The real problem is not US-64
US-64 was based on a notion that there can be a disconnect between the value of a financial product as seen by the investor as opposed to the value known to the fund manager. When the true value of a unit of US-64 was Rs.10, UTI felt free to buy/sell it for Rs.11 or Rs.9. US-64 has performed a valuable lesson by teaching everyone in Indian finance that there is great value in the discipline and transparency of NAV pricing.
The most sensible path today lies in announcing that each unit of US-64 is actually worth only Rs.9 (say). The investors in US-64 would take a one--time negative return of 20% to 30%. From today onwards, US-64 would operate like a normal mutual fund, with the discipline and transparency of NAVs.
Political economy. Will a second bail-out take place? This depends on the configuration of constituencies that stand to gain or lose from a bail-out. What are these competing forces?
- Corporate and retail investors The existing investors into US-64 will obviously be extremely pleased if a gift is made to them.
- The UTI agent network To the extent that US-64 can stay off the risk-return frontier that now exists in the Indian economy, the UTI agent network stands to benefit.
- The People of India To the extent that tax revenues are utilised for helping the above two groups, the People of India suffer from an inferior provision of public goods.
In this situation, the first two groups have incentives to engage in focused lobbying. As a first approximation, the NPV of a bailout for one of these might range from Rs.1 lakh to Rs.1000 lakh per economic agent. Retail investors are a more diffused constituency. The NPV of a bailout might range from Rs.1000 to Rs.10,000 for each retail investor. So retail investors are unlikely to take the effort of political lobbying. Finally, a bailout that costs Rs.1000 crore is effectively a price-tag of Rs.10 per person for the People of India. So they have a near-zero incentive to engage in political efforts to protect their interests.
In summary, we can imagine that there are strong pressures on the finance ministry in favour of a bailout. The opportunity cost of every rupee spent on a bailout is the inferior production of public goods like health, education and law enforcement. If the People of India are not on the table when the decision about US-64 is being made, it would reveal a serious failure of the process of public policy formulation.
In recent years, we have seen four such situations:
- The call for a gift to NBFC investors.
- The repeated gifts to public sector banks.
- The gift to US-64 investors in 1999.
- The gift to Madhavpura bank depositors.
In three of these four cases, we have seen the middle class and rich successfully use the State to extract gifts from the People of India. There is a terrible contradiction when we say that public funds are inadequate to vaccinate and educate every child in India, but public funds are adequate in coming up with such choice gifts for the middle class and the rich.
Rescuing banks. Banks are in much worse shape when compared with US-64. Like US-64, banks like to promise returns to depositors with no concern about their asset-side performance. Banks have much less discipline than US-64 when it comes to measurement of NAV. Most banks hold huge amounts of opaque assets, so that marking to market of assets is very difficult. Existing empirical evidence suggests that dozens of banks in India are bankrupt, if marking to market were done. Bank deposits are 50 times larger than US-64, so unlike a US-64 bailout, bank bailouts threaten India's macro-economy. Unlike US-64, the present legal structure makes it genuinely difficult for nationalised banks to dishonour their promises of assured returns, or to be closed down.
In the case of US-64, there is an easy institutional design at hand which can be readily operationalised: a shift to NAV pricing and an elimination of opaque assets (like real estate). In contrast, in the area of banking, policy makers have not done their job in terms of building the institutional machinery required to obtain safe and sound banking.
Banks should be required to hold equity capital in order to fund the promises of assured returns. Banks should be pre-emptively closed down by the Deposit Insurance Corporation (while they are still solvent) when the equity buffer is inadequate. Until this institutional machinery to handle banks comes about, we will have a steady procession of episodes where middle-class and rich bank depositors will use the State to force the People of India to come up with gifts for them. Unlike US-64, this is a serious problem.
Surgery to UTI. It is interesting to observe that the one situation where government did not come through with a gift to investors was in the context of failing NBFCs. The fact that these NBFCs were all private sector firms did help: it is harder for the government to resist calls for a bailout when there is some connection between the State and the failing financial firm.
This reiterates the importance of government exiting from the business of financial intermediation. In the context of UTI, there is a special problem given the large market share of UTI. Hence, the way forward consists of breaking up UTI into three mutual funds, each of roughly equal size, and completely selling them off into the private sector.
The difficult problems. All said and done, US-64 is an easy problem. The amount of money at stake is tiny when compared with the Indian economy. The only interesting feature that we should focus on is giving a voice to the People of India, so they can block a bailout. Once US-64 moves over to NAV-based valuation, the mutual fund industry presents few risks in terms of future demands for gifts.
The really difficult questions lie ahead:
- How does government go about extricating itself from UTI altogether? How will the finance ministry chart a course for us to move from one public-sector UTI to three pieces with no government shareholding?
- How can the People of India be given a voice in such questions, so as to ensure that in the future, failing banks are closed down and not bailed out? This is a genuinely important question because bank failures in the next few years can easily torpedo public finance in India.
- How can the finance ministry chart a course for us to move to a point where government owns no shares in any financial intermediary?
The US-64 crisis is useful insofar as it brings these really important questions to the fore.
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