How the plot thickens

Indian Express, 2 August 2006

The Orissa governement has acquired land and handed over 1135 acres of land to Korean steel company Posco. A few weeks ago the Haryana acquired land for the Reliance SEZ. As it does all over the world, the issue of land acquisition by the State for private use has raised questions.

Traditionally the "eminent domain" principle allows the state to acquire land for public use such as roads. In reality, however, land is acquired by governments for commercial enterprises like real estate projects, malls, townships etc. This usually involves purchasing contigious private plots of land, consolidating them, and then selling them to a private developer who makes profits from resale or rent. But should the state acquire land only for public use or does it have a legitimate role to play when a private commercial enterprise wants to buy land? This question arises when the land is owned by a large number of private individuals and the project in question requires the land to be contigous. If a developer wishes to buy 10,000 acres of land which is owned by one individual all he needs to do is to make a deal with the property owner. This happens all over the world all the time and the state does not intervene.

However, if the land is owned by a hundred small owners there is a "coordination problem". No individual land owner wants to be the first to accept a bid for his property. Each small land owner would like to hold out. If his property were to be the last to be sold, he would clearly be able to blackmail the developer and get an infinitely high price for it because the project becomes feasible only if he sells and collapses if he does not sell. As a consequence, no small property owner agrees to sell. The coordination problem makes it impossible to consolidate small and fragmented holdings into large holdings. It is the reason tribals in Orissa do not sell to Posco. Farmers in Haryana do not sell to Reliance and cultivators in West Bengal do not sell to Tata motors.

But should the government intervene and force property owners to sell to solve the coordination problem for a private developer? The "good" being produced is not a public good. Is there a rationale for state intervention?

One of the reasons why the state has been seen to intervene in such land transactions is when the project is expected to have positive externalities. Development of the land could bring prosperity to the area, create infrastructure, bring new business, raise employment, raise taxes and so on. These have been the grounds on which land acquisition has been done in various countries. China had 233 cities in 1981. By 1999 the number had risen to 667. This involved massive property development, a huge increase in infrastructure and large scale land acquisition.

Land acquisition for commercial projects has been controversial all over the world, but, in general, it has not been stopped. Whether in an effort for development of an underdeveloped area in a poor country, or the revival of a dying city centre in a rich country: governments have been involved in land development projects all over the world. In other words, there is a case for government to use force in order to get existing land owners to sell their property.

Having agreed that there are grounds for the government to meddle in the land market to solve the coordination problem, the next question that arises is that of the right payment to the existing land owners. While the principle of eminent domain indicates that the prevailing market price is to be paid, the level of compensation often runs into political difficulties. The problem arises because before the land is developed its price is low. After it has been developed, the price goes up. The developer is often seen to make huge profits from resale. Neighbouring plots of land also see a sharp increase in price due to the effect of the land development. This sharp increase in land prices makes the previous land owners feel they have been short-changed.

West Bengal has addressed this problem by paying 30 percent above the market rate. Even China, land is not private property and people merely have 'Land Use Rights'. China is grappling with the compensation problem which is currently based on previous income from the land. The standard compensation is 4-6 times the average production value of the land in the past 3 years. There is no land market which can determine a market price. Strictly speaking it is not "land acquisition" but "compulsory land resumption" because the government is the owner of the land and merely takes back the Land Use Rights. In Britain the compensation is based on the value of the land to the owner and this has difficulties because the value, say, of an ancestral home, may be above the market value.

The fair price thus remains an unsolved question. Ultimately, land is like a financial asset whose price moves as the expected returns from it change. The way the price of shares change when the prospects of a company change, the price of land changes when the prospective rental revenue stream from that piece of land changes. This depends on the use to which it is put. Forest land owned by tribals as in the Tata Steel project in Orissa had a low expected income from it and thus each parcel of land has a low market price. Agricultural land owned by farmers in Haryana has low productivity. If the land contintues to be used for forestry or agriculture, its market price would be low. Yet, when the same land is put to a different use, the cashflow from the land changes. This different use, and enhanced valuation, is possible only when the land is consolidated.

The price of land thus varies depending on what use the land is being put to and what are the expected returns from it. The net present value, and hence the price of a consolidated 10,000 acres could be very high if the land was to be developed as an SEZ while it could be very low if the land remained in small fragments and was used for farming.

What is the main problem with the way land acquisition for private use is being done in India? When farmers are paid the fair market price of land by the government when land is acquired they get paid, say, a total of Rs 100 crore. The government may sell the land to the developer at, say, Rs 200 crore. Another Rs 300 crore may line the pockets of politicians who have facilitated the transaction. The value of the land on day one, right after the developer becomes the owner of the large contigous piece of land, even though no investment has been made, jumps from Rs 100 crore to Rs 500 crore, a five time increase, creating discontent among the previous land owners. In this framework while the developer pays the Rs 500 crore, the famers have received only Rs 100 crore. The exchequer has received Rs 100 crore for solving the coordination problem. The difference has gone to the pockets of the politician for selling the land to developer A and not to developers B, C or D.

How should India make sure that the farmers receive a better deal and the money does not get siphoned off into the pockets of politicans who grant the projects? Eminent economist Shubhashis Gangopadhyay, Director, India Development Foundation, proposes an elegant solution to the problem. There should be an auction in which the role of the government is only to solve the coordination problem. In this framework the government would identify the land, forcibly take possession of the land, and auction the large contigious piece of land for a stated use. Developers who well understand the value of the property would participate in the auction. The price of the property, as the price of any such asset, would be based on the net present value of the future cashflow from the land. If the developer had paid Rs 500 crore in the non-transparent purchase, that is the minimum that the auction would fetch. This high price would be passed on to the farmers. The role of the State then becomes only that of being a facilitator, that solves the coordination problem, and thus enables farmers to do much better than any one of them could have done on their own.

Why is this framework not adopted? The answer is fairly obvious. Why would the political class give up the opportunity to make big money on these deals? But given the need of the country to undertake land development and the possibliity of such disputes setting back these projects by many years, it is also clear that transparent auctions in land deals is the direction in which India needs to go.

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