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Exchanging shadow for substance

Print edition : Feb 19, 2000

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The ongoing financial sector reforms are making the economy vulnerable and volatile; they must be deemed to be against the interests of the long-term stability and development of the country.

ARUN GHOSH

ONE of the important segments of economic reform in India during the 1990s pertains to the financial sector; and these reforms are described succinctly in the Reserve Bank of India's Report of Currency and Finance for 1998-99. The process of fina ncial sector reforms has two aspects: first, reforms pertaining to the domestic capital and financial markets; and second, the progressive integration of the Indian capital and financial markets with global capital and financial markets. The RBI is expec tedly upbeat about all financial sector reforms; and, indeed, one must accept that some aspects of reform were long overdue. Yet, grave doubts arise in respect of several aspects of the reforms initiated, which lead to a wholly "market-led" patter n of economic development, and also tend to integrate the Indian financial market with the international financial system.

The positive aspects, briefly, concern both the deepening of these markets and the focus on transparency and accountability, resulting in an increase in the reliability of these markets from the point of view of household savers in India. These are posit ive aspects of the reforms initiated. The positive role played by the Securities and Exchange Board of India (SEBI) in regard to certain norms for new issues (seeking to restore investor confidence); or, in the area of banking, the introduction of new no rms of 'capital adequacy' are obvious examples. There are others. This brief essay will not go into the positive aspects of financial sector reform in India during the 1990s. The focus here is on certain ill-advised (and premature) reforms which pose a s erious threat to the long-term development and, indeed, even the stability of the Indian economy, which is now being made increasingly vulnerable to the speculative ups and downs in the international financial markets.

The major threat to India's long-term development - through some part of the extant reforms - appears to stem from external pressure. Take the problem of the 'direction' of investments to infrastructure build-up and other high-priority areas. Under the W orld Trade Organisation (WTO) regime, the Agreement on Trade Related Investment Measures (TRIMS) makes nonsense of any domestic 'priorities' of development. Since the free flow of investments in tune with market demand and supply are supposed to make for optimality of investments, the 'direction' of investments, to accord with any set of priorities, is ruled out. Yet, the thesis of market-driven investments making for the most desirable pattern of development is both incorrect in theory and proven wrong historically. Even in theory, the problem of 'externalities', the inequalities in the distribution of income and wealth do not make for an investment pattern in developing countries that would lead either to steadily improving labour productivity or to improved employment and incomes. Historically, it is easy to see that long-term flows of international capital do not occur in response to 'liberal' economic policies; indeed, even 'conditionalities' - or the absence thereof - do not influence capital fl ows to developing countries. The recent trends of capital flows to China - where all policies are generally opaque and all external investments are individually screened even to this day - against negligible or even zero flows of external capital to the least developed countries (which follow the most liberal and open policies) is ample evidence of what really makes for the inflow of external capital. The problem of 'externalities', the lack of infrastructure, the inadequacy of home demand in the host c ountries are enough to make potential investors shy away from countries with the most liberal trade and investment regime.

Two further problems - which are now obvious from recent Indian experience - must be noted here. The pattern of external capital flows - the 'herd instinct' of investors - is exemplified by the rush of dozens of new 'models' of automotive passenger vehic les in India of late, largely by way of c.k.d./s.k.d. (completely knocked down/semi-completely knocked down) components imported lately (many, to be merely assembled in India). This is, so it seems, an offshoot of the TRIMS Agreement under the WTO regime . Clearly, many of these would soon disappear; but that may not affect the foreign car-maker. To the extent that domestic capital is deployed for these new investments, such capital would be wasted. While the automotive industry is doubtless a spinner of employment and industrial growth, the diversion of scarce domestic savings for wasteful investments can only be to the detriment of long-term development.

To the extent that the above example indicates the switch from 'state-directed' investments to the 'market-led' pattern of growth, it exemplifies the essential problem highlighted earlier; and considering the fact that in the post-Second World War period , no country (which had earlier missed the bus in regard to industrialisation) has developed without positive state direction and support - including South Korea, Taiwan, Singapore - the ongoing financial sector reforms must be deemed to be against the i nterests of the long-term development of the country.

