SOEs in Sri Lanka : Beyond "Profit & Losses"

The state has a long history of involvement in the economy in Sri Lanka; state ownership of utilities dates back to the colonial era. Post-independence experiments with socialism saw the expansion of the state into many new areas of business. Despite some reforms in the 1977-2005 era, state enterprises still account for a significant share of the economy.

The 2005-2015 period saw a halt to the privatisation process and a renewed wave of expansion in state businesses. Between 2009 and 2014 the number of SOEs grew from 107 to 245 while the number employed grew from 140,500 to a staggering 261,683.

Although the Department of Public Enterprises is supposed to improve governance in Public Enterprises (Commercial Corporations, Government Owned Companies and Statutory Boards), by its own admission only 55 SOEs come under its purview. The last available performance report (2014) indicates the 55 SOEs that were considered strategically important obtained budgetary support of Rs.126bn and treasury guarantees of Rs.47.6bn that year. Bank borrowings by these SOEs stood at Rs.471.2bn as at end 2014.

The size of the SOEs and the breadth of their activity make it an important determinant of the overall productivity of the economy. Consequently, the governance of SOEs will be critical to ensure their positive contribution to a country’s overall economic efficiency and competitiveness.

Ensuring that whether held nationally, regionally or locally – the state’s investments to actually deliver the societal outcomes desired is extremely difficult due to certain inherent problems.

1) Governments are run by politicians, not businessmen. Politicians can only make political decisions, not economic ones and these decisions will tend to be focused on short term publicity and benefits, ignoring long term consequences. An example is the launch of a company called Polipto Lanka to convert rubber and polythene waste to diesel. It was launched in 2009 amidst much fanfare but despite regular grants from the treasury it is yet to show any commercial results or even demonstrate that the process is economically feasible. Coincidentally, the launch took place a week before a general election. Polipto Lanka receives regular budget support from the Treasury; support for the last three years amounting to Rs.120m.

2) Governments use other people’s money; businesses must risk their own money. If a business does not earn a profit, the owner will need to keep infusing funds and this provides a powerful incentive to improve efficiency. The general public, whose money is effectively at risk in a state venture do not have the wherewithal or knowledge to hold managers or politicians to account. Politicians would prefer to postpone hard decisions than risk personal unpopularity, which is why state enterprises can keep running losses year after year.

The Janatha Estates Development Board (JEDB) and Sri Lanka State Plantation Corporation (SLSPC) have not reported a profit in the last five years, Mihin Lanka has barely made a profit since its inception, yet they continue to operate, the losses being paid by taxpayers because politicians will not risk bad publicity that may follow any attempts to reform them.

The Director General of Public Enterprises admitted as much in his report of 2009:

"We have found some boards take affairs of the enterprise very lightly regardless of their strategic importance even in a situation where PE [Public Enterprise] faces very difficult time. Since there is

no formal procedure to hold the chairman and the board of directors accountable, for their weak performance or unacceptable practices, some boards act with sheer indifference in discharging their responsibility."

3) State enterprises tend to be monopolies or restrict competition from the private sector. A business that faces no competition will find it easier to report profits. Where state businesses face competition the Government may grant SOEs preferential tax or other benefits that hinder the ability of the private sector to compete, causing deterioration in service or increasing costs to consumers. A few years ago VAT was imposed on large supermarkets but LakSathosa was exempted from this. The previously unprofitable LakSathosa started to make profits, while the efficient local supermarkets were penalised.

SOEs which operate as monopolies may not deliver an adequate level of service or charge excessive prices, which may lower the productivity/efficiency of the wider economy.

When Telecom was in state hands, obtaining a telephone connection, essential for business was a luxury that required a wait of several years. Thanks to liberalisation of phone connections, now they are available over the counter but businesses still struggle to obtain power connections and may have to invest in standby generators due to unreliability.

Energy costs (fuel and electricity) do not reflect the decline in global oil prices partly due to inefficiencies within the CPC/CEB (Ceylon Petroleum Corporation/ Ceylon Electricity Board), impacting on the competitiveness of business.

