Privatization and Emerging Equity Markets

Author: Christopher D. Kirkness | Ira W. Lieberman

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Privatization and Emerging Equity Markets

Privatization and Emerging Equity Markets

© 1998 The International Bank for Reconstruction and Development/ THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing March 1998 The findings, interpretations, and conclusions expressed in this study are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. Library of Congress Cataloging−in−Publication Data Lieberman Ira W., 1942− Privatization and emerging equity markets/ Ira W Lieberman and Christopher Kirkness. p. cm. Includes bibliographical references. ISBN 0−8213−4187−1 1. Privatization. 2.Capital investments. 3.Capital market. 1. Kirkness, Christopher, 1954−. ll. Title. HD3850.L54 1998 338.9—dc21 98−9379 CIP

Privatization and Emerging Equity Markets Edited by Ira W. Lieberman and Christopher D. Kirkness

CONTENTS Foreword

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Jean−François Rischard and William Garrett Preface

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Ira W. Lieberman and Christopher D. Kirkness aaaaaa University Contributors

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Privatization and Emerging Equity Markets Part 1 Introduction 1.1 Overview of Privatization and Emerging Equity Markets

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Ira W. Lieberman and Robert Fergusson Part 2 Privatization Provides Critical Mass to Kick−Start New Stock Markets

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2.2 Privatization and the New Securities Markets in the Czech Republic, Poland, and Russia

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Gary J. Fine and Enna Karlova 2.3 Peru's Privatization Program, 1990−96

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Richard Cabello and David Shiguiyama 2.4 China's Efforts to Raise Capital through Privatization

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Cristina Rueda Part 3 Privatization Supplies Investment Opportunities that Deepen Existing Stock Markets

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3.5 Morocco's Case−By−Case Privatization Program

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Olivier Frémond 3.6 Privatization and Equity Markets in Mexico and Argentina

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Mike Lubrano and Luis Urrutia 3.7 Privatization and Capital Market Development in Turkey and Egypt

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Ira W. Lieberman

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Privatization and Emerging Equity Markets Part 4 Privatization Often Receives a Crucial Boost from Telecommunications

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4.8 The Flagship Role of Telecom Privatizations

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Phumchai Kambhato 4.9 Privatizing and Regulating Telecommunications

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loannis N. Kessides Part 5 Privatization Generates New and Broader Types of Investor Participation

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5.10 American Depository Receipts, Global Depository Receipts, and Other New Financing Instruments

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Phumchai Kambhato 5.11 The Evolution of Emerging Market Equity Funds

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Ira W. Lieberman 5.12 Pension Funds, Capital Markets, and Privatization in Chile, Bolivia, Singapore, and Peru

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Carol Gabyzon 5.13 Broad Ownership Schemes in Chile, Malaysia, and the Kyrgyz Republic

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Gary J. Fine

FOREWORD This book represents a unique collaboration between two institutions that have been deeply involved in privatization and the development of emerging stock markets. Although the World Bank and Flemings have different perspectives on privatization and emerging markets, our views are identical as to their importance for economic growth. The World Bank's Private Sector Development Department (PSD), in conjunction with other parts of the World Delivered by The assistance World Bank e-library Bank Group, provides policy advice and technical to its to: clients—generally government institutions aaaaaa University charged with privatizing state enterprises—on IP designing and implementing privatization programs and linking : 111.111.11.11 Jan 2111 11:11:11 them to the development of stock markets. Tue, For11example, PSD has advised on mass (voucher) privatization in Russia and other members of the Commonwealth of Independent States, the Capitalization Program in Bolivia, FOREWORD

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Privatization and Emerging Equity Markets and case−by−case privatization in Mexico, Morocco, and Turkey, PSD also has advised its clients on the regulations and institutions required to privatize natural monopolies such as utilities and infrastructure. In addition, PSD helps the World Bank's regional departments develop structural adjustment and other programs that support privatization in member countries. And PSD helps design technical assistance programs that allow governments to hire privatization advisers—including lawyers, investment banks, technical experts, regulatory economists, and communications specialists. Flemings, on the other hand, is a leading international investment bank that advises governments on the sale of state enterprises in a variety of industries. Transactions in China, Indonesia, and Peru, for example, are discussed in this book, Flemings plays a direct role in emerging capital markets by advising on the initial public offerings of companies being privatized, managing emerging market investment funds, and marketing and underwriting offerings, both domestically and internationally, often involving global depository receipts. In addition to its experience on the sell side on behalf of client governments, Flemings advises private corporate clients on the buy side when they want to acquire a stake in a company being privatized. The diversity and depth of experience of both institutions is reflected in this book. The introduction provides important lessons on privatization for governments and other stakeholders. The case studies elucidate experiences with privatization in an important group of emerging markets. The book makes an important contribution to the literature on privatization and capital markets, linking these two vital subjects. It is also an important primer for policymakers and private practitioners involved in privatization. We recognize that this book is being published during a period of deep financial distress in Asia's financial markets, particularly in Hong Kong, Indonesia, the Republic of Korea, and Thailand. The crisis has also affected

emerging markets outside Asia. Thus this work could not be more timely, as it offers important lessons on the value of well−designed structural reforms (such as privatization), on the importance of integrating and sequencing privatization with sound macroeconomic policies and other reforms (such as financial sector reform), and on the creation of a sound regulatory framework for utilities and other natural monopolies. The book deals with the links between privatization and domestic equity markets, emphasizing the importance of developing such markets—their liquidity, their infrastructure, their regulation—for privatization to succeed and support economic development. The book also discusses the need for emerging markets to develop new financial institutions—such as privately managed pension funds—to promote domestic savings and provide institutional stability for local equity markets. It is our pleasure to present this volume and to warmly thank its editors for compiling a comprehensive and insightful analysis of privatization and emerging equity markets. JEAN−FRANÇOIS RISCHARD VICE PRESIDENT FINANCE AND PRIVATE SECTOR DEVELOPMENT WORLD BANK WILLIAM GARETT GROUP CHIEF EXECUTIVE FLEMINGS Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

FOREWORD

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Privatization and Emerging Equity Markets

PREFACE This volume is the result of a joint effort between Flemings and the World Bank's Private Sector Development Department. As such it is a unique private−public collaboration between two organizations that together can offer readers a rich diversity of experience in emerging market privatization and its links to emerging equity markets. Although there is a considerable literature on privatization and perhaps even more on emerging equity markets, there is little information linking the two. The relationship between privatization and emerging equity markets is direct but subtle. On the one hand privatization can kick−start newly created capital markets such as those in Central and Eastern Europe and the Commonwealth of Independent States. It can also awaken moribund markets such as those in Egypt and much of Latin America. And it can deepen and diversify emerging markets such as those in Hong Kong, Malaysia, and Turkey. But sound domestic markets and financial institutions—such as pension funds and investment and mutual funds—are also needed for privatization to succeed and to have the desired effect. To attract a stable investor base, most emerging capital markets must improve the basic infrastructure and regulatory framework governing the market. The book starts with an introduction to privatization and emerging markets—a historical overview, a statistical presentation of results to date, and a discussion of lessons learned. It then turns to country studies that analyze privatization and the creation of new equity markets in Central and Eastern Europe and the Commonwealth of Independent States, the well−publicized privatization programs in Argentina and Mexico, and the less well−known achievements of Egypt, Morocco, and Peru. After that the book focuses on privatization of telecommunications—clearly a crucial sector in terms of transaction values, economic development, and emerging stock market development. Finally, the book considers important market instruments and institutions—depository receipts, privatization bonds, emerging market investment funds, and pension funds—and their contribution to privatization and emerging stock market development. In preparing this book we were helped by a number of people, and we want to take this opportunity to thank them. Magdi R. Iskander, director of the World Bank's Private Sector Development Department, supported this work from the start and encouraged our public−private partnership. Bill Chernenkoff of the World Bank and Lee C. Buchheit of Cleary, Gottlieb, Steen & Hamilton served as external reviewers and offered important comments and suggestions for the book. Claudia Morgenstern of the International Finance Corporation reviewed an early draft and steered us in the right direction. Raj Desai of the World Bank's Private Sector Development Department and Robert Fergusson, head of Flemings' Privatization Unit, reviewed drafts

and offered comments and criticisms. Meg Garlinghouse of the World Bank guided the project in its early stages. Our co−authors contributed their time and effort to producing the case studies that provide so much richness to the work. Paul Holtz and Bruce Ross−Larson of Communications Development Incorporated provided excellent editorial guidance, helping to ensure that the manuscript is accurate and readable. Peter Grundy, Graeme Kendrew, and Tilly Northedge of Grundy & Northedge provided an innovative design for the book and outstanding graphic presentation of the data. Garrett Cruce of Communications Development Incorporated laid out the chapters. Finally, we are grateful to our many colleagues in Flemings and the World Bank Group who reviewed specific parts and made helpful comments throughout. IRA W. LIEBERMAN WASHINGTON D.C. CHRISTOPHER D. KIRKNESS LONDON

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PREFACE

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CONTRIBUTORS Richard Cabello is director of investment banking at Fleming Latin Pacific in Lima, Peru. During 199295 he worked for COPRI, Peru's privatization agency, where he was involved in the design and execution of airline, cement, and telecommunications privatizations and Peru's mass privatization program. Robert Fergusson is head of privatization at Flemings, with responsibility for coordinating its global privatization efforts. He has more than sixteen years' experience in international investment banking, advising on a wide range of transactions. Before joining Flemings, he worked for Deutsche Morgan Grenfell. Gary J. Fine is on the staff of the Private Sector Development Department at the World Bank. He has extensive experience working on privatization in transition economies, including Albania, the Kyrgyz Republic, Russia, and Ukraine. Olivier Frémond is on the staff of the Private Sector Development Department at the World Bank, where he advises governments on privatization. He has worked extensively on Morocco, Previously he worked in investment banking. Carol Gabyzon is on the staff of the Development Prospects Group at the World Bank, where she studies the effects of financial crises on the real sector. Previously she worked on privatization and capital market development in the Private Sector Development Department at the World Bank, and on trade policy and tax policy at the Institute for International Economics. Phumchai Kambhato is manager in the capital markets department at Flemings, where he is involved in arranging equity and equity−linked issues in emerging markets, particularly in Southeast Asia. He has extensive experience with telecom privatizations, including India's VSNL and Pakistan Telecommunication Company Limited. Enna Karlova is on the staff of J.P. Morgan, where she focuses on Russia. Previously she was on the staff of the Private Sector Development Department at the World Bank, where she worked on privatization and capital market development in Russia and on privatization in Kazakhstan.

Ioannis N. Kessides is principal economist in the Development Economics Vice Presidency at the World Bank. He has worked on restructuring, privatization, and regulatory issues in Argentina, Brazil, Central and Eastern Europe, and the Commonwealth of Independent States. Before joining the World Bank, Kessides taught at the University of Maryland. He has been published widely on industrial organization. Christopher D. Kirkness is head of investment banking for Latin America at Flemings and was previously head of privatization. He has been actively involved in privatizations around the world throughout his career in investment banking. He played key roles in several early U.K. transactions, and in the 1990s has led Flemings' global privatization activities, most recently in Latin America. Ira W. Lieberman is senior manager in the Private Sector Development Department at the World Bank. He has advised a number of governments on privatization, including Argentina, Albania, Kazakhstan, Poland, Russia, Turkey and Ukraine. He has also worked with Russia's Securities and Exchange Commission on capital market reform and has been widely published on privatization. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Capital Markets Department at the Tue, 11 Jan 2111 11:11:11

Mike Lubrano works in the Central International Finance Corporation. He has extensive financial sector and capital market experience in Chile, Mexico, and other parts of Latin America. CONTRIBUTORS

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Privatization and Emerging Equity Markets Previously he worked on securities and financial sector transactions for Cleary, Gottlieb, Steen & Hamilton, a major international law firm, and Ritch, Heather y Mueller; a prominent Mexican law firm. Cristina Rueda is a member of Flemings' investment banking team for Latin America. Previously she was an intern in the Private Sector Development Department at the World Bank. David Shiguiyama is capital markets manager at Fleming Latin Pacific in Lima, Peru. During 199295 he worked for COPRI, Peru's privatization agency. Luis Urrutia is counselor for central banking affairs at Banco de Mexico and a master's candidate at the Irving B. Harris Graduate School of Public Policy Studies at the University of Chicago. Previously he was a stagiaire at Cleary, Gottlieb, Steen & Hamilton in New York.

1— INTRODUCTION 1.1 Overview of Privatization and Emerging Equity Markets

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Privatization and Emerging Equity Markets

1.1— Overview of Privatization and Emerging Equity Markets Ira W. Lieberman and Robert Fergusson Revenues from privatizations in emerging markets have grown dramatically over the past ten years—from just over $2 billion in 1988 to $25 billion in 1996 (World Bank 1997).This enormous jump has been made possible by increasing investor interest. Yet even these data substantially understate investor participation in privatization, as billions of dollars in assets have been privatized in the transition economies of Central and Eastern Europe and the Commonwealth of Independent States through mass (voucher) privatization (see Lieberman, Nestor and Desai 1997). Thus privatization has attracted millions of new investors from within emerging markets and from abroad. Moreover investment has come from a variety of sources, including retail investors, institutional investors (international and domestic pension funds, emerging market investment funds, voucher investment funds), and corporate investors. Recent Trends in Privatization. International investment in privatized enterprises is part of a global increase in private capital flows to emerging markets. Whereas in 1991 official and private capital flows to emerging markets were roughly equivalent, by 1996 capital flows were overwhelmingly private. Of net long−term resource flows of $285 billion in 1996, private flows accounted for $244 billion, or 86 percent—up from $57 billion in 1991 (World Bank 1997). Privatization's Quickening Pace

Why has privatization become so important to emerging markets? The debt crisis of the early 1980s is a common explanation. In many countries external debt spiraled out of control, leading to years of macroeconomic instability, painful economic adjustment, and low or negative growth. Thus, the argument goes, developing countries simply could not continue to absorb the fiscal burden of state enterprises. While the effects of the debt crisis cannot be minimized, a number of other developments in the 1980s would have made privatization inevitable in any event (Lieberman 1993). The first was East Asia's astounding economic performance. Despite significant differences in their domestic economies and industrial structures, Hong Kong, the Republic of Korea, Singapore, and Taiwan (China) pursued a growth model based on intense competition, an outward orientation emphasizing exports and international competitiveness, and a significant role for the private sector (World Bank 1993). Second, there was growing recognition that other models of economic development—such as the central planning model of the Commonwealth of Independent States, Central and Eastern Europe, Vietnam, and China and the import substitution model of much of Latin America—needed to be changed. One of the main weaknesses of an inward−looking approach to development is that it distorts the infant industry argument. That is, it implies that once developing countries have established strategic or priority industries (such

as steel, cement, fertilizer, oil refining, and petrochemicals), usually through state monopolies and almost always through subsidies, they must continue to protect them because they are too fragile to be exposed to global The World Bank makes e-library to: competition. Moreover; the antiexportDelivered bias ofbysuch regimes it difficult for industries to compete in world aaaaaa University IP : 111.111.11.11 markets even if they are inclined to do so. Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets A third development is what some analysts call the fourth industrial revolution. Driven by information technologies, this revolution involves industries such as telecommunications, computers, microelectronics, robotics, fiber optics, and advanced and composite materials. The technology embodied in these industries helps determine competitiveness in many others—yet they have been largely absent in developing and transition economies. Moreover, important new managerial practices, such as just−in−time inventory and distribution systems, total quality control, and computer integrated manufacturing systems, have also passed by countries with an inward orientation.The pace of technological change and the research and development commitment it requires have made it counterproductive for many firms to remain under the control of the state, where decisions are politicized and response to market pressures is sluggish. That brings us to the fourth factor, the role of state enterprises. In Latin America, as well as in Egypt, Turkey, and much of Africa, state enterprises played enormous roles in industry and services. By the end of the 1970s state enterprises in Latin America dominated extractive industries (mining, oil and gas), basic industrial subsectors (steel, petrochemicals, fertilizers, shipbuilding), and services, utilities, and infrastructure (electricity, telecommunications, railways, ports and shipping). In Central and Eastern Europe and the Commonwealth of Independent States state enterprises accounted for more than 90 percent of industrial production in almost all countries prior to privatization. In many closed economies state enterprises were overstaffed, had poor financial and export performance, depended on subsidies and unilateral budget transfers, maintained highly centralized and politicized organizations, and relied on their protected monopoly status. And because state enterprises are often important suppliers of goods and services to the private sector, their poor performance undermined private sector performance, particularly in protected markets. In the mid−1980s countries like Mexico tried to restructure large state enterprises. It quickly became apparent, however, that restructuring would be long and difficult, requiring extensive resources and substantial labor reductions, and offering few short−term benefits. The bureaucracies that were incapable of managing these firms were certainly not capable of turning them around. Moreover, countries could not afford to continue propping up these enterprises in the interim. After the debt crisis many state enterprises, reliant on subsidies and unilateral budget transfers, became decapitalized and increasingly obsolescent (Lieberman 1990). After the debt crisis many state enterprises became dacapitalized and increasingly obsolescent Fifth, many industrial countries expressed a strong ideological commitment to private enterprise. Under Prime Minister Margaret Thatcher, Britain sought to revive its flagging economy through a large−scale privatization program. The creation of millions of small shareholders through the privatization of British Telecom, British Gas, and the electricity and water industries was a cornerstone of the administration's political and economic reforms. Although the program initially met with stiff political and union resistance, popular support grew as an enormous body of new shareholders came to enjoy handsome investment gains. Moreover, the intellectual debate that arose over privatization and restructuring piqued interest in the subject worldwide. Finance Minister Roger Douglas led a similar charge in New Zealand, initially corporatizing state enterprises—that is, forcing them to operate according to commercial principles—and subsequently privatizing them (Franks 1993). Among developing countries Chile was perhaps the first and most successful privatizer. Privatization efforts began in 1974, following the overthrow of Salvador Allende's regime, but were largely unsuccessful.The economic crisis in 198283, partly induced by overleveraging of the privatization process and excessive industrial concentration, forced the government to intervene in a number of financial holding groups. From 1984 onward, however, Chile's privatization efforts Delivered blossomed. a number by TheChile World used Bank e-library to: of privatization methods to divest nearly all aaaaaa University state enterprises. Perhaps the program's most innovative feature was its privatization of pension funds. This move IP : 111.111.11.11 Tue, 11investors Jan 2111 11:11:11 created a sizable and stable base of institutional for Chile's equity market, allowing a number of large privatizations to be absorbed domestically .Pension funds acquired some 23 percent of the shares in divested state 1.1— Overview of Privatization and Emerging Equity Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets enterprises (Luders 1993). Chile's move toward private management of pensions

has been emulated by other Latin American countries, including Argentina, Bolivia, Mexico, and Peru (see chapter 12). Finally, the political and economic revolution in Eastern Europe and the Soviet Union since 1989 has given privatization a new push. Newly emerging democracies have used privatization to form the basis for a market economy. In these countries privatization has economic, social, and political implications that go far beyond those in most developing countries. By the end of 1996 more than half the workforce in most countries in Central and Eastern Europe and the Commonwealth of Independent States was employed by the private sector. Moreover, more than half of state enterprises had been privatized, primarily through small−scale privatization of retail and service firms and through mass privatization of medium−size and large firms in the tradables sector (Lieberman, Nestor, and Desai 1997).1 Privatization is merely the first step—alleit an important one—in restructuring former state enterpirses Privatization's Purpose

Privatization programs often cite a laundry list of objectives, including reducing the fiscal deficit, raising revenue through asset sales, generating additional tax revenue, encouraging the return of flight capital, promoting foreign direct investment, deepening and broadening domestic equity markets, boosting investor confidence, increasing efficiency and fostering competition, improving the quality of goods and services, and reducing the state's role in the economy. Some of these objectives, such as reducing the fiscal deficit or raising revenue, could be direct outcomes of privatization. Others, such as increasing efficiency and productivity are longer−term objectives that depend on what new private owners bring to a company. Privatization is merely the first step—albeit an important one—in restructuring former state enterprises. (Active restructuring, however, should generally be carried out by a company's new owners.) This multitude of objectives boils down to three key issues: Getting government out of business —by strengthening market forces to promote competition, which will increase productivity and efficiency, lowering the cost and raising the quality of goods and services (Galal and others 1994). Generating new sources of cash flow and financing for enterprises —by eliminating government crowding out of equity markets, encouraging the return of flight capital, promoting foreign direct investment, facilitating domestic savings and investment, and broadening and deepening domestic equity markets. Reducing the government's fiscal deficit —by using privatization revenues to retire external and domestic debt, reducing fiscal transfers to state enterprises, and increasing tax revenues through the higher profits generated by privatized enterprises. Privatization's Current State

Privatization revenues reached $25 billion in 1996, up from $21 billion in 1995. During 199096 revenues totaled Delivered by The World Bank e-library to: more than $ 155 billion (figure I. I ).As noted, aaaaaa however, these figures significantly understate privatization flows. University IP : 111.111.11.11 In recent years countries in Central and Eastern Europe and the Commonwealth of Independent States have Tue, 11 Jan 2111 11:11:11 privatized billions of dollars in assets through mass privatization—revenues that are not included in reported Privatization's Purpose (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets privatization transactions (Lieberman, Nestor and Desai 1997). Institutional investors now have the international reach to go wherever good companies are being privatized. These investors prefer infrastructure: since 1990 it has accounted for $65 billion (42 percent) of the $155 billion in global privatizations (figure 1.2). Manufacturing, mainly steel, chemicals, and construction materials, has attracted $37 billion (24 percent). Natural resources companies, mainly oil and gas, accounted for $26 billion (17 percent), and financial sector privatization, primarily banking, for $22 billion (14 percent). Direct sales targeted at strategic investors are the most common method of divestiture in developing and transition

Figure 1.1 Privatization revenues by region, 199096 Source: Table A 1.1.

Figure 1.2 Privatization revenues by sector, 199096 Source: Table A 1.2. economies. But in all regions equity markets are facilitating—and benefiting from—privatization through initial public offerings and mixed sales (a combination of a strategic sale and initial public offering). Public offerings have become increasingly common in recent years and now play a significant role in privatizations (figure 1.3). Privatization, which was heavily concentrated in Latin America during 199193, became geographically diverse during 199596. (Still, several countries in Latin America, notably Bolivia and Peru, implemented extensive privatization programs in the mid−1990s, and Brazil has initiated what could become the region's largest program in terms of the value of assets sold; figure 1.4) East Asia and the Pacific generated $5.4 billion from privatizations in 1995 and an estimated $2.7 billion in 1996 (figure 1.5).The 1995 sales of PT Telekom in Indonesia ($1.7 billion) and Petronas Gas in Malaysia ($1.1 billion) Delivered by The World Bank e-library to: were the largest transactions in these countries' privatization programs. aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Figure 1.4 Privatization revenues in Latin America and the Caribbean, 199096 Source: Table A 1.1.

Figure 1.3 Portfolio investment and foreign direct investment in privatization, 199096 Source: Table A 1.3. Public offerings have become increasingly common in recent years and now play a significant role in privatizations Several countries in the Middle East and North Africa have launched aggressive privatization efforts, and in 1996 the region generated some $1.5 billion in privatization revenues. Egypt is the region's privatization leader; with $1.9 billion in revenue during 199096 (55 percent of the regional total; figure 1.6). Egypt's program has focused on divesting small companies in the tradables sector though public offerings on the Cairo Stock Exchange. Morocco also has made impressive progress on privatization, generating $1.1 billion during 199096. In Europe and Central Asia the Czech Republic, Hungary, and Poland have started selling large strategic enterprises, generating $6.5 billion in 1995 and $2.6 billion in 1996. Many members of the Commonwealth of Independent States are still selling companies in the tradables sector through mass

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Privatization and Emerging Equity Markets Figure 1.5 Privatization revenues in East Asia and the Pacific, 199096 Source: Table A 1.1.

Figure 1.6 Privatization revenues in the Middle East, and North Africa, 199096 Source: Table A 1.1. privatization or selling residual state shareholdings resulting from mass privatization. Hungary has been the region's most successful privatizer, raising $10.2 billion during 199096 (33 percent of the regional total; figure 1.7). Political instability has prevented Turkey from launching its long−stalled privatization program. There are many more privatizations to come in developing and transition economies While much has been achieved in the past few years, there are many more privatizations to come in developing and transition economies. Most countries in Central and Eastern Europe and the Commonwealth of Independent States have barely started privatizing large, strategic firms. The Fifteenth Congress of China's Communist Party, held in September 1997, endorsed radical reform for state enterprises, including outright divestiture of the state's stakes in all but the biggest firms. India has liberalized its markets but has barely begun privatizing large state enterprises. Turkey's struggle to mount a significant privatization program has stalled under a series of coalition governments. And Brazil has just started to privatize, with a focus on its vast federal and state utilities. Privatization's Lessons

Much has been learned from these privatization efforts. One set of lessons involves the context in which privatization is carried out: successful privatization requires transparency political support, a clear legal framework, a strong regulatory and structural framework, integration with overall macroeconomic and structural reforms, and a level playing field to attract foreign investment and create a strong role for equity markets. The second set of lessons involves privatization's ability to maximize value for government.

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Privatization and Emerging Equity Markets Figure 1.7 Privatization revenues in Europe and Central Asia, 199096 Source: Table A 1.1. Achieving this goal usually requires that governments retain external advisers, limit presale restructuring, keep sale conditions to a minimum and select the right sales method, create incentives for employees and small investors, and disseminate information to generate interest in the sale. Privatization programs must be transparent. Transparency means that privatization is governed by a clear legal framework and that sales procedures are well defined. Governments that deviate from these principles devalue their programs—and so lower the value of privatization, since investors shy away from nontransparent transactions. Political support is a must. Privatization is intensely political. It starts from the belief that private ownership is better than public ownership, and it often involves a massive redistribution of wealth and power. Thus success requires high−level political commitment. Where the political process has been fragmented or leaders have been unclear about objectives, privatization has been undermined and eventually derailed. High−level commitment is insufficient, however. All stakeholders—employees, legislators, foreign investors, and the public—must be brought into the process and convinced of its merits. The legal framework should support privatization. Most governments have passed laws and supporting regulations to implement privatization programs. These laws and regulations generally spell out the scope of government authority in privatization, the need (if any) for legislative approval of transactions, and the accepted methods of privatization.

Countries that lack experience with market activities have had to go even further; creating company laws, securities laws, and bankruptcy and antimonopoly laws. Such efforts are essential, because the absence of an adequate legal framework can slow or derail privatization programs. The regulatory framework must balance competing objectives. Privatization of large, strategic enterprises requires that an adequate regulatory framework and institutional structure be established before or in line with the privatization transaction. At a minimum, this framework should: Protect consumers and investors by determining how prices are set. Create conditions for future competition. Define basic guidelines for environmental policies and labor practices (Kikeri 1997). For natural resource enterprises, define maximum rates of exploitation and royalty rates on production. For banks, set prudential limits on borrowing and loans. Regulation involves balancing potentially conflicting objectives, such as ensuring that the public receives services at a fair price and that investors receive an equitable return on their investment. Thus regulators must have sufficient knowledge and authority. Regulation is complex, however; and building regulatory expertise takes time. Delivered by The World Bank e-library to: aaaaaa University Privatization should be integrated with other reforms. Governments that have tried to privatize in isolation, IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 outside the framework of more comprehensive economic reforms, have inevitably failed to achieve expected gains in productivity and efficiency. Russia, for example, privatized in the midst of rampant inflation, adopting a

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Privatization and Emerging Equity Markets stabilization program only after mass privatization had ended. By contrast, countries that have incorporated privatization within a comprehensive reform program—Argentina, Chile, the Czech Republic, Poland, and Egypt among them—have achieved substantial economic gains. Programs should maintain a level playing field to attract foreign direct investment . . . Privatizations in emerging markets have attracted considerable foreign direct investment and foreign portfolio investment. These flows have been concentrated in a fairly small number of countries, however; Foreign direct investment is most likely to flow to countries that maintain a level playing field between domestic and foreign investors. Foreign investors demand a stable and predictable tax regime and must be able to repatriate the capital and dividends that flow from their investment. . . . and foster equity market development. Governments often ignore the link between privatization and equity markets. Most domestic equity market reforms have come too late in the privatization cycle, making it difficult for governments to use the domestic market to float large public offerings. As a result global depository receipts (GDRs) and American depository receipts (ADRs) have become important instruments for governments seeking to attract foreign capital to their privatization programs. However, governments should generally try to reduce reliance on international capital markets by fostering domestic market development and should at a minimum address three issues: Governments often ignore the link between privatization and equity markets Ensuring that that there is a carefully defined trading structure, whether a formal exchange or an over the counter market. Otherwise most trades will take place outside the formal market. Developing an adequate trading infrastructure—brokers, clearing and settlement agents, registries, depositories, and payment systems—to allow efficient and prudential operations. Creating a regulatory authority and setting clear guidelines for the market in areas such as information disclosure, accounting standards, and insider trading. Outside experts should be used. Complex transactions involving large trade sales, mixed sales, or even initial public offerings usually benefit from experienced financial advisers—whether domestic, foreign, or both. Advisers should be used once an enterprise has been selected for privatization, to assess the likelihood of a successful transaction, to perform due diligence, to prepare an information memorandum or prospectus on the sale, to approve public information campaigns, to handle the road show and book−building exercise, to control share tendering and allocation, and to provide research on and support for the company's shares after the initial public offering. Preprivatization restructuring should be limited. In most cases governments should not extensively restructure state enterprises prior to sale. There is a difference, however,

between defensive restructuring and active restructuring. Defensive restructuring involves corporatizing an enterprise or creating a legal entity (in most cases a corporation or joint stock company). Corporatization allows for different classes of shareholders, establishes the opening balance sheet of the newly formed corporation, and creates a governance structure for the corporation. Defensive restructuring may also involve financial engineering—restructuring the enterprise's debt and shedding excess labor: Active restructuring, such as making new investments or reorganizing the company beBank avoided most governments lack the institutional Delivered byshould The World e-librarybecause to: University capacity to implement such changes and most aaaaaa private investors prefer to make such changes themselves. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets A well−functioning equity market allows an emerging merket to harness domestic and foreign portfolio investment to support its investment needs Sale conditions should be kept to a minimum. Establishing too many preconditions for a sale—such as minimum sales prices and unrealistic timetables for sale—reduces competitive bidding and ultimately lowers transaction values. In sales of strategic enterprises that provide services to the public—telecommunications, electricity, water and sanitation—governments have often chosen to retain a golden share (that is, one share with special voting rights) or a significant minority shareholding. Investors accept such conditions if the golden share is of limited duration (say, five to seven years) or the government clearly defines its role in enterprise governance with the residual shares and the terms and conditions under which it expects to divest them. Information about privatization should be widely disseminated. There is a strong need for public information about privatization at several levels. One level is to educate the public about the objectives and economic importance of privatization and the potential benefits that will accrue from the private operation of enterprises. Another is to promote privatization to key stakeholders such as legislators, enterprise managers and employees, and potential investors. A third level is to promote the individual transaction through public relations campaigns, advertising, and road shows in major financial markets such as New York, London, and Tokyo. Recent Trends in Emerging Equity Markets Equity markets play a crucial role in capitalist economies, channeling investment where it is needed and can be put to best use.Through the pricing mechanism, companies that are perceived as offering the highest returns and the best growth prospects can finance their investments on the most favorable terms. In an efficient equity market stock prices continuously adjust to reflect all available information that affects each company's prospects, as investors buy and sell shares and market makers adjust their prices accordingly. Equity markets also make it possible for companies to be largely owned by private investors—both retail and institutional—who are not managers of the company and cannot individually influence management decisions. These shareholders need an efficient trading mechanism that allows them to vote with their feet by selling their shares and reinvesting elsewhere. Investors' ability to buy and sell shares in a liquid market helps discipline and govern companies. Companies that reward investors can return to the market and raise funds at an attractive cost for future expansion. Those that do not reward investors cannot tap the market and often have limited potential for growth.Thus active equity markets contribute to the efficient allocation of resources in an economy and enable projects to be financed that would not otherwise attract investors. In addition to their economic functions, equity markets can fulfill a political function by giving people a financial stake in their country's economy and allowing them to share the rewards of its success. Many governments have encouraged wider share ownership, particularly during the marketing and structuring of privatization share offerings. This approach can soften public resistance to the privatization of entities that have been perceived as service providers rather than businesses, such as electricity or water companies. Investment Ups and Downs

Transition economies and developing economies in Latin America, Africa, and Asia will require large−scale investment for many years to modernize plants, introduce new technologies, and upgrade and expand infrastructure. Most of this money will have to come from the private sector with a large portion coming from foreign investors. Delivered by The World Bank e-library to:

aaaaaa University A well−functioning equity market allows an emerging market to harness domestic and foreign portfolio IP : 111.111.11.11 investment to support its investment needs.Tue, Attitudes toward foreign investment are shifting in many emerging 11 Jan 2111 11:11:11 markets, moving away from hostility toward foreign ownership of companies

Recent Trends in Emerging Equity Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets and assets toward welcoming the revenues, technology transfers, and management know−how that foreign investment can bring. Although foreign direct investmentis still the main form of foreign investment, portfolio investment accounts for an increasing share of external financial flows (see figure 1.3). During the early 1990s there was strong growth in the capitalization of emerging equity markets (figure 1.8). An improving outlook for emerging market growth attracted funds from foreign investors, pushing valuations upward. In 1993 alone the capitalization of emerging equity markets jumped some 80 percent. Although emerging stock markets faltered in 199495 in response to Mexico's peso crisis, growth recovered in 199697. Investor confidence sagged again in mid−1997, however; as economic difficulties became evident in several Asian countries, leading to sharp contractions in the value of most emerging markets—particularly Asian emerging markets such as Indonesia, Korea, and Thailand. Although the recent crisis is unlikely to affect the long−term growth of emerging equity markets, it reflects the vulnerability of emerging markets to swings in confidence. The Move to Market

In the early 1990s equity markets in many emerging markets were not wide or deep enough to support large−scale issues of privatization shares. Equity markets had played no role in economies making the transition from central planning. In other countries, such as those in Latin America, the economy had historically been dominated by state−owned entities and family−owned companies. Moreover, governments oftencrowded out equity markets by floating international bonds at high real interest rates to cover large fiscal deficits.

Figure 1.8 Market capitalization in emerging markets, 199096 Source: IFC 1997. While many governments recognize the desirability of a strong, active, and well−regulated stock market, creating one is no simple matter. A stock market must achieve a critical mass in terms of the number and size of companies listed and the level of daily trading in order to provide the liquidity and diversification required by investors and to support an infrastructure of intermediaries, advisers, and regulators. Yet companies of the desired size and quality will be attracted to the stock market only if it is sufficiently large and liquid that the benefits of fund−raising capacity and prestige outweigh the drawbacks of increased disclosure and dilution of ownership. As noted, a liquid and well−regulated domestic market is of particular concern to foreign investors. In recent years the number of companies listed on emerging capital markets has boomed A carefully structured and well−articulated program for privatizing major state−owned entities, combined with efforts to establish a suitable regulatory and legislative framework, can give a stock market the needed boost in Delivered by The World Bank e-library to: size and quality. In some cases a single privatization—say aaaaaa Universityof the national telecommunications operator—can have IP : 111.111.11.11 this effect, creating a base of domestic retail investors, encouraging the establishment of domestic investment Tue, 11 Jan 2111 11:11:11 institutions, and attracting foreign portfolio investors to the country for the first time. In recent years the number The Move to Market

17 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets of companies listed on emerging capital markets has boomed (figure 1.9). Peru and Poland show this process at work. Peru's experience, described in chapter 3, demonstrates the benefit of establishing a coherent long−term privatization plan at the outset, in line with wider market reforms and stock market

Figure 1.9 Listed companies on emerging capital markets, 199096 Source: IFC 1997.

regulation, so that market participants can anticipate a steady flow of blue−chip companies moving on to the market. Peru also used mixed sales (see below). Poland's government made an early decision to establish rigorous securities regulations, enforced by a well−staffed Securities and Exchange Commission modeled on the U.S. commission (see chapter 2). Although this approach may have slowed the initial growth of the Warsaw Stock Exchange, it established a strong foundation, especially for attracting foreign portfolio investment. It also enabled the government to implement large−scale privatizations through stock market offerings—including the privatizations of KGHM, one of the world's largest copper producers, and Bank Handlowy, a major bank, which were completed in mid−1997. The best approach to privatization may be mixed sales Trade Sales, Strategic Sales, and Mixed Sales.

In high−income countries share offerings are the main privatization method (in terms of total proceeds). In emerging markets trade sales play a larger role, reflecting these markets' need for technology and management expertise from foreign investors as well as their less developed equity markets. Strategic investor sales can also play a role in equity market development, however, since they enable companies to come to the market with the technology, investment, and corporate governance standards introduced by the investor. In addition, such companies can set new standards for financial disclosure and corporate governance—standards that will be imitated by other major domestic companies. The best approach to privatization may be mixed sales, which have been used in Argentina, Mexico, Peru, and most recently Brazil. In mixed sales a controlling (usually majority) stake is first sold to a strategic investor. The investor is selected based on its planned investment, training and development, transfer of technology, and commitment to a later share offering. In subsequent phases the company's shares are publicly offered in order to Delivered by The World Bank e-library to: sell off more of the government's stake and, if aaaaaa required, to raise new capital for the company. The privatization of University IP : 111.111.11.11 Telefonica del Perü illustrates this process (see chapters 3 and 9). Tue, 11 Jan 2111 11:11:11

Trade Sales, Strategic Sales, and Mixed Sales. (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets In addition to maximizing proceeds for the state and ensuring that the companies that come to the market can attract the widest possible base of investors, mixed sales ensure that needed restructuring is carried out quickly and efficiently with the government retaining sufficient control over the process to achieve its strategic priorities.The existing management of a state−owned entity often has neither the experience nor the motivation to carry out this task. Public Share Offerings

Public share offerings are generally used to privatize large, profitable, well−known state enterprises—for example, utilities (electricity, telecommunications, water and sewage), companies that extract natural resources (oil, gas, mining), and banks. Initial public offerings of privatization shares tend to be much larger than general issues of new shares. As a result privatizations have been the most important factor driving equity market growth over the past decade. Although most privatizations through public offerings are secondary offerings of government shares, initial public offerings also allow companies to raise capital by issuing new shares in parallel with the offering of government shares. In Canada, for example, state enterprises were allowed to go to market with new shares in the first tranche to establish a market for the shares, with the government selling its shares in a subsequent tranche (Welch and Frémond 1998). As noted, governments have used initial public offerings to broaden share ownership by targeting small investors with a variety of incentives. In the United Kingdom, for example, small investors were offered one free share for every ten shares purchased in the sale of British Telecom. Some offerings use a clawback method, which allows the number of shares offered to small investors to increase and the number offered to institutional investors to decrease if there is heavy demand for the share issue. In some countries, such as Sri Lanka, the percentage of shares offered to small investors is simply fixed (Welch and Frémond 1998). Similarly, many initial public offerings have allocated a percentage of shares to company employees on a preferential basis. In most cases 310 percent of shares are allocated to employees, either for free or at a substantial discount. Governments have a strong incentive to bring employees on board, thereby reducing potential union resistance to the sale. Most initial public offerings of government shares are politically priced to ensure their success, while subsequent tranches are normally priced tightly to maximize sales revenues. A share offering's success depends on several factors—market conditions, whether the shares are being offered

internationally as well as domestically, measures taken to widen domestic share ownership, how well the offer is promoted or advertised, and, above all, its pricing. Transparency is readily achieved through initial public offerings because of the advertising and disclosure requirements generally required for a public sale. This is especially true if the sale is also offered in international markets such as New York or London. Book building is the most common approach to pricing public offerings, particularly offerings with a tranche offered to international markets. The price for the offering is set by the lead financial adviser and other members of the placement syndicate, who build books of bids from institutional investors around the world. The books are consolidated by the lead adviser, who is then able to determine a price range within which the offer will be absorbed by the market. Attractive issues are usually oversubscribed with the understanding that orders are often scaled back (see Welch and Frémond 1998 for an extensive discussion of book building). Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Public Share Offerings (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Returns to Investors and Postprivatization Performance

Despite concerns that the large number and value of privatizations in developed markets (primarily Western Europe) would crowd out emerging market issues, international institutional investors have proven willing and able to absorb both types of issues—so long as they are attractively priced and governments can be trusted not to interfere in the operations of the newly privatized firm. The reasons for such investor loyalty are self−evident: the returns to investors on privatization issues average 17.4 percent in the first year following the issue. Moreover, the five−year net (market−adjusted) return averages 71.9 percent.2 Studies have found that the performance of firms privatized through initial public offerings improves in a variety of ways, as measured by increases in productivity, efficiency, liquidity, and profitability. Moreover, employment in newly privatized firms appears to increase after privatization (Boubakri and Cosset 1996; Meggison, Nash, and Van Raddenbororgh 1994). Conclusion Privatization in emerging markets appears to be meeting government objectives. Above all, privatization is improving the financial and economic performance of newly privatized firms. Equity market development also has benefited from privatization—and countries that focus on strengthening these markets build investor confidence and can use them during privatization. Perhaps of greater importance, these markets can then support the future financing needs of newly privatized and other private sector companies. Notes

1. One exception is Hungary, which focused on joint ventures with foreign investors and case−by−case privatization to divest its larger firms. Poland, meanwhile, recently began implementing its mass privatization program after years of delay. In the interim, however, Poland used a rich menu of privatization options to divest its state enterprises, including small−scale privatization, privatization through liquidation (a form of installment sale to employees of and selected investors in small and medium−size firms), and initial public offerings.

2. These data do not include the United Kingdom, where returns on privatization transactions have been substantially higher.

The performance of firms privatized through initial public offerings improves in a variety of ways References Boubakri, Narjess, and Jean−Claude Cosset. 1996. The Financial and Operating Performance of Newly Privatized Firms: Evidence from Developing Countries. Universite Laval, Centre de Recherche en Économie et Finance Appliquées, Quebec. Franks, Stephen. 1993. Rigorous Privatization: The New Zealand Experience. Columbia Journal of World Business 28(1). Galal, Ahmed, Leroy Jones, Pankaj Tandoon, 1994. Welfare Consequences of Selling Public Delivered byand The Ingo World Vogelsang. Bank e-library to: aaaaaa University Enterprises. New York: Oxford University Press. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

IFC (International Finance Corporation). 1997. Emerging Stock Markets Factbook. Washington, D.C. Returns to Investors and Postprivatization Performance (c) The International Bank for Reconstruction and Development / The World Bank

20

Privatization and Emerging Equity Markets Kikeri, Sunita. 1997. Privatization and Labor: What Happens to Workers When Governments Divest? World Bank Technical Paper 396. Washington, D.C. Lieberman, Ira W 1990. Industrial Restructuring: Policy and Practice. Washington, D.C.: World Bank. ———. 1993. Privatization: The Theme of the 1990s: An Overview. Columbia Law journal (spring): 911. Lieberman, Ira W., Stilpon S. Nestor, and Raj M. Desai. 1997. Between State and Market: Mass Privatization in Transition Economies. Studies of Economies in Transformation 23. Washington, D.C.: World Bank.

Lüders, Rolf. 1993. The Success and Failure of State−Owned Enterprise Divestitures in a Developing Country: The Case of Chile. Columbia journal of World Business 28(1). Meggison, William L., Robert C. Nash, and Matthias Van Raddenbororgh. 1994. The Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis. journal of Finance 49(2). Welch, Dick, and Olivier Frémond. 1998. The Case−by−Case Approach to Privatization: Techniques and Examples. World Bank Technical Paper 403. Washington, D.C. World Bank. 1993. The East Asian Miracle: Economic Growth and Public Policy. A Policy Research Report. New York: Oxford University Press. ———. 1997. Global Development Finance 1997. Washington, D.C.

Table A1.1 Privatization revenues in emerging markets, 199096 Millions of U.S. dollars Region/country

1990

1991

1992

1993

1994

1995

1996

Total

Latin America and the Caribbean

10,915

18,723

15,560

10,487

8,198

4,615

13,919

82,417

7,532

2,841

5,741

4,670

894

1,208

642

23,527

Bolivia

—

—

9

13

—

789

34

844

Brazil

44

1,633

2,401

2,621

2,104

992

5,770

15,564

Chile

98

364

8

106

128

13

187

904

Colombia

—

168

5

391

170

—

1,851

2,585

3,160

11,289

6,924

2,132

766

167

1,526

25,964

Peru

—

3

212

127

2,840 1,267

1,751

6,209

Venezuela

10

2,278

140

36

8

39

2,017

4,527

Other

71

147

120

393

1,289

132

140

2,292

Delivered The World Bank e-library3,956 to: 2,551 by 3,626 3,988 aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

9,641

5,466

30,491

111

48

350

Argentina

Mexico

Europe and Central Asia Bulgaria

1,262 —

—

—

45

147

Returns to Investors and Postprivatization Performance (c) The International Bank for Reconstruction and Development / The World Bank

21

Privatization and Emerging Equity Markets Czech Republic

—

—

—

645

7 1,545

—

2,197

483

798

779

1,685

1,507 3,988

945

10,185

Poland

62

338

240

733

980

605

3,599

Russia

—

35

88

110

— 1,002

1,192

2,426

Slovake Republic

—

—

—

63

415 1,004

486

1,968

Turkey

437

212

780

483

354

572

297

3,134

Other

280

1,168

1,739

224

886

440

1,893

6,630

East Asia and the Pacific

376

835

5,161

7,155

5,507 5,411

2,679

27,123

China

—

11

1,262

2,849

2,226

649

919

7,916

Indonesia

—

190

14

31

1,748 2,031

1,008

5,002

Malaysia

375

387

2,883

2,148

798 2,519

214

9,326

Philippines

—

244

754

1,638

494

207

22

3,359

Thailand

—

—

238

471

242

—

291

1,241

Other

1

2

10

18

—

4

226

261

Hungary

641

(Table continues on next page)

Table A1.1 Privatization revenues in emerging markets, 199096 (continued) Millions of U.S. dollars Region/country

1990

1991

1992

South Asia

29

996

1,558

Bangladesh

—

—

India

—

Pakistan

1994

1995

1996

Total

974

2,666

917

889

8,029

—

43

12

5

—

60

931

1,098

861

1,505

810

495

5,700

11

63

343

17

1,106

36

317

1,894

Sri Lanka

18

2

106

52

42

65

77

362

Other

—

—

11

1

1

—

—

13

Sub−Saharan Africa

74

1,121

205

630

595

472

745

3,843

Côte d'Ivoire

—

2

10

5

19

74

103

213

Ghana

10

3

15

28

476

87

186

804

1

8

—

12

13

137

170

Delivered by The World Bank e-library to: aaaaaa9University 6 5 2 IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

26

38

89

—

−

730

Kenya Mozambique Nigeria

4 16

35

114

1993

541

24

Returns to Investors and Postprivatization Performance (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets South Africa

—

1,073

—

—

—

—

122

1,195

Tanzania

—

—

3

27

5

77

13

124

Uganda

—

—

12

19

24

47

30

132

Zambia

—

—

—

3

14

69

30

115

Zimbabwe

—

—

—

—

12

75

−

87

Other

45

2

34

2

9

5

86

183

2

17

70

417

782

746

1,477

3,510

Egypt

—

—

—

118

393

262

1,150

1,923

Morocco

—

—

—

273

347

240

271

1,130

2

17

60

—

—

32

36

148

—

—

9

26

42

212

21

310

1995

1996

Total

Middle East and North Africa

Tunisia Other —Not available.

Source: World Bank Privatization Database. Table A1.2 Privatization revenues by sector, 199096 Millions of U.S. dollars Sector

1990

1991

1992

1993

1994

Infrastructure

9,704

6,863

9,715

5,360

9,399

9,240

15,201

65,481

Industry

1,402

5,558

7,188

7,491

6,091

5,787

3,546

37,063

Agriculture and mining

1,367

3,608

3,394

6,215

4,068

4,336

2,787

25,776

47

7,793

5,263

3,411

1,065

1,933

2,671

22,182

138

420

621

1,184

1,088

606

1,108

5,165

12,658

24,242

26,181

23,661

21,712

21,901

25,313

155,667

Financial services Other services Total

Source: World Bank Privatization Database. Table A1.3 Portfolio Investment and foreign direct investment in privatization, 199096 Millions of U.S. dollars Type Portfolio investment Foreign direct investment

1990 106 6,888

1991

1992

1993

1994

1995

1996

Total

Delivered2,752 by The World5,190 Bank e-library to: 3,873 5,965 aaaaaa University

2,959

5,627

26,472

IP : 111.111.11.11 6,039 Tue, 11 Jan 21116,429 11:11:11

6,380

5,498

43,164

5,517

6,414

Returns to Investors and Postprivatization Performance (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Total

6,994

9,390

8,791

11,619

12,378

9,338

11,125

69,636

Source: World Bank Privatization Database. Table A1.4 Foreign exchange raised through privatization in emerging markets, 199096 Millions of U.S. dollars Region

1990

1991

1992

Latin America and the Caribbean

6,358

7,384

4,037

3,765

5,058

2,206

6,302

35,111

586

1,892

3,069

2,932

1,588

4,778

1,880

16,726

1

102

1,556

4,156

4,036

2,026

1,990

13,865

Sub−Saharan Africa

38

5

66

566

453

275

299

1,702

South Asia

11

4

44

16

997

38

528

1,638

0

3

19

183

246

16

126

594

6,994

9,390

8,791

11,619

12,378

9,338

11,125

69,636

Europe and Central Asia East Asia and the Pacific

Middle East and North Africa Total

1993

1994

1995

1996

Total

Source: World Bank Privatization Database.

2— PRIVATIZATION PROVIDES CRITICAL MASS TO KICK−START NEW STOCK MARKETS 2.2 Privatization and the New Securities Markets in the Czech Republic, Poland, and Russia 2.3 Peru's Privitazation Program, 199096 2.4 China's Efforts to Raise Capital through Privatization

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2— PRIVATIZATION PROVIDES CRITICAL MASS TO KICK−START NEW STOCK MARKETS (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets

2.2— Privatization and the New Securities Markets in the Czech Republic, Poland, and Russia Gary J. Fine and Enna Karlova Delivered by The World to: shares left to sell. As mass privatization Privatization programs are not completed when there areBank no e-library more state aaaaaa University : 111.111.11.11 programs sell off hundreds and even thousandsIPof companies in a short period, investors need to be able to buy Tue, 11 Jan 2111 11:11:11 and sell those issues once they are divested. This requires liquid securities markets. Moreover, investors must

2.2— Privatization and the New Securities Markets in the Czech Republic, Poland, and Russia (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets have regular access to consistent information about companies and markets. Securities market development followed different paths in the Czech Republic, Poland, and Russia. These differences reflected the design of each country's privatization program (and how the benefits were distributed) and the degree of securities market development at the start of the program. The different outcomes also resulted from the different approaches to securities market regulation and development adopted by these governments. Different Approaches, Different Effects. Until 1995 most privatizations in Poland took the form of management−employee buyouts and direct sales to foreign or domestic investors. Still, the Polish authorities always expected securities markets to develop as a result of both economic growth and the increased supply of companies made available by the privatization of medium−size and large state−owned enterprises through initial public offerings. The government has played an active role in ensuring that a sufficiently developed market infrastructure is in place to support the primary sales of these shares as well as their subsequent secondary trading. Although mass privatizations have encouraged securities market development in most transition economies, they have not fostered the efficient trading infrastructure that characterizes the Polish marketplace. Instead, the light−handed approach to capital market development adopted in the Czech Republic and Russia led to the spontaneous emergence of securities markets in response to the trading needs generated by mass privatization. The Czech authorities advocated a freemarket approach and for the most part avoided influencing the development of securities markets. The Russian government took the middle ground, initially focusing on mass privatization (to the detriment of an organized national securities market and at the expense of market infrastructure development) and later attempting to provide coherent direction by introducing an active securities commission. Mass privatization used investment coupons in the Czech Republic and privatization vouchers in Russia to rapidly transfer ownership of thousands of state enterprises to private citizens and institutions.1 Both programs managed to establish fairly broad−based ownership of state enterprises. About 75 percent of the adult population became shareholders during the first wave of privatization auctions in the Czech Republic. In Russia privatization created some 40 million new shareholders, more than in most other countries. Poland's mass privatization program, which is only now being implemented, focuses on enterprise restructuring by private owners and the ultimate sale of 512 medium−size and large companies.

