Why Public Enterprises Often Fail in Small Island Developing States and Least Developed Countries: Governance, Institutions, and Lessons for Timor-Leste

By Dionísio Babo Soares*

“Good governance does not depend on whether the State owns enterprises, but on its ability to manage them effectively.” This proposition encapsulates one of the central dilemmas facing Small Island Developing States (SIDS) and Least Developed Countries (LDCs). Conceived as strategic instruments of national development, state-owned enterprises (SOEs) have, in too many contexts, become synonymous with chronic financial losses, weak accountability, and persistent dependence on government subsidies.

This raises a fundamental question: why do enterprises established to promote development so often become a burden on the very State that created them?

The answer lies, above all, in the quality of institutions. Experience demonstrates that public enterprises prosper when they operate within strong institutional environments, supported by professional management and sound governance. Where these conditions are absent, however, they tend to mirror—and often amplify—the weaknesses of the State itself, becoming vulnerable to political capture, operational inefficiency, and fiscal indiscipline.

Three major schools of political economy help explain this phenomenon.

The first is the developmental state theory, articulated by the American political scientist Chalmers Johnson in his seminal work MITI and the Japanese Miracle (1982), and further developed by MIT economist Alice Amsden in Asia’s Next Giant (1989) and sociologist Peter Evans in Embedded Autonomy (1995). These scholars demonstrate that success does not arise from state ownership itself, but from the existence of competent, meritocratic bureaucracies insulated from short-term political pressures. The experiences of Japan, Singapore, and South Korea illustrate that strong institutions and long-term strategic planning, rather than ownership alone, explain successful state-led development.

The second is the principal-agent theory, commonly known as agency theory, developed by economists Michael Jensen and William Meckling in their landmark article Theory of the Firm (1976) and later systematised by Stanford professor Kathleen Eisenhardt. This framework explains how delegating management creates governance challenges whenever oversight is weak, information is asymmetric, and incentives are misaligned. Without independent audits, transparency, and rigorous performance evaluation, inefficiency and rent-seeking inevitably emerge.

The third is public choice theory, associated with Nobel Laureate James Buchanan and Gordon Tullock, co-authors of The Calculus of Consent (1962). This school warns that public enterprises may become instruments of political patronage through appointments, procurement, and investment decisions driven by electoral considerations rather than economic efficiency, ultimately undermining both performance and public trust.

These governance challenges are particularly acute in SIDS and LDCs because of well-known structural constraints: limited domestic markets, high operating costs, geographic isolation, dependence on imports, and heightened vulnerability to climate change.

Timor-Leste shares many of these structural characteristics, yet it also possesses the conditions to overcome them. Since the restoration of independence, the Government has established a number of state-owned enterprises with the legitimate objective of addressing market failures and promoting national development. In an economy where private investment remains limited and financial markets are still evolving, these institutions continue to play an important role that deserves recognition.

The next stage of their institutional maturation lies in strengthening governance. This requires ensuring that appointments to senior management positions increasingly combine institutional trust with technical merit. While political confidence remains both legitimate and important, modern corporate management also demands specialised expertise in finance, engineering, law, and corporate governance—areas in which Timor-Leste has steadily expanded its pool of qualified professionals.

Institutional economics offers an important insight in this regard. Douglass North, the Nobel Prize-winning economic historian, argued in Institutions, Institutional Change and Economic Performance (1990) that organisational performance ultimately depends on the quality of the institutions within which organisations operate. Weak systems of recruitment, oversight, contracting, and evaluation inevitably result in unclear mandates, inadequate financial control, and chronic dependence on the State Budget.

From this institutional weakness emerges a self-reinforcing vicious cycle. Political interference undermines professionalism; poor performance justifies continued government subsidies; and those subsidies, in turn, weaken incentives for reform. Public enterprises gradually cease to function as commercial entities and instead become little more than administrative extensions of the State.

International evidence nevertheless demonstrates that this outcome is far from inevitable. Governance quality remains the decisive variable.

A particularly compelling illustration comes from the International Monetary Fund’s Fiscal Monitor (2020), which found that in fragile states, state-owned enterprises achieve, on average, only one-third of the productivity of comparable private firms. In countries with stronger institutions, however, that productivity gap narrows to approximately seven per cent. In other words, the same policy instrument—a state-owned enterprise—can represent either a fiscal liability or a strategic national asset, depending on the institutional environment in which it operates.

The experience of several Asian economies following the 1997–98 Asian Financial Crisis reinforces this conclusion. Through professionalising management, introducing performance contracts, strengthening transparency, and enhancing corporate governance, governments transformed previously loss-making public enterprises into financially sustainable organisations that contributed positively to national development.

These reforms are also reflected in the OECD Guidelines on Corporate Governance of State-Owned Enterprises, the leading international standard in this field. The Guidelines advocate a clear separation between the State’s ownership and regulatory functions, independent boards of directors, merit-based appointments, transparent reporting, and performance-based accountability.

For Timor-Leste, the path forward is both demanding and promising. The country’s priorities align closely with internationally recognised best practices: strengthening transparent and merit-based recruitment; enhancing the independence of boards of directors; clearly separating political oversight from executive management; expanding the use of performance contracts; ensuring regular independent audits; and adopting measurable, verifiable performance indicators.

Within this framework, periodic evaluations of state-owned enterprises would enable the Government to make informed and objective decisions regarding consolidation, restructuring, or, where necessary, the reallocation of public resources towards initiatives capable of generating greater social and economic returns.

It is equally important to continue investing in the education and professional development of technical specialists and corporate managers—an effort that Timor-Leste has already begun and should continue to deepen. Qualified human capital remains the indispensable foundation upon which lasting institutional reform is built.

Ultimately, state-owned enterprises should serve as genuine instruments of national development and public value. Comparative experience consistently demonstrates that their success depends less on ownership than on the quality of governance, leadership, and accountability. With sustained institutional reforms and the political commitment that Timor-Leste has repeatedly demonstrated at critical moments in its history, public enterprises can evolve from recurring fiscal burdens into strategic national assets capable of advancing sustainable development and shared prosperity.

*This article solely reflects the personal views of the author and is intended for academic reflection and public debate. It does not necessarily represent the views of the institutions with which the author is affiliated.