Electoral Verdict to Spur Reforms

With the return of the Congress government to power and with Dr. Manmohan Singh set to continue as Prime Minister, corporate India is likely to witness a series of reforms in the near future. Unlike the previous stint where the Government was hamstrung by coalition politics (but nevertheless achieving a record rate of economic growth), the reforms are likely to be bolder this time around as it appears to largely have a free hand in policy-making. Industry has given its thumbs up to the verdict and the markets are likely to witness a steep climb today when they open for trading, signalling the acceptance of the electoral result.

As far as matters relating to economic laws are concerned, the key outcome could be the enactment of reforms to company law. The Companies Bill, 2008 was introduced in the Lok Sabha on October 23, 2008. It seems not to have gained much traction since then as that was followed by the Mumbai attacks in November 2008 when the attention of law makers was diverted to more pressing concerns such as safety and security of the country (and rightly so), after which the election process put the issue to the backburner. The issue will hopefully be brought to the forefront so as to achieve an overhaul of Indian company law, which has been pending for over a decade now.

At a broad level, other issues on the agenda include the clarification of the tax regime for limited liability partnerships, finalisation of merger control provisions under competition law and streamlining of the foreign investment policy of the country (particularly with reference to the sectoral limits on foreign investment). This column in the Mint sets out a more detailed list of the key tasks ahead for the new government in terms of economic reforms. Finally, another event that would be viewed with a great sense of anticipation is the full Budget, which reports suggest will be presented in the Parliament session beginning in June (note that the Government had only presented an Interim Budget prior to the elections).

FDI and Globalisation: Where Does India’s Policy Stand?

The theme for the January 2009 issue of Halsbury's Law Monthly is Foreign Direct Investment (FDI) and Globalisation. The issue carries two articles that generally deal with FDI and three that specifically discuss issues on Indian policy.

The first, an article titled “Globalisation and Foreign Direct Investment: Topical Issues and Case Studies” by Dr. Linda S. Spedding sets out some general principles governing FDI and also discusses the role of transnational corporations in improving risk management and governance. The article also covers the importance of linkages between globalisation and sustainable development.

In “Capturing Opportunity and Controlling Legal Risk : India’s US-Bound Deals in Challenging Times”, David Laverty outlines the legal landscape in the US that applies to Indian companies investing there. Laverty observes that, unlike India, the US does not have a detailed set of systems dealing with foreign investment notification and approvals, but that “there are still restrictions that apply in the US, but these are less common for acquisitions of private companies that are not engaged in defense or national security related activities”.

The three remaining articles discuss specific matters involving FDI in India:

1. The cover story “FDI and Globalisation” by Dara P. Mehta outlines the significant changes in economic policy that were effected in 1991 when the Indian economy was opened up to foreign investment. That represents a radical approach as the Indian economy had followed protectionist policies for several decades until then. Although this has resulted in economic development and growth since the early 1990s, Mehta outlines a series of issues involving FDI that continue to act as a bottleneck towards attracting further FDI. The first is a general issue that signals that a robust legal set up for FDI that is yet to fully evolve. The article notes:

“The Legal Framework to Regulate FDI

Ideally, a complex subject like FDI should be regulated by a single agency of the Government, acting under the authority of the same statute or of rules and regulations, properly framed under that statute. Unfortunately in India, this subject is administered by several agencies, some of whose function overlap each other. To make things worse, matters relating to policy are announced and reviewed by at least two agencies of the Government of India, the Department of Industrial Policy and Promotion (“DIPP”) whose executive arm is the Secretariat for Industrial Assistance (“SIA”) and by the Foreign Investment Promotion Board (“FIPB”).

Statutory regulation is effected by the Foreign Exchange Management Act 1999 (“FEMA”) and by the rules and regulations made thereunder. But, very often, the non-statutory policy measures that are announced by the SIA in the form of the so called Press Notes conflict or are inconsistent with some of the regulations and regulations issued under FEMA. Policy measures that are announced by these Press Notes are non-justiciable, whereas the decisions of the Reserve Bank of India made under FEMA or under any of the rules or regulations made under FEMA can in appropriate case be made subject to judicial review. These multi-level agencies of administration of FDI cause bewilderment and confusion to foreign investors and certainly do not promote the cause of the globalisation of FDI. Moreover, the bureaucracy considers that these press notes are equivalent to a rule or notification issued under a statute and regards them to be as immutable as the laws of the Medes and Persians!”

Mehta then goes on to deal with certain specific issues such as (i) Press Note 1 of 2005 (that prevents foreign investors who had previous ventures in India from availing of the automatic route for further investments); and (ii) downstream investments by “foreign owned holding companies”, which present significant obstacles to foreign investment. In the case of Press Note 1 above, it is the strict rules laid down by the Government that pose an issue, while in the case of downstream investments it is a difficult (and somewhat far-fetched) interpretation adopted by the bureaucracy that causes problems. These are technical matters involving specific regulations, and the interested reader may refer to the article for further details.

2. In “Recent FDI Dampeners”, Atul Dua and Amit Mehta paint the issues with a broader brush. Apart from interpretation of the FDI regulations discussed by Dara Mehta above, they argue that certain recent decisions by Indian courts and tribunals on taxation matters will prove to be a dampener for further FDI. In particular, they refer to the decision of the Bombay High Court in the Vodafone case and that of the Authority for Advance Rulings (AAR) in the Fosters case. In both these cases, income earned by foreign investors was held to be taxable in India although the income was arguably earned and received outside India. The basic message is that the long arm of the Indian tax man is a cause for concern for foreign investors.

3. Amid this mood of pessimism comes a more sanguine outlook in Ramni Taneja’s article “Judicial Perspectives Regarding Foreign Direct Investment and Globalisation”. Ramni points to various decisions of Indian courts that have usually refrained from interfering on matters of economic policy. She concludes that the “Indian judiciary has in its judgments consistently preserved as unassailable the economic and industrial policy of the Government of India, and its natural concomitant, i.e. the FDI policy”. But, note that this assessment is confined only to the FDI policy, and does not deal with taxation matters which present the opposite position as discussed by Atul Dua and Amit Mehta above.