In the first two waves of mass privatization in the Czech Republic, between 1991 and 1994, shares of 1,849 companies were offered to the public in exchange for previously issued privatization investment coupons.2 (About 2,700 other enterprises were privatized through direct sales, cash auctions, and tenders.) In 1995 mass privatization entered its third stage, during which the enterprise shares divested in the first two waves were amassed by control−oriented investors. During this phase residual state shareholdings have also been divested and large case−by−case privatizations begun, further deepening securities markets. In Russia 14,000 medium−size and large enterprises employing two−thirds of the industrial labor force were privatized during a twenty−month period starting in late 1992. By the start of 1996 nearly 32,000 firms had been privatized (Saburov and Simonyan 1996). As noted, the sudden and dramatic supply of state enterprises available for purchase as a result of mass privatization drove the nearly spontaneous development of the Czech and Russian securities markets. This supply of shares, coupled with the surge of demand created by the distribution and subsequent trading of investment coupons and privatization vouchers, led to thebyemergence ofe-library formalto:and informal securities markets and to the Delivered The World Bank aaaaaa University founding of numerous market intermediaries. In the early days of privatization many Russian securities brokers IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 began working in the country's numerous commodity and other asset exchanges. Many of these exchanges had sold shares and vouchers during mass privatization, then transformed themselves into the local and regional stock Different Approaches, Different Effects. (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets exchanges now found throughout the country. Other intermediaries, such as the hundreds of (often unlicensed) voucher investment funds that sprang up during mass privatization, have turned out to be disappointing investments but were successful in collecting vouchers and generating demand for the shares being privatized. Czech and Russian policies have emphasized the rapid implementation of mass privatization. Lacking the needed financial infrastructure and regulatory framework, securities market development has lagged behind. A weakened central government in Moscow, for example, was unable to implement basic rules on trading or develop the necessary infrastructure. It also had trouble rallying market participants to do so. Recognizing that securities markets would develop regionally, away from Moscow's control, the government focused instead on rapidly completing mass privatization. The supply of and demand for the securities of newly privatized enterprises encouraged the emergence of multiple securities markets in the Czech Republic and Russia. Institutional weaknesses and the lack of securities markets regulation caused off−market trading in corporate shares to expand rapidly in both countries. In mid−1997 the Czech Republic's two organized exchanges accounted for just 65 percent of trading. In terms of trading volume, the market is dominated (60 percent) by the Prague Stock Exchange, which trades blue−chip and other primary issues. (The smaller RMS system, which accounts for 5 percent of trading volume, is an over−the−counter; second−tier trading intermediary and share subscription vehicle serving mainly small investors.) In 1996, however, an electronic share registry (the Securities Center) began to handle most equity trades, and off−market trading was essentially converted to overthe−counter New, stricter disclosure regulations governing the over−the−counter market and the exchanges have eliminated the incentive to trade off−market to conceal trading data, considerably expanding formal exchange trading. Lacking the needed financial infrastructure and regulatory framework, securities market development has lagged Securities Regulation Shapes Securities Markets Securities markets moved to higher levels of trading as mass privatization proceeded. Still, the Czech authorities had no intention of influencing the market after having developed an enabling structure like mass privatization. Weak securities regulation and limited information and transparency allowed investors to gain control positions, driving the market. The premiums for control positions were so high and the buying and selling so opaque, however; that foreigners began leaving the market. Furthermore, many off−market trades were not reported for several days, depriving the market of data on price and volume and so reducing efficiency. In 1996 the Czech authorities responded to the lack of transparency and culture of secrecy. Regulation was strengthened in several key areas, introducing requirements and deadlines for reporting trades, strengthening minority shareholder protection (ownership stakes greater than 10 percent must be disclosed, and minority investors must be offered at least the current market price), and tightening accounting and disclosure rules (requiring complete annual and quarterly financial statements from traded companies). An industry regulator; the Czech Securities and Exchange Commission, is not yet operational, however.

Russia's securities markets were also unregulated during the early stages, and lacked an organized and controlled environment for trading securities. These shortcomings impeded the development of a liquid secondary market in Russia. Moreover, mass privatization was easier in the Czech Republic than in Russia, which is so large that most companies were of only regional investment interest. In addition, Russia's weak telecommunications infrastructure made it difficult to collect and tabulate voucher share subscriptions on a national basis. As a result voucher auctions were conducted primarily regional basis. Theto:Russian securities market developed on a Deliveredon byaThe World Bank e-library aaaaaa Universitymanner, with many regional stock exchanges regional basis as well, in a fragmented and nontransparent IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 established during the first year of mass privatization alone.

Securities Regulation Shapes Securities Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Local opposition substantially delayed the divestiture of many Polish enterprises Most issues of newly privatized companies in the Czech Republic and Russia had little or no liquidity because mass privatization typically distributed a minority parcel of shares to the public in exchange for investment coupons or vouchers. The Czech Republic's privatization rules did not require that a minimum amount of shares be offered for investment coupons,3 as a result about 40 percent of the book value of privatized assets remain in state hands (World Bank 1996). In Russia the political compromise required to obtain approval for the privatization program put a large portion of enterprise shares in the hands of insiders, limiting the number of shares (the free float) available for trading. Trading occurred mainly through informal arrangements among brokers and was conducted almost entirely off the market—that is, outside the purview of the many regional exchanges, where trading was costly because market infrastructure was inefficient and unreliable. Brokers relied on their connections with enterprises to find shares—and even camped out at the gates of factories to purchase workers' shares—and then set their own prices, which could be very different from seller expectations. Information on transactions and prices was rarely disclosed, and when it was it was unreliable. In many cases ownership was recorded by share registers that were not necessarily independent of the company they served. Poland crafted a more controlled market environment. Authorities there sought to ensure that securities market infrastructure, including trading functions and back office mechanisms, would be in place to facilitate privatization and the secondary trading of privatized issues that would follow. Regulation and trading rules, modeled on Western standards, emphasized transparency and prudent behavior (Pohl, Jedrzejczak, and Anderson 1995). An active securities commission was developed to regulate market and exchange activity. Despite these efforts, by December 1996 no more than twenty−five large enterprises had been privatized through initial public offerings on the Warsaw Stock Exchange as part the government's capital privatization program for large enterprises. A lack of consensus on privatization strategy, especially within the Solidarity movement, impeded the formation of privatization objectives and policies. Privatization officials had to balance their desire to enhance enterprise efficiency through privatization—usually through the sale of enterprises to investors with the managerial skills and capital needed for post−privatization restructuring—with the oftenconflicting goal of achieving an equitable and acceptable distribution of wealth among the public. (Krawczyk and Lopez−Lopez 1993). Moreover, privatization legislation gave employees considerable influence on the privatization of their companies, including veto power over privatization plans. As a result local opposition substantially delayed the divestiture of many enterprises. The Polish authorities also discovered that although privatization through initial public offerings may foster securities market development by increasing the number of issues available for trading, the success of these transactions is determined by the perceived attractiveness of the issue as well as by general securities market conditions. In voucher−based privatizations, by contrast, program rules can ensure rapid and predictable divestiture. For these reasons the state has claimed that it had to retain as many as half of the enterprise shares because it could not sell them at initial public offerings. Despite the obstacles, the Polish government raised much−needed budgetary funds through initial public offerings on the Warsaw Stock Exchange: $600 million in 1995 and $750 million in 1996. As mass privatization proceeds, trading is expected to increase as shares of privatization investment funds start being traded and the funds begin selling shares of their portfolio companies. Privatization Investment Funds Stimulate Securities Markets Privatization investment funds have played anbyintegral all three Delivered The Worldrole Bankin e-library to: countries' privatization programs, though aaaaaa University their role IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Privatization Investment Funds Stimulate Securities Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets and impact have differed. Voucher−based privatization in Russia and coupon−based privatization in the Czech Republic laid the foundations for establishing and broadening the stock market in both countries. Both programs developed infrastructure for holding voucher or coupon auctions and created privatization investment funds. In Poland national investment funds are expected to boost markets as shares of companies held by the funds as part of mass privatization are sold off, many as public offerings.4 Poland's mass privatization program was designed to promote market intermediation by relying on voucher investment conducted exclusively through market intermediaries, the national investment funds. All three types of investment funds were created to intermediate the sudden large demand for enterprise shares. Poland's funds also sought to foster enterprise restructuring by the foreign owners and managers of investment funds and by others with restructuring expertise. Funds in Russia and the Czech Republic, by contrast, were primarily classical market intermediaries, managing the supply of and demand for shares, in large part because of restrictions on fund investment.5 These funds were supposed to allow coupon and voucher holders to own part of a diversified (and therefore lower−risk) portfolio of enterprise shares. They were also intended to help small investors by channeling investor demand and promoting market−based securities prices. In addition, fund investment decisions were to play a key role in adjusting the market price of undervalued and overvalued shares. These goals were only partly realized, however. Czech Investment Funds

Most privatization investment funds in the Czech Republic were founded by financial institutions in response to a perceived market opportunity created by privatization. Investment funds gained control of more than 60 percent of privatization vouchers in the first wave and 70 percent in the second. The more than 470 legally registered funds in Czechoslovakia (before separation) were dominated by the largest. After the first wave the six largest funds held 40 percent of voucher points, or nearly 60 percent of the voucher points acquired by funds. In the second wave the six largest funds accounted for 24 percent of voucher points and 40 percent of points acquired by funds (Kenway and Klvacova 1996). Most of the largest funds were subsidiaries or affiliates of large commercial banks and still partly (if only minority) state owned. The banks were well positioned to found and promote funds because they were widely known, with a customer base and financial expertise, and often with a branch infrastructure conducive to collecting and processing coupons. Extensive advertising and promises of large returns increased investor enthusiasm and participation.6 Most privatization investment funds in the Czech Republic were founded by financial insitutions As it turns out, few bank−run investment funds have been interested in enterprise restructuring, preferring quick−profit transactions that enhance the banks' business and often taking advantage of the banks' dual role as creditor and investor In many cases fund−invested companies have been pressured into banking transactions perceived by the founding banks as more profitable than the activities of their investment fund affiliates, and some investment funds have been pressured to provide financing to poorly performing bank clients. Conversely, investment funds have pressured banks to provide credit to companies in their portfolio on a less than arm's−length basis. These and other potential conflicts of interest result from the lack of legal segregation of commercial banking and investment fund operations. The potential for abuse is enhanced by ownership patterns in which bank−founded investment funds have invested in the publicly traded securities of the founding banks. While in most markets unit trusts and similar investments typically trade at some discount to their net asset value, these legal and regulatory shortcomings may explain why many Czech funds trade at as much as a 60 percent discount. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 nonbank These Tue, 11 Jangroups. 2111 11:11:11

Some Czech investment funds are run by include funds like Motoinvest, which is run by unknown individuals and groups seemingly interested in building a power base, and Harvard Capital and Czech Investment Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Consulting, which aligned with Bahamas−based Stratton Corporation to take over and restructure Czech companies. Finally, there is a group of smaller funds interested in increasing the value of their assets. The number of such funds has been falling, at least prior to the introduction of new market regulations, as disillusioned foreign−managed funds begin leaving the Czech securities market. Russian Investment Funds

As in the Czech Republic, Russia's voucher investment funds were created to intermediate demand for the shares of privatized companies. This process was largely in place by late 1993, with funds controlling a large share of the sales that went through brokers. By the time voucher privatization was

completed in July 1994, funds had accumulated 45 million vouchers, or 31 percent of those distributed, and invested 75 percent of these. The rapid growth of the Russian securities market and the lack of measures to protect investors provided a breeding ground for potential abuses The rapid growth of the securities market and the lack of measures to protect investors provided a breeding ground for potential abuses. Nearly from the start, funds and their affiliates were allowed to act simultaneously as fund, broker, transfer agent, and registrar—a mix that, if not prohibited, is strictly segregated in most developed securities markets. Moreover, funds were often unlicensed and not only participated in voucher auctions but also often acted as agent for the local branch of the State Property Fund (the legal seller of state enterprises), setting up and conducting local voucher auctions. By 1994 there were more than 660 licensed and unlicensed funds with 23 million stockholders, or 15 percent of the population. By late 1996, however, only about 350 active funds remained, and only 25 to 30 had active portfolios with long−term prospects (Pistor and Spicer 1997). Several factors affected funds' development. Limitations on their investment activities and unfavorable tax rules (double taxation on investors, failure to index capital gains) contributed to the funds' lack of profitability. In addition, the concentrated insider ownership resulting from privatization prevented funds from participating in the ownership of many attractive companies. Making matters worse, the voucher−induced stock market was illiquid—especially the regional funds, most of which ended up owning only the stocks of illiquid small and medium−size enterprises, which were never in great demand. Most funds remained small and unable to maintain sufficient cash flow. A few, however, managed to survive by trading large blocks of shares, bypassing the restrictions on diversification, and engaging in considerable voucher trading. Polish Investment Funds

Unlike the Russian and Czech programs, Poland's mass privatization is designed to harness the skills of international fund managers, selected for their experience in financial, investment, and industrial management and their expertise in corporate restructuring. State enterprises, primarily engineering and chemical firms, are being placed under the ownership of fifteen national investment funds.7 The funds were created in December 1994, and by July 1995 ten−year agreements were concluded between their supervisory boards and domestic and international fund managers, chosen through international tender. Major U.S. and EU corporations, such as Philips Electronics, have taken majority stakes in several fund portfolio companies. The 512 companies participating in the program have a book value of about $3 billion and aggregate sales of $6.5 billion, representing 7 percent of GDP. Delivered by The World Bank e-library to:

The program's initial phase, a one−year subscription period that ended in November 1996, has inspired optimism aaaaaa University IP : 111.111.11.11 about the program's ultimate success. About 25.6 million Poles, or 95 percent of the eligible population, spent 20 Tue, 11 Jan 2111 11:11:11 zloty (about $7) on certificates good for one share of each investment fund. Since July 1996 these certificates Russian Investment Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets have been traded on the Warsaw Stock Exchange, climbing in price to 140150 zloty. In February 1997 trading of the certificates started on the London Stock Exchange through depository receipts issued by a Western bank. All fund prospectuses were approved by the Polish securities commission in early 1997, and fund shares started trading on the Warsaw exchange in June 1997. In addition, shares of several dozen fund portfolio companies have already been sold through public share offerings.8 Funds have not been without controversy. The apparent overlap between the roles of the foreign fund managers and the funds' supervisory boards has created disputes. For instance, a supervisory board dismissed the fund management arm of a U.S. investment bank for alleged negligence, and the board of another fund was removed by the minister of privatization after it tried to fire its fund managers. In addition, supervisory boards have been under pressure from parliament and trade unions, which are anxious to avoid labor downsizing, fueling tensions with cost−cutting fund managers. According to the treasury, nearly all the companies in the fund portfolios have undergone some restructuring. The most widespread changes have been in financial management and recapitalization. Poland's Securities Markets Facilitate Privatization Established in April 1991, the Warsaw Stock Exchange is the only securities exchange in Poland. In 1995 market capitalization reached $4.6 billion (table 2.1); by December 1996 it had nearly doubled, to $8.4 billion, and by December 1997 it was $14 billion. The WIG, as the exchange's index is known, rose 65 percent (in U.S. dollar terms) in 1996 and hit a new high in February 1997 (the previous peak was in October 1996). The attention being paid to market regulation and infrastructure development has encouraged stability

(price movements are limited to 10 percent a day) and resulted in fairly high share liquidity on the exchange. The exchange is owned by fifty−three brokerage firms and by the treasury, which holds 9 percent. The exchange trades enterprise shares and government bonds on an orderdriven, call−market basis five days a week. Continuous trading, introduced in 1992, was fully computerized in 1995. At the beginning of 1997 twenty−one stocks were traded continuously, along with investment fund certificates. All share trading is dematerialized, and clearing and settlement are conducted through a well−functioning centralized depository mechanism in which shares are held in the name of the nominee. At first the depository was operated by the Warsaw Stock Exchange, but it became a separate entity in 1994 and is now co−owned by the exchange and the state treasury. Clearing and settlement rules are made and monitored by the depository and the state securities commission.9 Despite the exchange's rapid development, by April 1997 only ninety−five companies—seventy−seven on the main market and eighteen on the parallel market, and most of them small or medium−size—were listed. This was partly because of the lower than anticipated volume of privatization−led initial public offerings. Still, given the limited number of issues, liquidity is high, with about sixty issues actively traded. In 1996 monthly turnover was 8.2 percent of capitalization, more than twice the level in the Czech market. There is also considerable off−market trading, primarily by banks, of large blocks of shares. The exchange cannot yet support such trading without causing large price fluctuations. In October 1997 market capitalization was equal to about 7.8 percent of GDP (Economist Intelligence Unit Country Alert, 30 October 1997), a comparatively low level.10 As a result some analysts have claimed that strict regulation and disclosure requirements have impeded the initial growth of the market. Critics have charged that the considerable financial and human resources devoted to creating the securities commission, modeled on the U.S. Securities and Exchange Commission, have been on further developing securities market Deliveredmay by The World Bank better e-libraryspent to: aaaaaa University infrastructure. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Poland's Securities Markets Facilitate Privatization (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Table 2.1 Securities market data for the Czech Republic, Poland, and Russia, 199496 1994 Czech Republic

1995 Poland Russia

Czech Republic

Czech Republic

Poland

Russia

1,635

65

170

1,588

83

73

30,000 15,644

4,564

15,863

18,077

8,390

37,230

3,630

2,770

465

8,431

5,538

2,958

176

25

72

50

85

511

7,473

426

7,586

540

14,343

Number of listed companies

1,024

44

Market capitalization (millions of U.S. dollars)

5,938

3,057

Trading value (millions of U.S. dollars)

1,328

5,134

Turnover ratio

1996

145

308

Poland Russia

Local index Local market index

557

Change in index (percent)

−44

−40

−24

2

27

89

60

12

65

17

74

31

25

Share of market capitalization (percent)

147

48

65

44

Price−book value ratio

1.0

2.3

0.9

1.3

17.6

14.3

6.3

Dividend yield (percent)

1.1

0.4

1.4

2.6

0.9

2.6

0.35

Total return index

81

484

65

450

1.4

1.2

0.86

−19

−42

−20

−7

20

71

156

36,988

86,219

10

33

9

19

22

IFC global index Number of stocks

Change in index (percent) Economic data GDP (millions of U.S. dollars) Inflation (percent)

285,700 39,990

107,829

331,948

9

22

130

307 Source: IFC 1997. In 1996 monthly turnover on the the Chech market

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 21118.2 11:11:11 Polish exchnage was percent of capitalization,

Poland's Securities Markets Facilitate Privatization (c) The International Bank for Reconstruction and Development / The World Bank

more than twice the level in

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Privatization and Emerging Equity Markets In response to these concerns and in consideration of the hundreds of companies still to come to market following their privatization, the exchange adopted a three−tiered approach to company listing requirements, permitting trading on the main, parallel, or free markets. Distinctions between tiers are based on company size, track record, and number of shareholders. The largest companies trade on the main market. Small and medium−size companies with short histories are typically found on the parallel market. Companies that do not meet the requirements of the parallel market can trade on the free market with exchange approval. Disclosure rules require all traded companies to report immediately any price−sensitive information and to submit quarterly semiannual, and audited annual reports. In addition, a new over−the−counter market called CETO, development of which started in 1996, expects to capture many new issues of privatized companies. Over−the−counter disclosure and other listing requirements will be less restrictive than on the Warsaw Stock Exchange. Monitoring and enforcement guidelines should be the same, however. The Warsaw Stock Exchange's stability, liquidity, and strict regulatory environment have attracted significant foreign capital Among the nascent stock exchanges in transition economies, the Warsaw Stock Exchange has developed a capable primary, or new issues, market. No other privatization program in a transition economy has relied on public offerings as extensively as Poland's—nor could they given their generally insufficient liquidity. While the number of privatization initial public offerings turned out to be less than was initially forecast, one−third of companies traded in 1995 represented initial public offerings of enterprises previously privatized using management−employee buyouts. And many enterprises have followed initial public offerings with public issues, including rights offerings.11 A number of foreign and domestic brokers have emerged as the leaders in handling initial public offerings.12 Individuals are encouraged to participate through special incentives offered to small investors, such as a small discount (for example, 3 percent) from the public offering price. Numerous subscription points have been established around the country. The marketing, pricing, and share allocation of new issues have become increasingly sophisticated since the early days of Poland's privatization program, when the first large companies to be divested were done so through initial public offerings. New mechanisms include book−building and similar share allocation methods common in developed markets. Many new issues are underwritten by one or a group of domestic financial institutions, although underwriting is generally limited to buying unsubscribed shares, for which the institutions charge significant fees.13 While the high risk of underwriting in a young marketplace is reflected in the steep commissions charged for the service, the willingness of financial institutions to underwrite reflects their confidence in the securities market. The Warsaw Stock Exchange's stability, liquidity, and strict regulatory environment have attracted significant foreign capital, which reportedly accounts for as much as 25 percent of trading and is expected to rise further. There are no restrictions on the movement of this capital. Foreign institutional investors are already significant investors in Polish offerings, and additional foreign capital will be needed to finance the investment requirements of Polish enterprises. In addition to the securities that will be traded as a result of mass privatization, growth in and sustained demand for securities is expected to come from closed−end investment funds and pension fund schemes once new legislation is in place. Securities markets should continue to experience healthy growth in the short to medium term as a result of continued privatizations conducted as initial public offerings. Several large companies were privatized in 1997, including KGHM, the largest copper producer, and state−owned banks such as PBK Warsaw. (The initial public offering of Bank Hadlowy in mid1997Delivered was several timesBank oversubscribed.) Many privatizations have been by The World e-library to: aaaaaasold University conducted as mixed sales, with a portion of shares through an initial public offering and a portion through a IP : 111.111.11.11 Tue, 11 Janwidespread, 2111 11:11:11 diverse ownership resulting from a public offering direct sale. The mixed sale approach combines the with the potential benefits of investment by a strategic investor. In the first eight months of 1997 Poland earned Poland's Securities Markets Facilitate Privatization (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets $1.3 billion from the sale of twenty−five state enterprises. Another fifty firms are scheduled for sale in 1998, among them the state telecommunications enterprise, Telecomunikacija Polska. Czech Securities Markets Respond to the Supply of Privatized Shares The Prague Stock Exchange maintains restrictive enterprise listing requirements and membership standards. By late 1995 the exchange had 101 members—31 banks and 70 brokerages—with 17 listed securities and nearly 1,000 unlisted securities traded. (By March 1996, 1,700 unlisted

securities were traded.) International portfolio investment has played a significant role in the exchange's growth, with estimates of foreign capital invested ranging from 50 to 90 percent of exchange capitalization. In 1994 total market capitalization exceeded 50 percent of GDP; a level typical of advanced industrial economies (Pohl, Jedrzejczak, and Anderson 1995). An alternative trading venue, initially known as the RM System, or RMS, was created in 1993 to provide greater market access to individual investors. The RMS uses the coupon bid collection network created by mass privatization to facilitate share purchase and sale by small investors at 400 locations without the assistance of brokers. The transition from an auction bid collection network to a share subscription center is unusual among mass privatization programs; bid networks rarely acquire new roles once they are no longer part of the government−funded privatization program and are forced to develop related business services to compete in the post−privatization environment. Apart from helping companies create business plans, conduct business seminars, and the like, few networks survive to become financial market participants. Russia's networks are another exception—they are operated by financial market participants such as brokers and storefront stock shops. The RMS initially cleared its orders once every two or three weeks, but rapid growth enabled it to begin continuous share trading in 1995. The RMS requires both parties to a trade to provide the shares and payment before executing the trade. This feature reduces counterparty risk—an important concern because the RMS deals primarily with small investors who do not trade through brokers. This rudimentary clearing and settlement system has several disadvantages, however such as the need to freeze buyer funds, sometimes for a long period. This has made short−term investing on the RMS less attractive. Market participants are focused on increasing market liquidity. In 1996 foreign portfolio investment inflows were just $720 million. Turnover should increase as a result of investment funds having become compulsory open−end in late 1997. Closed−end funds complicate the redemption of old shares and the issuance of new ones. Open−end funds will trade on the open market and create new shares easily. In creating liquidity, many listed companies will be removed from trading through continued consolidation through buyouts, takeovers, and share tenders, most likely leaving several dozen blue−chips trading daily on the Prague Stock Exchange and possibly on the RMS. By May 1997 the Prague exchange had eliminated 1,000 unlisted stocks from trading. These companies, left over from mass privatization, accounted for less than 1 percent of the previous year's trading. The reduction in companies should be offset by continued state divestiture, including the sales of residual state interests left unsold during mass privatization. Privatization in Russia Leaves Its Mark on Securities Markets. In Russia ad hoc securities markets have emerged in response to the need for share trading venues in an inefficient market environment. Despite an organized privatization program, the decentralized, regional orientation of Russian securities markets is the resultDelivered of underdeveloped infrastructure and weak regulation, enforcement, and by The World Bank e-library to: aaaaaa University protection of shareholder rights, making interregional trading, settlement, and clearing difficult and risky. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

The Prague Stock Exchange maintains restrictive enterprise listing requirements and membership standards Czech Securities Markets Respond to the Supply of Privatized Shares (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Of 400 tradable stocks, Russian securities markets are dominated by the trading of about 30 large, relatively liquid issues. At the end of 1997 estimates of the capitalization of Russia's securities market ranged from $80 billion to $200 billion. This wide range reflects the difficulty in assessing the reliability of stock quotations, which often do no reflect the prices at which transactions would take place—the result of little or no activity in many issues. In fact, thousands of privatized shares do not trade at all. In 1996 Russian securities markets used favorable economic developments, such as low inflation and a stable ruble, to attract considerable foreign portfolio investment, making them one of the top emerging market performers that year. This trend continued in 1997, when gains of more than 150 percent were recorded before the financial crisis in Asia (which depressed markets worldwide in late 1997). Most privatization issues, are illiquid, suffering from insufficient trading float—that is, the portion of an enterprise's outstanding shares available for trading—the result both of the small percentage of shares offered to the public during voucher auctions and the large number typically remaining with managers, employees, and the state. Limited float also reflects the difficulties associated with ensuring that the sellers of shares have proper title, that title is correctly transferred and recorded, and that payment is received.

Privatization without sufficient securities market investor protection, transparency, or infrastructure has facilitated the accumulation of shares by individuals and groups interested in maintaining and increasing enterprise control, be they managers, brokers, or outside investors. Despite the existence of a dozen exchanges throughout Russia, as much as 90 percent of trading takes place off−exchange, directly between buyers and sellers. Examples of such traders include large investors (who prefer to trade with people they know and trust) and managers and others who buy shares from enterprise workers (for whom the cost of exchange trading is prohibitively high). In 1993 the government introduced high−yield, shortterm government securities known as GKOs. Because their high liquidity is artificially supported, a number of investors left the market for corporate shares for the safety and high returns of these instruments. As a result the market's most risk−free securities were also the most profitable. In 1994 government bonds accounted for 43 percent of capital markets capitalization; the shares of privatized companies accounted for just 38 percent (Saburov and Simonyan 1996). Only since 1996 have Russia's securities been an attractive emerging market investment option. As much as 90 percent of trading in Russia takes place off−exchange, directly between buyers and sellers. In recent years privatization in Russia has moved away from the fairness and accessibility of mass privatization. The loans−for−shares transactions initiated in 1995, for example, gave certain buyers the inside track in a nontransparent process that has transferred controlling interests in major enterprises at low prices to domestic banking conglomerates. These conglomerates now wield considerable influence over the government and economy. Such transactions offer no short−or medium−term benefit to the securities markets. Such benefits could have been obtained if the shares of these large and potentially liquid issues had been offered to multiple buyers in an environment offering sufficient access to enterprise and pricing information. Building Sustained Demand for Securities in Poland Although much of Poland's heavy industry has closed or downsized to meet the demands of the competitive marketplace, service sectors—financial services, tourism, and health care among them—have driven 67 percent annual GDP growth. Rapid expansion in real incomes should provide the savings to rebuild Poland's infrastructure as well as the capital for its estimated 2 million private companies. Delivered by The World Bank e-library to: aaaaaa University Essential market institutions include savings banks, pension funds, insurance companies, and investment funds IP : 111.111.11.11 Tue, 11 Jandemand 2111 11:11:11 that intermediate savings and so create sustainable for securities. The mutual fund industry already boasts three large funds, including the hugely popular Pioneer open−end funds, and has begun to mobilize Poland's

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Privatization and Emerging Equity Markets significant under the mattress savings and flows of funds from relatives and others abroad. The mass privatization program also has tried to address this need by requiring the development of investment funds as well as their exclusive intermediation of share demand, expressed in the form of privatization certificates. Efforts are also being made to strengthen other demandintermediating institutions. The current pay as you go pension plan costs employers up to 45 percent of gross wages, yet without additional support it may not provide pension payments past 2010. Current plans call for the implementation of a private pension fund system that would cut pension−related expenses by reducing the number of participating individuals and indexing pension funds to inflation rather than to wages. The new pension structure is expected to force employees to save more, providing more investment capital for industry. It is also hoped that the plan will attract foreign investment, although there has been some debate about whether foreign−owned insurance companies and others should be allowed to run Poland's pension funds. The domestic insurance industry also expects to attract more foreign capital by no longer limiting foreign participation to joint ventures with Polish partners, a move linked to Poland's efforts to join the Organisation for Economic Co−operation and Development (OECD). Competition has increased as foreign firms have started to enter the market, and the domestic industry has responded by streamlining operations. Developing sources of demand is crucial because capital is insufficient for the long−term funding of the thousands of former state enterprises and other private companies that must now rely on short− and medium−term bank financing. As long as inflation remains high, there will not be a market for ten−year or longer corporate bonds. Lacking cash−rich shareholders, companies will continue to rely on issues of new shares on the Warsaw Stock Exchange to raise long−term equity capital.

Securities Markets and Corporate Governance in the Czech Republic Analysts are often concerned that mass privatization will produce large numbers of orphaned enterprises, each with numerous disparate shareholders. Orphaned enterprises lack sufficient ownership concentration to facilitate corporate governance. The potential for orphaned firms was not nearly as big an issue in the early days of mass privatization as were the speed and scope of the program. As stated early on by Finance Minister Vaclav Klaus, the main designer of the Czech privatization program, early, fast, and massive privatization was essential to rapidly achieving economic efficiency, including the restructuring of enterprises by new owners (Sacks 1993, p. 188), Experience seems to indicate, however; that the lack of regulation to encourage transparency, foster open dissemination of information, and prevent potential abuses of market power has facilitated the expansion of the Czech market for corporate control. Many holding groups and others in the Czech Republic are intent on amassing control positions. By some estimates more than half of the companies sold during mass privatization now have majority owners. Secondary trading in securities has contributed to the rapidly increasing concentration of ownership needed for enterprise restructuring—suggesting that orphaned status following mass privatization can be short−lived, particularly if securities markets enable share trading. In developed markets unit trusts and mutual funds are passive portfolio investors. In the Czech Republic, however; it was hoped that analogous privatization investment funds would take an active role in operational and governancerelated changes, much like high−risk venture capital and other equity funds in the United States and elsewhere. The evidence suggests that this has not been the case; for example, bank related investment funds have not been particularly active in effecting corporate governance−related changes. Like managers of unit trusts and mutual funds, Czech fund managers have neither time nor the expertise to take an active role in managing Delivered by Thethe World Bank e-library to: aaaaaa University their portfolio companies. The 25 percent enterprise shareholding maximum further limits fund managers' ability IP : 111.111.11.11 11 large Jan 2111 11:11:11 to promote change. To escape this limit, theTue, few funds that have become active control purchasers have converted themselves into more loosely regulated holding companies. Securities Markets and Corporate Governance in the Czech Republic (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets In any event, since 1995 securities markets have contributed to changes in corporate ownership, which is moving from individuals and passive investment funds to the more activist corporations and other investment groups that are beginning to dominate the Czech industrial structure. Over the long term these groups may also mitigate the potential for abuses arising from ownership concentration by promoting and facilitating changes in ownership. Deepening the Securities Markets in Russia A string of financial market scandals involving pyramid schemes and similar frauds made the Russian authorities recognize the importance of a regulatory framework in securities market development. Thus in November 1994 the Federal Commission on Securities and the Capital Market was established. Headed by reformers, the commission began developing securities market institutions and infrastructure. It also sought to foster self−regulation by market participants and to provide regulatory oversight of the markets by self−regulating organizations. In its early days, however the commission's limited staff for developing regulation, combined with weak or no enforcement, further hampered market development, as did the lack of information−efficient and cost−effective trading, clearing, and settlement structures. Secondary trading in Czech securities has contributed to the rapidly increasing concentration of ownership needed for enterprise restructuring Trading systems

To counter the regionalization, fragmentation, and considerable off−market trading that characterized Russian securities markets, in mid−1995 the commission helped establish the Russian Trading System, a national electronic system based on the U.S. NASDAQ. The system is now the main over−the−counter market in Russia, handling 60 percent of all over−the−counter trading in Moscow, which dominates the market. Initially the system linked eight major Russian cities (with more than 400 brokers using the system by the end of 1997); it now spans twenty−four cities. The system has become the main pricing mechanism for over−the−counter securities and has greatly improved the quality of pricing information. In late 1996 the Russian Trading System−2, a secondary market facility, was launched. At the end of 1997 the Russian Trading System listed 703 companies; the Russian Trading System−2

listed 207 shares, including preferred stock, connecting fortyseven regional brokerages. The Russian Trading System is owned by more than 400 dealers and brokers from thirty−nine cities, each of which belongs to one of six regional trading associations of market participants. These self−regulating associations are responsible for developing and enforcing the rules for trading on the system, crafting governance, trading, and fair practice rules and compliance and enforcement procedures to help promote fair markets for Russian and foreign investors. In several cases the associations have taken disciplinary action against members who violated trading rules, thus promoting the transparency of the trading system. Association memberships have been rising steadily. As more brokers adhere to their standards, it will be increasingly difficult for shadow trading to take place. Russian mutual funds are expected to significantly boost securities market development By introducing a voluntary system of market makers prepared to set firm bid and offer quotes on a daily basis, the Russian Trading System has increased transparency and narrowed spreads. Standardized purchase and sale agreements enable market makers to handle directly Deliveredmost by Thetransactions World Bank e-library to: on the system, although the lack of aaaaaa University centralized settlement means that trades must still be concluded by telephone and fax. The system also has IP : 111.111.11.11 enacted strict securities listing requirements. Securities divided into primary and secondary listings. A Tue, 11 Jan 2111 are 11:11:11 security's rating depends on the company's market capitalization, disclosure practices, and methods for registering Deepening the Securities Markets in Russia (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets shareholders. Disclosure is particularly important because only a handful of privatized Russian companies provide any meaningful financial information. Other Market Infrastructure

The Federal Commission on Securities and the Capital Market has devoted considerable time to resolving infrastructure problems—for example, establishing a functioning centralized depository system and reliable independent registries—that have discouraged investors. While mass privatization sought to eliminate the costs and administrative burden of issuing physical share certificates, these functions are not performed by a centralized depository that facilitates secondary market activity. As a result they are the responsibility of numerous issuers and registrars throughout the country (Morgenstern 1994). Moreover, only companies with more than 1,000 shareholders are required to use an independent share registry; companies with fewer shareholders can maintain their own registries. Despite recently enacted laws designed to prevent the abuses of shareholder rights common during mass privatization, evidence suggests that a large portion of enterprises with more than 1,000 shareholders are not using independent registries (Blasi 1997). Still, even though many company−run share registries are poorly maintained and do not protect shareholder rights, progress has been made. For example, third−party registries expect to provide services to large issuers on an interregional basis. The securities commission has also tried to establish a central clearing and settlement facility. Although the Depository Clearing Company, a Russian firm, initially was expected to fill this role, a lack of capital and disagreements among the potential users of the system have diminished these expectations. Instead, several Russian and foreign banks, including Chase Manhattan and ING Bank, are trying to fill this gap by acting as custodian for U.S. mutual fund investment in Russian shares. These services are available only to foreign investors, however. Russian mutual funds are expected to significantly boost securities market development by mobilizing some of the estimated $20 billion in household under the mattress savings. However; early prototypes of the mutual funds, such as voucher investment funds and other investment schemes, were plagued by a lack of transparency and pyramid scandals. Investor confidence plummeted, the industry nearly collapsed without having even been started, and urgent regulatory reform was needed to salvage the remains and provide a fresh start. Russian President Boris Yeltsin authorized the creation of mutual funds in 1995, and a year later the securities commission put in place the regulatory framework (based on Western standards) needed for the funds to operate. At that time the first three Russian companies to manage mutual funds under the new rules were licensed. At the same time, the securities commission began developing plans for restructuring or liquidating unlicensed investment funds. Funds that legitimately manage assets were given the opportunity to restructure, most likely into licensed mutual funds. Assets of unlicensed funds being liquidated could be used to compensate defrauded

investors. In 1995, 883 unlicensed investment funds with 20 million shareholders were in operation. Like U.S. mutual funds, unit investment funds, known by their Russian acronym as PIFs, enable small investors to pool their investments and minimize risk. By the end of 1997 eleven PIFs were in active operation, with assets totaling $30 million in September 1997, up from $ 17 million in May 1997. Double taxation problems are solved because the new funds are registered as contractual agreements, not joint stock companies, so income is taxed only at the investor level. The unit investment areBank either open−end, investing in government securities and Delivered byfunds The World e-library to: aaaaaa University quoted equities, or interval, investing in less liquid securities such as real estate and unquoted securities.14 IP : 111.111.11.11 Unlicensed funds and possibly voucher investment will most likely be restructured into interval funds. PIFs Tue, 11 Jan funds 2111 11:11:11 are legally required to use specialized depositories, or custodians, to maintain records of their holdings. The Other Market Infrastructure (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets development of custodian regulation, however; has been delayed by government disagreement over their content. These issues should be resolved soon, however; because authority over custodian activities shifted to the securities commission in 1997. Depository Receipts

Large companies in each of the countries under review have been actively issuing depository receipts in better−capitalized foreign markets. Depository receipt issues provide a key advantage in the eyes of Russian managers. Unlike foreign direct investment, in which a strategic investor typically insists on control rights (particularly in a weak or underdeveloped legal and regulatory environment), depository receipts allow managers to attract foreign capital without relinquishing enterprise control. Russian American depository receipts (ADRs) have become increasingly prominent in international equity markets. By May 1997 ten outstanding Russian ADR issues accounted for 8.6 percent of the market value of traded Russian securities.15 The capitalization of Russian ADRs increased from $28 million in early 1996 to $4.6 billion in May 1997 as a result of the increase in the number of ADRs issued as well as their increase in market value.16 Continued issues of ADRs may, however stifle the local Russian market if capital−raising activities remain offshore. This effect should be limited, however, by the extent to which investment risks in the local market are reduced by further regulatory and other market infrastructure development. This issue is not limited to the direction of the securities markets but to the wider success of Russian reforms, which should encourage the return of substantial Russian flight capital, greatly increasing local market liquidity and development. Privatization's Effect on Further Securities Market Development The impetus for securities market development provided by privatization in the Czech Republic, Poland, and Russia led to the development of market intermediaries that have tried to channel market demand and contribute to the development of securities market infrastructure. Top−down, government−led development of infrastructure and regulation has provided considerable stability and liquidity to Poland's securities markets. Weaker regulation in the Czech Republic and Russia, by contrast, stymied efficient securities market development in the past few years Russia has made efforts to strengthen the operational and regulatory base of its markets, building investor confidence and contributing to rapid growth. The Czech Republic's hands−off approach to similar issues has eroded investor faith in its market, resulting in considerable capital flight. In transition economies well−functioning securities markets can also provide a vehicle for changing and consolidating ownership, increasing the potential for active corporate governance and enterprise restructuring by new owners. To a large extent Poland's mass privatization program relies on the market and its participants to accomplish this goal. This process will continue to be stifled in Russia, however; because substantial insider control continues to constrain the markets' ability to encourage good management and governance. If Czech markets are to play their intended roles, the authorities and market participants must increase transaction transparency and disclosure and protect further the interests of all investors. Depository receipt issues provide a key advantage inthe eyes of Russian managers Notes.

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets 1. In the Czech Republic about 8.5 million citizens paid the equivalent of $35 to buy a book of vouchers, registered in the name of the holder. In Russia 144 million citizens were given vouchers with a face value of 10,000 rubles ($25 at late 1992 exchange rates).

2. Of the 1,849 companies, 988 were offered in the first wave and 861 were offered in the second. These data are for the Czech Republic only. The first wave began in 1991 and was nearly completed by the time Czechoslovakia was formally divided. For the Czech and Slovak republics combined, 1,492 companies were offered in the first wave.

3. True to their bottom−up approach, the designers of the Czech privatization program allowed enterprises to determine the number of shares to be privatized.

4. The number of brokerage accounts in Poland is expected to increase to 2.53.0 million as a result of mass privatization. In 1996, when trading was dominated by several large institutions, there were 843,000 accounts.

5. Czech investment funds could not own more than 20 percent of the shares of a single enterprise. By the end of the first wave of privatization, 55 percent of fund portfolios were represented by investments of less than 0.5 percent of enterprise shares, and in the second wave, by 28 percent. Russia's voucher investment funds initially were prohibited from owning more than 10 percent of the voting shares of a single company or placing more than 5 percent of the fund's assets in the shares of a single issuer. While intended to prevent overexposure to a particular investment and to avoid concentration of ownership control in the funds, these restrictions limited the funds' ability to effect enterprise change. In July 1994 the 10 percent ownership limitation was raised to 25 percent.

6. The Harvard Capital and Consulting Corporation, for example, attracted more than 800,000 investors during the first privatization wave by promising a tenfold return within a year on all investment coupons invested with it.

7. Under the program 33 percent of each enterprise is allocated to a lead fund, with each fund acting as lead fund in fifteen enterprises. An additional 27 percent of each enterprise is divided among other funds, 15 percent is given to enterprise employees, and the balance is retained by the state. In the future the state's share may be allocated to social security and pension funds.

8. By the end of the third quarter of 1997, forty−five companies had been eliminated from the funds' investment portfolios. Of these, thirty were sold (mostly to strategic investors) and fifteen went bankrupt.

9. Of Poland's thirty−six licensed brokers, many of which are owned by commercial banks, more than 30 percent of market share is accounted for by the brokerage units of Bank Handlowy and Bank Pekao SA. Bank Pekao SA is a recent amalgamation of four major regional banks, combined to facilitate the privatization of these banks. Delivered by The World Bank e-library to: aaaaaa University markets grew rapidly in response to mass 10. In comparison, in the Czech Republic, where securities IP : 111.111.11.11 11 Jan exceeded 2111 11:11:1150 percent of GDP a level typical of advanced privatization, market capitalization in 1995Tue, already industrial economies.

Depository Receipts

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Privatization and Emerging Equity Markets 11. Unlike privatization initial public offerings, where proceeds from share sales are paid to the state as the seller, public offerings for privately or publicly held companies consist of newly issued shares, shares offered by selling shareholders, or both. Proceeds from the sale of newly issued shares are paid to the company; proceeds from sales by shareholders are paid to the shareholders.

12. These include HSBC, which raised 895.4 million zioty for client companies through new issues in 1995, and Schroder Polska, which raised 625.0 million zloty.

13. Underwriters charge a small fee for extending their underwriting facility to an offering and a separate, larger fee for buying shares not taken up in the public offering.

14. Interval funds can redeem investment units at periodic intervals, but not in between.

15. Eight Russian companies issued ADRs in 1996: five oil and gas enterprises (including the natural gas production and distribution monopoly Gasprom and four oil producers, including giant Lukoil and Tartarstan's Tatneft), an electric utility, a metals product manufacturer, and GUM, the upscale Moscow shopping complex.

16. Depository receipts are described more fully in chapter 10. References Blasi, Joseph R. 1997. The Hundred Largest Companies in the Russian Federation: A Preliminary Research Note on Ownership, Governance, and Restructuring. Paper presented in Moscow, 24 March. IFC (International Finance Corporation). 1997. Emerging Stock Markets Factbook, Washington, D.C. Kenway, Peter; and Eva Klvacova, 1996. The Web of Cross−ownership among Czech Financial Intermediaries: An Assessment. Europe−Asia Studies 48(5): 797809. Krawczyk, Marek, and Jose A. Lopez−Lopez. 1993. Role of Government in Poland's Economic Transition: Ideas and Experience from the Recent Past. Columbia journal of World Business 28(spring): 180−87. Morgenstern, Claudia. 1994. Capital Market Development and Financing Russia's Transformation. In Ira W. Lieberman and John Nellis, eds., Russia: Creating Private Enterprises and Efficient

Markets. Studies of Economies in Transformation 15.Washington, D.C.:World Bank. Pistor, Katharina, and Andrew Spicer 1997. Investment Funds in Mass Privatization. Viewpoint 110, World Bank, Washington, D.C. Pohl, Gerhard, Gregory T. Jedrzejczak and Robert E. Anderson, 1995. Creating Capital Markets in Central and Eastern Europe. World Bank Technical Paperby295. Washington, D.C. Delivered The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111in11:11:11 Privatization Russia:

Saburov, E.F., and V.I. Simonyan. 1996. on Russian Economic Development 7(6): 503−12.

Results and Prospects for Development. Studies

References

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Privatization and Emerging Equity Markets Sacks, Paul M. 1993. Privatization in the Czech Republic. Columbia Journal of World Business (spring). World Bank. 1996. World Development Report 1996: From Plan to Market. New York: Oxford University Press.

2.3— Peru's Privatization Program, 199096 Richard Cabello and David Shiguiyama The far−reaching privatization and other market reforms implemented in Peru since 1990 by Alberto Fujimori's government show how a carefully planned and executed privatization program, with strong political backing, can kick−start near−dormant capital markets. The program's most notable feature was its widespread public participation, due in large part to an effective public education campaign. In 1990 Peru's capital markets played a marginal role in the economy, with a total stock market value of $0.8 billion, or 2 percent of GDP. By the end of 1996 the value of the stock market had reached $13.8 billion, or 23 percent of GDP, with annual trading of $2.5 billion. During this period some 100 state−owned enterprises were privatized, culminating in a number of major international share offerings. These transactions raised $4.3 billion in investment. Associated investment plans and commitments are worth another $3.5 billion. Privatization was guided by a legislative framework designed to liberalize the economy, create needed regulation, and encourage foreign investment. Peru in 1990 Peru was experiencing a severe economic and social crisis when the Fujimori government took office in mid−1990. The Garcia administration (198590) had implemented a number of measures that distorted the free market, including subsidies, exchange rate and price controls, and restrictions on the movement of goods and capital. During 198590 GDP fell more than 7 percent, international reserves stood at −$352 million, annual inflation averaged more than 3,300 percent (in 198890), and net direct foreign investment flows were just $181 million. Guided by a free−market philosophy, the Fujimori administration implemented radical economic reforms that liberalized prices, abolished subsidies, permitted the free flow of goods and capital, established monetary and fiscal discipline, and greatly encouraged private investment, both foreign and domestic. At the beginning of the 1990's Peru's capital markets were almost nonexistent. Private long−term capital was lacking, and markets were extremely volatile: in 1991 annual trading volume was only $591 million, with equities accounting for just 35 percent. The remaining trading volume was concentrated in short−term instruments (62 percent) and bonds (3 percent). In 1991 the Lima Stock Exchange had a capitalization of $1.1 billion, or 2.3 percent of GDP. Of this, common shares accounted for 49 percent and labor shares for 51 percent.1 The Privatization Program and Related Reforms Legislative Decree 674, passed in September 1991, redefined the role of the state and established the private sector as the engine of Peru's economic growth. (The state will continue to regulate economic activities that require the nurturing of fair competition and the supervision of consumer services— Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets typically public services such as telecommunications, electricity, water and sanitation, environmental protection, and consumer rights, among others.) The decree created the Commission for the Promotion of Private Investment to plan, execute, and control the privatization program and to formulate privatization objectives, policies, and strategies (see below). The privatization program had several objectives: For privatized companies—a principal goal was to ensure each company's long−term viability and growth, with a sustained increase in investment and a swift recovery in operating performance. Political—including transparency, efficiency, the transfer of state companies to the private sector, and the widespread involvement of the public and former state employees in the share ownership of privatized companies. Legal—including implementation of modern regulation for public services such as telecommunications, electricity, and water, and development of a sound legal base for each transaction to ensure the program's irreversibility. Economic and financial—including creation of productive sources of employment, an increase in domestic and foreign investment, an increase in the production of goods and services, promotion of competition to raise the quality of services and goods at a reasonable cost, and generation of revenues for the state. The program was launched in February 1992. One factor contributing to the program's success, not only in terms of raising revenue for the government but also in achieving other goals, was the early realization that privatization was an integral part of other reforms that had to be executed before it or at the same time. Some of these reforms were intended to achieve economic stability. Others sought to make the distribution of resources more efficient. The overall aim, however, was to create an environment favorable to private investment. These reforms included: Adopting strict fiscal and monetary policies, including a constitutional amendment that forbids the Central Bank from financing a public deficit. Deregulating prices and public tariffs and eliminating subsidies. Simplifying and modernizing the tax system. Deregulating interest rates. Abolishing the fixed multiple exchange rate system and eliminating restrictions on the free disposal of currencies. Lifting trade restrictions and opening up the country to international trade. Removing restrictions on capital flows. In addition, the government implemented reforms that completed the overall framework needed for privatization's success and laid the foundations for capital market development. These included efforts to promote private investment, establish a new stock exchange law, and create a private pension system. Promoting Private Investment

Legislative Decrees 662 and 757, passed in 1991, guaranteed equal rights and obligations for domestic and foreign investors. The decrees also protect property rights and established the concept of free enterprise, the Delivered by The World Bank e-library to: aaaaaa University private sector's right to invest in all parts of the economy, and the freedom to engage in international trade without IP : 111.111.11.11 interference. Both decrees protect the free repatriation profits and royalties, following the payment of Tue, 11 Jan 2111of11:11:11 applicable local taxes, without exchange rate controls or prior authorization. In addition, the government was Promoting Private Investment (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets empowered to sign agreements with foreign and domestic investors guaranteeing taxation levels and access to foreign currency for a specified period. From an early stage, Peru's government recognized that privatization was an integral part of other reforms Promulgating the Stock Exchange Law

The Stock Exchange Law, Legislative Decree 755, was enacted in 1991 to: · Protect the rights of domestic and foreign investors (by establishing market confidentiality and creating risk classification companies). · Increase the transparency of the stock market (for example, by obliging equity issuers to present audited financial data to CONASEV, the securities market supervisor and to inform it of price−sensitive corporate information). · Establish a regulatory framework that conforms to international standards for stock market operations (for example, by creating a guaranty fund in the Lima Stock Exchange) and fixes clear rules for the agents involved. The law also stimulated capital market development by liberalizing brokers' commissions, previously fixed at 2 percent of UIT.2 As a result commissions fell to 0.5 percent of the total volume traded. CAVALI.the securities depository and settlement house, is governed by the Stock Exchange Law. Fully computerized,

CAVALI is responsible for registering securities, issuing certificates, and clearing and settling transactions carried out on the Lima Stock Exchange. It was created in 1994 to replace a similar institution created in 1989. Under the law the ownership of securities can be represented by share certificates or register entries. Representation through register entries is irrevocable; representation through certificates is revocable. Security holders can choose either approach. Pension funds can now invest up to 35 percent of their portfolios in equities Creating a Private Pension System

Peru's public pension system traditionally had operated on an unfunded pay as you go basis. Like many other countries, however, Peru faced a potential crisis in future years, when the burden on the working population of supporting a growing number of state pensioners could become unacceptably high. To address this issue, a private pension system was created in December 1992. The new pension funds provide fully funded, defined contribution pensions. Participants pay monthly contributions into a private fund that entitles them to a share of the fund in proportion to their contributions. Fund managers are entrusted with investing the funds in a diversified portfolio under the supervision of the Superintendency of Pension Fund Administrators. To encourage capital market development, since 1993 the superintendency has tried to diversify fund portfolios by limiting the concentration of funds in certain instruments. Delivered by The World Bank e-library to:

At the outset the funds could invest only in interestbearing aaaaaa Universityinstruments, causing them to place 77 percent of their IP : 111.111.11.11 funds in bank deposits. Since 1994, however, the funds have been given more flexibility and can now invest up to Tue, 11 Jan 2111 11:11:11 35 percent of their portfolios in equities. The funds have played a key role in capital market development. At the Promulgating the Stock Exchange Law (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets end of 1996, 78 percent of their portfolio, worth $952.9 million, was made up of instruments traded in the stock market. (See chapter 12 for a discussion of privatization and the creation of privately managed pension funds.) The Commission for the Promotion of Private Investment. The Commission for the Promotion of Private Investment (COPRI) is headed by a group of ministers responsible for sectors in which the state plays a dominant role: energy and mines, economy foreign affairs, industry and transportation and communications. The group acts as a quasi board of directors, overseeing an executive directorate and special committees, and is responsible only to President Fujimori.The group's main functions are to establish the goals and policies of the privatization program, appoint members of the special committees, and approve crucial steps of each privatization. The executive directorate acts as general management, drawing up action plans and procedures for the special committees to give coherence to the overall process. The directorate also provides technical support to the special committees and supervises privatizations. The special committees execute specific privatizations. Committee members typically include high−ranking executives from the private sector chosen for their professional capabilities, personal integrity and business acumen. The committees plan, organize, and control the process, directly executing tasks for which they are qualified. If the committees need help they usually contract internationally recognized advisers such as auditors, technical advisers, investment bankers, and law firms. The special committees interact regularly with COPRI's executive directorate and ministerial commission to ensure close coordination of the program, maintain control over deadlines, and share lessons to solve common problems. Privatization Strategies Peru's privatization program covers all sectors of the economy including telecommunications, oil and gas, electricity banking, mining, fishing, and airlines. The first companies to enter the process, in 1992, were large corporations that needed substantial lead time prior to privatization because their operations were complex or because they needed an adequate regulatory framework. Some companies that were experiencing critical financial and operating problems but that were viable from a long−term perspective were also included on the short list to minimize further loss of value and increase their chances of recovery. Privatization strategies were chosen to achieve established goals. Some helped prepare companies prior to their transfer to the private sector; others related to the marketing of the company to be sold: · Regulatory frameworks were developed to reduce the perception of business risk and attract potential investors. COPRI helped create regulations designed to encourage business growth and increase efficiency.

