Keep A Close Eye On The Middle

Somewhere between the late eighties and the early nineties, a new word — “disintermediation” — was silently introduced into our collective consciousness and vocabulary, especially in the context of the financial sector. It was a bit like how the words “paradigm” and “synergy” have attached themselves, uninvited and somewhat unobtrusively, to our conversations. Disintermediation is no longer restricted to the financial sector and it is changing many parts of our familiar world. Many other unfamiliar parts will also alter immutably. But, yet, there might still be some parts of this world that will continue to require a middle tier.

Disintermediation, when it was introduced into the Indian market jargon, simply meant savers taking their hard-earned savings directly to those who needed it most — that is, companies setting up projects — instead of lending it to intermediaries (such as banks), which then eventually lent it to the companies. The word was used repeatedly in the perspective of developing the Indian capital markets. It is another matter that in the meantime a larger number of intermediaries have reinforced their presence in the capital markets.

But, beyond the framework of the capital markets, the word “disintermediation” found new currency during the internet boom and, once the dust settled, in all kinds of consumer offerings. The term also inspired new theories on organisational structure and management strategy. What disintermediation simply meant was cutting out the middleman from — or delayering — a company’s supply chain or distribution networks. For example, Michael Porter’s value chain concept became the foundation for re-engineering corporate structures to e-commerce applications.

Two examples of disintermediation are threatening to change two industries beyond recognition.

Reams have already been written about Apple’s iTunes and how this business model has changed the music industry. Apple realised early on that the internet would modify the music distribution business forever. That model — which has the sale of hardware layered on the software promise — has now become the defining template for music distribution. It peeled off many layers — such as, the music stores and the distributors, all of whom meant additional costs for the ultimate customer. But, there are further changes coming, which drive the disintermediation process further and promise to even do away with the need to buy hardware to access the software. A new service called “Spotify” allows users to hear songs of their choice from a virtual jukebox, all free, provided they agree to listen to 20 seconds of ads between 30 minutes of uninterrupted music. The songs can only be heard, not downloaded, reducing the piracy threat for music companies. The promise becomes attractive, given the easier access to the internet today, especially through mobile phones. It not only does away with the need to carry an iPod around or manage shelf-space overflowing with CDs, but it also has music labels signing on to offer their music. The service is still developing, but it has already created a buzz.

The second example is “Kindle”, an e-book reader launched by Amazon, which is now in its second version. It would be instructive to remember that Gutenberg’s invention freed ordinary people from the tyranny of priests and godmen, when he made available printed copies of the holy texts and scriptures at affordable prices. That was disintermediation 101. With Kindle-2 comes the second phase. With the help of the net, readers can download books, magazines and newspapers on their e-reader, which can then be read at leisure. Most importantly, if Amazon becomes a publisher also (which is not too distant a likelihood), the Kindle would have eliminated — in one stroke — the whole middle kingdom of agent, publisher, distributor and book shops. Sure, the Kindle-2 still has a long distance to travel — readers are unlikely to give up the printed, paper version completely in favour of a Kindle (at least, not yet), or eschew the option of browsing in a bookshop. But, the field has been set and a game is certainly afoot. Watch this space to see how traditional publishers respond to this challenge, especially with Google and Sony also adding their hats to this e-space.

But, despite the seeming invincibility of disintermediation as a business process, a few things in life will always come with middle-men. For instance, our desire to live a life of good health is no longer within our control. Doctors have taken over every aspect of our health and maintain a stranglehold over the whole medical well-being business. With all of us leading complex lives, there is no way we could even begin thinking of a disintermediated surgical procedure.

There is another category which we love to hate and yet cannot eliminate from our lives — politicians. Post 26/11, many embittered citizens asked resentfully whether we needed politicians at all. The emotional outburst at that moment was understandable, but we elect politicians to govern on our behalf. If they’re abolished, we have to police ourselves, clear the garbage, or finance and oversee road-building through mosquito-infested swamps. The least we could do is elect the right guy and then monitor his work, his questions in Parliament or the quality of his debate. Since we have to live with this devil, we might as well keep an eagle eye on him.

