The Importance of Paying More Attention to the Hidden Liabilities of SOEs in South Asia

South Asia’s State-Owned Enterprises: Surprise Liabilities versus Positive Externalities 3

State-owned enterprises (SOEs) in South Asia offer many important benefits. They provide public goods and help address market failures related to risky, longterm investments and natural monopolies. However, because their operations and liabilities are backed by government guarantees, they also expose governments to large financial risks and potential (contingent) liabilities. Using firm-level panel data from India, this chapter assesses whether SOEs are more prone to financial distress than comparable private firms—and thus impose unforeseen liabilities and expenditure needs on the governments. It further studies whether SOEs’ financial distress relates to the persistent underperformance and indebtedness of some SOEs or to the greater risks that SOEs confront compared to private firms. Drilling deeper, the chapter tests alternative hypotheses for the underperformance of SOEs, including weak corporate governance and soft budget constraints in the form of both debt and equity bailouts. To illustrate some possible positives of SOE operations, the chapter searches for evidence that SOEs could provide strategic direction in their industries when they undertake riskier longterm investments, such as into research and development (R&D). In other words, can SOE investments in R&D crowd in additional R&D investment of private firms in the same industry?

The importance of Paying More Attention to the Hidden Liabilities of SOEs in South Asia

Nonfinancial state-owned enterprises (SOEs) have a large footprint in South Asia. Total SOE revenues amount to nearly 8 percent of GDP in Sri Lanka, 12 percent in Pakistan, and 19 percent in India (see table 3A.1).1 These shares are significant by international standards, although some other countries— particularly formerly socialist countries of Eastern Europe and East Asia—have much larger SOE sectors. The total number of SOEs

Note: This chapter draws on the background research paper: Melecky, M., S. Sharma, and D. Yang. 2020. “StateOwned Enterprises: The Distresses, Adjustments, and Fiscal Contingent Liabilities in South Asia.” Background paper for Hidden Debt. World Bank, Washington, DC.

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exceeds 200 in Pakistan, 400 in Sri Lanka, and 1,300 in India. Although present in nearly all sectors of the economy, they concentrate in the energy, transport, utilities, and trading sectors.

Rationales for government involvement

in SOEs. One major rationale for government ownership of firms in South Asia, as in other parts of the world, is the need to address market failures related to natural monopolies. Network industries in energy and transportation have high fixed costs, often leading to their monopolization. In such cases, an unregulated private sector cannot be relied upon to produce goods and services efficiently and affordably. Public sector ownership could improve welfare if the government’s capacity to regulate the private sector is limited (Stigler 1971; Peltzman 1976; Dal Bo 2006). This could be why South Asian SOEs are concentrated in network sectors such as energy, transport, and communication, where the potential for such market failures is high.

Another major rationale for public ownership is that long-term and risky investments in innovation are underfunded by private investors because failures in financial markets limit funding (Hall and Lerner 2010). In Europe, SOEs tend to invest more in R&D than private firms, particularly in sustainable technologies with low commercial returns (Bortolotti, Fotak, and Wolfe 2019). Some SOEs in South Asia are undertaking such investments. For example, the Solar Energy Corporation of India has been a pioneer in the commercialization of solar power—an investment with high risk and potential positive spillovers.2 Our analysis of firm-level data from India indicates that SOEs on average spend more on R&D than private firms do—and account for a disproportionate share of total R&D spending in several industries. Moreover, the R&D activities of SOEs in South Asia have positive spillovers on the performance of private firms, regression analysis suggests.

Relatedly, SOEs can complement the private sector by helping solve coordination problems. An example is a case of a strong complementarity between new technologies and specialized skills in an industry, with the risk that coordination failures between private firms and skills providers could block the supply of needed skills.3 The public sector could play a role in breaking the deadlock. Not surprisingly, many SOEs in South Asia have been early leaders in technical fields. For example, RITES India, the engineering arm of the Indian Railways Corporation, today provides infrastructure consulting services in India and abroad.4

South Asian SOEs also serve broader developmental or public interest objectives. The economic rationale for public ownership is less compelling in these situations. A case in point is the mobilization of SOEs to improve the connectivity of remote or underserved areas. For example, India’s flagship BharatNet Program, which aims to extend the reach of the telecom network to remote and rural villages and is one of the largest rural connectivity projects of its kind in the world, is implemented in part by a state-owned enterprise, BBNL (Bharat Broadband Network Limited) (BBNL 2019). Pakistan Railways subsidizes select routes to provide mobility and connectivity to far-flung areas (Government of Pakistan 2016).