· The sale of companies as ongoing concerns was considered preferable to liquidation, subject to a detailed study of each company's long−term viability. · To facilitate analysis of the businesses being sold and to boost investor confidence, the provision of quality information on the companies was considered a priority. Internationally respected advisers were hired to provide technical, legal, and financial analyses. Leading investment banks were employed to market companies being privatized. Delivered by The World Bank e-library to: aaaaaa · Sales prices were intended to be determined by theUniversity market. Thus all transactions have been carried out through IP : 111.111.11.11 Tue, 11 2111 11:11:11 public auctions, and emphasis has been placed onJanmarketing each company to attract the greatest possible number of potential investors.

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Privatization and Emerging Equity Markets Stages of Privatization To strengthen the stock market and widen its shareholder base, several privatizations have been carried out in two stages.The first stage consists of selling a controlling stake to a strategic investor who assumes management of the company. The strategic investor must maintain the stake for a specified period and list the company on the local stock exchange. In addition, a stake in the company—typically 10 percent—is offered to employees, usually at the same price paid by the strategic investor (though discounts can be given). During the second stage, after allowing time for the potential benefits arising from the involvement of the strategic investor to take effect, the remaining shares are offered to domestic and foreign institutional investors and to domestic retail investors through the citizen share ownership scheme, known as the Citizens Participation (Participación Ciudadana) program. This scheme was created to encourage public participation in privatization, so that Peruvians would benefit directly from the increased value of privatized companies resulting from more efficient private management. The program also seeks to promote the development of local capital markets, foster domestic savings by providing alternative savings methods, generate popular support for privatization, and reduce public debt. The main obstacles to the program were the public's lack of understanding of capital markets and the financial instruments used, as well as its lack of confidence in investment and savings vehicles. Still, the benefits of the new investment opportunities were self−evident. Foremost among these were the spectacular returns available in the stock market as foreign institutional investors, attracted by the low prices of locally listed companies, bid up their ratings to international levels. Benefits also came from the country's economic recovery and from general optimism that private owners would substantially increase the efficiency of privatized companies. A scheme with special sales conditions was devised to overcome the stumbling blocks to domestic retail investment. The scheme involves sale by installments and sale by exchange of recognition bonds (state pension bonds) for shares.To date only installment sales have been used. This method was designed to facilitate payment for the shares, be conceptually simple, be used to sell companies whose profitability is not extremely volatile, minimize the risk to investors of falling prices, act as an educational program, and be accompanied by a wide−reaching and intensive advertising campaign. The privatization program was launched in November 1994 with the sale of the government's stake in the cement company Cementos Norte Pacasmayo. Of the 49 percent of the company in state hands, 10 percent was sold to 7,258 Peruvians for $19.7 million at the end of 1994. In June 1995, 11,182 Peruvians purchased another 7 percent of the company's state−owned stock for $12.0 million. COPRI estimates that 80 percent of the shares were acquired by first−time investors. Privatization and International Equity Markets As noted, most privatizations in Peru have involved sales to strategic partners as part of the first stage. Then, during the second stage, shares are offered in international (and domestic) equity markets. A number of privatized companies whose controlling stakes have been transferred to strategic investors are now in this second stage, with issues planned in the near future. The Citizens Participation scheme was created to encourage public participation in privatization The following sections highlight three state−owned companies that have accessed international equity markets during their privatization. Cementos de Limaby was first privatization targeted at capital markets. Telefónica del Delivered Thethe World Bank e-library to: aaaaaa University Perú and Luz del Sur illustrate the interaction between the first and second stages of privatization in Peru. It is IP : 111.111.11.11 Tue, to 11 international Jan 2111 11:11:11and domestic markets required changing the worth noting that none of the equity offerings regulatory framework of the domestic stock market or the Lima Stock Exchange. Stages of Privatization (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Since its public offering Cementos de Lima has outperformed the Lima Stock Exchange index Cementos de Lima

The public offering in June 1994 of shares in Cementos de Lima, Peru's largest cement producer, was the first privatization transaction directed exclusively at portfolio investors (international institutional investors and Peruvian institutional and retail investors). The company was already listed on the Lima Stock Exchange, but only its labor shares were traded (see note 1). The company's common shares were owned by the state (49 percent) and by a controlling group of shareholders who did not want to sell their shares. The Peruvian government agreed to sell a 10 percent stake (about 80,000 common shares) to the controlling shareholders. In June 1994 the state offered its remaining 39 percent of shares through a public offering to domestic investors and international institutional investors, including a rule 144A offering in the United States,3 raising $82 million. This offering was Peru's first experience with tapping international equity markets through privatization. Almost 59 percent of the offering was placed with international institutional investors (sixty−five investors from seven countries). This privatization was carried out before implementation of the Citizens Participation program.Thus a successful offering was achieved despite the absence of special incentives for domestic investors or different terms for retail and institutional investors. Since its public offering Cementos de Lima has outperformed the Lima Stock Exchange index (figure 3.1). Although this performance may have more to do with Peru's recent construction boom than with the offering, the market has also deepened. Trading in Cementos de Lima shares increased sharply after the offer, with much higher trading volume for common shares than for labor shares. Telefónica del Perú

Telefónica del Perú is a classic example of how the first stage (trade sale to a strategic partner) and second stage (sale to institutional and retail investors) of a Peruvian privatization interact. In February 1994 the state sold a 35 percent controlling stake in Peru's two telecom companies, Compañífa Peruana de Teléfonos (CPT) and Entel Peru. The state owned all of Entel but just 20 percent of the equity of CPT, with the rest widely dispersed and actively traded on the Lima Stock Exchange. After that sale (which included a capital increase in CPT) the state no longer held shares in CPT but it retained 65 percent of Entel. The state's stake in both companies, which had been allotted a base price (that is, minimum tender price) of $546 million, was auctioned to a consortium led by Telefónica Internacional S.A., a subsidiary of Telefónica of Spain. The consortium offered an astonishing $2 billion for the stake, well above the base price and the two other offers submitted. The consortium's offer valued CPT and Entel at a combined $5.7 billion. CPT was then merged with Entel to form Telefónica del Perú. After the merger Telefónica Internacional S.A. held 35 percent of the new company the state held 28.7 percent, and the rest was in the hands of institutional and retail investors. In July 1996 the state sold 26.7 percent (keeping 2.0 percent) of the new company in a simultaneous offering in the international and domestic markets. A total of 619.3 million

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Cementos de Lima

47 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets

Figure 3.1 Comentos de Lima's trading performance, June 1994January 1997 Source: Datastream.

shares were placed for $ 1.24 billion. The international tranche, offered though American depository receipts (ADRs) listed on the New York Stock Exchange, raised $918 million (74 percent of the total offering) from U.S. (56 percent) and European and other investors (18 percent). Domestic institutional investors paid $41 million, or just 3 percent of the issue, because most private pension funds already held shares in the company. Finally the domestic retail tranche, sold through the Citizens Participation program, accounted for $280 million, or 23 percent of the total. The deal was the fourth largest equity issue in Latin America and, to some extent, reopened Latin American markets after the 199495 Mexican peso crisis. The international allocation was more than 4.5 times oversubscribed, indicating strong appetite for the company In fact, 15 percent of the domestic institutional tranche was allocated to applications by international investors, despite the availability of ADRs, reflecting the high confidence international investors have in Peru's stock exchange. Domestic retail demand (through the Citizens Participation program) was strong. Peruvian retail investors applied for $324 million and in the end were allocated $280 million (well above initial official estimates of $100150 million). More than 262,000 people participated, acquiring packages of shares ranging from the equivalent of $190 to $6,050 (with an average of $1,060 per person). This operation was executed using CAVALI (see below), simplifying the paperwork for tasks such as the payment of dividends. The offering increased the number of CAVALI accounts from 90,000 to nearly 337,000. Telefónica del Perú's privatization led to an upswing in its stock market valuation. Before the first stage of privatization (sale to a strategic investor), CPT was already one of the most traded stocks on the Lima Stock Exchange. The price at which CPT shares were trading just before the company was sold to Telefónica Internacional S.A. would have indicated a combined value for it and Entel of some $1.2 billion.This compares with Telefónica del Perú's market capitalization of $6.2 billion in July 1997. Prior to the July 1996 offering Telefónica del Perú's price was falling, in part because of market uncertainty over such a large offering (figure 3.2). After the successful offering the stock price increased during the stabilization period, as did the daily traded volume. Since then the stock performance has been closely correlated with the Lima Stock Exchange index. This is not surprising given that Telefónica del Perú is the leading stock on the exchange, representing more than 15 percent of the general index and accounting for 3060 percent of trading volume. Delivered by The World Bank e-library to: aaaaaa University The volume of trading on the Lima Stock Exchange increased significantly immediately after the Telefónica del IP : 111.111.11.11 Perú offering (figure 3.3). Thereafter however monthly Tue, 11 Jan 2111 trading 11:11:11 volumes fell back to pre−offering levels. Despite the company's ADR listing on the New York Stock Exchange, a large percentage of trading in Telefónica del Perú

Cementos de Lima

48 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets has stayed in the Lima Stock Exchange. A large percentage of trading in Telefónica del Perú has stayed in the Lima Stock Exchange Luz del Sur

Luz del Sur, one of two electricity distribution companies in Lima, was created from the split of the former state−owned company Electrolima. Electrolima was a vertically integrated electricity company with generation capacity of 693 megawatts and a concession to distribute electricity to 1.2 million clients in Lima. Under the new electricity law the company separated its generation and distribution activities into three companies: Edegel (generation), Edelnor (distribution), and Edelsur (distribution), which was later renamed Luz del Sur: Both distribution companies were privatized in July 1994 by selling 60 percent of their equity to strategic partners. The controlling stake in Edelnor was acquired for $ 176.5 million by a consortium formed by Endesa of Spain, Chilectra and Enersis of Chile, and COSAPI of Peru. Luz del Sur was sold for $212.1 million to a consortium comprising Chilquinta of Chile

Figure 3.2 Telefónica del Perú's trading performance, February 1996January 1997 Source:Datastream.

Structural reforms have significantly strengthened Peru's capital markets

Delivered by The World Bank e-library to: aaaaaa University Figure 3.3 IP : 111.111.11.11 Tue, 11 Jan 21111996June 11:11:11 Telefónica del Perú's monthly trading volume, January 1997 Source: Economatica

Luz del Sur

49 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets and Ontario Hydro of Canada. In accordance with the privatization law, 10 percent of Luz del Sur's shares were offered to employees, who bought the full 10 percent (in many cases to sell them to institutional investors). The state sold its remaining 30 percent stake in Luz del Sur during the second stage of privatization in November 1995. Unlike Telefónica del Perú, Luz del Sur was only listed in Lima and had no foreign stock exchange listing. The state offered its shares internationally under rule 144A in the United States and under Regulation S outside it. The domestic tranche was successful among institutional investors (mostly private pension funds) and retail investors (through the Citizens Participation program). Domestic institutional demand reached $122 million and domestic retail demand, $240 million. Allocations of $42 million were made to domestic institutional investors (26 percent of the offer) and of $97 million to retail investors (59 percent). Almost 150,000 people acquired shares under the Citizens Participation program; of these, 103,000 had not bought shares in Telefónica del Perú. At $80 million, international demand was weak, especially from U.S. accounts. In the end only $24 million—15 percent of the offering—was allocated to the international tranche. Until the public offering the 10 percent of Luz del Sur shares that had been sold to employees were trading actively The stock price, which was high, fell just before the December 1996 offering (figure 3.4). After the offering the stock price was relatively stable, ranging from 3.103.22 soles. At this level it was underperforming the Lima Stock Exchange index. The traded volume of the stock did not increase as much as might have been expected because a large portion of the offering was placed among private pension funds (which are usually long−term investors) and retail investors through the Citizens Participation program (who lack immediate freedom to deal in the stock). Still, the privatization deepened the market with the addition of a new blue−chip stock Moreover Luz del Sur is the first electricity company to be widely traded and the third largest utility stock in the Lima Stock Exchange. Reforms and Capital Market Development The structural reforms initiated by the Peruvian government have significantly strengthened Peru's capital markets. By 1996

Figure 3.4 Luz del Sur's trading performance, September 1996Febraury 1997 Source: Datastream

stock market capitalization was manyDelivered times higher than Bank in 1991 (figure 3.5), and by June 1997 it had reached by The World e-library to: aaaaaa University $19.5 billion. A number of factors are responsible for this sizable increase. The first is a decrease in country risk IP : 111.111.11.11 and, with it, an increase in share prices. TheTue, second is the increase in the number of common shares quoted on the 11 Jan 2111 11:11:11 Lima Stock Exchange—151 in June 1997 compared with 112 in 1993. Public service companies that were Reforms and Capital Market Development (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets privatized during 199196 have enjoyed the greatest increases in share value: their stock market capitalization increased from $172 million in 1991 to $5.91 billion in June 1997. Since 1991 trading volume on the Lima Stock Exchange has multiplied, from $592 million in 1991 to $8.5 billion in 1996 (and an estimated $11.7 billion in 1997; figure 3.6). This boom was partly due to the growing involvement of foreign investors in the stock market and to the presence since 1995 of foreign companies with local listings (such as Credicorp and Southern Peru Copper Corporation).4 In 1996 foreign investors accounted for 22 percent of trading volume. Furthermore, the success of the privatization program is encouraging large private companies in Peru to obtain a stock exchange listing and sell stock to the public. The Lima Stock Exchange now has a broader and more solid base. In 1991 trading in short−term instruments totaled $368 million, or more than. half of all trading. In the first ten months of 1997 short−term instruments accounted for $394 million, or just 4 percent of all trading. At the same time, the presence since 1993 of private pension funds as the main domestic institutional investors has strengthened the stock market. These funds have maintained a constant level of investment in fixed−income securities, such as subordinated bonds and leasing bonds. In June 1997 subordinated bonds accounted for 11.1 percent and leasing bonds for 4.9 percent of the funds' portfolios. In addition, the funds are increasingly investing in equities; in June 1997 common shares accounted for 26.2 percent and labor shares for 8.6 percent of their portfolios.

Figure 3.5 Peru's market capitalization, 199196 Source: Lima Stock Exchange. The mechanism created by COPRI for the public offering of state shares in privatized companies has generated a huge increase in domestic and international investors. More than 400,000 new domestic retail investors have opened accounts with CAVALI, the agency responsible for registering transactions and managing accounts. Furthermore, CAVALI has become much stronger since 1992, with the number of accounts under management (retail and institutional) rising from 17,000 to nearly 500,000 and their value rising tenfold. Privatization has fostered the rapid development of the Peruvian stock market Despite the recent growth, Peru's market is still small relative to those of other Latin American countries (both in absolute terms and as a share of GDP; figure 3.7) and depends on foreign investors (who account for 48 percent of accounts registered with CAVALI). At the same time, the concentration of shareholdings continues. By June 1997 the ten most liquid shares accounted for 54 percent of trading in same−day operations in the Lima Stock Exchange. Privatization has fostered the rapid development ofWorld the Peruvian stock Delivered by The Bank e-library to: market by providing it with greater aaaaaa University liquidity, new instruments (in the form of blue−chip companies such as IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets

Figure 3.6 Trading volume on the Lima Stock Exchange, 199196 Source: Lima Stock Exchange

The international and domestic investor base of Peru's stock market should continue to expand

Figure 3.7 Market capitalization in Latin America, December 1996 Source: IFC data. Luz del Sur), and new investors. New investors include international institutions but mainly consist of the more than 400,000 domestic retail investors attracted by the Citizens Participation program. Moreover the introduction of a reliable regulatory framework, together with the other marketliberalizing reforms of the early 1990s, has ensured that the stock market's infrastructure has developed in line with its growth in size and trading volumes. A number of companies whose controlling stakes have been sold to strategic investors (the first stage of privatization) are ready to issue shares through the capital markets (the second stage). As these privatizations proceed and new companies are listed, the international and domestic investor base of Peru's stock market should continue to expand, building on the successful experience with the Citizens Participation program. Notes.

1. Labor shares were created in 1970 to make industrial and mining employees shareholders in their company. Each year companies had to set aside a portion of pretax profits to fund a separate capital account that could Delivered by The World BankLabor e-library to: account for up to half of the company's shareholder funds. shares were issued from this account and aaaaaa University distributed to employees. In 1991 new legislation abolished the labor shares requirement. Existing labor shares IP : 111.111.11.11 11 Janin2111 could be exchanged for nonvoting ordinaryTue, shares the11:11:11 companies concerned.

Notes.

52 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Labor shares made an important contribution to the early development of Peru's stock market because most employees quickly sold their shares, creating liquid secondary markets in most stocks. Despite their lack of voting rights, labor shares have tended to be more liquid than common shares because of their wider shareholder base. Thus they have been more attractive, especially to foreign investors. Labor shares have been less important since 1991, however because of the privatization of state companies.

2. The UIT is a taxation unit that was equivalent to $1,562.

3. Under a rule 144A offering shares listed overseas may be offered to qualifying U.S. investors (usually sophisticated institutional investors) without undertaking a full registration with the U.S. Securities and Exchange Commission.

4. Although incorporated outside Peru, almost all of these companies' operations take place in Peru.

2.4— China's Efforts to Raise Capital through Privatization Cristina Rueda The Chinese government has relied on public share offerings in foreign and domestic exchanges to finance its ailing state enterprises.The result? Share sales have fueled the growth of the Chinese securities market. Moreover, capital markets have developed despite the cautious, experimental approach the Chinese government has taken toward state enterprise reform. Still, state enterprise reform remains a burning issue in China. Why Reform? The poor performance and deteriorating finances of state enterprises have made Chinese policymakers realize that their reform is essential to continued economic growth.1 State enterprises are a significant financial drain, both in terms of the losses they generate and the subsidies they absorb (figure 4.1). In 1996 the state sector lost 3 billion yuan ($362 million—the first time since the 1949 revolution that the state ended the year in a deficit position. Industrial losses were particularly high, up 45 percent from 1995 (Financial Times, 25 April 1997, p. 6). But while government leaders agree on the need for state enterprise reform, they have conflicting views on the nature and final objective of that reform. Moreover, the government is anxious to avoid accusations that it is selling state assets. As a result state enterprise reform has been slow and often lacks focus. The ambiguity of reform has been partly due to the political risks involved in changing the relationship between state enterprises and the government. State enterprises play a central role in the Chinese economy, providing jobs to more than 100 million people and indirectly supporting more than 340 million people. Furthermore, political uncertainty about the post−Deng regime has made leaders cautious about policy changes. Still, new president Jiang Zemin has moved forward with needed economic reforms. Jiang, a cautious centrist, realizes that China must reform its large state enterprises and restructure its banking sector. Delivered by The World Bank e-library to:

In an effort to justify state enterprise reform inaaaaaa a socialist context, the government has avoided direct privatization University IP : 111.111.11.11 until now. Rather, state enterprise reform has focused on industrial restructuring aimed at modernizing key Tue, 11 Jan 2111 11:11:11 Chinese enterprises and making them internationally competitive without drastically changing their relationship 2.4— China's Efforts to Raise Capital through Privatization (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets with the state. The underlying goal is to separate government and commercial activities and embrace efficiency—while ensuring that the Party manages to control both efforts.2 State enterprise reform strategies have focused on changing the policies that govern state enterprises (reducing subsidies, eliminating trade barriers, facilitating foreign investment, and so on) and on changing internal incentives by making enterprise managers more autonomous (diversifying ownership, reforming corporate governance, and so on). State enterprise reforms have relied mainly on corporatization—that is, listing company shares in foreign and domestic exchanges—often followed by public offerings, auction sales (particularly of bankrupt or nearly bankrupt companies), or joint ventures with private partners (foreign or domestic).

Figure 4.1 Losses subsidies of China's state enterprises, 198696 Source: China State Statistical Bureau. Despite growing recognition that lagging industries might best be brought up to speed through joint ventures with foreign partners, public offerings remain the preferred mechanism for financing state enterprises.3 Strategic enterprises are the primary candidates for such offerings, particularly energy, transport, steel, and petrochemical plants. Most of these companies require considerable funding for modernization and expansion. Thus enterprise listings have occurred more in response to their financing needs than in an effort to reform their management or operations. Although this fundraising technique has been successful, it has not had much effect on corporate governance. By offering minority holdings on public exchanges, the government has avoided concentrating ownership and has maintained a controlling stake in all listed enterprises. Moreover, Chinese company law allows the holder of more than half of enterprise shares to elect all board members simultaneously. Thus, as long as the state holds more than half of the shares, strategic investors have no incentive to amass a key block of shares. And even though new listings can dilute state ownership, no new owners have enough rights to significantly affect enterprise management. In terms of foreign investors, no listed Chinese company has a majority of its shares in foreign hands.4 Thus Chinese listings, domestic and foreign, have been only partial divestitures. Securities Market Development China's securities markets have developed in line with its gradual move toward a market economy. The Chinese government began liberalizing the economy in 1979. In 1981 it started issuing government bonds to finance the budget deficit, and a few years later some enterprises began issuing securities informally. The government initially approved bond trading in 1988, and in December 1990, with the establishment of the Shanghai securities exchange, officially recognized securities markets. Delivered by The World Bank e-library to: China's securities markets have developed

aaaaaa University IP : 111.111.11.11 Tue,line 11 Jan 2111its 11:11:11 in with gradual

move toward a market economy

Securities Market Development (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets There are three main stock exchanges in China—Shanghai, Shenzhen, and Hong Kong.5 At the end of 1996,540 companies were listed in Shanghai and Shenzhen (figure 4.2). The exchanges trade equities, government and enterprise bonds, futures, investment funds, and warrants.There are also nearly twenty−five informal exchanges (primarily bond trading centers) scattered throughout the country. The issue and trading of state enterprises shares have catalyzed the development of China's capital markets. New capital from the public offerings of state enterprises and China's strong economic prospects have attracted considerable domestic and foreign investment and spurred the growth of securities markets. Issues are offered at domestic exchanges in the form of A and B shares and at foreign exchanges in the form ofH,N, and other types of shares. As these categories indicate, Chinese markets for shares are highly segmented. Only Chinese nationals can hold A shares; shares held by foreigners are divided among those that can be traded only in domestic exchanges (B shares) and those designed to be traded in foreign exchanges (such as Hong Kong's H shares and New York's N shares; table 4.1 ).6 In general, issuers ofB shares must be reviewed by the Securities

Regulation generally has been more concerned with market performance than investor protection

Figure 4.2 Companies listed on the Shanghai and Shenzhen stock exchanges, 199296 Source: IFC 1996. Regulatory Commission (China's equivalent of the U.S. Securities and Exchange Commission) and the local authorities where the shares are being issued. Issues of H shares and N shares are determined by the Securities Regulatory Commission and the State Council (subject to compliance with the prospectus requirements and listing regulations of relevant foreign exchanges). To date the companies selected for listing have been chosen according to quotas assigned to localities. After receiving their allocations, provinces or municipalities decide which companies to send to the Securities Regulatory Commission for final approval. Chinese officials generally try to ensure that only attractive enterprises or those in need of foreign currency are open to foreign investment. Regulation of Securities Markets The Securities Regulatory Commission has struggled to keep up with the rapid growth of securities markets. Established in October 1992, the commission's regulatory oversight has grown in response to events rather than in a coherent and coordinated manner aimed at smoothing the functioning of the markets. Regulation generally has been more concerned with market performance than investor protection. Without a national securities law it is Delivered by The World Bank e-library to: aaaaaa University hard to enforce regulation. As a result regulation is highly segmented, with local administrations and market IP : 111.111.11.11 participants often making their own marketTue, rules. 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets

Table 4.1 Types of Chinese share issues Share type

Holders

Trading venue

A

Chinese only

Domestic exchanges

B

Foreigners only Domestic exchanges

H

Foreigners only Foreign exchanges (Hong Kong)

N

Foreigners only Foreign exchanges (New York)

To address these shortcomings, Chinese authorities are developing a national regulatory framework that will provide a transparent and enforceable regulatory infrastructure. In the meantime, the government relies on ad hoc intervention to control securities markets and manage their development. For example, the central government uses local government securities offices to influence the pricing of initial equity offerings, sets margins on coupon rates for corporate bonds, and manipulates rates of return on different securities. Perhaps the greatest problem with China's capital markets is that their growth and development are embedded in an environment which still retains many elements of a nonmarket economy (World Bank 1995, p. 172). Market Volatility Between 1990 and early 1994 there was a spectacular increase in the number of listings of A and B shares on the Shanghai and Shenzhen stock exchanges (see figure 4.2). Soon after however; listings of Chinese companies in domestic and foreign exchanges waned as investors realized the risks involved in the domestic markets. From its peak in 1994, market capitalization dropped by 3.4 percent in 1995 (figure 4.3). Trading value fell by 49 percent over the same period (figure 4.4). Confidence rebounded in 1996, when the number of companies listed on the two exchanges increased by twothirds. By the end of the year total market capitalization had risen 170 percent, to $114 billion. In the second half of 1997 the Hong Kong Stock Exchange—having become a part of China's markets in July 1997—suffered from the financial crisis that hit many Asian countries. Because of the enormous volatility in China's stock exchanges, foreign investors prefer to invest in Chinese companies listed on foreign exchanges rather than buy domestically traded, dollar−denominated B shares. In addition, there are sharp price differences between A and B shares issued for the same company.During 199194, $1.3 billion was invested in Chinese B shares. By contrast, in 1995 alone Chinese companies raised an estimated $3.7 billion overseas.

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Market Volatility

56 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Figure 4.3 Chinas market capitalization, 199196 Source: IFC 1996. Most trading in Chinese stocks by foreign investors takes place on the Hong Kong Stock Exchange through H shares. Some trading takes place on the New York Stock Exchange through N shares and, with the March 1997 listing of Datang Power on the London Stock Exchange, trading in London is expected to increase. In addition, Chinese companies are now able to issue stocks in the Tokyo and Singapore exchanges; the first, Tianjin Conxing Pharmaceuticals, was listed in June 1997. Discussions with Australian exchanges have taken place as well. Meanwhile, the well−regulated and highly liquid Hong Kong exchange has served as a proxy for Western investors and emerging market funds eager to participate in China's economic expansion but unwilling to risk investing in domestic exchanges. Red−Chip Fever Red−chip fever refers to the recent burst in demand for mainland−backed companies listed in Hong Kong. Red chips are stocks of companies whose main line of business is in China.7 In late May 1997, for example, investors lined up to purchase shares in Beijing Enterprise, the investment arm of the capital's municipal government (table 4.2). The offer was 1,000 times oversubscribed—a record for the Hong Kong market and a clear sign of investor confidence (Financial Times, 23 May 1997, p. 8).The share price of the forty or so red−chip stocks climbed more than 40 percent in 1997.

Figure 4.4 Trading volume on the Shanghai and Shenzhen stock exchanges, 199196 Source: IFC 1996. Although considered the hottest investment since junk bonds, some analysts are concerned about the political sensitivities and regulatory issues raised by the red chips. Zhu Rongji, vice premier in charge of economic affairs, has warned that state enterprise assets must not be sold at a discount, especially to foreigners. Regulators are concerned about transparency and equal access to information. The Securities Regulatory Commission has warned that it might not approve transactions that have followed unusual trading patterns. Still, rep−chip fever continued until the recent economic turmoil in the region. Current Conditions and Outlook Why are China's markets so volatile? One reason is the shortterm trading instincts of most Chinese retail investors. Another is the lack of a structured divestiture program: many of the companies selected by localities to by The World Bank e-library to: fill share−issuing quotas have troubleDelivered attracting investors. But the greatest problems facing China's securities aaaaaa University markets are substantial and IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Red−Chip Fever

57 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Table 4.2 Selected red−chip issues Funds raised (HK$ billions)

Month and year of issue

Company

January 1996

Citic Pacific

3.24

October 1996

Cosco Pacific

1.55

December 1996

China Resources Enterprise

1.02

January 1997

China Travel International Investment

2.52

January 1997

China Overseas Land and Investment

1.53

April 1997

Shanghai Industrial

4.78

April 1997

China Merchants

3.92

May 1997

Beijing Enterprise

2.15

Source: Hong Kong Stock Exchange. Most trading in Chinese stocks by foreign investors takes place on the Hong Kong Stock Exchange

Market volatility has significantly slowed the reform of large state enterprises ad hoc government intervention and inadequate enforcement of regulations. For instance, Chinese companies disclose information slowly and selectively if they think that it will affect their share prices. Government intervention in the market has made them even more susceptible to political intangibles. And the Securities Regulatory Commission, which is not located near exchange markets, does not have the authority or the staff to effectively supervise markets and the companies listed. Market volatility has significantly slowed the reform of large state enterprises because public offerings are the main channel for divesting such enterprises. Still, relative to 199495 the number of share issues in 1996 and the first half of 1997 was large. But increased volatility in the second half of 1997—brought about by the shocks that battered Asia's stock markets—will likely lead to a slowdown in Chinese state enterprises coming to market. Notes.

1. In 1995 it was estimated that 70 percent of state enterprises were operating at a loss, with 40 percent suffering chronic deficits. Unofficial estimates suggest that in 1995 state enterprises cost the state 100 million yuan (about $12 million) a day (Cooper 1996).

Delivered by reaffirmed The World Bank e-library to: 2. The 15th Party Congress in September 1997 the importance of state enterprise reform, designating aaaaaa University Vice Premier Zhu Rongji as the official responsible for such reforms. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Notes.

58 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets 3. Still, the number of joint ventures has increased rapidly in recent years. By 1995, 153,537 equity joint ventures and 37,080 cooperative joint ventures had been established in China.

4. This is not the case for joint ventures, where foreign parties can negotiate for majority ownership and so control the venture (Cooper 1996).

5. The Hong Kong Stock Exchange served as a proxy for investment in China until the territory's handover from the United Kingdom to China in July 1997. Now Hong Kong, as a major financial center and capital market, is playing an integral role in China's securities market development.

6. As of July 1997 H shares are no longer considered foreign. It remains to be seen, however, whether the segmentation between A and H share will be retained.

7. In 1997 seventeen red−chip initial public offerings in Hong Kong raised $3.9 billion. In 1996 there were just six red−chip initial public offerings. References Cooper Paul. 1996. China: Privatization by Any Other Name. In Henry Gibbon, ed., Privatisation Yearbook 1996. London: Privatisation International. IFC (International Finance Corporation). 1996. Emerging Stock Markets Factbook 1996. Washington, D.C. ______. 1997. Monthly Review of Emerging Stock Markets. Washington, D.C. Mitchell, John. 1995. China Readjustment and Consolidation. In Henry Gibbon, ed., Privatization Yearbook 1995. London: Privatisation International. World Bank 1995. China: The Emerging Capital Market. Report 14501−CHA. Washington, D.C.

3— PRIVATIZATION SUPPLIES INVESTMENT OPPORTUNITIES THAT DEEPEN EXISTING STOCK MARKETS 3.5 Morocco's Case−by−Case Privatization Program 3.6 Privatization and Equity Markets in Mexico and Argentina 3.7 Privatization and Capital Market Development in Turkey and Egypt Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

References

59 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets

3.5— Morocco's Case−by−Case Privatization Program Olivier Frémond Morocco's privatization program has driven the development of the Casablanca stock market, increasing market capitalization and liquidity, broadening share ownership, and attracting foreign capital and foreign direct investment. The program also has promoted transparency, fostered new local financial services and instruments, and catalyzed reform of the domestic capital market. The Stock Market before Privatization When privatization began in earnest, in 1993, the Casablanca Stock Exchange had a market capitalization of $1,869 million, equivalent to 7 percent of Morocco's GDP (table 5.1). In 1992, 1.8 million shares worth $198 million had been traded, representing 10.6 percent of market capitalization and 0.7 percent of GDP. Sixty−nine companies were quoted on the exchange, and of these twenty−five saw almost no trading. Only a few local institutional investors and a handful of wealthy individuals owned stock. Foreign investors were scarce. Before privatization there were fewer than 10,000 Moroccan shareholders. Trading was conducted by open outcry on weekdays between 11:00 a.m. and 12:00 a.m., though investors could Delivered by The World Bank e-library to: trade among themselves outside business hours. Clearing and settlement took place two days after the trading aaaaaa University IP : 111.111.11.11 date. Disclosure requirements for quoted companies were minimal, antiquated, and often ignored. The stock Tue, 11 Jan 2111 11:11:11 exchange was owned by the state under the authority of the Ministry of Finance. Stock market operations were 3.5— Morocco's Case−by−Case Privatization Program (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets not regulated or monitored. The Privatization Program King Hassan II announced the privatization program in his speech convening Parliament in December 1989. Divestitures started in 1993. In the meantime the privatization framework was developed, including the enactment of a privatization law and the creation of three special−purpose institutions: a Ministry of Privatization under the authority of the prime minister; a five−member interministerial Transfer Commission that advises on transaction structures, and a Valuation Authority empowered to set prices for privatization. A number of reforms accompanied privatization. In January 1994 the Conseil Dóntologique des Valeurs Mobilières (CDVM, or Securities and Exchange Commission) was established under the authority of the Ministry of Finance. Later that year, disclosure requirements and regulations governing mutual funds went into effect. In January 1995 the Casablanca Stock Exchange was privatized to stockbrokers with seats on the exchange, and the Securities and Exchange Commission and Ministry of Finance approved thirteen mutual funds. New legislation was put in place to allow capital to freely cross borders, including repatriation of capital gains and dividends. Accounting standards were improved by a new accounting plan, and preparation started for a law governing limited liability companies. Also during 1995, several closed−end private investment funds were incorporated in Morocco and offshore to take advantage of privatization.

Table 5.1 Basic indicators for the Casablanca Stock Exchange, 198996 Indicator

1989

1990

1991

1992

1993

1994

69

69

68

65

65

61

44

47

Market capitalization 620 (millions of U.S. dollars)

964

1,522

1,869

2,698

4,465

5,930

8,779

Number of companies listed

1995

1996 a

Historical price−earings ratio

5.7

6.5

8.0

10.5

13.2

20.4

20.5

15.8

Trading volume (millions of U.S. dollars)

83

224

141

198

243

406

1,221

1,157

Shares traded (thousands)

—

758

1,517

1,796

5,507

5,571

13,251

12,460

2.6

3.7

5.1

7.0

10.3

13.9

17.5

22.6

Trading volume/GDP 0.35

0.85

0.48

0.74

0.93

1.27

3.59

2.87

Trading volume/market capitalization

23.3

9.3

10.6

9.0

9.1

20.6

12.7

Market capitalization/GDP

13.3

a. Estimated. Source: Casablanca Stock

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Privatization and Emerging Equity Markets Exchange. The privatization law lists seventy−five companies and thirty−seven hotels that represent 40 percent of state enterprises.1 Listed companies are engaged in agriculture, mining, energy, manufacturing, financial services, commerce, transport, and services. Utilities (telecommunications, electricity, and water) initially were excluded from the list. As the program evolved, however; steps were taken to privatize utilities or transfer management and investment responsibilities to private operators. The privatization minister can offer listed enterprises for sale at any time and in any sequence. The privatization law says that enterprises can be privatized in four ways: fixed−price initial public offerings or public offerings, tenders, or private placements; or by hybrids of these methods. For example, management control might be sold by open tender, employee participation brought about by private placement, and the remaining shares floated in an offering. Most terms of reference for tenders prohibit new management from selling their shares for up to five years. This safeguards the enterprise as a going concern, solves the corporate governance issue, and allows broader public participation. Between 1993 and 1996 twenty−eight companies and seventeen hotels were wholly or partly privatized. Sixty−six transactions were closed by the Ministry of Privatization, with cumulative proceeds of $1.06 billion (excluding proceeds from privatization bonds; see below). The transactions involved two issues of privatization bonds, five initial public offerings, five public offerings, sixteen tenders, twenty−four direct negotiations, four transfers of troubled companies, and ten transfers to employees. Privatization through the Stock Exchange Early hybrid transactions were enthusiastically received. The first took place in June 1993 with the privatization of CTMLN, a well−known bus company (table 5.2). A 35 percent stake with a management contract was first sold by open tender to a consortium of Moroccan financial institutions, the Group of Stable Shareholders. This was followed by an initial public offering on the Casablanca Stock Exchange, with 40 percent of the company's share capital sold exclusively to the public at 26 percent less than the price paid by the consortium.The offering was structured with a minimum and maximum number of shares per applicant. Shares were first allotted to all subscribers with the minimum number of shares then allocated on a pro rata basis.The offering was 4.6 times oversubscribed, with 11,238 new shareholders (including 4,141 Moroccans living abroad). Within two weeks the share price had gained 35 percent—despite the fact that the initial offering price was 18.7 times estimated 1992 earnings. A similar transaction privatized CIOR, Morocco's largest cement plant, in December 1993. First, a controlling interest (51 percent) was sold to Holderbank, the Swiss cement company. Then a 34 percent stake was floated on the stock market at 25 percent less than the price paid by Holderbank. A small tranche of shares was placed with foreign institutional investors through a private placement. The domestic offer was almost eight times oversubscribed and the share price gained 30 percent within a few days, though the company was not expected to report a profit in 1994. Between 1993 and 1996 twenty−eight companies and seventeen hotels were wholly or partly privatized in Morocco

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Privatization and Emerging Equity Markets Table 5.2 Major privatizations on the Casablanca Stock Exchange, 199396 CTM−LN

Société Nationale d'Investissement

SOFAC

CTM−LN

Interurban bus Cement plant company

Credit company

Interurban bus Investment company company

Offering date

June 1993 December 1993

April 1994

September 1994

Shares offered

337,224

Type of company

CIOR

715,700

October 1994

174,100

1,303,678

280

300

448,138

7,456,924

6,592

45,758

2.57

6.20

137,775 Price per share (dirham)

250

230 290

Shares subscribed

1,540,447

Number of subscribers

11,238

Times subscribed

4.57

5,505,613 541,500 16,241 15,158 7.69 3.93

Source: Morocco Ministry of Privatization; Casablanca Stock Exchange. (table continued on next page) Then came the secondary offering of SOFAC, a quoted company specializing in consumer finance, in April 1994. A 35 percent stake was first sold to a consortium of Moroccan investors. The remaining shares owned by the state were then divested by public offering. Because the issue was small, the offering was reserved exclusively for retail investors. Institutional investors played an active role in the secondary market, making the share price rise. A similar transaction took place in September 1994, when the state's remaining shares of CTM−LN were sold. This time the shares were reserved for Moroccans living abroad. In October 1994 the Ministry of Privatization used a secondary offering to sell a 15.6 percent stake in Société Nationale d'Investissement, a well−known portfolio company quoted on the Casablanca Stock Exchange. This issue took place before the closing of the tender for the strategic shareholder: Despite a lack of management visibility and the steep offer price (twenty−five times 1993 earnings), more than 45,000 investors subscribed to the issue, which was 6.2 times oversubscribed. The share price rose 35 percent immediately after the offering. The price paid by the winning consortium for the 51 percent stake sold by tender was 42 percent higher than the price of the secondary offering. The operation was repeated for the privatization of Banque Marocaine du Commerce Exterieur, the second largest retail bank in Morocco, already quoted on the Casablanca Stock Exchange. In January 1995 a 14 percent stake was offered to the public. More than 51,000 subscribers participated in the offering, which was 6.1 times oversubscribed. In April 1995 the tender for 26 percent of the bank's share capital was closed at a 47 percent Delivered by The World Bank e-library to: premium to the price of the secondary offering.aaaaaa TheUniversity winning consortium, which paid nineteen times anticipated IP : 111.111.11.11 earnings for 1994, was led by a Moroccan entrepreneur and included institutional investors from London and New Tue, 11 Jan 2111 11:11:11 York. Privatization through the Stock Exchange (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets In February 1995 General Tire Morocco was presented in an initial public offering. The Ministry of Privatization had agreed to sell its privatizable shares (a 20 percent stake) in the company to a consortium of Moroccan institutional investors in October 1994. The sales and purchase agreement included a commitment from the new owner and Continental Inc., the company's operator; to float General Tire Morocco on the Casablanca Stock Exchange. The transaction took the form of an increase in capital. More than 15,000 subscribers participated in the offering, which was 9.4 times oversubscribed. The share price gained 75 percent in the secondary market before stabilizing at 20 percent above the issue price. In June 1995 Credit Eqdom, a quoted company specializing in consumer finance, was privatized by secondary offering. More than 22,000 subscribers participated in the offering, which was 3.5 times oversubscribed. The company's share price rose 46 percent immediately after the privatization transaction. A New Financial Instrument: Privatization−Going−Public Exchangeable Bonds By the middle of 1995 the Ministry of Privatization was experiencing delays in completing audits and valuations. In addition, it was having trouble estimating demand for shares quoted on the Casablanca Stock Exchange. Privatization issues

(table continued from previous page) Banque Marocaine du Commerce Exterieur

General Tire Morocco

Credit Eqdom

Samir

Sonasid

Fertima

Steel company

Fertilizer company

Type of company

Bank

Tire Company Credit company

Refinery

Offering date

January 1995

February 1995

June 1995

March 1996

July 1996

Shares offered

1,401,000

126,000

200,000

5,160,375

1,365,000

690,000

Price per share (dirham)

325

228

360

243

308

174

Shares subscribed

8,533,127

1,185,600

691,168

6,192,450

2,235,041

3,077,567

Number of subscribers

51,485

15,365

22,013

59,560

11,449

11,960

6.09

9.41

3.46

1.20

1.64

4.46

Times subscribed

October 1996

had been oversubscribed, but their size had been rather small. Anticipating larger transactions, the ministry wanted to gauge overall demand for shares in the market. These two considerations led the ministry to create a new financial instrument, and in January 1996 it issued $176 million of privatization−going−public exchangeable bonds. These hybrid instruments—combining equity and The World Bank e-libraryand to: are tradable and quoted on the Casablanca fixed income components—are issuedDelivered by the by Moroccan Treasury aaaaaa University IP :Treasury 111.111.11.11 Stock Exchange. The bonds resemble Moroccan bills but can be exchanged for shares of privatized Tue, 11 Jan 2111 11:11:11 companies sold by public offering. Bond holders receive a first−order allotment priority over cash subscribers, A New Financial Instrument: Privatization−Going−Public Exchangeable Bonds (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets appealing because initial public offerings had been oversubscribed, causing subscribers to receive only a fraction of requested shares.2 In March 1996 Samir; Morocco's main oil refinery ,sold shares in an initial public offering. A 25 percent minority holding worth $147.5 million was offered through the Casablanca Stock Exchange, ahead of the closing of the tender for the company's strategic shareholder . The size of the issue was fixed because of the amount of exchangeable bonds in circulation. The issue was structured in two tranches, one for retail investors (70 percent) and the other for institutional investors (30 percent), with a clawback clause to cut the institutional tranche by as much as 50 percent if the retail tranche was oversubscribed. The issue was 1.2 times over subscribed. To serve cash subscribers in part after having served exchangeable bond subscribers in full, the size of the issue was increased to 30 percent. In the secondary market the share price gained 25 percent in the days following the offering. By the beginning of the summer; however it had returned to just above the issue price. Drawing on the strength of the first conversion of privatization bonds, the ministry issued a second tranche in April 1996 for $87 million.This was followed by the initial public offering of 35 percent of Sonasid, Morocco's leading distributor of steel products, in July 1996, and by the offering of 30 percent of Fertima, a fertilizer company in October 1996. The offerings were 1.6 times and 4.5 times oversubscribed. A Deeper Stock Exchange. Privatizations have enhanced the Casablanca Stock Exchange in several ways. Market Capitalization has Soared

In the past few years the market capitalization of the Casablanca Stock Exchange has skyrocketed. From $1,869 million in 1992, it reached $8.779 million in 1996 (see table 5.1).3 This rise occurred despite a drop in the number of quoted companies: twenty−two companies that were not in compliance with disclosure requirements or for which trading was minimal were delisted by the Securities and Exchange Commission. In addition to bringing new paper to the market, privatization triggered a revaluation of nonprivatized stocks. In December 1992 the average price−earnings ratio on the Casablanca Stock Exchange was 10.5; by December 1996 it was more than 15 (Casablanca Finance Group 1997). Market Liquidity has Increased

The volume of shares traded has increased in line with market growth (though it remains small in absolute terms). Between 1992 and 1996 the number of shares traded In the past few years the market capitalization of the Casablanca Stock Exchange has skyrocketed

Foreign investors have provided 26 percent of Morocco's Privatization revenue jumped from 1.8 million to 12.5 million. In dollar terms trading volume increased from $198 million in 1992 to $1,157 million in 1996. About 88 percent of trades took place off the market—that is, among brokers outside the stock exchange's trading hours.4 In 1992 the value of shares traded accounted for 0.7 percent of GDP and 10.6 percent of market capitalization. By 1996 the ratios had improved to 2.9 percent of GDP and 12.7 percent of market capitalization. The turnover ratio in the Republic of Korea's stock market, by contrast, was 130 percent.5 Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 from ONA (a Jan diversified holding company) Tue, 11 2111 11:11:11

A secondary offering in June 1994 was followed in 1995 by increases in capital from banks seeking to comply with new capital adequacy ratios. In 1996 seven issues from the private A Deeper Stock Exchange. (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets sector reached the market, including two initial public offerings, Crédor and Maroc−Leasing. The liquidity of the stock exchange also increased thanks to the dematerialization of the privatization bonds. In addition to facilitating the trading of securities by removing settlement problems, this step stimulated market liquidity by creating arbitrage positions between fixed−income instruments and straight equity. Share Ownership Has Broadened

The privatization program was designed to attract public participation. The Ministry of Privatization developed share allotment strategies that favor small investors. A ceiling was set on shares per applicant, with up to 70 percent of issues reserved for small investors and provisions to reduce institutional tranches if public tranches were oversubscribed. And when necessary, stock splits were implemented to lower the value of shares so that small investors could participate in new issues. As a result the number of subscribers increased from 11,238 for the first public offering in June 1993 to more than 50,000 for the January 1995 offer of Banque Marocaine du Commerce Exterieur. Foreign Investors Have Played an Important Role

Several methods were used to attract foreign investors. If the size of the issue allowed it, international tranches of shares were reserved for foreign emerging market funds to invest in local offerings. Foreign investors were also invited to bid for the role of shareholders of reference of privatized companies listed on the stock market.6 This allowed more foreign institutional investors to participate in privatization and enhanced the corporate governance of the privatized entity. In addition, the law on Moroccanization, instituted just after independence, was lifted to encourage foreign direct investment. This law had stipulated that Moroccan companies be majority owned by Moroccan nationals. Fifteen of twentyeight privatized companies and three of seventeen privatized hotels were partly or wholly sold to foreign buyers. According to the Ministry of Privatization, foreign investors—including industrial operators and institutional investors—have provided 26 percent of privatization revenue. New Financial Services Companies Have Emerged

Extensive use was made of private financial services companies to execute the privatization program, using local firms whenever possible. As a result investment banking activities have developed in Morocco. Commercial banks have set up corporate finance divisions, and new financial services firms (including independent stockbrokers and research houses) have grown. As a result new private companies have had initial public offerings and secondary issues have reached the market. In addition, privatization led to the first global depository receipt (GDR) issue by a Moroccan firm, Banque Marocaine du Commerce Exterieur,soon after its privatization. Other Reforms Are Under Way

Privatization has provided a springboard for other reforms in the domestic capital market. · In January 1995 privatization catalyzed mutual funds to become operational by reserving shares for them in the public offer of Banque Marocaine du Commerce Exterieur. · The Securities and Exchange Commission had to develop regulations governing mutual funds and companies raising capital through public offers. Although the privatization law allows the Ministry of Privatization to bypass by The World Bankits e-library the commission, the ministry preparesDelivered prospectuses for all initialto:public offerings and submits them to the aaaaaa University commission for approval. In addition, the ministry has tried to eliminate multiple applications during offerings to IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 observe the rule of one person−one allotment. Share Ownership Has Broadened (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets · The Ministry of Privatization challenged the Ministry of Finance's decision to restrict the subscription and trading of privatization bonds in the secondary market to certain groups of investors.

