Irrationality as reform

Why the manner in which divestment is occurring is clearly distorted.

IN an effort to convey the message that it is a government committed to accelerating reform, the National Democratic Alliance government on February 5 chose to announce simultaneously a broad set of policy changes covering diverse areas of the economy. The measures were a motley combination of more privatisation of large public sector undertakings (PSUs), a cost-cutting voluntary retirement scheme (VRS), further liberalisation of the foodgrain trade, and moves to dilute price control in the case of a number of commodities, notably sugar and pharmaceuticals. The synchronised announcement of these measures suggests that they are not just significant in themselves, but noteworthy because they were announced simultaneously. The intent, it appears, was to make "economic reform" the focus of the February thrust.

In fact, many of the new measures constitute marginal adjustments in areas where liberalisation has already been the norm. Take the area of foodgrain trade, for example, where it has been decided to remove all restrictions on the movement of foodgrains, edible oils and sugar and to decontrol completely the sugar industry after operationalising futures trading. These measures were provided for in last year's Budget speech itself, when Finance Minister Yashwant Sinha had declared that his government intends to "review the operation of the Essential Commodities Act (ECA), 1955 and remove many of the restrictions that have been imposed on the free inter-State movement of foodgrains and agricultural produce and also on the storage and stocking of such commodities". He had also said that the government would "review the list of commodities declared as essential under the said Act and bring their number down to the minimum required". The February 5 announcement removing 12 of the 29 items covered by the ECA merely begins implementing a decision announced in last year's budget speech.

Even at the time of the last Budget, the government was emboldened to announce these measures largely because in the case of many commodities covered by the ECA, capacity expansion or supply increases accompanied by sluggish demand had resulted in unutilised capacities or large stocks. Unless the demand situation changes substantially and supply fails to respond, as is quite possible in areas like foodgrains and sugar, the controls had no major role to play. And even if that were to occur, other elements of the process of liberalisation were rendering control meaningless. Thus, import liberalisation was contributing to easing domestic supply constraints, since commodities in short supply could be easily accessed from abroad, even if with adverse consequences for indigenous production. And the gradual erosion of the importance of the public distribution system (PDS), in the name of limiting subsidies, was reducing the need of the government to service the PDS for guaranteed access to a minimum amount of a commodity like sugar.

THIS is not to say that this round of decontrol is not without significance. The removal of an additional 36 bulk drugs from the list of those 74 whose prices are controlled would result in a substantial increase in drug prices, as experience with such initiatives illustrates. According to reports, an ORG-MARG Survey of 270 drugs decontrolled in a round in 1995 found that around 45 per cent of them have registered a 20 per cent increase in price, while the prices of another 5 per cent had risen by 40 per cent.

Similarly, the decision to remove quantitative restrictions on the export of wheat, wheat products, non-basmati rice, coarse grains and pulses can, if international prices rise and domestic supply falls, have major implications for the quantum and cost of domestic availability and therefore for food security. These measures are clearly driven by the "confidence" generated by a food surplus that results from consecutive good harvests and depressed domestic demand. But in an area where production tends to be volatile and acreage shifts are the norm, the basis for such confidence can be short-lived.

These likely or possible consequences notwithstanding, all of these measures are part of processes that have been afoot for quite some time now. Hence, though important in themselves, the real explanation of the timing of further advance in those directions lies in two other measures which the government has announced: the VRS scheme for surplus government employees and the announcement of the strategic sale of Videsh Sanchar Nigam Limited (VSNL) and four hotels owned by the India Tourism Development Corporation (ITDC) and the Hotel Corporation of India.