(Courtesy: The Economic Times)

It’s High Time ICAI Set Its House In Order

A incident is usually one which alters the course of events forever. Champions for improved corporate governance norms had hoped that the Satyam episode would probably turn out to be a defining moment in the history of Corporate India, a turning point that would help introduce better compliance and disclosures. What a delusion, a load of nonsense, that’s been!

Soon after the Satyam episode came to light, the most indignant lot seemed to be some of the regulators. For instance, the Institute of Chartered Accountants of India (ICAI) — which regulates all the auditors in the country and lays down all accounting rules and audit norms — tried deflecting the blame by pointing fingers at certain firms and individuals, instead of introspecting about the quality of accounting and reporting norms that it endorses. Sure, there is the possibility of an unholy collusion between the Satyam management and its auditors — which is still the subject of an investigation by the police — but in the absence of any proof, ICAI launched a broadside, through calculated leaks to the media, about the culpability of certain individuals, some of whom are important elected ICAI members and have therefore cultivated bitter rivals, eager on usurping those coveted positions.

In the meantime, the minister for corporate affairs PC Gupta also publicly lamented the lack of corporate governance in many Indian companies and dropped broad hints about how his ministry would vigorously pursue and bring to book some 100-odd companies that had violated accounting guidelines blatantly. It did not occur to him to also add that this broad-based abuse of regulations had transpired under his watch as minister over the past five years, and that they had gone unnoticed, unreported and unpunished by his ministry. Or, that these “gross” violations had been endorsed by numerous auditors, who remain affiliated to — and licensed to practise by — the ICAI. To the astute and the cynic, the outpourings seemed to have been made with an eye on the forthcoming elections, rather than with an honest intention of improving corporate governance or the state of disclosures in Corporate India.

One of the issues with India Inc that will continue to plague investors will be the extent of comfort they can draw from the published accounts and the degree to which they can trust these numbers. In this high season of righteous anger, one doubtful accounting practice continues unabated and untrammelled. This is writing off impairment to assets through the balance sheet rather than bringing it to the profit and loss account. While the bull run was rampaging through valuations, many companies used this accounting sleight to botox their revenue and profit numbers. And, minister Gupta, as well as, ICAI continue to look the other way as camouflaged corporate numbers hide losses and dupe investors.

Here’s how it happens. Suppose, Company A bought 75% of Company B, which is a foreign company, about 18 months ago. At the time of acquisition, an exuberant A had paid $500 for B. But, given the economic cataclysm in the global system, B’s value today stands reduced to $100. In effect, what A bought for $500 has now become $100. How does A account for the $400 that has vapourised because of the global economic meltdown? Well, normally, best practice should have required him to deduct that amount from his net profit, or add to the loss. But, since he’s in India, he does things differently — he deducts the amount from the share premium reserve, an account created from the money that a company receives for issuing shares at a premium — the face value is credited to paid-up share capital and the balance goes to share premium reserve. In short, the loss in the value of A’s investment is not reflected in the bottom line at all.

The objective of such account-brushing is to get a better reception at the fancy ball, known as the stock market. Companies relentlessly pump up revenues and profits while masking losses and brushing accounting misdemeanours under the carpet. Sure, some auditors do raise some flags, but companies are able to use the legal cracks in the system to wriggle out. In such cases, the auditors should voice their reservations loudly and clearly; the ICAI should back them with clear rules that favour investors and not audit firms that tone down their criticism for fear of losing a client. So, the issue here is: does ICAI frame rules and guidelines that eventually benefit its member firms over the interest of minority shareholders? That raises another pertinent point: should ICAI then be governed solely by elected representatives from member firms, as is the norm for all other self-regulated organisations? These questions must be answered if we are serious about corporate governance, and if we want to avoid the next Satyam.

(Courtesy: The Economic Times)

Rural Job Schemes Are Cool, But They Too Have Problems

Economics has a strange way of looping back and whacking you on the back of your head. Governments take great pride in formulating grandiose schemes that are purportedly pro-poor but end up hurting the intended beneficiaries. Sometimes, the intentions are honest but the execution is poor, without much thought given to entire chain of consequences.

