138 India Infrastructure Report 2002
6 REGULATORY AND CONTRACTUAL
FRAMEWORK
6.1 PRIVATE FINANCE TO PRIVATE ENTREPRENEURSHIP
For the last few years, there has been much discussion and
agonizing about how to attract private finance to infra-
structure. This paper argues that we have so far tried to
attract private finance without welcoming private
entrepreneurship. The government, while attempting to
withdraw from the financing of infrastructure, has sought
to retain its decision-making role in the selection, design,
and operation of infrastructure projects. This means that
even today capital markets have not been assigned much
of a role in allocating capital in the infrastructure sector.
There has not been much room for entrepreneurs willing
to take large risks in anticipation of large rewards. The net
effect is that while there have been sporadic successes in
attracting private finance to infrastructure projects, there
has been little success in transferring the risks of these
projects to the private sector. As long as the government
continues to assume the principal risks of the projects, the
only effect of the so-called private finance is to convert
what would have been an immediate borrowing requirement
of the government into an off-balance sheet liability. Thus
this form of private finance neither contributes to fiscal
stabilization nor promotes allocative efficiency. In fact,
when the government’s attempts to promote private finance
in infrastructure are ill designed or market distorting, the
net result might well be negative both for fiscal stabilization
and allocative efficiency. On the other hand, private
entrepreneurship in infrastructure could give large benefits
in terms of fiscal consolidation and allocative efficiency.
To achieve this result, the government needs to:
• give the private sector substantial freedom (subject
only to very broad guidelines) to identify and design
profitable infrastructure projects;
Jayanth R. Varma
• adopt broad-brush non-distorting incentives; and
• desist from premature and excessively rigid sectoral
regulation.
There would remain a class of infrastructure projects
that the government may consider of strategic importance
but which entrepreneurs do not find profitable to implement.
These would require direct government support in the
form of an outright subsidy (a negative licence fee
established through competitive auction) or some form of
credit enhancement. But these should be the exception
rather than the rule.
MARKET DRIVEN RESOURCE ALLOCATION
Pitfalls of the Current Approach
Most of the attempts to attract private capital into
infrastructure have involved inviting private participation
in projects that have been identified and designed by the
government. For example, the government decides on a
road project, lays down the specifications, and calls for
bids from the private sector. Typically, in this approach,
the private sector bidder demands a traffic guarantee, or
even worse, a revenue guarantee in what is euphemistically
called an annuity model. At this stage, the private sector
bears very little of the demand side risks of the project.
Fiscal Deterioration
Whatever legal form such a contract may take, it is clear
that in economic terms, the net result is no different from
the government borrowing to finance the project in the

public sector. The only difference is that the government’s
liability in the so-called private sector infrastructure project
is off-balance sheet. It is not an immediate liability that
shows up as government debt, but is a contingent liability
to make good the revenue shortfalls under the infrastructure
project. Even if the government had borrowed and built
the project itself, it would have had to dip into the tax
revenues to service the debt only to the extent that the
revenues from the project fell short of the debt service
obligations. Private financing of infrastructure in this model
therefore offers an advantage to the government only if the
revenue guarantees that it provides are less than the debt
service obligations that would have arisen under straight
borrowing. But the reverse is certain to be the case.
Domestic investors regard government debt as risk free
and are therefore willing to accept low rates of interest.
The guarantees provided under infrastructure projects
involve a wide variety of legal, operational, and regulatory
risks for which any rational investor would demand a large
risk premium. Thus, private sector financing in this model
only substitutes low cost debt with high cost off-balance-
sheet borrowing.
If the objective of private financing of infrastructure is
the reduction of the fiscal deficit, it should be evident that
the current model does not achieve this at all. In fact,
substitution of high cost off-balance-sheet borrowing for
low cost debt will only increase the fiscal deficit in the long
run as this higher cost borrowing is serviced out of general
revenues. The headline numbers of fiscal deficit and
government debt may show improvement, but this improve-
ment is wholly illusory and is a result of the faulty accounting
techniques that are used to measure these quantities.
Politicization of the Investment Decision
The flip side of this fiscal burden is that the government
has not surrendered its role in resource allocation. Projects
are chosen and designed not according to the rules of the
market economy, but according to the dictates of the
political and bureaucratic considerations that underlie
resource allocation by the state. Thus, the current model
fails to achieve the key objective of de-politicizing
infrastructure investment decisions and subjecting them to
the discipline of market economics. Public sector
infrastructure investment decisions are often guided by the
lobbying power of the various political constituencies that
influence the decision making process. They often have
very little to do with the actual demand scenarios and the
true demand–supply gaps in the economy. Unfortunately,
these grave deficiencies of the public sector decision making
process carry over into the current model of private
participation where the private sector has little or no role
in the resource allocation process.
Regulatory and Contractual Framework 139
Unregulated Monopolies
The process of tapping private finance tends to run ahead
of setting up an adequate system of regulation. In most
sectors, regulation was not considered necessary in the past
as the service providers were all in the public sector.
Private participation under a weak regulatory framework
carries with it the danger of creating unregulated monopolies
that are subject only to the contractual provisions governing
their participation in the infrastructure project. To the
extent that these contracts are incomplete or deficient,
there is scope for monopolistic behaviour.
What is worse is that by the time the sectoral regulator
starts functioning effectively, the pre-existing contracts
with private sector participants in infrastructure projects
could become a barrier to the creation of a fair and
effective regulatory regime. Even where an industry has the
potential to function in a near-competitive manner, the
pre-existing contracts may preclude the adoption of such
an industry structure because of the exclusive rights that
the incumbent enjoys.
REASONS FOR THE EMERGENCE OF THE CURRENT
MODEL
Given that the pitfalls of the current model of private
participation in infrastructure are obvious to any discerning
observer, it is clear that there must be some strong reasons
for its popularity.
Exclusive Government Privileges
Quite often when the private sector is invited to participate
in some infrastructural activities, many of the related
activities are reserved for the government. For example,
while private sector participation is being welcomed in
power generation, it is not permitted in the distribution
of power. A power plant is thus precluded from selling
power directly to the consumers, and must perforce rely
on a power purchase agreement with the monopoly state
owned distributor of power. The power generated is thus
insulated from the actual power demand and relies entirely
on take-or-pay contracts with the government owned
utilities.
To take another example, many infrastructure projects
are land intensive and rely on land acquisition by the state.
Under the antiquated land acquisition laws, the state pays
compensation far below fair value in the name of the public
interest. The alternative of the private sector buying its
land at market prices thus becomes unviable. It is not true
that compulsory land acquisition is necessary for even
location sensitive projects like roads and railways. The
railroad companies in the United States in the nineteenth
140 India Infrastructure Report 2002
century demonstrated that cities and towns would pay large
amounts to the railroads to persuade them to lay the rails
through their cities. The appreciation of property prices
consequent on the completion of a railway or a road is
a powerful incentive for landowners to offer a part of their
property to the builder on payment of a reasonable
compensation.
In the telecom sector, government licensing policy has
created artificial restrictions on the number of players even
where there is no genuinely scarce resource (like the
frequency spectrum) to be allocated. This again serves to
limit the role of market oriented resource allocation and
divert entrepreneurial resources to the more profitable
pursuit of capturing regulatory rents.
Ideological Commitment
In many cases, the reluctance of the government to give
up control over the decision making process in favour of
the market is driven by the ideological commitment of
large sections of the political establishment to the principle
of public sector dominance of the commanding heights of
the economy. No doubt a large part of this ideological
commitment is self-serving as it maximizes the rents that
accrue to the political establishment, but at least a part of
this commitment is genuine. In either case, this commitment
can be expected to weaken in the face of mounting public
dissatisfaction with the pathetic state of government provided
infrastructure.
There is also an ideological aversion to ‘profiteering’.
In the highly regulated economy of the past, it was true
that large profits were rarely achieved by fair means.
There is therefore a tendency to regard large profits as
evidence that unethical or corrupt practices have been
adopted. It is difficult for large sections of the political
establishment to accept that in a competitive entrepreneurial
economy, large profits can be the reward for risk taking
or innovation. If a significant fraction of projects can fail
with large losses, the projects that do succeed must provide
sufficiently large profits to make it worthwhile for the
entrepreneur to take the risk of failed projects. In the
licence–permit raj, the risks of failure were low and
consequently the rewards of success did not have to be
as high. This is again an area where perceptions would
change gradually, as the reality of a competitive economy
becomes more apparent.
THE WAY FORWARD
From Government to Markets
The way forward is clearly for the state to withdraw from
its earlier role in identifying and designing infrastructure
projects. Ideally, an entrepreneur desiring to implement an
infrastructure project identified by him would not need too
many more regulatory and governmental approvals than he
would need to set up a normal manufacturing project. He
would make an assessment of demand, prices, and costs,
identify projects that appear profitable, and proceed to
implement them. He would have to negotiate with private
owners or local authorities for various resources needed
to implement the project and pay the going market rate
for them.
Just as there are various competing enterprises negotiating
right of way to lay fibre optic cables across the country
today, there could be competing enterprises trying to build
highways across the length and breadth of the country. Just
as competing railroads in nineteenth century America
quarrelled among themselves about right of way, about
interchange of equipment, about standardization of gauge,
and about standard time zones, these competing enterprises
may also have their various quarrels. As in nineteenth
century America, they would find ways to resolve these
disputes through negotiation, arbitration, or litigation. Box
6.1.1 provides a good example of these processes at work.
Similarly competing power generating companies would
be with each other to set up plants at optimal locations
based on demand opportunities and transmission and
generating costs. They would compete for business from
large consumers of power and would put in place the
transmission and distribution infrastructure to reach these
consumers. For this they would also compete for right of
way. Other entrepreneurs might try to set up the trans-
mission facility on a common carrier model.
The role of the state in all of these cases would only
be to provide a transparent and neutral regulatory framework
within which all these entrepreneurs would operate. For
example, the government may well want to lay down safety
standards for roads and also impose common carrier
obligations on them. Entrepreneurs guided by the profit
motive could well be relied upon to decide whether the
road should be six-lane or eight-lane as also what precise
route it should take.
For all this to happen, the government will have to give
up many of the controls and exclusive privileges that it has
established for itself. There is no reason for the state to
do what the market can do as well or better. The political
establishment would have to reconcile itself to location
decisions being made by market forces rather than on the
basis of which location is closer to the hometown of an
influential politician. Whether it is willing to do this is an
open question.
We are so accustomed to the land being acquired by
the state for infrastructure projects that we tend to assume
that it cannot be done by private negotiations. Boxes 6.1.2
 Regulatory and Contractual Framework 141

Box 6.1.1
Standard Times in Nineteenth Century United States

The ability of competing enterprises to achieve standardization by private initiative without the help of government interference
is best exemplified by the adoption of Standard Times in the United States in the nineteenth century. Stover (1961) tells the
story: ‘As the railroads spanned the nation and became a national network after the civil war, they ran their trains with a crazy-
quilt pattern of dozens of several mean local sun times. When it was noon in Chicago, it was 11:27 am in Omaha, 11:50 in
St. Louis, 12:09 pm in Louisville, 12:17 in Toledo, and 12:31 in Pittsburgh. In fact in Pittsburgh there were six different times
for the departure and arrival of stations. The train station in Buffalo had three clocks, each with a different railroad time.
. . . It was William F. Allen (1846–1915), managing editor of the Official Guide of the Railways and secretary of the Central
Time Convention who finally convinced the lines that they should adopt a standard time. His plans, as conceived in 1881, were
accepted in October 1883 to go into effect at noon on Sunday, November 18, 1993. . . Public adoption of the new railroad
time was general, although one editor did complain that he would rather run his clock on ‘God’s time—nor Vanderbilt’s’. Just
before the change, the Attorney General righteously declared that no government department need use the new time until
authorised by Congress. The same gentleman, according to a doubtlessly apocryphal story, was astonished when he missed a late
afternoon train on the 18th by eight minutes and twenty seconds. Congress officially adopted standard time thirty-five years
later in 1918’. [pp. 157–8]

and 6.1.3 on US railroads and US oil pipelines respectively
provide examples from nineteenth century United States
to show how private negotiation actually worked.
Broad-brush Incentives
The entrepreneurial model of infrastructure development
would also require the state to restructure the system of
incentives that have been created for the infrastructure
sector. To the extent to which the nation faces a shortage
of infrastructure and to the extent that these projects have
large positive externalities that are not easily appropriated
by the developers, there may be a case for government
incentives. The need for such incentives should not be
overstated. Markets are quite good at finding solutions for
many problems of externalities that appear insoluble in the
abstract. Nevertheless, there may indeed be a justification
for some incentives. The important point is to ensure that
these incentives are as non-discriminatory and non-distorting
as possible. This would usually require that the incentives
be ‘broad brush’ in nature, applying in a transparent and
non-discretionary manner to a wide range of projects in
the same sector. Many examples of existing incentives that
are highly market distorting in nature are given below.
These are the kinds of incentives that ought to be avoided.
Flexible Regulatory Structure
A distinction must be made between the regulatory structure
appropriate for mature industries in mature economies

Box 6.1.2
Right of Way for US Railroads

Cleveland and Powell (1909) describe how the US railroads obtained their right of way and the land for their stations from
the individual landholders either free or at moderate prices: ‘. . . the railroads of this country have very generally obtained releases
for right of way by donation. . . . Many of the landowners along the route of the Boston and Worcester united to agreement
to release the company from all claims for damages or compensation for the use of their land. Others sold their property at a
moderate price. The Ohio and Indiana also generally obtained its right of way through donations. The same was generally true
of the Sadusky and Mansfied and many other routes of the Middle West. The fact that so many of the people along the route
of the New York and Erie owned stock in the company not only made general the free cession of right of way and lands for
station purposes, but it also created a sentiment which kept down the prices of materials to reasonable figures. Landholders on
the route of the Georgia railroad generally gave the right of way, and also in many instances, timber for the superstructure. [ p.
199–200]’. Cleveland and Powell (1909) also describe how towns often paid the railroad to route the railway through them:
‘Towns situated at some distance from a line of railroad have not infrequently been required to furnish liberal subsidies to the
railroads as a bonus before a desired connection or extension would be furnished. In 1856 the people of Mansfield, Ohio applied
to the Atlantic and Great Western for terms upon which the road would be extended through their town. In return the directors
prescribed a subscription of $100,000 and a right of way and station sites at fair prices payable in stock. Under these conditions,
the road was built. . . . The Northern Pacific in 1880, in response to a request for an extension into Superior, promised to build
to that town for one-third of the ‘lands, premises and real estate’ in the city, together with a right of way. Hard as these terms
were, ‘the town was railroad hungry’ and the offer was accepted [p. 203].
142 India Infrastructure Report 2002

Box 6.1.3
Oil Pipelines in Nineteenth Century United States

The manner in which independent pipelines were laid in the United States provides a very good example of the ability of the
free market to secure right of way under the most adverse conditions imaginable. To begin with, people are naturally worried
about the hazards of leakage, fire, and explosions associated with oil pipelines. These fears were much greater in the early days
when safety standards had not yet been well established. Second and more important, these pipelines were built in the face of
the fierce and determined opposition of the most powerful and ruthless business monopoly of the time—Rockefeller’s Standard
Oil.
Tarbell (1904) provides a graphic account of the successful struggle of the United States Pipeline Company: ‘Mr. Emery of
the United States Pipeline Company] sent his men into the field to get the right of way. They had made a good beginning
before the project was known, but as soon as it was rumoured there appeared promptly on the route surveyed, a number of
men known to be Standard employees. They too wanted a right of way, the same as Emery wanted. They bought strips of land
across his route, they bought up mortgages on farms where rights had already been acquired, and, mortgage in hand, compelled
farmers to give them rights. It was an incessant harassing by men who never used the rights acquired—who did not want them
save to hinder the independent project.’
Despite all these efforts, Emery succeeded in laying most of the pipeline. However, Emery’s route involved crossing the Erie
railroad, and Emery had obtained permission for this from the president of that railroad before beginning the construction of
his pipeline. Emery had laid the pipes on either side of the railroad and the time came to join the pipes: ‘Hardly had [Emery’s
men] arrived before there descended on them a force of seventy five railroad men armed for war . . . The pipeline men camped
near by for three months, but they never attempted to join the pipes. Mr. Emery had concluded . . . that the Erie officials
. . . had found that it would be unwise to disturb their relationship with the Standard, and while his men were keeping attention
fixed on that point he was executing a flank movement securing a right of way from a point seventy miles back.’ The United
States Pipe Line became a reality despite the determined efforts of the most powerful industrial empire of its time, in an
environment where in the absence of anti-trust laws, monopolies were free to do very much as they pleased. How much easier
it would be today for modern day infrastructure entrepreneurs who have the benefit of competition laws in their battle with
incumbent monopolists.

and nascent industries in developing economies. In the
former case, the regulatory structure is based on the
industry structure that has evolved through market forces
and seeks to regulate the monopolies that have emerged
in this process. Except at points of time when disruptive
technologies change this equilibrium, the regulatory
structure can be relatively stable. However, in the case of
nascent industries in developing economies, the equilibrium
industry structure is not clear. Premature regulation can
freeze in place inefficient industry structures and
inappropriate technologies and remove the incentive for
innovation and entrepreneurship. This point is elaborated
further later in this paper.
Instances of Market Distorting Incentives
Currently, the government provides a wide variety of
incentives to encourage private sector participation in
infrastructure. A large number of these are market distorting
in nature as may be seen from the following examples:
Discretionary Tax Incentives: The infrastructure sector
receives a wide variety of tax incentives. The government
allows some entities mainly in the public sector to issue
tax-free bonds. For example, the Indian Railway Finance
Corporation (IRFC) has issued several trances of tax-free
bonds. The difficulties with this tax incentive are manifold.
First, it is available principally to the public sector. Second,
it is highly discretionary and there is no transparent and
objective criterion by which this incentive is extended to
different entities. Third, since it is an incentive to the
investor rather than to the entity itself, it applies differentially
to different investors depending on their tax status and tax
bracket. For example, mutual funds and small investors
may not be benefited at all. Thus, these bonds tend to be
sold to high net worth individuals and corporates as tax
saving devices. To a great extent, this kind of incentive
weakens the ability of capital markets to allocate resources
optimally.
Corporate and institutional lenders receive a tax break
on interest income received by them from infrastructure
companies under Section 10(23G) of the Income Tax Act.
This provision has the great advantage of being largely non-
discriminatory as it operates on a transparent definition
of infrastructure companies (this definition is discussed in
the next paragraph while dealing with the tax holiday under
Section 80-IA of the Income Tax Act). However, it is highly
discriminatory as regards the lender since the benefit is
by and large restricted to corporate entities. Moreover, this
benefit has been largely diluted by the government’s
interpretation that the tax exemption applies only on the
profit (interest spread) earned by the lender and not on
the gross interest receipts.

Infrastructure companies receive a tax holiday under
Section 80-IA of the Income Tax Act. This is the closest
that we have to a non-distorting broad-brush incentive.
It uses a broad and transparent definition of infrastructure
companies. The tax break is granted to the infrastructure
enterprise itself and is thus non-discriminatory as between
different kinds of lenders. The entire profits from the
infrastructure business are exempt for a period of ten
years. Moreover, to deal with long gestation projects
where there may be no profits in the initial years, the
company can choose to avail of this tax holiday during
any period of ten consecutive years in the first fifteen
years. The tax holiday is available to the following
infrastructure sectors:
• A road including toll road, a bridge, or a rail system;
• A highway project including housing or other
activities being an integral part of the highway project;
• A water supply project, water treatment system,
irrigation project, sanitation and sewerage system, or solid
waste management system;
• A port, airport, inland waterway, or inland port;
• Telecommunication services1 whether basic or
cellular, including radio paging, domestic satellite service,
network of trunking, broadband network, and internet
services;
• Industrial park or special economic zone2; and
• Generation, transmission, and distribution of power3.
Discretionary Access to Foreign Borrowing: It is axiomatic
that in a country with exchange control restrictions on the
capital account, the Fisher Open condition does not hold
in general. The Fisher Open condition (also known as
uncovered interest parity) asserts that, in a regime of free
capital flows, the interest rate differential between two
countries merely reflects the expected change in the exchange
rates between them. There is no advantage to be gained
by borrowing in a foreign currency with a low interest rate
since that currency is expected to appreciate and the
savings in interest cost would be offset by exchange losses.
In a country like India that imposes restrictions on
capital flow, this condition is not expected to hold at all.
In fact to the extent that India is a capital scarce country,
the ex-ante costs of foreign borrowing may be lower than
that of domestic borrowing, even after adjusting for expected
exchange rate changes. This means that access to foreign
1 The tax holiday is not available to companies that start
providing telecom services after 31 March 2003.
2 The tax holiday is not available to companies that develop
industrial parks or special economic zones after 31 March 2006.
3 The tax holiday is not available to companies that start
generation, transmission, or distribution of power after 31 March
2003.
Regulatory and Contractual Framework 143
borrowing can be a powerful incentive for infrastructure
projects. Since many infrastructure projects lack the credit
standing needed to access foreign capital directly, guarantees
by domestic financial institutions for foreign borrowing
also act as very powerful incentives.
Again the permission to tap foreign borrowing and the
provision of guarantees by domestic financial institutions
for this purpose are both governed by highly non-transparent
case-by-case approval procedures.
Discretionary Access to Restricted Savings Pools: Pension
funds, provident funds, charitable trusts, and several other
institutions that control vast amounts of investible funds
are subject to government regulations that limit their
investments to approved trust securities. One would expect
the definition of trust security to be based on the principle
of investor protection so that contractual savings and other
similar savings pools are protected from imprudent
investments. In reality, however, the definition of trust
security has been an intensely political one in which
considerations of investor protection have only a marginal
role to play. Bonds issued by public sector bodies have
often received trust security status regardless of their
creditworthiness. Moreover, since the definition of trust
security is left to individual states, there has been a marked
tendency to favour securities issued by state government
undertakings of the same status.
Reform of these regulations that replace arbitrary
judgement of a government functionary by objective
standards of creditworthiness or credit rating are essential
both to protect the investors concerned and to allow the
unimpeded play of market forces in resource allocation in
the economy.
Closure of Existing Infrastructure to Make New Project
Viable: One of the incentives being sought by some
infrastructure developers is that existing facilities that could
compete with the proposed new project should be shut
down to make the project viable. A good example is the
Bangalore airport project where the developers have been
arguing that the existing airport should be closed down
when the new airport becomes operational. It is not at all
unusual for old airports to be closed down when new
airports become operational. But when this is done, these
costs are internalized. For example, if the same company
owns both the old and new airports, then while evaluating
the new airport, the company would factor in the foregone
revenues from the old airport in the cash flow computations
for the new airport. If they were owned by different
companies, the old airport might still be closed on terms
mutually agreed between the two. Any payments made to
the owner of the old airport would again form part of the
project costs for the new airport. It is also possible that
144 India Infrastructure Report 2002
the two companies might decide to compete with each
other. There is nothing unfair about such competition any
more than there is anything unfair about a new modern
factory competing with an old factory whose plant has been
fully depreciated.
Similar issues are cropping up in many other sectors.
For example, expressway builders would like the existing
non-tolled highways to be closed once the new tolled
expressway becomes operational. What complicates the
matter is that since the old airport and the old highway
are in the public sector, they might not operate on purely
commercial lines. For example, the public sector highway
does not charge tolls while the privately built expressway
would. This might make the internalization of closure costs
more complex. One simple solution would be to privatize
the existing facility along with or prior to the private
participation in the new project. In fact, it has become
increasingly clear in recent years that the unwillingness of
the state to privatize existing facilities while simultaneously
attracting private participation in new projects causes a
great deal of inefficiency and needless complexity.
In any case, it should be clear that the closure of
existing facilities without explicitly internalizing the costs
of such closure in some manner would lead to faulty
resource allocation and sub-optimal utilization of existing
resources.
Anti-competitive Contracts That Make Subsequent Deregulation
Difficult: In its eagerness to attract private participation
in infrastructure, the government has often offered
contractual inducements that impede subsequent pri-
vatization and deregulation of the sector as a whole. The
power sector is a good example of this where the initial
power purchase agreements with take or pay clauses
constitute a major obstacle to the eventual creation of a
competitive market for power. Such a competitive market
would involve power producers selling directly to consumers
or to competing distribution companies. New power plants
could be built on this model and existing public sector
power plants could be privatized on this basis. The difficulty
would be with the existing private plants with their power
purchase agreements. Even if all other activities of the
State Electricity Boards were privatized, they would still
have to exist to honour the old power purchase agree-
ments!
The lesson is that while attracting private participation
in infrastructure, care must be taken to ensure that the
contractual terms are fully consistent with the competitive
free market regime that would be the end result of all the
reforms. If the existing regulatory structure does not permit
this, then the answer is to carry out necessary reforms first
and then invite private participation on a basis that is
sustainable in the long run.
EXCESSIVE AND PREMATURE REGULATION
Experience of Developed Markets
In the twentieth century, it became fashionable to argue
that some industries are natural monopolies and must be
subjected to government regulation to protect the
consumers. The regulatory regime in the United States
received a big boost during the New Deal of the 1930s.
The United Kingdom set up a large number of sectoral
regulators along with the privatization of several state-
owned infrastructure undertakings in the 1970s and 1980s.
Countries that started privatizing thereafter have often
followed the same path.
In recent years, however, there has been considerable
criticism of the role and functioning of these regulations
(see, for example, Martin 1971). The power crisis in
California has drawn attention to the antiquated regulatory
structures that impede investment in the power sector in
the United States (Robb and Sugalski 2001; Taylor and
VanDoren 2001). For example, the investment legend,
Warren Buffet, announced that he would invest several
billion dollars in the sector if the Public Utility Holding
Companies Act (Puhca) were repealed (Edmonds 2001).
In the United Kingdom also, there has been mounting
dissatisfaction with the functioning of the regulators. The
independent Better Regulation Task Force submitted a
report strongly critical of the sectoral regulators in the UK
(Better Regulation Task Force 2001; Haskins 2001). The
task force made three key points:
• Competition has not developed as much as might
have been expected and as a result, the regulations have
become too complex. This complexity is confusing and
easy to exploit.
• There are concerns that the regulatory processes
discourage investment. Sectors like energy and
telecommunications had high levels of investment at the
time of privatization and the bias against investment did
not matter. Prices tumbled, costs reduced dramatically,
shareholders prospered, and everyone was happy. But
telecommunications for example now requires a new wave
of heavy investment and nobody seems satisfied with the
regulations.
• ‘[R]egulatory bureaucracies flourish in the industries,
within the regulators’ offices and in the sponsoring
departments. The complexity encourages game-playing and
leaves consumers confused and suspicious.’ (Haskins 2001).
However, the Better Regulation Task Force does not
have much to offer in the form of a solution. It does
suggest that some of the functions of the regulators should
be taken over by the competition authorities. Lurking
behind this suggestion is the idea that the utilities are not

