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Sunday, July 31, 2016

CAG concerns about public debt management

by Radhika Pandey and Bhargavi Zaveri.

The CAG report on public debt management tabled in Parliament on 26th July, 2016, has made several adverse observations on the current state of public debt management in India.

  1. It found the legal framework governing public debt lacking in several respects. The present legal framework on public debt does not define basic concepts such as 'public debt', does not indicate the objectives of public debt or the purposes of borrowing. It does not require the formulation of a strategy for the management of public debt.
  2. Over the past two decades, all expert committees have recommended setting up a public debt management agency (PDMA) for performing the debt management function. However, except for a middle office (which also does not perform the functions assigned to it), no progress has been made on this front.
  3. There is no entity that performs functions relating to the external debt of the Central Government such as analysing and monitoring risks and assessing the performance of debt managers against strategic targets or benchmarks.

Apart from the desire of the government to make more-than-incremental reforms, there are two other reasons why it is an opportune time to resume the long-delayed work of reforming the framework for public debt management in India. One, RBI has formally adopted inflation-targeting as the objective of its monetary policy, which heightens the conflict of interest between its role as the investment banker for the Government and the inflation target. All mature market economies separate debt management from monetary policy. As an example, the IMF guidelines on public debt management have emphasised that there should be separation of debt management policy and monetary policy objectives and accountabilities.

Two, RBI has formulated a road map for progressive reduction in SLR (the funds that banks are forced to keep invested in government securities). The SLR is proposed to be brought down by 0.25% every quarter till March 31, 2017. Reducing this `financial repression' is a good thing. But simultaneously, this makes life more difficult for public debt management. We need new institutional arrangements alongside breaking with the old, distortionary ways. Greater diversification of the investor base of government securities, in the quest for voluntary buyers, is required. The cosy arrangements of today for debt management and the bond market will not work in the emerging world.

It is poor policy analysis to proceed with inflation targeting, but not give the central bank the tool of a liquid bond market through which the inflation target will be achieved. It is poor policy analysis to  reduce financial repression, but not plan for the complexities of public debt management in that new environment. This article summarises the problems with the prevailing framework on public debt management in India and sketches the broad countours of a stand-alone law that should govern the same.

Problems with our public debt management framework

  1. The elephant in the room is the lack of an independent public debt management agency (PDMA). This has formed the subject of much discourse in academic and policy circles. From the mid 1990s onwards, all expert committees in India have advocated setting up the PDMA. A recent IMF Working Paper on designing legal frameworks for public debt management has advocated ``centralisation of all debt functions in one single unit to reduce fragmentation and enhance coordination in debt managment''.
  2. When a principal engages an agent to undertake a specific task, the contract between the principal and agent must be tight enough to build in accountability, performance measures, and at the same time allow the agent to perform its task without interference in transactions. While there is a lot of talk of "independence" for government agencies in India, this needs to shift to a mix of accountability on performance and autonomy on transactions. The current legal framework dealing wth public debt management in India is scattered across several laws such as the RBI Act (which obligates the Central Government to entrust the debt management function to the central bank), the Government Securities Act, 2006 (which deals with manner in which RBI will hold government securities, terms and conditions of government securities, etc.) and the Public Debt Act, 1944 (which continues to apply to Jammu and Kashmir). None of these laws codify performance measures or build accountability mechanisms for the agent to perform its task.
  3. As the RBI only deals with marketable debt, a single repository containing all the data which is required for an overall picture of the outstanding liabilities, including contingent liabilities, of the Central Government is not available. As this information is absent, it is not possible to formulate or implement a strategy for public debt management. What we do in public debt management is all transactions and no strategy.
  4. Market infrastructure for the government bond market (the exchange and clearing house) is owned and managed by RBI. The weaknesses in how this management is done has been an important source of failure in bond market development. Decisions about the appropriate market infrastructure for government bonds are best placed at the PDMA, which would be accountable for delivering low cost financing for the government, and would thus have the incentive to think about how to organise these markets.

What should a law governing public debt management look like?

The Financial Sector Legislative Reforms Commission (FSLRC) which recommended the establishment of a PDMA also drafted the blueprint of a law, the Indian Financial Code, that will govern its functioning. The key elements of the Indian Financial Code governing the functioning of PDMA are summarised below:

  1.  It defines 'public debt' to mean internal and external borrowings of the Central Government. This would ensure that there is one single entity that has an overall picture of the outstanding liabilites of the Central Government, both internal and external.
  2.  It codifies the objectives of the PDMA, namely, to minimise the cost of raising and servicing public debt over the long term and to keep the public debt within an acceptable level of risk at all times. For the first time, the manager of the public debt has clearly defined objectives which also translate into measures by which its performance may be judged.
  3. It entrusts the management of existing and contingent liabilites on the PDMA. This ties in with the requirement of having a single manager who will manage all outstanding liabilties of the Central Government. The concrete output will be a single repository of liability-related information.
  4. It codifies the relationship between the principal (Central Government) and the agent (PDMA, as the debt manager) in precise terms. For example, it obligates the PDMA to formulate an annual debt plan and a medium term (three year) debt plan, get the same approved from the Central Government and then implement it. The law also codifies detailed requirements for publication of the debt plan as well as a calendar for issuance of government securities.
  5. It obligates the PDMA to foster a liquid and efficient market for government securities. It empowers the PDMA to advise the Central Government on market design and allow equal access to this market, as an integral part of this market design. Contrast this with the existing framework which is lacking in details on the market structure for government debt.
  6. The entire machinery of governance, such as annual reports of defined standards, performance evaluation, external audits, etc. have been made applicable to the PDMA.


A short while ago, this work was done, but then it was rolled back. The Finance Bill, 2015 tabled in the Parliament proposed the establishment of a PDMA and its functioning broadly on lines described above. Subsequently, the reform was rolled back with a promise that the "...Government in consultation with RBI, will prepare a detailed roadmap separating the debt management functions and market infrastructure from the RBI, and having a unified financial market." It is a big missing link in the Indian reforms.

The authors are researchers at the National Institute for Public Finance and Policy.

Monday, July 25, 2016

Interesting readings

How to regulate professions by Ajay Shah in the Business Standard, 25 July.

Sebi needs a new regulatory structure by Pratik Datta in the Business Standard, 23 July; this analyses and proposes solutions to the recent news:  Sebi snafus make it sitting duck for SAT by Pavan Burugula in the Financial Express, 22 July.

Players and playing fields in the Internet age by Ajay Shah on Medianama, 18 July.

No bridges over troubled waters by Alok Gupta in the Thirdpole, 18 July.

Cheaper flights and scientific collaboration by Christian Catalini, Christian Fons-Rosen and Patrick Gaule in VoxEU, 16 July.

It's time for new regulations to protect clients from sly lawyers by Pratik Datta in the Economic Times, 16 July.

Medical Malpractice around Legally Defined Code of Conduct for Medical Professionals by R. K. Sharma in NIPFP YouTube Channel.

Govts must explain, explain, explain. Potential beneficiaries of reforms are unorganised, they don't know they will ultimately benefit: Arun Shourie by Shaji Vikraman in the Indian Express, 13 July.

Consultation Paper on Proliferation of Broadband through Public Wi-Fi Networks by TRAI in The Telcom Regulatory Authority of India website, 13 July.

Farm marketing reforms: Not in NAMe alone by Pravesh Sharma in the Indian Express, 30 June.

Thursday, July 21, 2016

Privacy concerns in the Aadhaar Act, 2016

by Vrinda Bhandari and Renuka Sane.

On 23rd March 2016, the Government of India enacted the Aadhaar (Targeted Delivery of Financial and Other Subsidies, Benefits and Services) Act, 2016 ("Aadhaar Act"), touted as India's biggest welfare legislation. The Act aims at the targeted delivery of subsidies, benefits, and services by providing unique identity numbers based on an individual's demographic and biometric information. The passage of this Act has been controversial, especially since the Lok Sabha rejected the amendments passed by the Rajya Sabha. Given the magnitude of data collection about individuals that would arise under the Aadhaar system, the law needs strong safeguards about privacy. In this article, we review the law from the viewpoint of concerns about privacy.

In this task, we use the conceptual framework that was constructed in our previous three articles: Protecting citizens from the State: The case for a privacy law (16 February 2016), Elements for the proposed privacy law (9 March 2016) and Analysing the Information Technology Act (2000) from the viewpoint of protection of privacy (18 March 2016). In these articles, we have setup an eight-fold path for evaluating laws from the viewpoint of privacy, which (in turn) builds on the nine privacy principles of Notice, Consent, Collection and Purpose Limitations, Access and Correction, Disclosure, Security, Openness, and Accountability. In this article, we use this approach to think about the Aadhaar Act, 2016.

Component 0: Objective of the law

By virtue of the large-scale and centralised collection, storage and use of an individual's demographic (e.g. name, date of birth, address) and biometric (e.g. iris scan, fingerprint, photograph etc.) information, the Aadhaar Act has great privacy implications. However, the Aadhaar Act does not consider privacy as one of its objectives. The word privacy does not even find mention in the Act. In fact, even the government's arguments in the Supreme Court during the challenge to Aadhaar, make it clear that it (and therefore, the Aadhar Act) does not view privacy as a fundamental right. Thus, while the text of this law is better than the UPA's 2010 draft, it is weak on privacy.

Component 1: Value of personal data

While the Aadhaar Act, on first blush, seems to understand the value of the information it collects, it is not underpinned by an understanding of the right to privacy. As discussed before, laws are shaped by the value we place on personal data, and function on an underlying premise of privacy being valuable in and of itself. However, the Aadhaar Act lacks any understanding or articulation of the  importance of privacy of personal data. Privacy considerations in the Act appear to be a minor afterthought, especially when juxtaposed with the needs of 'national security' which is given prominence in the Act.

