The Hard Battle for Croatian Shipbuilding Has Not Been Lost Yet

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03.09.2018.

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Shipyard Uljanik in Pula, Croatia

It is clear that Croatia has a comparative advantage in shipbuilding ‒ neither significantly smaller than Finland and Greece, nor larger than Norway and Romania. Shipbuilding in Croatia is thus not a useless pursuit, but the question is just how to go about it.

Subsidies can bring short-term benefits but make it harder for creative disruption to eliminate inefficient operators from the market.

The time is way back in 2006. The place is the Faculty of Economics in Zagreb, the course is International Finance, and the lecturer is the current Central Bank Governor, Prof. Boris Vujčić, PhD. The professor is a few minutes late, probably delayed by the exigencies of being, among other things, Deputy Chief Negotiator in the process of the accession of our country to the EU. Apart from Yours Truly, the audience is composed of a small number of students of Economics. Not a few of them have become successful academics since. The atmosphere is almost intimate, the relationship with the professor not unlike that at the best American universities.

That sunny afternoon, he offered an alternative to a conventional ex-cathedra lecture. Rather than retelling facts from a textbook, he told us about the burning problems in shipbuilding, to illustrate in a practical way where our knowledge might actually take us.

We learned that shipbuilding as a branch of industry most exposed to currency risk, receiving payment in dollars but covering the costs in kunas. A fall in the dollar exchange rate necessarily leads to loss. The professor then explained that the problem of currency risk can be solved by hedging the receivables, i.e. by bridging the risks by using forward contracts at pre-arranged exchange rates. As far as he knew, the shipyards did not practice it back then. In fact, an anonymous manager in a public company had told him he had no interest in insuring against foreign exchange risk. When he gains on the currency rate no one gives him any credit for that, he said.  When he loses, the taxpayer foots the bill. Next year, the dollar depreciated by more than 10 percent against the kuna and the 2007 shipyard losses amounted to 0.34 percent of the GDP.

False dichotomy

More than a decade later shipyards were privatized, but the financial misfortunes were not over. It was another example of the false dichotomy between public and private, in which the change of ownership change is considered a kind of a magic wand that will improve business results. True reforms, however, are only those that affect the behavior of individuals ‒ owners, managers, and workers ‒ by changing their economic incentives. A sober discourse is further blurred by the passions of both those who have chosen to stand on the side of the workers and those who do not want the tax money further to finance the ailing shipbuilding.

In reality, the problem the shipyards face is multidimensional and it will certainly not be cured with a one-dimensional solution. Anyone who is willing to think about it coolly is going to ask two questions. The first is whether shipbuilding is profitable under the conditions of fierce competition from the East and the interventionist constraints by the European Union. In other words, can Croatian shipyards be profitable, even provided they are efficient, given the external, market restrictions? The other question is: if shipbuilding in Croatia can be profitable, why is it so often not?

Advanced ship niche

The prevailing opinion among economists is that the global shipbuilding industry suffers from oversupply, with as much as a quarter of the current world fleet being surplus to requirements. Three fifths of the world's shipyards work at only 55 per cent capacity. Particularly worrying is the fact that the number of shipyards using 80 per cent or more of their capacity is dropping drastically. As a result, the ship prices have been falling. When the demand for ships and shipping in non-elastic in terms of price, the result is the drop in shipyard revenue. On the cost side, the downward pressure on profitability is coming primarily from the climbing prices of raw materials, in particular steel, and the sharp rise in payroll costs in China, which is one of the world's largest shipbuilders. Profit margins have fallen to 4 per cent, and an increasing number of shipyards have negative cash flow margins, which effectively means that, although they do have sales revenue, their continuing business generates losses. Structural imbalance is thus global; the economic landscape is currently shaped by the interaction of eastern competitors. For Croatia the process is completely exogenous.

Although Articles 87 and 88 of the EC Treaty do not allow state interventionism in which member countries favor and directly assist certain industries, a number of directives have been issued to allow shipbuilding to make structural adjustment. The maximum amounts of subsidy, restructuring aid, and workforce relief assistance were carefully planned instruments by which the European Union attempted to restructure shipbuilding relatively painlessly and through a long period of adjustment.