that very different from the other industries and that the
same competition law that prevents monopolistic abuses
in other industries might be sufficient to do the job in the
infrastructure sector as well. This is surely an idea that
needs to be pursued.
More importantly, the report fails to recognize the key
problem that the lack of competition that it deplores is
probably the result of the regulatory structure that
discourages investment. It is hard to see how any new
competitor would emerge on the scene if it has no incentives
to make the large investments needed to challenge the
incumbent. If the putative challenger believes that the
regulator would restrict his profits, then he would see too
little rewards for waging a competitive battle that succeeds
in dislodging the incumbent through lower costs or better
service. He would probably look to other industries to
apply his talents.
On the whole, the report is pessimistic about what can
be done: Most important of all, the culture of bureaucracy
and game-playing that remains endemic in the management
and regulation of these industries can be changed only if
we reduce the power of the utility regulators without
damaging the rights of consumers. That will not be easily
achieved. [Haskins 2001]
Effects of Premature Regulation
Much of the criticism that the Better Regulation Task Force
has directed against the UK regulators is equally valid in
the Indian context. What is of the utmost importance in
the context of India and other emerging markets is the
finding that regulation has discouraged investment. It is
investment that we are seeking to promote and if regulation
has prevented adequate investment even in a mature market
with a well-developed capital market, there is cause for
worry.
In fact, there is reason to believe that early regulation
would have an even more pernicious effect in an emerging
market like ours. We are not dealing with mature industries
in mature economies where stable industry structures and
established technologies make for a relatively static regulatory
perspective. By contrast, we are dealing with a situation
of considerable flux as both the technology and the industry
structure is evolving. Furthermore, we are not dealing with
well-established incumbent giants that have achieved
sufficient scale and financial standing to withstand a fair
amount of regulatory pressure. On the contrary, the fledgling
infrastructure companies of our country today may find
the capital markets closed to them if the regulators start
breathing down their neck.
Some of the effects that premature regulation can have
in this fluid context are discussed below.
Regulatory and Contractual Framework 145
Freezes Poor Technological Choices: In the early stages of
infrastructure development, the optimal technological
choices are not clear and there is a process of trial and
error that goes on. At this stage, a regulator could easily
impose a variety of constraints that effectively freeze an
initial technological choice that turns out to be inefficient.
Incumbents who have invested in the wrong technology
would lobby with the regulator to prohibit the use of a new
technology that is disruptive. The ban on internet telephony
in India is a good example of what incumbents can achieve
in a friendly regulatory regime.
At a deeper level, the point is not whether the regulator
gets its decision right or not. The point is that regulators
start arbitrating on technology choices that ought to be left
to the free play of market forces. For example, there has
been a fierce battle in the Indian telecom industry on
whether wireless communication should be allowed in the
local loop. The entire debate has centred on whether the
government/regulator should permit this technology. To
my mind, this whole debate is about the wrong question.
The question that we should be asking is how did we end
up with a regulatory regime where this technology choice
became a decision to be taken by the regulator rather than
the free market. Rather than debate the merits of WiLL
(Wireless in Local Loop) technology, we should be trying
to dismantle the rigid system that made this a regulatory
question.
Discourages Entrepreneurs Willing to Internalize Risk: At
early stages of development of an industry, the demand
risks and technology risks are much greater than in a
mature industry. An entrepreneur wishing to enter at this
stage needs mechanisms to contain those risks. The natural
thing to do is to internalize the risks as much as possible
and to internalize the externalities as much as possible to
maximize returns and minimize risks. Quite often, the
entrepreneur would want to integrate vertically and extend
his operations horizontally. The vertical integration would
internalize some of the demand side risks and facilitate
their management. The horizontal extension to related
projects, products, and services would make it possible to
internalize the positive externalities of the core projects by
appropriating as much of the benefits as possible. The
regulatory framework tends to frown on such ideas because
of its focus on narrow projects. With a few exceptions like
real estate development alongside highway projects, it does
not appear that internalization of risks and benefits has
been given much importance in the design of infrastructure
projects. In telecom particularly, the tendency to issue
narrow licences tied to specific technologies has limited
the ability of players to provide a complete package of
services to a common market. A recent proposal to permit
various telecom companies to offer internet telephony but
146 India Infrastructure Report 2002

prohibit internet service providers (ISPs) from offering this regulation, what is important is to keep entry costs low
facility is an extreme example of this kind of thinking. and not frown upon consolidations that are cost reducing.’
• ‘In other sectors with slower growth but with the
Facilitates Regulatory Capture: Regulatory capture is an
potential for much faster growth than the rest of the
ever-present threat in any regulatory regime. The risk is,
economy, it may still be possible to hold back regulation.’
in my view, greater in an evolving industry where the
• ‘In less developed countries (LDCs) with as yet little
regulator tends to assume a developmental role as well. It
coverage of people, the focus should shift from prices to
is easy for the incumbents to persuade the regulators that
growth of the service.’
various anti-competitive practices that they may adopt are
• ‘In sectors with massive undercoverage and a large
necessary from a systemic point of view to ensure the
number of “outsiders” who would typically pay very high
healthy growth and development of the industry as a whole.
prices. . . [a]llowing many kinds of players with little or
In an evolving industry structure, it is not easy for the
no territorial or ownership restrictions . . . has a
regulator to make informed decisions on many of these
functionality that arises out of increased coverage.’ Morris
issues. Matters become more difficult when technological
thinks that in such situations, price deregulation would be
uncertainties complicate the decision making even further.
a useful transitional phase in which surpluses are invested
Tends to Create Monopolies and Oligopolies: Regulation has in the service to produce rapid expansions. Thereafter,
the unfortunate tendency to create monopolies and traditional price regulation could be adopted.
oligopolies in markets that might be potentially competitive.
Essentially, it appears from the above analysis that there
Paradoxically, the resulting non-competitive industry structure
are two competing dynamic equilibrium situations. The
becomes the most potent argument for the continuance of
first dynamic equilibrium is characterized by high
the regulator. We have already seen this process at work
regulation, low investment, and a non-competitive industry
in the conclusion of the Better Regulation Task Force in
structure. This is the mature utility industry conforming
the UK discussed earlier in this paper. The task force ended
to the US or UK type of regulation. The second dynamic
up concluding that the regulators could be reformed only
equilibrium is characterized by low regulation, high in-
by reducing their powers substantially, but this could not
vestment, and an industry structure that is highly contestable,
be done since consumers had to be protected in an
if not actually competitive. This is the more important and
environment where competition had not developed to the
more desirable equilibrium from the point of view of an
expected extent. The irony of this is that it is the regulators
emerging economy trying to attract investment into
themselves who are responsible for the lack of competition.
infrastructure.
The report itself pointed out that regulation had discouraged
investment, but failed to recognize that since any new
entrant would have to make large investments, to discourage STRATEGIC INFRASTRUCTURE PROJECTS
investment is to discourage entry. The point is that regulators
create barriers to entry, thereby helping to create a market It is possible that there would remain a set of infrastructure
structure that is non-competitive. By this process, the projects that do not attract entrepreneurial interest, but
regulators perpetuate themselves. are believed to be of strategic national importance. This
situation may arise because of very large externalities that
the project developers are unable to internalize. Some
PRO-COMPETITIVE REGULATION infrastructure projects may also have benefits that are not
purely economic in nature. A strategic road network for
In this light, I would argue that the key regulatory objective
example may have benefits in terms of national integration,
in any evolving industry in an emerging economy should
military uses, and redistributive effects that go far beyond
be the creation of a competitive industry structure in the
its direct economic payoff. It is conceivable that the state
long run. Once this has been achieved, the competition
may want to promote such a project even though it does
law would be the principal regulatory framework for that
not attract private sector interest without additional
industry.
government support.
Morris (2000) has summed up the appropriate regulatory
However, even in these cases, it does not follow that the
stance exceedingly well, and I would merely like to repeat
current model of risk transfer to the government is a good
his conclusion:
solution. Two other options are available. The first is to build
• ‘When growth and technological change is rapid, as the project entirely in the public sector. For projects whose
it is in the case of telecom (defined broadly), there is little benefits are primarily strategic and whose direct economic
role for the traditional regulatory stance. More than price payoffs are relatively small, this might indeed be the best

solution. In cases, where the direct economic payoffs are
substantial and strategic considerations make a relatively
small contribution to the viability of the project, private
sector participation is possible with some government
support. The important point here is that this support should
be provided in a non-distorting and transparent manner.
Earlier (IIR 2001), I argued that negative licence fees
represent the most transparent and efficient way of
supporting infrastructure financing in a mature capital
market. I also argued that credit enhancement could also
have a role to play in a country with underdeveloped debt
markets. I summarize these arguments briefly here.
Negative Licence Fee
If an infrastructure project has a high social rate of return,
but an unacceptable private rate of return, the socially
desirable level of investment can be achieved by a transfer
payment from the state to the private sector. This is a
standard proposition in the economic theory relating to
externalities. The theory would also say that the transfer
payment should not exceed the amount of the externality
itself (the difference between the social and private returns
to the project). If this is violated, then projects which earn
an unacceptable social rate of return may be undertaken.
The negative licence fee arrived at through a bidding
process can potentially achieve this transfer payment. The
auction process must include a reservation price (or upset
price) to set a ceiling on the transfer payment and ensure
that it does not exceed the externality.
Credit Enhancement
There is a fairly large literature that shows that the privately
financed infrastructure of the nineteenth century in fact
made substantial use of public funds. For example, the
United Kingdom was the only large country that did not
support railway construction with public funds in that century.
In a country like the United States, the federal, state, and
local governments provided financial support in various
forms. They subscribed to some of the railways’ bonds, they
guaranteed the interest on some bonds, and they provided
the collateral for many bonds through their land grants (see
for example, Eichengreen 1994; Dobbin 1994).
All these forms of credit enhancement made infra-
structure bonds more easily marketable to domestic and
foreign investors. Yet, except in the case of colonial India
(discussed in greater detail in Varma 2000), the government
support was nowhere near complete.
In the nineteenth century, financial markets in most of
the North American and European countries were still in
the process of development. It is significant that the country
with the best financial markets and institutions (the United
Kingdom) did not find it necessary to provide any financial
Regulatory and Contractual Framework 147
support at all.4 Thus the public support reflects the state
of the financial sector even more than the unique
characteristics of infrastructure projects.
This analysis suggests that the principal argument in
favour of credit enhancement as a tool for promoting
infrastructure development in India is our relatively
underdeveloped bond markets. Government support in the
form of credit enhancement and related techniques can
facilitate the process of developing the debt market by
creating a critical mass of borrowers. For example, if the
state were to offer to subscribe to one bond for every two
bonds that are placed with the public, developers would
have a huge incentive to raise bonds on a large scale. If
the government were to provide a partial guarantee, then
the fillip to the market would be even greater. A partial
guarantee may mean for example:
• A Brady-bond5 style guarantee of the principal with
or without a rolling interest guarantee.
• An interest guarantee covering only the gestation
period
• A guarantee covering only a percentage of the holdings
of an investor with or without a monetary cap.
It is possible that these techniques need be used only
for a few large high profile projects in the initial period.
Thereafter, if the debt market gathers steam, subsequent
projects may well be able to stand on their own feet without
much state support.
It is important from a moral hazard perspective to keep
the guarantee limited in scope. If the guarantee covers the
bulk of the present value of the debt service obligations,
the bondholders have little incentive to monitor the project
and to make a careful assessment of its creditworthiness.
For the capital markets to perform their resource allocation
function fairly well, it is necessary that bondholders face
sufficient residual risk to take their monitoring role seriously.
And as I have emphasized earlier, it is even more important
that equity holders bear practically all the demand side
risks, technological risks, and operational risks of the project.
Political Considerations
The cynic would doubtless argue that once the principle
of project specific government support is accepted, political
considerations, rather than economic merit, would guide
4 ‘The United Kingdom is the only important country whose
railways have been developed practically without public aid’, (Dunn
1913).
5 Brady bonds named after the then US Treasury Secretary were
created in the 1980s as part of the restructuring of Latin American
sovereign debt. The principal value of these bonds was backed by
zero coupon US Treasury bonds, so that the principal was effectively
guaranteed by the US government. In some cases, a part of the
interest was also guaranteed by a rolling guarantee.
148 India Infrastructure Report 2002
the choice of projects for which this support is provided.
This is to a great extent unavoidable and inherent in the
very notion of strategic importance. However, the provision
of this support in a transparent manner would make these
political decisions explicit and more easily subject to
political accountability.
Needless to say, the whole model of infrastructural
entrepreneurship is founded on the belief that a large number
of infrastructure projects would not need government support
and would be governed by market economics. The political
process would hopefully be confined to a small minority of
infrastructure projects whose strategic importance requires
that they be built with government support when the private
sector is not sufficiently forthcoming.
CONCLUSION
After a few years of struggling with somewhat half-hearted
efforts to attract private finance into infrastructure, the
6.2 THE GUJARAT GAS BILL AND ITS GENESIS
ANTECEDENTS
Studies on the demand projections of gas6 reveal that in
Gujarat alone, by the year 2007 the demand is likely to
be 44 million metric square cubic meter per day
(MMSCMD). The dismantling of the Administered Price
Mechanism (APM) would allow market prices for gas and
its substitute fuels. This would increase the demand for
gas in many applications since gas is expected to be
cheaper per unit of energy than competing fuels like fuel
oil, and possibly coal. It is also clean and easy to use.
Significant amounts of gas are traded internationally through
long term (price) contracts. Some of these contracts are
linked to oil prices, and to baskets of fuels. The spot
market for gas is also beginning to develop.
The sector can be divided into: exploration or
regassification, that is the supplier end; gas transmission,
that is the gas trunk lines; and distribution. Distribution
would include the spur lines going to a large customer,
besides the retail gas distribution network. The last two
parts of the business constitute the gas infrastructure, and
are capital intensive. Gujarat has been one of the largest
users of gas and has the highest registered demand in the
country. The need to develop the sector and its structure
was felt in 1998.
6 Natural gas, regassified liquified natural gas or natural gas
piped from wells.
time has now come to move forward more aggressively.
The government must now prepare to relinquish its exclusive
role in decision making in the infrastructure and allow
much of these decisions to be made by the free play of
market forces. This would open the way for private
entrepreneurship in infrastructure. The private sector would
then bear the risks and reap the rewards of infrastructure
projects. The design and location of these projects would
follow economic logic rather than the dictates of political
considerations. I have argued that the private sector would
come forward to build most of the infrastructure that India
needs without the government having to bear the risks. Yet
a small number of strategic infrastructure projects, that the
state considers important, but the private sector does not
consider attractive may remain. It is only for these few
projects that the state needs to step in either by undertaking
the project with public funds or by providing subsidies or
credit enhancement.
Atanu Chakraborty
Since gas infrastructure involves large investments and
a large part of the financial resources had to be raised from
the market, it was imperative to put in place a framework
that would bring the private sector in. The framework also
had to allow the risks to be appropriately segregated, to
enable subsequent correct attribution and sharing of the
risk. Gujarat had taken up port privatization in an ambitious
way in 1995. LNG became a favoured cargo for the port
operators, which meant that downstream investment in gas
using industries was likely. Hence, there was a need to put
in place the gas infrastructure7. Furthermore, the fertilizer
and power plants in the state were starved of gas as the
HBJ line carried a large quantum of the available gas up
north. The number of gas suppliers was bound to increase
as the monopoly of GAIL was to end.
The Challenge
The Gujarat Infrastructure Development Board and the
Gujarat State Petroleum Company initiated the legal
framework for the sector. Some of the considerations and
needs that were recognized in the framework were as
follows: (a) The resultant gas infrastructure had to be
neutral between both suppliers as well the user. This meant
that the sector had to segregated. (b) It ought to provide
equal access to all users and suppliers. (c) The transportation
charges have to be equitable and regulated, since the gas

transmission systems have characteristics of a natural
monopoly. The entry barriers are high, and contestability
is out of question. (d) The need to avoid the waste in
duplicate pipelines that competing suppliers could build in,
if a common carrier system were not to develop. (e) A
regulatory framework for the transmission system and
distribution systems was necessary. (f ) A framework for
the contracts to be entered between various players in the
sector was to be evolved. (g) Development of the other gas
market products such as spots, swaps would have to be
facilitated etc.
Developing the framework for a sector like gas was not
easy. There were no ready parallels available from the
developed economies such as USA or UK. In these
countries, the gas industry had developed much before the
regulatory systems were put in place. Not many successful
examples were available from other developing countries
either, as state owned companies tended to dominate the
sector. Such companies were typically vertically integrated
across exploration, transmission, and distribution. It was
essential to contextualize these developments to a nascent
market such as Gujarat. In India too, the near monopoly
of the state owned GAIL, had to be contended with.
The Issue of Jurisdiction
The very first question that came up related to the jurisdiction
of the state government in regulating the sector. The
constitutional provisions on this issue were very clear. Item
25 in the states list of activities under the Constitution8
clearly stated ‘gas and gas works’. Nevertheless, there were
doubts as to how other entries, including the central list,
under the Constitution would impinge upon it. The central
government was unsure whether the Gujarat government
could go ahead with the Gas Act. This was despite the fact
that another legislation relating to gas existed on the statute
books. Also there was a clear judgment from the Supreme
Court on the issue of jurisdiction over gas. Several leading
legal luminaries in the country scrutinized the issue and
found that the state government indeed had the jurisdiction
to legislate on the gas transmission and distribution, on
the strength of the entry item 25 mentioned above.
FEATURES OF THE GAS ACT
As mentioned earlier, models from developing and developed
countries were studied. The likely stakeholders from the
market were involved. Stiff opposition emerged from certain
quarters to this scheme, as they perceived the Act to be
a threat to their business plans. One must also mention
that during the discussions it transpired that a large number
of worries expressed were merely initial impressions, and
the opposition to the Act melted on sustained dialogue.
Regulatory and Contractual Framework 149
Within the state government, the Gujarat State Petroleum
Corporation (GSPC), along with the Gujarat Infrastructure
Development Board (GIDB), initiated and piloted the
development of the legislation to create an unbundled
sector. The government set up a separate gas transmission
company, in which GSPC is a minority shareholder. Within
the government, there was a large measure of support, but
the proposed government legislation had go through of
scrutiny at multiple levels. The issue was new and there
were no ready models or precedents to go by in the country.
Much energy and time was spent by officers and others
in making the draft Bill and ironing out all the details.
The transmission line connects and separates the user
and the supplier of gas. Essentially, it creates an open
access common carrier form. This means that every supplier
can use the transmission line, and the line would
simultaneously carry gas for more than one supplier or
buyer. Since, the transmission is on the basis of energy
delivered at the end points, it really does not matter
whether the characteristics of the gas sent into the line by
each of the suppliers varies (within certain limits). Volumes
pumped in and drawn could differ somewhat as the
accounting is in energy terms. This principle ensures a free
movement of gas in the transmission line. The transmission
entity is entirely independent, having no interests in gas
purchase, production, or trade. As such the market for gas
buying and selling is rendered competitive. Some of the
key features of the Gujarat (Regulation of Transmission,
Supply and Distribution) Bill, 20019 are as follows:
• It envisions setting up of a three member regulatory
authority for the gas sector. Some of the key functions of
the regulator are: regulate the charges of transmission; to
set and enforce operational standards of safety and
environment in transmission and distribution of gas; to
adjudicate in disputes between various players such as a
specified company, a supplier, or a distribution licencee;
to lay down and enforce the principles of common carrier
mode of working.
Specified Company
Gas Transport Agreement
R-LNG Supplier
Gas Seller User
Sales Agreement
Regulator
Fig. 6.2.1 Gujarat Gas Act: The Actors and Relationship.
150 India Infrastructure Report 2002
• The Act limits the companies that can participate
in the transmission of gas, and they would be called
‘Specified Companies’. Initially this activity was sought to
be kept in the public sector, as not many private gas
transmission entities would have come forward. But, as the
private sector showed interest, Section 23(1) of the Act10
which provided for more than one company to participate
in the transmission of gas on the ‘Common Carrier ‘ basis
was brought in. The charges for the same, were subject
to regulation.
• The law now prohibits others (than those licensed)
to transmit gas. It would thus facilitate the orderly
development of the network, regulation, as well as
investment in the gas grid.
• A clear distinction has been made between
transmission and distribution. Transmission is defined as
the movement of gas at a high pressure, while distribution
consists of activities further from the ‘city gate’ where the
pressures would be low and would not exceed 6 kg per
sq. cm.
• The distribution of the gas, that is taking it off from
the transmission line and retailing, is also licensed as per
Section 25 (1) of the act. The Commissioner of Gas
established under this Act would be the licensing authority.
• To ensure a transparent selection of the licensee as
well set the commercial and operational terms upfront, the
procedure would be as per the Gujarat Infrastructure
Development Act, 199911.
• The Act also provides for adjudication of disputes
between various players. Section 30 of the Act envisages
a tribunal to hear appeals against the orders of the authority
as well as against any order of revocation of licence.
• While the act protects the interests of the existing
entities in the transmission of gas, it brings excess capacities
available with them under regulation. Any future additions
by them in any case would come within the ambit of this
law.
While the Act was being deliberated upon, the state
government set up a company, the Gujarat State Petronet
Ltd. (GSPL), to carry out the business of transmission. It
6.3 CORRUPTION AND GOVERNANCE: INSIGHTS FROM THE LITERATURE
‘Up to the time when a huge corruption scandal, popularly
labelled “tangentopoli” (Bribe City), brought down the
political establishment that had ruled Italy for several
decades, that country had reported one of the largest
share of capital spending in GDP among the OECD
countries. After the scandal broke out and several
is a company that is envisaged as a venture of users and
suppliers of gas and thus able to represent the interests of
all the stakeholders .Of course, there are existing players
such as GAIL and Gujarat Gas Company, but, they will
have to alter their business model to fit in to the requirement
of meeting the ‘Common Carrier’ principle. GSPL has
already rolled out part of the gas grid in the southern part
of the state. See Fig. 6.2.1 for a schematic representation
of the players as envisaged in the Gas Act.
Contextualization
There had been some criticism of this law, not on the
fundamental requirement of having one, but of some of
its provisions. While as mentioned earlier, some criticisms
were based on mere apprehensions, it is still worth sampling
the main ones:
• The regulator is too weak. It is dependent upon the
government
• Bringing a state sector company in transmission is
not in keeping with the winds of time.
If one looks at the Act more closely, both concerns
would seem to be not so well founded. Removal of a
member of the Commission is fairly difficult, and the Act
lays out a comprehensive procedure for this. Also there
are certain prohibitions on members of the Authority in
taking up, after his/her retirement/tenure, assignments
which are connected to the gas sector. Transmission being
a natural monopoly had to be structured carefully and it
was that consideration that lead the state to set up a venture
where all the stakeholders are represented. It is not the
usual government company, but one that has formal
participation of stakeholders. In any case, the Act provides
for more than one company to be the ‘specified company’.
Every law is born out of the conditions of society, and
draws much from the previous experience that the lawyers
and opinion makers have with institutions. The Gujarat
Gas Act is one such law that in contextualizing sound
economic and institutional principles, hopes to take the
sector forward.
Ajay Pandey
prominent individuals were sent to jail, or even committed
suicide, capital spending fell sharply. The fall seems to
have been caused by a reduction in the number of capital
projects being undertaken and, perhaps more importantly,
by a sharp fall in the costs of the projects still undertaken.
Information released by Transparency International reports

