Malaysia Airlines
Privatization offers the possibility of financing an airline’s capital expansion and improving efficiency. However, the airline industry is characterized by substantial and increasing capital costs, low profit margins, and periodic downturns. This has led to regular bankruptcies and mergers, and necessi- tated state subsidies and bail-outs because of the economic cost of failure. In this context, the benefits of private ownership are less clear cut as it does not necessarily provide a more credible promise for the state not to intervene.
Furthermore, the substantial capital costs are often beyond the financial capacity of the private sector, necessitating some form of state financial assistance or implicit guarantee of commercial loans as has been the case historically. This potentially undermines incentives as risks are shared.
Furthermore, national airlines are prestigious and usually created and maintained for political reasons. This introduces a moral hazard where the government has a vested interest in the viability of the airline, and privatiza- tion does not necessarily promote a more ‘arm’s length’ relationship between government and enterprise in this case.
The privatization of Malaysia Airlines1 (MAS) aimed to help finance the airline’s expansion plans. However, privatization was arguably not ‘feasible’
in terms of ‘attractiveness to the private sector’ given the significant industry challenges, MAS’s low profitability and institutional constraints arising from its role as national carrier. It was also not feasible for the government because the substantial capital costs involved were prohibitive for any potential private investor. Why then did privatization proceed? On the one hand, it appeared to have been motivated by political considerations related to state efforts to promote Malay entrepreneurs. The candidate was also closely associated with the political leadership, in particular Finance Minister Daim Zainudin, suggesting that the privatization decision was shaped by political factors related to intra-party rivalry within UMNO.
On the other hand, recent evidence suggests that the sale may have been related to government attempts to cover substantial foreign exchange losses by Bank Negara Malaysia (BNM), the central bank, by raising much needed funds on the private financial markets.2 According to the owner, he was
‘instructed’ to purchase a controlling stake in MAS in the ‘national interest’
(see The Sun, 6 July 2006). This would partly explain why MAS was sold at RM8 per share when this was only worth RM3.50, with commercial banks likely to have been ‘instructed’ to lend the money.3 It may also explain why the government paid RM8 per share upon renationalization when shares were worth only RM3.80, and despite already having a controlling stake in the airline.
In either scenario, the outcome was the same. Ex ante failure to properly structure incentives affected performance. Privatization improved produc- tivity in certain areas, but MAS remained inefficient by regional standards.
This ongoing inefficiency compared to its regional competitors, and its debt burden, had a negative impact on the airline’s financial performance, and the government was forced to intervene when the new owner, faced with mounting company and personal debts, was unable to continue financing the airline. While it remains unclear what actually motivated privatization, the central issue is why the government, despite being aware, was unable to address problems that arose from ex ante failures to properly structure incentives.
Regardless of whether the candidate was the actual owner or merely a nominee or agent of the government, privatization did not significantly change the institutional relationship between the airline and the state.
Management decisions were generally constrained by the state, and the government continued to have a say in major decisions, although the new owner appeared to have some autonomy over certain decisions (including those related to the airline’s contracts with third party companies). As an agent, the owner would have had few incentives to improve efficiency. The purchase structure of the airline and subsequent fleet expansion also placed a huge debt burden on the new owner which was unsustainable and acted as a further disincentive, particularly given the problems inherent in the airline industry. These factors, independently or in combination, arguably created perverse incentives for the pursuit of short-term profits (in this case, through the third-party purchase of aircraft and the creation of separate cargo and catering divisions)4 (e.g. see New Straits Times, 25 February 2002).
The near bankruptcy and subsequent renationalization of MAS thus had a series of contributing factors that can be classified as ex ante and ex post failures of government. In the former category, the choice of candidate was poor (regardless of government motivation), and the government failed to ensure that the financial structure of the privatization was viable, or account for the substantial capital demands and cyclical nature of the industry. In the latter category, it failed to correct this ex ante failure, including addressing problems related to previous government policies (which affected MAS) and monitoring and disciplining the new owner, despite being aware of problems fairly early on. Here, successful privatization would have required that the government structure the purchase of the airline viably, or implement correc- tive measures by providing operational subsidies (especially as domestic fares were regulated), monitor performance and enforce conditionality.
