Monday, June 18, 2012

Auditors and policy populism

Official auditors in India appear to have been bitten by the discounted cash flow (DCF) analysis bug. Ever since the news of the Rs 1,76,000 Cr loss causing 2G spectrum scandal broke out, auditors have realized the populist appeal of such assessments. The temptation to scrutinize every resource allotment decision exclusively through the lens of expected future cash flows is irresistible.

This auditing formula is simple. Scarce and valuable revenue generating public resources have been allocated on preferential basis at concessional rates, allegedly in return for massive amounts of bribes. These resources, when subjected to standard DCF analysis, are estimated to have benefited the private allottees with massive revenues (and profits) running into several decades. The net present value (NPV) of these future cash flows is calculated at the current market price of the resource. The allotment price is deducted from the NPV and the difference is declared as revenues foregone and resultant loss caused to public exchequer.    

The latest in the series of such auditor discovered scams is the development rights of the New Delhi airport allotted on concessional terms. The Comptroller and Auditor-General (CAG) claims that Delhi International Airport Ltd (DIAL) could earn up to Rs1,636 tr ($29bn) over 60 years from using government land leased at an annual ground rent of just Rs 100, on top of a one-time payment of $ 324m.

Auditors who put such valuations at the center of their exercise risk simplifying very complex business problems. Even assuming such auditing reports (any audit is after all based on certain assumptions and formulas), it is surely irresponsible for responsible people analyzing these reports to take such assessment at face value to the near total exclusion of all other factors. If the mainstream debate on complex and multi-dimensional policy issues is driven by such DCF-based revenues foregone assessments, policy populism and decision paralysis become inevitable.     

In recent months, there have been three high-profile instances of policy populism in very important areas. First was the draft mining bill, second the land acquisition bill, and the last related to the revised 2G spectrum auction process.

Mineral exploration and extraction has been the subject of intense scrutiny due to both the corruption involved and its environmental and social costs. In the prevailing discretionary, first-come-first-serve basis mining block allotment regime, price discovery was always a problem. The lack of clear policy regime and uncertainty associated with environmental and other clearances made this a very risky activity for prospective developers. In addition, since most of these mines are in the remote forests and interior parts, such mining activity invariably affects the lifestyles and livelihoods of tribals and other indigenous people. The sensational CAG report which alleged a $210 bn scam in preferential mine allotments and widespread environmental and local opposition to mining activity in any area drove the government into formulating a new mining policy. 

Under the proposed Mines and Mineral Development and Regulation (MMDR) Bill, 2011, it would be mandatory for coal mining companies to share 26% of their profits with people displaced by mining activities. In case of non-coal mines, the new law will provide for payment of an amount equivalent to royalty paid to the state government to project-affected persons. Apart from this, it also obligates mining firms to pay a 10% cess to state governments and 2.5% to the Centre on the total royalty paid.

It was, as part of this populist drive, that the government announced the "no-go" areas policy in mid-2010, which barred mining in many major coal bearing areas on environmental grounds. The move blocked the development of 203 coal blocks with reserves of a 660 mt – enough to fire a power generation capacity of 130,000 MW. Though this has been done away with, the Environment Ministry is now working on demarcating "inviolate areas" where mining will be prohibited due to high forest cover.

A few high profile cases of forcible land acquisition by government to build public infrastructure assets or to benefit private parties, like with the Special Economic Zones or Singur or Nandigram, saw a series of often violent protests by land losers in many parts of the country.The fundamental political rallying point was that it was plain unfair for the government to use its eminent domain powers to dispossess rural poor from their primary livelihood source, land, in the name of development. There was a clamour to replace the century-old Land Acquisition Act 1894, which in any case had other stifling provisions.

In response the Union Government drafted a land acquisition bill that swerved to the other extreme. Its provisions include payment of compensation that is four times the highest registered sale price in the last three years in that area, mandatory consent of 80% of people in those cases of acquisition where the land is to be given to private parties, those made "landless" to get Rs 2000 per month for 20 years, emergency acquisition clause to be invoked only when security of the people is involved, and so on. The recommendations of the Parliamentary Standing Committee includes the payment of five times the market price of land acquired, returning 20 per cent developed land to the owner, job guarantee for next 20 years, and 70 per cent consent of land owners for any acquisition for commercial purposes.

The Land Acquisition, Rehabilitation and Resettlement Bill 2011 (LARR) is currently awaiting parliamentary nod before being promulgated into law. And even this fairly generous bill is being rubbished as being too little. Even a cursory reading would indicate that the draft bill goes much beyond the basic requirement of fairness in compensation and relief and rehabilitation package, and clarity in the definition of "public purpose".