Component 2: Scope and ambit of the law

The scope of the Aadhaar Act is a bit unclear since the working of key provisions have been left to regulations that are to be notified in the future. For instance, Section 2(g) of the Act defines 'biometric information' to mean photograph, finger print, Iris scan, or such other biological attributes of an individual as may be specified by regulations. It is thus possible that DNA can be included under this definition, and become part of a centralised government database. The consequences of DNA-based  profiling and its potential misuse are terrifying.

The Act oddly defines 'core biometric information' in Section 2(j), which is the same as biometric information, except that it excludes photographs.

Another example of the lack of clarity is found in Section 23(2)(k), which permits the Unique Identification Authority of India ("UIDAI") to share information about individuals in such manner as may be specified by regulations.

Similarly, Section 29(2) permits the sharing of identity information, other than core biometric information, in such manner as may be specified by regulations. Even more worryingly, Section 29(4) permits the publication and display of an individual's core biometric information or Aadhaar number for purposes as may be specified by regulations.

Together, these examples undermine the idea of a watertight database that will be used exclusively by the government for the purposes of giving subsidies, benefits or services. Even if the first wave of subordinate legislation is drafted with thought and care, the Act leaves the possibility of future changes to these rules and regulations in ways that undermine privacy.

Component 3: Coverage

The Aadhaar Act justifies the collection, storage, and use of personal data on the premise that it is a "condition for receipt of a subsidy, benefit or service", as stipulated under Section 7 of the Act. Thus, the Act is portrayed as covering (or regulating) only the interactions between the State and its residents.

However, a closer look reveals that under Section 57, the Act also facilitates interactions between private parties and residents of India by allowing "body corporate" to use the Aadhaar number for their own purpose. This raises concerns about violations of privacy when UIDAI shares data with private entities.

For instance, TrustID is an app that allows the user to verify any individual using their Aadhaar number, and offers a range of services including pre-employment, credit background, tenants, business partners, employers, and property owners' verification. It is not clear that the information access by TrustID is taking place in ways that protect the privacy of individuals. As Usha Ramanathan notes, many private companies have begun the process of trying to expand and leverage the uses of Aadhaar. The use of Aadhaar by a large number of private persons has long been touted as a contribution of the Aadhaar system to the Indian economy. There may be many conflicts about privacy in this process of expansion.

These applications suggest that the Aadhaar system will not be narrowly limited to the applications described in Section 7. The Act potentially covers everyone. It can include all the transactions conducted between an individual and the State in relation to benefits and subsidies; and the transactions between an individual and a corporate entity, where the private entity uses the Aadhaar number for identification and authentication.

The expanded scope of coverage, along with the absence of protection privacy, implies that this Act has reduced the overall privacy protections enjoyed by residents in India - whether in their interactions with the State to access subsidies/benefits or in their interactions with corporate entities.

Component 4: Collection and retention of personal data

With regard to data collection and its retention, it is important to provide an opt-in/opt-out clause to users, as this is consistent with the 'Choice and Consent' principle. This is particularly important in the Aadhaar Act, given our ownership over our own personal (demographic and biometric) data and the pervasiveness of our biometric data (e.g. we leave our fingerprints wherever we go).

The Aadhaar Act does not provide an opt-out clause, wherein Aadhaar number holders can choose to leave the system (and forego all its benefits) and ensure that their identity information is permanently removed from the Central Identities Data Repository.

Mr. Jairam Ramesh proposed an amendment to Clause 3 of the Bill in the Rajya Sabha, allowing a person to 'opt out' even if they had already enrolled, with the consequence that their authentication, biometric, and demographic information would be deleted from the system within 15 days. Although passed by the Rajya Sabha, the amendment was rejected by the Lok Sabha.

The absence of an opt-out clause is closely related to the issue of retention of personal information inasmuch as there are no time limits for the retention of data. This is unwelcome in light of the inherent non-revocability of biometric information and the fact that traces of our biometric data, for instance fingerprints, are left everywhere.

Component 5: Use and processing of data

The principle of 'Purpose/Use Limitation' is lacking in the Act. For instance, Section 33(2) carves out an express exception to Section 29(1)(b)'s stipulation of "using" core biometric information for any purpose other than generation of Aadhaar numbers and authentication under this Act if it is in the interest of [undefined] `national security'.

Section 3(2) and Sections 8(2)(b) and 8(3) of the Act require the enrolling agencies to inform the individual about the manner in which their information shall be used and shared and ensure that their identity information is only used for submission to the Central Identities Data Repository.