Both types of failures were in part related to the nature of resource alloca- tion through patron–client networks, and the legacy of previous state capital accumulation strategies discussed in Chapter 3. The choice of candidate was consistent with ongoing state attempts to create a class of Malay industrialists who were also closely associated with (and loyal to) segments of the political leadership. However, the new owner did not have the financial and managerial capacity, having based his corporate expansion on the takeover of existing profitable enterprises through his political connections (e.g. see Gomez and Jomo 1997). This compromised his ability to finance and run the airline. His close association with the political leadership and the national importance of the airline also led to a moral hazard, where the government was unlikely to allow it to fail, but was also unable to intervene earlier to enforce discipline (or replace the owner) and prevent the airline’s financial deterioration.
This chapter is structured as follows. The next section will provide a dis- cussion of the challenges faced by the airline industry, how privatization addresses these, and the challenges posed specifically by MAS (including government objectives). This is followed with an overview of MAS, its privatization and renationalization. We then evaluate the operational and financial performance of MAS in relation to its immediate regional com- petitors, accounting for the effects of the Asian financial crisis. The following section identifies the main problems in terms of ex ante and ex post failures.
The final section summarizes the main findings and concludes.
Challenges
The aim of privatizing airlines is to finance capital expansion and enhance operational efficiency. However, the airline industry is characterized by low profit margins, high indebtedness, rising capital costs and overcapacity, with state subsidies and bail-outs common features, especially in recent years. The airline business model is also highly risky, being capital-intensive and highly leveraged, with a high controlling premium of around 30 per cent. Profitability is cyclical, with high profits attracting excessive entry and fare competition, followed by a period of losses and restructuring. Airlines thus need high margins and a guaranteed uptake (passenger load), but demand is susceptible to the industry’s cyclical nature and external shocks, resulting in problems if not failures.
Historically, airlines have only been able to make profits on their operations in favourable circumstances and the industry has only been marginally profit- able between 1960 and 1990 (Davies 1964; Doganis 1991). Even in 1984–89, the most successful period in airline history, operating profit only averaged about 4–6 per cent (at its peak), and dropped to 1–2 per cent after interest and non-operating items were included (Doganis 1991). Operating margins were further reduced after taking into account operating revenues, expenses, profit and loss. High capital costs and low profit margins led to airline debt.
The significant difference between operating results and profits after tax
for the industry as a whole in 1990–99 indicates a huge non-operating (fixed) cost, i.e. aircraft purchases (Table 6.01). Profit was only 2.9 per cent of operating revenue in the best year (1997), and averaged 0.26 per cent for the whole period.
While the financial performance of Asia Pacific airlines was generally better than the industry average, apart from 1997–98, both operating results and profits as a percentage of operating revenue were still very low, at 5.4 and 3.1 per cent respectively, for the most profitable period in 1995 (Table 6.02).
Table 6.01 International airlines: Revenue and expenditure, 1990–1999 (current US$ million)
Total operating revenue
Total operating expenditure
Operating result
Operating result/
operating revenue
Profit after tax
Profit/
operating revenue
Operating revenue/
operating expenditure 1990 199,500 201,000 (1,500) (0.8) (4,500) (2.3) 99.3 1991 205,500 201,100 4,400 2.1 (3,500) (1.7) 102.2 1992 217,800 219,600 (1,800) (0.8) (7,900) (3.6) 99.2 1993 226,000 223,700 2,300 1.0 (4,400) (1.9) 101.0 1994 247,400 239,000 8,400 3.4 (100) (0.0) 103.5
1995 267,000 253,500 13,500 5.1 4,500 1.7 105.3
1996 282,500 270,200 12,300 4.4 5,300 1.9 104.6
1997 291,000 274,700 16,300 5.6 8,550 2.9 105.9
1998 295,500 279,600 15,900 5.4 8,200 2.8 105.7
1999 306,500 294,000 12,500 4.1 8,500 2.8 104.3
Source: Adapted from ICAO (1992–99).
