Despite the wave of privatization across developing markets in the 1980s and ’90s, state-owned enterprises continue to control vast swaths of national GDP: more than 50 percent in some African countries and up to 15 percent in Asia, Eastern Europe, and Latin America. These companies, controlled by a government or a government agency, struggle to meet the private sector’s performance levels, and potential profits remain unrealized. During the current downturn, some state-owned enterprises—even as they face increased pressure to become more efficient—have been called on to support government stimulus plans through higher spending and job retention. Nonetheless, our research and experience show that notwithstanding the constraints of the public-sector model and the tough economic times, these enterprises can significantly improve their performance.

Even in normal times, for example, the average return on assets at state enterprises in China was less than half that of the private sector, a McKinsey study showed a few years ago. One reason is that many such companies, in China and elsewhere, are shielded from competitive pressures, but other factors contribute greatly as well. State enterprises often juggle multiple, unclear, or conflicting financial and social objectives, such as providing blanket, low-cost telephone service. Political interference can...