Online dispute resolution in India: Looking beyond the window of opportunity

by Rashika Narain and Smriti Parsheera.

Online dispute resolution (ODR) refers to the use of electronic communications and other information and communication technology for dispute resolution (UNCITRAL, 2016). Its objective being to bring the gains of efficiency, reach, cost-effectiveness, and convenience that technology has brought to so many sectors into the domains of redress, resolution and justice delivery. Some of the use cases of ODR include internal dispute management systems of businesses, electronic forms of alternative dispute resolution (often referred to as e-ADR), and operation of online courts.

India has seen a spate of recent developments in this space. There has been a rise in the number of ODR startups and businesses that are willing to experiment with ODR as an alternative to the traditional forms of dispute resolution. On the institutional side, COVID-19 induced pressures forced courts and Lok Adalats to switch to an online mode, the Reserve Bank of India directed payment systems operators to adopt ODR for failed payment disputes and the NITI Aayog put out a draft ODR Policy Plan.

Collectively, these developments signal the intersection of the problem, policy and politics streams to create a window of opportunity (Kingdon, 2013) for ODR in India. However, alongside the many benefits and opportunities of ODR lie a few areas of caution. First, the push toward ODR should account for the country's narrowing yet persistent digital divide. ODR solutions must, therefore, be designed in a manner that avoids extending digital exclusions into the domains of justice delivery and redress. Second, the immediate focus needs to be on building trust in the ODR sector though an emphasis on competence, accountability, equity, and transparency. These priorities should emerge from within the ODR ecosystem rather than being imposed through external forces. Lastly, the ecosystem should remain wary of any kind of central planning, particularly in terms of technical design. While controlled technical standardisation may seem attractive for initial adoption, it could result in the locking in of specific technologies and standards in the long run.

In this article we describe the meaning and evolution of ODR, explain the state of adoption in India, and introduce the Handbook on Online Dispute Resolution (ODR Handbook, 2021) created by a group of nine institutions that was recently launched by Justice D.Y. Chandrachud at a virtual event. The Handbook serves as an invitation to businesses to adopt and mainstream ODR solutions in India. While sharing the optimism generated by recent advancements in this space, we emphasise certain areas of caution and desirable practices for ODR to succeed beyond the current window of opportunity.

What is ODR?

ODR refers to the use of technology for enabling more accessible and efficient dispute resolution. Its genesis is often traced to the growth of Internet-based businesses and the resulting search for mechanisms to deal with online disputes and their accompanying jurisdictional uncertainties (Katsh, 2012). eBay and its payments arm PayPal are recognised to be among the early adopters of tech-enabled solutions for resolving cases arising on their platform (Rule, 2008). Similar tech-mediated systems for grievance redress are now commonplace across online businesses. Examples include the order returns management policies of e-commerce companies, feedback mechanisms of ride hailing companies and content reporting systems of social media firms. Beyond grievance management, e-ADR processes like mediation and arbitration are another popular use case.

The factors responsible for the growth of ODR include its efficiency, reach, cost-effectiveness, and the ability to improve business intelligence through data about dispute management. The possibility of asynchronous communication in many ODR models, which allows parties to respond at their own convenience, is another significant draw. Globally, ODR's reach has expanded to a range of sectors, such as property matters, family settlements, domain name disputes and financial matters (Kinhal et al, 2020). Further, tech solutions have also permeated into different layers of the dispute management process. For instance, negotiation tools like Cybersettle guide parties in making financial settlement bids and communication tools like Our Family Wizard are being used by courts to monitor parental custody settlements.

There are also many cases of institutional adoption of ODR in the public justice delivery system. Notable examples include Canada's British Columbia Civil Resolution Tribunal that uses ODR to handle condominium property claims, small claims, and motor vehicle injury cases, Hong Kong's ODR scheme for COVID-19 related cases, Mexico's Concilianet platform for consumer dispute resolution, and various small value claims courts in the United States (NITI Aayog, 2020).

State of play in India

The ODR industry in India has seen significant movement in the last few years although it still remains in the early stages of development. As per the ODR Handbook, the number of ODR start-ups has grown from 3 in 2018 to 13 by mid 2020. This includes operators like Presolv360, Centre for Online Resolution of Disputes (CORD) and SAMA that are directly involved in delivering online arbitration and mediation services as well as platforms like CREK ODR and Resolve Disputes Online that specialise in offering technology solutions to others.

A pilot project initiated by ICICI Bank in collaboration with SAMA presents one of the early examples of ODR adoption in India. As per the ODR Handbook, this mechanism was used for the resolution of 200 loan repayment related disputes before the introduction of the COVID-19 related loan moratorium. This reportedly led to significant cost and time savings for the bank -- its resolution effort went down from six person-days per case to only half a day (ODR Handbook, p. 61). In another example, SAMA recently organised an e-conciliation camp, called Suljhav Manch, which saw participation from companies like Udaan, Snapdeal and ICICI Housing Finance. An aggregate of over 8,000 loan and customer disputes were recorded for online resolution, of which 1,860 disputes have already been settled.

The COVID-19 situation has also created an impetus for institutional adoption through online filings, electronic court hearings and organisation of e-Lok Adalats in several states (Nair, 2020). Further, in line with RBI's directions for adoption of ODR by payment operators, the National Payments Corporation of India (NPCI) recently went live with its online resolution system for BHIM UPI app users. Others in the payment space are expected to shortly follow suit. The Income Tax Department has also introduced a Faceless Assessment Scheme that is meant to offer greater convenience and transparency in the assessment process.

In another interesting development, last year, the Supreme Court declared that the sole appointment of an arbitrator by a party interested in the dispute would be unlawful, even if previously agreed by the parties (Mehta et al, 2020). This may shift the standard practice of consumer facing companies appointing arbitrators en masse for low value, high volume disputes in favour of the incorporation of ODR clauses in commercial agreements.

Some areas of caution

While the developments above are cited as victories for ODR, the long term trajectory of tech-enabled dispute resolution will depend on a number of factors. First, there is the reality of India's digital divide, which spans across issues of connectivity, device ownership, digital literacy and skills, and social norms. A combination of these factors ends up generating varying levels of digital adoption across demographic groups. While sectors such as digital payments and e-commerce, which cater to an already digital population, are more conducive for ODR adoption, a broader policy push towards mandatory ODR could end up disenfranchising several sections of the population. For instance, the Tax Department's faceless assessment scheme has drawn criticism for the lack of opportunity for individuals to explain their case in person and limitations in technical skills and infrastructural facilities required to comply with the online processes (Chatterji, 2020).

Possible ways to minimise the harms of digital exclusion include keeping ODR adoption voluntary in most circumstances, investing in training and capacity building of intended users, and allowing them to opt for a combination of online and offline interactions. The emergence of a hybrid model where an intermediary can step in to facilitate the engagement between the parities and the technological requirements of the ODR system is another interesting solution. This is illustrated in the work being done by the Aajeevika Bureau to help migrant workers claim unpaid compensation from employers using an ODR process (ODR Handbook, p. 71-72).

Second, there is also the question of how to build trust in the ODR ecosystem in order to facilitate its adoption by businesses and individuals. There are some who argue that a certain level of government intervention and control is a necessary part of trust building (Schluz, 2004) while others have discussed interventions such as increasing knowledge about the process, certification of neutrals, and the existence of a code of ethics as mechanisms to bolster trust (Abedi et al, 2019). This points to the need for a discussion on the role of voluntary codes of conduct in building trust in ODR systems. We discuss this in the next section.

The third area of caution would be to avoid the creation of monolithic technical architectures in the ODR space. All too often in India, there is a temptation to create a state-mandated monopoly in a field, with government controlled technological standards (e.g. the Unified Payments Interface (UPI)) and a government controlled monopoly vendor (e.g. the NPCI). The NITI Aayog's draft report suggests a similar path for the ODR sector. It makes a case for the government's role in developing a 'scalable platform using technology' that will allow for the development of private sector services relying on government-led free and open source software (NITI Aayog, 2020, p. 96-97).

This is a less efficient path for several reasons. Government-mandated engineering designs tend to stagnate over time, and fall out of touch with the requirements of the people and of the technological possibilities. India is highly heterogeneous, and even if an efficient state-run planning process is able to emerge with a sound design for a modal use case, that may only cover a small fraction of the situations in the field. Further, despite being labeled as 'open', such solutions are often designed in a closed environment, with consultations being used as a tool for information dissemination rather than technical collaboration.

