State Owned Enterprises in Less Developed Countries (Privatization and Alternative Reform Strategies)

European Journal of Law and Economics, 12: 217–252, 2001
© 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
State-Owned Enterprises in Less Developed

Countries: Privatization and Alternative
Reform Strategies
D. ANDREW C. SMITH asmith3@exchange.ml.com
113 West 13th Street, 3rd Floor, New York, NY 10011, USA
MICHAEL J. TREBILCOCK michael.trebilcock@utoronto.ca

University of Toronto, Faculty of Law, 84 Queen’s Park, Toronto, Canada M5S 2C5
Abstract
State-owned enterprises (SOEs) have typically played a much larger role in the economies of developing coun-
tries than developed countries. However, empirical evidence on the economic performance of SOEs generally
yields negative results and suggests that SOEs are a major tax on the economies of developing countries
reflected in the large operating subsidies required to sustain them. These inefficiencies seem in part attributable
to ownership effects and partly to lack of competition effects. Empirical evidence on the effect of privatization
of state-owned enterprises in both developed and developing countries suggests that this is often likely to lead
to major improvement in economic performance. However, where privatization is not politically feasible, SOE
reform alternatives such as management contracts, performance contracts, and greater exposure to competition
may, in some contexts, enhance SOE performance, although typically they are second-best policy options to
privatization.
Keywords: state-owned enterprises, SOEs, privatization, management contracts, performance contracts
JEL Classification: H11, H42, K23, L32, L33
Examples of the inefficiencies of state-owned enterprises (SOEs) abound;1 cases like

Turkiye Taskorumu Kurmu, a Turkish state-owned coal mining company, which accumu-
lated losses in 1992 of approximately U.S. $12,000 per employee (six times the average
national income), while poor health and safety conditions in the mine reduced miners’ life
expectancy to 46 years (eleven years below the national average).2 The response of much
of the developed world to poor SOE performance, beginning with the Thatcher adminis-
tration in the United Kingdom, has been privatization. Developing countries (outside of
the eastern European transition economies), on the other hand, have been slow to follow
this course. Is privatization the appropriate policy response to poorly performing SOEs?
The purpose of this paper is to examine SOE reform—privatization and its alterna-
tives—in developing countries. We do not principally focus on SOE reform in the so-
called “transition” economies in Central and Eastern Europe, although we recognize that
many issues are common to those that arise in developing countries.3 We argue that pri-
vatization is a and not the only policy response to poor SOE performance. When effective,
privatization is likely the best solution to the shortcomings of state ownership. However,
218 SMITH AND TREBILCOCK
a successful privatization requires many elements that are often not available in develop-
ing countries, e.g., a stable political environment, an absence of corruption and effective
competition in the private sector. Other reform measures, such as contracting out, man-
agement performance contracts or enterprise closures, may often be more appropriate
than privatization. The main finding of the paper is that each less developed country
(LDC) should tailor its reform strategy to its current political and economic climate, and
should modify this strategy as these circumstances change.
Apart from the introduction and conclusion, the paper is divided into three parts.
In the first part we examine whether SOEs are in fact the sources of inefficiency for
which they are commonly criticized. We do so by briefly reviewing: (i) the purposes
of SOEs; (ii) the theoretical inefficiencies of public ownership as compared to private
ownership; and (iii) the empirical literature comparing public and private ownership. We
conclude that SOEs are indeed inefficient, and briefly discuss the costs of poor SOE
performance in terms of LDC development. In the second part of the paper, which
focuses on privatization, we review the empirical evidence evaluating the success of
privatization. The evidence indicates that privatization has the potential to increase net
social utility, but may also be efficiency-reducing if not implemented effectively. The
success of privatization depends greatly on the political and economic environment in
which a given SOE operates. Thus, the policy is not a universal cure for the problems
of poor SOE performance. We devote the third major part of the paper to a discussion
of alternative SOE reform measures.
1. SOEs: Background, theory and performance
1.1. Background
A brief review of the purposes behind the creation of SOEs may enhance our
understanding of the social benefits attributable to public enterprise. SOEs arose in the
developing world for a mix of political, ideological and economic reasons. Profitability
was one, but often not the most important, goal behind their creation. SOEs were often
formed (and subsequently expanded) to marshal support for LDC governments; the larger
an SOE sector, the larger a government’s direct influence over the public. Meanwhile,
many LDC governments were influenced by the spread of socialist ideology following
World War II, which dictated that the state control the “commanding heights” of its
economy.4 Nationalism, often in the form of sovereignty concerns post-decolonization,
similarly fueled the desire for an LDC to control the critical sectors of its economy.
Nationalism and public ownership may operate to society’s benefit where national
security issues are relevant. SOEs may also pose a workable method of income redis-
tribution, e.g., by reducing prices of goods which are primarily consumed by the poor,
especially in LDCs in which income redistribution cannot practically be accomplished
through a progressive income tax. Socialism also promises the direct benefit of lower
unemployment. On the other hand, state ownership is rarely the “first best,” or even
the “second best,” solution to the problems to which it has been applied, e.g., prop-
ping up inefficient enterprises is rarely the best method to promote long term gains in
employment.
STATE-OWNED ENTERPRISES 219
The primary economic motivation behind SOEs was increased capital investment. Sev-
eral real constraints hindered capital investment in developing economies in the years
following World War II, the most important of which was low domestic savings rates.
For example, from 1960 to 1985, the average savings rate of developing economies in
Africa was approximately 15 percent of GDP. The highest domestic savings rate during
the period, approximately 35 percent of GDP, was that of Japan.5 Meanwhile, the typical
LDC also lacked the institutions, such as stock exchanges and financial intermediaries,
necessary to facilitate allocative efficiency in capital markets.
Apart from real constraints, private capital investment in developing economies also
suffered from market failure. Firstly, private investors do not take into account either
the existence of external economies to proposed investments, such as the effects of an
investment on the reputation of an economy as a viable place of business, or the spin-
off economic growth an economy might experience as a result of increased investment.
Secondly, many LDCs were caught in low-level investment traps. In an underdeveloped
economy, investments are often not successful unless they are coordinated with other
investments, e.g., an investment in a manufacturing plant would not be successful with-
out, among other things: the energy and human capital required to operate the plant, a
retail sector to sell the manufactured products, transportation to carry the products to
retailers, and the infrastructure necessary to facilitate transportation.6 While basic infras-
tructure is taken for granted in the developed world, it was (and continues to be) absent
in many developing countries, meaning that many investment opportunities that would
have been profitable in the developed world offered little or no chance of profitability in
the developing world.
A major goal behind SOEs, therefore, was increased capital investment, and in par-
ticular, investment in infrastructure. The fact that so many LDCs are still caught in low
level investment traps indicates the lack of success LDCs have had in building infras-
tructure through public enterprise. Other economic purposes behind SOEs have included:
(i) the control of inflation;7 (ii) the effective control of industries susceptible to natural
monopolies such that consumers are, firstly, not forced to pay inefficiently high prices,8
and secondly, are assured of a reliable supply of the relevant good or service;9 (iii) the
protection of fragile LDC economies from external shocks;10 and (iv) the promotion of
regional development within LDCs.
Thus, at least to some extent, SOEs were intended to generate social benefits above and
beyond the mere transfer of revenue to LDC governments.11 While SOEs have in many
cases proved to be an ineffective means of fostering such benefits, e.g., employment
creation and investment in infrastructure, any comparison of public and private enterprise
performance would be inadequate if it did not at least consider the putative positive
social externalities of SOEs.
1.2. The theory of public and private ownership
If SOEs offer the benefit of positive social externalities (a benefit not necessarily spe-
cific to public enterprise),12 they do so at a significant cost to firm efficiency. Public
ownership typically translates into reduced incentives for good management performance
and reduced incentives and capabilities to monitor management performance (collec-
tively, these management and control effects are referred to as the “ownership effect”).
Secondly, while not an inevitable by-product of public ownership, SOEs generally oper-
ate in the absence of competition (the “competition effect”). The costs of the ownership
and competition effects of public enterprise are discussed below.
i. The ownership effect. The ideal ownership structure in terms of management per-
formance is the owner/operator. Where there is no separation between management and
control of a firm, all efficiency gains of the enterprise accrue to the owner/operator who
then has every incentive to operate the firm efficiently. However, this type of ownership
structure places grave limits on the availability of capital to the firm, and so increas-
ingly the ranks of shareholders have expanded and the professional manager has replaced
the owner/operator. Unfortunately, the professional manager has fewer incentives than
the traditional owner/operator to manage the corporation effectively since far fewer effi-
ciency gains flow directly to the professional manager than to the owner/operator. In
the modern firm shareholders must monitor managerial performance to ensure effective
management.13 The efficacy of this type of ownership structure can thus be analyzed in
terms of management incentives, monitoring incentives and monitoring ability.
In the modern corporation, the lack of managerial incentives to improve firm per-
formance is to some extent alleviated by the market. The job market rewards proven
management skills. The takeover market (affecting as it does only publicly traded corpo-
rations) punishes poor management skills (although, admittedly, top managers of a target
firm subject to a takeover will often benefit from golden parachutes in spite of poor man-
agerial performance).14 The product market may, at the limit, punish poor management
performance with unemployment via bankruptcy. Finally, apart from any market-based
effects, managerial performance in the modern corporation can be improved by linking
managerial compensation to firm performance (which is easily identified by share prices
and firm profits).
The market has a much more attenuated impact on SOE managerial performance. The
job market has a less significant impact on SOEs because SOE managerial appointments
are often made on the basis of politics and not merit. SOEs are not subject to the takeover
market. And since governments rarely permit SOEs to go bankrupt, the product market
has a less significant impact on managerial performance. As will be discussed in part 3.2
of the paper, while it is possible to tie managerial compensation to SOE performance,
such initiatives face many pitfalls. To date the implementation of performance contract
systems has had only mixed success. Finally, if SOE managers have few incentives
to increase SOE performance, they may have sizable incentives to interfere with SOE
efficiency. According to Public Choice theory, SOE managers, like other bureaucrats,
aim to maximize pay, power and prestige, which goal is accomplished through budget
maximization, not efficiency.15
Like managerial incentives, monitoring incentives are much weaker in relation to SOEs
than to the modern corporation. Typically, a shareholder will only monitor the activities
of a corporation if the shareholder can expect returns from its monitoring greater than the
opportunity cost of the time and resources spent on monitoring. Two types of investors
fit this description: the controlling shareholder and the institutional investor. Only the
largest private enterprises have share offerings so diffuse as to prevent effective control
by an owner.16 Where there is a controlling shareholder, its investment will obviously
warrant monitoring firm management. The institutional investor will also often have an
investment in a corporation large enough to make investments in monitoring profitable.

