UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN

The Latin American Economics

PRIVATIZATION IN LATIN AMERICA:

ITS BENEFITS AND RISKS

Himmet Parmaksiz

Masters of Science in Policy Economics

April, 2007
 ABSTRACT1

Privatization issue has still continued its positive popularity in the world especially in the
developing countries in spite of some criticisms, which have generally been stated by
socialist economists and advocated by some political figures. Although privatization
processes in developed countries such as European countries, which include huge
economies, have been barely accomplished by the end of twentieth century, privatization
processes in developing countries such as Latin American countries have still continued
because of various factors; discontents and doubts towards privatization, the structures of
these economies, shortage of domestic capital accumulation, lack of foreign investments,
and so on. These delays in the privatizations cause not only the inefficiencies in these
economies but also the discontents and doubts towards privatization, which have
weakened these economies more and made them more vulnerable to new crises. Besides,
unproductive state enterprises operated in these countries have retarded their economic
growth, and these time lags in privatizations have deteriorated the credibility of these
countries. Thus, according to empirical evidences, it can be concluded that all developing
countries, except for some countries such as China, Cuba, Venezuela, believe in the
benefits of privatization, which decrease the public borrowing requirements, improve
economic stability and efficiency, and provide better goods and services for the people
although it brings some risks or costs.

In this paper, in Latin American countries, the economic structures and frameworks prior
to privatization periods and its processes will be examined, and its effects on these
economies will be discussed in terms of its benefits and risks. Finally, the lessons will be
tried to draw from the privatizations in Latin America countries.

1
I selected this topic because I have worked as Planning Expert on
State Owned Enterprises (about 40 firms including huge companies
such as TUPRAS, BOTAS, TURK TELEKOM) and their privatizations in
State Planning Organization of Turkey for six years. From my
experiences, I have concluded that SOEs have not generally been
managed according to economic conditions because of political
appointments, so they naturally have damaged the resource allocation
and efficiency in the economy.

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I- INTRODUCTION
Privatization is the transfer of ownership from the public sector or government in state
owned enterprises (SOEs) or other public utilities to the private sector or business. In
literature, the opposition of this transfer could be often called as the nationalization of
some public property or responsibility. In most countries, SOEs had or have generally
been operated to meet the basic needs of people such as water and electricity because of
the shortage of private capitals in these sectors, or as a result of their economic systems
they applied.

During the industrializing periods of nations, many famous economists and politicians
advocated state ownership in some sectors as monopoly power and externalities, but
implementations showed that most of them produced market failures in the long term.
However, towards the end of the twentieth century, the evidences on the failures of SOEs
around the world and developments in contract and ownership theory have led to a
reassessment of the benefits of state ownership in production (Shleifer, 1998). As a result
of this evaluation, in most countries, privatization process started in the middle of
twentieth century (Silanes, 2003).

From the historical perspectives, it can be seen that the economic structures and
frameworks in Latin American countries had neither supported capital accumulation
sufficiently in these economies nor increased the number of entrepreneurs even though
they accomplished to attract huge foreign investments in the beginning of nineteenth
century. Foreign direct investment (FDI) flow figures in some Latin American countries
during the period of 1913 to 1929 compared to the period of 1970 to 1986, just before the
recent acceleration of FDI started in 1990s, shows that annual FDI flows in the 1913 to
1929 period were much higher as a fraction of GNP than FDI flows in the 1970s and
1980s. The great majority of FDI in Latin America originates in the United States,
Europe, and Latin America itself. (Rivera, 2000)

