Viewpoin't The World Bank October 1995 Note No. 57 State-Owned Enterprise Restructuring Better performance through the corporate structure and competition Russell Muir and The modern corporation-as an by regulation (company and securities law, Joseph Saba ownership and management structure bankruptcy law). The interplay of the internal and external incentives causes the managers The legal structure of the modern corporate form to act in accordance with the goals of efficiency has four fundamental elements-separate iden- and profitability set by the owners-and causes tity, limited liability for shareholders, centralized the modern corporation to act with a clarity management, and transferability of shares. These, and singleness of purpose. The absence of any together with the dynamics of the governance of the internal or external incentives can seri- relationship between the owners (shareholders), ously undermine performance. the supervisory board (board of directors), and the executives of the firm, provide what can be The SOE-as a modern corporation called internal incentives for efficiency. Countries as diverse as Chile, New Zealand, The legal form, while necessary, is not suffi- the Republic of Korea, Sweden, and the United cient to ensure efficiency, however. In addi- Kingdom have tried, with some success, to re- tion to the internal incentives, certain external form their state-owned enterprises (SOEs) by incentives must be in place for sustainable ef- imposing on them the same framework of in- ficiency gains. Corporate performance is influ- ternal and external incentives that applies to enced by external pressures from competition the successful modern corporation. This Note in product, factor, debt, and equity markets and reviews the measures that appear to be the most crucial in improving performance. FIGURE 1 THE MODERN CORPORATION AS AN OWNEISHIP AND MANAGEMENT STRUCTURE' Internal incentives Owners Internal incentives External incentes Clarify the principal and agent incentives Principal and agent incentives are best clarified through three mechanisms. First, property rights should be defined, used, and accounted for un- andotas . -eparts : 'itL"Ut4t"g: der the same rules as pertain to modern private sector corporations. In practice, many SOEs have been operated as if part of a government agency. Often their accounts resemble those of a gov- ernment office and as a result cannot be relied op tes . - 3U_ ; on by creditors nor used to evaluate performance against similar private firms. Second, the corporation and its owners should have separate legal identities to insulate man- agement from political leadership. One of the Private Sector Development Department -Vice Presidency for Finance and Private Sector Development State-Owned Enterprise Restructuring to generate or preserve high levels of employ- ment. Whilte SOBs can act as model employ- ers, honor labor market legislation, and provide comprehensive benefits to employees, the re- ality of their employment strategies is not en- couraging. Many SOEs are overstaffed, with unacceptably low levels of productivity, absen- teeism well above the private sector average, and unbridled growth in nonmonetary benefits. These conditions place too heavy a financial burden on the enterprise and make targets set by the government unattainable. The tempta- tion to mix social and commercial objectives most common features of inefficiently run SOEs should be resisted. Governments should set has been continual intervention by the state's commercial objectives for SOEs and give them designated representative in day-to-day man- incentives similar to those that apply to pri- agement (to achieve noncommercial goals), to vate firms. Where social objectives are imposed, the detriment of the enterprise's profitability. the cost should be identified and the enter- prise fully compensated. Third, among successfully reformed SOEs, share transferability has turned out to be a fundamental Provide incentives to corporate participants attribute. In private sector firms, the residual risk bearers must have effective control over man- Effective internal governance for corporatized agement decisionmaking or have the ability to SOEs has been achieved when the state has pro- sell their ownership rights to new owners (for vided adequate incentives to boards, managers, example, through the sale of shares to a strate- and employees to meet commercial objectives. gic investor). But in SOEs, the residual risk is Efforts to seek efficiency gains through increased borne by the entire population-taxpayers and managerial autonomy in the day-to-day opera- consumers-which has no easy way to control tions of the SOE will inevitably fail if the finan- the enterprise or to sell its ownership rights. So cial rewards for management are insufficient. the incentives for state agencies to ensure that The more efficient reformed SOEs-such as SOEs perform efficiently are weakened. While Statoil, Semen Gresik (Indonesian cement), a corporatized SOE like Coalcorp in New Usinor Sacilor (French steel), and Coalcorp- Zealand or Statoil in Norway may look like a have all recognized that to attract and retain privately owned enterprise, it lacks the disci- top-level managers willing to assume their full pline imposed by residual risk. This deficiency responsibilities, the link