Remaining Weaknesses of the Stock Exchange By the end of 1996 turnover in the Casablanca Stock Exchange was 12.7 percent of market capitalization and 2.9 percent of GDP. Both ratios reveal a small and relatively illiquid market. Despite recent progress, further increases in liquidity are required to improve the allocation of capital and enhance long−term growth prospects. Liquidity will increase once dematerialization takes places; this is expected to happen during the first half of 1998. Liquidity will also increase once money and interbank markets develop and rates are freely determined instead of arbitrarily fixed by the central bank. Without an efficient interbank market and liquid monetary instruments, investors cannot shift between short−term and long−term investments or predict monetary policy. Arbitrage possibilities between the money market and the capital market are required to increase the exchange's liquidity and to attract foreign institutional investors. The market remains concentrated in a few stocks. At the end of 1996, for example, the financial sector accounted for 39 percent of capitalization (Casablanca Finance Group 1997). The ten largest stocks account for 70 percent of capitalization. There are fewer than fifty quoted companies, and the free float of the ten most traded shares is often limited. New issues are needed, particularly from the private sector and instruments such as convertible bonds and convertible preference shares are required to attract issuers and investors to the Casablanca Stock Exchange. The stock exchange now charges 0.39 percent (down from 0.5 percent) for transactions, compared with 0.6 percent for off−market transactions. Still, commissions remain high and impede market liquidity. The Casablanca stock market remains segmented and disconnected from global markets. According to the Casablanca Finance Group, a leading stockbroker in March 1997 the stock exchange was trading on the basis of 15.2 times 1996 earnings and 16 times prospective 1997 earnings. Other emerging markets in the region have much lower valuation multiples: Turkey's is 8.4 times earnings, Egypt's 7.6, and Greece's 10.5 (IFC 1996). Morocco's high valuations reflect the scarcity of shares and the privatization program's indirect effect on the valuation of quoted equities. Because privatization issues were attractively priced and profitable for small investors, and as foreign institutional investors became interested in Moroccan equities and privatization issues in particular, demand for shares outstripped supply, increasing share prices. Secondary market valuations were determined not by fundamentals but by scarcity. This became more evident when share prices rose following a bonus share issue (achieved through the incorporation of reserves) instead of falling to reflect the dilution of earnings per share. Morocco should further accelerate its integration with the global economy by issuing more global depository receipts (GDRs). Doing so would broaden the investor base and encourage foreign institutional investors to participate in corporate growth. In addition, a rating system would boost investor confidence in Moroccan financial data and help attract foreign investors. Until recently the Valuation Authority priced privatization offerings on the basis of valuation reports; demand for shares was not taken into account. Moreover, the Ministry of Privatization has not underwritten any issues. This has not caused problems because the rising stock market has been driven by the scarcity of shares. But as the stock exchange integrates with globalDelivered markets, be handled with more regard to demand. by pricing The Worldshould Bank e-library to: aaaaaa University IP : 111.111.11.11 Jan 2111 operations 11:11:11 book−buildingTue, or11circling

The ministry should conduct with institutional investors to estimate value before asking the Valuation Authority to fix prices. Such preplacement exercises help gauge the appetite of Remaining Weaknesses of the Stock Exchange (c) The International Bank for Reconstruction and Development / The World Bank

67

Privatization and Emerging Equity Markets institutional investors for an issue as a function of the offer price. Changing market conditions and the need for the ministry to estimate revenue more accurately also require that the ministry start underwriting its public offerings or obtain underwriting commitments from investment banks handling the distribution of initial public offerings. The number of new shareholders generated by privatization remains low—probably less than 50,000, most of them middle−income subscribers from Casablanca and Rabat, in a country with 28 million people. To broaden share ownership, efforts should be made to sell shares throughout the country. For example, tranches of initial public offerings could be reserved for certain regions and marketed on radio and television. The retail networks of high−street banks could also be used, and mobile share boutiques could be developed. In addition, the nominal value of shares could be reduced, and the minimum value that subscribers can apply for in public offerings could be lowered. Further increases in liquidity are required to improve the allocation of capital and enchance long−term growth prospects

Capital markets are only one part of financial markets—and the parts cannot function in isolation. Until the end of 1995 Morocco saw little of the flowback phenomenon.7 But Samir's March 1996 offering seems to have reversed this trend. By June 1996 Samir's share price was barely above its issue price—despite an initial rise in the secondary market of some 25 percent. To limit flowback, the Ministry of Privatization could start using price stabilization techniques known as greenshoe operations. These allow lead managers to overplace shares in the primary market with a view to mopping up flowback in the secondary market to satisfy overallotment.8 The Securities and Exchange Commission has not yet prepared regulations (takeover code) governing the substantial acquisition of shares. Mergers and acquisitions cannot develop freely in the absence of such rules. Consolidations are likely, however; particularly among financial services firms, because Moroccan banks are too small to compete with their international peers. The Securities and Exchange Commission should also improve the treatment of minority shareholders. The traditional concept of corporate governance, with a shareholder controlling the board of directors of a company with a minority shareholding (sometimes as low as 5 percent to 10 percent), is not recognized in Morocco. Except for financial institutions that are regulated by the central bank, investors are not obligated to disclose their participation interests in quoted companies, nor are shareholders obliged to tender for the outstanding shares of a quoted company once they have reached a certain level of interest. Shareholder protection would greatly improve if the Securities and Exchange Commission extended the disclosure rules applied to banks to all quoted companies and if shareholders were required to tender for all outstanding shares once their participation exceeded the blocking minority (33 percent). Conclusion. Morocco is entering the global economy, aided by a privatization program that has deepened the local stock market. In June 1996 Morocco was included in the International Finance Corporation's emerging market index. Privatization has attracted foreign investment, encouraged popular participation, and increased the Casablanca Stock Exchange's market capitalization and liquidity. It also has helped modernize Morocco's capital markets and fostered the growth of local financial services while increasing transparency. Delivered by The World Bank e-library to: aaaaaa University Still, much remains to be done. The stock exchange remains relatively small and illiquid. Increased liquidity is IP : 111.111.11.11 11 enhance Jan 2111 11:11:11 required to improve the allocation of capitalTue, and long−term growth prospects. To this end Morocco must develop a financial market that includes interbank, monetary and foreign exchange components, with rates that

Conclusion.

68 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets are determined by the market rather than administratively fixed. Capital markets are only one part of financial markets—and the parts cannot function in isolation. Foreign investors would be more likely to invest in Moroccan equities if they could park their liquidity in money market instruments when switching among equities and if they could choose between capital markets and money markets. As the stock market matures, the privatization program must begin using more sophisticated techniques to price its issues and control flowback. Among the most important outstanding issues are the treatment of minority shareholders and the preparation of a takeover code. Notes

1. In 1995 the list was amended to include Samir and SCP, Morocco's two oil refineries, which until then had been classified as strategic.

2. More than 31,500 subscribers participated in the bond issue, which was oversubscribed by almost $59 million. As a result the Ministry of Privatization raised the size of the issue to $207 million. The bond price gained 10 percent in the aftermath of quotation.

3. Calculations are based on the number of shares listed on the Casablanca Stock Exchange exclusively, not on the number of shares in issue per company. Thus market capitalization is underestimated.

4. Off−market trades were common because until early 1996 off−market transactions costs were cheaper.

5. By February 1997 an average of 202 trades a day were taking place on the Casablanca Stock Exchange, with an average of 180,704 shares traded, for a trade value of $18.4 million. Privatization stocks accounted for six of the ten most traded stocks.

6. Shareholder of reference means strategic investor: But instead of just one operator; the expression refers to consortiums of investors involving an operator and a group of local or foreign institutional investors. The expression was coined by the French, who used this approach during their first wave of privatization under Francois Mitterand's administration.

7. Flowback refers to the phenomenon encountered in initial public offerings of privatized companies when small investors sell

their shares immediately after the primary issue. Small investors do so because the share price has increased in the secondary market, providing capital gain.

8. A greenshoe is an option on about 10 percent of issued stock that by can be exercised by the placing agent to stabilize the share price in the secondary market. The technique involves an overallotment by the placing agent in the primary—that is, more share are placed have been Deliveredthan by The World Bankgiven e-librarytoto:the agent. If the share price rises in the University to manage the overallotment. If the share price falls, secondary market, the placing agent exercises aaaaaa the greenshoe IP : 111.111.11.11 Tue, 11 Jan the agent does not exercise the greenshoe; instead he2111 or 11:11:11 she buys shares in the secondary market.

Notes

69 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets References Casablanca Finance Group, 1997. The Year 96 in Review, 97 Preview. Casablanca. IFC (International Finance Corporation). 1996. Emerging Stock Market Factbook 1996. Washington, D.C.

3.6— Privatization and Equity Markets in Mexico and Argentina Mike Lubrano and Luis Urrutia Ambitious privatization programs were adopted by the Mexican government in 1983 and the Argentine government in 1989. By 1993 both programs had relieved the state of most of the commercial and financial enterprises previously under government ownership. Between 1983 and 1994 the Mexican government reduced the number of state−owned enterprises from 1,155 to 215. Airlines, mining companies, tourist centers, telecommunications companies, steel plants, and commercial banks were transferred to private ownership. As a result government spending as a share of GDP fell from 42 percent in 1983 to 26 percent in 1994 (United Mexican States 1995). Still, the largest state enterprises—petroleum and electricity monopolies—remain state−owned. Argentina's program was faster and more complete, including the petroleum, gas, and electricity industries as well as less strategic commercial and service enterprises. In 1988 Argentina had about 300 state enterprises. Although these companies accounted for just 10 percent of GDP in 1989, their combined deficits (before transfers) totaled 3.4 percent of GDP. The sale of these enterprises relieved taxpayers of this burden, raised $ 12.4 billion in cash, and by June 1996 had cut the government's external debt by $15.4 billion (through debtequity swaps; Republic of Argentina 1997). Both Mexico and Argentina made adjustments in the mechanisms used in privatization based on lessons from the early deals. Some initial transactions followed ad hoc procedures, involved private negotiations, and were not entirely transparent. In neither country were capital markets used as the principal mechanism for privatization. Privatization strategies ultimately relied on a variety of disposition mechanisms, including sales of controlling interests, assets, and concessions to strategic investors through negotiated transactions or auctions, offerings of minority (and in rare cases, majority) stakes through domestic and international capital markets, and (to a greater extent in Argentina than in Mexico) employee stock ownership plans. The relative importance of each mechanism varied by country and transaction. Argentina generally took greater advantage of domestic and international offerings of state−held shares, with the most dramatic example being the 1993 initial public offering of the federal and state governments' controlling interest in Yacimientos Petrolíferos Fiscales (YPF),the state petroleum company With the notable exception of the national telephone company, Teléfonos de México (Telmex), Mexican privatizations typically did not involve public offerings of government−owned shares. Still, the second−order effects of Mexican privatization on the development of the country's equity market have been perhaps equally profound.

Local Capital Markets Prior to Privatization

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 country's capital market determined the Tue, 11 Jan 2111 11:11:11

The initial conditions of each options available during privatization. The different effects the process had in each country were also partly attributable to pre−privatization conditions. References

70 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Mexico

The Bolsa Mexicana de Valores is Mexico's only stock exchange. Although established in 1907, its activities were limited until the mid−1970s. During the late 1970s the exchange enjoyed a brief period of growth, only to suffer a substantial setback with the onset of the debt crisis in 1982. By 1985 the number of listed companies had fallen dramatically. Moreover market capitalization (that is, the market value of all listed companies) had dropped to $4 billion, or 2 percent of GDP, from $13 billion in 1980 (Shah, Lubrano, and Mecagni 1996). In 1982 the administration of President José Lopez−Portillo nationalized almost all commercial banks. Mexico's Constitution subsequently was amended to classify commercial banking as a strategic sector reserved for the state. Once nationalized, the banks began cutting back on lending to the private sector. By 1986 about two−thirds of the banks' assets were invested in obligations of the government and state enterprises. This contraction in bank lending to the private sector increased the importance of capital markets and brokerage firms as sources of enterprise finance. Starting in the mid1980s the legal and institutional framework for capital market transactions was overhauled in an effort to reinvigorate the nonbank financial sector. Brokerage firms expanded rapidly and broadened the array of services they provided to corporate clients—for example, commercial paper markets developed as a substitute for bank lending. In the late 1980s construction began on the stock exchange's new headquarters and trading floor. A modern central depository (Indeval) was established, new procedures were implemented for trading of debt and equity securities, and on I January 1990 reforms of the Securities Markets and Investment Companies Laws went into effect that expanded the types of services that brokerage firms could offer. By the end of 1990 the exchange's market capitalization had risen to $33 billion, or 13 percent of GDP and trading volume averaged about $50 million a day (table 6.1). Mexico's equity market was still quite shallow in 1990, however: fewer than 50,000 brokerage accounts are likely to have been active.1 A number of factors impeded broader public participation in securities markets, including: · Low incomes (GDP per capita was about $3,000). · A depressed private savings rate.

Table 6.1 Mexico's equity market 198596

Year

Market capitalization (billions of U. S. dollars)

Market capitalization growth (percent) —

Market capitalization/GDP (percent)

Average daily trading value Number of (millions of U.S. listed companies dollars) a

2

157

9.5

1985

4

1986

6

56

5

155

15.5

1987

8

41

6

190

62.7

1988

14

65

8

203

23.1

1989

23

64

23.1

1990

33

45

203 Delivered11 by The World Bank e-library to: aaaaaa University : 111.111.11.11 13IP 199 Tue, 11 Jan 2111 11:11:11

49.2

Mexico

71 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets 1991

98

200

34

209

127.9

1992

140

42

42

195

179.8

1993

201

44

55

190

251.8

1994

130

−35

34

206

334.5

1995

91

30

36

185

138.6

1996

105

15

193

173.6

—

—Not available. a. Calculations assume that each year had 248 trading days. Source: IFC, Emerging Markets Database; World Bank 1997. The intial conditions of each country's capital market determined the options available during privatization

Until 1988 Argentina's equity market was moribund · Limited financial system penetration (the banking system maintained fewer than 4 million checking accounts; Comisión Nacional Bancaria 1994). · Negative public perceptions of securities markets after the spectacular declines in 1985 and 1987. · Underdeveloped institutional investors (insurance companies, pension funds). · Competition from U.S. capital markets for Mexican investors and issuers. Foreign interest in Mexican securities was growing, however. In 1981 the Mexico Fund, a closed−end investment company listed on the New York Stock Exchange, was organized to give international retail investors access to a managed portfolio of traded Mexican securities. Several other large Latin American and Mexican investment funds were offered in the public and private markets in the late 1980s and early 1990s. Still, in 1990 only one issuer maintained a listed depository receipt program—the American depository receipts of Tubos de Acero de Mexico (TAMSA) had been listed on the American Stock Exchange since the mid−1960s. Argentina

Until 1988 Argentina's equity market was moribund. What little trading took place was conducted on the trading floor of the Mercado de Valores (Merval) in Buenos Aires, a traditional stock exchange with individual members and open−outcry trading. The macroeconomic upheavals of the 1980s, high income taxes, heavy stamp duties, restrictions on foreign investors, and discriminatory tax treatment of foreigners (as well as state dominance of much of the industrial sector) limited the exchange's potential for growth. The shares of fewer than 200 companies were listed on Merval, and few were traded on a daily basis. In 1988 trading value was less than $2.5 million a day, and market capitalization at the end of the year was a mere $2 billion (table 6.2). Economic and Political Conditions Prior to Privatization Delivered by The World Bank e-library to: aaaaaa University Both countries' privatization programs were initiated during periods of economic crisis. In Argentina privatization IP : 111.111.11.11 Tue, 11policy Jan 2111response; 11:11:11 Mexico's program also came to be an element of was an explicit component of the government's the overall recovery strategy.

Argentina

72 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Mexico.

From the end of World War II until the mid−1970s Mexico experienced mostly stable growth in GDP, industrial production, and per capita income. Economic policies ensured

Table 6.2 Argentina's equity market, 198596

Year

Market capitalization (billions of U.S. dollars)

Market capitalization growth (percent)

Market capitalization/GDP (percent)

Average daily trading value Number of (millions listed of U.S. companies dollars) a

2

227

2.6

1985

2.0

—

1986

1.6

−22

1

217

1.3

1987

1.5

−5

1

206

1.0

1988

2.0

33

2

186

2.4

1989

4.2

109

5

178

7.7

1990

3.3

−23

2

179

3.4

1991

18.5

466

10

174

19.5

1992

18.6

1

8

175

63.2

1993

44.0

136

17

180

41.7

1994

36.9

−16

13

156

45.9

1995

37.8

3

13

149

18.5

1996

44.7

18

147

17.7

—

—Not available. a. Calculation assume that each year had 248 trading days. Source: IFC. Emerging Markets Database World Bank 1997.

heavy government spending on social programs, public investments in industry, high tariffs and other barriers to foreign competition, growing reliance on oil revenues, and, toward the end of the period, increased external borrowing. In 198182, however, the sudden drop in oil prices and hikes in international interest rates triggered economic crisis. In 1982 inflation hit record highs, the currency was devalued by nearly 500 percent, the public sector deficit reached 17 percent of GDP and a foreign exchange crisis required dramatic restructuring of the country's by The World e-library external debt. GDP fell 4.2 percent in Delivered 1983, followed byBank three yearsto:of economic stagnation and a further decline aaaaaa University of 3.8 percent in 1986. From these events it became clear that long−standing policies encouraging import IP : 111.111.11.11 Jan 2111 11:11:11 substitution and heavy state participation inTue, the11economy were failing. The government's strategy for a return to sustained growth, implemented through the midto late 1980s, included deregulation, fiscal discipline, tax reform, Mexico.

73 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets trade liberalization, opening to foreign investment, public sector pricing reform, exchange rate and monetary policies to contain inflation, and privatization of nonstrategic public enterprises (United Mexican States 1997). It took time to reach consensus on the need for privatization and to agree on the enterprises considered nonstrategic, the timing of their disposition, the eligibility of participants, structures for the transactions, and regulations for subsequent operation of privatized public services. Since the government began consolidating and rationalizing the operations of public enterprises in 1983, politically sensitive issues—such as privatization of the petroleum and electricity industries and the degree of foreign participation in other key industries, including the financial sector—have remained salient. Indeed, only in 1990 was it feasible to remove commercial banks from the state sector. Even today most petroleum and electricity activities remain off−limits, and the ambitious privatization schedule announced in the aftermath of the December 1994 peso devaluation has not been realized. Argentina

In Argentina privatization was a direct response to the nearcollapse of the Argentine economy in the late 1980s. After years of economic stagnation, the macroeconomic situation went from bad to worse in 1989. GDP fell 6.2 percent, the government deficit reached 11.5 percent of GDP external debt accounted for more than 80 percent of GDP, and inflation reached 5,000 percent. The depth of the crisis, particularly the free−fall in the value of the national currency provided Carlos Menem's incoming administration with a public prepared for drastic change. (Indeed, the severity of the crisis led Raul Alfons´n's outgoing administration to cede power to Menem before the original inauguration date.) The Menem administration radically restructured the economy. After a few false starts (and several violent challenges to the new constitutional order), a new economic plan was announced by Minister of the Economy Domingo Cavallo in March 1991. The plan increased taxes, cut spending, reduced the public debt, and accelerated privatization. In addition, the Convertibility Law was enacted, fixing the value of the peso at one U.S. dollar and prohibiting the monetary base from exceeding the country's international reserves. Inflation was stopped in its tracks. Although he was leader of the Justicialist (Peronist) Party, which had been largely responsible for the increase in government involvement in the economy over the preceding five decades, President Menem supported privatization. Unlike in Mexico, the Argentine process was radical—and clearly articulated—from the start. No effort was made to cloak the effort in the guise of state reform or to adopt a gradualist strategy. From the outset the administration was willing to expend political capital to sell privatization to a public willing to consider a dramatic shift in economic policy The Privatization Programs As noted, economic calamities inspired privatization in both Mexico and Argentina. Both governments recognized the public costs generated by state enterprises—as well as the potential benefits of transferring them to private hands. Mexico

Together with measures such as deregulation and greater openness to foreign competition, privatization was expected to increase the productivity and competitiveness of Mexican industry and in the long run to create jobs and increase tax revenue. The program's main objectives were to: Delivered by The World Bank e-library to:

· Generate immediate revenue and restore equilibrium in public spending. aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

· Reduce nonpriority public spending and allocate scarce resources to strategic and high−priority sectors. Argentina

74 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets The ambitious privatization schedule announced in the aftermath of the December 1994 peso devaluation has not been realized

Foreign investors generally participated as minority partners of Mexican bidders · Focus the government's human and financial resources on meeting the basic needs of the population. · Promote efficiency and productivity through exposure to private competition. · Increase the efficiency of remaining state functions by reducing the role of the state (Rogozonski 1997; Secretaría de Programación y Presupuesto 1989). These objectives proved consistent with the gradual—and to date still partial—privatization of the state's industrial, commercial, and financial enterprises. Privatization transactions differed by industry and even within industries. In most cases privatization was initiated by the line ministry charged with overseeing an enterprise's activities. Ministries would submit proposals to the Interministerial Commission of Public Expenditure and Finance (Comisión Intersecretarial de Gasto−Financimiento ) for enterprises to be divested from state ownership.2 Once the commission determined that privatization was the best option for the government, control of the company was transferred to the Ministry of Finance and Public Credit for preparation and sale.3 Preparation generally involved both financial and operational restructuring. Financial restructuring (often involving the assumption of some or all of the enterprise's outstanding debt by the government) was often required to give the company a positive net value. Restructuring of management and operations was expected to demonstrate to investors the company's potential and increase its ultimate sale price.4 In some case this process became quite protracted, providing opponents of privatization (including employee representatives and old−line statists) greater opportunity to attempt to extract concessions. Financial restructuring and the actual sale were generally carried out with the assistance of an agent bank selected from among the nationalized commercial banks (which were themselves privatized in 199192). The approach to disposition varied by enterprise. As noted, some early transactions in both Mexico and Argentina were negotiated on an ad hoc basis, lacked transparency, and did not rely on market mechanisms. But in most large privatizations a twostage bidding process was used once the decision was made to sell the enterprise as a going concern. Potential buyers were first required to submit a business and financing plan identifying the participants and describing how they would finance the purchase of the enterprise and how they would conduct and finance the company's operations after privatization. Qualified bidders then submitted financial offers, with the winning bidder determined on the basis of the best offer. The winning bidder was required to retain ownership of a majority of a company's voting shares for a certain period to ensure competent management and compliance with the business and financing plan submitted in the first stage of the bidding process. No limits were imposed on foreign participation in privatization per se. Foreign individuals and corporations were, however, subject to the limits on foreign control set out in the Foreign Investment Law and other laws in effect at the time. These statutes limited foreign investment to a minority interest in several key industries that eventually underwent privatization, including telecommunications, airlines, mining, and commercial banking. But even in industries where majority ownership was permitted, foreign investors generally participated as minority partners of the Mexican bidders who ultimately bought the enterprise. Delivered by The World Bank e-library to: aaaaaaenterprises University In certain transactions the employees of privatized participated directly in the company's capital as part IP : 111.111.11.11 11 Telmex—the Jan 2111 11:11:11 government transferred a portion of the company's of privatization. In two cases—AeroméxicoTue, and shares to workers as part of the transaction. In most cases, however, the government encouraged bidders to adopt

Argentina

75 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets an employee stock ownership plan that would reserve for workers about 5 percent of the privatized company's shares. Many of the winning bidders implemented such plans. Airlines, 198889. The privatization of Mexico's two largest domestic carriers—Aeronaves de México (Aeroméxico) and Mexicana de Aviación (Mexicana)—demonstrates some of the shortcomings of early privatizations. These sales were conducted quite differently, and although attempts were made to encourage transparency and use market mechanisms (especially in the case of Mexicana), several factors limited their success. These included continued economic stagnation, uncertainty in the private sector about the government's commitment to privatization, and restrictions on foreign investment. Still, both transactions ultimately demonstrated the government's willingness to divest itself of large, well−known enterprises and gave impetus to the more aggressive (and more transparent) privatizations that followed.

By 1988 both Aeroméxico and Mexicana were insolvent and increasingly costly for the government to operate. Rather than assume its financial and contractual liabilities, in April 1988 the government placed Aeroméxico—a state−owned company since 1934—in bankruptcy in Mexico and other jurisdictions (including the United States) in which it had important operations. A state−owned development bank, Banobras, was appointed receiver in the bankruptcy proceedings. In October 1988 a new company, Aerovías de México, was incorporated and began servicing a limited number of routes. This company, owned initially by Banobras and ASPA (the airline pilots union), was created to acquire the assets of Aeroméxico from the bankruptcy estate. In November 1988 the shares held by Banobras (and some of the shares held by ASPA) were sold to Bancomer (then a state−owned commercial bank) and lcaro Aerotransportes (a holding company that controlled 55 percent of the shares of Aerovías). After this transaction Aerovías de México acquired nearly all the fixed assets of the bankrupt airline in a negotiated transaction requiring payment over three years. Most of Aeroméxico's debts and contractual obligations (especially labor agreements) were not assumed by the new enterprise. Mexicana's privatization initially involved a number of unsuccessful attempts to use auction and capital market mechanisms. In 1982, just as the debt crisis was looming, the government bought 58 percent of the airline's stock. In 1986 the government tried to sell this interest using a two−stage bidding process (in which only bidding groups controlled by Mexican nationals could compete). The first round, however failed to qualify even a single bidder. Private investors apparently lacked sufficient faith in the government's commitment and the economy's prospects to put up the substantial capital investment that the government required for qualification in the first round. As an interim measure the Interministerial Commission authorized the placement of 7 percent of Mexicana's stock in a public offering conducted through the stock exchange and managed by Banamex (then the largest commercial bank and under state control). The sale of the government's shares raised needed resources, increased market liquidity, and fostered market interest in the company. A second effort to sell the government's controlling block of shares in a twostage auction in late 1988 failed, however. Thus in 1989 the government modified its strategy to permit the sale of a minority equity block that would be able to exercise managerial control over the company. The government established a holding company, CMA, for its 51 percent position, the controlling interest of which could be sold with the government retaining a minority position. In August 1989 the government transferred 25 percent of CMA's capital stock to the winning investor group, headed by Grupo Xabre and including Chase Manhattan Bank, DBL American Development Association, GO Ltd., and six Mexican individuals. The group offered a price per share equal to 1.07 times book value and agreed to an additional capital commitment of $140 million. An additional 25 percent of CMA's shares were placed in trust, subject to a three−yearDelivered purchase option to the by The Worldgranted Bank e-library to: winning bidders. Some of the government's aaaaaa University remaining interest in CMA was then sold on the stock exchange. In the end the winning investor group bought IP : 111.111.11.11 11 Jan 2111 11:11:11 about 22 percent of CMA's capital stock inTue, transactions on the exchange and thus—with only a partial exercise of its purchase option—secured control over the company. Argentina

76 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Telecommunications, 198991. The privatization of Telmex, then Mexico's sole domestic and international telecommunications company involved the largest securities offering ever by a Mexican company. The shares resulting from the initial public offering and a second offering in 1992 are by far the most traded equity security in Mexico. Moreover, the depository receipts representing these shares are among the most active stocks traded on the New York Stock Exchange.5 The methods used in the Telmex privatization were more transparent and market−oriented than those used in the airline privatizations. Telmex's sale was more like Argentina's privatizations than the earlier or most of the later Mexican privatizations—that is, a controlling block of shares was sold to strategic investors, followed by public offerings of the government's remaining shares in the company. After a two−step auction process initiated in September 1989, the government transferred a majority of Telmex's controlling shares (which represented only a minority of its equity capital) to the winning investor group, which included Grupo Carso (Mexico), Southwestern Bell (United States), and France Telecom. This transaction was accomplished through the sale of special AA shares that represented 51 percent of the company's voting shares (although amounting The Privatization of Telmex involved the largest securities offering ever by a Mexican company

Steel was the first industrial sector to be fully divested in Mexico to less than 21 percent of its capital stock; table 6.3). After the privatization the government conducted a $2.3 billion offering of L shares (mostly in the form of depository receipts) with limited voting rights. Of the shares issued in the MayJune 1991 domestic and international offering, about a third were placed in Europe and more than half were in the United States. The rest was split evenly between Mexico and Japan (about 7 percent each). The success of Telmex's initial public offering—and of the series of depository receipt offerings of private Mexican issuers that followed—encouraged the Mexican government to offer most of its remaining shares in Telmex in a domestic and international offering in May 1992. This offering of almost 500 million shares (again, mostly in the form of depository receipts) sold at more than twice the price of the initial offering ($56.125 per depository share compared with $27.25 in the initial offering; see chapter 8). A third public offering in late 1993 relieved the government of another 329 million shares of Telmex. These offerings made Telmex shares the most important equity securities in the Mexican market, accounting for 46 percent of the stock exchange's market capitalization in 1991, 17 percent in 1992, and 15 percent in 1993. Telmex also represented the largest portion of trading volume—7 percent in 1992, 18 percent in 1993, and 34 percent in 1994 (table 6.4). Steel, 1991. By the early 1980s Mexico's state−owned steel industry—the second largest in Latin America after Brazil's—was suffering from large and growing losses, overstaffing and low productivity, obsolescent technology, and few prospects for new investment. In the mid−1980s, independently of the privatization program, the government began work on policy reforms and operational restructuring of the sector. This program sought to reduce the fiscal burden of the steel industry and to subject state−owned steel enterprises to greater market discipline, allowing the industry to play a more dynamic role in the economy.6 The state's interests in the steel industry were consolidated into a single holding company (Sidermex) with five main independent subsidiaries: AHMSA (a large integrated steel plant), SICARSTA (other mills), CMC (a raw materials division), a technical operations unit, and an international marketing operation. Minor and noncore operations were merged, liquidated, orDelivered sold off at an early stage. Sidermex assumed the debt of the enterprises, by The World Bank e-library to: aaaaaa University and each subsidiary began rationalizing operations. Between 1986 and 1991 the industry's workforce was reduced IP : 111.111.11.11 Tue, 11of Janthese 2111 11:11:11 from 36,000 to 18,000; Sidermex bore the costs cuts.

Argentina

77 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Privatization was not the original goal of the government's restructuring of the steel industry Partly because restructuring efforts were successful, however, steel was chosen as the first industrial sector to be fully divested. The decision to privatize Sidermex was announced in 1990. For assistance the Ministry of Finance hired a team of technical and financial advisers, including officials who had played a role in privatizing British Steel. Before conducting the standard two−stage auction, the government assumed $2.3 billion of the steel companies' foreign debt. The government also clarified property rights and environmental regulations, and renegotiated labor contracts to provide potential investors with sufficient certainty to formulate a realistic offer.

Table 6.3 Telmex shares sold by the Mexican government, 199093 Capital stock Millions of Share shares (percent)

Month,Year

Series type

Value (millions of U.S. dollars)

Buyer

December 1990

187

4.40

A

325

Employees

December 1990

2,163

20.40

AA

1,758

Strategic investors

MayJune 1991

1,745

16.45

L

2,271

International and domestic investors

SeptemberOctober 1991

541

5.10

L

477

May 1992

500

4.70

L

1,360

International and domestic investors

OctoberDecember 1993

329

3.10

L

903

International and domestic investors

Strategic investors

Source: Comptroller General of the Republic; Telmex, various years.

Table 6.4 Market capitalization and trading volume of Telmex shares and Mexico's stock exchange, 199197 Market capitalization (billions of U.S. dollars)a

Average daily trading volume (millions of shares)b

Year

Telmex c

Telmex c

1991

29

1992

22

Domestic market — 10.0

Domestic market

Delivered by The World Bank e-library to: aaaaaa 114.3University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

63

127

141.1

Argentina

78 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets 1993

22

25.5

144

122.1

1994

25

32.4

188

96.1

1995

13

18.2

91

95.4

1996

12

17.4

106

169.9

1997d

13

6.0

116

−

a. Monthly average. b. Assumes that each year had 248 trading days. c. Includes A and L shares. d. January−May 1997. Source: IFC. Emerging MarketsDatabase. The main operations were auctioned in three parts: AHMSA and CMC, SICARTSA I, and SICARSTA II (the second and third reflecting the geographic division of SICARTSA's operations). In November 1991 each part was awarded to a different group of Mexican investors. The transactions totaled $1,470 million—$340 million in cash, $545 million in debt assumed by the buyers, and $585 million in investment pledges made by the buyers. AHMSA and CMC, the largest share of operations, was acquired by Grupo Acero del Norte, an investment group dominated by people with extensive experience in the mining industry. AHMSA and CMC sold for $145 million in cash, $350 million in assumed long−term debt, and $535 million in investment commitments. Banks, 199192. In terms of revenue and psychological impact, the privatization of the nationalized banking industry in 199192 was perhaps the high point of Mexico's program. The government reaped more than $12 billion from the privatization of banks, with controlling interests selling for, on average, well over three times book value.7 Commercial banks had been nationalized during the debt crisis and, as noted, the Constitution had even been amended to designate commercial banking as a strategic activity reserved for the state. Thus the return of commercial banks to private hands signaled that the government was committed to free markets and to redefining the role of the state. Two developments before banks were privatized had implications for Mexico's capital markets. First, after Miguel de la Madrid's administration took office in 1982, former bank owners were allowed to repurchase the nonbank assets of the nationalized banks. Then, after changes were made to the legal structure of the reorganized banks in 1987, the government allowed up to 34 percent private participation in the statecontrolled commercial banks through the issue of nonvoting equity shares structured as capital contribution certificates (certificados de aportacion patrimonial ). These certificates were usually privately placed with bank executives, bank employees, and other domestic investors (foreign investment was initially restricted). The certificates were, however, listed on the stock exchange and contributed to the growth in market capitalization and trading volume that occurred during 198590. As a result of this pre−placement of minority interests, by the late 1980s state holdings in large banks were often only slightly larger than a majority equity stake.This contrasts with the Argentine example, where in most cases a large government minority interest (often 49 percent) was available for sale through the capital markets and to employees once a majority stake had been sold to strategic investors. Privatization of the banking system proceeded separately from privatization of other industries. In May 1990 Delivered by The World Bank e-library to: President Carlos Salinas presented Congress with to the Constitution removing commercial banking aaaaaaamendments University IP : 111.111.11.11 from the list of activities reserved for the state. Then a new Law of Credit Institutions and a Financial Groups Law Tue, 11 Jan 2111 11:11:11 were enacted that, among other things, established financial conglomerates as the model for Mexico's financial Argentina

79 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets system and set limits on foreign participation in Mexican commercial banks. Foreign ownership was limited to C shares, which could represent no more than 30 percent of the voting shares of a bank or financial holding company.Subsequent changes to legislation allowed foreigners to hold other types of shares through neutral trusts that effectively strip them of their voting rights and through L shares that have limited voting rights. In the aftermath of the 1994 peso devaluation and the resulting banking crisis, the limitations on foreign control of major banks were substantially relaxed. The Bank Divestiture Committee was formed in September 1990 to establish procedures for selling the government's interest in the eighteen state−owned commercial banks.8 Before privatization each bank was Privatization of the nationalized banking industry was perhaps the high point of Mexico's program

The Mexican government sold most or all of its holdings in eighteen commercial banks converted back into a joint stock company. The government's interest was converted into a 51 percent controlling block represented by A shares; the rest was represented by B shares.The capital contribution certificates held by private parties were converted into B shares eligible for purchase by Mexican investors only. No C shares were issued at this point. Controlling blocks of government−owned A and B shares were sold in a series of auctions in 199192 (table 6.5). The size of the block of shares that was auctioned was determined on an individual basis. In three cases where the government owned a 100 percent interest, it decided to auction the entire block because the banks were small. In about half the remaining cases (where capital contribution certificates had been issued to the public but the bank was relatively small) the government decided that it would be cost efficient to auction its entire interest (usually about 66 percent). The government concluded that the winning bidder would offer more for the government's shares in excess of 51 percent than could be obtained from a subsequent public offering. In the remaining banks the government opted, at first, to retain a portion of its equity after privatization. In most of these cases, however, the excess shares were later sold to the winning bidder in a private transaction. Such sales occurred either upon the exercise of a prenegotiated option (as in the case of Banca Serfin) or after the government received an attractive offer from the majority shareholder group (as in the case of Banco Nacional de México). Only in the case of Bancomer did the government retain a considerable block of shares (about 20 percent), which remain available for a subsequent offering.9 In all, though, the eighteen privatizations resulted in numerous new listings on the stock exchange as the financial groups organized mainly to buy the banks sought capital to make the purchases and expand operations. Argentina

One of the reasons Argentina was able to privatize quickly was the clarity with which the government articulated the program's rationale at the outset. As noted, privatization was an important component of the emergency plan to rescue the rapidly

Table 6.5 Privatizations of Mexican banks, 199192

Bank Multibanco Mercantil de México

Amount paid (millions of U.S. Share sold Delivered by The World Bank e-library to: Auction date dollars) (percent)

Price/book value ratio

June 1991

2.66

aaaaaa University IP : 111.111.11.11 203 Tue, 11 Jan 2111 11:11:11

77.2

Argentina

80 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Banpais

June 1991

181

100.0

3.03

Banca Cremi

June 1991

236

66.7

3.40

Banca Confia

August 1991

294

78.7

3.73

Banco de Oriente

August 1991

73

66.0

4.04

Banco de Crédito y Servicio

August 1991

140

100.0

2.53

Banco Nacional de México

August 1991

3,203

70.7

2.62

Bancomer

October 1991 2,379

56.0

2.99

Banco BCH

November 1991

286

100.0

2.68

Banca Serfin

January 1992

919

51.0

2.69

Multibanco Comermex

February 1992

883

66.5

3.73

Banco Mexicano Somex

February 1992

613

81.6

3.31

Banco del Atlántico

March 1992

475

68.8

5.30

Banca Promex

April 1992

351

66.0

4.23

Banoro

April 1992

371

66.0

3.95

Banco Mercantil del Norte

June 1992

569

66.0

4.25

Banco Internacional

June 1992

476

51.0

2.95

Banco del Centro

July 1992

279

66.3

4.65

Source: Comptroller General of the Republic.

deteriorating economy. The newly elected Menem administration was determined to relieve the state of lossmaking public enterprises as part of its plan to cut the government deficit, stabilize the economy, and promote recovery. Privatization promised short−run fiscal benefits in the form of sale proceeds, reduced subsidies, and higher tax revenues. In addition to the financial burden state−run industries placed on public resources, it was apparent that in the hands of the impoverished state they would continue to suffer from disinvestment, inefficiency, and obsolescence. During the late 1980s the quality of public services (power; communications, water; roads) had significantly worsened. Power rationing in Buenos Aires—often involving regularly scheduled outages—was perhaps the most notorious example. Public frustration helped the government generate support for change. In arguing for a by The World Bank to: redirection of policy, the government Delivered repeatedly stressed thee-library importance of privatization for technological aaaaaa University innovation, attraction of foreign capital, long−term job creation, and the future competitiveness of the Argentine IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 economy. Argentina

81 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets While fiscal and structural issues were foremost on the agenda, the government's privatization program also sought to develop capital markets into an effective mechanism for allocating long−term savings. Argentina's high per capita income10 and the public's financial sophistication made it likely that a large share of the population would be interested in channeling savings through the capital markets. Two elements of the program supported this objective: the sale of government−owned shares directly to the public and the allocation of part of the shares of privatized companies to employees through the Programa de Propiedad Participada (Capital Participation Program).11 Of course, these two elements were also important to other parts of the government's strategy—namely, maximizing revenues12 and gaining labor support for the process. Administration of the Argentine privatization program was largely decentralized. The biggest transactions were carried out by specially formed committees and managed by fairly independent officials within general procedural guidelines. These guidelines were developed by a number of executive and legislative entities, including the Bicameral Congressional Commission, the privatization unit of the Ministry of Economy, and the public enterprise auditing agency. Before disposition most large enterprises underwent fairly rapid organizational restructuring, labor force reductions, and debt reduction (through assumption of debts by the state). To gain the full benefits of private competition, several monopolies (including telephone, electricity, and gas and petroleum companies) were broken up prior to sale and new rate−setting regimes and institutions established. Disposition usually involved a two−stage competitive bidding process. The first stage involved qualifying bidders on technical grounds. During the second stage qualified bidders presented their financial offers (based on purchase price, debt reduction, or future service rates). For larger privatizations bidding groups were composed of a local partner; a foreign company with technical expertise, and a major financial backer (usually an international investment bank). Winning bidder groups typically received 51 percent of the company's capital stock in the form of A shares, which were subject to restrictions on transfer for a certain period to ensure compliance with the bidding group's technical proposal. All shares purchased by the bidding group in excess of 51 percent of the capital stock, as well as shares retained by the government for later sale to the public, were issued in the form of unrestricted B shares. Shares issued to employees under the public participation program were documented as C shares initially but were convertible to freely transferable B shares once they were fully paid for. Telecommunications, 1990. The privatization of Entel in 1990 set the general pattern for later large Argentine privatizations. Although Entel's privatization was not perfect—some transactions involved last−minute renegotiations with the winning bidders on key terms of the deal—it convinced the markets of the government's commitment to divesting most of its industrial and commercial entanglements. Before privatization Entel was divided by region and by the type of services provided, with four companies providing basic services. To prepare for privatization, the government assumed $1.76 billion in company debt and established a new regulatory agency to administer better−defined rate−setting procedures and performance standards. After the privatization it became clear that the regulatory framework as well as institutional capacity to handle regulation were inadequate. As a result the government has found itself in the difficult position of needing to substantially adjust regulations post−privatization (see chapter 1). Although minor staff reductions occurred prior to privatization, union resistance to privatization was Argentina's privatization program sought to develop capital markets into an effective mechanism for allocating longterm savings

Union resistance to privatization was overcome, setting the stage for more economically rational labor policy after privatization overcome, setting the stage for more economically rational labor policy after privatization. Delivered by The World Bank e-library to: aaaaaa University Privatization of the two largest basic service companies (one covering the north, the other covering the south) was IP : 111.111.11.11 Tue, equity 11 Jan 2111 11:11:11 accomplished through the sale of a 60 percent stake to strategic investors in November 1990 (table 6.6). The winning bidding groups were headed by Telefónica of Spain (for the northern company) and STET/Cable and

Argentina

82 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Radio (for the southern company). These transactions were followed by public offerings of the government's remaining shares in the domestic and international markets about a year later. In a pattern that was to be repeated in later privatizations and that would significantly boost Argentina's equity markets, the government's residual 30 percent interest in the northern company (renamed Telefónica de Argentina after privatization) was sold in December 1991 in a domestic and international offering that raised $838 million. In March 1992 the government sold its interest in the southern company (renamed Telecom) for $1,227 million in a similar offering. In both cases depository receipts representing about 60 percent of the shares offered were listed on the New York Stock Exchange (10 percent of the shares remain in trust for the companies' employees). Electricity, 1992. The 1992 privatization of Argentina's largest power company, Servicios Eléctricos del Gran Buenos Aires (SEGBA), followed the pattern established by Entel's privatization. SEGBA generated, transmitted, and distributed electricity, mainly in Buenos Aires. Before privatization it accounted for 15 percent of power capacity, 40 percent of demand, and 50 percent of industry employment. In preparation for SEGBA's disposition, the government divided it into seven units—three for transmission and distribution and four for generation. In addition, the workforce was cut by 22 percent through attrition, special retirement programs, and severance payments in excess of the legally required amount. The balance sheets of the new units were cleaned up through the government's assumption of more than 92 percent ($4.45 billion) of the company's outstanding debt. Finally, a new regulatory agency was created and market−oriented rules were established for setting rates under the privatized system. Controlling interests in the new units were auctioned off in two stages. These interests represented 51 percent of the shares of the transmission and distribution companies, 60 percent of the shares of the two larger generation companies, and 90 percent of the shares of the two smaller generation companies. In all cases 10 percent of shares were reserved for the public participation program. The government's residual minority interests in two larger generation companies (Central Puerto and Central Costanera) were ultimately sold through a domestic and international public offering at effective share prices well above those received in the auction of the controlling interest (table 6.7). Petroleum, 199294. Unlike earlier privatizations, the sale of Yacimientos Petroliferos Fiscales (YPF) gave the government an opportunity to use the capital markets to create a company with a public float representing a majority of its voting shares. This was possible because the first stage of the company's reorientation involved ceding effective operational control over most of its activities to private partners and concessionaires. During 198990 most entry barriers, price controls, and other restrictions on the petroleum industry were lifted. Subsequently, nonstrategic assets were auctioned off through a series of transactions. Interests in certain activities, such as exploration, drilling, and some refining, were retained. But day−to−day management of most operations passed to private entities through joint

Table 6.6 Disposition of government interests in Argentina's telephone companies Millions of U.S. dollars Sales proceeds Debt retired

Company

Winning consortium

Delivered by The World Bank e-library to: (cash aaaaaa University Public IP : 111.111.11.11 offering Cash Tue,equivalent) 11 Jan 2111 11:11:11

Amount of liabilities transferred

Argentina

83 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Telefónica

Telefónica (Spain)

114

517

838

202

Telecom

STET/Cable and 100 Radio

438

1,227

178

214

955

2,065

380

Total Source: World Bank data.

Table 6.9 Disposition of government interests in Argentina's electric utilities Millions of U.S. dollars Sales proceeds

Company

Winning consortium

Debt retired (cash Public Cash equivalent) offering

Amount of liabilities transferred

Date

Central Puerto

Chilgener

92

—

132

51

April 1992

Central Costanera

Endesa

90

—

97

66

May 1992

Central Dock Sud

Polledo

25

—

—

4

September 1992

Central Pedro de Mendoza

Acindar/Massuh

9

—

—

—

September 1992

Edenor

Electricidad Argentina

30

398

—

95

August 1992

Edesur

Distrilec

30

481

—

136

August 1992

Edelap

Cia. de Inv. Electricidad

5

134

—

18

December 1992

281

1,013

229

370

Total Source: World Bank data.

ventures and concessions. Thus by 1992 YPF had essentially been transformed into a holding company for a collection of interests in the Argentine petroleum industry, with technology and management expertise for most operations already provided by the private sector. Accordingly, it was possible to contemplate a sale of a majority (and controlling) interest in the company to the public. The initial public offering of a portion of the federal and state governments' shares in the restructured company Delivered by The World Bank e-library to: just over 45 percent of the enterprise's took place in July 1993 (table 6.8). This packet of shares represented aaaaaa University capital stock and was aggressively marketed both internationally and domestically. Of the 160 million shares IP : 111.111.11.11 11 Jan 2111 11:11:11 placed, three−quarters were represented byTue, depository receipts listed on the New York Stock Exchange and one Argentina

84 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets quarter was domestically placed (though it is impossible to know how many foreigners bought shares in the domestic offering and how many. Argentines hold depository receipts). The offering was heavily promoted to retail Argentine investors, with kiosks established in major shopping centers and a promotional campaign undertaken by the domestic underwriters. As in most major Argentine privatizations, 10 percent of YPF's shares were reserved for purchase by employees through the public participation program. But in an unusual development, these shares were liquidated well before their release to the workers (which was to occur when the shares were fully paid for out of retained earnings and a portion of profit sharing, as originally contemplated). In July 1997, with the market price of YPF shares well above the initial public offering price, Merchant Bankers Asociados conducted an international public offering of the shares on behalf of the workers. The proceeds were used to pay the remaining purchase price to the government (dividends and profit sharing having already been applied to partial payment); the rest (after fees and expenses) were distributed to the workers. Of total proceeds of $976 million, the government received $585 million and the workers shared $389 million (YPF 1997).This move boosted the public participation program's impact on the market—though perhaps at some cost in terms of broadening the investor base and encouraging long−term participation by persons of modest means (workers) in the capital markets. Capital Markets after Privatization Privatization in Mexico and Argentina has had undeniable effects on the development of equity markets. Although these

Table 6.8 Disposition of government interests in the initial public offering of Argentina's YPF, July 1993 Share class

Millions of shares

Share of capital stock (percent)

D

160

45

Worldwide offering

B

40

11

Transfer to provinces

D

46

13

Exchange of pension bonds and other claims

C

35

10

Transfer to employeesa

Type of transaction

a. The shares were held in trust by the Argentine government for the benefit of YPF employees. In July 1997, 33.8 million shares (representing 9.6 percent of the capital stock) were sold by employees through an American depository receipt program. Source: YPF 1995, 1996. By 1992 YPF had essentially been Argentine petroleum industry

Delivered by The World Bank e-library to: aaaaaa University transformedIPinto a holding company : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

for a collection of interests in the

Capital Markets after Privatization (c) The International Bank for Reconstruction and Development / The World Bank

85

Privatization and Emerging Equity Markets Privatization has had dramatic second−order effects on Mexico's capital markets effects have differed, several lessons can be drawn from capital market development. Mexico

Except for Telmex, most of Mexico's privatizations have been carried out through auctions of the state's entire interest to a strategic investor group. Yet relative to Argentina, Mexico's stock exchange was more capitalized, more liquid, and more developed prior to the privatization program. The reasons Mexico did not make greater use of capital markets than Argentina include: · A smaller domestic investor base (a result of lower per capita GDP and greater income inequality). · Lack of an institutional investor base, with underdeveloped pension funds, mutual funds, and insurance companies. · In the bank privatizations, lack of sufficient minority interests to make a public offering cost effective. · Stock exchange listing requirements that required a track record of positive earnings.13 · Equity market requirements for greater disclosure than enterprises were willing or able to make. · Foreign investment restrictions. · Investor uncertainty about corporate governance. · A desire to quickly dispose of the government's entire interest in companies. · A sense that privatized companies would require subsequent capital increases and that selling controlling shareholders more than a 51 percent interest would give them the leverage to conduct new share offerings without losing control. · The gradual pace of privatization, which failed to inspire as much capital market interest as in Argentina. Nevertheless, privatization has had dramatic second−order effects on Mexico's capital markets (see table 6.1). Of the ten largest listed companies on the domestic stock exchange (representing 47 percent of market capitalization and 70 percent of trading value in 1996), most were companies that were directly privatized (such as Telmex) or whose main assets were acquired through privatization (such as the bank holding companies). A significant portion of currently traded shares result from capital increases accomplished through the issue of new shares in domestic and international markets. The dramatic growth in the market for Mexican equity securities (both in Mexico and abroad, through depository receipts) can be attributed to several factors, including macroeconomic stability, fiscal restraint, external debt restructuring, reorientation of the economy away from dependence on oil revenues, and Mexico's greater integration with the North American economy (culminating in 1994 with the North American Free Trade Agreement). So while it would be an exaggeration to say that the privatization program was the sole reason equity markets grew, privatization transactions clearly contributed in a number of direct and indirect ways, including through: Delivered by The World Bank e-library to: · Direct placements of stock by the

aaaaaa University IP : 111.111.11.11 government and Tue, 11in Jandomestic 2111 11:11:11

international markets.

Mexico

86 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets · Equity offerings by companies organized to purchase privatized assets. · Selloffs of minority interests in privatized entities by controlling shareholders. · Capital increases by newly privatized companies effected through issues of new stock to the public. · Equity offerings by companies not involved in privatization, made possible by the demonstration and publicity effects of successful offerings associated with privatization. Direct placements. As noted, direct placements have been the exception rather than the rule. In most cases where the government retained shares for a possible later offering through the capital markets, this offering did not materialize. Still, the government continues to regard direct placement through domestic and international capital markets as a viable option. This has been evidenced in recent privatizations, including the 1997 sale of Ferrocarriles del Noreste, in which 20 percent of the stock of the privatized railway was retained by the government in expectation of a possible future initial public offering. Offerings by purchasers. Although the privatization of the banking system did not include secondary offerings of government−owned shares in international or domestic markets (as was typical of Argentine privatizations), the ultimate effects on the capital markets were profound. After the large banks were auctioned, the financial holding companies organized to hold their majority shares conducted initial public offerings in international and domestic markets.