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Initially, the policy that foreign investors were insured as quarantined rate of return
instruments caused FDI to come into these countries, but these contingent liabilities
deteriorated domestic capital accumulations, and indirectly these economies. In some
sectors, these countries gave some high level of rate of return even before operating or
some lower tax incentives to foreign investors as well as removed some bureaucracy,
which caused production costs to increase. Moreover, when some of these foreign
investments come into these economies as direct investments, the others were in shape of
lending, which had been used to finance the lavish government spending such as
constructing prestigious buildings and military purposes. (Fetter, 1947) Therefore, the
cost of borrowing was very high in these countries, and they did not get the whole portion
of borrowing, sometimes 80-90 %, but they had to pay 100 % and higher interest rates.
For examples, good risks like Brazil or Chile could float loans with 5 percent coupons at
a price of 80 or 90, for a yield of fewer than 6 percent, and Peru could offer
approximately the same yields. Argentine coupons ran to 6 or 7 percent, and the issues
sold at around 90, while Costa Rica floated 6s and 7s and sold them for about 70. But
war-torn Paraguay had to offer 8s and Honduras 10s, and these bonds still could not be
sold for more than 80 (Marichal, 1989).

Upon made in especially railroads, mining, plantations, trade and finance places, foreign
investments had come into these economies, but these investments had not turned into
positive capital accumulation for these countries because these investments were just
made to strengthen and maintain the economic interests of these countries, instead of
strengthening the economic structures. For instance, in the second half of the nineteenth
centuries, foreign investments used to not only build the railroads in order to transport
raw materials especially mining goods produced in this region, but also trade them, as
well as give credits to foster these products. In other words, these investments did not
sufficiently produce permanently manufacturing sectors in these economies. Although the
investments made in railroads linked interiors, where mining were found, to the ports,
this did not provide transportation network for the whole country. (Fetter, 1947)

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As a result of these economic structures, labor diversification had not improved in most
sectors because of dual economies. In dual economies, foreign investors in most sectors
used unskilled labor locally, but managers and engineers were expatriates. This situation
had deteriorated the labor divisions in these economies. Shortly, economic structures in
these countries depend on exporting primary goods and importing secondary or
manufactured goods.

In addition to the disordered economic structures and frameworks in these economies, the
Great Depression, which followed the US stock market crash of 1929, impacted heavily
on Latin American economies. Before the global Great Depression of the 1930s, links
between the United States economy and Latin American economies had been established
through US investments in Latin America, and Latin American exports to the US. When
the US stock market crashed in 1929, Latin Americans felt heavy reverberations because
the existing economic relationships come up to stop between US and Latin American
countries. Especially Chile, Peru, and Bolivia were, according to a League of Nations
report, the countries worst-hit by the Great Depression. As a result, the rise of fascism
and dictatorial managements also became apparent in Latin American countries in the
1930s due to the Great Depression (Skidmore, 2000).

Overall, they became dependent economy because these economies were not diversified,
and borrowing requirements were very high. In other words, these economies were
mono–export economies, which made them dependent in absence of diversification, and
the economic structures in these countries caused the troubles in economic growth
because the supply of this primary goods is nearly inelastic, whereas the demand for them
is very elastic in developed countries, so the reasons such as recession cause the price of
export to go down, which create current deficits for these economies.

II-STATE OWNED ENTERPRISES (SOES) AND PRIVATIZATIONS IN LATIN

AMERICAN COUNTRIES

State owned enterprises (SOEs)

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In Latin American countries, SOEs and some utilitizes in many sectors have been
basically operated to meet the local needs. For example, Brazil had the same local private
steel firms. But, in long term, these firms needed government support to operate and
maintain them. Then government took over these firms and managed them
uneconomically. In most cases, politicians used their powers for political purposes such
as unproductive employment or “managerial positions”. In other words, someone who
had a connection with politicians is more likely to get the position regardless of his/her
capability and education. Therefore, these countries needed to borrow from abroad,
which caused foreign debts to increase.

As for the public utilizes, government invest in them because foreigners did not find them
attractive to invest. Besides, price controls on public utilities and fear of nationalization
discouraged foreign investments. Therefore, Latin states founded many SOEs both in
state and federal level and main supplier of these services. Moreover, these clumsy
enterprises had exploited also natural resources in especially petrol as import-distribution
and chemical sectors, which are very important in development process. Besides, many
SOEs abused their monopoly power. For example, public steel company was not working
well, so it was not be able to meet the orders of private firms in time. This was causing
firms to increase their steel-input inventory, which increase the costs. This shortage of
supply was also causing briberies. For example, firms were giving the bribery to get the
early delivery.

