FDI Controls in India – what are they really about?

From time to time you hear some government minister or bureaucrat in Delhi making a proclamation that the FDI limit (Foreign Direct Investment) on such and such industry has been raised from X% to Y%. The press dutifully covers it, the Communist parties huff and puff about it and another credit is chalked up on the Indian government’s liberalization scoreboard. But most people like me, remain uninformed about the issues behind the decision.

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Indian startups making a mark

Last week’s post on IndiaPost raised quite a storm of comments. Some of them were supportive of my central thesis that for Indian citizens to get better public services the issue of labour flexibility within public service organizations is the most important one to address. Many were not. Of these some thought that IndiaPost has actually done well, given the circumstances, and that I was looking at the glass half-empty.

So for a change, let’s look at the glass half-full. Let’s talk about some Indian startups that are being noticed.

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Indian Public Services – Crying for Change

An article on the Indian Postal Service in the Wall Street Journal (subscription required) portrays the service so pathetically, it almost reads like a children’s book describing a distant kingdom where everything goes wrong all the time. Unfortunately, this is no fairy tale. It is very, very real.

Here are some damning stats and facts about Indiapost:

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The Unfinished Business of Labour Reform

Property rights form the fundamental bedrock of capitalism. In a capitalistic society an individual’s right to own property and dispense with it as he deems fit, must be protected. Only then is the individual encouraged to invest money and effort to add to his property. (Here the term property applies to all assets, not just real estate)

If India is to keep the momentum going on its recent economic growth, it must strengthen the pillars that hold up the edifice of capitalism in the country. Property rights are the most important ones. There are many laws like the rent control act that impact an individual’s right to property. In some cases, the inability of the state to protect its citizens’ property may be construed as something that erodes property rights. I see labour inflexibility in India in the same light. Many will not agree with me on this. I believe that shareholders of a company ‘own’ the company. Not allowing the company to conduct its business as it deems fit, including hiring and firing employees, is in effect constraining the shareholders’ rights to property.

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Review: Never Say Goodbye

So you can’t say you never saw a Bollywood movie reviewed on this blog, here’s one.Last night my wife and I went and saw Kabhi Alvida Na Kahna (Never Say Goodbye). We got a baby-sitter for the kids and went and saw the 7pm show at Naaz8, the local Indian cineplex. This was the first day and the shows were all sold out. I haven’t done this in a while and it was great fun.

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Indian websites haven’t earned my trust

The other day I had to create a user id on an Indian financial news web-site. I wanted to create a portfolio that included mutual funds and Yahoo Finance doesn’t cover Indian mutual funds. The portfolio worked alright, but eventually I decided to keep it on Yahoo Finance after all. That should have been that.

But then I started getting email from that web-site. One email a day about products, investment ideas and news summaries that I had no interest in. I did not opt to get these emails. That was foul number one.

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Salaam Bombay

Last week the dastardly terrorist bombing of Bombay’s suburban trains brought global terrorism another step closer to the largest democracy in the world – India.

Bombay is a city very dear to me and my wife. We started our working life in Bombay and worked there for 5 years. Took the train from Andheri to Churchgate and back everyday. I traveled in the same first class coaches that seem to have been targeted by the terrorists. Life wasn’t all roses – the 3.5 hours total commute didn’t leave us much time to enjoy Bombay. But when we did we fell in love with it. We loved the theatre (Prithvi), restaurants (Samraat, Mahesh lunch home), movie halls (Eros, Regal). The heady mix of high finance and Bollywood. The professionalism at work. They all endeared us to Bombay. But most of all it was the people of Bombay.

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Namaste America

Last week Al Gore was a guest on Jon Stewart’s Daily Show. He was there of course to talk about the Climate Crisis and his new movie the Inconvenient Truth. Since the audience at the Daily Show is fairly liberal, Gore got a very warm welcome from them. But what was strange was that Gore greeted them with folded hands. Damned if it didn’t look exactly like a Namaste. It was very casually done, no theatrics around it. I suspect he had done the very same thing many times before.