Providers and adopters of ODR have the incentives to understand opportunities, customer needs, and figure out innovative solutions. It would, therefore, be more efficient to allow a diverse set of actors to develop technology, protocols and standards in this space. Notably, ODR initiatives would also be bound by existing legal frameworks, such as the rights to data access and portability proposed under the draft Personal Data Protection Bill, 2019 and the safeguards available under competition law. Accordingly, government-backed technical standards are neither the only, nor the most efficient, path to achieving data access, portability, interoperability, and empowerment in this field.

A voluntary code for the ODR ecosystem

While resisting the push for government-backed standards and protocols, we recognise that a sound governance framework could be one of the ways to engender trust in the ODR ecosystem. There are several examples of non-binding ODR principles that have emerged globally. For instance, the International Council for Online Dispute Resolution (ICODR) is a US-based non profit that has put out a set of open standards on ODR. This includes requirements that the ODR programs must be accessible, accountable, competent, confidential, equal, neutral and impartial, legal, secure and transparent. Similar standards and guidelines have also been put out by other institutions such as the UNCITRAL's Technical Notes on ODR and the National Center for Technology and Dispute Resolution's Ethical Principles for ODR. The overlap in the principles outlined in these documents indicates a convergence of ideas on the basic requirements of a well functioning ODR system. Many ODR providers in India have also voluntarily adopted different international standards.

Given the current stage of development of India's ODR system, having mandatory standards or strict legal requirements could impede innovation and create entry barriers (ODR Handbook, p.51). However, this does not preclude the adoption of voluntary codes of conduct that are developed and operationalised by ODR players themselves. This could be done by having a basic set of good practices (see table below for the principles suggested in the ODR Handbook) that may be agreed to among the service providers in an open, inclusive and collaborative manner. Further, voluntary mechanisms such as peer review, ratings and accreditations can be used to verify the extent to which each platform is complying with these principles.

Principle	Description
Accessibility	Ensuring ODR platforms can be used across devices and by different demographic groups, accounting for the diversity of Indian languages and the ability to engage with technology.
Competence and neutrality	Neutrals should possess substantive knowledge and understanding of processes and must be free of conflicts of interest.
Accountability and fairness	Adherence to due process standards. Remain mindful of the possibility of unequal bargaining powers between parties.
Information and transparency	Proactive disclosure of conflict of interest, risks, and benefits to enable informed consent. Anonymised data on ODR trends and statistics can help in building trust.
Confidentiality and robust data security	Adherence to data protection norms, including safe storage and established protocols to deal with breaches, cyber attacks, and disasters.

Besides such voluntary adoption, providers of e-ADR are also bound by the existing laws and principles applicable to ADR processes. However, in many cases, these principles might need to be reframed to account for the impact of technology on ADR processes and the responsibility of ODR platforms and third parties neutrals conducing the mediation or arbitration processes (Rainey, 2014). For instance, use of the online medium might impose additional requirements of how confidentiality in mediation needs to be enforced in practice. This is because the mediator's ability to ensure confidentiality in ODR depends both on their own conduct as well as the design of the ODR platform. The ODR principle for confidentiality must, therefore, account for appropriate technical standards to ensure that the information transmitted on the platform remains confidential and secure. The practitioner also bears the responsibility to convey the risks of online communications to the parties (Rainey, 2014).

Conclusion

Developments in the past year or two have opened a window of opportunity for the adoption of ODR systems in India. As policymakers and private actors start warming up to the benefits of tech-enabled dispute resolution, the immediate goal should be to demonstrate capacity and build trust in ODR systems. This includes the realisation that not all sectors and user groups are equally equipped to immediately transition to ODR. Any kind of mandatory adoption should, therefore, be carefully considered so as to avoid extending digital exclusions into the domains of justice delivery and redress. An emphasis on hybrid models of ODR, both in terms of the choice between offline and online interactions and emergence of intermediaries who can help users in bridging the technological gap, would be useful.

Creating digital trust requires a framework that incorporates accountability, equity, ethics and auditability in its functioning. Thus, another priority at this stage should be to pursue the adoption of a voluntary code of conduct that is conducive to building trust in the ecosystem. Such a code of conduct should emerge, and be implemented, from within the ODR ecosystem rather than being enforced through State coercion. In addition to concerns of stifling innovation through over-regulation, it is also important to avoid excessive central planning in the technical design of ODR systems. This could result in the locking in of specific technologies and standards, hampering the long term prospects of the ODR sector.

References

Chatterji, 2020: B.M. Chatterji, Faceless Assessment: Concerns & Recommendations for Seamless Digital Integration, Tax Guru, 28 November 2020.

Katsh, 2012: Ethan Katsh, ODR: A Look at History, Online Dispute Resolution: Theory and Practice, Mohamed Abdel Wahab, Ethan Katsh & Daniel Rainey (Eds.), Eleven International Publishing, 2012.

Kelkar & Shah, 2019: Vijay Kelkar and Ajay Shah, In service of the republic: The art and science of economic policy, Penguin Allen Lane, 2019.

Kingdon, 2013: John W. Kingdon, Agendas, Alternatives and Public Policies. 2nd ed., Pearson, 2013.

Kinhal et al, 2020: Deepika Kinhal, Tarika Jain, Vaidehi Misra & Aditya Ranjan, ODR: The Future of Dispute Resolution in India, Vidhi Cenre for Legal Policy, July 2020.

Lederer, 2018: Nadine Lederer, The UNCITRAL Technical Notes on Online Dispute Resolution - Paper Tiger or Game Changer?, Kluwer Arbitration Blog, January 2018.

Mehta et al, 2020: Ankoosh Mehta, Maitrayi Jain & Anushka Shah, SC refuses unilateral appointment of single arbitrator, Indian Corporate Law, A Cyril Amarchand Mangaldas Blog, May 2020.

Nair, 2020: Ria Nair, E-Lok Adalats In India, August, 2020.

NITI Aayog, 2020: The NITI Aayog Expert Committee on ODR, Designing the Future of Dispute Resolution: The ODR Policy Plan for India, October, 2020.

ODR Handbook, 2021: NITI Aayog, Agami, Omidyar Network India, Ashoka, ICICI Bank, Trilegal, Dalberg, Dvara Research, NIPFP and Cracker & Rush, Online Dispute Resolution: Shifting from Disputes to Resolutions, April, 2021.

Rainey, 2014: Daniel Rainey, Third-Party Ethics in the Age of the Fourth Party, 2014.

Rule, 2008: Colin Rule, Making Peace on eBay: Resolving Disputes in the World's Largest Marketplace, ACResolution Magazine, Fall 2008.

Schluz 2004: Thomas Schulz, Does Online Dispute Resolution Need Governmental Intervention - The Case for Architectures of Control and Trust, 6 N.C.J.L. & Tech. 71 (2004).

UNCITRAL, 2016: UNCITRAL Technical Notes on Online Dispute Resolution, 2016.

Rashika Narain is lawyer and mediator associated with SAMA and the Centre for Mediation and Arbitration, Mumbai. Smriti Parsheera is a Fellow with the CyberBRICS Project and was previously a researcher with the National Institute of Public Finance & Policy (NIPFP). NIPFP was one of the contributors to the ODR Handbook. The authors would like to thank Vimal Balasubramaniam, Keerthana Medarametla, Renuka Sane and Ajay Shah for valuable inputs.

Why is India's business history important?

by Tirthankar Roy.

Remembering Dwijendra Tripathi

In September this year, Professor Dwijendra Tripathi passed away. Until recently, he was the only business historian of India whose works were internationally recognized and respected. In the last twenty years, he produced as author or co-author a set of books, the Oxford History of Indian Business. The deep knowledge of the facts, love of the field, and a direct writing style, for which Tripathi was known, are in full display in these books.

I had interacted with Professor Tripathi closely in the 1990s, reviewed his books, visited his home, and admired him for his warm personality, scholarship, and his distance from ideological camps. On the last occasion we were in touch (7th July 2017), I emailed him the draft of a paper where there was a reference to Tripathi and Jumani in a mildly critical fashion, asking him if he would think that my criticism was unfair. He wrote: “Please go ahead with your paper; criticism is the life blood of scholarship.” Few Indian scholars I know of are so sporting.

With Tripathi’s benchmark books in existence, why write another book called "business history of india"? For that is what I did earlier this year (Cambridge University Press, 2018).

What is the idea of this new book?

