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Thursday, April 26, 2012

S&P putting India rating outlook to negative - comments

Everyone knew that India's situation is precarious. Lack of reforms, rising fiscal deficit and lack of focus from a dream-team that brought in first wave of reforms. So it is hardly a surprise that India's rating outlook is changed to negative. It is made big news, was shrugged off by the markets. But it deserves a few comments.

It ratifies that India's policy direction has reversed signifying the third phase of reform process - reversal. Between 2001-2004 the direction of policy reform was positive. Between 2004-08 there was a policy logjam, primarily attributed to stifling policy of the Left parties. However, post-2008 the policy environment has turned adverse despite no participation by Left in present government.

The current policy environment is typically familiar territory of Congress party - it is a poisoned policy environment. There are arbitrary decisions (Spectrum allocation), abnormal legislations (retrospective tax liabilities), populist measures (NREGA, reversal of first fare hike in 8 years in Railways), arbitrary intervention in infrastructure sectors (under the heading of environmental clearances - POSCO deal), gross corruption aimed at filling the party coffers (commonwealth games scandal), disregard for law and order particularly by government, etc.

To top it all, no change of policy-scene is likely in future despite the promises of finance minister and Prime minister. These people were not waiting for S&P to turn negative before bringing in the main reforms. They do not want reform.

For everyone, investors, general public, firms, foreign investors etc, consistent long-term strategic direction about policy is more important that precise current policy regime. It is immaterial if you have high fiscal deficit, but it matters if you have no plan to come out of such deficit. It is immaterial if there are high taxes so long as there is a progressive clarity in tax laws and consistency in application.

In all, the only change possible is that this government is defeated and subsequent government will bring in a clear long-term strategic view to policy making.

Sunday, April 15, 2012

Deploying Public Assets (spectrum, coal blocks, etc.)

One of the important functions of the government is to deploy public assets for public gain. However, selling these assets or renting them has landed many a government in a soup. Be it the mill-land fiasco in Mumbai, spectrum auctions for 2G or coal block allotment, governments seem to fumble at every step. And this is not the only problem with deployment of public assets. Let us look at problems and solutions to selling or deploying public assets in the interest of public.

The problem with deploying public assets
The process of deploying public assets is difficult. Inappropriate deployment usually turns into allegations of scams and threatens the political order.

  1. An infant nation is compelled to deploy the assets it owns in a legal environment that is not yet sophisticated and evolved. Thus, such a nation is faced with immediate prospects of inappropriate deployment and therefore political disorder.
  2. Asset deployment theories themselves are still evolving. Thus, the jury is still out on whether renting is better than sale of assets in conditions of uncertainty, how long should lease durations be,etc.
  3. The asset pricing mechanism is ill-developed for untested or new technology. Here, it is difficult to estimate the present value of the asset. These new technologies are sensitive to choices and, in scientific parlance, to initial conditions. thus, what may be a good technology elsewhere,and therefore priced at premium, may become a failed idea at high costs. In such cases it is nearly impossible to estimate in advance and accordingly price such assets.
  4. The question of opportunity cost is of prime importance. If I sell an asset to a firm and the firm does not develop it but simply sits on it. That may be advantageous for that firm but it defeats the purpose of sale of assets by the state.
  5. The risk being taken in new development must be paid for. In other words, when the entrepreneurs bid for a technology that has not established itself, they are taking risk. If the government starts demanding higher initial payments, the entrepreneurs' risk is amplified resulting in under-developed sector. A better way is to let the initial payment be lower while gain from profit sharing or revenue sharing mechanism.
Two types of asset sale problems or mistakes
Even when there is no corruption, there are two types of problems or mistakes government can face or make with asset deployment. 

  1. The government sells the asset at lower than market value thus resulting in loss for the exchequer. This is usually because the government cannot value the asset correctly. Alternatively, government is advised to "leave some value on the table". In all these circumstances, the exchequer is the loser. 
  2. The second type involves selling the asset at market price but to someone less qualified or simply, preferring one buyer over the other. Here the problem is not for exchequer directly. Here the shareholders of the company denied the asset end up losers while those of winning company gain windfall profits. It is possible that the preferred buyer may not have technical capabilities to effectively deploy the investment thus resulting in second order loss for exchequer. 

Out of the two types of problems with asset deployment, first is detrimental to the exchequer but the second is indifferent (at least directly). It follows that the level of tolerance for first type of mistake should be lower than the second one.

Types of Asset pricing
Asset pricing depends on various mechanism for cash flows and availability of asset itself. 

