Making State-owned Enterprises Work for Commercial Investors

Attracting more investors to state-owned enterprises allows more funds to flow to public services such as hospitals and schools. Photo: ADB
Attracting more investors to state-owned enterprises allows more funds to flow to public services such as hospitals and schools. Photo: ADB

By William P. Mako, David Robinett

Commercial financing of government-owned or controlled companies is crucial for their success but major reforms are needed before private investors will step in. 

State-owned enterprises have long provided crucial infrastructure and other goods and services across Asia and the Pacific. Historically, these companies raised money directly from governments, or with the benefit of government guarantees. Increasingly however, state-owned enterprises are accessing commercial financing not backed by any sovereign guarantee – leaving private equity or debt investors exposed to substantial financial loss. 

More than 800 state-owned enterprises with a combined market value of $5.3 trillion are listed on major stock exchanges.  In emerging markets alone, the commercial debt of state-owned enterprises approaches $1.4 trillion.

This is good news – except for when bad things happen.

Commercial financing of state-owned enterprises provides fiscal headroom for governments to fund other public needs – including health, education, climate change mitigation, and infrastructure.  Just for infrastructure, the Asian Development Bank (ADB) estimates that developing countries in Asia need to invest almost $2 trillion a year through 2030 to maintain growth, reduce poverty, and respond to climate change. 

In addition, commercial financing can incentivize productivity gains and provide market supervision to supplement a government’s own capacity for corporate governance. The pandemic has only made fiscal and financial pressures worse, while increasing pressure to improve service delivery and maintain investment.

But commercial financing of government-owned or controlled companies can go wrong.  First, the state-owned enteprise may experience financial distress (e.g., default, forced restructuring, bankruptcy), causing financial loss to commercial lenders and/or equity investors. Distress that, if sufficiently severe, could threaten the financial system. 

Second, government interventions to rescue or promote state-owned enterprises may distort private investment decisions and financial markets.  For example, a survey by the International Monetary Fund finds that state-owned enterprises enjoy interest rate discounts of 1.1-1.4 percentage points.  Often based on expectations of government bailouts, even in the absence of explicit government guarantees, such discounts may make it easier for state-owned enterprises to compete with private firms, encourage additional borrowing and investment in marginal projects, and facilitate inefficiency. 

Financial risks will vary according to business-entry decisions made or supported by the management, boards, and shareholders of state-owned enterprises. For example, more volatile sectors may be subject to earnings swings that threaten the ability of the enterprise to service its debt.  But without transparent financial reporting and strong corporate governance, diversification-fueled corporate complexity increases financial risk, including through related party transactions lacking economic merit or conducted for personal gain. 

Shareholders of state-owned enterprises should aspire to an “investment grade” rating.  The enterprise may even be rated by multiple domestic or international rating agencies. The decision to seek a rating from several agencies should reflect an assessment by the board that the resulting value of additional or cheaper financing more than offsets the costs of obtaining and maintaining such ratings.

More than 800 state-owned enterprises with a combined market value of $5.3 trillion are listed on major stock exchanges.

Country risk may be general or specific to the state-owned enterprise. General country risk factors may include macroeconomic stability, vulnerability to external shocks, banking sector resilience, and governance – especially rule of law. Improvements in the rule of law could improve the country rankings for some Asian jurisdictions. On average, Asian countries now place in the middle third of worldwide rule-of-law rankings.

In addition, state-owned enterprises may benefit or suffer from special treatment related solely to their state ownership.  For example, the government may require state-owned enterprises to provide goods or services (e.g., electricity) too cheaply, or otherwise pay to support the government’s regional development, employment, or macroeconomic goals. 

Broadly, special treatment may involve differences in regulation, taxation, public procurement, public service mandates, financial assistance, or the compensation for public service mandates or for special treatment relating to state ownership.  Reliable and transparent compensation – to or from the state-owned enterprise – to offset the financial effects of special treatment is important for competitive neutrality between the government-backed enterprises and private firms. 

Even apart from competitive neutrality considerations, differential treatment of state-owned enterprises may pose financial risks unique to state-owned enterprises. The government may remove an advantage it has granted or impose new costs or disadvantages.

State ownership of an enterprise can complicate corporate governance.  Often insulated from hostile takeover or bankruptcy (possibilities that tend to discipline private corporations), state-owned enterprises may suffer from too much political interference or too little effective oversight. 

There may be conflict and confusion over the boundary between ownership and regulatory regulation, and between commercial performance and support for government agendas.  Bureaucrats may also lack familiarity with financial concepts and normal corporate governance practices.

Proper actions on portfolio composition, state shareholding practices, boards of directors, and financial reporting can move state-owned enterprise corporate governance toward private best practice.

Key recommendations include more partial public listings (even a majority) of shares; centralization of the exercise of state ownership rights in a single ownership entity; financial statements prepared according to International Financial Reporting Standards and independently audited; and board governance consistent with OECD guidelines and the Corporate Governance Development Framework adopted by 35 or so development finance institutions, including ADB.