that, within the space of two or three years, in the city
of Milan, the city where the scandal broke out in first
place, the cost of city rail links fell by 52 percent, the cost
of one kilometre of subway fell by 57 percent, and the
budget for the new airport terminal was reduced by 59
per cent to reflect the lower construction costs’.
Tanzi and Davoodi 1998
The anecdotal evidence of increase in costs of providing
infrastructure in Italy due to corruption, as pointed out
by Transparency International and cited above, underscores
the importance of corruption as an important determinant
of governance within infrastructure sectors. Though
corruption, or use of public office for private gains, is
not the only governance issue in infrastructure sectors,
it acquires prominence in the context as the state (and
therefore, public office) invariably comes into play in
policy formulation, implementation, and at times in
regulation of these sectors even though they may have
been privatized. Corruption, and its consequences as well
as determinants, has attracted the attention of several
economists and others over the last 40–50 years, as it
has often been seen as a distinguishing feature of
developing countries, in terms of both intensity and
extensiveness.12 This paper reviews the literature on
corruption to draw out the issues and implications relevant
to infrastructure sectors in the context of a developing
economy (See Box 6.3.1).
ECONOMIC ANALYSIS OF CORRUPTION AND
EVIDENCE
The initial arguments put forth in the literature were
predominantly in favour of corruption, as corruption,
particularly petty bureaucratic one, was seen as ameliorating
the economic ills or effects caused by sub-optimal policies
and bureaucratic inefficiency,13 that is, red tape. Leff
(1964) and Huntington (1968) argued that when a state
errs in terms of policy decisions (and lowers social welfare)
or when it is inefficient, the optimal level of corruption
in the society is strictly positive. These two arguments are
also known as ‘second best’ and ‘efficiency wage/speed
money’ arguments in support of efficiency enhancing
corruption. In addition, some authors have viewed
corruption as a ‘Coasean bargaining’ process, through
which the bribe taker and bribe giver negotiate their way
to an efficient outcome. Later, many authors have critiqued
12 See Bardhan (1997), for a comprehensive review of the
impact of corruption on economic development. Also, see Shleifer
and Vishny (1993).
13 In the specific case of bribery with waiting, see the review and
analysis in Chapter 2 and Section 6.6.
Regulatory and Contractual Framework 151
these arguments and have pointed out at least three major
reasons as to why corruption may never be efficiency
enhancing. These are: (a) endogenous characteristics of
performance parameters of the corrupt official, that is, the
bribe taker himself decides on the quality and quantity of
goods and services to be supplied; (b) illegal and, therefore,
secretive nature of corruption, which distorts the decisions
of the bribe taker as he tries to maximize his payoffs while
minimizing the probability of detection and penalty; and
(c) poor enforceability of obligations contracted for through
corruption. The literature also has analysed the effects of
centralized vs. decentralized corruption in an economy and
the determinant of its existence and persistence. This
section starts with the conceptualization of corruption in
the literature and some distinctions invoked, and details
the arguments used by both apologists as well as radicals
on corruption. Lastly, it points out some evidence, which
does point out the negative consequences of corruption on
economy.
Forms of Corruption
Corruption, in common usage, means different things in
different contexts, ranging from ‘illegal’ and/or ‘immoral’
acts to ‘misuse of office for private gains’. It is only in the
limited sense of misuse of public office (which allows the
incumbent to sell property rights over a public resource
or allows him the right to buy from private sector) for
private gains, corruption is amenable for economic analysis.
Political corruption, when the gains are in the form of
political capital or for building/nurturing the constituencies
of the public official, is not suited for similar treatment.
Accordingly, much of what is written by economists (and
therefore, in this paper) is limited to corruption where the
payoffs line the pocket of the corrupt public official himself.
Sometimes, the term ‘political corruption’ has also been
used for grand, as opposed to petty, corruption (Tanzi and
Davoodi 1998). Grand corruption can be seen as a
manifestation of high and centralized corruption, where
the public officials at the very top collect payoffs. In the
case of petty corruption, the collection of bribes is
decentralized and the top of the government is seen as
relatively less corrupt.
Another useful distinction made by Shleifer and Vishny
(1993) is corruption with theft, as opposed to, corruption
without theft. Corruption with theft takes place when the
bribe taker pockets the entire proceeds of the transaction
without parting with anything for the government. A customs
official, who charges less than the official custom rate for
allowing passage of the goods is an example of corruption
with theft, and so is the case when a train conductor allows
someone to travel in a higher class compartment, while
holding lower class ticket, after accepting a bribe. Unlike
152 India Infrastructure Report 2002

Box 6.3.1
Why Governance Matters: A World Bank Perspective
Praveen Kulshreshtha

. . . causes of financial crises and poverty are one and the same . . . (If countries) do not have good governance, if they do not
confront the issue of corruption, if they do not have a complete legal system which protects human rights, property rights and
contracts . . . their development is fundamentally flawed and will not last. 1
(James D. Wolfensohn)
Governance has become an important focal point of debate, discussion, and concern among bilateral aid-donors, aid-recipient
countries, and international development agencies such as the World Bank. 2 It is generally recognized as an important determinant
of a country’s long-term economic growth and development. 3 The Bank, in its well-known report Governance and Development
(1991) defined governance as ‘the manner in which power is exercised in the management of a country’s economic and social
resources’. In its update, Governance: The World Bank’s Experience (1994), the Bank viewed governance more broadly and asserted
that ‘Good governance is epitomized by predictable, open, and enlightened policymaking (that is, transparent processes); a
bureaucracy imbued with a professional ethos; an executive arm of government accountable for its actions; and a strong civil
society participating in public affairs; and all behaving under the rule of law.’
The above view of the Bank is shared by most donor countries and major development organizations (such as UNDP, other
agencies of the UN, regional development banks, European Union, OECD, WTO, professional and private organizations, and
non-governmental organizations (NGOs)). More importantly, the Bank’s governance framework has influenced and shaped the
development programmes of various developing nations of the world during the past decade. The framework is not only relevant
to the core functions of governments (such as public expenditure management, tax administration, public enterprise and civil
service reform, legal reform), but also incorporates governance concerns in specific sectors such as education, health, and
infrastructure.
This Box highlights the key factors in the World Bank’s approach to governance as they have evolved, especially in the social
and infrastructure sectors.4

GOVERNANCE AND DEVELOPMENT ASSISTANCE

In its earliest years, the World Bank focused primarily on providing technocratic solutions to development related problems,
assuming that sound policies and well-designed projects will yield maximum social benefits when they are implemented by
development-oriented governments. In the 1980s, the Bank realized that development projects may not succeed when the policy
frameworks of governments are seriously faulty. A little later, in the 1990s, the Bank also began to realize that development policies
may themselves fail if the governance structure in a country is weak and public institutions work poorly.
Since the publication of its World Development Report (1997), the World Bank has proclaimed that reforming public institutions
(or, the public sector) and improving governance is key to all successful development and poverty-reduction work (as the Bank’s
president, James Wolfensohn, asserts in the quote above). According to the latest Bank view, good governance matters for poverty-
reduction as it improves the overall quality of basic social and infrastructural services while making them more accessible to the poor.
During the past few decades, the World Bank has promoted good governance in developing countries by reviewing their
internal accounting and audit systems, budgeting mechanisms, and rules governing the civil service and judiciary. However, during
recent years, the Bank has begun to emphasize various other mechanisms which developing societies can use to facilitate reform
of their public institutions, particularly in the social and infrastructure sectors. For instance, encouraging citizen (local community)
participation or ‘voice’ in decision making and allowing private and public sector firms to compete in providing public services
can reduce incentives for corruption and hence improve transparency and accountability in government.
The World Bank has also applied the mechanisms of ‘voice’ and competition in its anti-corruption efforts, following its 1997
strategy to help developing countries fight corruption in their public institutions.5 The Bank has assisted specific countries in
designing and implementing surveys of citizens, private firms, and public officials, which help strengthen the involvement of
civil society in supervision of public officials and ensuring greater transparency in public decision making and service delive ry.

1 Reforming Public Institutions and Strengthening Governance: A World Bank Strategy, November 2000, The World Bank, Washington, D.C.,
p. 1.
2 See P. Kulshreshtha, (1993), ‘Governance Issues at CG Meetings: 1990–Present, An Analysis’, mimeo.
3 Many empirical studies have confirmed that governance influences economic growth. See, for instance, P. Mauro (1995), ‘Corruption and
Growth’, Quarterly Journal of Economics, Vol. 110, No. 3, 681–712. Also, a series of cross-country studies have found empirical evidence of
a strong causal relationship between better governance and better development outcomes such as D. Kaufmann, A. Kraay and P. Zoido-Lobaton
(1999), ‘Governance Matters’, Policy Research Working Paper No. 2196, The World Bank, Washington, D.C.
4 For a comprehensive account, see Reforming Public Institutions and Strengthening Governance: A World Bank Strategy, November 2000, The
World Bank, Washington, D.C.
5 See Helping Countries Combat Corruption: Progress at the World Bank Since 1997, June 2000.
 Regulatory and Contractual Framework 153

Governance concerns also affect the aid-disbursement decisions of the World Bank as well as other development agencies and
bilateral donors.6 For instance, the Bank has started to incorporate governance concerns such as corruption or lack of transparency
and accountability in its assessments of country or project lending risk. The Bank has also considered taking additional steps to
safeguard accountability in the use of its funds by recipient governments with a poor governance record in the past. In fact,
almost all Bank projects approved in recent years have a strong governance component and have attempted to reform the public
institutions in the recipient country. The significance attached by the Bank to governance issues is also evident by the fact t hat
about one-fourth of the Bank’s total aid-disbursement during 1997–9, which amounts to approximately $5–7 billion per annum,
has been spent on institution-building efforts. 7

MIXED SUCCESS
Despite increased spending on governance reform in the 1990s, the World Bank has not always succeeded in improving
governance via its development projects in core areas of government as well as in specific sectors. Some important lessons that
emerge from the Bank’s experience with institutional reform are as follows. Firstly, development projects that are ‘technocratic’
in nature and insensitive to the institutional realities in a developing country are less likely to succeed in strengthening governance.
In particular, if the Bank does not consult with important stakeholders or groups whose support is crucial to mobilizing ideas
for reform, institutional change becomes very less likely.
Secondly, in the past the Bank has often depended upon models of ‘best-practice’ which may not fit all developing countries
equally well. Although broad goals of good governance such as transparency, accountability, equity, and efficiency are common,
the specific means that can be employed to achieve these goals may vary across countries. A deep understanding of the institutional
realities of a country is essential before deciding upon the strategies and means for reform. Hence a ‘one-size-fit-all’ approach to
governance and institutional development would tend to be inferior and lack effectiveness. Thirdly, weaknesses in Bank’s lending
instruments and deficient staff and expertise on governance at the Bank can hamper long-term efforts to promote institutional
reform.
Lastly, traditional project lending and governance reforms are often in conflict with each other. This is because development
projects typically target a specific action to be executed rather than attempt to change the larger institutional set-up in a developing
country. Hence, achievement of project-specific objectives often comes at the expense of, and can even undermine, institution-
building efforts.8 However, it is important to note that in countries where governance structures are very poor, pushing project
lending may be the only viable way to create and sustain economic growth.
In the area of public service delivery, the Bank has also had limited success due to a variety of reasons similar to those abov e.
Firstly, during the past few decades, the Bank devoted much attention to improving the capacity of public monopolies and other
public organizations to deliver social and infrastructural services, rather than looking at available options for institutional reform.
The mechanisms of decentralization or ‘voice’ and competition were practically ignored by the Bank for a long time, even though
they were available. Secondly, the Bank has failed to avoid the trap of ‘best-practice’ models and to account for institutional
complexities in the public service sector because of a poor understanding of institutional realities in this sector.

6 However, most bilateral aid-donors accept that aid-conditionality, i.e. making development assistance to a recipient conditional upon
improvements in governance, can be effective only if it accords with the broad policies of the recipient country government and is agreed upon
mutually. See ‘The Role of Donors and IFIs in Curbing Corruption’, Global Forum on Fighting Corruption, The Hague, 28–31 May 2001.
7 See World Bank (2000).
8 This is specifically true in projects controlled by donor countries. For instance, donors often provide salary supplements to local project
employees which leads to diversion of superior skilled labour from important core areas of government. Also, availability of loans under an aid
agreement can lead to lower budget discipline and distort government priorities for development across sectors. Finally, different donors may have
different procedural requirements, which increases administrative burden and hampers the development of simple and efficient administrative
systems in the recipient country.

these examples, corruption without theft takes place when
extra money is asked for issuing a ration card or a passport.
Corruption with theft is a useful construct, however, only
when the government has set the price of a public resource.
Under such conditions, the distinction changes the marginal
cost of supplying goods and services for the bribe taker.
Efficiency Enhancing Corruption: The Arguments
Corruption as ‘Speed Money’ or ‘Efficiency Wage’: Corruption,
when the bribes are given to speed up the decisions or
to cut through the red tape, is seen as efficiency enhancing
by some authors. Huntington (1968: p. 386), viewing
corruption as a lubricant in the wheels of bureaucracy,
states: ‘In terms of economic growth, the only thing worse
than a society with a rigid, over-centralised, dishonest
bureaucracy is one with a rigid, over-centralized, honest
bureaucracy.’ More formally, Lui (1985) models the
corruption or bribery in a setting of queue formed for
provision of a public service. In his model, the corrupt
official is able to practise price discrimination based on
154 India Infrastructure Report 2002
the opportunity cost of the clients in the queue, and the
size of the bribe is linked to this opportunity cost (bribe
is decided by the bribe giver). The equilibrium strategy
in his model minimizes the waiting costs associated with
the queue and thereby increases efficiency in the service.
Intuitively, the presence of bribe in this case acts as ‘piece
rate’ paid to the official serving the queue, increasing his
efficiency. Moreover, since the rate itself is paid on the
basis of opportunity cost of waiting time, it allows the
official to serve those clients first who put maximum value
to their waiting time. Iniquitous though it may be, it thus
improves welfare and allocational efficiency.
Corruption as a ‘Second Best’ Solution to Policy Induced
Distortions: Besides viewing the potential of corruption
as a way to cut through red tape and bureaucratic
inefficiency, it is also seen as ‘second best’ solution to pre-
existing policy induced distortions. In such cases, the state
imposed distortionary policies are nullified by the
corruption facilitated blackmarketing, smuggling, etc. The
nullifying economic activities circumventing irrational policy
and administrative decisions with the help of corruption
can improve allocational efficiency and welfare, even if
some resources are wasted in the process.
Corruption as Efficiency Enhancing ‘Coasean Bargaining’
Process: Corruption as ‘Coasean bargaining’ process may
increase efficiency by improving the welfare of an economic
agent, if the public official has discretion to lower the
welfare of that agent, either by imposition of penalties or
denial of a public resource. The effect is stronger when
the decision or action of the public official can harm the
individual more than he gains from the decision. For
example, if a public official, by taking a particular decision,
gains Rs 100 as payoff and if the decision results in loss
of Rs 200 to an individual, the individual may bribe any
amount up to Rs 200 to the public official to get the
decision changed. This would improve his own welfare as
well as that of the public official.
Corruption and Efficiency: Critique
Compelling though these arguments are, the effects of
corruption on efficiency are not so straightforward if the
real life issues related to information asymmetry between
the bribe taker and bribe giver, endogenous characteristics
of red tape, lack of enforcement/secrecy associated with
corruption, as well as the decentralized nature of corruption
are incorporated in the analysis.
Endogenous Characteristics of Red Tape and the ‘Speed Money’
and ‘Second Best’ Arguments: Myrdal (1968), quoting the
1964 Santhanam Committee Report14, argues that corrupt
14 Government of India appointed the committee for prevention
of corruption.
officials instead of speeding up the administrative work
may increase the delays in order to maximize the bribes.
Corrupt officials may create more red tape in order to
screen clients in order to maximize their payoffs (Banerjee
1997). The problem is essentially due to the endogenous
nature of red tape or the process as well as criteria used
in allocating public resources in bureaucracies. Concept-
ualizing the relationship between public officials and public
as that of agents (public official) engaged by the principals
(public or a benevolent government), as has been done in
the literature, the moral hazard [expropriation of principal(s)
by the agent(s)] problems arise in the first place due to
information asymmetry. In addition, the complications in
this case are due to the free rider problem faced by a large
number of principals, making it extremely difficult for
them to write the terms of contract at which the agents
are going to work for them, giving in turn considerable
discretion to the agents to offer those contracts, that are
in their own interest. Not only do the processes and
criteria used by the public officials have the potential to
be opaque, endogenous, and self-serving, the quality and
quantity of public service would also be unobservable and
unenforceable. Only in very special cases, such as Lui’s
model discussed earlier, corruption may be efficiency
enhancing. If the public officials have disutility of effort
(a typical principal–agent characterization) and very weak
accountability, the end result will be sub-optimal. As Andvig
(1991) points out, the queues in allocation mechanisms are
more complex than the queuing models used in the literature
to analyse the effect of corruption in efficiency. The results
on these models may not be robust to new offers of bribe
made by new entrants to the queue and there is no
compulsion on the part of the corrupt official to stick to
the deal of maintaining priority in the queue if the
information is imperfectly observable to the clients.
Similar to the effect of the endogenous nature of red
tape on ‘speed money’ efficiency, the policy induced
distortions which corruption can ameliorate in the ‘second
best’ argument are endogenous to the bureaucracies.
The bureaucracy, particularly an over-centralized one
(decentralized ones may find it difficult to do it as effectively
owing to difficulty in co-ordinating its members), may
induce such distortions in the policy framework to maximize
its own payoffs.
Effect of Secrecy and Lack of Enforcement Associated with
Corruption: Even in the context of an economy with
worst bureaucracy, corruption is illegal. Considerable
inefficiency can result from the distortions created by
corrupt officials to prevent detection (Shleifer and Vishny
1993). A corrupt official will induce distortions in the
resource allocation to prevent detection, or to hide
corruption, even if otherwise corruption is neutral to

