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INTERNATIONALF INANCE

CORPORATION DISCUSSION PAPER NUMBER I

Private Businessin Developing Countries

Improved Prospects

Guy P. Pfeffermann

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INTERNATIONAL1 EJE@ FINANCE=_._J____CORPORATION

DISCUSSION PAPER NUMBER 1

Private Businessin Developing Countries

improved Prospects

Guy P. Pfeffermann

The World BankWashington, D.C.

Copyright ©) 1988 The World Bank andInternational Finance Corporation

1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing September 1988

The International Finance Corporation (IFC), an affiliate of the World Bank, promotesthe economic development of its member countries through investment in the privatesector. It is the world's largest multilateral organization providing financial assistancedirectly in the form of loan and equity to private enterprises in developing countries.

To present the results of research with the least possible delay, the typescript of thispaper has not been prepared in accordance with the procedures appropriate to formalprinted texts, and the IFC and the World Bank accept no responsibility for errors. Thefindings, interpretations, and conclusions expressed in this paper are entirely those of theauthor(s) and should not be attributed in any manner to the IFC or the World Bank orto members of their Board of Executive Directors or the countries they represent.

The material in this publication is copyrighted. Requests for permission to reproduceportions of it should be sent to Director, Economics Department, IFC, at the addressshown in the copyright notice above. The IFC encourages dissemination of its work andwill normally give permission promptly and, when the reproduction is for noncommercialpurposes, without asking a fee. Permission to photocopy portions for classroom is notrequired, though notification of such use having been made will be appreciated.

The complete backlist of World Bank publications, including those of the IFC, is shownin the annual Index of Publications, which contains an alphabetical title list and indexes ofsubjects, authors, and countries and regions. The latest edition is available free of chargefrom Publications Sales Unit, Department F, The World Bank, 1818 H Street, N.W.,Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenued'Ina, 75116 Paris, France.

Guy P. Pfeffermann is director of the Economics Department of the IFC and chiefeconomic adviser of the Corporation.

Library of Congress Cataloging-in-Publication Data

Pfeffermann, Guy Pierre.Private business In developing countries : improved prospects /

Guy P. Pfeffermann.p. cm. -- (IFC discussion papers ; no. 1)

'Published for the IFC."ISBN 0-8213-1130-11. Business enterprises--Developing countries. 2. Investments,

Foreign--Developing countries. 3. Privatization--Developingcountries. I. International Finance Corporation. II. Title.III. Series.HD2932.P46 1988338.6 1'091724--dc19 88-27402

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ACKNOWLEDGMENTS

The Discussion Paper is based on contributions by Dale R.

Weigel and Boris Velic (Economics Department), E. Peter Wright and

Helmn B. Nankani (Consultants).

TABLE OF CONTENTS

Page No.

Executive Summary . . . . . . . . . .1

I. Background .... . . . . . . . . . . . . . . . . 3

II. Growth Prospects . . . . . . .5

III. Prospects for the Private Sector inDeveloping Countries . . . . . . . . . . . . . . 8

IV. Privatization . . . . . . . . . . . . . . . . . . 13

V. Foreign Direct Investment . . . . . ... . . . . . . 27

PRIVATE BUSINESS IN DEVELOPING COUNTRIES:IMPROVED PROSPECTS

Executive Summary

The next two or three years look like being a period of moderateg::owth in world production and trade. In such a context continuedadjustment is a unifying theme for the private sector in different partsoil the developing world. This will call for difficult financial as wellas physical corporate restructuring.

However, structural adjustment also creates new private businessmpportinities:

- devaluation makes exports and import-substitution moreprofitable;

- trade liberalization offers the ready availability ofimported inputs and makes it possible for many firms toexpand exports;

- deregulation creates a freer environment for privatecorporations;

Firms have begun to take advantage of the new businessenivirorment. Investment and exports have picked up, among others, inMexico, Chile, Ghana, Morocco, Pakistan, Korea and Thailand.

With structural adjustment many governments have improvedconditions for foreign direct investment:

- restricted sectors have become fewer;

- screening procedures have been simplified;

- the share of enterprises which may be owned by foreignershas been raised;

- new investment incentives have been created;

- restrictions to the transfer of profits have been relaxed;

- perhaps most promising, debt/equity conversion schemes havebeen created, which enhance investment opportunities; theseschemes have been very successful in attracting new privateforeign investment.

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Many developing countries have embarked on privatizationprograms which should open up new business opportunities. Privatizationis seen as a way of reducing the politicization of the economy, relievingthe budget of public enterprise financing, raising cash for thegovernment, improving enterprise management and mobilizing additionalsavings for development. Significant privatizations have now beencompleted in about 20 developing countries and plans are well advanced inanother 15. Although privatization is a slow process, it reflects a mostimportant change of policy which has led to a distinct improvement in theclimate for private investment in many parts of the Third World.

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I. Background

After decades of growing state involvement in development andmany years of government hostility to private foreign investment, thingshave been changing over the past few years, and business prospects in thedeveLoping countries have taken a distinct turn for the better. Thispape:r deaLs with this historic improvement which is part of theworld-wide efforts at structural adjustment. It addresses the question:what lies in store for private business? Particular attention is paid torecent trends in foreign direct investment and to privatization efforts.

Remarkable progress has been made over the past 20 years inbuilding up the economies of what are now called the middle-incomecountries, and of some of the most populous of the poorer countries aswell, Between 1965 and 1985 no fewer than 17 of these countries with acomb:ined population of 1-1/2 billion (500 million even without China)achieved an annual average increase in per capita GNP of 4 percent orbetter. Another 16 countries with a population of 375 million averagedbetween 2-1/2 and 4 percent a year--and these are per capita figures,implying in most cases increases in total production of 5 percent a yearor more. At that rate GNP doubles every 14 years or less.

Of course, it is an uneven picture, with some impressive successstories in East and Southeast Asia--Korea, Thailand, Malaysia, Indonesia,ChinaL, not: to mention Hong Kong and Singapore--while much of sub-SaharanAfrica andl one or two major countries elsewhere (Bangladesh, for example)have barely progressed at all. Indeed, there are a few countries inAfrica and Latin America where living standards are actually lower nowthan they were 20 years ago. But the weighted average for all developingcountries over the past 20 years is an annual growth rate in per capitaGNP cf 3 percent, and by historical standards that is a tremendousachievement.

It could not have taken place if the economies of the industrialcountries had not been growing as well, providing the developingcountries with expanding markets for their exports--manufactures as wellas primary products--and supplying most of the capital goods andintermediate products needed for the transformation of industry andagriculture. Prior to the first oil shock in 1973-74 per capita GNP inthe OECD countries was rising at an annual rate of nearly 4 percent.This slowed down to 1.7 percent during 1973-80 and only 1.5 percent inthe years since 1980. Per capita growth in the developing countries hasslowed down in parallel from 3.7 percent a year to 1.6 percent a year.

Interdependence is, of course, a two-way process. While thedeveloping countries depend on the growth of demand in the industrialcountries, the reverse is also true: growth in the developing countriesacts -is a stimulus to the economies of the industrial countries. Thecombinied GDP of the highly-indebted developing countries in 1985, which

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include most of the population of Latin America, is about $800 billion,some 25 percent larger than that of the Federal Republic of Germany. TheGDP of the oil exporters is about the same as that of France. Altogetherthe developing countries constitute a market larger than Japan and equalto nearly 50 percent of the United States. This means that the recentslow-down of developing country growth has been one of the factorsholding back the growth of output in the OECD countries.

Two groups of developing countries which have been particularlyhard hit in the last few years, in addition to sub-Saharan Africa, arethe oil exporters and the heavily-indebted countries, with severalcountries--Mexico, Venezuela, Nigeria, Ecuador--belonging to bothgroups. The economies of most of the heavily-indebted countries havebeen virtually stagnant since 1980, and their per capita consumption hasactually fallen, in some cases quite severely (Brazil and Morocco are theprincipal exceptions). China, India and Pakistan on the other hand havefared relatively well, at least until last year when India experiencedone of the worst droughts of this century. Middle-income exporters ofmanufactured goods which did not borrow excessively have also managed tomaintain the momentum of growth: Korea, Malaysia and Thailand all fallinto this category. Even in sub-Saharan Africa there are a few countrieswhich have sustained high rates of growth in the 1980s: Cameroon is anotable example.

The adjustment problems of the developing countries in the 1980shave been seriously aggravated by the higher cost of borrowing, coupledwith a marked deterioration in their terms of trade. Prices of both foodand industrial raw materials fell on average by 20-30 percent between1980 and 1986, while the prices of manufactured goods exported by theindustrial countries rose slightly. Countries heavily dependent fortheir exports on commodities such as tin, bauxite, copper, rubber, cocoaand groundnuts have suffered a major loss of income on this account,although copper prices staged a marked recovery in the second half of1987. The sharp drop in petroleum prices was a phenomenon of the lasttwo years.

The oil exporters, the highly-indebted countries and thecountries of sub-Saharan Africa have all experienced major cutbacks intheir levels of investment during the past five years, and only a handfulof these countries are showing signs of sustained recovery. Theirnear-term prospects remain at best uncertain. Indeed, in many of thehigh-debt countries the savings required to finance foreign interestpayments abroad are so great that domestic interest rates have beenpushed up and private investors crowded out. In spite of the innovationsin financial engineering of the past few years, the debt burden of thesecountries has not diminished in relation to exports or GDP. A more rapidresolution of the debt crisis would undoubtedly make adjustment easier,and for some countries a reduction of the debt overhang may be anecessary condition for the resumption of sustainable growth.

