Link divestments with modernisation of investment policies of EPFO, ESIC

There is a strong case for linking the divestment process involving public sector undertakings (PSUs) of the Central and State governments with modernisation of investment policies of the two social security institutions —- the Employees’ Provident Fund Organisation (EPFO) and the Employees’ State Insurance Corporation (ESIC).

As their membership is mandatory, the members have a legitimate interest in ensuring that they deliver benefits commensurate with the costs they impose on them. Their current all-debt (fixed income) portfolios, almost wholly in public sector entities and instruments, do not serve the interests of the members.

A simple method of bringing about such a linkage would be for the two organisations to consider investing in the PSUs being divested on a case-by-case basis. They could be allocated the shares on a preferential basis, but at market prices. Many variations of this method are possible to suit particular circumstances.

The divestment process
The official policy of the Central government is to gradually list on India’s stock exchanges all profitable PSUs, with investors holding at least 10% of the total equity. The public sector must retain at least 51% of equity, thus retaining control. The policy may thus be termed ‘divestment with control’.

A competently managed divestment process could enable the government as a seller and the investors as buyers to discover appropriate market value of the PSUs. It also could enable investors to benefit from the accumulated brand value and from the future business growth of the PSUs (such as State Bank of India and Indian Oil) being divested.

The divestment process permits the government to transform its physical assets into cash, i.e. divestment receipts. The finance minister reportedly hopes to raise Rs 40,000 crore (0.72% of the country’s gross domestic product, or GDP) during 2010-11.

The transformation of physical assets into cash, however, does not alter the overall balance sheet of the government as it represents simply changing one type of asset into another. It is therefore inappropriate to regard divestment receipts as current revenue financing the fiscal deficit.

The National Investment Fund, which was established in 2005 but became operational in 2007, focused on the allocation of divestment receipts for urgent social sector expenditure; on strengthening technological and human resource bases of the PSUs. Its suspension, hopefully temporary, reflects government’s relaxed attitude towards sound public finances and towards improving effectiveness of delivery of public services.

EPFO’s investment policies
In 2008-09, EPFO had total mandatory contributions of Rs 39,500 crore (0.71% of GDP); while its investments at the end of March 2009 were Rs 3,48,800 crore (6.26% of GDP).

This makes EPFO among the largest non-bank financial institutions in the country. It can potentially play a constructive role in developing India’s financial and capital markets, and in reducing the volatility in the markets arising from the shorter investment horizon of some of the important participants such as foreign institutional investors. Lack of long-term domestic institutional investors in India’s capital markets has often been cited as one of its major limitations.

EPFO’s investment portfolio (including exempt funds managed outside EPFO) as on March 31, 2009 comprised 38.5% in Special Deposit and Public Account with the Central government, on which it is paid administered interest rate; 23.8% in fixed-income instruments with public sector financial institutions; 22.4% in Central government securities; and 15.3% in State government guaranteed securities.

EPFO has thus allocated all of its balances to debt or debt-like fixed-income instruments, almost wholly issued by the Public Sector. It thus has no exposure to equity or to other asset classes. For a long-term mandatory savings institution, and for an institution with membership involving the young and the middle aged, an all-debt (fixed income) portfolio concentrated on public sector instruments is not consistent with modern investment management principles and practices. The portfolio lacks the asset and geographical and sectoral diversification essential for prudent portfolio risk diversification. It also does not provide members options in exercising risk-return preferences to its diverse members.

Subscribing to the divested shares of the PSUs would preserve the preference, however dysfunctional, of EPFO’s board to predominantly invest in public sector entities, while permitting limited diversification of its portfolio. If the board is reluctant to exercise the option, there is another avenue. Contrary to good governance practices, EPFO is currently both a service provider and a regulator of exempted provident funds, resulting in a conflict of interest.

Moreover, the exempted funds are required to follow the same all-debt investment portfolio, and pay the same interest as politically determined rate which EPFO has been accustomed to.

The exempt provident funds can be provided with different investment guidelines, under which subscribing to divested Central and State PSU shares would be permitted. They can be supervised and regulated by the Pension Fund Regulatory and Development Authority. This will provide contestability to EPFO and enable it to focus on being a service provider.
Investment policies of ESIC

For ESIC, contributions for 2008-09 were Rs 3,700 crore (0.07% of GDP) and its reserve funds and investments were Rs 13,300 crore (0.24% of GDP).
Its investment portfolio as on March 31, 2009 was 94% in fixed deposits with public sector financial institutions and 6% in Special Deposit with the Central government.

This allocation is also inappropriate for a health insurance organisation as it forgoes potential returns and does not permit matching of long-term assets and liabilities on a sound actuarial basis. Nearly all of the reserves are to meet future benefits already promised; and if the utilisation rate of ESIC services increases significantly, these could turn into deficit quickly.

An indication of the inappropriateness of ESIC’s portfolio is that its administrative expenses for 2008-09 were equivalent to 27% of benefits paid; 9% of total receipts including mandatory contributions; and 62% of interest income from reserves and investments. ESIC, therefore, needs to consider ways to improve income, and to reduce administrative expenses. Investing in divested PSUs is one of the ways in which it can improve its income.

Linking PSU divestments with investments of social security funds is a common practice internationally. The time has come for India to emulate it.

The writer is a professor of public policy at the National University of Singapore and can be reached at sppasher@nus.edu.sg. Views are personal.