By W.A. Wijewardena –
The Annual Report of the Ministry of Finance and Planning for 2011, just released, has, among many others, one important positive message for the nation. It has reiterated the Government’s commitment, as it had done earlier too, to improving the performance of what it calls State Owned Business Enterprises or SOBEs to ensure their sustainability, social responsibility and strategic role in the economy. There is a four – fold strategy which the Government will pursue to attain this goal: management reforms, corporatisation initiatives, best corporate practices and higher investments (p 16). All these solutions are what a private company will do in a similar situation. Later in the report, it has diagnosed several ailments from which these SOBEs are suffering. These ailments, reproduced below, have been known all along to the country’s policy authorities. Though several attempts have been made in the past under such reform programmes as privatisation, peopleisation, placing them under a public enterprise reform commission or PERC and later replacing PERC with a strategic enterprise management agency or SEMA to do the same job and so on, these ailments have not answered to any of the medicines prescribed for them previously.
Diagnosis of ailment: Incompetency of those in control
The Ministry Report has identified the main ailments as operational deficiencies in SOBEs as follows:
a) Limited capacity to adjust output prices to reflect market conditions and profitability
b) Inadequate competencies in corporate management
c) Rigid outlook in addressing structural deficiencies in the organization to position them in the middle income country policy framework
d) Inability to separate the business focus from welfare objectives and development
e) Lack of proper business models with a long term vision
f) Contradictions in socio political considerations versus commercial business objectives
g) Over reliance on the national budget and concessionary foreign funds to improve their balance sheets, without making an effort to raise capital on the strength of their own balance sheets through improvements in commercial viability (p 209)
In addition to these seven deficiencies, the Ministry Report has identified serious governance issues (incompetence and ignorance of Chairmen and directors) and structural weaknesses like over staffing, bad human resource practices and lack of core skills in employees in SOBEs (p 209).
Three reasons for poor performance
All these deficiencies identified by the Ministry relate to the general inefficiency of the boards and managements running SOBEs and they all are critical to their success. But all of them point to three basic economic problems associated with such public operations. The first is the Moral Hazard Problem and the associated activation of what economists call the Gresham’s Law. The second is the Adverse Selection Problem that relates to the bad choices made by the Government. The third is the inability of the Ministry of Finance to get the SOBEs to deliver what it wants them to deliver, a problem known as the Principal – Agent Problem.
Incidentally, a Private Owned Business Enterprise or POBE would have tackled these three problems easily without allowing them to fester to such an alarming level as it has happened in the case of the country’s SOBEs.
Moral Hazard: Protecting and making state enterprises dependent
The Moral Hazard Problem, in relation to SOBEs, occurs when the Chairman, Board of Directors, management and employees of a public enterprise do not make even a simple effort to run an enterprise efficiently because they have the confidence that the Government will come to their rescue even if they continue to make losses, when their capital is all eaten up making them unfit to function as going concerns and when they are unable to borrow from banks on their own due to unsatisfactory financial records. Since there is no risk of losing jobs or having to close the enterprise, there is no incentive for them to acquire the competencies which the Ministry of Finance has identified as critical to a successful business. It leads to further deterioration of the performance of a public enterprise thereby passing a greater burden on the Government and through the Government, the tax payers of the country.
Gresham’s Law: Tolerate inefficiency once and then make it universal
When one enterprise is rescued by the Government in this manner, it sets a bad example to other enterprises thereby giving rise to the operation of what economists now call the Gresham’s Law. This Law is credited to Sir Thomas Gresham who wrote in 1558 to England’s Queen Elizabeth when she planned to issue cheap metal coins along with gold coins of same denomination to cut costs that she should not do so, because it will lead to hoarding of gold coins by people and use of only cheap metal coins for transactions. This is because when a person gets a gold coin, he has the incentive to hoard it because of the gold value in it. On the contrary, when he gets a cheap metal coin, he would use it as money because it, having the same denominational value, too could do the job of a gold coin. He warned the Queen that “bad money (cheap metal money) so released will drive out good money (gold coins)” thereby making the economic system filled with only bad money. Economists today use this proposition as a general rule called Gresham’s Law to describe any situation in which the toleration of an inferior thing will invariably lead to the elimination of the superior things in the system. Thus, if permitted to prevail, bad products will drive out good products, bad politicians will drive out good politicians and bad public enterprises will drive out good public enterprises and so on.
