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Bailing out a scam

The attempted bail-out of the Unit Trust of India by the government at the expense of the taxpayer is but a bid to protect those whose actions have driven the UTI to its current state.

ON the last day of August, the National Democratic Alliance (NDA) government formally launched its scheme to bail out the more than 20 million investors who had invested in the Unit Trust of India's (UTI) US-64 and Monthly Income Plan (MIP) schemes. These investors were faced with the threat of major losses a year back, when, following the collapse of the net-asset value (NAV) of the units the UTI announced its decision to stop repurchase of units under US-64. Faced with justified opposition to the move, the government worked out a scheme whereby the UTI would redeem the units at a pre-specified price (starting at Rs. 10 and rising at the rate of 10 paise a month to Rs. 12). To enable the UTI to realise this commitment, the government has announced a more than Rs. 14,500-crore bail-out scheme, which would protect investors and allow for redemption of US-64 units at the assured price.

The bail-out involves splitting the UTI into two units, UTI-I and UTI-II, with the former managed by an administrator and team appointed by the government taking responsibility for the US-64 and MIP schemes. The NAV-based schemes, which would be the responsibility of UTI-II, are to be managed by a professional chairman and board of trustees. This is seen as a prelude to privatisation.

Besides providing the assurance that it would back the UTI's promise to redeem units at a pre-specified price, the government has indicated that through measures like enhanced tax benefits, it would seek to encourage investors to stay with the scheme. This strategy, if implemented, would stagger redemption. This would reduce the need to offload investments made by the UTI in stocks in order to finance at least a part of the redemption burden. If UTI-I is forced to retrench a large volume of stocks, the impact on the market would be disastrous. Staggered redemption would also help reduce immediate outflows from the government's kitty.

Finally, if the hope that the stock exchange would revive, taking the Sensex from its just-above-3000 value to about 4500, the NAV of the US-64 and MIP schemes would improve, allowing a larger share of the redemption burden to be met out of sales of the UTI's own assets.

In sum, the government's strategy is to protect small investors as well as to prevent any collapse in the stock market, at the cost of the exchequer. This cost is two-fold. It takes the form of direct payments to UTI-I in support of redemption. It could also take the form of a loss of revenue through larger tax concessions linked to holding of UTI paper.

The government's initiative was in a sense inevitable, since it would have been politically suicidal to let a large number of small investors suffer the consequences of developments in the financial sector in general and the UTI in particular. However, it would be wrong to see the government's action as being solely driven by small-investor interest. The bail-out at the expense of the taxpayer is also an effort to protect those whose actions have driven the UTI to its current state.

SAVITA KIRLOSKAR/REUTERS
The government's bail-out strategy for the Unit Trust of India is to protect small investors and to prevent any collapse of the stock market, but it is at the cost of the exchequer.

IN one sense, the survival of the UTI in its older mould after the onset of financial liberalisation was almost impossible. While the organisation assured investors relatively comfortable returns on investments with long maturity periods, the returns it could make on its own investments were tied to developments in the financial markets. In the latter, investments that promised stable returns were increasingly characterised by lower yields. This forced the organisation to turn increasingly to the market for conventional commercial debt and equity, wherein higher risks were associated with higher returns.

It could be argued that in doing so, the UTI was not professional enough in its investment practices and was pressured into making investments that it normally may not have made. These judgements, made with hindsight when the organisation was on the brink of failure, were not altogether invalid. However, both these features have been used to argue that the basic problem with the UTI was its public ownership, which ostensibly affected the quality of management and made it prone to interference in decision-making, that resulted in decisions being driven by extraneous considerations rather than business-like judgments.

That conclusion is indeed problematic. Private organisations in India's (and the world's) financial sector are by no means characterised by adherence to transparent, best-practice investment strategies. While this does not constitute a defence of the erstwhile UTI management, it does call for caution when arriving at public-private comparisons based on the UTI episode. Further, with the market turning volatile, the so-called professionalism of the private mutual funds, including those run by foreign entities, has not been adequate to secure the capital of investors. NAVs in a large number of cases rule at levels that imply capital losses. In fact, volatility has implied that investments in such financial assets rise in periods of actual or speculation-driven stock market buoyancy. This tendency has been aggravated in recent times by the government's effort to engineer a decline in interest rates by driving down yields on small savings schemes.

What is more, no private organisation has been called upon to undertake the task that the UTI was expected to perform: guarantee rather high returns, while being left to garner its own revenues from an uncertain and volatile, liberalised financial market. In fact, the UTI was adversely affected by four tendencies in India's liberalised financial sector. First, given the promise of assured and comfortable returns and the fact that tax benefits linked to UTI schemes made the implicit return on units even higher than the explicit return, the UTI had to accommodate the large number of small investors who turned to it as a safe destination for their savings. This made the volume of funds the UTI had to manage within the constraints it faced, quite substantial. Any failure to earn the revenues needed to assure returns could imply substantial losses.

Second, sensing the gains to be derived from investment in the UTI's offers, leading corporates invested large sums in schemes that were at least in principle meant for small investors. What is more, when it became clear to insiders that the UTI would be hard put to redeem at assured values all of the liabilities it had taken on, this information was clearly leaked to these corporate investors, who sold out and booked profits, while the UTI was left with a situation where the gap between the value of its assets and liabilities widened. Just before the suspension in July of repurchase, the UTI experienced a Rs.4,100-crore outflow over the two-month period of April-May, 90 per cent of which was reportedly thanks to institutional investors.

Third, the UTI made large investments in corporate debt in a few major borrowers from core industries, particularly in the steel sector. While some of this was undertaken based on the judgment of the UTI's management, there is enough circumstantial evidence to show that a prod from different government sources played a major role in many instances. A lot of that debt has now been declared or will need to be declared non-performing assets (NPAs). Thus, when it became clear that the investments made by some steel majors were unviable, payments due in the form of interest and amortisation dried up, increasing the portfolio of NPAs of the UTI.

Finally, as the stock market, in which periods of boom during the 1990s could be only explained by financial liberalisation and the speculation it engendered, entered one more inevitable bear phase in recent years, with stock indices falling by substantial margins, the UTI found the value of its equity assets considerably eroded. Unfortunately for it, the UTI's portfolio reflected a strategy of high exposure in a few ostensibly "dynamic" shares. The losses it suffered made it even more difficult to redeem its liabilities at promised values.

ALL of this created a situation where, even if the management of the UTI had decided to pull up its socks and get to work in the new environment, as it reportedly did, salvaging the assured income schemes was bound to prove impossible. The government, which was responsible for the UTI's structure and practices and for the process of financial liberalisation that has weakened it, had to step in and protect investors who made their decisions based on the implicit guarantee that the state seemed to provide. But stepping in requires the state to investigate trades based on insider information from which particular business groups benefited, penalise those who violated the law, and salvage as much of the UTI's assets that have been rendered non-performing through expropriation and liquidation of the assets of companies that have defaulted but are allowed to go scot-free.

Clearly, the bail-out package announced by the government does not propose to undertake any of these tasks. Moreover, by using public funds to pacify investors it seeks to paper over the weaknesses in the financial system that are responsible for the UTI's present plight. By doing this the signal that is being sent out is that so long as public funds are available, they can be accessed without much risk. This implies that the existing bad business practices would not be corrected and that such practices would be encouraged in the future. If the government adopts a similar policy with regard to the Industrial Finance Corporation of India (IFCI), as it reportedly proposes to, this tendency would only intensify. But clearly, from the government's point of view, this outcome is better than having its own role and the role of its financial policies in engendering various financial scams exposed.