In the 1960s, Europe had a 60 per cent share of the world shipbuilding; today only one ship in five is built in Europe. It is also important to note that the European shipyards, at least those that have survived, have turned to the production of high value vessels such as cruise ships, ferries, fishing boats and megayachts, with the help of funding from the EU directives. European shipbuilding has thus entered the niche of advanced ships, where having the cheapest steel and the lowest wages, as in the building of tanker ships, it is not enough ‒ you need high investment in research and development and new technology, such as artificial intelligence that would make crew-less autonomous ships possible.

Resource management

If Croatia chooses only to produce tankers and cargo ships, the battle for shipbuilding has already been lost. Chinese and Korean shipbuilding industries, in addition to enjoying direct state support, have already achieved significant economies of scale there. Nevertheless, it is clear that Croatia has a comparative advantage in shipbuilding ‒ not significantly smaller than Finland and Greece, nor larger than Norway and Romania. The share of Croatian ship exports may be small in the absolute amount (just 0.39 per cent of the world's production) but it is still disproportionately large given the size of our economy. The share of Croatian ship exports is 5.57 times greater than the overall share that ships have in the total world trade.

Over the past 30 years, ships from our shipyards have won 40 awards for quality and design. It is time to find our niche, adjust ourselves to it and, most importantly, stop expecting too much direct aid from the state because it is neither healthy nor technically feasible anymore. The current imbalance in supply and demand on the ship market is a direct consequence of state interventionism behind Chinese and Korean shipyards. China has reduced the apparent cost of building ships by about 20 per cent using state subsidies -- right in the shipbuilding segment that our shipyards traditionally compete in. The expansion of shipbuilding in South Korea was driven by market factors, but it is not possible to ignore the impact of state-owned financial institutions that have financed shipyards to the tune of 3.5 per cent of GDP.

Subsidies can bring short-term benefits but in the medium to long term they make it difficult for creative disruption to eliminate the inefficient companies from the market. This is especially negative in shipbuilding, in which quitting is painful due to the expensive and specialized capital equipment. Despite the overseas competition, shipbuilding in Croatia is thus not a useless pursuit; the question is what kind of ships to produce, with which people and technology. Also, for a change, ships should really be delivered in time.

Workers and owners

The problem of Croatian shipbuilding seems to be one of management of resources, including human resources. There is no economic logic in euthanizing it without a deeper analysis. Employee shareholding advocates forget that the so-called principal-agent problem, extensively described in the literature on corporate governance, does not disappear automatically if the shares are assigned to employees.

Company owners, in this case employees, should be interested in the growth of the company value, while the management has other, more 'selfish' goals. In other words, someone should control the directors and timely remove them if they do not meet the goals of the shareholders. Employees of Uljanik have admitted that they did not bother much with the management of the company while their pay was regular. The controlling package of shares carries the responsibility, too, not just the benefit. It brings along more worry, not less.

The operational implementation of the workers' self-management in the former socialist Yugoslavia was poor primarily because the employees were expected to be both successful workers but also canny investors. They were also expected to carry a significantly higher burden of risk than they were ready to accept. In addition, it is not necessary to allocate shares to have employees influence the strategic decisions of a company. In Croatia, employees have the right to have a representative on the supervisory board in all companies employing more than 300 people. In the Scandinavian countries, one-fifth to one-third of the management are directors elected by the workers.

By assigning shares to workers, you do not avoid the principal-agent problem, that is, the moral hazard that arises between the administration and the workers who have appointed it. A director can be elected from the ranks of workers, but he will act as a manager when he sits in the director's chair. Even if he was your best friend while you were working together, once he becomes a manager he will not hesitate to conceal information about business from you. When the employees are 'anesthetized', the only way for the employee-shareholder system to triumph is obviously to appoint a hybrid of Mahatma Gandhi and a Jedi Knight as the general manager. That would be the only way to prevent the problem well known in the economic literature from asserting itself.

The design of optimal contracts and management bonus schemes that tries to eliminate this problem won the Nobel Prize for Economics for Oliver Hart and Bengt Holmström in 2016. It remains to see if anything of their wisdom can penetrate the models of corporate governance in the Croatian shipbuilding. Because, if our shipbuilding is not unprofitable in itself, does it mean that we are - simply incompetent?