This book is different, because it asks two questions that I have not seen others ask before. The first question is, how does a study of history help us understand the resurgence of private enterprise in India in recent times? We can ask this question for all emerging economies, which have seen dramatic transformations led by private capital. What are the historical roots of this emergence? I will call this the emergence question and come back to it ahead.

The second question is this. In a Bengali essay from the 1980s, Ashin Dasgupta wrote, “the more I browse the history of the last 300 years, the more I believe that Indian business has certain Indian features.” Dasgupta was writing about the descendants of Akrur Datta, a Bengali merchant of the 18th century. If this is true, if capitalism – like human beings – have different personalities, we should ask, what is Indian about Indian capitalism?

When I was a student, we learnt a way to connect the present with the past, according to which India was a great place for business until the 18th century -- a dark age unfolded when the British made money exploiting Indian resources, and Indians struggled to get a share of it -- and after 1947, a new dawn broke out. Most professional historians do not believe in this epochal transition model, because its facts are mostly wrong. But what is the alternative model linking the present with the past?

Observe any emerging economy today, and what we should see are hubs of private enterprise that are wealthy, innovative, and institutionally advanced, against the backdrop of a poor countryside that is changing slowly, even regressing by some benchmarks. The past looked exactly like this. Hubs of dynamic, wealthy, innovative capitalists did business in the backdrop of a poor countryside. We find such hubs in the Mughal cities, in the 18th century textile trade, in 19th century port cities, and in the IT or garment clusters today. We can then connect the past with the present by asking, are these hubs similar or are they different? That is what the book does.

We see surprising parallels across time. The most dynamic business towns of the past and those in the present are cosmopolitan, outward-looking, globally connected places. They traded with the world. Whether they exported textiles, or raw cotton, or software is a matter of detail. The people whom trade made rich had access to state-of-the-art knowledge and technology of their times, and knew the value of such knowledge. As an example, without the rich Indian merchants of nineteenth century selling cotton or indigo, you would not get the Presidency College of Calcutta (Kolkata) or the Elphinstone College of Bombay (Mumbai).

But this isn’t a happy story. Making money was a struggle against enormous odds. Interest rates were high, institutions were undeveloped, politics often unfriendly. Have these obstacles disappeared today? Hardly. Capital is still costly in India, all global metrics measuring institutional quality still place India towards the bottom of the list, and politics is still unpredictable. Why does capitalism work at all in an environment of expensive capital and dangers of expropriation by State agencies? The book answers, cosmopolitanism helped. And so did some very Indian resources, such as the idiom of caste or community, if only in some situations. These obstacles and the resources used to overcome them make Indian business history Indian. This is my story.

Who am I writing it for?

Three types of audience: business historians, economic historians, and India-watchers.

Business history emerged in the US and until recently was North American in its choice of examples and theoretical frameworks. This is changing and there is a drive to include more emerging market examples. While the book was not written with that aim, it helps that project.

My own field, economic history, has been preoccupied with a different question. For us, the big question is, “why do some countries grow rich while others stay poor”? While the modern West forged ahead (from early-1800s), why did countries like India and China stagnate and fall behind? Writers like Daron Acemoglu and James Robinson call this one of the most important questions for the social scientists. I am not sure of that, but certainly divergence has been the only game in town for some time.

I think this is a bad question to ask, for many reasons. Let me show only one reason here: The question prejudges India to be a basket case. Those who think this is the greatest question are forced to ignore and overlook the hubs of enterprise that I talked about above.

Business history does not judge. It does not carry the burden on its shoulder as economists do, that we must answer the greatest question in social science. It treats individual business decisions as context-bound, which is a more flexible approach to doing history.

My third intended reader is anyone interested in the historical roots of economic emergence. Many people try to answer the emergence question, and the answers can be odd. Around 2007, a team of 11 people published an article in the IIMA house journal about India’s emergence. The authors were top professionals, and like many thinking people, they felt compelled to say something about history. This is what they said. We should not be surprised that Indians are so good at buying and selling things, they have been doing that for centuries. Still, until now they failed in their historic mission to create a world-class capitalism thanks to “foreign invasions”. The authors wisely left the identity of the invaders open, you can write your favourite invader (Turks, Europeans) in the blank space.

But this cannot be right. India has not had a foreign invasion in the last 70 years, and still scores poorly on Ease of Doing Business index. Indeed, India has not been a cradle of capitalism, not now, not in the past. Doing business has always been a struggle to overcome obstacles. Economic history tends to exaggerate the obstacles. Business history shows the struggle as it was, and helps us understand the struggle today. My book is about that endeavour.

 

Tirthankar Roy is an Economic Historian at the London School of Economics.

The investment technology of foreign and domestic institutional investors

Ila Patnaik and I have a recent paper in the Journal of International Money and Finance on the investment technology of foreign and domestic institutional investors.

The question

Do the firms chosen by FIIs do well? What is the stock market performance, and the operating performance, in the period after a firm has been selected for investment by FIIs?

This is an important question for many reasons. Investors (both foreign and domestic) would like to know the information content of seeing an FII or DII present in the shareholding of a firm. If, hypothetically, domestic financial regulation hampers DIIs, there may be a special role for FIIs in rationally allocating capital and alleviating financing constraints. If FIIs fare poorly in security selection, as has often been the case in the international finance literature, these mistakes have consequences for the allocation of capital and the incentives of entrepreneurs. Perhaps what India requires is policies that foster deep engagement with international capital, through which FIIs would achieve better information and thus fare better in security selection.

The opportunity for measurement

There is strong evidence of home bias: foreigners own too little of most Indian firms with an ownership of 0 for most firms. Less than a thousand companies have over 1% investment by FIIs. This is true for DIIs also. This opens up the opportunity to see how the chosen companies fare against those that were not chosen. To construct a quasi-experiment, we identify three groups of firms: 

1. Those chosen by FIIs but not DIIs
2. Those chosen by DIIs but not FIIs
3. Those chosen by neither.

On the 31st of each year, it is possible to make these three lists of firms. An examination of future performance would give us insights into the investment technology of FIIs and DIIs. Specifically, if the firms chosen by FIIs but not DIIs (i.e. Group 1) do much better than those in Group 3, then we would think that FIIs have a valuable investment technology.

Pitfalls in measurement

Institutional investors are different. Institutional investors are different from individual investors. Hence, a fair comparison is between FIIs and DIIs.

Treatment effects or selection effects or both. Why might a firm fare well after FII investment? There can be two channels. There can be a `selection effect' where FIIs identify better firms. There can be a `treatment effect' where FIIs exert governance, and push firms to behave better. Investment technology is about the overall effect, i.e. the reduced form outcome. The economists' perennial quest for separating out selection effects from treatment effects is inappropriate here.

Asset allocation versus security selection. It is well known that the firms chosen by foreign investors are different in many dimensions such as beta, size, liquidity, etc. This hampers comparison. As an example, when Nifty fares well, high beta firms tend to do well. In such times, the portfolio held by foreign investors will look good as they have loaded up on high beta firms.

In order to address this, we utilise the three Fama-French empirical asset pricing factors: size, B/P and beta. For each firm chosen by the FII (but not DII), we find the partner firm (that was chosen by neither FII nor DII) where the Mahalanobis distance in size, B/P and beta is the lowest. If a good match cannot be found, the firm is dropped. This gives us a series of pairs of firms, which are alike in size B/P and beta, where one got FII (but not DII) investment and the partner got neither.

Holding a money manager accountable for security selection after controlling for asset allocation is an old idea in finance. However, the application of this idea into the question of investment technology of FIIs and DIIs is new, as is the matching-based quasi-experimental strategy through which we control for the asset allocation.

Results

We find that the firms chosen by FIIs have exuberant growth in fixed assets in the following 3 years. But their output growth is not commensurately strong; there is some evidence of a decline in productivity. In terms of stock market performance, these firms under-perform over the three years after observation date.

Firms chosen by DIIs are strikingly different. They seem to be firms that are retrenching: both capital and labour drop slightly. But output grows. There is productivity growth. In terms of stock market performance, these firms outperform by 18 percentage points over three years.

These results suggest that foreign investors have a weak investment technology. Their access to information, and their ability to process information, adds up to poor security selection. In contrast, DIIs -- who are present in India and are likely to have ample information about portfolio companies -- fare better.

Implications

Implications for persons analysing Indian securities. A firm which has FII investment but not DII investment is probably going to grow assets but not give strong results. Conversely, a firm which has DII but not FII investment is likely to have slow growth but improve productivity and deliver stock market returns.

