Poor management and losses at Sri Lanka’s largest state-owned enterprises (SOEs), its petroleum and electricity utilities and its airline, were major contributors to Sri Lanka’s economic crisis. As part of a crisis solution, Sri Lanka now needs to figure out how it will settle the debt accumulated by these three institutions, which are in the billions of dollars.

In some areas of the economy, the state’s role is indispensable, like in infrastructure that is beyond the capability of the private sector to fund due to their scale and risks.

However, states intervening in multiple areas of the economy, monopolistic control, and crowding out funding rarely serve the long-term interest of taxpayers who fund these. Sri Lankan managers of state ventures have demonstrated a general lack of capacity, alignment with objectives and poor governance can, indeed, lead to disaster.

A former BOI and Agency for Public-Private Partnerships Chairman, Thilan Wijesinghe, and a former economic advisor to the finance minister Daniel Alphonsus, joined a conversation about reforming the state enterprises and the role of the state in business.

One big problem we see with SOEs is their not market-pricing products or services they offer. This is an obvious one. But if we step back and look at the plethora of challenges that confront SOEs, how would you outline them and what are they?

Daniel: The challenge Sri Lanka faces is figuring out what the role of the government is vis-a-vis SOEs. I think we need to come to terms with two big principles.

Firstly, when exactly should the state intervene in the market? Currently, there seems to be no clear principle. The state involves itself in areas where there are natural monopolies, for example, railways, where it often doesn’t make sense to have multiple train tracks.

But then the state is also involved in many highly competitive areas; for example, hotels, or retail distribution. It is involved in very large enterprises that require a huge amount of capital, for example, oil refining, but also in very small enterprises, like BCC, which produces choir products and chemicals. So there seems to be no clear rationale behind why the state is engaging in private enterprise. That’s something that first needs to be established.

In my view, considering the consistent lack of capacity of the Sri Lankan state in general, and in particular, in commercial areas where we see consistent losses, the state should withdraw from any areas where the private sector can deliver those services at a cheaper price more efficiently, and at higher quality and improved productivity. In other words, the government should withdraw from any area where there is competition. In the case of natural monopolies, it’s a little bit more complex. That can be a second phase of the discussion. But I think the very first step is for a complete withdrawal of the state from any competitive market.

Now, the second principle, insofar as the state is engaged in private enterprise, in other words, where there are SOEs is that there are no subsidies. In other words, there is full cost recovery.

The reason for this is it creates huge conflicts of interest when you start packaging subsidies with commercial operations. There is often a very good case for providing targeted subsidies of various sorts, but those should be done through specialized agencies.

Thilan the state appears to be conflicted about its role in the enterprises it owns.

Thilan: The role was quite clear in the late 1990s when I was chairman of the Board of Investment and on the board of the Public Enterprise Reform Commission (PERC), we adhered to the same principles that Daniel outlined, and would continue to get out of businesses like gas, steel, Sri Lankan airlines, etc.

But there was a reversal of that policy commencing around 2005. You had situations where privatized companies were taken back, such as Sri Lanka Insurance. Looking at the statistics today, losses by state enterprises are at such vast proportions. A case in point would be Sri Lankan airlines, which was breaking even under private ownership. It was re-acquired a few months before peace came to this country. Despite the growth of tourism and other favourable factors, Sri Lankan airlines continued to rack up losses.

There’s sufficient information and a track record to prove the state cannot run any business.\

How do we approach unpacking this? Is unravelling this the priority? Can we do that without an overarching vision for state enterprises?

Thilan: An overarching policy framework and a legal framework are required. The PERC law was annulled more than 10 years ago. We need to, go back, and legislate to ensure that we have a policy framework and can enable it, whether it’s divestiture, Public-Private Partnerships etc.

Once that happens, we can put state enterprises into different buckets. That would be the easy ones, such as the Building Material Corporation, Sathosa, the hotels and BCC, which manufacturs soap, could all be divested.