There is yet another, and a deeper, reason why the present reforms (pertaining to long-term investments) is misguided. According to a 1993 report of the Organisation for Economic Cooperation and Development, the profitability of investment has steadily g rown from around 12 per cent in the early 1980s to around 15 per cent in the early 1990s; more recent OECD documents indicate a continuing trend in profitability, to nearly 16 per cent by the mid-1990s. This development has occurred, surprisingly, in the background of generally low growth in all OECD countries (other than the United States), and a slowing down in the growth rate of world trade. Analysing the reasons for such a development, experts have pointed to the increasing possibilities of profit-t aking (by intrepid 'fund' managers) in the 'assets market'; typically, in the stock markets and foreign exchange markets, especially in the developing countries.

The problems herein are manifold. First, with the 'expectations' of profitability on the increase - even as the problem of 'externalities' leads to low returns on long-term investments - the focus on the need to attract external capital at any cost leads to obvious aberrations in investment priorities in developing countries (which have characterised the 'reforms' in India also). Profit 'guarantees' - at a minimum of 16 per cent, effectively 20 per cent or more - to foreign investors leads to high-cost equity inflows in sectors where the marginal productivity of capital is much lower than the (guaranteed) cost of the capital; and such capital inflow can be serviced only by squeezing the already low domestic savings, thereby imparting a setback rather t han a positive thrust to the development process. The Enron power project at Dabhol in Maharashtra vividly exemplifies this pernicious effect; already, Enron power, sold at generation site, is priced at Rs.5 per unit; and Maharashtra State Electricity Bo ard (MSEB) has to incur further costs for transmission and distribution, even as it has to forgo the use of cheaper Tata power, available at Rs.1.80 per unit to the MSEB; and the MSEB is forced to shut down its own thermal power generation, at Rs.1.20 pe r unit. (For carefully documented details in this context, Power Play by Abhay Mehta, Orient Longman, 2000.) Thus, the inflow of external capital with high profit guarantees is tantamount to 'borrowings' at very high cost; and apart from these guaranteed returns being more than three times the rate at which funds could be borrowed with sovereign guarantees, there is a strong possibility of the external equity being 'padded'. The equipment financed by external capital without 'global tender ing' has a strong suspicion of being unduly high priced and 'padded', so that effectively, the profits remitted are much higher than even the high returns 'guaranteed'. (The capital cost of a similar capacity power plant set up in Malaysia by the same fi rm of Enron, at around the same time, has turned out to be some 60 per cent of the Dabhol plant.) But the worst feature of this investment is the resultant enforced shutdown of the much cheaper existing thermal power plants of the MSEB, which effectively makes Enron power that much more expensive, and therefore totally ill-advised.

Second - and importantly - to the extent that the pattern of economic reform of the finance and capital markets in India tends to follow the trend of 'global' developments, it leads to two totally misguided types of development in the formulation of econ omic policy in India. First, the very notion that external capital must play an important part in developing the Indian economy - the figure of foreign direct investment (FDI) import considered necessary and feasible is $10 billion annually - means that all investment policies, including investment priorities, must be attuned to attracting external capital; and that implies, in turn, 'globalising' the Indian capital market, and making all investments in India patterned on the forces of international sup ply and demand. The fact that in order to get over the problem of 'externalities', the Government must invest in developing both the social and economic infrastructure - that the returns herein simply cannot meet the test of current discount rates , that in fact the future generations' welfare would only be thrown to the wolves at the current market discount rates - is forgotten. The focus being on 'market-led' development, the focus on even capital market developments is on making that market res pond to market sentiments. Hence the ill-advised attempt to integrate the long-term and short-term financial markets; to make the Industrial Development Bank of India (IDBI), the ICICI, the Housing Development Finance Corporation (HDFC) get in the market for short-term loans also. This is the OECD pattern; and what is good for the OECD must be good for India also. This is 'aping' without any heed to the specific needs of economies at different stages of economic development; this is tantamount to giving up even the pretence of planning for development (although, in order to dupe the people, the facade of a Planning Commission must be maintained at public cost).

It is the same mindset that leads to the opening up of the capital market in India to global flows; the opening up of the insurance sector, for example - involving the handing over of scarce domestic savings to foreign investors - is simply a part of thi s frenzy, on the specious ground of problematic (or perhaps, temporarily) providing 'better service' to a small upper middle class in India. Thus, this pattern of development in effect involves the scuttling of the worldwide pattern of 'state-directed' p riorities of development. And, interestingly, it puts paid to the Pachmarhi Resolution of the Congress(I), adopted after much soul-searching, following the electoral debacle in 1996, which took note of the fractured economy that had gradually evolved - a nd got accentuated as a result of the process of 'economic reforms' initiated in 1991.