With the election bugles having been sounded, speculation is rife about the contents of each party’s manifesto. Some of it will be very predictable. For instance, the Congress will definitely try to display two large feathers — one for claiming to have sewn up the nuclear deal with the US and another on the spectacular success of its rural employment programme, the National Rural Employment Guarantee Scheme. Time for a quick look at the last one.

The NREGS was implemented nationally through an Act in 2005 to provide a social safety net for the most vulnerable section of rural society. The scheme’s operational guidelines define the NREGS goals: “Through the process of providing employment on works that address causes of chronic poverty such as drought, deforestation and soil erosion, the Act seeks to strengthen the natural resource base of rural livelihood and create durable assets in rural areas. Effectively implemented, NREGA (NREG Act) has the potential to transform the geography of poverty.”

The Act also stipulates that every worker be paid minimum wages fixed by the state for agricultural workers. This is where economics starts playing up — unseen and unheard. It works in two ways. One, where market wages are higher than the minimum wage rate (or, even the wage rate fixed under the particular works programme), the demand for labour for NREGA projects is never met fully. But — and this is the fun part of economics — the converse also holds true. In many cases, where the state has fixed a high minimum wage rate, which then acts as the floor in that localised market, other agricultural enterprises find it difficult to employ labourers at economical rates.

One can argue that providing minimum wages isn’t such a bad thing. For one, it provides an administered floor — beyond which wage rates can’t possibly fall — to minimise economic exploitation. But, where political compulsions and oneupmanship lead to rising wage rates, it could even affect the cropping pattern of that state and lead to shortages of certain crops.

A recent report by Swiss bank Credit Suisse predicts that many farmers in western Uttar Pradesh are likely to replace their sugar crop with a rice-wheat crop. One of the reasons responsible for the crop-switch is the rural employment scheme. The report says: “The government’s national rural employment guarantee scheme (NREGA) has resulted in shortage of agricultural labourers in this region. Migration of labour from eastern UP and Bihar has slowed considerably as work is easily available under NREGA. The average daily labour cost has increased from Rs 50-60 per day to Rs 80-100 per day (NREGA daily wage is Rs100 per day in UP). Labour shortage and cost affect cane more than R-W (rice-wheat). For one, cane requires about 75-90 man days of labour per acre per year, while R-W requires about 60 man days per acre per year. Moreover, many jobs in R-W cultivation is readily mechanisable (harvester combines, threshers, etc, readily available for hire in the region), while cane is not amenable to mechanisation (due to lack of or high cost of machinery in the area or due to lack of technology.

There is another government policy — ostensibly to insulate poor farmers from the vagaries of an unpredictable marketplace — that is also boomeranging on the people it’s supposed to protect. Many years ago, the government introduced the minimum support price (MSP) to assure farmers of a reasonable price for their produce. The government announces a price at the beginning of each crop cycle, thereby providing an artificial and administered floor price below which market prices can’t fall. Sometimes, competitive politics forces the government to announce further price increases in mid-season.

Again, nothing arguable with this noble objective. But, as the report from Credit Suisse says: “Over the last four years, the increases in rice (+61%) and wheat procurement prices (+69%) have significantly outpaced the increase in cane prices (+31%).” The end consequence of this shift in cropping pattern is already showing up in the inflation indices where, despite the downward pressure exerted by petro-products prices, inflationary pressures exist for food items. For instance, the category “sugar, khandsari and gur” has been showing a very high rate of price rise among all the food categories that are included in the inflation index.

But, that is not all. These same high procurement prices also result in food prices rising across all categories. Since the poorest — the NREGA target — have no access to the public distribution system (which is well documented), the high MSP for staple food items leaves daily-wage-earning rural poor with a lower disposable residual income for healthcare, clothing or any other contingency. So, should NREGA doles be indexed to minimum wages or inflation rate, or even MSP? You can bet your bank passbook that there will be lots of research coming up on this, but what’s going to be even more interesting is to see how the NREGA beneficiaries vote.

