Academic journal article Journal of Financial Management & Analysis

Formulation of a Model of Ineffective Privatization in the Context of Developing Countries

Academic journal article Journal of Financial Management & Analysis

Formulation of a Model of Ineffective Privatization in the Context of Developing Countries

Article excerpt

The author thanks, to name a few, S. M. Akram, Xu Cheng, David Goalstone, Guido Jesurum for their helpful suggestions. The author owns full responsibility for the contents of the paper.

Introduction

A model of ineffective privatization appropriate to the circumstances of developing countries is presented followed by a welfare-theoretic typology of various types of privatization, following Bhagwati's1 seminal paper. It is pointed out that in order to ensure that privatization increases social welfare, the authorities must satisfy a host of conditions.

The main theoretical argument in this paper is illustrated with the example of Bangladesh. Among developing countries Bangladesh is one of the pioneers in the privatization of public enterprises. Outside of the transitional countries it has undertaken one of the most extensive privatization programs2. The ineffectiveness of the program to bringing about a noticeable turnaround in the performance of privatized firms has been the subject of several studies, such as Sen2 and Akram3. The floundering experience of privatization of Bangladesh lends itself to a model of ineffective privatization. In contrast to Boycko, et al4, this model reveals that perverse post-privatization outcomes are possible because the firm retains a soft-budget constraint even after privatization.

Model of Ineffective Privatization

In many developing economies, including Bangladesh, privatization has been unable to deliver the promised benefits. Firms borrow from state-owned Nationalized Commercial Banks (NCBs) and Development Financial Institutions (DFIs) for financing deficits, for investment in new plants and equipment and for working capital, but fail to repay the state banks. Privatized enterprises, too, continue to rely on financing from state-owned banks. For the authorities the political cost of financing privatized enterprises, as measured by the politician's opportunity cost of handing over public funds to privatized enterprises, need not necessarily be less than the political cost of financing public enterprises, as measured by the politician's opportunity cost of handing over public funds to public enterprises. In a society where vertical ties are much stronger than horizontal ties, the authorities can benefit substantially from financing private and privatized enterprises. Even after privatization the authorities may connive with the management of the privatized enterprises to secure more loan capital than the socially optimal level. The case of Bangladesh suggests that privatization may not decrease state-directed credit and the volume of financing in a regime with weak institutions and bad governance. The authorities' cost of financing a private firm may not be greater than the cost of financing public activity. A simple model is presented below to demonstrate that after privatization the volume of misdirected credit might not decrease. Non-performing loans, misallocation of resources, inefficiency, and sub-optimum outcomes can still prevail and render privatization ineffective.

Incomplete Privatization

There are two players: The authorities and the manager of the firm. Suppose the share of the private ownership of the firm is (0,1). As [alpha][arrow right]0, the firm is under state ownership; as [alpha][arrow right]1, the firm is under private ownership. Here [alpha] can be interpreted in two-alternative ways. In "micro" terms, it is the private sector's share of a particular firm. Alternatively, in "macro" terms, it is the share of firms in the private sector. Correspondingly, (1-[alpha]) is the public sector's share of a particular firm, or public sector's share out of the total number of firms. Here, the "micro" interpretation is more natural. Privatization is simply the increase of [alpha], that is, the transfer of ownership, such, that the control of the firm's managerial decisions passes frpm the state to the private sector. However, the state either owns or controls the banks that are responsible for financing. …

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