BUT we must return to the other segment of the money and capital market, namely, the market for finance, without further elaborating on the above (long-term) problem concerning the capital market. Herein, the recent reforms - tending to globalise the fin ancial market in India with the world financial market - have grave dangers; for what we are doing is not merely distorting the priorities of investment, thereby delaying economic development; we are opening up the economy to all the dangers of volatile flows of short-term capital, to the 'herd instinct' of finance managers of large liquid funds, floating around the world.

Some of the 'financial sector' reforms - purporting to 'integrate' the Indian financial system with the global financial system (and developments therein) - are likely to increase only the volatility of India finance. Again, one must start by saying that some part of the reforms pertaining to the stock exchanges were overdue and were necessary. Yet, recent developments - as well as the recent focus - appear to be wrongly focussed; and, indeed, the present focus of the Indian policymakers (on the stock m arket developments, including the present, ongoing boom in stock prices) is ill-advised and wrongly directed.

Take but two examples: the extraordinary attention to introducing trade in 'derivatives', and the enormous effort to promote 'dematerialised' stock market transactions. For whose benefit, and for what purpose are they designed? These developments help only the professional speculator; and the deliberate encouragement (through all manner of means, including the steep reduction of capital gains tax to a nominal 10 per cent) to foreign institutional investors (FIIs) to invest in portfolio investment s is symptomatic of the effort to attract even 'short-term' external capital to India, in order to meet a fundamental, long-term disequilibrium in the current balance of payments caused by a mounting deficit in the trade balance.

The focus of not only the speculator but unfortunately even the policymaker appears to be on the growing 'market capitalisation' of the corporates listed on the stock exchanges. A speculative boom in the stock market is taken to reflect 'real progress'; and this incorrect (and unreal) approach started as far back as 1992 is unfortunately the focus even to this day. The fact that the 'market cap' of Wipro or Infosys exceeds Rs.2,00,000 crores is hailed as a sign that the Indian corporate sector - or at l east a major part of it - has already achieved such maturity as to warrant the integration of the entire corporate sector into the world financial system. More immediately, it does not obviously occur to anybody that at the current share price of either Wipro or Infosys, an investor buying shares in these companies can at best hope to make a capital gain (by selling while the share is on an upswing); long-term investment in these shares would fetch a return of perhaps less than one per cent.

Or again, as per the RBI Currency and Finance Report, by October 1999, FII investments in the Indian stock market (by way of portfolio shares) aggregated Rs.32,391 crores; and this is treated as a highly positive development. The fact remains that as of today, all bullish and bear market pressures on the stock markets are almost entirely driven by FII activity. And, even though FIIs can suddenly withdraw only at considerable cost (to them), by way of both depressed share values and a depreciated exchange rate, as the Asian currency fluctuations over 1996-98 have shown, such potential dangers are always present.

To take another related issue: what precisely does the increase in the 'turnover ratio' on the stock market, from 34.4 per cent in 1994-95 to 178.3 per cent in 1998-99, indicate? It indicates increased investor interest and activity only in the secondary market, especially when seen in the context of the steep decline in the new capital raised (from the primary market) by non-government public limited companies from Rs.26,417 crores in 1994-95 to Rs.3,138 crores in 1997-98, which increased only marginal ly to Rs.5,015 crores in 1998-99 and to Rs.2,438 crores during April-October 1999 (or an annual rate of Rs.4,180 crores this fiscal year).

We are thus exchanging the shadow for the substance, erroneously treating a speculative boom in the 'secondary' market as a sign of strength, of development, even as primary market raisings of capital are declining steeply. One unfortunate effect of thes e developments is that an increasingly larger part of household savings is now deployed in the 'assets market' rather than deployed for new investments. In effect, savings so deployed take on the character of a 'hoard', and are thus lost for purposes of new investment. Ex-ante savings do not fructify as ex-post savings.

Finally, with daily cross-country flows of (short-term) capital now approximating $1,500 billion (let us repeat, daily), as given in the 1999 Human Development Report of the United Nations Development Programme (UNDP), the increasing financial integration of the Indian financial sector with the international financial market has grave potential danger for the economy in that it is increasingly becoming subject to the 'volatility' which is a characteristic of international finance ca pital.

Arun Ghosh has been associated with economic policymaking in India for more than two decades, including as a member of the Planning Commission.

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