IN the last decade, many steps have been taken to disinvest public sector enterprises in India, both in terms of listing central public sector enterprises companies on the stock market and selling controlling interest. After a lull, disinvestment is now back on the UPA government’s agenda. There appears to be a political consensus on disinvestment in non-navratna profit making enterprises, and in chronic loss making PSUs. Hence, it is important to revisit the issues of rationale and mechanisms of disinvestment.

In this paper we argue that the main rationale for disinvestment is the increased efficiency of utilisation of resources of the economy, both labour and capital. An excessive focus on the fiscal aspects of disinvestment leads to undesirable consequences. Even partial privatisation, with the government retaining control, has yielded improved productivity. Disinvestment of profit making enterprises by public offering of shares is desirable insofar as it takes India towards a greater mass of companies with dispersed shareholding and avoids concentration of economic power.

However, for chronically loss making PSUs, the public at large is neither interested in buying shares, nor is it able to effect a transformation of management. For these firms, strategic sales are the best option, where full control of the PSU is auctioned off to the highest bidder. Some of these firms are in such bad condition with chronic losses and requiring regular infusions of capital, that the highest bid may be negative – the government should be willing to pay someone to take the PSU.

Normally the term ‘public sector’ includes activities of the government at all levels – central, state and local. These include defence, health, education, judiciary, police and other public utilities. Here, for the purposes of this paper, we refer to central public sector enterprises, companies that are owned and controlled by central government, as the public sector. Table 1 gives an indication of the size of this sector. There are 290 central government PSUs, including banks and insurance companies. These have an annual gross value added of Rs 2.8 trillion. Eighty-one companies out of the 290 have been partially privatised (listed). These 81 create Rs 1.8 trillion of gross value added per year, while the remaining 209 unlisted companies create Rs 0.9 trillion of value added per year. Thus the unlisted PSUs are roughly half the size of the listed PSUs.

While media discussions may suggest that India has moved sharply forward in establishing a market economy since 1991, a look at the data suggests that in some of the most important spheres the public sector continues to dominate the Indian economy. Nearly 55% of the value added in the organised sector in India is in the public sector. The government controls 56% of parts of the finance industry such as banking and insurance, and 81% of oil production and distribution. A key element of infrastructure is electricity and telecom in which 79 and 83% of the value added is in the public sector respectively (Table 2). These facts suggest that even though there has been an attempt to encourage liberal economic policies for many years, the public sector remains a dominant aspect of the Indian economy.

Let us now turn to the arguments in favour of disinvestment. Privatisation as a concept was first taken up energetically in the UK from where it spread to other OECD countries, and has since become a global phenomenon. It is part of the process of rethinking the role of government and trying to obtain higher levels of efficiency in resource utilisation. However, disinvestment is a complex process with multiple goals. The most important argument in favour of disinvestment lies in the improvement of efficiency. Why are PSUs inefficient in utilising labour and capital? Though there are many elements of reasoning which lead to this conclusion, the central theme remains that of incentives.

 

In a private firm, the owner has a strong incentive to ceaselessly watch changes in technology, changes in input or output prices, and the changing preferences of customers so as to constantly evolve the firm in the direction of lower costs and greater productivity. A company is not like a government department, where work goes on year after year in a mostly unchanged fashion. It needs to constantly react to changing prices, technology and preferences. In a PSU, there is no person or group of persons with an incentive to take interest in running the company effectively. The ceaseless process of watching prices, watching technology and watching consumers – and consequently ceaselessly reshaping the firm – does not take place in a PSU.

 

A key part of the problem lies in the human resource policies. A private company recruits from the broad labour market by paying market wages. The recruitment is done by senior people who are well incentivised to recruit the best candidate for the job. The firm then puts employees under strong pressure to perform. Well performing employees get promotions and bonuses. Those who fail to perform are penalised in many ways, ranging from wage stagnation to transfer to removal. This combination of carrot and stick gives employees in the private sector incentives to work. PSUs, in comparison, fail at all levels:

* PSUs do not recruit at market wages. They pay too much at junior levels – such as peons and drivers – and too little at senior levels. The salary of a CEO of a bank in India today is roughly Rs 1 crore per year. But PSUs try to recruit a CEO by offering only Rs 5 lakh a year. Since it is not possible to recruit an adequately competent person at this price, few of the CEOs of PSU banks in India today are good enough to get a job as the CEO of a private or foreign bank.

