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Guaranteeing the future growth of government business enterprises



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M inister for Transport and Communications ES/

Senator Gareth Evans Q.C. 22 MaY 1988

54/88

Π””--_____________ GUARANTEEING THE FUTURE GROWTH OF GOVERNMENT COMMONWEALTH ” 1 PARLIAMENTARY LIBRARY I BUSINESS ENTERPRISES

L — .... C. I. S.

The issue of the capital needs of Australia's public enterprises, and how those needs might best be met, must continue to be sensibly and seriously debated within appropriate ALP forums, the Minister for Transport and Communications, Senator Gareth Evans,

said today

In an address to the NSW ALP Privatisation Forum in Sydney, Senator Evans:

- Stressed that Labor Governments should strive, consistent with democratic socialist principles, to keep public enterprises viable and expanding, to improve services, and to enable the enterprises to contribute to the health of the economy (p.3)

- Outlined five options for meeting the capital formation needs of Australian Airlines and Qantas (p. 6-11)

- Said the result of failing to address the needs of the two airlines would be "privatisation by default", through the progressive reduction of their market share (p. 12).

"For the Labor Party, the critical need now is to focus case-by­ case on the predicament of each enterprise, to forget the barricades and bunkers and to search, through whatever consultative or review process emerges from the current ideas circulating, and can be established at the National Conference,

for a rational, long-term basis for the future growth of government business enterprises (p .14)."

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SYDNEY

GUARANTEEING THE FUTURE GROWTH OF GOVERNMENT BUSINESS ENTERPRISES

Address by Senator Gareth Evans, Minister for Transport and Communications, to NSW ALP Privatisation Forum, Parramatta, 22 May 1988.

Thank you for your invitation to participate in what looks likely to the last significant occasion for Party debate on the so-called privatisation issue before the ALP National Conference. My acceptance will no doubt confirm

the prejudices of those who have suggested over the years that my most highly developed political instinct is masochism!

It has been perfectly obvious for a number of months that the Party is simply not prepared at this stage to make any significant change to the existing Platform commitment to full public ownership of a number of major government business enterprises. What is important, however, is that the issue of the capital needs of our public enterprises,

and how those needs might best be met, continues to be sensibly and seriously debated within appropriate Party forums, with everyone involved in setting the ground rules for Labor Governments keeping at least a slightly open mind as to what the best solutions might be.

Why I keep putting valour ahead of discretion, by

participating in discussions like this, is that I have

come to strongly believe three things since I have had the Transport and Communications portfolio - with all the access to information and analysis, and all the

responsibility, that brings:

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. that some of our major wholly-publicly owned

enterprises are facing serious capital formation

problems;

. that their relative position in the market place

(and perhaps in some cases their absolute viability as well) will rapidly deteriorate unless answers can be found to those problems; and

. that there are simply no obvious soft options for the solution of these problems.

I am happy for all these propositions to be tested, and if a workable option emerges that solves the problems without requiring any changes to the Platform I will be very happy indeed. But tested, and found wanting, these propositions must be - not just rejected out of hand.

Given what is at stake for the economic health of the country, for the many thousands of Australians employed by the enterprises, and indeed for the future of effective public enterprise as such, it is simply too important for

the issues to be decided by closed minds on the basis of preconceived or entrenched positions, whatever they are and however long they may have been held.

My own starting point throughout this debate has been one of strong personal belief in, and commitment to, the role

of public enterprise in a mixed economy. I am happy to accept that the onus is on anyone who would seek to sell an existing enterprise, or dilute present levels of public

ownership in it, to make a convincing case for doing so.

But I have an equally strong conviction, in no way at odds with that, that it is the job of a Labor Government,

consistent with its democratic socialist principles, to

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keep public enterprises viable and expanding, to improve and increase services, and above all to enable the

enterprises to contribute through their own vigour and growth to the health of the national economy on which the maintenance of acceptable standards of living for all

Australians depends.

The question that confronts us is whether this can be achieved within our existing Party ground rules, or whether those ground rules need to be modified.

For the purposes of today's discussion, I think it is probably most useful if I limit myself to looking at Qantas and Australian Airlines - the two enterprises within my own portfolio which best encapsulate the sharp end of the current argument on the questions I have just

posed.

There can be no dispute that the fundamental present constraint on the growth and competitiveness of both airlines is the problem of capital formation. The capital problems facing Qantas and Australian Airlines are dramatic and difficult. Let me begin by setting out

briefly what the position of each airline is.