A third type of investor should also not be overlooked: the shareholders’ rights advocate,
whose motivations for monitoring corporate activity are partially non-economic. Finally,
every corporation is governed by a board of directors, the members of which may be
held personally liable for corporate wrongs.
SOEs are owned by the state, and each citizen of the state can, in some sense, be
considered a shareholder of the state’s SOEs. Since these ownership interests are not
transferable, the returns to any one citizen as a result of monitoring would never be
greater than the opportunity cost of the time invested in such activities.17 In other words,
the cost to a member of the public of sifting through two levels of government bureau-
cracy (SOE managers and the government ministers responsible for them) in order to
determine the source of SOE inefficiencies and attempt to correct them would far exceed
the benefits which improved SOE performance would generate for that individual. While
we should not overlook the possibility of the altruistic shareholders’ rights advocate,
investigating SOE inefficiencies is much more difficult than investigating the inefficien-
cies of a private corporation (as discussed below), and so shareholders’ rights advocates
of SOEs will be few and far between. More often than not public interest in an SOE
will take the form of a private interest group furthering its own agenda. Finally, although
government ministers, like members of corporate boards, may be subject to the threat of
replacement, depending on the political structure of the LDC government, voters may
have little control over the composition of the state’s executive. Certainly government
ministers are not held liable for the corporate wrongs of the firms they monitor in the
same way as corporate directors.
The third factor making private ownership more efficient than government ownership
is the greater monitoring capabilities of private enterprise monitors relative to govern-
ment enterprise monitors. The information asymmetries which cause grave problems in
SOEs are not as significant in private enterprises, which are required by law to pro-
vide shareholders with information regarding firm performance.18 Moreover, stock mrket
prices provide a ready index of corporate performance. Meanwhile, shareholders of pri-
vate enterprises are able to use this information to improve firm performance in a fairly
immediate and direct way through their ability to elect and remove directors.
Returning to information asymmetries, in contrast to the one overarching objective
facing private enterprise—profit maximization—SOEs may have multiple economic and
non-economic objectives.19 Moreover, these objectives may conflict or vacillate wildly
over short periods of time, depending on government political stability.20 Thus, it is
difficult for SOE monitors to properly assess the performance of SOE managers who
can blame poor enterprise performance on his or her SOE’s non-commercial objectives.
The problems of information asymmetries are compounded by the resource constraints
faced by SOE monitors. The typical LDC bureaucrat charged with briefing a minister
on SOE performance is overburdened with too many responsibilities and does not have
the time or expertise necessary to review and reflect adequately on all available SOE
information.21 Meanwhile, just as SOE managers have incentives to pervert SOE perfor-
mance to their own ends, so too do the government ministers responsible for SOEs,22
creating yet another obstacle to the private monitoring of SOE performance.23 If the
heads of government do not want to effect a change in SOE performance,24 private mon-
itors are likely to have little success in doing so; as already mentioned, unlike boards of
directors, which are subject to re-election annually, SOE managers have greater security
of tenure.
ii. The competition effect. Not only does private enterprise offer better management
incentives, better monitoring incentives and better monitoring capabilities than govern-
ment ownership, absent natural monopoly private enterprise fosters competition. Govern-
ment ownership, on the other hand, tends to encourage monopoly ownership.
Private managers and shareholders are motivated by profit maximization, not social
utility. Thus, it is in both managers’ and shareholders’ interests alike to charge the high-
est price possible for their firm’s products. Where producers (rather than a competitive
market place) determine the price of their goods, that price will be inefficiently high;
producers will earn economic profits and society will suffer a deadweight loss. This
result arises because monopoly (and oligopoly) producers are able to influence the price
at which they sell their products, and thus maximize profits by supplying goods at a
level at which their marginal revenue equals their marginal cost of production. How-
ever, at this production level there are still consumers who, while not wishing to pay the
demanded price for the monopolist’s product, would happily purchase the product for a
price greater than or equal to the monopolist’s marginal cost of production. Competition
engenders allocative efficiency by removing the ability to set prices from the monopolist
and placing it in the market. In theory, where producers in a competitive market are
earning economic profits, other producers will enter the market and supply consumers
with goods until the price of the product has been driven down to the marginal cost of
production. In this way, consumers’ demands are brought in line with marginal costs of
supply and the deadweight loss associated with monopoly production is eliminated.
Competition also engenders productive efficiency by encouraging producers to min-
imize costs. Where the market rather than a firm itself controls the price of the firm’s
product, a primary way by which a firm may increase profits is through cost reduction.
Where cost reductions permit producers to earn economic profits, then new producers
will enter the market to capture some of those economic profits, once again driving
prices down to firms’ marginal cost of supply. In these circumstances, constant attention
to productive efficiency becomes a matter of a firm’s very survival. In contrast, monop-
olists are not faced with the threat of being priced out of the market place, and so do
not have the same incentives to increase productive efficiency. An additional benefit of
competition worthy of note is that it provides clear information on relative management
performance to corporate monitors.
Of course, monopoly is not peculiar to public enterprise. Natural monopoly arises in
the private sector either where there is a unique source of supply of a raw material,
or where economies of scale enable one firm to supply the entire market at a lower
price than that which could be charged by two or more firms. These types of private
monopoly can be and typically are subjected to extensive regulation. Given the need
for extensive regulation, one might argue that public ownership would be appropriate
in such circumstances. However, this argument ignores the negative ownership effect of
public ownership discussed above. Moreover, often so-called “natural monopolies” which
have been nationalized and operated as a single entity are divisible into parts, some of
which are amenable to competition, e.g., while the national grid or transmission system
of electricity and gas, respectively, are true natural monopolies, competition is feasible
in the generation of electricity and the production of gas and the retailing thereof.25
In any case, government ownership in LDCs has rarely been limited to natural monop-
olies, but has instead been extended to all manner of enterprises.26 Where a government
operates in an industry, the government has a direct stake in protecting that industry and
much of the experience of the last two decades has shown that the result is reduced
competition.27 In fact, in many LDCs, SOE dominance of the industrial sector by, among
other things, preferential access to domestic credit, foreign financing and import licenses
has effectively “crowded out” the indigenous private sector.28 Where public ownership
extends over a number of enterprises operating in similar sectors,29 it is unlikely that pric-
ing decisions would be made independently (thereby allowing for competitive pricing).
iii. Theoretical conclusions. Theoretically, apart altogether from the inefficiencies

inherent in pursuing non-productive goals, e.g., supporting inefficient industries to
bolster employment, SOEs exact their toll in terms of government failure. Management
and monitoring incentives are reduced as are monitoring capabilities. Competition is
stifled. And while private enterprise has its limitations, e.g., natural monopoly, these
limitations are more efficiently addressed via regulation than public ownership. We now
turn to the empirical evidence comparing public and private enterprise performance to
determine whether it supports these conclusions.
1.3. Performance
In the 1950s and 1960s, SOE inefficiencies were masked by high overall growth rates
in developing economies. It was not until the late 1970s and 1980s that lower growth
rates and severe resource constraints in LDCs made SOE inefficiencies conspicuous.30
According to the World Bank, problems and losses in SOEs continue to mount so rapidly
that they threaten many other reform efforts being made by LDCs.31 It is not surprising
then that China, which may have the largest public sector in the world, recently singled
out SOE reform as the country’s number one policy priority.32 What is surprising, in light
of the theoretical conclusions reached above, is that the empirical evidence comparing
public and private sector performance in LDCs is equivocal.
SOEs have generally been found to be unprofitable. For example, Bovet studied SOE
performance in 12 West African countries and found that 62 percent of the SOEs ana-
lyzed showed net losses and 36 percent of the firms were operating at negative net
worth.33 Susungi analyzed 48 African SOEs and found that only 12 had a net profit
margin of more than 4 percent.34 Profitability, however, may be a poor indicator of firm
performance, especially relative firm performance. Firstly, it reflects short term rather
than long term performance. Secondly, it fails to take into account the positive externali-
ties which SOEs are, nominally at least, supposed to generate.35 Unfortunately, while the
first concern has been remedied by many studies which have examined relative firm effi-
ciency rather than relative profitability, few studies have attempted to internalize positive
and negative externalities.
When SOE performance is measured in terms of either cost (input) efficiency,36 or
technical (production) efficiency37 , the cross-sectional empirical literature does not con-
clusively demonstrate that private enterprise is more efficient than public enterprise. In
a comparative study of Tanzania’s SOEs and private firms, Kim concluded that SOEs
were less cost efficient than private firms.38 Abdouli conducted a study of 500 firms in
ten industries in Africa and concluded that the technical efficiency indices of SOEs were
about sixty percent of those of private firms.39 On the other hand, Krueger and Tuncer,
Dholakia, and Gupta each found SOEs to have relatively higher productivity growth rates
than the private sector.40
Many of these studies suffer from methodological flaws. The Kim, Abdouli, Krueger
and Tuncer, and Kholakia studies all fail to provide information on the nature of the
firms included in the respective samples, creating uncertainty as to whether industry-
specific factors affected the studies’ results, e.g., how comparable is an Egyptian bakery
with a Tanzanian cooking oil producer, both of which would have been grouped in the
food processing sector of the Abdouli study?41 Secondly, each of the studies, apart from
ignoring externalities, also relied solely on a single performance criterion. Such studies
are not as reliable as those which employ multiple performance indicators.42 Killick,
an example of one such study, found the performance of the African SOE sector to
be disappointing (the study does not provide comparable information in relation to the
private sector).43
Trivedi attempted to account for externalities in his comparative study of six public
and eight private Indian cement manufacturers.44 Although private manufacturers were
found to be far more profitable than SOEs in the normal sense of the term,45 the “public
profitability” of SOEs was only slightly below that of the private sector, with the trend
in profitability favouring the public sector46 . The concept of “public profitability” nor-
malized for all endogenous influences upon profitability which were not attributable to
management performance in the current period. However, Trivedi internalized the effects
of only two externalities into his study: the benefits of developing “backward” regions,
and of providing exemplary treatment to SOE employees, disregarding numerous other
externalities.
Notwithstanding the equivocality of the empirical evidence on the comparative effi-
ciency of public versus private enterprise in LDCs, this finding is largely irrelevant when
one considers that the government failure affecting SOEs does not stop with public enter-
prise, but extends to private enterprise as well. Corruption, lack of competitive pressures
as a result of import barriers, lack of basic infrastructure, etc., are problems associ-
ated with LDCs generally, not SOEs in particular. In fact, in the face of interventionist
and arbitrary government institutions, private actors may have greater incentives to fos-
ter wealth through government relationships, e.g., management positions in SOEs, than
through private enterprise, as independent initiatives may prove excessively risky. From
this perspective, the equivocal evidence on comparative enterprise efficiency primarily
suggests that where governments reform SOEs through privatization, such efforts will
have little effect if private sector efficiency-inhibiting problems are not also resolved.47
A review of the literature comparing the efficiency of public and private enterprise
in the developed world should be more telling of actual relative efficiency, given the
reduced incidence of private sector performance barriers in the developed world. Once
again, however, the evidence is not entirely unequivocal. Some studies (or reviews) have
found the private sector to be relatively more efficient than the public sector; others have
rejected this conclusion.48 In attempting to explain the lessons to be learned from this
seemingly conflicting literature, especially given our desire to focus primarily on SOE
reform rather than the relative efficiency of public versus private enterprise, we feel that
we can do no better than reiterate the conclusions drawn from the literature by Vickers
and Yarrow:49
[W]here firms face little product market competition and are extensively regulated,
there is no generally decisive evidence in favor of [either public or private] ownership.
***
[W]here competition is effective, the available evidence suggests that private enterprise
is generally to be preferred on both internal efficiency grounds and, subject to the
qualification that other substantive market failures are absent, social welfare grounds.
The empirical evidence suggests that ownership (public or private) and competition
both have a significant impact on firm efficiency.50 To the extent that ownership does
not affect firm efficiency in non-competitive environments, the suggestion above that
even natural monopolies would be more efficient if operated in the private rather than
the public sector is impugned. (The issue of the optimal ownership structure for natu-
ral monopolies is discussed further in the next part of the paper.) However, the finding
that competition triggers the benefits of private ownership is consistent with the theory
of public versus private ownership discussed above.51 In highly regulated environments
effective (private sector) management has a decreased impact on firm performance. Sec-
ondly, excessive regulation may severely impact upon shareholders’ ability to monitor
management performance, since it allows managers to hide poor management behind
claims of “distorting government regulation.”
The finding that public ownership (in a competitive environment) is to be favoured on
social welfare grounds only in the absence of substantive market failures is consistent
with our conclusion above regarding the relative efficiency of public and private firms
in LDCs: where private enterprise is shackled by performance-inhibiting government
policies and corruption, one cannot necessarily expect private ownership to be more
efficient than public ownership
These conclusions suggest that privatization would often be the optimal route of SOE
reform in an ideal world. However, they also underscore the importance of private sector
reform to privatization; few gains can be expected when SOEs are privatized into uncom-
petitive markets. In the presence of substantial policy paralysis with respect to private
sector reforms, alternative reform measures may be socially optimal.52 In any case, the
significant costs of poor SOE performance discussed immediately below indicate that
SOE reform should be a priority for LDC policy-makers.
1.4. Costs of poor SOE Performance
Between 1986 and 1991, the SOE savings-investment (S-I) deficit averaged 1.7 percent
of GDP in the typical low-income economy and 0.8 percent of GDP in LDCs generally.53
An SOE has an S-I deficit where it is unable to generate the resources needed to finance
its operation, expansion and the servicing of its debt. While it may be efficient to invest
with borrowed money where an investment is expected to reap positive gains in the
future, it is inefficient to finance low productivity or economically inefficient price levels