allocational efficiency. Using the example of competitive
bidding of bribes for a government procurement contract
under imperfect information, Beck and Maher (1986) have
shown that the lowest cost firm offers the highest bribe
and gets the contract. The only effect of bribery is that
producer surplus is cornered by the corrupt official. However,
as Shleifer and Vishny (1993) have pointed out, the corrupt
official is likely to distort the procurement contract itself
in a manner that competitive bidding is avoided (as it
increases the possibility of detection) by altering
technological, technical specifications and qualifying
requirements of bidders. This may result in the creation
of inappropriate and/or low quality public assets. Similarly,
due to the lack of enforceability of any commitment made
in a transaction involving a bribe (but for the ‘reputation’
effect, for which usually there is no incentive as it is rarely
a determinant of jurisdiction given to the official), the
effectiveness of corruption as a Coasean bargaining process
is very weak. In the example given earlier, having realized
that a decision can hurt someone more than personal gains
from the decision, the corrupt official can threaten and
blackmail the individual to bargain for more and more
bribe, resulting in a collapse of the equilibrium. This
explains why bargaining or bribing one’s way through,
when the other side (say, police, tax officials) has the power
to harm, is usually avoided. Only those agencies and parts
of bureaucracies that have less potential to harm and can
grant favours are mainly solicited for bargaining through
bribes. Shleifer and Vishny have also pointed out that the
type of penalties imposed on corruption also affects
efficiency. If the penalty is the same on detection (does
not vary with bribe), then the corrupt official will lower
output (to avoid detection) and will demand a higher bribe.
However, if it varies with the size of the bribe then he
will increase output and lower the bribe size.
Decentralized Corruption and Efficiency: The previous
arguments for and against corruption as efficiency enhancing
mechanisms can be summarized by thinking of a corrupt
official as a monopolist supplying goods and services or
selling property rights over public resources. To the extent
corruption allows him extraction of consumer (public)
surplus as a discriminating monopolist, it is neutral to
social welfare. As a consequence, at times it may also
increase the output, thereby increasing efficiency. If the
corrupt official creates more screening devices to
discriminate clients and restricts output due to information
asymmetry and/or secrecy (which is usually the case),
corruption becomes inefficient. The presence of endogenous
characteristics of the policies, rules, processes, performance
evaluation, and decision making criteria within a
bureaucracy with little accountability towards the public
may increase the distortions even further.
Regulatory and Contractual Framework 155
An even more serious manifestation of the inefficiency
of corruption takes place when corruption is decentralized
and when each official acts as an independent monopolist
to maximize his own payoff. For an economic activity, if
multiple clearances are required, then each of the officials
will act as an independent monopolist. Decentralization of
corruption, in this context, simply means that multiple
members of the bureaucracy act independently in the
context of decision making and have independent juris-
dictions. The multiplicity of decision makers and not the
level of state, where the locus of decision making lies, is
relevant to the concept of decentralized corruption.
Extending the well-known consequence of independent
monopolists, when the product demands are interde-
pendent, Shleifer and Vishny (1993) show that the aggregate
bribes asked for by such independent officials will reduce
the activity as compared to when there is a single profit-
maximizing corrupt official. Though decentralized
bureaucracy is worse than centralized bureaucracy for
efficiency, purely in terms of economic analysis, it is
politically more sustainable in a fractious society (Shleifer
and Vishny 1993; Mauro 1995).
Summing up, it is clear that if the bureaucracy would
not move otherwise and would act perversely (presumably,
due to inability of principals to get their acts together),
corruption may have some beneficial impact by aligning
the interest of bureaucracy with public. However, when
the same argument is pushed further (unaccountability of
the agents and therefore, corrupt bureaucracy), it is likely
that the actions and decisions of bureaucracy are more
likely to be in its own interest and corruption-reinforcing,
to the detriment of others.
Corruption and Economic Growth: Other Issues and
Evidence
Besides the effect of corruption on economic efficiency,
several authors have analysed and commented upon the
relative size of rents (as compared to bribes) that bribery
is supposed to procure for the bribe givers, the effect of
corruption on dynamic efficiency (growth), factors
explaining persistence of corruption and differences
observed across countries, and policy issues to mitigate the
incidence of corruption and its consequences. Given the
nature of corruption, the empirical research is limited to
a few cross-country studies, which we review later.
Institutional Framework and Relative Size of Rents vs.
Bribes: In an institutional framework, where co-ordination
among corrupt officials is required in order to facilitate
procurement of economic rents for bribe givers, the difficulty
in co-ordination may make bribes relatively insignificant
compared to the rents, a phenomenon known as ‘Tullock’s
156 India Infrastructure Report 2002
Paradox’ after Tullock (1980). In settings where no such
problems exist due to the existence of a single decision
maker, Krueger (1974) shows that competitive bidding by
rent-seekers dissipate rent. Even in the face of co-ordination
problems, the bribe takers may be able to extract higher
bribes when they are well organized (Rose-Ackermann
1978). Though democracy presumably reduces the
corruption by increasing the co-ordination problem for the
decision makers and legislators, it may fail to eliminate
rent-seeking behaviour. Institutions such as civil services
clubs, disciplined party factions, etc. within a democracy,
on the other hand, facilitate higher bribes for their members
by reducing the co-ordination problem.
Corruption and Growth Process: Dynamically, corruption
can affect growth negatively as it acts as a deterrent to risk
taking (Bardhan 1997). Unlike taxes which allow deduction
of losses of the past against profits, the effect of bribes
and corruption is asymmetrical. The growth process gets
affected when the public resources are diverted from
infrastructure projects, having positive externalities, to line
the pockets of corrupt officials (or their private
consumption). Murphy, Shleifer and Vishny (1993) show
that rent-seeking activities often have increasing returns,
and consequently returns to entrepreneurship and
innovations often fall in comparison with the rent-seeking
activities, impacting growth. Tanzi and Davoodi (1998)
point out that a higher level of grand corruption is likely
to bias public expenditure towards capital, as opposed to
operating (revenue) expenditures, resulting in low quality
of infrastructure stock.
Persistence of Corruption and Differences Across Countries: In
addition to cultural differences and differences in tolerance
of (and even perceptions of ) corruption across societies,
one major explanation offered for the relative differences
in corruption across societies, is the possibility of frequency-
dependent multiple equilibria15 (Cadot 1987; Andvig 1991).
In Andvig’s simple model, a society can easily move towards
relatively corruption-free or corruption-ridden status
depending on the fraction (frequency) of honest (or
dishonest) officials. It pays to be honest when most of the
others are honest and vice-versa. The model by Andvig and
Moene (1990) shows how profitability of corruption is
linked to its frequency and that a temporary shift may lead
to permanent changes in corruption. An increase in the
frequency of corruption lowers the cost of corruption to
15 Existence of multiple possible equilibria of honest vs. corrupt
public officials. Intuitively, this means that whether it is optimal to
be honest in equilibrium depends upon whether others are honest
or not. A multiple of such equilibria are possible, each dependent
on the frequency or proportion of honest people. The subsequent
text makes this point clearer.
the corrupt official (lower detection and penalty) and
increases the demand for corrupt services (by reducing
search costs for bribers). Tirole (1996) explains the
persistence of corruption through bad collective reputation
of previous generations. Younger generations inherit this
reputation, eliminating the incentive to be honest. Shleifer
and Vishny (1993) point out that corruption with theft is
more likely to be self-reinforcing as the bribers do not have
any incentive to report the corruption.
Reducing Corruption: Policy Issues: Corruption arises, in
the first place, due to monopoly power vested with the
public official to allocate public resources. The more
extensive the jurisdiction of public officials is and the more
is the dependence of the private sector on public resources,
the greater is the possibility of corruption. Privatization
and deregulation, as Klitgaard (1988) notes, reduces the
corruption in the affected jurisdictions. Multiple officials
with competing and/or overlapping jurisdictions (Rose-
Ackerman 1978,1994) reduce the monopoly power of
bureaucrats and/or increase the difficulty of co-ordination.
Reducing the size of government (its functions) reduces the
jurisdiction of the bureaucracy. Better monitoring,
accounting and disclosures (making accountability possible)
can reduce the incidences of corruption with theft, which
is self-preserving (Shleifer and Vishny 1993). Incentive
payments to officials may also improve efficiency, particularly
when accompanied by better accountability (Klitgaard 1988).
The legal framework towards corruption, particularly
penalties, may itself improve the incidences and
consequences of corruption (Shleifer and Vishny 1993).
The literature on fiscal decentralization (in the sense of
moving the locus of decision making closer to the client
group) has arguments both for and against its effect on
lowering corruption. Wade (1997) attributes corruption in
the Indian irrigation bureaucracy to its over-centralized,
top–down structure. Brueckner (1999), as quoted by Fisman
and Gatti (1999), however, argues that corruption is more
likely in local governments. Just as a centralized bureaucracy
is more likely to divert the resources to the non-poor, who
are willing to pay, local governments are also vulnerable
to ‘capture’ by local wealthy/powerful clients or groups
(Bardhan and Mookherjee 1998), quoted by Fisman and
Gatti 1999). In the context of fiscal decentralization, it has
been argued that if the spending decisions are decentralized
while revenue generation remains with the higher level of
government, the corruption and local rent-capture may be
exacerbated (Fisman and Gatti 1999).
Empirical Evidence: Given the nature of corruption, there
has been limited empirical research on its causes and
consequences. However, anecdotes, allegations, case studies,
and reports in the academic as well as popular press appear

rather frequently. There are few cross-country studies that
have looked at the effect of corruption on the attributes
of economic performance of the cross-section. Mauro
(1995) used an index compiled by Business International
for 68 countries to measure the extent of corruption.
Analysing cross-sectional data, he found that corruption is
strongly negatively correlated with the investment rate,
regardless of red tape. He concludes that corruption lowers
economic growth by lowering the total and private sector
investments. In addition to the Business International index,
Tanzi and Davoodi (1998) used the International Country
Risk Guide index, compiled by Political Risk Services, Inc.,
as a measure of corruption across countries. Using datasets
of attributes of public expenditure across countries, they
find that high corruption is positively associated with high
public (capital) expenditure, low governmental revenue,
high ratio of wages and salaries to total current expenditure,
and poor quality of infrastructure. Fisman and Gatti (1999),
using the latter index, find a negative association between
decentralization and corruption. Working with the state
level data, they also point out that decentralization is more
effective in reducing corruption when revenue responsibility
is also local (less federal transfers).
To sum up, the negative effect of corruption on economic
growth is widely recognized and empirically supported
(albeit, in a limited sense). The institutional arrangements,
extent of political decentralization (accompanied by revenue
generation responsibility), privatization, deregulation,
monitoring, disclosures, etc. are argued as ways to lessen
the corruption or distortions caused by it.
INFRASTRUCTURE SECTORS AND CORRUPTION
Corruption manifests itself in the context of infrastructure
by increasing the cost of infrastructure goods and services,
even if they are provided by an otherwise efficient entity.
This vitiates the economic, financial, and political viability
of infrastructure projects in the context of economies
increasingly willing to privatize infrastructure sectors. In
the context of state provided infrastructure goods and
services, corruption usually leads to widespread thefts,
particularly when it is difficult to measure and monitor the
output or when it is difficult to make officials accountable.
The high incidence of theft of power or water in India
are illustrative cases. Corruption also induces capital
expenditure bias in decision making, thereby lowering the
quality of the existing stock of assets in infrastructure
sectors as fewer resources are allocated towards operating
and maintenance expenditures (Tanzi and Davoodi 1998).
In a similar vein, the softer infrastructure sectors (such as
health and education) tend to attract lower allocations, due
to fewer opportunities for corruption (Shleifer and Vishny
Regulatory and Contractual Framework 157
1993). On the other hand, infrastructure sectors involving
large outlays are more susceptible to grand corruption.
Even within the context of privatized infrastructure sectors,
corruption by public officials can affect the private entity
while framing policies and deciding on terms of entry and
operation. This may include awarding of licences (if the
entry is restricted), decisions related to the technology,
decisions related to allocation of risks, conditionalities,
and clearances required, etc. Later, the corruption may
affect them through the dependence of continued operations
on public officials or on the entities controlled by them,
in their regulatory role or even as a buyer/seller of the
output/input.
Here, we focus on five main issues related to
infrastructure sectors and corruption. These are:
(a) decentralisation; (b) stability of policy framework and
effectiveness of ‘Coasean bargaining’; (c) unbundling and
corruption with theft; (d) multiplicity of independent
regulators; and (e) independence of regulator/auditors. We
have not discussed some of the themes such as deregulation,
reducing administrative jurisdictions (size of the
government), disclosures etc., which are important, but
their effect on corruption in general as well in the context
of infrastructure sectors is obvious.
Infrastructure Projects: Decentralization and Corruption
Even in the case of private provisioning of infrastructure
services, the issue of decentralization is important.
Centralized licensing, planning, and execution of such
projects have their own pitfalls, if motivated by the private
payoffs to the decision makers. The qualifying requirements
and the process followed in awarding licences can be easily
designed to minimize competition in bidding. Usually,
enactment of such barriers also entails increasing the
capital outlay requirements, as the scope of the project can
be enhanced even when it is economical to unbundle it
or capital-intensive technology is mandated even when
other economically efficient technologies exist. The impact
of these distortions, created to maximize payoffs to the
decision makers, is ultimately borne by the users and
economy. This is not to argue that there are no possible
benefits from centralized infrastructure planning and
implementation. When there are substantial economies of
scale in execution and/or operation or optimal utilization
of the projects, there is a good case for such centralization.
However, the experiment of decentralized provisioning of
primary and adult education in Madhya Pradesh shows
that in certain cases (when the geographical externalities
are non-existent), the locus of control at the decentralized
level may result in benefits outweighing the costs of sub-
optimal design and execution. The effect is, however, likely
to be satisfactory if the interests of stakeholders are aligned.
158 India Infrastructure Report 2002
Outside grants, if any, should be linked with the performance
and revenues, so that the cost of corruption is internalized
at the local level. Much of what has been said is true for
even public services provided by local governments. As
argued by Tiebout (1956), decentralization can induce
competition as the inhabitants can vote by their feet (move
out of a jurisdiction). This is true, however, only if the
framework for decentralization does not permit pork-
barrel politics (promise and/or delivery of ‘pork’ to the
constituency by the politicians).
Even in the case of centrally planned and executed
projects or infrastructure services centrally provided, there
is a case for giving time-bound jurisdiction to local
governments for the local dimensions of the project though
it may not have any effect on corruption. For example,
the exact course of a road or rail location of facilities, etc.
can be easily decided by the local governments, even if they
cannot veto the project and/or its specifications. As we
have discussed earlier, overlapping but not independent
jurisdictions tend to reduce corruption.
Stability of Policy Framework and Effectiveness of
‘Coasean Bargaining’
While reviewing the literature, we have seen that one of
the arguments for corruption is that it allows the briber
and bribee to improve their respective welfare through
Coasean bargaining. The effectiveness of such bargaining,
as has been argued, depends upon whether the outcomes
bargained for are binding (Shleifer and Vishny 1997). In
a corrupt democracy, politicians may use (or threaten to
use) major or even minor changes in the policy framework
to force the client (an operating entity) once again to the
bargaining table. Stability of policies in the infrastructure
sectors has been considered desirable as it reduces the
risks for the entities and their financiers, thereby resulting
in higher investments and/or lower costs. Besides the
desirability of stability in policy framework from this
perspective, it is also desirable as it reduces the possibility
of arbitrarily high costs imposed on a private infrastructure
entity. Stability in policy keeps the costs of corruption
within bound in the case of a privatized but regulated
sector. It is no coincidence that less corrupt countries also
tend to have more stable policies and policy frameworks,
and it comes as no surprise that the policy changes seem
to be more frequent when the private sector is involved
than when the infrastructure services are provided by the
state. The costs of too frequent policy changes are low
investments and high cost infrastructure.
Unbundling to Reduce Corruption with Theft
The economic arguments for unbundling of infrastructure
services mainly come from the viewpoint of efficiency, as
unbundling allows competition wherever possible, as in
case of generation and distribution in power sector as
opposed to vertically integrated monopolies (created because
of natural monopoly, transmission (wires) business).
Moreover, unbundling and pricing of services allows more
effective signals for consumption as well as investments.
In addition, unbundling in the context of vertically integrated
businesses can also be helpful in reducing corruption with
theft and better accountability. I recall my childhood
memories of lay people advocating the splitting up of
vertically integrated electric utility (a state electric supply
board, typical of the notoriously inefficient State Electricity
Boards (SEBs) not on account of economic efficiency
arguments, but because it would reduce corruption. They
made two arguments: (a) it will help in accounting for
thefts or losses as there will be metering done between the
different entities so created, and (b) it will reduce the
compulsions for corruption as the jobs will be non-
transferable across the entities. To elaborate the latter
argument, as the maximum side payments were in
distribution, everyone wanted to be posted in distribution
(even the effort required on the job is less), because of
which they had to pay maximum bribes for such postings.
Having acquired the posting, they had to recover the same
through bribes and permitted thefts. Moreover, those left
out continuously tried to get such postings. The decision
makers, in order to maximize payoffs over their discretion
of transfer, also kept on rotating people to such postings,
accentuating corruption and theft even further,
simultaneously eliminating any incentive for ‘reputation
building’ by the posted official. This has entrenched
corruption. Though not applicable in all contexts, the
arguments are still valid. Unbundling can also help by
decentralizing the bureaucracy (an incentive for ‘reputation
building’), by specialization of skills, and by better
monitoring (mutually reinforcing arguments)16.
Multiplicity of Independent Regulators
Unlike the producer or seller of infrastructure services,
when jurisdiction of public official is to act as a specialist
regulator of the firm engaged in providing services,
specialization gives rise to decentralized corruption, as
pointed out earlier. Acting as independent (over their
jurisdiction) monopolists, these independent multiple
regulators (corrupt officials) regulating a firm can choke
off investments more than a single corrupt regulator. Multiple
clearances required for infrastructure projects increase
administrative costs as well as potential costs of corruption.
The accountability suffers due to diffusion of responsibility
16The most challenging unbundling of all would be that of the
bureaucracy [Ed.].

and efficiency suffers due to inadequate treatment of
externalities. Ideally, regulatory jurisdictions over infra-
structure projects, as the analysis suggests, should be com-
bined and vested with a single regulator with a well-defined
domain. Specialization, if required, should be developed
or outsourced by the regulator.
In the Indian context, the power sector suffers from
similar problems as it is in Concurrent list of the Consti-
tution. For any private sector player, the state government
matters more, and hence the state bureaucracy has to be
satisfied. The central government/national initiatives for
specific private sector investments or reforms may therefore
not yield results, unless states were to internalize the cost
of being the independent monopolist regulator.
Independence of Regulators
Besides centralization of the regulatory function, another
important element of reducing the corruption and associated
costs is to have regulators who are independent in the sense
that they are not part of the state and represent neither
producers nor consumers (in a meaningful sense). Even in
the case of an independent regulator, though the possibility
and instances of ‘regulatory capture’ exists, separation
from the state facilitates policy making to be more stable.
This, by itself, is a desirable characteristic. Separation
6.4 ACCRUAL ACCOUNTING FOR INFRASTRUCTURE ASSETS: A REVIEW
Large investments in infrastructure assets by governments
are indicative of the contribution of such assets to the
viability and effectiveness of governments, and of the
public needs they serve. In the USA, for example, an
estimated $150 billion is annually spent every year by the
government for construction, improvement, and
rehabilitation of physical infrastructure assets such as roads,
bridges, dams, tunnels, water, and sewerage systems. Yet,
until recently, little attention had been given in the
governmental financial statements to the valuation, the
measurement of depreciation, and the disclosure of the
condition of infrastructure assets. As a result, financial
reporting practices for infrastructure assets have been
diverse and there is currently no consensus on an accounting
technique for infrastructure assets (Rowles 1991).
There have been sporadic attempts to deal with the
issues associated with financial reporting for infrastructure
assets. Standard setters in several countries, including the
UK, Australia, and New Zealand, have recently issued
pronouncements on accounting for infrastructure assets to
Regulatory and Contractual Framework 159
from the state increases the monitoring of regulator (by
the State as well as by others) and makes it easier to ensure
disclosures of decision, transparency of process, as well as
insistence on regulatory rationale. Being independent of
the state, regulators are likely to be more effectively
scrutinized by the courts. The government or the state on
the other hand can easily avoid this scrutiny, particularly
in economic matters, by enacting or changing laws with
the help of the legislature and by invoking the ‘public
interest’ argument. The independence of the regulator
requires a careful enabling framework, wherein the only
scrutiny is by courts and not by any other part of the state.
Similarly, the personnel associated with the regulator must
not be a part of a civil service club, producers’ employees,
or potential employees (often, ex-regulators are found in
employment with producers) and the process should make
co-ordination for corruption difficult.
In the Indian context, all the five dimensions discussed
in this paper are weak as far as governance in infrastructure
projects is concerned. Multiplicity of regulators, lack of
stable policies, little and irrational unbundling, inappropriate
decentralization, and absence of independent regulators
are institutional features that make for widespread
corruption and increase associated costs. Policy makers
and public debate need to address these issues if we are
to improve governance in the infrastructure sectors.
Mahendra Gujarathi • Samir K. Barua
address the problem of widely diverse financial reporting
practices by the state and local governments (SLGs). The
Canadian Institute of Chartered Accountants (CICA) has
launched a study on how to account for infrastructure in
public sector financial statements. Even a small country
such as Mongolia has introduced a draft legislation requiring
government accounting to be done on an accrual basis.
While the public sector reforms have a longer history in
these countries than in the US, the 1999 issuance of
Governmental Accounting Standards Board Statement No.
34 (GASB 34) in the US has attracted world attention to
the issue of infrastructure accounting. GASB 34 has been
dubbed as the most significant change in the history of
governmental financial reporting. It reflects a significant
departure from the budgetary compliance type of financial
reporting to one that uses economic and business criteria
for reporting the operations and financial condition of
local and state governments. Its departure from the
budgetary compliance type of financial reporting to accrual
accounting has been quite controversial.
160 India Infrastructure Report 2002
In most countries in the world, accounting standards for
public sector entities in general, and infrastructure assets in
particular, have either not been developed or are in the very
early stages of development. The International Federation
of Accountants (IFAC) has initiated a project to set accounting
standards for governments. A core set of accounting standards
for governments—called International Public Sector
Accounting Standards (IPSASs)—have been issued by IFAC.
South Africa is the first country that formally announced
in August 2001 that it intended to use the IPSASs for
development of public sector Generally Recognized
Accounting Practice for its national government. Ian Ball,
the ex-Chair of the Public Sector Committee of IFAC, was
quoted in the Chartered Accountants Journal of New
Zealand (June 2000) that IPSASs will gain authority because
(a) IFAC has a significant international reputation and
(b) as countries recognize the improvements in the quality
of reporting, they will incorporate such standards in their
local laws. However, there are others who believe that
GASB 34 and IPSASs represent an artificial implantation
of business reporting standards on the governmental sector,
and hence holds little promise of enhancing decision
usefulness of governmental financial statements. Whether
the costs of implementing such standards are worth the
expected benefits is another important concern expressed.
This paper summarizes the developments in infrastructure
accounting internationally (using the GASB 34 as an
example), critically examines the theoretical soundness and
practical difficulties in implementing the current standards,
and conjectures about the prospects of adoption of accrual-
based infrastructure accounting by governmental entities,
particularly in the developing countries. The exposition in
the paper would be of interest to the countries considering
issuance of infrastructure accounting standards, or adoption
of the IPSASs into their local laws.
ACCOUNTING STANDARDS FOR INFRASTRUCTURE
Prior to the issuance of GASB 34, SLGs had the option
of reporting infrastructure assets in any fashion as long as
it was consistently done and disclosed. This was perhaps
the result of a judgment by the standard setters that the
costs of establishing and maintaining cost records for such
assets might exceed the benefits from such data. State and
local governments in most of the countries currently report
expenditures on infrastructure assets in the year incurred.
Therefore, infrastructure assets do not appear in the
statement of financial position on a continuing basis. Such
accounting is consistent with the position of some
authors (Mautz 1981, 1988, for example) who argued that
infrastructure investments do not conform to the traditional
definitions of assets.
However, the view that infrastructure expenditures
indeed constitute assets is gaining increasing support in
the US and elsewhere. The Public Sector Committee of
the IFAC concluded that it is now generally accepted that
infrastructure expenditures represent assets. GASB 34 also
requires the use of full accrual accounting for all government
activities and the reporting of the value of infrastructure
assets in the balance sheet. GASB 34 concluded that
infrastructure asset reporting was ‘essential to provide
information for assessing financial position and changes
in financial position, and for reporting the cost of programs
and functions’.
GASB 34 requires all the infrastructure assets acquired,
renovated, restored, or improved after the effective date
of GASB 34 to be reported in the statement of financial
position. The requirements of GASB 34 come into effect
from the fiscal year 2002 for large SLGs (with annual
revenues of $100 million or more), 2003 for medium
SLGs (revenues between $10 million to $100 million), and
2004 for small SLGs (revenues less than $10 million).
Additionally, significant infrastructure assets that have been
acquired or significantly reconstructed since 1981are also
required to be reported in the statement of financial
position by the large and medium SLGs although they
would have additional four years for such retroactive
reporting.
As per GASB 34, the amount at which infrastructure
assets should be reported is the historical cost. Historical
costs represent the total cost, inclusive of capitalized interest
and ancillary charges incurred to put the asset into its
intended location and condition for use. However, since
most of the infrastructure assets were constructed under
the cash accounting regime, historical costs are usually not
available. In such cases, therefore, the historical costs are
to be estimated by calculating the current replacement
value for a similar asset, and deflating the same by applying
price-level indices to the year of acquisition.
After initial capitalization, infrastructure assets are to
be depreciated by allocating their net cost (that is, cost less
the salvage value) over the estimated useful lives in a
systematic and rational manner. The depreciation expense
must be recorded, allocated to functions, and reported in
the statement of activities of SLGs. Any established method
of depreciation is acceptable and composite methods can
be used when depreciating groups of assets with different
service lives.
Several infrastructure assets, however, such as bridges
and roads can be used for a very long period if properly
maintained. Hoover Dam, for example, is expected to last
2000 years! Spreading the construction costs over such a
long period makes the depreciation expense in each year
to be immaterial. In recognition of the effect of preventive