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II. Growth Prospects

For the developing countries as a whole, the most importantexternal determinant of growth is the level of economic activity in theindustrial countries, particularly those which are members of the OECD.Fear-s of an impending recession, stimulated by the stock market crashlasi: October, continue to haunt the pessimists amongst the businesscomxaunity, but so far demand in the OECD countries appears to have beenwel.L maintained, and in several of these countries production in 1987exceeded official forecasts made at the beginning of the year. Likewisethe volurme of world trade last year increased by 4 percent, which was adistinct improvement over 1986. Continued low rates of inflation andsome stabilization of exchange rates in recent months are encouragingsignis. While the stock market decline must be expected to have somenegative impact on consumer spending, particularly in the United States,most: official observers are still looking for output in the industrialcountries to rise in 1988 and 1989 at the rate of 2-1/2 to 3 percent ayear--that would be about the same as last year, but 1/2 to 1 percentless tharn the annual average over the 1983-1986 period. The possibilityof EL more severe slow-down cannot, however, be entirely discounted.

For the United States, the increase in exports as a result ofimproved competitiveness should go some way to offset any slow-down indomestic consumption, while the reverse is likely to happen in Japan,with increased demand for consumption and investment at home more thanmaking up, for any slow-down in exports. The Japanese economy isremarkably buoyant. German exports are likely to decline further in 1988and 1989, and the expansion of domestic demand may continue to beconstrained by the pursuit of cautious fiscal and monetary policies.With similar caution in France, and the possibility of a significantdeterioration in the United Kingdom's foreign balance, the growth of theEurcpean economies can be expected to lag behind Japan, with the UnitedStates probably somewhere in between.

The slowing down of growth in the industrial countries and thecontinued high levels of unemployment in Europe have understandablyresulted in increased demands for the protection of domestic industriesand in the proliferation of non-tariff barriers to manufactured importsfron developing countries, especially in textiles and steel. Inagriculture, of course, export opportunities for the developing countrieshave long been severely restricted by the support given to farmers in theindustrial countries. While the Uruguay Round of multilateral tradenegotiations under GATT provides a vital opportunity for lowering thesebarriers, it would be unrealistic to expect the pressure for protectionto subside unless there is a noticeable acceleration in the pace of worldeconomic growth.

Nevertheless, in spite of all this pressure, energetic exportershave not 'been deterred from selling abroad, and quite a number ofdeveloping countries have succeeded in maintaining high rates of export

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expansion in the 1980s--above 10 percent a year in Turkey, Portugal,Korea, Mexico and Cameroon; between 5 and 10 percent a year inBangladesh, China, Sri Lanka, Thailand, Brazil, and many others. In allthese countries except Cameroon, manufactures have accounted for asizeable share of overseas sales.

Developing countries with diversified exports, includingservices, will probably continue to fare better than those which aredependent on primary products for the bulk of their overseas earnings.There is no reason, however, why the latter should experience any furtherdeterioration in their terms of trade comparable with that which hasoccurred in recent years. World prices for non-oil commodities haverisen sharply during 1988, returning, on average, to their 1979-81 levelfor the first time since then. While forecasts of commodity prices arenotoriously fallible, no dramatic changes are presently in sight, and thevolume of trade in primary products should continue to grow slowly.

Interest rates in international capital markets are anothermatter of great concern to the developing countries, particularly, ofcourse, to those already carrying a heavy burden of debt. Six-monthLIBOR for dollars fell from almost 10 percent in 1983 and over 11 percentin 1984 to around 6 percent at the end of 1986, but then rose during mostof 1987, ending the year close to 8 percent. It would be optimistic toexpect it to fall much below this level: indeed, there has recently beensome hardening of rates as a result of measures to restrain demand in theU.S. and protect the U.S. balance of payments.

The developing countries are now spending more on servicingtheir external debts than they are receiving in new borrowing. For thehighly-indebted countries as a group this is a reflection of the sharpreduction in new commercial bank lending. At the same time, a number ofEast Asian countries have taken advantage of the surge in theirmanufacturing exports deliberately to reduce their indebtedness. Thecommercial banks in North America and Western Europe are showing littleenthusiasm for fulfilling the role assigned to them under the Baker Plan,and the heavily-indebted countries will continue to have difficulty inattracting new lending. On the other hand, there should be a significantincrease in the net flow of official development assistance, which hasbeen running at around $25 to $30 billion a year; this will mainlybenefit the indebted countries of sub-Saharan Africa for which specialmeasures of concessional aid were recently agreed under the auspices ofthe World Bank and the International Monetary Fund.

More important for the private sector is the flow of directforeign investment, which has amounted to only $11-12 billion net in eachof the past three years, far less than in the past; except for investmentby Japanese firms most of it is being financed out of retained earnings

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rather than the injection of fresh capital. It is heavily concentratedIn a few large countries, with China, Brazil, Mexico, Egypt, Argentina,Colombia and Malaysia prominent among them. There has been a large surgeof new foreign investment in China which accounted for nearly 40 percentof all direct foreign investment in Asia in 1986. Preliminary datasuggest that foreign investment flows increased during 1987.

In short, the years ahead look like being a period of moderategrowth in world production and trade. Accordingly, the possibility ofthe external environment providing any fresh stimulus to the expansion ofthe developing countries' economies appears for the moment to be fairlyxemote. It would be imprudent, moreover, not to recognize the risks onthe downside stemming from the recent instability of financial marketsand the persistent trade and payments imbalances between the leadingindustrial countries. If things go reasonably well, and a concertedeffort is made to correct these imbalances, growth of output in thedeveloping countries this year and next could be in the 4-5 percent ayear range, which would be about one percentage point better than in eachof the past two years.

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III. Prospects for the Private Sector In Developing Countries

Structural Adjustment

In a context of moderate growth in the world economy, adjustmentis the name of the game for the private sector throughout the developingworld. This is clearest in Latin America, where prospects are depressedin most major economies by heavy external debt, and where countries arebeing forced to restructure their economies in order to save more andincrease production for export. The private sector has been the mainvictim of the debt crisis. Most of the massive borrowing which caused itwas done by governments. Now the private sector is bearing the burden ofgenerating the surpluses needed to service the debt. Private sectorresources are transferred to governments through higher taxes and throughinflation; the private sector is also penalized by crowding out, whichraises interest rates. It is no coincidence that many of the high-debtcountries are experiencing unprecedented inflation, which increasesuncertainty and risks for the private sector. In short, privateinvestment is depressed largely because of the need to service governmentdebt.

Likewise, in Sub-Saharan Africa, declines in GDP and balance ofpayments difficulties have forced many countries in the region toundertake adjustment programs designed to encourage efficiency ofresource use. However, the weak international markets for Africa'sprimary exports (and most countries depend on one or few commodities),the huge debt overhang, and reduced resource flows reflected in depressedimport levels are major concerns for the private sector.

The countries in South Asia voluntarily began to liberalizetheir economies in the late 1970s/early 1980s in order to increaseefficiency by giving greater scope to the private sector and byincreasing imports and exports. As a result, both India and Pakistanhave enjoyed substantially higher rates of growth in manufacturing thantheir post-independence averages. This growth is likely to continue.China likewise has begun to open the economy and provide greater scopefor private initiative in order to increase efficiency and productivity.

In East Asia, Thailand and Korea are expected to continue theirimpressive growth performance--with Thailand a new entrant to the club ofnewly-industrialized nations. After years of political disruption andpressures created by the external debt overhang, prospects in thePhilippines appear to be brighter--reflecting an upsurge in manufacturingexports and a revival in investment, which led to a 5 percent increase inGDP in 1987. Malaysia and Indonesia have been affected by adversemovements in their terms of trade, but prospects have improved followingsome revival in commodity prices and a strong effort at adjustment,particularly in the case of Indonesia.

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The mix of and severity of adjustment required depend on whetherit is f'orced or voluntary, and on the political will to make fundamentalchange. The essential components involve a revamping of the externaltrade sector (e.g., devaluation, import liberalization), liberalizationof' controls in the domestic economy (e.g., price controls, investmentlicensing), a move to economic pricing of inputs (e.g., removal ofsubsidies for utilities, energy, fertilizers), and a shift in therelative roles of the public and private sectors. Adjustment policiesof'fer both challenges and opportunities to the private sector.

Real devaluation causes distress among firms which had borrowedexcessively in foreign currencies but it also pulls resources intomanufacturing and agriculture and makes exports and import-substitutionmcre profitable. Real effective exchange rates have depreciatedsubstantially between 1982-87 in fifteen out of the seventeen heavilyirdebted middle income countries classified as such by the Bank../

In some countries of Latin America, such as Mexico and Chile,exports have been booming as a result. Mexican non-oil exports haveirncreased rapidly, particularly automotive products, tourism and borderir.dustry exports. Firms which are partly or wholly foreign-owned haveplayed a crucial role in this positive response and their share ofmanufactured exports has risen from 30 percent to nearly 60 percent sincethe early 1980s. Chilean agricultural and agri-business exports haveincreased by 60 percent over the past three years, reaching about $800million in 1987. Opportunities for the private sector also have openedup in Africa, following devaluation of the local currency (e.g., inNigeria and Ghana). Non-oil exports have been increasing since theadjustment program was introduced in Nigeria, and some previouslysHuggled products are being exported through official channels.

