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Only a Combination of Internal and External Policy Reforms Can Help Better Manage Contingent Liabilities from SOEs in South Asia
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in the private sector. This is to explore whether public sector R&D has any spillovers on the private sector.
We estimate a positive relationship between a firm’s own R&D stock and its revenue productivity (as measured by TFPR).21 Further, an increase in the R&D stock in the CPSE’s own industry is also associated with higher revenue per unit input: controlling for firm fixed effects, the estimate of δ is positive and statistically significant at the 10 percent level (column 2). This is not the case with the private R&D stock. The estimate of δ is only marginally sensitive to including controls for the share of the public sector in total industry revenue (column 3).
Given the potential endogeneity of R&D spending, further research would be needed to better establish causation. But these patterns suggest that SOE R&D spending has positive spillovers on private firms in the same industry. This is consistent with the idea that SOEs make long-term investments with positive externalities that would otherwise not be undertaken by the private sector. Any efforts to reduce the state’s direct presence in the economy by reducing SOE ownership could thus start with a review to identify those industries in which state presence could be beneficial in the long term, could be needed to create markets, or could expand reach in the medium term and then exit, as opposed to those industries in which state presence is hard to justify.
Only a Combination of internal and External Policy Reforms Can Help Better Manage Contingent Liabilities from SOEs in South Asia
This chapter has shown that the contingent liabilities arising from SOEs in South Asia can be large but difficult to precisely quantify due to their largely implicit and opaque nature and the lack of data. Governments in South Asia do not track contingent liabilities from SOEs in a systematic manner. Hence, they are ill prepared if those liabilities are triggered. In some cases, it is difficult to quantify even the total liabilities and debt of SOEs, let alone the contingent liabilities associated with them.
Therefore, the fundamental policy message emerging from this chapter is that it is important for governments to better assess and monitor the fiscal risks from SOEs, incorporate them into their fiscal planning and debt management frameworks, and ensure that adequate provisions have been made for meeting triggered contingent liabilities without disrupting public spending plans. For instance, the government’s medium-term fiscal framework (MTFF) should incorporate these contingent liabilities by assessing SOE debt trajectories and their sensitivity to shocks, keeping track of likely government commitments in case of distress (World Bank 2019b).
Corporate governance guidelines should be strengthened and enforced, and more and better performance contracts should be adopted.
It is also important to mitigate unnecessary contingent liabilities from SOEs. The evidence presented in this chapter suggests that this will entail combining internal, SOE-level reforms to improve their efficiency with external reforms to address the soft budget constraint on SOEs and undue political intrusions into their operations. Internal reforms alone are unlikely to be enough because they seem to work only when SOEs operate in a truly competitive environment (Bartel and Harrison 2005). Global lessons for the World Bank’s experience with SOE reforms also suggest that efforts to improve SOE financial performance entail working on several levers, many of which entail efforts to strengthen the broader governance environment of SOEs (World Bank 2019b).
internal, SOE-Level Reforms: improving Corporate Governance and Performance incentives
Corporate governance reforms that professionalize the boards of SOEs, increase their autonomy, and improve financial reporting and
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external audits can help improve SOE performance by reducing unnecessary costs arising from poor employee or management effort, misaligned incentives, and political interference. This recommendation is supported by the observed positive association between the quality of corporate governance and performance measures in Indian CPSEs (as shown in this analysis) and in India SPSEs (Pargal and Mayer 2014). Although South Asian countries have pursued corporatization of SOEs in recent years, there is still room to strengthen corporate governance guidelines and enforce their full implementation. For example, most state-level power utilities in India comply with the basic corporate governance requirements of the Companies Act, but not with the more stringent guidelines that apply to CPSEs and are recommended for state-owned enterprises (Pargal and Mayer 2014). The formal stringency of financial disclosure and audit requirements appears sound in Indian and Pakistan, but implementation is not well assessed (OECD 2017; Naveed et al. 2018).
Performance contracts could help address SOE underperformance by ameliorating agency problems. A performance contract system typically defines SOE objectives and how they are to be assessed; monitors the achievement of objectives; and creates incentives by linking management rewards to the achievement of objectives. Elements of performance contracting have already been adopted in South Asia. For example, India has introduced a system under which CPSEs sign an annual memorandum of understanding (MOU) with the responsible ministry and get rated on compliance with that MOU. India has also introduced performance-based pay in CPSEs. However, there are doubts about how well this scheme is being implemented (Singh and Mishra 2013).
Overall, we caution that the evidence on the corporatization of SOEs is limited and has been mixed. Our findings on the positive association between CPSE corporate governance and performance are only suggestive. Similarly, evidence on the impacts of performance contracts on SOEs is limited and does not point to encouraging findings (see the survey in Smith and Trebilcock 2001). Relying solely on internal SOE reforms to address the issue of contingent liabilities from SOEs may not be enough.