with borrowed money, which is the case with many LDC SOEs.
The perpetual deficits of SOEs trigger derivative social costs. Firstly, SOEs receive
a disproportionate amount of domestic investment, significantly increasing the cost of
capital of LDC private enterprises. More generally, inefficient levels of production in
SOEs result in the removal of resources from areas of the economy in which they might
be more productively employed. An SOE sector typically represents about 11 percent of
GDP in developing economies, rising to an average of 14 percent in the poorest LDCs.
In contrast, the SOE share of gross domestic investment (GDI) is generally much higher,
in 1991 accounting for about 18 percent of GDI in developing economies, and about 27
percent of GDI in low-income countries in particular.54 By way of contrast, SOE sectors
typically represented about 8 percent of GDP and 13 percent of GDI, respectively, in
high-income economies in 1988.55
Second, LDC governments, which are often reluctant to raise taxes or cut social expen-
ditures, tend to cut expenditures with long-term benefits (such as infrastructure) in order
to pay down SOE deficits. For example, average capital expenditures in Sub-Saharan
Africa fell from 8.7 to 6.1 percent of GDP during the 1980s.56 The direct and indirect
losses attributable to poor SOE performance have been estimated at 5–8 percent of GDP
in the typical LDC, and where an SOE sector is relatively large, as high as 8–12 percent
of GDP.57
With respect to externalities, SOEs have often not delivered the social benefits they
were meant to achieve.58 For example, notwithstanding that one of the key economic
rationales behind the creation of SOEs was an increase in capital investment in infras-
tructure so as to make private investment in LDCs more attractive, the World Bank
estimates that the poor quality of utilities and infrastructure adds 10–25 percent to firms’
costs in Sub-Saharan Africa.59 SOEs are providing poor quality infrastructure. Increased
capital investment and the externalities that this is likely to generate is often more likely
to occur through private rather than public investment (as developed in the next part of
the paper).
In light of the costs of SOE inefficiencies, Barro’s recent finding of a negative correla-
tion between government consumption (exclusive of spending on education and defence)
and investment in his cross-country empirical study of approximately 100 countries from
1960 to 1990 is not surprising.60 Barro also found the ratio of government consumption
to real per capita GDP to be negatively and significantly correlated with real per capita
GDP,61 i.e., big governments are bad for growth.
Small gains in SOE efficiency could have a sizable impact on developing economies.
Jones has estimated the impact that a 5 percent increase in SOE efficiency would have
had upon the GDP of several developing economies in 1980–1981. The results were
favourable: Pakistan would have experienced a 1 percent increase in GDP, while Egyptian
GDP would have grown by 5 percent, and South Korean GDP would have grown by 1.7
percent.62 Another study conducted by the World Bank produced similar results, e.g., a
5 percent increase in SOE efficiency would have improved GDP in Turkey, Tanzania,
Bolivia and Mali by 2 percent, 1.5 percent, 1.4 percent, and 2.2 percent, respectively.63
To place the benefits of SOE reform in context, by diverting SOE operating subsidies to
basic education the central governments of Mexico, Tanzania, Tunisia and India could
increase central government education expenditures by 50, 74, 160 and 550 percent,
respectively. Likewise, redirecting SOE subsidies to health care would permit the central
government of Senegal to more than double health care expenditures in that country, and
the central governments of Turkey, Mexico (and Tunisia), and India to increase health
care expenditures by threefold, fourfold and fivefold, respectively.64 The question of how
these efficiency gains are to be accomplished is discussed in the next two parts of the
paper: Privatization; and Alternative Methods of Reform.
2. Privatization
Privatization is one, and not the only, solution to the sizable social costs inflicted by poor
SOE performance.65 In certain circumstances it is the optimal solution to poor SOE per-
formance, i.e., in competitive markets not plagued by substantive market failures (and, as
is discussed below, possibly in uncompetitive markets as well). However, as mentioned
above, in LDCs these circumstances may be rare. The significant institutional failure
which exists in many LDCs may render privatization efficiency-reducing, at least in the
short term. Where institutional failure does not stand in the way of privatization, political
factors may still make successful privatization difficult or impossible. We examine the
prerequisites to the successful implementation of privatization later in this part. Prior to
doing so, we first discuss: (i) the history of privatization in the developing world; (ii)
the empirical literature comparing pre- and post-privatization performance of privatized
SOEs, in order to verify the conclusions stated above regarding the merits of privatiza-
tion; and (iii) the benefits of privatization other than improved SOE performance. We
conclude this part of the paper by briefly discussing the benefits and costs of different
methods of privatization.
2.1. The history of privatization in LDCs
While there were isolated cases of privatization prior to the 1980s,66 privatization as a
broad-based economic policy did not truly come of age until its implementation under
the Thatcher administration during the 1980s. When Prime Minister Thatcher came to
power in 1979, about 11.5 percent of her country’s GDP was attributable to state-owned
enterprise. By 1990, that number had fallen to less than 5 percent.67 From another per-
spective, during the 1980s the United Kingdom sold thirty major enterprises employing
800,000 people for approximately U.S.$127 billion.68 It was not until the latter half of
the decade, however, that privatization programs outside the U.K. truly began to acceler-
ate. Today, privatization represents a major policy change in the economies of the world:
between 1985 and 1993 governments in 100 countries raised approximately U.S.$328
billion by selling SOEs to private investors.69
The value of privatizations since 1989 has actually been much greater if one considers
that, following the collapse of communism, many SOEs in the former Soviet Union and
Eastern Europe were privatized in unique ways not requiring capital. Given the lack
of institutions capable of facilitating a market economy in these states, e.g., financial
intermediaries, stock exchanges, convertible currencies, and legal systems grounded in
property rights,70 transition economies had to resort to “ingenious and unconventional
mass privatisation programmes designed to help create capitalism without capital,”71 e.g.,
the voucher programs of the former Czechoslovakia and Lithuania.72 By 1995, the private
sectors of Poland, Hungary, the Slovak Republic, Estonia, Lithuania, Latvia, Albania,
and Russia all accounted for approximately 60 percent of GDP, while the private sector
of the Czech Republic accounted for 70 percent of GDP.73
With respect to LDCs generally, divestitures in the developing world in the first part of
the 1980s involved relatively small SOEs, primarily in commerce, services, light manu-
facturing and agribusiness,74 whereas privatizations since that time have included the sale
of large SOEs in major infrastructure sectors, such as utilities and transportation.75 Not
surprisingly, the value of privatizations has increased dramatically since the last decade.
For example, by 1992 the value of government divestitures in the developing world,
U.S.$19.5 billion, was nearly as significant as that in the developed world, U.S.$26.6
billion; this compares to the U.S.$2.4 billion and the U.S.$36.9 billion which government
divestitures raised in LDCs and developed countries, respectively, in 1988.76
However, the data reveal wide regional variations in government divestiture in LDCs.
Latin America accounted for 55.1 percent of the value of all divestitures occurring in
the developing world between 1988 and 1993, while in the same period, divestitures in
Asia and Africa, respectively, accounted for just 19.7 and 3.2 percent of the value of
total LDC divestitures.77 Furthermore, the concentration of privatization activity has been
very pronounced within these regions, e.g., in Latin America, Chile, Mexico, Argentina
and Brazil were responsible for the bulk of privatization activity during the 1980s and
1990s.78 Between 1988 and 1993, privatizations in Argentina, Brazil, Mexico, Hungary
and Poland accounted for approximately 30 percent of LDC transactions and about
60 percent of the value of government divestitures. During the same period, LDCs in
general sold an average of less than three SOEs per year, against the hundreds of SOEs
that could potentially have been divested in almost all countries.79
2.2. Pre- and post-privatization relative performance
In recent years a number of illuminating studies have been published comparing the pre-
and post-privatization performance of a variety of divested SOEs. The results of these
studies largely support the accumulated findings of the paper: that privatization generally
increases social utility when implemented in the appropriate environment; but where
such an environment is lacking, privatization offers greatly reduced social benefits. The
one result which conflicts with the cross-sectional empirical evidence discussed in Part I,
supra, is that privatization may be beneficial even in uncompetitive environments, i.e.,
private ownership may foster efficiency even in the absence of competition.
Three studies in particular, those of Galal et al., and Megginson, Nash and van
Randenborgh,80 report very favourably on the effects of privatization. Rather than merely
comparing pre- and post-privatization performance, which approach would overlook the
many changes in the economic environment of an enterprise occurring post-privatization,
Galal et al. compare post-divestiture enterprise performance of 12 corporations in 4 coun-
tries with a construct of what enterprise performance would have been in the absence of
divestiture (the “counterfactual”). Performance is measured in terms of the social value
of an enterprise, i.e., the value of an enterprise to all of the groups it affects, namely: con-
sumers, the government, any other existing shareholders, buyers, employees, competitors,
and the public at large.81 Relative to the cross-sectional approach to examining public
versus private enterprise performance, the Galal et al. method resolves both the problem
of relying on a single performance criterion, and (to a large extent) the difficulty posed
by externalities. Not only do the authors attempt to internalize all of the major external-
ities of an enterprise, but we can assume that some externalities would not change as a
result of divestiture.
Galal et al. conclude that, in the twelve cases studied, divestiture definitively and
uniformly improved social welfare.82 In more than half of the cases gains in welfare
exceeded 10 percent, in four cases welfare gains were around or greater than 50 percent,
and in the single negative case the welfare loss was just 7 percent. The gains primarily
resulted from increases in productivity, investment and output.83 In terms of the dis-
tribution of these welfare gains, enterprise profits rose in all cases, and both domestic
and foreign investors were the recipients of welfare gains in eleven of the twelve cases.
Governments were subject to welfare losses in only three cases.84 More remarkable,
however, given the common labour union opposition to privatization, was the impact of
divestiture on workers: workers as a class did not lose in a single case, and in ten cases
they were net gainers (gains accrued to workers through severance pay, post-privatization
wage increases and through increases in the value of shares awarded to SOE workers
upon divestiture). This result may be the outcome of a selection bias, in that labour may
be able to block divestitures which are perceived as threats to their interests. However,
the provision of severance pay and shares in divested enterprises to workers indicates
that in some cases a portion of the efficiency gains from privatization were used to pur-
chase the support of labour, creating a “win–win” solution to poor SOE performance.
Finally, consumers, the other major group which might have been expected to lose from
divestiture,85 did indeed suffer welfare losses in five cases. However, the evidence indi-
cates that where the losses were the most substantial, pricing was not being moved to
exploitative levels, but rather to efficient levels; so while substantial losses did accrue to
some consumer groups, this was not necessarily a socially negative result.86
In their study of the pre- and post-divestiture performance of 61 companies in 32
industries from 18 countries,87 Megginson, Nash and van Randenborgh find privatization
to be equally beneficial. However, we note that while the study is much broader than
the Galal, et al. study, in other respects it is less comprehensive. Since post-privatization
performance is measured against pre-privatization performance as opposed to a coun-
terfactual of post privatization performance, the study does not control for exogenous
economic variables to the same extent as the Galal et al. study, i.e., post-privatization
exogenous economic shocks in the Galal, et al. study affected both the private and the
public (counterfactual) enterprise data. Moreover, with the exception of employment, the
criteria for performance evaluation (profitability, operating efficiency, capital investment,
output, employment, leverage, and payout) tend to measure enterprise welfare rather net
social welfare. Externalities are largely ignored.
In terms of profitability, the mean increase in return on sales post-privatization was
2.49 percent, and 69.1 percent of all firms experienced increased profit margins after
privatization. Across the sample, increases were also documented in output (adjusted
for inflation) and capital spending. Average real sales increased by 24.14 percent post-
privatization from its pre-privatization level. Capital investment relative to sales increased
on average by 5.2 percent, from 11.7 percent of sales pre-privatization to 16.9 per-
cent of sales post-privatization. Moreover, the operational efficiency measures—sales
per employee and net income per employee—both showed significant increases follow-
ing privatization for the full sample. Finally, like the Galal et al. study, Megginson,
Nash and van Randenborgh found that the impact of privatization on labour was posi-
tive: employment levels actually increased by an average of 2,346 employees per firm
post-privatization (although the median change in employment, while positive, was less
substantial, at 276 employees).88 However, the study does not examine wage levels post-
privatization. Lower wage levels may have been a contributing factor to the increased
post-privatization employment levels, and thus it is difficult to say whether all workers
gained as a result of privatization.
Boubraki and Cosset89 review pre and post privatization performance of 79 firms
in 21 developing countries—mostly middle income but including Bangladesh, Jamaica,
Nigeria, Pakistan and the Philippines—and conclude that on average the firms in their
sample showed significant increases in profitability, operating efficiency, capital invest-
ment, output and employment.
On the whole, privatization seems to be a very beneficial tool for increased economic
performance. However, the “success” of privatization, as reported in the Galal, et al.,
Megginson, Nash and van Randenborgh, and Bourbraki and Cosset studies, must be eval-
uated in light of the methodology of these studies. The Galal, et al. study is limited to
12 enterprises in four countries: one developed country, the U.K.; and three developing
countries, Chile, Malaysia and Mexico. Besides its size and its non-random nature—
Chile, Malaysia, and Mexico were virtually the only developing countries with enter-
prises meeting the study’s goal of five years of post-divestiture operation—the sample
does not include a single enterprise from either a low-income, or a lower-middle-income
economy.90 The Megginson, Nash and van Randenborgh study suffers from a similar
selection bias. The 61 enterprises analyzed in the study are located in 18 countries:
12 developed and six developing. None of these six LDCs is a low-income economy,
and only one, Jamaica, is a lower-middle income economy.91 The authors claim that
any selection bias in the sample is eliminated by the fact that the divestitures analyzed
were the largest and most important privatizations to have occurred in the world prior to
1992.92 However, this still limits the study’s applicability to the situation found in may
low-income and lower-middle income LDCs. The Boubraki and Cosset study also has a
middle income LDC bias.
The Galal, et al., and Megginson, Nash and van Randenborgh, and Bourbraki and Cos-
set studies also suffer from a second serious selection bias, one which is impossible to
remove in these types of time series studies: only completed privatizations are examined.
The studies ignore SOEs which, while targeted for privatization, could not be divested
due to labour opposition, political opposition or lack of demand. The result is that such
studies only reflect the success of privatization in political and, to some extent, economic
climates amenable to privatization. When we also consider the limited evidence of suc-
cess of privatization at lower levels of development, the empirical evidence does not
suggest that privatization is a universal remedy to poor SOE performance. On the other
hand, the three studies do demonstrate that privatization offers substantial social welfare
improvements to middle and upper-middle income LDCs, at least in circumstances where
divestiture is politically practicable.
Evidence generated by Adam, Cavendish and Mistry, examining the effects of priva-
tization upon 7 LDCs (one upper-middle-income; two lower-middle income; and four
low-income),93 suggests that the benefits of privatization are much less significant in
low-income and lower-middle-income LDCs than in wealthier LDCs. The domestic
economies of such states are typified by limited market competition, extensive concentra-
tion of economic power and limited import penetration in certain sectors.94 For example,
of the seven countries studied by Adam, Cavendish and Mistry, only in the largest and
second wealthiest (in terms of per capita GDP), Malaysia, did the private sector appear
deep enough to provide a sufficient degree of competition in the industrial sectors. In a
number of states, e.g., Sri Lanka and Kenya, the public sector extends over a number
of enterprises operating in similar industries, such that coordinated privatization might
create a competitive market.95 However, given the concentration of economic power in
LDCs and the risks faced by new entrants, the creation of a competitive market is by
no means a certainty. The consequences of low-income LDC market structures in terms
of privatization possibilities are clear: unless privatization is coordinated with significant
private sector reform (including the regulation of anti-competitive behaviour), the lack of
competition in these economies will guarantee privatized SOEs (and the few individuals
and corporations who control them) monopoly profits; society will gain little.
Moreover, the resource costs of regulation are extensive, a problem which is com-
pounded by the limited experience and expertise LDC governments have with regulatory
policy. Historically there has been very little explicit regulation of the SOE sector in
LDCs (an experience broadly shared by the seven countries studied by Adam, Cavendish
and Mistry).96 For these reasons, LDCs have been slower to adopt effective regulation
than they have been to adopt privatization. Where LDCs have adopted regulatory pro-
cedures, they have often made the mistake of copying the regulatory models of other,
structurally different economies. To be effective, regulation must be tailored to the struc-
ture of the industry in the country in which it is to be implemented.97 The conclusion
of Adam, Cavendish and Mistry that, in the countries studied, efficiency gains from
privatization were not substantial, is largely attributable to regulatory failure.98
The uncompetitive market structures found in many LDCs may also limit efficiency
gains from privatization in a less direct way. According to a recent study of 452 Russian
shops privatized between 1992 and 1993 conducted by Barberis et al., the presence of
new owners and new managers raises the likelihood of restructuring, but the provision
of equity incentives to old managers does not promote restructuring.99 In other words,
the presence of new human capital plays a key role in the efficiency gains induced by
privatization. This finding is supported by the Megginson, Nash and van Randenborgh
study, which documented greater performance improvements for those firms that experi-
enced a 50 percent or greater turnover on their boards of directors post-privatization.100
Unfortunately, a combination of factors in many LDCs, including: (i) high concentra-
tions of economic power; (ii) low domestic savings rates (making wide share ownership
difficult); and (iii) an aversion to foreign investment, limit the probability of privatization
resulting in new human capital being employed in divested enterprises. Buyers tend to
be existing enterprises and are often competitors in the same market.101
To this point, the empirical evidence relating to privatization performance seems to
largely echo the findings of the cross-sectional empirical studies discussed in Part I,
supra, i.e., privatization will likely yield social gains if implemented in a competitive
sector not plagued by significant institutional failure; but where such institutional failure
does exist, privatization is less likely to be socially optimal. However, unlike Vickers
and Yarrow, both the Galal, et al. study, and the Megginson, Nash and van Randenborgh
study demonstrate that the ownership effect of private enterprise works to improve firm
efficiency even in non-competitive, regulated environments.102 Moreover, the finding that
privatization increases capital investment is very encouraging in the context of natural
monopolies (especially utilities). Where LDCs are caught in low-level investment traps,
increased capital investment will generate far greater positive externalities than it would
in the developed world. Thus, the ambivalence of Bishop, Kay and Mayer in their report
on the success of the privatization of natural monopolies in the U.K. (i.e., an economy
unconstrained by low investment levels) is less persuasive in the context of the develop-
ing world.103 The authors conclude that the significant improvements in post-privatization
efficiency experienced by utilities in the U.K. (which gains they attribute to the incen-
tive effects of share prices) have not come without a price. The cost of regulation and
the management time that is spent “fighting the regulator” constitutes a serious cost of
privatization.104
Even where the privatization of a natural monopoly does not seem appropriate, often
efficiency gains can be realized by close scrutiny of the monopoly, locating competi-
tive sectors within the monopoly and subjecting those sectors to competition through
privatization. Tandon, one of the authors of the Galal et al. study, argues that many of
the improvements in post-divestiture firm performance noted in the Galal et al. study,
particularly in the telecommunications sector, stemmed from the unbundling of monopo-
lies and the consequent increased competition.105 For their part, Bishop, Kay and Mayer
argue that the failure to sufficiently identify and subject to competition those portions of
monopolies which could not truly be considered to be part of a natural monopoly was
the main failure of the U.K. privatization program.106
In summary, the empirical literature comparing pre- and post-privatization perfor-
mance, like the cross-sectional empirical literature discussed in Part I, supra, demon-
strates that privatization can generate substantial social welfare gains. It is more likely
to be successful in higher-income LDCs with competitive markets and effective pri-
vate sector regulation than in lower-income LDCs. That is to say that there are cer-
tain institutional and political prerequisites to privatization, the absence of which will
jeopardize the social gains promised by the policy. Where institutional failure can be
effectively redressed, privatization may be optimal even in low-income LDCs. Certainly
low-income LDCs would benefit greatly from the increased capital investment, among
other things, promised by privatization. Finally, the issue of whether the privatization
of natural monopolies makes sense can only be decided on a case-by-case basis, but
certainly those portions of monopolies which do not naturally benefit from monopoly
power should, where otherwise appropriate, be considered for privatization.
2.3. Other benefits of privatization
Four potential benefits of privatization worthy of mention were not discussed above.
Firstly, divestiture may improve the efficiency of an economy’s remaining public sector.
Shirley evaluated the performance of the SOE sectors of nine developing and three tran-
sition economies on a number of performance criteria and found that the countries which
divested the most also experienced the greatest performance increases in their public sec-
tors. This increased performance could result from a greater ability to concentrate scarce
managerial skills and scarce government capital on a smaller SOE sector, or alternatively
from increased competitive pressure on remaining SOEs from newly-privatized SOEs.107
Secondly, the revenues earned from privatization (and the absence of deficits of
divested SOE) should result in lower government deficits, and consequently, improved
macroeconomic performance. For example, by 1994, the Mexican privatization program
had generated U.S.$20 billion in revenues. These funds were used to reduce the gov-
ernment’s domestic debt, which in turn contributed to a fall in both interest rates and
inflation and an increase in confidence in the Mexican economy.108
Thirdly, an increase in equity supply through the sale of shares in privatizing SOEs
may “kick-start” a capital market by increasing the volume of equity listed on the market.
Increased equity market depth and liquidity may induce private actors to switch from
real and informal asset holdings into financial assets, which would in turn lead to greater
efficiency in resource mobilization and allocation. However, in the short term, the listing
of privatization issues on small exchanges might crowd-out other issues, inhibiting the
access of private companies to capital.109
Finally, privatization enhances the credibility of a government’s commitment to mar-
ket liberalization. In contrast to many reform alternatives, privatization cannot be undone
with the stroke of a pen, especially in situations of wide share ownership in a domes-
tic capital market. The greater the credibility of an LDC government’s commitment to
economic liberalization, the lower the risk associated with investments in that LDC.
Investments which were formerly unattractive become feasible. Meanwhile, investors are
willing to pay more for any given SOE given the reduced risk of expropriation, etc.
Thus, privatization should indirectly increase both domestic and foreign investment, and
government revenues, in LDCs. The net result of all of these indirect benefits should be
increased economic growth in the economies of divesting nations.
2.4. The prerequisites for successful privatization
We concluded above that the economic and political environment which provides the
context for a divestiture will often determine the divestiture’s success. In other words,
there are certain economic and political prerequisites to the successful implementation
of privatization. We discuss these prerequisites, and the costs of privatizing in their
absence, below. Before doing so, we wish to stress that these environmental factors are
not only country-specific, but industry-specific (and possibly enterprise-specific). There-
fore, divestiture decisions must be made on a case-by-case basis.
i. Economic prerequisites. Many of the economic prerequisites to privatization have

