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close this bookPrivate Sector Development in Low-Income Countries - Development in Practice (WB, 1996, 188 p.)
close this folderChapter 1-From state to market uneven progress
View the document(introduction...)
View the documentRecent policy reforms
View the documentFast and slow growers
View the documentThe drag of public
View the documentRegulation and barriers to competition a harsh business environment
View the documentPoor quality of physical infrastructure and human resources
View the documentThe reform agenda

The drag of public

Recent policy reforms in many low-income countries have failed to reduce significantly the dominance of the public sector in the economy. The inefficiency of public enterprises and the spread of their losses throughout the economy continue to drag down savings, investment, and economic growth.

The dominance of the public sector

In most low-income countries, the public sector is dominant in infrastructure, heavy industry, agricultural marketing, and finance—typically accounting for more than 10 percent of GDP, 20 percent of employment, and 25 percent of investment. But public enterprises account on average for 14 percent of GDP, 18 percent of employment, and 27 percent of investment in Sub-Saharan Africa. In many countries public enterprises have retained their shares of production and employment even after public sector reform. This persistence reflects continuing investment in public enterprises as well as the slow pace and limited scope of divestiture. With few exceptions, divestiture programs in low-income countries have consisted mainly of privatization or liquidation of small enterprises, with little impact on the structure or performance of the economy.

Public enterprises dominate large industry, especially in Asia. In China, stateowned enterprises are particularly dominant in capital goods, such as steel, machinery-building, cement, and energy production, despite the growth of COEs and private firms during the past decade. This pattern also holds in other Asian economies that historically have adopted a mixed economy approach. In India, the public sector owns 50 percent of industrial assets, mainly in heavy industry; and accounts for 25 percent of industrial production. In Pakistan, the integrated steel works is publicly owned, while the private sector owns small arc furnaces, foundries, and ship-breaking. In the heavy engineering sector, large state enterprises in machine-building and machine tools exist alongside private engineering firms.

Agricultural development is still circumscribed by heavy state intervention, mainly through direct involvement in the marketing of inputs, outputs, and support services. The inefficiencies of these institutions have muted the supply response of the agricultural sector since increases in the price of tradables resulting from exchange rate reform often have not been fully passed through to producers. Even when marketing systems have been liberalized, private sector entry has been limited because of restrictive and discretionary licensing systems and the limited, high-cost credit provided by a state-dominated financial system.

The dominance of public enterprises in the economies of low-income countries means, when they perform poorly, that they drag down overall growth rates. In Kenya, for instance, total factor productivity in majority-owned state enterprises declined 3 percent during 1986-91, compared with a 5 percent increase in the private sector. If state enterprises had been as productive as the private sector during this period, Kenya's GDP would have grown by an additional 2 percent each year. Public enterprise inefficiency has an even larger impact in countries with more dominant public sectors than Kenya's.

For private firms, the inefficiency of public enterprises raises the cost of doing business. In Sub-Saharan Africa, the poor quality of utilities and infrastructure services adds 10-25 percent to firms' costs. It has been estimated that the efficiency losses of the publicly owned petroleum sector in Sub-Saharan Africa amount to about $1.4 billion a year (box 1.3)-more than the Bank's annual disbursement of adjustment policy loans to the region, and about two times the foreign direct investment in 1993.

Fiscal drain and financial sector leakages

The losses of unprofitable public enterprises are typically financed by a combination of transfers from the fiscal budget, a tax on the financial system through forced investments and portfolio requirements, and domestic credit, which increases the cost and reduces the volume of credit to the private sector. Public enterprise losses often are large relative to the size of low-income economies and reduce the availability of resources to finance private sector activity as well as alternative public investments. Often, the lack of data on state-owned enterprises, their losses, and the distribution of those losses throughout the economy makes it even more difficult to deal with them.