In the following periods, inward-looking import substitution policies were adopted by

most Latin American countries from the 1930s to 1960s because of especially the Great
Depression of the 1930s. In particular, the Argentine economist and UNECLAC head
Raúl Prebisch was a visible advocator of this policy in the 1950s. Prebisch believed that
developing countries needed to create forward linkages domestically, and could only
succeed by creating the industries that used the primary products already being produced
by these countries. The tariffs were designed to allow domestic infant industries to
prosper. (Ocampo, 2003) But, in reality, inward looking ISI policies in many countries
including Turkey in 1980 did not succeed in significantly expanding and deepening

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industrialization in the countries applying them. Often they resulted in inferior and
costlier substitutes for products that were readily available on world markets. For
example, Brazilian small arms production is a result of ISI. Nowadays, Brazil has a
native weapons industry, even exporting to countries such as Venezuela, yet these
weapons are of inferior quality. Shortly, these countries had used SOEs as a way of ISI
policies both to maximize vertical integration and to build the necessary infrastructure in
especially steel industry and public utilities.

Overall, all these structures and frameworks in these economies had produced many
SOEs in many sectors, most of which come up to market failures in the long term, not
because of ideological reasons, but just because of pragmatic reasons in many cases. For
examples, SOEs in electricity sectors made power cheaper, development bank made
credits available for developing sectors in the absence of capital market. However, these
economic structures that states keep the economies under control caused crowding out
due to inefficiency and corruption etc. Towards the end of the industrializing in the world,
most of these nations accelerated the privatizations of these SOEs and other public
utilities in order to close the growth lags between these countries and developed
countries, as well as to save their economies from global crisis, and attract more foreign
investments.

Privatizations
Debt crisis of 1980’s and runaway inflation caused Latin American Countries to reassess
their fiscal management, and they need some fiscal adjustments, which were arisen from
most of their fiscal deficits and foreign debts regarding SOEs. Over time, these states
became a “crowding out” phenomenon, and privatization was viewed as a solution.
Besides, IMF and World Bank made their loans depend on the privatization of SOEs and
liberalization of trade policies. In other words, in order to get foreign debt from these
institutions, these countries had to apply privatization and outward-looking policies.
Hence, privatization experiences in Latin American countries illustrate the rapid rise, the
recent relative fall, and the continuing puzzle of this contentious economic policy.

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Privatization started early in Chile in the 1970s and then in the United Kingdom in the
early 1980s (Baer, 1994). This policy spread rapidly around the world as a result of the
change of economic systems. The first ownership changes in Latin American countries
came in the mid-1980s, not long after Britain’s pioneering sales. As elsewhere, Latin
American privatizers—with the notable exception of Argentina—began with the sale of
state firms operating in competitive markets before moving to involve the private sector
in the management, financing and eventually the ownership of state firms in the
infrastructure, or utility sectors. Outside the industrialized OECD countries, privatization
spread faster and more extensively in Latin America than in any other region of the
world, and sales raised more revenues than elsewhere. In the 1990s, in 18 Latin American
states, accumulated privatization revenues averaged a sizeable 6% of GDP. (Inter-
American Development Bank [IADB], 2002) By the end of the decade, in distinct
contrast to other regions (outside the OECD states), most of all Latin American
privatizations were of high value infrastructures or utility firms. From 1990 to 2001,
private investment in infrastructure alone in Latin America totaled $360.5 billion USD,
$150 billion USD more than the next most attractive East Asia-Pacific region. (Harris,
2003) Early privatizing countries included Chile and Argentina, while Mexico and Peru
have also carried out major privatization programs. More recently, Brazil has become the
region's most important privatizing country; in 1998, Brazil received privatization
receipts of around US$6 billion, including from the sale of Telebras (Griffith-Jones,
1996).