Note: ( ) = loss.
Table 6.02 Asia Pacific airlines: Revenue and expenditure, 1990–1999 (current US$ million)
Total operating revenue
Total operating expenditure
Operating result
Operating result/
operating revenue
Profit after tax
Profit/
operating revenue
Operating revenue/
operating expenditure
1990 38,800 37,200 1,600 4.1 1,700 4.4 104.3
1991 n/a n/a n/a n/a n/a n/a n/a
1992 47,200 45,650 1,550 3.3 1,000 2.1 103.4
1993 52,400 51,200 1,200 2.3 50 0.1 102.3
1994 61,000 58,300 2,700 4.4 1,600 2.6 104.6
1995 69,000 65,300 3,700 5.4 2,150 3.1 105.7
1996 68,000 64,850 3,150 4.6 1,700 2.5 104.9
1997 65,800 63,100 2,700 4.1 (750) (1.2) 104.3
1998 60,180 58,300 1,880 3.1 320 0.5 103.2
1999 64,800 61,800 3,000 4.6 1,900 104.9
Source: Adapted from ICAO (1992–99).
Note: ( ) = loss.
The industry is further characterized by short-run marginal costs close to zero, encouraging airlines to sell remaining seats at virtually any price above the very low marginal cost of carrying an additional passenger. Price instability is aggravated by the tendency of new entrants to aggressively try to capture market share, and financially weak or subsidized (often national) carriers to generate sufficient cash flow by undercutting existing tariffs (Doganis 1991). The high cost of exit has also jeopardized the profits of efficient airlines as loss-making or inefficient airlines continue to operate with substantial subsidies. Besides direct payments, indirect government support may involve rescheduling debts, cross-subsidies, as well as undercutting existing fares in order to generate sufficient cash flow to meet daily payments (Doganis 1991). Subsidies have been made available either as a support for an adolescent industry, or for political and prestige reasons (Davies 1964).
Although new technology reduced operating costs per capacity tonne- kilometre, it also drastically raised capital costs. The cost of a new aircraft increased from US$2 million (for a 200-seater Boeing 707 or 250-seater Douglas DC-8 in the mid-1950s) to US$45 million (for a 265-seater Airbus A310 in 1984) and US$60 million (for the same plane in 1990). At least three European airlines suffered losses of around £8 million each in 1961 as a result of plane purchases, while US airlines merged as a means to survive (Davies 1964). Nonetheless, airlines continued to purchase new aircraft as a result of easier access to financing, facilitated by manufacturers and leasing com- panies, and competitive pressures, despite the industry performing poorly.
The result was high levels of indebtedness among many major airlines by the early 1980s.
High capital expenditure increased the debt–equity ratios and interest repayments. A large part of current revenues is needed to finance interest payments on accumulated debts. After paying interest, International Air Transport Association (IATA) member airlines collectively lost US$5.65 billion in 1980–82 (Doganis 1991). Interest charges for the world’s airlines totalled around US$4.0–4.5 billion in 1987. (To finance the estimated US$400 billion invested globally on aircraft between 1990 and 2000, airlines would have needed an operating profit before interest of 6 per cent a year which had not been achieved since 1969.) Additional earnings, not leverage alone, are key to financing the industry’s needs (Mandell 1979). The growing reliance on external finance, rather than self-financing or equity capital, also contributed to very high debt–equity ratios, with many airlines under-capitalized and needing capital injections to manage interest payments and order new aircraft without bankrupting themselves (Doganis 1991).