In response to the Supreme Court's decision in February 2012 to cancel the 122 2G spectrum licenses, the government initiated the process to auction spectrum through competitive bids. The telecoms bureaucracy was then asked to fix the auction reserve price and other bid parameters. It was also decided that the spectrum would be technology-neutral, thereby allowing bidders to provide 2G, 3G, or even 4G services with the spectrum. Accordingly, the Telecom regulatory Authority of India (TRAI) recommended a reserve price of Rs 3,622 crore for 1 MHz pan-India spectrum, which is around 10 times higher than the price at which 2G licences were allocated in 2008.

Not to be outdone, while scrutinizing the TRAI proposal, the Department of Telecom (DoT) went one step further and hiked the reserve price by a further 17% to Rs 4,245 crore per unit. It also rejected the TRAI's proposal to allow telcos to stagger payments for spectrum over a 12-year period and the permission for telcos to mortgage spectrum to raise funds from financial institutions. The clarification by DoT officials on the rationale for the price fixation was revealing,
TRAI had determined the reserve price in the 1800 MHz band based on the 3G auction price of 2010. We feel that 3G auction price must be indexed for a period of two years to determine the present value of spectrum. During this period, State Bank of India's PLR rates have been between 11.75-14.75% and therefore the revised figure works out to Rs 4,245 crore for every unit of 2G spectrum in the 1800 MHz band.
Consider this. There is already enough evidence that the telecos over-paid during the 3G auctions and therefore a more efficient spectrum price should be lower. Instead, the DoT does a simple linear extrapolation of prices on the auction price, and that too based on the prevailing bank lending rates. Furthermore, influential sections within the government view such auctions as a convenient and costless way to raise resources to bridge fiscal gaps.

There are three concerns with such populism. One, when eye-popping figures like Rs 1,760 trillion or Rs 1,636 trillion are so casually bandied about, it does tend to focus attention on the sensational issue of bringing those responsible to light while glossing over the more important task of systemic changes that can sustainably prevent the recurrence of such scams. This is clearly evident in the aftermath of the 2G spectrum scandal when the focus was on implicating and punishing those accused. A great opportunity to put in place effective mechanisms to manage allotments of public resources has been missed.

Two, such highly simplistic assessment of loss caused to public exchequer based on DCF analysis of revenue flows, priced at prevailing market prices, immediately puts public servants on their guard. It completely divorces all other practical real world problems, challenges, and risks in such business decisions and encourages public officials to avoid pricing them into contracts. The result is still-born markets and contracts, and possibly even more corruption.

Three, they tend to mix often conflicting priorities. The primary objective of the mining and telecom bills ought to be the regulation of two critical sectors, so as to eliminate policy uncertainties and enable their efficient development. However, influential sections within the government tend to view them as excellent resource mobilization opportunities that can bridge the government's fiscal imbalances. Alternatively, they are also viewed as opportunities to expand the government's social programmes, like in case of the mining bill to the huge tribal belts of the country and generate funds for local development in such areas.  

It is obvious that such mechanistic, but procedurally safe, and financial returns maximizing, decision-making on such important policy issues is the inevitable result of the extreme vitiation of the political and bureaucratic environment in the aftermath of the spate of recent resource allocation scams. It cannot be denied that these revelations have provided the much needed wake-up call to begin cleansing public life off corrupt practices that had spiralled out of control.

However, its collateral damage has severely debilitated the policy making apparatus. It has induced a form of decision-paralysis and play-safe attitude among officials and even political representatives at all levels. The biggest casualty in the process is likely to be economic growth in general, and the development of these sectors in particular.


KP said...

Dear Gulzar,

Your column takes a nuanced position between bureaucratically defined efficiency and the pragmatic response to market reality that needs to be bridged by politicians.

However, interpreted narrowly it may add to the current chorus among politicians to lay the blame for 'policy paralysis' at the door of the CAG.

Recently a senior minister of the GOI has blamed the choice of the CAG, and held the person responsible for the 'paralysis'.

We can clearly see a pattern where the commons is sold-off cheap and then immediately re-sold at a large financial gain - clearly a political and bureaucratic nexus with unscruplous players.

There is strong reason to believe that this paralysis could be strategic - waiting out time till the current focus on corruption and governance is diluted.

While an audiors note is subject to (further) interpretation - windfall gains with no value addition clearly points to a corrupt dispensation - and while the legal strength of these observations are being argued in courts (through corruption cases, establishing a quid pro quo), to a layman whats going on is quite obvious.

(contnued in part 2)

regards, KP

KP said...


If it is the case that politicians and bureaucrats are being victimized for no fault of theirs other than attempting to maximize public good - then I think there is sufficient space for a politician / bureaucrat to step up and make the case.

I found an interesting view of 'policy paralysis' recently, which is closer to how I personally feel.

