition, the Bank supports greater openness to foreign trade (largely using instruments other than PE reform programs) and export rivalry. Domestic competition is promoted by abandoning monopoly rights, breaking-up large monopolies, facilitating entry of new firms and liquidating PEs thet cannot survive on their own.15/ Measures to reduce the bias against or in favor of PEs include the elimination of preferential access to and terms of credit and foreign exchange. They also include measures to reduce/eliminate PEs' access to government funds; i.e., operational subsidies and the like. (The latter measure is motivated by efficiency as well as fiscal considerations).

22. In addition, the Bank supports 2rice liberalization, especially for products produced in competitive markets, and price revision, on the basis of long-run marginal costs, for non-tradable commodities that are produced in non-competitive markets. Price reforms are intended to: correct for relative price distortions, and allow managers the flexibility/autonomy to respond to market signals; both of which should lead to better allocation and use of resources. Cost-plus formulas are discouraged on the ground chat they promote 13/ Hemming and Mansour, 1988, Nellis and Kikeri, 1989, and Galal, 1989a elaborate on the a priori conditions under which efficiency improvements are expected from divestiture.

14/ Competition policies may neither be feasible nor desirable where economies of scale or scope are so large that only a monopolist could attain them. In such cases, appropriate control mechanisms are especially recommended. These recommendations are reviewed below under the heading "the institutional set-up".

15/ For further details on competition policies, see: Frischtak et. al., 1989.
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inefficient behavior at the enterpr_se level and impose a burden on the consumers and os :ar -uavers.

23. As marnv ?Es are overstaffed and face rigid labor and wale policies, the Bank often supports staff reductions and changes in the rules of hiring, firing and compensation. The objective of these reforms is to encourage efficiency by ensuring an optimal mix of capital and labor,<sup>and a</sup> stronger link between labor productivity **and** compensation. To alleviate<sup>the</sup> adverse welfare effects resulting from lay-offs, the Bank supplements **its** support to these changes by funding and assisting its borrower<sup>countries to</sup> implement training, severance pavments, and redeployment programs.16/ 24. The Institutional Set-up: Increasing competition, reducing price distortions, and eliminating the anti-or-pro PE bias will pave the way to force PE managers to behave more efficiently. Without parallel reforms<sup>in the</sup> institutional fr.mework to increase PE autonomy to respond to market challenges and co hold mar.agers accountable for outcomes, market-related reforms may no. necessirily stimu.late the appropriate supply response<sup>at the</sup> enterprise level. PEs will not respond to increased ccmpetition aind removal<sup>of</sup> distortions with increases in efficiency if rhe Governn._ne-PE inscitutional relationship is one in which PE managers are forced to: (1) pursue multiple and conflicting cob,ecuives, (2) respond to too many government agencies (princi?als), (3) face ineffective monitoring and reward systems, and<sup>(4) have</sup> limited managerial and financial autonomy in operational decisions of<sup>a sort</sup> largely left to managers of private firms; e.g. pricing of products<sup>produced</sup> in competi. se markets, firing redundant workers and attracting and<sup>retaining</sup> tnose with the appropriate skills, procurement and distribution, etc.

25. The Bank, in addressing each of these issues in tl:rn, supports reforms to clarify enterprise objectives, better specify the role of the government as che owner and regulator change the control structure<sup>from ex-</sup> ante to ex-post, hold managers accountable for outcomes and reward them on the basis of achievements. Commercial PEs are encou-aged to pursue profit maximization. Non-commercia'l objectives should be pursued by other instruments, such as direct taxes or subsidies. In cases where PEs are the most effective vehicle to at:ain these objectives, the Bank supports their quantification and explicit compensation to PEs. Concerning the role of the government as the owner, it has been suggested thac this role should be limited to functions similar to those exercised by a head office in a nultidivisional private firm. 17/ These functions are: setting enterprise objectives, appoirting the managing director, evaluating performance, rewarding or penalizing managers accordingly, approving investment decisions when they require government funds, planning and coordinating across units and activities, and --most importantly-- doing nothing else. The role of the government as a regulator should be assigned to a government agency<sup>different</sup> 16/ For a review of the Bank's experience in public sector pay<sup>and</sup> employment, see: Nunberg, 1988.

17/ The list of government functions as the owner is first ccmpiled<sup>bv Jones</sup> and further elaborated upon by Galal, 1989b and Shirley, i989a.
from that performing the owner:nip function; mixing the two risks producing a conflict of interest.1'/ The regulatory function should be designed to compensate :.r nczAents of market failure (e.g. provide irnformation, regulate monopo'y pric.ng, support infant indvstries, etc.), supplement .ather .han supplant markecs (e.g. collecuving and disseminating information about markets, technology, setting product specification for health and other similar public concerns), and be ownership neutral (i.e., no distinction should be made between public or private enterprises). Operational decisions should be left to the managers of PEs.

26. The above reforms often require searching for appropriate agencies to perform the ownership and regulatory functions, modifying the laws and procedures that are inconsistent with recommended settings, phasing out some superfluous or countLrprodu-tive supervisory institutions, strengthening others, and/or creating new ones, training and technical advice. The magnitude. scope and nature of the required changes in a given country depend on the existing setting and how far it deviates from the desired arrangements. Therefore, the details are often considered on a case-by-case basis. To ensure the sustainability of attempted reforms, however, the Bank frequently supports the implementation of mechanisms, such -s program contracts or signalling systems, the objective of which is to facilitate the process of holding managers accountable for results and rewarding them accordingly. 19/ 27. PE Rehabilitation/Restructuring: Problems at the individual enterprise level may still block efficiency improvements, thus rendering the above reforms (policy and institutional) ineffective. For a given enterprise, these problems could be tne result of, among other things: uneconomic investment decisiors, technological bottlenecks, distorted financial structures, poor management of inventorv, weak marketing capabilities, and/or lack of' skilled and motivated workers and mana3ers. Of course some PEs cannot be helped; i.e., those that are neither able to cover their variable cost, nor have the potential to do so. In such cases, the Bank supports their liquidation. Other PEs legitimately need assisrance and can be turned around. Here, the Bank, as noted, supports their rehabilitation and restructuring, focusing on PEs whose performance is critical to the performance of other actors in the economy. Regarding commercial PEs that operate in competitive 18/ Assigning the ownership and regulatory functions to separate government agencies has been suggested in socialist economies, but the same notion is equallv applicable in mixed economies.

