Photo: iStockphoto
Photo: iStockphoto

Investing in the right infrastructure

The inadequacies of the country's rule of law mechanisms have a real and extensive economic cost

The government’s continued focus on investing in India’s infrastructure is welcome. However, this focus has almost entirely ignored one critical area where the infrastructure is so decrepit that its condition is severely restricting the country’s economic growth—that which is needed to ensure the rule of law.

One key part of the rule of law infrastructure concerns courts and judges. Recent reports state that India currently has just 16,400 court halls and even fewer judges. Over 36% of high court judges’ posts and more than 4,500 posts of subordinate judges lie vacant. Most see these shortages as contributing to the backlog of cases in the judiciary. That is but the tip of the iceberg.

The country’s inadequate rule of law infrastructure isn’t only affecting the millions of cases languishing in its courts. It has far-reaching effects every day—on the hundreds of millions of cases that don’t even get to court, and the billions of transactions where there aren’t even any disputes.

To witness these effects on matters outside the court system, one need only review the state of private sector lending in the country today. Almost all private sector lending (other than credit card debt) is secured. Lenders insist on collateral because of the cost, delay and uncertainty associated with enforcing creditor rights. Borrowers have no choice but to provide the collateral, as alternative sources of funding are unavailable. Such secured lending is not an economically desirable outcome, as it comes with high hidden economic costs.

First, with secured lending, the loan decision is no longer driven by the potential economic benefit expected from the activity for which the loan is sought. The lending decision is more closely linked to the value of the collateral provided to secure the loan. Second, loan defaults and non-performance don’t just impact the activity for which the loan was taken—they adversely impact otherwise healthy assets that have been provided as collateral.

And there’s more: encumbering capital assets creates artificial scarcity in those assets and prevents the use of those assets for additional (potential revenue-generating) economic transactions; secured lending makes the encumbered capital assets vulnerable to value erosion from unrelated transactions; and it hinders effective signalling by markets in relation to the price and value of encumbered capital assets, and thereby impedes effective allocation of capital.

Take the example of a borrower, B, who borrows 1,000 crore and pledges the publicly traded shares of another listed company, C, as collateral to secure this loan. The pledged shares cannot be traded until the loan is repaid. Therefore, until the loan is repaid, the supply of company C’s shares is artificially lowered. Economic transactions involving the pledged shares are also frozen for this period. The pledged shares are also more vulnerable to value erosion during this time. If company C were to make a poor business decision, then while the pledge is valid, B would not be able to sell those shares in response to C’s poor business decision. In fact, borrower B effectively would have no option other than to sit by and watch its asset value erode. This also shows that B has no way of managing or limiting the adverse effects of a poor economic decision by C, while the shares are pledged.

While the above principles apply most acutely when the collateral is in the nature of assets like shares, the principles would also hold to a varying degree if other capital assets, such as real property, were pledged as collateral. To then gauge the scale of economic harm the poor rule of law infrastructure is wreaking on the country’s economy every day, one need only extrapolate the above example and apply it to the total outstanding bank credit that is secured by capital assets in India today.

This lack of adequate infrastructure is not only affecting credit-related transaction costs—because enforcement of creditor rights is impacted—it is also affecting equity-based investments where the enforcement of shareholder rights face similar challenges.

In the areas of venture capital and private equity funding, investors are now requiring promoters to deposit their shareholding in escrow—so that in the event of having to enforce shareholder rights, a private third party (that is, the escrow agent) can provide relief and the investor doesn’t have to face the uncertainty, cost and delay associated with court-based remedies. These arrangements also carry similar hidden economic costs, and the escrow fees increase overall transaction costs.

Other aspects of the economy are also being affected by the country’s poor rule of law infrastructure. Court delays are seen as an opportunity to game the system. For instance, unscrupulous high-value borrowers identified as wilful defaulters by banks are using court delays as a device to buy time and delay or defray the impact of their defaults. The resulting costs are being picked up by the banking system, because of their impact on capital adequacy and overall risk within the banking system. In other instances, parties sign contracts with little or no intention of performing their obligations. They do so comfortable in the knowledge that the cost and time that would be taken by counter-parties to obtain redress from the courts makes the likelihood of any court-based recourse extremely remote. These unhealthy practices are in turn forcing counterparties to look at alternative methods of securing their contractual rights in ways that don’t rely on court-based redress. The alternatives used inevitably increase transaction costs and carry hidden economic costs.

Investing in rule of law infrastructure would reduce transaction costs in India, and thereby increase transaction volumes and associated revenues to the government, benefiting economic growth and productivity. More importantly, ensuring that the rule of law is well supported with sufficient infrastructure also assures the people of India that their fundamental rights are secure and well protected.

Ramanand Mundkur is a Bengaluru-based lawyer.

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