At first blush, thus, the Act seems to incorporate principles of 'Purpose Limitation', especially since Section 41 imposes a penalty on the requesting entity for non-compliance. However, the lack of an effective enforcement mechanism, as discussed later, undermines these provisions. For instance, the Act does not detail how an Aadhaar number holder can escalate the issue (since only the UIDAI can file a complaint) or what standard will be used to determine whether the requesting entity has provided the information in a clear and suitable manner.

Further, the Aadhaar number holder's identity information can be used both by the State and body corporates, without any further regulation governing the use by third parties.

Component 6: Sharing and transferring of data

This component of privacy design focuses on the 'Disclosure' principle, namely the sharing of personal data with third parties. In the case of Aadhaar,  this entails the identity information of the Aadhaar number holder. One of the most controversial sections of the Aadhaar Act is Section 33, which provides for the disclosure of information, including identity information or authentication records, under certain circumstances.

Section 33(1) permits the disclosure of such information pursuant to a judicial order by a Court not inferior to that of a District Judge. Nevertheless, the proviso only requires a hearing to be given to the UIDAI, and not to the Aadhaar card holder, whose information is being disclosed. Consequently, this deprives the individual of their essential right to be heard.

Section 33(2) is even more controversial because it makes an exception to the security, confidentiality and disclosure provisions on the direction of the Joint Secretary in the interest of national security. Such a direction has to be reviewed by a three member 'Oversight Committee', consisting of the Cabinet Secretary, the Secretary of the Department of Legal Affairs and the Secretary of the Department of Electronics and Information Technology. The second proviso further provides that such a direction shall be valid for three months, after which it can be reviewed and extended every three months. This is problematic for various reasons.

  1. As Mr. Jairam Ramesh and Mr. Sitaram Yechury noted while moving an amendment to Section 33(2), "national security" is an undefined term, and thus there is no transparency concerning covert surveillance. Consequently, the Rajya Sabha passed an amendment to replace the phrase "national security" with "public emergency or in the interest of public safety" (as is present in the Telegraph Act dealing with wiretapping). Unfortunately, this amendment was rejected by the Lok Sabha, and Section 33 remained as is.
  2. The scope of Section 33 is vague and it seemingly permits, and even facilitates, the furnishing of personal information to any third party, if it is in the interest of `national security'.
  3. The Oversight Committee is basically a committee of three Executive nominees. Thus, the possibility of effective oversight remains low. 

Component 7: Rights of users

As discussed previously, the right to access and correct one's own information, the right to data breach notification, and the right to data portability are extremely important from the perspective of the user.

Unfortunately, the Aadhaar Act does not grant these rights to the Aadhaar number holder. With respect to the right of access, it is instructive to examine the proviso to Section 28(5) of the Act, which states that an Aadhaar number holder may "request" (not demand) the UIDAI to provide access to her identity information. Nevertheless, the proviso excludes requests for her core biometric information.

It is unclear what the powers of the UIDAI are to accept or deny such a request or why a carve out has been made to restrict access to one's own finger print/iris scan, especially considering they can be wrongly entered in the system, as has been documented in Rajasthan (where the biometric information of potential food ration beneficiaries did not match the data stored on the Aadhaar servers).

Correction or change of demographic information (e.g. on getting married) or biometric information is governed by Section 31 of the Act, which requires the Aadhaar number holder to "request" (not demand) the UIDAI to alter such information in their records. The section states that the UIDAI, on the receipt of such a request, "may, if it is satisfied" make such changes. It is unclear what the standard for such "satisfaction" is, and the Act does not prescribe any statutory penalty or means for judicial redress for the delay/failure to act. Given the centrality of the Aadhaar number in linking various databases and services, such truncated rights of access and correction are worrying.

The Aadhaar Act also fails to prescribe 'data breach notification' requirements, mandating the UIDAI to inform an individual, the Aadhaar number holder, that their identity (biomentric and demographic) information has been shared or used without their knowledge or consent. Similarly, there is no concept of 'data portability' since information cannot freely be transferred amongst different service providers, since there are no alternatives to the UIDAI.

Component 8: Supervision and redress mechanisms

Effective supervision and redress mechanisms require individuals to be informed when there is a breach of confidentiality or disclosure of their personal information.

Section 47 of the Act prescribes that only the UIDAI or its authorised officer can file a criminal complaint under the Act. Thus, all the criminal penalties prescribed under the Act (e.g. for disclosing identity information under Section 37 or for unauthorised access to the Central Identities Data Repository under Section 38) can only be initiated by the UIDAI, and not the aggrieved Aadhaar number holder.

Consequently, even though the Act prescribes civil and criminal remedies for unauthorised access, use, or disclosure by the prescribed authority, the criminal remedy is not available to the aggrieved Aadhaar number holder. Such a person only has recourse to civil law, and the fines prescribed under the Act.

Unfortunately, a conjoint reading of Sections 28 and 47 of the Act disclose the possibility of conflict of interest since it may be in UIDAI's interest to cover up breaches of privacy. Without the UIDAI's proactive action, an individual Aadhaar number holder is left without remedy.