Implications for foreign investors. The results of this paper are about the average foreign investor, and there are surely many foreign investors who fare very well on security selection. However, on average, foreign investors need to be more cautious about their activities in India. They need to either amplify their efforts in security selection, so as to achieve strong information and information processing on Indian firms, or not attempt security selection.

How can a foreign investor improve security selection? Two paths are visible: To establish operations in India, and hold the team accountable for security selection using the methods of this paper, or contract-out to money managers who have deep roots in India.

How can a foreign investor harness asset allocation to India without attempting security selection? It is possible to setup index funds for the three Fama-French factors and thus replicate the bulk of the desired portfolio characteristics.

Implications for policy makers. Many of the pathologies of international finance are rooted in asymmetric information and the lack of deep engagement of foreign investors. These results are a reminder that even a large emerging market like India suffers from these problems. It is in India's interest to have a deep engagement with foreign capital, so as to obtain higher allocative efficiency. This suggests a re-examination at the constraints placed against deep engagement by foreign capital:

1. It is difficult for foreign investors to contract-out money management to locals.
2. `Permanent establishment' rules by the tax authorities have encouraged foreign investors to not open offices in India. This hampers deep engagement. Offices in Singapore or London will not be able to match the information and information processing that can be done in India.
3. Source-based taxation, capital controls, and taxation of transactions, give incentives for foreign investors to avoid transacting in India. It is cheaper for a foreign investor to invest through the PN and NDF markets. However, not being in India hampers deep engagement.

How might this change over time?

In my opinion, in the 2000s, a certain kind of Indian entrepreneur started producing companies that look good to foreign investors. But you can't fool all the investors all the time. I think many investors are now more circumspect. Wall Street is changing course, and this is changing incentives for entrepreneurs. When finance rewards honest businessmen, more honest businessmen will show up asking for capital from the financial system. Many years from now, we might say that the results of this paper described a moment in time in the evolution of Indian capitalism.

Important work by cobrapost that illuminates high-powered incentives

The investigative journalism by cobrapost, their videos, and Monika Halan in Mint add up to an important story.

Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.

Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.

In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.

Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.

A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don't, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.

For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it's easy for us to overdo this message. In many situations, I feel it's better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.

These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay. 

This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.

One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.

A prominent example of this debate has been `financial market infrastructure institutions' (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.

Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.

Indian capitalism is not doomed

India's problem of crony capitalism

by Ajay Shah.

The rise of modern capitalism in India in the 1990s was at first viewed in optimistic terms. A new breed of companies were born, who seemed to exhibit a new kind of competence, international competitiveness and high ethical standards. We could start putting our old mistrust of corrupt business houses behind us.

These hopes were substantially dashed by the fresh emergence of crony capitalism. Doing business in many areas in India involves an extensive interface with the government. In these areas, the weaknesses of the State generated an opportunity for crooks. At first, the financial system sent massive resources into dubious companies, with an attitude of being blind to anything but profits. When these companies controlled vast resources, and were shown the promise of even bigger valuations to come, they embarked on systematically undermining the State. Through this, we got a feedback loop: The crooks came up where the State was weak, and their activities further undermined the State.

In some cases, we saw rotten companies spring up in one part of the economy where the State was weak, and once these companies were up and running, they turned their attention to related fields and devoted themselves to undermining State institutions in related fields. Through this, the gangrene spread from one area to the next.

In the the early 1990s, we could hope that India would smoothly moving up to the ranks of middle income countries, powered by world class local companies in addition to global companies building operations here. These hopes have substantially receded. The heart of the Indian story is now about the feedback loop between rotten companies and the State. If we manage to bootstrap ourselves out of this, we have a bright future. But will be be able to bootstrap ourselves out of this? Many countries got mired in this `middle income trap': we shouldn't assume that our destiny is rosy.

At first blush, stopping the rotten companies seems infeasible. These are typically efficient and competent firms in a day to day tactical sense. They are staffed with hard-driving amoral people (typically incentivised very strongly using high-powered incentives), who fully understand the weaknesses of the system and attack it. Considerable resources are invested into subverting politicians, bureaucrats, judges and the media. The Indian system is rotten and ripe for attack. It's like computer criminals attacking Microsoft Windows. Resistance is futile. Indian capitalism is doomed.

There is, however, an array of homeostatic forces in place which are generating push back. Some crooked companies have faced enforcement actions by arms of the State. In some cases, India has had good discussions in the public domain which has generated checks and balances. In addition, while many people are devoid of ethics and will support the latest nouveau riche entrepreneur who is throwing cash around, a large number of people get revulsed by the sight of this, and quietly and doggedly refuse to cooperate.

Enforcement in India does not work perfectly. The key point of this blog post is that medium grade enforcement has far reaching implications. The key insight is to look at the way the goals of labour and capital (i.e. investors and employees) are reshaped by medium grade enforcement.

The perspective of the investor

The enforcement push back against rotten firms is yielding results. Many crooked companies have grossly underperformed the index. Some have experienced enforcement actions and have experienced jaw-dropping returns. Some have experienced dogged opposition from pockets of high ethics in the system, which have effectively led to systematic and sustained under-performance of the index over five- and ten-year periods. The stock market has become wary about ethical issues. As Shekhar Gupta says in the Indian Express yesterday:

If you draw a simple chart of the large companies that have lost the most value on the stock markets over the past three years, you'd notice that almost all of these were doing business on the same cusp of politics, finance and natural resources. To that extent, you have to admit that the market has been the first to sense the rot and has applied a stunning self-correction, severely punishing those responsible for it.

There was a time when investors used to be oblivious about ethical standards of portfolio companies. The attitude of the investor in the 1990s used to be I don't want to know how you do business; I will hold my nose since you stink; but as long as you will produce returns, I will happily invest in you. This attitude has been thoroughly broken. The investors who pursued such strategies have often been devastated. Even if you have only 10% invested in a crooked company, if you get -80% returns on it, this generates a -800 basis point returns drag on your overall portfolio performance. As a consequence, portfolio managers have started caring about the ethical standards of portfolio companies.

Enforcement does not have to be 100% perfect for it to impact on the decision making of investors. Even if there is only a 10% chance of getting caught and thus getting -80% returns, that is a big risk from the viewpoint of the investor. From the viewpoint of the investor: Why take the risk? Why not make a thorough analysis of the ethical standards of a company one element of the security selection process?

The problem of freedom of speech

Journalism is printing
what someone else does not want printed.
Everything else is public relations.
-- George Orwell.

India is supposed to be a liberal democracy, and a free press is supposed to write vigorously about misdeeds (link). By and large, this has not worked out as it was meant to be. On one hand, it is quite easy for the bad guys to corrupt the media. Whether this is done through gifts of shares to a media company, or through advertising and sponsorship, it is fairly easy to obtain a supportive media. In addition, defamation is a criminal offence in India: a legacy of colonial law that we have not yet been bright enough to undo. Putting these together, the bad guys have a nice combination of carrot (throwing money at the media) and stick (litigation).

Analysts and financial intermediaries are supposed to make a living out of spotting problems in firms. Here also, there is quite a bit of corruption which impedes speaking freely. Few are willing to go against the latest nouveau riche entrepreneur who is throwing cash around, including his efforts at buying respectability. The mainstream strategy is to participate in the gravy train, and look for ways to part the fool and his money.

This is a real shame: India should be much better than China in the role of freedom of speech acting as a check against corporations. However, the Indian media has largely caved in the face of carrot and stick: it is largely doing public relations.

At the same time, there is strong demand among investors for skills in identifying the crooks, given that this is an important investment fundamental. The problems of the conventional media and financial firms, which inhibit naming the crooks openly and in the public domain, has created a business opportunity in this space. Supply has come up to fill this demand; a new breed of companies has come up, reflecting this need. Examples of firms with these capabilities include Ambit Capital, Veritas Investment Research, Forensic Asia, and Espirito Santo. Numerous investors are building in this analysis into their portfolio process, and this is helping to channel capital away from dubious companies.

Foreign firms seem to be more prominent in this field of research and analysis from the viewpoint of ethical standards, because they are relatively immune to the problems of intimidation through courts and police in India, and because they are relatively cutoff from the reciprocity that binds everyone in the world of business in India. See Veritas' report on Indiabulls has put in contrast the research by India-based analysts in the Economic Times by Uday Khandeparkar. But even they are not immune to the problems of the Indian legal system. Now we have a new investment tool: sell shares of the companies that embark on such litigation.