Qantas

Forty two years after the Chifley Government purchased Qantas from BOAC and Australian private interests (because, among other reasons, it was felt that only the public sector could then provide the capital necessary for

its development!) Qantas finds itself a medium-sized international airline, with a fleet of 30 planes, and

annual revenue of $2.45 billion, flying 3 million

passengers a year and employing nearly 14,000 people.

It competes internationally with 30 other airlines, most of them privately owned, and faces an international

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aviation environment which is not only fiercely

competitive, but dominated increasingly by mega carriers who can take big marketing risks on particular routes while hardly noticing the pain (e.g. British Airways with 164 planes, United with 364, and Continental/Texas Air

with 497).

The potential for growth of Qantas's traffic is high. Visitor arrivals are expected to grow in 1988 by 27.4%, with Qantas's total traffic increasing by 16%, up from the

14.4% experienced in 1987. Given the sustained success of Australia as a tourist destination, growth in 1989 is expected to be around 10%, and 11% in each of the

following three years to 1992.

The basic prospect facing Qantas, and other airlines of similar size, is to get big or wither on the vine. Qantas is, accordingly, planning a massive re-equipment program to replace and extend its fleet from 30 planes to 51 by 1992, at a capital expenditure of $5,400 million. The airline can raise most of this ($4.8 billion) by a

combination of

. borrowing (assuming no limits from the Loan Council), and

. retained earnings from profits

but Qantas argues very strongly that it needs another $600 million (most of it before the end of 1989) by way of

capital injection to meet its capital expenditure target - at least if it is to achieve and maintain a commercially

acceptable debt to equity ratio in its capital structure.

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Australian Airlines

Since its establishment by the Chifley Government in 1945 as a fully government-owned enterprise, to prevent the development of a private monopoly in the provision of interstate air services, the airline has developed, within

the framework of the two airlines policy, to the point where it now operates a fleet of 38 aircraft on interstate services throughout Australia carrying about 50% of the domestic trunk route passenger market and 40% of total domestic air freight.

When the Two Airline Agreement expires in October 1990 it will be essential that Australian Airlines is strong,

viable, efficient and able to provide effective

competition across the Australian trunk route network. So that it can compete on an equal footing in the new

deregulated environment, Australian wants to revitalise its operation and upgrade it aircraft fleet capacity.

Australian is currently in the early stages of a major re-equipment program to upgrade its fleet. Twelve B737 aircraft were introduced recently and Australian has placed orders for a further 15 aircraft to come into

service progressively by the early 1990s. Australian wants also to improve its resort and airport terminal facilities. Ansett has already completed its upgrading program. The quality of Ansett's fleet is superior to

that of Australian (for example, the average age of Ansett aircraft is 5.2 years, compared with 8.1 years for

Australian).

Australian's upgrading program is needed to allow it to remain competitive and viable - and to take advantage of the surge in domestic air travel associated with tourism boom in Australia.

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The Advisory Group on Australian Airlines (which included among its members Bill Kelty and Peter Wilenski) and which reported to me in March 1988, has concluded that

Australian requires capital expenditure of $1400m in the period 1988-92, and an additional $2200m between 1988 and the year 2000 - a total of $3600m.

The Advisory Group also concluded that an equity injection of $240m in three instalments of $80m between 1988-89 and 1990-91 would be necessary to achieve this capital expenditure program at least - again - if it is to achieve

and maintain an acceptable commercial debt to equity

ratio.

The Capital Formation Problem: Possible Options

The question for both airlines, then, is that, given that massive capital expenditure is necessary to keep the businesses growing, where is the money coming from to meet the respective targets?

One obvious solution is to rethink existing policy to allow private equity to contribute directly, in the form of a significant minority shareholding, to meeting the capital needs of the enterprises. But at least five kinds of alternative approach have been proposed, and it is only

right that the Labor movement should demand that all of them should be fully explored before any assumption is made that direct private equity is the only way forward.

The first alternative is: let the airlines raise the money bv borrowing.

The Qantas and Australian Airlines capital expenditure programs already contain a huge borrowing commitment: of the $5.4 billion required by Qantas, it is assumed that

$4.8 billion would be raised by a combination of retained

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earnings and, mostly, borrowings; and of the $1.4 billion required by Australian Airlines, $1.16 billion would be raised from these sources.

The crucial point to appreciate is that even if Loan Council restrictions could be, and were, wholly removed, there would be a limit to the extent to which either

airline could blow out the proportion of debt to equity on its balance sheet. Both airlines' gearing ratios are already of the order of 80:20 (i.e. 80% debt to 20%

equity), and both have been strongly commercially advised to haul that back to at least 70:30, and preferably 65:35 or less, to bring matters more into line with prevailing aviation industry norms. By way of comparison, United States domestic airlines have traditionally had

debt:equity ratios in the order of 50:50 to 60:40. Ansett had a debt:equity ratio of 66:34 in 1986-87, down from 72:28 in 1985-86.