Overall, the timing of this topic for Halsbury’s Law Monthly is interesting. Governments all over the world (let alone India) are busy working on economic packages to boost development and employment, in order to overcome the economic slowdown and crisis. FDI forms an important part of this package. India too has consistently been taking measures to boost FDI, slowly but steadily, through a cautious approach. In that context, it is useful to pause and assess matters of legal policy and interpretation regarding FDI, as Halsbury’s Law Monthly has done. The take away from this discussion is that there is a need for greater certainty on the FDI policy – that ought to come from clearer policies written by the Government and appropriate (and purposive) interpretation of these policies in their working by the bureaucracy

Research Paper: Achieving India’s Growth Potential

Just as the Indian economy reels from its double-digit inflation to the tune of approximately 11%, Goldman Sachs, the leading investment bank, has issued its latest research paper titled Ten Things for India to Achieve its 2050 Potential. This is part of a series of papers published over the last few years by Goldman Sachs covering the BRIC economies of Brazil, Russia, India and China.

The paper builds on Goldman Sachs’ Growth Environment Scores (GES), in which India scores below the other three nations. Further, it ranks 110 out of 181 countries, and for 7 of the 13 components India scores below the developing country average. The current report contains some prescriptions for India to achieve its potential by 2050, noting that “[h]aving the potential and actually achieving it are two different things”. This effectively boils down the lack of proper implementation of reforms that slow down economic progress.

The following are the key recommendations extracted from the paper:

“We highlight ten key areas where reform is needed. In all likelihood, they are
not the only ten, but we consider them to be the most crucial:

1. Improve governance. Without better governance, delivery systems and effective implementation, India will find it difficult to educate its citizens, build its infrastructure, increase agricultural productivity and ensure that the fruits of economic growth are well established.

2. Raise educational achievement. Among more micro factors, raising India’s educational achievement is a major requirement to help achieve the nation’s potential. According to our basic indicators, a vast number of India’s young people receive no (or only the most basic) education. A major effort to boost basic education is needed. A number of initiatives, such as a continued expansion of Pratham and the introduction of Teach First, for example, should be pursued.

3. Increase quality and quantity of universities. At the other end of the spectrum, India should also have a more defined plan to raise the number and the quality of top universities.

4. Control inflation. Although India has not suffered particularly from dramatic inflation, it is currently experiencing a rise in inflation similar to that seen in a number of emerging economies. We think a formal adoption of Inflation Targeting would be a very sensible move to help India persuade its huge population of the (permanent) benefits of price stability.

5. Introduce a credible fiscal policy. We also believe that India should introduce a more credible medium-term plan for fiscal policy. Targeting low and stable inflation is not easy if fiscal policy is poorly maintained. We think it would be helpful to develop some ‘rules’ for spending over cycles.

6. Liberalise financial markets. To improve further the macro variables within the GES framework, we believe further liberalisation of Indian financial markets is necessary.

7. Increase trade with neighbours. In terms of international trade, India continues to be much less ‘open’ than many of its other large emerging nation colleagues, especially China. Given the significant number of nations with large populations on its borders, we would recommend that India target a major increase in trade with China, Pakistan and Bangladesh.

8. Increase agricultural productivity. Agriculture, especially in these times of rising prices, should be a great opportunity for India. Better specific and defined plans for increasing productivity in agriculture are essential, and could allow India to benefit from the BRIC-related global thirst for better quality food.

9. Improve infrastructure. Focus on infrastructure in India is legendary, and tales of woe abound. Improvements are taking place, as any foreign business visitor will be aware, but the need for more is paramount. Without such improvement, development will be limited.

10. Improve Environmental Quality. The final area where greater reforms are needed is the environment. Achieving greater energy efficiencies and boosting the cleanliness of energy and water usage would increase the likelihood of a sustainable stronger growth path for India.

Perhaps not all these ‘action areas’ can be addressed at the same time, but we believe that, in coming years, progress will have to be made in all of them if India is to achieve its very exciting growth potential.

While the research report does well to identify key concerns relating to growth and the areas to be addressed, it does pose some fundamental issues at a macro level. One of the criticisms that may be levelled against the report is that it does not present any new findings or prescriptions, and all of those contained in the report are well-known and debated (with perhaps little concrete action being taken). But, this critique is more to do with the form and less with the substance of the matters covered.

More fundamental is the approach towards some of the solutions to the problems. Here, one finds that most prescriptions turn towards market-based models of economic policy and liberalisation—for instance the recommendations for removal of capital controls, for liberalisation of the financial markets and so on. It is important to note, however, that all of those solutions may not directly apply in the Indian scenario. There is a need to contextualise the prescriptions for reforms so that they appropriately fit into the Indian macroeconomic framework as well as with its past experience. Some of the ideas (and materials) that support this thinking are as follows:

(a) Commentators have argued that some level of restrictions and governmental regulation on economic and financial activity may be necessary in the context of developing economies. Joseph Stiglitz is a leading proponent of this view, as he strenuously makes his arguments in his book “Globalization and Its Discontents”.

(b) Similarly, as far as India is concerned, arguments have been made that it is India’s partially restrictive policies that have helped weather the recent global credit crisis or even the Asian financial crisis that swept the region over a decade ago (see this column by T. N. Ninan in the Business Standard).

(c) It is also useful in this context to review Dr. Shankar Acharya’s critique of the Draft Report of the High Level Committee on Financial Sector Reforms headed by Dr. Raghuram Rajan, where the point has been made about the need for taking into accounting the realities in India while examining the nature of reforms.

Derivatives in Commodities: Some Issues

The issue over commodities exchanges and trading of futures and options in respect commodities has been brought to the fore with the Left parties deciding not to support the Forward Contracts (Regulation) Amendment Bill.

By way of background, commodities trading can occur in two ways. One is spot trading, where a buyer and seller of commodities enter into a contract, and settle the same by delivery of the commodities and the corresponding payment within a predefined time period (usually up to 11 days). The second is forward trading, where the delivery and/or payment occurs beyond such pre-defined period. Under the Constitution, spot trading is left to States to legislate, while forward trading is within the domain of the Parliament. It is under the latter powers that the Parliament enacted the Forward Contracts (Regulation) Act, 1952 (FCRA) that governs forward trading in commodities. Under the FCRA, while forward trading was permitted in some commodities and restricted in others, options were prohibited. To explain an option, it is a contract under which one party has the option or right (but not the obligation) to buy or to sell a commodity at a predetermined price. The administrative authority under the FCRA was the Forward Markets Commission (FMC), which was a government body.

