We’ve reached peak state capitalism – what comes next?

9 Apr 24

Dag Detter explores how governments might maximise the benefits of public wealth, through managing their assets better and using Net Worth-based fiscal rules.

The limits of state capitalism are visible worldwide, from China, Pakistan, Egypt, and Nigeria to Ukraine. Globally, state-owned enterprises’ assets are worth the equivalent of half of global GDP, while government-owned real estate is worth twice that amount.

Decades of research, including from the IMF, have shown that government-owned businesses are, on average, one-third less productive than private firms. This is hampering financial sector reform and the efficient allocation of capital, leading to constrained economic development and growth.

What is needed is more private sector, more competition and economic growth. However, launching a wholesale privatisation drive like in the 1980s and 1990s is neither politically desirable nor financially efficient, as this usually results in an undue transfer of public wealth to the private sector. This time around, it will be paramount to ensure that public wealth is maximised to the benefit of society as a whole, helping to pay for the investments required to improve infrastructure, climate, and the needs of a greying population.

Adopting accounting-driven, Net Worth-based fiscal rules or targets for the government in general, along with professional management of public assets, creates major opportunities to improve a country’s long-term public finances while simultaneously addressing short-term problems. IMF research makes clear that governments with stronger net worth (assets minus liabilities) recover faster from recessions and have lower borrowing costs.

Introducing professional management of the portfolio of public assets consolidated within a holding company – a Public Wealth Fund (PWF) – will maximise the portfolio’s value and dividends, thereby improving the government’s fiscal space and financial sustainability.

Setting up a PWF requires four parallel workstreams (commercial, legal, accounting, and financial) coordinated by a project management office or team that will help define, execute and manage stakeholders under the leadership of a steering committee or independent non-executive board.

The commercial workstream would typically have the support of a management consultancy firm that would make assumptions about the ‘best use’ of assets and prioritise the sectors and assets with the best potential to be managed successfully. Designing a strategy and a business plan for each sector and the underlying assets, resulting in a comprehensive strategy for the portfolio, including the sequencing and timing of potential investments and divestments required.

A law firm would support the legal workstream and conduct the due diligence, including an asset review, legal approvals, constraints, and requirements. The firm would also advise on the group’s legal structure and governance to function as a private-sector holding company. With the help of an international accounting firm, the accounting workstream is responsible for formalising asset valuations and producing an initial set of financial statements using International Financial Reporting Standards (IFRS).

The financial workstream involves rating advice by an international investment bank and its rating specialists, who help tailor all the above workstreams to obtain the best possible bond rating to achieve the lowest possible cost of debt funding. The financial advisor would also advise on the sequencing and optimal timing of potential IPOs and divestitures to streamline the portfolio and each business. All of these efforts would not only boost private sector development but also help deepen capital markets.

Professionalising portfolio management requires independence from short-term political influence, including the capacity to hire professional managers and advisors at market rates. Although a PWF should not be market-leading in compensating professionals, it will need sufficient political and financial independence to attract the right talent and hire professional advisors. Modelled on private equity and infrastructure funds, the professional portfolio management team would be organised into sector teams, with the aim of transforming the portfolio towards a similar level of productivity and profitability to that of its private sector equivalents in each segment.

The strategies laid out for each portfolio company are executed by its CEO, with the support of an independent supervisory board of experienced business executives.

Institutionalising the independent holding company at arm’s length from short-term political influence requires the PWF to conduct its business transparently and to at least the same standards as a listed investment company in the private sector. This is because the PWF is truly a public company owned by the taxpayers.

This also requires a transparent performance evaluation of each management and non-executive board member in a comprehensive process. This yearly evaluation should be set against the business plan and market analysis to gain the trust of the stakeholders. This process ensures that relevant competencies are present on the board and that governance works in accordance with objectives and relevant market outlook.

Adopting accounting-driven, Net Worth-based fiscal rules/targets along with professional management of public assets creates major opportunities to improve long-term public finances. It will help generate an additional income for the government of several per cent of GDP annually, depending on the size of the portfolio that is consolidated. This without cutting public services or increasing taxes – to the benefit of society as a whole.

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