Inefficiencies in the state managed port terminals are a drag on trade but fortunately throughput at the privately managed SAGT (South Asia Gateway Terminal) Queen Elizabeth Quay is far greater and a boon to business.

The SAGT terminal has been ranked number one for terminal productivity in South Asia by the Journal of Commerce in the USA and ranked number four in the world. Because of the faster turnaround time ships prefer to dock at Queen Elizabeth Quay where it operates.

SOEs, especially those that lose money, are partly funded by banks. When a large chunk of bank lending is directed towards SOEs, the private sector will find it harder to obtain funds and higher interest rates could lead to a phenomenon referred to as "crowding out".

4) Governments cannot boost overall employment by hiring workers to the state sector. Giving people state-sector jobs may appear to create employment but this causes a problem because each new position brings with it a tax obligation that imposes a burden on the private sector, where wealth is generated and taxes paid. Effectively, since the salary of a public-sector employee reduces the amount of funds available to private employers, a job created in the public sector causes an offsetting loss in the private sector.

5) State-owned enterprises may enjoy hidden subsidies in a variety of forms including preferential borrowing costs, lower rents or taxes. Thus the actual costs will be higher than reported in the accounts and very difficult to quantify without detailed analysis. For example, imagine if ministries or SOEs had to pay market rents for the space in Government buildings that they utilise. Few would occupy the highly-valued areas they do now and would probably occupy less office space.

Indeed there is a massive opportunity cost of state- owned property in that they do not generate a net tax income for the state. If these properties were utilised by the private sector they would generate taxes as well as rents. Secondly, government office buildings in city centres create additional congestion. Given the current state of information technology, most government offices could and should be moved far from city centres. Hence, it is clear that the problems with SOEs are not limited to losses; their inefficiencies also can be a serious drag on the wider economy.

A more worrying issue is that the public is unaware of the full extent of the problem. The Treasury and other bodies that are supposed to monitor SOEs do so only partially and by all accounts ineffectively. Hence the question is - how much of public resources are being drained away in this financial black hole? The tax payers and citizens surely deserve better.

At a minimum, the Government needs to publish regular, comprehensive performance report giving the investments, outstanding debts and profits/losses of all SOEs. The question of reform needs to be urgently addressed and privatisation should remain an option.

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A version of this article originally appeared in “The State of State Enterprises in Sri Lanka” Report as well as The Island.

Reforming State Owned Enterprises - Q&A with Razeen Sally

Razeen Sally is Associate Professor at the Lee Kuan Yew School of Public Policy at the Notional University of Singapore. He is Chairman of the Institute of Policy Studies, the main economic-policy think tank in his native Sri Lanka. Previously he taught at the London School of Economics, where he received his PhD. He has been Director of the European Centre for International Political Economy, a global-economy think tank in Brussels. He has held visiting research and teaching positions at Institut D’Etudes Politiques (Sciences Po) in Paris,

Australian National University, University of Hong Kong, Institute of Southeast Asian Studies in Singapore and Dartmouth College in the USA. He was also Chair of the World Economic Forum’s Global Agenda Council on Competitiveness. He is an Adjunct Scholar at the Coto Institute and is on the advisory boards of the Institute of Economic Affairs (UK) and Centre for Independent Studies (Australia).

He is a member of the Mont Pelerin Society. Sally’s research and teaching focuses on global trade policy and Asia in the world economy. He has written on the WTD, FTAs and on different aspects of trade policy in Asia. He has also written on the history of economic ideas, especially the theory of commercial policy. His new book on Sri Lanka will be published in 2017

Razeen Sally, a Professor at the National University of Singapore, shared his experience about the experience of state-owned enterprises (SOEs) in South Asia and East Asia with Advocata, a Colombobased think tank promoting free market. While privatization is the best option to reduce the burden of state enterprises on society and improve t h e i r p e r f o r m a n c e , s u b j e c t i n g them t o competition, shielding them from politicization can also give benefits, he says in this interview.

There seems to have been an epidemic of state enterprises after World War II, especially in newly independent countries like Sri Lanka. When did state enterprises start to emerge in the world and in Sri Lanka? What is the historical background to SOEs?