Section 30 of the Act treats biometric information as "sensitive personal data or information", as understood in Section 43A of the Information Technology Act. The treatment of such information under the IT Act has been dealt with in detail in our previous post. The IT Act itself fails to handle sensitive personal data or information in ways that embed privacy concerns.

Finally, as discussed in the sections above, the supervision mechanism for one of the Aadhaar Act's most controversial sections (Section 33), is the constitution of an 'Oversight Committee'. This Committee is tasked with reviewing the disclosures made in the interest of `national security', and thus serves to fulfill the 'Accountability' and 'Security' principles of privacy law. However, this three member Committee comprises of three government bureaucrats, especially after the Lok Sabha rejected the Rajya Sabha amendment to include either the CVC or the CAG as part of the Committee.


In this group of four articles, we have established a systematic eight-fold path for analysing laws from the viewpoint of concerns of privacy. We have used this framework to analyse two laws: The IT Act, 2000, and the Aadhaar Act, 2016. Both these laws have important failures in enshrining privacy. These laws thus hamper India's emergence as a mature democracy.

Vrinda Bhandari is a practicing advocate in Delhi. Renuka Sane is a researcher at the Indian Statistical Institute, Delhi.

Author: Vrinda Bhandari

Vrinda Bhandari is a practicing advocate in Delhi.

Monday, July 11, 2016

The gains to US GDP from a Doing Business score of 100

by Dhananjay Ghei and Nikita Singh.

Can a country achieve growth by implementing large pro-business reforms? If yes, then how much growth is really possible from such reforms? In a recent WSJ op-ed, Cochrane takes a stab at this question for the United States. Using data from the World Bank's ease of doing business index, Cochrane claims there is a log-linear relationship between GDP per person and business climate. By extrapolating this relationship out of sample, he predicts that the US would register a 209% improvement in per capita income (or, 6% additional annual growth if the required reforms are implemented over the next 20 years) by achieving the ease of doing business index value of 100.

Brad Delong disagrees. He fits a fourth-degree polynomial on the same data. He justifies this on the grounds that the third degree coefficient is negative and statistically significant. His forecast shows that an increase in the index value beyond 90 would actually lead to a lower GDP per person. Figure 1 juxtaposes the log-linear and polynomial regression fit, and we can see how the two views are sharply different. The straight line yields higher and higher GDP as you go to 100; the polynomial droops off at the end.

Figure 1: The analysis of John Cochrane and Brad DeLong

Areas of concern

There are many areas of concern with this analysis:

  1. Assuming linearity is surely a stretch. But polynomial regressions are a bad way to deal with nonlinearity. In particular, polynomial regressions are very fragile at the end points. This can be easily seen in Figure 2 as the prediction interval increases at edges of the data. In addition, extrapolation using a polynomial is almost always sure to give a wrong answer as the curvature of the polynomial is unidentified outside the sample.
  2. Using a cross-sectional regression with one variable is a poor guide to the causal relationships. Labour and capital matter to GDP per capita. There are stark differences in law and governance, institutions and culture across countries; it is unlikely that the doing business score is a sufficient statistic.
  3. Hallward-Driemeier and Pritchett (2015) show that the "doing business index" is not a good reflection of how the laws on paper are implemented in reality. The main point of their argument is that better de jure regulations do not necessarily imply improved de facto outcomes specially when a country has weak governmental capabilities for implementation and enforcement. Even if the US does well on the rule of law, and this gap between rules and deals is absent, this is a serious issue for many (most?) observations in the dataset.

Figure 2: The 95% prediction interval for the polynomial regression

Can we do better?

Criticisms 2 and 3 are hard to handle. But a little bit of statistics helps us do better on the first. We use non-parametric regression as a way to have nonlinearity in the relationship between business climate and GDP per person without having to take a stand on a particular functional form. This involves three steps:

  1. Selecting an optimum bandwidth using cross-validation
  2. Estimating a nonparametric model using the chosen bandwidth
  3. Tests of statistical significance and specification

We use a second order Gaussian kernel and fit a local linear estimator to identify the functional form in sample. Business climate is significant at 1% level in the local linear non-parametric model. Moreover, based on a lower cross validation score, the non-parametric regression is favoured.  In addition, we do a bunch of robustness tests by changing the type of kernel and regression. The results do not change much in either of the cases. These calculations were done in  R using the np package.

Figure 3: Non-parametric regression gives us the best of both worlds

The results, shown above, show that there is nonlinearity in the data. The linear model used by Cochrane is not appropriate. But we're better off as compared with using a polynomial regression; the confidence interval is tighter at the edges.

Figure 4 superposes the three models. The coloured dots show the predicted value of GDP per person using the three different specifications when the doing business index takes the value of 100.

