The fifth estate

Foreign investors may achieve what the anti-corruption movement has not: forcing this runaway government to become accountable


By Mohan Sule

Foreign portfolio investment is a double-edged sword. For small investors, presence of foreign funds imparts assurance that the company is on the growth path and the transparency levels are high. The management also turns cautious, avoiding taking any step that would antagonize this class of investors. On the flip side, foreign investment pushes up valuations. Many times, events back home influence the decision of these investors to exit from stocks rather than any company-specific reason. They also create an invisible pressure for companies to set ambitious goals, which may not always be possible to attain. In such a case, the punishment is swift, with heavy withdrawals affecting sentiment towards the stock. Before the opening up of the economy early 1990s, LIC and UTI were the movers and shakers of the market and their misuse by government has been extensively documented. But even these state institutions are looking puny in terms of the sheer size and scale of foreign equity inflow into the Indian market. The presence of foreign investors has spread to mid-cap stocks, too. As a result, overseas investors exercise far more influence on the Indian market today than before liberalization. An offshoot has been the government’s diminishing power to influence the market by direct interventions. No doubt, budget, fiscal stimulus or policy rate cuts by the central bank do create an impact. Yet global events tend to overshadow them. The domestic market was affected by the liquidity crisis of September 2008, with the Reserve Bank of India scaling down the growth to 6% for 2009-10 from 8% in 2008-09.

The side-effects of the credit crunch were visible in markets around the world but India was particularly vulnerable because of the shallow retail investor base. Foreign investors are assumed to reward or shun companies that succeed or fail to operate in the environment created by the government. Some sectors and companies are favored or bear the brunt more than the others. A wholesale stampede to enter or exit, however, pivots around government policies rather than across-the-board performance of companies. In fact, correction is viewed as an opportunity to enter long-lusted stocks, thereby offering support to the market. Ramping up of interest rates to control inflation does induce selling and halts the bull-run but does not provoke panic reaction. Attempts to dictate the market by tightening control over inbound or outsource of foreign funds can. The Asian tigers, as these countries were fondly called for their explosive 8%-12% growth, became the target of foreign investors’ ire when Thailand in July 1997 allowed its currency to float to attract overseas funds to service its mounting foreign debt. On the other hand, Brazil in October 2009 announced a 2% tax on foreign purchases of fixed-income securities and stocks to prevent its economy from heating. Both measures resulted in flight of foreign capital. The Far Eastern countries lost the momentum they had acquired, subsequently ceding their hot-button status to emerging economies like China and India.

India seems to be facing similar problems. Once tipped to rival China, everything seems to be going wrong now: unmanageable inflation, ballooning expenditure, rising import bill. On top of this, the government annoyed foreign investors with retrospective amendment to tax capital gains on transfer of assets in India and by intending to bring those registered in tax haven Mauritius under the tax net. The rupee nose-dived as foreign investors decamped. The government had to roll back the implementation of the General Anti-Avoidance Rules for one year. The prime minister has decided to focus on infrastructure projects to boost foreign investment. But loosening government hold on the economy and creating a level-playing field to attract long-term foreign investors to help in creation of jobs would balance the negative impact of withdrawal of subsidies. Otherwise, the country has to face social unrest. Street riots forced Indonesia’s President Suharto to step down after 21 years in power a year after the currency turmoil in the region. Therefore, what the anti-corruption movement has not been able to achieve so far, foreign investors are likely to: putting the government on notice that it cannot play with the country’s finance to perpetuate its rule by plundering the nation’s treasure to hand out freebies. If that happens, the country’s sovereign rating is reduced, signaling flight of capital, debasing the nation’s currency, and leaving a big gap in the current account. Thus, foreign investors will be increasingly viewed as the fifth estate after the legislature, executive, judiciary and media, with their ability to force a runaway government to become responsible, thereby taking an important step towards stamping out corruption.

