India's problem of crony capitalism
The rise of modern capitalism in India in the 1990s was at first
viewed in optimistic terms. A new breed of companies were born, who
seemed to exhibit a new kind of competence, international
competitiveness and high ethical standards. We could start putting our
old mistrust of corrupt business houses behind us.
These hopes were substantially dashed by the fresh emergence of
crony capitalism. Doing business in many areas in India involves an
extensive interface with the government. In these areas, the
weaknesses of the State generated an opportunity for crooks. At first,
the financial system sent massive resources into dubious companies,
with an attitude of being blind to anything but profits. When these
companies controlled vast resources, and were shown the promise of
even bigger valuations to come, they embarked on systematically
undermining the State. Through this, we got a feedback loop: The
crooks came up where the State was weak, and their activities further
undermined the State.
In some cases, we saw rotten companies spring up in one part of the
economy where the State was weak, and once these companies were up and
running, they turned their attention to related fields and devoted
themselves to undermining State institutions in related
fields. Through this, the gangrene spread from one area to the
next.
In the the early 1990s, we could hope that India would smoothly
moving up to the ranks of middle income countries, powered by world
class local companies in addition to global companies building
operations here. These hopes have substantially receded. The heart of
the Indian story is now about the feedback loop between rotten
companies and the State. If we manage to bootstrap ourselves out of
this, we have a bright future. But will be be able to bootstrap
ourselves out of this? Many countries got mired in this
`middle
income trap': we shouldn't assume that our destiny is rosy.
At first blush, stopping the rotten companies seems
infeasible. These are typically efficient and competent firms in a day
to day tactical sense. They are staffed with hard-driving amoral
people (typically incentivised very strongly using high-powered
incentives), who fully understand the weaknesses of the system and
attack it. Considerable resources are invested into subverting
politicians, bureaucrats, judges and the media. The Indian system is
rotten and ripe for attack. It's like computer criminals attacking
Microsoft Windows. Resistance is futile. Indian capitalism is
doomed.
There is, however, an array of homeostatic forces in place which
are generating push back. Some crooked companies have faced
enforcement actions by arms of the State. In some cases, India has had
good
discussions in the public domain which has generated checks and
balances. In addition, while many people are devoid of ethics and
will support the latest nouveau riche entrepreneur who is
throwing cash around, a large number of people get revulsed by the
sight of this, and quietly and doggedly refuse to cooperate.
Enforcement in India does not work perfectly. The key point of this
blog post is that medium grade enforcement has far reaching
implications. The key insight is to look at the way the goals of
labour and capital (i.e. investors and employees) are reshaped by
medium grade enforcement.
The perspective of the investor
The enforcement push back against rotten firms is yielding
results. Many crooked companies have grossly underperformed the
index. Some have experienced enforcement actions and have experienced
jaw-dropping returns. Some have experienced dogged opposition from
pockets of high ethics in the system, which have effectively led to
systematic and sustained under-performance of the index over five- and
ten-year periods. The stock market has become wary about ethical
issues. As Shekhar Gupta
says in
the Indian Express yesterday:
If you draw a simple chart of the large companies that have lost the most value on the stock markets over the past three years, you'd notice that almost all of these were doing business on the same cusp of politics, finance and natural resources. To that extent, you have to admit that the market has been the first to sense the rot and has applied a stunning self-correction, severely punishing those responsible for it.
There was a time when investors used to be oblivious about ethical
standards of portfolio companies. The attitude of the investor in the
1990s used to be I don't want to know how you do business; I will
hold my nose since you stink; but as long as you will produce returns,
I will happily invest in you. This attitude has been thoroughly
broken. The investors who pursued such strategies have often been
devastated. Even if you have only 10% invested in a crooked company,
if you get -80% returns on it, this generates a -800 basis point
returns drag on your overall portfolio performance. As a consequence,
portfolio managers have started caring about the ethical standards of
portfolio companies.