With the development of the commodities futures markets over the last few years, the Government proposed an overhaul of the FCRA to take these recent developments into account. The principal changes relate to the allowance of options in commodities (that were earlier prohibited), the reestablishment of the FMC as an independent regulator (on similar lines as SEBI) rather than as an arm of the Government itself, and the organisation of commodities exchanges (to enable commodities futures trading) on corporate lines similar to stock exchanges. While these issues were part of the Forward Contracts (Regulation) Bill, 2006 that was pending in Parliament, the Government accelerated the reform process by ensuring the promulgation of the Forward Contracts (Regulation) Ordinance, 2008. The key features of the Ordinance are set out in a press release issued by the Government.

While there could be some questions as to the way in which the Government secured the changes through an Ordinance just two weeks before the Parliament commenced its session, there is little doubt that these changes were long overdue. Like the stock markets in India, the commodities markets too have been developing in a structured fashion over the last few years. Two large electronic exchanges in the form of the Multi Commodity Exchange of India Limited (MCX) and the National Commodities and Derivatives Exchange Limited (NCDEX) have been established and they now handle a significant portion of futures trading that occurs in commodities in India.

Economically, futures trading provides several benefits; it creates liquidity in the markets, enables price discovery by signaling the best price to the rest of the market participants, and most importantly, it provides traders with an avenue to hedge their risks. But, we must bear in mind that derivatives (such as futures and options) are complex instruments and hence are inherently risky. They are largely based on movements in commodity prices, and wrong bets on market movement can prove to be very costly, sometimes even to sophisticated players.

The Left has largely attacked the Ordinance by attributing the recent surge in commodity prices to extensive futures trading. However, that seems somewhat misdirected, as there is no correlation established between futures trading and increase in prices. Price increases could possibly arise due to myriad other factors.

I find that an important aspect that the Ordinance has failed to tackle is the issue of complexity of derivatives. It is not sufficient if the law merely provides a platform for derivatives trading in commodities. There needs to be a proper mechanism for disclosure, which requires persons that are selling futures and options in commodities to disclose all details (the risks in particular) relating to these products in a manner that the buyers of such products are able to appreciate the risks involved before they decide whether to participate in that market or not. In relation to derivatives in the stock market, the detailed rules issued by SEBI largely serve that purpose. It is also to be noted that the commodities futures market is likely to be patronised primarily by traders (some of them who may be of medium to small-scale) who may not possess sufficient sophistication to comprehend the risks involved in such complex instruments. The experience with derivatives in the financial markets (where the level of sophistication is somewhat higher) has not been good either, what with several companies now filing suits against banks (with whom they entered into derivative transactions) to renege on their commitments, including on the grounds that they did not fully understand what they were entering into. For details, see here and here on the Indian Corporate Law Blog). Therefore, a proper disclosure regime is called for in commodities trading so as to ensure informed trading in commodities derivatives, and thereby a transparent market.

The Left has also opposed foreign direct investment (FDI) in commodities exchanges. Although the press reports (referring to the Left objections) indicate that the FDI has been permitted under the Ordinance, it is not the accurate position. FDI is governed by various policies issued by the Department of Industrial Policy and Promotion (and not the Ordinance). The Press Note 2 of 2008 allows foreign investment of 49% in commodities exchanges (with 26% FDI and 23% FII investment) with the prior approval of the Government. Further, no foreign investor/entity, including persons acting in concert, will hold more than 5% equity in such companies. This appears to me to be a balanced approach towards foreign investment. While it allows major world players in this industry to participate in the Indian market and thereby introduce their expertise and business practices, it guards domestic interests as well. It is fairly restrictive as (i) investment is possible only with prior Government approval, (ii) majority shareholding still remains with domestic owners; and (iii) there is no risk of dominance by a single foreign player (or group) on an exchange as individual investments are capped at 5%.

It is likely that these issues will be the subject of heated debate in the near future, especially as the Bill comes up for discussion in Parliament.

Stock Market Turmoil and the Role of Regulation

Riding the downward tide of the global capital markets, Indian stock prices too tumbled 1,408 points on Monday, January 21, 2008 making investors poorer by $155 billion in a single day. The rout continued on Tuesday as well, before the markets partially recovered towards the end of the week. Reports indicate that investors have lost Rs. 18.05 trillion in 7 days; many of them saw their life-savings being wiped-out while some went bankrupt. The Gujarat police despatched a posse of policemen to secure Ahmedabad’s largest lake – yes, there is a connection – due to the fear of suicides by distraught investors and brokers.

Reasons

Several reasons have been proffered for the Indian stock market crash. First is the fear of a recession in the United States (US) sparked by the subprime crisis, which is expected to have an impact on the global markets. The Economist reports (in the general context of the global crash):

“For some, this merely represents a case of stockmarkets catching up with reality. It is now a year since the subprime crisis first emerged. In that time central banks have cut interest rates, investment banks have announced big write-offs and various rescue packages have been suggested. But the end of the crisis is not yet in sight. Indeed, another leg of the debt crisis may be under way, if problems of monoline debt-insurers (an obscure but important bunch who guarantee the timely repayment of bond principal and interest when the issuer defaults) are not contained. If the American economy is not now in recession, it is close enough not to make a practical difference to sentiment.

For much of past year equity investors knew those salient facts but chose instead to take comfort from three more bullish factors. First was that the Federal Reserve would rescue both the markets and the economy, as it has done so often before. Second, even if the American economy faltered, the rest of the world (particularly Asia) could take up the burden of producing global growth. Third, given the global picture, corporate profits could stay high.

All three assumptions are now coming under question. … An indication of the change in sentiment came when America's administration announced plans for a fiscal stimulus on Friday. In good times, that would have kick-started a market rally; in the current mood, the package was seen as a sign of desperation.”

