## Friday, September 07, 2012

### 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 (link). By 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 Veritas' report on Indiabulls has put in contrast the research by India-based analysts in the Economic Times by Uday Khandeparkar. But even they are not 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.

1. You shud go ahead and name the dubious companies.Having worked in the Indian market you have got it wrong that Bombay club has any ethics.They have decided what the rules of the game are.Fairplay allows new players to emerge.Until the time who you know matters in getting jobs(senior) and mistakes are not allowed(risk taking) we will continue to be copycats and not produce a single notable consumer global brand.This problem is so acute that I cannot think of even one company's single risk taking decision(in Bombay,it does happen in IT/BPO/KPO in B'lore) in the last ten years even at junior levels and yes Nano was a big failure & not innovative enuf.

You are correct to an extent about self correcting mechanisms of market to weed out crooks but its right now weeding out out and out criminals not crooks.We havent yet mentioned the rigged nature of stock market or tamasha of P-notes and real estate mess.

No,I ask you to think again;dont just pick out one or two things from here and there and paint a rosy picture.We are in deep shit and not getting out of it anytime soon.

2. CJI of Apex Court verdicts in Curative Petition for Bhopal Gas Victims and Vodafone Tax Appeal to the tune of Rs. 11000 cr. tax evasion were rejected favouring foreign firms weded to capitalism against Constitutional mandate in 42nd Constitution Amendment in Preamble- "socialist and secular" republic of India

3. While I agree with all that you have stated, I have a problem with Shekhar Gupta's claim, that the market has applied a stunning self-correction. That this implies some semblance of ethics imposed on these firms is at best a partial view. If ethics were to be a theme investors are concerned with, investments in these notorious firms would not have happened in the first place. If the coal blocks were allocated to firms and the markets thought this was unethically won, they would have dumped these stocks right then.

A better argument to my mind is that the market perceived threat to these firms in this environment and saw that their investment is at stake. I'm not suggesting that there was no learning; yes, firms in the future will hopefully be concerned as markets did punish bad behaviour thoroughly. This punishment will be repeatedly witnessed only when the balancing forces in a democracy are seen to be working.

I'd rather think that this is the channel than claim an invisible force that is far removed from the pulls and pressures of a democracy.

4. Would like to comment on some of your statements: Part 1/2
“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”
It is easy to blame the capitalists for being crooks but the fact is it is almost impossible to do business otherwise. So they have 2 options – either bribe their way around or don’t do any business. The business community would mostly prefer the latter – including the old ‘Bombay Boys’ . I’m not arguing whether that is the correct way but it is a way of life. Focus should be on handing out exemplary punishment to the Government officials and companies involved rather than blaming crony capitalism.
“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.”
I agree that a big reason for the above is greed but to a certain extent these people don’t have an option because, as I said above, certain industries and sectors there is no honest way of doing business and often people don’t have an easy option to get out of the sector due to professional and personal reasons. For example, a coal mining engineer ought to work in coal mining company even if it is scam-tainted rather than becoming a programmer in Infosys!
“Some crooked companies have faced enforcement actions by arms of the State.”
It is true but somehow these actions have been slow and ineffective. Most of the decisions take years to come and often to not cause great harm to the crooked companies – possibly due to control of these companies over their bosses Believe me, if the enforcement agencies (CBI, IT, ED, police, etc) are effective half of India’s problems would be solved. Unfortunately, there is rampant corruption within these entities which allow these crony companies to get away.
“Shekhar Gupta’s quote: 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.”
To believe that investors care about honesty and governance is foolhardy. They still have the 90s mindset “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.” It is just that these companies, through enforcement push or not, have failed to deliver expected profits – immediate and future. The investors will happily return if they see visibility on profits.
“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.”
You forget to mention the upside. If there is 90% chance of a reasonable upside, most people will buy. It is simply a risk-return calculation.
“Putting these together, the bad guys have a nice combination of carrot (throwing money at the media) and stick (litigation).”
While this is true the prevalence has surely declined in the last couple of years. It is difficult to find a business house which has not been criticised by the media. Post-Anna, hammering business houses and the government has become a favourite past time of the media and they seem to spare no one – even at the expense of carrots and sticks.

“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”
Very true. Definitely need research firms like Veritas.
“Foreign firms seem to be more prominent in this field of research and analysis from the viewpoint of ethical standards”
Not correct. Look at Facebook IPO for reference. Investment banks work solely to make money for themselves. Period.

5. Part 2/2
“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”
Unfortunately, this is still not true. Most people – young or old – still bill in the paradigm - 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.The only change would in their attitude of unwillingness to do something which could land them in Tihar
“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?”
The above statements are exaggerated. While it may be true that some of the companies have crooks. But not all employees in these companies are crooks. Infact, the companies you are alluding to have, unfortunately, the best brains in the industry. Working with them can fast track the career prospects of bright individuals. It again boils down to the risk-reward proposition – similar to the stock price situation.
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.
For every such person, there could be many persons who still join these companies.
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.
You seem to equate low moral value with low grade (professional quality?). I think that most of these crony capitalists would have, professionally, extremely high quality senior management executives. Infact, because of their money power, they are able to buy-out, top notch professionals.
To summarize, I’d say the following
1. There is too much corruption in the government – country has to choose between rotten entrepreneurs or no entrepreneurs.
2. It’ll be better to mend the politicians, bureaucrats, judges and media before targeting the capitalists – they at least contribute to the growth of the economy
3. Investors and employees still retain old habits – don’t care as they themselves are not affected

6. Optimistic post, but tough to agree.
On crony capitalism the 2G and the Coal scandals highlight the fact that it is well and perverse. The 'good practices' of the old rich are available for full display - tata and reliance have had big advantages. The fact is that Bombay club closed ranks and controlled the process/govt and therefore are the beneficiaries. Reforms should have thrown up many more standalone cos.

No, the supply of research on the companies is pathetic. Veritas is the only one and the firm and it's employees are not domiciled in india. Please do analyze the research reports of Ambit!!

About employees, all the data points are anecdotal and hearsay. 'Smart' people are happy to work for all the corporate houses named in various scams.

Indian capitalism is crony and has got worse in the last 8 years

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