1/ Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Coted'Ivoire, Ecuador, Jamaica, Mexico, Morocco, Nigeria, Peru,Philippines, Uruguay, Venezuela, Yugoslavia.

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Trade liberalization is another component of adjustmentprograms. Often combined with devaluation, it involves an eventualreplacement of quantitative restrictions on imports by tariff protection,with tariff levels to be reduced and made more uniform. This has beentried in a number of countries including Mexico, Chile, Bolivia, Korea,Philippines, Turkey, Morocco and Ghana--and is being attempted inNigeria. The first impact of trade liberalization is to expose thedomestic private sector to import competition, but the freer availabilityof higher quality imported inputs has permitted a substantial improvementin product quality, making it possible to expand manufactured exports.This kind of effect has been seen in most of the countries mentionedabove.

Deregulation has also been a common element of structuraladjustment programs. It improves the business climate by allowing marketforces to assert themselves and by reducing the cost of lobbying andnegotiating with government over licenses and other permits. Severalcountries have created "one-stop" agencies where many administrativesteps used to be required. The relaxation of price controls cuts bothways: firms which used to benefit from artificially cheap inputs such asenergy may suffer, but many firms will find themselves able to sell theirproduct at higher prices. Financial sector liberalization also opensdoors to private firms; it reduces credit rationing, which is usuallyrisk-adverse, by freer interest rate determination, which improves thechances to obtain credit for bolder ventures. Reduction in licensingrequirements for new investments is generally welcomed by the privatesector, though even in this case existing firms may be adversely affectedby freer entry. These changes are being made in a variety of countries.

Challenges and Opportunities

When governments adopt the structural adjustment policies,particularly when they do so under duress, private firms often respond byvarying degrees of restructuring. They may attempt to weather the stormthrough the accumulation of payables and deferment of debt obligations.A next stage often involves some liquidation of assets. Companies whichsee some potential in tapping opportunities arising from the new pricestructure created by devaluation and trade liberalization might thenstart physical restructuring, adding new product lines or processes whileeliminating some others. Modest investments are required at this stage.Lastly, a full recovery in investment, including large greenfieldundertakings with long gestation periods, is a sign that structuraladjustment is working.

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Physical corporate restructuring tends to occur in countrieswhich have basically outlined the complete content of their adjustmentprograms, and where the intent to implement adjustments is not in doubt.In contrast, mere refinancing is more likely to occur when economicpolicies are seen as short-term in nature and do not provide a basis forthe more comprehensive business restructuring that is essential in mosthigh-debt economies.

In Latin America the high-debt countries except Peru andVenezuela have gone through the financial stages of restructuringpunctuateid by numerous bankruptcies. Physical restructuring is wellunderway in Chile, Mexico and Jamaica. Colombia, having started theeighties with a much lower inflation and debt, has had to undertake amuch more modest adjustment. Greenfield projects are developing inChils, Colombia and Venezuela. In the first two countries, this reflectsadjustment programs. In Venezuela, while the overall process ofadjustment has only just begun, the contraction in oil revenues has ledto thae promotion of non-oil exports and import substitution. Prospectsare good for the establishment of joint ventures to tap into thecountry's vast natural resources, especially petrochemicals based onnatural gas and energy-intensive industries.

Special mention should be made of Brazil, the largestmiddLe-income country. Brazil has diversified its exports to aremarkable degree. Coffee, formerly a major export, only accounts forabout 10 lpercent of the total today. Manufactured exports now make upmore than half. This has not been a result of trade liberalization:BrazLl's uniquely large market has meant a high degree of internalcompetition. Consequently it is easier for Brazil to switch from homesales to exports than for most developing countries. Furthermore,BrazLl's debt is smaller relative to the size of the economy thanMexico's or Argentina's. The country's recent economic difficulties arecaused by the large public deficit and by political uncertainty ratherthan by deep-seated structural problems. Moreover, the incentivesframework favors exports. Despite the unsettled course of the economy,there are indications that years of low investment in new assets haveresu:Lted :in capacity constraints in a number of sectors. Selectivegreenfield projects continue to be implemented. Brazilian firms facemuch better medium-term market prospects than firms in most otherhigh debt countries.

In Africa, the process of corporate restructuring is furthestalong in Ghana and Morocco, where manufacturing investment is picking up,as well as in Cote d'Ivoire. In Nigeria, until the reforms of 1986, mostof the corporate sector was in distress. Since 1987, some investment isbeing planned as companies are better able to discern the long-runframework which is likely to prevail.

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Business prospects in Asia are promising owing to the morefavorable economic outlook for most countries. There the process ofeconomic change has been more in the nature of voluntary continuousadjustment as opposed to the more abrupt changes being forced on othercountries. Even in the Philippines, one of the high-debt countries,limited investment for modernization, export, and increments to capacityare being contemplated. In Indonesia, the corporate sector is respondingto trade liberalization and limited deregulation. In Korea and Thailandprivate firms are dealing with the challenges created by growth andeconomic success. Major greenfield investment for the growing domesticmarket are occurring in Thailand.

For the private sector in South Asia, adjustment has essentiallymeant deregulation, involving reduced licensing requirements, liberalizedimport policies, relaxed price controls, freer foreign investmentapprovals, and a greater role in investment in the productive sectors--aspublic sector growth has been reined in. There has been a sharp spurt inprivate investment in both India and Pakistan and prospects remainbright. In India, the relaxation of government controls on entry intoindustry has created its own problems, however, as private sectormanagements grapple with the new environment in which a license toproduce is not necessarily a barrier to further competition. Similarly,the entry of foreign investors, some into sectors previously discouraged,has raised the quality of products in the domestic market and threatenedthe profitability of established manufacturers. Despite the short-rundisruption caused by some of these measures, the longer-run impact onoverall economic growth and on the ability of the Indian private sectorto penetrate export markets will be enhanced by the ongoingliberalization. A greater extent of corporate restructuring may well berequired in the South Asian context in the future.

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IV. Privatization

A decade ago the concept of privatization as a force foreconomic change was barely acknowledged; today the concept is recognizedand the reality flourishes in both the industrialized and the developingworld.

Not surprisingly, this success story has spawned a great deal ofrhetoric, principally in the form of ambitious government announcementsof privatization programs, and of premature claims of success fromenthusiastic observers.

How does the reality compare to the rhetoric? In recentexperience of privatization world wide, what difficulties haveconstrained and what advantages have eased the progress ofprivatization? What do the trends imply for private sector developmentand foreign direct investment? These are the questions addressed here.

In particular, this paper makes the case for the following threepropositions:

- Rhetoric and Reality. The reality of privatization, accordingto the empirical data, is far less impressive than the rhetoricwould suggest. But the reality should not be belittled: muchhas happened in six years. Empirical data do not capture thefull story, particularly if account is taken of the broaderphenomenon of divestiture;

- Constraints: Some clear impediments to the progress ofprivatization can be identified, principally: political economyconsiderations, high transaction costs, and the practicalproblems associated with its implementation;

- Some Prerequisites of Success. Despite the relative lack ofprogress, perspectives are emerging on what features underliesuccessful privatizations, among them: strong politicalcommitment, a pragmatic and creative approach that exploitscountry-specific opportunities, and a focus on private sectorincentives.

In what follows, the words "privatization" and "divestiture" areused in the sense suggested by Mary Shirley (1988):

"Divestiture can mean (i) liquidation, both formal and aninformal form of mothballing, whereby operations are suspended, butthe enterprise retains a legal and economic life; (ii) privatizationDf ownership through the sale of the firm as a going concern or ofall or part of the assets; and (iii) privatization of managementthrough leases and management contracts."

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Shirley goes on to note that divestiture encompassesprivatization of ownership and/or management, as well as liquidations;and that the broader concept of privatization includes various forms ofderegulation of markets.

This paper addresses the concerns of the Development AssistanceCommittee of the OECD and deals with privatization in developingcountries. Nevertheless, examples which are useful to developingcountries are also drawn from selected OECD countries. Throughout, theword "sector" refers to the commercially-oriented state-owned enterprisesector.

The Rhetoric and Reality of Privatization

Before 1979, privatization was virtually unheard of. Yet withinabout seven years, privatization is being proclaimed as "the mostrevolutionary innovation in the recent history of economic policy" (Hanke1987). A forthcoming book by Rothschild, entitled "Privatizing theWorld," proposes to offer governments the tools to turn overgovernment-owned enterprises to the private sector. Privatization issaid to be sweeping -- and changing -- the developing world (McPherson1987). Such pronouncements have, in fairness, been a response togovernments' ambitious announcements of their intentions to dispose oftheir enterprises. In the last six years, governments of economies fromTogo and Bangladesh to Argentina, Brazil and Mexico, have announced plansto sell the state-owned enterprises to the private sector.