How important are financial risks of

SOEs to governments? Although SOEs can contribute to development objectives, they are a source of financial risk to South Asian governments. Moreover, not all the risk is justified for achieving the development objectives through state ownership. Owning firms exposes government budgets and debt position to a host of external, macroeconomic, and sector-specific shocks that depend on the industry profile of the SOE sector. To an extent, this risk is an unavoidable side effect of public ownership of firms. However, South Asia’s SOE sectors regularly generate big losses. For example, the SOE sectors of

Many individual SOEs are persistent lossmakers and financially unsustainable. While the performance of SOEs should not be judged solely on commercial terms, these large and persistent SOE losses often culminate in costly government bailouts.

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Pakistan and Sri Lanka generated net losses in two out of the three years between 2015 and 2017, and India’s state public sector enterprises (SPSEs), the SOEs owned by subnational governments, lost an amount equal to 0.5 percent of GDP in 2017.

For example, in 2014 the Sri Lankan government had to inject SL Rs 123 billion (approximately 1.2 percent of GDP) from the budget into SOEs.5 In the same year, the Indian government approved a total assistance package of Rs 411 billion (approximately 0.3 percent of GDP) to revive 46 “sick” federal government–owned SOEs (Government of India 2014).

Many individual SOEs are persistent lossmakers and financially unsustainable, often culminating in costly government bailouts.

Analyzing fiscal contingent liabilities

from government ownership of SOEs. The main part of this chapter analyzes the fiscal contingent liabilities from government ownership of firms (SOEs) in South Asia. The analysis relies mainly on a detailed firm-level panel data set for India that has good coverage of firms that are majority privately owned as well the SOEs majority owned by the federal government (central public sector enterprises, or CPSEs). It is the only such data set available for the South Asian countries. This firmlevel analysis is supplemented with more aggregate data from reports published by South Asian governments.

This analysis begins by assessing the incidence of SOE distress. A firm is defined to be in distress when its earnings are not enough to cover its interest payments. The interest coverage ratio (ICR) is used to capture this relationship. The firm-level data from India show that Indian CPSEs are generally more likely to be in distress than comparable private firms. This is not because CPSEs are concentrated in particular sectors where profit margins are lower, nor because they are engaged in inherently more risky activities. Yet CPSE distress tends to last longer, often exceeding one year. While data limitations preclude a similar analysis for other countries, this study finds that persistent loss-making SOEs—prone to distress—are present throughout the region.

Next, this study assesses the magnitude of the contingent liabilities arising from SOE operations for the government fiscal stance (budget and debt positions). This requires information on the government’s financial commitments in case of SOE distress and the conditions under which they are triggered. Such information is not easily available. Even explicit government commitments, such as guarantees on SOE debt, are not always well documented. The data available suggest that explicit commitments are sizable. For example, SOE loans amounting to 1 percent of GDP were under government guarantee in Pakistan in 2017. The implicit government commitment to cover SOE debt is even harder to quantify due to data limitations.6 This study presents approximate upper-bound estimates by assessing the total liabilities of SOEs in high likelihood of needing bailout funding. The upper-bound estimate is large. For example, the total liability of all chronically distressed Indian national-level CPSEs has ranged, since 2008, between 3 percent and 5 percent of national GDP. This figure excludes subnational SOES, the SPSEs, which are in a much worse shape. Pakistan’s numbers are even more concerning. In the past five years, the total liabilities of loss-making SOEs in Pakistan has hovered around 12 percent of GDP.