The tendency of airlines to embark on massive fleet expansions has created overcapacity in times of sharply falling profit margins, particularly with newer, higher-capacity and faster aircraft. Airlines have historically expanded their fleets, which increased aircraft capacity without corresponding growth in passenger traffic (Davies 1964). This is largely due to the time lag between ordering (when growth rates are high) and receiving new aircraft, and the
inability of airline managements to match supply (which they have consider- able control over) with demand (which they have relatively little control over) (Doganis 1991). The best performing airlines tend to purchase new fleets counter-cyclically.
Airlines also have little control over externally determined input costs such as prevailing wage levels, aviation fuel prices and (airport) user charges. In particular, they are very sensitive to exogenous factors, which affect cost (e.g.
aviation fuel prices) and demand (i.e. global economic conditions), with the best airlines implementing fuel price hedging policies to insulate against price volatility. Dramatic increases in fuel prices in 1978 in the face of stagnating demand and falling yields led to the 1979–83 industry crisis, while the market turnaround after 1986 was essentially due to a fall in the real price of aviation fuel and a sudden increase in demand for air services (Doganis 1991). More recently, the 1997–98 Asian financial crisis, events post-11 September 2001, and the outbreak of the SARS epidemic in 2002–3 in East Asia resulted in heavy losses for Asia Pacific airlines.
Additionally, MAS had specific problems related to historical factors, operational inefficiency and institutional constraints. Following the split with Singapore International Airlines (SIA) in 1972, SIA inherited most of the lucrative international routes and was able to develop new routes because of Singapore’s position as an international hub while MAS focused on domestic routes and was left with loss-making domestic operations, no international routes, an ill-equipped fleet, and a ‘less than decent’ home airport (The Star, 10 June 1993; The Edge, 12 November 2000). While MAS operated in a monopolistic domestic market, it was not able to determine domestic fares due to government regulation which sought to promote national integration,5 and no domestic fare increases were allowed between 1983 and 1990. As a result, international revenues largely subsidized the domestic sector (which provided only a quarter of total revenue in 1985 despite accounting for almost half of passenger trips).
Although MAS had seemed profitable since 1982, profits were modest and in part due to accounting practices and the sale of assets. For example, increasing the residual value of assets from 10 to 20 per cent reduced depreci- ation expenditure,6 allowing MAS to show a RM16.1 million profit, as opposed to a RM65 million loss, for 1994, while the sale of seven aircraft (totalling RM337.1 million) contributed to the bulk of earnings in 1993 (New Straits Times, 2 June 1994). Although gains from sales are usually treated as operating profit, excluding aircraft sale figures provides a better measure of performance of airline-service operations. MAS’s operating profit from 1990 to 1994 (before privatization) compared poorly with SIA and Cathay Pacific, and its paid-up capital was also well below the major airlines in the region (Malaysia Airlines 1992b).
Background
The privatization of MAS was partly to overcome government financial con- straints and meet the airline’s capital expansion plans in 1984 (which would have otherwise required MAS to generate an unrealistic profit of US$30 million a year) (Doganis 1991). Partial divestiture was seen as an attractive solution to meet the airline’s capital investment needs in the absence of additional equity capital from the government, and MAS was corporatized7 in 1985 (Doganis 1991). Some equity was sold to the public and the Brunei government in September 1985 for RM180 million, but the Malaysian government retained a significant interest through the Ministry of Finance (MoF) (Gomez and Jomo 1997). The airline was publicly listed on 16 December 1985. In 1988, Bank Negara Malaysia (BNM), the central bank, acquired a 32 per cent stake in MAS from the MoF.
While divestiture of MAS shares8 (based on a 1985 consultant’s proposal) reduced the government’s share from 90 to 42 per cent by November 1986, it did not really change the institutional relationship between MAS and the government (Jones and Fadil 1992). The creation of a ‘golden share’ allowed the government to retain control by having the right to appoint three directors, ensure repayment of capital paid up on the special share in priority over any other shareholder in the event of the company winding-up, and require MAS to redeem the special share at par at any time (Malaysia Airlines 1995). However, the government would stop guaranteeing MAS loans and credit facilities.
