Ownership & governance of critical financial infrastructure

SEBI has released the Bimal Jalan committee report about the ownership and governance of critical financial infrastructure. We're going to need a similar report on the questions about entry into banking also.

Governments riding in to rescue firms

What is a government to do when a company faces a near-death situation? In almost all cases, the right answer is to let the company go under: It is not the job of a government to prevent companies from dying. Indeed, creative destruction is central to the proper functioning of capitalism. Capitalism without failure is socialism for the rich.

But sometimes, the cost-benefit ratios can look startling. Sometimes, the disruption to the economy that comes from the death of a company can be rather large. Let's look at three stories.

Three examples

GM

In July 2009, the US government chose to put $50 billion into the auto maker General Motors (GM) as part of complex rescue, which included wiping out the existing shareholders and embarking on a complex restructuring of the firm. The old GM died there.
GM got back to profitability this year. Seventeen months later, in 17 November, GM got back on its feet with an IPO which raised $23.1 billion. How impressive! See this story by Michael J. de la Merced and Bill Vlasic in the New York Times. This IPO was at $33. With this IPO, the US Treasury got down from 61% ownership to 26% ownership, so this IPO was the re-privatisation of GM. From here, if the US Treasury is able to sell its remaining 0.5 billion shares at $53 a share in the future, it will fully recoup the $50 billion that went into the rescue (ignoring time value of money).

Satyam

On 7 January 2009, Satyam announced that a lot of money was missing from their balance sheet. In the aftermath of this crisis, the government put Deepak Parekh, Kiran Karnik, Tarun Das, and three others in charge. Read this interview of Deepak Parekh with Tamal Bandyopadhyay in Mint, and this blog post by John Elliott.
The new board put the firm up for sale. It was bought by Tech Mahindra. A collapse of the firm was averted; the employees and customers largely stayed in place.

UTI

When UTI got into trouble, I was opposed to government intervention. But by and large, I think the intervention worked well. US-64 unitholders did suffer losses: half of the gap between the NAV and market value was paid by the unitholders and half by the government. And the follow-through was excellent. The staff quality that MoF was able to muster on the problem was outstanding. The UTI Act was repealed, and UTI was turned into an ordinary company. `Bad UTI' was separated out by `Good UTI'. The ownership was modified including the recent work of bringing in T. Rowe Price as a shareholder. All in all, the exchequer did well when selling off the shares in SUUTI. Privatisation hasn't yet come about, but where we are is progress.

When is it right for a government to go in?

Should the US government have gone into GM? There was a fair amount of criticism of the Obama administration for the decision. There was concern that they were doing this owing to pressure from trade unions. But the outcomes have been quite nice, so (at least ex post) it looks like a good call.

In the case of Satyam, the existing shareholders were not expropriated. It can be argued that the failure of the firm was not their fault. But by that argument, many firm failures in India in the future will justify government intervention since most public shareholders are fairly powerless when the inside shareholders have over 50% shares. In his interview, Deepak Parekh says Had it happened to a consumer finance company or a small, or even big, manufacturing company, the government would not have come out and superseded the board. The normal procedures for bankruptcy and liquidation would have taken place.. I am not sure how the future will work out.

The problem of execution capability

Satyam, GM and UTI are success stories in that the government packed a mean punch in the execution. In particular, in Satyam's case, I had simply not expected that such a nice outcome could be achieved by the government. We should really admire the teams that worked on these problems.

But can we count on such high quality execution on such problems in the future? Our success in the Satyam or UTI stories should not be generalised to the view that in the future such high quality execution will always come about.

The exit strategy

The really amazing feature of the GM story is the clarity and commitment of the government in getting out of `Government Motors' by doing a privatisation just 17 months after going in. All too often, government interventions turn into nationalisation and then you're stuck with a public sector company for a long time, with all the usual politics of the privatisation.

In the deep past, numerous weak companies have been nationalised in the decades of Indian socialism (e.g. National Textile Company) and generally the outcomes have been bad.