I was of course very tickled about it. I have long held the view that Namaste is a superior greeting to the handshake in the age of the Avian Influenza. Handshakes transfer germs and are a surefire way of spreading the virus when there is an outbreak. The WHO realizes this and has come up with the ‘elbow bump‘ which is just too hokey to work. Asian greetings like Namaste and the Japanese bow are, in this respect, superior. Although in Japan the formal greeting in business is still a bow, while Indian business (though not politicians) has completely adopted the handshake. Pity.

The other thing going for Namaste in the US is that it is closely associated with India and India is hot right now. India is of course in the news because of the nuclear deal still winding its way through Congress. As an investment destination for business it has to be number one or pretty close. Bollywood dancing is all the rage. You can find Kurti inspired women’s fashions all over the place. And Indian food in the grocery stores.

The big news is that from next summer, Indian mangos will be available in the US. Being that they are much superior to the Mexican variety I think that will win us a few more fans state side. Some say that the mangos are a fair trade for nuclear technology. Some say that we’re giving away the mangos too cheap! The mango deal was done during President Bush’s visit to India along with the nuclear technology deal.

The affinity between the two countries is good for both countries and for democracy everywhere.

Gimme a break – a tax break

Are there industries in India more profitable than the IT industry? If there is one, it must have an awesome business model. Companies like Infosys make 25% net margins after taxes. At $20B in revenues, the industry is no longer a small industry needing encouragement.

So why does the IT industry not pay corporate income tax? Not just that, under the SEZ act, that tax holiday will now be extended, indefinitely.

In the late 80s, early 90s, the STPI Act was used to incentivize the then fledgling IT industry. It was needed. The Software Technology Parks were needed. The cost of a telecom link to the US was high. Many small companies in the STP could share a telecom link. Custom duties were very high on computer hardware, software and networking equipment which could make IT company uncompetitive. So there was the duty-drawback. Last but not least, there was a 10 year tax holiday on export revenue out of the STP. For all this the companies within the STP had to be 100% export oriented.

So far so good. I might have an issue with the tax holiday, but the incentives were timely and well directed. The industry, led by a few major companies like Infosys, TCS and Wipro grabbed the opportunity. Later their ranks swelled with many other smaller companies. Soon the BPO industry (also called ITES or IT enabled services, I think to justify their need for special treatment) also swung into action.

Fast forward to 2006. We now have a large and still rapidly growing IT and BPO industry entirely focused on offshore services to developed markets. Most of the larger firms are very profitable. The custom duties are way down. Telecom bandwidth is dirt cheap. So why in the world would the industry need more tax breaks?

That it doesn’t is very clear. Not just because of the reasons I give. But because industry leaders like Nandan Nilekani say that they don’t. However, if the SEZ provision is available, it would be irresponsible for them to not secure the best tax status for their shareholders.

The income tax lost to the IT industry, by my calculations came to $1.3 B last year. That would be a pretty significant % of the Indian govt. budget. Why would the Indian govt. run a deficit budget, skimp on investment in infrastructure yet spare the wealthy shareholders in Indian IT companies? One could argue that since deficit financing causes inflation, the government is taking from the common man and giving to the wealthy shareholders of IT companies. It is no wonder that the Finance ministry does not support this loss of revenue.

You could also argue that a tax holiday has no impact in the IT industry. If you make profits, you get the benefit of the tax break. But if you make profits, why do you need the tax break? The IT industry is not a capital intensive industry like say the steel industry, where a certain RoI must be met, beyond just being profitable.

The SEZ Act might make sense for many, especially manufacturing industries. For the IT industry it does not. But, profitable industries have wealthy industrialists. Some of them know how to lobby the government. Then there are the real estate developers, who too stand to gain by getting the right to develop the SEZ parks. They too have deep pockets and political connections.

In 10 years when we need to take a relook at the SEZ act, the IT industry will be even bigger. The industrialists will be wealthier. If I were a betting man, I’d say, this ain’t going away.

The right time for labour market reform is now

In my first job out of business school with Hindustan Lever, as Area Sales Manager I had a team of over 20 unionized salesmen. I ran a Voluntary Retirement Scheme in my first year and then again in my third year by which time we were down to half the original team size. Yet we introduced new brands in the market, grew our sales and in general did well as a team.

