This article first appeared in Forum, The Edge Malaysia Weekly on January 28, 2019 - February 3, 2019

Malaysia’s use of public-private partnerships (PPPs) since the mid-1980s for the provision of goods and services traditionally provided by the government generated a great deal of controversy almost from the outset.

We can distinguish two key forms of PPPs. One is the privatisation initiative (PI) and the other is the private finance initiative (PFI). Our failure to use competitive bidding in the choice of a partner and thereafter in opening up the privatised activity to competition (or our inability to do so due to the presence of natural monopoly elements in the privatised activity) have created many controversies or, more seriously, led to disputes on the compensation to be paid upon the cancellation of a PPP or the takeover of a privatised asset.

The PFI has also been mired in some contentions more specific to it.

Where a PPP involves a land swap, the underlying land value is “invariably underpriced while the cost of the public works project is overpriced”. And the effective interest rate incurred by the public sector on the lease provided is also excessive. Furthermore, by placing a PPP concession agreement within the purview of the Official Secrets Act (OSA), such arrangements have become even more one-sided.

In their early years, PPPs took the form of privatisation whereas in more recent years, they have assumed the more limited form of PFIs. Privatisation entails the government granting a concession to a private-sector entity to build, finance and operate a business over a specified period and transfer or surrender its ownership rights to the government at the end of the concession.

Electricity generation, provision of roads and supply of telecommunications services are among those concessions franchised by the government to the private sector under its privatisation initiative.

Under PFI, services such as education, healthcare and accommodation are still provided by the government. But they are provided on premises constructed and financed by the private sector and whose ownership will be transferred to the government, again after a specific period. These are deemed build, lease and transfer (BLT) agreements or build, lease, maintain and transfer (BLMT) agreements, depending on whether the premises are maintained by the private partner or the public sector.

Under the privatisation initiative, there is usually a risk transfer from the public to the private sector. The investing/bankruptcy risk is assumed by the franchisee as the debt incurred is typically its own. To the extent that the privatised entity is no longer a state-owned enterprise, privatisation leads to a decline in the level of public-sector debt and thus an improvement in government finances.

The demand risk is also passed on to the franchisee. But its exposure to this risk is minimised to the extent that the privatised activity is not fully opened to competition. As this is more often the case in Malaysia, such privatisation does not benefit the consumer or the economy very much.

There is one other key weakness, especially with respect to the earlier generation of privatisations, where the government assumed an obligation to honour the debt liabilities of the privatised entity in the event the concessionaire was not able to operate the entity as a going concern. The benefits of this contingent or implicit liability of the government was enjoyed by the concessionaire and the lender but not necessarily the consumer or the economy.

With PFI, there is nominally a reduction in the size of public-sector debt to the extent that the government does not incur any debt to build and own the premises but only has to make regular lease payments under its long-term lease contract to the private-sector BLT partner. However, based on market talk and back-of-the-envelope calculations, it appears that the public sector is in fact paying an exceptionally high effective interest rate — as much as 12% to 17% per annum — on the lease commitments that it has entered into with the private-sector BLT partner.

If the public sector uses its own balance sheet to borrow and build the premises, its effective interest rate is unlikely to exceed 4% to 5% per annum even where its fixed-rate borrowing stretches over 10 or 30 years. Provided that the public sector enters into a BLMT contract under which the maintenance of the premises is on the account of the private-sector partner, the charge is unlikely to exceed 1% per annum. Part of the big differential in the interest rate may also be necessary to compensate the BLT partner for tax disadvantage because of its low building allowance and offset against its chargeable income (but this disadvantage is minimised by maximising the sum borrowed).

The use of off-budget borrowings by the Najib administration to keep the size of the federal government’s direct debt small is apparent in the debt and liability numbers disclosed in new Minister of Finance Lim Guan Eng’s Budget 2019 speech.

As at the middle of last year, the government’s direct debt stood at RM725.2 billion (or 50.7 % of gross domestic product) whereas the size of its committed contingent liabilities (including the unpaid portion of the 1Malaysia Development Bhd debt) was RM155.8 billion. Its lease payment commitments to the PPPs (including loans the government had extended to privatised entities) amounted to another RM184.9 billion. In total, the GDP share of the government’s debt and liabilities was 74.5% — well in excess of the borrowing limit of 55% permitted under the law. So, it is clear that the Najib administration was able to keep the government’s borrowings within the statutory limit only by resorting to off-budget borrowings.

To the extent that the government’s lease commitments are payable over a period of time, the GDP share of these lease payments will be overstated in present value terms. However, note that the discount rate that should be used to derive the present value of these lease payments is the yield-to-maturity of an equivalent MGS issue, and not the internal rate of return associated with the lease payments.

The extent to which public works contracts were overpriced came to light upon the renegotiation of the MRT2 and LRT3 contracts in the run-up to the announcement of Budget 2019 in October last year. In respect of the 37km LRT3 project, the Pakatan Harapan government was able to reduce its cost by 47% from RM31.6 billion. For the MRT2 project, which was already in an advanced stage of construction, the cost was reduced by 22.4% from RM39.3 billion (although this entailed a slight reduction in the number of stations from 35 to 33). The willingness of the contractors to agree to such massive reductions implies that the original contracts were richly priced or over-specified.

Malaysia’s mid-1980s and late 1990s crises were substantially aggravated by the massive size of its debt and off-balance sheet liabilities, including those of its public sector. That the Najib administration did not learn any lesson from the crises is clearly evident from the recent revelations on the extent to which it had relied on off-balance sheet liabilities to fund its activities and without fully disclosing the quantum or the expensive terms on which they had been raised. Only the annual lease and interest payments to service these off-balance sheet obligations may have been captured in the government’s annual operating expenditure numbers and, to some extent, the size of its fiscal deficit (although the nature of these obligations also may not have been fully disclosed).

Malaysians should be happy that the new administration has decided to bite the bullet and make the required disclosures on the government’s off-balance sheet liabilities. We should also be happy that it has now committed to come out with the Fiscal Responsibility Act (with regard to disclosures and transparency) and to shift to accrual-based accounting from cash accounting within three years. Under this, the government will have to disclose its balance sheet numbers (including its off-balance sheet numbers) as required by the International Financial Reporting Standards.

It was also heartening to note from Lim’s Budget 2019 speech that going forward, government contracts, including those under PPPs, will be awarded in open tenders and thus at more competitive prices.

Based on this new model, Lim stated unequivocally that “24 PPP projects, such as schools, army camps, police and fire stations as well as affordable housing, worth RM5.2 billion will be implemented and the government expects to gain an excess of RM800 million over the cost of the public works from land sales”.

He also plans “scheduled and staggered land sales via auction to the highest bidders, based on the conditions imposed on the land, to maximise revenue for the government”. Where external funding is required, it is also hoped that the government will issue MGS to fund such PPP projects and not rely on the much more expensive leasing route.

With respect to privatised projects, the government must also rely on open tenders to encourage bidding from interested parties for any activity that is to be privatised.

The market for the provision of the goods or services of the privatised activity must also be opened to competition so that the benefits of privatisation can flow to the consumer and the economy and not be captured only by the franchisee. If the activity that is being considered for privatisation is a natural monopoly, as in the case of Tenaga Nasional’s transmission network, such an activity should continue to be owned and operated by the government so that the benefits of its monopoly rights accrue to the country at large and not to any favoured shareholder.

Dr R Thillainathan is the past president of the Malaysian Economic Association

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