with typically rigid and could undermine all the other reforms. Many inflexible civil service pay and conditions must countries, including New Zealand and the United be severed. These SOEs have offered terms and Kingdom, have confronted this problem by go- conditions more akin to the risks and rewards ing beyond restructuring and diversifying SOE in private firms and have sought to compete ownership. In some cases, these countries have with private firms in hiring experienced and fully divested SOEs to secure the full benefits of competent management. Incentives for employ- diversified ownership. ees-such as profit sharing and equity distribu- tion-have also worked well. Separate commercial from social objectives Put the private sector on boards Many SOEs are told to pursue a complex agenda of social and political targets that often It is important to establish a strong board struc- conflict with sales or profit-maximizing objec- ture to develop the overall strategy for the SOE tives. For example, SOEs often face pressures and to monitor the performance of management. BOX I SEMEN GRESIK: THE IMPACT OF THE INMAL PUBLIC SHARE OFFERING But choosing board members on the basis of strong political ties or alliances should be In JulyM91, Semen Gresik became the first Indonesian SOE to issue avoided. This usually encourages political in- shares on the Jakarta Stock Exchange in orderto finance a major terference in the day-to-day operation of the capital investment project This initial public offering comprised 27 business and will achieve little by way of im- percent of total share capital and generated about 280 billiorn npiah proved corporate governance. A more effective way~~~~~~~~~ of enuigta orspefr hi taUS$140, million). Of the new shares sold, about 85 percent are held by way of ensuring that boards perform their stra-r tegic and monitoring role is to introduce pri- foreigners, nwstly institutional investors. vate sector representatives. In Norway, Statoil The successful listing of the compaty has led to significant has had nongovernment representatives on its changes in the managemuent and oversight of the enterprise. First, board for some time, as have the French steel under regulation 5511990, the companybecame exempt from firm Usinor Sacilor, all the large Korean SOEs cumbersome government supervision and monitoring and onerous (known as government invested enterprises), and, more recently, Semen Gresik in Indonesia. government procurement rules, and it enjoys greater flexibility i the But experience shows that maintaining the dis- sourcing of funds. Second, comnpany performance has come under tance between politics and business is difficult. close scrutiny by the (ninority) private shareholders. Public reporting tn New Zealand, the SOEs that have not yet now takes place every three months, and companyfinances are been privatized have begun to suffer from the audited in line with intermational accounting standards by a reputed reemergence of interference from politicians. international auditing firm. Company pertonrance is also scrutinized Avoid large holding company structures by external financial analysts, who publish periodic evaluations of the attractiveness of Semen Gresik's shares for current and potential International experience suggests that the sig- investors. Management and government officials agree thatthe much nificant disadvantages of large holding com- closer scrutiny and the external pressures that have accompanied panies far outweigh any limited advantages they the listing of shares have led to greater transparency in the com- were perceived to have-such as centralized panysperformanceandcreatedagretersenseoaccottbilit by support services and economies of scale in pany Pfanemand creayeiagreaerensf auili by procureent. Hlding sructurs creat addi-company management for efficiency improvements. Whflile Semen procurement. Holding structures create addi- tional layers of bureaucracy, they fail to shield Gresik's perfonmance remained satisfactory in 1994, further improve- the operating companies in the group from ments in efficiency and financial perfomance are expected as a undue political intervention, they allow cross- result of new capital investmentscoming on streanm subsidization between the companies, and they distort signals and incentives for management. Finally, it is notoriously difficult to control their both its owner-the Norwegian government- growth and longevity once they are established. and its managers have been united in their re- Experience in France (Usinor Sacilor), India solve to match the efficiency levels of their (Hindustan Machine Tools), Italy (IRI), and larger private competitors in order to survive Turkey (Sumer Holdings), as well as in Alge- commercially, particularly in the absence of ria, Egypt, and Kazakhstan, amply demonstrates large state subsidies. Similarly, Coalcorp in New many of the drawbacks of these structures. Zealand has maintained acceptable financial performance despite hard budget constraints External incentives and competition from other energy sources. This success has been due in large measure to Encourage competition the pressure Coalcorp faces in the domestic market, from forty to fifty privately owned coal Perhaps the most important external factor in mining companies, and in the international