The Government of Brazil, in November 1985, promulgated aprogram to privatize 120 state-owned enterprises, of which 52 wereidentified as of high priority. The Mexican government announced itsintention to privatize a large number of the 1155 parastatal entitiesthat existed when the 1982 debt crisis commenced. In Argentina, theAlfonsin government has, since the initiation of the Austral plan inmid-1985, sought to implement a restructuring of the public sector,including a major privatization effort.

In Nigeria, in his first broadcast soon after assuming power,President Babangida singled out four fundamental issues for urgentattention, one of which was "the large role played by the public sectorin economic activities with hardly any concrete results to justify thatrole." Privatization was soon declared "a priority of priorities."(This Week, September 15, 1986). Malaysia produced a set of "Guidelinesto Privatization." Expensive studies were undertaken in severalcountries, including Turkey, Jamaica and Ghana, to study the sector. InLatin America, countries appeared ready to sell, on the average, about25% of their state enterprises and in the African context, on theaverage, the corresponding number was about fifty percent (see below).

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But this rhetoric, as the data comparing the differentcDuntries' targets with their achievements (Table 1) reveals, has faroutpaced the reality. The picture that emerges from the Table withrespect to the actual privatizations that have taken place as of January1988, is disappointing.

A word of caution about data on privatization. Such data aredifficult to come by, and when available are based on numbers ofenterprises rather than the value of assets, employment or value-addedinvolved, and this can be misleading. For example, the forty enterprisesout of the 260 to be divested (targeted) in Turkey, represent 40% of thecDuntry's industrial production and over 30% of fixed investment, whilethe thirty enterprises (out of 130) to be divested in Ghana are mostlysmaller enterprises, some of whose operations have been informallysuspended. The numbers in Table 1 are therefore merely indicative ofbroad orders of magnitude.

With the appropriate caveats taken into account, the numbersshow tlhe Latin American countries (excluding Chile) to have, on theaverage, privatized about 17% of targeted enterprises. The correspondingnmuber for Africa (excluding Zaire and the Ivory Coast) is also about17%, w]hile that for the few Asian countries for which there are data ishigher, at about 30%. Thus, in Brazil, to date only a few unimportantstate-owned enterprises have been privatized: of total net assets in thesector valued at $40 billion, those privatized represent only $27million. In Mexico, since 1982, it estimated that less than 1% of thet.otal assets of the parastatal sector have been sold. In Argentina, a1387 resview concluded that far-reaching privatization plans initiated in1381 have been implemented only slowly. Generally in the Africancontext, the enterprises involved tend to be not significant in terms ofasset value (Berg 1985). In Zaire, most of the enterprises involved wereknown to be small farms (and therefore, cannot be counted as significantprivatizations). Only in the Ivory Coast has reality exceeded rhetoric.In Nigeria, despite the plans announced by President Babangida, no majorSDE has been privatized. The story is not very different in Turkeywhich has undertaken a far-reaching study of privatization options buthas not divested any major enterprise either. What explains this widegap between rhetoric and reality?

Since some of the Asian and Latin American countries aremiddle-income countries with reasonably well-developed capital markets,t'he usual argument that weak capital markets hinder privatization appliesless forcefully than in say, the smaller African countries. Essentially,this gap is explained by the finding (amplified in the next section) thatprivatization has turned out to be a slow, complex and difficultprocess. But some part of the gap can be attributed to the differencebetween privatization and divestiture: Table 1 attempts to measureprivatization of ownership and management rather than the broader issueoE divestiture which includes liquidations -- both formal and informal.Divestitures in the form of "creeping liquidation" and "back-doorprivatizing" (Berg 1987) have apparently been administratively and

Table 1: RECENT PRIVATIZATION OF PUBLIC ENTERPRISES

1 2 3 4 5 6 7 8Total Total or Total Ratio ofNumber of Targeted2-' Partial Number of TargetedNon-Financial Number of Sales of Management Privatizations Privatization Liquidation

Region/Countr Enterarises.' Privatization Enterprises Contracts Leases (6=3+4+5) (7=6 2) Closures

AFRICA

Cameroon 150 60 1 16 NA 17 .28 5Ghana 130 30 0 1 0 1 .03 0Guinea 181 43 17 NA NA 17 .39 16Ivory Coast 147 20 28 3 NA 28 1.40 15Kenya 113 20 NA NA NA NA NA 5Liberia 21 7 0 0 0 0 0 0Mali 57 28 2 1 1 4 .14 7Niger 45 28 11 0 0 11 .39 3Nigeria 3002' lOO 0 0 0 0 0 0Senegal 188 25 5 0 0 4 .20 25Sierra Leone 21 10 0 0 4 4 .40 -Sudan 138 NA 7 NA NA 7 NA 10Togo 73 40 6 0 4 10 .25 11Uganda 120 67 NA NA NA - NA 1Zaire 130 37 27 4' 6 NA 33 .72 NA

Argentina 353 20 3 NA NA NA .15 NABrazil 415 ' 77 12 NA NA 12 .15 9Chile 700 600 527 k0 0 0 527 .87 NACosta Rica 29 " 14 1 NA NA 1 .07 NAJamaica 300 + 41 8 NA NA 8 .20 NAMexico 430 A' 236 78 NA NA 78 .33 47Panama 28 4 1 NA NA 1 .25 NAPeru 60 60 4 NA NA 4 .06 NA

ASIA & OTHERS

Bangladesh NA NA 701 2' NA NA 701 -India 199 26 0 NA NA 0 NA NAMalaysia 150 22 11 0 0 11 .50 0Pakistan 75 NA 5 NA NA 5 NA NAPhilippines 389 '^ 50 2 12 NA 14 .28 25-30Sri Lanka 177 36 11 5 NA 16 .44 NAThailand 55 9 2 NA NA 2 .22 NATurkey 260 ' 40 2 NA NA 2 .05 NA

DEVELOPEDCOUNTRIES

Canada 57 NA 11 0 0 11 6Italy 124 NA 21 0 0 21 NASpain NA NA 157 0 0 157 - 379 '

Footnotes to Table I

NA = Not Available- = Not applicable

1/ In many instances it has been difficult to determine the total number of enterprises. The most often quoted number between the years1982-86 has been used. Unless otherwise noted, these do not include financial enterprises.

Z/ The definition of "targeted" is not precise. It is indicative of the order of magnitudes involved. Two definitions have been usedto estimate the targets:

(i) decisions made by government in question as reflected in an official statement; and(ii) a combination of government statements and agreements with the World Bank under structural adjustment loan or credit

conditions.

Where there is a discrepancy between the two, we have used the government's figures.

3/ These are enterprises receiving government subsidies. There are an additional 260+ enterprises.4/ Twenty-six (26) of the enterprises were small farms.5/ Brazil has an additional 351 state governments' enterprises.6/ Informed estimate. The number includes about 250 previously nationalized enterprises which were returned to their original owners.7/ Includes the 4 subsidies of the holding company CODESA which were targeted for privatization.fl/ The number of enterprises have been changing from 1,155 (before 1985) to 430 (recent statements by governmient).9/ These were nationalized enterprises which were returned to their original owners.10/ These are non-performing assets.II/ Includes 10 financial institutions.12/ Refers to Federal Crown Corporations. There are also Provincial Crown Corporations.13/ As part of the Rumasa divestiture, 355 enterprises were closed; and 24 were liquidated.

I-J

Sources: 1. Eliot Berg, et al, "Divestiture of State-Owned Enterprises in LDC's," unpublished World Bank Report, November 1985.2. R. Hemming and A. Mansoor, "Privatization and Public Enterprises," IMF Working Paper, February 1987.3. H. Nankani, "Techniques of Privatization," Volume II - "Country Case Studies," forthcoming World Bank Report, March 1988.

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politically easier for governments to implement without inviting theconflicts that often accompany the formal procedure. These divestituresare difficult to detect and may indeed be more prevalent than suspected.Formal liquidations in fact have been significant: Mexico is reported tohave liquidated about fifty enterprises as of December 1987; thePhilippines, between twenty-five and thirty; the Ivory Coast fifteen,Senegal twenty-five enterprises and Togo eleven.

Implementing Privatization Programs: Selected Issues

The gap that has arisen as governments have tried to implement theirannounced programs may be explained by three main factors:

(a) the political economy of privatization;(b) the financing of the effort; and(c) implementation issues.

The Political Economy of Privatization

The arguments in favor of privatization are almost alwayscouched in economic and financial terms -- reducing the financial burdenon the budget, mobilizing financial and managerial resources, improvingthe management efficiency of public enterprises, etc. In practice,political economy factors have frequently obstructed the implementationof these otherwise rational economic and financial policies.

The principal issues involved in the political economy ofprivatization are the the relative strength of its proponents andopponents, public perceptions of its potential effects particularly onemployment, and the issue of foreign ownership.

Vernon (1987) explains that, "as long as the proposedprivatization program was devoid of specific targets and operationaldetails, the concept could be accepted by political groups of manydifferent persuasions." When it is time to implement, however, "thedebates between prospective winners and prospective losers (grow) morefocussed and acute." In the rhetoric in favor of privatization, afavorite argument put forward by governments and advocates is the need tocurb the growth of the public sector and public sector spending. Otherreasons are to raise revenues, to broaden ownership, to foster popularcapitalism, and to encourage innovative management that will respond tomarket incentives. But privatization has many enemies. Employed laboropposes it for obvious reasons. Government officials may resent itbecause it restricts their jurisdiction. The intellectual community, andoften the military, may oppose it because the "beneficiaries ofprivatization are perceived to be the rich and the privileged" (Berg1985).

