Role of divestments in overcoming present economic challenges

The Government of Sri Lanka (GoSL) has very ambitious plans for the country’s economic transformation, including an economic growth expectation of more than 6 percent during the five-year period of 2022-2027. The national budget announced in 2022 forecasts public investments to be at 5.1 percent of GDP. A similar figure was announced during the last budget as well, where it was targeted at 5.4 percent of GDP but currently the estimate for 2021 is at 3.5 percent.

The total tax revenue estimated in the national budget was an optimistic expectation as well with a growth projection of 50 percent (Rs.662 billion) in 2022. This is far more than what past budgets had also projected. This increase in revenue is expected to reduce the budget deficit as a percentage of GDP to 8.8 percent in 2022, from 11.1 percent in both 2020 (actual) and 2021 (forecast).

Therefore, the government needs substantial funding in order to invest in relevant sectors of the country to accelerate economic growth. If this is to be raised through borrowings, it will crowd out the private sector while also put pressure on interest rates, given the government’s policy of utilising domestic financing.  

Observing the 52 state-owned enterprises (SOEs) monitored by the Finance Ministry, an aggregate profit of Rs.103 billion was generated during the first seven months of 2021 but was eroded by loss-making entities, with a total loss of Rs.96 billion. Ninety-four percent of this loss was contributed by three entities, namely Ceylon Petroleum Corporation, SriLankan Airlines Ltd and Sri Lanka Transport Board, while 85 percent of profits were contributed by five entities. 

In this regard, letting go of significant stakes in nonstrategic assets and minority stakes in strategic assets could be the best course of action that can be followed, given the political milieu of the country. This will enable strategic assets to be sustained for a long period of time while enabling growth in the economy. A clear distinction between strategic and non-strategic assets should be drawn for this purpose. This can avoid divesting controlling stakes of strategic assets, which could undermine the long-term growth potential of the country. 

History of divestments in Sri Lanka
Sri Lanka is no stranger to divesting SOEs. Divestment of public enterprises were incorporated into the state policy in 1987 with an aim of reducing the fiscal burden and improving the efficiency and profitability of entities. This led to extensive SOE reforms being carried out between 1989 and 2002, with partial and full divestiture of 84 enterprises.
SOE divestments have been a key channel of foreign direct investment (FDI) into Sri Lanka. During 1990 and 2000, the 11 largest SOE divestment transactions that occurred in the country amounted to US $ 609 million of the US $ 1,791 million received as FDI during the same period (Central Bank, 2002). Therefore, divesting SOEs can bring in the much-needed FDI into the country and aid the government in their efforts towards post-pandemic economic revival. A list of few key divestments that occurred during the period of 1990-2001 is given in the table. 

Benefits of divesting non-strategic assets
Improve current account
In line with the savings and investment model, the current account of the balance of payment (BOP) is identical to government savings and private savings minus investments. In 2020, private savings accounted for Rs.4,007 billion while government savings stood at a negative Rs.1,180 billion. Therefore, by increasing government income or by cutting down government expenditure, the current account deficit can be reduced. 
Barring five years, Sri Lanka has been recording primary balance deficits (non-interest government expenditure greater than government revenue) since 1950.  Hence, selective divestment of assets will allow the government to generate a one-off income, reduce the fiscal burden and improve this persistent government dissaving, which thereby can translate into a favourable current account balance. 

Reduce financial and administrative 
burden on govt.
The total turnover of the 52 SOEs monitored by the Finance Ministry was significant in 2020, amounting to Rs.1,804 billion, which was close to 1.5 times of the total government revenue collected in 2020. However, the cumulative bank credit that was pumped into SOEs as at November 2021 was Rs.1,185 billion and treasury grants provided to the 52 SOEs in 2020 was at Rs.75 billion. Therefore, the financial burden of SOEs on the government is substantial and in return detrimental for the economy. The increase in bank credit also increases money supply, which then exerts pressure on inflation. Hence, selective divestments can help the government alleviate the financial and administrative burden of SOEs on the government and thereby the economy.

Another dimension of the fiscal burden is the relationship between Sri Lanka’s rating and the performance of SOEs. For example, Moody’s changed the country’s rating outlook from stable to negative in June 2016, owing to weak financial performance of SOEs.

Improve efficiency and effectiveness of operations 
The private sector operating under a competitive environment is generally deemed to be profit oriented and is expected to strive towards minimising costs through improvements in its effectiveness of services offered. 
Therefore, divestiture can bring in the much-needed efficiency and effectiveness to SOE operations. It can also provide the SOEs the freedom to operate outside of political and bureaucratic constraints and separate the state’s operational activities, from its policymaking and regulatory functions. 