  1. One-time sale - this transfers public asset to private ownership: This involves higher risk to government as the real value of the asset may not be correctly assessed at the time of sale. However, once sale has concluded there is not much that can be legally claimed from this type of transaction. 
  2. One-time payment for right of usage for few years and renegotiated every few years: This is capitalized rent and the value of this changes as perception of risk changes. The risk involves depends on what the asset is and how long is the first lease period. E.g. Mumbai Mill lands have been leased to companies on 99 year leases. Recently 99 year period has expired but the ownership of those lands has not reverted back to government.
  3. One-time license-fee payment followed by share of revenues/profits: Here the one-time component is lesser to account for untested risk that entrepreneur must take. Thus, this option is less risky for entrepreneur as well as government. There are sub-categories within this option depending on where the government takes its cut - at revenue stage or at operating profit stage or net profit stage.
  4. Only share of revenues or profits: Technically Taxation achieves this effect either through general tax or specific industry based levy, either in the form of excise, cess etc.

The first three methods are used where the asset is scarce (usually resources like spectrum, mines, land etc.). The fourth method is used for everything else.

Structure of Corruption around these problems
Corruption is structured around these potential problems to aggravate the loss to exchequer. Following problems occur generally:
  1. Asset is impaired and sold thereafter: Impairment can be positive act or negative acts. Positive act means the asset is deliberately impaired wherein losses increase and asset appears hopeless. A negative act means allowing the asset to degenerate without actively doing so.
  2. Mechanism of Asset pricing is changed midway: Here the original intention of pricing the asset is ignored. First, the asset is priced lower to encourage investment by lowering the risk in the asset deployment. Thereafter, an argument is evoked at the deployment is only profitable at such low prices and hence the asset value is actually low. Thus, Mill lands went from following method 2 above to method 1 without commensurate payment.
  3. Concessional rate for PSU buyers: In this form the government allots a public asset to a public sector undertaking (PSU) company. This seemingly benevolent act can be hideously corrupt. Unless the PSU is 100% owned by the government, it is reducing public gain and has same effect as selling the asset at throw-away prices. A PSU in receipt of such asset must not complain if the government caps the prices of the end-products it produces.
  4. Concessional allocation to PSU and subsequent divestment: This is modified part of third problem in which asset is alloted to a 100% government owned PSU and thereafter the ownership is divested. This buries the asset under the PSU performance and makes it less valuable to lay-person. 
  5. Asset Valuation is not proper: In this case, the sum-of-parts value of the asset is higher than the asset itself. Thus the parts must be valued appropriately. Thus the land owned by a specific PSU that is divested may be of more value for other use than for use of PSU itself.
  6. Profitability Estimation is impaired: This form works with assets like airports and roads where the right to collect toll or charge for services is leased to private entities. Recent experience suggests the estimation can go wrong in both ways as has happened in toll-roads and airports privatized recently.
  7. Arbitrarily choosing pricing mechanism for two similar assets (Inconsistency): For reasons unknown, without effecting a policy change, government allots one asset in one manner and other using different pricing mechanism.
  8. Granting asset to unqualified buyer: When asset is granted to an unqualified buyer who sells the license to other party at substantial profit, there is ground for doubt to believe that asset is underpriced and opportunity exists for arbitrage trade.
Note: The list is not exhaustive as people are infinitely more creative than anyone can anticipate.

The solution
The real solution is not a model for asset pricing but one of transparency. 
  1. Conservative approach: I believe, from the exchequer's point of view the risks associated one-time outright sale are quite high. Instead, a non-trivial license fee in addition to share of revenues forms a better alternative. It allows for future adjustments of asset value and exchequers share in the same.
  2. Transparency: If the process is transparent and mechanisms are fair, there is not much corruption that can happen. 
  3. Changes to reflect true assessment of changing value of asset: If it so appears that initial payments were underpriced, then subsequent revenue sharing could be raised and net effect can still be adjusted.
  4. Consistent changes: Any policy driven choice must be applied consistently. Thus if government chooses auction method then auction should be followed everywhere. If First-come-first approach is used it should be used consistently and fairly.
  5. Principles of natural justice and equity: Any solution accepted by government must abide with principles of justice and equity enshrined in the constitution. Thus, if all qualified parties are given equal opportunity to bid for asset, there is not much scope of corruption.
In Sum
The focus of asset deployment is to get best value for the asset being deployed for public interest. The duty of the government is to deploy public assets for public gain. So long as basic principles are adhered we can have a flexible system that can account for past mistakes in an on-going manner.