By Tony Chen
Tony attended the 2016 World Bank and IMF Annual Meetings in Washington D.C. Tony is studying a Bachelor of Commerce at the University of Melbourne Faculty of Business and Economics.
This policy paper explores the topic of Asset Recycling. Asset Recycling (which will be referred to via the abbreviation AR from here forth) is a process of funding and creating new infrastructure developments through the privatisation of current nationally held physical assets and utilities.
There are three broad parts to this paper. The first considers the economic costs and benefits surrounding privatisation and brings them together in a decision rule. The second section examines how the government can optimise the balance between these costs and benefits in order to attain the most favourable outcome for society. Finally, the paper analyses how privatisation and Asset Recycling should be considered in the context of global and domestic economic stability. This will be accomplished through a case study of the Brazilian electricity industry during the 1990s under the government of Fernando Cardoso.
- That Asset Recycling schemes should only be carried out if the revenue from privatisation exceeds the associated welfare tradeoff
- That the government focuses upon the privatisation of economically competitive industries in order to induce efficiency gains
- That Asset Recycling schemes should be avoided in times of economic instability or downturn
While the economic schools of thought disagree on a number of a macroeconomic issues – the importance of infrastructure in the long term is a topic which brings accord from all sides (Summers, 2016) (Cochrane, 2016). Better highways, ports, and utilities are crucial for increasing a nation’s productive capacity, reducing long term maintenance burdens and sustaining growth (Summers, 2016). Over the last fifteen years the percentage growth in the net capital stock has outpaced GDP growth in Australia (SMART Infrastructure Group, 2016). However a growing population and foreign trade demand will increase pressures upon the current infrastructure system (Infrastructure Australia, 2016). Governments must therefore consider their options to raise funding for construction and infrastructure. The two most common sources are taxes and debt, however a third method is through Asset Recycling (AR). This is a process of gathering revenue from the privatisation of current national assets – and only issuing additional debt if the revenue from the sale does not meet the required construction costs. This paper defines two new AR terms which will be used throughout the piece. The ‘source asset’ is the infrastructure asset which is to be privatised. The ‘target asset’ is the new infrastructure asset which will be constructed.
AR has the potential to raise the infrastructure level at a lower cost to the government, and therefore could be a viable alternative to traditional revenue sources (SMART Infrastructure Group, 2016). When fiscally constrained, AR is also less risky than increased borrowing which could compromise the government’s credit rating (SMART Infrastructure Group, 2016).
Issues surrounding privatisation
Privatisation is a politically and economically contentious issue. From microeconomic theory one of the most common cautions is that the private company, which purchases the source asset, will seek profits and move production away from the government’s socially optimum level. The private firm will charge a higher price, thereby creating a welfare loss (Kwame Sundaram, 2008). This welfare loss occurs because individuals are forced to consume less than they were previously able to, or must change to a cheaper substitute good.
The standard arguments for privatisation are the purported efficiency gains from having less government bureaucracy involved, as well as the private firm’s higher incentive for investment compared to public administration. Higher long term investment from the firm could result in fewer wasted resources, a higher quality product, and potentially lower market prices (Goodman & Loveman, 1991). Lower prices could potentially offset the entire welfare loss and even lead to a welfare gain for society.
Cost/benefit analysis and a decision rule
To examine some of the costs and benefits of AR consider the following scenario. The government decides to expand the Victorian highway network to ease traffic congestion. A portion of the electrical utility network is then chosen as a source asset for privatisation. In addition to the revenue from selling the asset, there will be a number of positive externalities stemming from the new road. For instance, these include the productivity gains from improved commute and freight times.
In the short term the electricity utility sale will cause a negative social welfare change. As the private firm increases the price of electricity, households are forced to divert their spending from other essential areas. Families may also be forced to limit their electricity use, leading to a loss of welfare. However, in the long term, as the private firm is incentivised to innovate and reduce their costs, the efficiency gains of privatisation may take over and lead to a fall in prices (Winston, 2010). This means that there is a level of uncertainty regarding the final gain or loss in welfare – and factors impacting the end outcome will be considered later on in this paper.
If the sale of the utilities fails to cover the full bill of the highway construction, this would result in a funding gap cost requiring additional taxation/debt. The last cost is the loss of any profits currently received from the utilities. If we assume that public administrators produce at a breakeven point, which also implies no profits gained from running the new target asset, then this loss would be zero.
The net social benefits from an AR scheme can then be written as:
Now consider the situation if the target asset was paid for through a conventional funding source such as debt. In this case the benefit to society would still equal the externality benefit, however the cost would be the full price of the target asset. For simplicity this model ignores the interest repayments upon debt.
To calculate the comparative benefit of AR over conventional funding, the second equation is subtracted from the first.
Note that the following statements holds true by definition
Therefore, the final decision rule can be calculated as:
Maximising comparative benefit
Ultimately the comparative benefit relies solely upon the source asset revenue and the welfare change. An AR scheme should only be utilised when the comparative benefit is positive. However the goal should be to maximise this figure.