The weaknesses of freedom of speech in India have thus emphasised a greater role for information processing and analysis away from Indian shores. I am reminded of what is going on in China, where some of the most important short sellers who are bringing out the misdeeds of Chinese companies are located abroad: it's too dangerous to do the same things within China. We in India are evolving towards a similar structure of information processing.

The perspective of the employee

In the modern world, a vital determinant of the success of an enterprise is the kind of people it is able to attract. Here also, at first, there was a relatively amoral attitude on the part of most young people: I don't want to know how you do business; I will hold my nose since you stink; but as long as you offer me the highest wage, I will join you. But over the years, it has been demonstrated that this is a bad strategy:

• The sight of senior employees going into Tihar Jail has given out powerful messages to everyone in Indian companies that good people should not hang out with crooks.
  
• The second phenomenon is reputational damage. It makes business sense for an individual to engage in fair play. I have been in recruitment conversations where a person is being discussed but his name gets shot down as he has not been careful about the company that he keeps. Birds of a feather flock together. I recently heard a senior person say: ``I knew XXX was a rotten firm when a bunch of corrupt people from SEBI joined it''. Low ethical standards in people and in firms go together; a cloud of mistrust envelops them.
  
• Gradually, as regulators develop and refine the doctrine of `fit and proper' such people will increasingly suffer career damage. We aren't fully there in Indian finance yet, but it will increasingly be the case that a name is shot down for a CEO position because he was part of a team that was caught doing nasty things by SEBI or RBI.
  
• These factors are particularly important for the best and the brightest. If you are the best and the brightest, why would you suffer even epsilon risk of going to jail? Why would you run with crooks if this could hamper your rise to CEO? Why would you suffer reputational damage, and not be able to hold your head high at your class reunion?

These factors are inhibiting the flow of talent to dubious companies. I know of several situations where a person was made an offer, and chatted about this with his friends, and turned it down. It was just too much of a risk to be seen in the wrong company.

Second rate people recruit third rate people. Once a firm is contaminated with a series of low grade staff at senior levels, it becomes increasingly hard to draw in top quality talent, which drags down capabilities all across the board.

I believe this is one of the factors which has generated systematic under-performance in the stock price of dubious companies. It isn't just the case that they are in danger of enforcement actions. It is also the case that on an every day basis, they find it harder to operate well given that they generally fail to recruit as well as their competitors.

How might Indian capitalism develop?

If the crooks had thundered ahead producing super-normal stock market returns, and attracting the best talent, I would have been truly gloomy. What is fascinating about the Indian story is that things have worked out differently. Some dubious companies have cratered with -80% returns over short periods. Others have generated substantial under-performance when compared with the index over 5- and 10-year horizons. The best people are avoiding rotten companies. Putting these together, the bad guys are finding it difficult to obtain both capital and labour, which are seeking out better firms.

Wall Street tells Main Street what to do. At a time when the investors did not care about ethical standards of portfolio companies, and only asked for earnings growth, this sent out powerful signals into the economy (a) Favouring rotten firms and (b) Encouraging rotten entrepreneurs to setup firms so as to harvest the opportunities available by selling shares. We got a precipitous collapse of ethical standards in India in the last decade in India, partly because that is what a financial system that was oblivious to ethical standards was encouraging. Some of the most rotten companies rose to the top. Now that the investors and the employees are seeing things differently, this is sending out signals into the economy (a) Favouring healthy firms and (b) Encouraging healthy entrepreneurs to setup firms so as to harvest the opportunities available by selling shares. We will also see some chameleons turn a new leaf: You will see the oddest of characters preaching purity.

Vishal Kampani pointed out a remarkable fact to me: Some of the biggest successes of the last decade have been the old `Bombay Club' companies. All too often, they have outperformed when compared with the hard-driving unethical nouveau riche entrepreneur. What is going on? I would conjecture that there is a survivorship bias. A large number of different strands of corporate DNA compete. Over the long run, the survivors are those where elements of policy and strategy are of a certain kind. The old rich of the `Bombay Club' are not paragons of virtue, but they have developed certain good practices which are conducive to survival and stock market returns.

I am reminded of the mighty German Wehrmacht in the Second World War. At the level of tactics and operations, it was second to none. In the short run, it generated the most amazing achievements in battle. After the campaigns from September 1939 till December 1941, many contemporary observers thought that Germany was unstoppable. But at the same time, Germany was making profound mistakes at the levels of strategy and policy. No amount of operational art could overcome those fundamental mistakes in strategy and policy.

In similar fashion, we tend to get very impressed by the hard-driving take-no-prisoners nouveau riche entrepreneurs and their hypercharged sidekicks. Their dynamism and willingness to play dirty seems to be unstoppable, particularly given the weaknesses of politicians, bureaucrats, judges and media in India. But it appears that in India, these strengths in tactics and operations have often been unable to overcome fundamental mistakes in strategy and policy. Indian capitalism is not doomed.

The resource curse of land ownership

by Ajay Shah.

 

Land ownership in pre-modern India

 

In India, 50 or 100 years ago, land was a defining feature of wealth. The stock of land generated a flow of income. The landless were low-paid agricultural labour. The landed gentry of rural India were the kings of their heap. They had power, prestige, position, prosperity.

In the eyes of many, the initial conditions of high inequality of land ownership were a key barrier that held India back. It was argued that a one-time bout of bloodshed was essential, to expropriate the rich, and to transfer land ownership into a more equitable distribution. In India, this capacity for State-inflicted bloodshed was present in some places only. In much of India, the unequal distribution of land ownership found in 1947 was left intact.

Fast forward into the present, and there has been a sea change in the fortunes of the owners of agricultural land.

Agriculture is less important

 

Particularly after we escaped from the Hindu rate of growth (3.5%) in 1979, the share of agriculture in GDP has dropped sharply. In relative terms, the wealth created through firms in industry and services has dwarfed the wealth of the landed gentry. The richest man in India today is born of one who started out with no land. Government interventions continued to stifle agriculture, but shifted to a greater laissez faire approach in industry and services; this helped accelerate the decline of agriculture.

The plight of those who stayed back

 

Rural to urban migration has unleashed new forces on the role and status of the landed lords. Within rich families, high IQ children may be going off to the city to a greater extent, e.g. based on the filtration by competitive examinations where outcomes are correlated with IQ. To the extent that such a process has been afoot, it has given a selection bias where the low IQ children were the ones more likely to stay back in the `idiocy of rural life' (as Marx characterised it). Over a couple of generations, the interplay of nature and nurture can add up to substantial effects.

That there was an easy option - to live off the land - was a `resource curse' which afflicted the households who had land. In contrast, for landless households, there was no conflict of interest in moving to cities (other than the recently introduced NREG, which tries to perpetuate poverty by hindering rural to urban migration).

The power and status of the landed lords was now twice undermined. Their quick-witted cousins who established themselves in the cities were connected into capitalism and getting ahead. Families of the landless have tended to move to cities, connect into capitalism, and get ahead. The erstwhile lords have started looking nervously at both groups of escapees, wondering whether land ownership was such a nice initial condition.

In a fascinating recent article, Devesh Kapur, Chandra Bhan Prasad, Lant Pritchett and D. Shyam Babu gave us some insights into these changing social structures. In their survey data, in 2007, 98.3 per cent of Harijans were contracting-out the work of tilling their fields to their erstwhile lords, the upper-caste men who owned and operated tractors. The upper tail of the Indian income distribution has, in a few generations, been reduced to operators of agricultural equipment.

The importance of engaging with the market

 

A defining issue of modern times, for an individual, is a continued and deep engagement with the market. For insights into this idea, see this interview with Tom Sargent. The Ljungqvist/Sargent story matters even more in India, when compared with what has happened in the West. At 7 per cent GDP growth, every few years, far-reaching change comes about in technology and processes. Each individual builds knowledge and human networks by continually engaging with the market. If a person is cut off from engagement with capitalism for even a few years, this generates a lot of human capital depreciation. At that reduced human capital, the person has to either accept an offer at a much reduced wage, or stay unemployed (which further undermines human capital).

The Ljungqvist/Sargent story helps us understand the plight of adivasis in India, who have been away from the market economy, and are unable to plunge into it. It helps us understand the plight of the unemployed of Europe: the welfare state pays them dole to stay warm and well fed for many years of unemployment, but after this they are unable to come back into the labour market.