19/ "Program Contracts" and the "Signalling System" are conceptually the same. Both are negotiated agreements specifying the government's obligations toward the PE (e.g. financial obligations, pricing formulas) and the obligations of the PE toward the government (e.g. performance targets). They are intended to facilitate the process of evaluating _PE_ managers against agreed targets and compensating those who show superior achievements. In implementation, the two mav differ. This point is discussed below. For further details regarding Program Contracts, see: Nellis, 1989. For further details regarding the Signalling Svstem, see: Jones, 1981 and Shirley, 1989b.
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markets, the Bank supports the transfer of their ownership to the p.ivate sector.

# II. REFORM EXPERIENCE

# A. Documentation of Reform

28. On the basis of the _PE_ sector-wide approach, the Bank had, by June 1989, approved 147 projects in support of PE reform, of which 24 operations were approved during the last year alone (July 88-June 89). (See Table 1). Most of these reforms were associated with structural adjustment loans (67 projects), followed by technical assistance loans (34 projects), and sectoral adjustment loans (33 projects). In addition, 13 loans focus exclusively on PE reform (PELs) .20/ 29.

29. Bank support for PE reform has been concentrated in Africa, which alone accounted for 54 % of the total number of PE lending operations, followed by the Latin American and Caribbean region (LAC), the Europe, Middle East and North African region (EME.NA) and, finally, the Asian region. The widespread and apparent incidence of market and bureaucratic failures in African countries in comparison with others, and the excessive size of the PE sector in this region largely account for the concentrated effort.

Table l: Number of PE Reform Projects a/

|Tec|hnical<br>Stru|ctural<br>PELs b/|<br>Sec|toral<br>Total||
|---|---|---|---|---|---|
|Region|Assistance|Adjustment||Adjustment||
|..<br>..............................|.................................|||||
|Africa|21|36|8|15|80|
|LAC|10|16|2|4|32|
|EMENA|3|8|2|11|24|
|Asia|0|7|i|3|11|
|Total|34|67|13|33|147|

Notes: a. Approved as of June 1989, b. Includes PE rationalization/rehabilitation loans, PE institutional development projects, and PE sector adjustment loans.

Source: Statistical Annex.

20/ Public enterprise loans (PELs) include PE rationalization/rehabilitation loans (PERLs), PE institutional development projects, and PE sector adjustment loans.
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30. The principal components of Bank-supported PE reforms and their distribution bv countrv and lending instrument are given in the attached statistical annex. On the basis of available information, some general observations can be made: First, the components of reform correspond to the Bank's sector-wide approach to FE reform. Most operations deal with: the sector's size (through liquidation and divestiture), the policy environment in which ?Es operate, their institutional set-up, and the liquidation, sale or rehabilitation of individual ?Es. This observation reflects the extent of dissemination and wide acceptability of the approach. Second, despite the similarity in coverage of issues across operations, some variations in project design can still be detected. To some extent, these variations appropriately reflect country-specific circumstances. For example the magnitude of the problem of the state/PE and the PE/PE cross-debts and the excessively interventionist institutional set-up in the Moroccan case led to a focus on these issues in the PEL operation. To some extent, however, some variacions in diagnostic studies reflect government's reluctance to undertake some reforms (e.g. divestiture in India). There are also examples of mistaken diagnosis, such as the early phase of PE reform in Senegal, in which the TA project focused too much on control mechanisms and less on divestiture and PE-policy related issues.21/ Third, the bulk of attempted reforms concerns the government/PE relationship. The emphasis on institutional reforms can be explained in terms of: (a) the weak and often inappropriate institutional arrangements governing the government/PE relationship in most countries, and (b) the fact that the overall policy and market-related reforms are often addressed by the Bank under other umbrellas (e.g. structural adjustment loans, trade loans, export promotion loans, sectoral loans). Fourth, the Bank's support for divestiture is extensive, the evidence of which is apparent from a recent Bank trview pointing out that the Bank has supported divestiture in as many as 35 countries through some 70 operations, by the end of June 1989. (Kikeri, 1989).

# B. Reform Outcomes

31. FE reforms should, first, lead to a reduction in the size of the PE sector. Governments, as they adopted import substitution strategies in the sixties and seventies, overextended their involvement in the direct ownership and management of resources.<sup>2 2</sup> / Reforms should correct for this overextension. Second, PE reforms should improve the operational efficiency of PEs. They support a more competitive environment and more flexible institutional arrangements, both of which should pressure PE managers to strive for improved performance and enable them to do so. Finally, PE reforms should increase the contribution of PEs to the goverament's budget because, as efficiency dnd profitability improve, remitted dividends and taxes should go up, and their dependency on the budget for subsidies and other transfers should decline. The question is whether attempted reforms have led to these outcomes.

21/ For a detailed assessment of the early phase of the PE reform in Senegal, see: The Project Completion Report for PPTAl, 1985.

22/ Occasionally, with the active support of the Bank.
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32. Thus far, svstematic empirical evidence regarding the impact of PE reforms on outcomes has been relatively scarce, in part because of the short time horizon during which PE reforms have been attempted on a sector-wide basis (only in the 1980s). More recently, however, some preliminary Bank reports are beginning to address this question. The findings of these reports, which are summarized below, have to be interpreted with caution for two reasons. First, it is difficult to isolate the effect of attempted PE reforms from the effect of other factors (e.g. p^licy changes at the macro level, external shocks and the state of economic activity). Second, it is also difficult to establish the counter-factual story; what would have been the case without attempted reforms?

33. Bearing these caveats in mind, some tentative conclusions can be drawn.23/ In short, PE reforms appear, where they have been implemented, to have on the whole brought about positive improvements. Further details and examples follow.