Overall, privatization has been an extremely important source of revenue for Latin
American countries; for example, between 1985 and 1992, more than 2,000 publicly-
owned firms such as public utilities, banks and airlines were privatized throughout the
region (ECLAC, 1998). Hence, it can easily be accepted that privatization has been very
big business in Latin American countries.

III- THE BENEFITS AND RISKS OF PRIVATIZATION

The benefits of privatization

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It has generally been accepted that the privatization remove the costs of SOEs on the
economies, hence its benefits is equal to the operating costs of SOEs.

Almost all empirical studies of Latin American privatization show that it improves firm
performance. Profits, operating efficiency, and output tend to rise. An early but rigorous
privatization study (Galal et al. 1994) found increased performance and welfare gains in 5
of 6 Latin American cases reviewed. A more recent IADB study of six Latin American
countries found an average increase in profits (return on sales) of 29.8 % in a large
sample of privatized firms. Efficiency gains, as measured by output per worker or ratio of
costs to sales, averaged a remarkable 67 %. Output increases averaged 34 %, “regardless
of the indicator used.” (IADB, 2002, 3) (Nellis, 2003)

A political government tends to run an industry or company for political goals rather than
economic ones. As well as SOEs generally tend to have bureaucratic and clumsy
managements, governments may put off improvements in these firms due to political
sensitivity and special interests — even in cases of companies that are run well and better
meet the needs of their customers. Besides, nationalized industries are prone to
interference from politicians for political or populist reasons. Examples include making
an industry buy supplies from local producers when these may be more expensive than
buying from abroad, forcing an industry to freeze its prices/fares to satisfy the electorate
or control inflation, increasing its staffing to reduce unemployment, or moving its
operations to marginal constituencies. Therefore, it can generally be accepted that
privatization makes these economic enterprises more productive and efficient for the
economy.

A monopolized function is prone to corruption. Therefore, SOEs are wide open to many
corruptions. In other words, their decisions are made primarily for political reasons,
personal gain of the decision-maker, rather than economic ones. Also, corruption, called
as principal-agent issues during the privatization process can result in significant
underpricing of the asset. Hence, over time maintaining the existing of SOEs causes
many irreversible problems.

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Managers of privately owned companies are accountable both to their
owners/shareholders and to their consumers, and they can only exist and thrive where
needs are met. Managers of SOEs are required to be more accountable to the broader
community and to political "stakeholders". This can reduce their ability to directly and
specifically serve the needs of their customers, and can bias investment decisions away
from otherwise profitable areas.

Civil-liberty concerns are other problems in SOEs. These enterprises may have access to
information or assets which may be used against dissidents or any individuals who
disagree with their policies. This situation damages the justice and peace within the
country.

Privately held companies can sometimes more easily raise investment capital in the
financial markets when such local markets exist and are suitably liquid. While interest
rates for private companies are often higher than that for government debt, this can serve
as a useful constraint to promote efficient investments by private companies, instead of
cross-subsidizing them with the overall credit-risk of the country. Investment decisions
are then governed by market interest rates. State-owned industries have to compete with
demands from other government departments and special interests. In either case, for
smaller markets, political risk may add substantially to the cost of capital.

Governments have had the tendency to maintain poorly run SOEs often due to the
sensitivity of job losses. So, governments may think that it may be better to let these
firms fold, but unproductive enterprises damage the efficiency and resource allocation in
the economy.

Privatization provides market discipline for the economy. Poorly managed state
companies are insulated from the same discipline as private companies, which could go
bankrupt, have their management removed, or be taken over by competitors. Private

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companies are also able to take greater risks and then seek bankruptcy protection against
creditors if those risks turn sour.

The existence of natural monopolies does not mean that these sectors must be directly run
by state. Governments can enact or are armed with anti-trust legislation and bodies to
deal with anti-competitive behaviors of all companies public or private. Therefore, thanks
to privatization, natural monopolies can be managed more efficiently.