In this setting, consider the plight of a land owner, who has been living off the land, and has never engaged with modern India. Particularly in the post-1979 period, when India has experienced relatively rapid growth, each year of being a country hick owning land meant being further away from the skills required to participate in the contemporary Indian economy. The landed gentry of India lacks the skills to participate in the market economy. Income from the land, their resource curse, dulls their incentive to overcome the barriers. They are often too proud to accept low wage assignments which are the starting point through which the unskilled connect to capitalism. These problems have come together to give a unique vicious cycle of dis-engagement with modern India.

Sale of land in the outskirts of cities

 

At the edges of all cities, urbanisation is proceeding through developers buying land from the local landed rich and transforming it into the endless suburbs. In the short term, this has generated immense windfalls of wealth for the landed rich. But in some ways, this is a bit of a disaster for many of them. Lacking in knowledge about the market economy, they are scammed by insurance salesmen and such like. Much of this newfound wealth tends to get dissipated in a few years.

Urbanisation and land development throws open vast opportunities for trade and industry. But the erstwhile landed rich tend to be uniquely ill equipped at harnessing these opportunities. They tend to be too proud to work for someone else, and inadequately equipped to stake out on their own. They experience a brief blaze of glory when paid fabulous prices for their land, and then fade away into insignificance.

Some politicians have been moved to advocate special legal protections for the hapless rural rich who sell land to the modern sector. It's quite a turnabout within a few generations: from landed elite that oppress the others, to witless folk who need to be protected by special laws that inhibit the sale of land.

The curse of land

 

A few decades ago, the left-of-centre view dominated the thinking in India. It was felt that inequality of land was a major bottleneck that held India back. Many argued that the failure of Indian democracy to engage in a one-time bout of class warfare through `land reform' was a major mistake that was holding India back. It was argued that the Chinese path was the right one: to expropriate the landowners and then start a capitalist economy under conditions where everyone is equal.

With the benefit of hindsight, things look different. I think this story reiterates the dangers of social engineering. We are dealing with enormously complex systems that we only dimly understand. As far as possible, it is wise on our part to use the force of the State as little as we can, and to always avoid treading on fundamental human rights such as property rights.

Acknowledgments

 

I am grateful to K. P. Krishnan, Suyash Rai and Mihir Thaker for insightful conversations.

India's governance crisis: Tales from the battlefront

The Competition Commission of India (CCI) has written an order on NSE and MCX-SX in the currency derivatives market. Even if you do not take interest in financial markets, this is an interesting episode in Indian governance. It illuminates the larger problems of building regulatory agencies, and India's middle income trap.

In an impressive show of strength with the media, there was a flurry of editorial and other commentary praising CCI for this order - even before the order had been released. The files are now on the CCI website. Here is the main order and here is the dissent by two members of CCI.

Gautam Chikermane has written an excellent analysis of the order in the Hindustan Times. Unlike much of the other commentary on this order, he has actually read the two PDF files above. Also see this editorial and column by Mobis Philipose, in Mint, on 6 June.

The order has breathtaking ramifications. If this works as a precedent, it would impose huge complexities upon an array of industries where some products and services are given out free. This feature is particularly prevalent in the new economy, where systems such as google search are free and have been free for the longest time, and where a blizzard of new product launches (e.g. google plus) are free.

In India, regulatory organisations are still finding their feet. They have to gradually build up credibility and respect. When a regulatory body signs on a breathtakingly large penalty which will have huge implications for the economy, they have to be absolutely sure they are right. Otherwise, the institution loses credibility. I fear that with this order, CCI is now in a soup. If the appeals process is half decent, the order will be overturned, which will make CCI look bad. If the appeals process is not half decent, CCI will be seen as a source of trouble in the Indian regulatory landscape. In numerous industries, zero pricing will run into trouble. More generally, such muggings will be a new dimension of the political risk faced by firms operating in India.

India's crisis of governance is about the puzzle of building agencies like the Competition Commission of India, of taking these agencies closer to the competence and honesty seen at SEBI in recent years. How do we master the intricate recipe of public administration, so that such events don't happen? Until this is done, the structure of incentives encourages a certain kind of entrepreneur, and will damage the outlook for India.

Succession problems in Indian firms

Democracies are more stable

Autocratic countries often appear to have a clean and stable political system. A government is clearly in charge. Businessmen like to deal with such a government, because you can go into a room with a powerful person and walk out holding a deal. You can do business with them.

Democracies, in contrast, are messy. The essence of a democracy is the dispersion of power. When power is dispersed between many individuals and institutions, decision making is slow and messy.

Differences are visible in public. A businessman finds it difficult to deal with such a government: He can't walk into a room and do a deal. Instead, deals (such as an airport contract or a mining concession) go through a contentious procurement process in the public domain. In the third world, the procurement and regulatory procesess are often riven with corruption, which makes a benevolent dictator look good.

While an autocracy may appear to be calm and stable, it actually suffers from two dimensions of instability. The regime suffers from the silent reproach of a million tear-stained eyes: You never know when an upheaval will come about. And autocracies suffer from problems of succession. When the strongman dies or gets killed, you never know what's going to happen next. When power and decision making is centralised, succession becomes difficult.

When the caudillo comes towards the end of his life, this triggers off instability because people around him are solving dynamic programming problems. I suspect this was part of the story of how Mubarak's world fell apart.

A business with a strong CEO is like an autocracy

Many firms have centralisation of thinking, power and decision making in the hands of one person or one family. This often looks nice for a while. There is clarity about who is in charge; the CEO is generally well incentivised; the CEO generally works hard and many such firms are highly successful.

But such firms face difficulties of succession. Precisely because so much power and decision making was concentrated in one person, it is difficult to replace him or her.

As with good countries, good companies evolve from concentrated power to dispersion of power. A good country is one in which power is highly dispersed, where thinking and problem solving is taking place in millions of places by empowered individuals who are not waiting for instructions. In similar fashion, a good company is one in which the CEO does not dominate the landscape: the board of directors (above) and the management team (below) play a much stronger role when compared with conditions of dictatorship. As with a country, if one person is doing all the thinking, the firm is capable of little. In a good firm, the energy and imagination of dozens or hundreds or thousands of people is harnessed.

For small problems, one thinker is often adequate. As an example, to run a coffee shop, one mom and pop suffices. But to run a large, complex, modern knowledge-intensive firm, we need to harness the energy and imagination of hundreds or thousands of people. When such a firm is limited to the capabilities of one person, no matter how good he or she is, that yields stagnation.

In an autocratic company, there are serious problems of succession. A dominant CEO is hard to replace even if one were recruiting from the open market. Matters are often made worse by limiting CEO search to a family. In contrast, when power is dispersed, succession is inherently safer. Even if there is a lot of sound and fury in succession, there is less that can go wrong.

It takes a long time for a country to learn how to live within the complex checks and balances of democracy. In similar fashion, it is not easy to be a sophisticated modern firm, where the CEO is not a demigod. It is a difficult transition to make, to go from an autocratic environment to a democratic environment.

I believe that political analysts, globally, make the mistake of overstating the stability of a dictatorship and underestimating the stability of a democracy. In similar fashion, I feel that many people underestimate the succession problem of a family business and overstate it in a professionally managed company.

On the other hand, agency problems

This case against family run companies is very strong, for large organisations where it is essential to have many people thinking. However, the key problem that the professionally managed company faces is that of agency conflicts. With a family company, the incentives of the CEO are clear. With a professionally run company, it is not easy to ensure that the management team works for the interests of the shareholders.

On one hand, power needs to be dispersed because otherwise we can't have hundreds of people who are empowered and thinking. But when power is dispersed in such fashion, there is the heightened danger of theft.

The management of a professionally run company is therefore all about the tension between the efficiencies (economies of scale + large number of people who are thinking) on one hand versus theft on the other. Once again, it isn't so different from the agency problems that democracy is riven with.

Infosys

When a dictator is succeeded by his son, it looks like a smooth and easy transition, but it is actually a situation that is fraught with risk.

Succession at Infosys has been contentious and in the public domain. As with an Indian general election, it looks messy. But the problems here are overstated. Infosys is doing something relatively new in India: they are a professionally-managed dispersed shareholding company with disperson of power. While such succession looks messy, there is greater stability under the hood.

Governance problems of Indian firms

India is remarkable in having high quality firms. But at present, very few firms have the checks and balances of dispersed shareholding, a genuinely powerful board of directors, a professional management team, and the absence of dominant founders or family. There are a few such examples -- L&T, Infosys, ITC, Axis Bank, ICICI -- but as of yet, it is rare.

