Friday, February 21, 2014

The Real reform agenda

My column in Wealth Insight Jan edtion is here. The unedited original follows:


Policy reform – different strokes
Speak to a day trader in India’s equity market, and government policy “reform” equals changes that help equity markets go up for the day. Removal of STT (securities transaction tax) is a significant “reform” measure. Speak to foreign brokerages (as the current finance minister often does) and reform implies allowing foreign investment without restrictions and without taxes in all sectors of Indian economy.  But what reform would actually change the Indian economy in a meaningful and sustained manner – and would be good for Indian citizens and businesses? A possible candidate is “administrative reform”.

Administrative reforms fall in the category of “most boring” reforms. A paean on such reforms is unlikely to feature in the “must-do” list of any equity strategist. Importantly, a government order is often all that is needed to implement it – quite unlike many others that require “coalition dharma” to be violated. Of many administrative reforms, one that can make an immediate impact on the economic scenario of India is legal reform.

The economic effect of poor legal systems
A study carried out some years ago found that in India, for every 1000 citizens, only 1.2 cases were filed as against 17 in Malaysia and 14 in Korea. Does that mean that Indians are less prone to litigation? Details of pending cases do not suggest so. There are approximately 3.5 million cases pending in High Courts and over 20 million cases in subordinate courts. It appears that lower per capita cases files is a sign of fatigue - litigants do not expect to receive a judgement in their lifetime through the formal judicial system – and do not approach it for resolution. This fosters informal or alternate mechanisms – many that operate outside the legal system to “fix” problems. There are several consequences – societal and economic.

Higher borrowing costs, lower leverage
Consumer lending in India has suffered considerably due to lenders inability to recover dues from defaulters. Typically, lenders build in 6% or more as default risk. Borrowers of good credit worthiness are charged almost 50% much more than they would need to pay, if defaulters could have been legal proceeded against, and recovery achieved in a time bound manner. 
Small and medium enterprises (SME’s) are even worse affected. Since a lender knows that loan contracts cannot be legally enforced, practices such as demanding a personal guarantee of a “promoter” for a limited liability company have become commonplace. The purpose of limited liability itself is lost – leading to slower growth in the organized sector.
Not only is lending cost padded up for potential losses, multiple collateral is expected for every loan. This reduces the borrowing power of small business in no small measure. Despite this, rising levels of non-performing assets with banks reveals that liquidating collateral itself may be a difficult legal process.

Delayed justice – slower development
India’s judicial system has civil suits lasting over 20 years. Decades old land disputes prevent development of prime real-estate, leading to artificial land scarcity and higher costs of living.
Commercial contracts require quick and just remedies for them to be effective. With no hope of achieving that in India, corporate India has to often agree to use international jurisdiction (say Singapore) for international contracts. This has an adverse impact on the legal business in India. Longer term, it restricts the sovereignty of the Indian State. 

Cost of justice
Another deterrent for going to court is cost. Often, cases drag on through various levels of judiciary – with ever increasing costs of advocate fees. The reimbursement of fees in event of a win is totally inadequate compared to the real cost of legal representation in higher courts. Even a win will often represent a pyrrhic victory. More often, less well-to-do litigants will simply give up despite having a strong case – leading to miscarriage of justice – and increasing social disparity.

Economic and human loss
Despite several judicial reform commissions and studies, the problem of an ineffective judicial system continues to prove a drag to the Indian economy. While no study seems to have estimated the economic costs of delayed justice, it would not be difficult to accept that direct and indirect effects reduce GDP growth by 0.5% to 1% per annum – and that may be a serious underestimate.
The effect of this slower growth in terms of human cost of unemployment - and consequent poverty, and unrealised potential of Indian youth needs serious soul searching. Besides economic costs, demonstration effects of unscrupulous behaviour going unpunished results in erosion in faith in rule of law and leads to distortions in social behaviour and ethics that are far reaching.

Simple solutions can help
In the current calendar year, the Supreme Court was on “vacation” for 7 weeks – from 13th May till 30th June – (13.5% of the year). Other courts too have similarly long vacation periods. This is a colonial vestige and can be immediately removed.

While judges often lament the lack of resources and infrastructure, courts can utilise existing infrastructure in two shifts and manage the court calendar better to avoid having to postpone hearings repeatedly. Studies have suggested the need for special courts to take up cases of similar nature or requiring detailed domain knowledge. These can be implemented without significant cost or effort.   
Other more elaborate methods have also been suggested by Judicial reform commissions. However, the urgency with which reform needs to be implemented is sorely lacking. Perhaps judges too need reminding that like politicians, they exist to serve the masses, not rule them!