Covering public enterprise losses with fiscal transfers forces governments to finance larger fiscal deficits and increase tax revenues or reduce public expenditures in other areas, or both. Increasing tax revenues to finance the losses of state enterprises is difficult in many low-income countries, where the tax base is narrow and tax administration weak. During the 1980s most reforming low income countries reduced their budget deficits by cutting spending rather than by increasing revenues. Faced with strong political pressures, governments often sacrificed public investments with long-term benefits—including social and infrastructure investments—rather than cut current expenditures. In Sub-Saharan Africa, for example, average capital expenditures fell from 8.7 percent of GDP to 6.1 percent during the 1980s.


Oil products in Sub-Saharan Africa represent 70 percent of total commercial energy consumption, consume one-third of available hard currency reserves, and account for two-fifth-sofindirect taxes. The petroleum products industry in Sub-Saharan Africa is extremely inefficient. A 1992 study estimated total annual potential savings of more than $1.4 billion (approximately $51 a ton). The scale of these efficiency losses can be gauged from the facts that they exceeded IDA's total disbursements in that year to Sub-Saharan Africa for adjustment programs and they were twice the FDI inflows. The key areas of inefficiency: Procurement ($690 million). Most countries suffer from lack of foreign exchange and from monopolistic and inefficient government involvement in procurement. Refining ($550 million). Most refineries are too small, lack adequate technology, and face inadequate incentives for efficiency improvements. Distribution ($180 million). Transportation infrastructure is run-down. The study indicated that more than half the estimated savings could be achieved without new investments— by changing policies and procedures, particularly opening markets to competition and providing adequate pricing policies, and by regional cooperation. The key investment require meets would be for rationalizing and rehabilitating transport and storage facilities.

Governments in low-income countries often have controlled interest rates to reduce the fiscal cost of accommodating budget deficits. But reduced real deposit rates, often negative, have been a disincentive to savings (encouraging savers to seek nonfinancial assets), fostered capital flight, and encouraged over-borrowing by enterprises. As a result, financial depth is shallower in low-income countries than in other economies. This is especially true in Sub-Saharan Africa, where bank deposits are only 15-20 percent of GDP (compared with 40 percent in Pakistan, 60 percent in India, and 80 percent in China).

The financing of state enterprise losses through the domestic financial sector—directly, through credit to state enterprises, or indirectly, through credit to the government to finance budget transfers—increases the cost and reduces the availability of credit to the private sector. In Africa, the public share of domestic bank credit averages around 40 percent and exceeds 80 percent in some countries. In countries where banks are required to invest a certain portion of their assets in government paper or other forced investments at belowmarket returns, the effect is a tax on the financial sector that is usually reflected in higher intermediation margins. Even in countries that do not require banks to invest in particular industries, the allocation of credit often is not fully market-determined. Where state-owned banks dominate the financial sector, as they do in most low-income countries, they often channel resources to public enterprises rather than act as independent financial intermediaries. In addition, where the public sector is a dominant force in the real sectors, banks are under continual pressure to lend to public enterprises to prop up the banks' own nonperforming assets and to prop up their client firms that are linked with state enterprises (figure 1.9).

In many low-income countries, state enterprise losses are so large that they are two to three times public expenditures on education and health. Typically, a majority of these losses is attributable to a relatively small number of large state-owned enterprises. These normally are utilities (power, telecommunications, water, railways, ports), capital-intensive industries (steels, fertilizers, chemicals, pulp and paper, cement), and agricultural marketing boards. The fiscal drain of public enterprise losses is a form of continual government dissaving that makes it difficult for low-income countries to generate the total savings needed for accumulation and growth.

Figure 1.9 Public enterprises crowd out private credit, 1986-88

In Africa, the drain on the fiscal budget and the leakages from the financial system resulting from public enterprise losses can be as high as 12 percent of GDP, nearly as great as gross domestic savings (averaging 12.5 percent) and two to three times the spending on health and education. So, few resources remain for investment, public or private.

In China, fiscal losses of SOEs (that is, not counting losses in the banking system) are 3-5 percent of GDP. They are less significant in crowding out investment since gross savings have been about 39 percent during 1987-93. Still, accommodating such losses threatens the viability of the financial system, where it is estimated that 15-20 percent of the loans of state banks are nonperforming. The fast-growing economies would thus have done better but for the drag of the public sector on savings and investment.