A particularly attractive feature of the Satyam story is that no government money was involved. The presence of government money makes things much harder. In India, all too often, it's easy to ask for government money and it's easy to get it. And if the government had got shares in Satyam, it's not easy to see how they would have got out of it.

Similarly, a nice feature of the UTI story is that in the end, the UTI Act was repealed, and UTI is on course for turning into a normal financial firm. Government intervention in the rescue did not yield an ossified PSU.

At the same time, while Satyam and UTI are good stories in terms of the exit path, we cannot generalise too much from this given the fact that GOI is at a standstill on privatisation. In general, we have to assume that what is purchased is never sold, which puts a crimp on a vast array of situations where government intervention might be evaluated.

To summarise

When most firms approach death, the decent thing to do is to let the firm die. We must rejoice in the extent to which Indian capitalism is able to bring about a steady pace of firm death. Building a good quality bankruptcy mechanism will increase the class of firms where resolution is handled in a routine and humdrum way, without the possibility of a special intervention. (Note that going through the bankruptcy process was an integral part of the GM story).

When a potential intervention situation arises, six questions need to be asked:

1. Are the negative externalities of firm death really that onerous?
2. Can government intervention be envisaged without requiring money?
3. Are the Union ministers involved in the problem known for being smart and clean?
4. Can a top quality team be put together which will work on a time-bound project starting from intervention until exit? Does this team combine competence with cleanness?
5. Do we see an exit strategy through which, within a short time, the firm will be fully out of government hands?
6. Are we very sure that in the end, we will endup imposing no costs upon the government?

Ex post, these questions worked out well for GM, UTI and Satyam.

Let's go metric

T. N. Ninan, writing in Business Standard, calls for a shift away from lakh and crore to thousand, million, billion and trillion. We agree! And we've moved our Indian Business Cycle page to metric.

Indian economics is easier in the metric system. GDP is Rs.55 trillion. The market capitalisation of Reliance is Rs.3.5 trillion. On a good day, Nifty as an underlying has derivatives turnover of Rs.1.5 trillion. A billion dollars is Rs.44 billion. When I was at the MoF, I had tried suggesting that the budget documents should be switched to metric, without success.

Interesting readings

C. Raja Mohan in Foreign Policy magazine on India's strategic future.

Vivek Kulkarni in the Hindu Business Line estimates the magnitude of corruption in Karnataka.

Ashish Nandy in Outlook magazine on India's proclivity towards censorship.

How to improve tax compliance in India: Thorsten Beck, Chen Lin and Yue Ma have an article where they say that financial development helps reduce tax evasion: when firms use more external financing, they have greater incentive to not `cook the books', which induces bigger tax payments.

Salil Tripathi in Caravan magazine on improving freedom of speech in the UK.

Robert F. Worth in the New York Times on the shift of the State in Saudi Arabian away from tolerating Islamic fundamentalism to fighting it.

Who was right: Aldous Huxley or George Orwell?

Nicholas Schmidle in The Atlantic with a story from Ghana about something we badly need in India: serious investigative journalism.

Anand Giridharadas in the New York Times, and Kimberly Brooks on the Huffington Post on alternatives to the handshake, particularly `Namaste'.

I just read this beautiful obituary for Milton Friedman, written by Larry Summers.

In continuation of the Indian debate on ownership and governance of critical financial infrastructure, see Jeremy Grant in the Financial Times.

India's liberal foundation

I just read The off-key notes of a Sena scion by Rahul Pandita in Open magazine. The quick summary: Aditya Thackeray is the son of Uddhav Thackeray and the grand-son of Bal Thackeray, both of whom are the most-feared politicians of Bombay. He is now being initiated into politics, and has led the charge by threatening violence against those who would read Rohington Mistry. But his resume up to here features all sorts of nice nineteenth century liberal values such as writing poetry, mostly in English, rap music, Urdu, wearing jeans, and a bit of French. The article correctly draws attention to the hypocrisy of those involved.