been touched on above. They tend to be institutional in nature, and so one would expect
that countries having greater levels of institutional capacity (which will usually, but not
necessarily, be wealthier LDCs) would have greater success with privatization. The four
primary economic prerequisites we identify and discuss below are: (i) a healthy private
sector; (ii) effective regulatory structures; (iii) macroeconomic stability; and (iv) a lack
of corruption.
We have already identified the lack of a competitive market place into which SOEs
might be privatized as a major impediment to successful privatization. Privatizing in
such environments without accounting for the lack of competition will result in: (i) the
deadweight losses associated with monopoly pricing; (ii) few increases in firm efficiency
if high concentrations of economic power prevent the entry of new human capital; and
possibly (iii) further crowding out of the indigenous private sector as private monopo-
lists take advantage of their economic power. How LDCs may deepen their indigenous
private sectors is a complex subject, especially in the face of low domestic savings rates.
While this was accomplished in many of the eastern European transition economies via
large scale voucher privatization, many of those economies at least benefited from sig-
nificant industrialization, i.e., industries were often large enough that competition could
be created through privatization of the industry.
One solution to the lack of a competitive private sector, especially in the case of
natural monopolies, is regulation. Lack of regulation has been a major cause behind
mediocre privatization performance in lower-income LDCs. In fact, according to Bishop,
Kay and Mayer, lack of efficient regulation has also been a significant problem in the
U.K. However, the formulation of efficient regulation, like reform of the private sector,
is a complex topic which does not fall within the scope of this paper. Apart from the
comments we have already made on the subject in Part II, supra, the only comment we
make is that regulatory arrangements should be finalized prior to divestiture. Changes in
regulatory structure following privatization undermine the government’s credibility with
potential investors, and thus impact negatively on investment.
With respect to macroeconomic instability, the dangers of privatizing in a crisis are
obvious. Macroeconomic instability increases economic uncertainty and therefore invest-
ment risk, and so results in decreased interest by foreign and domestic investors in an
LDC’s SOEs (as expected returns from investments in the economy fall in tandem with
the economy’s macroeconomic outlook). Perversely, LDC governments have increased
incentives to privatize in times of economic crisis as a result of a dire need for revenue.
With severely constrained bargaining power, such LDCs may be forced to accept deals
which are far less attractive than they could have achieved in the absence of a crisis.
For example, while social utility is maximized by the unbundling of monopolies prior
to privatization, and the exposure to competition of those portions of a monopoly not
truly subject to natural monopoly, short-term revenue maximization involves the sale of
monopolies as they are (allowing buyers to maximize monopoly rents).110 Meanwhile,
with government attention diverted to major economic issues, privatizing in times of eco-
nomic crisis may result in significant issues surrounding a privatization being ignored.
This limitation on bureaucratic capital explains why so many SOEs have been priva-
tized in LDCs in the absence of efficient regulation to address the harmful effects of
monopoly power.
LDC governments should resist the impulse to privatize in times of macroeconomic
crisis. Decisions to privatize should be made on the basis of an analysis of the social
benefit of a given divestiture, not the state’s need for immediate revenue. Moreover, these
decisions may be more likely to be made more efficiently through a central privatization
authority, the implementation of which would allow for the development of a team of
bureaucrats with much needed expertise in the nuances of privatization. Where privatiza-
tion is a ministry’s key function, the many subsidiary issues surrounding divestitures are
more likely to be given the attention they deserve. Finally, the centralization of decision-
making regarding privatization avoids the difficulty of conflicts in authority where more
than one government ministry has an interest in an SOE.111
The final economic prerequisite to successful privatization is an absence of corruption.
Prima facie, one might think that corruption in the public sector would make privatization
(a reduction in the public sector) desirable: where corruption is rampant, the greatly
reduced monitoring capabilities of SOE monitors, discussed in Part I, supra, become
much more costly. However, privatizing in LDCs with highly corrupt public sectors could
greatly increase the costs of such corruption.
The most obvious costs of corruption in the context of privatization are kickbacks
on divestiture transactions, which result in a significant reduction in public revenues
from privatization in LDCs. But the costs of privatizing in a corrupt environment are
not limited to kickbacks. High level officials who are motivated by corruption receipts
rather than political or bureaucratic duty may make privatization decisions on the basis
of personal gain rather than social benefit. In such cases, SOEs may be sold to the bidder
offering the highest bribe rather than the bidder offering the maximum welfare gains; or
worse, SOEs may be divested in circumstances where privatization is welfare-reducing.
SOE managers may even decide to sell their employers’ assets to themselves (at a price
well below fair market value),112 resulting in reduced revenues to the government and a
loss of the potential gains which might have been achieved by new human capital. The
costs of high level corruption provide an additional argument for a central privatization
authority. Where individual ministers (or even SOE managers) are permitted to make
privatization decisions, divestitures cannot be effectively scrutinized for corruption. But
where all privatization decisions are channeled through one ministry, corruption detection
resources can be focussed, and may be more effective.
The final feature of corruption in the context of privatization worthy of mention is
that all corruption, and not only high level divestiture corruption, threatens to reduce the
social gains resulting from privatization. Like macroeconomic instability, the presence
of corruption in an LDC undermines investor confidence. If LDC governments hope to
attract significant investment, especially (in the case of LDCs suffering from low domes-
tic savings rates) foreign direct investment, they must be able to make credible commit-
ments to investors regarding the security of their property rights and the structure of the
post-privatization regulatory regime to which newly privatized firms will be subject. For
private sector investors alteration in a regulatory regime can have the same effect as out-
right expropriation of sunk investment.113 Mauro, in a study examining corruption in 68
countries, concludes that a negative and significant correlation exists between corruption
and the investment rate.114 Studies conducted by both the World Bank and Wei confirm
this finding.115 Finally, corruption may not only impede original investment in SOEs,
but it may also impede subsequent investment in the divested enterprise.116 Thus, cor-
ruption may destroy one of the key benefits promised by privatization: increased capital
investment.
ii. Political prerequisites. Even where an LDC has the institutions in place and the
economic stability to make privatization welfare-increasing, privatization will only suc-
ceed if it is politically practicable. Political practicability involves two considerations:
(i) are LDC policy-makers desirous of implementing privatization (political desirability);
and (ii) if so, can the privatization succeed in the face of political opposition (political
feasibility)? Shirley, in a study examining the success of SOE reform in 12 countries
(nine developing economies and three transition economies), found that both political
desirability and political feasibility were necessary elements of SOE reform.117
It is not surprising that political desirability is a necessary precondition of privatiza-
tion. Firstly, a large portion of LDC labour forces have a stake in the continued existence
of SOEs. Secondly, SOEs are themselves valuable tools to LDC leaders in maintain-
ing political support. In deciding whether to support an SOE reform program, LDC
leaders must not only incorporate the alienation of a large and well organized portion
of the public into their decision-making calculus, but they must also consider the loss
of the expected political returns that would have been generated by the relevant SOEs
in the future. According to Shirley, privatization will be politically desirable in only two
circumstances: (i) where an LDC government has experienced a change in leadership
and the new leader does not depend on SOE interests for his or her support (although
even here a new leader may not wish to dispense with a useful source of power); and
(ii) where privatization is demanded by an economic crisis.118 However, there was no
instance in Shirley’s sample of 12 nations where an economic shock alone made SOE
reform desirable to a government that relied heavily on SOE support.119 Meanwhile,
Campos and Esfahani, in a study of SOE reform attempts and crisis episodes120 in 15
LDCs over the period 1972–1991, found that 19 of a total of 24 SOE reform attempts
were preceded by a crisis.121
Considering our conclusions above regarding the costs of privatizing in times of
macroeconomic instability, the finding that SOE reform will only be politically desirable,
absent a change in LDC government leadership, in circumstances of macroeconomic
crisis is deeply troubling. Of course, the data in both studies are now somewhat dated.
Where public discontent with the poor performance of SOEs is strong, and the support
of labour can be purchased with the proceeds of privatization (as discussed below), then
privatization should be more politically desirable. The task of increasing the political
desirability of privatization in times of macroeconomic stability must be undertaken by
the international development community. The benefits of privatization should be pro-
moted to LDC governments before they are faced with economic crisis. Moreover, devel-
oped countries should actively encourage (and perhaps even help facilitate) investment
by developed country private sector corporations in LDC SOEs.
The second political precondition of a successful SOE reform program is political
feasibility—even if an LDC leader supports reform, his government must still overcome
opposition from SOE stakeholders. While government opposition may pose a barrier to
privatization, the influence of any such critics will often rise and fall with public, and
especially labour, opposition/support for divestiture. Thus, the question becomes, when
will labour support privatization,122 i.e., when will privatization operate to the benefit of
labour?
While both Galal et al., and Megginson, Nash and van Randenborgh, found that pri-
vatization did not harm workers, and often improved their welfare (although the latter
study only addressed employment levels and not other considerations, such as wage and
benefit levels), these studies may have suffered from a selection bias in that, in all of the
cases studied, worker opposition was not significant enough to preclude reform. In other
words, while the efficiency gains yielded by the privatizations in these two studies may
have allowed workers to be compensated for their losses, such may not always be the
case. Secondly, since the SOEs represented in both studies were overwhelmingly owned
by relatively wealthier LDCs, the applicability of the studies’ results to low-income and
lower-middle-income LDCs may be questioned. Since SOEs in poorer LDCs tend to be
relatively more over-staffed than SOEs in wealthier LDCs,123 workers in poorer LDCs
may incur a greater risk of losing from privatization. On the other hand, where there are
greater inefficiencies there are also greater returns to be realized from divestiture, and
so greater gains with which to purchase the support of LDC labour. Decisions on the
political feasibility of divestiture will thus have to be made on a case-by-case basis.
However, before we leave the topic of political feasibility, we stress that it will be
affected by the credibility of the LDC government, especially where the government
seeks to win labour’s support with the carrot of shares in the divested SOE. Unless a
government’s reform plans are credible, workers will not likely give up the rents they are
presumably receiving from their public sector jobs for shares which have some probabil-
ity of being worthless. However, where workers are permitted to purchase under-priced
shares in a divested enterprise, the government instantaneously creates a constituency
which will oppose a reversal of the divestiture,124 i.e., the government increases the
credibility of its divestiture program in the eyes of other constituencies.
iii. Conclusions regarding prerequisites to privatization. While privatization may