mar- performance is the degree of competition that ket, where the company is a small player in a the enterprise faces. Statoil, the fully integrated highly competitive environment. The increases Norwegian oil company, has had to compete in Coalcorp's export sales in 1993 and 1994 vigorously in international markets against large are testimony to its emphasis on commercial multinational companies. As a consequence, practices and productive efficiency. State-Owned Enterprise Restructuring But governments sometimes prohibit competi- motivate improved governance can be created tion between SOEs, even when there are many by selling even a minority portion of the operating in the same sector, and restrict entry government's shares to the private sector. More or competition from private sector firms. The and more governments have done so in recent Indonesian cement industry comprises nine years (box 1). The market exerts an important companies, of which five-including Semen discipline on management, demanding infor- Gresik-are state owned. The government in- mation flows and, through pricing of equity, tervenes in the domestic market by setting re- evaluating management performance. Indeed, gional benchmark prices and by allocating experience suggests that there are in fact sys- regional markets on the basis of proximity, in- temic limits to SOE reforms that do not increase stalled capacity, and projected cement demand. private participation in financing, management, Exports of cement must be authorized and are and, especially, ownership. allowed only when domestic cement demand has been met. This market control system pro- Avoid complex monitoring vides Semen Gresik and the other producers with captive regional markets. The minimal Some countries-France, Indonesia, Korea, competition has led to supply bottlenecks and Mexico, New Zealand, and Pakistan, for ex- shortages. The government is therefore con- ample-have put a great deal of effort into de- sidering deregulating cement pricing and mar- signing elaborate monitoring systems. These keting to improve efficiency and provide systems usually include management controls incentives for investment in the sector. and complex formulas for various markets. Some are poorly designed: they distort incen- Improve financial discipline: The role of debt tives and are difficult to enforce. There is little hard evidence that these systems have been Creditors can exert a discipline akin to that im- able to develop and-equally important-main- This series is published posed by shareholders. But where the state as tain objective performance benchmarks that to share ideas and invite owner protects its corporations from that dis- reflect decisions that management can control. discussion. It covers financial and private cipline-usually by guaranteeing their debts- An efficient internal governance system coupled sector development as it removes a strong incentive for management with the discipline of external incentives works well as industry and to be efficient and it introduces the possibility better than these complex, centralized moni- energy. The views expressed are those of of moral hazard. All too often-as in Italy, Ja- toring schemes. the authors and are not pan, Pakistan, and Turkey, for example-gov- intended to represent ernments have been unwilling or unable to an official statement of This Note Is based on a paper by the authors, Improving State Enter- Bank policy or strategy. impose debt market discipline on SOEs through prisePerformance, TheRoleof isternaland Externallncentives(World the banking system. Turkey's Sumer Holdings Bank Technical Paper, Washington, D.C., forthcoming). The paper Comments are welcome. is a case in point With most loans to Turkey's analyzes the modern corporate forrn and summarizes the interna- Please call the FP pitTuky tional experience with state-owned enterprises. Eight SOE cases were Note line to leave a SOEs backed by government guarantee, man- chosen for detailed study: Semen Gresik (cement, Indonesia), Usinor message (202-458-11111) agement has faced little commercial discipline Sacilor (steel, France), Statoil (oil and gas, Norway), Coalcorp (coal, or contact Suzanne in investment decisions. Bad SOE loans have New Zealand), IRI (hoLding company, Italy), Sumer Holdings (hold- Smith, editor, Room ing company, Turkey), Hindustan Machine Tools (India), and Ksiaz G8105, The World Bank, become a major drain on the Turkish govern- Porcelain Factory (Poland). This case study sample is skewed to- 1818 H Street, NW, ment's finances. ward generally good performers drawn primarily from industrial and Washington, D.C. 20433, middle-income countries. The sample demonstrates just how diffi- or Internet address cult it is to achieve successful reform and to make it last while still ssmith7@worldbank.org. Improve performance through equity markets maintaining state ownership. ePrinted on recycled Where there is an active equity market, diver- Russell Muir, Senior Industrial Economist paper. sified sales of SOE shares or the dilution of (email: rmuir@worldbank.org), andJoseph government ownership through rights issues Saba, Principal Private Sector Development can do much to improve a company's perfor- Specialist (email: jsaba@worldbank.org), Private mance. Some of the external pressures that can Sector Development Department