Bancomer is an illustrative example. The winning bidder, a group of investors associated with the VISA group of companies (which includes Fomento Económico Méxicano, Mexico's second largest brewing company), established a holding company to hold its interests in financial institutions, including banking, brokerage, and insurance. The newly created financial group, called Grupo Financiero Bancomer, then conducted a $850 million international and domestic offering of shares, the proceeds of which were used to pay part of the bank's purchase price (Grupo Financiero Bancomer 1992). Sales of minority interests by controlling shareholders. Activity by controlling shareholders also has contributed to capital market development. As explained above, Grupo Acero del Norte was the winning bidder for AHMSA. In December 1993 the group placed about 5 percent of AHMSA's outstanding shares in a public offering conducted entirely in Mexico. Since the stock's liquidity was an issue, as a condition of the sale Grupo Acero del Norte agreed to conduct a tender offer for the shares by the end of 1994 if the public float did not exceed 15 percent of the outstanding shares.The group had to make good on the offer, but less than 1 percent tendered. In July 1995 Grupo Acero del Norte placed an additional 9 percent of the company's outstanding shares in a private offering to U.S., European, and Mexican investors. Demonstration and publicity effects. The remarkable success of the first Telmex offering attracted considerable interest in Mexican stocks. In 1991 market capitalization reached $63 billion, average daily trading volume was 114.3 million shares, and 14 new equity issues hit the market (table 6.9). More important in terms of raising capital, the Telmex initial public offering was followed by a flood of depository receipt offerings in 199192 (both U.S.−registered and under rule 144A), including GFB, ICA, Cemex, FEMSA, Vitro, TAMSA, Televisa, Situr, Posadas, Carso, Empaques Ponderosa, and Gigante. The list of issuers includes companies that were the result of (or participated in) the privatizations as well as companies that were much more removed from the process. Although much of this activity was attributable to general developments in the economy, Telmex's offering and Delivered by The World Bank e-library to: aaaaaa University the impending privatization of banks clearly played a role. And, as noted, increased interest encouraged the IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 Mexican government to offer most of its remaining Telmex shares in a domestic and international offering in May 1992. Mexico

87 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Argentina

In contrast to Mexico, in Argentina direct offerings of government shares to the investing public (both domestic and international) have had an enormous effect on capital market development (see table 6.2). Between 1992 and 1997 the seven largest privatized companies accounted for between one−quarter and one−half of market capitalization (although they accounted for a significantly smaller share of trading volume, a fact partly attributable to the depository receipt market; table 6.10). Of the twenty−four publicly traded depository receipt programs established by Argentine companies, seven are depository receipts of former state enterprises. As in Mexico, the offerings by state companies and the deepening of the market for these securities have boosted confidence in Argentine securities and increased trading in other equity securities. The rapid growth in tradable equity securities prompted a series of institutional changes and legal and regulatory reforms in Argentina's securities markets. Just as the privatization program began to get under way, the Merval (stock exchange) found itself challenged by a new dealer market, the Mercado Abierto Electrónico (Open Electronic Market, or MAE).14 The MAE was established in 1990 as an electronic over−the−counter trading system but almost immediately came to dominate trading in government securities and the small market in corporate debt. As

Table 6.9 Equity offerings of Mexican companies in domestic and ADR markets, 199196 Domestic market

ADR market

Year

Number of new stock issues made for cash

Value (millions of U.S. dollars)

Number of new stock issues made for cash

Value (millions of U.S. dollars)

1991

14

3,054

18

3,580

1992

23

1,799

12

3,472

1993

25

2,698

17

2,307

1994

100

2,796

18

1,422

1995

22

1,545

1

67

1996

48

1,936

14

316

Source: IFC, Emerging Markets Database; Bolsa Mexicana de Valores. In Argentina direct offerings of government shares to the investing public have had an enormous effect on capital market development

Neither program seems to have created much impetus for the listing of shares of small and mediumsize enterprises Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Argentina

88 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Table 6.10 Participation of major privatized entities in Argentina's equity market, 199297 Millions of U.S. dollars Market capitalization of major privatized companies a Year Market capitalization

Amount Share(percent)

1992

22,158

8,011

36

1993

26,674

13,319

50

1994

44,637

10,637

24

1995

33,513

8,973

27

1996

41,244

10,534

26

1997b 51,436

12,813

25

a. C:a. Central Costanera, Central Puerto, Metro Gas, Telecom, Telefónica, Transportadora de Gas Sur; and YPF. b. JanuaryJune. Source: IFC, Emerging Markets Database. privatization progressed, MAE also came to dominate trading in equities of the newly listed companies. In 1992 the MAE's equity trading volume surpassed that of the Merval. Faced with extinction, the Merval opened up its membership to financial institutions in 1992, and several active traders in the MAE (mostly banks) began participating in the Merval. For a brief period there was active competition in equity trading between the two markets. In April 1993, however, the two exchanges agreed to unify the market. Accordingly, the Merval maintains two equity trading systems; one is openoutcry with a central clearinghouse and the other is an electronic dealer market with telephone trading and electronic confirmation (essentially the MAE system for equities). Government and corporate debt trades on the MAE (Shah 1994, pp. 3351). Regulations governing the conduct and treatment of securities transactions were overhauled in the wake of the privatizations (unlike in Mexico, where these reforms largely preceded the major privatizations). The Public Offerings Law and subsequent reforms of other securities market regulations modernized the framework for information disclosure, listing requirements, mutual funds, conduct of market operations, and coordination of domestic and international offerings. Fixed brokerage commissions, transfer taxes, and capital gains taxes were eliminated in November 1991. Stock market fees were cut and tax treatment of foreigners and nationals was equalized at the same time. Subsequently dividend taxes and stamp taxes in the Federal District (where the major exchanges are located) were eliminated. Role of Small and Medium−Size Firms. Delivered byprogram The World Bank e-library to: created much impetus for the listing of Neither Mexico's nor Argentina's privatization seems to have aaaaaa University shares of small and medium−size enterprises. Both markets still have only a small number of listed shares, and IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 efforts to encourage more companies to access equity markets have had limited success. Mexico's exchange

Role of Small and Medium−Size Firms. (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets established a second−tier market in 1994. In 1996 this market was renamed the Market for Medium−Size Mexican Companies and an active promotional campaign was initiated. Still, only thirty−seven companies have shares listed on this market, and in 199596 only $33 million in equity was raised through initial public offerings. The recent economic crisis (particularly in Mexico) is one reason small and medium−size enterprises have not made greater use of equity markets. Moreover the characteristics of the companies that were privatized with capital market involvement and the market activity that followed were not particularly conducive to creating an environment where small−cap companies were likely to find equity offerings attractive. Most privatizations that made use of the capital markets were of large companies at the commanding heights of the economy such as heavy industry and regulated utilities. In the public offerings of these companies most of the placement went to foreign investors. Accordingly, both countries lack a broad base of domestic portfolio investors and the kinds of market infrastructure (specialized research, rating agencies, accounting standards, market−makers) that would have supported equity markets for smaller−cap companies. Role of Depository Receipt Markets

Argentine and Mexican issuers have made extensive use of depository receipts since the early 1990s.15 In many cases depository receipts have been the main mechanism through which to sell shares in initial or secondary offerings of recently privatized companies. Most of the shares sold to the public in the two largest privatization transactions (Telmex and YPF) were represented by depository shares. Indeed, most trading in the equities of these companies is conducted on the New York Stock Exchange through depository receipts. In other cases managers have sponsored depository receipt programs without simultaneously conducting initial or secondary offerings. Such programs facilitate the holding of shares by foreigners and provide domestic shareholders with another outlet when they decide to sell.

Prior to the advent of the Latin American depository receipt programs, experience indicated—at least in the case of American depository receipts—that while such programs expanded the global market for the underlying securities, the principal market usually remained the home country of the issuer. This tendency was evidenced by the flowback phenomenon. In the case of European and Japanese shares traded as depository receipts in New York, the number of shares represented by such receipts typically fell over time. Particularly during market downturns, inadequate demand outside the home country would result in the depository receipts being arbitraged back into the underlying shares traded in the home country. Thus programs established by or for European or Japanese issuers would require periodic replenishment through new issues in the depository receipt market or would be terminated because of inactivity. Larger depository receipt issues have exhibited the opposite tendency. The disproportion between the small investor base in Argentina and Mexico and the large public, over−the−counter, and institutional (through rule 144A) markets in the United States has resulted in capital outflows. The locus of trading has shifted to the depository receipt (offshore) market, and over time more and more shares are converted into depository receipts.This has had a number of positive effects on domestic capital markets. The preeminence of depository receipts has led issuers to focus on the needs of the offshore market, which is usually more demanding of transparent financial and other information than domestic exchanges and regulators. Accordingly more dependable public information is typically available from depository receipt issuers than from other publicly traded companies whose securities trade exclusively in domestic markets.16 As more companies access depository receipt markets and are forced to comply with their disclosure rules, there should be less resistance to tougher transparency requirements in World domestic markets. Delivered by The Bank e-library to: Better information on issuers, in turn, aaaaaa University should increase confidence for domestic and foreign investors in the home markets. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Although depository receipt markets have become the main markets for several important issuers, this does not seem to have caused a contraction in trading in the home country. In fact, the extra source of liquidity appears to have increased confidence (or at least contributed to increased domestic activity). Trading volume in Telmex and YPF depository receipts increased from privatization until the end of 1994, but this paralleled rather than substituted for growth in volume on the domestic exchanges. And the knowledge that there was a deep market offshore probably contributed to the recovery of Mexican markets in the aftermath of the December 1994 peso devaluation. Finally the depository receipt trend seems to have accelerated the dissemination of research on Argentine and Mexican companies, further improving the information available to domestic and international markets. Effects of the 1994 Peso Devaluation

The Mexican and Argentine equity markets experienced dramatic declines after the December 1994 devaluation of the Mexican peso and the economic contraction that followed in Mexico and other developing countries (the so−called tequila effect). Economic contraction, high and volatile interest rates, a sudden drying−up of foreign lending and investment flows,17 and banking weaknesses (particularly in Mexico) dramatically lowered share prices and stalled new equity offerings in 1995. The market capitalization of Mexico's market fell 35 percent in 1994 (reflecting the dramatic year−end decline in values) and another 30 percent in 1995. The Argentine market was hit less dramatically, with a 16 percent drop in market capitalization in 1995.Volatility was high, however. Some newly privatized entities were hit especially hard by the crisis. Mexican bank capital was severely damaged by the spike in interest rates and a significant deterioration in loan portfolios. A series of government interventions to support the banks and help debtors was required to restore stability to the financial system. Nevertheless, a number of publicly held banks failed, including one (Banpais) with depository receipts listed on the New York Stock Exchange. Argentina's banking system was also shaken by the crisis. The crisis caused credit to dry up, contributing to economic contraction and distress in major industries. The sharp reduction in access to credit triggered the financial collapse of the Mexican airline industry, which was already suffering from excess capacity and increased competition. Aeroméxico and Mexicana were taken over by their creditors and restructured beginning in May 1995.18 Exporters and producers of tradable goods were comparatively insulated from the crisis—in fact, the peso devaluation increased sales and improved margins for exporters. As more companies access depository receipt markets, there should be less resistance to tougher transparency requirements in domestic markets

An active U.S. market in depository receipts appears to have limited panic selling in the aftermath of the peso devaluation As disturbing as the crisis was to the domestic equity markets, there was no generalized collapse. The value of traded shares fell significantly (dramatically in Mexico), but the number of traded shares was less affected. Nor did trading in American depository receipts dry up. Indeed, the presence of an active U.S. market in depository receipts appears to have limited panic selling in the aftermath of the devaluation (particularly in Mexico). Market capitalization and trading value have returned to precrisis levels in Argentina. Although they have not yet done so in Mexico, in 1996 there were forty−eight new domestic equity issues and fourteen depository receipt offerings totaling more than $2.25 billion. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Notes

1. Even by 1996 only 100,000130,000 brokerage accounts are estimated to have been active (Shah, Lubrano, Mecagni 1996).

2. The Interministerial Commission comprises representatives of the Ministry of Finance and Public Credit, the Ministry of Social Development, the Ministry of Commerce and Industrial Promotion, the Ministry of Labor and Social Welfare, the Comptroller General of the Republic, and the Central Bank.

3. Apart from sale of an enterprise as a going concern, the Interministerial Commission (after hearing the opinion of the line ministry) could and often did determine that merger, liquidation, or transfer to the state or local administration would be more appropriate. Of the 936 enterprises divested between 1982 and 1994, only 314 were privatized as going concerns (Rogozinski 1997, p. 110),

4. In some state industries (for example, steel) extensive restructuring of management and operations was carried out independently of whether the industries were expected to be privatized.

5. In 1995 Telmex's American depository receipts (ADRs) accounted for 32 percent of Latin American ADR trading volume and 45 percent of Latin American dollar trading value on the exchange. In 1996 these figures were 22 percent and 25 percent.

6. The World Bank provided technical and financial assistance to this effort, culminating in the $400 million Steel Sector Restructuring Loan approved in March 1988.

7. Since the onset of a banking crisis after the December 1994 peso devaluation, however the government has been criticized for having paid insufficient attention to the qualification of winning bidders and for inadequately scrutinizing the sources of funds. Factors contributing to the crisis included poor management, insider lending, and capital financed with resources traceable to the banks.

8. During the 1980s the fifty−eight banks nationalized by President Lopez−Portillo were narrowed to eighteen through liquidations and mergers (six national, seven multiregional, and five regional banks).

9. The government's shares in Bancomer have been swapped for shares in the holding company (Grupo Financiero Bancomer) to accommodate the holding company's strategy to hold 100 percent of the bank and issue listed equity only at the holding company level.

10. In 1994 per capita GDP was about $8,248, compared with $4,181 in Mexico. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11entities Jan 2111 are 11:11:11 privatized allocated a

11. Under the program employees in portion of the shares of the privatized company (usually 10 percent). These shares are held in trust until the accumulated dividends and proceeds of Notes

92 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets employee profit−sharing plans equal the price per share paid by the winning bidder. Once this threshold has been reached, the shares are delivered to the workers, who may hold them or sell them through the capital markets.

12. The government often received more from the initial public offering of the minority interest in a privatized company than it did from the auction of the controlling stake.

13. The exchange likely would have loosened these requirements (with the approval of the National Securities Commission) for newly privatized companies had other obstacles not also been present.

14. Regional exchanges existed in Córdoba, Medoza, Rosario, Santa Fe, and La Plata, but the exchanges in Buenos Aires account for more than 90 percent of equity trading and an even larger share of trading in government and corporate debt.

15. In a depository receipt program, shares are deposited with a custodian bank in the country of the issuer. The custodian holds the shares on behalf of a foreign bank that issues depository receipts representing the beneficial interest in those underlying shares. The receipts can be traded on an exchange or over−the−counter. Once a depository receipt facility is established, holders of shares in the home country are free to deposit their shares and receive depository receipts to trade abroad. Likewise, depository receipt holders are entitled to redeem their receipts for the underlying shares and trade them in the home market.

16. Recognizing that prospectus disclosure standards were higher in U.S. and international offerings than in domestic issues. the Mexican Securities Commission instituted a policy in the early 1990s requiring issuers with depository receipt programs to provide the same information in their domestic prospectuses that was included in their offshore offering documents—even if such disclosure would not have been required in an exclusively domestic issue.

17. New foreign investment in the Mexican stock exchange dropped to just $519 million in 1995, after reaching $4.8 billion in 1992, $10.7 billion in 1993,and $4.1 billion in 1994 (Banco de Mexico 1995).

18. In 1995 there were fifty defaults and seventy debt reschedulings by issuers of securities in Mexico. References Banco de Mexico. 1995. The Mexican Economy, 1995. Mexico City. ———. 1996, The Mexican Economy: Economic and Financial Developments in 1995, Policies for 1996. Mexico City. Comisión Nacional Bancaria. Various years. Boletín Estadístico de Banco Múltiple. Mexico City. Grupo Financiero Bancomer S.A. de C.V. 1992, Prospectus for 7,400,000 Global Depository Shares, Each Delivered by The World Bank e-library to: aaaaaa University Representing 20 Series C Shares. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

IFC (International Finance Corporation). Emerging Markets Database. Washington, D.C. References

93 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Republic of Argentina. 1997. Annual Report Filed with the Securities and Exchange Commission under Form 18−K. Rogozinski, J. 1997. La Privatización en México: Rozones e Impactos. Mexico D.F: Edit.Trillas. Secretaría de Programación y Presupuesto. 1989. Plan Nacional de Desarrollo, 19891994. Mexico City. Shah, Hemant. 1994. Argentina: Capital Markets Study. Report 12963−AR, World Bank, Latin America and the Caribbean Department, Washington, D.C. Shah, Hemant, Mike Lubrano, and Laura Mecagni. 1996. Financial Markets and Savings Mobilization. World Bank, Latin America and the Caribbean Technical Department, Washington, D.C. Telmex (Teléfonos de México, S.A. de C.V). 199 1. Prospectus for 25,000,000 American Depository Shares. ———. 1994.Annual Report Filed with the Securities and Exchange Commission under Form 20−F. ———. 1995.Annual Report Filed with the Securities and Exchange Commission under Form 20−F. United Mexican States. 1992.Prospectus for U.S,$250,000,000 8.50 percent Notes due September 15, 2002. ———. 1995.Prospectus for $ 1,000,000,000 Floating Rate Notes due 1997. ———.1997.Annual Report Filed with the Securities and Exchange Commission under Form 18−K. World Bank. 1997. World Development Indicators 1997. Washington, D.C. YPF (Yacimientos Petroli'feros Fiscales). 1995. Annual Report Filed with the Securities and Exchange Commission under Form 20−F. ———. 1996.Annual Report Filed with the Securities and Exchange Commission under Form 20−F. ———. 1997. Prospectus for 33,794,525 American Depository Receipts of YPF Sociedad Anónima, dated July 15, 1997.

3.7— Privatization and Capital Market Development in Turkey and Egypt Ira W. Lieberman Turkey and Egypt provide interesting contrasts on privatization and capital market development. Until recently Egypt lagged behind other middle−income countries on economic reform, liberalization, and structural reforms such as privatization. In early 1996, however, a cabinet shakeup and the appointment of a new prime minister spurred the launch of a serious privatization program—a program that accelerated considerably during 1997. The program has focused on partial privatization through flotations on domestic share markets. As a result Egypt's inefficient capital markets are being forced to modernize. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 opposite direction. The Istanbul Stock Tue, 11 Jan 2111 11:11:11

In Turkey things have moved in the Exchange implemented significant reforms throughout the 1990s and has experienced some of the strongest growth among emerging markets, rising 3.7— Privatization and Capital Market Development in Turkey and Egypt (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets by nearly 50 percent (in dollar terms) in 1997 (ISE 1997). The robust privatization program initially championed by Tansu Ciller's administration was expected to significantly deepen the exchange. Yet Turkey is now lagging in terms of economic reform. And privatization, a part of much−needed structural reforms, has largely failed to materialize. Turkey's Halting Steps toward Privatization Turkey's political instability has delayed needed stabilization and structural adjustment—including privatization.1 Under Turgut Ozal's administration in the mid− 1980s, Turkey was among the first developing countries to announce a comprehensive privatization program. This program failed to meet expectations, however; and since 1985 revenues from privatization have totaled only about $3.4 billion (Hyman 1997; Undersecretariat of Treasury 1997). Most privatizations have been in the tradables sector. Major privatization transactions in energy and telecommunications continue to be delayed (although a 1015 percent share divestiture for Turk Telekom is promised for early 1998). The Cillier administration's heavily publicized privatization program, announced in 1993, was continuously derailed by legal challenges that continue to plague privatization efforts. Then several political crises resulted in a series of short−lived governments, further delaying economic reform and privatization. The December 1995 elections caused government paralysis, with centrist secular parties eventually forming a coalition to block a fundamentalist Muslim coalition. But the centrist coalition failed in June 1996, leaving a fundamentalist coalition to form a new government. In June 1997 yet another new government, led by Prime Minister Mesut Yilmaz, promised to tackle the long−delayed privatization program. But even this program appears to have been delayed by the government's left−leaning coalition partners. The government had hoped to raise $4 billion in 1997 by selling shares in enterprises long targeted for privatization, including Turk Telekom, Eregli steel operations, Etibank, the

Tupras oil refineries, and the Petrol Ofisi oil and gas distribution network (Financial Times, 14 November 1997). The government hopes to generate another $12 billion in privatization revenues in 1998 from sales of major state−held banks and electricity distribution and power generation companies (Oxford Analytica, 20 August 1997). Given recent history and the many factors working against privatization such goals appear excessively optimistic. In 1997 revenues from privatization totaled about $500 million, in line with the disappointing results of previous years (Reuters, 13 November 1997). Despite the turbulent environment and lack of progress on privatization, Turkey's equity markets have grown significantly over the past ten years and are now the center of capital market activity in the region. Still, further progress is possible—both for capital market development and overall economic growth. Achieving it, however, will require structural change. The macroeconomy must be stabilized. A robust privatization program must be implemented. Government crowding−out of private sector activity must be reduced. And the pension system must be reformed and possibly privatized. Recent Economic Performance

During the 1990s Turkey's GDP growth has been erratic, averaging just 1.2 percent during 199093, falling 5.3 percent in 1994, and reviving to 6.9 percent in 1995 and 6.0 percent in 1996. Growth in 1997 is projected to be 67 percent (World Bank 1996). Most of this growth has been generated by Turkey's vibrant and responsive private sector. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 from a failure to 11:11:11 address Tue, 11 Jan 2111

Spotty performance has partly resulted pressing macroeconomic problems—in particular, high inflation (hovering near 100 percent a year since 1994; table 7.1) and large public deficits (9 Turkey's Halting Steps toward Privatization (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets percent of GDP in 1996). These weaknesses have required enormous public sector borrowing and increased foreign and domestic government debt. Consolidated public sector borrowing reached 1112 percent of GNP in 199293, though it dropped to 8 percent in 1994 and 6.5 percent in 1995. By 1996, however, borrowing was back to 12 percent of GNP. Macroeconomic instability has been exacerbated by the sizable losses generated by stateowned enterprises and the unsustainable cost of the public pension and social security system. Moreover, poor macroeconomic management has eroded the gains from liberalization and privatization in the early 1990s and threatened a systemic crisis in the banking system. The need for public borrowing comes from three main areas: state enterprises,2 the consolidated budget deficit, and the public pension and social security system. Eight state enterprises account for most of the sector's losses and public borrowing. Because Turkey's debt rating has fallen, constraining external borrowing, deficits are increasingly being financed by the domestic capital market. The government, constantly forced to refinance its debt, has to borrow at short maturities and high interest rates.3 Privatizing state enterprises would significantly alleviate inflationary borrowing (World Bank 1997b). Turkey requires integrated, comprehensive structural reforms to achieve macroeconomic stabilization and longterm growth. Such reforms are difficult and require political will.4 Short−term political gains must be set aside, and hard tradeoffs must be made. Equity Market Structure.

Turkey's first securities market emerged in 1866 during the Ottoman Empire; the modern Istanbul Stock Exchange dates only to 1986. Despite sluggish privatization, political and macroeconomic instability, and high interest rates from government borrowing crowding out equity investment, Turkey has reformed its capital markets in recent years. Moreover, its equity market has boomed because of strong corporate performance and a large domestic retail investor base. It is estimated that domestic retail investors account for 80 percent of secondary market trading (Moore 1997).

Table 7.1 Inflation and public sector borrowing in Turkey, 199097 Indicator

1990

1991

1992

1993

1994

1995

1996

1997 a

Inflation (percent)

60.3

66.0

70.1

66.1

106.3

85.7

80.4

99.1

7.4

10.2

10.6

12.2

8.1

6.5

12.0

7.0

Public sector borrowing (percentage of GNP) a. Estimated. Source: World Bank data.

Turkey's equity markets are now the center of capital market activity in the region

Turkey was among the first developing countries to start privatizing state assets in the mid−1980s Average turnover on the exchange went from $250,000 a day in 1985 to $225 million a day in 1997, peaking at $723 million on 20 October 1997. Market capitalization went from $657 million to $53 billion over the same period (table 7.2). In 1996 twenty−five initialbypublic offerings sold to: shares worth $147 million (Euromoney, July Delivered The World Bank e-library aaaaaa University 1997). In 1997 one of Turkey's largest corporate groups, Sabanci, launched a $207 million initial public offering, IP : 111.111.11.11 the country's second largest, in domestic and markets. Preceding the Sabanci offer by just a week Tue,international 11 Jan 2111 11:11:11 was a $100 million international offering by Yapi Kredi Kankski, Turkey's largest private commercial bank. Equity Market Structure. (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets In 1994 the stock exchange became fully automated and moved to a new complex with two exchange floors. Moreover, the exchange's monitoring and disclosure standards are moving toward European standards. To that end, the exchange recently set up a new settlement and custody bank (Euromoney, November 1996). And in May 1995 the exchange, in cooperation with eleven regional exchanges, launched the Federation of Euro−Asian Stock Exchanges. Headquartered in Istanbul, the federation has received applications for membership from three other exchanges since its founding. In early 1995 the exchange split into three stock markets: the National Exchange (with about 200 listed companies, 100 of which make up the Istanbul Stock Exchange Composite Index), Regional Markets (listing small and medium size companies and those delisted from the National Exchange), and the New Companies Market (providing for entry of new listings, particularly small capitalization stocks). In 1996 the Istanbul Stock Exchange opened an International Securities Market to attract international and nonresident listings (ISE 1996a). Table 7.2 Stock market valuations in Turkey, 199497 Percent Indicator

1994

1995

1996

Market capitalization (billions of U.S. dollars)

21.8

20.8

30.8

52.5

Change (percent)

−42.2

−4.6

47.9

—

Average daily turnover (millions of U.S. dollars)

91.7

208.6

153.0

225.0

Market price−earnings ratiob

23.2

11.6

12.2

18.8

Price−cashflow ratiob

23.1

9.9

7.3

3.5

2.8

3.6

2.9

2.0

Dividend yieldb,c

1997 a

a. End−November data. b. Current figures. c. Includes only cash dividends. Source: Istanbul Stock Exchange, ISE Factbook; ISE 1997. Privatization Experience

Privatization is not new in Turkey. As noted, Turkey was among the first developing countries to start privatizing state assets in the mid−1980s. But progress has been slow. Since 1986 privatization revenues have averaged less Delivered by The World Bank e-library to: than $300 million a year, mostly in smaller industrial companies or minority shareholdings in larger investment aaaaaa University IP : 111.111.11.11 groups (tables 7.3 and 7.4). The Ciller government's attempt to step up privatization at the end of 1992 hit Tue, 11 Jan 2111 11:11:11 well−publicized legal challenges to the Constitutional Court, delaying the creation of the legal framework for Privatization Experience (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets privatization. Privatization has also suffered from the institutional weakness and instability of the Privatization Administration. Since 1992 twelve managing directors have led the administration, and senior staff has experienced substantial turnover. Yet the government continues to transfer state enterprises to the administration's portfolio—by 1997 it held forty−eight companies. The administration has majority ownership in thirty−two and substantial ownership (1050 percent of shares) in sixteen (Undersecretariat of Treasury 1997). By default the Privatization Administration has become a major state holding group—a role for which it is ill equipped. Companies that languish in wait of privatization eventually decapitalize and suffer efficiency losses. The administration's substantial portfolio shareholdings, however, make it a potentially important player in Turkey's equity markets. Although legal challenges have delayed privatization, many major companies have been prepared for it. With sufficient political will, several companies could be privatized in a short period, including the remaining Sumer Holding plants (textiles), Eregli (steel), Petkim (petrochemicals), and Poas and

Table 7.3 Gross revenues from privatization in Turkey, 198697 Millions of U.S. dollars Type of sale

198695

1996

1997

Total

Block sale

1,275

218

239

1,732

Asset sale

204

72

115

390

Public offering

433

0

0

433

International offering

330

0

0

330

Domestic offering

522

2

0

524

2

0

0

2

2,766

292

354

3,412

Incomplete asset sale Total

Source: Undersecretariat of Treasury 1997.

Table 7.4 Significant privatizations in Turkey, 198896

Type of sale/company

Privatization Administration share as percentage of offering

Public offering Erdemir

48.65

Share sold (percent) Industry

Data of sale

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2.93

Steel manufacturing

Privatization Experience (c) The International Bank for Reconstruction and Development / The World Bank

Sale amount (U.S. dollars)

Number of applications

335,514,641

189,636

53,105,711

33,953 98

Privatization and Emerging Equity Markets April 1990 Arçelik

13.32

5.83

Household goods manufacturing

April 1990

19,890,196

12,618

Bolu Çimento

34.50

10.38

Cement

April 1990

8,268,150

8,157

Çelik Haltat

19.42

13.25

Metals

April 1990

7,750,179

6,517

Petkim

99.97

8.09

Petrochemicals

June 1990 150,617,183

76,119

Konya Çimento

39.87

31.13

Cement

October 1990

Unye Çimento

49.21

2.86

Cement

Mardin Çimento

46.23

25.46

Turkish Airlines

100.00

Adana Çimento

17,663,979

6,396

November 1990

927,162

281

Cement

November 1990

9,161,501

1,280

1.55

Airline

November 1991

4,976,165

2,488

47.28

34.32

Cement

February 1991

27,958,470

3,355

Migros

42.22

36.40

Supermarket chain

February 1991

5,609,246

3,951

Ditas

14.77

2.51

Automotive spare parts manufacturing

May 1991

219,411

1,263

Tupras

100.00

1.66

Petroleum refining

May 1991

6,036,589

15,456

Petrol Ofisi

100.00

4.02

Petroleum marketing

May 1991

14,386,888

17,206

Tofas Oto. Fabrika (I)

23.13

0.85

Automobile manufacturing

June 1991

6,119,572

3,147

Tofas Oto. Fabrika (II)

4.46

0.13

Automobile manufacturing

March 1994

2,824,239

804

345,564,660

98,914

Combined public offering and block sale Public offerings

97,682,621

Block sales

247,882,039

Teletas Public offering Block sale

Telecommunications 40.00 18.00

22.00 Delivered by The World Bank e-library to: aaaaaa University 18.00 IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

February 1988

13,090,225

August 1993

21,002,400

Privatization Experience (c) The International Bank for Reconstruction and Development / The World Bank

41,695

99

Privatization and Emerging Equity Markets Usas Block sale Public offering

Catering 100.00

70.00

February 1989

14,450.000

30.00

29.99

October 1993

15,205,871

13,000,000

Afyon Çimento

4,672

Cement

Block sale

99.60

51.00

September 1989

Public offering

48.60

39.87

March 1991

8,422,698

12,591

April 1990

38,829,409

22,184

February 1993

81,096,791

Çukurova elektrik

Electricity production

Public offering

18.65

5.45

Block sale

11.50

11.25

Kepez elektrik

Electricity production

Public offering

42.05

8.14

Block sale

25.39

25.39

Tofas Oto Tic.

April 1990

9,390,359

February 1993

33,158,988

13,070,000

8,320

Automobile distributor

Block sale

39.00

16.00

February 1991

Public offering

23.00

1.36

June 1991

3,147

966,248

(Table continues on next page. ) Companies that languish in wait of privatization eventually decapitalize and suffer efficiency losses

Eight state enterprises account for 95 percent of the sector's losses

Table 7.4 Significant privatizations in Turkey, 198896 (continued)

Type of sale/company

Privatization administration share as percentage of offering

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Share sold aaaaaa University IP : 111.111.11.11 (percent) Industry Tue, 11 Jan 2111 11:11:11

Sale amount Date (U.S. of sale dollars)

Privatization Experience (c) The International Bank for Reconstruction and Development / The World Bank

Number of applications

100

Privatization and Emerging Equity Markets Nigde Çimento

Cement

Public offering

99.84

12.72

May 1991

Block sale

87.12

87.10

March 1992

Gima

22,500,000

Supermarket chain

Public offering

54.68

4.15

Block sale

50.38

94.05

Netas

June 1991

406,902

283

March 1993

21,787,413

27,816,447 4,897

Telecommunications

Block sale

49.00

20.00

March 1993

Public offering

29.00

7.75

March 1993

International offering Tofas Oto. Fabrika

2,647,286 1,125

8,723,623 330,000,000

21.13

16.67

Automobile manufacturing

March 1994

330,000,000

Source: Privatization Administration, Annual Report, various years. Tupras (oil distribution and refining; table 7.5). Privatizing these companies would increase the program's credibility both in Turkey and in international capital markets. Except for Sumer Holding, these enterprises are among the most important listings on the lstanbul Stock Exchange. Completing these privatizations would significantly deepen the equity market. The partial flotation of Turk Telekom would also deepen the market, as has been the case with telecommunications privatizations in other emerging markets (see chapter 8 and Undersecretariat of Treasury 1997). Restructuring State Enterprises for Privatization

A number of other companies need to be restructured (before eventual privatization) to cut operating losses. Defensive restructuring could include reducing staff, restructuring debt, eliminating or reducing subsidies, and (in the case of coal) closing plants. Certain sectors, such as energy, also require structural and regulatory reforms. Eight state enterprises account for 95 percent of the sector's losses, 85 percent of borrowing requirements, 75 percent of direct budgetary transfers, and almost 60 percent of debt (World Bank 1997b). Moreover, the performance of these companies—TMO, SEKER, TEKEL (agricultural enterprises that receive large subsidies), TEAS (electricity generation and transmission), TEDAS (electricity distribution), TCDD (railways), TDCI (iron and steel), and TTK (hard coal)—has declined sharply in recent years. TEAS and TEDAS represent the breakup Delivered by The World Bank e-library to: of TEK, the original energy monopoly. Plans call for TEDAS to be split into a number of regional operators, each aaaaaa University IP : 111.111.11.11 slated for privatization. Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets In addition to these large industrial enterprises, the government has prepared Turk Telekom for sale and has proposed licensing telecommunications services and privatizing government holdings in the services sector. After Turk Telekom was separated from its postal operations, Parliament approved the sale of 49 percent of its shares. A tender for financial advisers was concluded in early 1997, and 1015 percent of the shares are expected to be sold in the first quarter of 1998. For equity investors, Turk Telekom would be the jewel in the crown of Turkey's privatization program. Other major government services proposed for sale include Turkish Airlines and Turban (tourism).5 Although many companies have been analyzed for privatization, few have been prepared for sale by financial and other advisers. With political commitment, Turkey could mount a privatization program on par with Argentina's in terms of scale and effect on economic performance (see chapter 6). Such a program could lower fiscal deficits, strengthen the private sector, attract substantial foreign investment, and deepen domestic capital markets. Securing support for privatization from a coalition government, however, is no easy task (see Euromoney, November 1996).

Table 7.5 Major planned privatizations in Turkey, 19982000 Company

Industry

Type of sale

Tupras

Petroleum refining

Trade sale

Poas

Petroleum distribution and retail sales

International and domestic initial public offering

Petkim

Petrochemicals

Trade sale

Erdemir

Steel manufacturing

Block sale (3040 percent of shares)

Havas

Airport handling services

Public offering (40 percent of shares)

Turk Telekom

Telecommunications

Public offering (49 percent of shares, with 1015 percent in early 1998)

GSM

Spectrum licensing

Pending

Four commercial banks

Commercial banking

Trade/block sale

TEAS

Electricity generation and Five power plants to be built on a transmission build−own−operate (BOO) basis; eight plants to be lessed for twenty years

TEDAS

Electricity distribution

To be split into regional companies and privatized

Source: Undersecretariat of TreasuryDelivered 1997. by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Pension Reform

Turkey's public pension and social security system is quickly becoming a major financial burden. The system is underfunded and lacks financial discipline. Pensioners are used to drawing full benefits at early retirement ages—and with increasing life expectancy, this is an unsustainable setup. Government leaders are examining options for reform. Longterm privately managed pension funds linked to capital market development, such as those pioneered by Chile and emulated by other Latin American countries, are a viable alternative (see chapter 12). Egypt's Faster Pace Until recently Egypt was lagging on economic reform, particularly privatization. In 1996, however, privatization accelerated. The privatization program, largely oriented toward the rapidly emerging domestic stock exchange, has been the focus of structural reforms and is integrated with overall economic stabilization efforts. If progress is maintained, Egypt will develop a substantial privatization program and deepen its equity market. In fact, the recent boom in Egypt's stock market is largely due to the quickening pace of privatization. Recent Economic Performance

Egypt's GDP growth was 4.9 percent in 1996 and is projected to reach 5.0 percent in 1997. In 1996 inflation fell to 7.4 percent and external debt to $30 billion (from its peak of $42 billion in 1988). Because of Paris Club reschedulings, external debt dropped from more than 130 percent of GNP in 1989 to about 50 percent in 1996 (World Bank 1997a). The lifting of interest rate and capital account restrictions has attracted inflows of private capital, resulting in official reserves equal to seventeen months of imports. Other signs of the international community's renewed confidence in Egypt's markets include Standard & Poor's recent investment grade rating (BBB−) and the successful issue of several global depository receipts (GDRs). Privatization Experience

Egypt's privatization program began in 1991, when Law 203 stipulated the privatization of 314 state enterprises. These enterprises were separated from their line ministries and organized into twenty−four sectoral holding companies that were designed to establish state enterprises as autonomous companies free from government intervention and subsidies. The enterprises were later reorganized into seventeen diversified holding companies. This was not a promising start to privatization given the negative experiences of other countries that had created such holdings. In 199293 privatization focused on employee share purchases. In 1994 the privatization program entered a second phase that included partial sales (1020 percent) of enterprise shares on domestic stock exchanges. The diverse set of enterprises selected for privatization were mainly in the tradables sector—cement, pharmaceuticals, fertilizers, chemicals, food processing—as well as in housing construction. Although the program generated significant interest among The recent boom in Egypt's stock market is largely due to the quickening pace of privatization

The Egyptian government has indicated that it is committed to addressing problem cases local and international portfolio investors, most sales involved small companies or minority stakes of larger Delivered by The World Bank e-library to: companies. These sales did little to stimulate the largely moribund stock exchange. aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

The 1996 program. In 1996 President Hosni Mubarak introduced sweeping cabinet changes to his administration, Pension Reform

103 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets naming Kamal El−Ghanzouri as prime minister with a mandate to accelerate economic reforms. With these changes came the beginnings of a robust privatization program that is scheduled to continue through 2000, at which time 314 industrial companies are expected to have been divested. Several achievements were made in recent years: · Partial divestitures continued, but the percentage of company shares sold rose, and by mid−year several majority sales had occurred on the stock exchange. During 199196 Egypt completed forty−two partial divestitures (table 7.6). By August 1997 this number had risen to seventy−six, and an additional thirty−four companies were expected to be divested by the end of the year. · In September 1997 the government announced plans to privatize significant holdings in the tourism industry—including hotels, restaurants, and land at tourist sites. · A handful of companies were sold to strategic investors (table 7.7). · Egypt floated its first GDRs. In 1996 revenue from privatization reached $1.2 billion, up from $173 million in 1995. Foreign direct investment hit $2.6 billion, up from $1.3 billion in 1995. Although most sales were still confined to mid−cap companies, progress on privatization was impressive. For 199798 the government has announced the sale of an additional thirty−three state enterprises, with a total of ninety−one to be divested by June 1998. Of these, twenty−five to thirty will be through the stock exchange. The government plans several international offerings using GDRs. Areas of concern. Egypt began privatization with a large, highly protected state enterprise sector—some 285 state enterprises with a book value of $8.7 billion. The program has not yet addressed the large problem cases, such as the four large national banks or the large integrated textiles companies. The government has indicated, however, that it is committed to addressing problem cases. It is not clear what role the holding companies will play in enterprise governance. Will the government still play an active role? Who will manage the companies that are divested on the stock exchange? If necessary, will managers of former state enterprises be replaced to force needed restructuring? It is also difficult to know whether companies that have never been forced to compete can learn to do so, both within Egypt and internationally. Egypt has a limited outward orientation, exporting just $4 billion a year of non−oil goods and services. Competition will be required to lock in efficiency gains from divestiture and ensure long−term competitiveness. On the other hand, Egypt's large domestic market offers strong growth potential for these companies—assuming strong economic growth continues. Other concerns include: · Egypt's reliance on externally generated resources to finance domestic spending, which could make it vulnerable to developments over which it has little control. · The companies being privatized. Are they the ones that matter, fiscally speaking? Do they represent the problem cases or larger loss−makers? · Whether the government will privatize its heavy industry holdings and large infrastructure companies, including state telecommunications and electricity companies.6 Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Pension Reform

104 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Table 7.6 Privatizations by method in Egypt, 199196 Method

1991

1992

1993

1994

1995

Initial public offering Liquidation

4

2

1

1

Employee stock plan

10

Anchor investor

3

Total Share of total (percent)

2

1996

Total

15

15

1

11 10

4

2

1

14

2

10

5

2

33

5

3

6

19

42

45

100

Source: World Bank data.

Table 7.7 Sale proceeds by method in Egypt, 199196

Method

Value (millions of Egyptian pounds)

Share of total (percent)

Majority initial public offering

2,147

23.7

Minority initial public offering

1,412

15.6

Liquidation

478

5.3

Employee stock plan

245

2.7

Anchor investor

1,301

14.4

Employee share purchase

3

0.0

300

3.3

3,033

33.5

128

1.4

9,046

100.0

Local government Sale of unused assets Joint venture Total

Source: World Bank data. Delivered by The World Bank e-library to: aaaaaa University Its recent success gives reason to believe that Egypt will follow through on privatization. The political IP : 111.111.11.11 commitment secured from the president andTue, prime are essential, just as in Argentina when President 11 Janminister 2111 11:11:11 Carlos Menem and Finance Minister Domingo Cavallo drove an accelerated program of economic reform and Pension Reform

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Privatization and Emerging Equity Markets privatization (see chapter 6). Capital Market Activity

Egypt provides one of the world's clearest examples of privatization awakening moribund stock exchanges, making the country a rising emerging market. In 1996 turnover totaled $3.8 billion. Between 1995 and 1996 the value of trading increased 130 percent. In 1996 market capitalization stood at $13.4 billion—equivalent to 25 percent of GDP, low by advanced market standards. During 199596 average price−earnings ratios moved from thirteen to almost eighteen, indicating that the market has heated up significantly despite the large number of offerings that have entered it. Egypt was the top−performing emerging market in 1996. Starting in February 1997, however, prices sunk as retail investors started selling shares and institutional investors became concerned about high price−earnings ratios. By September, however, market sentiment began to recover as Egypt seemed to steer clear of the turmoil hitting Asian markets. In addition, the International Finance Corporation agreed to add Egypt to its emerging market indexes starting in November 1997. The stock exchange lists 645 companies, although just 60 trade actively. This is actually fewer than in 1995 (746) and 1994 (700) because of the enforcement of more stringent listing requirements by the Capital Markets Authority. Foreign portfolio investment accounts for 35 percent of market activity—a low level for an emerging market. Market infrastructure. Market infrastructure has been a significant concern. The brokerage industry is weak. Clearing and settlement systems remain a problem despite 1996 reforms and the establishment of a central depository. (Some transactions made before that, however, are still unsettled—that is, title has not been transferred although payment has been made; World Bank 1997a.) In addition, there are concerns about insider trading and unbridled speculation. To thwart speculation, the government has tried to cap market moves for any given day. Moreover, it knows that other reforms are needed. To that end, reporting requirements and frequency have been improved (statements are now reviewed quarterly), and listed firms must report using internationally accepted accounting principles. Mutual funds. The establishment of thirteen domestic mutual funds—as well as research coverage by international emerging market investment houses and the addition of Egypt to the International Finance Corporation's emerging market indexes—has bolstered activity on the Egyptian Stock Exchange. Since June 1996 these mutual funds have attracted an estimated $700 million in foreign portfolio investment (World Bank 1997a). Notes.

1. The author advised the Ciller administration on its privatization program and has followed Turkey's program since that time.

2. State enterprise deficits may be higher than reported by the Treasury because of off−budget financing of state enterprises held by the Privatization Administration.

3. A 5 August 1997 auction of Treasury bills by had effective annual Delivered Thean World Bank e-library to: interest rate of 119 percent (Oxford aaaaaa University Analytica, 20 August 1997). IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets 4. See Oxford Analytica, 20 August 1997, for a discussion of reforms proposed by the Yilmaz government and political resistance to them. See also Hyman (1997) and Moore (1997). Egypt was the top−performing emerging market in 1996

5. Undersecretariat of Treasury (1997) contains a complete listing of companies and assets approved (in principle) for privatization.

6. In September 1997 the state−run holding company for metallurgical industries announced plans to divest 20 percent of its subsidiary, Aluminum Company of Egpyt—10 percent to retail and institutional investors and 10 percent to employees (Reuters, 14 September 1997). In December 1997 the government announced plans to privatize its main utilities, starting with telecommunications. The government has offered private investors a license for a second cellular network and plans to privatize the first cellular network (Reuters, 17 December 1997). References Hyman, Tim. 1997. Decision Time for Turkish Privatization. Global Investor (April). ISE (lstanbul Stock Exchange). Various years. ISE Factbook Istanbul. ———. 1996a. 1996 Annual Report. Istanbul. ———. 1996b. Privatization in Turkey. Istanbul. ———. 1997. Most Recent Values of ISE Stock Market Indices. Website URL: http://www.ise.org/indices.htm . Istanbul. Moore, Philip. 1997. Will Thing Be Different This Time? Euroweek 10: 3943. Privatization Administration. Various years. Annual Report. Ankara. Undersecretariat of Treasury 1997. Privatization in Turkey. Website URL:http://www.treasury.gov.tr/e/privatize/privatize.html.Ankara. World Bank. 1996. Global Economic Prospects and the Developing Countries 1996. Washington, D.C. ———. 1997a. Egypt Country Assistance Strategy. Washington, D.C. ———. 1997b. Turkey Country Economic Memorandum. vol. I. Washington, D.C.

4— PRIVATIZATION OFTEN RECEIVES A CRUCIAL BOOST FROM Delivered by The World Bank e-library to: TELECOMMUNICATIONS aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

4.8 The Flagship Role of Telecom Privatizations References

107 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets 4.9 Privatizing and Regulating Telecommunications

4.8— The Flagship Role of Telecom Privatizations Phumchai Kambhato The privatization of telecommunications companies has taken center stage in privatization programs worldwide. Of the $123 billion invested in emerging market privatizations during 199096, the largest share—$30 billion, or 24 percent—went to telecommunications (figure 8.1) A country's monopoly telecom operator is often the first major state−owned utility to undergo the complete privatization process: incorporation, licensing and regulation, introduction of competition, partial sale to strategic investor (in many cases), and flotation of equity on domestic and international markets. This is because governments consider the privatization of telecom companies to be strategic privatizations. As a result the share Delivered by The World Bank e-library to: offerings associated with telecom privatizations tendUniversity to play a crucial flagship role in emerging capital markets, aaaaaa : 111.111.11.11 broadening the domestic market and preparingIPthe ground for subsequent privatizations (table 8.1). Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Telecom privatization offerings in emerging markets usually: · Are a country's first major privatization issue and largest capital raising of any nature. · Are one of the largest companies on the domestic stock exchange, substantially increasing market capitalization and trading volume. · Attract significant foreign portfolio investment into the domestic market for the first time. · Increase the size and sophistication of the domestic institutional investor base. · Broaden the domestic retail investor base, attracting first−time equity investors. · Set a precedent for the marketing and execution of future privatizations. These characteristics are discussed in more detail below. Rationale Behind Telecom Privatizations For most of its history telecommunications was a user−pay service administered by central governments. A few exceptional countries struck a balance between government ownership and market competition through the use of regulated private utilities. That is, franchised monopolies were created, then the firms within these monopolies were subjected to detailed regulatory scrutiny. Both government ownership and the private utility paradigm were founded on the premise that telecom is a natural monopoly. Competition, it was believed, would duplicate investment, raise costs, inflate rates, and make services unaffordable to the subscriber public. Today, however, the global telecom industry is undergoing massive changes in manufacturing, investment, and market orientation and is experiencing freer entry, increased rivalry, and greater diversity. No longer considered a natural monopoly, telephony is beset by multi−industry competition. Many developing countries require a substantial increase in investment in telecom infrastructure. Moreover, almost all

Figure 8.1 Emerging market privatizations, 199096 Delivered by The World Bank e-library to: Source: Privatisation International database. aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

developing countries—as well as most industrial countries—have significant cross−subsidies embedded in the Rationale Behind Telecom Privatizations (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets structure of telecom prices. These subsidies have been justified by arguments based on social equity, the economic characteristics of the telecom market, and the relationship between different services. But rapidly changing telecom markets and technologies raise serious doubts about whether cross−subsidies within a regulated monopoly are the most efficient way to provide these services. As a result many countries, developing and industrial, have privatized their telecom industry. These privatizations have helped kick−start, deepen, and broaden domestic capital markets, as well as attract foreign investment. Sequencing of Telecom Privatizations Privatization of a telecom company is typically a mixed sale that takes place in two stages: sale of a strategic stake to a telecoms operator or a small group of strategic investors, and an initial public offering. In many cases strategic investors—often foreign telecom companies—are initially brought in to transfer expensive technologies. An example of a mixed sale is the privatization of Telmex, which involved an initial trade sale of a controlling block of shares to a consortium of Mexican and foreign companies in 1990, an initial public offering in 1991, and an additional public offer in 1992. Through the mixed sale the Mexican government was able to raise more than $5 billion from the Telmex privatization program. As noted, the telecom industry is typically the first major privatization share offering, both in industrial nations (for instance, the privatization of British Telecom in the United Kingdom) and emerging markets (Indosat and Telekom in Indonesia, Telmex in Mexico, and Telefónica del Perú). Telecoms tend to be chosen for this role because:

Table 8.1 Major emerging market telecom privatizations, 199197 Issuer

Economy

Date

Issue amount (millions of U.S. dollars)

Telefonos Mexico SA de CV (Telmex)

Mexico

May 1991

2,173

Telefonica de Argentia SA

Argentina

November 1991

637

Telecom Argentina STET−France Argentina Telecom SA

February 1992

932

Telecom Malaysia Bhd

Malaysia

April 1992

251

Telefonos de Mexico SA de CV (Telmex)

Mexico

May 1992

1,403

Singapore Telecommunications Ltd

Singapore

October 1993 1,488

Pakistan Telecommunication Co Ltd

Pakistan

September 1994

898

PT Indonesian Satellite (Indosat)

Indonesia

November

1,680

PT Telekomunikasi Indonesia (Telekom)

1994 Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Indonesia November 1,162 Tue, 11 Jan 2111 11:11:11 1994

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Privatization and Emerging Equity Markets Telefónica del Perú

Peru

July 1996

1,110

Compagnia Anonima Nacional Telefonos de Venezuela

Venezuela

November 1996

1,144

PT Telekomunikasi Indonesia (Telekom)

Indonesia

December 1996

611

Videsh Sanchar Nigam Ltd

India

March 1997

527

China Telecom (Hong Kong) Ltd

Hong Kong

October 1997 3,965

Source: Capital DATA Bondware. Many developing countries require a substantial increase in investment in telecom infrastructure

The telecom industry is typically the first major privatization share offering · The company's name, products, and services are well known to the public, many of whom are familiar with the company's activities as customers. This familiarity provides a good base for marketing and awareness campaigns aimed at first−time equity investors, though there may be negative perceptions resulting from a history of low service standards and poor consumer relations. · The company's market capitalization is usually very large, so the privatized entity will represent a significant portion of the country's stock market index. As a result institutional investors seeking a balanced exposure to the country's stock market will need to invest in the issue. · A telecom privatization can attract international investors because of the size of the issue (offering the possibility of significant investment while maintaining adequate liquidity), the global nature of the industry (so that the company can be compared with its peers), the strength of its earnings, and the growth prospects in telecoms, particularly in emerging markets. · The company is usually allowed to retain most of its monopoly privileges for some period after the issue (figure 8.2), although pricing is controlled by a regulator; Combined with strong growth prospects, this means that the company can be almost certain of having respectable financial

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Figure 8.2 Competition−free periods for selected telecom flotations Source: Flemings.

performance after flotation and hence generating returns for investors. This period of exclusivity can be followed by the introduction of value−added services such as mobile telephone and satellite communication concessions. Catalyst for Additional Privatizations A successful large−scale telecom privatization can serve as the springboard for additional privatizations because of the gains enjoyed by investors in the first privatization and the general education of the public and broadening of the market. The increased market capitalization of the domestic stock market and its improved liquidity, infrastructure, and information flows will be viewed favorably by international investors, who will then be likely to invest in further privatizations. Governments can use this positive investor sentiment to guide the next phases of privatization. In Argentina, for example, the government privatized five additional state−owned enterprises after privatizing by The World Bank e-library to:STET in February 1992 (table 8.2). These Telefonica de Argentina in NovemberDelivered 1991 and Telecom Argentina aaaaaa University additional privatizations included YPF, the oil IPand gas company, which raised more than $3 billion in June 1993. : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Similarly, Indonesia took advantage of the successful PT Indonesian Satellite (Indosat) privatization in October 1994, following it up with an international listing of PT Semen Gresik in July 1995 and the large−scale initial public offering of PT Telekomunikasi Indonesia in November 1995 (table 8.3). Benefits for Domestic Capital Markets As noted, telecom privatizations bring many benefits to emerging markets: they increase market capitalization and liquidity, serve as a catalyst for further flotations, attract foreign investment, and increase the involvement of domestic retail investors.