Adverse Selection: Put bad guys in high places and reap undesired outcomes
Adverse selection, again when applied to public enterprises, occurs when the chairmen, directors and top managers of public enterprises are selected from among a politically loyal group without considering the talents and skills which they should have to run these enterprises so that, once they are appointed, they do not have the required competencies to run the enterprises efficiently. These competencies are exactly the operational deficiencies identified by the Ministry of Finance in its Annual Report and reproduced above. When people realise that they do not have to have competencies but only the political loyalty to get appointed to a public enterprise, they would take part in politics purely for the purpose of acquiring a high position in a public enterprise. This increases the pool of political supporters from among whom an incumbent government can select for filling the places in public enterprises. Hence the selection is adverse, right from the very beginning, to the good performance expected of public enterprises. A Government may put bad people in high places, but then it should be ready to reap undesired outcomes that come along with that decision as well.
The Principal – Agent Problem: Unsupervised servant will always rob the master
The Principal – Agent Problem occurs when the Government, as the principal financing a public enterprise for a set of specific goals, is unable to exercise an effective supervision over the chairman, directors and top management of an enterprise – all are agents in this case – to attain the results which the Government wants them to deliver. Instead of using their talents, skills and competencies to deliver the principal’s goals, the agent uses them for his own personal benefits. Thus, the Government wants SOBEs to be efficient, productive and profitable; but the agent wants to maximise his own personal benefits. There are several mechanisms introduced by the Government to rein in the agents who are prone to misbehaving: Appointing a Finance Ministry representative to the Boards (an outside disciplinarian), getting the Auditor General to audit the financial records (independent detection of irregularities) and reviewing the performance of SOBEs by a Parliamentary Committee called the Committee on Public Enterprises or COPE (control by people’s representatives on behalf of the public). But none of these measures have been effective in getting the agent to the fold of the Government because as the Ministry Report has highlighted there has been a serious erosion of the governance in SOBEs. The chairmen and boards of some of the entities, according to the Ministry Report, do not adequately contribute to their performance and remain ignorant of their responsibilities. Worse, they have been in the habit of making important decisions when the Treasury representative is not there and without consulting the relevant Ministry or the Treasury (p 209).
Private businesses will not tolerate incompetency
A private business will not tolerate bad performance by its chairman, board of directors or the management and does not leave room for them to engage in moral hazard practices for long. In the very first instance these deficiencies are brought to light, the responsible parties will be called upon to leave the business enterprise without making further damage to it. Since it would select people based on merit, talents and competencies, they will not allow bad people to run the show and activate Gresham’s Law. Similarly, since people are selected on merit, the selection is not adverse but beneficial to the business right from the beginning. The Principal – Agent Problem is minimised by exercising an effective supervision by shareholders on the chairman and the board and on the management by the board. Hence, private businesses do not have to lament over the so called operational deficiencies in their businesses and they have the powers, commitment and willingness to tackle them before they become critical.
All stakeholders are to be blamed
So, who are to be blamed for the current pathetic state of the public enterprises of the country? All the stakeholders: the Government, legislators, tax payers and the media for failing to play their respective roles in exercising an effective supervision over them. The Government for failing to ensure professional management by allowing all the three economic problems mentioned above to creep into them and fester their operations, legislators for failing to raise vital issues in them without bringing narrow political biases or prejudices to the discussion, tax payers for being passive shareholders and the media for not effectively educating the members of the public about the sorry state of affairs in them are all to be blamed.
Operational profits or losses are misleading
Unlike the private companies which report net profits of their operations, the public enterprises are in the habit of reporting their operational surpluses or deficits and even then, before their accounts have been properly audited. Even the official sources such as the Central Bank and the Ministry of Finance have been reporting these operational surpluses or deficits to the public without any clarification in their official publications. This indicator is misleading on two counts.