The ownerships and profits of successful enterprises tend to be dispersed and diversified
-particularly in voucher privatization. The availability of more investment vehicles
stimulates capital markets and promotes liquidity and job creation.

Corporations basically exist to generate profits for their shareholders. Private companies
make a profit by enticing consumers to buy their products in preference to their
competitors' goods or by increasing primary demand for their products, or by reducing
costs. Private corporations typically profit more if they serve the needs of their clients
well. Corporations of different sizes may target different market niches in order to focus
on marginal groups and satisfy their demand. A company with good corporate governance
will therefore be fostered to meet the needs of its customers efficiently. Therefore,
privatization makes the economy more efficiency.

Finally, the achievement of privatization is enhanced by two complementary policies: re-

regulation or deregulation of industries previously shielded from competitive forces; and
an effective corporate governance framework that facilitates privatized firms’ access to
capital at lower costs. Shortly, the empirical record shows that privatization leads to
increased profitability and productivity, firm restructuring, fiscal benefits, output growth
and even quality improvements (Silanes, 2003).

The Risks of Privatization

The macroeconomic and fiscal effects of privatization in these economies have been
negatively assessed by some economists and politicians. For example, if governments sell

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SOEs for much less than their market value because of corruption or incompetence, or if
they squander the proceeds on economically unproductive operations, which includes
simple theft, then privatization could have a negative impact on government finances, on
the provision of state-supplied social services, and in turn on growth—and thus,
eventually, contribute to poverty and perhaps inequality. One of the few studies to
examine this complex question concludes that the close to $80 billion USD in
privatization inflows in Brazil in the 1990s substantially “…went down the drain in the
disarray of public finances,” and that inequality was increased. (Macedo, 2000) A
somewhat similar accusation is made about Argentina. (Mussa, 2002) Of course, the
focus of this criticism is governmental incompetence and mismanagement of available
proceeds, not privatization. Besides, privatization will not result in true competition if a
natural monopoly exists.

A democratically elected government is accountable to the people through a legislature,

Congress or Parliament, and is motivated to safeguarding the assets of the nation. The
profit motive may be subordinated to social objectives. Therefore, it has been viewed that
governments should manage SOEs in the name of their people. Besides, the governments
can also contribute to its revenues through operating them well. Hence, the governments
give up these revenues because of privatization.

Government ministers and civil servants are bound to uphold the highest ethical
standards, and these standards are guaranteed through codes of conduct and declarations
of interest. However, the selling process could lack transparency, allowing the purchaser
and civil servants controlling the sale to gain personally.

The public does not have any control or oversight on private companies. On the contrary,
a democratically elected government is accountable to the people through a parliament,
and can intervene when civil liberties are threatened. Besides, the government may seek
to use state companies as instruments to further social goals for the benefit of the nation
as a whole. Therefore, governments have chosen to keep certain companies/industries
under public ownership because of their strategic importance or sensitive nature. For

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example, if a government-owned company providing an essential service (such as the
water supply) to all citizens is privatized, its new owner(s) could lead to the abandoning
of the social obligation to those who are less able to pay, or to regions where this service
is unprofitable. Moreover, governments may more easily exert pressure on SOEs to help
implementing government policy.

Governments can raise money in the financial markets most cheaply to re-lend to SOEs.
Besides, private companies often face a conflict between profitability and service levels,
and could over-react to short-term events. A state-owned company might have a longer-
term view, and thus be less likely to cut back on maintenance or staff costs, training etc,
to stem short term losses. Many private companies have downsized while making record
profits. Moreover, private companies do not have any goal other than to maximize
profits. A private company will serve the needs of those who are most willing to pay, as
opposed to the needs of the majority, and are thus anti-democratic.

Overall, for some cases, it has been observed that privatization include many risks and
costs economically as well as many benefits mentioned in the beginning of this section.
But, all these costs and risks arise from distorted and shallow economies instead of
privatization. Hence, many economists have accepted that enforcing economic
frameworks and deepening capital markets can prevent these costs and risks.