Many of the successful giant firms of the present Indian landscape are a bit like China: They look great today but they run the risk of a USSR event as they face the transitions of the future. The Indian corporate sector has a lot of work in store, in refashioning the giants of today, using the governance DNA of firms like L&T, Infosys, ITC, Axis Bank and ICICI. Those transitions will not be easy. As Lant Pritchett says: I recently did a study examining the growth consequences of sudden large democratisation (a shift in the POLITY index of more than 6 points). Of the 22 cases that experienced rapid democratisation with above average growth: (a) all but one had a growth deceleration, (b) the average deceleration was 3.5 ppa, and (c) the predicted deceleration was increasing with growth—roughly, post-democratisation countries reverted to world average growth. Transitions out of dictatorship are not easy.

Geniuses and economic development

by Ajay Shah.

On VoxEU, there is a fascinating article titled China and India: Those two big outliers by Jesus Felipe, Utsav Kumar and Arnelyn Abdon.

The interesting fact that they highlight is that both India and China are wise beyond their per capita GDP when it comes to the sophistication and diversification of their exports.

The evidence that they show, on the change in export diversification, is quite striking:

	China	India
1962	105	71
2007	265	254
Change (times)	2.52x	3.58x

In India's case, in 1962, in the depth of India's autarky, there were 71 commodities exported with `revealed comparative advantage'. By 2007, this number had gone up by 3.58 times. Both China and India are outliers (with excessively high values seen for export diversification) when compared with other countries at the same level of per capita GDP on a PPP basis.

Explaining the unusual export diversification

One element of the explanation of diversification is sheer size. Continental India has a diverse array of locations. Coastal Gujarat is a good location for processing crude oil for export, and Bihar is a good place for growing Litchis for export. By aggregating both places into a single country, we get high levels of export diversification. A casual examination of their graph (Figure 2) makes me think there is some support for this conjecture - positive outliers in the graph are big countries like the US and Germany; negative outliers are small countries like Ireland and Finland.

Explaining the unusual export sophistication

Why does India do sophisticated export, well beyond what one would expect for its level of per capita GDP?

1. Sheer size matters. Consider the distribution of a certain specific kind of knowledge across individuals in the country. Suppose you set a high cutoff for the minimum knowledge required of that field in order to assemble a large sized firm. So if you want to build a large sized firm in that field, you need to recruit 1000 people who have this specialised knowledge in excess of this cutoff. In a country of 1.2 billion people, you have more draws from the same distribution. So even if the lay of the land is quite bad in the sense that most people have bad knowledge, the sheer size of the country enables the establishment of firms which require building groups with high end specialised knowledge.
   Consider the distribution of IQ. One in a thousand people have an IQ of above 146. To help fix your intution, it appears that GRE V+Q of 1450 is roughly IQ=146. In India, with a population of 1.2 billion, we have 1.2 million of them. These 1.2 million very smart people in the country can serve as a core around which extremely high quality firms can be built. These effects are accentuated by increasing returns to scale, and the operation of Metcalfe's Law, in the gains from interaction and competition between these people within a country.
2. There is an odd upper tail in Indian human capital. Looking back 100 years ago, there has been a bizarre upper tail of very highly skilled people in India. Think Ramanujan: by rights, you would have never expected that kind of incredible knowledge to be found in a place like India. But pre-independence India managed to have incredible geniuses like Ramanujan, C. V. Raman, S. N. Bose and C. R. Rao -- well before the post-independence push that created the IITs. Is this merely about size (a lot of draws) or was there actually a bizarre upper tail?
   On this subject, see India shining and Bharat drowning: comparing two Indian states to the worldwide distribution in mathematics achievement by Jishnu Das and Tristan Zajonc. Some fascinating estimates are shown in Producing superstars for the economic Mundial: The team in the tail by Lant Pritchett and Martina Viarengo, who estimate the number of 15 year olds in a country with a OECD PISA score of above 625. The US is estimated to have between 240,000 and 270,000 individuals in this rarefied zone. India has (a) A lot of people, (b) An abysmally poor mode, and (b) A strange upper tail. Putting these together, they estimate India has 100,000 and 190,000 individuals in this rarefied zone - which is incredibly impressive considering that the Indian per capita GDP is one-thirtieth of that seen in the US. This also tells me that we need to scale up the universities in India so that atleast 200,000 individuals each year: it's a shame underutilising these kids.

Aside: PISA > 625 is a much weaker condition than IQ > 146.

Some people bemoan the inequality of human capital that is found in India, i.e. the huge gap between this upper tail and the modal value. But given that we have a low per capita GDP, would we rather have equality where everyone has low skills, or would we rather have an incredible upper tail in the distribution of knowledge, that is able to learn new technology, plug into globalisation, and power the country along?

This is also related to Albert Hirschmann's theme of unbalanced growth: he had argued that growth involves developing an `unbalanced' capability (e.g. India and the software industry led by a small core of high end capabilities), and then harnessing the benefits of the catchup by the rest of system (e.g. telecom reforms, mass scale computer programming education, broad business skills in running globalised firms out of India).

In a recent NBER working paper, Eric A. Hanushek and Ludger Woessmann offer interesting evidence about the tradeoff between `rocket scientists or basic education for all'. They say:

Both the basic-skill and the top-performing dimensions of educational performance appear separately important for growth. From the estimates in column 3, a ten percentage point increase in the share of students reaching basic literacy is associated with 0.3 percentage points higher annual growth, and a ten percentage point increase in the share of top-performing students is associated with 1.3 percentage points higher annual growth

....

the effect of the top-performing share is significantly larger in countries that have more scope to catch up to the initially most productive countries (col. 5). These results appear consistent with a mixture of the basic models of human capital and growth mentioned earlier. The accumulation of skills as a standard production factor, emphasized by augmented neoclassical growth models (e.g., Mankiw, Romer, and Weil (1992)), is probably best captured by the basic-literacy term, which has positive effects that are similar in size across all countries. But, the larger growth effect of high-level skills in countries farther from the technological frontier is most consistent with technological diffusion models (e.g., Nelson and Phelps (1966)). From this perspective, countries need high-skilled human capital for an imitation strategy, and the process of economic convergence is accelerated in countries with larger shares of high-performing students.

Many countries have focused on either basic skills or engineers and scientists. In terms of growth, our estimates suggest that developing basic skills and highly talented people reinforce each other. Moreover, achieving basic literacy for all may well be a precondition for identifying those who can reach “rocket scientist” status. In other words, tournaments among a large pool of students with basic skills may be an efficient way to obtain a large share of high-performers.

On a related note, it is very, very hard to create high end skills when starting from scratch. Witness the difficulties faced by China which had to start from scratch after destroying the elite in the Cultural Revolution. When the economy is ready with demand for a particular set of specialised skills, it may take decades to fill these gaps. As an example, by the late 1980s and early 1990s, it was obvious that there is a giant opportunity for India in software exports and in BPO. But it took 10 years for the education system to re-engineer itself to produce these skills in large quantities, and then make possible large numbers for IT/ITES exports. In similar fashion, the NDA got going on raising expenditure on infrastructure by 2003, but last month, Vikas Bajaj has an article in the New York Times about shortages of civil engineers. It is convenient, in economic development, to have a pre-existing base of high-end skills ahead of time, before the phase of high growth arrives.

Size and economic development

The argument in this blog post has emphasised size. There are many other good things about size, such as economies of scale in the domestic economy, and paying for the fixed costs of global firms in learning about a country in order to do business in it.

If size is such a good thing for economic development, why has it failed so far: as of 2010, why are India and China far behind OECD levels of per capita GDP?

One key story lies in globalisation. Big countries feel they can get away with autarkic policies. They feel self-sufficient and are prone to cut themselves off from the world. Policy makers in small countries don't think they have a choice in trying to create a domestic car industry, but their counterparts in places like Brazil or India or France feel they can experiment with industrial policy. Once this problem is solved -- as seems to be partly the case with India and China where trade liberalisation has arrived though capital account liberalisation has not -- big countries are no longer held back by autarkic policies. In addition, plugging into globalisation, by itself, yields world scale, and thus boosts certain dimensions of size.

Another story, emphasised by Lant Pritchett, lies in the extent to which India is not a single common market, and has thus squandered these potential gains from size. Conversely, as we strip away the legal and tax impediments against intra-India movement of goods, services, capital and labour, and as we bulk up on the infrastructure of transportation and communications, we will obtain returns to size which were not visible in the pre-2000 Indian GDP data.