Table 8.2 Major privatizations in Argentina, 199194 Issuer

Date

Telefonica de Argentina

November 1991

637

Telecom Argentina STET

February 1992

932

YPF

June 1993

3,040

Central Puerto

November 1993

134

Central Costanera December 1993

97

Transportadora de May 1994 Gas del Sur

527

Metro Gas

122

November 1994

Issue amount (millions of U.S. dollars)

Source: Capital DATA Bondware. Increase in Capitalization and Liquidity.

Telecom privatizations typically are quite large: recent major issues in emerging markets have exceeded $1 billion. Issues in industrial countries are even larger. For example, in 1996 Germany's Deutsche Telekom sold a 24 percent stake for more than $13 billion, while three offerings for British Telecom in 1984, 1991, and 1993 raised nearly $23 billion. Before privatization, capital markets in emerging market economies are generally unsophisticated, with few large companies listed, a low volume of dealings, and small market capitalization. Thus, as noted, telecom privatization is likely to account for a large part of the stock market index. The issue boosts stock market capitalization considerably and increases domestic liquidity. Catalyst for Further Flotations

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 likelyTue, to raise 11 Jan the 2111profile 11:11:11 of the local

A successful telecom privatization is stock market, thereby attracting investors and encouraging other flotations. For example, the number of companies listed in Singapore's stock Benefits for Domestic Capital Markets (c) The International Bank for Reconstruction and Development / The World Bank

113

Privatization and Emerging Equity Markets market increased significantly after the 1993 privatization of Singapore Telecom. The $1.5 billion initial public offering not only became the largest locally listed company, it also boosted market capitalization at the time of the offering by some 30 percent and increased the average trading volume by more than 40 percent. Similar rises in market capitalization and trading volume have been observed in other countries in the year of telecom privatization (table 8.4).

Table 8.3 Major privatizations in Indonesia, 199496 Issuer

Date

Issue amount (millions of U.S. dollars)

PT Indonesian Satellite

October 1994 1,162

PT Semen Gresik

July 1995

127

PT Tambang Timah

October 1995

224

PT Telekomunikasi Indonesia

November 1995

PT Bank Negara Indonesia

October 1996

397

PT Telekomunikasi Indonesia

December 1996

611

1,680

Source: Capital DATA Bondware. A successful largescale telecom privatization can serve as the springboard for additional privatizations

Most telecom privatizations are too large to rely solely on local investors

Table 8.4 Stock market data for Indonesia, Mexico, and Singapore, 199096 Millions of U.S. dollars unless otherwise noted Country

1990

1991

1992

1993

1994

1995

1996

Market capitalization

8,081

6,823

12,038

32,953

47,241

66,585

91,016

Percentage of GDP

7.6

6.0

9.4

22.7

27.5

33.9

41.8

Trading value

3,992

14,403

32,142

Indonesia

2,992

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:1111,801 3,903 9,158

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Privatization and Emerging Equity Markets Number of listed companies

125

141

155

174

216

238

253

Market capitalization

32,725

98,178

139,061

200,671

130,246

90,694

106,540

Percentage of GDP

13.5

34.2

41.6

54.5

34.5

36.3

38.5

Trading value

12,212

31,723

44,582

62,454

82,964

34,377

43,040

199

209

195

190

206

185

193

Market capitalization

34,308

47,637

48,818

132,742

134,516

148,004

150,215

Percentage of GDP

94.0

111.8

100.4

240.9

206.9

200.5

158.8

Trading value

20,293

18,074

14,084

81,623

81,054

60,461

44,365

150

166

163

178

212

240

223

Mexico

Number of listed companies Singapore

Number of listed companies

Note: Year of first telecom privatization offering is shown in bold. Source: IFC 1997. Telecom privatizations also tend to deepen domestic capital markets by: · Bringing in new domestic investors who previously would have invested or dealt in equities. Their interest is piqued because telecoms is an important utility and telecom companies are household names that can be readily identified by domestic retail investors. · Catalyzing the development of new and more sophisticated infrastructure and professional services, including more published research, better valuation techniques, more market makers, reduced price volatility, and investment in custody operations. Boost in Foreign Investment

Most telecom privatizations are too large to rely solely on local investors to absorb the entire offering. Thus the strong participation of foreign investors is essential. Among major emerging market telecom privatizations, foreign investors accounted for at least three−quarters of the issue in all cases except Singapore Telecom and PT Telekomunikasi Indonesia (figure 8.3).1 Participation by foreign institutional investors not only helps ensure the success of an individual offering, it also Delivered by The World Bank e-library are to: often more sophisticated than domestic broadens the emerging stock market as a whole. Foreign investors aaaaaa University investors (in terms of their investment criteria)IPand tend to be longer−term holders. These factors contribute to a : 111.111.11.11 Jan 2111 11:11:11 better price for the stock, as does the abilityTue, to 11 exploit pricing tension between international and domestic demand Boost in Foreign Investment (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets for the stock. The involvement of foreign institutional investors also tends to foster the development of more sophisticated infrastructure and of domestic services to meet the demand for dealing in large sizes, fast and reliable settlement procedures, and high−quality information. Involvement of Domestic Retail Investors

The active participation of domestic retail investors is one of the keys to a successful initial public offering. Without domestic support for the issue, providing liquidity and information, foreign investors will probably not be comfortable investing in emerging markets. Moreover, broadening share ownership is often one of the political objectives of privatization. Public information and incentive schemes are usually essential to attract public participation in an offering. A public education program may take the form of advertising in newspapers or on radio or television, combined with a twenty−

Figure 8.3 Distribution of emerging market telecom privatization issues. Source: Capital DATA Bondware. four−hour toll−free telephone number to answer questions. Incentives can include discounts for cash buyers, payment by installments, subsidized credits, and loyalty share bonuses for long−term holders. Peru used these incentives in the privatization of Telefónica del Perú (table 8.5). And in utility privatizations in the United Kingdom, such as that of British Telecom, customers who subscribed to the issue were entitled to a preferential allocation of shares in the issue and to a discount on their telephone bills if the shares were held for a minimum period. Future Telecom Equity Offerings During 199899 telecom companies worldwide are expected to raise some $62 billion in equity capital. Of this, more than $57 billion will come from privatizations, including about $16 billion from emerging market issuers (table 8.6).

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Table 8.5 Marketing tools used in selected emerging market telecom privatizations Although the large number of forthcoming telecom privatizations is a good sign for the future growth and development of emerging equity markets, the potential crowding−out effect is problematic. With the competition to win international investor support for privatization issues likely to increase, greater efforts will be needed to develop an effective domestic investor base in order to ensure the success of emerging market telecom issues. Depository receipts have emerged as the instrument of choice for emerging market issuers seeking to attract international investors (see chapter 10). Most emerging market telecom privatizations, for example, have been offered through depository receipt programs. In the case studies that follow, issuers have used different names for depository receipt offerings, including American depository receipts (ADRs), American depository shares (ADSs), and global depository receipts (GDRs). To investors these instruments differ in name only. Case Studies Among emerging market telecom privatizations, four of the most significant have been Mexico, Singapore, Peru, and Indonesia. Telefonos de Mexico

Telefonos de Mexico (Telmex) is the only licensed supplier of fixed−linked public telecom services in Mexico. It owns all public exchanges, the national telephone network, and the main public long−distance telephone transmission facilities. The privatization of Telmex in 199092 played an important role in Mexico's privatization program and promoted the privatization of emerging market telecoms Depository receipts have emerged as the instrument of choice for emerging market issuers seeking to attract international investors

The privatization of Telmex promoted the privatization of emerging market telecoms worldwide

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Case Studies

117 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Table 8.6 Anticipated emerging market telecom privatizations, 199899 Economy

Company

Estimated Expected issue size date (millions of U.S. dollars)

Brazil

Telebras system

n.a

1998/99

Bulgaria

Bulgarian Telecommunications Company

n.a

1998

Croatia

Croatia Telecom

n.a 1998/99

Czech Republic

Ceska Radiokomunikace

100

1998

Estonia

Eesti Telekom

200

1998

n.a

1998

2,000

1998

Kazakhstan Kazakhtelecom Korea, Rep. of

Korea Telecom

Kuwait

Kuwait Telecoms

n.a 1998/99

Lithuania

Lietuvos Telekoms

n.a

Morocco

ONPT/Ittisalat

n.a

1998 1998/99

Oman

General Telecoms Organisation

n.a

1998

Pakistan

Pakistan Telecommunications

n.a

1998

Peru

Telefónica del Perú

150

1998

Poland

TPSA

3,000

1998

Romania

Romtelecom

2,000

1998

Russia

Rostelecom

500

1998

Slovakia

Slovenske Telekomunikacie

n.a

1998

Slovenia

Slovenia Telecom

n.a

1998

Taiwan (China)

Chung Hwa Telecom

2,500

1998

Thailand

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1,500

Case Studies

118 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Telephone Organization of Thailand Thailand

Communication Authority of Thailand

1998/99 500 1998/99

Turkey

Turk Telecom

1,000

1998

Ukraine

Ukr TeleKom

2,500

1998

Total

15,950+

Source: Flemings. worldwide. The privatization was a two−stage mixed sale, comprising a trade sale of a controlling block to a consortium of Mexican and foreign investors in December 1990 and a $2.2 billion initial public offering in May 1991.The success of the initial offering led to a second offering in May 1992 that raised an additional $ 1.4 billion. In all the sale raised nearly $5 billion for the Mexican government. Strategic sale, 1990. Telmex's privatization, announced by the government in September 1989, accounted for a large portion of Mexico's mass privatization program. There are three classes ofTelmex shares. Before privatization, AA shares accounted for 20.4 percent of the total number of shares outstanding, A shares for 19.6 percent, and L shares for 60.0 percent. AA shares carry the most voting rights; L shares have the most limited voting rights. Privatization began in December 1990 with the sale of all the AA shares (accounting for 51 percent of voting rights) to a trust for the benefit of controlling shareholders.The bidding process attracted sixteen international telecom companies, including Japan's Nippon Telephone and Telegraph, Italy's STET, and the U.S. companies Nynex and Sprint. Control was eventually sold for $1.76 billion to a consortium comprising Carso Group of Mexico (who received 10.4 percent), Southwestern Bell of the United States (5 percent), and France Cable et Radio (a subsidiary of France Telecom, 5 percent). This was followed by an acquisition by the consortium of additional L shares representing 5.1 percent of issued capital. Initial public offering, 1991. The initial public offering followed in May 1991, reducing the government's shareholding in the company to 9.5 percent. The issue was a great success, paving the way for the privatization of other emerging market telecoms. The offering comprised 3.99 million ADSs, representing 79.75 million L shares priced at $27.25 apiece (each ADS represented twenty L shares), for a total offering value of $2,173 million. The offering was almost entirely distributed in the international market, particularly in the United States (55 percent) and the United Kingdom (14 percent). Only 7 percent was sold to domestic investors (4.4 percent was bought by the telephone workers union). At the time the offering represented about 2 percent of the capitalization of the Mexican stock market. Moreover; Telmex's entry enlarged the size of the market by more than $14 billion, to $115 billion. Telmex ADSs became one of the most actively traded stocks on the New York Stock Exchange. After a slow start, the share price picked up and the stock began to outperform the Mexican market (figure 8.4). Within a year by The World Bank e-library to: Telmex shares more than doubled theDelivered initial public offering price and the privatization was regarded as a aaaaaa University IP : 111.111.11.11 phenomenal success. Tue, 11 Jan 2111 11:11:11

Case Studies

119 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Second offering, 1992. In May 1992 the Mexican government sold an additional 4.5 percent stake in Telmex, reducing its holding to 5 percent. The second offering was aimed at a wider audience and to be allocated among

investors in Mexico (40 million L shares), the United States (13.5 million ADSs), and the rest of the world (9.5 million ADSs). To maintain fungibility with the existing stock, one ADS again represented twenty L shares. The ADSs were listed in New York, quoted on SEAQ International, and traded over the counter in Tokyo. The L shares were listed on the Mexican Stock Exchange. Favorable investor response was expected following the announcement of better than expected first−quarter earnings and an agreement with the union on labor issues just before the offering. Moreover, demand was expected from new investors, especially from Europe, that were becoming more aware of developments in Mexico. However, a flood of new issues coming to the international markets at the time—including equity offerings by Grupo Financiero Bancomer ($840 million), Empresas ICA Sociedad Controladora ($490 million), and Cemex ($608 million) during March and April 1992—significantly reduced investor appetite. Moreover, demand from the United States was restrained because many U.S. investors already had substantial holdings in Telmex. Nevertheless, the Mexican and U.S. tranches of the offering were easily absorbed. Demand from the rest of the world, however, was below expectations. As a result that tranche was scaled back to 8.65 million ADSs, while the Mexican tranche was increased to 57 million L shares.

Figure 8.4 Telmex's trading performance after its first two offerings, May 1991−April 1995. The ADSs were priced at $56.125 (with no discount to the closing price on the day) and the L shares at 8.69 pesos. There was active trading of Telmex on the New York Stock Exchange on the first day, with about 7.5 million ADSs changing hands (compared with an average daily volume of 12 million ADSs). Telmex closed up $0.25 at $56.375 despite the weakening of the Dow Jones and the Bolsa. Telmex's strong performance did not last, however, and shortly after the second offering the share price tumbled in line with a collapse in the Mexican market. The Mexican market was responding to fears that the North American Free Trade Agreement would not be completed, a deterioration in U.S.−Mexican relations, and rumors that Telmex union members might dump their shares in the market. Telmex and the Mexican stock market as a whole began to recover in mid−1993 when some European funds started shifting Mexico from their emerging market holdings into their North American portfolios. The market continued to rise into 1994, when Telmex Delivered by The World Bank e-library to: aaaaaa$75.50 University shares and ADS prices peaked at 11.75 pesos and on 8 February (see figure 8.4). IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Case Studies

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Privatization and Emerging Equity Markets As the peso crisis took hold in late 1994, however, the Mexican stock market plummeted 30 percent as a result of the devaluation and subsequent flotation of the peso. The Telmex ADS fell by more than 60 percent as international investors lost confidence in Mexico. The strong recovery of the Mexican market since early 1995 has bolstered share and ADS prices, though both have continued to underperform relative to the underlying market (figure 8.5). Telmex L shares reached a new high of 19.30 pesos in late June 1997, while the price of ADSs has risen to $48 following recent rallies. Effect on domestic capital market. The Mexican market grew strongly during 199093, both in absolute terms and as a share of GDP (figure 8.6).The peso crisis, however,caused the market's value to drop in 1994 and 1995. The marked decrease in 1994 was primarily due to the devaluation of the peso against the dollar, since in peso terms market capitalization grew from 624 billion pesos in 1993 to 641 billion pesos in 1994, to 699 pesos in 1995. In 1996 the Mexican stock market recovered in both dollar and peso terms. The value of trading on the exchange rose significantly during 199094 as international investors turned increasingly toward emerging markets (figure 8.7). The peso crisis, however, scared these investors away, causing trading value to drop sharply in 1995. Stock market activity revived in 1996 Within a year Telmex shares more than doubled the initial public offering price

Stock market activity revived in 1996 with the return of investor confidence in Mexico

Figure 8.5 Telmex's trading performance after the peso crisis, May 1995−June 1997 Source Datastream/ICV. with the return of investor confidence in Mexico and in emerging markets as a whole. While it would be overly simplistic to attribute the rapid growth in the Mexican stock market in the early 1990s solely to the effect of the Telmex privatization transactions, they were undoubtedly important catalysts in the process, expanding and deepening the stock market and drawing in new investors, domestic and foreign. Singapore Telecom

The October 1993 privatization of Singapore Telecom, the provider of fixed−line, national, and international mobile telephone services, was destined to be Singapore's biggest flotation ever. The stock market was already Delivered by The World Bank e-library to: well developed, with a total value at the end ofaaaaaa 1992University of $49 billion—about equal to the country's GDP.At a IP : 111.111.11.11 proposed initial offering price of S$2.00 ($Tue, 1.20), Singapore Telecom would be valued at $24 billion, making it 11 Jan 2111 11:11:11 three times larger than Singapore Airlines (the largest domestically listed company at the time) and increasing Singapore Telecom

121 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets stock market capitalization by as much as 30 percent.

Figure 8.6 Mexico's market capitilization, 199096. Source: IFC 1997. Strong initial response followed by disappointing performance. The offering took the form of a tender offer of 1.1 billion shares, equivalent to 7.3 percent of the company, and was structured in three tranches (table 8.7). Market sentiment was extremely positive because the Straits Times index was climbing toward a record high of 2,055.59. Nevertheless, there were complaints that the proposed pricing was too expensive. At S$2.00 a share, the company's price−earnings ratio would be thirty times 1993 earnings and twenty−seven times 1994 earnings. At the time most emerging market telecom stocks were trading at price−earnings ratios in the range of fifteen to twenty. Domestic investors, however, were undeterred by the premium pricing or the high price−earnings ratio. Singapore Telecom was perceived as both glamorous and safe to invest in, with the government retaining more than 90 percent of its capital.The bidding range for the public tender tranche crept up to S$2.50−3.50, which would have yielded a price−earnings ratio of thirty−four to forty−eight. Under normal circumstances the Stock Exchange of Singapore requires Singaporean investors to maintain a central depository account in order to apply for and sell

Figure 8.7 Trading value on Mexico's stock exchange, 199096 Source: IFC 1997. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Singapore Telecom

122 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Table 8.7 Initial structure of share offerings for Singapóre Telecom's privatization Share group

Description

A

Fixed−price offering with a discount for members of the Central Provident Fund

Number of shares (millions)

Price

Notes

350

S$1.90

· Maximum 600 shares per applicant

· All applications to be met in full · Loyalty bonus shares of 40 per 100 held more than six years · Option to increase by 250 million shares, subject to demand B

Fixed−price offering for Singaporeans only

200

S$2.00

· 40.7 million shares reserved for employees

C

Public tender for foreign and domestic investors

550

S$2.00 minimum

· Option to increase by 100 million shares, subject to demand

shares. As the offering progressed and excitement took hold, locals scrambled to open these accounts. Eventually the exchange waived this rule in the case of B shares. Instead investors could apply for shares through an electronic share application system that was set up at eighty branches of local banks and at the offices of the exchange's twenty−six member companies. The enormous retail enthusiasm for B shares spurred institutional interest. As a result the expected tender price for C shares rose, with some bids rumored to be as high as S$5.00. The final prices of the offering are shown in table 8.8. To facilitate the listing and trading of Singapore Telecom shares in the secondary market, the exchange amended its trading hours from two sessions (9:00 a.m.to 12:30 p.m. and 2:00 p.m. to 6:00 p.m.) to on twelve−hour session (8:00 a.m. to 8:00 p.m.). In the end 1.69 billion shares were offered, equivalent to 11 percent of the company's paid−up capital of 15.25 billion shares and raising S$4.3 billion ($2.6 billion). At the C share offer price of S$3.60, the price−earnings ratio was forty−nine. Success, however, comes at a price. The large premium pricing, combined with the high first−day closing price of S$4.14, led to some immediate profit−taking. Nonetheless, even though the stock has largely underperformed since the offering, domestic investors who subscribed to A or B shares have either made a handsome profit (if they sold the shares) or are still in the money (if they held on to them; figure 8.8). Delivered by The World Bank e-library to:

Singapore Telecom's underperformance has had several causes: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Singapore Telecom

123 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets ·Overpricing —this might have been avoided had the government used a book−building approach rather than a tender offer. Essentially a demand−driven concept, book building could have established a more realistic market price. ·Exclusion from the Morgan Stanley Capital International index —because of its small free float (just 11 percent), Singapore Telecom has not been included in the Morgan Stanley Capital International (MSCI) index, a common benchmark for emerging market fund managers. As a result many investors have been deterred from buying the stock and others have been prompted to sell it. ·Stock market doldrums —the stock market's strong rally in 1993 has not been repeated, and the Straits Times index has been largely stagnant since 1994. Nonetheless, the Singapore Telecom offering has provided valuable lessons and should set a precedent for future privatizations in Singapore. The government is considering the privatization of a number of state enterprises, including the Public Utilities Board, Port of Singapore Authority,and Mass Rapid Transit Corporation. Effect on domestic capital market. Despite Singapore Telecom's underperformance, its listing significantly deepened Singapore's stock market (figure 8.9). Before the October 1993 offering, stock market capitalization was $59 billion; afterward it was $97 billion—a $38 billion increase. Between 1990 and 1996 the exchange's capitalization more than quadrupled. Trading value also has been boosted considerably (figure 8.10).

Table 8.8 Final structure of share offerings for Singapore Telecom's privatization Share group

Number of shares (millions)

Price

Notes

240 percent increase to meet demand in full

A

837

S$1.90

B

200

S$2.00

C

650

S$3.60

80 percent premium pricing

Singapore Telecom was perceived as both glamorous and safe to invest in

Singapore Telecom should set a precedent for future privatizations in Singapore

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Singapore Telecom

124 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Figure 8.8 Singapore Telecom's trading performance, November 1993−June 1997 Source: Datastream/ICV. Moreover, the number of companies listed in Singapore increased by 20 percent in 1994, to 212, and by nearly as much in 1995, to 240. Trading on the exchange also rose steeply in 1993, the year of the privatization. For the two months following the offering, market turnover averaged more than twice the pre−offering level. The average level of trading in 199395 was 325 percent higher than in 199092. Telefónica del Perú.

The July 1996 privatization of Telefónica del Perú was the largest, most successful equity offering from a Latin American issuer since Mexico's peso crisis in 1994. As part of its privatization program the Peruvian government sold a 26.7 percent stake in the company.The $1.1 billion offering became the biggest in Peru's history and the largest in Latin America since 1993. Its success is leading the way for at least four other international offerings from Peru.

Figure 8.9 Singapore's market capitilization, 199096 Source: IFC 1997. Background to the offering. In February 1994 the Peruvian government sold a controlling stake in its two telecom companies: Compa&tilde:nia Peruana de Teléfonos (CPT), of which the government held 20 percent, and Entel Peru, which was entirely state−owned. After the selldown, which also involved a capital increase by CPT, the government no longer held shares in CPT but retained 65 percent of Entel.The controlling stake, which had been given a base price of $546 million, was sold by a controlled auction to a consortium led by a subsidiary of Telefónica of Spain.The consortium offered an astonishing $2 billion for the stake, well above the two other offers submitted by consortiums led by GTE ($803 million) and by Southern Bell/Korea Telecom ($857 million). Telefónica of Spain's offer valued the two companies at $5.7 billion. Once Telefónica of Spain had acquired the companies, CPT was merged with Entel to create Telefónica del Perú. After the merger Telefónica of Spain held 35 percent of the new company, the government held 28.7 percent, and the public held the rest. In July 1996 the government sold an additional 26.7 percent, keeping the residual 2.0 percent, in a simultaneous offering in the domestic and international markets. The offering was structured into three tranches for investors in Delivered by The World Bank e-library to: Peru, the United States, and the rest of the world. Class B shares were offered to domestic investors and ADSs to aaaaaa University : 111.111.11.11 international investors (one ADS representsTue, tenIP B shares). 11 Jan 2111 11:11:11

Telefónica del Perú.

125 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets

Figure 8.10 Trading value on Singapore's stock exchange, 199096. Source: IFC 1997.

The domestic marketing strategy for Telefónica del Perú's privatization built on the experience the government had gained with the selldown of Cementos Norte Pacasmayo, the cement company. This pilot transaction, in 199495, had sold a $35 million stake to 19,000 small investors.Though small, the transaction provided valuable lessons about stimulating the retail investor base. Local incentives were crucial to the success of Telefónica del Perú's privatization. The government established the Citizens Participation program (Participación Ciudadana ), which included the following features to attract retail investment: · Packaging of shares in units of 50020,000 soles ($190$7,700). · Payment by installments (10 percent downpayment, with the rest paid over eighteen months) at a 10 percent discount to the international offer price. · Subsidized credit—at just I percent a month interest—for investors paying by installment. · A 5 percent discount for cash buyers. · Loyalty bonus for holding shares more than eighteen months (one free share for every twenty held). In addition, forty−two financial institutions set up special counters to facilitate share purchase. As a result of these measures domestic retail demand reached 160 million shares—making the issue two times oversubscribed—and involved 263,000 individuals. There was also strong demand for the international offerings, which were more than five times oversubscribed. The ADSs were priced at $20.50. This was equivalent to 5.02 soles per share, a 2 percent discount to the 5.11 soles close. B shares were priced at 4.90 soles. More than $1.1 billion was raised (table 8.9). The Telefónica del Perú offering became the fourth largest equity issue in Latin America and helped reopen Latin American markets after the Mexican peso crisis. Privatization has given a sizable boost to the company's stock market valuation. Before the first phase of privatization (sale to strategic investors) CPT had been one of the most Delivered The World Bank immediately e-library to: traded stocks in the Lima Stock Exchange. Itsbytrading price before the sale indicated a combined aaaaaa University value for CPT and Entel of about $1.2 billion. IP By: 111.111.11.11 April 1997 Telefónica del Perú's market capitalization had Tue, 11 Jan 2111 11:11:11 reached some $5.6 billion.

Telefónica del Perú.

126 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Telefónica del Perú's price fell just before the July 1996 international offering, partly because of market uncertainty about such a large offering (figure 8.11). After the highly successful offering, however, the stock price recovered, with active first−day trading pushing both the ADS and share prices up to close at $23.625 in New York (a 15 percent premium) and 5.55 soles in Lima (an 8.6 percent premium). Telefónica del Perú's subsequent performance in the secondary market has been somewhat variable. Although the ADS price has generally remained above the initial public offering price ($20.50), it did not trade above the first−day closing price ($23.625) until April 1997—nine months later: Nonetheless, the stock's performance has been closely correlated with that of the Lima Stock Exchange index.This is not surprising given that Telefónica del Perú is the leading stock on the exchange, representing more than 15 percent of the general index and accounting for 3060 percent of daily trading volume. Several factors were crucial to the success of the Telefónica del Perú offering: · The presence of dedicated Latin American funds, for which Telefónica del Perú formed a significant part of their holding. · Increasing exposure of generalist funds, which had been underweight in Peru. · Telefónica del Perú's listing solved the liquidity problems of the Peruvian stock market, attracting international investors. Effect on domestic capital market. The privatization of Telefónica del Perú greatly deepened and broadened the domestic capital market (figure 8.12).The increase in domestic retail and international institutional investors has been particularly notable (figure 8.13). Building on the success of Telefónica del Perú, the Peruvian government has since privatized Luz del Sur, the electricity distribution company, raising $171 million in Table 8.9 Structure of share offerings for Telefónica del Perú's privatization Allocation (percent)

Tranche Size

Price

Peru

101.24 million B shares

28

4.90 soles (per share)

United States

29.21 million ADSs

54

$20.50 (per ADS)

Rest of the world

9.75 million ADSs

18

$20.50 (per ADS)

The Telefónica del Perú offering helped reopen Latin American markets after the Mexican peso crisis

The privatization of Telefónica del

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11deepened Jan 2111 11:11:11 Perú greatly and broadened

the domestic capital market

Telefónica del Perú.

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Privatization and Emerging Equity Markets

Figure 8.11 Telefónica del Perú's trading performance, July 1996−June 1997 December 1996. Additional sales have also been considered, including 12 percent more of Telefónica del Perú to meet unsatisfied local demand and a 19 percent stake in Banco Continental (the second−largest bank in Peru). (Peru's privatization program is described in greater detail in chapter 3.) Indonesian Telecoms

During 199496 Indonesia privatized PT Indonesian Satellite (Indosat) and PT Telekomunikasi Indonesia (Telekom). Both issues boosted the Indonesian stock market, broadening and deepening it, encouraging foreign investment, and improving stock market liquidity. In addition, Indosat's issue helped pave the way for Telekom's.

Figure 8.12 Peru's market capitilization, 199096 Source: IFC 1997. Indosat. The 1994 initial public offering of Indosat, the international service provider, was Indonesia's first global offering and second privatization issue (PT Semen Gresik was privatized in August 1991). At the time it was also Asia's largest international initial public offering. At the initial offering price Indosat was valued at $3.3 billion, equal to 8 percent of the value of the Jakarta Stock Exchange prior to flotation.The flotation raised the exchange's market capitalization to more than $47 billion. The Indonesian government originally expected to raise up to $2.5 billion through the offering—$2 billion through international ADSs and $500 million through domestic shares—through a selldown of 28 percent of existing capital and an additional issue of 11 percent of new capital. Pricing created problems, however. There Delivered by The World Bank e-library to: exists an established market practice for initialaaaaaa public offerings on the Jakarta Stock Exchange that a new issue University IP : 111.111.11.11 may not be priced at a priceearnings ratios Tue, higher than fifteen; Indosat's indicative pricing was pitched at twenty 11 Jan 2111 11:11:11 to twenty−four times 1995 earnings.As market resistance took hold, the anticipated selldown was reduced to 35 Indonesian Telecoms (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets percent of the company, 25 percent of it distributed internationally and 10 percent domestically. This was equivalent to raising $900 million internationally and $360 million domestically In the meantime, international sentiment improved following the successful New York listing of PT Trypolyta, the first Indonesian company to seek an overseas listing. That issue, of 6.5 million NASDAQ−listed ADSs at $21 apiece, raised $137 million. As a result the structure of the Indosat

Figure 8.13 Trading value on Peru's stock exchange, 199096 Source: IFC 1997.

offering was altered again, increasing the international tranche to 27.75 percent and reducing the domestic portion to 7.75 percent. A maximum fixed price of 7,000 rupiah ($3.20) per share was set for local investors, with an indicated book−built range of $27.5032.00 per ADS (each ADS represented ten shares) for tenders by international investors. Market sentiment continued to improve until the pricing of the issue in October 1994. The offering was more than twice oversubscribed, both in the Indonesian tranche at the fixed price and in the international tranche at the top of the indicative price range. About 32.9 million ADSs were sold at $32.05 apiece (above the indicative range), raising more than $1.1 billion at a price−earnings ratio of twenty−six. Secondary trading was extremely active, and the stock closed up $5 at $37.125 in New York and up 1,475 rupiah at 8,475 rupiah in Jakarta (figure 8.14). Performance of the Indosat shares and ADSs has been rather volatile, moving in line with or outperforming the Jakarta Stock Exchange index for fifteen months after the issue. Although the prices remained above the initial prices during this period, they rarely exceeded the first−day closing prices. Prices of both the shares and the ADSs began to fall in January 1996, however,despite the upward trend of the exchange. Prices recently recovered somewhat but are still below the first−day closing levels. Telekom. Telekom, Indonesia's fixed−line public telecom service provider, followed on the success of Indosat. The government planned the initial public offering to be a largescale privatization of up to $3 billion. In an unusual move, eight global coordinators were appointed: four domestic houses (Bahana, Danareksa, Jardine Fleming Nusantara, and Makindo) and four international firms (Goldman Sachs, Lehman Brothers, Merrill Lynch, and SBC Warburg). The offering, launched in November 1995, consisted of a local tranche and three international tranches (Asia, Europe, and the United States). The domestic offering was planned to be for 12.5 percent of the company at a Delivered by The World Bank e-library to: aaaaaa University fixed price of 2,800 rupiah ($ 1.23) a share. The international offering was planned to be for 15 percent of the IP : 111.111.11.11 company in the form of ADSs (each representing twenty shares) priced at $ 19.5024.50 apiece (equivalent to Tue, 11 Jan 2111 11:11:11 2,2002,800 rupiah per share). Indonesian Telecoms (c) The International Bank for Reconstruction and Development / The World Bank

129

Privatization and Emerging Equity Markets The offering strategy was that domestic investors would subscribe initially at the maximum price while international investors would submit their bids through book building. Thus international investors were able to determine the final price.If the shares were priced below 2,800 rupiah, domestic investors would be given a rebate for the difference. The structure of the domestic offering was designed to encourage local demand (table 8.10). The government implemented the domestic offering first, using an extensive publicity campaign that included national television commercials, toll−free telephone numbers, and fullpage advertisements in major daily newspapers. Ten banks were nominated and eight registration points were set up to handle share applications. As a result 337,000 applications were received for 1.2 billion shares, totaling 3.43 trillion rupiah ($ 1.43 billion) of subscription money. The local tranche was fully subscribed at the maximum price of 2,800 rupiah (see table 8.10). In the meantime investors were expressing a number of concerns, including that: · The size of the offering, both domestic and international, was overly ambitious. · The indicative price range was too high. · The lock−up period was too long. · The five joint venture agreements had not yet been signed. · The poor performance of PT Tambang Timah, which was listed just before the launch of Telekom, creating an unhelpful market backdrop. These concerns weakened international demand for the issue during the book−building period, particularly in the

Figure 8.14 Indosat's trading performance, October 1994− June 1997 Source: Datastream/ICV. Performance of the Indosat shares and ADSs has been rather volatile

Telekom contributed to an increase in the market capitalization of the Jakarta Stock Exchange of more than $8 billion Deliveredresistance by The Worldfrom Bank e-library United States. As a result of the unexpected foreignto:investors, the government: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

· Downsized the international tranches from 70 million ADSs to 35 million ADSs (including a 5 million ADS Indonesian Telecoms (c) The International Bank for Reconstruction and Development / The World Bank

130

Privatization and Emerging Equity Markets greenshoe option that was subsequently exercised), representing 7.5 percent of the company. Thus only a 20 percent stake was sold in this offering. · Set the price below the indicative range, at $ 18.00 per ADS and 2,050 rupiah per share. The government's pragmatic adjustments restored support for the issue. Whereas the original indicative price range would have resulted in a price−earnings ratio of fifteen to nineteen times 1996 earnings, the final offer price reduced the ratio to fourteen times. At this price the stock looked attractive and demand was comfortably met. To facilitate the trading of Telekom shares, the Jakarta Stock Exchange was opened for a special night session on the day of listing to coincide with the opening of the New York Stock Exchange. Trading was active throughout the first day, with the stock closing up at $18.625 per ADS in New York and 2,175 rupiah per share in Jakarta. Despite the cut in its size and price, the offering raised $1.7 billion and was considered a success. Telekom contributed to an increase in the market capitalization of the Jakarta Stock Exchange of more than $8 billion.Thus a positive climate was created for the government's continuing privatization program.Telekom's privatization was followed by the $397 million privatization of Bank Negara Indonesia in October 1996.

Table 8.10 Structure and distribution of domestic share offerings for Indonesia Telekom's privatization Target

Percentage of company

Public

7.25

Local institutions

2.25

Fixed allotment with two−year lock−up

Pool (individuals and institutional investors)

5.00

50 loyalty bonus shares for the first 500 shares purchased and held one year

Government institutions

4.00

373.3

Fixed allotment with two−year lock−up

Employees

1.25

116.7

One−year lock−up

12.50

957.0

Total

Number of shares (millions)

Notes

467.0

by The World Bank e-library to: shares and the ADSs have been trading Telekom has performed quite well in Delivered the secondary market. Both the aaaaaa University significantly above the initial offering price and strongly outperformed the Jakarta Stock Exchange index IP have : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 of the employee lock−up period and the issue of (figure 8.15). Strong performance continued after the expiration the loyalty bonus shares at the end of the first year.

Indonesian Telecoms (c) The International Bank for Reconstruction and Development / The World Bank

131

Privatization and Emerging Equity Markets Given the stock's strong performance, the Indonesian government decided in December 1996 to sell an additional 388 million shares, representing 4.15 percent of the company and cutting the government's holding to 77.2 percent. This second offering took the form of an international private placement, chosen because of the speed of execution that this method allowed and capitalizing on the success of Bank Negara Indonesia's offering. The indicative price range was 3,4003,650 rupiah ($1.45−1.55).In the end the offering was priced at 3,700 rupiah, a discount of 4.5 percent over the day's close, and raised $61 1 million. Effect on domestic capital market. Indonesia's stock market has grown throughout the 1990s, with the number of companies listed on the exchange doubling between 1990 and 1996—from 125 to 253—and their market capitalization jumping from 8 percent of GDP in 1990 to 42 percent in 1996 (figure 8.16). Liquidity, as reflected in the value of trading on the exchange, has shown similarly strong growth. Between 1995 and 1996 trading value more than doubled as international

Figure 8.15 Indonesia Telekom's trading performance, November 1995−June 1997 Source: Datastream/ICV.

Figure 8.16 Indonesia's market capitilization, 199096 Source: IFC 1997. investors started turning their attention toward Indonesia (figure 8.17). The growth of the Indonesian stock market in the 1990s reflects the country's economic growth as well as the by The World Bank e-library to: effects of government policies aimed Delivered at liberalizing Indonesia's markets. The privatizations of Indosat and aaaaaa University Telekom helped deepen and broaden the market boosting its capitalization and increasing the number of large IP :by 111.111.11.11 11 been Jan 2111 companies traded on it. But Indonesia mayTue, have a 11:11:11 victim of its own success. The rapid growth of the domestic stock market was due in large part to foreign investment. Asia's recent financial crisis, which caused Indonesian Telecoms (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets foreign funds to exit the region in general and Indonesia in particular, has exposed the weaknesses of the stock market in the absence of foreign investment support.

Figure 8.17 Trading value on Indonesia's stock exchange, 199096 Source: IFC 1997. Note

1. Singapore Telecom was targeted at domestic retail investors to promote wider domestic ownership of government assets. The Indonesian government initially planned to sell 45 percent of its issue domestically and 55 percent internationally. Reference IFC (International Finance Corporation). 1997. Emerging Stock Markets Factbook. Washington, D.C. Between 1995 and 1996 trading value more than doubled as international investors started turning their attention toward Indonesia

4.9— Privatizing and Regulating Telecommunications Ioannis N. Kessides Privatization can vastly improve the economic and financial performance of telecommunications and other network industries. Efficiency gains, however; depend on the regulatory and competitive environment in which privatized firms operate. It is not enough to simply replace a public monopoly with a private one. There must be a commitment to rely on competition wherever feasible, and regulation should protect consumers and ensure a fair opportunity for all firms to compete for business. What is the best regulatory scheme? That depends on the industry's economic characteristics and the country's institutional endowment. The government must lay down economically sound criteria distinguishing between those areas where intervention by the public sector is warranted and those where it is not. Otherwise, regulation Delivered by The World Bank e-library to: may do more harm than good. Furthermore, if aaaaaa the regulatory University system is incompatible with the country's IP to : 111.111.11.11 institutional endowment, privatization may lead disappointing results, recrimination, and calls for Tue, 11 Jan 2111 11:11:11 renationalization. This chapter analyzes the interaction between regulation and privatization from a general Note

133 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets perspective and specifically within the telecommunications sector. When to Regulate—and how Much? Even in the best of circumstances, market forces work imperfectly in pushing an economy toward efficiency, and in many instances the market cannot be relied on for selfdiscipline. Thus government intervention can be justified if there is a market failure, and if the intervention has a reasonable chance of correcting it. Most regulatory schemes, however; have been based on undue skepticism about competition and undue optimism about the ability of government to increase efficiency through intervention, Moreover, there are many examples of maladministration even where regulatory rules are simple. Thus serious doubts have been raised about the efficacy of regulation. Is the cure worse than the disease? Over the past decade many countries have made great strides toward total deregulation of some markets and less comprehensive regulation of others. While the most dramatic manifestations have been in industries with competitive market structures, there has also been a major reassessment of regulatory policy in natural monopoly (or oligopolistic) industries. It is increasingly recognized that government intervention imposes substantial economic costs. It discourages investment, shelters inefficiency, raises costs, undermines incentives, promotes misallocation of resources, engenders wasteful competition, and limits the public's price and quality options. In addition, developments in the theory of industrial organization have increased tolerance of natural monopoly while lessening the need for public intervention. Recent intellectual developments call for a major reorientation of traditional regulatory rules and procedures and offer guidance to regulators. They provide better criteria for distinguishing between cases where intervention is

warranted and those where it is not. They also establish better guidelines for appropriate intervention in the structure and conduct of firms when intervention is called for—that is, they offer more effective tools to the regulator that increase the public welfare effects of intervention. The need for regulatory scrutiny has been increasingly called into question in markets with low entry barriers, even in the case of natural monopoly. (It has been plausibly argued that potential competition can constrain market power almost as effectively as would actual competition.) In most regulated sectors, rate−of−return regulation or cost−of−service regulation has been the main government control over potential monopoly abuse. Both have serious defects, however, Most notable are the lack of incentives for regulated firms to minimize costs and the high direct administrative costs of enforcement—for both the regulator and the regulated.Thus there has been a shift toward incentive regulation, which offers financial rewards or imposes penalties tied to some measure of the regulated firm's performance. Basic Privatization Considerations A primary objective of economic policy should be to promote effective competition, to induce a more efficient allocation of resources. Privatization, along with other instruments of microeconomic policy, can help achieve that goal by changing the structure of incentives and opportunities for decisionmakers within firms. Efficiency improvements, however depend crucially on the competitive and regulatory environment in which privatized firms operate. In infrastructure industries, where public ownership is extensive, private participation has been constrained by concerns about market failure. But recent advances in economic theory—especially recognition of the importance Delivered by The World Bank e-library to: aaaaaa University of principal−agent effects—and substantial technological and structural changes in these industries call for a IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 The primary concern now is how to promote and reassessment of conventional policies and ownership structures. maintain effective competition through privatization of natural monopolies. When to Regulate—and how Much? (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets The structure of property rights has significant effects on the behavior and performance of firms. Private firms are generally more efficient than public ones, and in most markets the benefits of private monitoring seem to easily outweigh the potential drawbacks in allocative efficiency. It is widely recognized that markets are remarkably effective at allocating resources among competing uses and at promoting innovation, productivity and growth. But it is also widely (though not universally) accepted that in some industries technological conditions and other unavoidable circumstances render the laissez−faire position untenable. The relationship between the managers and owners of a firm gives rise to specific agency problems. The owner of the firm (principal) seeks to establish incentives that will induce the manager (agent), who does not necessarily share the same objectives, to act in ways that contribute maximally to the principal's interests.The main difficulty in establishing such an incentive structure is that the principal does not have full information about the agent's circumstances and behavior. In a private firm the pursuit by management of its own objectives is constrained by shareholders, creditors, and potential investors. Other mechanisms also provide incentives for managers to act in shareholders' interests. First is the market for managers inside and outside the firm—the value of the manager's human capital is likely to depend on the value of the firm as reflected in its share price. Second, managers will try to maintain the value of the firm's shares to minimize the cost of capital to the firm.Third, privately owned firms can tie managerial compensation to corporate performance through bonuses and stock options. All these mechanisms are less effective or nonexistent in state−owned enterprises. Principals (governments) do not seek to maximize profits, their shares are nontransferable (so there is no market for corporate control), and there is little threat of bankruptcy as a constraint on financial performance. Politicians, who have the power to dismiss managers, are subject to pressure from customers and employees, who do not want to see profits achieved at the expense of high prices or low wages. On the other hand, public ownership can correct failures in the markets for goods, factors, and corporate control. Government can take immediate account of deviations between social and private returns in goods and factor markets. Other alleged advantages of public ownership include the channeling of returns on capital to the state rather than to a few private individuals, and the ability to raise capital at no risk premium through government risk pooling. Neither form of ownership—public or private—is superior to the other in all industries and all countries. Privatization can induce a more efficient allocation of resources by changing the structure of incentives and opportunities for decissionmakers within firms

Privatization must be supported by a policy plan that specifies the industry structure and regulatory regime Nevertheless, the evidence on comparative performance indicates that the weaknesses of public monitoring are so serious and so pervasive that a general presumption in favor of private ownership is justified. The Need for a Policy Plan Infrastructure sectors run by state−owned monopolies must be restructured to contribute to economic growth. One key element of restructuring is to develop an internal organization of network utilities that provides managerial incentives, disseminates information, Delivered and decentralizes to foster efficiency, market by The World decisionmaking Bank e-library to: aaaaaaisUniversity responsiveness, and fiscal responsibility. Another to unleash market forces of competition. Private ownership is IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 For privatization to make the maximum not a panacea for improving economic performance, however. contribution to economic efficiency and prosperity, it must be supported by a policy plan that specifies the The Need for a Policy Plan (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets industry structure and regulatory regime. Industry Structure.

One important lesson that emerges from the experiences of both developed and developing countries is that for privatization to generate significant gains in economic efficiency, it must be accompanied by market liberalization and competitive restructuring. The public interest in competition should not be sacrificed for short−run fiscal benefit. At the same time, privatization should not support overlapping concessions if there are conditions for natural monopoly with high sunk costs. Policymakers have taken two broad approaches to restructuring network utilities. The radical approach has been to vertically separate the monopoly segments (for example, transportation and distribution) of these industries from the structurally competitive ones (upstream production and downstream marketing). In telecommunications this entails separating local from long−distance service. The second approach is to allow integrated operations by the dominant incumbent provided that it makes its facilities available to other entities on a fair and equal basis. The primary virtue of the separation option is that it may allow active or potential competition to reign, with corresponding assurance of efficient selection among firms for provision of services at efficient prices. But although vertical separation mitigates, it does not fully resolve the difficulties of determining and regulating access charges. On the other hand, the competitive access option could be fraught with problems if bottleneck holders are averse to efficiency and competition. Regulatory Regime

Defining and establishing components of the regulatory regime is an indispensable precondition for successful privatization. Pricing policy. The public is not well served by regulations that make network utilities unable to compete in the financial marketplace and result in systems that are increasingly obsolete and run down. (Witness Brazil's telecommunications sector, where a government−imposed pricing policy effectively decapitalized the system.) Thus rate regulations should avoid undermining the financial viability of firms. There is no need for regulatory control over rates for competitive utility services. Government intervention merely impedes the efficiency of rate determination and resource allocation. Moreover little control need be exercised over rates set by a utility whose revenues are inadequate. In the long run the best rates (in terms of the public interest) are those that maximize a utility's net revenues, and any utility with inadequate revenues has powerful incentives to select such rates. In such a case the utility has no monopoly power that offers it excessive profits, and for individual services for which competition is inadequate, the stand−alone cost test protects consumers. Regulator commitment. Effective privatization and sustained large−scale private investment require that a country have the institutional capacity to restrain arbitrary political interference and credibly commit to a stable regulatory process. In many infrastructure sectors, transportation and distribution networks require large investments that are mostly sunk. Private utilities that are vulnerable to political interference may invest less than is optimal. Without government commitment to regulatory stability, frequent changes can have the same effect as expropriation of sunk investment. Substantive and procedural restraints on regulatory discretion and regulatory opportunism are another necessary condition for effective private investment. At the same time, regulatory flexibility is imperative in sectors that are Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Industry Structure.

