Ever since winning independence in 1947, India has had a strong central government that closely controls many aspects of the economy. But with growth surging, the country is adopting more and more features of a free-market economy.
Government retirement plans are evolving, with the traditional guaranteed pension giving way to a form of defined-contribution plan that shifts the risk from government to worker. And scores of big, government-owned companies have been privatized. But both initiatives are moving slowly. Two papers presented at Wharton’s April 4 global conference on India’s Financial System look at why these changes are not coming faster. The conference was organized by Wharton’s Financial Institutions Center with the Centre for Analytical Finance at the Indian School of Business in Hyderabad and the Stockholm-based Swedish Institute for Financial Research.
Limited Choices in New Pension System
Who takes care of the elderly? In undeveloped countries, it’s the family. But as countries develop, they look for more reliable systems that reduce the number of impoverished people and free family members from the burden of care, thereby making it easier for workers to move from job to job and helping to stimulate economic growth.
The United States, for example, uses a “three-pillar” approach: a government-guaranteed Social Security benefit, retirement plans through employers, and private savings and investments.
India moved to modernize its system with the New Pension System (NPS), launched in 2004 and covering new employees of the central government. Legislation pending in Parliament would open the plan to other workers. But is the NPS good enough?
It is a step forward, but has some serious handicaps, says Hélène K. Poirson, senior economist at the International Monetary Fund. The lack of a guaranteed program like Social Security may cause the NPS investment mix to be too conservative to produce the needed returns, she says in her paper, Financial Market Implications of India’s Pension Reform.
“The problem in India is they don’t have this first pillar,” she said, outlining her paper at the conference. Also, the plan’s focus on civil servants leaves vast numbers of workers uncovered. “The current plan might just be too limited,” she noted, and may thus fail to meet one of its chief goals — stimulating development of the financial markets.
Only about 13% of India’s workforce is covered by any kind of pension program. Government employees are covered by a defined benefit plan and private-sector workers are covered by defined benefit and defined contribution plans.
Liabilities in the government’s plan have soared since the mid-1990s, causing adoption of the new system in 2004. The previous system was fully funded by the government, required no employee contributions and provided a guaranteed benefit. Under the new system, workers will contribute to the plan and receive a retirement income based on their investing success, as in a 401(k) plan in the U.S. The system thus shifts the investment risk from the government to the workers.
Until the new system receives final approval in Parliament, new civil servants’ payroll deductions are being matched by government contributions, and the government is guaranteeing an 8% annual rate of return.
Further measures, if approved, will open the program to other workers. The goal is to provide participants with retirement incomes equal to about 50% of their wages upon retiring. As in a 401(k) or similar defined-contribution plan, participants will have a variety of investment options. Workers will contribute 10% of their incomes, and they will be able to stay in the system when they change jobs.
But because there is no first pillar guaranteeing a minimum retirement income, Poirson worries that too many participants will choose overly conservative investments with low returns. “In other countries that have undertaken such reforms, the public pension system continues to provide a first pillar, or comprehensive reform legislation is being considered to introduce one…,” she writes.
India’s system is modeled after Chile’s, which is generally viewed as successful. In that country, workers covered by the old system had the option of switching to the new one, and many did so because the new one promised better benefits. India has no switching provision.
With many aspects of the program yet to be finalized, Poirson warns of the hazards of adopting the overly conservative investment practices seen in other developing countries. Many, for instance, limit the portion of investment assets that can go into stocks. “There’s a very conservative and risk-averse stance among pension fund managers in these countries,” she said.
Among four Asian countries — Indonesia, Korea, Thailand and Singapore — the highest pension-fund allocation to stocks is the 15% found in Thailand. In the U.S. and United Kingdom, the figure is around 60%.
Developing countries also tend to severely limit investing in stocks outside the home country, leaving them with too little diversification and facing too much volatility from domestic issues. Polish pension funds, for example, invest only about 2% of their assets in foreign stocks.
Chile is an exception, allowing 30% of assets to go into foreign stocks, and actually exceeding that slightly as of last June. By allowing pensions to use foreign mutual funds, Chile solves the problem of not having enough experienced portfolio managers at home, Poirson writes.
If it restricts investments to a highly conservative portfolio of 100% government securities, the NPS could replace 43% to 49% of the typical participant’s final wage, she found. A riskier, growth-oriented portfolio of 20% government securities, 30% corporate bonds and 50% stocks could lift that replacement rate to as high as 73%, she said.
Poirson is also concerned that the program, because it is limited to only some workers, “may not generate sufficient critical mass early on to kick start financial market development. India’s pension sector is small relative to more advanced Asian economies and other emerging countries,” she writes. Pension assets equal only 5.8 % of gross domestic product, compared to 61% in Singapore, 63% in Japan and 64% in Malaysia — and 95% in the U.S. “Pension reform is a logical catalyst for increased local institutional investment and asset diversification, resulting in improved allocation of financial savings and instruments.”