What markets believe about government guarantees to SOEs matters. For instance, in 2015, the Baoding Tianwei Group became the first Chinese central government SOE to default on its debt, shaking the market’s faith in the implicit government guarantee behind SOEs. This reduction of implicit guarantees led to a decline in investment and net debt issuance, an increase in cash holdings, and reduced investment efficiency of SOEs in China (Jin, Wang, and Zhang 2018).
Moreover, political influence on bank lending to SOEs is a worrying issue in the region. The existence of a large state-owned commercial bank (SOCB) sector in much of South Asia is notable in this regard because “soft” loans of SOCBs to SOEs could be one channel through which governments soften the SOE budget constraints.22 However, even private sector banks are not immune to this problem. For example, in Pakistan, where banks are largely privatized, preferential lending to politically connected firms has been estimated to cause a significant level of GDP loss through misallocation of capital (Khwaja and Mian 2008). Such banking issues are discussed at length in chapter 2 of this report. Banking sector reform that increases competition and makes banks less susceptible to political influence could help reduce preferential lending to SOEs and discipline their soft budget constraint.
However, reforms to improve the efficiency and competitiveness of the banking sector and financial markets might not end soft loans to SOEs: banks will find SOE loans attractive as long as they believe them to be implicitly guaranteed by the government.
The most urgent and difficult policy issue, therefore, is to address the soft budget constraint by making a credible commitment to not giving unconditional government support to SOEs. The first step toward a credible commitment is to make the objectives of each
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SOE clearer and more measurable. In addition to being central to any performancebased management scheme in SOEs, this will allow governments to distinguish between losses incurred because of inefficiencies and losses incurred in efforts to meet socioeconomic objectives.
Making the objectives of every SOE clearer and more measurable will also impose more discipline on the government itself, reducing the temptation to use SOEs as instruments of ever-shifting, short-term policy objectives without due consideration to alternative instruments. The expectation of an implicit, unconditional guarantee to SOEs could arise because financial markets cannot always ascertain whether government support to an SOE is justified by that SOE’s mandate, or is simply masking production inefficiency or mismanaged financial risks. Public sector firms should be compensated for excess costs incurred in pursuit of explicit socioeconomic mandates. They should not be compensated for costs arising from inefficiencies to sustain SOEs for political reasons—as is the case with the frequent recapitalization of South Asian public utility companies for losses due to unmetered electricity connections, uncollected energy bills, electricity theft, fraud, and payment evasion (Pargal and Mayer 2014; Zhang 2019).
To introduce greater financial discipline, subsidies for providing public service at affordable (below-market) prices should be channeled through users, to the extent possible, rather than through the obscure financial management systems of SOEs.
Functions and business lines of SOEs should be well aligned with SOE objectives to control possible frivolous diversification and the empire building tendencies of SOE management or their higher-ups.
Governments can also better signal a credible commitment to not giving unconditional support to SOEs by extending them regular support based on previously specified criteria and avoiding bailouts. In 2015, the government of India announced a scheme (Ujwal DISCOM Assurance Yojana, UDAY) under which state governments would take on the debt of loss-making state-owned utility companies in return for a commitment to a charter of reform, which included better metering and reduction in operational losses.23 Progress on achieving the charter is being monitored through a set of indicators. It is too early to assess the success of the scheme, but the commitment to reform that is required by UDAY is a good idea. It prevents the scheme from devolving into an unconditional bailout. It will be critical for the credibility of this scheme to ensure that the charters are taken seriously by the utilities and state governments. Of course, it would have been even better if the debt of the utilities had not been allowed to build up in the first place.
To be effective, reforms must signal a credible commitment to not giving unconditional support to SOEs.
Governments must also define clear criteria and methods for determining how to compensate SOEs for costs incurred to meet development objectives. The design of the compensation scheme will depend on the objective of the SOE. For example, SOEs that provide subsidized goods or services should be compensated based on the gap between the price and the marginal cost of provision. The market price gap could be calculated by an independent body, such as a subgroup of the fiscal council. To the extent possible, grants to an SOE should be associated with the specific subsidy programs that it is implementing and kept separate from other balance sheet items. Even better, this subsidy should be channeled through consumers/users of SOE services to install greater financial discipline. Similarly, government loans to fund specific developmental investments should be earmarked as such.
Governments should also adhere to their own rules of SOE compensation and avoid postponing their obligations. For example, subsidies to utilities are not always paid on time. During fiscal 2016, the difference between subsidies booked and subsidies received by state-owned power utilities in India was Rs 24 billion (Zhang 2019). Had the government been paying this