* Recruitment in PSUs is done by individuals who (themselves) have poor incentives to maximise the performance of the firm. A variety of conflicts of interest induce bad decisions in recruitment. Interference by the political system plays its own part in reducing the quality of recruitment. For example, the Banking Division of the Ministry of Finance, and the RBI, are known for meddling in recruitment decisions of banks. In contrast, neither have a say in who gets recruited in HDFC Bank or ICICI Bank or Citibank, where decisions are meritocratic.

* Once a person is recruited, PSUs fail to adequately incentivise the person. Whether a person performs well or badly, there is little variation in the wage. The probability of being sacked from a PSU is negligible. Under these circumstances, lacking either carrot or stick, employees have little incentive to work in the best interests of the firm.

 

Every firm procures raw materials and contracts out various services. A private firm is more likely to make such decisions in a meritocratic fashion, giving contracts to the best vendor, mixing strategic, technical and price considerations in the choice of the vendor. The procurement process of the public sector fails on these issues. On one hand, the rigidity of the procurement process frequently pushes in favour of contracting with the lowest bidder, without taking into account the considerations of strategy and technical merit. On the other, various influences which do not have the best interests of the PSU at heart come into play in trying to influence the procurement process. The huge delays in the procurement process also hurt the PSU, which is unable to match the rapid decisions of the private sector.

These difficulties amount to poor mechanisms for resolving the principal-agent problems between owners and employees of a company. In the best of firms, this principal-agent problem is a difficult one and can lead to poor behaviour on the part of employees. The institutional structures of PSUs involve extremely poor handling of this problem, and consequently result in low efficiency of utilisation of labour and capital.

The international empirical experience has thrown up evidence which is consistent with such arguments, and indicates that firms are more efficient after disinvestment. A number of research papers, which have examined the empirical evidence of disinvestment episodes in various countries, have found significant performance improvements after disinvestment, be it productivity, output and profits.

 

In the case of India, even when we consider the modest PSU disinvestment efforts of the early 1990s, recent research indicates that the sale of minority stakes had a positive impact upon firm performance and productivity. In a study of 40 firms over the period 1990 to 2000 in which only non-controlling shares were sold, Gupta (2005)¹ found that even with such partial privatization, the levels and the growth rates of profitability, labour productivity and investment spending improved significantly.

At the simplest, we can think about the direct impact upon GDP because of improvements in value added by the PSUs. The value added by 290 central PSUs was Rs 2.8 trillion which is about 10% of GDP. Amongst these 290 are 27 companies with negative value added, i.e. GDP would go up if these companies ceased to exist.

 

Each 1% of efficiency gain is roughly worth a GDP flow of Rs 28 billion per year. Thus the efficiency gains from privatisation are likely to be large. An international sample of 61 firms in 18 countries reported post-privatisation improvements of +27% in output and +45% in profitability. India’s public sector firms are likely to be laggards, by world standards, in terms of the efficiency of public sector firms. Hence, we may think that privatisation in India may yield a 30% to 50% increase in value added out of the existing labour and capital. In this case, the impact on Indian GDP – of full privatisation of all PSUs – might work out to somewhere between Rs 0.8 trillion to Rs 1.4 trillion per year. These are big numbers – between 2% to 4% of GDP. This suggests that privatisation policy alone can yield an additional 0.5% of GDP growth per year over a few years.

Another argument in favour of privatisation in most countries relates to the state of government finances. India too, like many other countries, is facing serious difficulties with fiscal deficits and the consequential growing stock of public debt. Disinvestment proceeds could directly help contain the situation if used to retire debt.

In India there has sometimes been excessive focus on the impact of disinvestment on public finances. For example, following the disinvestment of BALCO, the ministry of disinvestment argued: ‘The price received was higher than the values indicated by the various methods of valuation used. The government, thus recovered Rs 827.50 crore from this privatisation against approximately Rs 10 crore as dividend against the 51 per cent shares it used to get in earlier years, during the peak aluminium cycle.’

 

However, a narrow focus on maximising proceeds from disinvestment may be inappropriate for two reasons. First, disinvestment involves multiple goals, and to only pursue one of those goals would innately involve faring poorly on the others. Second, while proceeds do have a useful one-time impact upon the stock of debt, a more important link between disinvestment and fiscal dynamics is through the impact upon the GDP growth rate. An improvement in the GDP growth rate would impact on the flow of tax revenues, and on debt sustainability.

