Demand for protectionism
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The last few months have seen demands that the government intervene in preventing “capital dumping” by certain foreign firms in the e-commerce and taxi markets. Ironically, these same companies that are looking for government intervention were criticized in the past by the unorganized retail firms and incumbent taxi service providers for engaging in predatory pricing. The proponents of government intervention claim that a significant capital infusion by established global companies such as Amazon and Uber constitutes market manipulation and distorts the level-playing field. They further argue that benefits from the growth of global companies do not accrue proportionately to local labour markets when compared with the benefits from the growth of local firms. A section of opponents to that demand argue that the local firms rallying for protection from foreign capital inflows have themselves been their beneficiaries in the past. Therefore, a sudden change in stance for these companies is anomalous, to say the least. The opponents also argue that an inferior service offering is the prime reason for the loss in the market share of local firms and a call for protectionism is a convoluted rent-seeking effort on their behalf. Amid this rhetoric and cacophony of arguments from both sides, we risk the ability to parse the real issue—the effect of a firm’s capital structure and predatory pricing on the nature and degree of competition in the market.
James A. Brander and Tracy R. Lewis initiated a strand in academic research in 1996 that analyses the impact of choice of capital on the degree of competition. This body of cross-disciplinary research integrating corporate finance with strategy and market structure establishes that the type of financing used by a firm will affect the competitive response in product markets. Specifically, whether firms will accommodate or respond aggressively to price discounts is influenced by their source of funding. Start-up firms have traditionally accessed venture capital to pursue their business objectives, both globally and in India. A typical venture financing arrangement involves a “staged commitment” where a capital provider’s continued participation with the enterprise is contingent upon the firm’s future performance. This contingent nature of commitment results in two distinct benefits for the capital provider. Firstly, it reduces the adverse selection problem as a firm with a belief in its ability to meet promised staged goals is more likely to accept such financing arrangements. Secondly, it reduces agency problems related to misappropriation or wasteful expenditure of investor funds considering that promoters will need continued access to capital providers to ensure the longevity of their business. The threat of termination as it relates to future capital participation serves as an effective incentive mechanism to align goals of incumbent management with capital providers. The promoters prefer this staged financing arrangement, believing that their company will be more valuable at a future date and the next round of financing will be less dilutive than the current one. But the staged nature of financing also creates an extremely valuable strategic opportunity for competitors. Being aware of the contingent nature of funding available to the firm, the competitors will rationally engage in strategies that are likely to result in the firm not achieving its promised goals to its investors. The constraints on future funding will drive the firm out of business and will increase competitor’s economic surplus.
What we are witnessing today in Indian markets is an instance of this multi-stage competitive dynamics. With the knowledge that local firms need access to future funding considering their operating deficits, global companies are rationally attempting to increase the intensity of competition. The past record of local firms on missed revenue targets, higher than targeted cash-burn and anecdotal stories of excessive remuneration being paid to certain employees is indeed not helpful to their cause. It is naïve to expect that the government will offer protection for organized firms and their foreign capital partners when it has not done so for the unorganized sector that bears more political capital.
An appropriate and prudent strategic response at this time may be to consider raising the bar by innovating product and service offerings and differentiating themselves from the global players. Migrating successful business models from the West and relying upon network effects to offer a competitive barrier is not the best strategy in this era of globalization. This is particularly true in instances where switching costs for customers is negligible, suppliers are unconstrained to a network owing to limited benefits, and the concept of customer loyalty is utopian.
A business with superior customer offering will find caterers of capital irrespective of predatory competition as the relevance of price-based competition becomes marginal in this context. The staged model of capital infusion works best when there is a new, promising chapter in the story at every round of financing. Local companies need to acknowledge this fact, pursue innovations that complement local realities and develop a distinct Indian model. Else, the cries of protectionism will continue to prevail and only firms demanding protection from the competition will change.
Ashish Pandey is the founder and managing partner of Quadrature Capital.
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