Just to give you the case of the Building Materials Corporation, which I looked at about four years ago when I was the chairman of the PPP agency in the finance ministry, they had 700 million rupees of liabilities, to the state banks, which they couldn’t meet. But they also had over 12 billion rupees in assets, mostly land. They had land in all of the key commercial locations in Sri Lanka, in the major towns, including Colombo. It would have been a fairly simple exercise.

Now, for whatever reason, if the government wanted to remain in the building materials business, it could have done so with a narrow goal to meet the needs of society in a targeted manner. But it could have been structured in a manner where the BMC could have paid off its debt, the government could have gotten a huge dividend from the disposal of the land when there is significant demand for it.

You need an overarching policy framework and one or several pieces of legislation to govern these. The individual enterprise should be put into separate buckets of short-term, medium and long-term. Each enterprise’s reform will have to be considered in isolation, once an overarching policy is in place.

The equity in all these enterprises is owned by the finance ministry. How are they managed, should not the shareholder have a say, and does the shareholder enforce governance and set expectations for these institutions? Does that offer some structure with which we can work?

Daniel: One of the challenges is the heterogeneity of governance. You have state-owned enterprises that have government departments like the Ceylon Government Railway, which is administered under administrative and financial regulations. Then you have SOEs that are set up under specific acts, like the Ceylon Petroleum Corporation, the Bank of Ceylon or People’s Bank, which have their own set of governance standards, then you have SOEs that come under general government-owned business undertakings and ones like Sri Lankan airlines, established under the companies act.

You have all these different companies, and they all have different reporting requirements. In my view, all state-owned enterprises should be subject to the disclosure requirements of a company listed on the Colombo Stock Exchange. And to make that practically enforceable is to list debt, which will force them to comply with that regulation.

You’ve had two stints in government as Chairman BOI and then later as chairman of an initiative within the finance ministry looking at public-private partnerships. You may have a view about how decisions are made, and how things are run. Do we have enough to harness in terms of governance structures and legal frameworks?

Thilan: I believe that the finance ministry needs to play the role of a shareholder activist, so to speak. Currently, the public enterprise department within the finance ministry does not have the required teeth, they are merely a postbox to approve cadres, vehicle purchases; and things of that sort. Representation on boards is extremely weak.

For example, in many organizations, it’s relatively junior level officers of the public enterprise department that sit on boards, who usually are overruled by the board Chairperson of some of these state-owned enterprises.

Effectively, the balance of power has shifted significantly in the direction of ministers in charge, and the ministries as opposed to the owners. Therefore, I advocate that certain administrative reforms are required. I believe that any loss-making state enterprise, a senior level treasury official, either the secretary treasury or DST level should sit on the board. Such boards should be given directions as to spending and required to stick to KPIs.

Until such time the finance ministry exerts authority over these assets and shares that they own, I’m afraid that the line ministries will continue to mismanage these enterprises.

You need an overarching policy framework and one or several pieces of legislation to govern these. The individual enterprise should be put into separate buckets of short-term, medium and long-term. Each enterprise’s reform will have to be considered in isolation, once an overarching policy is in place

You’ve seen how the government works from the inside? Do you feel it has the capacity, the vision as currently, it is structured, to start addressing these challenges?

Thilan: Well, now is a better time than any. We are facing issues connected to overexposure by the banking system to state-owned enterprises.

We had a similar situation in the late 90s. When I joined the government, we had a war situation and at the time we had not started to tap into international capital markets, so there was a capital shortage. And decisions were made that the CEB would encourage the private sector to build power plants. And that’s how we started our first private mini hydro and thermal power plants. A decision was made that the port should not remain a monopoly and we proceeded to do SAGT.

I certainly believe now is the time to develop a strategy and a communication strategy. I cannot emphasize enough the necessity to generate stakeholder support. This must be done at the level of the finance ministry to implement state enterprise reform. This was the case in the late 1990s.