It is indeed true that even these two initiatives announced in early February are part of processes that have been under way for quite some time. Privatisation has been on the agenda of successive Central governments ever since the beginning of accelerated reform in the early 1990s, though the present government has been desperate in recent months to speed up the process. And the plan to reduce the size of the Central government's workforce by combining a carrot-and-stick policy has been in the air since the submission of the report of the Expenditure Reforms Commission. However, unlike the other measures discussed, these two are directly related to the Budget, as a precursor to which the package being discussed was announced. Recent budgets have made clear that the government has failed to achieve its own self-imposed, and often irrational, targets regarding fiscal deficit reduction, because of the tax concessions it has provided as part of economic 'reform'. This makes some show of expenditure reduction imperative, if its oft-repeated commitment to 'fiscal reform' is to remain credible. The Finance Minister had indeed committed himself to reducing the number of employees in government by limiting recruitment and exploiting attrition, in his budget speech for 2001-02. With attrition in the government establishment placed at 3 per cent of the current labour force, he promised to reduce employment in government establishments by 2 per cent a year by keeping new recruitment at the level of 1 per cent of the current labour force. If this is done over the next five years, as he claimed it would, government would be downsized by 10 per cent of current employment, which was the goal he had set himself.

As has been argued earlier in this column, an examination of the salary bill of the government suggests that there is little to be gained in terms of resources released by this process. There are currently close to 3.5 million employees in government. However, of these 2.2 million are employed in the Railways and the Department of Post, both of which organisations undertake a huge task given the size of the country, and are known to have accomplished their task creditably given the complexities involved. Another 50,000 persons are employed in the departments of Atomic Energy and Space, which like Defence need to be kept out of the downsizing initiatives of the Finance Ministry. That implies that Yashwant Sinha's downsizing exercise can apply only to around 1.2 million employees, earning Rs.11,459 crores by way of pay and allowances. Even if he successfully implements his downsizing commitment made in last year's budget speech, the amount saved in a single year would work out to just 0.08 per cent of total revenue expenditure, making the 10 per cent saving to be garnered in five years just 0.4 per cent of total revenue expenditure.

The recently announced VRS can be seen, therefore, as an effort to advance further in this direction. It is targeted at government employees in the "surplus pool" resulting from the reorganisation of existing departments and the closure of departments identified as being superfluous. These employees are to be offered a VRS package consisting of an ex-gratia payment equal to 35 days' emoluments (basic pay plus dearness allowance) for each completed year of service and 25 days for each year of remaining service until the age of retirement. The payment will be subject to a minimum of 250 days' emoluments or Rs.25,000, whichever is higher, and a maximum set by a ceiling of 33 years for the computation of the payment. If those who are declared surplus do not accept the scheme, they would be retrenched if not redeployed in one year.

On the surface, the package appears attractive and could result in a substantial one-time payment from the state's coffers if taken up by large numbers of employees. Further, offering a larger number of days of compensation for years of service already completed than for years still due to be completed will bias acceptance in favour of older employees, making the average quantum of compensation paid much higher. Given the small savings that seems to result from this process of employee reduction, it is unclear whether this scheme is rational at all. Its primary purpose appears to be to declare that the government is "committed" to expenditure reduction and fiscal reform, irrespective of the net benefit of the initiative.

What accounts for this desperation to be seen as being truly "reformist" on the eve of the Budget? The real explanation seems to be a need to make the same reformist tag stick when it comes to privatisation. Starting with Modern Foods Industries and Bharat Aluminium Company Ltd (Balco), the government has been facing substantial opposition to its "strategic disinvestment" drive, aimed at transferring management control of PSUs to private agents at a small price.

There have been two allegations which the drive has generated: first, that in its desperation to sell large enough volumes of PSU shares for budgetary reasons the government has been forced to offer private agents a concession in the form of management control in return for the acquisition of as little as 25 per cent of the shares at extremely low prices; and, second, that in the rush for the acquisition of profitable PSU shares this has generated in the private sector, non-economic considerations have influenced and distorted the process.