Figure 4: Comparing the three predictions

Our nonparametric estimate shows that gains from achieving a score beyond 90 are increasing and somewhere in between Cochrane and DeLong's numbers. Cochrane predicts that the US would achieve 6% additional annual growth for 20 years by moving to a score of 100. If we go out of sample to estimate using the nonparametric fit, this shows an annual growth of 2.22% for the next 20 years. This is not something to laugh at, but it's a smaller, and we think a more plausible estimate.


Hallward-Driemeier, Mary and Lant Pritchett. 2015. "How Business Is Done in the Developing World: Deals versus Rules." Journal of Economic Perspectives, 29(3): 121-40.

Tristen Hayfield and Jeffrey S. Racine (2008). Nonparametric Econometrics: The np Package. Journal of Statistical Software 27(5). URL

Dhananjay Ghei is a researcher at the National Institute of Public Finance and Policy. Nikita Singh is a MRes. student at London School of Economics and Political Science. The authors thank Ajay Shah for valuable discussions and feedback.

Interesting readings

Worst case analysis for the banking crisis by Ajay Shah in The Business Standard, 11 July.

The Human Cost of Zoning in Indian Cities by Shanu Athiparambath in The Fee, 10 July.

The Silent Role of Credit Ratings in India's Bad Loan Crisis by Praveen Chakravarty in The Bloomberg Quint, 08 July.

For friendlier laws by Bibek Debroy in The Indian Express, 07 July.

Flying an unregistered drone in Ghana could send you to jail for 30 years by Yomi Kazeem in The Quartz, 07 July.

Bill seeking to amend Sarfaesi Act, 2002 needs to be reconstructed by ET Edit in The Economic Times, 06 July.

"I would like to share some sad stories from economics related to these issues" by Andrew Gelman in Statistical Modeling, Causal Inference, and Social Science, 06 July.

Central banks as 'pawnbrokers' by Suyash Rai in The Business Standard, 05 July.

Meet Justice Sanjay Kishan Kaul, who defended Perumal Murugan and MF Husain by FP Staff in The First Post, 05 July.

India offers rupee-dollar market on a platter to Dubai, Singapore by Mobis Philipose in The Mint, 05 July.

When Gujarat's Kachchhi Traders Had the World in Their Palms by Tirthankar Roy in The Wire, 04 July.

RBI should not regulate asset reconstruction companies by Pratik Datta and Rajeswari Sengupta in The Business Standard, 02 July.

We are still not a fully open, competitive economy... too much government interference: P Chidambaram by Shaji Vikraman in The Indian Express, 06 July.

National Doctor's Day: Greed, lack of firm laws allow unethical practices to flourish by Dr P. Raghu Ram in The First Post, 01 July.

Asset quality and bank loan ratings by Harsh Vardhan in The Mint, 01 July.

Regulation of the medical profession by Gopinath N. Shenoy in NIPFP YouTube Channel.

Against Prestige by Robin Hanson in The Overcomingbias Blog, 30 June.

A Rant on Peer Review by George J. Borjas in The Labor Econ Blog, 30 June.

Luck Runs Out for a Leader of 'Brexit' Campaign by Sarah Lyall in The New York Times, 30 June.

Inflation targeting: A long way to go by Rajeswari Sengupta in The Mint, 29 June.

Time has come for 'Move India' by Pradeep S. Mehta in The Hindu Businessline, 29 June.

The Multiplier Debate and the Eurozone Crisis by Joshua Felman on NIPFP YouTube Channel.

'Badass Librarians' Foil al Qaeda, Save Ancient Manuscripts by Simon Worrall in The National Geographic, 12 June.

Integrating Regulatory Impact Assessment in lawmaking in India on NIPFP YouTube Channel.

Dissenting Diagnosis by Arun Gadre and Abhay Shukla on NIPFP YouTube Channel.

Friday, July 08, 2016

Tata-Docomo: What went wrong, and what we need to do different

by Bhargavi Zaveri and Radhika Pandey.


An international arbitration tribunal recently reportedly ordered Tata Sons to pay $1.17 billion to NTT Docomo for breach of a contract between Tata Sons and Docomo. The contract obligated Tata Sons to buy back the shares held by Docomo in Tata Teleservices at a pre-agreed price that was higher than the `fair market value' of Tata Teleservices. Paying Docomo this price for its shares would have violated the regulatory framework governing capital controls in India, which prohibits a non-resident from 'putting' her shares on a resident at a pre-determined price.

The Tatas had reportedly applied to the Reserve Bank of India for an exemption from this restriction. RBI was reportedly keen to allow a one time exemption from its regulations. An earlier article on this blog expressed concern about an individual transaction being exempted from FEMA: while such an exemption may bring temporary cheer to an individual investor, it is more important to (a) stick to the rule of law; and (b) fix the mistakes in FEMA, as opposed to applying discretion in exempting some persons from the the bad law. When the matter was referred to the Central Government, the Central Government argued against case-by-case departures from the law, exhorted RBI to carry out deeper regulatory reform, and refused to grant this ad-hoc exemption.

