Market economy: depoliticizing SOEs and equal market opportunities

Citizens of Bosnia and Herzegovina vote with their feet[i]and migrate to countries where they can taste the fruit of their labor. Global migration trends are showing that citizens of countries with strong state control over economy migrate to countries where functional market economy is established which is evident from the example of BiH population which more intensively migrates to Western European countries and North America.

That is why the transition to market economy is so important and in this mandate reform of SOEs should become its priority.

Transition

Transition of economy in BiH from state-controlled (planned) to market economy has never been completed.

Evaluation provided by the World Bank group in their Report for BiH dated in November2015[ii] is that the reform of sector of public companies, which has not been performed since the brake-up of Yugoslavia, would significantly change the country’s economic image. Although several reforms have been implemented in this area, from privatization to efforts to introduce corporative management into public companies, the fact is that they made no significant impact. It was also emphasized that for the purpose of creating a well-functioning market economy in BiH will require reducing the public sector’s role in the economy through cutting the number of SOEs, in particular those that no longer function, which would help to re-allocate resources such as land, buildings and labor to a more productive use.

In their blog, entitled „Three reasons why economy of Bosnia and Herzegovina is off balance“ leading economists of the World Bank state that the first reason is a large public sector and limited private wealth creation. They also estimate that the size of public sector (including public expenditures which sum up to 45%  of GDP, SOEs and corruption costs) could amount to 70% of GDP and they also emphasize that it is close to the level of level of state control over economy (in other words, control of political parties over economic activities) from the 1980s. And all that, despite the fact that from 1999 to 2015, 1,000 SOEs were totally privatized and 100 partially privatized. Let’s remember that it was the lack of transparency and efficiency which characterized the entire process that resulted in significant economic losses and created predominant opinion in the public eye that unemployment raises with privatization and that it only serves to increase the wealth of people with connections in political parties.

According to the Index of economic freedom published by the Heritage Foundation, in the past three years Bosnia and Herzegovina has been ranked as moderately free country, but the repression over economic freedom has been observed in business freedom, government spending, property rights and judicial effectiveness.

So, instead of being a market economy, Bosnia and Herzegovina has characteristics of a country held captive.

Position of SOEs and POEs

In its commercial guide for BiH, U.S. Country Commercial Guides,Bosnia and Herzegovina[iii], US Ministry of foreign trade estimates that in practice SOEs have advantage over POEs. Such unequal treatment is mostly observed in monopolizing the market through regulation, and different treatment in terms of paying public revenues, tax debts and debts to creditors and significant (vertical) help from the state where SOEs are in privileged position and enjoy state concessions. Despite that, they are dominating among the tax debtors in the country and most of them are on the verge of insolvency and they pose a great risk for governments.

In developed market economies there is great ideological dispute over economic policies which should ensure growth of private sector, especially SMEs, mostly family businesses, which are back bone of each economy – even one in Bosnia and Herzegovina, despite all the unfavorable circumstances and unequal market position. In BiH we are still talking about how to generally place private sector in equal position with state-owned enterprises and how to ensure that SOEs are not losers in the fair and equal market competition. Due to state the SOEs are currently in, that is going to be special kind of challenge.

State of SOEs

The IMF Report[iv] (International Monetary Fund) presented analysis of enterprises where government owns at least 50%. In 2017, there were 548 companies in BiH where majority owner was the state, which comprises 1.4% of all companies in the country. Having in mind that the reporting system is underdeveloped, and that out of 548 SOEs 134 of them (24.5%) failed to deliver financial reports timely, business report covered 414 SOEs where financial data was available. Out of analyzed 414 companies, 242 are in FBiH and 172 in RS. In terms of size, 227 are small enterprises, 114 medium enterprises and 73 large SOEs.

This small number of (state-owned) enterprises has BAM 30.9 billion funds which is significant 29.2% of all funds of BiH companies. They employ around 80,000 workers, which is 10.6% of the employed. Their total annual turnover is BAM 6.4 billion, which is only 9.3% of total turnover of all companies in BiH. These numbers clearly suggest that average efficiency in utilization of funds of these enterprises is much lower than efficiency of privately-owned enterprises, and productiveness of the employees is lower than the productiveness of the employed in the private sector.

Overall debt of the SOEs is constantly rising, and in the end of 2017, it amounted to BAM 8.1 billion, which is 17.2% of debt of all companies in the country.  Out of all liabilities, significant portion is in tax liabilities which amount to BAM 1.2 billion (primarily to social funds) and they comprise 34.3% of all tax debts in the country. Simultaneously, although tax discipline of the private sector strengthened, SOEs were still being tolerated their failure to pay taxes, which is characterized by IMF as quasi-fiscal support. Overall debt of SOEs is greater than their annual turnover of BAM 6.4 billion. In addition to the negative impact on pension and health care system in form of avoiding payments and therefore causing lower service quality in the health care system and lower pensions, second significant issue in short-term obligations of SOEs are liabilities to suppliers, which causes negative impact of SOEs to the liquidity of private sector. In other words, all the concessions the state, as owner, makes in favor of SOEs in the long run have negative effect to all the citizens, pensioners and private sector.