often be the optimal method of SOE reform, there are many preconditions to its success-
ful implementation. In terms of economics, an LDC should have a healthy private sector,
effective regulatory structures, a stable economy and not be plagued with corruption.
With respect to politics, privatization must be desirable from the perspective of LDC
government leaders, as well as politically feasible. One concern raised by the above
discussion is that privatization is often only politically desirable in times of macroeco-
nomic crisis. If the maximum benefits are to be derived by LDCs from privatization,
members of the international development community must not only encourage private
sector and institutional development in LDCs, but also promote privatization in times of
macroeconomic stability rather than crisis.
2.5. Methods of privatization
Prior to discussing the last major topic of the paper, alternatives to privatization, we make
a few brief comments regarding the differing modes of privatization. There are several
ways in which privatization may be accomplished: (leaving aside the innovative meth-
ods used to privatize SOEs in some transition economies, e.g., voucher privatizations):
the public offering, the management buy-out (MBO), the private placement, and partial
privatization.125 Given the importance of new human capital to the success of a divested
SOE, discussed in part II, supra, MBOs are a poor method of privatization (since enter-
prise management typically does not change as a result of a MBO). In addition, there
are a number of other reasons why MBOs are not an optimal (and possibly not even
a beneficial) method of divestiture: (i) MBOs are often highly leveraged, leaving the
new enterprise vulnerable to macroeconomic shocks; (ii) managers of SOEs, given their
information advantages and political influence, may be able to purchase their SOEs for
less than fair market value; and (iii) where management is not able to secure adequate
financing, the LDC government is (acting as guarantor or lender) left bearing the risk of
enterprise failure.126 Thus, notwithstanding that MBOs often have the support of labour,
the MBO is an inefficient method of divestiture and should generally be avoided.
The choice of which of the other routes of divestiture to adopt in any given privatiza-
tion will often depend heavily on the size of the enterprise being divested. To date, direct
investment by the domestic private sector in LDCs has been concentrated in smaller-scale
activities associated with the commerce, manufacturing, service and agricultural sectors.
The divestiture of larger enterprises such as utilities has relied more on direct foreign
investment and public share issues.127
However, foreign investment represents a paradox to developing governments: while
capital-starved LDCs are in great need of foreign capital, foreign investment is often
perceived as a neo-colonialist threat to demiurgic states attempting to fashion their own
societies rather than be absorbed into the political economy of the developed world.
Thus, domestic investment is very attractive to developing economies, implying that a
country’s savings rate (savings as a percentage of GDP) will be a significant factor in
the determination of the mode of divestiture to be adopted. Presumably, an LDC with
a relatively higher savings rate would not only rely to a greater degree on domestic
investment, but would also employ the public offering more frequently as a means of
placing some portion of large SOEs in domestic rather than foreign hands.128 Moreover,
LDCs with higher savings rates are more likely to have the financial institutions necessary
to facilitate a public offering.
Partial privatization of an SOE may be a desirable interim option for governments
for whom full privatization is not politically desirable or feasible. Partial privatization
could take the form of a partial public offering which, if the stock are widely traded,
will introduce stock prices (and changes thereto) as a benchmark of an SOE’s perfor-
mance, as well as creating a private constituency with a direct stake in SOE efficiency.
Alternatively, government could sell a minority interest to a single commercial partner or
joint venturer with needed capital and expertise and a role in SOE’s governance, again
with a direct stake in enhanced SOE performance. Under both options, full privatiza-
tion may ultimately be rendered more politically feasible. Government credibility may,
however, prove a serious problem with both of these options, in that minority investors’
stakes are at risk of expropriation or devaluation by changes in policies by the control-
ling shareholder/government motivated by non-efficiency considerations. Hence, minority
shareholders may be difficult to attract at all, or only at severely discounted acquisition
prices, reflecting this political risk.
3. SOE reform alternatives
Several conclusions can be drawn from our discussion of SOEs and privatization in parts
I and II, supra. SOEs in the developing world are sources of great inefficiency; they
typically have not generated the social benefits they were created to provide. Privatization
offers one solution to this problem. In fact, if implemented in an acceptable environment
(including an efficient post-privatization regulatory environment), privatization is likely
the optimal solution to SOE inefficiencies, triggering as it does the maximum benefits of
private ownership and competition. However, an acceptable environment for privatization

is missing in many LDC industries.
Nevertheless, there are reform alternatives to privatization. While LDCs work towards
improving their institutions and strengthening their private sectors in preparation for
divestiture, they can also improve their economies by implementing several public sec-
tor reforms. The following reforms, to a greater or lesser extent, seek to benefit from
the ownership effect and/or the competition effect: (i) management contracts; (ii) perfor-
mance contracts; and (iii) inducements to competition.
3.1. Management contracts
A management contract is an agreement between a government and a private party (often

enforceable through international arbitration or governed by the law of a recognized cen-
ter of commerce) by which the private party agrees to operate an SOE for a fee, which
will usually be tied to firm performance, but which may be fixed. In other words, man-
agement contracts privatize SOE management without divesting firm assets. Management
contracts are typical in only a handful of industries. According to Shirley, a worldwide
search for management contracts revealed only 202 contracts: 46 in agriculture (24 in
sugar, 22 in Sri Lankan tea and rubber plantations), 44 in the hotel industry, 23 in infras-
tructure, 13 in food processing and beverages, and 12 in extractive sectors. Moreover,
the use of management contracts has been concentrated in Africa, which accounted for
91 of the 136 management contracts identified by Shirley which did not relate to hotel
management or Sri Lankan tea and rubber plantations.129
Do management contracts improve SOE performance? Shirley studied the experience
with twenty contracts in a range of countries and industries, measuring their impact on
SOE performance in terms of increases in post-contract profitability and productivity. The
study is apparently the first to analyze systematically LDC experience with management
contracts.130 A contract was considered a success if both profitability and productivity
unambiguously improved following contract execution. On this measure, 13 out of the
twenty SOEs (counting all 22 Sri Lankan plantations as one SOE), or 65 percent, were
successes (moreover, profitability or productivity improved in three other firms).131 While
Shirley’s methodology is not perfect (e.g., externalities are not taken into account), her
study does provide some support for the use of management contracts as a means to
improve SOE efficiency. Evidence compiled by Whitworth regarding the use of manage-
ment contracts in Papua New Guinea also demonstrates that management contracts can
be an effective means of increasing SOE efficiency.132
From a theoretical perspective, management contracts have their drawbacks. Firstly, in
order for management contracts to reap significant benefits from the incentive effects of
private management, contract remuneration must be tied to firm performance. However,
often contracts include fixed fees, and some do not even attempt to relate fees to firm
performance.133 Secondly, the transitory nature of the management contract may create
perverse management incentives. Management contracts often have terms much shorter
than the life of the assets under management. Because of uncertainties over contract
renewal, a problem compounded by the lack of credibility of many LDC governments,
management may be tempted to maximize short-term gains, often at the cost of long-
term performance, e.g., capital investment might be lowered to inefficiently low levels
or assets degraded.134 And while a well drafted management contract may mitigate such
perverse incentives by, e.g., increasing the term of the contract, such a modification is
not without its own costs. Technological uncertainties, uncertainties relating to market
demand and uncertainties relating to surrounding government policies may negatively
affect the costs or revenues associated with a project over the long term, making longer
contract terms relatively unattractive to private firms.135 Thus, LDC governments can
expect to derive a greater benefit from their management contracts if they signal to
private managers their commitment to a long-term relationship, e.g., by making costly
political allowances, such as layoffs, or new investments in related infrastructure. LDC
governments would also be wise to choose private sector partners motivated by a desire
to protect international reputational capital.
An important question is the relative efficiency of the management contract and divesti-
ture. We stated in the introduction to part III that privatization, assuming appropriate
post-divestiture regulation, takes full advantage of both the ownership effect and the
competition effect of private ownership. Management contracts are not able to do so. As
discussed above, the incentive effects created by private management are weaker than
those created by private ownership. For example, private ownership, as opposed to man-
agement, of assets will be much more likely to result in increased capital investment.
Moreover, relative to management contracts, divestiture is a much stronger signal to the
investing world of a government’s commitment to market liberalization. Finally, provided
the privatized SOE does not have monopoly power, divestiture may not result in the
same degree of transaction costs as management contracts, e.g., the costs of ongoing
negotiations and monitoring.136 With respect to the competition effect, so long as SOE
assets remain in state hands, state actors will be tempted to discourage competition, and
private actors will be nervous about entering an industry dominated by an SOE or SOEs.
Thus, where the economic and political prerequisites to privatization are present, priva-
tization is likely a better reform alternative than the management contract. However, the
major benefit of the management contract is that it can be successfully implemented in
circumstances where privatization cannot. For example, while concerns over monopoly
power and crowding out arising from a weak private sector are still relevant to the social
success of a management contract, these concerns may be specifically dealt with in the
management contract itself. In this way, the management contract offers a direct method
of regulation which LDC governments may find more workable than the free standing
types of regulation required following divestiture. Given that management contracts do
not offer LDCs ready money with which to stabilize their reserves, LDCs are less likely
to accept sub-optimal management contracts than sub-optimal divestiture agreements in
times of economic crisis. Finally, while corruption is always costly, there is less at stake
in the case of the management contact. In terms of politics, the management contract
offers a less drastic alternative to divestiture; rather than being an all or nothing bar-
gain, the contract can be structured to win the necessary political support. Of course,
the less independence management has from an LDC government, the less effective it is
likely to be.
This is not to say that management contracts are appropriate for every SOE which
is not ready for privatization. Many types of SOEs may not be readily amenable to the
management contract. Firstly, the crux of the management contract is the identification
of clear performance objectives and the linkage of management compensation to the
fulfillment of those objectives. In industries lacking readily agreed upon or assessable