(Courtesy: The Economic Times)

Taking Up Aam Aadmi’s Cause Just Can’t Add Up

The government ads disappeared as soon as the model code of conduct kicked in. No longer is the public being subjected to ads highlighting government did this, or achieved that unique record. But, one category of state-sponsored ad continues to play on — those nudging consumers into wakefulness, to be aware of their rights. These use examples from a wide variety of industries where consumers run the chance of getting short-changed — telecom, retail, consumer durables, and so on. These ads are beyond the sweep of the Election Commission’s eagle eyes because they purport to serve public interest and do not applaud the feats of any government ministry, department or politician.

All very nice. But are they appropriate? Or, timely? Actually these ads are quite evergreen but on the scale of priority, may be the government seems to be missing out on something. The strategic thing to do might be underlining corporate mis-governance and pressing investors to exercise greater discretion while choosing their investments. A series of ads highlighting how to detect corporate fraud, or how to see through accounting sleight, might have also provided the right kind of learning for the wet-behind-the-ears stockpickers. No one is saying remove the consumer awareness ads. But, post Satyam, there is simmering anger against what is seen as government’s tacit support for corporate malfeasance. A series of ads asking ordinary Indian savers and investors to awaken to their rights might have struck a right chord with a certain section of the electorate. In one stroke, not only would the government found resonance with voters but would have also been able to distance itself from the perception of being too close to the perpetrators.

But short-sighted politics refuses to relax its stranglehold over common sense. Despite all that has happened, the government continues to send out signals that it’s still strongly on the side of the majority shareholder, that its policy-making apparatus is still guided by the interests of the politically marginal, but influential, pressure groups. This is a calculated gamble, but can have disastrous results as has been experienced by many in the past. In the past couple of months, some government ministers have occasionally used the media to threaten punitive action against certain companies with suspect governance practices. But, these ministers are blind to the other side of the coin — that their threats raise questions about why were they sleeping at their jobs for the past five years. But, in the end, politics of expediency triumphs and government chooses overt action only for the consumer, and reserves covert support for the majority shareholder.

One would have expected some accelerated regulatory action after the Satyam episode. Take a look at the Institute of Chartered Accountants of India (ICAI). It has shrugged off any culpability for the Satyam scam. Sure, global audit firm Price Waterhouse was remiss in its duties as statutory auditor, but no one at ICAI stood up and declared that there’s probably something intrinsically wrong with, or missing in, the ICAI rules, regulations and guidelines. Most recently, in the accounting norms for foreign currency convertible bonds (FCCBs), instead of acting as the regulator, the ICAI is once again capitulating to the demands of its clients and is planning to relax the accounting rules.

Most FCCB issues were made in the heady days of the bull run and the continuing sensexual fizz gave issuers the confidence that their share price was divinely destined to move in only one direction — up. This belief then propelled many issuers to promise to redeem their FCCBs at a premium to face-value, in case the conversion to the underlying shares did not take place. Unfortunately, that dream run is now over, most bonds are trading at a discount to their face value and, given the depressing state of the stock market, are unlikely to get converted into common stock. Consequently, issuers now have to get ready to start redeeming these bonds, which will require large amounts of cash. What’s acted as a double whammy is the appreciation of the dollar, requiring companies to pony up greater sums of rupees. Prudent companies have been squirreling away money for this contingency from their profit and loss accounts over the past few quarters.

But, these are only a handful. Most of the companies are not recognising this impending liability; they are deluding themselves that the bonds will get converted into shares and, therefore, there is no need to set aside cash for redemption day. The compulsion to show higher profits today, in disregard for the tomorrow’s looming danger, is playing havoc with investor sentiment. Has the ICAI descended like a ton of bricks on these companies or the auditors that have chosen to ignore this phenomenon? You must be joking. It is instead studying the possibility of giving the corporate sector some relief on cash that was provided earlier. Investor sentiment be damned. As long as the investor population does not become a powerful voter lobby, don’t expect any meaningful corporate governance.

