The Myth That SOEs Return 18.5% when the Borrowing Rate is 4%

Last year Roger Kerr wrote extensively on the myths of privatisation.  Two relevant pieces in relation to the above myth were: Privatisation Myths Need to be Busted and The Truth About Privatisation # 13: Government Finances Benefit

The fallacy arises from the failure to spot that if a SOE returned 18.5%, with the same certainty as the 4% return on government stock, the market value of the SOE would be so high that its rate of return to the owner would be only 4%.  To illustrate:

Maths Teacher:  If one unit of government stock provides an income of $4 a year, how many units would you have to buy to get an income of $18.50 a year?

Pupil:  Let’s see, 18.5 divided by 4 equals 4.625 units.

Maths Teacher:  That’s right.  So if the government sells any other asset that pays an income of $18.50 a year, and uses the proceeds to repay government stock, how many units of government stock could be repaid and what would be the reduction in the annual interest income paid on government stock?

Pupil:  4.625 units could be repaid, reducing annual interest paid by $18.50.

In short, under these assumptions the government would be selling the SOE at a 4 percent yield to the buyer, reducing its dividend income by $18.50 and using the proceeds to repay public debt at an annual savings on interest paid of $18.50.  The posited transaction is fiscally neutral.

Yet here is the widely respected Jane Clifton, The Listener, 3 March 2012 on exactly this point:

The opposition is asking why we would sell something earning us 18.5% because we are terrified of borrowing at 4% to keep it capitalised and performing?  The question [that] has to be asked of the Government … [is]: Are you mad?”

And here is Tracy Watkins, The Dominion Post, Saturday 25 February implicitly propagating the same fallacy

Given the healthy dividends paid to the Government by the state-owned power companies, selling them makes about as much sense to most people as hocking off the family business to pay your credit card

In a less myth-dominated public discourse, public debate would be able to focus to a greater degree on the national interest arguments for and against privatisation.


One thought on “The Myth That SOEs Return 18.5% when the Borrowing Rate is 4%

  1. Ah yes, but… They sell something for a $billion. Instantly the financial ignoramuses in Parliament (most of them) think “Wow! A THOUSAND million dollars, I need $50million for my project to get re-elected, that’s not much”

    ..and instantly Mr Smile & Wave caves into the special interest MPs he has had to bribe to stay in power, and your billion dolars DOESN’T get put against debt, the Govt just increases its spending!

    The Govt should never have owned those assets in the first palce, it is NOT their job. Its time for voluntary taxation, to really sort out what people want and what they are willing to pay for!

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