Finally, on the role of size and sophisticated technological civilisation, see Insufficient data on Charlie's Diary.

I am grateful to Lant Pritchett, Jishnu Das, Pratap Bhanu Mehta, and Josh Felman for comments and improvements on this post.

India's middle income trap

In the Financial Express today, I have a piece on India's middle income trap: Don't take growth for granted. Coincidentally, on the same day, T. N. Ninan in the Business Standard had a piece on a similar theme, and in the Indian Express, Shekhar Gupta ponders where UPA-II went astray.

My thinking about these questions in recent weeks has been prodded by questions about entry of private banks, and by the campaign against C. B. Bhave.

Don't like the SKS valuation? Compete, don't complain

by Bindu Ananth and Nachiket Mor.

Much has been said about the astronomical SKS valuations and the personal fortunes of the original investors. Speaking for ourselves personally, we are not at all disturbed by how much money was made by whom. On the contrary, we are very excited that an area that was once thought to be the exclusive turf of, as Monika Halan (http://bit.ly/SquidorDevta) puts it so graphically in Mint, `the nexus of political doles and the rural bank branch system rotting under the weight of corruption and dysfunction' thanks to pioneers like Vikram Akula, Padmaja Reddy and Udaya Kumar, has moved firmly into the domain of `mainstream commerce'.

People forget that we are a country of over 500 million very-very poor people, so very large amounts of equity capital are required in building an ecosystem of financial firms which will serve the poor of India. Now that the ball has been tossed up high in the air we are hoping that other people who also know how to build India sized businesses (Ratan Tata, Kumar Birla, Mukesh Ambani, Sunil Mittal, Azim Premji and several others) take notice of this ball and hit it with all the power that they can bring to it. Curiously, the fact that so much money was made and was seen to be made is good news because this kind of money even makes the big boys sit up and take notice. Preventing Vinod Khosla or Vikram Akula from making some money is not going to eradicate this poverty, but the power of their ideas taken to scale will.

Should we then not be concerned at all about how much money was made? For sure! Not because somebody got rich but because it calls into question the oft-stated MFI position that their high interest rates are only just about covering their high operating costs. A paper (http://bit.ly/Nvw6k) by Chaudhary and Rai shows that valuations are very sensitive to interest rates. They show that just a 1% decline in MFI interest rates leads to a Rs. 1.5 billion drop in valuation for an MFI with 500 branches. They also show that should the large MFIs choose to cut interest rates by as much as 10% (from the over 30% per annum that most of them currently charge, to under 20% per annum), they would still deliver a holding period return on equity of over 25% per annum. The focus on individuals making money distracts our attention from this very important fact.

And attempts that are intended to bring about `orderly conduct' (http://bit.ly/MFINCode) could have the consequence of preventing competitive forces from coming in and bringing these rates down there is a real need to make sure that this does not happen and to actively encourage intense competition amongst new and existing players. Experience, for example with housing finance in India, shows that this was the only reason why the rates fell and services standards improved without any dilution of credit quality. There is also an urgent need to bring in completely new models of financial services for low-income households (we are associated with one such attempt: www.bit.ly/LocalTouch). For example, the rapid scale-up of ATMs in India changed the entirely banking landscape by changing the very nature of the service models.

Bindu Ananth (bindu.ananth@ifmr.co.in) is the President of IFMR Trust (and the corresponding author). Nachiket Mor is the non-executive Chairman of the Governing Council of IFMR Trust and the President of ICICI Foundation for Inclusive Growth. Views are strictly personal.

Taxi companies in Bombay: an episode in India's urban transportation

by Ajay Shah.

The problem

The best thing that you can ask for, in getting around a city, is a comprehensive underground metro system, where a tube station is at worst 200m away from wherever you might be. There is no city in India that has this. While the Delhi Metro is very impressive, it is still not aiming to intensively criss-cross the city in this fashion (a walk of no more than 200m to the metro station from any point, i.e. a grid of lines which are no more than 400m apart).

The next best thing you can ask for is: well functioning taxis. A good success story in India is the black/yellow taxis of Bombay. They are ubiquitous, can be hailed down on the fly, will charge you by the kilometre, and the meters are not grossly off. I am not aware of any other city in India where taxis work like this. But the quality of vehicles is atrocious, and the customer experience unsatisfactory.

Air-conditioned taxis were tried in Bombay but collapsed into the wrong equilibrium. Customers came to believe that the meters were tampered with, so there were few customers, so the only way to make ends meet for the provider was to tamper with the meters, and so on. Somehow, the law enforcement, which went into ensuring veracity of meters of the traditional black/yellow taxis, did not come about with the blue taxis.

The solution

So it was a big step forward when the Maharashtra government setup a policy framework for corporations to setup a fleet of taxis, as is found in most good cities outside India. These are high quality vehicles. The Transport Department of the Maharashtra government, through its RTOs and the Weights and Measures Department, takes responsibility for ensuring that the meters are not tampered (and this is easily verified by the corporations operating these fleets, thanks to GPS and GPRS). Access through call centres and the Internet makes it easy to call a cab. In addition, as the number of taxis per city builds up, it becomes feasible to just step out into the street and grab one.

The place where I noticed this change the most was at the domestic airport. As a traveler, an incoming flight would bring me to the Bombay airport. I would then walk to a dedicated bay which could hold two taxis at a time, and grab a Meru. This would take me anywhere, with metering by the kilometre, and no fuss. It was just great.

The collapse

This worked so well, it took away business from the traditional black/yellow taxis. There were bays for 20 traditional taxis and 2 Merus at the airport, but customers would line up for the Merus while the traditional taxis stood around without customers. Bombay unfortunately has a trade union of taxi owners. They created a ruckus about this, engaged in a little violence, and pressurised the local government and the airport. In a sensible market economy this should have been no issue. Violence should have been dealt with by the police. Meru's services should have continued to make progress regardless of what the incumbent felt.

The authorities buckled and Meru was evicted from the airport. That is, the 2-bay which they had earlier been given was taken away. So the traveler could no longer step out of the plane, step out of the terminal and grab a Meru.

To me, these events symbolised the governance problems of India. Here you had a very nice new piece of infrastructure. The incumbent (black/yellow taxis) should have lost market share when the new technology came in, and that creative destruction was taking place just fine. But the incumbent then engaged in hooliganism. The forces of law and order did not work effectively in blocking small-scale violence at the street level. The authorities did not have the spine to think about what was best for the users of the airport. The rule of law was not strong enough for Meru to enforce its rights as a legitimate taxi operator authorised by the government - the 2-bay which had been promised to them was taken away. It was a black mark for the quality of governance in Bombay and in Maharashtra. A very nice initiative that had improved the airport lay in shambles.

I single out Bombay and Maharashtra here because Meru is also operating in a few other cities, and this kind of collapse did not come about in any of those cities.

Resurrection

In recent weeks, Meru has comprehensively solved this problem. Here are the steps that I went through a few days ago:

1. As I was stepping out of the plane, I called 4422-4422
   
2. At the menu, I punched 5: a hotkey which says that I have just come in at the domestic airport.
   
3. The call centre employee asked me which airline I had come in from. I named the airline, and they then knew which terminal I was at.
   
4. Immediately, the call centre employee said: ``Your car is number 9152'' and hung up.
   
5. This call was at 00:27 and it lasted all of 37 seconds. (If you don't have a cell phone, there are telephones inside the terminal where this call can be made).
   
6. At 00:29 I got an SMS giving me details about the car.
   
7. At 00:32 the driver called me and said he's waiting for me.
   
8. I stepped out of the terminal and the car was waiting to pick me up, alongside the private cars that had come to pick up other travelers.

It was a very impressive use of technology. Through this, in effect, Meru has comprehensively solved the problem of being denied the 2-bay where taxis would be waiting for customers. Through this, they have successfully routed past the impediment of the breakdown of law and order and contract enforcement in Bombay.

Not yet fully plugged in

These new facilities are not yet properly in place ubiquitously. A few examples:

• At the Delhi airport, the airport penalises users of Meru with a charge of Rs.80. The Meru arrangement there is not as frictionless as that in Bombay. And, they use the same rigid zone definitions of the traditional pre-paid taxis, which isn't relevant in this new setting.
• Every Metro station in Delhi should have an associated bay for taxi pickup and dropoff. So far, that hasn't been a part of DMRC's planning.
• At the international airport in Bombay, there is no access to Meru.

So it seems that a lot has yet to be done to properly integrate taxi services into multi-modal urban transport.