The second reason attributed to the Indian stock market’s decline is massive divestment of Indian stocks by hedge funds and foreign institutional investors (FIIs) either to cash in on the previous bull run in the Indian markets or as a result of reallocation of their investment portfolios arising out of the battering they may have taken due to the US subprime crisis and the lack of liquidity. The global movement of capital in and out of countries (including India) may have caused stocks to turn volatile.

The third is tight domestic liquidity position caused by investors blocking their money in large IPO applications such as that of Reliance Power and Emaar MGF.

The fourth is several chinks exposed in the financial markets’ infrastructure. Just to list a few (and these may not be the only ones), stock exchanges required brokers to pay additional margin money amid declining markets, but brokers were unable to do so as payments from their clients were still awaited as cheques take at least 2 days to clear for the brokers to obtain money from their clients. It has been argued that there is a mismatch between the financial market system and the banking system in terms of timing. Some have gone even further and argued that the margin system enforced by SEBI and stock exchanges is itself questionable (see this column by Surjit Bhalla in the Business Standard).

Last, but not the least, is the omnipresent spectre that pervades any stock market crash – the idea of “irrational exuberance” (a phrase said to have been coined by the former chairman of the US Federal Reserve, Alan Greenspan) on the part of investors and overvaluation of stocks which results in a correction of the markets at some point in time. Some see this as the correction of the markets bringing them down to their real levels.

The Debate

Speaking for myself, it may still be early days before blame can be pinpointed on any single person or institutions or groups of them for either triggering off the present crisis or failing to take adequate steps to prevent or mitigate such a crisis. This may require an in-depth study of the turn of events. Unlike certain previous stock market crises (which have been termed “scams”, and appropriately so), there yet appear to be no allegations of shenanigans in any of the market players. Readers will recollect that the 1992 scam was largely attributed to the (mis)conduct of the late Harshad Mehta, while the 2001 scam to broker Ketan Parikh. Those scams did propel the Government to set up Joint Parliamentary Committees (JPC) to investigate the actions of various parties involved in stock market transactions. I am yet to come across either any such allegations of deviousness or any calls for such a JPC in this case.

This episode nevertheless has assumed political proportions. The Government, speaking through the Finance Minister has reiterated that the fundamentals of the Indian economy are strong, and that the market fall is attributable to continuing uncertainties in the global economy. Unsurprisingly, the BJP and the CPI have refused to buy the Government’s argument. The BJP has not only demanded intervention by SEBI, but has also blamed the Finance Ministry and SEBI for allowing overvalued IPOs, not restraining over-speculation and not improving the faulty settlement mechanism. Not to be left behind, the CPI alleges ‘malpractices’ in the stock markets that led to the crash (without further substantiation) and has called for an increase in the securities transaction tax.

All this begs the question: would the existence of a better regulatory system governing markets have prevented the turmoil? Should the financial market regulators (the Finance Ministry, SEBI and RBI) have taken measures to prevent the occurrence of such a crisis? Does this episode demonstrate the need for tighter governmental regulation on financial markets?

Role of Regulation

Since events are still unfolding and we do not have intricate details of acts by market players, and further there is no evidence of egregiousness or fraud, this analysis will necessarily have to be limited to the reasons for the crash as set out earlier in the post. The reasons can be categorized into three types: (i) external shocks (US recession, subprime crisis and sell-down by hedge funds and FIIs), (ii) internal system failures (illiquidity due to large IPOs and failure of markets’ infrastructure), and (iii) irrational exuberance of investors (overvaluation of stocks).

1. External Shocks

This seems the most plausible reason for the crash on the Indian markets. Not only does the crash come in the wake of the subprime crisis and fears of a US recession, it correlates directly with the decline in markets all over the world; it is not as if this was a phenomenon isolated to India. To blame Indian regulators for this would not hold water. It is nothing but the result of globalization and free flow of capital across the world. That naturally leads me to my next point. One important lesson that the Indian financial regulators can learn from this, though, is that “decoupling” of emerging economies (like India and China) from those of the developed economies (like the US and Western European nations) is a myth. Events that occur in one part of the world are bound to have a serious impact in other parts of the world. It seems to me that the turmoil of last week takes a further step in silencing the proponents of the “decoupling” theory. It is important that the Indian financial regulators recognize this while tailoring their policies for the financial markets.

Let us look at the menu of options available to the policy makers. A safe option would be to revert to the protectionist policies that were followed before India embarked on its new economic policy in 1991. While that would effectively insulate India from global volatility, this is not something one would advocate because we are not only far ahead down the path of economic liberalisation but any such stance would lead to India’s economic isolation. The other option would be to let the market control events (and correct itself) and hence impose minimal governmental regulation. But, to embrace dogmatic capitalism and a laissez-faire approach would be counterproductive. The path that the Indian regulators have adopted is somewhat of a midway approach of progressive liberalisation and de-regulation.

India still does have several restrictions on foreign investment, both on the strategic side and the portfolio side. On the portfolio side, which is what the stock markets are largely concerned with, SEBI has prescribed regulations for foreign institutional investors (FIIs) that require FIIs to register with SEBI and also imposes various curbs on their conduct. More recently, SEBI has placed severe restrictions on investments by hedge funds and required them to “come through the front door” (a statement attributable to the SEBI Chairman, Mr. M. Damodaran) rather than investing through the opaque participatory note (PN) structure that they hitherto used. Despite resistance from market players as being a harsh move and the consequent mini-market-crash in October 2007, SEBI did not relent under pressure and persisted with the rule, which became final on October 25, 2007. India is one of the few nations that tightly regulate hedge funds, in as much as this move is constantly pounded with criticism from the western media as indirect strengthening of capital controls on the Indian economy. The reader might well ask: why then was there a sell down in last week’s turmoil purportedly by hedge funds and FIIs that SEBI could not prevent? Perhaps the answer lies in the fact that the revised regulations on hedge funds are not only new, but also have inbuilt time periods (e.g. an 18-month period) for parts of it to come into effect.

While regulators or regulations cannot prevent external shocks altogether, measures can be taken to mitigate its impact.

2. Internal System Failures

While the external shocks seem primarily responsible for causing the markets to tumble, the downfall may have exacerbated by internal system failures. These include settlement-related issues, margin requirements, circuit breakers and other technical matters involved in stock trading and stock exchange operations. This does give rise to the need for introspection – perhaps it is this precise area where regulatory reforms will play a significant role to prevent recurrences. SEBI needs to investigate further to identify the systemic failures in the financial markets and make suitable modifications and corrections to the system with the assistance of financial market experts.

3. Irrational Exuberance

Investors pump money into the stock markets in the expectation that the price of their stock will go up and provide (sometimes quick) returns. But, often stocks are overvalued and investors enter the markets during a boom and then suffer losses when there is a subsequent downfall. The criticism is that investors make investment decisions without regard to the underlying fundamentals of either the company in which they invest or the economy itself. What role can regulation play here, and is there always a failure of regulation when markets go on a downward spiral and cause losses to investors?

At the outset, I find it hard to sympathize with the position that the government should be blamed for all the adverse outcomes (and consequent ill-fortunes) of its citizens’ financial choices. Financial markets are risky indeed, and it is not everyone who plays in that market that can absorb or handle the risk involved. Is it right to ask the government to adopt a paternalistic attitude and protect all investors against such risks? If not, to what extent can investors rely on the government for protection?

There are two types of investors. One consists of the institutional investors, such as FIIs, hedge funds, banks, insurance companies and so on, or individual investors such as high-net worth individuals, who possess a certain level of sophistication – their funds are managed by qualified and experienced investment managers. Such sophisticated investors may require less regulatory protection as they are well aware of the risks of the stock market; they are also well funded and capitalized to absorb shocks.

It is the second type of investors, the men and women on the street (referred to as retail investors) that do not possess knowledge and sophistication when it comes to investment matters, who beseech governmental protection. They often invest their life-savings that sometimes turn into dust, as many of them experienced during last week’s meltdown. While law and regulation cannot hand-hold such investors and protect them from their irrationalities, it can certain equip them and provide them with enough information and knowledge that can help them make rational choices. Regulators lay down disclosure norms that require companies to publish all investment risks in their offer documents.

In the Indian context, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 that have been strengthened over the years, impose strict disclosure norms on companies issuing capital to investors. However, this is applicable only when companies make public offerings (an initial public offering (IPO) or a follow-on public offering (FPO)) or qualified institutional placements (QIP) of shares to investors; these are typically known as primary market transactions. But, once the shares of the company are already traded on the stock exchange, the obligations of companies to make disclosure are much less severe. Hence, a person who buys shares of a listed company on the stock exchange in a secondary market transaction has far less information compared to a person who purchases shares in a public offering. This causes many retail secondary market investors to acquire shares in overvalued stocks during a boom without having understood the fundamentals of the company and the economy. This disparity between disclosures in primary market transactions and secondary market transactions may require correction by SEBI.

Another area to protect individual investors is through investor education. Though SEBI and the Ministry of Company Affairs have initiated several programmes to this end (here is SEBI’s Investor Awareness site) they do not appear to have gathered enough steam. This is an area where regulators can play a far greater role in minimizing the damage caused to investors in case of market turmoil.

Suggestions have been made (by the CPI General Secretary, A. P. Bardhan in particular) that the securities transaction tax (STT) must be heavily hiked from its current rate of 0.1%. It is not clear if this is mere rhetoric or how this proposal will help, as it will still be the individual investors (in addition to the other investors of course) who will have to bear the burden of the additional outgo.

In sum, the recent market turmoil has exposed the need for further regulatory action to safeguard investors in the Indian markets as we have seen above, but it is my belief that commentators are overplaying the scenario and taking it too far by attributing the crisis to regulatory failure. The crises would have occurred anyway, but its blow could have been softened with better regulation.

The ShockGen Effect

On a slightly different note, but still remaining within the confines of financial market regulation, a single trader named Jerome Kerviel belonging to Societe Generale (SocGen) was reported last Thursday to have caused the bank a loss of over €5 billion in the largest ever fraud in the investment banking history. He is said to have far exceed his sanctioned trading limits, manipulated computer records and created elaborate fictitious hedging limits to cover up his scheme, and still managed to remain undetected for almost 10 days despite high levels of compliance controls. Query: will any number of regulators or any amount of regulation have prevented this crisis?

Opposing editorial analyses of the scrapping of SEZs in Goa

As we await further developments on the Goa Government’s decision to scrap SEZs in the state, two prominent dailies have issued contrasting editorials. Yesterday, the Hindu’s editorial team weighed in, speaking out in favour of the Goa government’s stance. The Hindu editorial views the decision as responding to the public protests in the state against SEZs, and advises the Central Government to “respect this democratic outcome and help the State government speedily resolve all remaining issues, especially the question of how land already allotted to private parties in the three notified SEZs will be recovered.”

In making its case, the Hindu editorial focuses on the following points:

A coastal State with an area of 3,700 square kilometres and a population of about 1.4 million, Goa has always been extremely sensitive to the impact of unrestrained economic development. The upsurge of public activism against the setting up of Special Economic Zones, which eventually forced the State government to announce the scrapping of all 15 such projects, is an impressive case in point. Early last year, a similar agitation coerced the government into calling for a re vision of the Goa Regional Plan 2011, a controversial document that opened up large swathes of land, including green belts and coastal stretches, for construction. The broad-based agitation against SEZs has demonstrated the power of popular protest in the State. Those opposed to the projects had questioned the propriety of the government acquiring large tracts of land and then selling them to promoters at low prices. There were also suspicions that some of the SEZs were real estate speculative plays, fronts for the entry of big construction companies.

The Express editorial, which is featured in today's issue, draws attention to the overall policy implications for SEZs in general, and urges the Central government to “stand firm in rejecting the decision” of the Goa Government. Here are the details it relies upon:

Of the 15 proposed SEZs three have already been notified by the Centre after the state government earlier recommended them. The other 12 SEZs too have been recommended by the state government but remain to be notified. However, the land has been formally allotted in the case of all the SEZs. In the case of SEZs already notified construction is under way and investments worth Rs 500 crore are in the pipeline. Equipment has already been imported at zero duty by one of the SEZs being set up by a well-known pharmaceutical company. The company also has other non-SEZ operations in Goa where the bulk of the people employed are locals. The Centre will have to decide whether it wants to generate more employment or let rent seekers have their way.

Addressing the legal issues involved, the Express editorial avers:

Legally, the state government just cannot cancel SEZs which have already been notified and where work has started. The courts may not allow that. However, since land use is a state subject, the Goa government will try to cancel the SEZs which have not been notified. Technically they can do so. It is here that the Centre must stand firm. Technical arguments will not help restore the credibility of the UPA if it gives in to pressure from the Goa Chief Minister Digambar Kamat.

The Express editorial ends by making a pitch for the “integrity of the process” of national policy-making:

The country has gone through a fairly robust debate on the feasibility of SEZs. Several modifications to policy have been made in the area of land acquisition. Even within the UPA it is now accepted by all that SEZs are indeed desirable to drive development. It is of paramount importance that India moves large sections of its population from low-yielding agriculture to industry within a democratic framework. That is precisely what the SEZ policy seeks to do. The UPA must do everything to maintain the integrity of this process.

In my view, these contrasting editorials do a decent job of representing the diverse policy issues involved. One can, however, quibble with particular arguments made by each editorial. The Hindu may be emphasizing ‘people power’ to the detriment of other factors, such as the problems involved when governments go back on policy decisions, thereby adversely affecting investors who have acted on such undertakings. The Hindu also ignores the messy political calculations involved, and its act of commending the current leaders, who were party to all the overruled decisions, seems a bit much. The Express editorial, on the other hand, makes the mistake of overemphasizing the “integrity” of the policy debate over SEZs. In particular, its claim that “the country has gone through a fairly robust debate” over SEZs seems particularly misplaced. When exactly did such a debate take place? Were all stakeholders party to such a debate, and how do we know that all the legal and policy implications were discussed?

These problems aside, the editorials do set up the policy dilemmas involved in debating SEZs reasonably well. Together, they point to the many challenges involved in crafting a balanced policy towards SEZs.

Update, 2 pm: In the comments section, Dilip provides links to two papers by Aradhna Aggarwal which provide very useful background context, facts and statistics, and analysis. I am providing links to those documents in the text of this post: those interested getting a deeper understanding of this issue will benefit from reading these two pieces. This is a shorter EPW piece, while this is a longer working paper under the institutional aegis of ICRIER.

SEZ Troubles ... Again

On Monday, the government of Goa decided to scrap all SEZ projects in the state, as reported in the Hindu. Today’s Hindustan Times has an editorial which provides more details:

The decision was taken after a panel, set up to study the viability of the SEZs, observed that these tax-free havens were not “right” for Goa’s development. It added that the proposed SEZs would not match the talent skills in Goa, would further burden the existing infrastructure and will not create any employment. Goa has three notified SEZs — a pharma hub and two other Information Technology (IT) and IT-enabled services (ITeS) ones. The state had also sought permission to set up seven more SEZs, and allotted over 1,500 acres of land through the Goa Industrial Development Corporation. The proposal came under fire after villagers alleged misappropriations in land sale to real estate majors.

The opposition is on three main issues: displacement from prime agricultural lands, access to water resources and large-scale migration from other states. Migration, the protestors believe, will upset the state’s harmony and create law and order problems — not to mention, put pressure on available resources. The other major reason, and this is common to anti-SEZ protests across the country, is the perceived role of the State in acquiring lands on behalf of industry. The State is seen as colluding with industry in ‘grabbing’ arable land and, thus, the livelihood of people. Considering that there is no data of the employment generated by SEZs with their thrust on IT, ITeS sectors, which are not labour intensive, such fears are understandable. While the people are losing land, the industry is perceived to be in a win-win situation with the tax breaks provided

Here is the HT editorial team’s prescription:

The SEZs will only become attractive if the approach is inclusive. They will be attractive if the compensation is commensurate. Gujarat has shown how the process can be carried out effectively. But first, the State needs to be seen as a protector, not as an aggressor. The scramble among Chief Ministers for rosy figures will not take us anywhere, because figures seldom tell the true story. For the sake of the reputation of SEZs — not to mention the well-being of people — the State must understand this.

For previous blog entries detailing SEZ troubles in other parts of India, click here, here and here.

Update, Jan 03: In the comments section, Umakanth notes that the Central Government has taken issue with the Goa government's decision to scrap all SEZ projects, and suggests that this has now become a Federalism dispute, which may end up in court. As this news-item from today's issue of the Indian Express details, the Central Government seems to concede that the Goa Government does have authority to cancel pending projects, but disputes the state government's ability to cancel the three projects that have already been notified by the Centre. The article also notes the political complications involved, since Goa is currently ruled by a Congress government, and the current Chief Minister was intimately involved with the previous government's decisions to approve the SEZ projects.

Given all these factors, unless a private party that is adversely affected by the decision to scrap the SEZs takes this to court, my own view is that this is likely to be settled behind closed doors, among the powers-that-be in the state and central Congress circles. Umakanth's point is, however, valid for other SEZ projects, where the state governments involved are ruled by non-Congress parties. Observers of the Indian polity have long foretold the coming battles over our unwieldy Federal system, which was created to cater to the situation existing in India in the 1940s. Perhaps that battle will be joined over the issue of SEZs.

The March of Sovereign Wealth Funds

In this era of globalization and free-market economy, one would imagine that the state’s role as a market participant would dwindle over a period of time. However, that seems to be untrue in one important respect – the surge of activity in the international financial markets that has been precipitated by sovereign wealth funds that are themselves state players. A sovereign wealth fund (SWF) is defined by Investopedia as “pools of money derived from a country’s reserves, which are set aside for investment purposes that will benefit the country’s economy and citizens. The funding for SWF comes from central bank reserves that accumulate as a result of budget and trade surpluses, and even from revenues generated from the exports of natural resources”.

Although SWFs have been in existence for nearly half a century without much fanfare, they have recently become the subject matter of contentious debate in the international financial circles. The concept of the SWF has assumed significance because of the exponential growth in its size, which is currently estimated anywhere between US$ 2 trillion and US$ 3 trillion. While SWFs in countries like Norway and Singapore (through the Government of Singapore Investment Corporation (GIC) and Temasek) traditionally managed substantial investments, the recent surge in sovereign wealth is due to increase in commodity prices, oil in particular, that has left several SWFs in the Middle East flush with funds (a.k.a Petro Dollars). Examples are the Abu Dhabi Investment Authority, Kuwait Investment Authority, Qatar Investment Authority and similar entities in Saudi Arabia. China too set up its SWF in mid-2007 the form of the China Investment Corporation (CIC) that has been modeled on the lines of GIC.

Over the last few months, these SWFs have made multi-billion dollar investments in stocks of companies situated in various countries around the world. A bulk of these investments have been made in US companies, such as Citigroup (by Abu Dhabi Investment), UBS (by GIC), Blackstone (by China Investment) and even London Stock Exchange (by Qatar Investment). It would not be long before Indian companies begin attracting large sums of money from SWFs, as it is a favourite investment destination for such funds as an emerging economy. Since SWF investment transcends beyond a pure commercial transaction, there could be sensitive issues of national sovereignty that might be affected by these investments. This would require appropriate consideration by the Indian regulatory authorities (such as the Ministry of Finance, Reserve Bank of India and the Securities and Exchange Board of India), which are reportedly seized of the issue already.

Some of the risks that the authorities need to be cognizant of are as follows:

1. Market Impact: Since the investments by SWF could be of gigantic proportions, any withdrawal of these investments over a short period of time could adversely affect stock markets in which investments have been made, as this could trigger a massive fall in stock prices. Such impact was felt by the Asian economies during the Asian financial crisis of the late 1990s when foreign investors such as hedge funds and other institutions pulled out these markets all of a sudden thereby exacerbating the collapse of these economies.

2. Security Concerns: There are certain sensitive industries such as defence equipment, telecommunications, media and the like where investment by foreign sovereign entities would be of grave concern to recipient countries’ governments. Even countries such as the United States (US) that led the free-market and liberal investment policy juggernaut have taken to closed-door policies when it came to such sensitive sectors of the economy. For instance, recent amendments to the US legislation governing the Committee on Foreign Investment in the United States (CFIUS) give wide powers to the US Government to block deals by foreign players that are against US national interest. These legislative changes were triggered due to overtures in the past by the state-owned China National Offshore Oil Corporation (CNOOC) to take over Unocal, and by Dubai Ports World to acquire Peninsular and Oriental Steam Navigation Company, that were eventually warded off by the US. Even key European nations, through outspoken heads of states in the likes of Angela Merkel (of Germany) and Nicholas Sarkozy (of France) have called for protecting important industrial sectors from political influence of other nations.

3. Political Influence: Some commentators perceive a risk that investing sovereigns will exercise political influence by leveraging their large stakes in the markets of other countries, although it is not entirely clear whether such instances have yet occurred. Fears have been expressed that investing sovereigns could lobby for favourable tax treatment, special benefits for companies in which they have invested and the like.

4. Lack of Transparency: Unlike financial investors and commercial entities that are answerable to their shareholders, and thereby have disclosure and reporting requirements, SWFs by and large do not have similar obligations. Hence, their investment policies and strategies are shrouded in secrecy. Information about investment patterns of SWFs may not be generally available in the financial markets or to countries in which they make investments.

In this background, there appear to be two schools of thought emerging with respect to SWFs. The first school takes a more liberal approach, whereby commentators argue that SWFs should not be restricted from investing in other financial markets and ought to be treated on par with commercial investors. They urge a dispassionate and financially prudent strategy on the part of recipient countries. The only area where they call for a different approach is to enhance disclosure obligations on SWFs so that an element of transparency is introduced in their operations. Finance & Development, a quarterly magazine of the International Monetary Fund (IMF) states “[t]here's no apparent reason to see the continued existence of these funds as destabilizing or worrying. In fact, the IMF has strongly encouraged exporters of nonrenewable resources to build up exactly such funds in preparation for a “rainy day.”” Similar views have been adopted in http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4234 where Vinay Nair, a senior fellow at the Wharton Financial Institutions Centre argues:

“Not all sovereign funds are similar. Moreover, in my view, laws curbing capital inflows are unlikely to be helpful. Such regulations are often blunt instruments. Capital is an important ingredient of development – especially in India, and the country needs to attract overseas investment to sustain the world’s second fastest pace of economic growth. At such a time, laws that place investment barriers on SWFs would be a step in the wrong direction”.

On the other hand, there is another school of thought that adopts a more cautious approach. In an earlier article in DNA - Money, Mukul Asher states:

“Open societies with still-developing regulatory, and data gathering and mining capabilities such as India need to be particularly cautious when the investments by the SWFs are involved in strategic areas such as banks, telecommunications, and ports.

There is a possibility of national policies being undermined by transactions undertaken by SWFs of different countries. India also needs to substantially enhance its regulatory and monitoring capacity for not just approving the foreign direct and portfolio investments, but also their behaviour over time. India should consider developing a database of foreign investments by type of financial institutions, including SWFs.”

In a recent article in Rediff Money, MR Venkatesh argues:

Obviously, all this is not about economics, as it seems on a superficial level. As SWFs deploy their assets, political friction with target countries is likely to accelerate. No wonder many countries have now put in place well-defined foreign investment review processes.

It is indeed time that the Indian regulators too discuss this issue and ensure appropriate policy response to this vexatious issue. Nevertheless, what is ironical to note here is that globalisation had contained the seeds of this protectionist state of play -- a point that was missed by many.

Obviously, the challenge to the policymakers is to find a balance for government-backed funds that contain geo-political issues without discouraging orderly global movement of capital -- a Herculean task considering the inherent paradox contained in the idea.

Naturally issues get blurred when questions are raised concerning direct or strategic investment by SWFs -- i.e. when management stakes, sensitivity and security risks, size and, of course, strategic interests are involved. The response would naturally be equally blurred, diffused and to that extent arbitrary.

Who said capital did not have colour?”

Even though there is no consensus on the approach towards SWFs, one thing appears fairly clear – that SWFs are likely to continue to undertake substantial investments in various countries, and hence investment destinations such as India need to adopt a clear policy stance towards such investments. We could expect pronouncements not only a national level by the Indian regulatory authorities, but also from the World Bank and IMF that are currently exploring guidelines and standards for SWFs. This debate is not likely to fade away soon.

Doing Business: Where Does India Stand?