The UPA government has tried to argue that privatisation proceeds should be quarantined and deployed into the ‘social sector’. Such a position, reminiscent of the ‘education cess’, fails to understand the innate fungibility of resources within the state. Indian public finance policy would do better without these kinds of notions.

The implementation of disinvestment and the ensuing political economy is an equally important issue in the road to disinvestment. The two broad approaches that can be adopted for privatisation are ‘strategic sales’ (where a controlling stake is sold to one buyer) or ‘open market sales’ (where shares are sold to the public at large). In the Indian discourse, the former has been called ‘privatisation’ and the latter has been called ‘disinvestment’. We argue that in general the optimal strategy of disinvestment for profit making PSUs is open market sales and, for chronically loss making PSUs, is strategic sales.

Open market sales have been widely used in all major countries which have strong capital markets and democratic institutions. Table 3 shows a breakup of transaction mechanisms used in OECD. The summary statistic for OECD countries as a whole, in the decade of the 1990s, is that two-thirds of privatisation proceeds were obtained using public offerings of shares in the stock market. In Asia, countries like China and Korea have also predominantly relied on open market sales.

Open market sales could be done for a company that is already listed on the stock market, or one that has yet to be listed. An Initial Public Offering (IPO) is a public issue where the company gets listed for the first time. IPOs in the private sector in India today predominantly use the ‘screen based bookbuilding’ procedure, where an auction takes place on the NSE screen.

The stock market in India has made enormous progress in technology, whereby millions of investors now access the market using tens of thousands of satellite terminals and Internet trading. Mutual funds, banks and FIIs also exclusively trade through these computer screens. Thus, selling shares through these screens is a powerful tool for accessing a very large investor base, which includes Indian retail households, Indian institutional investors such as banks, insurance companies and mutual funds, and foreign institutional investors. This is in contrast with the narrow group of buyers who interact with GOI on strategic sales.

 

From an international perspective, strategic sales have been heavily used in countries which lack domestic capital markets, such as the erstwhile communist countries. This is not a constraint that India suffers from. The National Stock Exchange and the Bombay Stock Exchange are now amongst the largest exchanges in the world, measured by the number of trades per year, where they occupy ranks three and six respectively. The stock market mechanism in India today using electronic trading, clearing corporation deposits – coupled with vibrant equity derivatives markets – is now up to the best international standards.

In short, open market sales are the path to obtaining dispersed share ownership, leading to widely-held, professionally managed companies and creation of widespread shareholder wealth. In contrast, strategic sales are less competitive, involve politicised dealings between government and potential oligarchs, and can concentrate ownership in a few hands.

 

In every country, the movement towards a modern market economy has accompanied a shift away from family-run firms towards broadly-held companies owned by a dispersed mass of shareholders. This includes a framework for corporate governance including rules about disclosure, insider trading and keeping the management team under check by having a vibrant market of hostile takeovers. Though undoubtedly difficult problems, there is absolutely no question that India has to confront them and overcome them.

India has limited experience with the corporate governance problems of professional management teams with widely dispersed share-holding, where no one family has a controlling stake in the company. Yet, such a concept is not unknown to us. Some of the best-run and most-respected companies in India, such as HDFC and Infosys, are widely-held, professionally managed companies.

According to CMIE data, there are over 100 companies in India today where the ‘promoters’ control below 10%. In each of these companies, though the managing director and the rest of the top management team do not own a controlling stake in the company, yet these companies continue to function without being captured by other firms or individuals. This suggests that we do have requisite skills and institutions in the country in the creation and operation of professionally-managed, widely-held firms.

Disinvestment could be the vehicle through which we make progress on the important problems of corporate governance in the country. This would pave the way for a further flowering of widely-held, professionally managed companies in the years to come. PSUs which turn into private, widely-held, professionally managed companies could perform a valuable role in economic policy.

The incentives of employees of PSUs could be influenced by sale of shares, and employee stock option plans (ESOPs), whereby every employee in the company would end up having a stake in obtaining a higher stock price. This would serve to align the interests of employees with the interests of owners, and help improve the working of PSUs, since workers are then less likely to shirk work or steal from the company.

 

The disinvestment programme could explicitly target conversion of many PSUs into widely held, professionally managed companies. There could be provisions in the disinvestment mechanism that creeping acquisitions – which are currently regulated by SEBI – would not be permitted for a few years. For instance, there could be a rule requiring that no one individual or firm could own more than 5% of the firm for a period of three years. This would give time for the professional management team to develop modern corporate governance mechanisms.