But the Indian system may be too small to produce these economic benefits, she says, arguing that the system would be improved by allowing workers covered by the old system to switch to the new one, and by putting the plan’s assets into the hands of private portfolio managers.
Fortunately, she said, India’s population is young, creating a heavy demand for modern retirement programs. “All these young people will be more likely to invest in equities. They essentially have this fantastic window of demographic opportunity.”
Many working-age Indians, however, have yet to focus on the issue, Poirson said, noting that the government has not launched a sweeping awareness campaign. That’s partly because legislation needed to make the program fully functional has been stuck in Parliament for two years, facing opposition from parties that prefer a system with a guaranteed benefit. “There’s kind of a chicken and egg problem, where the law has to be passed for this awareness campaign to begin.”
The Politics of Corporate Privatization
Most economists agree that privately owned companies are more efficient and profitable than government-owned ones.
Why, then, are so many countries slow to privatize their government-owned enterprises? Politics, says Nandini Gupta, of Indiana University’s Kelley School of Business. “We’re going to try to convince you that electoral support does matter,” she said, introducing her paper, The Decision to Privatize: Finance, Politics and Patronage, co-authored by Serdar Dinc of the Kellogg School of Management at Northwestern University.
In India, government ownership was originally justified as a way to insure that large projects were undertaken, and there was a wave of nationalization in the 1960s and 1970s, Gupta and Dinc write. By 2000, government firms accounted for about one-fourth of gross domestic product and two-fifths of the value off all stock in the country. Some firms are run by government departments, particularly those involving railways, the postal service, telecommunications and power. Other firms have separate boards of directors.
Government firms are heavy employers, and they tend to be poor performers. The ratio of wages to sales revenues for government firms is twice that of private companies. More than half of government firms lose money, with most doing worse than private-sector counterparts.
“Between 1990 and 1998, while the ratio of profits after tax to sales averaged -4.4% for government-owned manufacturing firms, profits after tax to sales averaged 6.7% among private manufacturing firms,” the authors write.
Following the balance-of-payments crisis of 1991, India undertook economic reforms that included privatization. Yet by 2004, only 50 of the 300 firms owned by the federal government had been privatized. In the vast majority of cases, privatization was only partial, with the government remaining in control after selling minority equity stakes. Proceeds from equity sales are generally used to pay down the federal budget deficit.
Like many other studies, this one found that privatization makes companies more efficient and profitable. The privatized firms enjoyed significant increases in sales and profit, and a decrease in the ratio of wage expenses to sales.
But many groups oppose privatization, especially workers who feel they will pay the price for greater efficiency. “Privatization is often opposed by interest groups, such as workers of government-owned firms who fear layoffs, and may be perceived negatively by the public as an inequitable or corrupt transfer of publicly owned assets to private owners,” Gupta and Dinc write. In addition, government-owned firms may provide politicians with opportunities for political patronage and campaign donations, making them reluctant to privatize.
To measure the political factors, Gupta and Dinc gathered data on more than 250 government-owned firms, including 49 which were privatized. They then looked at political conditions in the area where each firm was located.
Firms that were privatized were quite different from ones that were not. Annual sales at the privatized firms were nearly three times larger, and the privatized firms were profitable, while the un-privatized firms were not. The rate of privatization is nine times higher for companies in the 75th percentile of sales than for those in the 25th percentile, for example. The privatization rate is 84% higher for firms in the 75th percentile of profitability than for firms in the 25th percentile.
Gupta and Dinc conclude that it is easier for larger firms to issue equity.
“By selling profitable firms early it appears that governments placed a greater emphasis on increasing sale proceeds and building public support for privatization than on achieving efficiency improvements,” they write. “Privatized companies also have lower wage expenses on average compared to their fully government-owned counterparts, as measured by the ratio of the total wage bill to sales.”
“The result that privatization is likely to be significantly delayed for firms with a large wage bill suggests that employees of firms with large workforces may successfully oppose privatization,” the two authors write.
They also found evidence that politicians fear a backlash from privatization. Between 1991 and 1996, there was not a single privatization of a firm whose primary operation was in the home state of the cabinet minister overseeing it. “If the politician with jurisdiction over a firm is elected from the state where the firm is located, he may be reluctant to privatize that firm because the ability to secure campaign contributions and reelection through political patronage is likely to matter more in the politician’s home state,” they conclude.
Further underscoring the political considerations, they found that privatization was far less likely in regions with close elections, or where the party in power held only a slim majority of seats. The government, Gupta and Dinc write, “acts to minimize the effect of a political backlash on electoral outcomes by privatizing firms that are located in states where the governing party does not face a competitive race.”