While it is true that the existence of express or implied government guarantees means that both Qantas and

Australian could sustain ratios marginally higher than

their private sector competitors, basic commercial imperatives point to the need to keep that margin within narrow bounds.

Maintenance of a higher gearing ratio reduces future capacity to borrow, invest and respond flexibly and quickly to new opportunities or to downturns in the

market; it would make strategic and other investment decisions dependent on endless government approvals. High gearing ratios also undermine managerial morale, directors' responsibility and the general corporate culture.

The basic problem, at the end of the day, is that the

airlines would find themselves totally dependent on the government of the day being sympathetic, able and willing to bail them out if they get into financial trouble as a result of volatility in the industry - not the best

environment from which to take on the domestic Australian

aviation scene, let alone the world!

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It is interesting to note that, as the debate on these matters has progressed, the need for sensible gearing ratios in government business enterprises has ceased to be seriously or vigorously contested by those opposed to any

private equity participation in capital structure.

The second alternative is: redefine budget conventions so the Government can provide the money but it doesn't show u p in Budget accounts.

This alternative involves major practical problems:

- a major change would be needed in the way in which we define the outlays side of the Budget;

- enormous public attention is. paid to our outlays performance, with stiff penalties in terms of interest rates and growth being attached to negative market perceptions;

- any change to the outlays accounting rules would need to be explained to, and accepted by, a sceptical

audience of international investors, many of whom are

likely to question our motives if the change

apparently suits our case;

- the numbers involved in the airlines' cases are very large both absolutely, and relative to the

deficit/surplus outcomes of recent years; and

- the greater the amounts involved, and the shorter the time frame within which changes are made, the greater the international scepticism, and the greater the economic risks we accordingly run.

The third proposed alternative is: fund the capital injections from the Budget.

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It is argued that if a capital injection is a productive

investment for the private sector, it is equally so for government, and the investment will bring returns through

future dividends.

While this argument has validity, the facts of government budgetary life are that making a large payment now in order to get a (bigger) return later cannot always be

readily justified.

Government is constantly having to decide between competing demands for the provision of services (such as the maintenance or increase in social security payments) in the prospective budget year. As well it has to

accommodate demands for investment in areas (such as education, health, roads) which are not capable of being provided by the private sector.

It is extremely unlikely, on present indications, that the capital injection needs of any of the government business enterprises will be able to met from the Budget, either this year or in the foreseeable future, given the overall discipline on outlays which must be maintained and competing demands for other expenditure.

A fourth alternative: establish an airlines* equity trust along the lines of the Victorian Equity Trust

The Victorian Equity Trust has been set up recently for the express purpose of raising funds from the private sector, but in an ideologically acceptable way, for four

Victorian Government authorities: the State Electricity Commission, the Gas and Fuel Corporation, the Melbourne and Metropolitan Board of Works and the Portland Smelter

Unit Trust.

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The essence of the scheme, which seems to have no real parallel elsewhere, is that in return for the provision of funds to the four authorities, the Trust is assigned income calculated at a fixed proportion of the dividend

income which is determined by the Government to be payable by the four authorities. It is a crucial feature of the scheme that the Victorian Government has committed itself to buying back any units offered to it four years after allotment, on terms which significantly reduce risk to the original purchaser.

The funds raised by the Victorian Equity Trust appear to have more of the characteristics of debt (controlled rate of return and guaranteed redeemability) than of equity; certainly they are being treated as subject to Loan

Council global borrowing limits.

While the various defining characteristics of the VET obviously enhance its market attractiveness, similar provisions simply could not, however, be applied to an airlines trust. The difficulty is that Qantas and

Australian operate in competitive environments: their rates of return reflect market performance and cannot be guaranteed in advance. In addition, any buy-back option in an airline trust would expose the Government to a probably unacceptably high level of risk due to the volatile markets in which the airlines operate.

A fifth alternative: establsh an airline equity trust to directly hold shares in the enterprise.

This proposal involves establishing a genuine equity trust by vesting voting shares in the trust. As with the VET, such a trust would raise funds by issuing units to

investors who would receive their returns in the form of dividends paid to the trust by the airline. The

difference would be that the Qantas or Australian Airlines Development Trust, as the case may be, would have a direct

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percentage shareholding in the airline company, ensuring that the trust would be linked directly to the airline's asset base rather than just to a controlled future income stream as with the VET.