The disinvestment of VSNL and the petro-marketing firm IBP Co. Ltd were indeed instances of the big-ticket privatisation drive of the NDA government. The irrationality of the process of setting a reserve price based on questionable assumptions and accepting the highest bid among those falling above this figure comes through in both these cases. This is most obvious in the case of IBP. Indian Oil Corporation Ltd (IOC) won control over IBP with a bid of Rs.1,153.68 crores for 33.58 per cent stake, which is close to three-and-a-half times the reserve price. Was IOC's bid irrational, or was it the reserve price and the price of just Rs. 595 crores offered by the second highest bidder, Shell? Sections of the financial media have been putting out speculative, and possibly planted, reports that this occurred because the Petroleum Minister forced IOC to more than double its bid in order to prevent the company going into private hands. The fact of the matter is that IOC is not only willing to stick to its commitment, but has raised objections against the Disinvestment Ministry's decision to keep IOC out of the round of bidding for Hindustan Petroleum Corporation Ltd (HPCL) and Bharat Petroleum Corporation Ltd (BPCL) on the specious grounds that in the event of it being successful in the bid, it would become a monopoly in the petroleum area.

The argument is specious for a number of reasons. First, in capital intensive areas like petrochemicals a high degree of oligopoly, even if not monopoly, is the norm. And collusion between oligopolists, which is common in the oil industry, can yield results similar to those in situations of monopoly. Second, since the divestment of HPCL and BPCL is to occur only after the administered price mechanism is dismantled, import prices would set limits to the prices which can be charged by domestic players. Finally, as IOC itself has been quick to point out, in other areas, such as the divestment of the petrochemicals giant Indian Petrochemicals Corporation Ltd (IPCL), players like Reliance have not been kept out even though it would enjoy a position of monopoly in the case of many products if it wins the bid for that company. Clearly, the effort to keep IOC out is driven by the Disinvestment Ministry's desire to save itself the embarrassment of receiving a quote which makes nonsense of its reserve price and the price offered by private bidders who tend to win the bid. The results that occur when private players are the sole bidders is clear in a case like VSNL's. The government had fixed a reserve price of Rs.1,218.38 crores for the 25 per cent stake being divested in VSNL. The VSNL stake was handed over to Panatone Finvest, a Tata group company, which made a bid of Rs.1,439.25 crores amounting to Rs.202 a share. Reliance, Tata's competitor in this case, reportedly bid Rs.1,346.25 crores. Are these rational offers?

They would appear to be so when measured against the prevailing market price of VSNL shares. But interestingly, since sale at a higher-than-market price would require the bidder to make an open offer to individual shareholders of the company to purchase their shares at the price offered for the stake divested by the government, public sector shares have perked up in the markets. On the day the results of IOC's bid was announced, the share prices of IBP rose by 20 per cent. This was only to be expected since shareholders already had the option of receiving a premium from IOC. But what is interesting is that simultaneously the shares of IOC and of BPCL and HPCL also shot up. That is, the market was accepting the explicit and implicit valuation that IOC had made of the shares of petroleum companies.

If the market was wrong in doing so, there was no reason to believe that the original valuation it held was right either. On the other hand, if it was right, the influence that prevailing stock prices have on the valuation process is indeed irrational and could be exploited to favour those who want to divest or acquire PSU shares at bargain prices.

Put simply, even if we ignore the many arguments against privatisation, the manner in which divestment is occurring is clearly distorted. There could be one or a combination of two explanations for this. First, the government's desperation to find resources for its Budget is pushing it to court private buyers with bargain prices, given its emphasis on the immediate benefit of garnering budgetary resources and its refusal to recognise the long-term loss involved for the exchequer. The second possible explanation is that factors other than firm level or social rationality could be driving the process.

In either case, opposition to the accelerated privatisation thrust is bound to be intense. It is possibly in an effort to deflect or dilute such opposition that the government chose to combine the disinvestments announcement with other unrelated "reform measures", so as to cloak a faulty process in the garb of economic reform and use that to defend the decision.