But in it, I see another dimension. An upbringing in the Thackeray family is as strong an indoctrination into the sectarian perspective as you could ask for. I find it quite striking that between a certain strong ideology being sold at home, and the broader liberal worldview that pervades India, young Aditya evolved into the culture of an open and inclusive India.

The idea of India is about a great coalition of people who differ in ethnicity, language, religion, skin colour, education, income etc., who have figured out how to live together with a mixture of tolerance and individualism, without getting trapped in hatred or envy. This liberal India was strong enough to be appealing to Aditya Thackeray, and this story tells us that we're in good shape.

Why does Bombay have abysmal governance?

The resource curse

For many years, economists have been puzzled at the way things have gone wrong in countries where natural resources were discovered. In 1993, the economist Richard M. Auty coined the phrase `Resource curse' to convey the extent to which natural resource finds are a curse and not a blessing. But the idea had been kicking around well before that. I suppose it was an obvious conjecture after watching the failures of the Middle East, where trillions of dollars of oil revenues were squandered by not one but many countries.

In the 1970s, when oil was discovered in Venezuela, former Oil Minister and OPEC co-founder Juan Pablo Perez Alfonzo said: "Ten years from now, 20 years from now, you will see, oil will bring us ruin." His phrase for oil was: "the devil's excrement."

Why are resources a curse? In a country blessed with no natural resources (think Japan), the only way forward for the ruling elite is the slow hard work of building public goods, so that GDP builds up, which then feeds back into the power and importance and utility of the ruling elite. When the ruling elite gets their wealth for free, without having to do the hard work of building public goods and thus GDP of the country, the rulers emphasise the wrong issues. That's how Venezuela ended up with Hugo Chavez.

On one hand, rulers get focused on finding ways to maximise their rent from the underlying resource flow, without developing the knowledge about how to build a State that delivers public goods. In parallel, competition between politicians becomes an unpleasant process of trying to grab the riches by means fair or foul, rather than a process of competing in doing better on public goods. If there are XX billion dollars to be grabbed by becoming head of state, fairly unpleasant tactics get used by rivals aiming for that job.

Bombay's resource curse

I just read Maharashtra's Audacious Chief Ministers by Ashok Malik and it is a chilling story. It made me think: Why did governance in Bombay go wrong so comprehensively?

Maybe the story runs like this. Winning elections in Maharashtra does not require serving the citizens of Bombay. A party can do various things in trying to win seats in the legislature across Maharashtra. Once this is done, the ruling party gets the rents that come from control of Bombay.

The wealth and prosperity of Bombay is like an oil well which is gushing out cash for the ruling party in Maharashtra. They did not earn it. The slow, long, hard work of learning how to run a State, of building public goods: these things do not matter for the ruling party in Maharashtra. They get a rental cashflow from Bombay for free.

In (say) Jaipur, the Chief Minister and his ilk do not have an oil well gushing cash at them. Their incentives are to worry about public goods, and grow the GDP of Rajasthan. The importance and rental cashflow of the leadership in Rajasthan are primarily about the GDP of Rajasthan. Their hard work in improving public goods in Rajasthan feeds back to them as a higher rental cashflow.

People often compare the problems with Bombay with the decline of Calcutta after the Left took charge. The two stories are similar in that parties which won rural votes got to run a great city into the ground. But the Left did not take rents from Calcutta on this scale. That was an age where the GDP of Calcutta, while impressive by Indian standards, was still small change. Bombay of the last 20 years is in a different league altogether. This connects with the middle income trap meme: when capitalism first bloomed in India, some governance problems got worse and not better.

Implications

I think this suggests that the right to govern a prosperous city should not be based on elections taking place somewhere else. If Bombay were a full fledged state, as Delhi is and as the four big cities of China are, then elections to control Bombay would require persuading voters in Bombay.