In terms of profitability and stability of business operations, only 5 out of 20 largest SOEs were categorized as “healthy” and “low-risk”, and only 17 enterprises paid dividends in 2017. SOEs paid to governments, as owners, BAM 80.7 million of dividends, and remunerated BAM 214 million of incentives, grants and subventions from them. Three of them: BH Telecom, BiH Electric Utility Company and RS Motorways paid 95% of BAM 80.7 million of dividends paid.

Regardless of their (in)efficiency, it was further stated in the report that average salaries in SOEs were 47% higher than average in private enterprises and even though this significant difference may be explained by tax evasion which is predominant in private enterprises, the fact that it is perceived by the citizens that public sector offers employment security and better salaries, it also leads to the labor market distortion and additionally causes damage to private companies in their efforts to attract talented employees.

In period 2015–2017 SOEs had negative returns on investments (ROE: -0.3%) and return on assets also turned to be negative (ROA: -0.2%). That means that as much as 29% of all the assets in the economy and all available net worth they have at disposal are not used by the SOEs adequately, they fail to create value and benefit from it, but instead create losses for entire society.  

Potential for development

IMF estimated that BiH GDP would be around 3% higher for 4% ROI in SOEs, which is the level suitable for the level of SOEs operating with moderate level of profitability. That may be interpreted as implicit opportunity cost of 3% GDP caused by inefficient SOE sector. ^[v]

In practice, there are situations when both private and state-owned companies are not in equal positions due to the fact that their operational aims are not the same – SOEs sometimes have aims other than profit; sometimes they meet aims for social development placed before them.  But, despite political request or social need that the state should finance expensive and extensive investments that private sector would never dare to undertake at certain times, costs of social programs should not be placed on the shoulders of SOEs and present a burden and a threat to sustainability of their business, but to be financed from the budget created for that purpose. In this aspect, SOEs are in more difficult position than privately-owned ones. It is common that SOEs invest in infrastructure in the areas without financial justification due to political demands.

For example, distant area in a municipality has no access to utilities (water, electricity, internet). Local government, lacking the funds to finance that infrastructure, put pressure to their colleagues from political parties at high positions in SOEs to finance the infrastructure for small number of users which would never pay off. Since the enterprise is state-owned, it is perceived by majority of BH public that it is their obligation to neglect the financial aspect of the investment in favor of social aims. Due to financial power of part of SOEs and lack of critical attitude of the public towards this practice, number of SOEs where commercial and developmental aims are separated is low, even in developed countries, which is more pronounced in the developing countries.  

Such practice gradually lead to other forms of misusing SOEs by politics for the purpose of ‘solving’ social issues – primarily unemployment, in other words covering them, and lack of criticism and control (which are very difficult to be performed because companies have business secrets) lead to misuse so instead of operating with low risk and providing efficient and accessible services to the citizens, they became expensive centers for providing employment to fellow political party members whose services are below satisfactory level, if they exist at all, but for the reason of their ‘social significance’ they are constantly being saved from financial problems by budget subventions.  So, public budget gets burdened again, but this time costs are becoming permanent.

Declaratively, reform of SOEs was priority of entity government in the previous mandate. Measures that should have been undertaken in form of development of the private sector and increase in economic activities set out in the Reform agenda and the arrangement made with the IMF also covered the issue of solving the status of public/state-owned enterprises. Majority of the measures [vi] has never been undertaken nor have they been adequately prioritized, and none of them was implemented within the time frame.  Overall process of taking (no) activities by the government may be characterized as lack of  courage and willingness to enter the process which would be painful to the part of employees in the public sector, but which would take the strings of economic power from the hands of politics.

Solutons

Market liberalization and equal treatment of all the companies are zero priorities
Increase in competition among the enterprises through removing regulation which monopolizes the position of  SOEs or go in their favor in all branches of economy, utility services included, may result in increase of quality and often reduction of services cost.  With strong competition, liquidity and competitiveness of BH companies would improve and there would be room for rationalization of SOEs. That would result in opening new positions as a result of real market demands.  Additionally, that would allow people to ‘vote with their feet’, but instead of leaving the country frustrated with poor public services, they could choose better service provider.

Together with opening the market, there is great work ahead of us in form of solving the status of SOEs, and involvement of competent experts is going to play crucial role in that area. It is necessary to perform in-depth analysis for each company and make educated choice between three basic options:  restructuring, restructuring followed by privatization and in cases where situation is beyond repair bankruptcy or closing.  For companies operating in sectors where market competition is possible, one of the mentioned scenarios may be chosen. On the other hand, companies which have ‘natural market monopoly’, which are unable to have competition for objective reasons (water supply, waste management) require restructuring in order to improve their efficiency, quality and price of services, as well as treatment of employees and users.

Accent is on the fact that there is no universal recipe for all SOEs.  Copying the model from other countries and providing quick-fix universal solutions offered by international consultants may pose a risk to success, and decision of each SOE’s destiny should be reached in line with specific circumstances of company’s business operations.