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Privatization and Emerging Equity Markets experiencing rapid technological and market changes. The challenge is to ensure regulatory flexibility, stability, transparency and predictability. Harmonizing regulatory policies. The regulatory oversight of monopoly activities must be harmonized with that of increased competition. Many privatized utilities are subject to restraints that are not present in unregulated markets and that do not apply to the same degree, to potential entrants. This lack of harmony distorts the forces that would otherwise drive market outcomes to efficiency and might create inefficiencies of supply. Moreover; traditional regulation often leads to prices with elements of cross−subsidization. With competition, entrants will be impelled by the profit motive to divert the overpriced business but are unlikely to relieve incumbents of the financial burden of providing services if prices do not cover costs. Regulatory Issues in Telecommunications In recent years global demand for better and more varied telecommunications services has increased substantially. Many commercial activities—banking and international finance, tourism and travel, publishing, commodity exchange, most export−oriented manufacturing—depend on global information and efficient electronic exchange. Consequently, the quality of a country's information infrastructure is considered increasingly important in determining its success in improving its balance of trade and economic performance. Information is vital to corporate survival, and it is crucial to an economy's viability. For the past twenty years telecommunications policy in many industrial countries has been formulated as part of far−reaching global strategies. In Great Britain, for example, a liberalized telecommunications regime was intended to support and augment London's role as an international financial center. In the Netherlands telecommunications policy was intended to stimulate the development of electronic publishing and to promote Amsterdam as a point of access to Europe for international networks, in direct competition with London. A key objective of Australia's telecommunications policy has been to attract commercial traffic destined for Southeast Asia and encourage financial services businesses to locate in Australia. In Japan national pricing structures were adopted to stimulate the growth of sectors with vital links to the information infrastructure. In the past most countries provided telecommunications as a user−pay service administered by the central government. This approach was based on the premise that the industry was a natural monopoly. Competition, it was believed, would duplicate investment, raise costs, and inflate rates. Today the telecommunications industry is undergoing massive changes in manufacturing, investment, and market orientation and is experiencing the throes of entry, rivalry and diversity. Technology is the force driving these adjustments. Advances in technology have led to the transfer of larger volumes of information, at faster speeds, with superior accuracy and at rapidly declining costs. In some countries these changes have led to the introduction of competition, and the evidence suggests that the benefits are substantial: a proliferation of new products and services, more efficient and sophisticated means of transferring information, more efficient use of scarce telecommunications resources, more price options, and greater responsiveness to the needs of consumers. The technological revolution has generated enormous pressures on many countries to modify public policies toward telecommunications. Traditional telephone systems are increasingly seen as incapable of responding to the information challenge. Many industrial countries have already made profound changes in the policies, structure, and regulation of their telecommunications sectors. Technological Change and Telecommunications Delivered by The World Bank e-library to:

University and the impact has been massive—but uneven. Cost New technologies involve both switching and aaaaaa transmission, IP : 111.111.11.11 reductions have been notable in long−distance transmission; access technologies have advanced less rapidly. Tue, 11 Jan 2111 11:11:11 Although technological change has driven the entire industry it has undermined natural monopoly in

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Privatization and Emerging Equity Markets interexchange markets more than in local−exchange service. In local−exchange service digital technology has been rapidly supplanting analog applications in switching. Systems for load balancing, billing, number changes, and other housekeeping functions are now available in automated form. Furthermore, the development of remote maintenance and housekeeping technologies implies that even relatively small firms can capture economies of scale in these overhead activities by centralizing The telecommunications industry is undergoing massive changes in manufacturing, investment, and market orientation

Regulation tends to react much more slowly than the marketplace to changing technology them. As a result economies of scale in overhead activities are now probably small and certainly declining. New transmission technologies for local exchanges include cable−based telephone access, cellular radio, and direct microwave links to local or long−distance switching nodes. Cable−based access exhibits economies of scale similar to those of wire−based access. For cellular radio, the problems of allocating scarce radio frequency still limit the number of allowed carriers. Finally, microwave links typically entail large fixed costs and carrying capacities and thus are limited to highvolume transmission routes. As such, they do not offer a viable option for linking individual users to the basic telephone network. Despite these advances and the increase in the number of potential competitors to local−exchange carriers, economies of scale in local transmission and distribution have not been eliminated. The impact of new technologies on network planning and management economies is more ambiguous. Costs are likely to fall but, to the extent that such overhead costs are fixed, the economies of scale are reduced. But greater computing power may increase the advantages enjoyed by the competitor with the most extensive network. Similar countervailing forces may be at work regarding network externalities. The important point is that the impact of new technologies in reducing natural monopoly elements is likely to be smaller in network externalities and network management economies than in basic service provision. Rapid technological change is likely to accentuate the advantages of large networks in raising capital, which could reinforce the argument for natural monopoly in telecommunications. Such change may effectively increase the risk perceived by investors because product innovations face an inherently uncertain reception from consumers, stable pricing arrangements are no longer feasible, the likelihood increases that investments will be made in the wrong technologies, and the proliferation of suppliers raises the risks of incompatible equipment. As a result the difficulty of raising capital on acceptable terms is likely to increase and the advantages of having a single, stable service provider may become greater. Alternative Strategies for Regulatory Reform

Only sound regulatory policies that optimize the efficient use of telecommunications resources will allow continued innovation (especially by the private sector) and ensure that society does not suffer an unnecessary reduction in economic welfare. The case for deregulation. In telecommunications a primary goal is to control monopoly power and protect the consumer. For much of this century and in most countries, fairness and efficiency have been sought through the public utility form of government regulation. Critics argue that government intervention in telecommunications Delivered by The World Bank e-library to: Universitydirect and indirect (or opportunity) costs on society. through regulation and ownership has imposedaaaaaa significant IP : 111.111.11.11 They say it exacts significant efficiency costs allocation by: Tue,in 11 resource Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Distorting prices with the use of average prices for groups of services rather than individual prices for the services in each group, shifting costs to future periods by using uneconomically slow depreciation rates, and crosssubsidizing local with long−distance service and residential with business customers. Distorting investment decisions and limiting private incentives to innovate with new technology. Discouraging innovation that would render obsolete large quantities of embedded equipment included in the rate base. Such regulation also tends to deter price competition, provides only limited incentives to cut costs or increase managerial efficiency and generally limits the choices available to consumers. Furthermore, regulation tends to react much more slowly than the marketplace to changing technology and frequently limits the ability of market participants to respond quickly to changes in demand and supply. Finally regulatory rate making not only leads to significant administrative costs but also is subject to serious practical difficulties, making elusive the goal of keeping prices close to costs. Thus an optimal regulatory strategy in telecommunications should seek to isolate those segments of the market still considered to involve natural monopoly (local telephone service) from segments that are no longer natural monopolies (such as long−distance services and the provision of terminal equipment).The network externality is the other market failure that prompted regulatory intervention in telecommunications. It is most significant at low levels of household telephone penetration, and in some countries has been extremely important in the development of the system. If deregulation

happens, this form of market failure is likely to return. Hence some other means of control must be identified. Promoting regulatory reform. Regulatory reform depends on a country's circumstances—in particular; its regulatory background and administrative and political institutions. Most regulatory reform seeks to establish an arms−length relationship between government and service providers to ensure that providers have the flexibility needed in a rapidly changing market environment. Separating operational activities from government oversight and regulation is perhaps the most important element of regulatory reform.This separation is necessary to ensure fair and impartial policy development, insulate telecommunications from short−term political pressure, and ultimately admit competition. Governments have a strong incentive to pursue policies with short−term benefits, even if they have high long−term costs. As a result the financial targets imposed on public enterprises often vary from year to year creating uncertainties in planning. When budgetary constraints are tight, governments also use public enterprises to advance political and social goals. The costs imposed on telecommunications carriers by public service obligations should be accounted for as carefully as possible and made publicly known. In addition, financial targets and other requirements should be set on a medium−term rather than an annual basis. In some countries efforts at regulatory reform could be unduly constrained by inherited problems. Experience indicates that most governments do not easily and willingly give up the instruments they have in hand. As long as publicly owned telecommunications operators comply with government requests, they may face little pressure to make efficient use of resources. In such cases the only way to break through bureaucratic inertia, political favoritism, and apathetic service delivery is through more fundamental and radical structural change—in most cases, privatization. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Structural Issues

Structural regulation determines which firms are allowed to engage in which activities. In telecommunications structural regulation is often concerned with the extent to which firms operating in one regulated market are allowed to enter others. For example, should a telecommunications firm be allowed to vertically integrate across manufacturing, interstate toll service, and local−exchange service? Vertical integration. The main argument against vertical integration is that it can be used strategically to achieve anticompetitive effects. Established firms may use vertical integration to increase finance requirements and discourage entry if potential entrants feel compelled to adopt the prevailing structure (and they often do). Moreover; firms may use the excess profits they realize in activities where they enjoy market power to finance aggressive behavior in markets where they face competition. Telecommunications regulators must ask whether separation should be imposed on the activities of network operation and equipment manufacturing; local, long−distance, and international operations; fixed and mobile network operations; and the activities of network operations and the retailing of services over the network. These questions entail a tradeoff between cost−efficiency advantages and anticompetitive disadvantages of integration.Thus the case for allowing vertical integration depends on the effectiveness of regulating conduct. In most cases regulatory policy should encourage equal access to local telephone systems. Freedom of entry is preferable to arrangements that bar local telephone operators or other firms from manufacturing or selling telephone equipment. Vertical integration in equipment manufacturing, however, allows monopolists to evade regulation by transferring monopoly prices of services to the manufacturer through high equipment prices. Another concern is that monopolists might engage in economically unwarranted self−dealing by purchasing from their affiliates even if competitors offer better equipment at lower prices. The issues involving local service relative to long−distance service are more complex, partly because of the problem of shared costs and the efficiency derived from coordinated operation of an integrated network. Dominant telecommunications carriers might use their market positions in basic transmission services to discriminate against competitors that rely on those services. For example, dominant carriers could adopt network interconnection standards to limit competition from other carriers.They could also improperly subsidize competitive services with revenues from regulated services. In most cases regulatory policy should encourage equal access to local telephone systems

Although market liberalization has generally led to significant improvements in service and performance, many policymakers question its appropriateness for developing countries Regulators generally face a difficult, if not hopeless, task in preventing cross−subsidization of competitive services, discriminatory acts against competitors, and, ultimately evasion of regulatory objectives for captive monopoly customers. Given these realities of regulatory practice, quarantine (whereby the regulated monopoly carrier is prevented from participating in potentially competitive markets) might be appropriate. In this context the separation of local and longdistance services represents an attractive structural option. Access pricing and interconnection issues. Like other network utilities, telecommunications features transportation and distribution networks (transmission media and switching centers) linking upstream production with downstream consumption. In many activities is much competition; in others it is weak or nonexistent Delivered by The there World Bank e-library to: aaaaaa University (at least given current technology). Whereas interexchange service is now regarded as fully competitive, entry IP : 111.111.11.11 into this market requires access to subscribers the2111 local−exchange loop, which retains many of the Tue, in 11 Jan 11:11:11 characteristics of natural monopoly. These basic network elements are inputs without which suppliers cannot hope Structural Issues

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Privatization and Emerging Equity Markets to operate. As such, these services are called bottlenecks or essential services. Without regulatory constraint, the holder of the bottleneck monopoly could repress competition by creating artificial handicaps for its rivals.This is the fundamental complicating phenomenon hindering the deregulation of local−exchange service. As technological change and deregulation reduce entry barriers in telecommunications, rival firms will seek to interconnect to the network at more locations than in the past. At each point an access price will have to be determined. The primary challenge for public policy is to set a level and structure of access prices that promote dynamic efficiency through efficient entry and investment decisions while enabling the incumbent firm to remain financially solvent and sustain the cost of social obligations. Thus regulation should ensure that there is sufficient pressure on the incumbent to operate in an efficient manner but that no unnecessary duplication of network construction takes place. Policy Tensions in Countries with Underdeveloped Networks

Since the early 1980s many countries—notably the United States and several countries in the European Union—have liberalized their telecommunications markets. Most enjoyed fully developed telecommunications networks and had already made significant progress toward rate rebalancing by the time they embarked on regulatory reform. Although market liberalization has generally led to significant improvements in service and performance, many policymakers question its appropriateness for developing countries. There is no empirical evidence that a public network can move from low penetration to universal access while simultaneously allowing competitive entry for providers of network infrastructure and basic services. No firm is likely to target less attractive market segments until significant rate rebalancing is implemented. Countries that have introduced competition did so only after most of the population was served by a fully developed network. Without exception, these countries used internal price subsidies to develop their public networks. Subsidies were directed from international services to domestic, long distance to local, business to residential, and urban to rural. In a developing country a successful open entry policy would depend on a firm's ability to serve both the lucrative, telecommunications−intensive, large−customer market and the residential and rural markets. But if a firm is obligated to provide universal access, it may not be able to generate sufficient revenue to finance the development of the public network infrastructure while other entities compete for more lucrative segments of the market. Competitive pressures would drive down the margins available from services sold to large customers. All this suggests that there is a serious policy tension between basic network development and market liberalization. Indeed, several developing countries that have privatized their telecommunications industries in recent years have granted an exclusivity period during which privatized entities have been protected from competition—ostensibly to finance network expansion with retained profits. Opponents of this approach argue that the rapid technological change of the past few years has largely eliminated the need for exclusivity to finance network development, since new technologies are offering low−cost alternatives to the traditional fixed−loop network. Consequences of Structural and Regulatory Ambiguity—Russia's Privatization

In late 1995 the Russian government sought to sell a 25 percent stake in Svyazinvest, the holding company for regional

telecom firms, to a strategic investor. The effort failed, however, because the government lacked a clear vision for Delivered by The World Bank e-library to: the sector's medium−term structure, and because sector regulations were poorly defined. aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Especially problematic was the uncertainty about the future structural and competitive relationship between Svyazinvest and Rostelecom, the long−distance carrier. The Ministry of Communications sought to protect Rostelecom's market position by attaching significant restrictions to Svyazinvest's international services. Such protection was likely to prove unsustainable, however, because of Svyazinvest's control over bottleneck input facilities (local loop). Without access to these facilities, Rostelecom would not be able to offer long−distance service. Many industry observers argued that direct competition between Rostelecom and Svyazinvest would lead to socially wasteful duplication of investment in telecommunications infrastructure. Some called for an outright merger of Rostelecom and Svyazinvest. A protected national monopoly structure has several advantages. First, it would facilitate privatization and almost certainly increase the sales price. Second, it would respond to the concern that with an unbalanced structure of tariffs, entrants will cream skim the most profitable markets and leave the incumbent national entity to serve the unprofitable ones, causing network development to suffer. Third, its implicit internal cross−subsidy mechanism would eliminate the need for immediate and substantial tariff rebalancing—a politically painful process. A protected national monopoly suffers from several serious disadvantages, however. Because of modern technology, there will likely be no element of the system that is a secure natural monopoly in the future. Indeed, the most important potential impediment to competition is likely to be anticompetitive government intervention. A ubiquitous monopoly structure would thus be artificial because it would be inconsistent with the emerging technological and economic characteristics of the industry. With the expected technological onslaught, its regulatory preservation would impose substantial costs on the Russian public. Second, the current regulatory pricing structure varies substantially from that which effective competition would produce. Indeed, economic efficiency would dictate significant changes in rates for different basic services. A national protected monopoly would eliminate most pressure for serious tariff rebalancing. And as international callback and other arbitrage mechanisms spread, value added services become ever closer substitutes for basic services, and other forms of effective competition become feasible with rapidly changing technology, today's artificial pricing structure would collapse, leading to serious dislocations for the industry and its customers. Third, even if extensive cross−subsidies need to be maintained on social equity grounds, this is not the way to do it. The best approach is specific, targeted subsidies based on competitive bidding to customer classes that cannot profitably be served and that, as a matter of policy, deserve to be. Subsidy revenues can be raised from a tax on telecommunications services and equipment. Service to areas with low population density can be provided by competitive bids for franchises. The relatively low level of investment in telecommunications technology in Russia implies that it can largely bypass the era of a ubiquitous monopoly telephone company. With most citizens currently unserved, and few enhanced services available, Russia will experience relatively little disruption and other transition costs from adopting an aggressively procompetitive policy. What are the key elements that will accelerate investment in telecommunications infrastructure? First, the extent of desirable subsidization must be clearly identified and the means of providing it isolated so that the damage to the efficiency of the rest of the system can be minimized.The best policy is to create competition for the role of providers of subsidized service, and to separate raising subsidy funds from allocating them. Second, the government must promulgate and enforce nondiscriminatory interconnection rules. Separation of operational and regulatory activities. OneBank of the main Delivered by The World e-library to: reasons the initial effort to privatize Universitytelecommunications mixes operational and regulatory Svyazinvest failed is that the regulatory regimeaaaaaa governing IP : 111.111.11.11 Tue, 11playing Jan 2111 11:11:11 responsibilities and so does not promote a level field. The first step toward liberalization of telecommunications markets generally is to separate the two activities to ensure fair policy development and Policy Tensions in Countries with Underdeveloped Networks (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets ultimately admit competitive entry. An efficient and well−focused regulatory structure is crucial to the success of telecommunications reforms. The regulatory agency ultimately must establish regulations, work with carriers, assess developments in the marketplace, and The first step toward liberalization of telecommunications markets generally is to separate operational and regulatory responsibilities

Regulatory uncertainty undermines investor confidence and weakens the government's bargaining position develop and modify telecommunications policies for the future. It is not enough to make an initial determination of what is reserved for monopoly, what is competitive, and identify the social obligations to be met. A strong and effective regulatory entity could act as a buffer between operators and government, ensure that operators conform to economic and social objectives, resolve disputes between competitors and between consumers and operators, and monitor changing industry conditions. Regulatory commitment. The lack of a well−defined regulatory regime and the policy uncertainty during the previous Russian privatization effort resulted in investors demanding high risk premiums—their offer for a 25 percent interest in Svyazinvest was well below the valuations achieved in comparable transactions. Such premiums are unlikely to decline because potential investors have little confidence in the government's ability to implement any proposed regulatory regime. Government commitment to refrain from interfering in the activities of private firms in competitive markets is a crucial component of a market−friendly economic environment. That the Russian government cannot commit itself is illustrated by investors' concerns about tariff policy. In November 1995 the government proposed a specific mechanism to regulate telecommunications tariffs, with precise formulas for adjusting such tariffs. Nevertheless, potential investors complained about the lack of clarity on the overall price and rate regulatory scheme.The investors simply did not believe that the government would implement the proposed rate scheme. After several aborted attempts, in the summer of 1997 a 25 percent stake in Svyazinvest was finally sold to a consortium led by the Russian bank Oneximbank.The $1.8 billion price paid was hailed by the officials who managed the transaction as evidence of transparency and competitive bidding. That was probably not the case, however—because of the continuing lack of structural and regulatory clarity, the price paid was far below those offered for other systems of similar size and market growth potential. Moreover, claims that the tender process was truly competitive and transparent were contradicted by revelations of collaborative pre−tender strategic positioning and apparent exchange of information between the two competing consortiums. Importance of Regulatory Commitment—Privatization in Argentina.

Telecommunications was the first major sector to be restructured and privatized by the Argentine government (see chapter 6). Because it had little experience, the government did not pay enough attention to establishing a clear legal and regulatory framework for the sector. No sector law was enacted, as was the case in the subsequent restructuring of electricity and gas, and the telecommunications regulatory agency was established after the privatization transaction was completed. The regulatory regime remained largely undefined until the end of the bidding process. This delay prevented the Delivered by The World Bank e-library to: aaaaaarespect Universityto the functions of the sector's regulatory agency. Thus implementation of key provisions, especially with IP : 111.111.11.11 bidders had no information on the agency'sTue, operating rules and procedures—for example, procedures for verifying 11 Jan 2111 11:11:11 compliance with the terms and conditions of the license, tariff adjustment mechanisms, and so on. Moreover, Importance of Regulatory Commitment—Privatization in Argentina. (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets frequent regulatory revisions during the tender process created confusion and uncertainty in the minds of potential investors. The effective tariff level remained undecided at the June 1990 deadline for submitting final bids. Initial investor interest in the privatization of Empresa Nacional de Telecomunicaciones (Entel) was strong. Fourteen potential investors bought bidding documents. Only seven consortiums applied for prequalification in April 1990, however. Although all seven qualified, only three submitted final bids for the two telecommunications entities that were created out of the geographic splitting of the company. This attrition, largely due to regulatory uncertainty, substantially weakened the government's bargaining position and almost surely depressed the price offered. Subsequent analyses of the price offered have indicated that the sale of the first tranche of the two telecommunications companies entailed substantial risk premiums. These premiums seem to have declined, however, as the government made progress in implementing its regulatory regime. The reduction in regulatory risk was accompanied by significant investment by the two newly privatized entities.

5— PRIVATIZATION GENERATES NEW AND BROADER TYPES OF INVESTOR PARTICIPATION 5.10 American Depository Receipts, Global Depository Receipts, and Other New Financing Instruments 5.11 The Evolution of Emerging Market Equity Funds 5.12 Pension Funds, Capital Markets, and Privatization in Chile, Bolivia, Singapore, and Peru 5.13 Broad Ownership Schemes in Chile, Malaysia, and the Kyrgyz Republic

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5.10— Delivered by The World Bank e-library to: University American Depository Receipts,aaaaaa Depository Receipts, and Other New IPGlobal : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 Financing Instruments 5.10— American Depository Receipts, Global Depository Receipts, and Other New Financing Instruments 145 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Phumchai Kambhato International issues of emerging market equity have boomed in recent years. With this boom comes a need for instruments that enable international institutional investors to invest in companies located in countries with nascent capital markets. Depository receipts, for example, allow international investors to trade in the equity of an emerging market company using the custody and settlement facilities of the major international markets (London, New York). A going public bond enables a not−yet−privatized company to raise equity capital on the terms of its eventual initial public offering before it has achieved listed status. These instruments allow companies and countries to raise foreign capital earlier and on better terms than would otherwise have been possible. And if they are used in conjunction with—rather than as a substitute for—the development of a fully functioning domestic capital market, the instruments foster local market development by creating broader demand for its equity, establishing international reporting and disclosure standards, and encouraging the application of cross−national valuation benchmarks.This chapter assesses some of the financing instruments used in privatizations—including depository receipts, exchangeable bonds, and going−public bonds—and documents their interaction with capital market development. Depository Receipts A growing number of companies, particularly those in emerging markets, are raising capital from international investors by issuing depository receipts. The globalization of equity markets and emerging market companies' increasing demand for capital have hastened the growth of depository receipt programs. Despite setbacks resulting from the 1987 U.S. stock market crash and the 1984 Mexican peso crisis, the number of participating companies and the amount raised through depository receipt issues have risen exponentially since their inception in 1983 (figure 10.1). By the end of 1996 more than 1,300 depository receipt programs had been established by companies from sixty−three countries. Some 736 programs raised almost $95 billion of new capital. Of these, 27 percent came from Asia and the Pacific, 53 percent came from Europe and Africa, and 21 percent came from Latin America. The secondary market trading value of depository receipts totaled $341 billion in 1996 and rose 53 percent in 1997. Depository receipts have played an important role in nearly every recent major privatization, particularly in emerging markets—mainly because the size and profile of these offerings are attractive to international investors. Moreover, depository receipts deliver several useful benefits to companies and equity markets. They: · Provide access to a broad investor base and large pool of investment funds—even for companies that have already attracted the attention of international fund managers—thereby increasing liquidity.

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Privatization and Emerging Equity Markets Figure 10.1 New depository receipt issues by region. 198396 Source: Capital DATA Bondware. · Introduce international investors to a market that they would not otherwise have been comfortable entering. In the long run this will deepen the local stock market, as it establishes itself as the primary market for issuers' shares. · Increase competition in the local market, forcing it to become more sophisticated to attract international investors. · Affect a company's valuation because foreign investors tend to apply international valuation benchmarks. This may result in a higher valuation and contribute to lower price volatility. · Create a culture requiring better reporting and higher disclosure requirements, which can also encourage domestic investor interest. Anatomy of Depository Receipts

Depository receipts are negotiable certificates that evidence ownership of a company's shares. Thus they are a direct proxy for the underlying shares. These certificates are created through a depository in a custodian bank that holds the equities on the local market. Depository receipts are typically listed on the primary stock exchanges in the United States, London, or Luxembourg. Because they may be more liquid and more easily traded than the underlying shares, depository receipts are an effective mechanism for equity investment by international investors in emerging markets (table 10.1). Depository receipts are generally targeted at sophisticated international investors—mainly financial institutions. Regulations governing the activities of many such investors require that a significant portion of the securities in which they invest be listed on a recognized stock exchange (such as those in New York, London, and Luxembourg). But the issuing company may have difficulty fulfilling the requirements for a direct listing of its equity, and the associated costs may be prohibitive. By using depository receipts, the issuer gains access to the broadest possible investor base through an instrument that is listed or traded over the counter on a recognized stock exchange—and avoids the onerous compliance requirements of a direct listing. In most cases depository receipts can be converted back into a direct holding of the underlying shares. And because depository receipts are registered, ownership rights are clear. Finally, depository receipts can be issued with or without the voting rights of the underlying shares. Depository receipts are denominated in U.S. dollars, which are universally accepted by international investors. Since dividends and other distributions on depository receipts are paid in U.S. dollars (translated at the prevailing spot exchange rate), investors avoid the conversion costs and accounting complexity of dividends and other distributions that are declared and paid in a foreign currency. Investors remain exposed to the currency in which the underlying company operates, however. Clearing and settlement of depository receipts are done though the Depository Trust Company in the United States and through Euroclear or Cedel in Europe. These institutions are familiar to Depository receipts are an effective mechanism for equity investment by international investors in emerging markets

ADRs were developed in 1927 as markets

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issuers seeking access to U.S. equity

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Table 10.1 Ten largest emerging market d epository receipt offerings

Issuer

Economy

Issue size (millions of U.S. dollars) Date

Yacimientos Petroliferos Fiscales (YPF)

Argentina

2,280

June 1993

19.00

New York, SEAQ International

China Telecom (Hong Kong) Ltd

Hong Kong

2,237

September 1997

30.50

New York,

Teléfonos de México (Teimex)

Mexico

2,017

May 1991

27.25

New York, SEAQ International

Teléfonos de México (Teimex)

Mexico

1,243

May 1992

56.125

New York, SEAQ International

Uniao de Bancos Brasileiros

Brazil

1,122

May 1997

33.75

New York

Yacimientos Petroliferos Fiscales (YPF)

Argentina

988

July 1997

29.25

New York, SEAQ International

Teleónica del Perú

Peru

918

July 1996

20.50

New York, SEAQ International

PT Indonesia Satellite Corp

Indonesia

904

October 1994

32.05

New York

Compania Anonima Naciaonal Telefonos de Venezuela

Venezuela

904

November 1996

23.00

New York, SEAQ International

Pakistan Telecommunication Co

Pakistan

898

September 179.62 1994

Offer price (U.S. dollars)

Depository receipt listing/quotation

Porta

Source: Capital DATA Bondware. international investors, and clearing and settlement through them are generally more efficient than through the domestic market. Types of Depository Receipts

There are two main types of depository receipts. The first is American depository receipts (ADRs) and American depository shares (ADSs), which are traded and listed in the United States. The second is global depository receipts (GDRs) and global depository shares (GDSs), which are typically listed in London or Luxembourg (figure 10.2). A company occasionally issues international receipts (IDRs), though these are relatively uncommon. Delivered depository by The World Bank e-library to: aaaaaa University IDRs are denominated in currencies other than the U.S. dollar, usually issued in bearer form, and traded only in IP : 111.111.11.11 Europe. Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets American depository receipts. ADRs were developed in 1927 as the main vehicle for non−U.S. equity issuers seeking access to U.S. equity markets. ADRs may be issued by the company (sponsored) or by a third party (unsponsored). There are four levels of access for ADRs. Level 1 ADRs are traded over the counter in the United States. They are not listed on a U.S. stock exchange, though they may be listed on exchanges outside the United States. These receipts are generally considered the first step into the U.S. public equity market. Level 1 ADRs offer some important advantages: there is no requirement for compliance with U.S.

Figure 10.2 New depository receipts issues by type, 198396 Source: Captial DATA Bondware.

generally accepted accounting principles or for full disclosure to the U.S. Securities and Exchange Commission, and the associated direct costs are low relative to other types of ADRs. The lack of a formal stock exchange quote can, however, result in subsequent illiquidity and opaqueness of trading. In addition, no new capital can be raised through this type of ADR. Level 1 ADRs are meant to support secondary trading of an issue and to acquaint international institutional investors with a particular company. Level 2 and level 3 ADRs are listed on a U.S. exchange. Level 2 ADRs are created against existing shares and cannot be used to raise new capital. Level 3 offerings can be used to raise new capital, thus involving a U.S. public offering. Both have the same U.S. Securities and Exchange Commission registration and reporting requirements, and must adhere to U.S. generally accepted accounting practices and comply with the listing requirements on the U.S. exchange where they choose to list (New York Stock Exchange, American Stock Exchange, or NASDAQ). The strict reporting regulations are intended to protect U.S. investors, particularly the largely unsophisticated retail base. The initial direct transactions costs associated with level 2 and level 3 ADRs can be substantial. Companies wishing to avoid the full registration and reporting requirements associated with a U.S. public offering can place ADRs privately in the United States under rule 144a, thereby gaining access to U.S. institutional investors but not the retail base. A rule 144a registration allows qualified institutional buyers to subscribe to and trade ADRs and thus increases their liquidity. The initial costs associated with a rule 144a ADR are much lower than a registered ADR offering. Global depository receipts. There are no subclassifications of GDRs, which can represent new and existing shares and are normally listed in London or Luxembourg. ADRs and GDRs are essentially identical in terms of their Delivered by The World Bank e-library to: differ from ADRs in that their listing operational, legal, technical, and administrative requirements. GDRs aaaaaa University regulations and reporting requirements are no more stringent than those of the issuer's home market. As with IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 ADRs, in order to tap the U.S. investor base, GDRs can be offered through rule 144a to qualified institutional Types of Depository Receipts (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets buyers without the need to comply with U.S. Securities and Exchange Commission disclosure and reporting requirements or to conform with U.S. generally accepted accounting principles. GDRs are increasingly becoming the instrument of choice for emerging market issuers wishing to sell their securities in international markets—mainly because their transactions costs are lower and their listing and offering procedures are easier than U.S.−listed ADRs. Supply of Depository Receipts

The depository receipts market has grown rapidly since the early 1990s, reaching a record $34 billion in issues in 1996. European issuers accounted for more than two−thirds of new depository receipt issues that year (see figure 10.1). With thirty−seven new depository receipt programs, the United Kingdom was the most active issuer market. Emerging market issues, which accounted for two−thirds of new issues in 1993, fell to less than 30 percent of the total in 1996 (figure 10.3). This change reflected a major increase in issues from Europe and a drop in issues from Latin America, which in 1996 was still recovering from the collapse in international confidence following the 1994 Mexican peso crisis. Despite the 199495 setback, companies in emerging markets became increasingly active in issuing depository receipts in 1996. Latin America and India returned to the market after having been virtually dormant throughout 1995. Use of depository receipts as part of the global privatization phenomenon also increased significantly. Notable examples included: · Telefónica del Perú, the Peruvian telecommunications company ($918 million). · Compania Anonima Nacional Telefonos de Venezuela, the Venezuelan telecommunications company ($904 million). · Guangshen Railway, the Chinese railroad operator ($461 million). · RAO Gazprom, the world's largest gas producer and Russia's largest company ($429 million). · South African Breweries, South Africa's largest brewer ($413 million). New issues of depository receipts should continue as privatization programs proceed in emerging markets. Exchangeable Bonds Exchangeable bonds are bonds issued by one entity that provide investors with the right, over the life of the instrument, to exchange the bonds for the shares of another entity. In a privatization the bond issuer is typically a GDRs are increasingly becoming the instrument of choice for emerging market issuers wishing to sell their securities in international markets

Many governments have used exchangeable bonds during privatization

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Figure 10.3 Emerging market depository receipt issues, 199096 Source: Capital DATA Bondware. government or government−owned entity, which is also the shareholder in a wholly or partly state−owned company usually already listed on a stock exchange. Exchangeable bonds are similar to convertible bonds. But whereas convertible bond investors can convert the bonds for new shares in the same issuing company at a predetermined price, exchangeable bond investors can exchange the bonds for existing shares in the underlying company owned by the issuer (also at a predetermined price). The proceeds of the exchangeable bond issue are received by the issuing company, rather than by the company into whose capital the bonds can be exchanged. Exchangeable bonds tend to attract investors seeking yield advantage over the underlying equity, upside potential of the equity performance, and downside protection through the bond portion. Many governments have used exchangeable bonds during privatization. Examples include the $190 million issue of Telekom Malaysia by the Malaysian government in 1991 and the $1.1 billion issue of INA by the Italian government in 1996 (table 10.2). An issue of an exchangeable bond must take into account the credit quality of the issuer (that is, the credit rating of the issuing government or guarantor), the availability of a guarantee structure (if the issuer is a company rather than a government), and the accessibility of the underlying shares. Exchangeable bonds offer several benefits during privatization: · Cheaper debt funding. The coupon rate for an exchangeable bond is lower than that for straight debt and is generally the lowest−cost debt funding available to governments.

Table 10.2 Emerging market exchangeable bond offerings into state−owned enterprises, January 1990November 1997

Issuer

Exchangeable into

Country

Size (millions of U.S. dollars)

LUKinter Finance BV

LUKoil−JSC Oil Co

Russia

350

Islamic Republic of Pakistan

Pakistan Pakistan 150 Delivered by The World Bank e-library to: Telecommunicationaaaaaa University IP : 111.111.11.11 Co Ltd Tue, 11 Jan 2111 11:11:11

Maturity Issue date (Years)

Coupon (percent)

October 1997

6

1

February 1997

5

6

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Privatization and Emerging Equity Markets Nortel Inversora SA

Telecom Argentina STET−France Telecom SA

Argentina

298

March 1996

5

10

Compania de Inversiones en Telecomunicaciones SA

Telefonica de Argentina SA

Argentina

320

March 1994

4

7

Banco Nacional de Mexico SA

Grupo Financiero Banamex Accival

Mexico

565

November 1992

7

7

Federation of Malaysia

Telekom Malaysia Bhd

Mexico

190

March 1991

10

6

Source: Capital DATA Bondware

· Long−term financing. Most bonds have a maturity of up to seven years, during which time there is a high probability of the bonds being exchanged. · Wide investor base. Exchangeable bonds appeal to a broad international investor base, including equity, fixed income, and specialist convertible bond investors. · Premium pricing. The exchange price is based on a premium over the share price at the time of the issue. In a straight equity offering, by contrast, shares are typically issued at a discount. · No dilution. The shares that the issuer is reserving for the exchange (that is, selling down) are existing shares. Thus there is no dilution of the underlying stock. In summary, exchangeable bonds allow a government (or another shareholder) to raise funds on favorable terms through the deferred disposal (assuming the bonds are eventually exchanged) of a shareholding in a company at a premium to its current market value. Going−Public Bonds. A going−public bond is a convertible bond, exchangeable bond, or bond with warrants that is issued prior to (and in anticipation of) a listing on a stock exchange.This instrument can be ideal for a company with good credit that plans to use an initial public offering in the near future but requires funds now—for example, a first−class state enterprise being privatized through an initial public offering that needs to raise finance for current capital spending. Recent issues of going−public bonds have been in the form of convertible or exchangeable bonds from East Asia, mainly Hong Kong (table 10.3). An investor in a going−public bond has three main options: redeeming the bond at a given price on a prespecified date (the put option), converting or exchanging the bond for shares during the initial public offering at a prespecified price (the initial public offering price or a small discount thereto), or converting or exchanging the bond for shares in the period between the initial public offering and maturity at a premium (the conversion or exchange price) to the initial public offering Deliveredprice. by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 going−public Tue, bonds must to 11 Jan 2111plan 11:11:11

Companies hoping to issue a achieve a listing in the near future. Accordingly, the bond may be structured in a way that motivates the issuer to complete the offering within a specified Going−Public Bonds. (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets time—for example, two years from the issue of the bonds (figure 10.4). If the offering does not take place within the agreed period, the investor normally has the right to redeem the bonds at a premium under a put option. The premium provides investors with an appropriate, prespecified yield. Companies that issue a going−public convertible bond effectively receive part of their initial public offering proceeds in advance, without fixing the initial public offering price. Investors receive an instrument that has downside protection for the life of the bond and the upside potential of the underlying equity (as long as the initial public offering takes place). In addition, investors obtain the valuable guarantee that they will be able to secure meaningful amounts of stock at the initial public offering. This is particularly beneficial for bondholders if the issue is oversubscribed, resulting in a high post−issue premium and small allotments to public investors because the bondholders would already have secured their allocations. (See chapter 6 for a discussion of Morocco's experience with going−public bonds.)

Table 10.3 Selected going−public bonds, 199497

Issuer Lai Sun International Finance Ltd

Size (millions of U.S. Exchangeable/convertible into Economy dollars) Asia Television Ltd

Date of issue

Maturity Coupon (Years) (percent)

Hong Kong

100

February 7 1997

5

New World New World China Ltd China Finance Ltd

Hong Kong

350

October 1996

3 years, 2 months

4

FPD Finance Ltd

First Pacific Davies Ltd

Hong Kong

39

July 1995

3

7

PT Sierad Produce Tbk

PT Sierad Produce Tbk

Indonesia

19

July 1995

5

2

October 1994

7

7

March 1994

3

3.5

Hutchison Hutchison Delta Ports Delta Finance Ltd Ltd Global Mark International Ltd

PT Indofood Sukses Makmur

Hong Kong

275

Indonesia 500

Source: Capital DATA Bondware A going−public bond can be ideal for a company with good credit that plans to credit that plans to use an initial public offering in the near future but requires funds now

Going−public convertible bonds initial public offering

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privatized during the preparation of its

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Figure 10.4 Diagram of a going−public convertible bond issue Note: The process is the same for an exchangeable bond. Going−public bonds offer a number of advantages to issuers. As with exchangeable bonds, the issuer benefits from a medium−term source of fund that tends to be cheaper and more diversified, with the prospect of permanent capital upon conversion. Going−public convertible bonds, however, also provide: · Cost−effective funding in advance of an initial public offering, providing for enhanced earnings growth and potentially a higher initial public offering price. · Opportunity to create a strong platform with high−quality international investors in preparation for an initial public offering. · Full control of the company being privatized during the preparation of its initial public offering. · Protection for investors if the privatization is deferred, usually in the form of a put option at a premium for a given period—say, five years—after the bond is issued.

5.11— The Evolution of Emerging Market Equity Funds Investment funds have played a prominent role in privatization and emerging equity markets.These include venture capital funds and private equity funds, which often exit their investments through an initial public offering, and voucher investment funds, which have been instrumental in mass privatization in Central and Eastern Europe and the Commonwealth of Independent States (see chapter 2). But emerging market equity funds, the focus of this chapter; have provided the greatest catalyst for the growth of emerging stock markets.These funds intermediate financial resources from international investors, primarily in the advanced industrial economies, and invest in emerging stock markets in developing countries. They also invest in American depository receipts (ADRs) and global depository receipts (GDRs) of emerging market companies. Emerging market funds, primarily structured as mutual funds (United States) or investment or unit trusts (United Kingdom), intermediate funds at the wholesale level from institutional investors (such as pension funds and insurance companies) or at the retail level from individual investors. The first emerging market fund, the Japan Fund, was introduced in 1962. But the Korea Fund, introduced in 1984 with $60 million in capital, is generally credited with launching the dramatic growth of emerging market funds. Delivered by The World Bank e-library to: aaaaaa University The first global emerging markets fund, the Emerging Markets Growth Fund, was created in 1986 with some $50 IP : 111.111.11.11 million in capital. In less than ten years its Tue, capital had reached 11 Jan 2111 11:11:11 $5.5 billion. By the mid−1990s about one thousand emerging market funds were managing more than $100 billion in capital (IFC 1996a, p. 11). 5.11— The Evolution of Emerging Market Equity Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Despite the market turbulence in 199495 caused by Mexico's peso crisis, more than half of U.S. pension funds had assets invested in emerging markets by the end of 1996. Of these funds, 35 percent had increased the share of assets allocated to emerging markets during 1996. Moreover by 1996 the International Finance Corporation's (IFC) Global Composite Index included 1,650 stocks, and its Investable Composite Index covered twenty−seven emerging capital markets.At some $2 trillion, the capitalization of emerging capital markets is ten times its level ten years ago (Conrad 1996 and IFC 1996a). And despite the current financial crisis in Asia, emerging market funds continue to form In Latin America, the Middle East and North Africa, and Central and Eastern Europe. In just over a decade, emerging funds have evolved from an exotic boutique industry to a complex one that spans the globe. Emerging market funds have been instrumental in raising investor awareness of the potential returns—as well as the risk diversification—offered by emerging market equities. They have also called attention to frontier markets—countries where overall reforms, particularly structural reforms such as privatization, will soon lead to the growth of nascent capital markets.1 And they have strengthened emerging market infrastructure through their requirements for better clearing and settlement systems, improved disclosure requirements, and higher standards for regulation of and information from companies in which they invest.

Types and Structure of Emerging Market Funds Initially only a few investment groups focused exclusively on emerging markets. But because of the pioneering efforts of, for example, Mark Mobius (New York Times, 7 September 1997), emerging market funds are increasingly a part of larger fund management groups that offer investments from across the risk spectrum—from high−income bond funds to highgrowth equity funds. Having seen the potential of emerging markets, major investment firms have promoted them aggressively to both institutional and retail investors. As a result emerging market fund managers now control billions of dollars in investments. Emerging market funds can be structured in a variety of ways according to the strategies of their managers and the preferences of investors. Although these funds are diverse, they generally focus on a country (for example, Brazil, China, or Russia) or region (Asia, Latin America, Eastern Europe and the Commonwealth of Independent States), or on emerging markets overall. In addition, specialized funds invest in infrastructure firms (telecommunications, electricity, water), privatization initial public offerings, and other funds (that is, a fund of funds), among others. Funds also vary in terms of structure (closed−end, semi open−end, open−end), placement (private or public), and investment (private or listed). Closed−End Funds

Most emerging market funds were established as closed−end funds, meaning that they are closed to new investors once a given amount of capital is raised. Closed−end funds were deemed to have a significant structural advantage over open−end funds given the illiquidity and volatility of many emerging capital markets and the difficulties in timely clearing and settlement. Listed funds normally trade at some discount or premium to their net asset value. For example, on 31 October 1997 seventeen global emerging market funds were trading at a 16.9 percent discount to their net asset value, and one fund was trading at a 17.0 percent premium. The performance of closed−end funds varies greatly by region and country. On 31 October 1997 seven Indonesian funds had returns for the year averaging −38.6 percent relative to their net asset value, and ten Korean funds had returns averaging −51.6 percent relative to their net asset value (in U.S. dollar terms). In Russia, by contrast, eight funds had returns averaging 105.7 percent relative to their net assetto:value, and in. Mexico six funds had returns Delivered by The World Bank e-library aaaaaa University averaging 40.9 percent relative to their net asset value (Lipper International Closed−End Funds Service, IP : 111.111.11.11 November 1997). Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Open−End Funds

Open−end funds, specifically single country funds, have become more common in recent years. These funds allow periodic or continuous redemption, which assures investors that they will receive close to the full net asset value of the fund at redemption. This benefit comes at a price, however because fund managers have to focus on making the fund more liquid. Thus the fund portfolio must contain more liquid stocks, ADRs, and GDRs and have a larger balance in cash, all else being equal (Prochiniak 1996). Continuous redemption can encourage—or indeed, force—fund managers to liquidate investments when markets are volatile, potentially exacerbating market volatility. For example, during the week ending 5 November 1997 the fourweek moving average of funds flowing into emerging markets turned negative—down from an average of $800 million in flows during each four−week period in the spring of 1997. The financial crisis in Asia was the reason for the reversal (New York Times, 9 November 1997). What Makes Emerging Market Funds Unique? Emerging market funds have played a unique role in mobilizing resources from institutional and retail investors in the world's major financial centers. Most emerging capital markets initially lack sufficient market infrastructure—for share registry and depository, clearing and settlement, and so on. Governed by domestic regulators, institutional investors have used emerging market funds to lower transactions costs, diversify risks, and still comply with regulatory standards. Emerging market investments still account for a small portion of the portfolios of pension funds and insurance companies. A March 1996 survey of sixty−five major U.S. pension funds, for example, found that just 3.75 percent of assets were allocated to emerging markets. A survey of a larger group of U.S. pension funds found that allocations to emerging markets averaged only 1.3 percent. And a 1995 survey of U.K. pension fund managers found that emerging markets accounted for I percent of assets. (IFC 1996a, p. 9). Emerging market funds are increasingly a part of larger fund management groups

Most emerging market fund managers have relied on the imperfect nature of emerging markets to secure returns for their investors Thus there is enormous scope for increasing the funds flowing to emerging markets from major institutional investors. Perhaps a more pertinent question—given the 199495 peso crisis in Mexico and the current crisis in Asia—is whether investors will retreat from emerging markets given the market turbulence and volatility of the past few years. Imperfect Nature of Emerging Markets

To secure returns for investors, most emerging market fund managers have relied on such emerging markets imperfections as: · Information asymmetries—little information is published on listed firms or firms to be privatized through initial public offerings or other means. · Lower reporting and disclosure standards—so that even when information is published, it is often unreliable. · Illiquid and volatile equity portfolio investors.

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by hot money flows from external

Open−End Funds

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Privatization and Emerging Equity Markets · Market infrastructure imperfections—such as inadequate clearing and settlement, use of materialized shares, and lack of independent registrars and acceptable custodians. · Regulatory weaknesses—lack of independent oversight of firms and markets (for example, with respect to insider trading). · Country risks—mainly from macroeconomic management and structural reforms such as privatization, but also from politically driven gyrations in economic policy. · Foreign exchange risks—foreign exchange risks are not easily hedged in most emerging markets or, if hedged, can significantly increase the cost of trading in these markets. For example, during the current financial crisis in Asia emerging market investors have not only suffered a loss in share value but also taken a significant hit when, for example, the Thai baht or Korean won has fallen (Wall Street Journal, 22 December 1997). Investment Strategies

Fund managers have had to show that they can steer investors through the minefields associated with international emerging markets and provide a return commensurate with risks. Their investment strategies depend on their market expertise and basically vary between two theoretical extremes—top−down allocation and bottom−up stock selection. The top−down strategy implies a portfolio weighting within, say, a Latin American fund in which the manager varies the percentage of investment by country within the region. The greatest weight would be given to major economies (Argentina, Brazil, Mexico) or to countries where economic reforms have created the potential for substantial capital market growth (Bolivia, Brazil, Chile, Peru). Managers then choose specific stocks within countries to maximize returns. Privatization has had an important influence on such choices. The returns to investors from initial public offerings have been substantial, and emerging market portfolio investors have generally significantly oversubscribed the first and even subsequent equity tranches of privatized firms (see chapter 1). The bottom−up strategy implies that fund managers will focus on the best investment opportunities within a region, without necessarily focusing on a country allocation in a portfolio weighting. Thus a Latin American investment fund might weight heavily in favor of Brazil and Peru if they offered the best investment opportunities, relying on individual firm selection rather than a country diversification strategy These two approaches reflect theoretical strategies, however; and most emerging market fund managers have followed a middle strategy. And with emerging markets becoming more transparent—investors have better information about markets once considered esoteric or obscure—fund managers have tended to compete by anticipating capital market growth based on privatization and other economic reforms. Thus during 199697 significant portfolio capital flowed into Russia and Turkey, making the Moscow and Istanbul stock exchanges the hottest emerging markets. Such developments have given rise to perceptions that external portfolio flows from investment funds can undermine any emerging market development particularly if the flows account for a large part of market turnover and move in and out quickly. Technical Trading.

The increasing emphasis on technical trading has many causes: the growing complexity of emerging equity markets, the increasing competition in this market niche, the explosion of information on emerging markets Delivered by The World Bank e-library to: (particularly on the Internet), and, until recently, theUniversity increasing capital flowing to emerging markets. One sign of aaaaaa : 111.111.11.11 this increased emphasis on technical tradingTue, isIP the recent move away from purely allocational selection criteria to 11 Jan 2111 11:11:11 more technical analysis when Investment Strategies (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets choosing companies in which to invest, Index funds have also become more popular. As one analyst notes, fund managers specializing in developing countries today have largely become desk−bound number crunchers who spend most of their time in front of computer screens and use sophisticated systems to determine asset allocation (Conrad 1996). The first emerging market index fund was established in 1994. Since then the share of money invested in emerging markets that is indexed has risen (IFC 1996b). Critics of indexing note the continued imperfections in emerging markets—including the lack of adequate information and continued liquidity problems—yet the trend seems clear: indexing will increase as markets grow and become more sophisticated. In addition to indexing, a range of emerging market options and derivatives are being offered by the futures exchanges in New York, Chicago, and Europe. Emerging capital markets in Brazil, Hungary Malaysia, the Philippines, Russia, and South Africa have their own derivative exchanges, and a number of others are being developed (IFC 1996a.) Measuring the Performance of Emerging Market Funds

The performance of emerging market funds has varied greatly over time and by country and region. Fund mangers generally benchmark their performance to the IFC's emerging market indexes (Global Composite Index, Investable Index), to subsets of these indexes (such as regional indexes), or to the Morgan Stanley Index. These indexes have changed substantially in line with the dramatic growth of emerging capital markets. The Global Composite Index, which began in mid−1981 with just ten emerging capital markets and ten to twenty stocks per market, was totally revamped in 1987. Additional countries added to the index include China, Hungary, Peru, Poland, and Sri Lanka in 1993; the Czech Republic in 1995; and Egypt, Israel, Morocco, the Slovak Republic, and Russia in 1997. In response to the needs of investment fund managers, the IFC tightened its methodology in 1992 and developed the Investable Index. Since then other improvements have been added, including regional subsets of the indexes, daily updates, and continuous fine−tuning of the methodology. By 1996 the Investable Index was tracking 1,200 stocks in twenty−six emerging markets, and the Global Composite Index was tracking 1,600 stocks in twenty−seven markets. (IFC 1996a). In addition, a number of information services track emerging market funds, including Micropal (which reports performance on some 1,000 emerging market investment funds) and Lipper Analytical Services (which tracks closed−end funds). Outlook for Emerging Market Funds During 198493 the growth of emerging capital markets was spectacular. This growth was driven by and contributed to the impressive growth and diversity of emerging market investment funds. Once an exotic offshoot of the mutual funds industry, emerging market funds have become an important institutional feature of global financial markets. The performance of emerging market funds has been erratic since Mexico's 1994 peso crisis. The market declined in 1995 but recovered in 1996 (though not to 1993 levels). In 1997 emerging markets were expected to take off once again, but Asia's financial crisis severely hurt emerging stock markets—especially funds that focused on Asia. Other emerging markets were also hurt by the crisis. Moreover, emerging market fund managers have had to compete with a spectacular rise in U.S. equities in recent years. In late 1997 money began flowing out of emerging market investment funds. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 institutional will substantially Tue, 11investors Jan 2111 11:11:11

The main question now is whether reduce their exposure to or pull out of emerging markets. The outlook for emerging market funds is closely tied to the performance of emerging market Measuring the Performance of Emerging Market Funds (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets economies. Only countries that pursue needed reforms—including structural adjustments such as privatization—will be able to attract continued portfolio investment. Note

1. To wit: As if emerging markets did not prove exciting enough for investors recently now comes an even more speculative alternative: The Pre−Emerging Markets Fund introduced last week by State Street Global Advisors (New York Times, 9 April 1997). References Conrad, Anelle. 1996, A Walk on the Mild Side: Emerging Market Fund Managers Become More Conservative. Institutional Investor 30 (12): 101−04. IFC (International Finance Corporation). 1996a. Emerging Stock Markets Factbook. Washington, D.C. ———. 1996b. Investment Funds in Emerging Markets. Washington, D.C. Prochiniak, Andrea L 1996. A New Opening into Emerging Markets. Fortune 134: 207. The outlook for emerging market funds is closely tied to the performance of emerging market economies

5.12— Pension Funds, Capital Markets, and Privatization in Chile, Bolivia, Singapore, and Peru Carol Gabyzon More and more countries are recognizing that publicly financed, pay as you go pension systems are a losing proposition. Thus many countries are moving toward fully funded pension systems that rely on individual capitalization; examples include Chile's private pension funds and Singapore's Central Provident Fund. Such reform is unavoidable in countries with aging populations and depleted government budgets. Over the next thirty−five years the share of the world's population that is over 60 will almost double, from 9 to 16 percent, and 80 percent of the world's elderly will live in today's developing countries (James 1996). Thus most public pension plans are fiscally unsustainable and must be reformed. Pension reform must achieve three objectives: saving, redistribution, and insurance. This chapter focuses on saving because of the direct link between fully funded pension systems and capital market development. Emerging market pension funds are important institutional investors and contribute to the growth of capital markets by providing long−term savings for investment. By 1999 the world's pension funds are expected to have $11.2 trillion in assets, up nearly 60 percent from $7.1 trillion at the end of 1994 (Pensions and Investments, 15 May 1995). This chapter describes private and public pension systems in Chile, Bolivia, Singapore, and Peru and analyzes how these systems have complemented privatization efforts and capital market development. Although Singapore's pension system is publiclyDelivered managed, is private, and Bolivia's is moving toward a private by TheChile's World Bank e-library to: aaaaaa University system, all three are fully funded. (Peru's pension system is modeled after Chile's.) Workers' contributions IP : 111.111.11.11 accumulate in pension funds and are invested, with effects on savings and financial markets. The three Tue, 11 Jan positive 2111 11:11:11 systems also have generated substantial domestic demand for shares of state assets being privatized. Proper Note

159 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets regulation of pension investments is key to the funds' success. In all three countries regulations have been cautious initially and gradually relaxed to allow diversification, higher returns, and greater capital market development. Chile's Pension Funds In 1981 Chile created a revolutionary social security system, replacing its bankrupt, government−funded pension system with privately administered pension funds (Administradoras de Fondos de Pensiones, or AFPs). These funds allow individuals to contribute to their own pension accounts; benefits are based on the contributions and on the accumulated investment returns on those contributions (a system known as individual capitalization).1 Ten funds were created initially, but that number has since doubled. Between 1981 and 1996 assets in the private system grew from $292 million to about $27 billion, or 38 percent of GDP (Superintendency of Pension Funds Administrators 1996). Revenue from the funds is based on assets and volume,

and individuals are free to select and switch among funds. The funds compete on the basis of service fees, service quality, and rate of return on assets. During 198196 the funds yielded an average annual return of about 12.2 percent (table 12.1). Regulation

Prudent regulation, provided by the Superintendency of Pension Funds Administrators, accounts for much of the success of Chile's private pension funds. Regulation ensures that fund members receive benefits in the time and manner established by the system and that fund resources are soundly invested. Two features in particular ensure that fund resources are safeguarded and profitable: the minimum yield and investment ceilings. The minimum yield. Pension administrators are required to guarantee a monthly minimum yield based on the average yield for all the funds.2 However, a safety mechanism goes into effect if a fund's yield falls below the required minimum. This mechanism relies on three potential sources to fill the gap. First, a fund can use its yield fluctuation reserve (made up of its yield surpluses over the preceding year). If the yield fluctuation reserve is nonexistent or insufficient, the fund can rely on its cash reserves (I percent of the fund's value, using the resources of the fund rather than those of its affiliates). Finally, if cash reserves cannot cover the difference, the state will provide the money and wind up the fund. This system has built−in incentives for fund managers to perform well and can prevent the damaging consequences of a fund's bankruptcy.

Table 12.1 Annual returns to Chile's private pension funds, 198096 Percent Year

Return

1980

12.7

1985

13.4

1990

17.7

1995

−2.5 Delivered by The World Bank e-library to:

1996

3.5

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Privatization and Emerging Equity Markets Accumulated annual average

12.2a

a Covers July 1981December 1996. Source: Superintendency of Pension Funds Administrators 1996. Investment ceilings. The superintendency fixes investment ceilings for each type of asset. Since 1981 the rules have become more flexible and investment ceilings on riskier investments, such as equities, have been raised.3 As a result the funds' portfolio allocation has changed. In 1981 pension fund portfolios were almost entirely invested in state securities, bank deposits, and mortgage securities. By 1995, however, funds were investing in corporate equities, foreign bonds, and stocks (table 12.2). Moreover funds have recently been allowed to use derivatives for hedging purposes and to invest in project financing and venture capital. Pension Funds, Privatization, and Capital Markets.