"If the Competition Commission continues its crusade against abuse of dominant positions by market leaders in industries from real estate to cement to sugar to LPG cylinders, this should help improve economic efficiency. If the CAG continues its practice of scrutinising public spending and regulatory decisions in the manner that it has over the past two years, it will revolutionise the way the Indian Government works. Without such interventions from well meaning regulators and from a powerful judiciary, India could go the way of numerous “banana republics” in Latin America and Africa."

Our treatment of tribals and indigenous people - outside the radar of the urban midde class / elite has been less than commendable - and the belief that poor compensation / eviction / resettlement without the slightest concern for their well being is the acceptable cost of development has never been challenged, like it is being now. That may explain the shift in policies being advocated (on paper) - it is a response to militant activism and has exposed our huge democratic failing.

Why the entire Indian economy is paralysed because of disallowing FDI in retail, beats me.

Why an honest bureaucrat feels victimized is not so apparent to me, not in the way it is being connected to 'good' decision making. We are not running kangaroo courts, If anything the inability to efficiently prosecute corrupt pols and bureaucrats is the systemic issue.

Why a politician feels stymied by having to be pragmatic - is not evident.

Policy populism has always been our weakness, but while that may explain part of the problem - letting private players arbitrage off the commons with no value addition is also not the solution to ramping up investor interest.

Why reforms as articulated by politicians is always about FDI ( and in retail) and never about governance is the bigger question.

From an LSE, IDEAS report on Corruption in India

"First, the state needs to address the substantial legislative failings surrounding the pursuit of judicial and political corruption, which presently grant public officials inexplicable immunity from prosecution in a bewildering array of contexts"

Or as The Economist stated in "Farewell to Incredible India"

"...two deeper political problems. First, the state machine has still not been modernised. It is neither capable of overcoming red tape and vested interests nor keen to relax its grip over the bits of the economy it still controls. The things that do work in India—a corruption-busting supreme court, the leading IT firms, a scheme to give electronic identities to all—are often independent of, or bypass, the decrepit state....Second, as the bureaucracy has degenerated, politics has fragmented."

I see institutions like the CAG forcing a 'decrepit state' to confront its findings, not through the politics of demagoguery or appealing to emotion alone - but by building its credibility using its poitical capital wisely ( and should I add with integrity).

If there is any larger crisis - it is one of political credibility across the board.
regards, KP.

gulzar said...

Thanks KP for those remarks. I agree with many of the points raised. I do agree with the need to squarely address the emergence of crony capitalism in allotment of public resources. but i do not believe that simplistic audit based assessments, which almost completely exclude all other factors, is the way to address that problem.

the reference in the quote to the manner in which 2G spectrum prices were fixed betrays the play-safe policy-making attitude which is increasingly prevalent in Delhi and state capitals.

we need to realize that any major policy decision is a judgement call, which invariably involves benefiting some group or businesses. this is all the more so when such decisions involve policies relating to sunrise sectors and path-breaking initiatives. there are strong risks associated with such decisions, both by way of failures and successes (disproportionate private gains). in government such policies are invariably initiated by some bureaucrat, widely discussed, and then decided upon. given the mechanistic DCF-based assessments of a populist (and this is the problem) auditor and the presumption of being immediately branded as having sold out to private interests, it is no surprise that even honest and proactive bureaucrats are thinking twice before putting their judgement calls on files.

and in sectors like infrastructure, involving policies to attract private investments, the risks of judgement calls which do not pass the "populist auditor and media trial" test are considerable.

and i am not speculating here. I am only reflecting widespread similar sentiments across the bureacratic spectrum in delhi and states.

Anonymous said...

First, I would like to thank KP for those comments on Gulzar's post. I am sure most independent public would feel the same that the increased public scrutiny and responsibility are hardly too constraining to paralyze the political and bureaucratic decision making process.

Also, it is hard to believe that in the current system, well-thinking bureaucrats have the independence and latitude to offer optimal solutions to business problems that balance public good and private profit. From my own observations in relation to the state of AP, it is obvious that ruling politicians have the first and final say in most policy making processes. Take the case of most recent revised liquor policy that has shifted from auctioning to lottery. In both the cases, the interests of liquor mafia (the political and low-level bureaucratic nexus) are well protected at the cost of public welfare and windfall gains to a few.

DCF models offer good metrics of PV in a transparent fashion. Though the policy makers are not required to see scarce public resources as sources of govt revenues, the quantification of commercial value of projects that utilize public resources can provide a reasonable basis for resource pricing that balances private and public interest. In cases where a substantial leeway was given to certain private parties, a quantified value of intangible/indirect public benefits of such decisions can come in handy in substantiating such decisions.

atul said...

gulzar... food for thoughts... yes there are many things ..we discussed in Hyderabad during training also ... mental castration of beaurocrat by politicians, over enthusiastic \ngos, malign seniors and dubious social activists hv come together .... \india need freedom again