In Sri Lanka as in India, many state enterprises date back to mid-1950s when the government policies took a turn towards to more intervention, more protection and using the state to promote investments in heavy industry and other areas. In this respect, the S.W.R.D. Bandaranaike government was following what the Nehru government was doing in India. So, the SOEs were intended to be the spearhead of economic development. And of course in Sri Lanka, this was really ratcheted up under Mrs. Bandaranaike’s government in 1970, when the state intended to take control of the commanding heights of the economy.

What were the intentions of the architects of SOEs? Have these objectives been met?

The answer is clearly no. The idea was to use the SOEs as part of an alternative model of economic development.

The model people had in mind was Soviet Union and its five-year plan. And here there is a contrast with what was done in the East Asian countries and what was done in South Asia. South Asia went for heavy state-led investment, nationalisation, for various government internal controls and external protection - import substitution. And this model clearly failed, which led to later market reforms, from 1977 in Sri Lanka and from 1991 in India.

The East Asian countries - some of them actually had SOEs - like Taiwan. But on the whole they didn’t nationalise rampantly and they relied much more on the private sector to be the engine of economic development. It was part of a different model which was more open to international trade, which had fewer domestic controls, which had macroeconomic stability and so on.

I would argue that the old model, which had nationalisation and SOEs controlling significant parts of the economy, definitely failed. And you see the costs of failure of SOEs in Sri Lanka. There are 250 or more SOEs, some that are hugely loss-making, that are a drain on an already depleted exchequer, that are heavily politicised, that crowd out private investment and that constrain consumer choice. So, it is a bad deal all around.

Why do so many state enterprises get into trouble and end up becoming burdens on the tax payer? Is there an inherent problem in the incentives or structure behind the SOEs that leads them on this path?

the world, state enterprises fail because there are disincentives to competition.

They are shielded from competition. They have a close link to the state. They are highly politicized. Appointments are not made on merit. The market is rigged in their favour, on prices and on production. Often they are protective from international competition as well as domestic competition. For all those reasons they fail.

And they are a drag on the economy, on the exchequer and on consumers - they limit competition. There are of course, exceptions.

One can point to a minority of SOEs in a few countries in the world that have not prevented fast and successful economic development. One thinks in particular of the government-linked companies (GLCs) in Singapore. Singapore, which is a fantastic and successful economy, still has large companies that are majority state-owned, that are grouped under Temasek - the state holding company - and are commercially viable. Some of them have done very well competing internationally. Singapore Airlines is perhaps the best example.

That they have been subjected to competition is the basic answer - and in a small economy like Singapore, which is highly open to the world. It is the most open economy of any size in the world with trade at close to 400 percent of gross domestic product (GDP).

The GLCs that play in the international market place are subject to fierce international competition in the market place. That’s true of Singapore Airlines, that’s true of the port services authority and that’s true of state-owned banks and so on. Over the decades the government has put in place the mechanisms to separate ownership - that is to say by the state - from the management, of commercial enterprises. In other words, they’ve been depoliticised to a large extent. It would be wrong to say that all SOEs in all countries have failed.

That’s not true. For the most part it is true. But a handful of exceptions are there. Singapore is the one that really stands out for exceptional pieces. But it’s very difficult to try and replicate in a country like Sri Lanka, what Singapore has done - in a country where politics is much more extrusive, where it is much more difficult to depoliticise the running of SOEs and also much more difficult to subject them to competition from domestic players and also from international players. Malaysia has a holding company called Khazanah, which is similar in some ways to Temasek in Singapore.

This holding company houses a number of leading SOEs in Malaysia, which accounts for about one third of Malaysian output. At least one of them is a big player in Sri Lanka. The Malaysian GLCs don’t perform nearly as well as Singapore GLCs - for two reasons. Firstly, they are less subject to competition and secondly, they are much more politicized. However, some of them are actually not too bad or are reasonably good because they have been shielded more than the others from politics.

What can be done?