34. The Size of the PE Sector: Attempts to reduce the size of the PE sector have been made in the Philippines, Jamaica, Mexico, Togo, Guinea, Mali, Madagascar, Benin, and elsewhere. Most of these attempts have been made in Africa. Available empirical evidence regarding the impact of these reforms on the size of the PE sector in relation to GDP is inadequate to assert that PEs now play a less significant role in the economic activity than in the past. 24/ The evidence seems, however, to point in this direction. For example, the Philippines has sold almost 25% of the state's 1985 portfolio. Mexico, as of March 1989, had sold 180 PEs, liquidated 260, merged 70, and transferred 25 PEs to local governments. Tunisia has sold some 25 holdings. Jamaica divested J$500 million worth of assets. Togo and Guinea have sold, put under management contracts or leased a significant portion of their industrial PEs. Guinea closed some 70 PE units. Togo, Mali, Madagascar and Benin have each liquidated 12-15 firms (Kikeri, 1989).

35. Against these accomplishments, the divestiture process has been relatively slow in other countries. For instance, in Senegal, despite the government's announced policy of 'withdrawal of the state" in 1985, hardly any PEs have in fact been sold as of early 1989. In Turkey, where a large and costly preparation for divestiture has been undertaken, very modest actual divestiture has taken place. Moreover, the process is likely to be slower and more complex in the future. In the first wave of divestiture, Governments focused on the sale of profitable, small or medium-scale enterprises. In the 23/ Clearly, more systematic empirical evidence is necessary before passing a sound judgment about the effect of PE reforms. The LAC region's on-going study regarding the impact of PE reforms in Chile, Argentina and Mexico is a beginning in this direction. Other regions of the Bank should initiate a similar exercise.

24/ To assert that the size of the PE sector in relation to GDP has declined, one would have to rely not on the number of divested firms, but on the sector's value-added in relation to GDP, its share in total capital stock, investment, and/or employment.
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second phase, as larger PEs come up for sale, the process will be slowed ky limitations imposed by domestic aggregate savings, sensitivity to foreign buyers, labor redundancy and che weak administracive capacitv to regulate private monopolies. In addition, greater restraint would be necessarv to avoid the temptation of granting undesirable concessions (tax exemptions and the like) to sweeten the deal.

36. From the Bank's perspective, some preliminary conclusions are emerging. First, divestiture is better viewed as an instrument of public policy, which may or may not improve efficiency, depending on the conditions of the sale, the market structure facing the enterprise in question, and whether or not the transfer of ownership is accompanied by the creation of effeccive regulatory mechanisms in the case of divesting non-competitive firms. Holding the alternative view (i.e., that divestiture **is** an end in and of itself) risks portraying the Bank to be ideologically biased. Second, the bulk of divestiture, as noted, has taken place in Africa. Paradoxically, the conditions prevailing in most African countries appear to be less suited to undertake effective divestiture programs; most notably, several of these countries have relatively underdeveloped capital markets, limited competition and scarce entrepreneurial talents. Therefore, further Bank support to divestiture in these countries should emphasize liberalization of the economy and financial sector reforms prior to the sale of assets to the private sector. Third, divesting monopolistic firms is proving difficult because many LDCs have weak regulatory capacity. Therefore, attention to building such capacity should be emphasized in the future. But even then, given the less than satisfactory performance of regulatory agencies in developed countries, it would be important to weigh the costs of and benefits from divestiture-cumregulation versus those of maintaining PEs in the public hands and reforming them. Fourth, the process of implementing divestiture programs is proving to take longer than anticipated; time is required to prepare a strategy, select candidate enterprises, evaluate their assets, select appropriate modality, announce and screen applicatlons, and strike the deal. Therefore, it may be necessary for the Bank to employ or devise a lending mechanism that spans over a longer pericd of time than is, for example, permitted under SAL operations.

37. Operational Efficiency: Available empirical evidence for a sample of countries suggests frequent, but not universal, association between the implementation of PE reforms and improvements in the sector's operational efficiency. The evidence from Africa shows that the financial performance of PEs has been improving over time.<sup>25</sup> / 'Out of a sample of 18 countries, 8 have shown an improvement as early as 1985 (e.g. Mauritius, Ghana, Niger), 8 are showing mixed results, and two are showing a deterioration (e.g. Ivory Coast, Senegal)'. (Swanson and Wolde-Semait, 1989). In Thailand, where direct lending for PE reform did not take place but implemented reforms are consistent with those recommended in Bank reports on Thai PEs, aggregate profits of the non25/ Financial profitability and operational efficiency are used interchangeably in the text. The two will diverge, however, when changes in profitability reflect, for example, greater subsidies or higher output prices. Since available data do not allow such verification, the conclusions of this subsection have to be incerpreted with caution.
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financial PEs went up from Bahe 11.1<sup>billion in 1983 to Baht 19.4 billion in</sup> 1988. ('world Bank Report No. 7787-TH,<sup>1989). Bv contrast, net aggregate losses</sup> (profits -losses) of the non-financial<sup>PEs in Senegal (excL.uding t:axes and</sup> subsidies) have increased from<sup>CFAF 12.3 billion in 1982 to CFAF 17.3 billion</sup> in 1986. (World Bank Report No.<sup>7774-SE, May 1989).</sup> 38. Changes in the operational efficiency<sup>of PEs are in part tne</sup> product of implemented policy and<sup>institutional reforms. Regarding the</sup> immediate PE-policy framework,<sup>price liberalization or increases have taken</sup> place in almost all PE reform programs,<sup>for example, in Turkey, Jamaica,Togo,</sup> the Ivory Cost, Morocco and Niger.<sup>(See Table 4 in the attached statistical</sup> annex for details). Significant<sup>staff reductions have been implemented in</sup> Ghana, Niger, Togo, Panama, Jamaica,<sup>the Ivory Coast, and elsewhere. Reforms</sup> of investment and c:edit policies<sup>and procedures have been introduced, for</sup> example, in Congo, Ghana, Jamaica,<sup>Mexico and the Philippines.</sup> 39. Despite the desirability of these<sup>reforms, it is cause for concern</sup> that price liberalization has<sup>not always been introduced in tandem with or</sup> prior to introducing measures to<sup>increase domestic ccmpetition. In the</sup> majority of cases, attempts have<sup>been made, through trade liberalization, to</sup> increase competition in the import<sup>and export markets. Yet, evidence is</sup> lacking to support the notion that<sup>measures to increase domestic competition</sup> in markets where PEs operate (by<sup>breaking-up large monopolies, facilitating</sup> entry and exit of firms and the<sup>like) have been addressed systematically. (A</sup> few exceptions can be noted. In<sup>Hungary, for example, price reforms,</sup> bankruptcy laws, deregulation<sup>of entry, etc. have been dealt with.26/ In the</sup> Niger SAL, tax exemptions for<sup>PEs have been abolished). Finally, it appears</sup> that the generous severance pay<sup>arrangements in face of restrained government</sup> budgets are causing difficulties<sup>in implementing staff reduction plans, for</sup> **example in** Ghana. More importantly, it is not clear<sup>how redundant workers have</sup> been identified. Short of any rigorous<sup>documentation, it is feared that</sup> enterprise efficiency may have suffered<sup>in case the remaining work force did</sup> not possess the desired skill mix.