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The most organized and effective resistance to privatizationoften comes from labor. More than two years after officials announcedNexico's intention to sell scores of "nonessential" governmententerprises, only a handful have been sold. In a recent article entitled"Denationalization in Mexico is Meeting Resistance," some businessmenwere said to be willing to purchase some of these enterprises only if"they can shut half the place down, cancel labor contracts and fire halfof the workers." A presidential advisor said, "We can't allow that."

In an article entitled "Nigeria: Not for Sale," theprivatization program was attacked because "it will amount to adeliberate attempt to use public funds for the enrichment of a fewindividuals at the expense of the nation" (This Week, September 15,L986). Fears of ethnic domination, regional imbalance and ownershipconcentration dominate public debates about such programs. In Brazil,the Sescretary of the Interministerial Council on Privatization recentlycesigned reportedly due to the lack of political commitment to followthrough on legislated reforms. The current effort to rejuvenate theArgentina privatization program follows a three-year period in whichunclear political commitment and ambiguous legal mandates made progressdiffi,cult.

Ownership issues have also constrained privatization. They areparticularly acute in multi-racial/ethnic societies, such as Malaysia andNigeria. In Malaysia, the Guidelines on Privatization (and indeed anobjective of the New Economic Policy (NEP) of the Mahathir government)specifies that the target of ownership restructuring in the corporatesector is to have at least 30 percent Bumiputera (indigenous Malay)ownership, 40 percent other Malaysians, and 30 percent foreign interest,by 1990. As late as 1986, Mexico had numerous restrictions on directforeign investments, including their exclusion from strategic andpriority areas, and their restriction to sectors in which they would notdisplace domestic investments. Argentina still aims at "de-monopolizing"but also introducing "social control" in its privatized firms through thedistribution of non-voting shares gratis to selected groups.

The ownership question is not limited to developing countries.In New Zealand, the government agreed to sell Petrocorp, the state-ownedoil and gas company, to British Gas, but was forced by political outcryto back down and sell to a local buyer. In Canada, the sale of deHaviland to Boeing (USA) raised a hue and cry. Subsequently, the PrimeMinister announced that Air Canada (previously on auction block) was notfor sale, after a public opinion poll had indicated that Canadians likedhaving Air Canada as a government-owned airline.

The political economy of privatization has many parallels withthat of trade liberalization. The high rents enjoyed by import-substituting industries have led industrialists, particularly incountries such as Argentina, Brazil, and until recently, Mexico, toresist moves to liberalize trade. Similarly, in the inefficiently runpublic enterprises, the beneficiaries of economic rents are the employees

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of the enterprises, and they, in turn have resisted privatizationattempts. In addition, both policy approaches tend to be resisted bybroader groups in the interests of perceived national or strategicobjectives.

Transaction Costs Associated with Privatization

For governments strapped for cash, the short- and medium-termtransaction costs of privatization can be a burden. Typically, suchcosts involve: the costs of financial restructuring or partial physicalrehabilitation of the enterprises; redundancy and severance payments toworkers; restructuring or transfer of the debts owed by the enterprise togovernment or the private sector; the cost of advisory services; and thecost in time to busy government executives.

The rhetoric in favor of privatization often stresses theprospects of an increase in revenue, or at least a cessation of transfersto public enterprises. With implementation comes the realization that atleast in the short to medium term, privatization is expensive forgovernments. For many money-losing enterprises, governments have takenover their outstanding financial liabilities (Vuylsteke 1988). InBrazil, while an accurate estimate of the cost of physical rehabilitationhas not been completed, officials have offered a subjective estimate ofUS$1.0 billion. Financial restructuring would increase this figuresubstantially. The government of Togo had to assume the liabilities ofits leased steel mill, while relieving it of its tax obligations andoffering other concessions.

The privatization of SEAT, the car manufacturing firm, alonecost the government of Spain, including liabilities that had to beabsorbed, close to $1.8 billion (de la Dehesa 1986). Before sellingCanadair to Bombadier Inc., the government of Canada removed all debtfrom its books (about $2.2 billion Canadian dollars) and, in addition,left $100 million in cash on the company's books to give the purchaserthe liquidity needed to operate.

Redundancy payments are an additional expense borne bygovernments anxious to minimize labor unrest associated withprivatization. The Malaysian government has an elaborate personnel plan,designed specifically to accommodate privatization (Nankani 1988), underwhich an employee opting to join a newly divested company cannot be firedfor five years. Others opting to retire are given generouscompensation. In Sri Lanka, the government at first decided tocompensate labor and retire all the employees in its divestiture of threetile factories. Strapped for cash, the government had to modify itsstand and leave in place a large number of employees; the sale prices forthe factories dropped substantially as a result.

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Finally, the implementation of privatization is costly in itsdemands on the time of busy ministers and government officials oversustainled periods. Experience has shown that the planning and managemento:. privatization is an involved process that necessarily takes time.

O-her 'Implementation Issues

Other relevant impediments to the implementation ofprivatization programs include the newness of the phenomenon, weakcapital markets, weak private sectors, and valuation difficulties.

The newness of the phenomenon often means that governments areentering uncharted territory: there are few tested answers and no "toolkits." Experts quite often treat the approach to privatization "as thesame kind of apolitical, managerial technique (much) as corporate plansused to be packaged" (Heald 1988). Governments are generally short ofstaff experienced in planning and implementing privatization programs.Too often government officials busy themselves with turf battles.

Inefficient capital markets in many third world countries,coupled with restrictions on who is an acceptable buyer, limit the rangeof options available for privatization in the developing countries: Itis believed that capital market constraints have hindered privatizationin countries as varied as Argentina, Ghana, Malaysia and Sri Lanka. Ithas, however, been argued (Gill 1987) that privatization can lead tocpportunities for the development or improvement of capital markets --f'or instance, in the privatization of the National Commercial Bank inJamaica, the first public offering in the country's history, where tensof thcusands of Jamaicans purchased shares for the first time (Leeds1.987).

In an environment in which the private sector has nocpportunity or liberty to operate competitively and profitably, or wheret:he 'rules of the game' were unclear, investors will hesitate tooperate. The relative success of Chile, the Ivory Coast and Malaysia(see T'able 1) may be partly due to the governments' generally positiveaLttitude towards the private sector.

Experience indicates that there is no acceptable and simple wayt:o measure the value of an enterprise, nor a single value that predictswhat the market is willing to pay. Various valuation methods are usedincluding discounted cash flow, comparable transactions, replacement costand book and liquidation value. Frequently, the ambiguity associatedwith valuations have delayed many privatizations such as the sale ofAustral airlines in Argentina. Valuation difficulties have also hamperedprivatization in Mexico significantly: thus, the privatization of theN[exicana airline has been held up for about two years, because no'acceptable' bid has been received (this is largely because bidders havet:aken account of the constraints on routes and on employment levels thatare part of the package). In the U.K. the share prices for Britoil andEnterprise Oil which were set too high was largely responsible forslowing down their divestiture.

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Overall, therefore, many implementation issues have encumberedthe translation of the rhetoric of privatization into reality.Unfortunately, the rhetoric has tended to continue to ignore thesedifficulties.

Key Features of Successful Privatizations

While privatization attempts have been difficult, the fewsuccessful experiences do have central lessons. The use of privatizationas part of a package of policy instruments designed to improve theefficiency of the public sector has tended to be most successful in thefollowing circumstances:

Political Will

The critical prerequisite for success is political commitment,preferably at the highest level, to the principle of privatization (andliquidations) as an integral part of the reform package to improve theefficiency of the sector. Specifically, the presence of an individualwith the backing of the highest authority, armed with clear objectives,and committed to overseeing the planning and implementation of theprogram, has frequently been critical.

Privatization affects many vested interests. The difficultfinancial, political and legal issues involved can easily lead to anabandonment of the process if the government is not fully committed inthe sense of being willing to expend some of its necessarily limitedpolitical capital in this policy arena.

For example, in both Chile and Malaysia, the relative success ofprivatization program has been attributed to the willingness of thesegovernments to pursue such programs relentlessly.

But political will is only a necessary, not a sufficient,condition for success in privatization. In the well-publicized case ofTurkey, there was strong commitment, all the appropriate studies weredone, yet no major state-owned enterprise has been privatized (Leeds1987).

Developing a Pragmatic Approach

A pragmatic rather than an ideological approach has frequentlyeased some of the problems. This is not to deny the need for aframework, but to recognize that within this framework there is a needfor practical, creative approaches that respond to the uniquecharacteristics of countries and of different enterprises.

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Governments willing to embark on a divestiture program oftenhave a coimpelling urge to succeed (Vernon 1987). Given the limitedtenure of government officials, and the complexities involved withprivatization, two things are necessary for "success": (i) thatenterprises chosen for divestiture should be those likely to succeed e.g.previously nationalized enterprises that have been subjected to privatesector tests, profitable or potentially profitable enterprises; and (ii)that only a handful of enterprises with significant impact on the budgetshould be concentrated on. In the latter case, efforts should be made tomake the sales "successful."