Now we have the arbitration award. This arbitration award will likely lead to the following fall-out:

  1. Docomo will apply for enforcement of the award in India.
  2. Tata will argue that the pre-agreed contractual price cannot be paid, as it violates the laws governing foreign exchange transactions in India.
  3. If the Indian court refuses to allow the award to be enforced, the global press will write about the repercussions of this on India's competitiveness as an investment destination.

This situation is likely to come up in all transactions where foreigners seek to exit their Indian ventures by asking their Indian partners or the Indian company to buy-back the shares held by the foreigners at a contractually agreed price. The root of this problem lies in the capital controls framework which imposes restrictions on the manner in which a foreigner may exit from an Indian venture.

In this article, we argue that the restrictions on the exercise of put options by non-residents lacks an economic rationale. We then attempt to sketch a broad outline for designing a clean and coherent legal framework for governing capital controls in India.

Put options as an exit mechanism

Put options are a very common tool for exiting an investment. Typically, in an investment agreement, investors negotiate several time-bound exit rights for themselves, such as:

  1. Exit by an IPO or offer for sale by existing shareholders on the exchange - The investee company will list and the investor will sell her shares pursuant to the listing.
  2. Put or buy-back options - The investee company or the Indian promoter will buy or procure a buyer for, the shares held by the non-resident. The timing for the exercise of such options is linked to specific triggers. For example, in the Tata-Docomo agreement, Docomo reportedly had an option to put its shares on Tata within three years at half the value of the orignal investment. Similarly, investors often negotiate a put option linked to the investee's failure to achieve performance targets and the like.
  3. Tag and drag along rights - Depending on the stake held, the investor may negotiate a right that where any other shareholder in the investee company sells her shares, the selling shareholder will be bound to ask the new purchaser to buy the other shareholders' stake as well (i.e. the investors 'tag along' with an exiting shareholder). Where the investor sells her stake, she may require another shareholder in the investee company to also sell her shares to the same purchaser (i.e. the investor may 'drag along' another shareholder).

Flip-flops on put options

From a capital controls perspective, RBI had reportedly been objecting to the creation of put options in favour of non-residents prior to 2011, even when the law did not explicitly prohibit the creation of such rights. Thereafter, on September 30, 2011, the Department of Industrial Policy and Promotion (DIPP) issued a press release declaring that a put option in favour of non-residents would be regulated like an external commercial borrowing (which, at that time, meant that it would be regulated under the framework applicable to foreign currency denominated borrowings). DIPP mandated that:

Equity instruments issued/transferred to non-residents having in-built options ... would lose their equity character and such instruments would have to comply with the extant ECB [External Commercial Borrowing] guidelines.

This effectively meant that the proceeds of such shares could be used only for permissible end-uses and that there would be a cap on return on such equity, etc. After a month of heavy lobbying by parties that had already contracted such rights, the DIPP withdrew its restriction. After more than a year of uncertainty on this issue, RBI issued a circular which represented a somewhat compromised position by allowing put options in favour of non-residents, subject to certain conditions:

  1. The non-resident investor should have been locked in for a minimum period of one year, that is, she cannot exercise the put option unless she has held shares in the company for atleast a year.
  2. The non-resident should exit without an assured or pre-agreed return. This restriction fundamentally defeats the reason for negotiating a put option which is intended to protect the investor from a downside.
  3. Until 2014, the price payable to a non-resident when she 'put' her shares on a resident, could not exceed return on equity (calculated as Profit After Tax divided by Net worth) as per the latest audited balance sheet of the investee company. From 2014 onwards, the price cannot exceed the fair market value of the shares arrived at as per any internationally accepted pricing methodology in the case of unlisted companies and the price of the shares on the floor of the exchange in case of listed companies.

The futility of restrictions on rupee-denominated instruments

The claimed reason offered for restricting non-residents from obtaining an assured pre-agreed return on the exercise of put options is: a put option with a pre-agreed price would make the contract akin to debt. As RBI has a relatively stricter regulatory framework governing issuance of debt instruments by Indian residents to non-residents, allowing non-residents to obtain an assured return on put options would allow them to circumvent the RBI-framework governing debt. This argument is incorrect at several levels.

If there is an equity spot asset at $S$, and there is a put and call option at an exercise price $X$ on date $T$, where the options are valued at $P$ and $C$, and the interest rate is $r$, then put-call parity tells us that $S+P = C + X(1+r)^{-T}$. In other words, a spot investment that's risk-managed using a put option is not tantamount to a bond. It's tantamount to a complicated combination of a bond and a call option.

The rights in a default situation are different. There is neither any underlying security if the company or the promoter defaults on the put nor does the default on put give the non-resident rights which a creditor generally has (such triggering dissolution, etc.).