The first best solution to the running of SOEs in Sri Lanka is to have a timetable to privatise. So yes, would use the ‘P’ word without feeling embarrassed about it. The obvious economically efficient solution is to privatize as many of the SOEs as possible over a realistic period of time. We know that politically this is not on the cards at the moment.

So the ‘P’ word is not used. As a matter of expediency that’s understandable. But I think as a medium to long-term objective, privatisation should be the way to go. However, now we have to get the second-best scenarios and second-best solutions. If large-scale privatisation is not feasible, what can be done in the short term, over the next one or two parliamentary terms, to improve the current dismal situation of the SOEs that won’t be as good as and as efficient as full privatisation, but might deliver a better result than what we have at the moment?’ In other words, improve the running of the enterprises; make them more commercially viable, more productive. In this scenario, we have to look at the other countries that have better practices. So Singapore comes to mind and so does Malaysia.

So we should look at the Temasek and Khazanah models of having a state holding company for SOEs. The lesson I would draw from the best example, which is Temasek, is that first you subject them to all-round competition, including international competition. And second, you put in place mechanism to depoliticise them as much as possible. In other words, separate ownership from management.

That’s the starting point. Then we can ask ourselves, ‘What should be the criteria for making these principles real?’ I was at a conference in Goa to discuss Indian reforms and I was part of a group that looked at this Temasek - Khazanah type of a model. And the local participants were interested in what lessons could there be for India, which is also not in the game of big privatisations.

As a first step, there is no point setting up a state-owned holding company and calling it something that’s done on the Temasek or Khazanah model if you’re not going to change the current operating procedures. So, the point is to have serious reforms, even if you can’t do privatisation. So what can you do? Firstly, identify the enterprises that essentially operate in a commercial sphere, where there is some competition already or where there could be more competition. If you have a state-run monopoly or oligopoly, then don’t put it in such a holding company.

Keep it separate. Because that’s probably going to be more politicized anyway there may be other public policy objectives that will get involved in the running of that enterprise. So keep that to one side. Rather, put in this basket enterprises that are commercial. So, that would include SriLankan Airlines, Mihin Air and the Sri Lanka Transport Board (SLTB) but not the Ceylon Electricity Board. So, in other words, don’t put all SOEs in this holding company, only put some of them that operate in a commercial sphere.

These should be corporatised with initially majority state’s ownership. Then you should start introducing the minority equity participation. And Temasek is interesting because, in the key enterprises, the government still retains the majority equity, therefore control. But they have actually gradually beefed up the minority equity in most of the Temasek enterprises.

That’s also a boost for the stock exchange or financial markets. And in some cases with nonpriority enterprises, they have actually taken the private sector stakes to a majority of equity and the government has retained only a minority of equity - and in some cases actually exited altogether. But in the meantime, the government could be with the minority equity - up to 19 percent. Maybe when the time is right politically, move into the majority private ownership. But the holding company should include airlines, buses, telcos and whatever is commercially viable and subject to competition.

We talk of loss-making state enterprises hurting the people. Are there other fallouts of badly managed SOEs? What’s a reasonable way of counting the total costs of SOEs on the economy?

Losses are the tip of the iceberg. And of course there are other SOEs in other countries that are hugely profitable. But that’s not an indication of overall economic efficiency. They are profitable because they have monopoly rents. They are not subject to normal competition.

So, I think the cost of SOEs that operate in rigged markets is the costs that fall on the consumer because of lack of competition. These might be difficult to quantify. We are talking of usually higher than normal prices, restricted product variety, often restricted supply of the product or service in question. I think probably the biggest losses to the economy are the losses that come from lack of competition.

When the Public Utilities Commission was set up here by Prof. Rohan Samarajiva, the law provided that you cannot replace the entire board in one go. Two or few members can be appointed for one year. What is your opinion on a procedure of that nature?

You could try to introduce independent directors. Having independent anybody in Sri Lanka is very difficult at the moment. Some of the Temasek companies have had foreign CEOs. Mind you SriLankan had a foreign CEO when it tied up with Emirates. What happened to him? You could try to maybe have a regulation that there should be a minimum number of independently appointed directors to the boards of these companies and to the boards of the holding company as well. So, the government appointees would be restricted to a certain number and there would be some mechanism to appoint some of the rest.