In the privatization of the Japanese National Railways (JNR),which had long-term liabilities of Y37,000 billion (more than the debtsof Mexico and Brazil combined), the Government took steps to take thecompany's debts off the books to give purchasers a healthy financialstart (Financial Times, December 12, 1986). In addition, much effortwent into ensuring that alternative jobs were found for 61,000 JNRworkers.

Another pragmatic example is provided by Togo: to be able toprivatize the management of its steel mill, it absorbed liabilities ofabout $42 million. The privatization of Austral airlines in Argentinawas undertaken after the Government had absorbed its debt and guaranteedits routes for 15 years.

Pragmatism can also mean the flexibility to use creativetechniques. One of the earliest and most successful "opening up" of apublic service to the private sector took place in Buenos Aires in 1962,when private buses were allowed to enter the urban transportationindustry. Sri Lanka has used diverse techniques of privatization as arespDnse to its political constraints. The preferred technique has beenmanagement contracts -- the least problematic (for them) of theinstruments of divestiture. Chile's program first involved a "debt-led"swift privatization of about 350 enterprises between 1974-77, in whichthe buyers of the enterprises were effectively offered loans to purchasethe enterprise. The new owners were frequently neither experienced norfinancially able to withstand a turbulent business environment. In theearly eighties, many of these enterprises went bankrupt. The post-1982phase of privatization has instead been "equity-led," emphasizing theneed for experienced and financially strong purchasers of enterprises aswell as the sale of shares to small share-holders and employees (Marshalland Kontt, 1987).

Other options, such as contracting out, potentially providegovernments with an opportunity to reduce expenditures while retainingcontrol over the quality and quantity of public goods and services.Typical examples in the OECD countries for contracting out have been inurban transport, refuse collection, and prisons (OECD 1986).

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The choice of potential purchasers of shares or enterprises hasalso required creative approaches to the packaging of shares, such asdebt-equity swaps. Such swaps have been important in Chile, and havegrown in importance in Mexico, and more recently are being pursued inBrazil and Argentina. In these transactions, would-be foreign investorsbenefit from a preferential exchange-rate, which in turn benefits thecountry by helping to extinguish part of its external debt. Even thecapital market argument has been known to have been tackled creatively inTogo where, without a capital market, shares have been sold to thepublic. Privatization may even lead to the development of capitalmarkets (Gill 1987). Similarly, resentment towards foreign experts canbe minimized if foreign expertise is creatively combined with localskills, as in Malaysia. Indeed, it has recently been claimed that,recognizing the disincentive posed by Malaysianization policies toforeign investment, the government has considerably relaxed the foreignownership ceiling of the NEP to over 30 percent (Far Eastern EconomicReview, September 25, 1986). Recent decisions in Argentina to beginnegotiations and/or preparations to privatize partially AerolineasArgentina, the telephone system and the petrochemical sector may havesurmounted nationalistic concerns.

While economic considerations suggest that privatization shouldideally occur in a competitive environment and with regulatorysurveillance, pragmatism has often meant that the private sector has hadto be offered high financial returns, either through some underpricing ofthe assets sold, or some form of protection or both. The continuation ofregulatory policies that support monopolistic or oligopolistic pricingafter privatization is common. The valuation of enterprise shares isoften criticized as including an element of under-pricing. Although ithas been argued that there are good economic reasons for this (Walters,1987). It is believed to increase the number of potential shareholdersand therefore to reduce the risk of renationalization, and increase thevalue of the remaining shares. Thus, the privatization of Australairlines was at a price of $27 million, well below the "technicalevaluation" of $39 million. Even in private placements, privatizationoften involves a package of strong financial incentives--protection, debtwrite-offs or reschedulings, under-valuing of shares, etc. This conflictbetween the fiscal and the efficiency aspects of privatization on the onehand, and the financial aspects of privatization on the other isdifficult to side-step in the initial phases of privatization. Over timehowever, through import policy and regulatory policy, actual or potentialcompetition could help to address this conflict. It is important to bearin mind that under certain conditions, the expected discounted socialvalue of a privatized firm may be greater than if the firm were left inthe public sector (Jones-Pankaj); in this overall assessment, the priceat which the firm is priced is important but is only one of the manyfactors that must be weighed.

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Focus on Private Sector Development

The experience of privatization also suggests that a key featureof s:uccess has been an emphasis on improving the environment for privatesect:or ac:tivity, both domestic and foreign. Clearly, it is not the casethat: "less public means more private sector activity," since manyenterprises have been liquidated in the process of privatization. Ingeneral, however, the more successful country experiences have been thosein which governments have emphasized a strong private sector role by (a)simplifying the regulatory framework and introducing greater transparencyin the a(dministrative requirements that businesses have to satisfy suchas simpler foreign investment codes; (b) expanding the scope for theprivate provision of typically publicly provided services such as urbanbus transportation, refuse disposal, etc.; and (c) moving away from areluctance to have enterprises sold to foreign investors or managed byforeign eLxperts. Thus, Chile's privatization owes its success in part tothe openness to foreign investments. Argentina's recent attempts tolaunch a privatization program are seen to depend heavily on awillingness to allow foreign participation, such as by Telefonica deEspaIa in Entel, currently being negotiated. Debt-equity swap programsin Chile and Mexico already have, and in Brazil and the Philippines areexpected to involve the purchase of equity by foreigners in state-ownedenterprises.

It should be noted that in several countries, some success hasbeen achieved in opening the economy to both local and foreignconpetition both as a prerequisite for privatization, and to improveoverall economic performance. In Mexico, it is believed that the fullwithdrawal of the government from a number of sectors such as trading,appliances, etc. has had a beneficial effect on the willingness of theprivate sector to enter these sectors and has fostered competition. InSri. Lanka, there have been few ownership transfers; but compared to thepositiorL before 1977, there has been wide-ranging deregulation and, ingerneral, greater reliance on the market as an instrument for resourceallocation. The trading sector has been revolutionized, and foreignbanks have multiplied (Heald 1986). In Bangladesh, the positive effectthat divestiture has had on the performance of the other publicenterprises is generally acknowledged.

New Zealand's "Corporatization" or its policy of convertinggovernment departments into commercially-run autonomous corporations as ahaLfway house on the road to privatization has markedly improved theperformance of the sector.

Conclusions

In conclusion, privatization continues to evolve and its scaleis expanding gradually. More interesting than its growing scale has beenthe var:iety and the increased differentiation of approaches thatpr:ivatization has involved. In different countries, pragmatic and

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creative approaches have been used to circumvent the typical problems ofpolitical resistance by potential losers, the need for financialincentives to potential purchasers, valuation difficulties, concernsabout foreign ownership, nascent capital markets and private sectordevelopment. It might even be said that a second phase in theprivatization process is within sight, in which less will be said andmore will be done about privatization through pragmatic approaches on acase-by-case basis, but building upon recent experience. Assisting thisprocess promises to be one of the important challenges facing donorcountries in the coming years.

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V. Foreign Direct Investment

Introduction

The flow of private foreign direct investment (FDI) tocleveloping countries and the role it is playing in the developmentprocess are not nearly as large as they could be. We all know about thesharp decline in commercial bank lending to developing countries aftert:he onset of the debt crisis in 1981, but the decline in FDI over thesame period is less widely recognized. Foreign direct investment flowsl:o developing countries fell, according to the IMF, from about $15billion net in 1981 to about $10 billion net in 1983 and have remained atabout that level ever since. And whereas FDI constituted about 25% offoreign capital flows to developing countries in the 1960s and early:L970s,, that share has fallen in recent years, even after the decline incommercial bank flows, to about 10% of total capital flows from:industrial to developing countries.

As the quantity of FDI has been falling, there has been agrowing realization among developing countries that FDI, underappropriate conditions, might make a substantial contribution to theirdevelopment. Among other factors, this realization reflects adisenchantment with foreign debt and a new appreciation for foreign riskcapital. It also is due to the shortage of foreign capital of all kinds,and the hope that the flow of FDI can increase to take take up some ofthe slack left by reductions in commercial bank lending. Finally, therenewed interest in FDI reflects a growing confidence on the part ofdeveloping countries in their own ability to control abuses and obtainbenefits from FDI.

This evolving attitude contrasts with that held by manycountries during the 1960s and much of the 1970s, when there was ageneral trend towards more restrictive policies to regulate the entry,activities and operations of foreign investors. With changing attitudesthere has been a liberalization of foreign investment policies in anumber of countries. In Sub-Sahara Africa alone, for example, since1982, some 22 countries have either introduced or have revised investmentcodes.!/ Some other countries have opened doors to foreign investors forthe first time (e.g., the Soviet Union, Poland, Guinea, Mozambique,VietrLam).

It is not enough to simply change investment codes in order tocreate the conditions conducive to FDI. Policies at three levels have tobe reviewed in terms of their effects on the amount and character ofdirect investment that a country receives. Macro-economic policies thataffect the availability of domestic resources, relative prices,

1/ S'ee Keith Marsden, Promotion of Foreign Direct Investment in Africa,IFC, 1987, mimeographed.

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inflation, the exchange rate, foreign exchange allocations, and interestrates are the most important: These policies establish the incentivesand the risks to which investors respond. Sectoral policies also areimportant, sometimes critically so, in influencing direct investmentdecisions.