The appointment of the AIDC - in effect the Government's own merchant bank - as the trustee holding shares in the airline, would enable the Government to maintain Qantas and Australian in full public control, while at the same time ensuring that the interests of the unit holders would

be fully protected through the normal arrangements that apply to unit trusts.

The units in the trust would be traded on the stock

exchange, and as such market pressure would be exerted on the airlines to perform consistently well and pay

dividends.

This would allow ordinary Australians to have an

investment in Qantas more directly than via their taxes, and therefore a greater commitment to Qantas's future.

The major problem with this kind of proposal is that the

units would probably need to be offered to investors at a significant discount on the price that would apply if ordinary equity shares were issued.

The level of this discount (which would mean in effect it would be dearer to raise capital by this method) would depend on the attractiveness of the package that could be offered, and how it was structured to gain maximum market

appeal.

Nonetheless, the concept is at first sight an attractive one, satisfying a number of competing practical and ideological demands simultaneously, and it certainly deserves closer examination than I and the Government have

had the opportunity so far to give it.

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What happens if the equity is not provided?

If none of the alternative approaches I have mentioned do prove to be workable, and if as a result the equity

required by Australian Airlines and Qantas to undertake their capital expansion programs is not provided, the simple reality that has to be faced is that they will not be able to grow to take up the opportunities in their

respective rapidly growing markets.

Progressively, but inexorably, private sector airlines would increase their share of the domestic and

international aviation markets at the expense of

Australian and Qantas. Australian and Qantas will stagnate and others will grow - and as the others grow, the public enterprise share will diminish accordingly.

The outcome of failing to address the capital needs of the two airlines can with complete accuracy, accordingly, be characterised as "privatisation by default" - and, in the

case of Qantas, with the even worse result that the

beneficiaries of the process would be the private

airlines, and economies of other countries.

The message is starkly clear for both airlines. In the view of the Australian Airlines Advisory Group, without

the needed equity,

"... Australian's future in a competitive, deregulated environment would be significantly weakened and commercially untenable ... As a result Australian would be a weak player in a market dominated by its

competitor(s).

The Group considers that divestment of part or all of the Government's interest in the airline would be preferable to this situation developing" (p87).

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' / , *v ’

The Advisory Group considered options other than equity

injections, but concluded that

"Other options for meeting Australian's capital requirements were examined, but were not considered as viable long term alternatives. In particular the major alternatives of borrowing exclusively, leasing

or explicit statement of Government financial backing will not provide an appropriate financial structure for the airline nor satisfactory accountability and discipline on management" (p 7).

In the case of Qantas, it is equally clear that if it is unable to both expand and upgrade its fleet, its ability to compete in a highly competitive market will be

seriously impaired. The new B747-400 aircraft has greater range and better fuel efficiency, which would enable Qantas to introduce services that are impractical at present. This is particularly important on the

UK-Australian and US-Australian routes. Modern aircraft that reduce journey times and offer greater comfort are the key, in particular, to attracting the lucrative first class and business class passenger traffic. This has been Qantas's forte - achieved as the result of high levels of

service and operation of a consistently modern fleet.

If its capital needs cannot be met, Qantas will stagnate, reduced to the status of a bystander in the international aviation scene. It would be unable to take up new market opportunities and would be weakened on the existing major routes, and eventually forced to withdraw. Its future role would be as a regional airline, a marginal player competing against mega-carriers dominating travel on the major routes such as to the US and Europe. Qantas would not be able to be a major participant in the extraordinary

level of traffic growth which is occurring in the Pacific

^ <

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region. This would restrict our ability to promote tourism to Australia and to direct air services to the smaller gateways.

Qantas market share would progressively decline from the current level of 43%, and the contribution that it makes to Australia's balance of payments ($576 million in 1986/87 and estimated to be $758 million in 1987/88)

would be reduced as other international airlines take larger shares of the market.

These are the stark consequences of failure to provide the airlines with the capital injections they need. The problems are there and have simply got to be resolved if we are not to bear the stigma of having let our

enterprises slide to second rate, bit-player status, at severe long-term cost to the whole country.

I hope I have made it clear that I hold no fixed brief for any particular solution - but we have to find one, and the obstacles and pitfalls of some which have been more or less glibly advanced are clear. For the Labor Party, the critical need now is to focus case-by-case on the

predicament of each enterprise, to forget the barricades and bunkers and to search, through whatever consultative or review process emerges from the current ideas

circulating, and can be established at the National Conference, for a rational long-term basis for the future

growth of government business enterprises.