40. Reforms on the institutional front<sup>figured prominently in almost</sup> all FE reform programs, for example,<sup>in the Philippines, Mexico, Morocco,</sup> Ghana, Togo, Niger and Ivory Coast,<sup>and elsewhere. Attempts have been made to</sup> strengthen information gathering<sup>and auditing, create focal points for policv</sup> formulation and supervision of<sup>performance, alter the supervisory function to</sup> become ex-post rather than ex-ante<sup>oriented, and to institute performance</sup> evaluation and incentive mechanisms.

41. These reforms seem to have achieved<sup>most, but not all, of their</sup> intended objectives. In Pakistan<sup>and South Korea, the implementation of a</sup> signalling system appears to have<sup>had a positive impact on the efficiency and</sup> managerial motivation of PEs (Shirley,<sup>1989b and 1989c, Song, 1988). In</sup> Senegal, information gathering and<sup>auditing have been substantially improved.</sup> In Morocco, the support given<sup>to the Directorate of PEs of the Ministry of</sup> 26/ For reasons discussed in section<sup>III, F4nkruptcy laws have not led to</sup> noticeable actual exit of firms in Hungarv.
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Finance (to supervise program contracts, draft divestiture legislation, advise on policy formulation, coordinate training programs, build MIS, and clean-up arrears) is showing positive results (Ne-lis, 1989).

42. Against these achievements, some deficiencies remain. The implementa.ion of program contracts in Senega.. has been hampered bv the fact that the govwnment did not fulfill its financial obligations (Nellis. 1988). The minimum content of an effective program contract has not always been specified.<sup>2 7</sup> / In such cases, it is feared that the bargaining process may not have always led to optimal contracts. The applicability of the signalling system, especially in African countries, is limited because the system demands detailed, audited and reliable information. Institutions which were supposed to act as buffers between different government agencies and PEs proved in some cases to be an aa'itional layer to the existing bureaucracy (e.g. the holding companies in Egypt, and possibly in Pakistan). Finally, insticutional reforms are proving to be both difficult and time-consuming, largely because they involve altering behavior. (For example, introducing a performance evaluation in Ghana and the Philippines is taking years, not months).

43. Budzetarv ImRact: Attempts to reduce the budgetary burden of PEs have been made in a wide range of countries (e.g. Thailand, Turkey, Mauritius, Malawi, Congo, Senegal, Morocco, Mexico and elsewhere) by means of reducing/eliminating operational subsidies, clearing cross-debts, and commercializing PEs' access to credit from the banking sector. The evidence on the budgetary impact of these reforms is inconclusive. On the one hand, the non-financial PE sector in Thailand, for example, has remitted to the government more than it has received during the period 1983-1988. In other words, PEs remitted more dividends, income tax, and loan repayment '.o the Treasury than they received in the form of subsidies and loans. (World Bank Report, op. cit.). In Mauritius, the PE budgetary impact improved between 1983 and 1985, net transfers from the treasury to PEs went down from Rs 290 million in 1983 to 160 in 1985 (Swanson and Wolde-Semait, 1989).28/ 44. These attempts have not been as effective in other countries. In Malawi, for example, while the budgetary impact of PEs improved between 1980 and 1985, net budgetary transfers from the Treasury to PEs declined from K 75 million in 1980 to K 13 million in 1985, but worsened again in 1986 (up to K 112 million). The case of Senegal is most illumin&ting. In this country, the non-financial PEs have increasingly relied on government financing for their 27/ One exception is the way Program Contracts have been specified in India, where they are known as the Memoranda of Understanding. In this case, appropriate criteria, criteria value and compensation systems are all explicitly specified. For further details, see: Trivedi, 1989.

28/ The fact that PEs in the countries referred to have remitted positive returns to the Treasury does not necessarily mean that these returns were equivalent to the foregone earning opportunities for the government elsewhere in the economy. If that were to be true, further reforms would be necessary.
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saving-investment gap. The **net** budgecary burden **has** gone up from FCFA 16.3 billion in 1981, to FCFA 27.1 in 1986. (World Bank Report **No.** 7774-SE, 1988). Direct operational subsidLes (specifically that portion coming out of the government budget and defined as the base for the subsidy reduction program under SAL conditionality) have declined from FCFA 6.2 billion in 1985/86 to FCFA 4,1 billion in 1988/89. At the same time, however, 10 major loss-making PEs have received an increasing amounc of resources - in the form of overdrafts - from 10 money-making PEs. **(See** Graph 1). Since recipient PEs were in no position to pay back these overdrafts, the government had to carry the responsibility of settling them, In essence, therefore, the temporary budgetarT9 relief, resulting from subsidy reductions, was offset by future outlays. / GRAPH 1 <!-- Start of picture text --> Seregc:: -cvet i.siCes c vVerc cfts<br>3<br>* /<br>'4 /<br><!-- End of picture text -->

