Summary: Dispensing Privatisation Proceeds: Scenarios and Effects
LFMI has completed analysis of possible uses of income from privatisation and their likely effects on market processes and the country’s macroeconomic indicators. All of the scenarios rest on the government’s promise to maintain the currency board arrangement. LFMI explored the following options of the use of privatisation income: repaying state debt, redesigning social security, reducing taxes and compensating the ensuing shortfall of budget revenues, compensating lost savings, and financing economic programmes. In addition, LFMI analysed the possibility of increasing official reserves or forming another reserve fund in foreign currency.
Privatisation is a revenue-generating process, which means that when state-owned assets are privatised, the market receives an extra inflow of capital in addition to changes in the structure of ownership. These factors form the basis of analysis of the effects that the use of proceeds from privatisation may have on the economy. According to the functioning legislation, two thirds of proceeds from privatisation must go towards compensation of savings lost to rouble depreciation, with one third being allocated for economic programmes.
Repaying state debt
If the money received from privatisation were used to repay foreign debt, no changes on the domestic market would occur. If the income from the sale of the Lithuanian Telecom alone were used for that purpose, the foreign debt would decrease by one forth. The repayment of debt is a positive move as it reduces state obligations. The only weakness or pitfall is that it is a single action. It would have a short-time effect if no new approach to state debt were introduced and no radical reform were launched to trim government spending.
Redesigning social security
Privatisation income could be used to form a sinking fund that would serve as a source of money for the Social Insurance Fund. Given that the Social Insurance Fund has long-term liabilities that are supported only by current payments, it is difficult to quit the pay-as-you-go system without additional funding. When privatising social insurance, contribution rates should be reduced. A temporary shortfall of funds could be covered from privatisation. This would bring long-term benefits and provide a unique opportunity to dismantle the pay-as-you-go system smoothly while privatising one of the largest state functions, social insurance, and reducing the tax burden by the amount of its financing.
Lifting the tax burden
Another option is to use proceeds from privatisation for tax reform: privatisation income would cover a shortfall of budget revenues caused by tax cuts. Unlike social security obligations, the liabilities of the national budget are not specified, personalised or legislated. The absence of the continuity of state obligations facilitates the conditions for tax reform. Government liabilities and taxes can be reduced simultaneously. Privatisation of state functions, which would give rise to new, paid services and lead to a reduction in redistribution, would provide conditions for cutting the income tax. In the long run, privatisation of state functions and a reduced tax burden would enhance the competitiveness of Lithuanian companies on the world market and people’s welfare.
Compensating lost savings
A major advantage of using privatisation income for savings compensation is that the money is distributed to people, as if completing the privatisation process. However, this option does not provide necessary conditions for reducing government functions and liabilities. Also, the economic rationale for savings restoration whereby one rouble equals one litas and the choice of criteria – savings holding – are questionable. Retrospectively, however, savings compensation was a positive and timely measure as it helped to alleviate the negative effects of the Russian crisis by maintaining the purchasing power of companies and people in Lithuania.
Financing economic programmes
This use of privatisation income was included in the analysis only because it is provided for in legal acts. As it is impossible to foresee what kind of economic programmes may be launched, this option is not transparent and its impact on the market is difficult to predict.
Proceeds from privatisation can be used to increase official reserves or to form a reserve fund in foreign currency that could be held abroad. Privatisation money would not be exchanged into litas and would prevent fluctuations in the money supply. Just like with savings compensation, privatisation would be completed because the income would de facto belong to all people as holders of litas. This would increase public confidence in litas, especially at the time when foreign reserves shrink due to the repayment of the Bank of Lithuania’s and state loans. If revenues from privatisation were used to augment official reserves, it would be necessary to establish a requirement that the Bank of Lithuania has no right to use them to increase the money supply.
The effects on the money market and interest rates
When state assets are sold to foreign investors, foreign currency reserves at the Bank in Lithuania increase in two ways: the privatisation fund’s money is kept in foreign currency at the Bank of Lithuania or the money is exchanged into litas. In the latter case, an increase in foreign currency reserves is accompanied by a corresponding increase in the money supply. The increase in foreign currency reserves and the money supply is not related directly with savings compensation but rather with privatisation itself and the use of privatisation income inside the country. If revenues from privatisation are used domestically, the increased amount of official foreign currency reserves will shrink as litas are exchanged into foreign currency. The money supply will diminish accordingly but will not result in an increase in the money unbacked by reserves.
An increase in the money supply creates conditions for interbank interest to fall and for the interbank market to grow. This is also indicated by statistical data on the interbank market provided by the Bank of Lithuania.
A short-term surplus liquidity in the banking system which occurs as a result of savings compensation is caused by the Savings Bank, which is carrying out the programme. A government-approved savings programme (which offers high interest on restored savings that are left in the bank) has been intensified this trend by impeding a faster redistribution of the money according to priorities that are not influenced by their owners. If under these conditions monetary policy is aimed at reducing surplus liquidity (which refers to commercial banks’ reserves in excess of mandatory reserves), as the Bank of Lithuania’s policy action indicates, it follows that the goal of the monetary policy is not to solve the problems of the banking system but to help one specific bank to “employ” money.
The impact that the compensation programme will have on macroeconomic indicators will depend mostly on whether people who have received compensation consume actively (i.e., savings are spent on current purchases and payments) or moderately, saving the money (by depositing it) or investing (buying securities or other assets).
If people consume actively, the demand for goods and services increases. As a result, prices go up and the turnover increases. Imports increase too, as they constitute a large share of non-food goods consumed in Lithuania. As companies import, they exchange litas into foreign currency (US dollars), which in the long run will lead to a decrease in the Bank of Lithuania’s reserves. Effective interest rates will drop negligibly.
When people consume moderately, keep their money in banks or invest, credit resources and opportunities to attract capital increase. Consequently, the price of capital and interest rates falls, invigorating the capital market. The demand for consumer goods increases, although not as sharply as in the first case. Prices change (increase) insignificantly. In such conditions, commercial banks’ ability to effectively utilize increased resources is of prime importance. Imports grow and influence the current account balance.
The current account deficit, which is being hotly debated of late, is influenced not so much by people’s tendency to consume or to save, but rather by an additional inflow of funds to the market. What distinguishes the two cases is only the way in which money is delivered to business people: either through direct purchase of goods or indirectly through loans. However, if one takes into account the peculiarities of the monetary policy, a current account deficit should be no worry. More than that, it is essential to refrain from restricting private decisions, no matter what allegedly threatening level this deficit reaches. If this kind of non-interference policy is pursued, self-regulatory mechanisms, operating with the help of unregulated prices, turn money flows in another direction and by doing so even out the current account balance.
Compensating lost savings with privatisation income should be viewed favourably as it creates conditions for the completion of the privatisation process. On the other hand, savings restoration augments state liabilities, whose reduction would be more acceptable. Given that the cancellation of savings compensation would entail negative social consequences, this programme should be completed, and a proper execution of these liabilities should be ensured.
The laws regulating the use of income from privatisation should be amended and a mechanism should be defined that would guarantee that two thirds of privatisation proceeds be used for savings restoration. Savings compensation should be carried out only and immediately upon the inflow of revenues from privatisation.
Since the potential of privatisation is large, one third of privatisation income and income from future privatisation should be used for pension reform and additional reserves of the national currency.
With a currency board regime in effect, self-regulatory market forces restore the market equilibrium and neutralise short-term fluctuations of inflation, the money supply, and foreign reserves. Under such conditions, the use of privatisation income does not imply any consequences in the long run nor does it require interventions from the Bank of Lithuania.