Tuesday, December 24, 2013

Corruption and Economic progress

My column for Wealth Insight Dec issue - here.The unedited version is below:


The scourge of corruption
N Vittal, former Central Vigilance Commissioner, in a recent book titled “Ending Corruption: How to Clean up India”, defines corruption as “the lack of integrity – whether intellectual, moral or financial”. International studies indicate that India falls among the bottom half of countries in the world in corruption rankings.  Corruption reduces competitiveness of industry, leads to lower investments, misallocates capital, and increases income disparity – among other effects.    

Measuring corruption – usually based on surveys
One of the key challenges to empirical research in the area of corruption is an appropriate measure of corruption. During the nineties, three different groups of measures appeared – indices like the International Country Risk Guide (ICRG), and Business International (BI) that were based on assessments of country experts. The next group were based on surveys of business people or the local public – these included  indicators tracked by World Economic Forum (WEF), or the World Development Report (WDR). The last group was a set of “poll of polls” – the “Graft Index” of World Bank or Corruption Perception Index (CPI) of Transparency International.  Given its amorphous nature, corruption measures tend to rely on surveys.              

Survey of attitudes of Indian corporations
Between March and May 2013, E&Y along with FICCI conducted a survey among Indian businesses, and foreign companies operating in India. This survey was supplemented by inputs from private equity investors. The target companies surveyed had incomes between Rs5000crs, and Rs10,000crs.  The report estimates that between October 2011, and September 2012, corruption related cases reported in the press (excluding large scams like 2G, commonwealth games and mining) led to potential loss to the Indian economy to the tune of Rs36,000crs.
Some of the report’s conclusions bear repeating:
-       “Strain on ethical behaviour: Alarmingly, a large number of respondents appeared to be comfortable with (or were aware of) unethical business conduct, including irregular accounting to hide bribery and corruption, gifts being given to given to seek favours and third parties being used to pay bribes.
-       Taking the easy way out: More than half of the respondents agreed that it is the lack of will to obtain licenses and approvals the “right way,” which leads to bribery and corruption.
-       Need for greater enforcement of laws: Around 89% of the respondents felt that there should be greater enforcement of laws to curb the proliferation of bribery and corruption.”

The survey further goes on to point out that 44% of the respondents were in favour of legalizing “facilitation payments”.

The other end of society
Centre for Media Studies (CMS) – a not-for-profit think tank, has been studying corruption in India over years. In 2012, CMS revealed its 8th study in the series - focused on slums and basic services availed by residents of slums – and the amount of bribes to be paid to receive such services.
               
 The figures speak for themselves. The incidence of corruption is high, but more disturbingly has doubled over the period 2008-2012.

A lack of accountability
Vittal, in his book, identifies a lack of accountability as a key factor behind poor governance in India. He gives an example of dysfunctional governance – where policies, while existing, are not implemented. He states - “An example .. is the Benami Transactions (Prohibition) Act, enacted in Sep 1988. Section 5 of the Act says that benami property will be confiscated by the government. Section 8 says that the government will prescribe the rules under which the confiscation will take place. … Over 20 years have passed, and the government has still not issued such instructions.” He goes on to add that when he was CVC, he wrote to the Secretary of the revenue department requesting that the rules be framed. He received no response.
The most corrupt sectors
Chart: Sector wise corruption heat map
The E&Y survey referred to earlier, asked respondents to rank sectors based on perceived level of corruption. It is no surprise that sectors rated as most corrupt were those where government interface was the highest. Lowering government touch-points is definitely a way to reduce corruption.

Investment take-away
While making investment decisions, investors are forced to rely on financial statements as a source of information of how a company is performing. What happens when that document itself is not reliable? In the case of corrupt sectors, businesses, by their own admission tend to distort financial reporting. If a management is willing to color the accounts to adjust for bribes paid, is it likely that they will represent a true and fair picture in the account books for minority share-holders.
The irony is that even institutional investors who should know better are all too often prone to look the other way.  The survey notes that “Around 93% of the respondents representing PE firms indicated that accounting fraud is the most common fraudulent practice observed in India.” Despite this, “73% of PE respondents’ organizations do not conduct anti-bribery and corruption due-diligence before investing in enterprises.”
As investors, it is important to realise that “audited” statements do not necessarily mean a true picture of a company’s health. Investing in real estate companies is, for example, more a macro call on the sector – rather than a careful analysis of the financial statements. The financial statements reveal nothing of importance – only a carefully crafted story that the management wants investors to see.

Correction has to start from the top
As India enters into another set of elections – first for state legislatures, and then for Parliament, it is important to realise that each one of us is impacted by corruption, and in most cases, negatively. If leaders we chose are honest, the system will start to correct itself. Each one of us has a stake in a corruption free country.  When voting, as in investing, choose carefully and avoid the rotten apples.

Subscribe Now: standard