Mohan Sule

Three mistakes

Populism without reforms, failure of PSU divestment, and targeting foreign investors to mop up tax revenue


By Mohan Sule
The more things change, the more they remain the same. Rewind to Indira Gandhi’s Garibi Hato days of loan melas. A ‘foreign hand’ was blamed for the people’s wretched life under the Hindu Growth Rate. The remedy? Nationalisation of banks and increasing government say in running businesses, be it issuing licences for new capacity, determining bosses’ pay or releasing foreign exchange. Unwind to the present day of Sonia Gandhi’s loan write-offs, rural employment guarantee scheme, and the proposed food security bill. Inflation, slowing growth, and debasing of the rupee due to flight of foreign capital and costlier imports are attributed to the euro-zone crisis. After nearly eight years in power, the government notes that petrol is deregulated but forgets to add that it had abandoned the practice of fortnightly price revision, initiated by the NDA government, which resulted in small doses of ups and downs in retail prices. The bottom line is that the nation is paying a heavy price to keep the UPA II government afloat. Looking back, of the many mistakes that the Grand Old Party committed, three stand out. The first is acting on the insecurity that this might be the last chance it has got to govern. As a result, the party that was willing to let its government collapse on the US civilian nuclear deal was afraid of offending its partners on various issues including 51% FDI in multi-brand retail and 49% in insurance, removing the cap on voting rights in banks, and increasing railway tariffs. The land acquisition and mining bills are embedded with anti-business bias in terms of valuation and royalty payment.

The ripple effect of these short-sighted policies is being felt not only on investment in the power sector — problems in buying land to set up plants on one hand and in acquiring coal blocks on the other — but also in the manufacturing sector. In its second term, the Congress is already occupying the left-of-center space vacated by the Left parties, shedding off any pretense of being centrist. Initially, most of the posturing was with an eye to the Uttar Pradesh elections. Hence, the compulsion of coalition politics that Prime Minister Manmohan Singh has bandied about in justification of the scam in allotment of second-generation telecom spectrum in 2008. All these populist stances could have proved to be aberrations and corrected subsequently had the vigorous campaigning of Rahul Gandhi paid off. In fact, the strategy has boomeranged, with the party retaining its miserly seat total in the state and also facing the prospect of increasing dependence on regional satraps to form a government after the 2014 elections. The second error of judgment was the bet that PSU divestment would bail the government out from the fiscal mess caused by increase in spending on social schemes and subsidies to the oil and fertilizer sectors. The calculation was that PSUs would be attractive investment propositions due to their monopoly status. The first blow to the myth was in the form of lukewarm response to the ONGC follow-on offer due to the high price combined with the auction method implemented for the first time since its introduction.

The fact is foreign investors are wary of buying into a company that is sharing the subsidy burden of downstream refineries. The vocal opposition to the Central government’s direction to Coal India to sell its products cheaply to power plants is the beginning of the end of days when big-ticket foreign fund managers would meekly buy into PSU shares. With the divestment proceeds falling short of the target and non-plan expenses ballooning, the finance minister resorted to raising indirect taxes in the budget, contending that these were being restored to their pre-2009 stimulus level. This upward revision would have not caused a flutter if the economy were firmly on the growth path and inflation under control. In a slowing economy, the temptation of increasing taxes to compensate for the fall in revenue due to sluggish industrial activity is always strong. But this proves self-defeating as the move contributes to inflation and further slowdown in sales. Compounding the problem is the third mistake of amending the income tax laws retrospectively to tax capital gain arising to foreign entities on transaction of Indian assets and plugging the tax avoidance loophole exploited by foreign investors by registering in Mauritius. As has been time and again demonstrated, besides hard numbers, the market also runs on sentiment. And the perception is that the UPA government is unable to think out of the box and going back to the days when getting rich was looked at suspiciously and helping the poor meant handouts instead of inviting investments.

