Why sell Srilankan Airlines?

By Ravi Ratnasabapathy

This article originally appeared on the Echelon

STATE-OWNED ENTERPRISES CARRY INHERENT STRUCTURAL WEAKNESSES IN GOVERNANCE. STATE AIRLINES ARE PARTICULARLY PROBLEMATIC AS THEY ARE COMPLEX BUSINESSES AND FACE DYNAMIC MARKETS.

According to reports in the press, the government will take a final decision on the future of the country’s national carrier, SriLankan Airlines, by July 2017. Coincidentally, the Indian Government is about to decide on the sale of Air India, so the timing may be opportune.

The Indian Government is exploring three options: A full 100% sale, or the sale of a 74% or 51% stake. Like SriLankan, Indian Airlines is staggering under a mountain of debt, so a part of the restructuring may involve the creation of a special purpose vehicle (SPV) to get rid of a major portion of its debt, which is in excess of INR500 billion. A similar arrangement may be necessary for SriLankan, whose had debt of Rs67.9 billion as at March 2016. The government has infused funds regularly to keep it running; recent injections include Rs14.28 billion in 2012, Rs12.6 billion in 2013 and Rs19.58 billion in 2014.

Citizens may be comforted to learn that the drain on public funds has a long international tradition; Sri Lanka and India are not the only governments that keep rickety state airlines in flight. Malaysia, Italy and Poland are among the countries that have bailed out state airlines in the past few years. Why is it so?

I T ’S DUE TO THE FOLLOWING T WO REASONS:

1 . Airlines are complex businesses to manage.
2. Governments cannot fully shield state airlines from competition.

Airlines are unlike many other businesses that a state gets involved in. They are big and complex: Aircraft leases are expensive and the support infrastructure is large. They are much more complex than, for example, running bus or train services. Given their size, even minor mistakes carry major consequences.

Crucially, they must also compete on an international level. Airlines, by definition, are not local businesses. Wherever they are located, they compete with other airlines to their home country; they cannot be insulated from competition.

State-owned enterprises (SOEs) tend to play in protected or semi-protected domestic markets. Some are monopolies; others find various ways to restrict competition. A business that faces limited competition will find it easier to make profits. Even where state businesses face competition, the government may grant SOEs preferential tax or other benefits that prop up its business model. As the state is the owner, it has incentive to tilt the playing field in its favour.

Shielding airlines from competition is harder to do, which is probably why losses are a recurring problem the world over. It is a combination of these two factors that make state airlines prone to failure.

Competition exposes the weaknesses in management, and the scale of the business usually means that the losses are spectacular. Admittedly, some do run well, Singapore Airlines being a notable example. People may wonder as to why this is so. Surely if one country can do it, why can’t another?

Profitability depends on good management, and ensuring that management is good is dependent on the governance that the owners can exercise. Herein lies the second challenge. Let us digress to understand the fundamental problem of governance in corporate entities: the problem of agency.

Let’s look at a small business, a shop or restaurant run by its owner. The owner puts down the money to start his business and is involved in the daily running of it. He can see if there is waste and can control it. His interest in the business is personal; naturally, he will try to do everything in the best interest of the business.

In the case of a company, things become more complex. Companies have many shareholders, so they cannot all be involved in running the business. They appoint directors who must act on their behalf. The owners are no longer running the business. The shareholders (owners) must trust the directors (agents) to do the best for the business.

This is not an easy thing to achieve. The Companies Act provides some safeguard such as the need to publish accounts (which must be independently audited) and face the shareholders at an annual meeting. For listed companies, the CSE and the SEC provide additional oversight, but it is not always certain that the shareholders are getting the best from the management. This is an inherent risk they must run, but it’s their choice to do so.

Investors in private companies take a risk when they put money down, but it is done by their own volition. Shareholders subscribe voluntarily to shares; they are not compelled to invest. Generally, people only invest in private companies if they know and trust the management.

If the business goes down, the shareholders will lose, but it is their own money, voluntarily invested, that is lost.

THERE ARE THE FOLLOWING TWO IMPORTANT DIFFERENCES WITH SOES:

1 . Unlike in a company, where willing investors are taking a calculated risk, the investment in an SOE is by taxpayers who contribute involuntarily and unwittingly.
2 . There is an extra level of agency. The SOE is owned by the citizens and run by managers, but controlled by politicians. It is politicians who decide who to appoint to manage the business and who must hold the managers accountable. Unlike shareholders, politicians have not invested their money and have no stake in the business, and therefore no particular interest in ensuring its proper functioning. The real owners, the citizens, have absolutely no voice in how the business is run.

Businesses must risk their own money when they go into trade, but governments risk other people’s money. If a business does not earn a profit, the owner will need to keep infusing funds, which provides a powerful incentive to improve efficiency. The general public, whose money is at risk in a state venture, do not have the wherewithal or knowledge to hold managers or politicians to account.

This structural problem, an additional agent, means ensuring good governance in an SOE, which is intrinsically harder than in a private company. The lack of oversight in bodies like the SEC/CSE, the lack of public scrutiny or the pressure to publish accounts compound the problem.

As it is difficult to shield a national carrier from competition, the weakness in management is exposed to the cruel forces of the market, so losses are hardly surprising. Perhaps the correct question to ask here is not why would you sell SriLankan off, but why wouldn’t you? The structural weaknesses with SOEs in general and airlines in particular seem to condemn state carriers, with rare exceptions, to perennial losses. SriLankan’s sorry track record speaks for itself.

It provides no public service that could not otherwise be provided. A potential private buyer would probably continue to operate flights to the country, and if not, an open skies policy will ensure that enough other carriers fly in.

A strategic disinvestment of the airline will free up funds for allocation in areas where they are more needed such as health and education, rather than an industry that is not one of the government’s core responsibilities.

The government must pursue the disposal of Srilankan Airlines aggressively. A potential investor was found earlier, but backed out claiming that allocating the human and financial resources to make the airline profitable will not realise sufficient returns; all the more reason for taxpayers to walk away. The government should put this for open bids; if nothing else, it will give citizens an indication of the real value of the business.

What if no buyers come forth? If no one wants it, then that’s an indication that the existence of the airline serves no purpose and the correct solution is simply to close it down.

Lee Kuan Yew recounts in his memoirs the advice he gave JR Jayewardene when he wanted to start an airline. He says Mr Jayewardene wanted an airline because he believed it was a symbol of progress.

L E E KUAN YEW SAYS:
“I advised him that an airline should not be his priority because it required too many talented and good administrators to get an airline off the ground when he needed them for irrigation, agriculture, housing, industrial promotion and development, and so many other projects. An airline was a glamour project, not of great value for developing Sri Lanka.

But, he insisted. So, we helped him launch it in six months, sending 80 of Singapore Airlines’ staff for periods from three months to two years, helping them through our worldwide sales representation, setting overseas offices, training staff, developing training centres and so on.

But, there was no sound top management. When the pilot, now chairman of the new airline, decided to buy two secondhand aircraft against our advice, we decided to withdraw. Faced with a five-fold expansion of capacity, negative cash flow, lack of trained staff, unreliable services and insufficient passengers, it was bound to fail. And it did.”

We never tire of claiming to want to emulate Singapore. Perhaps we should start by taking the advice of its founding father?