Monday, March 16, 2015

Bureaucrats in business: The tension between rule of law and commercial considerations

by Anirudh Burman, Shubho Roy, Ajay Shah.

How to achieve high performance in government

In government, the route to performance lies in clarity of objectives and accountability mechanisms, grounded in the rule of law. Every transaction undertaken by a government must be grounded in a written down process, must treat all legal persons equally (Article 14 of the Constitution), must go through due process, must be open to questioning later on. All persons must have full documentation about how the government will behave under various circumstances, must be given documentation about how their transaction was processed, and explained why. Coercive actions of the State must be subject to judicial review. Purchases must be made through General Financial Rules (GFR).

How to achieve high performance in business

These bureaucratic processes have no place in the world of business.

For a firm, counterparties have no Article 14 rights. A manager must choose to give a contract to vendor A or vendor B based on an overall sense of how this will work out. The manager is not obliged to give a reasoned order or even to treat vendors equally.

In finance, private persons choose to buy equity or debt by exercising their own judgment. There is no obligation to have due process or to face audits that question commercial decisions.

This gun-slinging exercise of discretion works because the competitive market sorts it all out. Firms are kept on their toes by the accountability mechanism of the market. Firms get high speed feedback from the market about how they are faring. Good decisions yield improved profits and improved stock prices, and vice versa.

Phase I of India's journey

When Indian socialism was being constructed, the government wanted to be in business. There is a fundamental contradiction between the decision processes that are required in business when compared with the rule of law.

The solution adopted was to sacrifice the rule of law. All across the Indian state, we got politicians and bureaucrats wielding arbitrary power. The construction of Indian socialism damaged India's institutional capital.

Phase II of India's journey

In recent years, the tide has turned decisively. The Constitution of India is asserting itself. We are building the rule of law, we are restoring the institutional capital. You can no longer fudge the process for allocation of spectrum or coal mines. The old clubby ways are being stripped away, all across government.

Some people continue to yearn for the bad old days when a bureaucrat wielded unchecked power, but those days are safely behind us. As an example, see: CAG asks why Air India sold five Boeing 777s at loss to Etihad in 2013 by Mihir Mishra in today's Economic Times.

This great push towards the rule of law has one important implication: the push for the rule of law makes it  harder for the government to do business.

In the olden days, a public sector company could exercise discretion, and participate in the world of business, because the rule of law in India was in tatters. Now that India is pushing back into rebuilding the rule of law, this makes life difficult for the parts of government that are engaged in commercial activities.

On an international scale, we generally see that in countries with strong rule of law, we don't see public sector companies. The intuition that has been offered, in the past, is that there is a deeper thing called `good institutions'; in countries with good institutions, we see the rule of law and we see the absence of public sector companies. Conversely, when there is low institutional quality, we see failures on the rule of law and we see the phenomenon of public sector companies.

The main argument of this article is that there is another causal connection in the picture. A country that sets out to have public sector companies will damage the rule of law, and a country that sets out to strengthen the rule of law will damage public sector companies. Perhaps countries with strong rule of law lack public sector companies as those rule of law strictures have interfered with their functioning.

Implications for public sector companies e.g. public sector banks

In the best of times, it is difficult for bureaucrats to be in business. All over the world, there is ample evidence that government ownership of business hampers productivity. Layered on top of this is this new twist. Earlier, a bank in India could exercise more arbitrary power in trading securities, giving loans, restructuring bad loans, etc. But once public sector banks come under the full strictures of the rule of law, this becomes harder. India's drive towards the rule of law is detrimental to the concept of a public sector company that is owned by the government but engages in commercial activities.

We repeatedly hear public sector bankers complain that it's impossible to do the business of banking when placed under the myriad accountability mechanisms of the government. Their solution is that the rule of law is optional, that banks should be exempted from these requirements even when banks are owned by the government. We suggest that the solution lies in government getting out of banking.

Where is the line drawn, where a public sector company is the State?

Article 12 of the Constitution says: In this part, unless the context otherwise requires, the State includes the Government and Parliament of India and the Government and the Legislature of each of
the States and all local or other authorities within the territory of India or under the control of the Government of India.

This is important because Part III (fundamental rights) can be claimed against the State, such as equal treatment, non-discrimination, etc.

Here the word `includes' implies that this is not an exhaustive definition. The courts have developed tests to determine what `other authorities' means. The key case is Ajay Hasia. These questions turn on the issues of control and financing: (a) the degree of government control over the administration of the authority, (b) the degree of funding/ grants made to the authority, (c) power to appoint/ remove officials, etc. Based on these criteria, various kinds of entities such as public sector companies, educational institutions that receive government money, etc., have been termed state.

When the government owns less than 50% of a commercial enterprise, that organisation is generally not classified as State. However, evidence of pervasive control in such cases may lead to a judicial
determination that the entity is "state" under Article 12. For statutory monopolies or organisations with pervasive State control, even going below 50% ownership does not elude classification as State. In the case of R.D.Shetty v. International Airport Authority of India the Supreme Court stated that an entity such as the International Airports Authority could not act arbitrarily, but was subject to constitutional requirements.

It stated that, ...power or discretion of the government in the matter of grant or largesse including award of jobs, contracts, quotas, licences etc. must be confined and structured by rational, relevant and non-discriminatory standard or norm.... It then went on to say that corporations established by statute, or incorporated under law (including any company under the Companies Act) are "state"
if they satisfy certain tests based on:

  1. The source of share capital.
  2. Extent of state control over the corporation, and whether it is deep and pervasive.
  3. Whether the corporation has monopoly status.
  4. Whether the functions of the corporation are of public importance and closely related to governmental functions; and
  5. Whether, what belonged to a government department formerly was transferred to the corporation.

For a more detailed answer, see this report of the Law Commission (page 4, paras 2.3 to 2.6).

Three important issues arise related to the 1979 ruling of the Supreme Court:

  1. A business entity making a commercial decision does not hand out contracts as a "grant or largesse", but as a competitive player in the market interested in purchasing goods or services that satisfy its own requirements. To constrain it by the rule of law is to fetter its commercial decision making process.
  2. The transition of the Indian state is different from the transition of many western democracies such as the USA and UK. These democracies transitioned from laissez faire states to
    regulatory states. The Indian state on the other hand, is transitioning from a pervasive state to a regulatory state. Until not too long ago, the state ran hotels and manufactured bread. As such, most functions sought to be deregulated and/or performed by companies/ corporations are or were of public importance, and closely related to governmental functions.
  3. In India, many government functions are being privatised or handed over to government companies. A good example is telecom. Telecommunication services were first transferred to public sector companies owned by the central government, and eventually privatised.

On a related note, GFR has a rule to prevent escaping from GFR through subsidiarisation: Once government provides majority funding to a body, it must accept GFR and CAG.

This results in a situation where though de jure transfers of control, ownership and management have taken place, for government owned/ controlled corporations, there is never a complete de facto escape from the constitutional constraints on the Indian state. Such entities are unable, from the point of inception to act purely on commercial motives. It is therefore questionable whether any government
strategy that aims at greater market discipline and efficiency in a sector can be successful through the route of establishing government owned/ managed entities. Alternatively, the precedent on what constitutes "state" needs to be reviewed. The judgements on what constitutes "state" were made in the era of a pervasive state. A regulatory state must be defined differently.

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