Why are firms short-sighted?

Firms and managers in India are routinely accused of being short--sighted; of not embarking on `far-sighted projects'; of not taking risks; of not being visionaries who are able to see a goal and endure pain in the short run in getting to that goal.

Broadly speaking, I share this diagnosis. I have seen few managers and firms in India that are able to plan for projects that yield serious returns more than a year or two into the future. There is an intense short-sightedness, a focus on the present, that dominates discussions and crowds out what appear to be remarkably inexpensive efforts which might be all--important a little bit into the future.

The attitude of Indian firms towards technology is that of adoption rather than development. Indian firms look to horizons of a few weeks -- to license foreign technology and put it to work -- instead of the horizons of a few years that are really required to thoroughly understand technology and to be able to generate significant improvements to it.

The question of short--sighted versus far--sighted, and the ability to endure risk, is often viewed as being about culture. Management "gurus" think that these problems can be solved by exhortation and moral upliftment. The moment we bring `culture' into the picture, we think of something that is irrevocably with us and extremely hard to change.

However, simple economic reasoning (presented ahead) reveals that short-sightedness and a profound risk aversion simply make business sense given the signals given out by India's financial system. Once we see this in the light of economic principles, we also see that there is nothing irrevocably ingrained about these behavioral traits. To the extent that this behaviour can be traced to economic motivations, it can be easily changed in a different macro-economic environment.

Let us start with short-sightedness. The best firms in India are able to borrow five--year money at around 13%. At 13%, a rupee five years from now is worth 54 paisa today. A rupee ten years out is worth 29 paisa today, and a rupee twenty years out is worth 9 paisa today. In contrast, a rupee next year is worth 88 paisa today. With this kind of discounting, it is not surprising that projects that yield returns next year (i.e. 88 paisa today for each rupee of profit) are very attractive when compared with projects that yield returns 10 years from now (i.e. 29 paisa today for each rupee of profit). This difference -- between 88 and 29 paisa -- is striking.

In a world with high interest rates, being short-sighted is rational. Suppose India had a rational interest--rate structure, and the best firms were able to borrow at 6% (roughly 3% in real terms, which is comparable with international standards). In this case, a rupee next year would be worth 94 paisa today, and a rupee 10 years from now would be worth 56 paisa today. Here, the contest between the short--sighted project and the far--sighted project -- between 94 paisa and 56 paisa -- seems to be a little more even.

So far, we have considered India's best firms which are able to borrow at 13%. Matters are much worse with smaller firms. The typical small business faces interest rates like 18% or worse. At 18%, a rupee next year is worth 85 paisa today, and a rupee just five years from now is worth 44 paisa. It is not surprising that small businesses often seem to be the most boorish in terms of ignoring long--term investments: it simply makes business sense for them to do so.

What about risk, and the willingness to undertake risky projects? Modern finance teaches us that when firms are able to issue equity into liquid and efficient capital markets, the risk premium that they face is driven by the `beta' of the company's stock against the index. The long run historical rate of return on Nifty is around 21%: this is also the long run historical cost of capital that the typical firm faces. A firm that has a beta of 1 against Nifty has to plan on giving a return to shareholders of around 20%. If the future is discounted at the rate of 20% per year, it makes sense to look for cashflows in one or two years. It also makes sense to look for less risky (i.e. low beta) projects. In a world with a high cost of capital, short-sightedness and a lack of venturesomeness are rational outcomes.

Internationally, interest rates and risk premia are much lower than those seen in India. This presents firms with a benign environment where managers are asked to produce lower required rates of return to support cashflows that are risky or deep in the future. Hence, it is not surprising that Indian firms appear boorish when compared with foreign firms in being short-sighted and avoiding all but the safest projects.

If you believe that this economic reasoning explains the bulk of the short-sightedness that afflicts India's firms and managers, then there is an extremely optimistic implication: it is not very difficult to change this behaviour. If we make a transition into an environment with low inflation, low interest rates, and low risk premia, then that would give us a whole new breed of risk-taking, far-sighted firms and managers. The management gurus would even write books about the new generation of Indian managers who have developed a `new culture' of doing risky, far-sighted projects.

Macro--management in India seems to be having a fair bit of success with obtaining a low inflation regime. Low interest rates and low risk premia can come about through a combination of financial sector reforms, pension reforms, fiscal strengthening and capital account convertibility. Eliminating small savings programs would break the hold of the 12% nominal interest rate. Fiscal strengthening would reduce the claims of the government on savings and reduce interest rates. Financial sector reforms would eliminate interest rate rigidities, and improve market liquidity.

Capital account convertibility would bring down interest rates and risk premia in India to much lower levels, and would make it possible for the government to finance the fiscal deficit by borrowing abroad at much lower interest rates than are found in India. In this picture, foriegn capital inflows into the debt market (which reduce the cost of capital in India and hence make firms less short-sighted) are about as attractive as foreign capital inflows into the equity market (which reduce risk premia in India and hence encourage firms to take risks). Our traditional hostility towards debt funds and bias in favour of equity funds needs to be questioned.

In summary, the `personality' or `cultural' traits of short-sightedness and avoidance of risky projects are to a good extent shaped by economics. For each of us as individuals, it makes sense to be far-sighted and venturesome. However, for us as a country, the best solution to these problems is not moral exhortation, but a transition into a macro-economic regime with low interest rates and low risk premia.

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