But of course they would have to be qualified. There is no point appointing a lawyer who leads someone’s political campaign without prior commercial experience to be an independent director of a commercial enterprise. That’s one thing to play around with that.

We have seen companies like Temasek advertise globally. So do you suggest that some people could also be hired globally?

Yes. Target the diaspora as well. See whether you could attract some of the qualified people from the diaspora to be directors of these companies, CEOs or the senior management.

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A version of this article originally appeared in “The State of State Enterprises in Sri Lanka” Report as well as Daily Mirror

The re-nationalisation of SriLankan Airlines and the follies of State enterprise

A couple of weeks ago, Prime Minister Ranil Wickremesinghe announced that the debts of SriLankan Airlines, amounting to a mammoth US$ 3.2 billion, will have to borne by the taxpayer. He said the government is taking this action to defuse an economic ‘landmine’ and that his government is actively looking for an international partner to manage the airline.

When a three billion dollar bill is passed on to ordinary Sri Lankans, many of whom have never flown the airline, it’s worth examining what let do this disastrous situation. In examining the data, it’s clear that Srilankan Airlines provides an excellent example of the problems that arise from state-owned enterprises.

Air Lanka, the state-owned airline was privatised in April 1998. The government of Sri Lanka sold a 40% shareholding to Emirates Airlines, which was also contracted to manage the company for a period of 10 years. The government of Sri Lanka continued to retain the majority shareholding but management was relinquished to Emirates.

Emirates re-branded the airline as ‘SriLankan’, overhauled the airline’s infrastructure and adopted a new approach to its operations. Cost-effective strategies were introduced; new pro-active management teams were put in place; Information technology became the basis of everyday activities. The airline’s network was constantly reappraised and product enhancement became a part of the airline’s philosophy. The airline was completely re-fleeted with an all-Airbus fleet of A340, A330 and A320 aircraft replacing the ageing Lockheed Tristars.

Although the privatisation and restructuring attracted a lot of criticism at the time, the exercise was eventually deemed a success; indeed in many quarters it was hailed as model for other airlines.

At an international seminar on airline restructuring and privatisation, held a couple of years after the divestment; the President of the employees union of Srilankan spoke on how union rights were protected and the improvement of working conditions.

At the time of the privatisation all employees were gifted shares by the government based on the number of years of service. Although a voluntary retirement scheme was also implemented the President of the union stated that employees were given an excellent deal if they wanted to leave and no-one was made redundant. Collective Agreements signed by the airline with employee unions guaranteed increments to employees. New human resource development programmes were instituted after privatisation to upgrade employees’ skills and a new grade and pay structure put in place.

Union representatives from other state-owned airlines were also impressed by the manner in which the airline disclosed information to employees; “they had never seen such transparency from an airline’s management,” said K J L Perera president of the employees union. SriLankan published its quarterly financial results in its staff newsletter.

Following a spat in December 2007 the Chief Executive Peter Hill, had his work permit revoked.The dispute began when Hill refused to bump 35 passengers from a full London-Colombo flight to make way for Sri Lanka’s president and his entourage. The Government cancelled the work permit of the CEO of the airline and in March 2008, Emirates did not renew the management contract. The airline, which had been consistently profitable under the management of Emirates last reported a profit in 2008; a bumper Rs.4.4bn. Since then the airline has racked up enormous losses; according to the latest published accounts for the year ended March 2015 losses stood 123.26bn rupees.

The airline reported an operating loss of Rs.16bn in the year 2015, an improvement from the loss of Rs.31.3bn in 2014. To put these figures into context, the Government bought out Emirates for only US$53m (or Rs.7bn at today’s exchange rate). Last year alone the airline lostfour times its original purchase price, a truly remarkable feat.  The airline’s accumulated losses amount to almost a billion dollars; the entire Southern highway was built for around 700 million dollars, cost overruns included.