Developing countries also use a wide range of specific policiesand institutions to promote and regulate direct investments. Promotionalpolicies usually include various fiscal and other incentives toinvestments, and other promotion activities such as the provision ofinformation, analysis of opportunities, etc. The regulations includerestrictions on (a) the sectors in which direct investments are accepted;(b) the proportion of ownership open to foreign firms; (c) the number ofexpatriates that can be employed; and (d) ownership of land. Bothpromotion and regulation usually involve an investment screening andmonitoring process of differing complexity and duration. This processitself becomes a deterrent to investment in many developing countries.1!Finally, a number of countries impose performance requirements on foreigninvestors such as requirements on the amount of output that is exported,or the proportion of domestic value added in total output.Z!

It is these specific policies that have been the main focus ofthe efforts by developing countries to attract more foreign investment.Recent changes in investment policies with respect to (a) the sectorsopen to FDI, (b) investment screening, (c) ownership restrictions, (d)investment incentives, and (e) repatriation of profits are reviewed inthe following sections.

Sectors Open to FDI

Many developing host countries have imposed barriers to entry ofFDI to certain sectors, either on grounds of political sensitivity (e.g.,publishing, banking, broadcasting, oil and gas industry) or to reservefor local enterprises certain sectors or industries where capital,technology, or know-how requirements may be relatively simple (e.g.,distribution of goods, retail sale). In recent years, however,developing countries have begun to remove these entry restrictions. InLatin America, for example, Decision 220 of the Andean Pact (May 1987)allows the member countries to regulate the sectoral entry of foreign

1/ See Dennis J. Encarnation and Louis T. Wells, Jr., "Sovereignty EnGarde: Negotiating with Foreign Investors," InternationalOrganization 39, Vol. 1, Winter 1985, pp. 47-78 for an analysis ofthe different approaches used by governments to screen foreigninvestments.

y/ See Stephen E. Guisinger and Associates, Investment Incentives andPerformance Requirements (New York, Praeger, 1985), pp. 51-55.

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investmient at the national level rather than imposing regionalrestrictions. In Bolivia, FDI is now allowed in the iron ore and goldse,:tors, as well as in the distribution of oil and its derivatives. InYugoslavia, since 1984, FDI has been allowed in several previouslyprohibited sectors such as scientific research and health and recreationreLated services.!/ In Argentina, oil exploration and exploitation havebeBn opiened to foreign investors. Indonesia also has been expanding inthe last three years the number of industries open to foreignparticipation. Similar relaxations have ocurred in Korea and Malaysia.J/

However, we must note the cases (particularly in Latin America)where some host countries have at the same time introduced new sectoralrestrictions. In Ecuador, for example, where restrictions on FDI in thebanking and insurance sectors were relaxed, the barriers to entry in thecommunications and media sectors were reinforced, while Brazil hasintroduced new restrictions in advertising and media communicationssectors, and has maintained restrictions in "informatics."

Screening Institutions and Procedures

In most countries, screening and monitoring mechanisms andproceduLres are established to help ensure that projects with foreigninLputs are structured in a way that conveys economic benefits to the hostcountry. This means that the conditions under which a foreign investorcan operate are clearly defined before such an investment takes place.In practice, numerous government institutions involved in the approvalprocess, cumbersome and complex screening procedures, and bureaucraticdelays have proved to be a critical deterrent to an orderly flow of FDI.Y/

Recent trends in developing host countries have been in thegenera:L direction of simplification and streamlining these procedures.This includes a shift from the multi-stop authorization procedures (whereall investor has to seek approval of several government agencies orbodies) towards a creation or reinforcement of one-stop agencies (e.g.,KeBnya, Ghana, Yugoslavia, Korea, Venezuela). To speed up the

1/ Seie, B. Vukmir, Recent Development in Joint Venture Legislation inYugoslavia, 1 ICSID Review 66-80 (1986).

2/ In Korea, for example, in 1980 only 50% of the industries were openfor foreign investment. This percentage was increased to 66% in1984, and it currently stands at nearly 80%. In the manufacturingsector alone, where FDI has been most active, 97.5% of all industriesare open to FDI.

3/ See Supra, Note 2.

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authorization process, a system of automatic approval for certain typesof investment project has been introduced (e.g., Korea, Venezuela), andvarious application forms and licenses have either been eliminated orsimplified (e.g., Indonesia, Yugoslavia, Korea, Mexico).!!

It is necessary to stress, however, that FDI entry systems donot always follow even the simplified rules set by the policy orregulatory framework. Sometimes, screening agencies base their decisionsnot only on the foreign investment laws and regulations, but also on anumber of unpublished internal regulations and guidelines. In othercases, officials at the working level enjoy a considerable degree ofadministrative freedom with respect to the interpretation of relevantlaws and regulations. The result is that in some cases the regime forscreening investment may be more limiting in practice than it appearsthrough proclaimed policies and the regulatory framework. In othercases, as in Mexico today, administrative practice is somewhat moreliberal than a strict reading of the law would suggest.

Ownership Restrictions

Restrictions on the share of any enterprise that can be owned bya foreign investor have been adopted by most host developing countries.Foreign investors are thus required in most cases to operate through ajoint venture with a domestic partner, or to release ownership andmanagement control through the sale of shares over a specified period oftime.

Faced with severe limitations on the availability of foreigncapital through commercial lending, and a reduction in domesticinvestment resulting from recessions and structural adjustments, a numberof developing countries in recent years have begun to relax theseownership restrictions. In some countries (e.g., Yugoslavia, thePhilippines, Mexico, Nigeria), the new rules permit the foreign investora larger share of ownership than previously allowed. In Yugoslavia, forexample, the foreign partner is now allowed to have a majority share inthe enterprise, although not yet 100%.

While wholly foreign-owned enterprises are still prohibited in alarge number of host developing countries, several countries haveintroduced new rules permitting foreign wholly-owned enterprises underspecified conditions. In Malaysia, for example, all project proposalsreceived from October 1986 to December 1990 are permitted with up to 100%of foreign equity if the enterprise exports 50% or more of its productsor employs 350 full-time Malyasian workers (provided, however, that thecompany's products do not compete with products presently manufactured

i/ See B. Velic, The Process of Entry Control for Foreign DirectInvestment, IFC (FIAS), May 1986, mimeographed.

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for the domestic market).!/ In the Philippines, 100% foreign ownershipis allowed in pioneer areas specified in the Investment Promotion Plan,in export-oriented projects where at least 70% of production is forexport, or- in the areas not adequately explored by Filipinos andrequi.ring no incentives. In India, 100% foreign ownership is permitted,in principle, where the entire output is exported abroad. Even severalsocialist countries (China, Hungary) allow 100% foreign ownership undercertain conditions, usually when the investing firm has technology thatis thoughl to be particularly important by the host country.

Fade-out provisions have also been relaxed by extending thenumber of years after which the foreign investor is forced to sell itsparticipation to a domestic partner (e.g., Indonesia, Colombia, Bolivia,Venezuela, Ecuador). For example, in Bolivia and Ecuador, theserestrictions have been extended from 15 to 30 years, while in Colombiaand Venezuela from 20 to 37 years. In Indonesia, the implementation ofthe requirement to move to majority Indonesian ownership within 10 yearsof commercial operations was extended to 15 years, with possibleextension to 20 years.

Investment Incentives

Most developing host countries offer a number of fiscal andfinancial incentives to attract FDI and to channel it either into desiredindustries or to preferred geographical areas. They can range from cashgrants, tax holidays and accelerated depreciation, subsidized industrialparks, to tariff incentives and subsidized credits. Their basicobjective is to change the expected return on the investment or the riskof such an investment.

There is an ongoing debate as to whether investment incentives,particularly tax incentives, are an effective instrument to increaseFDI. This debate is reflected in recent changes in investment incentivesgiven by developing countries. Several countries have abolished fiscalincEntives, including Indonesia which abolished tax holidays in 1983 andKorea which, since 1984, has been reducing tax privileges given toforeign investors in an effort to create an environment in which bothforeign amd domestic companies can compete equally.?! On the other hand,a number of countries have introduced a whole set of new fiscal andfinancial incentives, ranging from various tax incentives3/ (e.g.,

1/ There is also a provision that projects that export 80% or more ofprodulction can have up to 100% foreign ownership.

?! Some tax benefits have, however, been retained where FDI bringsadvanced technology, and for small and medium-sized industries toencourage investments in these areas.

]/ Such as tax holidays, reduction in income taxes both for companiesand individuals, reduction in surtax imposed on imported machinery,or a,ccelerated depreciation.

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India, Thailand, Yugoslavia, Zaire, People's Republic of China, Guinea,Zimbabwe, Ghana, Madagascar), to deduction of incremental labor expensesfor expanding firms (e.g., the Philippines), to liberalized policies onexpatriate labor (e.g., People's Republic of China, Malaysia).