In the case of the port, we developed a very simple message. A port cannot afford to go on strike and therefore, by definition, a port terminal should not be a monopoly of the state. Similarly with Telecom, then Minister Mangala Samaraweera said, why should anyone wait two and a half years to get a fixed telephone line?

There were certain issues that we put before the trade unions and consumers. We all appeared on television to justify why profit-making enterprises should be privatized, to benefit the consumer.

Daniel: Ideally, we would have done many of these reforms, as was the case in the ‘95 to 2004 period, roughly. Where there was effort put to improve governance and reduce politicization, improve the quality of management, and essentially, what can broadly be described as governance reform, improved meritocracy, and better management.

However, in the current situation, it’s simply going to be a necessity that drives these reforms. There are going to be two types of necessity.

First, for the government to hit its fiscal targets, because of the dire situation it’s in, it’s going to de facto, I imagine, impose hard budget constraints. That will force the quality of management to improve. What was impossible before has become possible now.

The second area is the necessity to drive privatization. Already there is a debate on whether domestic debt needs to be restructured. I cannot see how we will achieve debt sustainability without some level of restructuring of domestic debt. That will naturally affect the banking sector and may result in the necessity for recapitalization.

How the government of Sri Lanka is going to recapitalize the banking sector? I can’t see that happening without a significant divestiture of assets. That will automatically result in a process of privatization and improved governance and competence, in that sector.

If we look at our fundamental problem at the moment, it’s debt sustainability. How do we make that sustainable? It’s by increasing revenue, reducing expenditure, and increasing growth. Privatization targets every one of these, it increases revenue, both directly and through taxation

This notion about selling the family silver. Are these assets actually silver? Are these actually assets?

Daniel: In many cases, there are a bunch of liabilities. The question is what is the return you get. I suspect in a vast majority of cases, the taxpayer will get a greater return from the tax proceeds that arise as a continuous flow from the privatization, more so than even the value of the assets.

In either case, the taxpayer is benefiting from privatisation. Lower expenditure, higher tax revenue, and a windfall in the form of the actual divestiture of the assets as well, and finally, higher productivity and growth in the long term.

For all these reasons, it’s super important to privatize the SOEs.

If we look at our fundamental problem at the moment, it’s debt sustainability. How do we make that sustainable? It’s by increasing revenue, reducing expenditure, and increasing growth.

Privatization targets every one of these, it increases revenue, both directly and through taxation. It reduces expenditure by reducing losses, helps to drive growth a lot faster through productivity improvements, and also often brings in FDI. So it’s close as you get to a silver bullet.

If we get into privatization, we will be in a fire sale sort of situation. Is that something that we cannot avoid?

Thilan: One point to make is that we’ve delayed restructuring some of these enterprises that valuations will become an issue. For example, when I last looked at Sri Lankan airlines’ restructuring and privatization, the debt levels owed to the state banks and other state enterprises, such as Petroleum Corporation were in the region of about 475 million dollars.

Today, it’s close to 900 million dollars. Now, how do we just create value within Sri Lankan airlines? One would be to remove the state debt owed and refinance it so that you take it off the balance sheet. With some of the assets, such as Sri Lankan Catering and some of the landing slots in the routes it has, immediately the airline becomes profitable.

I’ll just give one more example, take the CEB. You’re not getting any price from the CEB because its revenue is far lower than its expenditure. But if you look at CEB’s renewable assets, you might be able to package them and market this to a renewable energy fund and get a couple of 100 million dollars into the CEBs balance sheet.

It may not necessarily be that you’re privatizing CEB, you’re instead looking at some of the assets that are within some of these state-owned enterprises and looking at their commercial value. The more you delay the lower the prices will be for such assets. But you can dress up the balance sheets in a manner that the state would receive optimum pricing.

There is another point: if the state continues to own a 30% to 40% minority stake, by attracting the new management, you would see greater value enhancement in that minority stake as opposed to the state owning 100%. So there can be compensatory factors over time, where the state could catch up on some of the value that it gives up at this stage.