performance objectives,137 the management contract will be ineffective. Secondly, an
LDC may not be able to attract suitable private sector management partners (especially if
private investors are not able to convert soft currency remuneration into hard currency).
Also, while LDCs may benefit from foreign management knowledge and experience via
the management contract, this reform alternative may not be practical in areas where
national security or sovereignty is a concern. Where the management contract is not a
workable reform alternative, another reform possibility is the performance contract.
3.2. Performance contracts
In part I, supra, in the context of our discussion of the benefits of private ownership, we
identified a key distinction between private and public enterprises: private enterprises are
generally motivated by one clear objective—profit maximization—while SOEs typically
face multiple, sometimes conflicting objectives. These multiple objectives, which are
subject to change at the whim of government officials with control over an SOE, on
one hand make good management difficult, and on the other, make poor management
easy to disguise. Thus, poorly defined corporate objectives severely inhibit management
performance evaluation in SOEs, while a lack of autonomy from government decision-
makers and a failure to tie management compensation to firm performance deter good
management performance. These are problems that may be resolved by the performance
contract.
The three major components of a performance contract system are: (i) a performance
evaluation system, in which national goals are translated into explicit SOE objectives
and quantified in performance criteria; (ii) a performance information system which
monitors actual achievements; and (iii) an incentive system, in which the welfare of
SOE managers and workers is linked to SOE objectives by a pecuniary or non-pecuniary
bonus system based on the achievement of particular target values.138 By the mid-1990s,
performance contract systems had been implemented in 28 developing countries, mostly
in Asia and Africa.139 Unfortunately, while the implementation of performance contracts
has had some successes,140 it has also had many failures.141 We limit ourselves to a
brief discussion of the reasons why performance contracts are difficult to implement
successfully and ways in which performance contract systems can be improved to avoid
these pitfalls.
Beginning with performance evaluation, SOE managers, who carry a large informa-
tion advantage over their government monitors, have an incentive to behave strategi-
cally by using this advantage to negotiate easily attainable performance targets, and/or
numerous and changing targets which make performance evaluation time-consuming and
difficult. For example, evidence from India indicates that some negotiations on perfor-
mance targets have dragged on for so long that targets have been set at the level of
actual performance.142 One reason for the success of SOE managers in negotiating per-
formance targets is that government negotiators have often been less powerful, middle-
and low-level government functionaries whose task is aggravated by frequent changes in
responsibility and authority.143
With respect to incentives, a surprising number of performance contracts fail to effec-
tively tie management remuneration to SOE performance, e.g., pecuniary bonuses were
available as a performance reward in only five of the twelve sample companies in the
Dyer Cissé study.144 Korea was the only country in the study where there was any evi-
dence that management performance had an effect on managerial careers; in all other
countries managerial assignments were still determined by political patronage.145 More-
over, the tendency of LDC governments to breach their performance contract covenants
without reprisal (e.g., none of the 12 contracts studied by Dyer Cissé provided for an
enforcement mechanism) seriously derogates from the significance attached to them by
SOE managers. Nellis notes that with respect to almost every enterprise submitted to the
Senegalese performance contract system, the government committed itself to a series of
promises and then failed to honour at least some of them—largely as a result of mak-
ing aggregate commitments that far exceeded the most optimistic estimates of resource
availability.146 Finally, it is possible that many SOE managers are so accustomed to SOE
inefficiency that no amount of incentives could prompt them to improve SOE perfor-
mance. This hypothesis is supported by the findings of a recent study by Barberis et al.,
who found strong evidence in their study of 452 Russian shops privatized between 1992
and 1993 that the presence of new owners and new managers raises the likelihood of
restructuring, but found no evidence that equity incentives of old managers promotes
restructuring.147
Thus, the implementation of performance contracts does not appear to be a broad solu-
tion to the problems of SOE inefficiencies. Relative to privatization, performance con-
tracts do not increase competition, and face serious obstacles in their attempt to induce
good management. The threat posed to SOE performance by instrumental management
of SOEs by politicians and SOE managers alike can only truly be overcome by privati-
zation. On the other hand, even where performance contracts have proven unsuccessful,
they have still helped to clarify the goals of SOEs and the financial responsibilities
of government, and have resulted in increased autonomy and responsibility on the part
of SOE management.148 Moreover, many of the problems with performance contracts
discussed above do have solutions, if LDC governments are willing to adopt them.
To maximize management incentives, management compensation must be tied to firm
performance. Moreover, while many markets (and thus market-based incentives) are
weakened or eliminated by public ownership, e.g., the product market and the market
for corporate control, public ownership is not strictly incompatible with the job market.
Poor management performance should be met with dismissal; good management per-
formance should be met with promotion. The finding of Barberis et al. that incentives
induce good management only following a change in management makes the provision
for performance-based (and not politically-based) management turnover all the more
important. Unfortunately, convincing many LDC governments to award SOE manage-
ment positions on the basis of merit rather than patronage may be very difficult.
The second change that must be made to performance contracts in order to increase
their effectiveness relates to credibility: if SOE managers are expected to be bound to
performance contracts, LDC governments must also act within the confines of these
agreements. Unfortunately, limited specialized human capital in the finance, budgetary
and treasury departments of developing governments has caused LDC governments to
undermine their credibility by committing to promises which cannot possibly be hon-
oured. One solution to this problem would be for LDCs to channel the negotiation of
all performance contracts through a central agency (as with privatization decisions). In
this way, an LDC could develop an expert body of bureaucrats to deal with perfor-
mance contracts, and potential conflicts in government commitments could be identified
before rather than after contract formation. Another solution to the problem of lack
of government credibility would be the inclusion within performance contracts of a
strong enforcement mechanism, something typically lacking from these contracts. Where
ordinary enforcement mechanisms such as a law suit for breach of contract are not
practical,149 more creative mechanisms will have to be developed, e.g., the mandatory
publishing of breaches of performance contracts, and the dismissal of any SOE manager
or government minister responsible for a fundamental breach of contract.
With respect to performance evaluation, the channelling of performance contracts
through a centralized agency should improve the transparency of performance contracts
by reducing any inequality of bargaining power between government negotiators and
SOE managers, as government bureaucrats become expert in performance contract nego-
tiation. Inequality of bargaining power will also be limited if targets are based on recog-
nized benchmarks, e.g., the average performance of similarly situated private enterprises
elsewhere in the world. The use of published (and frequently updated) benchmarks should
also remove a good deal of the content of performance contract negotiations, thereby
lowering transaction costs. Furthermore, the enforcement of contracts through a central
agency should help to ensure that government ministers, as well as SOE management,
are not indiscriminately revising SOE objectives to suit their personal whims. Of course,
one might worry about corruption in a central agency as well, and so it is suggested
that the process of performance evaluation should be made as transparent and public
as possible, e.g., mandatory publishing of performance targets and actual performance.
If the above improvements can be made to LDC performance contract systems, SOEs
which cannot (or should not) be privatized for economic or political reasons may still
benefit from improved enterprise management.
3.3. Inducements to increased competition
Management contracts and performance contracts attempt to improve SOE performance