In December 1993, the government announced that Malaysian Helicopter Services (MHS), a publicly listed company controlled by Tajudin Ramli, would acquire the 32 per cent stake in MAS from BNM for RM1.79 billion (or RM8 per share when MAS shares were trading for RM3.50).9 There was no open bidding, and according to Tajudin in a document filed in court in 2006, the actual sale was made to his private company, RZ Equities Sdn Bhd, to expedite the sale and bypass time-consuming approvals which MHS, as a publicly listed company, would have had to obtain; this was necessary to offset large foreign exchange losses incurred by BNM (estimated at RM16–RM32 billion) when it speculated on the sterling in 1994 (see The Sun, 6 July 2006).
However, rather than cash, the MAS acquisition was to involve a share swap, with BNM obtaining 112 million new RM1 MHS shares, issued at RM16 each (Gomez and Jomo 1997). After a fall in share prices, the share swap proposal involving MAS and MHS was rescinded, and RZ Equities acquired a 32 per cent stake (224 million shares) in MAS for RM1.79 billion in June 1994 (Gomez and Jomo 1997). MHS was given a one-year call option to acquire RZ Equities from Tajudin and did so in August 1994. MHS later changed its name to Naluri. Tajudin assumed control of MAS on 6 August 1994. The purchase was entirely financed by bank loans, the largest in the country, with Tajudin pledging most of his shares in Naluri and TRI and his
other interests as security for the syndicated loan. With the sale, Tajudin (through DCB Merchant Nominees (Tempatan) Sdn Bhd) owned 32 per cent of MAS, while the government owned 27.2 per cent10 and retained a ‘golden share’ through the MoF.
After successive losses and mounting debts between 1998 and 2000, Tajudin admitted he could no longer finance MAS. The government con- firmed on 6 November 2000, after two years of speculation, that it was involved in talks to buy Tajudin’s stake in MAS, and approved, in principle, the purchase of MAS on 23 November 2000 (Asian Wall Street Journal, 24 November 2000). On 20 December 2000, Tajudin signed an agreement to sell his share in MAS back to the MoF for RM1.79 billion, or RM8 per share, when MAS shares were trading for around RM3.80. The government was reported to have agreed on the price considering the net tangible assets of MAS and the premium for a controlling stake (New Straits Times, 21 December 2000) even though it paid less to the Brunei government and already owned 49.2 per cent of MAS by 12 December 2000 through various agencies.11
Performance
Privatization here will be taken to refer to the period after the sale of a controlling stake to Tajudin in December 1993 as the government continued to be the majority shareholder after corporatization in 1985. MAS’s per- formance can be measured in terms of operational efficiency (revex ratio, productivity, passenger load factor, passenger yield) and financial perform- ance (leverage, liquidity and profitability). Although both sets of indicators were affected by the 1997–98 Asian financial crisis, we can isolate external factors in assessing the performance of MAS before and after privatization in two ways.
The first is to examine data before the Asian financial crisis, which started in the second half of 1997. As MAS’s financial year ends in June, this allows us to consider data covering three years of privatization before the crisis (1994–97), with the three years prior to privatization (1990–93), excluding 1993–94 (which may be viewed as a transition year as privatization was announced at the end of 1993 and Tajudin only assumed control of MAS on 6 August 1994). Although this is a fairly brief period to assess, it does isolate, to a degree, the impact of the Asian financial crisis, and provides some indication of efficiency gains and financial performance.
Secondly, we can reduce the effects of external factors by comparing MAS’s average performance in each period (as well as post-1997) with the combined average performance of its main regional competitors (referred to as MAS’s ‘competitors’) – Singapore International Airlines (SIA), Cathay Pacific and Thai Airways. It is also important to examine trends for each of these indicators, and to locate them in the context of overall industry trends.
Hence, if MAS exhibited improvements which coincided with general