Daniel: I just want to make one very quick point, which is, that without stabilizing the situation, things are going to get worse. The costs of that are far greater than the opportunity cost of higher valuations. The immediate priority should be macroeconomic stabilization. As discussed earlier, privatization hits revenue, and expenditure impacts growth, and therefore even at fire sale prices, we should go ahead.

What is the fire sale price? Is that a 50% discount on net assets?

Thilan: It is a willing buyer and a willing seller. With every state enterprise, for example, Sri Lanka Telecom we issued RFPs and went through a transparent process. We had the highest bid coming from NTT, the Japanese telco, France Telecom and Korea telecom were also bidders.

So you can achieve price optimization by following due process on the one hand, and bringing in specialized transaction advisors who potentially understand where the buyers are, and where should we be targeting FDI to come into this, to attract the widest possible interest. Because if there is bidding competition for these assets then the government could optimize its value.

Daniel: The challenge for Sri Lanka is less in terms of timing, which we have much less control over. What we do have control over is the process. Ensuring a transparent, apolitical, clean process of privatization, is critical.

Start with companies where there’s already a market price established. If we look at SLT, if we look at some of the hotels and some of the other state-owned enterprises like SLIC, there is already a price established, because many are listed on the stock exchange. Therefore, the scope for any irregularities is limited and that can ensure that the highest value is captured for the taxpayer.

One challenge we will potentially confront here is that these SOEs aren’t reporting on IFRS. Very few of them are private limited companies. So you are confronted with understanding their net assets in the first place. This potentially before privatization requires some analysis, and valuation expertise to be brought to bear, to even understand where we stand.

Thilan: The Sri Lanka Ports Authority’s latest audited accounts are two or three years old. There should be specific penalties associated. We must follow Stock Exchange disclosure rules when it comes to financial reporting at a minimum. They must adhere to the standards under the Companies Act, even though it may operate as a separate authority and that is where oversight by committees of Parliament and by the finance minister, has to come into play.

Significant analysis has to be done particularly amongst the big fish. Let’s look at the highest loss-making four or five enterprises accounting for maybe 80% of the state enterprise losses. Sri Lankan airlines, petroleum corporation, the CEB and water board. Those four are the biggest.

Now at each one, the legal structure is different. The exposure to the two state banks from the CPC alone is over $2 billion. Then you add what Sri Lankan airlines owes to CPC and the state banks, that’s another 900 million dollars. The numbers are staggering.

The immediate priority should be macroeconomic stabilization. As discussed earlier, privatization hits revenue, and expenditure impacts growth, and therefore even at fire sale prices, we should go ahead

Therefore, we’ve got to look at it in the context of the overall debt restructuring to see whether some of these liabilities can be refinanced.

Now, in the case of Sri Lankan airlines, we started speaking to AIIB to see if we can refinance some of the exposure to the state banks via a separate loan taken under the Treasury.

But the fact of the matter is, to attract capital, whether it’s private, local capital or international capital, there has to be a confidence-building exercise. At the moment Sri Lanka suffers from a massive deficit in confidence.

Whoever the finance minister is, going forward, has a crucial role to play to win the confidence of the international community, which we were able to do at a time of war in the late 1990s and 2000s.

If you look at the blue chip companies that invested in this country at that time. I can’t remember the last time a non-state-owned blue chip foreign company invested in this country.

We are potentially about to embark on an exercise to recast the Constitution. Now you don’t always associate the Constitution with State Owned Enterprise reform. Should we look at the potential of SOE reform when we amend the constitution?

Daniel: There are ways in which SOE reform is linked to constitutional reform. The first is on the funding of SOEs and the second is with respect to their governance.

Let’s start with the funding. If strong fiscal rules are established for the government of Sri Lanka, that will mean that the quasi-blank cheques that SOEs have had will no longer exist. Therefore, hard budget constraints will start coming into place, and that will automatically improve SOE governance and performance.