largely through improvements in management incentives and monitoring, i.e., by attempt-
ing to simulate private ownership. These types of SOE reform have little impact on the
level of competition faced by an SOE. Competition, as discussed above in part I, has
a positive impact on firm performance and should be encouraged wherever possible. In
this section we suggest four means by which LDC governments may introduce greater
levels of competition in their SOE sectors: (i) the unbundling of monopolies; (ii) the
reduction of import barriers; (iii) price regulation; and (iv) competition regulation.
As already discussed in part II, a major benefit to be derived from privatization is the
unbundling of monopolies, i.e., separating those portions of a monopoly not subject to
natural monopoly from the rest of the SOE and subjecting them to competition via pri-
vatization. However, if privatization of the inherently competitive sectors of a monopoly
is not appropriate for political or economic reasons, an SOE should still be broken-up.
In fact, the unbundling of monopolies long before privatization will allow LDCs to avoid
privatizing a monopoly as a whole, rather than in unbundled parts, and thereby avoid los-
ing many of the gains promised by privatization. Following the break-up of a monopoly
(prior to divestiture), an LDC may divide each sector of the monopoly susceptible to
competition into several, competing SOEs. Eventually, the entire competitive SOE indus-
try (stemming from a single sector of the original monopoly) may be privatized, possibly
creating a private sector with enough depth to allow for true competition.
Secondly, competition may also be introduced to an LDC SOE sector via a reduction
in entry barriers, including import barriers. The SOEs of many LDCs have grown ineffi-
cient under various protectionist policies, which may take any one of a number of forms,
including: tariffs, import quotas, import licensing systems, and restrictions on the avail-
ability of foreign currency. The removal of such barriers would immediately increase the
competition faced by SOEs, and so would have to be engineered very carefully in order
that the viability of a state’s SOEs not be radically undermined.
Thirdly, we mentioned in part II. that there has historically been very little explicit
price regulation of the SOE sector in LDCs (although certainly some SOEs will have
been subject to direct price controls). The result has been SOE monopolies with little
incentive to improve cost efficiency. The introduction of price regulation, and specifically
performance-based regulation,150 into LDC markets dominated by public monopolies
should encourage greater cost efficiency within these monopolies. Moreover, initiating
regulation prior to privatization develops LDC government expertise with regulation,
increasing the credibility of a government’s pre-divestiture commitments regarding price
regulation.
Finally, many LDC governments operate numerous SOEs within a single industry, and
so may benefit from the introduction of competition regulation to their SOE sectors.
Such regulation would provide for greater competition by outlawing collusion between
SOEs operating within the same industry, and possibly by requiring that SOEs be given
enough autonomy from the central government to allow for proper competition. Again,
the side effect of the introduction of competition law to LDC SOE sectors is the growth
of regulatory expertise within LDC governments, allowing LDC bureaucrats to better
regulate an expanding private sector.
4. Conclusion
SOEs were formed and expanded in the developing world for a variety of political,
ideological and economic rationales, rationales the experience of the last two decades
or so have severely undermined. While concerns over national sovereignty remain
understandable in an increasingly interdependent world economy, the question becomes
sovereignty at what cost? Certainly state ownership has not achieved its primary eco-
nomic goal of increased capital investment. In the meantime, the perennial deficits of
the LDC SOE sector have severely compromised economic and social development in
the developing world.
The primary focus of this paper has been a consideration of the relative merits of
different reform options. We concluded that privatization may often but not always be
the optimal policy response to poorly performing SOEs. Privatization promises to gar-
ner the most benefits from the incentive effects of private ownership, and it should
also induce competition. However, unlike management contracts, and especially perfor-
mance contracts, privatization may seriously derogate from social welfare if implemented
in an economy characterized by lack of depth in the private sector and institutional
incapacity. Moreover, privatization may not even be an option for an LDC if it is not
politically acceptable from the perspective of both the state executive and the public at
large.
The first key conclusion of the paper is that each developing country must design
an SOE reform strategy which is compatible with its political and economic environ-
ment. For middle-income and especially upper-middle-income economies, the necessary
economic and political prerequisites to privatization may already be in place. For other
economies, privatization may still be an option in particular industries even where privati-
zation is not a viable option more generally. These are decisions which must be made on
a case-by-case basis. Other than privatization, an SOE reform strategy may include man-
agement contract systems, performance contract systems and inducements to increased
competition in the SOE sector, such as a reduction in entry and import barriers and reg-
ulation of SOEs. Again, the nature and extent of such reforms must be grounded in the
political and economic realities facing the particular LDC. Moreover, LDC governments
should adopt a dynamic approach to SOE reform, altering their portfolios of reform
measures over time to accommodate changes in the political and economic landscape
affecting their LDCs.
The second key conclusion of the paper is that SOE reform cannot take place in
a vacuum. Since the privatization of an SOE into a weak and shallow private sector
may be counter productive, private sector reform and development should coincide with
SOE reform. Corruption and administrative incapacity, issues that affect both the public
and the private sectors, must also be tackled by an LDC government wishing to reform
effectively its SOE sector. Thus, an SOE reform strategy must at once be both narrow and
broad in scope: narrow in order to take into account the circumstances facing individual
SOEs; broad in order to provide for both public sector and private sector reform. And
any SOE reform strategy must have the temporal flexibility to adapt to political and
economic changes in the LDC. In summary, the answer to SOE inefficiencies in the
developing world is not “privatization at any cost,” but rather “economic growth through
broad SOE reform.”
Notes
1. Aharoni has argued that, “incredible as it sounds, there is still no officially agreed upon way of defining
the size of the SOE sector, mainly because there is no agreed upon official definition of that sector,”
Yair Aharoni, The Evolution and Management of State-Owned Enterprises (Cambridge, MA: Ballinger,
1986) at 6, See also David Lim, “Recent Trends in the Size and Growth of Government in Developing
Countries” in Norman Gemmell, ed., The Growth of the Public Sector (Aldershot, England: Edward Elgar,
1993) at 35–36 in relation to the measurement of the public sector generally. For our purposes, and SOE
can be defined as a publicly-owned corporation—an entity having a separate legal personality and separate
accounts.
2. Mary M. Shirley et al., Bureaucrats in Business: The Economics and Politics of Government Ownership
(Washington, DC: World Bank, 1995) at 33.
3. For a helpful review of privatization issues and empirical experience in transition economies, see John
Nellis, “Time to Rethink Privatization in Transition Economies?”, World Bank Discussion Paper No. 38,
2000.
4. See e.g., Mehdi Haririan, State-Owned Enterprises in a Mixed Economy: Micro Versus Macro Economic
Objectives (London: Westview Press, 1989) at 10; Russel Muir and Joseph P. Saba, Improving State
Enterprise Performance: The Role of Internal and External Incentives (Washington, D.C.: World Bank,
1995) at 11; R.C. Dutt, State Enterprises in a Developing Country: The Indian Experience 1950–90
(New Delhi: Abhinav Publications, 1990) at 4; Dieter Bös, Public Enterprise Economics (Amsterdam:
North-Holland, 1986) at 26; Thomas J. Trebat, Brazil’s State-Owned Enterprises: A Case Study of the
State as Entrepreneur (New York: Cambridge University Press, 1983) at 65.
Among countries which created SOEs explicitly on the basis of socialist ideology were India, Tanzania,
Benin, Zambia, Sri Lanka and Pakistan, Aharoni, supra note 1 at 102. Meanwhile, nationalistic sentiments
played an integral part in the creation of many SOEs in Indonesia, Ghana, Algeria, Peru, Mexico and
Chile, Malcolm Gillis, “The Role of State Enterprises in Economic Development” (1980) 47: 2 Social
Research 248 at 263. In some cases, enterprises were nationalized for national security reasons, see
e.g., Aharoni, supra note 1 at 100; Ravi Ramamurti, “Strategic Behaviour and Effectiveness of SOEs in
High-Technology Industries: A Comparative Study in the Heavy Engineering Industry in India” (DBA
Dissertation: Harvard University, 1982).
5. World Bank, Private Sector Development in Low-Income Countries (Washington, DC: World Bank, 1995)
at 97.
6. Pranab Bardhan, “Introduction to the Symposium Issue on the State and Economic Development” (1990),
4 Journal of Economic Perspectives 3; Miranal Datta-Chaudhri, “Market Failure and Government Failure”
(1990), 4 Journal of Economic Perspectives 24.
7. SOE supply prices have often been maintained at below market levels by many LDC governments in
order to control inflation, Anne O. Krueger, Economic Policy Reform in Developing Countries (Oxford:
Blackwell, 1992) at 83.
8. Haririan, supra note 4 at 6–7; James A. Brander, Government Policy Toward Business, 3rd ed. (Toronto:
John Wiley & Sons, 1995) at 413.
9. Bös, supra note 4 at 27.
10. Muir and Saba, supra note 4 at 11.
11. For some LDCs suffering from a lack of bureaucratic capacity, more specifically an inability to tax and
regulate private enterprise at arm’s length, state ownership offered an alternative means of taxation, World
Bank, World Development Report 1991: The Challenge of Development (New York: Oxford University
Press, 1991) at 130.
12. Some of the positive social externalities of private enterprise (and more specifically, privatization) are
discussed in Part II, infra.
13. For a discussion of agency costs, see Adolph A. Berle and Gardiner C. Means, The Modern Corporation
and Private Property (New York: Macmillan, 1968 (rev. ed.)); and Michael C. Jensen and William H.
Meckling, “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure” (1976),
3 Journal of Financial Economics 305.
14. Henry G. Manne, “Mergers and Market of Corporate Control” (1965), 73:2 Journal of Political Economy
110. However, it may be the case that the takeover market is itself inefficient, see e.g. Lance Tay-
lor, “Public Enterprises, Private Enterprises and the State: Prospects Under Post-Socialism” in Amitava
Krishna Dutt, Kwan S. Kim and Ajit Singh, eds., The State, Markets and Development: Beyond the Neo-
classical Dichotomy (Aldershot, England: Edward Elgar, 1994) at 71; or not particularly responsive to
firm inefficiency, see e.g., Ha-Joon Chang and Ajit Singh, “Public Enterprises in Developing Countries
and Economic Efficiency: A Critical Examination of Analytical, Empirical and Policy Issues” (1993), 4
UNCTAD Review 45 at 54.
15. William A. Niskanen, ed., Bureaucracy and Representative Government (Chicago: Aldine-Atherton,
1971); M. J. Trebilcock; D. G. Hartle, J. R. S. Prichard and D. N. Dewees, The Choice of Governing
Instrument (Ottawa: Ministry of Supply and Services, 1982) at 13.
16. Some authors have estimated the proportion of shares required to control a modern widely-held cor-
poration to be as low as 4 or 5 percent, see e.g., William A. McEachern, Control, Compensation and
Performance in the Large Corporation (Lexington, MA: D.C. Heath, 1975); Dan Villajero, “Stock Own-
ership and the Control of Corporation,” 2 and 3 New University Thought 33 and 47.
17. See e.g., Louis De Alessi, “The Economics of Property Rights: A Review of the Evidence” (1980), 2
Research in Law and Economics 1 at 27–28; Shirley, 1995, supra note 2 at 36; B. Stevens, “Prospects
for Privatization in OECD Countries” (1992), August National Westminster Bank Quarterly Review 2 at
20; Michael J. Trebilcock and J. Robert S. Prichard, “Crown Corporation: The Calculus of Instrument
Choice” in J. Robert S. Prichard, ed., Crown Corporation in Canada: The Calculus of Instruments Choice
(Toronto: Butterworths, 1983) at 34.
18. E.g., corporate law requires corporations to distribute independent auditor’s report (where applicable) and
financial statements to their shareholders on a regular basis, see e.g., subsection 159(1) of the Canadian
Business Corporations Act, R.S.C. 1985, c. C-44, and subsection 154(3) of the Business Corporations
Act (Ontario), R.S.O. 1990, c. B.16.
19. In fact, a manager will often face as many sets of multiple objectives as government officials/bodies
having control over his or her SOE (e.g., senior bureaucrats, ministers of state, the head of state, etc.),
Leroy P. Jones, “Performance Evaluation for State-Owned Enterprises” in Ravi Ramamurti and Raymond
Vernon, eds., Privatization and Control of State-Owned Enterprises (Washington, DC: The World Bank,
1991) at 181.
20. Economic Council of Canada, Minding the Public’s Business (Ottawa: Minister of Supply and Services
Canada, 1986) at 107.
21. Aharoni, supra note 1 at 167.
22. SOE managerial posts may be used to reward specific supporters, and SOE demand prices (labour, inputs)
and supply prices may be used to win broader political support.
23. We recognize that politicians and bureaucrats might also practice opportunism in relation to private
enterprise, for example, through his or her control over the regulations governing an enterprise. To the
extent that government officials are able to exert sufficient indirect control over private enterprise to
achieve the same nefarious results as they would have achieved in relation to an SOE, the former is little
more efficient than the latter. For example, where a government official has the power to determine or
modify an investor’s profitability after an investment has been made, e.g., by lowering the permissible
rate a private utility might charge, then there is the potential for gradual expropriation, which would
be highly inefficient. However, generally investors will not invest in an LDC without some form of
credible government regulatory commitment, creating the kind of independence from government power
that permits for more efficient management.
24. Note, however, that in some LDCs bureaucrats rather than ministers may be making the major government
decisions. For example, Serhiy Holovaty, the Ukrainian Minister of Justice, recently commented on the
monopoly control exercised by bureaucrats in the Ukraine: “A ministry is not in control of its own agenda,
not even with respect to its own initiatives,” The Globe and Mail, 25 June 1997 at A1.
25. Matthew Bishop, John Kay and Colin Mayer, Privatization & Economic Performance (New York: Oxford
University Press, 1994) at 9. See also Pankaj Tandon, “Welfare Effects of Privatization: Some Evidence
from Mexico” (1995), 13 Boston University International Law Journal 329 at 333.
26. See Olivier Bouin, “Privatization in Developing Countries: Reflections on a Panacea,” OECD (Paris),
Policy Brief No. 3, 1992.
27. Mary M. Shirley, “Privatization and Performance” (1994), 17 Hastings International and Comparative
Law Review 669 at 674.
28. Christopher Adam, William Cavendish and Percy S. Mistry, Adjusting Privatization: Case Studies from
Developing Countries (London: James Currey, 1992) at 74.
29. Which is the case, for example, in Malaysia, Sri Lanka and Kenya, Ibid. at 73.
30. Muir and Soba, supra note 4 at 12–13; Dutt, Kim and Singh, supra note 14 at 12.
31. World Bank, 1995, supra note 5 at 94.
32. The Globe and Mail, 3 March 1997 at A15.
33. See John R. Nellis, Public Enterprises in Sub-Saharan Africa, World Bank Discussion Paper No. 1
(Washington, DC: World Bank, 1986).
34. See John R. Nellis and Sonita Kikeri, “Public Enterprise Reform: Privatization and the World Bank,”
(1989), 17 World Development 660.
35. But see V. V. Ramanadham, The Economics of Public Enterprise (Net York, Routledge, 1991), comparing
the purported rationales for SOE’s and their actual performance, and finding little connection between the
two.
36. i.e., using the least cost factor combination to produce a given level of output.
37. i.e., using the minimum level of inputs to produce a given pattern of outputs, independent of factor prices.
For an expalnation of cost or technical efficiency see Robert E. Millward and David M. Parker, “Public
and Private Enterprise: Comparative Behaviour and Relative Efficiency,” in Robert Millward et al., eds.,
Public Sector Economics (Harlow: Longman Group, 1983) at 225–235.
38. K. Kim, “Enterprise Performance in the Public and Private Sectors: Tanzanian Experience 1970–1975”
(1981), 15:3 Journal of Developing Areas.
39. A. Abdouli, “Sources of Technical Efficiency in an African Context” (1989), 9:1 Public Enterprise.
40. A. Krueger and B. Tuncer, “Growth of Factor Productivity in Turkish Manufacturing Industries” (1982),
11:3 Journal of Development Economics; B. Dholakia, “Relative Performance of Public and Private
Manufacturing Enterprises in India: Total Factor Productivity Approach” (1978), 1 Economic and Political
Weekly.; M. Gupta, “Productivity Performance of the Public and the Private Sectors in India: A Case
Study of the Fertiliser Industry” (1982), 18:2–4 Indian Economic Review.
41. Chang and Singh, supra note 14 at 63–64.
42. For a lengthy discussion of the problems associated with reliance on individual performance indicators,
see Chang and Singh, supra note 14 at 55–59.
43. T. Killick, “The Role of Public Sector in the Industrialisation of African Developing Countries” (1983),
7 Industry and Development.
44. Prajapati Trivedi, A Critique of Public Enterprise Policy (New Delhi: International Management Publish-
ers, 1992). Trivedi acknowledges at 114–115 that his was a very small sample, but argues that the sample
was in most other respects ideal.
45. Ibid. at 117.
46. Ibid. at 123.
47. This conclusion is supported by Adam, Cavendish and Mistry, who claim at page 74 that in many LDCs
SOE dominance has effectively “crowded-out” the indigenous private sector, and go on to suggest at page
102 that the primary objective for LDC policy-makers should be the development of the private sector
and the capital market, Adam, Cavendish and Mistry, supra note 28.
48. See A. R. Vining and A. E. Boardman, “Ownership Versus Competition: Efficiency in Public Enterprise,”
(1992) 73 Public Choice 205, especially summary of empirical studies of SOE’s at pp 214–215.
49. John Vickers and George Yarrow, Privatization: An Economic Analysis, (Cambridge, MA: MIT Press,
1991).
50. Cf. according to Borcherding, Pommerehne and Schneider, it is lack of competition rather than public
ownership per se which leads to the often observed less efficient production in public firms: Thomas
E. Borcherding, W. W. Pommerehne and F. Schneider, “Comparing the Efficiency of Private and Public
Production: The Evidence from Five Countries,” (1982), Supp.2 Zeitschrift für Nationalokonomie 127 at
136. See also Tandon, supra note 25 at 329–330.
51. The finding of Vickers and Yarrow that private enterprise is more efficient in competitive environments
may lead some to attribute the higher efficiency solely to the “competition effect” of private ownership.
This view overlooks the fact that the authors are speaking in terms of the relative performance of private
and public enterprises operating in competitive sectors.
52. See e.g., Borcherding et al., supra note 50 at 136, who conclude that “it is not so much the difference
in the transferability of ownership but the lack of competition which leads to the often observed less
efficient production in public firms.” See also Simon Domberger and John Piggott, “Privatization Policies
and Public Enterprise: A Survey,” in Mathew Bishop, John Kay and Colin Mayer, eds., Privatization &
Economic Performance (New York: Oxford University Press, 1994) at 40–41.
53. Shirley, 1995, supra note 2 at 42–43.
54. Ibid. at 34.
55. Ibid. at 33.
57. Muir and Saba, supra note 4 at vii.
58. See Ramanadham, supra note 35.
60. Robert J. Barro, Determinants of Economic Growth: A Cross-Country Empirical Study (Cambridge, Mass:
The MIT Press, 1997), Barro defines government consumption as government consumption less spending
on education and defence. His specific finding is that the ratio of per capita investment to per capita real
GDP was negatively correlated with the ratio of government consumption to per capita real GDP during
the period.
61. Ibid.
62. Leroy P. Jones, “Performance Evaluation for State-Owned Enterprises” in Ravi Ramamurti and Raymond
Vernon, eds., Privatization and Control of State-Owned Enterprises (Washington, DC: The World Bank,
1991) at 179; Leroy P. Jones, Efficiency of Public Manufacturing Enterprises in Pakistan (1981), Prepared
for Pakistan Ministry of Production, and Pakistan Division, World Bank.
63. World Bank, World Development Report 1983 (New York: Oxford University Press, 1983) at 75.
64. Shirley, 1995, supra note 2 at 48.
65. We define the term “privatization” to exclude management contracts, which are discussed as an alternative
to privatization in Part III of the paper.
66. For example, the German Christian Democrat governments of the 1950s and 1960s: William Meggin-
son, Robert Nash and Matthias van Randenborgh, “The Financial and Operating Performance of Newly-
Privatized Firms: An International Empirical Analysis” (1994), 49 Journal of Finance 403 at 406; and
the Pinochet government of Chile following the overthrow of President Allende.
67. Ahmed Galal, et al., The Welfare Consequence of Selling Public Enterprises: Case Studies from Chile,
Malaysia, Mexico and the U.K. (New York: Oxford University Press, 1994) at 47; see also Vickers and
Yarrow, supra note 49 at 1.
69. The Economist, 21 August 1993. Outside the U.K., governments did not begin to privatize in earnest until
the latter part of the 1980s. For example, there were more than five times as many privatizations in the
six years from 1988–93 than in the eight years from 1980–1987, Shirley, 1995, supra note 2 at 26.
70. Christos Pitelis and Thomas Clarke, “Introduction: The Political Economy of Privatization” in Thomas
Clarke and Christos Pitelis eds., The Political Economy of Privatization (London: Routledge, 1993) at 21.
71. Financial Times Survey, 3 July 1992.
72. World Bank, World Development Report 1996: From Plan to Market (New York: Oxford University Press,
1996) at 56. For a discussion of the costs and benefits of the various types of methods of privatization
used in the transition economies of the former Soviet Bloc see Cheryl W. Gray, “In Search of Owners:
Privatization and Corporate Governance in Transition Economies” (1996), 11 2 The World Bank Research
Observer 179.
74. Shirley, 1995, supra note 2 at 27; Adam, Cavendish and Mistry, supra note 28 at 39–40.
76. Paul Cook and Colin Kirkpatrick, “Privatization Policy and Performance” in Paul Cook and Colin Kirk-
patrick, eds., Privatization Policy and Performance: International Perspectives (New York: Prentice Hall,
1995) at 5.
78. Cook and Kirkpatrick, supra note 76 at 6–7.
79. Shirley, 1995, supra note 2 at 30. Similar, Adam, Cavendish and Mistry note that from 1980 to 1990 only
98 of approximately 2000 SOEs in Jamaica, Kenya, Malawi, Malaysia, Papua New Guinea, Sri Lanka
and Trinidad and Tobago were privatized, Adam, Cavendish and Mistry, supra note 28 at 39.
80. Galal, et.al., supra note 67; Megginson, Nash and van Randenborgh, supra note 66.
81. Galal, et al., supra note 67 at 22–23.
82. Ibid. at 527.
83. Ibid. at 532.
84. Governments were subject to welfare losses where the sum of the taxes, net quasi rents and net sale
proceeds generated from a privatized SOE were less than the taxes and net quasi rents which would have
been generated in the absence of privatization, Ibid. at 168, 218 and 248.
85. SOE output prices are often maintained at below-market levels, either to control inflation or for the
purposes of income redistribution/subsidization.
86. Galal, et al., supra note 67 at 527ff.
87. The authors limited their study to companies having at least two years of pre- and post-divestiture data.
However, nine other firms which did not meet the information requirements of the study were nonetheless
analyzed in relation to changes in their boards of directors following privatization, Megginson, Nash and
van Randenborgh, supra note 66 at 418.
88. Ibid. at 424–439.
89. Narjess Bourbraki and Jean-Claude Cosset, “The Financial and Operating Performance of Newly Priva-
tized Firms: Evidence from Developing Countries,” (1998) 53 Journal of Finance 1081.
90. Galal, et al., supra note 67 at 6–9. In 1994, the World Bank defined a “low-income” economy as an econ-
omy having a per capita GNP of less than or equal to $670, a “lower-middle-income economy” as an
economy having a per capita GNP of between $670 and approximately $2700, and an “upper-middle-
income economy” as an economy having a per capital GNP of between approximately $2700 and approx-
imately $7500. The per capital GNP of the world’s high-income economies ranged between $12,210 and
$36,080 in 1994, World Bank, World Development Report 1994: Infrastructure for Development (New
York: Oxford University Press, 1994) at 162–163. All statistics are reported in U.S. dollars.
91. Megginson, Nash and van Randenborgh, supra note 66 at 406. In fact, one of the developing economies,
Singapore, had a higher per capita GDP in 1994 than both the U.K. and Canada, World Bank, 1996,
supra note 72 at 188–189.
92. 21 of the share issues relating to the authors’ sample of divestitures raised over U.S. $1 billion, Megginson,
Nash and van Randenborgh, supra note 66 at 417–419.
93. Adam, Cavendish and Mistry, supra note 28 at 71.
94. Ibid. at 100.
95. Ibid. at 73.
96. Ibid. at 78.
97. Ibid. at 82.
98. Ibid. at 65.
99. Nicholas Barberis, et al., How Does Privatization Work? Evidence From the Russian Shops, Working
Paper No. 5136 (Cambridge, MA: National Bureau of Economic Research, May 1995).
100. Megginson, Nash and van Randenborgh, supra note 66 at 448. This result contradicts the authors’ sur-
prising finding that performance did not differ as between privatizations which did and did not result in a
change of control of the enterprise, i.e., as between control privatizations and revenue privatizations and
revenue privatizations.
101. Adam, Cavendish and Mistry, supra note 28 at 49.
102. Galal, et al., supra note 67 at 541. Megginson, Nash and van Randenborgh, supra note 66 at 448.
103. On the other hand, the authors found that enterprise performance could be improved substantially where
competition could be introduced, Bishop, Kay and Mayer, supra note 25 at 2–3.
104. Ibid. at 3 and 12.
105. Tandon, supra note 25 at 330.
106. Bishop, Kay and Mayer, supra note 25 at 10.
109. For a discussion of these issues see Adam, Cavendish and Mistry, supra note 28 at 88ff.
110. Ibid. at 65.
111. For a discussion of the relative merits of a more or less centralized approach to privatization, see Bouin,
supra note 26.
112. Following the fall of communism, many SOE managers in both Hungary and Poland privatized their
SOEs on their own authority, Cook and Kirkpatrick, supra note 76 at 9.
113. Robert D. Willig, “Public Versus Regulated Private Enterprise” in Michael Bruno and Boris Pleskovic,
eds., Proceedings of the World Bank Annual Conference on Development Economics 1993 (Washington,
DC: The World Bank, 1994) at 168. An LDC government could also effectively renege on a divestiture
transaction by: changing the tax structure for the industry; altering the conditions for access to the foreign
exchange auction; imposing price controls on the industry; or changing remittance conditions for profits
in the case of foreign-owned companies, Adam, Cavendish and Mistry, supra note 28 at 57.
114. Paolo Mauro, “Corruption and Growth” (1995), 3 The Quarterly Journal of Economics 681.
115. World Bank, World Development Report 1997: The State in a Changing World (New York: Oxford
University Press, 1997); Shang-Jin Wei, “How taxing is Corruption on International Investors?” (1997),
Harvard University, Kennedy School of Government, Cambridge, MA, cited in Susan Rose-Ackerman,
Corruption and Government: Cases, Consequences, and Reform (New York: Cambridge University Press,
1999).
116. E.g., the government of Zimbabwe has allegedly kept a local businessman from introducing a new cel-
lular telephone network into the country despite Zimbabwe’s notoriously bad telecommunications system
because the businessman has refused to pay bribes, The Economist 2 March 1996 at 44.
118. Ibid. at 178–179.