maintenance on the lengthening of the useful life of the
infrastructure assets, GASB 34 allows SLGs to follow a
modified approach. Under the modified approach, a
governmental entity does not need to report depreciation
expense for eligible infrastructure assets if (a) it manages
the eligible infrastructure assets using an asset management
system that possesses certain characteristics, and (b) it can
document that the eligible infrastructure assets are being
preserved approximately at or above a condition level set
by the government. The entity must perform condition
assessments every three years. In addition, it must provide
annual information about the estimated amount needed to
maintain the established condition level and the amounts
actually incurred for the past five years.
The modified approach resembles the method known
as ‘renewals accounting’ in other countries such as New
Zealand. Walker et al. (2000) define it as a ‘method of
accounting for fixed assets that are intended to be
maintained indefinitely whereby depreciation charges are
replaced with charges in an amount that provides an
allowance for renewals equal to the present value of the
renewal expenditure needed over a reasonable planning
period to bring the fixed assets up to a defined standard
of service and repair to maintain them at that standard’.
Renewals accounting is accepted in some, but not all,
jurisdictions for external financial reporting. In New
Zealand, for example, where accounting standards for
infrastructure is in existence for over a decade, the renewal
accounting method permitted by GASB 34 is not acceptable.
The Steering Committee on National Performance
Monitoring of Government Trading Enterprises in New
Zealand rejected renewals accounting, asserting that ‘it
does not result in the provision of information that is
relevant to the assessment of GTE performance and financial
position’. The N.S.W. Local Government Asset Accounting
Manual rejected renewals accounting as an acceptable
alternative to depreciation method arguing that the service
potential for most assets is, for practical purposes, used
up or lost and thus has to be replaced (Walker et al. 2000).
RATIONALE AND SOUNDNESS OF THE GASB 34
PROVISIONS
The reporting requirements of GASB 34 are intended to
improve the accountability for public investments in
infrastructure by enabling the users to determine whether
current year revenues were sufficient to cover the cost of
current year services, and to determine whether the
government’s financial position improved or deteriorated
as a result of the year’s operations. This will enable investors
and bond rating agencies to assess the governments’ ability
to repay their debts and support their service obligations.
Regulatory and Contractual Framework 161
Another benefit relates to the intergenerational equity.
Most of the infrastructure projects are funded through loan
finance. However, the projects last for a long time after
the loan is repaid. If the costs of infrastructure investments
are to be borne by the generations benefiting from them,
it is necessary to take into account whole-of-life expenditure
on asset maintenance, not just the amount of loan
instalments paid.
Yet another advantage of reporting infrastructure assets
is that it will provide a basis for securitization of these
assets (Dornan 2000). The identification and valuation
requirements of GASB 34 will enable SLGs to securitize
their infrastructure assets for issuing bonds to pay for the
costs of implementing asset management systems, and
rehabilitating infrastructure assets.
ACCRUAL ACCOUNTING: A SQUARE PEG IN A
ROUND HOLE?
Application of accrual accounting for infrastructure assets
of SLGs appears deceptively logical at the outset because
of the accounting practices followed for such assets by the
business sector. However, there is a fundamental difference
between private property owned by business entities and
community assets owned by SLGs. In the case of private
property, the owner has the right to exclude others from
use except in return for value received. In the case of
community property, each individual in the community
has a right not to be excluded, and the SLG has a duty
to make the asset available and accessible to the public.
Therefore, as noted by Sunder (1999), there are legitimate
economic reasons to expect that the control systems that
work effectively in private-good organizations will not
necessarily function well in public-good organizations.
Internationally, infrastructure accounting for govern-
mental entities is largely based on the experience of private
sector entities with such accounting. The International
Public Sector Accounting Standards (IPSASs) are an
adaptation of the standards issued for the private sector
by the International Accounting Standards Committee
(IASC). The preface to the IPSASs makes this clear: ‘As
most IPSASs are based on IASs, the IASC’s Framework
for the Preparation and Presentation of Financial Statements
is a relevant reference for the users of IPSASs’. However,
Pallot (1997) surveyed the characteristics of public sector
infrastructure and concluded that the nature of most
infrastructure lies outside the private sector experience.
The concept of depreciation on infrastructure assets is
of limited relevance for SLGs. Sunder (1999) noted that
depreciation serves three important purposes for business
organizations. First, it helps estimate the full cost of
production that can be used for pricing decisions. Secondly,
162 India Infrastructure Report 2002
it helps compute the residual surplus (that is, net income)
by providing an opportunity cost of the services provided
by fixed assets. Finally, it is an important inducement
device for the managers to make production–investment
decisions that are in alignment with the interests of the
stockholders. Since managerial compensation is directly or
indirectly (through stock options) dependent on net income,
the managers would not invest too much in assets because
the depreciation thereof would reduce the net income, and
they would not invest too little either because of its likely
adverse effect on revenue generation.
None of the reasons above apply to governmental
organizations. Inclusion of depreciation (and other fixed
costs) to arrive at full cost can result in sub-optimal
production decisions, especially in the short run. Secondly,
computation of full costs has limited utility for SLGs
because many public goods are not sold to customers at
a price. In fact, in the case of SLGs, productive activity
is intended to provide a service that will either be given
free or intentionally offered at a price below the cost. Even
for the priced services of the SLGs, allocation of depreciation
costs to different services or departments is difficult. Thirdly,
there is no residual claimant (stockholder) in such
organizations, and therefore computation of residual surplus
serves little purpose, if any. Indeed, as noted in GASB 1,
‘the governmental fund measurement focus is on
determination of financial position rather than upon net
income determination’. Finally, governing bodies, not the
hired managers, make the investment decisions in the
governmental organizations. The emphasis on accountability
and stewardship role played by governmental officials is
in diametric contrast to private sector entities where
stockholders elect a board of directors to monitor operating
and financial activities.
To preserve the operating capability of governmental
entities and to help them make sound pricing and production
decisions, depreciation needs to be recorded using the
current replacement costs of infrastructure assets, not their
historical costs. The determination of replacement costs
for SLGs is problematic. Many of the assets held by local
and state governments are either unique, or the organization
has such a dominant position in the market that its actions
largely determine the exchange value of the asset. In either
case, no meaningful valuation can be placed on these
assets. The reliability of such valuations would be
questionable and the cost, complexity, and effort involved
in obtaining and reporting them would be very high.
This leaves only two economic purposes of calculating
and reporting depreciation in the governmental sector:
computing the full cost of the governmental sector and
facilitating production decisions of the public sector
managers. Let us examine these further. Pricing and
production decisions based on historical costs—which, in
the case of infrastructure assets, could be several decades
or even centuries old—can only be expected to be
uneconomic. The use of historical costs frustrates the
objective of preserving the operating capability of
governmental entities.
Preparer Difficulties in Implementing Accrual
Accounting for Infrastructure
The recordkeeping involved in applying traditional fixed
asset accounting and reporting to infrastructure assets is
deemed formidable by many governments. Determination
of their replacement costs, which will serve some economic
purposes, is problematic and unreliable, as noted above.
The replacement cost valuation does not justify the cost,
complexity, and effort involved in determining the
replacement costs.
Taking the inventory of assets and their initial valuation
could be a challenge. GASB 34 responded to this concern
by allowing an extended adoption window. All governments
have a minimum of two years to adopt GASB 34, and
smaller governments have been given two more years to
begin following the provisions of the statement. Also, SLGs
have four additional years for reporting existing
infrastructure assets (acquired since 1981) and SLGs are
exempted from such retroactive reporting. Only those
assets acquired or constructed after the implementation
date would need to follow the provisions of GASB 34 for
such governments.
For infrastructure built under a cooperative agreement
with another government (foe example, regional authority
or two-state authority), the allocation to each government
is likely to be complex and contentious.
The prospects of securitization might appear appealing
to SLGs at the outset. However, many of the existing
infrastructure assets—those acquired before 1981—are
not required to be reported in the statement of financial
position and hence would not provide the securitization
benefit. Even for the assets reported in the financial
statements of SLGs, one needs to note that most
infrastructure assets are very large, indivisible, hetero-
geneous, and difficult to transfer. Finally, the historical
cost of such assets presented in the financial statements
will be of little use in deciding the market price of the
securities represented by such assets.
User Benefits from Accrual Accounting
While the accrual accounting for infrastructure might be
beneficial to the creditors and bond rating agencies, its
utility for other users appears quite limited.
Whether SLG will indeed make a transition to accrual
accounting is uncertain. There is no enforcing authority

for the GASB standards analogous to SEC (Securities
Exchange Commission) for the FASB (Financial Accounting
Standards Board) standards. Therefore, compliance with
GASB 34 or with IPSASs is voluntary. Previous attempts
to make financial reporting of SLGs more akin to that of
private sector businesses have not yielded much success
in the US. GASB 11 that addressed measurement focus
and basis of accounting for governmental financial
statements was indefinitely postponed by the issuance of
GASB 17. As a result, no government implemented GASB
11 and the GASB reopened its financial reporting project
that culminated in GASB 34.
Governments are only required to capitalize infrastructure
assets acquired—or on which significant costs were
incurred—since 1981. Only the major infrastructure fixed
assets are required to be capitalized retroactively. And they
have two more years to do it. Depending on when the
entities make the transition to the provisions of GASB,
and the options chosen for transition, the comparability
of governmental financial statements will be impaired for
several years of the phase-in period. Given that historical
costs are used, SLGs or citizens cannot use such data to
demand rate adjustments.
A Preferred Option: Additional Non-financial
Disclosures
Whereas switching to accrual accounting is suggested as
a panacea to serve the needs of users, it is not one indeed.
Appropriate and adequate accounting for state and local
governmental units involves a far more complex set of
interrelationships, to be reported to a more diverse set of
users with a greater variety of interests and needs, than
exists in business accounting and reporting (Mautz 1981).
Financial statements based on accrual accounting are still
limited to data that are both historical and financial. Such
data is often not responsive to the decision maker who
also need forward-looking and non-financial information.
Experience indicates that financial data must be
supplemented by non-monetary quantitative and qualitative
information to aid decision-usefulness of the users. Van
Daniker and Kwiatkowski (1986) noted that for eight out
of the nine issues about which users seek information,
engineering information was preferred ahead of other
forms such as historical cost, replacement cost, budget to
actual comparison, and financial plans. Such information
sheds additional light on what is necessary to maintain or
upgrade system functionality, identifies the potential risk
of systems failure, and states the assumptions upon which
these assessments are based.
The condition of the infrastructure managed by the
governments is a key indicator of their operational per-
formance. Given concerns about the disruptions caused in
Regulatory and Contractual Framework 163
recent years by system failure, it may be possible for
descriptions of infrastructure condition to refer to the
extent to which systems incorporate redundancy or other
safeguards against such risks. Users of reports on infra-
structure are likely to be concerned most about the physical
condition of those assets, and proposed or projected cash
flows associated with their use, repair, or modification as
well as qualitative information concerning assumptions
made about system functionality requirements. As noted
by Keenan (1997), providing the information about deferred
maintenance as supplementary disclosures gives a more
complete picture of the government’s financial position
and performance.
Another important issue is to whether, and how, to
report the loss, if any, in the future service potential of
infrastructure assets. The dire consequences for com-
munities of failing to maintain infrastructure adequately
is an argument for providing users with information about
changes in the physical condition of these assets, or about
their level of deferred maintenance.
Arguably, presenting the physical condition of the
infrastructure assets in a user-friendly format will be a
challenge to SLGs. Some heartening progress is, however,
being made in this direction. While comparable and
consistent methods to disclose qualitative information such
as engineering details are not easy to specify, frameworks
have been developed (Walker et al. 2000, for example) for
presenting, in summary form, key engineering information
about two of the major categories (sewerage systems and
water supply) of infrastructure for SLGs.
CONCLUSIONS
SLGs throughout the world are wrestling with the issue of
appropriate accounting and reporting of infrastructure
assets. In many cases, standard setters have embraced
accrual accounting for infrastructure assets as a part of the
larger efforts to institute better accountability regimes and
improved governance in the public sector. While such an
approach appears sound at the outset, it is fraught with
several conceptual weaknesses, and significant implemen-
tation difficulties for the SLGs.
Whether the infrastructure is adequately maintained is
not apparent from the disclosures currently provided in the
governmental financial statements. Walker et al. (2000)
suggest that a tally of investment in the infrastructure and
of the amounts required to keep it operational would be
critical for the policy makers within government to be fully
informed.
While infrastructure accounting for SLGs is a recent
development in the US, the experience in New Zealand
is instructive. A number of its councils started valuing
164 India Infrastructure Report 2002
infrastructure assets and reporting them in the statement
of financial position as early as 1991. However, Pallot
(1997) observes that nearly seven years later, there remains
a diversity of practice in accounting for infrastructure
assets. There are more questions than answers in the field
6.5 CRISES IN THE THE GOVERNANCE OF FINANCIAL INFRASTRUCTURE
At the beginning of industrialization in the developing
countries, financial markets were inadequate to meet the
demands placed on them. This justified some form of
government intervention. However, extensive directed credit
programmes at subsidized interest rates proved an inefficient
way of overcoming market failures and redistribution of
income. Macroeconomic instability, combined with credit
and interest rate controls, made matters worse. In July
1991, India, faced with the possibility of having to renege
on its international financial commitments, had to urgently
airlift 20 tonnes of gold to London to save its prestige in
the global financial arena. The crisis of 1991 gave birth
to the structural adjustment and economic liberalization
programme of the 1990s to restore macroeconomic stability,
both on the internal and the external fronts. The performance
of the Indian economy since the crisis has been
characterized by growth and increased levels of inflow of
foreign capital.
The Indian experience is yet another example of the
thesis of ‘challenge-and-response’ proposed by the famous
historian, Arnold Toynbee (1956), to explain the genesis and
growth of civilizations. Toynbee observes that ‘a society
. . . is confronted in the course of its life by a succession
of problems’ and that ‘the presentation of each problem is
a challenge to undergo an ordeal’. Civilizations either emerged
stronger or perished depending on how successfully they
responded to these challenges. Economic reforms too are
invariably triggered by grave economic crises and the degree
of success with which the crises are overcome determines
the subsequent performance of an economy. A decade after
the reforms began in India there is reasonable evidence that
there have been gains from the reforms. These gains have
been realized despite hiccups in the reforms process over
the years due to misguided political arithmetic.
Perhaps the biggest success story of reforms has been
the progress made in the financial sector. This has been
possible because of the creation and modernization of the
financial infrastructure. Since this phrase may have various
interpretations, it needs to be defined more precisely. The
word infrastructure typically conjures up images of roads,
of infrastructure accounting, despite the recent issuance
of accounting standards. While accrual accounting appears
to have significant costs and limited incremen-tal benefits,
additional non-financial disclosures have the potential to
enhance the usefulness to decision makers.
Samir K. Barua
bridges, ports, power plants, and dams—all large physical
structures. Financial infrastructure, however, consists of
intangible entities such as securities markets, foreign
exchange markets, financial institutions, investment
institutions, mutual funds, investment banks, commercial
banks, and non-banking finance companies. In addition,
it also includes the regulators in the financial sector such
as the Reserve Bank of India (RBI), the Securities and
Exchange Board of India (SEBI), and the Ministry of
Finance of the Government of India. Governance of financial
infrastructure, therefore, involves governance of the
operations of these entities. This is the sense in which
financial infrastructure has been interpreted in this paper.
FINANCIAL INFRASTRUCTURE: A BRIEF REVIEW
The financial infrastructure of the country was very much
centralized and archaic, till the reforms began in 1991. Its
governance was divided between the Reserve Bank of India
and the Ministry of Finance, the former governing the
banking sector, non-banking finance companies, and the
debt and foreign exchange market and the latter governing
the financial institutions, investment institutions, and the
stock markets. The limited freedom of decision making
given to the entities implied that there were no explicit
penalties for inefficient utilization of infrastructure.
However, the deficiencies of the insular nature of financial
infrastructure were realized after the 1991 financial crisis
and the 1992 securities scam. These crises led to significant
additions to the financial infrastructure in the 1990s. The
reforms resulted in:
• Setting up of the Securities and Exchange Board of
India (SEBI) in 1992 to oversee the operations of securities
markets
• Setting up of private mutual funds to channelize
savings into securities markets
• Setting up of a modern stock exchange, the National
Stock Exchange, with screen-based trading and computerized
settlement system

• Setting up of primary dealers and subsequent creation
of a network of dealers in government securities to activate
the government securities market
• Setting up of a network of dealers in foreign currency
• Setting up of National Securities Depository Limited
(NSDL) and subsequently Central Depository for Securities
Limited (CDSL) for electronic recordkeeping of holding
and transfer of securities and creation of a network of
depository participants
• Setting up of a large number of private banks to
introduce competition in the banking sector
• Constitution of Disinvestment Commission and
subsequently Department of Disinvestment to manage
privatization of Public Sector Undertakings (PSUs)
• Modernization of stock exchanges through the
introduction of computerized trading and settlement system
in all the major exchanges and dematerialization of securities
• Expansion of network of brokers dealing in securities
through use of satellite for on-line trading in stock exchanges
from all parts of the country
• Modernization of the settlement system for
government securities through computerization of operations
of the Public Debt Office (PDO) of the RBI.
The creation of these and similar facilities required
changes in the rules and regulations that governed operations
of various segments of the financial sector. Unfortunately,
the process followed for framing the right set of regulations
has by and large been quite unscientific and ad hoc, with
little prior application of mind. That has generally resulted
in continual changes in the regulatory structure, thereby
reducing the benefits derived from the infrastructure created.
As would be apparent later, many issues in governance of
the financial infrastructure arise from poor regulations.
Some of the regulations were framed without taking into
account the cost of prudential supervision required for
observance of the regulations. Since penalties arising from
non-observance of regulations still tend to be mild, and
easily challengeable in the courts of law, there have been
several instances of breach of regulations. As a result, the
financial sector has witnessed several scams/crises since
the onset of liberalization in 1991. Three major crises have
been analysed in the paper. The analysis provides the basis
for enunciating the key issues in governance of financial
infrastructure and the measures required for improvement.
The Three Crises
The financial sector has experienced several scams/crises
in the last decade. Since it would be infeasible as well as
repetitive to discuss all of them, it was decided to focus
attention on three scams/crises that together provide a
basis for covering most of the issues in governance of the
financial sector. Two of these crises occurred recently,
Regulatory and Contractual Framework 165
while the third occurred almost at the beginning of the
reforms process. The three scams/crises chosen for detailed
analysis and discussion are the following: (i) the securities
scam of 1992; (ii) the Madhavpura Mercantile Cooperative
Bank (MMCB) Scam of 2001; and (iii) the US-64 crisis
of 2001.
The above three events are described and discussed in
detail, identifying the fault lines that precipitated the events.
The events are then analysed to crystallize the issues that
arise from the point of view of governance of financial
sector. The issues discussed are brought together for a
comprehensive examination in the last section to spell out
the steps required to improve governance of the financial
sector in the country.
THE SECURITIES SCAM OF 1992
The 1992 securities scam was in essence a diversion of
funds from the banking sector, in particular from the inter-
bank market in government securities to the stock market.
The main motivation for the diversion was the significantly
higher cost of finance in the stock market as compared
to the cost of finance in the formal money market (the
inter-bank market). While the returns in the money market
at that time hovered around 18–20 per cent, the returns
from financing of carry-forward positions in the stock
market (that is, badla financing) were around 35–40 per
cent. The difference was much higher than what could be
justified on the grounds of higher risk in the informal
market. The reason for the excessive returns prevailing in
the badla market was the artificial segmentation of the
formal and the informal money markets. The stage was
therefore set for anyone who could find a way of breaching
the ‘Chinese’ wall that separated the two markets and
arbitrage between the two. The scam was essentially a
breach of this wall.
The Macro Environment
It is necessary to recall the macroeconomic environment
prevailing in 1991–2 to understand the setting for the
scam. The process of economic liberalization had started
in earnest after the jolt the nation received from the
transfer of 20 tonnes of gold into the vaults of Bank of
England as guarantee against urgent short term borrowing
from the Bank of Japan to ward off defaulting on international
financial commitments. The first task of the new government
that came into power in the summer of 1991 was to
strengthen the external sector. This sector therefore witnessed
major reforms. The immediate fallout of the balance of
payments crisis was the use of Public Sector Enterprises
(PSEs), particularly the oil sector PSEs, to raise resources
in the international markets. While this brought in the
166 India Infrastructure Report 2002
much-needed dollars to the country, the measure burdened
the PSEs with huge interest costs arising from excess cash
holding. The government therefore designed a Portfolio
Management Scheme (PMS) under which the PSEs were
allowed to park the excess cash with nationalized banks
to earn decent returns to meet the interest costs. The banks
in turn asked for and obtained relaxation in the norms for
investment to deal with the sudden rise in their liquidity.
The banks also started competing for these funds by
offering higher returns. They therefore had to find ways
of deploying the fund to earn returns higher than what they
had offered to the PSEs. Such returns were not available
in the formal money market where banks traditionally
deploy excess cash. This is when the brokers who were
operating in both the formal and the informal markets
became very useful to find an innovative way of deploying
funds from the formal money market to the informal
money market to earn higher returns. The stock market
was booming—in less than a year, from May 1991 to
February 1992, the stock market index (BSE-30 or the
SENSEX) had risen from a level of below 1000 to about
4500. The steep rise in the index resulted in an exponential
growth in the demand for funds required for supporting
the long positions in the market. Investors were willing to
pay high interest rates for these short-term funds since the
rise in prices of shares more than compensated the cost
of funds. This cultivation of brokers by the banking sector
is what finally culminated in the securities scam.
The Modus Operandi
The mechanism for transfer of funds from the formal to
the informal market was the ready forward (RF) deal,
which in essence is a secured short-term loan from one
bank to another. Ready forward deals are known as repo
(repurchase option) transactions in other countries. These
are used by the banking sector to manage short-term
liquidity. In fact, the RF deal is not a loan at all. The
borrowing bank (Bank 2) sells (government) securities to
the lending bank (Bank 1) while simultaneously agreeing
to buy the securities back at a slightly higher price at the
end of the agreed period. The difference in the buy and
sale prices is the cost of short-term borrowing. The
transaction essentially serves the short-term needs of both
banks—while Bank 2 needs cash, Bank 1 is looking for
deployment of excess cash for the period. In addition to
facilitating management of cash, the RF deals provide the
much-needed liquidity to the government securities markets.
It is clear that if the above process is strictly followed, then
the RF deals could not have been used for diversion of
funds. The following modifications in the process were
introduced imperceptibly to perpetrate the scam:
• As the importance of brokers rose with the intro-
duction of PMS, the settlement process in the government
securities market became broker intermediated, that is,
the delivery and payments started getting routed through
the brokers instead of being done directly between
transacting banks;
• Soon after the above procedure got established, the
brokers were able to persuade the banks to credit the
monies routed through them to their accounts for a few
days, though the account payee cheques were drawn in
favour of banks;
• While the above two steps just transformed the loan
to the borrowing bank to loan to the intermediating broker,
the loan still remained a secured loan. Very soon, however,
the brokers were able to persuade the lending bank to
dispense with security for the loan or to accept worthless
pieces of paper as security.
It would be instructive to understand why these
aberrations could be introduced in the processes since they
have a significant bearing on issues in governance.
Banks are required to invest a significant portion of
their deposits in designated securities to ensure adequate
liquidity of assets. These are known as SLR (Statutory
Liquidity Ratio) securities. These securities are essentially
government securities that yield low returns. The regulation,
however, exempted funds borrowed by a bank from SLR
requirements. There was, therefore, huge incentive for a
bank to do business using borrowed funds through repo
transactions. In such an environment, the brokers came
in handy, as they provided an opaque process, where the
identity of the counter-party (a bank) was not even revealed
or known. Slowly, as the size of the repo market grew, the
brokers started taking positions in their own account. The
process of settlement in the government securities market
started resembling the process of settlement in the stock
markets, where both the payment and delivery of securities
are broker intermediated.
Usually, an account payee cheque is deposited only in
the name of the payee mentioned on the cheque. However,
exceptions were being made even before the scam occurred
because the system of clearing of cheques was faster for
inter-bank transfers. Privileged customers were routinely
allowed to credit account payee cheques drawn in favour
of their banks into their own accounts to cut down the
clearing time by upto two days. Therefore, corporate
customers typically obtained a cheque in the name of their
bankers rather than in their own names, thereby reducing
the interest lost for the clearing period. The brokers were
quietly accorded a similar facility by the banks, as they
had in any case become major business partners of the
banks.