**29/** Th e Government of Senegal decided, in the context of the current SAL IV, to cease all cross-subsidies among PEs in the future.
45. '.here attempts to reduce the PEs' budgetary burden have been less effective, the following factors seem to have contributed to the result. First, subsici'v reduczions have not been matched bv a program of restructuring at the enterpri3e level. As a result, enterprise financial problems resurfaced elsewhere in the economv: in the form of zubsidies from alternative sources (e.g. Senega'), in the form of accumulated arrears (e.g. Argentina), or in the form of excessive borrowing from the banking sector (e.g. Kenya). Second, actempted reforms focused only on one component or the other of the flows of funds from the Treasury to PEs, neglecting the fact that what matters, from a fiscal point of view, is the net budgetary impact of PEs (i.e. total flow of funds from PEs to the Treasury minus the total outflow of funds from the Treasury to PEs). Finally, perhaps the most important elements of the budgetary impact of PEs are implicit (exemptions and preferential treatments of all kinds). But, the elimination of these distortions has proved to be mere difficult.

# C. Prereguisites for and Constraints to Better Implementation

46. Despite the positive effects of PE reforms in several countries, some prerequisites/constraints appear to limit the effective implementation of these reforms. Some of these constraints have been discussed above. Others of a more general nature are elaborated upon below.

47. For PE reform programs to be effective, they require that the macroeconomic framework be in order. In a highly distorted macroeconomic environment (the symptoms of which include: overvalued exchange rate, negative real interest rate, excessive protection, and widespread price controls), PE reforms (including managerial autonomy).may encourage responses to the wrong signals and lead to undesirable effects.30/ 48. PE reforms are politically sensitive. They entail the liquidation of some PEs and the sale of assets to the private sector. They diminish or eliminate the room for rent-seeking activities. They often involve staff reductions and reallocation of power. And they frequently include price increases and/or subsidy reductions. Therefore, they are resisLed by a variety of different interest groups; e.g. workers, bureaucrats, some politicians and even some in the private sector who stand to lose from zeforms (since they would have to compete in open markets). An important prerequisite for the effective implementation of PE reforms, therefore, is a strong political will.

30/ The Bank has generally adhered to this premise. Most PE reforms have been preceded by or introduced in conjunction with attempts on the part of governments to set the macroeconomic framework in order. In cases where these conditions were not met, the Bank has refrained from supporting PE reform on a sectoral basis. A case in point is Egypt, where an industrial sector loan focusing on PE reform was kept on hold because the Government was reluctant to move satisfactorilv on the macroeconomic fronc. By contrast, sound macroeconomic management in Turkey and the Philippines made PE reform both feasible and desirable.
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49. Assuming a solid macroeconomic framework and the political will to introduce PE reform, the proper design of PE reform programs is critical for these reforms co produce their desired effects. As noted, observed variatio.ns in project design are at times justified when they correspond to countryspecific circumstances (e.g. the more recent PE reform programs in the Philippires and Mexico). These variations are inappropriate, however, when they are the result of a mistaken diagnosis (e.g. the early phase of the PE reform in Senegal). (This observation raises a more general question regarding the appropriate phasing and sequencing of PE reforms, which is addressed in section III below).

50. PE reform must ultimately stimulate efficiency (alse why do ic?) at the enterprise level. Country case studies suggest that, while there are several necessary conditions (i.e. reforms of the sector's size, its policy and institutional environment, and restructuring of individual PEs), no one condition alone is sufficient to attain the desired results.31/ Therefore, the noted inadequate attention to promote domestic competition in markets where PEs operate appears to be one area deserving greater emphasis in 2E reform programs.

## III. CHALLENGES AHEAD

# A. Overviev

51. To sun up thus far: the Bank has developed a -igorous approach to PE reform which is well founded in theory. The outcome of attempted reforms, albeit not sufficiently analyzed, app irs to be positive in several countries. The question is: what next?

52. As many governments around the world are increasingly reexamining the role of the state, it is expected that the Bank will correspondingly be called upon for advice on managing the transition period. To meet the expected demand, the Bank needs to extend its PE analytical approach to incorporate emerging challenges, especially in Eastern Europe, further refine the components and tools of the approach, and to consolidate in a more systematic fashion the process of learning from experience. This section elaborates on some of these issues under three headings: (A) conceptual challenges, (3) reform components and tools, and (C) learning from experience. The objective is to propose a list of topics for further i.vestigation.

## B. Conceptual Challenges

53. Conceptual challenges stem primarily from observed developments in socialist economies, and the increasing emphasis on the private sector as an

**31/** On the one hand, Egypt tried several institutional reforms leaving the PE policy framework largely unchanged. The PE performance has been disappointing. In contrast, Hungary attenipted several policy reforms with limited institutional reforms. As noted, the performance of the industrial sector has been modest.
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importanc engine of growth. In addition, observed variations in PE project design and their limited effecriveness in some cases call attention to the possibilitv that reform programs mav noc have been proper.v packaged. Therefore, i_ is important zo address the question mf proper phasing and sequencing of PE refurms more systematically. To meet these challenges, further analvtical work seems warranted. The rest of this sub-section elaborates on the nature of these challenges.

