What do Indian telecom companies have to do with Indonesian coal? The short answer is everything, at least for investors in emerging markets

Every country has numerous types of property. The interests in property are governed by the peculiar laws of any country. Many investors believe that the law will determine the value of the property, but as the Nobel Laureate Ronald Coase pointed out in his famous theorem, the law itself probably does not make much difference because if there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. But in emerging markets there are transaction costs. The most glaring is poorly defined property rights. In India the property right was a license to use parts of the radio spectrum for second generation (2G) mobile telephones. In Indonesia the property right was a license to dig for coal.

In 2008 the corrupt telecom minister, Andimuthu Raja, helped by some well-connected tycoons was able to engineer a rigged auction of licenses to use the 2G spectrum that may have cost the Indian treasury as much as $39 billion. In February 2012, the Indian Supreme Court revoked 122 licenses declaring the sale “arbitrary and unconstitutional”. The court ordered the telecom regulator to reallocate the licenses by an auction to be held in four months.

The court was on solid legal grounds. The common law rule is that fraud cannot convey good title. This is quite logical, because it provides a disincentive to crooks, who may not profit from their acts and an incentive to buyers to investigate ownership before they buy. It is also a very important limit to the pervasive corruption that infects not only India, but all emerging markets.

Despite the validity of the ruling, it will have some far-reaching consequences. Three foreign telecom companies including Norway’s Telenor, Russia’s Sistema and Etisalat of United Arab Emirates made a mistake common for foreign investors in emerging markets. They trusted their sellers or just assumed that it was part of the business culture. Nigerian Internet scammers make a good living on the presumption that corruption is so prevalent that deals, no matter how nefarious, will be respected. Whatever their logic, these three companies stand to lose the billions they invested in networks based on the assumption that their licenses were valid.

The press on the ruling has also been mixed. The Indian muck-raking news magazine Tehelka called the court’s action “judicial over-reach” that resulted from “the abject capitulation of the executive”. One commentator stated that “India has become a banana republic in which the banana is peeled by the Supreme Court. Never has ‘brand India’ been so damaged.” Incredible India has become Undependable India”.

The truth is just the opposite. The Supreme Court’s actions go to the heart of any investment. All investing is a bet on the future. The future is filled with risk. The more investors can limit risk, the more likely they are to invest. Strict adherence to rules and well-defined property rights are the most important criteria for attracting foreign investment.

Contrast India’s license revocation with Indonesia. Gossips lament that the ‘I’ in BRICs now stands for Indonesia and not India. The shareholders of Churchill Mining would disagree.

The Nusantara Group is an Indonesian mining company controlled by Prabowo Subianto, a retired general, once the son-in-law to former president Suharto and future presidential candidate. Nusantara held licenses to mine coal in East Kalimantan on the Indonesian part of the Island of Borneo. These expired in 2006 and 2007.  A small British company called Churchill Mining bought interests in the licenses after the local government declared them available.

In 2008 Churchill discovered a giant coal deposit, estimated to be in 2.73 billion tonnes. It is the second-largest reserve in Indonesia and the seventh-largest in the world. Based on the authority of its license, Churchill invested more than $40 million in the project.

Within months of announcing its discovery, Churchill found that their property rights in the discovery were in question. The same local government that had declared that Nusantara’s license expired backtracked. They extended them which, if upheld, would nullify Churchill’s claims.

Churchill sued in the local courts but predictably lost. A final appeal to the Indonesian Supreme court could take years and a representative of Indonesia’s president Yudhoyono said that the issue was a local matter and denied any knowledge of the case.

It would be easy to dismiss these incidents as isolated cases, but they are not. They are part of the risk of any investment either direct or indirect. Before any emerging market can live up to the BRIC hype, it has to enforce property rights. India has proved that it is the ‘I’. The real problem has to with the C and the R.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected])