by Bhargavi Zaveri and Pratik Datta.
The World Bank's Doing Business report downgraded India's ranking from 140 in 2014 to 142 in 2015. This has not disheartened the government, which continues its campaign aimed at attracting interest in India as an investment and business friendly destination. The campaign has started rubbing off to other arms of government. Even RBI. Recently, the Reserve Bank, in a show of investor friendliness, has reportedly shown an inclination to exempt the Japanese investor, Docomo, from the onerous pricing guidelines applicable to foreign investors exiting India.
While this may bring much cheer amongst investors, such ad-hoc reactions are dangerous for three reasons:
RBI has conventionally frowned upon foreign investors having an assured return on equity investments made by them in Indian companies. Typically, a foreign investor is allowed to cash-out his investment through a public listing of the investee company, or failing a public listing, through a put option. A put option allows the investor to put his shares on the Indian JV or the Indian JV partner at a pre-determined price. Until 2013, RBI strongly objected to this exit mechanism. In January 2013, it finally allowed foreign investors to exit by putting his shares on the Indian JV partner or the Indian JV itself. One of the conditions for allowing this exit was that the price to be paid by the Indian JV partner to the outgoing foreign investor could not exceed the market price of the foreign investor's stake, at the time of exit. The foreign investor could not exit at a pre-determined price, the principle being that foreign investors could neither ask for nor get an assured return, for investing in the equity of an Indian company.
Docomo is now in the process of exiting from its telecom JV with the Tatas. The JV agreement between Tata and Docomo reportedly allows Docomo to exit through the put mechanism, at a pre-determined price to be paid by Tata to Docomo. This pre-determined price is reportedly 60% higher than the fair market value of Docomo's stake today. This, being contrary to RBI's policy (as codified in FEMA), the parties applied to RBI for an exemption from the policy. RBI has reportedly indicated its willingness to grant this exemption, although the proposed exit is not in compliance with the existing policy framework, for the following two reasons --
MFN stands for Most Favoured Nation. Bilateral investment treaties that India has entered into with other nations usually contain MFN clauses. When an investment treaty between India and Country A has an MFN clause, India cannot treat investments from Country A less favourably than investments from any other country. In recent past, an Australian investor invoked the MFN clause in the 1991 Australia-India bilateral investment treaty and successfully sued the Indian government.
RBI proposes to exempt the Docomo exit from the legal restriction on put option pricing. Reportedly, one primary reason for this exemption is the investment relationship with Japan - India happens to be the top investment destination for Japanese firms. RBI (being an extension of the Indian state), in its executive capacity, decided to exempt Docomo because it is a Japanese firm. If this exemption is, in fact, granted, it opens the floodgates for investors seeking similar exemptions, from RBI and the government in future. The refusal to grant such exemptions would amount to treating these investors less favourably than an investor from Japan. This would violate MFN clauses in bilateral investment treaties that India has entered into with the countries of such investors.
For an analogy, see this case where India was caught in the wrong in 2011.
The rule of law is a subtle and complex concept. All too often, the individuals who man government fall into the trap of doing justice instead of practicing the rule of law. But these are different in important ways.
The RBI `regulation' imposing pricing conditions for exit of foreign investors does not specifically allow exemptions from the requirement that the price must be not less than the floor specified in the policy. Even assuming that a regulator has an inherent power to make exemptions from its own policy, nobody knows the considerations for judging an application for such exemption. Particularly, in the capital controls regime, the government and RBI have repeatedly succumbed to the temptation of deviating from its own policy, on a case-by-case basis.
We may point out that while the Indian State repeatedly fails on problems of the rule of law, the lapses are particularly glaring in the field of capital controls. For instance, take the case of allowing FDI in the brownfield pharmaceuticals sector. In 2014, the government prohibited foreign investors from imposing non-compete restrictions on their Indian JV partners, in the brownfield pharmaceuticals sector. However, it retained the power to allow such restrictions in "special circumstances". What these special circumstances are, remains unclear. Neither the law nor the policy gives any guidance to JV partners as to what they should do to satisfy the government that theirs is a "special" case. While it is the government's prerogative to retain discretion, basic governance principles require that the law and the policy clearly specify the conditions on which executive discretion will be used.
If the government is serious about elevating India's status as a business and investor friendly nation, policymakers must look beyond seemingly well-timed special cases and exemptions. Such short-termism increases policy risk. It sends out the wrong signals that the investment framework in India is susceptible to extralegal considerations. The need of the hour is to take a deeper look at the way policy frameworks are framed and administered, to see whether they infuse certainty in policy administration. A robust rule of law system, instead of arbitrary exemptions, is the only way of improving investor confidence in India.
This is not an isolated example; it falls within a larger context of difficulties at RBI on thinking about the rule of law and public administration [example 1, example 2, example 3, example 4, example 5]. There is an urgent need for improvements in intellectual capability at RBI on these issues, which are the foundation of sound governance. The IFC would put the ship on the right course.
The World Bank's Doing Business report downgraded India's ranking from 140 in 2014 to 142 in 2015. This has not disheartened the government, which continues its campaign aimed at attracting interest in India as an investment and business friendly destination. The campaign has started rubbing off to other arms of government. Even RBI. Recently, the Reserve Bank, in a show of investor friendliness, has reportedly shown an inclination to exempt the Japanese investor, Docomo, from the onerous pricing guidelines applicable to foreign investors exiting India.
While this may bring much cheer amongst investors, such ad-hoc reactions are dangerous for three reasons:
- This exemption, if granted, would have legal consequences for India under the bilateral investment treaties that it has signed with several nations.
- From a broader perspective, such special exemptions reflect a persistent bias in the Indian executive in favour of the rule of men rather than the rule of law. This usurps discretionary power in the hands of the executive, and increases unpredictability for the economy. This would, ultimately, hurt business.
- These patchwork responses sap the energy from the deeper institutional transformation that India desperately requires. We do not need one investment from Docomo, as much as we require for RBI to solve the mistakes of its pricing guidelines. Enforcing the rule of law is more important than doing justice.
The Docomo story so far
RBI has conventionally frowned upon foreign investors having an assured return on equity investments made by them in Indian companies. Typically, a foreign investor is allowed to cash-out his investment through a public listing of the investee company, or failing a public listing, through a put option. A put option allows the investor to put his shares on the Indian JV or the Indian JV partner at a pre-determined price. Until 2013, RBI strongly objected to this exit mechanism. In January 2013, it finally allowed foreign investors to exit by putting his shares on the Indian JV partner or the Indian JV itself. One of the conditions for allowing this exit was that the price to be paid by the Indian JV partner to the outgoing foreign investor could not exceed the market price of the foreign investor's stake, at the time of exit. The foreign investor could not exit at a pre-determined price, the principle being that foreign investors could neither ask for nor get an assured return, for investing in the equity of an Indian company.
Docomo is now in the process of exiting from its telecom JV with the Tatas. The JV agreement between Tata and Docomo reportedly allows Docomo to exit through the put mechanism, at a pre-determined price to be paid by Tata to Docomo. This pre-determined price is reportedly 60% higher than the fair market value of Docomo's stake today. This, being contrary to RBI's policy (as codified in FEMA), the parties applied to RBI for an exemption from the policy. RBI has reportedly indicated its willingness to grant this exemption, although the proposed exit is not in compliance with the existing policy framework, for the following two reasons --
- The larger issue, of fair commitment in the contracts in relation to an investment; and
- India's relationship with Japan in relation to FDI flows.
Understanding the consequences of MFN treatment
MFN stands for Most Favoured Nation. Bilateral investment treaties that India has entered into with other nations usually contain MFN clauses. When an investment treaty between India and Country A has an MFN clause, India cannot treat investments from Country A less favourably than investments from any other country. In recent past, an Australian investor invoked the MFN clause in the 1991 Australia-India bilateral investment treaty and successfully sued the Indian government.
RBI proposes to exempt the Docomo exit from the legal restriction on put option pricing. Reportedly, one primary reason for this exemption is the investment relationship with Japan - India happens to be the top investment destination for Japanese firms. RBI (being an extension of the Indian state), in its executive capacity, decided to exempt Docomo because it is a Japanese firm. If this exemption is, in fact, granted, it opens the floodgates for investors seeking similar exemptions, from RBI and the government in future. The refusal to grant such exemptions would amount to treating these investors less favourably than an investor from Japan. This would violate MFN clauses in bilateral investment treaties that India has entered into with the countries of such investors.
For an analogy, see this case where India was caught in the wrong in 2011.
The temptation of lapsing into the rule of men
The rule of law is a subtle and complex concept. All too often, the individuals who man government fall into the trap of doing justice instead of practicing the rule of law. But these are different in important ways.
The RBI `regulation' imposing pricing conditions for exit of foreign investors does not specifically allow exemptions from the requirement that the price must be not less than the floor specified in the policy. Even assuming that a regulator has an inherent power to make exemptions from its own policy, nobody knows the considerations for judging an application for such exemption. Particularly, in the capital controls regime, the government and RBI have repeatedly succumbed to the temptation of deviating from its own policy, on a case-by-case basis.
We may point out that while the Indian State repeatedly fails on problems of the rule of law, the lapses are particularly glaring in the field of capital controls. For instance, take the case of allowing FDI in the brownfield pharmaceuticals sector. In 2014, the government prohibited foreign investors from imposing non-compete restrictions on their Indian JV partners, in the brownfield pharmaceuticals sector. However, it retained the power to allow such restrictions in "special circumstances". What these special circumstances are, remains unclear. Neither the law nor the policy gives any guidance to JV partners as to what they should do to satisfy the government that theirs is a "special" case. While it is the government's prerogative to retain discretion, basic governance principles require that the law and the policy clearly specify the conditions on which executive discretion will be used.
Conclusion
If the government is serious about elevating India's status as a business and investor friendly nation, policymakers must look beyond seemingly well-timed special cases and exemptions. Such short-termism increases policy risk. It sends out the wrong signals that the investment framework in India is susceptible to extralegal considerations. The need of the hour is to take a deeper look at the way policy frameworks are framed and administered, to see whether they infuse certainty in policy administration. A robust rule of law system, instead of arbitrary exemptions, is the only way of improving investor confidence in India.
This is not an isolated example; it falls within a larger context of difficulties at RBI on thinking about the rule of law and public administration [example 1, example 2, example 3, example 4, example 5]. There is an urgent need for improvements in intellectual capability at RBI on these issues, which are the foundation of sound governance. The IFC would put the ship on the right course.
was this exemption given under India-Japan CEPA?
ReplyDelete