54. Socialist Economies: In recent years, socialist economies have undergone substantial reforms, the basic features of which are grear3r decentralization and reliance on markec forces (e.g. Hungary, China, Poland and Yugoslavia). These reforms have noc yet produced much change in behavior. The problem is illustrated by the following examples: bankruptcy laws have been decreed to facilitate the exit of inefficient PEs, yet, hardly any PEs have gone bankrupt. Financial sector reforms and attempts to harden the budget constraint have been undertaken to increase the financial discipline of PE managers. Yet, limitations on private ownership, inertia and government commitment to social objectives have rendered these reforms largely ineffective. Attempts have been made to equip FE managers with sufficient autonomy in operational decision-making. Yet, many of them have continued to seek approval from the center, in part so that they could blame poor performance on decisions taken outside their domain. Attempts have been made to differentiate wages on the basis of productivity. Yet, self-management arrangements have diminished the effectiveness of these measures. Fear of inflation and possible abuse at the enterprise level have, in addition, led nome socialist governments to impose wage ceilings. In short, while many reforms have been attempted, an appropriate supply response at the enterprise level has not been forthcoming.32/ 55. The approach to PE reform current in the Bank suggests that PEs in socialist economies, just as PEs (or private sector firms) in mixed economies, are likely to function more efficiently when they face competition in the product, input, factor and financial markets, when their managers are held accountable for quantified objecti<s, when they have the capacity and motivation to behave efficiently, and when non-competitive enterprises go bankrupt. Therefore, to stimulate the desired supply response at the enterprise level in socialist economies, policy-makers in chese countries should be encouraged to alter the conditions facing their PEs to coincide with those recommended in mixed economies.

56. While che approach devised for PEs in mixed economies appropriately describes the alterations which PEs in socialist economies must adopt to become efficient, the path socialist economies have to follow to reach these conditions is likely to be different for several reasons. First, a private sector hardly exists in socialist economies. Therefore, the question of individual property rights has yet to be defined. Second, these economies lack well functioning capital markets. Therefore, financing divestiture 32/ In Hung:y for example, despite the substantial reforms introduced in the 1980s, the industrial sector grew at only 1.3% during the period 1980-86. For details, see Nagaoka, 1989.
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programs is made even more difficult. Third, the magnitude of the transfer of ownership is at a much larger scale than in mixed economies, thus posing questions regarding che limitations imposed by aggregate sav.ngs. :ourth. attampted reforms are obliged to pay attention to equirv conr;iderations, perhaps to a larger extent than in mixed economies. (After all, socialism has been founded on the basis of equity). Fifth, the transition from a command economy to a market oriented economy is unprecedented, which raises questions regarding the appropriate phasing and sequencing of reform. Finally, the widely applied self-and collective management arrangements in socialist countries impinge on managerial behavior in a distinct fashion; their reform requires special attention. On most of these issues, the mixed economy approach can provide guidance and techniques drawn from the experience of mixed economies. But the applicability and relevance of these lessons and techniques have to be verified and modified to suit socialist councry circumstances. (This subject is now being considered by PRE and the EMENA region).

57. Do Public Enterprises Create Barriers to or Provide Incentives for Private Sector Development? In the past few years, increasing emphasis has been placed on the role of the private sector as an important engine of growth in developing countrie.,. Yet, the Bank's approach has thus far insufficiently stressed the fact that PEs, by their mere existence, could constitute a barrier to or a vehicle for private sector development.

58. For example, PEs may act as a barrier to private sector entry, even if such entry is not prohibited by regulation, if the output of PEs is underpriced to the point where private enterprises could not be profitable. Conversely, PEs may act as a vehicle for private sector entry, for example, when PEs are the providers of infrastructure and inputs of production to private producers. A more subtle (and not uncommon) scenario is one in which the output of PEs is overpriced. In this case, even an inefficient private enterprise, producing in the same price-controlled markets, would still be profitable.

59. The story could be made more complex if one were to allow for various oligopolistic behavioral models; e.g. cartel, price leader etc. The main point, however, is that the approach to PE reform needs to be extended to more systematically analyze this relationship, and to identify ways to reduce the crowding out effect of PEs and to maximize their influence in crowding in efficient privace enterprises. (This issue is currently being addressed in the context of the on-going initiative on private sector development in the Bank) 60. Phasing and Sequencing of ?E Reform: Identifying the components of PE reform is one thing. Packaging these components and selecting an appropriate speed and intensity of introducing them is another. The problem is that, unlike trade reforms where significant knowledge on sequencing has been accumulated, the issue of sequencing PE reforms remains largely un,addressed in a systematic fashion. Consequently, it is plausible that some of the variations in pro,ect design and their limited success in improving the efficiency of PEs could be atrributed, at least in some cases, to this vacuum. Moreover, it is feared that, in the absence of such knowledge, reforms could
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be easily reversed, and the elimination of one market<sup>distortion, leaving</sup> others unchanged, mav lead to inferior solutions.

61. A few examples will illustrate the point. Policy reforms<sup>(e.g.</sup> prices, wages and incentives, investment, trade<sup>etc.) are important</sup> ingredients in any PE reform program. Yet, policy reforms will not have their full impact on the efficiency of PEs without simultaneously reforming<sup>their</sup> institutional set-up, and vice versa. (The deterioration<sup>in the performance of</sup> PEs in Senegal and the modest improvement in the performance<sup>of the industrial</sup> sector in Hungary appear to be consistent with this<sup>view). While price</sup> liberalization may be desirable in and of itself,<sup>such a measure, if not</sup> accompanied or preceded by measures to increase comperition<sup>or regulation in</sup> the case of privace monopolies, may indeed be counterproductive.<sup>Similarly,</sup> managerial autonomy is an important element if PE managers<sup>were to respond</sup> effectively to market challenges. Yet, autonomy without<sup>accountability may be</sup> a recipe for abuse. The examples are numerous. The<sup>point is the same.</sup> 62. To avoid the likely adverse repercussions resulting from improperly packaged PE reform, further work should focus on<sup>establishing the</sup> logical interdependencies among FE reform components. The product<sup>of such an</sup> exercise would be part of the answer to the question of<sup>how to phase and</sup> sequence future PE reform.

# C. Reform Components and Tools

63. The need to refine PE reform components and tools is not<sup>caused so</sup> much by the lack of knowledge of what needs to be done, nor ignorance concerning the principles underlying needed reforms. Rather, the<sup>challenges</sup> are caused by the need to define better ways to implement<sup>kncwn principles and</sup> techniques. Issues of this nature include: sequencing price<sup>liberalization and</sup> measures to increase competition, effective measures to reduce<sup>the budgetary</sup> burden of PEs, and valuation of enterprises for divestiture.<sup>These issues are</sup> elaborated upon below.