Investors with capacity to invest in expansions
Divestiture can bring in investors with the capacity to invest in expansions. For example, Hilton has much potential for further development but owing to financial constraints, the government is unable to pursue such developments. The Hyatt project is also another example that requires significant investments to reach completion, which the government is not in a position to undertake. 

Divestiture process
1. Identifying strategic and non-strategic assets
It is important to first differentiate state assets as strategic and non-strategic. Strategic assets can be identified as assets that should remain under state ownerships for non-commercial reasons such as national security, managing price, provision of essential public goods or services, etc. A case for divestment of significant stakes can be made for SOEs if it is no longer deemed to be aligning with these state-ownership objectives.
Examples of a few non-strategic assets in Sri Lanka can be identified in sectors such as real estate, finance, insurance, investment funds, shipping, oil and gas, handicraft, fisheries, etc. Some of these may be considered as strategic by the government for various reasons. However, the divestment process allows one to divest minority stakes without losing control of an enterprise. Even a single share in excess of a 50 percent stake will provide control of the enterprise. Absolute control can also be enjoyed with a 75 percent stake as that permits the government to pass extraordinary resolutions. Hence, reducing the ownership of an enterprise down to 75 percent will not result in any dilution of control.

2. Selecting method of divestment
Ideal method that can be followed is to offer significant stake through a competitive tender process or a bidding process conducted on a special board of the Colombo Stock Exchange (CSE) among shortlisted parties. Balance can be offered through an initial public offering (IPO) allowing the members of the public to become part owners of an SOE. 
Offering part of shares to employees can help overcome resistance and builds their commitment to remain and support the new management after the sale. A similar approach was followed in Sri Lanka during the first wave of divestments in 1988.
For example, when United Motors was incorporated as a public limited liability company, each employee received 500 shares as a gift. The divestments that took place in this period were also termed as “peoplisation” to limit resistance from the public. 

3. Specifying how proceeds of sale 
would be used
A weakness that was observed in divestments carried out by Sri Lanka in the past was that the proceeds were not allocated to an ear-marked account and instead went into miscellaneous expenditure. Therefore, carefully planning on how these will be used for Sri Lanka’s economic development is imperative and following a transparent process in this regard is essential. Much of the recent criticism is due to the lack of a transparent process, both in terms of selecting investors and the use of divestiture proceeds.

4. Detailed implementation plan 
The complexity of these transactions will mean that it requires a carefully crafted implementation plan. Therefore, it is vital to have a detailed plan specifying the entities that will be divested, method of divestiture, modality of divestments and earmarking the proceeds of these divestments. Much attention is also required to perform stakeholder consultations and obtain their support to ensure a smooth implementation process. The divestiture of significant stake in Sri Lanka Telecom can be cited as a successful case study that followed a due process, including conducting stakeholder consultations.

Other country experiences
Vietnam
In Vietnam, divestments have been a major focus for the government since it increases the efficiency of loss-making SOEs. Divestments are also a significant source of revenue for the government, which helps the government in managing the fiscal deficit and fund economic development plans. In 2016, earnings from SOE divestments in Vietnam reached VND 30 trillion (US $ 1.3 billion), while in 2017 it was about five times the figure in 2016 (VND 140 trillion – US $ 6 billion).

India
In 1991, with the liberalisation of the Indian economy, the government opted for SOE reforms with divestments in order to improve SOE viability as well as to raise revenue for the annual budget cycles. Last year, too, the country set an ambitious disinvestment target of INR 1.75 trillion (about US $ 24 billion) during its budget announcement. However, a lot needs to be done by the government to achieve this divestment target in 2022.

Conclusion
Partially divesting government ownership in SOEs does not correspond to a decrease in the government’s ability to influence or control the enterprises concerned. A 50 percent stake or more will provide control of the enterprise and absolute control can be retained with a 75 percent stake. Therefore, given the political milieu of the country and to avoid public resistance, options such as selling significant stakes with management for non-strategic entities and releasing smaller stakes for strategic entities can be considered rather than following a full-scale privatisation programme. 
In a few non-strategic sectors such as hospitality, even the divestiture of majority stake can be considered. To list on the stock market even with minority stakes can provide the SOEs with the much-needed transparency and efficiency in business operations through adherence to stringent regulations. It should also be noted that the three main loss-making entities aforementioned are high foreign currency-intensive businesses as well and hence, require extensive financial discipline. Therefore, in the present scenario, where Sri Lanka is facing significant funding constraints, SOE divestment should be seriously considered for inclusion in the economic recovery plan of the country. 
(Imesha Dissanayake is a Research Associate attached to the Economic Intelligence Unit of the Ceylon Chamber of Commerce. This article was developed as a follow-up to the Strategic Insight piece on ‘SOE Reform: The Impetus for Post-Pandemic Economic Revival’. The Strategic Insight series is a series of briefs that focuses on key contemporary topics that matter to the private sector)