Earlier this week, the World Bank and its investment arm, the International Finance Corporation, published the Doing Business Report 2008 that ranks 178 countries in the world, providing an objective measure of business regulations and their enforcement across those countries. This year, India ranks 120 out of 178 countries, which is 12 notches above its previous year’s ranking of 132. The Report also summarises India’s position (here) on the basis of various parameters. However, there is no cause for celebration as India ranks far below several other emerging economies in providing a legal and regulatory framework that facilitates business and commerce.

As for the good news, the report throws positive light on India’s improvement on two counts, viz. (i) reduction in the number of days taken for export – from 27 days to 18 days (improving India’s ranking on the parameter of cross-border trading from 142 to 79); and (ii) access to credit (where India’s ranking improved from a ranking of 62 to 36). On all other parameters, India’s rankings have either remained the same or deteriorated from the previous year.

One aspect that is worthy of note is India’s high performance in the area of protecting investors, where India is ranked at 33 (previous ranking of 32). This is thanks to a robust company law regime coupled with a widely-expanding corporate governance and disclosure regime that has been put in place by the Securities and Exchange Board of India (SEBI) over the last few years.

On a Chindia comparison (which is becoming increasingly inevitable these days!), India has fared marginally better than China in moving up 12 notches from the previous year compared to China’s climb of 9 notches. But, on absolute terms, China is ranked at 83 compared to India’s 120. India’s performance among other emerging economies is generally lackluster, though it is somewhat comparable with the two other BRIC economies, Brazil (at 122) and Russia (at 106).

Reports such as this offer impetus for introspection. The Government itself cites the Doing Business Report while contemplating economic reforms in various sectors. Once again, we need to revisit some of the issues that are responsible for India’s current ranking in the world economy.

First, there are the regulatory hurdles. Several aspects of doing business in India require multiple procedures to be complied with. There are multiple agencies involved in administering different regulations. Often, there is duplication involved – firms are required to file the same information (or variants of the same information) with different authorities who often act at cross-purposes. What is required therefore is proper streamlining of procedures for carrying on business in India – reduction in the number of procedures as well as number of authorities involved. Further, there is a need for proper coordination among authorities.

Second comes bureaucratic delays. Applications for approvals or licences take inordinately long due to delays in decision-making by the governmental authorities. This frustrates businesses and causes valuable time and opportunity losses. There is a dire need for cutting down time frames for governmental decision-making.

Third is the lack of transparency is decision-making. Often, little or no reasons are provided for delays or rejections in the governmental approval and licensing system. Such opacity is also the cause for corruption at several echelons of the governmental machinery, that in and of itself is another cause for obstructing ease of business activity in India.

Fourth is problems with enforcement. Although India does have robust substantive laws in various spheres (that have withstood the test of time – Contract Act being one example) there is much left to be desired in the enforcement of these laws. The primary problem is in lack of capacity within the judicial system to absorb enforcement tasks and perform them satisfactorily. The court systems are overburdened with so many pressing issues and are unable to cope with the caseload. It is disheartening to note India ranks at 177 for contract enforcement (only above Timor-Leste) and it takes 1,420 days on an average for a successful party to recover on a contract suit.

It is therefore obvious that the continuing reforms need to address all these issues in a timely manner.

The Retail Debate Widens

Previous posts on this blog (here) discussed the issue of foreign direct investment (FDI) in retail trade. More recently, though, the debate has progressed beyond FDI. The issue has morphed itself into one of organised retail versus unorganised retail. This is evident from the fact that over the last couple of months, organised domestic retailers have been shown the door by some State Governments, prominent among them being Uttar Pradesh, West Bengal and Kerala after protests by the local unorganised players in the industry in the form of mom and pop kirana stores. Curiously enough, some of these State Governments had themselves invited the organized players in the first place to set up operations in their states.

From a legal, regulatory and policy-making perspective, this has important implications. While the FDI debate was largely being driven at the Centre, the domestic organized versus unorganized sector debate has shifted to the states. The State Governments possess licensing powers under the respective Shops and Establishments Acts to allow organized retailers to operate in their state, subject of course to checks and balances in terms of judicial review. The inevitable result of this phenomenon would be fragmented policy making and knee-jerk reactions by states. This would impede uniform policy making on what is becoming an important issue – retailization, which is affecting all emerging economies including India.

Today’s Business Standard carries an editorial that advocates the need for a proper policy intervention on this issue. It says:

“Any policy intervention has to take into account several factors. For one, any change of technology or scale will inevitably result in market shifts, which in turn could yield to downside effects like job losses, whether it is in retailing or in powerlooms replacing handlooms. The policy response in each case has to be to ensure that there are as few difficulties in absorbing the displaced in other parts of the economy - this implies facilities for re-training as well as ensuring that other parts of the economy grow well. Tax breaks for enterprises employing more labour (instead of for those employing more capital) and more labour flexibility for textile/garment firms wanting to expand operations come to mind immediately as some logical policy options. Any social cost-benefit analysis must also include the benefits reaped by millions of customers across the country through lower retail prices as well the benefits to farmers once the substantial wastages in the distribution chain get reduced. The policy responses being planned — a cess on large retailers, or restricting them to the outskirts of cities — are not very desirable because the government is then weighing in against efficiency. While it may be legitimate to try and ensure that small shopkeepers will not get affected, it also means that consumers will pay higher prices and that farmers will not benefit from lowered wastages in the supply chain.”

From this, it appears that what is required is a proper policy study on the impact of organized retail trade in the economy, by way of a cost-benefit analysis. It is only on the basis of the findings of such a study that the Government can frame a clear and coherent policy on organized retail. This would avoid the flip-flop approach on this issue as we have been witnessing over the last few months.

The politics of economic liberalisation in India

Today's Indian Express carries an interesting column by a Mumbai based management consultant. The views expressed are a stimulating counterpoint to the conventional wisdom ( that the left parties are to blame for our current woes) that one finds repeatedly expressed in the contemporary media. Having said that, I found the columnist's claim that "the fruits of reform are now enjoyed by a broad swathe of our society, not just the middle classes" particularly difficult to swallow. The agenda that the piece marks out is ambitious. Perhaps those who are so gung-ho about market reforms in India should pay heed to the call - it certainly makes political sense.