64. Price Deregulation: The rationale for price deregulation is relatively well known; (1) market determined prices better<sup>reflect the</sup> relative scarcity of goods and services, (2) price decontrol is consistent with the notion that FE managers should be given the autonomy to respond<sup>to</sup> market signals, (3) price liberalization will improve the financial profitability of PEs, as many of them are forced to sell below average<sup>costs,</sup> (4) higher profitability will, in turn, reduce PEs' dependency on the government's budget, and (5) market determined prices, in contrast<sup>with cost-</sup> plus arrangements, are iikely to induce greater efficiency at the enterprise level. Equally well known is the principle that price deregulation should<sup>be</sup> accompanied or preceded by measures to ensure market competitiveness,<sup>or at a</sup> minimum market contestability. What is iess known is how to move<sup>from the</sup> state of controlled prices to a state of liberalized prices. Inappropriate sequencing of price liberalization and competition may cause PEs,<sup>as much as</sup> private enterprises, to exploit their monopoly power, with adverse consequences on the consumers and inflation. Therefore, it is important to develop an operational approach specifying the details of price liberalization-cum-increasing competition, and to demonstrate the approach's
applicability. (A draft paper on this issue is currentlv being finalized in the Sank).

65. Reduci.ng the Budgetarv Burden of PEs: "The 'w'arer:-bed Effect": As noted, numerous attempts have been made in Bank supported programs r^ reduce the budgetary burden of PEs. This objective has been pursued by reducing explicit operational subsidies to PEs and in many instances bv scaling down investment funds.

66. In implementation, two problems have emerged. First, while **subsidy r-eductions** have been adhered to, PEs have generally found a'.ternative sources to finance their deficits, e.g. the banking sector, customers and clients, foreign borrowing, or cross subsidization. (This is the so-called water-bed effect, holding down one area causes expansion in another). The second problem concerns investment cuts. These cuts, while arguably necessary on fiscal grounds, have tended, when they were applied to marginally productive ptoject, to have adverse repercussions on the ability of the economy to grow in the medium-term.

67, To minimize the possibility of transferring the financial problems of PEs from one actor to another in the economy and to reduce the cost of the trade-off between fiscal balance and medium-term growth objectives, it is therefore important to: (1) investigate, initially on the basis of multiple case studies, the extent to which the water bed problem exists, and whether the trade-ofi involved is significant, and (b) suggest ways and means to remedy these problems. **3/** 68. Enterprise Valuation for Divestiture: As divestiture intensifies, one central question that governments have to address is how much to sell an enterprise as an on-going concern for. If a government decides to merely sell the enterprise's assets, thus carrying the responsibility for liabilities, tne question is how much it should charge for these assets. If a government opts to sell part of an enterprise's equity in capital markets, the question is how much the share is worth. On all these questions, the Bank has not yet developed a recommended methodology. Rather, the exercise has largelv been left to investment bankers, accounting firms or bureaucrats. As a result, enterprise valuation has been determined on the basis of a variety of methodologies; for example: the price:earnings ratio, negotiation, the highest bid, the replacement cost of capital, or the discounted stream of future costs and benefits.

69. While each methodology has it own merits, it is not clear whether applied methodologies correspond to developing country conditions or reflect the well-being of society; especially in situations where capital markets are 33/ In a recent paper, Lacey (1990) analyses the different elements of the PE budgetary burden. He argues that needed macroeconomic reforms are likely to affect the finances of PEs negatively in the short-term and that substantial expenditure may well be required to enable PEs to survive in a more competitive environment, thus adding one more reason to support the need to explore the budgetary impact of PEs.
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underdeveloped and relative prices are distorted. To assist its borrower countries in this regard, the Bank will need to develop and d.isseminate an operational approach _ta_ div.estit..re decisorns, %which should t nen be rout ne'; applied in a manner similar to the wav cost/benefit analvsis is new being applied to project evaluation.34/ D. Learning From Experience 70. As ..ted, empirical evidence regarding the impact of attempted reforms on the performance of PE is relacively scarce. Similarly the effectiveness of some of the reform components remains largely un-analyzed. At this stage, sufficient time has elapsed to permit a systematic assessment of the experience to date. The most important aspects deserving further invescigation include: the outcome of PE reforms, the ex-post performance of divested firms, the efficiency ccnsequences of involuntary resettlement of labor, and the effectiveness of program contracts on the performance of PEs at the micro level. This sub-section elaborates on these issues.

71. Outcome of PE Reforms: With a few exceptions, most Bank assessments of PE reform either address the degree of compliance with conditionality, the effectiveness of the instruments used, o. the problems encountered in implementation. Rarely has the effect of PE reform been assessed in terms of outcomes; e.g. profitability, productivity, exports. budgetary impact, crowding out the private sector etc.

72. As noted, it may not have been possible in the past to measure the effect of PE reforms in terms of outcomes, in principle because of the brief period during which PE reforms have been attempted on a sectoral basis. It now appears, however, that sufficient time has elapsed, at least in a few cases, to permit such a study. The objectives would be to detail the outcome of attempted reforms, and provide insights a.dd feedback from experience to improve future attempts at reforming PEs. Notably, a study of the nature described here is underway for three Latin American countries; Chile, Argentina and Mexico. It would be desirable to mount similar regional studies in the rest of the Bank.

73. Ex-Post Performance of Divested PEs: Divestiture as a device for improvIng the contribution of PEs to a country's economic development has increasingly been used by developing and developed countries. It has been supported by the Bank in 35 countries in over 70 PE reform operations. 74. The intensified use of divestiture rests on two empirically verifiable propositions; first, it will improve productive efficiency and, second, it will reduce the budgetary burden of PEs. there has been no systematic empirical verification of these propositions, especially drawing upon the experience of LDCs, nor has there been an attempt to produce an

**34/** A theoretical welfare-based approach to divestiture decisions has been developed by Jones et. al. (Forthcoming). Further work may be necessary, however, to make the approach more operational and adaptable to various modes of divestiture and varving country circumstances.
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empirically-based set of stylized facts abouz the co-ditions under<sup>which</sup> divestiture will or will- not work.