In my third year I took over a small new business of hot beverage vending for Lipton (at that time a division of HLL). The business was small but growing rapidly as we expanded our city coverage. In Sales, Distribution and Service we had about 50 people. Of this the number of direct Hindustan Lever employees was 2. The rest were all outsourced, contract or distributor’s employees.

I then moved to Infosys in the US and over my 11 years there, hired scores of employees onto the company’s US payrolls. I also had to let go of some people for performance or other reasons. At all times, I was acutely aware that I myself was an ‘At Will’ employee. I could be fired with two week’s wages without giving a reason. As long as the reason was not discriminatory (race, sex, religion etc.) I could not bring legal action upon the company.

My experience with the vastly different labour environment in both India and the US has driven home a very important lesson – a business exists to make money for its investors, not to provide employment. And that is, paradoxically, the best way to generate employment.

Let’s take a look at how India’s labour laws distort the business environment and harm employment and employees:

1. It discourages capital investment – particularly in service oriented industries. Investing capital means taking risks. Market risk – the risk that the business may not succeed – is a risk that ‘comes with the territory’. In most countries, investors know that if their business fails in the market, they close down the business, sell off the assets at knocked-down prices, book the loss and take the remaining capital to some other investment opportunity. However, in India, failure, or a downturn, in the market also means that you are still saddled with the payroll costs because you can’t restructure or layoff anybody. You can’t exit the business because employees will lose jobs. That’s something investors don’t have to deal with in most countries. You look at so many rusting factories in every major city in the country where the factory owner has not been able to layoff employees even when the networth of the company has gone down to zero, and you wonder – what a colossal waste of assets. You also wonder –  what do future investors think when they see these rust-buckets? More likely than not it’s – ‘That could be my investment 10 years from now.’

2. It provides no incentive for raising productivity through automation. Look at all the government offices or offices that have unionized staff like banks. To the last one, they opposed computerization. Why? because it could do the job faster and so it would reduce the number of jobs.

Yes it will and that is a good thing. Doing more work with fewer people raises productivity. Productivity raises incomes. The developed world’s prosperity is entirely linked to higher productivity. Also higher productivity creates the surplus (or the profit) that can be invested to create more jobs.

3. If you want to produce a quality product or service it needs carrots AND sticks. With an employee who is not performing, you train, you mentor, you put them on Performance Improvement Plans. But in the end, the employee needs to know that if his performance does not improve he can lose his job. Without this freedom for businesses to manage for performance, it may be possible to compete against companies who are similarly hampered, but it is a clear disadvantage in the global market.

4. It pushes employment generation into the informal sector. In my second stint at Levers I would have loved to hire people directly into the company instead of outsourcing critical functions like Sales. With the Levers brand name as an employer we would have got great talent which would have been better for the company. However, Levers would not do that for a new business that could have failed leaving them with employees they wouldn’t know what to do with. So all of the hiring was done by outsourced contract firms. Did these employees get the PF and benefits they would have got at Levers? I doubt that very much. I don’t think these contract firms even paid any taxes since they were probably classified as Small Scale.

In summary, the current labour laws in India distort the business environment to where it reduces employment generation by discouraging investment, reduces income growth by discouraging productivity increases, reduces quality by taking away the freedom to manage for performance and pushes employment generation into the informal sector.

Whenever I bring this up with people in industry in India, I am given many reasons why this is not a problem. Someone says ‘Only 20% of my workforce is unionized, I just work around them’. Another one will say ‘If you really want to fire an employee for performance, it can be done.’ But most of all the reason I get is ‘But the economy is doing so well why do we need to think about redundancies and labour flexibility?’ On the contrary, it is because the economy is doing so well that this is the right time for labour reform.

I believe this is the most important reform that government must now address. However, this is also the most difficult. Dismantling industrial licensing was like a walk in the park compared to this. With the government dependent upon the CPI(M) to stay in power makes it almost impossible to do major reforms. But major one-shot reforms aren’t the right answer anyway. There should be a 10 year road map on labour reform. But starting now. Let’s begin the discussion.