IV. SOCIOECONOMIC RESULTS OF PRIVATIZATIONS IN LATIN AMERICA

In these countries, the effects of privatization on consumers, workers, and public finances
have been observed. Generally, ownership changes in these economies may have
distributive impacts and play a large role in public discussions on the fairness of the
privatization, specifically the methods of allocating and pricing shares in the privatized
enterprises. However, the absence of data on ownership distribution prevents any
comprehensive assessment of its impact. Moreover, the ownership effects are unlikely to
affect the bottom half of the income distribution. To the extent that the latter is of primary
interest, the consumer and worker effects would seem to be more important.

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The most widespread effects of privatization are on consumers of essential services
provided by utility companies. A lot of the public disenchantment stems from concerns
about price increases resulting from privatization. However, there is no clear pattern
concerning price changes in these countries, with prices going down in about half the
cases. More important, perhaps, is a finding that even if prices went up, their effects were
outweighed by the corresponding increases in access that occurred in the bottom or lower
half of the distribution. The only exception to this was the failed water concession in
Cochabamba. Most cases display no evidence of a significant increase in poverty, and we
find (patchy) evidence of noticeable improvements in service quality following
privatization (McKenzie, 2003).

Moreover, there were adverse impacts on the worker side, principally in the form of
layoffs associated with the privatization. Employment contractions were significant
within privatized enterprises relative to the rest of the economy, with the cutbacks
ranging from 30 to 75 percent. As the privatized enterprises were typically capital
intensive, however, the employment contractions were small in relation to the size of the
aggregate labor force (2 percent in Argentina, 1 percent in Mexico, and 0.13 percent in
Bolivia). A significant fraction of the laid-off workers seem to have found jobs in other
private enterprises in the same sector of activity in Argentina and Mexico. The medium-
term impact was thus much lower than the immediate impact. No simple inference could
be made about the effects on wage levels and wage inequality, but the relatively small
scale of the labor reallocation in Argentina, Bolivia, and Mexico makes it unlikely that
these were significant. Besides, this probably had a modest downward impact on the
average wage rate, and it raised wage inequality in the urban sector. However, these
effects were dwarfed by increasing market pressure on wage structures within both the
public and private sectors of the economy (McKenzie, 2003).

The fiscal impact of the reforms seems generally to have been favorable in these
economies. In addition to aiding macroeconomic stabilization, the privatization process
supported a shift in public spending away from expensive debt service obligations and
the funding of operating losses in SOEs, which eventually subsidize middle-income

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workers and consumers, toward increased social spending, which directly targets the old
and the poor.

In sum, the only signs of an adverse distributive impact on the bottom half of the
distribution involve a small proportion of workers who were displaced from their jobs in
SOEs, and many of them probably can find jobs elsewhere in the economy fairly quickly.
This must be weighed against the advantages derived from lower prices, widened access
for poorer consumers, enhanced service quality, and a changed structure of public
finances that encompasses a variety of increased benefits for the poor.

V-CONCLUSION AND RECOMMENDATIONS

The results of this study suggest that the benefits of privatization especially for the Latin
America case obviously exceed its risks or the operating costs of SOEs. Besides, it has
been observed in these economies that delays in privatization and the lack of policy
coordination can reduce the benefits of privatization and produce the extra costs for these
economies. Moreover, the push for privatization and the drive to restructure the role of
the state in production has lost its appeal in these countries.

Therefore, addition to accelerating privatization, economic policies should include

deregulation, trade liberalization, and antitrust reform. Also, future privatization
programs should be designed specifically to minimize the adverse nature of their socially
and economically distributive impacts. Privatization process should include three key
steps, first, designing regulatory institutions for the privatized enterprises that ensure that
prices are kept low, that the firms operate under competitive pressure and are induced to
innovate and keep costs low, and that requirements are set for service expansion, quality,
and access; second, cushioning the employment impact by funding severance packages,
unemployment benefits, retraining, and job search assistance for the laid-off employees;
and third, using privatization proceeds in a transparent fashion to retire public debt and
increase social spending.

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