Mohan Sule

In search of a theme

Post the timid listing of Facebook, no sector is emerging as a forerunner to catch investors’ fancy

By Mohan Sule

The market runs on sentiments. During every cycle, it latches on to some theme to justify the expensive valuations assigned to certain sectors and companies. Late 1990s, eyeballs rather than cash-flows were used to determine the pricing of dotcom shares. The focus was firmly on India’s back-office tech support services industry following its contribution in the smooth transition to the new century, dispelling apprehension about the global economy coming to a halt due to the Y2K scare. Subsequent to the inability of the dotcoms to live up to the hype, public sector enterprises were the next fad as the NDA government set up a divestment ministry to dispose of these entities through offer for sale or strategic sale. In 2004, the UPA government, propped up by Left parties, promptly disbanded the ministry, signally the end of the PSU story. India, meantime, was discovering mobile telephony and investors were going giddy over the market size. The beginning of the bull phase mid 2003 also triggered real estate companies’ rush to enter the capital market. Forgetting the lessons of the dotcom bust, analysts were measuring land banks to justify the pricey offerings. DLF’s mega IPO and its inclusion in the Sensex left no doubt about the obsession of the market with companies constructing residential and commercial units. Armed with their cash-chests, property developers eyed telecom, hospitality, retail, and other unrelated ventures.

After being shunned for their loose supervision and practices during the securities scam of 1992, banks, particularly in the private space, came back in fashion as they aggressively expanded their balance sheets, lending to the real estate sector on one hand and catering to the needs of the growing middle class by liberally disbursing home and consumer loans and credit cards on the other. Following the opening up the sector to private investment as well as public-private partnership, infrastructure became the flavor of the season, with Reliance Power’s IPO becoming the largest issue in the primary market till then. The going was good, with the market awashed with unprecedented liquidity due to the US Federal Reserve’s loose money policy. The Sensex crossed 21,000, sometimes surging 1,000 points in a few trading sessions. The inflow of foreign investors boosted the Indian rupee to 45 a US dollar, which was considered its fair value. The strength of the currency emboldened many Indian promoters to borrow in foreign currencies and acquire overseas targets. In the euphoria, few noticed the cracks that had started appearing. The first was the drying up of liquidity in the US and Europe as house prices crashed and financial institutions with exposure to mortgage-backed securities discovered a big hole in their balance sheets. Lehman Brothers, the fourth largest investment bank in the US, went into bankruptcy in September 2008. The scam of allotting second-generation spectrum to cronies of the telecom minister at throwaway prices has turned the sector, battered by tariff wars, unattractive. The crash in the value of the rupee offers small solace to the IT sectors, whose margin is being squeezed by the slow recovery of the US economy. Even forays into Europe was not much of help as the region is grappling with the huge debt accumulated by some members.

Real estate companies are disposing non-core assets to stay liquid and so are retailers, touted as the next big emerging sector. Banks are confronting rising bad debts and trying to shrink the balance sheet as inflation caused by rising demand for food and inflow of foreign funds forced the Reserve Bank of India to raise interest rates. The additional provisioning of capital to adhere to new global standards will contribute to the sector’s volatility. Investment in private banks is hobbled due to cap on voting rights. The power sector is still to take off due to unavailability of coal and failing health of its key consumer, the distributor, comprising mainly the state electricity boards. PSUs are facing irate foreign shareholders for subsidizing products. On the flip side, the listless market is putting off the government from pursuing an aggressive divestment program. Even large caps are not offering any solace. RIL and the government are engaged in a tussle to determine whether the falling output of gas from the company’s offshore blocks is due to miscalculation or deliberate. For a time, tech companies seemed poised for a comeback. But the post-listing performance of discount web site Groupon, business networker LinkedIn, and particularly of social interactive platform Facebook’s US$104-billion IPO last fortnight appears to have put a premature end to the story. If there is a theme at all for the market today it seems to be pizza chains. No wonder the finance minister has offered tax relief for preventive medical check-ups

Mohan Sule