(Courtesy: The Economic Tiimes)

The Trouble With Expectations

Late Freddie Mercury, who fronted for British rock band Queen, once crooned “crazy little thing called love”. That song has found a secure spot among the alltime favourites of pop/rock history, but its claims to an enduring place in the list of crazy and strange things may have to confront some occasional challenges. One of the peculiar things that demands immediate enlistment is the indefinable, indeterminate and intangible concept called “expectations”. It’s playing havoc with the economy and all the strategies conjured up by planners. It is time to get hold of this slippery creature.

The government has announced three well-publicised stimulus plans so far. These include duty cuts on manufactured products, tax relaxation for services provided and a host of other measures designed to spur people into spending more and companies into investing money for building new production capacities. Unfortunately, none of these seem to be working — consumers are not buying and companies are resisting new investments. Planners are perplexed (despite their brave public visage and statements), commentators foxed and politicians scared by this inexplicable systemic obstinacy. What they don’t realise is that, unseen and unheard, a phenomenon called “expectations” is at work below the surface.

So, what is this strange thing? The answer might be available in contemporary macroeconomics. It is a technique called the theory of rational expectations and is a device used in building models that try to predict a series of future decisions likely to be taken by consumers, investors or companies. This theory was first proposed by John Muth, a professor with Indiana University in the US, in the early 1960s. In the words of New York University professor Thomas Sargent, Mr Muth used the concept to “describe the many economic situations in which the outcome depends partly on what people expect to happen. The price of an agricultural commodity, for example, depends on how many acres farmers plant, which in turn depends on the price farmers expect to realise when they harvest and sell their crops. As another example, the value of a currency and its rate of depreciation depend partly on what people expect that rate of depreciation to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock, or bond, depends partly on what prospective buyers and sellers believe it will be in the future.”

The theory also posits that future outcomes do not tend to vary greatly with the general expectations of the people. This means that some people will always get their forecasts wrong, but generally the majority’s assumptions of the future tend to be right. If that is so, this understanding might hold some keys to sorting out the clogged economic arteries. People are probably not spending because of expectations that things might get worse in the next few months, and that their uncertainties about job losses might, unfortunately, come true. Therefore, they feel it is better to save today, rather than indulge in discretionary spending, in case the climate gets cloudier tomorrow.

But what might be interesting to note are two related theories that are based on the theory of rational expectations or contribute to its development. The first one is the “permanent income” theory of consumption formulated by Milton Friedman. The Chicago-based economist used this theory to strengthen John Maynard Keynes’ consumption function that showed a positive relationship between people’s consumption levels and their income. This might sound a bit like stating the obvious, but this was a necessary development in the realm of theoretical economics to understand what drove people to consume and to formulate policy around it. Mr Friedman said that people consume based not only their present income but also on their perception of what their future income is likely to be. Hence, expectations.

The second hypothesis built around the expectation theory — and which seems important from the economy’s standpoint — was the “policy ineffectiveness proposition”, which said that if policy-makers attempt to manipulate the economy by encouraging people to have false expectations, they are unlikely to succeed. This derivative theory — first articulated by Robert Lucas — argues that if people have rational expectations, it will be difficult for policy-makers to improve the economy’s performance by inducing false expectations. These two important theories lead to two inferences. One, the government needs to start working on those building blocks of the economy that create jobs, capacities and thus future incomes. A start could be the infrastructure sector, which is still under invested and tangled up in bureaucratic knots. Second, the excise duty cuts and the service-tax reductions are like the false promises described above. They try to induce false expectations and, therefore, do not lead to an improvement in the economy.

It may be instructive here to notice that the dismal third quarter GDP numbers — which showed that the economy had grown by only 5.3% — has one silver lining. While agriculture and allied activities contracted by 2.2%, and manufacturing grew by only 2.37%, services growth at 9.85% seems to have saved the day. As part of services, social sector spending grew by 17.3% reflecting the impact of the sixth-pay commission and the national rural employment guarantee scheme. There might be some clues here.

(Courtesy: The Economic Times)