Try a thought experiment. Imagine there is a holding company, XYZ Corporation. It is not a listed company and has a single owner. It holds controlling stake in two listed companies, ABC Limited and DEF Limited.
XYZ sells a portion of the DEF stake it directly owns to ABC, at the going market price. ABC transfers the equivalent cash to XYZ from ABC’s own reserves (ABC may even borrow to buy the DEF shares), and it receives DEF shares in return.
Since XYZ owns majority stake in ABC, it continues to control DEF. XYZ can follow through by selling a portion of the ABC stake that it directly owns, to DEF, again without affecting ownership or control of either company in any way.
It can carry out these transactions as often as it likes, building up cross-holdings where ABC owns chunks of DEF and vice-versa, without affecting ownership or control of management. Each time it makes a deal like this, it siphons cash away from ABC or DEF. This deprives ABC and DEF of the ability to invest the money they have earned in the growth of their businesses. Therefore, it discriminates against the minority shareholders of the two listed companies.
Substitute the Government of India for XYZ Corporation. This, in essence, is what the government proposes when it “asks” the Oil and Natural Gas Corporation Limited to buy some of the government’s stake in Hindustan Petroleum Corporation Limited. Both are listed public sector units with minority shareholders. The government owns 68% of the Oil and Natural Gas Corporation directly, and more through institutions it controls such as the Life Insurance Corporation (9.2%), Indian Oil Corporation (7.7%) and Gas Authority of India (2.4%). The Government of India owns 51% of Hindustan Petroleum Corporation directly.
The Oil and Natural Gas Corporation will pay Rs 36,915 crores to buy the 51% stake in Hindustan Petroleum Corporation. It will raise approximately Rs 35,000 crores of that by borrowing. That money will be received by the Government of India and spent any way it chooses. The Oil and Natural Gas Corporation will have to service that debt out of its future profits.
Creating this sort of tangled cross-holding is frowned upon by investors precisely because it treats minority shareholders poorly. Private business groups that indulge in such deals generally receive a thumbs-down and they can run into regulatory censure. The rules are different, of course, when the government is the majority shareholder.
From BJP to Congress
There is a long history of governments raiding the reserves of public sector units in this manner. Yashwant Sinha did it in the 1990s when he was finance minister in the Bharatiya Janata Party-led government under Atal Behari Vajpayee. He raised about Rs 6,200 crores by setting up cross-holdings between the Oil and Natural Gas Corporation, Gas Authority of India and Indian Oil Corporation among others. The Congress-led United Progressive Alliance did this in 2013-2014, carrying out a deal where the Oil and Natural Gas Corporation and Oil India Limited bought about Rs 5,000 crores worth of government stake in Indian Oil.
Any time the Central government feels cash-strapped, this sort of “hera-pheri” is going to be a temptation. It will attract minor protests from the political Opposition but will never result in an electoral backlash. Minority shareholders constitute a tiny percentage of the electorate and this is not a demographic that takes to the street and burns school buses either.
There is no point in railing against this behaviour. It is not ideologically-driven; it cuts across party lines. As an investor, this is only one of many good reasons to avoid putting your money in companies owned and managed by the government.
It may actually be a useful signal for somebody who is wondering about the state of government finances. Going by historical patterns, this step is taken when the government is cash-strapped and there is fiscal stress.
Sign of fiscal stress
More specifically, such deals may be connected to stress on the external account. The 1998-1999 cross-holdings came in the wake of India facing international sanctions for conducting the Pokhran II nuclear tests. The 2013-2014 cross-holdings occurred when crude was trading at levels of $100 a barrel and there was a large current account deficit (when a country imports more goods, services and capital than it exports).
The fact that this is happening again is no surprise. The government had announced in December that it would be borrowing an extra Rs 50,000 crores in 2017-2018 to fund an expanded fiscal deficit (the difference between the government’s total revenue and its total expenditure). It later whittled down its additional borrowing target to Rs 20,000 crores. The Oil and Natural Gas Corporation is picking up the rest of the tab, and more, by transferring Rs 36,915 crores.
The sources of stress are also clear. Crude prices have risen steadily over the last six months and the current account has gone into deficit. Tax collections are down, first because demonetisation affected growth and then because of the confusion caused by a poorly-designed Goods and Services Tax. Those stresses are bound to show up in the Budget that will be presented on February 1 as well, though there will probably be more financial jugglery designed to disguise it.
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