First, the operational surplus or deficit does not provide a true picture of these enterprises because the operational outcome has not taken into account the depreciation and the financial costs incurred by them in running their businesses. Once these two items are charged to the operational accounts, even an operational surplus can become a net loss and an operational deficit can become a still bigger net loss. Hence, they do not report the true value which these enterprises have added to their shareholders, namely, the tax payers.
Second, there is no proper disclosure of all the items that have been included in the operational performance of these enterprises. Hence, the operational accounts which have not been audited properly could have been inflated by adding extraordinary incomes such as Treasury grants, the sale proceeds of fixed assets or revaluation gains of both fixed and financial assets. If this happens, in the absence of a proper disclosure, the operational surpluses or deficits fail to report even the true picture of the core businesses undertaken by these enterprises. Hence, to make a meaningful evaluation of their performance, it is not the operational surplus or deficit which one should look at but the net profits or losses that have been certified by a proper audit.
Gaping operational losses in key public enterprises
A salient feature of key public enterprises in Sri Lanka is, with the exception of state sector banks, gaping operating losses in them as reported by both the Central Bank and the Ministry of Finance in their Annual Reports. As mentioned above, operating losses are an underestimate of the true loss positions of these enterprises. Yet, they point to a direction toward which they have been moving in the recent past. According to the Central Bank, in 2011, CEB has incurred an operating loss of Rs 26 billion, CPC Rs 94 billion, CTB Rs 4 billion, Railways Rs 4 billion, Sri Lankan Airlines Rs 19 billion and Mihin Air Rs 455 million. Only the Port Authority and the Water Board have been able to record modest operating surpluses in 2011. These gaping holes in the key public enterprises have been a recurring feature throughout and it prompted the Minister of Finance in 2005 Dr Sarath Amunugama to refer to four of such loss making public enterprises, namely, CPC, CEB, CTB and Railways, as monsters because they were eating up public funds which could have been used for more productive purposes; but since then, as revealed above, Sri Lanka has added many more to the list of those monsters and year after year the list appears to be expanding without limit.
When public enterprises lose, so will the people
Public enterprises are funded by the tax payers, either by paying taxes in the current period if they are set up by Treasury funds or taxes to be paid by them in the future if such enterprises have been set up out of borrowed money. Hence, they constitute the properties held by people collectively. They are being placed under the custody of the Government in power and under them the bureaucrats who run these enterprises. It is the duty of both the Government and the bureaucrats to ensure that the public’s funds are not wasted by running them at losses. If losses occur in public enterprises, then, it is a clear violation of the public property rights of the people just like the violation of their private property rights. This is because both violations reduce the net wealth of people, the private violations individually and the public violations collectively.
Kautilya: Loss making in kings businesses is a crime
Kautilya, the 4th century BCE Indian economist, philosopher and statesman, branded the losses made in the king’s enterprises as a grave crime. He advised the king that if he looks after the receipts and expenditure of his enterprises properly, he would not find himself in financial difficulties. To make them worthwhile, receipts should be higher than expenditure or in other words, the enterprises should make profits thereby making a net addition to the king’s treasury. About the officials who manage the king’s enterprises, Kautilya said that if they do not eat up the king’s wealth or in other words do not make losses, they should be made permanent. But according to Kautilya, “he who causes losses eats up not only the king’s wealth but also the labour of the workmen” because the efforts of the labour in producing goods and services are wasted by the losses of these enterprises. They should be punished according to the nature of the offence: The amount lost by the officials should be recovered from them after taking into account the number of the workmen employed and the wages paid to them. The king should employ spies to find out how the losses have occurred. Kautilya has also identified common reasons for losses and, by a strange irony, they broadly correspond to the list of ailments in SOBEs identified by the Ministry of Finance in its Annual Report. According to Kautilya, revenue losses can occur due to ignorance, laziness, neglect, corruption, short-temper, arrogance and greed of those who manage king’s enterprises.
Thus, even in Kautilya’s time, loss making in king’s enterprises was not tolerated. If they occur and if they are tolerated, it is the people who have to provide funds for meeting such losses. To do so, the people have to sacrifice their wellbeing by involuntarily agreeing to run down their net wealth. This is exactly what happens when private property rights are violated. Then, the losses of public enterprises too amount to a violation of their public property rights.
(Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT – W.A. Wijewardena can be reached at email@example.com )
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