The management of the airline has claimed that the recession in Europe and high oil prices caused the losses. The public was urged to look beyond the “mere profitability aspect” and understand the “catalyst role played” by the airline in tourism; in the words of the former CEO.

Airlines are global businesses and the same factors affect all airlines. Singapore Airlines cited by many who try to justify state ownership of airlines reported a marginal operating loss in only a single year during the last ten years; a loss of US$38m in 2009/10.

Singapore airlines is no less affected by the recession and oil prices, but it did not report losses. Singapore Airlines is a well-run state airline that is something of an exception. Many cite it’s example but few have been able to emulate its success, so we should not try to justify our Government’s ownership by looking to Singapore. Srilankan Airlines own track record is what we need to examine.

What changed when the Government took it over? They inherited a profitable business with the same staff, systems and infrastructure; the principal difference was in the management. The truth is that the airline suffered from gross mismanagement and corruption, some of which has recently been uncovered.

These problems seem to plague state owned enterprises (SOE’s), but why do they occur?

There are two elements to explanation: the principal-agent problem and the free-rider problem, both based on the assumption of self-seeking individuals.

An SOE is run by managers who do not own the firm. In a firm under state control managers know that their salaries will be paid regardless of how the business performs, therefore there is no incentive to maximise efficiency.

Frequently in Sri Lanka the Government will be under pressure to appoint various loyalists to key positions. In some, (although not all) instances, those who seek political patronage to be ‘fixed up in a job’ are people who lack the skills or abilities to find a job on their own merits. Thus the enterprise may become stuffed with incompetents; good staff will find it very difficult to work with these people so they either leave or give up trying to do any work and concentrate on keeping in the good books of the bosses.

The maxim of “more work, more trouble, less work, less trouble and no work, no trouble” is applied. In any case pay and benefits are not dependent on performance, so why bother to stick ones neck out? Soon, this attitude poisons the enterprise and staff work on surviving in their jobs rather than trying to manage the business.

This problem would not exist if the citizens, who are the owners (principals) of SOEs, can perfectly monitor the SOE managers (their agents) but individual citizens do not have the incentive, and means, to monitor the SOE managers.

This leads to the second element of the problem, even if they did try to hold the SOE to account, the costs that an individual citizen incurs in monitoring SOE managers (obtaining and analysing financial information, seeking explanations through public channels etc.) are solely his or hers, while the benefits of improved management accrue to all owners. Time and effort will be expended in the exercise by the citizen who receives no immediate benefit. Thus, individually, the citizens have little incentive to monitor the SOE managers, which means that in the end, no one monitors them. This is the so-called free-rider problem.

This is the fundamental structural flaw with SOE’s which explains why many operating in truly competitive markets are doomed to failure. There are apparently profitable SOE’s but In some instances they operate as a monopoly, like the Sri Lanka Port Aunthority.  In other instances such as LakSathosa, Governments  may  create an  uneven-playing  field  in  markets  where  an  SOE  competes  with private  firms,  as  they  have  a  vested  interest  in  ensuring  that  state-owned  firms  succeed. LakSathosa is exempt from the VAT and NBT charged on other supermarkets giving them a significant competitive advantage.

Accordingly, despite its role as regulator the government may, in fact, restrict competition through granting SOEs various benefits not offered to private firms. In such instances SOE’s may appear to be profitable but this is due to hidden subsidies and distortions which are ultimately borne by taxpayers.  

Airlines used to be regarded as a key part of transport infrastructure, like roads or bridges, which should be owned by the Government. Until the mid-1980s, most governments did own airlines and protected flag-carriers by restricting new entrants. This thinking has changed.

Privatisation made air travel more competitive and liberalisation brought competition from low-cost carriers. Most airlines in state control have failed to adapt and are losing money. There is little strategic interest in owning an airline; Switzerland and Belgium have done without a flag carrier for years.

The airline is currently a huge drain on the treasury and the previous experience with Emirates demonstrates the clear benefit of privatisation.

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A version of this article originally appeared in “The State of State Enterprises in Sri Lanka” Report as well as Ground Views