The third aberration of eliminating the security itself
was the most crucial. The following three approaches were
adopted to achieve this:
• Some banks were persuaded to part with cash without
receiving securities, with brokers paying interest at a rate
higher than the rate prevailing on the RF deals. The bank
management may have been tempted to adopt this route
to bolster the bottomline. As long as the scam lasted, the
banks benefited from higher returns on their lending.
• The second route was replacing the securities with
fake Bank Receipts (BRs). The BRs had come into existence
in the market to avoid actual transfer and re-transfer of
the securities underlying the RF deals, due to the inefficient
functioning of the RBI’s Public Debt Office (PDO), that
acts as the registrar and the transfer agent for government
securities. Legally, the transfers required submission of
Subsidiary General Ledger (SGL) forms to the PDO to
effect the changes in ownership of securities. The lethargy
of the PDO led to the ‘market practice’ of using BRs as
evidence of transactions. The BRs could simply be torn
and thrown away at the expiry of the RF deal period by
the lenders, thereby eliminating the need for actual transfer
and re-transfer of securities through the inefficient process.
• The third route was to forge the securities themselves.
The PSU bonds, typically, were represented by just the
allotment letters. Outright forgery, however, accounted for
only a small part of the total funds misappropriated.
Of the three, use of fake BRs was the most rampant.
The brokers used fake BRs, signed by colluding bankers,
to obtain unsecured loans from banks.
The Governance Issues
The scam was made possible due a complete breakdown
in the governance systems within the commercial banks
as well as the RBI. The governance system in the commercial
banks essentially relies on the following two mechanisms
for prevention of frauds:
Separation of Functions: The three different aspects of
transactions in securities, namely, dealing, custody, and
accounting are carried out by separate departments. Dealing
involves the decision to buy and sell; custody involves
receiving and delivering securities; and accounting involves
maintenance of the investment accounts of the bank and
reconciliation with the SGL account of the bank maintained
by the PDO of the RBI. Underlying the separation of
functions is the notion of double or multiple custody,
which ensures that if a fraud is to be committed, two or
more persons would have to collude. The need for such
collusion considerably reduces the chances of frauds.
Counterparty Limits: Whenever an RF deal was done on
the basis of BRs, the lending bank had to contend with
Regulatory and Contractual Framework 167
the possibility that the BRs might not be backed by adequate
securities. In effect, the bank could therefore be giving an
unsecured loan. The Banks therefore operated with credit
limits (counterparty limits), based on the creditworthiness
of the borrowing bank. The total exposure to the borrower,
at any time, was limited to this amount.
The scam revealed that either these basic principles of
governance did not exist or were ignored by several banks.
The governance system at the PDO required
reconciliation at the aggregate level and at the disaggregated
level (for each bank) of the SGL securities of each type.
This simple control mechanism was not being operated
efficiently by the PDO. Even if the SGL form sent by the
seller bounced due to inadequate inventory of securities,
the information to the buyer was intimated leisurely—
through a letter sent by ordinary mail. It was not uncommon
for transacting parties to receive confirmation or otherwise
of the transaction from the PDO after three weeks from
the date of transaction. The buyer in the meantime, acting
in good faith, may have sold the securities purchased. The
laid-back attitude of the PDO implied that at any point
in time there would be a large volume of unreconciled
transactions. This uncertainty was exploited to the hilt.
The RBI is also expected to carry out on-site inspections
and audit the investment accounts of banks. These were
not quite comprehensive and the RBI did not act decisively
against irregularities discovered either during such
inspection or in the SGL accounting.
Other Aspects of the Scam
There were several other aspects of the scam that have a
bearing on governance of financial sector. During the
period from September 1991 to June 1992, the government
raised the coupon rate on fresh borrowing three times. On
each occasion, the rate was raised by 0.50 per cent,
thereby raising the rate from 11.50 per cent to 13 per cent
over the period. A hike in rate for fresh loans leads to a
fall in the prices of old loans so as to bring the yields on
the old loans in line with the new rate. Anyone with
advance information about the rate hikes could benefit
immensely by short selling long dated securities (that suffer
the maximum decline in values) just before the hikes and
buying them back immediately after the rate hike. While
it will be impossible to prove conclusively that some
players in the market had advance information on the rate
hikes, there are reasons to believe that this information
was selectively made available to a few players who made
a killing on the basis of the information.
Window dressing of banks’ financial performance was
also rampant in those days. Banks were permitted to carry
their investments in securities at cost. This led to the use
of a subterfuge, whereby a bank could generate profits
168 India Infrastructure Report 2002
literally from thin air. The mechanism for achieving this
is best conveyed through an illustration.
Let us say Bank ABC holds two securities X and Y, each
purchased at Rs 100. Because of a rise in the interest rates,
suppose the securities are selling in the market at Rs 97
and Rs 99 respectively. The bank sells security X to a
broker at Rs 102 and buys security Y from the same broker
at Rs 104, receiving and paying thereby Rs 5 more than
the prevailing prices. This ensures that neither the bank
nor the broker incurs a loss on the two transactions taken
together. As a result of the transaction, however, the bank
would be able to show an accounting profit of Rs 2 on
sale of security X—since X is sold at a price of Rs 102
and it was bought at a price of Rs 100. The higher price
paid for security Y is inconsequential since that shows up
on the books at cost.
Such window dressing had become quite common. The
brokers were useful as they were willing to accommodate
such ‘spurious’ deals. While the broker typically did not
make any money on such transactions, he put himself in
the good books of the bank’s management and was in a
position to extract favours from the management in variety
of other ways, such as obtaining unsecured loans.
MMCB SCAM
Madhavpura Mercantile Co-operative Bank (MMCB) is
an urban co-operative bank. Such banks are essentially
local banks set up on the co-operative principles. They are
expected to cater essentially to the financial needs of the
members. There are over 2000 co-operative banks in the
country, with a deposit base of over Rs 70,000 crores.
Maharashtra and Gujarat together have more than 50 per
cent of the banks in number and about 75 per cent of the
deposit base, reflecting the strength of the co-operative
movement in the two states. The other two states that too
have a vibrant co-operative banking sector are Karnataka
and Andhra. The co-operative banks are an extremely
important part of the financial infrastructure of the co-
operative sector in the country.
Mechanics of the Scam
The MMCB scam is yet another instance of diversion of
funds from the banking sector to the stock market à la
the securities scam of 1992. MMCB started financing the
stock market operations of Ketan Parekh, the latest (now
fallen) Big Bull of the Indian stock markets. The modus
operandi of financing Ketan Parekh was through a simple
subterfuge that is best understood through the following
illustration.
You open one current account in the name of company
P in bank A and another current account in the name of
company Q in bank B. Now, present a pay-order (issued
by bank A) of company P to bank B and have it purchased
by bank B and credited instantly to the account of company
Q. It takes a few days—and the period can be lengthened,
if required, by greasing the palms of the concerned officials
in the bank—before the pay-order is presented by bank
B to bank A. You keep track and on the day of presentation,
you present a pay-order (issued by bank B) of company
Q to bank A and have it immediately purchased by bank
A. The cycle can be repeated again and again, and you
would enjoy few days’ credit every time. All you need is
accommodation from bank A to write the first pay-order
for you without adequate or any balance in the account
of company P. You write cheques against the money provided
by bank B when it purchases the pay-order from bank A.
Neither of the banks actually loses out since you would
be paying them the fee for discounting the pay-orders and
giving you immediate credit. However, a fraud is committed
when the pay-order is issued by bank A, without adequate
balance. Bank B has merely been imprudent in allowing
cheques to be issued without first collecting the amount
against the pay-order purchased from bank A. However,
bank B, may be excused if you happen to be Ketan Parekh,
the demi-god of stock markets, who has been a good client
of the bank for years! A pay-order of a mere Rs 137 crores
is a pittance, given the scale of his operations. Banking
after all is business based on relationship and trust carefully
built over a long period.
The Need for the Scam
The settlement procedure at the stock exchanges needs to
be understood to appreciate the raison d’être for the above
set of transactions. The stock exchanges have what are
known as pay-in and pay-out dates for each settlement
cycle. The pay-in date precedes the pay-out date by two
days. On the pay-in day, the buyer has to make the
payment for the purchases made and on the pay-out date
the sellers receive the monies due to them. An operator
therefore needs working capital, for two days, even if the
aggregate monetary value of his sales is greater than the
aggregate value of his purchases. Using the above method,
what Ketan Parekh did was to generate this working capital
required for his market operations. However, he needed
two banks to do the subterfuge—MMCB (which would be
bank A in the example above) that was willing to commit
the fraud and Bank of India (which would be bank B in
the example) that was willing to be lenient and had the
requisite resources to fund his requirements.
The Governance Failure
The issue that has exercised the passions of lakhs of
depositors is the monumental negligence on the part of the

regulators of co-operative banks—the State and the Central
Registrar of Co-operatives and the RBI. Each regulator
successfully got out of trouble by blaming the scam on the
‘dual control’ of the co-operative banks. A closer examination
however reveals that signs of wrongdoings were available
to both the regulators well before the scam of such
magnitude came to light. In its inspection report of 1998,
the RBI had pointed out irregularities in the management
of operations of MMCB. And yet, because of the political
patronage enjoyed by the management of the bank, no
corrective action was initiated by either of the regulators,
each secure in the knowledge that in case of an eventual
fraud, they would be able to get away by blaming it on
‘dual control’! There is little doubt that the scam was the
outcome of negligent and perhaps deliberate regulatory
bungling. After all, which agency would like to take up
cudgels against the might of political interference?
US-64 CRISIS
As the name makes it amply clear, Unit Scheme-64 (US-
64) was created in 1964. The scheme was conceived by
the government to mobilize savings from the household
sector for the industrial sector of the economy. The
management of the scheme was entrusted to the Unit Trust
of India (UTI), an autonomous investment institution
created through an act of parliament. Over the years, UTI
became a well-respected and important part of the financial
infrastructure of the country. Though UTI created several
schemes subsequently for the purpose of channelizing
savings, no scheme even came close to the level of success
that was achieved by US-64. The scheme, and through it
UTI itself, became synonymous with how public institutions
can successfully serve the needs of millions of Indians—
in this case, by providing decent returns on their hard
earned savings.
Absence of Supervision
The high profile of UTI was used by the management of
UTI to successfully counter the repeated attempts by the
Securities and Exchange Board of India (SEBI), to bring
UTI under the purview of its supervision. SEBI was
established in 1992 to supervise the functioning of stock
exchanges and the associated intermediaries, including
mutual funds. Though UTI essentially functions as a mutual
fund, it took refuge in the fact that it was created well
before SEBI was established and that it was created through
an Act of Parliament to stay out of the clutches of SEBI.
Operating Policies and Crisis
Since UTI is not covered by the regulations that govern
the mutual fund industry, it is not bound by the disclosure
Regulatory and Contractual Framework 169
requirements of the industry. As a result, even today, the
Net Asset Value (NAV) (the market value of the assets) of
the units of US-64 is not known with certainty. One of
the key reasons for the success of US-64 has been the
liquidity of the units. Till the imposition of the ban (from
2 July 2001), UTI provided continuous two-way quotes,
for sale and repurchase of units, without any restriction
on the number of units tendered or demanded. The sale
and repurchase prices were revised every month, essentially
to account for the dividend payable on the units in July
every year. Since the scheme was outside the purview of
mutual fund regulations, UTI was free to set the sale and
repurchase prices of units at levels that were unrelated to
the NAV. This unscientific pricing policy is what led to
the crisis facing the scheme today (August 2001).
The easiest way to understand the crisis is through a
simple illustration.
Let us assume that US-64 has a corpus of just 2 units
of Rs 10 each. One unit is held by Mr A and the other
unit by Mr B. The repurchase and sale prices for each unit
are say Rs 13 and Rs 13.25, respectively. Now suppose,
Mr B sells his unit to UTI at Rs 13, then the corpus of
the scheme would decline to Rs 7. After that, if Mr A too
tenders his unit, then UTI would have no money to
repurchase his unit at the declared price of Rs 13, since
the fund available would be only Rs 7. Every repurchase
at inflated prices thus adds to the losses of those who
remain invested in the scheme. The losses do not occur
only if the number of units sold exceeds the number of
units repurchased.
The ongoing crisis was triggered by the decline in the
value of equities after the discovery of the scam involving
the MMCB (Madhavpura Mercantile Cooperative Bank)
and other banks. As a result of the decline in equity prices,
the NAV of US-64 declined well below the repurchase
price. This generated an intense redemption pressure on
the scheme, and every repurchase at a price well above
the NAV compromised the financial viability of the scheme
further. Unable to stop the avalanche of redemptions, the
UTI Board announced, in June 2001, suspension of
repurchase and sale of units for an indefinite period. The
ban affected an estimated 20 million retail investors as the
liquidity of their investments disappeared overnight.
The nationwide uproar found an echo in the Parliament
where the proceedings of the house were held up for several
days on the issue. There were allegations galore of how the
interests of investors had been compromised by UTI because
of political and bureaucratic influences on its investment
decisions. One of the celebrated cases that resulted in the
forced resignation of the chairman and two executive
directors of UTI, and start of an investigation by the
Central Bureau of Investigations (CBI), is the investment
170 India Infrastructure Report 2002
made by UTI in the equity of Cyberspace Limited. The
head-office of this company is located at Lucknow and was
allegedly inaugurated by the prime minister himself.
The finance minister categorically denied having any
knowledge of the impending crisis and the precipitate
decision of the board. A new chairman was appointed
hastily and the UTI board was directed by the government
to work out a mechanism to ensure liquidity of US-64.
Response to the Crisis
After considerable deliberations, the UTI board proposed
a scheme, whereby, beginning 1 August 2001, UTI would
provide the facility of repurchase of upto 3000 units of
US-64 from each folder. Starting with Rs 10 for the month
of August 2001, the repurchase price for a unit would
increase by 10 paise every month, till it reaches Rs 12 by
May 2003. In addition, the UTI board has decided to
make US-64 NAV based scheme, that is, align the repurchase
and sale prices with the NAV, from January 2002. The
seriousness of the situation is evident from the line of
credit for about Rs 3000 crores that UTI had to seek from
a consortium of banks (led by the State Bank of India) to
meet the likely redemption pressure on US-64 and pay
dividends on its other schemes.
The proposal is a recipe for bankrupting the US-64 even
further. Since the current NAV of the units is well below
Rs 10 (market’s assessment is that the NAV is about Rs
8.50), every unit purchased at the announced prices would
result in erosion in the corpus of the fund (as explained
in the illustration). The proposal would thus inflict heavy
losses on the hapless unit-holders who are ‘forced’ to stay
with the scheme since they hold more than 3000 units.
The proposal sets US-64 on the path to certain doom and
bankruptcy since under the prevailing situation there is
unlikely to be any fresh inflows into the scheme. The
limitations of the proposal are as follows:
• It robs Peter (the unit-holders who are forced to stay
invested in the scheme) to pay Paul (the exiting unit-
holders).
• It is unfair to 20 million retail unit-holders vis-à-vis
the corporate unit-holders who exited in the nick of time—
just before the ban was imposed on repurchases—because
of (alleged) access to inside information.
• Even if legally UTI is well within its rights to revise
the repurchase price downwards by over 30 per cent
overnight, the move is morally bankrupt.
• The lock-in forced on units beyond 3000 in each
folder violates the understanding conveyed over 36 years—
that UTI would always stand ready to repurchase the units.
• The insurance companies that are bailing out UTI
by buying large parcels of equity portfolio of US-64 are
engaged in ‘cherry picking’, that is, picking up the best
stocks, thereby leaving the portfolio of US-64 poorer in
quality. Since repurchase prices would continue to be
above the NAV, every repurchase would bleed the scheme
(there would be cash-outflow from the corpus).
The saying ‘those who do not learn from history are
condemned to repeat it’ is applicable to the crisis facing
UTI today. The crisis of 2001 is a repeat of the crisis that
occurred in 1998 when the NAV of US-64 units declined
well below the repurchase and sale prices of units. On that
occasion, the government bailed out UTI through an
infusion of Rs 3300 crores. It is evident that UTI did not
learn from that experience and the problem has recurred.
Looking back, UTI failed to use an excellent opportunity
to completely restructure the portfolio of US-64 and make
the sale and repurchase prices of the scheme NAV based
when the SENSEX crossed the 6000 mark in February
2000. Aligning the repurchase and sale prices now with
NAV would be blatantly unfair to the millions of small
investors who have been loyal to the scheme and bought
the units at prices well above the NAV. The solution
possibly lies in the government coming to the rescue of
the trust yet again.
The Larger Concerns
In the prevailing circumstances, there is a distinct possibility
of a psychological backlash from investors. Any hint of
further unfavourable developments for the economy or UTI
could trigger a run on UTI for redemption. Besides, since
it is clear that some time or the other in the near future,
UTI will have to liquidate its equity portfolio, to pay
interest, and repay the funds being provided by the banks,
there would be selling pressure in the market at every rise.
The equity markets would, therefore, stay depressed. It
would, therefore, be hardly surprising if the first NAV that
is announced by UTI in early 2002 (as promised by the
Board) turns out to be quite low—say Rs 5 per unit. Such
an announcement would most certainly knock the bottom
out of the equity markets. Thus the equity market today
is on a precipice—in an unstable equilibrium. The slightest
hint of trouble would send it tumbling downhill. The country
cannot afford such a situation. The uncertainty could lead
to a sudden, massive withdrawal of funds by foreign
institutional investors (FIIs). It would also have a significant
negative impact on the ambitious programme of divesting
government’s stakes in PSEs and the ability of firms to raise
resources from the market. The government should be
seriously concerned about these possibilities and take steps
to avoid such eventualities.
Governance Issues
The crisis raises several concerns about the manner in
which public financial and investment institutions that are
key constituents of the financial sector are managed in the

country. The incestuous relationship between the corporate
sector and these institutions raises suspicions about the
quality of decisionmaking and corporate governance in
these institutions. For example, in the case of UTI, while
Reliance had invested several hundred crores in the units
of US-64, the UTI had ‘obliged’ by buying large quantities
of shares of the Reliance group companies. As reported
in the press, these shares have typically accounted for over
15 per cent of the equity portfolio of US-64 scheme. Such
quid pro quo was evident when UTI acquired a large parcel
of Reliance shares (worth about Rs 1000 crores) some
years ago at a very high price. Given such close liaison
between UTI and the large corporations, there is little
reason not to suspect that at least some corporations may
have been quietly tipped off about the impending suspension
of redemption. They exited before it was too late, leaving
the 20 million retail investors to take the losses arising
from mismanagement of the scheme!
The forced resignation of the top management of UTI
for purchase of shares of a small, unknown company,
Cyberspace Limited, at inflated prices is a clear pointer
to the fact that many of the investment decisions made
were not in the interests of the unit-holders. The absence
of denial by the government lends credence to the allegation
that the head-office of Cyberspace, located at Lucknow,
was inaugurated by the Prime Minister. There are also
persistent allegations, that have again not been denied
unequivocally by the government, that shares of many
companies have been purchased by UTI due to political
pressures and interference from officials from the Ministry
of Finance and even the PMO (Prime Minister’s Office).
These are clear evidences of exceptionally poor corporate
governance practices in the management of the financial
sector in the country.
It is amazing how the institutions never have to pay any
price in India for such clear breach of trust or down right
skullduggery. Removal of Mr Subramanyam, Chairman of
UTI, is hardly an adequate response to the fiasco. There
is a need for honest investigation to unearth the role played
by bureaucrats and politicians in the utter mismanagement
of funds entrusted to UTI by the common man. The fiasco
has after all affected 8–10 per cent of the country’s
population. There is an urgent need for complete
restructuring of the framework for governance of the
financial sector in the country. The opportunity should be
used by the nation to demand a thorough professionalization
of the functioning of not only UTI but all publicly funded
financial institutions.
LESSONS FROM THE SCAMS
It is quite clear from the exposition in the preceding
sections that the scams/crises were the result of both
Regulatory and Contractual Framework 171
erroneous operating policies as well as ineffective governance
structures. The broader issue is whether the right lessons
were learnt from these and whether measures were initiated
to revamp the operations and the governance of the financial
infrastructure to ensure its effective functioning.
Market Integration
One of the most important lessons from the scam of 1992
is that artificial insulation of closely related markets from
each other is counterproductive in the long run. Money
always seeks out the highest possible return, after due
adjustment for risks and liquidity. However, even almost
a decade after the scam, artificial barriers still exist between
the money market and the stock markets, between the
market for corporate securities and the market for
government securities, and between the formal and the
informal money markets. As a result, the market
infrastructure remains ineffective in guiding investment
choices and there are still pay-offs if funds could be
surreptitiously diverted from one market to another. It was
hardly surprising, therefore, that the MMCB scam occurred
in 2001, again involving diversion of funds from the
banking sector to the stock market. The fiat issued by RBI
to commercial banks to reduce their exposure to equity
markets after the MMCB scam is a retrograde step as it
accentuates the segmentation of markets. The need of the
hour is more effective prudential supervision and not a ban
on legitimate financial activity.
Over-regulation
Analysis reveals that very often scams/crises result from
over-regulation. The regulations of the money market in
1992 were such that legitimate and essential transactions
could not be put through openly, but had to be disguised
and camouflaged. The role of the brokers and some of the
banks as market makers was not recognized and they could
perform these functions only by subterfuge. The payment
and clearance systems were so antiquated that ‘alternate
systems’ had to be created for speedy transfer of funds and
securities. The net result of all these was total lack of
transparency in the operations of the money market.
Irregularities of all kinds were so common that no
suspicions were aroused even by highly irregular transactions.
One could even argue that some of the control systems
in the banks broke down because they were deliberately
allowed to weaken by both the commercial banks and the
RBI so as to facilitate normal transactions in violation of
the RBI’s own guidelines. While several steps have been
taken by the government to reduce the regulatory burden
of the market, the money markets continue to be excessively
regulated by the RBI.
172 India Infrastructure Report 2002
Dual/Multiple Control
The old adage ‘everyone’s responsibility is nobody’s
responsibility’ is what resulted in the MMCB scam. The
urban cooperative banks are currently regulated by three
authorities: the central government, the state governments
(through the central and state registrars of cooperatives),
and the RBI. Instead of strengthening governance, such
multiplicity of regulators for an entity in fact undermines
prudential supervision. That is exactly what happened in
the case of MMCB. Each regulator expected the other
regulators to keep an eye on the operations of the bank.
The irony is that, if reports appearing in the newspapers
are to be believed, the RBI is planning to propose the
creation of a fourth regulator, an apex supervisory body,
consisting of representatives from the central and the state
governments, the RBI itself, and outside experts, for
governance of cooperative banks. It is obvious that either
we do not learn from our mistakes or such governance
structures are deliberately created so that the regulators can
explain away lapses in supervision by blaming each other
when the scams do occur.
Integrated Prudential Supervision
By their very nature, financial markets are highly inter-
related. Crisis in one market, therefore, always creates
ripples of disturbances in the other markets. If different
regulators have jurisdiction over different markets, then
it is necessary for the regulators to evolve a well-coordinated
regulatory structure for effective prudential supervision. In
India, at least four regulators—RBI, SEBI, DCA
(Department of Companies Affairs), and the Ministry of
Finance—govern different aspects of functioning of financial
markets. The financial crises that have occurred in India
in the last decade, including the three discussed in this
paper, clearly show that the required degree of harmony
among regulators for effective supervision has not been
achieved. There is also a simmering turf war between the
regulators, particularly between SEBI and RBI. This has
immensely harmed the functioning and development of the
financial market infrastructure in the country. There is an
urgent need for improvement in the governance structure
either through better co-ordination or through a unification
of regulation under one super-regulator.
Multiple Role for the Regulator
The Reserve Bank of India is one of the two major regulators
of financial infrastructure in India. It has jurisdiction over
a diverse set of facilities such as commercial banks, non-
banking finance companies, cooperative banks, debt markets,
foreign exchange markets, and several other financial
institutions. In addition to being a regulator, RBI plays
several other roles. It is banker to the central and state
governments, it is merchant banker to the governments—
helping governments to raise resources from the market,
it is a major player (operator) in both the primary and the
secondary debt markets and the foreign exchange market,
and it is the custodian, registrar, and transfer agent for
government securities. It is a promoter of and a major
shareholder in several entities in the financial sector. For
example, it recently promoted Infrastructure Development
Financial Company (IDFC) to give a boost to development
of infrastructure in the country. It holds majority stakes in
the largest commercial bank in the country, the State Bank
of India (SBI) and National Housing Bank (NHB—another
institution promoted by RBI). The multiplicity of roles and
responsibilities dilutes the efficacy with which RBI can play
the role of an impartial regulator and adjudicator of disputes.
The partiality shown by RBI to NHB and SBI while
investigating the 1992 scam drew considerable criticism
and undermined its authority as a regulator. A similar
approach to dealing with the MMCB crisis is also visible
in 2001. A regulator commands moral authority over the
regulated only if it is not only fair but is also perceived to
be fair. Therefore, for effective governance a regulator must
shed all roles that have the potential for creating a conflict
of interest while performing its regulatory function.
Regulators on the Boards of the Regulated
Both SEBI and RBI have nominees on the governing
boards of stock exchanges. The RBI has its nominees on
the governing boards of commercial banks, primary dealers,
and several other entities in the financial markets. Their
presence in the governing boards creates a strange situation
when these entities are found to have acted in violation
of the prevailing regulations. The regulators themselves
become morally responsible for the violations of the
regulations since they have their representatives on the
boards of these entities. In the present day and age, it
should be easily possible to use appropriate statistical
analysis along with information and communication
technologies to monitor the operations of the regulated
entities, from regulatory perspective, on a real time basis,
if required, without representation on the boards of the
regulated entities.
Government’s Response
The ultimate responsibility for proper functioning of the
financial sector in the country rests with the government.
It is, therefore, necessary to examine the role played by
the government in establishing credible governance
structures. An analysis of government’s response shows
that the government has invariably panicked when faced
 Regulatory and Contractual Framework 173

Box 6.5.1
SEBI Report: A Damp Squib

It took SEBI over six long months to finalize its second ‘interim’ report on the securities scam of 2001. The report runs into
(as per the press) impressive four volumes and 1500 pages. As of now, the report is not available in the public domain. However,
excerpts from the report have been released selectively to counter the bad publicity SEBI has been receiving from the conclusion
reached by a survey conducted by FICCI that investors have lost confidence in SEBI.
The report makes little progress over the first interim report that was brought out soon after the crisis struck the markets in
early March. It simply reconfirms what is already known. The three distinct strategies that were being adopted by the ‘bulls’
to support their long positions in the market were: (a) use of funds siphoned off from the banking sector, that has been flush
with funds, for a long time; (b) transferring positions from one market to another, taking advantage of the asynchronous settlement
cycles, and thereby avoiding having to take delivery of shares; (c) convincing the management of the companies whose shares
were being bought to finance the purchases.
There would have been no crisis had the markets kept going North, as was widely expected, after the presentation of the
budget. However, that was not to be. The ‘bears’ in the market knew that the ‘bulls’ were sitting on a pin-head. They were
extended to a point where even a slight downturn in the market could snap them. The onset of downturn in the world markets
and the ‘tehelka’ episode could not have been timed better for the bears, and not surprisingly the market caved-in.
The timing of the release of the report by SEBI is uncanny—after the end of the monsoon session of the parliament. This
was done to ensure that the opposition did not have another weapon to hammer the already embattled Finance Minister. The
release also coincides with the ‘kiss and make up’ attitude the government is suddenly advocating (remember the reported
statement of the FM in the context of the scam that ‘there would be no witch hunt’ after the recent meet at the PM’s residence
to discuss measures to revive the economy!).
Based on the excerpts made available to the media, the inanity of SEBI’s findings is breathtaking! While there were perhaps
technical violations of some of the regulations, the reported value of sale by the ‘bear cartel’ is simply not large enough to have
caused a collapse of the market. The values of transactions assessed in the report of one of the main entities being investigated
for the fall in prices is about Rs 20 crores per day. In the case of another, the value of sales assessed after obtaining privileged
information is a mere Rs 3.9 crores. At a time when the combined volumes of transactions at the NSE and the BSE were running
at about Rs 7000 crores per day, it is unbelievable that the above volumes could have caused the slide in values that actually
occurred.
The report documents in great detail the manner in which prices of scrips of a few companies were relentlessly manipulated
through circular and dummy deals in the market. The participants in such exercises were not just brokers but several overseas
corporate bodies or OCBs and at least one FII. Unfortunately, while the report would make an excellent bed-side reading, the
evidence lacks the rigour required to nail the perpetrators of the manipulations in the court of law. As the lawyer of Ketan Parekh
is reported to have said, the only violation that his client can be found legally guilty of is the Rs 137 crore pay-order scam
involving the Bank of India.
The report raises concerns of two kinds. The first pertains to prudential supervision by SEBI of markets. Influencing prices
through circular and dummy deals is one of the most important market manipulations that SEBI is expected to monitor and
control. What was it doing when these were actually taking place in the market? It is clear that SEBI failed in its supervisory
role on this count. In some sense, the report is an indictment of SEBI itself!
The second concern pertains to the fact that the evidence gathered by SEBI does not build a case against the guilty that
cannot be challenged legally. It therefore appears that even on this occasion the guilty will finally go unpunished. What is the
value of a reprimand to an entity, no matter how severe, if the entity is permitted to continue its business as before? The report
raises the oft-stated shortcoming of our regulators. They are essentially toothless tigers, which can only growl, but cannot bite.
Or, am I missing the point altogether? Aren’t all investigations in this great nation of ours an exercise in obfuscation of evidence
so that the guilty go unpunished after appropriate deals have been struck and payments made in the right quarters? One will
have to wait to answer this question. If the final report of SEBI is as innocuous as the second interim report, then the answer
would surely be YES.