Chile's privatization program proceeded in two waves spanning 197390. The first wave ended just before the 198283 financial and economic crisis, which forced many privatized enterprises back under government control. The second wave started in 1985 with a new privatization program that covered thirty−nine core state enterprises (including public utilities and large enterprises in the tradables sector). In an effort to diffuse ownership, the government allowed pension funds to invest in shares of joint stock corporations. The private pension funds became active participants in the privatization of state enterprises whose shares were offered and traded on the Santiago Stock Exchange (Bitran and Saez 1994). The funds bought more than 25 percent of the equity in major privatized companies, including Chile Metro, Endesa, Entel, Schwager and Telefonos de Chile (Hachette and Luders 1993). Similarly, privatization spurred the growth of private pension funds by providing new instruments for investment. In the process domestic capital markets deepened. In 1981 domestic capital markets were underdeveloped, with a limited role for equity investments. The 1985 privatization wave, however, created a sizable supply of corporate stock in which pension funds could invest. In 1996, for example, the funds invested about $1,294 million in corporate bonds and $6,908 million in corporate equities (see table 12.2). Bolivia's Pension and Capitalization System In 1993 Bolivia developed an innovative response to the challenges of privatization and pension reform: privatization by capitalization and privatization coupled with pension reform. Both programs attempt to attract stable investors and to foster public participation in privatization. Privatization is Privatization spurred the growth of private pension funds by providing new instruments for investment

Bolivia's privatization by capitalization program is unique because the successful bidder pays the agreed price to the company, thereby doubling its capital

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Privatization and Emerging Equity Markets Table 12.2 Asset portfolio is Chile's private pension funds, 198196 Financial institution deposits Government−issued and promissory instruments notes

Mortgage bonds

Financial institution bonds and others

Stocks

Share of total Year (percent)

Millions Share of of U.S. total dollars (percent)

Millions Share of of U.S. total dollars (percent)

Millions Share of of U.S. total dollars (percent)

Millions Share of of U.S. total dollars (percent)

Millions of U.S. dollars

1981 28

82

62

181

9

27

0

0

0

0

1985 42

1,290

20

621

35

1,071

0

12

0

0

1990 44

4,303

16

1,591

16

1,571

1

107

11

1,103

1995 39

10,021

5

1,348

16

4,018

2

509

29

7,477

1996 41

11,587

4

1,156

18

4,927

3

688

25

6,908

Source: Superintendency of Pension Funds Administrators 1996. (table continued on next page) designed to inject foreign capital in cash−strapped state enterprises, although half the ownership of politically sensitive state enterprises remains in Bolivian hands. The new pension system is similar to Chile's in that it relies on private funds fed into individual accounts.4 Bolivia's pension reform differs, however because the private funds' start−up capital comes from the proceeds generated by privatization. Privatization is focused on six state industries that together account for 65 percent of GDP and employ 14,700 people. These are ENDE (electricity), ENTEL (telecommunications), ENFE (railways), EMV (mining), YPFB (oil and gas), and LAB (airline).5 In the first stage of the program workers can buy shares in the company (before it is capitalized).6 Workers can buy shares up to their social benefits, which amount to 23 percent of the total shares. In the second stage a strategic investor bids for a management contract and up to half of the shares. This combination (a management contract and half the shares) ensures that private investors have enough control to warrant investing in the company without giving them ownership control. Later, as domestic capital markets develop and trading occurs, investors can buy more shares on the market. The privatization by capitalization program is unique because the successful bidder pays the agreed price to the company, thereby doubling its capital. The cash is invested in the firm, and investment is regulated to ensure that it is used to strengthen the sector and create jobs. Finally, the remaining shares (amount half minus the shares bought by workers) are allocated to each adult Bolivian (about 3.4 million people) through privately managed pension funds. In January 1997 two Spanish−led consortiums, Argentaria and Banco Bilbao Vizcaya, were chosen through international bidding to manage the assets of the new private system (Financial Times, 31 January 1997). The two consortiums will enjoy a duopoly until 2002. Regulation

As in Chile, regulation of Bolivia's pension funds focuses on protecting individuals' accounts while encouraging the funds to invest in domestic capitalDelivered markets. To World achieve goals, the new pension law monitors the funds' by The Bankthese e-library to: aaaaaa University investments, and pension fund regulators will be given considerable power. As in Chile, regulations will be IP : 111.111.11.11 11 Janin 2111 11:11:11 cautious at first, allowing asset managers toTue, invest funds with short−term, low−risk investments inside or outside Bolivia. These rules will eventually be eased to allow funds to invest in equities on the Bolivian and Regulation

162 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets international markets. Pension Funds, Privatization, and Capital Markets

Bolivia's capitalization system has injected fresh capital into formerly cash−strapped state enterprises. For example, three foreign consortiums have agreed to invest $835 million in the oil and gas company (YPFB), and Italy's STET is investing $610 million in the telecommunications network. Five companies have been completely or partly privatized: ENDE, ENTEL, LAB, ENFE, and YPFB. Only MVN, the mining company, has not been capitalized. Workers' participation has been impressive: 91 percent of workers participated in ENDE's privatization, and 95 percent participated in ENTEL's. Bolivia's capital markets historically have been small, with only a few shares traded—mainly government, bank, and brewery paper. Inaugurated in early 1997, the pension funds provide a large pool of savings for the development of Bolivia's capital markets. The distribution to all adult Bolivians of shares from the five capitalized state companies provides

(table continued from previous page) Corporate bonds

Investment fund shares

Foreign instruments

Current accounts

Total assets

Share of Millions Share of Millions Share of Millions Share of Millions Millions total of U.S. total of U.S. total of U.S. total of U.S. Percentage of U.S. Year (percent) dollars (percent) dollars (percent) dollars (percent) dollars of GDP dollars 1981

1

2

0

0

0

0

0

0

1

292

1985

1

34

0

0

0

0

1

15

10

3,042

1990

11

1,083

0

0

0

0

0

10

24

9,758

1995

5

1,348

3

661

0

51

0

25

39

25,433

1996

5

1,294

3

826

1

138

0

0

39

27,523

start−up capital equivalent to about $1.7 billion, or 30 percent of GDP. In addition, 500,000 additional members are expected to sign up with the new pension funds within five years, bringing an additional $200 million a year in contributions (Financial Times, 31 January 1997). Singapore's Public and Private Pension Funds Singapore's Central Provident Fund, established in 1955, is a government−run, compulsory social security system. The fund has evolved from a simple old−age savings scheme to a comprehensive savings and investment instrument. Like the Chilean and Bolivian systems, the fund is based on individual pension accounts, investment, and returns on assets. During 195595 the rate of return on fund accounts averaged 4.3 percent a year (table 12.3).7 In 1995 the fund was the tenthlargest pension fund in the world, with $55 billion in assets— equivalent to 74 of Singapore's GDP (Pensions and Investments, 10 July 1995). In 1973 the fund had 609,300 members; by 1994 it had 1,138,900. Delivered by The World Bank e-library to:

Universitypension funds in Singapore, encouraged by 1994 Since 1995 twenty to thirty companies have setaaaaaa up private IP : 111.111.11.11 regulations allowing them to establish tax−exempt The private pension market is developing quickly, and Tue, 11 Janfunds. 2111 11:11:11 is expected to grow from less than $0.18 billion in 1994 to several billion dollars in 2004. Pensions are still

Pension Funds, Privatization, and Capital Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets dominated by the Central Provident Fund, however. Regulation

As with Chile's private pension funds, rules guiding the Central Provident Fund's investments have gradually been relaxed to encourage investment. In 1955 the fund balance could be withdrawn only upon retirement. By 1995 fund savings could be used to buy residential and nonresidential property and to invest in domestic stocks, bonds, unit trusts, gold, bank deposits, fund management accounts, and endowment insurance policies. Recent changes allow fund savings to be used to buy foreign stocks and bonds traded locally and equities listed on the stock markets in Hong Kong (China), the Republic of Korea, Malaysia, Taiwan (China), and Thailand. In 1999 funds and unit trusts will be allowed to invest in U.S. and other Western stock markets. Pension Funds, Privatization, and Capital Markets

Central Provident Fund assets have provided $55 billion in medium− and long−term savings for investment and capital market development. Information on investments made directly by the fund is hard to come by, but several trends are

Table 12.3 Annual returns to Singapore's Central Provident Fund, 195595 Percent Year

Returns

1955

2.50

1960

2.50

1965

5.25

1970

5.75

1975

6.50

1980

6.50

1985

6.50

1990

3.82

1995

3.10a

Accumulated annual average

4.30

a Covers JanuaryJune 1995. Source: Carling and Oestreicher 1995. Pension funds provide a large pool of savings for the development of Bolivia's capital markets Delivered by The World Bank e-library to:

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Regulation

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Privatization and Emerging Equity Markets

Table 12.4 Withdrawals from Singapore's Central Provident Fund, 196895 Percent Amount withdrawn as a share of total withdrawals

Year

Total withdrawals as a share of annual contributions

Approved housing schemes

Section 12 a

Medical schemes

Other b

1968

42.9

20.9

79.1

0

0

1970

28.8

50.8

49.2

0

0

1975

24.5

62.1

37.8

0

0

1980

33.9

66.9

32.9

0

0.3

1985

56.1

76.4

20.9

1.3

1.5

1990

55.8

56.4

25.5

5.9

12.1

1991

57.6

64.3

20.5

5.7

9.4

1992

58.8

66.7

18.7

5.1

9.5

1993

105.0

32.1

10.8

2.7

54.4

1994

64.7

48.0

18.7

3.8

30.0

1995

53.6

63.2

10.6

4.1

12.8

a Includes members withdrawing at retirement (age 55), the physically and mentally disabled, those who died during the year, and Malaysian citizens leaving Singapore. b Includes investment schemes and financing of tertiary education. Source: Asher 1996a.b. apparent in the investments made by fund members (table 12.4). In 1968, for example, all withdrawals from the fund were used for approved housing schemes or for retirement (with most for retirement). By 1995 these two categories accounted for Just 74 percent of fund withdrawals; about 13 percent was invested in tertiary education and investment schemes. Central Provident Fund assets have become more diversified, and rates of returns on investment have risen over the years (see table 12.3). In 1978 the government encouraged Singaporeans to use their fund savings to buy shares in the Singapore Bus Service. More recently, the government has deposited a fixed sum in each fund account that members can use to buy shares in, for example, the telecommunications company. Private pension funds should further diversify fund assets andbyincrease while Delivered The Worldreturns Bank e-library to: encouraging the full or partial privatization aaaaaa University of state enterprises. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Regulation

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Privatization and Emerging Equity Markets Peru's Private Pension Funds Peru's private pension funds (Administradoras de Fondo de Pensiones, or Pension Fund Administrators), created in early 1993, were modeled after Chile's. Initially, eight funds were in operation. With mergers, five remain. The private funds were created after the government realized that the state pension system would eventually face funding problems. Under the private system workers contribute a portion of their income into a fund, which then invests the money and must provide pensions upon retirement. Pension payments are linked to worker contributions. Workers that choose to switch to the private system can switch among the funds but cannot re−enter the public system. Members of the private pension funds must contribute: · 8 percent of their salary toward their fund. (In addition, workers can choose to contribute an additional 4 percent of their salary, for a maximum 12 percent of their insurable salary.) · A share of their salary as insurance for disability and survival services and for burial (1.181.68 percent of salary with a cap of 5,800 soles, or $1,060). · A fixed share of their salary for fund services (2.282.50 percent of salary). Employers are free to contribute to the funds as a benefit to employees. To encourage participation in the private system, workers who switched were given a 13 percent raise from the program's inception until July 1995 (in return, employers stopped making contributions to the public system for the switching workers). Workers can switch among private funds once they have made at least six consecutive contributions. Switching workers, however must pay transfer expenses as determined by the superintendency of private funds. Workers who switch to the private system receive a recognition bond (bono de reconocimiento ) that reflects their contributions to the public system through December 1992. To receive the bond, workers must: · Have been a member of the Peruvian Social Security Institute (Institute Peruano de Seguridad Social ) as of 6 December 1992. · Have contributed to the institute for the six months prior to December 1992, and for at least forty−eight months in the ten years prior to December 1992. The bond is transferred to the private fund and matures when the worker reaches retirement age (65). By May 1997 Peru's private pension funds had 1.63 million members and assets totaling $1.2 billion, equivalent to 2 percent of GDP (table 12.5). The funds grew by 21 percent in 1996 and by 30 percent from December 1996 to May 1997.

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Privatization and Emerging Equity Markets Table 12.5 Securities portfolio of Peru's private pension funds, May 1997

Security Government bonds

Amount (millions of U.S. dollars)

Share of total (percent)

5.8

0.5

Deposits

347.7

28.3

Leasing and subordinated bonds

200.5

16.3

Corporate bonds

193.1

15.7

6.2

0.5

424.8

34.5

Mortgage−backed securities Stocks Other

52.1

4.2

Total

1,230.2

100.0

Source: World Bank data. Lessons. Pension funds in Chile, Bolivia, Singapore, and Peru have made privatization easier and contributed to the development of capital markets. From the experiences of these and other countries a few common themes emerge. Private Pension Funds Generate Demand for Privatized State Enterprises

Pension funds have often provided a ready vehicle for the privatization of state enterprises. Chile's private pension funds have bought more than 25 percent of the equities released for private ownership. In Bolivia private funds are closely linked to privatization—their start−up capital comes from privatization—and will be able to invest their assets in corporate stocks and bonds, facilitating new privatization. Singapore has encouraged the purchase of state enterprise shares by allowing Central Provident Fund members to withdraw funds for this purpose. Private Pension Funds Outperform Public Ones

Private pension funds' diversified portfolios generally outperform those of public pension funds and contribute to capital market development (World Bank 1994; James 1995). Many public funds lost money during the 1980s because they were required to invest in government securities or to provide loans to failing enterprises. Moreover, most public funds cannot invest in equities, real estate, or foreign assets, making it difficult to earn high yields. (Singapore's Central Provident Fund is an exception.) Private funds, by contrast, generally diversify assets and so encourage financial market and private sector development. In addition, private funds must seek high rates of return because they compete to win members. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Lessons.

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Privatization and Emerging Equity Markets Private Pension Funds Offer a Pool of Long−Term Savings

Countries that have underdeveloped capital markets and that lack long−term financing for investment can benefit from pension funds. The fully funded pension systems in Chile, Peru, Singapore, and eventually Bolivia are an excellent source of medium− to long−term savings for investment in local and international capital markets. Since their inception Chile's private funds have grown from a mere I percent of GDP to 39 percent (see table 12.2). Similarly, the assets of Singapore's Central Provident Fund grew from 28 percent of GDP in 1976 to 76 percent in 1995.8 Capital Markets and Private Pension Funds Grow Together

Developed capital markets allow fully funded pension funds to flourish. Moreover, the funds' participation in capital markets facilitates the development of these markets. In Chile, Bolivia, and Singapore pension funds initially invested in local capital markets—which mainly comprised financial instruments issued by government and central banks—rather than in companies. But as more shares became available as a result of privatization and other policies, the funds were able to invest in more equities. Pension funds have boosted capital markets by financing projects, contributing to financial intermediation, making the allocation of resources more efficient, increasing the transparency and efficiency of stock exchanges, and spurring the creation of local risk−rating industries (Superintendency of Pension Funds Administrators 1996). Domestic Pension Funds Provide a Cushion against Volatility

Domestic pension funds offer a cushion against the market volatility that foreign investors may cause. In 1994 Chile's stock market dipped briefly because U.S. fund managers were dumping Latin American holdings in the wake of the Mexican peso crisis. But the bolsa quickly rebounded and stabilized as private pension funds began buying shares. The funds invested in domestic securities because of strong fundamentals: macroeconomic conditions were stable, the domestic currency was healthy, and interest rates were higher than on foreign securities. Fully funded pension systems are an excellent source of medium− to long− term savings for investment in local and international capital markets

Macroeconomic stability is essential for pension funds and capital markets to thrive Fund Investments Must be Properly Regulated

Pension funds must be overseen by regulations that guarantee the safety of invested funds. Regulations can, for example, stipulate investment allocations among domestic and foreign bonds and equities and other financial instruments. As noted, Chile, Bolivia, Peru, and Singapore strictly regulated pension fund investments at first, to protect the assets invested and ensure proper development of the funds. Rules have since been relaxed to increase diversification as pension assets grow and capital markets develop. Private pension funds should first invest in government−indexed bonds, but investment ceilings on the bonds should gradually be relaxed and investment in equities and foreign assets should increasingly be permitted.9 The changing investment mix of Chile's private pension funds is due mainly to changing regulations on investment ceilings and on eligible instruments for investment (figures 12.1 and 12.2).

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Privatization and Emerging Equity Markets

Figure 12.1 Asset portfolio of Chile's private pension funds, 1981 Source: Superindency of Pension Funds Administrators 1996.

Figure 12.2 Asset portfolio of Chile's private pension funds, 1996 Source: Superintendency of Pension Funds Administrators 1996. Avoiding Obstacles

Many countries privatizing their pension systems have run into at least four obstacles that have delayed their efforts and stunted capital market development. First, transition costs may be high. In Bolivia such costs are estimated at $198 million in 1997 and more than $2 billion by 2060. In Mexico the cost of social security reforms—estimated at $2.5 billion a year—led the government to delay the start−up of private pension funds (Financial Times, 1 November 1996). Second, the required regulations or infrastructure may be lacking. Bolivia's move toward private funds has stalled because new legislation is needed for each sector being capitalized; tax laws, a private pension law, and new regulatory agencies are also needed. Third, political resistance to private pension systems based on redistributive goals—has slowed efforts in Bolivia and other countries. Finally, macroeconomic stability—low inflation, small budget deficits, and positive long−term interest rates—is essential for pension funds and capital markets to thrive. Notes. The author is grateful to Meg Garlinhouse and Robert Palacios for helpful contributions. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Jan 2111 11:11:1193 percent system and Tue, the 11 AFPs coexist,

1. Although the public pension of the workforce (about 4.8 million people) uses the AFPs, and since 1983 the public system has accepted no new members. Workers who left the Avoiding Obstacles

169 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets public system received a payout equivalent to their retirement contributions.

2. More precisely, the minimum yield is calculated as follows: the actual yield over the past twelve months must be no less than either the average actual yield paid over the past twelve months of all the funds, minus 2 percent; or 50 percent of the average actual yield over the past twelve months of all the funds (Superintendency of Pension Funds Administrators 1996).

3. For example, pension funds were allowed to invest in equities of privatized state enterprises in 1985, in corporations with dispersed ownership in 1986, in real estate companies in 1989, in foreign securities in 1990, and in venture capital and infrastructure in 1993 (Vittas 1996).

4. The private pension system will initially coexist with the government−funded pension program.

5. Electricity company—Empresa Nacional de Electricidad (ENDE); telecommunications company—Empresa Nacional de Telecomunicaciones (ENTEL); railway company—Empresa Nacional de Ferrocarriles (ENFE);

Vinto (EMV); oil and gas company—Yacimientos Petroliferos Fiscales Bolivianos (YPFB); airline—Lloyd Aereo Boliviano (LAB).

6. Workers must buy and pay for one share and sign an option contract to become a partner of the enterprise to be privatized.

7. The fund earns a market−related interest rate (an average of the twelve−month fixed deposit and end−month savings rates of the four major local banks, revised every six months). The interest rate is a minimum 2.5 percent for funds placed for retirement. Funds placed for longer periods, like savings in the special and retirement accounts, earn 1.25 percentage points more than the normal interest rate.

8. The data for Chile and Singapore include both pension fund and life insurance assets.

9. Vittas (1996) believes that equities investment should start once pension assets reach about 5 percent of GDP, and foreign asset investments once pension assets reach 20 percent of GDP. References Asher, Mukul G. 1996a. Financing Old Age in Southeast Asia: An Overview. National University of Singapore, Department of Economics and Public Policy. ———. 1996b. Financing Social Security in Singapore: Are There Lessons for the Welfare States? Paper presented at the Western Economic Association Conference, June 28July 2, San Francisco. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111and 11:11:11 Privatization Regulation

Bitran, Eduardo, and Raul E. Saez. 1994. in Chile. In Barry Bosworth, Rudiger Dornbusch, and Raul Laban, eds., The Chilean Economy: Policy Lessons and Challenges. Washington, D.C.: The References

170 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Brookings Institution. Carling, Robert, and Geoffrey Oestreicher. 1995. Singapore's Central Provident Fund. International Monetary Fund, Washington, D.C. Hachette, Dominique, and Rolf Luders. 1993. Privatization in Chile: An Economic Appraisal. San Francisco: International Center for Economic Growth. James, Estelle. 1995. Averting the Old−Age Crisis. Finance and Development 32(June): 47. ———. 1996. New System for Old Age Security: Why, How, and So What? Paper prepared for a conference on Pension Systems: From Crisis to Reform sponsored by the World Bank, 2122 November, Washington, D.C. Superintendency of Pension Funds Administrators. 1996. The Chilean Pension System. 2nd ed. Santiago. Vittas, Dimitri. 1996. Pension Funds and Capital Markets. FPD Note 71. World Bank, Private Sector Development Department, Washington, D.C. World Bank. 1994. Averting the Old−Age Crisis: Policies to Protect the Old and Promote Growth. A Policy Research Report. New York: Oxford University Press.

5.13— Broad Ownership Schemes in Chile, Malaysia, and the Kyrgyz Republic Gary J. Fine Developing new sources of demand for securities is crucial for government divestiture programs; broad ownership schemes can help. Such schemes, introduced in Chile, Malaysia, and the Kyrgyz Republic as part of each county's privatization program, encourage the wide dissemination of shares within the population or to a targeted group. In either case the shares go to people who had not previously participated in securities markets. In the process share ownership is broadened and deepened, encouraging saving and investment, redistributing wealth, and promoting the development of local securities markets. Developing Broad Ownership Schemes—an Economic and Political Process Broad ownership schemes are a tool that, combined with other reforms, can provide significant economic benefits. But winning approval for such schemes and implementing them requires political consensus. As the following examples show, broadening ownership can be as much a political process as an economic one. Privatization as an Economic Process

Diversifying share ownership is one of several ways to implement economic reform. In Chile, Malaysia, and the Kyrgyz Republic such reforms have been made to reverse economic policies—such as public enterprise ownership and other forms of economic intervention—that enjoyed limited or temporal success. Chile. A stark example of such changes occurred in Chile in the early 1970s, when the military government Delivered byadministration The World Bank e-library to: to shrink the large public sector and divest installed after the ouster of Salvador Allende's rushed aaaaaa University : 111.111.11.11 the hundreds of enterprises nationalized under IP Allende. Ten years later, however, the country sought to overcome Tue, 11 Jan 2111 11:11:11 the deficiencies that had resulted from the concentration of ownership among a few financial−industrial groups. It 5.13— Broad Ownership Schemes in Chile, Malaysia, and the Kyrgyz Republic (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets did so by incorporating various mechanisms for broadening shareholding in its second privatization program, which started in the mid− 1980s. Chile privatized about 550 state enterprises in two phases, the first during 197379 and the second during 198489. During the first phase, after returning 300 nationalized enterprises to their original owners, the government began privatizing 207 enterprises in various industries. Because private investment capital was scarce (the result of an unfavorable foreign investment climate and of a lack of domestic private resources and resources held abroad by wealthy citizens), the public sector provided credit to a small number of new and rapidly growing financial−industrial groups. These groups were formed through the purchase of state−owned financial institutions and expanded through active participation in privatization, with the purchase of state enterprises financed with state credits or with credits granted by the financial institutions that formed the core of the groups. By late 1981 Chile, like much of Latin America, faced a worsening recession. Domestic sales and the value of the

domestic currency were falling, and interest rates (particularly for debt denominated in foreign currency) were rising quickly. These difficulties were compounded by the sudden termination of external credit that accompanied the region's debt crisis. In Chile asset prices—including share prices—that had skyrocketed during the period of easy credit began to plummet. These developments forced banking institutions to absorb enormous losses from borrowers who could no longer repay their loans (Larrain 1989). Changing economic conditions also forced financial−industrial groups to take out loans from the banks they held, hastening the insolvency of these banks and of the groups that held them. In the end the state intervened in sixteen of the largest insolvent financial institutions, regaining control of about half of Chile's largest manufacturing, insurance, and trading companies. These experiences provided important lessons to the Chilean authorities about the need to restrain easy credit and diversify ownership when these and other companies were privatized in the 1980s. Malaysia. Malaysia also introduced policies to strengthen private enterprise and reverse years of public sector growth. There, years of laissez−faire development ended in the early 1970s when the government, under its New Economic Policy, took a decidedly interventionist posture. The new policies were intended to redress a socioeconomic imbalance: although the native bumiputra represented the majority of the population, they held only 4 percent of corporate assets in 1970. The rest was held by nonindigenous Malaysians, primarily of Chinese and Indian ancestry, and by foreigners. Public enterprises were used to promote the economic participation of the bumiputra and were expected to play a leading role in enabling them to hold 30 percent of corporate assets by 1990. During the 1970s the number of public enterprises increased considerably and public employment grew dramatically, from 398,000 in 1970 to 693,000 in 1980. Other methods used to redistribute wealth included the creation of trusts and other financial institutions to hold shares on behalf of the bumiputra and the compulsory transfer of private enterprise shares to the bumiputra. By the early 1980s, however growth had slowed, and continued high public spending caused fiscal deficits to reach unprecedented levels—as did the external borrowings used to finance them. The public began to question the rationale behind the large public sector. Confronted with a worsening fiscal crisis and protracted deterioration in the balance of payments, in 1982 a new government began implementing economic reforms. These reforms were intended to spur growth, productivity, and efficiency while continuing to redistribute wealth and encourage bumiputra participation in the economy. Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11 of enterprise shares

To continue promoting broader ownership among the native population as state enterprises were privatized, the authorities required that 30 percent of privatization share sales be directed to the bumiputra, 5.13— Broad Ownership Schemes in Chile, Malaysia, and the Kyrgyz Republic (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets who would receive special incentives to encourage their participation. (An additional 5 percent of shares was reserved for company employees.) Even though not all privatizations took the form of share offerings—asset sales, leasing, and management contracts were also used—and the state continued to hold shares (in some cases the majority portion) in enterprises, the bumiputra wound up with 515 percent of the eleven large−scale privatizations that took place during the 1980s. These shares were acquired through direct share purchases by individuals or through a state−run investment fund in which only the bumiputra could invest. By the mid 1980s the bumiputra held 18 percent of Malaysia's corporate wealth. The Kyrgyz Republic. The reversal in economic policy was even more extreme in the Kyrgyz Republic, a small, landlocked nation that used to form part of the Soviet Union. After independence the Kyrgyz Republic suffered an unprecedented decline in output and real incomes, triggered in part by the breakdown in trade among former Soviet states. The drop in output was highest in the industrial sector, at 60 percent, with capacity utilization as low as 30 percent in some subsectors. The Kyrgyz Republic was also among the first former Soviet republics to pursue macroeconomic stabilization and market−oriented reforms. These reforms focused on eliminating distortions inherited from the command system and reducing the state's role in the economy. As part of the second goal privatization was given high priority. By the end of 1996, five years after independence, about half of the nation's shops and other small businesses had been divested, and about threequarters of the medium−size and large enterprises earmarked for mass privatization had been fully or mostly privatized. In the first eight months of 1997 privatization—along with agrarian reform, sound finance, and foreign assistance—increased Malaysia's native population wound up with 515 percent of the eleven large−scale privatizations that took place during the 1980s

Privatization is as much a political process as an economic one agricultural output by 23 percent and industrial output by 41 percent (albeit from very low bases). Privatization as a Political Process

In many ways privatization is as much a political process as an economic one. Those with vested interests in the status quo can generally be expected to oppose reforms. This is a particular challenge with privatization, because those who benefited from public enterprises are loath to give up those benefits. Reforms such as privatization are most likely to succeed when there is public consensus on their implementation. Such was the case in Malaysia where, from a political standpoint, privatization could not ignore bumiputra interests. Many businesspeople and economists, however, saw the special incentives provided to the native population as a drag on efforts to liberalize the economy. At the time the government planned to accelerate development of the manufacturing sector by further liberalizing the policy and legal framework, and a number of new incentives were proposed to attract private investors. Malaysian policymakers solved this sociopolitical dilemma with a share diversification scheme designed to increase share ownership among the bumiputra, who would receive favorable treatment when buying shares of divesting enterprises. (These benefits were not granted to the Chinese and Indian communities, though economically both groups were more powerful.) Broad share distribution was, in fact, just one of several programs used to redistribute wealth to the native Unlike Delivered by Thepopulation. World Bank e-library to: in Chile and the Kyrgyz Republic, where the aaaaaa University complete divestiture of state−owned companies was a key privatization objective, in Malaysia this took a back IP : 111.111.11.11 seat to wealth redistribution. Widespread consensus on the importance of this objective allowed privatization to Tue, 11 Jan 2111 11:11:11 proceed. Privatization as a Political Process (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Similarly, political realities dictated the broad scope and rapid implementation of mass privatization in the Kyrgyz Republic. A reasonably fast mass privatization program—offering about 1,200 medium−size and large enterprises over three years beginning in 1994—was needed to proceed in the face of parliamentary opposition, particularly to what was perceived as the sale of assets at unacceptably low prices. Privatization officials, primarily at the local levels, were generally able to ensure that companies in their regions were ready for coupon auction; at the height of the program almost forty companies a month passed through the national and six regional auctions, and auction calendars were approved as far as six months in advance. The program was, however often slowed when authorities refused to sell companies for less than a certain (inflated) price. And in some cases there were no bidders, reflecting the un attractiveness of many businesses and the amount of capital investment and debt reduction required to renovate them. Politics helped shape Chile's second privatization program as well. Because the government had come under strong public criticism for the abuses of the 1970s program, it used a new approach to win support for state divestitures in the 1980s. At the program's core were plans to encourage share purchases by institutions, workers, and the public. Unlike the earlier program, credit was extended only to employees and small investors, and purchase discounts and incentives were widely used. Rather than providing cheap credit to financial institutions, the state capitalized privatized pension funds with its debts, later swapping the debt for shares in privatizing companies, and prequalified buyers. Debt−equity swaps helped attract foreign direct investment. Strong public support for the redesigned program allowed it to proceed for several years, creating hundreds of thousands of new shareholders and strengthening Chile's securities markets (tanble 13.1). Building Demand for and Ensuring a Supply of Shares Policymakers must consider a range of mechanisms for encouraging investment and delivering shares to investors. They must, for example, consider the form of ownership in which shares are to be held and the benefits of shareholding Table 13.1 Stock market data for Chile, 198695 Millions of U.S. dollars unless otherwise noted Indicator Number of listed companies

1986

1988

231

205

1990 .215

1992 245

Market capitalization

4.062

Trading value

298

610

783

2.029

Turnover ratio (percent)

9.6

10.1

6.3

6.7

GDP

1994

1995

279

284

6.849 13.645 29.644 68.195 73.860 5.263 11.072 9.5

15.3

16.817 22.048 30.825 41.192 54.397 —

Inflation (percent)

19.5

Source: World Bank data.

14.7

26.0

15.4

11.4

8.2

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets to be allocated among program beneficiaries. Successful share ownership diversification schemes do not stop at simply disseminating shares to the public. Policy/makers must also design and implement mechanisms that sustain demand for securities long after share divestiture. Share diversification programs must also ensure a steady pipeline of share sales in order to maintain investor interest and reach securities market critical mass, enabling the broader and deeper trading that increases market liquidity and stability. Providing Alternative Investment Vehicles

The broad ownership schemes in Chile, Malaysia, and the Kyrgyz Republic promoted both direct and indirect investment, appealing to the different requirements of different investors. Direct investment involves direct participation in the buying and selling of shares, often at public offerings or, in the Kyrgyz Republic, at mass privatization auctions (where the medium of exchange was limited to privatization coupons). Indirect investment, through collective investment vehicles such as investment funds and pension funds, allows investors to rely on the judgment of market intermediaries and to reduce their risk through portfolio investment. Program designers have used a number of investment vehicles to implement broad ownership schemes and to build and sustain market demand. In Chile, for example, newly created private pension funds intermediated investor demand for privatized and other shares (see chapter 12). Chile's program also promoted direct investment by individuals. In the Kyrgyz Republic mass privatization allowed direct investment in both coupons and cash, while endorsing the creation of coupon investment funds to intermediate coupon demand. It was hoped that these funds would eventually begin intermediating cash investment as well. Malaysia adopted a variety of mechanisms to broaden share distribution to the indigenous population, including discounted public offerings in which only the bumiputra could participate and a state−run investment fund that intermediated bumiputra demand for privatized securities. Promoting Transparency and Easy Access.

Transparency and easy accessible participation are essential to broad ownership schemes. The Kyrgyz mass privatization provided citizens with a simple bidding format, standardized procedures, and numerous bidding locations nationwide. Information on enterprises, auction dates, and related topics was disseminated through the media. As a result the program attracted broad public participation: by the time coupon auctions ended in mid−1997, 95 percent of the coupons distributed to the public had been invested. Encouraging Direct Market Participation

Direct securities investment allows people to make their own investment decisions—provided, of course, they have money to invest. For this reason the Kyrgyz mass privatization, designed to maximize citizen participation in share distribution, allowed a portion of shares to be sold for coupon points. Privatization vouchers, or coupons, were distributed to all citizens. To allow holders to invest in several enterprises without purchasing additional coupons, coupons were issued in different denominations and amounts based on a citizen's age and years of employment. Coupon distribution was facilitated by a registration system, inherited from the Soviet Union, that tracked all aspects of a citizen's life. The Kyrgyz mass privatization was modeled on Russia's voucher auction program, which featured simple, transparent, and accessible bidding and gave citizens choices for investing their vouchers (including outright sale). As in Russia, Kyrgyz citizens could invest coupons directly at local auctions, where medium−size enterprises of regional interest were offered, or at nationwide auctions, where the largest and best−known enterprises were sold. Unlike in Russia, large concessions to managers and workers—in the form of a large The World Bank e-library to: portion of enterprise shares—were notDelivered neededbyaaaaaa to win acceptance for the program. Kyrgyz managers were not as University IP : 111.111.11.11 well organized or politically connected as were those in Russia, and free distribution of shares to Kyrgyz workers Tue, 11 Jan 2111 11:11:11 was limited to 5 percent. Providing Alternative Investment Vehicles (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets Providing Incentives to Promote Investment

To increase the direct participation of small investors in securities markets, many countries have adopted investment incentives designed to make investment more rewarding and less risky In Chile, for instance, a privatization initiative dubbed popular capitalism encouraged direct participation in the markets by selling shares at a discount and on highly favorable terms. This program initially was created to privatize the banks that had been recapitalized by the Policymakers must design and implement mechanisms that sustain demand for securities long after share divestiture

Competition between investment funds can improve funds management and generate higher returns for investors government, essentially through debt swaps with the central bank. New shares were issued and offered to the public on the basis of a long−term credit from the government, at zero percent real interest and a small downpayment. After a control sale to a strategic investor, remaining minority shares were sold in small lots directly to individuals, often with longterm credit arrangements and such generous tax credits—at first the entire investment was declared deductible for income tax purposes—that many investors believed they effectively had received shares for free.To spread ownership, however, the government limited sales as a function of people's past tax payments, averaging about $7,000 per person per enterprise. In a similar vein, labor capitalism encouraged workers to buy shares in their enterprise, financing the purchase with an advance of up to 50 percent of the future severance pay to which the employee was entitled. Workers typically acquired 510 percent of shares (Hachette and Luders 1988, p. 34), and the government promised to repurchase the shares if they fell below the purchase price. In some enterprises workers then used these shares as collateral for loans to buy additional shares. In a number of such enterprises the dividends from these shares accounted for a sizable portion of employee incomes. Thus, drawing on a variety of innovative incentives and investment arrangements, direct investment by individuals helped increase the demand for securities among new market participants. In the mid− to late 1980s the government began selling off controlling blocks of many large, infrastructure−related companies. This process had to proceed cautiously because of nationalist opposition from conservative supporters of the military regime. Dubbed traditional capitalism, the program sold 30 percent of these companies on the Santiago Stock Exchange, usually in two or more small offerings or auctions. Another 25 percent was reserved for private pension funds. Eventually, after one or two additional offerings, the state became a minority owner Teléfonos de Chile, of which 30 percent was offered through an international tender; is a prominent example of a company privatized in this way. The winning bidder was to invest an additional $337 million, increasing its stake in the company to more than 50 percent. Such sales substantially increased the stock exchange's capitalization during this period, placing it among the primary exchanges in Latin America (see table 13.1). Channeling demand through indirect investment vehicles Alternatives to direct investment limit the control investors have over their investments by allowing securities market professionals to make decisions about investment portfolios. Thus portfolio investments can be ideal for people with limited investment experience. Direct investment leaves investment decisions entirely with the investor; forced savings vehicles eliminate decisionmaking by the investor. Like Chile's original mandatory contribution pension scheme, beneficiaries of forced savings vehicles play a passiveDelivered role, with no voice in selecting the companies in the portfolio or the by The World Bank e-library to: aaaaaa University manager of the funds. IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

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Privatization and Emerging Equity Markets Between these extremes in investment control are indirect investment vehicles such as the investment funds used in Malaysia and the Kyrgyz Republic and the private pension funds used in Chile. Both kinds of funds give investors an active and a passive role. The Kyrgyz funds do not allow investors to select companies for investment, but investors can choose among coupon investment funds or can choose not to invest through a fund. In Chile pension funds compete for investors, who can choose among the funds. Malaysia's investment fund provided less investor choice—one fund was reserved exclusively for native Malay investors, so investors could choose only whether to invest. Competition between investment funds can improve funds management and generate higher returns for investors. Designing Indirect Investment Vehicles with Different Objectives

The design and establishment of indirect investment options vary depending on the fund's stated objective. In the Kyrgyz Republic the state wanted to provide a mechanism that would intermediate the demand among coupon holders. Thus it created the legal framework for establishing coupon funds but played no role in setting them up, preferring to encourage market mechanisms. Because the funds were limited to holding 25 percent of the shares of a single enterprise, however they could not play an active role in the governance of their portfolio companies. Similarly Chilean officials created the legal framework for private pension funds. These funds hold and manage shares purchased on behalf of citizens entitled to payments from the fund upon retirement. The government sold debt to the new funds to ensure that pensions outstanding under the old

system would be funded. Once privatization shares became available, they were purchased by the pension funds in exchange for the state debts. A government initiative known as institutional capitalism referred to the sale of packages of shares of some state enterprises, usually public utilities, to the pension funds. The funds soon became a significant source of funds for privatization, acquiring 25 percent of the largest privatized companies. Whereas the investment intermediation vehicles used in Chile and the Kyrgyz Republic were intended to broaden securities market participation, Malaysia's single fund targeted a particular group. This state−owned and −run investment fund, similar to a unit trust or mutual fund, invested in Malaysian corporations. Called the National Unit Trust, it offered units to the bumiputra at a price fixed for ten years (until 1990), with financial returns to investors expected in the form of dividends and occasional bonus units. Most significantly, only the bumiputra could purchase National Unit Trust units. By 1987 more than 2 million people—about 44 percent of the eligible population—had invested more than $1 billion. Besides broadening share ownership efforts to the indigenous population, the Malaysian authorities had additional concerns that led them to introduce the National Unit Trust. For one thing, they wanted to reduce the number of shares that the bumiputra would later sell to nonbumiputras. For another, they wanted to prevent privatized shares from being concentrated in the hands of high−ranking native officials. Thus, rather than only allowing direct share investment on preferential terms, they decided that a portion of privatization offerings should be allocated to a single privatization fund in which only the native population could invest. Of the 515 percent of the large 1980s privatizations owned directly or indirectly by the bumiptra, roughly half were purchased directly by individuals. The balance was held in the National Unit Trust. Given the wealth redistribution component of the Malaysian program, officials determined that the state should maintain control over this trust. Shares of other companies purchased by the government to meet indigenous ownership requirements have also been added to the trust. The Malaysian authorities, intent on the widespread distribution of units in the National Unit Trust among the bumiputra, instituted policies to achieve this goal. create demand Delivered by The To World Bank e-library to: for investment fund units among this largely aaaaaa University rural and risk−adverse population, the first M$4,000 investment in unit dividends was declared tax−exempt. In IP : 111.111.11.11 addition, the state could extend credit for nine units for every trust unit purchased. Moreover, the trust Tue, additional 11 Jan 2111 11:11:11 was allowed to sell poorly performing shares back to the state. Program rules also stipulated that no investor could Designing Indirect Investment Vehicles with Different Objectives (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets buy more than 50,000 units, and that all investors be at least 20 years old. (This second measure was intended to reduce additional share control by parents and guardians through beneficial ownership of shares held in trust for minors.) The Malaysian scheme resulted in widespread participation in the privatization investment fund by the indigenous population, which helped stimulate the local securities market. This initial exposure to securities markets helped increase direct investment by this group as well. Coupon investment funds were not as popular in the Kyrgyz Republic. During mass privatization coupons could be invested in one of seventeen national coupon investment funds. The funds, which exchanged coupons for their shares and invested them at privatization auctions, developed spontaneously. They were thought to provide coupon investors with an alternative to direct investment—considered risky because of inadequate information to help individuals make investment decisions—and to have better access to privatizing companies than the average citizen. The funds, however, accumulated just 20 percent of invested coupons. The investment scandals that rocked Russia in 1994 were one reason for the poor showing of the Kyrgyz funds. A more fundamental reason, however, was that the predominantly rural population preferred to invest directly in local enterprises with which they were familiar. This may also be the result of a perception that the best companies in the Soviet Union were in Russia, and that the best managers were now there as well. Kyrgyz coupon investment funds did not evolve into mutual fund−type investment vehicles, as many had hoped. Coupon investment funds were extremely strapped for cash. They did not have the benefit of the commodity and other asset exchanges that sprang up in Russia, where voucher trading became a big business and investment funds could stay afloat by trading in the exchanges. These exchanges did not develop in the Kyrgyz Republic because it lacked the economic resources and tradable commodities available in Russia at the start of reforms. In any event, many Kyrgyz investment funds sold shares to enterprise managers to raise cash, and some have even Widespread participation in the privatization investment fund by Malaysia's indigenous population helped stimulate the local securities market

The Chilean government actively sought foreign portfolio investment to supplement domestic savings and increase demand for securities borrowed to pay dividends to shareholders. To promote profitability, a recently adopted regulation allows the funds to engage in other businesses. Double taxation, which have had reduced the attractiveness of these investment vehicles, also has been eliminated. Since 1996 coupon investment funds have had to be licensed and follow new reporting and disclosure requirements and accounting standards. Share Diversification and Ownership Concentration

Chilean policymakers were so intent on avoiding past mistakes that many companies ended up as orphans, with shareholdings spread so thinly that outside shareholders had little opportunity to exercise their rights as owners. As a result effective control usually fell to enterprise managers. Broadening ownership involves more than just spreading shares in order to achieve a healthy market—it also implies a well−crafted share distribution program, with an appropriate portion of shares allocated to small investors and another portion for large, institutional investors. A mix of large and small investors is essential to building liquidity in a stock. Many enterprises wound up under management control in the Kyrgyz Republic as well, though here it was partly the result of a program design that discouraged market−based asset pricing, depressing sales. Until 1996, for example, the cash sales (for 70 percentDelivered of shares) followed coupon auctions typically set minimum prices far by Thethat World Bank e-library to: aaaaaa University above what investors were willing to pay. While in later cases the prohibition of floor prices expedited sales, early IP : 111.111.11.11 on many depressed, often highly leveragedTue, enterprises unable to attract even a single bidder. Thus one of 11 Jan 2111were 11:11:11 mass privatization's main objectives—to create a core shareholder or group of shareholders in these firms—did Share Diversification and Ownership Concentration (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets not materialize. In most cases this parcel of shares was bought by the old guard managers of the enterprise or by an entity, controlled by the managers, not under immediate pressure to reform. As a result many privatized firms in the Kyrgyz Republic continue to be controlled by their managers, not by their shareholders. Kyrgyz policymakers had hoped that these majority cash sales would prevent too wide a spread of ownership, fearing the potential for orphaned companies if too many shares were sold for coupons. Thus mass privatization limited the amount of shares earmarked for individuals by capping the coupon auction at 25 percent of shares, with 5 percent free for employees. The remaining 70 percent were to be sold in a number of ways, but nearly all the companies fully or majority privatized in the Kyrgyz Republic sold shares through, classic open−outcry auctions. Broad Ownership Schemes and the Growth of Securities Markets Securities markets must sustain the supply of and demand for new equity. The modes of divestiture used may be instrumental in strengthening securities markets. But levels of market liquidity, depth and breadth of market trading, and sophistication of market infrastructure are of equal importance, for they help define how shares can be distributed in developing markets and how secondary market trading will be supported. Without institutions to sustain investor demand and attract new share supply, the potential benefits of broad ownership schemes may not be realized. The demand for and supply of enterprises brought about by privatization in the 1980s propelled the development of Chile's securities markets. An enormous supply of enterprises became available for privatization as the government divested the hundreds of companies nationalized by the Allende government. By late 1989 only 50 of some 600 nationalized companies remained in state hands, and the volume of share transactions had increased many times—from $41.9 million in 1984 to $917.6 million, of which more than 65 percent represented trades of privatized shares. The broad ownership schemes implemented in the 1980s boosted the number of individual shareholders from 372,000 in 1984 to 630,000 by 1989, catalyzing demand for securities. The Chilean government actively sought foreign portfolio investment to supplement domestic savings and further increase demand for securities. Partly as a result, the capacity of the Chilean securities market to absorb new issues expanded rapidly during the 1980s, with more than 60 percent of all transactions in privatized companies occurring during this period. Growth in market demand was greatly stimulated by debt−equity swaps for foreigners, who could essentially exchange Chile's foreign debt (at 60 percent of face value) for shares in privatized companies. Nearly $500 million in foreign capital was invested in Chilean privatization during this period, partly as a result of this program. Malaysia's securities markets also have benefited greatly from the increase in the supply of and demand for securities resulting from privatization. Malaysia has a well−developed

equity market consisting of the Kuala Lumpur Stock Exchange, which boasts fifty−three members. In 1990 trading volume on the exchange totaled nearly $11 billion (table 13.2). The exchange has an active market for primary issues—in 1984 alone there were sixty−four public offerings worth more than $1 billion. The exchange's absorptive power is evidenced not only by the efficient primary market for privatization issues but also by the gains in market capitalization that these issues have experienced in secondary trading. For example, the combined market capitalization of two of the largest privatizations—MAS, the national airline, and MISC, the national shipping company—rose from less than $700 million in the mid− 1980s to about $3 billion in 1992. Privatization issues accounted for 29 percent of market capitalization by the same Delivered by The World Bank e-library to: year. aaaaaa University IP : 111.111.11.11 Tue, markets 11 Jan 2111prior 11:11:11 securities to

Chile and Malaysia had functioning initiating their share divestiture programs. The Kyrgyz Republic, as one of the former members of the Soviet Union, did not. The national network of auction bid Broad Ownership Schemes and the Growth of Securities Markets (c) The International Bank for Reconstruction and Development / The World Bank

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Privatization and Emerging Equity Markets collection centers, centered in Bishkek, served as a proxy for a sharetrading infrastructure. Kyrgyz authorities moved early on to encourage private establishment of a stock exchange, however During 1994 and 1995 the government promoted the creation of a national exchange, related infrastructure, and a legal and regulatory framework to support the sale and trading of privatized shares. Though thirty−eight companies were listed by the end of 1997, trading volume and market capitalization have been exceedingly low (table 13.3). During 1996, $200,000 in equities were traded (up from $54,000 in 1995, the exchange's first year of operations). In March 1997 market capitalization barely totaled $5 million. During mass privatization trading also took place in coupons and, more recently, in government treasury securities. Table 13.2 Stock market data for Malaysia, 198695 Millions of U.S. dollars unless otherwise noted Indicator Number of listed companies Market capitalization

1986

1988

223

1990

1992

1994

369

1995

238

282

478

529

15.065 23.318

48.611

94.004 199.276 222.729 21.730 126.458

Trading value

1.180

2.623

10.871

Turnover ratio (percent)

7.8

12.5

24.6

27.3

58.7

35.9

27.735 34.750

42.745

58.023

72.400

—

2.6

4.8

3.7

5.3

GDP Inflation (percent)

0.7

2.6

76.822

Source: World Bank data. While a number of mass−privatizing countries have allowed all privatized companies to trade on their exchanges, the Kyrgyz stock exchange's strict listing requirements demand a high level of corporate disclosure. Few of the many enterprises that have gone through coupon auction can meet these requirements. And even if they could, company managers have avoided listing, fearing increased disclosure and a loss of corporate control. Many are even concerned that sales proceeds would be taxed as income and seized by the tax authorities. A second−tier listing introduced in January 1996 does not allow companies to raise new capital through share sales, making it just as unpopular. Second−tier listing requirements were relaxed somewhat in 1997, however. As Kyrgyz privatization officials ran into problems selling remaining state shares following coupon auctions, they attempted to distribute privatization shares, on a selective basis, through the Kyrgyz stock exchange. This effort has not been entirely successful; in some cases no agreement could be reached on offering price. Using the stock exchange for remaining privatization sales could, however, supply new enterprises to the exchange and direct privatization demand—for the first time—through the securities markets. Have Broad Ownership Schemes been Successful? The broad ownership schemes in Chile, Malaysia, and the Kyrgyz Republic were undertaken for a variety of Delivered The World Bank e-library to: political objectives. In Malaysia the goal wasbyto promote economic activity among the native population. The aaaaaa University IP : 111.111.11.11 Kyrgyz Republic's scheme sought a rapid and massive redistribution of productive assets. In Chile the broad Tue, 11 Jan 2111 11:11:11 ownership schemes of the 1980s were designed to prevent the abuses that arose Have Broad Ownership Schemes been Successful? (c) The International Bank for Reconstruction and Development / The World Bank

180

Privatization and Emerging Equity Markets

Table 13.3 Stock market data for the Kyrgyz Republic, 199596 Millions of U.S. dollars unless otherwise noted Indicator

1995

1996

10

27

Market capitalization

4.35

4.93

Trading value

0.05

0.21

Turnover ratio (percent)

—

3.7

3.100

—

31.5

—

Number of listed companies

GDP Inflation (percent)

Source: Kyrgyz Stock Exchange Kyrgyz managers have avoided listing, fearing increased disclosure and a loss of corporate control

Investment funds and pension funds have helped create and sustain market demand from an earlier attempt at privatization. All three schemes created demand for equity by bringing in individuals and creating institutions that previously had not invested in enterprise shares or investment funds. In each case the shareholding population was broadened considerably. In terms of sustaining long−term demand for securities, Chile's private pension funds and Malaysia's bumiputra−targeted investment funds have been extremely successful. While the Kyrgyz Republic's privatization program has created a country of shareholders, securities markets have failed to develop. The lack of trading of privatization issues on the nation's young stock exchange, the absence of viable investment intermediaries, and the economywide lack of cash resources have made it difficult for the Kyrgyz authorities to use share ownership to develop active securities markets. The Kyrgyz Republic started from a much lower base than Chile and Malaysia, however, and market institutions will take longer to develop. Each broad ownership scheme has increased demand for shares. Still, it is the institutions that manage investment—such as the investment funds and pension funds discussed earlier—that have helped create and sustain market demand over the long term. Given the size of its potential trading activity and access to information, institutional investment propels market growth and sets its direction. Institutionally sustained demand for securities improves market values and provides an attractive, stable environment for investment by individuals. References Al'alim, Ibrahim. 1994. Rebalancing the Public and Private Sectors: The Malaysian Privatization Experience. Delivered The Worldnonmember Bank e-library to: Paper presented at the OECD workshop with by dynamic economies on privatization, 25 March, Paris. aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

Guevara, Ramiro. 1996. Capital Creation. Infrastructure Finance (April): 5556. References

181 (c) The International Bank for Reconstruction and Development / The World Bank

Privatization and Emerging Equity Markets Hachette, Dominique, and Rolf Luders. 1993. Privatization in Chile: An Economic Appraisal. San Francisco: International Center for Economic Growth. Larrain, Mauricio. 1989. How the 198183 Chilean Banking Crisis Was Handled. Policy Research Working Paper 300. World Bank, Washington, D.C.

Delivered by The World Bank e-library to: aaaaaa University IP : 111.111.11.11 Tue, 11 Jan 2111 11:11:11

References

182 (c) The International Bank for Reconstruction and Development / The World Bank