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Home > Business > Columnists > Guest Column > Ajay Shah


How important is privatisation in India?

March 21, 2007

How important is privatisation in India? The first order issue is that of competition policy. When the government hinders competition by blocking entry or FDI, this is deeply damaging. Once competitive conditions are ensured, there are, indeed, benefits from shifting labour and capital to more efficient hands through privatisation, but this is a second order issue.

The difficulties of governments that run businesses are well-known. PSUs face little "market discipline". There is neither a fear of bankruptcy, nor are there incentives for efficiency and growth. The government is unable to obtain efficiency in utilising labour and capital; hence the GDP of the country is lowered to the extent that PSUs control labour and capital.

When an industry has large PSUs, which are able to sell at low prices because capital is free or because losses are reimbursed by periodic bailouts, investment in that entire industry is contaminated. This was the experience of Japan, where the "zombie firms" - loss-making firms that were artificially rescued by the government - contaminated investment in their industries by charging low prices and forcing down the profit rate of the entire industry.

Further, in many areas, the government faces conflicts of interest between a regulatory function and an ownership function. As an example, the Ministry of Petroleum crafts policies which cater for the needs of government as owner, which often diverge from what is best for India.

There is a fundamental loss of credibility when a government regulator faces PSUs in its sector: there is mistrust in the minds of private investors, who demand very high rates of return on equity in return for bearing regulatory risk.

These arguments have led many economists to advocate large-scale privatisation, so as to clear the slate, and get on with the task of building a mature market economy. The role model in this regard is Germany. After the collapse of communism and the unification of East and West Germany, an auction was held for selling off all East German PSUs.

Negative bids were permitted; i.e. the government was willing to even pay a private manager to take over a loss-making business if no higher bid was to be found. Through this, Germany was able to erase the heritage of socialism, and get on with the task of running an efficient market economy.

While such a game plan is entirely feasible in India, the present Parliament desires no privatisation. Does this mean that in the immediate future, progress in economic policy on privatisation must merely wait for the next elections?

When we look at various industries in India, the gains from privatisation are quite heterogeneous. In some cases, there are hopelessly loss-making PSUs. These operate in industries where private and foreign firms have been able to come in, and the PSU has been left far behind the standards of quality and price set by the private sector.

The PSUs should ideally have been sold off long ago, but today, these firms are irrelevant for the competitive dynamics of the industries that they operate in. The only issue is that of getting the land, the labour and some machinery out of public hands.

When privatisation is achieved, India will benefit because the private buyer will produce more GDP using the same resources, and the flow of budgetary support to these firms will cease. The government should be happy to get these firms out of its hands with negative bids.

The next and most interesting category comprises industries like telecom and airlines. In these areas, India has witnessed the dramatic benefits that come from the entry of private players.

Telecom and airline services in India are now dramatically improved, if not yet up to world-class, by changing rules in a way that permitted limited entry to domestic and foreign players. The privatisation of VSNL was critically important because it was part of the opening up of the ILD sector to competition: the government would arguably have been more tardy in opening up if it had a vested interest through ownership of VSNL.

However, the key innovation, which broke with the stasis of socialism was opening up entry barriers - not privatisation.

In both sectors, the full benefits from permitting foreign competitors, which are only present in very muted fashion, remain to be harnessed. While Spicejet is a good airline, there are bigger benefits waiting to be obtained by having domestic flights run by Lufthansa and Singapore Airlines. In both sectors, the defining issue in policy is the removal of entry barriers, not privatisation.

Looking forward, there is a good chance that in some years, BSNL, MTNL and the merged airline will end up like one of the many defunct PSUs of today. It makes sense for the government to sell today - while the going is good. But the privatisation of these three firms is no longer the most important issue - the further elimination of entry barriers faced by domestic and foreign firms is.

What does this tell us about banking? The decline in market shares of PSU banks, while helped along by strikes of PSU bank unions, has proceeded only slowly. This is partly because there is a fundamentally non-level playing field where private and foreign banks have deposit insurance for only Rs 100,000 of deposits while PSU banks have unlimited deposit insurance. This gives one reason in favour of bank privatisation: it is inherently difficult to achieve competitive conditions without privatisation.

But equally, there is no industry in India where the licence-permit raj hinders entry more than in the case of banking. At a time when the Indian economy is booming, and every kind of business is being created, the one industry where we see no new firms starting up is banking. This has surely got to do with government restrictions on entry.

There is absolutely no industry in India where the opening of branch offices by foreign firms and private firms requires permission from the government. When Ford operates in India, it has to obey rules on FDI, but after that, it never has to go back to the government to take permission to open offices.

What is worse, all foreign banks - put together - are given permission to open 12 branches per year in the full country. There is no worse instance where contemporary Indian policy-making is animated by ideas from the 1960s.  


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