,5. To address .Lhese questions, the Bank has launched a research project which is expected to be completed by Jur.e 1991. Cn the basis of<sup>a</sup> sample of divestiture experience in 4 countries, the project is<sup>intended to:</sup> (1) quantif% -he effects of the change in ownership on economic efficiency<sup>and</sup> the budget, (2) attempt to attribute the outcome of divestiture<sup>to its causal</sup> factors, and (3) on the basis of the findings, make recommendations regarding future divestiture programs.

76. Involuntarv Resettlement of Labor in PEs: It has long been observed that the performance of PEs is adversely affected by redundant workers. Therefore, attempts to reform PEs have often included measures to reduce the labor force. To alleviate the adverse effects on workers resulting from lay-offs, programs to reduce the labor force in PEs have often been accompanied by training, redeployment and severance payments.

77. Despite these attempts, it is not clear how redundant workers have been identified in the past, what has been the impact on the enterprises in which these reforms were undertaken, and what safeguards were introduced to ensure that the enterprise's remaining work force possesses the appropriace skill mix. Put differently, while the approach to workers' redundancy has been appropriately welfare based, the approach's efficiency consequences have not been sufficiently analyzed. To address these questions, it would be desirable to analyze a few case studies in which workers resettlement has taken place, with a view to making recommendations to ensure that staff reductions are implemented in the future in a manner that is consistent with efficiency considerations.

78. Micro-Level Assessment of Program Contracts: It is obvious that not all PEs will be divested. For these, a mechanism of one sort or another will have to be put in place to ensure the accountabilitv of their managers<sup>to</sup> the government as the owner. Program contracts have been used, especially in Africa, but increasingly in India, the Maghreb, and some Latin American countries, as well as an instrument to clarify enterprise objectives, to ensure managerial autonomy and accountability, and ultimately to improve the performance of PEs. To date, we do know that performance has not improved or that when it has it cannot be rigorously traced to the execution of program contracts, especially at the micro level of investigation.35/ Given the uncertainties surrounding their outcomes (due tO the JLubiem if information asymmetry), and their continued intensive application, it is important to analyze their effect on enterprise efficiency and managerial motivation on a sample basis, with a view to determining their impact and drawing lessons for future application of this instrument.

35/ Programs contracts have recently been assessed at the aggregate level in developed (e.g. France) and developing countries (e.g. Senegal and Morocco) (Nellis, 1.988).
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# CONCLUDING OBSERVATIONS

79.

79. As noted, mans governments around the world are reexamining the role of the st.ate. Questions of divesting PEs and attempts to improve the efficiency of those that will remain public are likely to intensifv, rather than diminish, in che near future. In the process, the Bank will increasingly be called unon for advice and financial support in managing the transition period.

80.

80. To meet che anticipated demand, three main observations are noted. First, the Bank's focus on the rationalization of the size of PEs, through the liquidation of non-viable PEs and the transfer of ownership and/or control to the private sector when such actions are expected to promote efficiency, should continue. In assisting its borrower countries to improve the efficiency of PEs remaining public, the Bank should continue to emphasize the PE policy framework as well as their institutional set-up. Countries which tried one without the othAr have, as already noted, achieved only modest gains, if any, in the performance of their FEs.

81.

81. To increase the effectiveness of Bank supported PE reforms, the second observation concerns the need to extend the analytical approach, refine reform components and tools, and learn from experience. To reiterate from section IV, further work is necessary to: I. Extend the PE analytical approach to: * Socialist economies, * The relationship between PEs and the private sector, and - The issue of phasing and sequencing of PE reforms. 2. Refine PE reform components and tools. especially regardinz: - The phasing and sequencing of price liberalization and competition, - The budgetary impact of PEs, and - The valuation of enterprises for divestiture. 3. Learn more svstematically from experience by analyzing: - The outcomes of PE reforms and their causal factors, - The ex-2ost performance of divested PEs and its determinants, - The efficiency consequences of staff reduction, and - The effectiveness of program contracts on enterprise efficiency at the micro level.

82. The list of proposed topics is not exhaustive, but is still extensive, Therefore, it should be viewed as a medium-term agenda. It too requires some phasing and sequencing. Hore importantly, it requires, within the Bank, concerted effort and collaboration between PRE and the four regions. PRE is well positioned to provide inter-regional perspectives. Technical. and Country Departments can provide regional patterns, country-specific experiences, and operational direction for the needed research. Additional insights can be gained from collaborating with the academic community and other institutions concerned with the same issues.
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83.. The third, and final observation concerns: (1) the lending instrument, (2) the duration of PE loans, and (3) the quality of project design. Regarding the lending instrument, it has been noted thac most attemp::s to reform PEs have used SALs as their vehicle, rather than PELs. No doubc the choice of inscrument should be considered on a case by case basis. Yet, as FE problems are complex, and as SALs generally have to be selective and macrooriented, it may be desirable to use PEL operations more frequently than has been true in the past.3/ Concerning the duration of PE lending operations, it has also been noced that several components of PE reforms take longer to implement (e.g. divestiture, institutional reforms) than permitted under a typical SAL disbursing period (approximately 12-18 months). Moreover, PE loans often involve TA components and finance both imports and investment. Therefore, it may be more appropriate to extend the disbursement period of PE reform loans beyond the average time for SALs, say to 3-4 years. Finally, two recommendations can be made to improve the quality of project design. First, PE sector reviews should, to the extent possible, precede mounting the lending operation. In such reviews, the aim would be to identify the root causes of the PE problems and to recommend appropriate solutions. Second, in order to bring inter-regional perspective into PEL operations, it may be desirable to devise a procedure involving PRE at an early stage of project design. (Prior to the reorganization, a lead advisor mechanism was in place).

3/ The assumption here, which has yet to be verified, is that PEL operations will permit, better than SALs, adequate focus on PE issues, which should in turn increase the effectiveness of PE reform programs. This also assumes that macro reforms under a SAL precede the PEL.