Source: Economic Times, 11 September 2001.

with crises in the financial sector and initiated multi-
pronged investigations involving several agencies such as
SEBI, RBI, CBI (Central Bureau of Investigations), DCA
(Department of Companies Affairs), Enforcement
Directorate, Directorate of Revenue and Intelligence, and
the IT (Income Tax) department. The 1992 response was
repeated, under pressure from the opposition parties, and
a Joint Parliamentary Committee (JPC) has also been set
up to investigate the scam of 2001. The multiplicity of
investigating agencies typically leads to chaos and delays
174 India Infrastructure Report 2002
in investigations. The government also set up a special
court in 1992 to speed up resolution of court cases connected
with the 1992 scam. Despite that, nine years since the
occurrence of the scam, most of the cases are still to be
decided by the courts.
The speed with which the crisis arising from rogue
trading in the financial markets by a dealer of Barings plc
was dealt with by the Singapore government provides a
sharp contrast to the Indian government’s inability to deal
with crises in the financial sector in India. In less than a
week the crisis was resolved, with an organized take-over
of Barings plc and jail sentence for Nick Leeson, the rogue
trader. Similarly, the decisive intervention by the US Federal
Reservor in 1998 ensured orderly winding down of the
troubled hedge fund LTCM (Long Term Capital
Management) and defused a potentially global crisis in the
financial markets. The impact of the crisis on financial
markets was effectively contained. In India, however, such
crises invariably significantly impair the financial
infrastructure for long periods. The financial markets were
badly crippled for several years by the ‘tainted’ shares
created by the scam of 1992. And now even before the
aftershocks from the 1992 scam could subside, the financial
markets have been hit by another scam. There is little
reason to believe that the aftereffects from the recent scam
would be any less severe than the one that occurred in 1992.
SUMMARY
There have been significant additions to the financial
infrastructure in the country in the last decade. As a result,
the facilities available, on paper, in the financial sector, are
almost comparable to those available in the developed
countries. These facilities, however, are unable to deliver
the goods because of the faulty governance structure for
their operations. Based on the analysis of the three scams/
crises presented above, the measures required to strengthen
the framework for governance are summarized below.
• There is an urgent need to harmonize the regulations
for different segments of the financial sector to reflect the
6.6 IS BRIBERY WELFARE-PROMOTING?
During the past several decades, governments in India and
in many other developing and transitional economies
distributed essential commodities such as food and fuel
among the population at low prices and on a first-come-
basic inter-connected nature of operations of different
segments.
• If multiplicity of regulators makes it impossible to
achieve such harmonization, then there is a case for
unification of regulation under one regulatory authority
that would have jurisdiction over the entire financial sector.
• The regulatory agencies today are assigned the task
of both supervision and regulation and development of the
financial infrastructure. There is a need to separate the two
functions.
• There is an urgent need to strengthen the prudential
supervision through extensive use of appropriate statistical
tools for data analysis to anticipate and defuse a developing
crisis. With the advancement in the information and
communication technologies, such analyses can be carried
out even on a real time basis, if required.
• There is an urgent need to establish a speedier
process for dealing with frauds committed in the operation
of the financial infrastructure. If required, the government
should setup a separate entity with legal powers to deal with
white-collar crimes.
• There is a need for professionalization of the
management of the financial infrastructure as well as
extensive involvement of professionals in the governance
of the infrastructure created. As in other spheres, the
bureaucratic and political interventions must cease in the
operation and regulation of financial infrastructure.
A credible and effective governance structure is the key
to efficient functioning of financial infrastructure. Without
this, achieving sustained growth in the creation of real
infrastructure and high economic growth would remain a
pipe dream for the nation.
While several individuals and a few organizations bore
the brunt of penal action arising from the scams, the
regulators have typically escaped without having to pay a
price. The euphemistic phrase ‘system failure’ is invariably
used to describe regulatory failures and hide glaring short-
comings in the governance structure. The article reproduced
in Box 6.5.1 highlights the shortcomings of investigations
of scams and the break down of governance of the financial
sector in the country.
Praveen Kulshreshtha
first-served basis (rationing-by-waiting). Elaborate bureau-
cratic procedures as well as recurring delays on the part
of bureaucrats only added to people’s woes, leading to
greater uncertainty and longer periods of waiting. The

presence of large waiting times led to the creation of
thriving illegal markets which involved additional payments
to middlemen as well as bribe-taking by bureaucrats who
were in charge of distributing the commodities, in return
for reduced waiting times17.
Despite the fact that commodities were often in short-
supply, governments continued charging low prices for
commodities on account of equity concerns and a desire
to reach the poor. Bribery often led to fast and efficient
provision of essential commodities to individuals who had
the ability and willingness to pay bribes. However, the
poorest of the poor still faced long queues and large waiting
times, and in many cases, were unable to obtain the
commodities.
Following the onset of widespread economic reforms in
India in the early 1990s, there was a marked change in
the distribution of essential commodities. The government
started offering ‘Tatkal’-like schemes to consumers in various
forms, which essentially involved a greater price, or
premium, in return for reduced, or zero, waiting time to
obtain a good18. In general, differential pricing schemes
(high prices corresponding to lower waiting times) are now
being frequently used to improve the efficiency in the
allocation of essential commodities and to enhance social
welfare.
One can argue that differential pricing schemes are
superior to illegal markets involving bribery because in
such schemes, the higher price, or premium, is paid
directly to the government, who can use it either to cover
its distribution costs, or to finance other social welfare
programmes. In contrast, with bribery, middlemen and
bureaucrats simply usurp the higher payment (bribe) for
personal gain. Bribery is also strongly opposed on ethical
grounds.
However, in the past, arguments favouring bribery have
also come about. Since the early 1960s, various social
scientists (Leff 1964; Huntington 1968) have asserted that
bribes act like ‘speed money’, or that bribery helps
consumers reduce large and costly waiting times that arise
in public distribution of goods and services. Moreover,
researchers such as Lui (1985) and Rose-Ackerman (1978)
have used theoretical models of queuing to show that under
some general circumstances, bribery improves efficiency
17 Debroy et al. (1994a, b) conducted two independent
questionnaire surveys to document the waiting times as well as
illegal payments associated with obtaining essential commodities in
the mid-1990s. De Soto (1989) similarly documented illegal and
informal markets in Peru.
18 Such parallel pricing schemes have been used earlier in some
cases such as for passports and telephone connections. See Debroy
et al. (1994a, b). However, it is only over the last few years that
such schemes have been widely introduced and used to tackle the
problem of distribution of essential commodities.
Regulatory and Contractual Framework 175
and enhances social welfare in the allocation of
commodities 19.
It is our contention that the above claim fails to hold
in rationing-by-waiting situations where the official price
of the rationed commodity is kept low for reasons of equity
and reaching the poor. Using a simple framework to
illustrate our ideas, we show that although bribery leads
to greater efficiency and social welfare at prices which are
not reasonably low, it does not improve efficiency and
lowers the welfare of the poor at the expense of the rich
in rationing-by-waiting at low prices20. If the rationed
commodity is in great short-supply, the poor can even be
excluded from obtaining the rationed commodity at low
prices due to bribery.
A BASIC FRAMEWORK OF RATIONING-BY-WAITING
Let us consider a simple rationing situation where the
government distributes an indivisible commodity at a fixed
price P. For simplicity, suppose that individual incomes are
distributed uniformly in the range zero to Y, where Y is
the maximum possible individual income in society. For
the sake of convenience, let us suppose that Y equals 1.
To make things interesting, let us assume that each
individual can buy upto one unit of the commodity, either
by law, or due to preference21. However, the rationed
commodity can be supplied only to a fraction S of the
population, and hence is in short-supply. Now, consider
a typical scenario where the fraction of buyers at the given
price P exceeds S. This implies that there is ‘excess demand’
at P, or P is below the ‘market-clearing’ price.
Since the commodity is distributed on a first-come-first-
served basis, a queue is expected to form, with individuals
arriving before the counter opens. Individuals who arrive
early enough are expected to get the commodity, while
19 However, later researchers such as Andvig (1991) have argued
that queuing processes can be immensely complex and different
ways of creating and managing queues can result in different outcomes
regarding average waiting times (see also Bardhan 1997). Hence,
they try to argue that bribery may not always enhance allocational
efficiency in queuing situations.
20 The framework described here is a simplified version of the
model presented in Kulshreshtha (2000). The basic model of
rationing-by-waiting was developed in Barzel (1974).
21 See Gabszewicz and Thisse (1979) and Atkinson (1995)) for
use of similar assumptions. However, individuals may illegally obtain
several units of the commodity. According to Debroy et al. (1994b),
commercial truck drivers in India tend to obtain about 5 licences
at a point in time. When caught by a traffic inspector for a
violation, they can either pay a fine, or turn in their licence to be
picked up later from the police station. This is where having more
than one licence is useful. When all five licences have been turned
in, a new set of five licences is obtained.
176 India Infrastructure Report 2002
those who arrive later than others may fail to obtain it. In
short, waiting can help to clear the market. In fact, if there
are a large number of potential buyers and information
regarding individual waiting times is freely and easily
available, the individual waiting time needed to obtain the
good is determined by the market (that is, no single individual
can control the waiting time necessary to obtain the good)22.
Hence, the waiting time that clears the market (‘equilibrium’
waiting time) is expected to be uniform across individuals.
Figures 6.6.1 and 6.6.2 depict possible situations in the
rationed good market. We plot individual incomes on the
horizontal axis and individual satisfaction levels (corres-
ponding to individual incomes) on the vertical axis. We
assume for the moment that there is no bribery in the
market. Therefore, an individual has two options: he/she
can choose not to obtain the good (and hence not to join
the queue), in which case he/she spends his/her income
on other goods, deriving satisfaction UO, which for
simplicity is taken as equal to income itself. Or, the
individual can choose to join the queue, wait to obtain
the rationed good and derive satisfaction UQ.
To make things interesting, let us suppose that possessing
the rationed good affects individual satisfaction in two
ways. First, it enhances satisfaction regardless of income
by an amount V, reflected in the vertical intercept of the
UQ line. Second, it can also augment the satisfaction
derived from income spent on other goods (‘other income’)
by a factor b (>1), which is reflected in the greater than
unity slope of UQ as in Fig. 6.6.123. However, waiting
dampens both of these affects, resulting in a lower vertical
intercept as well as lower slope of the UQ line. In fact,
as Fig. 6.6.2 shows, the slope of UQ can become less than
unity because of the disutility of waiting. Finally, note that
the waiting time in the market adjusts until the fraction
of individuals in the population who prefer to wait and
obtain the rationed good (that is, those with incomes such
that UQ > UO) equals S. The uniform ‘market-clearing’ or
‘equilibrium’ waiting time is denoted t*.
RATIONING-BY-WAITING IN THE PRESENCE OF
BRIBERY: EFFICIENCY AND WELFARE IMPLICATIONS
Let us consider what happens if there is bribery in the
rationed good market. In its simplest form, bribery gives
rise to a parallel black market, with bureaucrats selling a
part of the rationed good supply (S) in exchange for a fixed
22 Hence, waiting time is analogous to the uniform market price
in a competitive market.
23 For instance, possessing a ration card, or passport allows an
individual to carry out transactions that require a proof of identity,
hence raising individual satisfaction from other trades and transactions.
bribe b per unit (in addition to charging the official price
P)24. Moreover, no waiting is needed to obtain the good
via bribery25.
Figures 6.6.3 and 6.6.4 show how the outcome in the
rationed good market is altered due to bribery. The line
UB captures the satisfaction levels of potential bribers in
the population, for a given bribe b. Note that the slope
of UB is b (>1), since there is no waiting associated with
obtaining the good via bribery. In Fig. 6.6.3, where P is
greater than or equal to V/b, individuals with incomes
greater than, or equal to yQO are willing to queue up to
get the rationed good (since UQ > UO). However, individuals
with incomes greater than or equal to yBQ would prefer
to pay the bribe instead of waiting (since UB > UQ). Hence,
there is a switch from waiting to bribery for individuals
at the upper end of the income distribution (that is, those
with incomes exceeding yBQ).
Clearly, as Fig. 6.6.3 shows, bribers are better off (that
is, obtain a higher satisfaction level) in the presence of
bribery, as there is no waiting time associated with bribery.
But, what about the individuals who still queue up to
obtain the rationed good (that is, those with incomes
between yQO and yBQ)? Recall that in Fig. 6.6.3 (where
bribery is present) as well as in Fig. 6.6.1 (where bribery
is absent), price P is great than or equal to V/b and all
individuals with incomes exceeding (1 – s) are willing to
obtain the rationed good. The only difference between the
two cases is that some of the rich buyers switch from
waiting to bribery, when the latter becomes possible.
However, the equilibrium waiting time t* remains the
same in both cases (If the waiting time changes, the UQ
line shifts in both cases and hence the fraction of rational
good buyers no longer equals S). In other words, bribery
does not affect the waiting time in the market and hence,
the queuing individuals are not worse off because of
bribery.
Thus, bribery makes some individuals (the bribers)
better off, while leaving others (the queuing and non-
buying population) no worse off. In other words, bribery
eliminates costly waiting time for some individuals, while
24 Given that there are a large number of individuals in the
population, it is likely that bureaucrat cannot learn each individual’s
income. Therefore, it is reasonable to assume that he charges a
uniform bribe b to all individuals who are willing to bribe. Moreover,
for simplicity, we assume that the bureaucrat is not caught taking
a bribe, or equivalently, the cost to him/her of bribe-taking is very
low (not an unrealistic assumption, given the pervasiveness of bribery
in many developing countries).
25 It is reasonable to assume that the bureaucrat distributes the
bribed units randomly. However, in case the number of bribers
exceed the number of units sold via bribery, it is expected that the
bureaucrat will simply raise the bribe until there is no excess
number of bribers.

UQ
U
UO
Utility/Satisfaction
V(1 – t*)
0 P 1 – S 1 Y
Income
Q
Fig. 6.6.1 P ≥ V/b
affecting nobody else adversely. Hence, we can conclude
that bribery improves efficiency and enhances social welfare
in the queuing situation described above26.
However, it can be shown that the market outcome is
strikingly different in the case where price P is less than
V/b. Figure 6.6.4 illustrates that at prices in the above
range, individuals who can afford the rationed good (incomes
no less than P) but have incomes less than yQO prefer to
queue up, while those with incomes exceeding yBO (> yQO)
prefer to pay the bribe and obtain the good. Note that in
the absence of bribery, all individuals with incomes between
P and (P + S) (> yQO) will obtain the good via waiting (see
Fig. 6.6.2). Hence, it is clear that via bribery, some of
the available units are siphoned off to the relatively rich
individuals (those with incomes greater than yBO), leaving
less units for the relatively poor individuals (those with
incomes between P and (P + S)) who would have obtained
the good via waiting in the absence of bribery. This results
in greater competition among the poor individuals who
26 An outcome is said to enhance social efficiency if it makes
some individuals better off while making nobody worse off. Also,
note that bribery can be made completely redundant if the government
raises the official price to PMC, or the ‘market-clearing’ price for the
given S (see Fig. 6.6.3). This is because, by definition, no buyer needs
to wait to obtain the good at PMC (reflected in the UMC line which
is parallel to the UB line), while the set of buyers remains the same
as at any other P ≥ V/b. Therefore, the outcome at PMC is preferred
by all buyers to the outcome at any other P in the above range, since
(costly) waiting time is eliminated for each buyer at PMC.
Regulatory and Contractual Framework 177
U UO
UQ
Utility/Satisfaction
V(1 – t*)
0 P P + S 1 Y
Income
Q
Fig. 6.6.2 P < V/b
would wait and therefore, the equilibrium waiting time
goes up (as depicted in Fig. 6.6.4 by a downward rotation
of the UQ line). As a consequence, some individuals (those
with incomes between yQO and (P + S)) decide to leave
the market altogether, due to the disutility of higher waiting
time.
Thus, when the official price of the commodity is lower
than V/b, bribery results in greater benefit for the rich who
bribe (because they are able to obtain the rationed good
without waiting) while the waiting poor face a loss (because
their waiting time is increased). Hence, we can say that
bribery does not enhance social efficiency and may not
increase social welfare because it makes the bribing rich
better off, but at the expense of the waiting poor who are
worse off due to bribery. In fact, it can be shown that when
the rationed good is in extreme short-supply (S is lower
than some critical value), the bureaucrat finds it optimal
to choose a bribe such that all units are sold to bribers
and hence, all waiting individuals are excluded from the
market. Hence, bribery can benefit some rich individuals
but may lead to exclusion of all waiting poor.
CONCLUSION
We have shown above that contrary to earlier assertions,
bribery may not enhance social efficiency and promote
social welfare in rationing-by-waiting situations. Although
bribery can have beneficial efficiency and welfare
178 India Infrastructure Report 2002
UB
UMC
U U
Utility/Satisfaction
V V(1 – t*)
V(1 – t*)
0 P PMC YQO = P + b YBQ
Income 1 – S
Q B
Fig. 6.6.3 P ≥ V/b
implications in cases where price of rationed commodity
is not very low, it fails to achieve overall positive results
in situations where the commodity is priced low, which
is the most common scenario in developing and transitional
economies in the past.
The above result raises two issues. First, we have shown
that if a rationed good is in limited supply, bribery leads
to competition among bribers (who wish to reduce costly
waiting time) and the waiting poor to obtain the good. If
bribery prevails at low prices, the poor can get excluded
from the market. However, one can argue that if bribery
was not allowed, then at low prices it is the rich who would
be excluded from the market instead (as depicted in Fig.
6.6.2). This is because the poor are more willing to wait
at low prices than the rich (since the poors’ disutility, or
cost of waiting, is less). If the commodity is an essential
one, such as electricity, or water, exclusion of the rich is
as much of a concern as exclusion of the poor.
The crux of the problem here lies in the fact that the
commodity is in limited, or short-supply. The solution to
bribery and the consequent problem of exclusion lies partly
in raising the supply of the rationed commodity, while
creating avenues by which willing individuals can pay to
obtain the rationed good without waiting, or waiting less.
One way to do so is to introduce differential pricing
schemes in the allocation of essential commodities, while
increasing the overall supply of the commodities. It can
UQ
UB
UO
UO
UQ
Utility/Satisfaction
V
1 Y 0 P YQO P + b YBO 1 Y
Income
Q B
Fig. 6.6.4 P < V/b
be shown, and is an intuitive proposition, that differential
pricing will lead to lower bribery in rationing-by-waiting
situations. This is because the rich can find an easy
substitute for bribery in the higher-price schemes, where
the good is distributed instantaneously, or the waiting is
reduced substantially, in lieu of the increase in the
commodity’s supply.
The second issue that can be raised here is that bribery
may continue to prevail despite the prevalence of differential
pricing schemes, if the bureaucrats can influence the waiting
times of individuals by creating delays, or wasteful red-
tape. If bureaucrats cannot be monitored well, they would
have an incentive to use wasteful red-tape to create a
demand for bribery. By creating delays, bureaucrats can
impose large waiting costs on individuals even when there
is no a priori reason for waiting times to be large (that is,
when the rationed good is not in great short-supply).
Thus, if waiting time is endogenous, that is, can be
influenced by bureaucrats, bribery can arise even in the
presence of differential pricing schemes, or more generally,
when the rationed good is in greater supply. This possibility,
which is observed quite commonly in many developing and
transitional countries suffering from rampant bribery and
corruption, calls for greater monitoring and control of
bureaucrats via anti-corruption policies, in addition to the
use of differential pricing schemes to reduce the scope of
bribery in rationing-by-waiting situations.