Investment incentives are sometimes coupled with performancerequirements. There has been some tendency, particularly in LatinAmerica, to impose an increased number of performance requirements aimedat promoting specific domestic objectives. In Mexico, for example, localcontent requirements in the automotive sector were increased. If coupledwith strong inducements such as very high protection, such performancerequirements may be acceptable to investors but lead to losses for thecountry. For example, requirements for exports imposed on an inefficientactivity can result in the export of goods that costs the country more toproduce than the foreign exchange so generated is worth. Local contentrequirements also can save small amounts of foreign exchange at anincommensurate cost in local resources, and sometimes raise coststremendously in a domestic activity that could have been internationallycompetitive if imports of a small but crucial number of components hadbeen permitted.

Repatriation of Profits

Remittances of dividends on foreign direct investment aresubject to restrictions in various developing countries.!/ The mainreasons why such developing countries seek to control the allocation offoreign exchange to foreign direct investment are: (a) to control thetotal amount of foreign exchange expended by the country; and (b) toinduce enterprises to meet some national objective, by favoring thoseenterprises that do so with allocations of scarce foreign exchange.

In recent years there has been some move towards progressivelyrelaxing profit transfer restrictions, despite worsening balance ofpayments position of many developing countries. In Latin America, theDecision 220 of the Andean Pact, while maintaining the principle of a 20%ceiling for profit remittances, allows member states to regulate thismatter on national level. In Chile, rules enacted in 1985 permit foreigncompanies to keep foreign exchange receipts from exports in bank accountsabroad for specified payments, including profit remittances. Similarlyin Ghana, under the 1985 Investment Code, when an enterprise is a netforeign exchange earner, it is allowed to operate an external account inwhich it can retain at least 25% of its earnings in foreign exchange topay dividends and service its debt. In Zaire, free transfer of profitsfor foreign investors was introduced in 1986. In China, while foreigninvestors are generally obliged to balance their foreign exchange

i/ Some countries limit remittance to a percentage of invested capital(e.g., Ecuador, Colombia). A large number of countries subjectprofit repatriation to additional taxes, while others imposetemporary restrictions as part of overall restrictions when facedwith serious balance of payment problems (e.g., Peru, Yugoslavia).

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earnings and expenditures (including the transfer of profits), theGovernment has in recent years introduced several measures aimed atalleviating this problem.J/ In Argentina, a creative scheme was devisedallowing remittances to be made through Argentine governmentdollar-denominated bonds (BONEX), even though the country suspendedexternal payments. Korea also has recently abolished restrictions on therepatriation of capital by foreign investors.

Evaluation

There are a number of other areas in which developing countrieshave reduced restrictions or provided additional inducements to foreigninvestors. Restrictions on local borrowing, for example, have beencurtailed in the Andean Pact and Indonesia. Debt-equity swaps have beenintroduced by a number of countries as an incentive to forei n equityinvestors (including, but not limited to direct investors).2 e

The trend has been clear: most developing countries are nowactively trying to increase the inflow of foreign direct investment.Besides liberalizing policies, they are pursuing this objective byinst:ituting active investment promotion programs. Countries in Asia(e.g., China, Indonesia, Thailand, Philippines, Malaysia, Bangladesh),manyr countries in Africa (e.g., Ghana, Kenya) and some countries in LatinAmer:ica are reaching out to attract foreign investors.

These promotion efforts, coupled with a thoroughgoing policy andins:itutional reform, hold promise for generating more productive FDI indeviloping countries. Yet the continued stagnation of FDI suggests thatthe3e changes have not gone far enough or deep enough to make a realimpression on investors. Liberalization of foreign investment policieshas to be a very thorough-going process, but in too many countries,changes have been only superficial, often involving some tinkering withan investment code, while a large number of other restrictive policiesremain in place. Ghana, for example, adopted a more liberal investmentcode in 1985, while continuing to impose marginal tax rates of over 80%on earnings repatriated to foreign investors! Yugoslavia still facesfundamental policy problems despite procedural streamlining.

1/ See, e.g., Ch. D. Toy, New Regulations on Foreign Exchange Balancingin Joint Ventures, International Bureau of Fiscal DocumentationBulletin, 154-156 (1986).

t/ Chile has pioneered this mechanism and has been most successful.Foreign investment rose from negligible amounts to over $300 millionin 1986 and nearly $900 million in 1987. Likewise, in Mexico,between May 1986 and November 1987 (when the scheme was suspended)264 operations totalling $2 billion were authorized. Argentina andthe Philippines have begun to convert debt into equity, and mostrecently Brazil re-activated debt/equity conversions.

- 34 -

The importance of a thorough policy reform is illustrated by therecent experience of developing countries in Asia. It is commonlybelieved that these countries are more successful than developingcountries elsewhere at attracting foreign direct investment. In someways this is true, but in several important respects this generally-heldview is incorrect. It is a fact that the total amount of foreigninvestment received in Asia is larger than for any other region in thethird world, including Latin America. In 1986, developing countries inAsia reported to the IMF that they had received 4 billion SDRs in foreigndirect investment, which equalled US$4.7 billion, reflecting thedevaluation of the U.S. dollar. Asian countries accounted for more thana third of all investment in developing countries worldwide.

Underneath this appearance of relative success for the region asa whole, however, the long-term trend is running in the direction ofdeclining flows of foreign investment to most Asian countries. Forseveral years, this trend has been masked from easy observation. From1981 to 1985, the IMF reported that direct investment flowing to Asiancountries grew annually by an average of about $200 million SDRs (seeTable 1). Apparently, Asia resisted the deterioration in the rest of thethird world, where total direct investment declined sharply over the sameperiod. In reality, though, the situation in most developing Asiancountries was not much different from elsewhere; flows of foreign directinvestment were actually on the decline.

To reveal this decline, it is necessary to strip away the effecton regional data of the opening of China to foreign investment. The newflows that followed the opening of China to direct investment were solelyresponsible for the growth in the regional aggregate. In fact, todayChina is the largest single recipient of direct investment among thethird-world countries of Asia, and it alone accounts for more than athird of total foreign investment in the developing economies of theregion. If the large portion consisting of China's share were subtractedfrom the regional total, then the remainder for the other countries ofAsia would exhibit a downward trend throughout the 1980s that was almostas rapid as experienced by all capital-importing developing countries.

What reasons lie at the root of dwindling investment? Externalcauses, such as declining commodity prices, growing protectionism, andincreased capital flows to the United States, while important, are notsolely responsible for the drop in flows to most Asian countries. Manypotential foreign investors have told the IFC's Foreign InvestmentAdvisory Service that they would like to establish or increase operationsin Asia. They are not dissuaded by the global situation, which theyalready have discounted. Instead they are often held back byinappropriate policies in the countries themselves.

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Table 1: Direct Investment in the Reporting Economy(In millions of SDRs)

1980 1981 1982 1983 1984 1985 1986

Bangladesh -1 2China 389 595 1,227 1,634 1,598Fiji. 28 31 33 30 23 33 29IndiaIndonesia 138 113 205 270 221 270 221Korea 6 86 62 65 109 227 365Malaysia 718 1,073 1,266 1,179 778 684 452PakLstan 45 91 59 29 54 132 94Papua New Guinea 58 73 78 130 113 ...

PhiLippines -82 146 14 98 9 -11 86Singapores 860 1,195 1,260 931 862 959 574Sri Lanka 33 42 58 35 32 26 26Thailand 146 249 175 327 394 159 219

Total Asia 2,258 3,478 3,601 3,692 3,824 4,247 4,054

Total w/o China 2,258 3,478 3,568 3,097 2,597 2,613 2,456

Africa 557 1,205 1,263 1,045 632 1,047 778

Latin America & Caribbean 4,777 6,570 5,608 3,284 3,281 4,003 2,493

Developing Europe 746 787 674 688 880 877 764

Total DevelopingCoumtries 8,338 12,040 11,114 8,709 8,617 10,174 8,089

Source: IMF Balance of Payments Statistics.

It may sound surprising to identify government policies as partof the reason for declining flows to Asia. Most of these countries aregenerally thought to be hospitable to foreign investment. FIAS work inAsia, however, has encountered a number of possible policy issues, someof which might help to explain the stagnation of direct investment in theregion. We would suggest that:

(a) many countries in the region have not formulated realisticobjectives with respect to FDI;

(b) there are conflicts between the investment objectives and actualpolicies of a number of countries;

- 36 -

(c) countries in the region are competing for the same types ofinvestments;

(d) investment promotion expenditures are often not clearly targetedor evaluated;

(e) investment incentives have little influence on investmentdecisions, but are costly to host country treasuries; and

(f) restrictions on ownership and control may have unnecessarilylimited foreign investment.

Structuring an appropriate policy framework for FDI is clearly acomplex task. China has implemented over 60 pieces of legislationdealing solely with foreign direct investment since 1979, and close to200 laws and regulations which deal in part with direct investment. Evenafter this extraordinary effort, China still has a ways to go toestablish a suitable policy environment for foreign direct investment.While China is a special case because it started with virtually no legalstructure relevant to private foreign investors, its efforts thus farillustrate the lengths to which a thorough liberalization process mighthave to go to establish an environment conducive to foreign investors.

Other developing countries in Asia and elsewhere have only begunto scratch the surface of the foreign investment liberalization process.It is not surprising, therefore, that the results thus far have beenunimpressive. In order to create an environment that is conducive toincreased flows of FDI, developing countries will have to continue theefforts aimed at policy liberalization that many countries have juststarted, and to introduce new measures and mechanisms to attract andaccelerate the flow of FDI.

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