Enforcement does not have to be 100% perfect for it to impact on
the decision making of investors. Even if there is only a 10% chance
of getting caught and thus getting -80% returns, that is a big risk
from the viewpoint of the investor. From the viewpoint of the
investor: Why take the risk? Why not make a thorough analysis of the
ethical standards of a company one element of the security selection
process?
The problem of freedom of speech
Journalism is printing
what someone else does
not want printed.
Everything else is public relations.
-- George Orwell.
India is supposed to be a liberal democracy, and a free press is
supposed to write vigorously about misdeeds (
and large, this has not worked out as it was meant to be. On one hand,
it is quite easy for the bad guys to corrupt the media. Whether this
is done through gifts of shares to a media company, or through
advertising and sponsorship, it is fairly easy to obtain a supportive
media. In addition, defamation is a criminal offence in India: a
legacy of colonial law that we have not yet been bright enough to
undo. Putting these together, the bad guys have a nice combination of
carrot (throwing money at the media) and stick (litigation).
Analysts and financial intermediaries are supposed to make a living
out of spotting problems in firms. Here also, there is quite a bit of
corruption which impedes speaking freely. Few are willing to go
against the latest nouveau riche entrepreneur who is throwing
cash around, including his efforts
at buying
respectability. The mainstream strategy is to participate in the
gravy train, and look for ways to part the fool and his money.
This is a real shame: India should be much better than China in the
role of freedom of speech acting as a check against
corporations. However, the Indian media has largely caved in the
face of carrot and stick: it is largely doing public relations.
At the same time, there is strong demand among investors for skills
in identifying the crooks, given that this is an important investment
fundamental. The problems of the conventional media and financial
firms, which inhibit naming the crooks openly and in the public
domain, has created a business opportunity in this space. Supply has
come up to fill this demand; a new breed of companies has come up,
reflecting this need. Examples of firms with these capabilities
include Ambit
Capital, Veritas Investment
Research, Forensic Asia,
and Espirito Santo. Numerous investors are building in this analysis
into their portfolio process, and this is helping to channel capital
away from dubious companies.
Foreign firms seem to be more prominent in this field of research
and analysis from the viewpoint of ethical standards, because they are
relatively immune to the problems of intimidation through courts and
police in India, and because they are relatively cutoff from the
reciprocity that binds everyone in the world of business in India. See
report on Indiabulls has put in contrast the research by India-based
analysts in the Economic Times by Uday
Khandeparkar. But even they are
immune to the problems of the Indian legal system. Now we have a
new investment tool: sell shares of the companies that embark on such
litigation.
The weaknesses of freedom of speech in India have thus emphasised a
greater role for information processing and analysis away from Indian
shores. I am reminded of what is going on in China, where some of the
most important short sellers who are bringing out the misdeeds of
Chinese companies are located abroad: it's too dangerous to do the
same things within China. We in India are evolving towards a similar
structure of information processing.
The perspective of the employee
In the modern world, a vital determinant of the success of an
enterprise is the kind of people it is able to attract. Here also, at
first, there was a relatively amoral attitude on the part of most
young people: I don't want to know how you do business; I will hold
my nose since you stink; but as long as you offer me the highest wage,
I will join you. But over the years, it has been demonstrated that
this is a bad strategy:
- The sight of senior employees going into Tihar Jail has given out
powerful messages to everyone in Indian companies that good people
should not hang out with crooks. - The second phenomenon is reputational damage. It makes business
sense for an individual
to engage
in fair play. I have been in recruitment conversations where a
person is being discussed but his name gets shot down as he has not
been careful about the company that he keeps. Birds of a feather flock
together. I recently heard a senior person say: ``I knew XXX was a
rotten firm when a bunch of corrupt people from SEBI joined
it''. Low ethical standards in people and in firms go together; a
cloud of mistrust envelops them. - Gradually, as regulators develop and refine the doctrine of `fit
and proper' such people will increasingly suffer career damage. We
aren't fully there in Indian finance yet, but it will increasingly be
the case that a name is shot down for a CEO position because he was
part of a team that was caught doing nasty things by SEBI or RBI. - These factors are particularly important for the best and the
brightest. If you are the best and the brightest, why would you suffer
even epsilon risk of going to jail? Why would you run with crooks if
this could hamper your rise to CEO? Why would you suffer reputational
damage, and not be able to hold your head high at your class
reunion?