It is important to consider what factors will impact the revenue gained from a source asset as well as the direction of the welfare change. Public and private interests are closely aligned when the source asset exists in a competitive market, and where managerial discipline is imposed from competition with other firms (Goodman & Loveman, 1991). Indeed, the level of competition in the source asset’s market will greatly influence the direction of the welfare change. Competitiveness is particularly important as public services, and in particular utilities, offer products which can be relatively homogenous. For example, assuming equal reliability in service, there is very little product differentiation between power retailers. When product differentiation is low, consumers will perceive products as strong substitutes for one another and therefore base their consumption decisions solely upon price (Pindyck & Rubinfeld, 2013). This incentivises firms to price undercutting, creating a situation in which the market price and output may be closer to the socially optimum level.
However this suggests that there may be an inherent trade-off between the two variables of the comparative benefit equation. The welfare change will be less negative in a competitive market, where the private firm holds less market power. Yet such a market will be less profitable for the private firm and therefore they will have a lower valuation of the source asset. Nonetheless the government should solely focus upon privatising competitive assets. This is because competition is required to enhance innovation, and to capitalise upon the full efficiency gains of privatisation (Kwame Sundaram, 2008).
Stimulus in a downturn
AR schemes should also be considered in the context of the domestic business cycle and the stability of the global economy. From one perspective, the lighter financial pressures of AR could make it an attractive way to implement fiscal stimulus during a downturn. By building a new infrastructure project, the government injects cash into the economy – increasing aggregate demand in the short run and providing a source of income for underutilised workers (Bernanke, Olekalns, & Frank, 2014).
In addition, as government borrowing increases so does the probability of default. Once the likelihood that the government cannot repay its loan exceeds a critical level, lenders will begin to demand a higher risk premium – making it costlier to borrow (Wren-Lewis, 2010). Thus for governments operating near critical levels of debt, the chance to pursue extra spending without borrowing could be beneficial.
Restrictions of low business confidence
Nonetheless there are several major counter arguments against the use of AR in a downturn. The most obvious is the fact that lower business confidence during a recession will have a dampening effect upon investment (Blanchard & Sheen, 2013). Most potential buyers would need to raise equity or debt revenue in order to purchase, and both of these outlets are more difficult to secure when markets are undergoing contractions (Field, 2011). Therefore, any firm willing to invest would likely require an elevated risk premium, reducing the revenue extracted and directly lowering the comparative benefit of AR. If the downturn were simply limited to a domestic level, a more revenue heavy alternative for the government might be to seek foreign investors. Nonetheless this option can be discounted in most situations upon the basis of being politically unpopular (Hall, Lobina, & Motte, 2005).
A case study in Brazil
The privatisation of the electricity industry in Brazil during the 1990s demonstrates the weakness of AR in an unstable economic environment. To combat high inflation and unsustainable government debt, Brazilian Finance Minister Fernando Henrique Cardoso introduced the ‘Plano Real’ or ‘Real Plan’ in 1994. The program introduced the Real as the new currency of Brazil and pegged it approximately one-to-one with the American Dollar ("The Real Plan: The echoes of 1994 | The Economist", 2016). Hoping to further reduce their debt officials chose to privatise national assets, beginning with the electricity industry. Initially a success, the first electricity distribution companies were sold at significant premiums above the reserve price levels. However much of the debt used to purchase the source assets had come from foreign currency and this was a fundamental fragility. This became a concern when the Asian and Russian debt crises hit at the end of the 1990s, and the Brazilian government was forced to float the Real. A severe depreciation followed and effectively doubled the value of debt held by firms. As additional investment in the industry stalled and supply side capacity halted, demand for electricity continued to grow. This set the scene for massive power shortages in the early 2000s (Tankha, 2009).
The impacts for Australia
While Australia’s dependence upon foreign debt has reached record highs, domestic privatisation projects would still likely involve borrowing Australian currency (Letts, 2016). This would largely negate the currency risk experienced by the Brazilian electricity companies. However the Brazilian case still demonstrates the danger of the government encouraging private leveraging during an unstable economic period. Indeed the policy of using AR to fund a target asset is essentially a transfer of borrowing from the public sector to the private sector, with the source asset being a reward for carrying out this transaction. The debt which would have been taken by the government to construct a new target asset, is now in the hands of the private firm purchasing the source asset. This subsequently means that the risks associated with the debt are now borne by the firm. While using conventional debt sources to fund target assets may shift the government closer to the critical debt level, in poor economic conditions the government has cheaper access to credit and is better placed to deal with leveraging risk compared to private firms. It is also clear that the efficiency gains from privatisation depend heavily upon the interactions between economic stability and debt risk. As with the Brazilian electricity firms, a sudden shock or pressure on private firms could completely void the feasibility of business investment (Tankha, 2009). Ultimately the risks of pursuing the policy in a downturn outweigh the fiscal stimulus benefits and governments should solely pursue AR in positive economic conditions.
The government must be innovative when looking to finance infrastructure projects, and should consider AR as a valid alternative to issuing additional debt or raising taxes. There are certainly a number of benefits to this policy, especially if the privatisation occurs in a market where competition can foster gains in efficiency. However, AR is hardly a panacea to the funding problem. It carries a certain level of risk, both financially and socially, and all aspects of the economic context should be thoroughly considered before implementation.
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