The second is on the governance side of things. Here, I see two ways in which the constitution could improve SOE governance. The first is with respect to the appointment of boards of directors. Currently, the process, as we all know, is highly politicized. In general, it’s at ministerial discretion. Instead, through a device like the Constitutional Council, or a body that is appointed by it, there could be a nominating authority or one that ensures that there is some process of veto in place to ensure that high-quality directors are put in place. Just like the fit and proper test established by the central bank for bank directors.

Another way governance can improve is through the introduction of competition and the resolution of conflicts of interest. Clear competition and anti-monopoly provisions in the constitution could prevent state-owned enterprises from exercising their monopolies, and these often lead to inefficiency and rent-seeking and other undesirable management practices. Ensuring that no sector is monopolized by a state-owned enterprise could be one aspect of it.

The second is establishing a clear principle that states that a given agency cannot perform multiple functions. Let’s take the Ports Authority as an example. It is the regulator of the port sector, it’s an operator of terminals and it is also the land owner. It’s performing all these different functions and there is a plethora of conflicts of interest, which lead to suboptimal policymaking, rent-seeking and even corruption.

This current constitution has been amended 20 times but we’ve also seen state enterprises operate under constitutions before the one we have. Was it different back then?

Daniel: The ‘72 constitution marked a clear break in the structure of the Sri Lankan state. The Public Services Commission, which was responsible for the appointment, promotions and transfers of civil servants was abolished. And that led to a huge politicization of the civil service, which up to that point, had acted relatively independently.

Second, a section in the constitution was introduced, which allowed the minister not only to appoint the Secretary but replaced a provision which said the minister can provide ‘general direction and control over the Secretary’s actions, to ‘direction and control’. The elimination of the word ‘general’ transformed the minister from a policymaker into an operational CEO.

Instead of setting broad policies, suddenly, ministers were responsible for transferring people from A to B, and for deciding where specific money was allocated, and projects were built, rather than setting the general direction of policy in that specific domain.

This led to a huge politicization and radically changed the incentives that ministers and secretaries had.

So to summarize, the minister who was the Chairman and the Secretary as CEO, almost swapped positions. The minister became the person who operationally dealt with everything and the Secretary became the chairman who dealt with policy issues.

Daniel is talking of an era when we had permanent secretaries. How was that different in your view from what we now have?

Thilan: I was still in school, but my father reported to permanent secretaries and there was consistency. Despite changes in ministries, the Permanent Secretary carried through with the policies.

But here what happens is, a new minister comes, and immediately whatever the plans, are thrown out, and the minister, who wants to learn on the job, starts yet another planning process and decides on what to implement. I’ve seen this time and time again. For instance, I have lost count of the number of tourism master plans we’ve had in this country.

I go back to the importance of a central unit such as the National Planning Department, an overarching economic council that will advise the head of state, Prime Minister, Finance Minister, etc. Over time these have been dismantled by autocratic bureaucrats, who themselves started behaving like politicians, possibly hiding behind this particular constitutional provision.

We’ve also got to attract talent into the bureaucracy. The last time I was in government, there was at a minimum one to eight gap difference between a secretary’s salary and an equivalent head of department in a private sector organization. I would certainly advocate that we should be having provisions to pay private sector salaries to Secretaries of Ministries so that we broaden the pool.

One of the problems I had was that, four years ago, when I set up the PPP agency, I was told that I cannot pay more than 300,000 rupees per month for any private sector professional I bring into government. Now, if I were to inflation-adjusted that to what I paid private sector professionals who came into government in the late 90s, it was a fourth of what I paid 20 years ago.

I’ve seen this time and time again. Any government implemented a form of reform, you had private sector professionals working for hand in glove with state sector officials, for true reform to happen. In the economic council of the CBK government, we had 8 to 10, eminent individuals.

So we’ve to go back to building capacity within the finance ministry, national planning and attracting private sector individuals to work with the government. We need to restore the dignity of a ministry secretary and heads of departments of various government ministries.