These factors are inhibiting the flow of talent to dubious
companies. I know of several situations where a person was made an
offer, and chatted about this with his friends, and turned it down. It
was just too much of a risk to be seen in the wrong company.
Second rate people recruit third rate people. Once a firm is
contaminated with a series of low grade staff at senior levels, it
becomes increasingly hard to draw in top quality talent, which drags
down capabilities all across the board.
I believe this is one of the factors which has generated systematic
under-performance in the stock price of dubious companies. It isn't
just the case that they are in danger of enforcement actions. It is
also the case that on an every day basis, they find it harder to
operate well given that they generally fail to recruit as well as
their competitors.
How might Indian capitalism develop?
If the crooks had thundered ahead producing super-normal stock
market returns, and attracting the best talent, I would have been
truly gloomy. What is fascinating about the Indian story is that
things have worked out differently. Some dubious companies have
cratered with -80% returns over short periods. Others have generated
substantial under-performance when compared with the index over 5- and
10-year horizons. The best people are avoiding rotten
companies. Putting these together, the bad guys are finding it
difficult to obtain both capital and labour, which are seeking out
better firms.
Wall Street tells Main Street what to do. At a time when the
investors did not care about ethical standards of portfolio companies,
and only asked for earnings growth, this sent out powerful signals
into the economy (a) Favouring rotten firms and (b) Encouraging rotten
entrepreneurs to setup firms so as to harvest the opportunities
available by selling shares. We got a precipitous collapse of ethical
standards in India in the last decade in India, partly because that is
what a financial system that was oblivious to ethical standards was
encouraging. Some of the most rotten companies rose to the top. Now
that the investors and the employees are seeing things differently,
this is sending out signals into the economy (a) Favouring healthy
firms and (b) Encouraging healthy entrepreneurs to setup firms so as
to harvest the opportunities available by selling shares. We will also
see some chameleons turn a new leaf: You will see the oddest of
characters preaching purity.
Vishal Kampani pointed out a remarkable fact to me: Some of the
biggest successes of the last decade have been the old `Bombay Club'
companies. All too often, they have outperformed when compared with
the hard-driving unethical nouveau riche entrepreneur. What is
going on? I would conjecture that there is a survivorship bias. A
large number of different strands of corporate DNA compete. Over the
long run, the survivors are those where elements of policy and
strategy are of a certain kind. The old rich of the `Bombay Club' are
not paragons of virtue, but they have developed certain good practices
which are conducive to survival and stock market returns.
I am reminded of the mighty German Wehrmacht in the Second World
War. At the level of tactics and operations, it was second to none. In
the short run, it generated the most amazing achievements in
battle. After the campaigns from September 1939 till December 1941,
many contemporary observers thought that Germany was unstoppable. But
at the same time, Germany was making profound mistakes at the levels
of strategy and policy. No amount of operational art could overcome
those fundamental mistakes in strategy and policy.
In similar fashion, we tend to get very impressed by the
hard-driving take-no-prisoners nouveau riche entrepreneurs and
their hypercharged sidekicks. Their dynamism and willingness to play
dirty seems to be unstoppable, particularly given the weaknesses of
politicians, bureaucrats, judges and media in India. But it appears
that in India, these strengths in tactics and operations have often
been unable to overcome fundamental mistakes in strategy and
policy. Indian capitalism is not doomed.
0 comments:
Post a Comment