Restructuring
Restructuring means radical changes in company management, finances, organizational structure, business processes, internal capacities and motivation of employees.  It can be financial in case of companies with liquidity issues by servicing liabilities, operational for companies with operational issues and strategic for companies with growth issues, and they cover change of long term audit, strategies and company direction[vii].

For the purpose of restructuring the company it is necessary to have competent experts who know how to prepare, organize and conduct the processes[viii]. Therefore, requirement is to implement principles of corporative management to SOEs, defined in line with OECD guidelines –principles of transparency, responsibility, quality and fair approach to business and depoliticizing of SOEs through management improvement.

In line with that, three priorities are: (1) Place and role of the board, board member qualifications[ix], (2) selection process of top managers, head and board members[x]and (3) reward system for top management and board members[xi].

What is important to emphasize is that restructuring is extremely painful and long process. It is comprised of many unpopular measures such as layoffs and increase of workers’ productivity to reasonable level. That should be accomplished primarily through quality selection of the remaining workers (which can be equal to mission impossible due to legal procedures in bankrupt companies), followed by demanding process of improving the organization of work, increase in workers’ discipline and responsibilities.  

Great portion of workers would be willing to support such measures because they are aware that their companies can perform better and many of them are also under great load due to common practice that ‘one person works and two other are watching, and third one is on sick leave’. However, introducing the practice requires the change in model of behavior and approach to each worker’s activities and accepting the culture of change[xii]in the company, which would not be accepted with the smile of those people who misuse the system striving to keep their privileges, so their strong opposing may be expected.  In such circumstances restructuring may be unsuccessful because cooperation of all the employees in implementation is as crucial as willingness and active participation of owners and management in the process.

That is why politicians are not ready for these changes, because they pose great political risk. Although they are aware that they would solve certain ‘side effects’ of inefficiency (building debts, destabilization of social system, market distortion etc.) and have long-term social benefits, maintaining the status quo in short durationof single mandate is less painful choice and it poses lesser threat to losing elections. That is certainly applied to actors who built their election campaign around practice known as sinecure.

Additionally, it may take time to start separating the matters of management from the matters of ownership. It should be preceded by defining the strategy of corporative management in the ‘strategic companies’, ideally at state level, where management would be defined through application of OECD guidelines. Such amendment to existing legislation, namely entity-level laws on state capital, law on SOEs and adopting sector strategies can take too long.

Slow pace and lack of willingness of policymakers to start the painful processes of restructuring are some of the most significant arguments behind wider application of the next solution.

Privatization
Second solution is well-performed and transparent privatization process (before or after restructuring, depending of company and profitability of restructuring). Basic argument is that there are many SOEs, primarily ones that provide services, which can benefit from privatization business-wise. They would be released of complicated procedures mandatory due to state ownership, especially in procurement procedures, negotiations and partnerships, and they would be provided with owners who bring capital, knowledge and technologies which are better equipped for going to foreign markets and acquisition of companies in and out of BiH and more agile to adapt business operations to all the aspects of rapidly changing market.

For consumers, privatization would mean fast access to high-quality and/or more affordable services, in short term labor market would be provided with another company where workers would be employed according to their competences and skills, and for workers that would be beginning of career in the company where individual advancement is possible, together with better productivity together with higher salary.

Privatization also offers strong social benefits which are less political control over economy and favoring certain companies.  Less SOEs means less ‘loot’ for political parties to fight for in elections. Less loot reduces attractiveness of entering political waters for better positions or any employment, all without any ‘hard labor involved’. That would also discourage those who are involved in politics because of possibility to influence business activities of SOEs for the purpose of gaining personal profit illegally (and creating financial damage to the company) over their own private companies which sign lucrative business contracts with SOEs.

Small number of SOEs reduces the number of companies which, for the purpose of maintaining social peace and with approval of executive government, evade taxes and liabilities to suppliers. Perception of companies in the eyes of citizens would be changed: choice of service would be based on price-quality relationship, they would have more critical attitude towards quality of services, and they would more frequently choose to change service provider in case of dissatisfaction.

Majority of expert community find that ‘strategic companies’ should be state-owned and that they should be excluded from privatization. What is important for the continuation of privatization is classification of ‘strategic companies’ according to criteria whether they are really taking care of ‘public goods’ because they are currently being evaluated by approximation and according to the criterion of financial power and not strategic developmental function. Therefore, it is important to reach consensus on which situations require justified state monopoly as well as defining public goods[xiii].

In defining new reform agenda with the purpose of resolving the status of SOEs defining objective deadlines for specific aims is going to be crucial. Significant issues remaining are matters regarding rule of law and implementation of related policies: how to start a process of depoliticizing SOEs which majority of political parties is not willing to do in a political system which is, according to all indicators, closed and highly corrupted, and at the same time secure public business operations which would prevent all the failures made so far.

For all decision makers who would like to learn more about restructuring SOEs we wholeheartedly recommend an article Restructuring of companies by Marijan Ožanić.