What might have escaped most people in the Reserve Bank of India's February 3 monetary policy review is the central bank's decision to give greater flexibility in the pricing of instruments/securities, including allowing an assured return on exit by foreign investors.
The RBI says "with a view to meeting the emerging needs of foreign direct investment in various sectors with different financing needs and varying risk perceptions as also to offer the investor some protection against downside risks, it has been decided in consultation with the Government of India to introduce greater flexibility in the pricing of instruments/securities, including an assured return at an appropriate discount over the sovereign yield curve through an embedded optionality clause or in any other manner".
Currently, there are entry and exit barriers on pricing of shares issued to foreign investors. The entry must be at a minimum price (the floor price) and the exit must not be higher than the maximum price (the ceiling price). In addition, foreign investors also do not have right to exit with an assured return promised by Indian shareholders or the Indian company.
Although the February 3 statement is just a policy announcement and has not become the law yet, kudos to RBI for thinking in the right direction, and along the same lines as its recommendations, barely two months ago, to the Ministry of Finance to exempt the Tata-Docomo share transaction from pricing norms. If the ministry accepts the recommendation, then Docomo, a foreign investor, can exit at a higher price than the prevalent ceiling price at the time of exit. This will be a rare but welcome exemption. If, however, the recommendation is turned down, Docomo runs the risk of losing substantially on its investment. Naturally, this will be a damper for other foreign investors as well. Interestingly, even if the Tatas were to contractually protect Docomo from any such downside risk, the law does not permit it to do so; as it would translate into an assured return promised by an Indian shareholder to a foreign investor. The situation would have been different if Docomo was an Indian shareholder. The Tatas could then have assured downside protection. Foreign and Indian investors have not been on a level playing field, according to existing norms. Hence, the enormous clamour to decontrol pricing for foreign investors.
Pricing on exit can have three options. One, where the investor does not expect assured returns and exits at a price not higher than the ceiling price. Two, where the investor expects an exit price which assures a certain rate of return on the capital invested, such as an internal rate of return (IRR) of 10 per cent. Three, when the investor wants assurance only up to the amount of capital invested. While the first scenario is allowed, the other two are prohibited at present. This is what the RBI wants to set right.
Regulating share pricing is not new for the RBI. While the methods to calculate pricing have changed over time from 'net assets value' to 'discounting cash flow' to 'return on equity' and, subsequently, to 'internationally accepted methods', what has remained unchanged is the RBI's control over share pricing. It does not want to give freedom to the parties where they can contractually decide the floor price and the ceiling price. The real change will not be when the central bank allows downside protection or assured returns as announced in the policy, but only when it decontrols share pricing. The logic is intuitive - Indian corporates should be able to decide and protect their interest on pricing instead of restrictive protectionist measures provided by the law. Unlike the past, Indian corporates are matured enough and should not be provided with any protectionist measure. They should be left to decide what price they can fetch for their shares.
We have travelled a long distance from the days of the controlled regime to a more liberal world. For example, the protectionist provision, which required foreign investors to seek a no-objection from its Indian partners before setting up another venture with a new Indian partner in the same or allied field, has long been repealed. Similarly, the limits on royalty payment from an Indian company to a foreign technology supplier have also been done away with since 2009. Then why shouldn't we be more liberal with share pricing? Complex share pricing norms only encourage creative thinking to overcome them by designing innovative legal structures that provides a desired exit price and assured return. It is time that the RBI takes a bold step and decontrols share pricing. This would be the real breakthrough for foreign investors to do business in India.
(The author is partner, J. Sagar Associates. The views expressed are personal)