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1 The Finance Ministry and all the other aficionados of privatization took a body blow last week, from an unexpected direction. An expanded panel of nine High Court justices, headed by Supreme Court President Dorit Beinisch, voided the cabinet resolution allowing prisons run by the private sector.

The High Court carefully avoids brutally intervening in the working of government, as the legal profession is well aware. Many hard tests had to be passed for the court to hand down such a ruling.

The prison had already been built and hundreds of millions of shekels spent. The ruling certainly has far-reaching implications. The court's reasoning will be studied in law and business school alike, but in the meantime the decision has created an opportunity for Prime Minister Benjamin Netanyahu, the Finance Ministry and all the other fans of privatization to rethink their tenets.

"Privatization" has become a sort of magic word in the economic debate. Supporters of privatization tried to train the public to believe that everyone who advocates free markets, progress and competition should believe in privatization; those who oppose privatization are Commies, or simply ideologically stuck at the beginning of the last century.

The professional literature lists four main goals behind privatization: to improve competitiveness, efficiency or productivity; to expand the private sector and scale back government intervention in the economy; to reduce government debt and create government sources to be used for good purposes; and to encourage a developed, free capital market.

Of all these goals, the most relevant and important to Israel is the first - competition, efficiency and productivity. The government debt problem must be handled through the budget, not via windfalls from privatization. The sell-off of a given company can't contribute that much.

As for the capital market, it's been a long time since Israel's has needed big government companies in order to develop. The flaws in Israel's capital market lie in entirely different places.

The problem is that Israel's stabs at privatization have done almost nothing to advance competition and efficiency. If anything, they have caused them to retreat.

Take Bezeq as a example. Competition in Israel's communications sector had advanced tremendously for 15 years until grinding to a halt for a variety of reasons in the period after the phone company's privatization. Or take the banking system. The "privatized" banks are not noticeably more efficient, nor have they chalked up any noteworthy achievements in business. Sometimes, quite the reverse is true: A month ago the CEO of a large "privatized" bank commented to us in private conversation that all Israel's banks are ruled by their unions. "Privatized" or state-owned - it's all a fiction, he said.

Some of the government companies that were sold did improve profitability, through hurting their workers. But that's no great trick either. Taking wealth from workers and giving it to the shareholders doesn't increase the economic pie. It merely redistributes it less fairly and therefore, if anything, damages the economy. Generally speaking improved profitability does not portend improved efficiency, which is generally construed as better production efficiency, or innovation and the provision of new services.

The way to achieve true economic improvement is through structural changes, first and foremost in competition. But it's infinitely harder to create competition than it is to privatize a company. That is why successive Israeli governments have preferred to dazzle the public with "privatizations" rather than aiming for genuine solutions that would improve competition and living standards.

Perhaps the stinging slap that the High Court of Justice delivered to the government over the privatization of prisons will force the Finance Ministry and the prime minister to seek genuine solutions.

It has two potential buyers lined up, Apax Partners and Hellman & Friedman. Roy Vermus, who has led Psagot with extraordinary success, will be taking home between NIS 20 million and NIS 25 million.

If the deal is finalized and the two foreign funds indeed wind up owning Psagot, it would be fair to underscore the attraction of the Israeli economy in the extremely competitive field of investment management.

York's exit from Israel could portend great ill for the local economy. Unlike most owners of companies that control other people's money, York gave its managers a free hand in setting investment policy. Psagot's managers never received orders from York about whom to lend to, whom to shun, what to invest in, who are "friends" and who it "owed."

Vermus had a free hand and as such, could and did become the most prominent figure in the institutional sphere to stand up against some of Israel's wealthiest and most powerful businessmen.

One can Psagot, like all Israel's institutional investors, for many things. Like all the rest, it bought lots of junk for client investment portfolios during the boom. But at least Psagot tried to turn the crisis into an opportunity to set better norms in the capital market.

Nobody can promise that the new owners will act the same. The farther they are from Israel, the less involved they are and the greater the chance that Psagot can continue its aggressive tactics on behalf of its clients. The fact is that most of the work still lies ahead: It must translate words into deeds.

If Psagot's next chairman is more preoccupied with social networking among the local business elites, then Israel's capital market will backslide.

It's been seven weeks since the Hodak committee published its recommendations, which include far-reaching ones in respect to investment management by Israel's institutional investors.

Unsurprisingly, the recommendations were met with howls from corporate Israel.

They want to make sure that even when times turn exuberant again, the institutionals will keep buying up their paper at inflated prices like good little investors.

Some of the criticism of the Hodak committee, is right on the money. The bond market isn't confined to top-tier companies that provide rock-solid collateral. Most companies can issue bonds: It's just a question of the terms they have to offer in order to persuade investors to come on board (interest rates, financial covenants, equity and so on).

Blocking the market to high-risk companies would be a big mistake. If only the biggest, most established companies are allowed to issue bonds this stymies the development of the smaller companies, which are the stuff of competition. They are the source of new jobs.

But the Hodak committee was comprised of experienced market animals who know the scene inside out. If they didn't reach the conclusion that limitations should be clapped on the investment committees of the institutional investors, they know why. They know, for instance, that all capital markets suffer from a market failure - including Israel's.

The market failure in the broader financial world is the disconnect that sometimes occurs between the performance of institutional managers and their compensation.

When the market is booming, they make a fortune in salaries and bonuses, which they don't return when the times turn sour.

There is another market failure, which is a more localized disease. It is a fact that most of Israel's institutional investors are controlled by companies that themselves are huge borrowers, who are intricately involved with hundreds of other borrowers.

The result is that the managers of some of these institutional investors are focused less on delivering for their clients and more on the directives they receive from upstairs, from their bosses and their bosses' social networks.

What are we to conclude? What's needed, badly, is regulation of the capital market, but of the type that addresses the tendencies of investment managers, not the type that pushes companies away from the capital market.

What the regulator should do is intervene in remuneration mechanisms at the institutional investors, as a starting point. Insofar as is possible, the regulator also needs to build walls between the investment people at the institutionals and the institutionals' controlling shareholders.

The best way to achieve that is to prohibit the big concerns and borrowers from owning institutional investment entities.

A few months ago the CEO of one institutional investor told us that the investment committee at his company was "completely independent" and that all their investment managers were consummate professionals. But when we asked who appointed the chairman of the investments committee, and why that person had so little experience in money management and finances, he fell silent.