Even if you ignore the call option part, and focus on the rupee debt, the rationale for capital controls on these is absent. There is no systemic risk arising from foreign investment in Rupee-denominated instruments, where the currency risk is borne by a non-resident. As explained in the Report of the Committee to Review the Framework of Access to Domestic and Overseas Capital Markets (popularly referred to as the Sahoo Committee Report on External Commercial Borrowings), systemic risk is limited to the situations where the currency risk is borne by the resident. When a firm undertakes foreign currency borrowing, its balance sheet is exposed to exchange rate fluctuations. If there are numerous firms that undertake foreign currency exposure that is not hedged, there is a possibility of co-related failure in the event of a large exchange rate movement. However, a rupee-denominated loan by a non-resident to an Indian resident is akin to a loan given by an Indian resident to another Indian resident. We do not impose any restrictions on the contractual arrangements involving put options amongst residents.

In keeping with this thinking, the regulatory framework for Rupee-denominated borrowings has been relatively liberalised in the recent past. For instance, there is no cap on the interest rate that can be charged by a non-resident for the Rupee-loans advanced by her to the Indian borrower. In light of such liberalisation, there is no case for continuing with the same restrictive regime for put options, under the apprehension that parties will structure debt flows as equity with put options.

Transitioning toward a clean regulatory framework for foreign capital flows

In India, there are multiple levels of capital controls through different methods such as sectoral caps to control quantum of inflows, conditionalities to control kind of inflows and end-uses, exemptions for certain investment routes, penalising other investment routes, etc. Restrictions of this kind do not belong in an aspiring emerging market.

An extensive academic literature has hypothesised that economic agents learn to evade capital controls over time (Browne and Mcnelis (1990), Mathieson and Suarez (1991) and Patnaik and Shah (2012)). We in India take cognisance of the methods agents employ, and impose further controls to plug such evasion, adding hundreds of pages of complicated law and bureaucratic overhead. This complex maze of restrictions increases the costs of administering the law on capital controls, increases transaction costs for economic agents and fails to address the real issue where capital controls have value: the systemic risk associated with unhedged foreign currency denominated borrowings.

The story of restrictions on put options is revealing: (a) RBI created a restrictive framework for foreign denominated debt that lacked economic rationale; (b) It then suspected that economic agents were structuring their transactions as put options on equity to over-ride the restrictions. This was followed by uncertainty on the enforceability of such put options. (c) RBI modified the law to alter contractual rights of parties that had contracted put options on rupee-denominated instruments, thereby vitiating genuine transactions along with suspected ones which may have intended to evade the law. (Also, see another recent example being played out in China.)

This regulatory risk and cost of dealing with bureaucracy is driving up the cost of doing business in India. Unless we undertake deeper reform, we will see this story playing out time and again. This calls for a neat and coherent legal framework of the kind codified in the draft Indian Financial Code Version 1.1, which, in turn, is a culmination of the U.K. Sinha-led Report of the Working Group on Foreign Investment and the Justice B.N.Srikrishna-led Financial Sector Legislative Reforms Commission. This clean framework is based on three core principles:

  1. Barriers, if any, on inflows must be placed at the point of entry. For example, sectoral caps are a barrier at the point of entry.
  2. Once the entry barrier is crossed, all investments of a kind, whether made by residents or non-residents, must be treated equally. For example, local sourcing norms must not be imposed on non-residents if they are not so imposed on residents. Put options must be allowed in favour of non-residents if they are so allowed for residents.
  3. Government approval for an investment, if at all, must be mandated only for considerations of national security, that is, for investment in critical technology and critical infrastructure.

The Finance Act, 2015 amended the Foreign Exchange Management Act, 1999 to allow the Central Government to regulate all capital flows which did not constitute debt. This was a major milestone in Indian financial reform. The power to transition the current regulatory framework into a clean law, to the extent applicable to flows which are not in the nature of debt, now vests in the Ministry of Finance. An extensive body of work in this field has been done in the last decade. The time is ripe to start implementing it and avoiding more Tata-Docomo like disputes and the ensuing damage to India's competitiveness as an investment destination.


Donald J. Mathieson and Liliana Rojas-Suarez, Liberalization of the Capital Account: Experiences and Issues, IMF Working Paper (1992).

Browne, Francis and Paul D. Mcnelis, Exchange Controls and Interest Rate Determination with Traded and Non-traded Assets: the Irish-United Kingdom Experience, Journal of International Money and Finance, Vol.9, No.1 (March 1990), pp. 41-59.

Ila Patnaik and Ajay Shah, Did the Indian capital controls work as a tool for macroeconomic policy, IMF Economic Review, Vol. 60, Issue 3 (September 2012), pp. 439--464. The authors are researchers at the National Institute for Public Finance and Policy.

The authors are researchers at the National Institute for Public Finance and Policy.