119. Ibid. at 178.
120. A crisis episode is defined as successive years of negative per capita GNP growth.
121. Jose Edgardo Campos and Hadi Salehi Esfahani, “The Political Foundations of Public Enterprise Reform
in Developing Countries” (World Bank, 1994, unpublished) at 23.
122. Broad public opposition to privitization may be a significant issue with respect to the privatization of
large SOEs, e.g., utilities, but it is likely to be less of an issue with the privatization of many small and
medium-sized SOEs. It is also the case that lack of competition is less likely to be a problem with the
latter class of SOEs.
124. Campos and Esfahani, supra note 121 at 9.
125. Commonwealth Secretariat, Management of the Privatization Process: A Guide to Policy Making and
Implementing (London: Commonwealth Secretariat, Management and Training Services Division, 1994)
at 32ff.
126. Ibid. at 38.
127. Cook and Kirkpatrick, supra note 76 at 15.
128. Unsurprisingly, African divestiture programs have relied on foreign direct investment to a greater extent
than other developing regions, while domestic investment has played a key role in divestiture in East
Asia, Cook and Kirkpatrick, supra note 76 at 14.
130. Ibid. at 134.
131. Ibid. at 136–139.
132. Alan Whitworth, Public Enterprise Policy: Independence to 1991, Institute of National Affairs Discussion
Paper No. 57 (Port Moresby, Papua New Guinea: Institute of National Affairs, 1993) at 35.
133. While all of the successful contracts in the Shirley study used success fees or equity stakes and many did
not include a fixed fee component, all of the borderline and unsuccessful contracts included fixed fees
and some did not provide for a success fee, Shirley, 1995, supra note 2 at 141.
134. Ronald J. Daniels and Michael J. Trebilcock, “Private Provision of the Public Infrastructure: An Organizational
Analysis of the Next Privatization Frontier” (1996), 46 University of Toronto Law Journal 375 at 404.
135. Ibid. at 405. Although the management contracts of the most successful firms in the Shirley study admit-
tedly did generally have longer terms.
137. Firm profitability will not always be the most important indicator of firm performance. In certain indus-
tries, such as the telecommunication industry, the government’s primary objective may be capital invest-
ment.
138. Jones, supra note 19 at 180; A. Hartman and S.A. Nawab, “Evaluating Public Manufacturing Enterprises
in Pakistan” (1985), September Finance and Development 27 at 28–30.
139. Shirley, supra note 2 at 112.
140. Performance contracts proved “workable” in Bangladesh, Ravi Ramamurti, “Controlling State-Owned
Enterprises” in Ravi Ramamurti and Raymond Vernon, eds., Privatization and Control of State-Owned
Enterprises (Washington, D.C.: The World Bank, 1991) at 225, and successful in both Kenya, B. Grosh,
Public enterprises in Kenya (London: Lynn Reinner, 1992), and Korea, D. Song, “Public Enterprises in
Korea” (August, 1992), presented to the Third Asia Pacific Conference of Management, Brisbane, Aus-
tralia (although see Penggui Yan, “South Korea’s Performance Evaluation System: Some Issues Further
Considered” (1995), 3 Annals of Public and Cooperative Economics 321, for a less optimistic view of
Korea’s performance contract system).
141. Nichola Dyer Cissé, The Impact of Performance Contracts on Public Enterprise Performance (Washing-
ton, DC: World Bank, 1994), Background Paper, Policy Research Department; John R. Nellis, Contract
Plans and Public Enterprise Performance (Washington, DC: World Bank, 1989), Policy, Planning, and
Research Working Paper 118.
143. Ibid. at 120–121.
144. Cissé, supra note 141.
145. Shirley, supra note 2 at 124–125.
146. Nellis, supra note 141 at 34 and 53.
147. Barberis, et at., supra note 99.

148. Nellis, supra note 141 at 38–39.
149. The law of an LDC may prohibit an SOE from suing the government since such an action would essen-
tially permit one party (the government) to sue itself. More broadly, the law of an LDC might severely
restrict the right of any party, including SOE managers and SOEs, to sue the government.
150. E.g., regulated price caps with price increase restricted to CPI - X (a productivity growth factor).

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European Journal of Law and Economics, 12: 217–252, 2001

© 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.

State-Owned Enterprises in Less Developed

MICHAEL J. TREBILCOCK michael.trebilcock@utoronto.ca

Keywords: state-owned enterprises, SOEs, privatization, management contracts, performance contracts

JEL Classiﬁcation: H11, H42, K23, L32, L33

Examples of the inefﬁciencies of state-owned enterprises (SOEs) abound;1 cases like

1. SOEs: Background, theory and performance

1.2. The theory of public and private ownership

investment in a corporation large enough to make investments in monitoring proﬁtable.

iii. Theoretical conclusions. Theoretically, apart altogether from the inefﬁciencies

1.4. Costs of poor SOE Performance

future, it is inefficient to finance low productivity or economically inefficient price levels

2.1. The history of privatization in LDCs

2.2. Pre- and post-privatization relative performance

2.3. Other beneﬁts of privatization

2.4. The prerequisites for successful privatization

i. Economic prerequisites. Many of the economic prerequisites to privatization have

iii. Conclusions regarding prerequisites to privatization. While privatization may

2.5. Methods of privatization

3. SOE reform alternatives

private ownership and competition. However, an acceptable environment for privatization

3.1. Management contracts

A management contract is an agreement between a government and a private party (often

fulﬁllment of those objectives. In industries lacking readily agreed upon or assessable

3.2. Performance contracts

3.3. Inducements to increased competition

Management contracts and performance contracts attempt to improve SOE performance

118. Ibid. at 178–179.

147. Barberis, et at., supra note 99.

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