The proximate cause of these contingent liabilities is the persistent financial underperformance of SOEs. The Indian panel data set shows that on average, CPSEs earn significantly less revenue per unit labor and per unit capital than private firms. They also have significantly higher debt-to-asset ratios than other firms. These findings are largely in line with the existing evidence base.7

Explaining the underperformance of SOEs. Why do SOEs underperform? One school of thought ascribes underperformance to an internal “agency problem” (Ehrlich et al. 1994): It is more difficult to align the incentives of managers and owners in the public sector because pay scales are more compressed, job security is higher, and employee monitoring is less rigorous compared with the private sector. Interestingly, South Asian governments

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have been “corporatizing” SOEs to professionalize their management and make it easier to monitor their performance by strengthening their corporate governance. For example, the Indian government issued corporate governance guidelines for CPSEs in 2010 and now rates CPSEs on compliance with the guidelines (Government of India 2010).8 We find that although there is a positive cross-sectional correlation between CPSEs’ corporate governance ratings and their commercial performance, improvements in these ratings over time are not significantly associated with improved performance. Therefore, insufficient evidence exists to conclude that corporatization has a causal impact on SOE performance.

Another, perhaps related, hypothesis is that SOEs underperform private firms because they operate in a more constrained or distorted environment.9 For example, they could be under pressure to hire excess workers (Shleifer and Vishny 1994). Indeed, our analysis of SOE performance measures suggests that CPSEs, on average, overemploy labor and capital. Similarly, Baird et al. (2019) exploit a natural experiment in India to show that excessive hiring by SOEs has caused a high level of labor misallocation in the manufacturing sector.

SOE pricing decisions are also constrained. For example, Indian SOEs in industries such as petroleum, electricity distribution, gas, and fertilizers have had to charge below-cost prices to subsidize consumers and farmers (Khanna 2012). In 2016, the electricity tariff for agricultural use was about 31 percent of the cost of supply, while the tariff for the residential sector was 77 percent of the average cost of supply (Zhang 2019). Likewise, Pakistan Railways subsidizes select routes to provide mobility and connectivity to far-flung areas (Government of Pakistan 2016).

Another potential external factor is the much-studied soft budget constraint of SOEs— the perception that SOEs have the implicit and unconditional support of the government (Kornai 1986). For example, SOEs might have access to softer loans with lower interest rates and looser conditions, as suggested by their persistently higher debt ratios. We find that, compared with private firms, there is a stronger positive association between accumulated losses and the debt-asset ratio among SOEs. This suggests that SOEs are more prone to covering losses through additional loans. Given that direct government loans are only a fraction of total SOE debt, SOEs must have preferential access to bank loans. This opens a question about the nexus between state-owned enterprises and state-owned banks, and more broadly, the preference of even private banks for lending to SOEs compared with similar privately owned companies.

Exploring the soft budget constraint hypoth-

esis. We explore the soft budget constraint hypothesis further by comparing how CPSEs and private firms in India adjust their assets and liabilities when in financial distress or when experiencing a revenue shock. The growth of fixed assets declines significantly for private firms when they are in distress, but this relationship is significantly weaker among CPSEs. Similarly, the growth of debt and equity capital declines significantly for private firms when they experience a negative shock, but does not for CPSEs. Correspondingly, the growth rate of debt increases more for private firms when they experience a positive shock than for CPSEs.

The lower sensitivity of SOE assets, debt, and equity to shocks is consistent with the hypothesis that SOEs enjoy greater access to soft funding because governments implicitly guarantee to bail them out. Banks can afford to discount shocks when assessing SOE creditworthiness if they believe there is an implicit government guarantee on SOE debt. In China, implicit government guarantees on SOEs are found to have reduced the sensitivity of SOE credit costs to risk (Allen et al. 2017) and to make SOE debt more attractive to financial markets (Jin, Wang, and Zhang 2018). Credit rating agencies explicitly include the likelihood of government support and bailout when assessing the credit risks of SOEs.10 Similarly, the lower sensitivity of equity investment in SOEs to shocks could be due to the belief among private investors that their equity is implicitly insured. Similar issues arise in the context of public-private partnerships (see chapter 1).

Although this soft budget constraint is not the only potential cause of SOE underperformance, it is likely to have been pivotal to the growth of unnecessary contingent liabilities