6.7 THE ENRON DISASTER
Enron, an American multinational corporation, made its
first entry into the Indian electricity sector in June 1992
by signing a Memorandum of Understanding (MoU) with
the power utility owned by the Government of Maharashtra,
viz. the Maharashtra State Electricity Board (MSEB).
The first Power Purchase Agreement (PPA) was signed
by the Dabhol Power Company (DPC), the Indian
subsidiary of Enron, and MSEB in 1993. This became
controversial with allegations of corruption in the deal. The
incumbent government in the state was defeated in the
subsequent elections. The new government promptly
cancelled the deal after assuming power in March 1995.
However, it renegotiated the deal with Enron, with equal
promptness. The amended PPA was finally signed in July
1996 and was further amended in a substantial manner as
late as December 1998.
Enron started commercial operation of the first stage
of the power project (with capacity of about 700 MW)
from May 1999. Though it is not utilizing the entire
capacity of the Enron plant, MSEB was paying about
Rs 95 crores per month to Enron as fixed capacity charges,
irrespective of the amount of electricity it bought from
Enron. This burden soon became unbearable for MSEB,
which had already been in a precarious financial situation.
Meanwhile, newspaper reports about the effective rate
of Enron’s power, which was quoted as Rs 7.80 per unit
[kWh], caused uproar in the state legislative assembly. The
state government agreed to appoint a high-power expert
committee to ‘review’ the deal. After a delay of more than
six weeks, the Godbole Committee was appointed, which
comprised of Madhav Godbole (Chairman), E.A.S. Sarma,
Deepak Parikh, R.K. Pachauri, Kirit Parikh, and V.M. Lal.
See Box 6.7.1 for a Summary of the Committee findings.
It would be appropriate to record two important
observations regarding the Committee at the beginning.
First, though many people raised protests that some
members of the Committee had a pro-Enron bias, there
cannot be any doubt that the Committee possessed a very
high-level of expertise and experience in the areas that were
crucial in this matter, viz. energy policy, infrastructure
finance, international trade and public administration.
Second, it is worth noting that all the members came from
mainstream institutions, and none could be branded as
having anti-privatization or anti-reforms leanings. The report
* An NGO based in Pune working for consumer and civil society
rights in energy and infrastructure.
Regulatory and Contractual Framework 179
Prayas Energy Group*
of the Committee should be viewed in the background of
these two distinctions, which make it clear that the pro-
Enron quarters do not have a basis to protest about the
composition of this Committee.
THE MALADY
This story of greed, deception, and intrigue is not restricted
only to the Enron project. Similar stories and criticisms
are being heard about other projects started by the
independent power producers (IPPs). Further, it needs to
be noted that the Enron project (as well as the other IPP
projects) is just one symptom or outburst of the malady
that is plaguing the entire Indian power sector. MSEB, like
all other SEBs, is experiencing severe crisis.
The questions raised by the report of the Godbole
Committee, the broad governance failure, and the
widespread malady destroying the Indian power sector
need to be analysed with an integrated perspective. This
is especially important when the sector is being reformed
and restructured in a fundamental manner.
The integrated analysis should begin with investigation
into the question of why were ‘the broad governance failure’
and the three crises allowed to happen and persist. These
must have been allowed because some people, who are
powerful enough, benefit handsomely out of this rot, while
the sector in general and most of the consumers suffered
very badly. Further, those who have been benefiting have
adequate control over the sector to perpetrate this rot,
despite the resultant destruction and suffering for many.27
It is often and quite rightly said that at the root of this
performance crisis lies the ‘political interference’, to be
more correct, interference by partisan interests represented
by politicians. But the politicians are not alone in this
game. In fact, they are only one of the key players in the
alliances (and nexuses), who turn even a genuine project
into a disaster and a dishonest project into a death trap
(as happened in the case of the Enron project). The other
key players in these alliances include sections of top-level
bureaucrats, contractors, suppliers, officials, employees,
and even some consumers. Obviously, members of these
unholy alliances work to serve their own interests by
drawing maximum possible economic and political benefits
in every possible way.
27In fact, they must be powerful enough not only to repress the
marginalized sufferers but even to silence the powerful ones who are
not willing to join them.
180 India Infrastructure Report 2002

Box 6.7.1
The Godbole Committee’s Findings

The Committee submitted the first part of its report on 10 April 2001. The report was extremely critical about the current
agreements and the process in which the agreements were cleared and passed by various government agencies as well as the
concerned autonomous agencies.
Here we bring out the findings and conclusions of the committee on the substantive aspect of the PPA for Enron’s DPC
project as well as those on the process in which the agreement was cleared (Government of Maharashtra 2001). (All figures in
brackets in the subsequent discussion refer to the page numbers in the Godbole Committee Report).
Substantive Problems with the PPA Instead of discussing, in detail, the findings of the Committee on the substantive aspects
of the agreements, this paper outlines the conclusive comments of the Committee only on the four major substantive issues in
order to maintain brevity.
The Inappropriate Project and Unwanted Electricity ‘The Committee finds that, while the initial demand projections for DPC
were flawed in that they ignored different load types in their projections, the demand projection that was the basis for
commencement of Phase II was based on patently untenable assumptions, given the information at that time; assumption that
have since proved to be completely unjustified’ (emphasis original) (53).
The Unnecessary Linkages with Supporting Projects with Excessive Capacities The Committee points out that various components
of the complex Enron project other than the power project such as the LNG Regassification Facility, Marine Facilities, Shipping
Charter and Gas-Supply Agreement were unnecessarily linked to the power project. Further, it also observes that the designed
capacities of all these supporting or connected projects were in excess of the needs of the power project. It also points out that
the cost of these overcapacities were loaded entirely on the power project (and hence on MSEB).
Surreptitious Overcharging of Rs 930 Crores per Year The most shocking revelation of the report is the surreptitious overcharging
done by Enron on at least four counts (with yearly excess payment figures in the brackets): (i) unnecessary capacity of the LNG
facility (Rs 253 crores); (ii) charges for the harbour facilities and shipping charter (Rs 100 crores); (iii) excessive operati on and
maintenance expenses (Rs 246 crores); (iv) inflated fuel consumption (Rs 332 crores). Thus, even within the framework of the
present agreement, it could be claimed that DPC is overcharging MSEB by about Rs 930 crores per year.
Unaffordability: Impacts on State Finances The Committee unanimously arrives at the conclusion that, in one year, the payments
to DPC have ruined the financial position of MSEB and put a heavy burden on the finances of the state government. This
prompts the Committee to comment: ‘This (burden of Enron payment) could conceivably lead to drastic cut in budget allocations
for the “State Plan” expenditure and can arguably lead to a declaration of a Plan Holiday’ (24).
Problems in the Process of Sanctioning the Project As mentioned before, the Committee also recorded severe criticisms of the
process in which the project was sanctioned. The process related criticisms are of direct relevance.
The ‘Fast Track’ Process of the Renegotiation Group While discussing the speed at which the Renegotiation Group functioned,
the Committee quotes from the judgement of the Bombay High Court: ‘The speed at which the whole thing was done by the
negotiating group is unprecedented. What would stop one to say, as was said by the Chief Minister in the context of the original
PPA, “Enron revisited, Enron saw and Enron conquered—much more that it did earlier”’ (39).
Negotiation vs. Bidding The state government had persistently defended the choice of the route of negotiations over the more
transparent route of competitive bidding. It has argued in the court that competitive bidding was not relevant, counterproductive
and inappropriate. The Godbole Committee found ‘(E)ach of these reasons to be deficient and suspect’ (43). The state
government has also argued that it had conducted intense negotiations before signing the contract. The Committee commented:
‘Both, the justifications and the quality of these negotiations are suspect’ (emphasis original) (42).
Central Electricity Authority (CEA) Clearances The Committee points out that, contrary to its regular practice, the CEA, in
its relevant letter, did not explicitly give the required ‘techno-economic’ clearance to the Enron project. Neither, at any stage, did
the CEA indicate that it reviewed the economic aspects of the project. This prompts the Committee to comment: ‘Thus, it is
a moot question whether the CEA discharged the statutory duty cast on it under the Electricity Supply Act adequately. It is
not clear from all this whether the economic aspects of the project have been comprehensively evaluated’ (48).
Tariff Competitiveness: A Fraud on the Public Interest In order to satisfy the legal requirement and also to establish that the
project is in public interest, it was necessary to demonstrate that Enron’s tariff would be competitive. Further, in order to
demonstrate its competitiveness, Enron’s tariff should be demonstrated to be lower than the tariff for an equivalent project
according to the central government norms. After detailed investigation into this issue of competitiveness, the Committee
comments: ‘Thus, in each and every instance, both for Phase I and Phase II, the assumptions are not only untenable; they are
also favorable to DPC. . . . The Committee considers this combination of circumstances to be beyond the realm of coincidence
 Regulatory and Contractual Framework 181

and thereby is constrained to conclude that these assumptions were deliberately chosen so as to show that the DPC tariff was
lower than GoI tariff. As can be seen, the entire demonstration of public interest owing to the lower DPC tariff is on extremely
shaky ground and in the opinion of the Committee utterly unsustainable’ (emphasis original) (61).
Lack of Due Diligence by DPC and Financial Institution The Committee found severe lapses on the part of the financial
institutions that provided funds to the Enron project: ‘The Committee also finds that the financial institutions showed poor
judgement and lack of due diligence in accepting these (demand) projections without demur . . . The decision of the financial
institutions to fund this project seems to have been based primarily on escrow account given by MSEB, guarantee by the state
government and the counter-guarantee by the central government (for Phase I) rather than on an independent and meticulous
appraisal of the project’ (53).
The ‘Broad’ Failure of Governance The Committee says: ‘The Committee is troubled with the failure of governance that seems
to have characterized almost every step of the decision making process on matters relating to DPC. This failure of governance
has been broad, across different government at different points of time, at both the state and the central level, and across different
agencies associated with examining the project, and at both the administrative and political levels. It strains belief to accept that
such widespread and consistent failure to execute assigned responsibilities is purely coincidental’ (84). These startling, if not
shocking, observations and findings of the Committee comprised of the men of high expertise and experience should certainly
give a severe jolt to every right thinking citizen. Obviously, the entire Enron saga could prove to be an illustrative case study
for the students of public affairs. The subsequent part of the paper draws lessons for governance from this saga.

There are many examples of such unholy alliances
operating in the Indian power sector and drawing benefits
for their members. As is evident in the case of the Enron
project, the political bosses, top-level bureaucrats, and
Enron joined hands to throw to the winds every legal
provision that posed even the slightest hurdle for the project.
But the next question is how exactly did these unholy
alliances manage to do this? As the analysis of the Enron
deal by the Godbole Committee suggests, these alliances
and nexuses effectively take control of one or many of the
three main functions of the governance process: (i) decision
making, (ii) implementation of the decisions made, and
(iii) regulation (ensuring adherence to rules) of the decision
making and implementation functions.
These three governance functions, in normal circum-
stances, are expected to work to serve the public interest.28
However, by taking over the control of these three governance
functions, the members and leaders of these unholy alliances
and nexuses ensure that, instead of the public interest, the
sector would function to mainly serve their own interests.
In this sense, there is a breakdown of the governance of
the sector. In other words, we can describe this situation
as the crisis of governance in the sector. Thus, we can
conclude that at the root of the performance crisis (as well
as that of credibility and financial crises) lies the governance
crisis.
Lack of Transparency
The answers to these questions could be provided in terms
of the three lacunae in governance, which are discussed
28 Here, the term public interest is used in a somewhat broader
sense. It includes interests of the disadvantaged sections of society
plus the broader and long-term interests of society as a whole.
in the following paragraphs. These alliances manage to take
control of the sector primarily because they can manage
to avoid examination of the propriety and rationality of
the decisions. This is possible because the alliances not
only manage to hide all this information about the decisions
but also deceive people by giving false information. The
Enron saga provides a plethora of illustrations to support
this observation.29
This lack of information (or provision of misinformation)
on crucial aspects of the decisions or their implementation
points at the first lacuna, viz. lack of transparency, that
allows the unholy alliances to take the control of governance
of the sector.
Lack of Accountability towards the Public
The second lacuna relates to the lack of accountability of
those who make the decisions or implement them. There
are many instances in which the politicians, bureaucrats,
and experts who made the decisions that proved to have
seriously adverse impacts on public interest could not be
forced to own up to their responsibilities and to pay for their
unjustifiable, irrational, and blatantly anti-people decisions.
This was again well illustrated in the Enron saga.30
29 Take the example of the separation of the regassification
facility as per the recommendation of the Renegotiation Group in
1995. MSEB and Enron (and possibly the Government of
Maharashtra) decided among themselves not to follow this
recommendation without informing the public about this decision
to deviate. This is despite the fact that the reduction in capital cost
due to this separation was one of the main arguments put forth by
the state government to justify the renegotiated deal.
30 The pro-Enron politicians and bureaucrats claimed that
Enron’s tariff would be Rs 1.89 per unit (in the case of the first
182 India Infrastructure Report 2002
Lack of Public Participation
There is another critical lacuna in the current governance
process, especially in the decision making and regulatory
functions. It has been clearly established that the major
decisions are, in most cases, made by a small coterie
comprised of politicians in power, top-level bureaucrats
and their commercial consultants, all coming from the
advantaged and largely urban sections of society. In effect,
most of their decisions reflect not only their limited
understanding of the socio-politico-economic reality at the
ground level but also result in welfare of the advantaged
sections. This lack of participation of diverse sections of
society with different socio-politico- economic backgrounds
provides scope for the unholy alliances to serve their own
narrow interests at the cost of public interest.
To sum up, because of the lack of transparency, the lack
of accountability of decision makers and executors of these
decisions, and the lack of public participation in decision
making and regulation, it was possible for these unholy
alliances to hold the sector for ransom. Thus, the breakdown
of the governance of sector, or the ‘crisis of governance’
in the sector, is rooted in the lack of Transparency,
Accountability and (Public) Participation (or TAP). Hence,
lack of TAP is seen in this analysis as the core malady
besetting the sector.31
THE REMEDY
World Bank Model’s Limitations
As far as the power relationship between the unholy alliances
and the consumers (these include industrial consumers
also) is concerned, privatization will certainly not make any
PPA, Rs 2.40 per unit). When Enron started sending bills with
an effective tariff of Rs 6.00 to Rs 7.80 per unit, it became clear
that MSEB, the state government, and the economy of the state
would soon be on the brink of financial disaster. However, all
these decision makers and the implementers continue to espouse
Enron’s cause.
31 This diagnostic analysis could be extended further. It must be
noted at this point that, even in the earlier model (of the earlier
era), there were certain provisions for TAP. For example, there has
been a provision in the Electricity Act for establishment of a
Consultative Council (CC), which is expected to advise the SEB on
policy matters. Similarly, the decision makers in the sector were to
be held accountable through the politicians who were the ultimate
masters of the sector. These politicians were to be held accountable
through democratic elections. However, the CCs were hardly
functional, if at all they existed. This was because their formation
and functioning has been left to the discretion of the SEBs. Similarly,
the politicians devised many ways and tricks to win elections
without being held accountable for their actions. This circumvention
of the existing TAP related provisions was possible mainly because
these provisions were indirect, vague, and discretionary.
change in favour of the latter. In fact, there is a danger
that with entry of the powerful corporations, the new and
equally (if not more) powerful and equally unholy alliances
of corporations, politicians, and bureaucrats might take
control of the governance of the sector. The situation after
the entry of Enron and other IPPs has demonstrated that
this apprehension is not ill-founded.
In a way, this is acknowledged even by the protagonists
of privatization. They agree to the need for stringent and
independent regulation to keep in check the ‘non-competitive
behaviour’ of private players, especially in view of the
natural monopoly in the Indian power sector, which is
going to persist at least for some decades to come.32
However, there is one crucially distinctive characteristic
of the independent regulation as envisaged by the pro-
privatization elements who largely subscribe to the World
Bank’s model of electricity sector reforms. In this model,
the regulation is to be independent of the state and ‘investor-
friendly’. This is because the main objective guiding the
design of the regulatory system in this scheme is to protect
private players and investors from ‘interference’ of the
state. Such a system will not automatically serve the purpose
of protecting interests of consumers and people in general,
and the disadvantaged sections in particular, from the
designs of the unholy alliances. This is mainly because such
a system does not pay necessary attention to the special
needs of these sections, and does not emphasize on creating
space for these sections in the regulatory process and on
building their capabilities to utilize this space. This effectively
excludes the small consumers and disadvantaged sections
from participating in the ‘independent’ regulatory system.
Further, as our earlier study of the World Bank’s Orissa
model demonstrates, the regulatory institutions in this are
severely prone to sabotage by powerful vested interests
(Dixit et al. 1998).33
Democratization
To be more precise, these requirements should be articulated
as: (i) complete transparency towards public (T); (ii) direct
accountability primarily (not towards the investors but)
towards public (A); and (iii) meaningful public participation
(P). Thus, TAP is essentially ‘public-friendly’ as against the
‘investor-friendly’ TAP envisaged by the World Bank.
32 It is by now clear that despite the enthusiasm of some, it is
quite difficult to bring in bulk competition in the Indian power
sector without precipitating the attendant legal, procedural, and
financial problems. There is no need to mention here that retail
competition will remain a distant dream, if not an impossibility, in
decades to come.
33 However, it needs to be acknowledged that there is some
space for the public and consumers to intervene in the regulatory
process. The new model is certainly better than the old, state
centred model, at least in this respect.

The Regulatory Commissions
The practical way to approach this task is to begin with
agencies that would be discharging the three governance
functions.
The regulatory commissions are products of the particular
reform model that is tailored largely on the lines of the
US model and actively sponsored by the World Bank. As
mentioned before, the main function of the ‘independent’
regulatory commissions, as envisaged in the World Bank’s
model, is to shield private players from the interference
of the state and politicians. However, their American
genealogy has left many provisions—which are conducive
to ‘public-friendly’ TAP—intact in the structure and
functioning of these regulatory commissions. As our
experience in Maharashtra suggests, the available space for
public-friendly TAP in the structure and functioning of the
regulatory commission could still be effectively utilized to
exercise public control, to a great extent, not only on the
regulatory function but also on the decision making and
implementation functions.
Continued Role for the State
However, in the Indian situation, many state governments,
despite establishment of the regulatory commissions, have
retained a considerable amount of decision making power,
especially in the case of policy decisions. In addition, to
make matters more complex, most of the state governments
maintain ownership of the SEBs. There is a growing demand
that these governments should hand over all the powers and
responsibilities to the regulatory commissions, which are
mentioned in the relevant reform Acts. However, at the
same time, the demand for divesting even the policy making
functions (that still remain with the state governments) and
hand them over to the regulatory commissions might prove
premature and counter-productive.34
TAPing the Governance Agencies
As Table 6.7.1 indicates, all the three agencies—government,
regulators and utilities—will be handling the decision
34 This observation is rooted, first, in our analysis of the structure
of the regulatory system in Orissa, which was designed by the World
Bank and found to be deficient on the grounds of ‘public-friendly’
TAP. It is feared that due to this lacuna, the regulators might turn
into the new unrestrained kings of the sector (Dixit et al. 1998).
The second reason for this caution is rooted in the fear that the
regulatory commissions—because of their particular structure,
mandate, and functioning style—will be much beyond the radius of
influence of the disadvantaged sections of society. As against this,
the state will be comparatively more amenable to influence of these
sections, who, despite their disadvantages, have gained considerable
political leveraging power in the five decades of not-so-perfect
democratic activity.
Regulatory and Contractual Framework 183
making function.35 The state will be handling mainly the
policy related decisions, while the utilities will be making
many important functional decisions in the techno-economic
and financial areas. The regulatory commissions, however,
will be adjudicating on major decisions such as tariff and
propriety of investments.
Further, while implementation function will be mainly
handled by the utilities, the regulation function will be
handled by the regulatory commissions.36
There are four main routes or mechanisms (or strategies)
to fulfil the task of TAPing the three governance agencies.
The first route is the ‘democratic-political’ means that are
available in the democratic system. These means include
activities such as submitting petition and organizing public
education or protest programs. These are especially useful
and effective in the case of publicly-owned utilities. Here,
the term ‘democratic-political means’ needs to be
differentiated from the term ‘political interference’, which
essentially means interference by partisan politicians aimed
at protecting narrow political or economic interest and not
public interest. As against this, democratic-political means
are used by various civil society institutions (CSIs) and
individuals to put forth either public grievances or their
own positions on public issues.
The second route is the judicial route. The state agencies
could be forced to respond to TAP related demands using
many existing laws, for example, the law such as the newly
enacted Right to Information Act.37 As far as the regulatory
commissions are concerned, there is provision in all the
reform Acts permitting judicial review of the decisions of
the regulatory commissions.38
The third route is using the TAP mechanisms that are
in-built in the structure and functioning of (especially of
the publicly-owned) utilities, the state, and the regulatory
commissions. As we have seen earlier, there have been
certain in-built TAP related mechanisms in the government
35 Table 6.7.1 is aimed at providing a somewhat simple picture.
Many intricacies and exceptions could be identified to make the
picture more sophisticated.
36 Though there will be considerable diversity in the functioning
of the State Electricity Regulatory Commissions or SERCs, the
different strategies to address this diversity will not be discussed in
this paper.
37 Though many observers have (rightly) expressed doubts over
the efficacy of this set of new laws. However, a lot can be achieved
by trying to enforce the existing provisions of these laws while
pressing for changes in the laws.
38 However, in the case of most of the states where the World
Bank consultants have drafted the Act, the Act allows review of the
orders of the decisions of the commissions only on procedural
grounds, precluding the substantive examination of the orders of the
commissions. However, in the other states, the orders of the
commissions are open to procedural as well as substantial review.
184 India Infrastructure Report 2002
Table 6.7.1
TAPing the Three Main Governance Agencies
Governance agency Governance function(s)
Utilities Decision-making
The State Implementation
Regulatory Regulation
Commissions
and the utilities, which are often given short shrift. CSIs
should undertake concerted efforts to press for adherence
to these in-built mechanisms. In the earlier era, the blatant
avoidance of these mechanisms was, in fact, allowed to
spread wide because of their neglect by CSIs.
The fourth route is using the inter-agency pressures.
Though not exactly designed with a comprehensive
perspective, the three governing agencies keep each other
in balance by exerting inter-agency pressures. For example,
the regulatory commissions can pull up the governments,
if it is demonstrated to them that certain actions on the
part of the government encroach upon the decision-making
powers of the commissions. Conversely, the governments
can give policy directions to the commissions, if desired.
The Two Preconditions: Space and Capabilities
Our experience with the Maharashtra Electricity Regulatory
Commission suggests that it is possible to TAP and to
democratize governance agencies to varying degrees
(functions) if the following two preconditions could be
fulfilled. First, there should be legal and procedural ‘space’
for effective TAPing of the governance agencies. Second,
the public (interest) institutions or civil society institutions
should have the resources, information, and capabilities
(expertise and skills) that are necessary to make optimum
use of this available space.
Creating the space (in terms of institutions, Acts, and
rules) for TAPing of the governance agencies through
appropriate legislation is a tougher task. This is very well
demonstrated in the case of deceptive legislation that has
been enacted in various states under the name of ‘Right
to Information’ Act. In the case of the Indian power sector,
the Central Reform Act (the Electricity Regulatory
Commissions Act of 1998) and the state-level reforms Acts
in most states allow, in principle, considerable space for
TAPing regulatory commission and utilities. However, in
some states, this space is not clearly articulated at the
operational level in the design of the ‘Conduct of Business
Rules’. This results mostly in leaving the TAP related
provisions vague, indirect, and discretionary. Further, there
Routes for TAPing the agency
Through democratic ‘political’ means
Through courts using laws (such as the ‘Right
to Information’ Act)
Through in-built TAP mechanism (such as the
Consultative Councils and public proceedings)
Through inter-agency pressures
is a need to set the right procedural precedents to create
and/or establish the TAP.
The task, which is equally daunting, is to evolve the
necessary capabilities (expertise and skills), resources, and
attitudes in various social and political (or civil society)
institutions in order to make the best use of the available
space for TAP. Because governance of the power sector
involves complex technological, economic, financial, and
legal issues, in order to be effective, the civil society
institutions would require information, analytical
capabilities, and legal skills of highly sophisticated levels.
All this also requires equally higher levels of human and
financial resources. It needs to be understood that the
structure, perspective, capabilities, skills, and resources
possessed by most of the civil society institutions in India
are geared to deal with the old, state-centred political and
economic regime. To make changes in all these would
require vision, concerted efforts, and leadership, all of
which seem to be absent from the scene.
CONCLUSION
The major contribution of the Godbole Committee is in
highlighting the ‘broad failure of governance’ as the root
cause of the fraud and tragedy that struck the state of
Maharashtra in the form of the Enron project. But, again,
Enron is not alone. The story is not much different in the
case of the other independent power producers (IPPs) in
the country.
Unfortunately, the prescription suggested by the main-
stream institutions to resolve the prevailing crises—
privatisation and independent regulations—are not
appropriately designed to address the root cause of the
governance crisis, viz. the control of unholy alliances. As
a result, the crucial governance agencies in the new model,
viz. the regulatory commissions, remain highly prone to
sabotage by the unholy alliances of the vested interests.
This leaves us no choice but to give centrality to the
public-friendly TAP provisions in our efforts to reform and
restructure the Indian power sector. This, in turn, would

require that all the governance functions and governance
agencies are made amenable, on mandatory basis, to full
transparency to the public, direct accountability to public,
and meaningful participation of public.
The three major governance agencies—the state, the
utilities, and the regulatory commissions—could be TAPed
in a variety of ways. However, the space and capabilities
of civil society institutions will be the important
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