If the disinvestment process is designed appropriately, it can lead to dispersed share ownership amongst crores of households with enormous economic and political consequences. It would help in sharing the benefits of disinvestment with the people of India; improve the stake in the functioning of the country as seen by households.

Through strategic sales, the company – with complete management control – is sold to the highest bidder. Three arguments which favour strategic sales are: (i) in some situations, the buyer brings in essential new technology or expertise, (ii) the buyer can exert sound governance inputs into the firm and has incentives to do so owing to the large stake, and (iii) the buyer can decisively displace government as the controller of the firm.

 

The public issue strategy will not work for chronic loss making companies as nobody might be prepared to buy them. There is a total of Rs 284 billion of fixed assets trapped in chronic loss making PSUs. They employ over 380,000 workers who received Rs 78 billion in salaries and wages last year. If these could be put to productive use, we estimate that there would be an increase in total production and income in the economy to the tune of Rs 400 billion.

These enterprises made a net loss of Rs 72.6 billion in 2004. Their accumulated losses have climbed to more than Rs 650 billion. Not only do these present a huge drain to the exchequer, they also keep resources locked up, preventing them from being put to productive use. Attempts made to revive them have failed. Some are sick because of government pricing and staffing policies, and others, such as the jute mills, due to sheer change in market conditions making them uncompetitive.

Of the 290 central PSUs, 92 are chronically loss making. These PSUs have accumulated losses for many years and continue to do so such that their net worth is now negative. The list is topped by the Fertilizer Corporation. It has accumulated losses of over Rs 100 billion. In 2004 it made a net loss of Rs 11 billion. If the problem is that of sacking workers, then it is easy to just pay them wages – the wage bill is only Rs 33.3 million – and privatise the rest of the firm. Similarly, the Hindustan Fertiliser Corporation has accumulated losses of Rs 85.4 billion. In 2004 it made a net loss of Rs 9.5 billion. It employs only 68 workers and pays Rs 49.5 million a year as salary. If GOI wanted to promise infinite job security to PSU employees – which is a questionable policy when the poor of India have no such comparable job security – it is still possible to pay them salaries on-budget while privatising the company.

It is unlikely that the public offering route, with no change in the management team, would work for these companies because there are few investors wanting to buy a minority share in a company that chronically makes losses. For these 92 companies the government must engage in strategic sales and bring in a new management team which believes that it can put the assets of the company to productive use. This has recently been done for the Great Eastern Hotel, Kolkata, that was owned by the West Bengal government and has been sold to the highest bidder, Bharat Hotels.

 

Sometimes it may be difficult to privatise these loss making companies even through the strategic sales route. The company can be in such poor shape, and saddled with such large obligations, that nobody in the private sector is willing to pay money to GOI to take on the responsibilities of the company. Yet, it remains important to take the company off the hands of the government and to utilise the resources that lie trapped within it. In order to do this, in a privatisation auction, the government should permit negative bids: a bid where government pays someone to take the company off its hands. Negative bids were an important part of the massive privatisation which took place in Germany after the end of socialism, and helped to rapidly get productive assets into the hands of efficient managers in the private sector.

Paying a management team to take over a PSU makes sense not merely because the government will not be paying the company year after year to cover its losses, but because this will lead to a better utilisation of resources. For instance, the fixed capital locked up in these companies, Rs 280 billion, can produce value when freed up. In the private sector the ratio of the value of output to gross fixed assets is 1.43. This means that the capital locked up in these PSUs can produce Rs 400 billion of output per year, which is over 1% of GDP.

 

Sometimes, bureaucrats argue that they will first spend money on a restructuring programme, nurse the company to health, and then sell it off at a positive price. An auction where negative bids are permitted is likely to give better value for money than the government implementing a restructuring programme where the new owner may have liked to spend the same money differently. The new owner has better incentives to spend the money in the most productive way. Instead of the government first spending money and then getting to a positive bid, it is better to accept a negative bid.

Overall we argue that the most important reason to disinvest is to increase productivity. Even partial privatisation achieves an increase in productivity. This can be achieved by listing of unlisted profit making PSUs. For chronically loss making PSUs the government needs to undertake strategic sales, where both negative and positive bids are entertained, so as to put underutilised labour and capital to productive use. The fiscal impact of disinvesment will operate primarily through the increase in GDP growth and tax revenue that disinvestment yields, and not through disinvestment proceeds.

 

Footnote:

1. N. Gupta, ‘Partial privatization and firm performance’, The Journal of Finance LX(2), 2005.