17 June 2014.
By Sabyasachi Kar.
(This post first appeared on The Hindu on 10 June 2014).
Reviving growth and checking inflation is the primary mandate that the Indian people have given to the government. It has to be understood, though, that there is no magic wand to achieve these goals. It will take time to put in place some of the institutional changes that are necessary for a return to high and sustained growth rates.
After a historic electoral battle, Indian voters have given their mandate and a new government is now in office. The government has promised the people that it will deliver on good governance and inclusive development. However, a number of challenges lie ahead, the biggest of them, without doubt, being the state of the economy. To use a term that has increasingly been employed in this context, the economy is in a state of paralysis.
So what are the most important steps that the government needs to take to help the economy recover from this paralytic state? To answer this, it is important to understand how the current state of affairs came about.
The reforms era
In the first slew of economic reforms and liberalisation in 1993, the traditional industrial and services sectors within the economy gained a lot of freedom that they had never enjoyed previously. Before 1993, the major constraints these sectors faced were legal and policy constraints, such as the industrial licensing policy, tariff and quota restrictions on import of raw materials and intermediate goods, etc. The 1993 reforms removed most of these constraints. This led to the first growth boom in India, with the average per capita growth rate of the economy going up from less than 2 percent to more than 4 percent per year.
Then came the second growth boom in 2004, with per capita growth rates increasing to more than 6 percent per year. This boom happened partly due to some of the traditional sectors continuing to do well and also because of a new kind of growth momentum from some specific sectors — minerals, construction, real estate and telecoms. The momentum in the minerals sector came from exports, as global demand and the price of minerals were very high during this period. In the real estate and the telecoms sectors, growth resulted directly from increased middle-class incomes due to the first growth boom. The impetus in construction was the result of conscious policy decisions of the government, which wanted to push for big infrastructure projects.
Interestingly, the growth momentum in all these sectors was based on a close relationship between the political class and big private investors. The mineral sector — which previously had been completely in the public sector, catering largely to domestic demand — was consciously opened up to big private investment and exports. The real estate sector, previously made up almost entirely of small players, saw a number of large private investments during this period. In the telecoms sector, the nature of the market ensured that only big players could participate. Even in the construction sector, some of the big projects like airports needed huge investment and big businesses.
Paralysis and backlash
Undoubtedly, these sectors needed to be developed for sustained and continuing growth in India. The problem was that policymakers thought that the set of reforms made in and after 1993 would be sufficient to regulate this new kind of growth. With hindsight, we now know that there were very significant regulatory failures in these sectors during the second growth boom. We also understand that the reforms of the 1990s, which focused on removing constraints on activity, were insufficient to provide broad-based, corruption-free growth in these sectors. Each of these sectors needed a different governance structure and set of regulations, which were not put in place before the sectors started growing at a very rapid rate. We also know that the regulatory failures during the second growth boom led to a very strong institutional and political backlash from 2010 onwards.
This backlash manifested itself in several ways. In 2010, the media began raising issues of corruption and crony capitalism in these sectors. Next, civil society got involved and voiced its opinion on the need for alternative regulatory and anti-corruption institutions like the Lokpal. Finally, the courts passed orders and rulings that criticised the decisions made by the government in these sectors. All this led to what is now being called ‘the paralysis’.
In fact, the paralysis manifested itself in the activity of two important agents of the economic growth — bureaucrats and private investors. Once the courts gave adverse rulings on the decisions taken by some bureaucrats, the bureaucracy as a whole became jittery about taking decisions, sometimes deferring to them to the extent that projects simply ground to a halt. Private investors, on the other hand, found out that formal and informal understandings that they had entered into with the political class were not as secure as they had thought them to be, especially in the face of court cases and popular political uprisings like the one in Singur. This uncertainty, that crippled both the bureaucracy and private investors, led to the collapse of investment and growth rates.
Bureaucracy and business
So, what should the new government do to bring back growth? The first thing it needs to do is to move the economy out of this paralytic state. Clearly, the approach has to attempt to rejuvenate both the bureaucracy and the private investor. Here, the government has indicated that it intends to do this on a priority basis, but these are complex institutional problems and having the right intent may not be enough, unless the nature of the problem is well understood.
Take the case of the bureaucracy. The government needs to ensure that the bureaucracy does not become a part of any deal-making with the business class which can lead to decisions that are not in the best interests of the country. This means that there needs to be strong penalties for any malpractice by bureaucrats. However, if the government adopts an approach that strongly penalises the bureaucracy for any outcome that is less than satisfactory, then this may lead to a very risk-averse bureaucracy, which also hampers vibrant decision-making. In effect, the government needs to put in place a system which can differentiate between the deliberate malpractice of the bureaucracy and poor decisions that may occasionally be made, even with the best of intentions.
The crony-capitalism associated with the second growth boom resulted in all sorts of informal deals between the political and the business class. Initially, these raised investor confidence in this period, but later they led to a breakdown in confidence when the deals were challenged by ‘accountability institutions’, such as the Comptroller and Auditor General of India (CAG), the Central Bureau of Investigation (CBI) and the courts. Any future relationship between the political class and the business elite has to be based on formal rather than informal deals. This will not only help investments become less costly, due to a fall in transaction costs, but also assure investors that these deals will not be reneged in future. Ultimately, only that can bring back investor confidence.
In practical terms, this means that sectors which are prone to high rents and crony capitalism need to have more appropriate regulatory mechanisms. This will encourage investment and growth without causing future political backlash. Once these sectors are taken care of, the investment climate will no longer be held hostage to investor paralysis. It is then that the government can shift focus to structural factors like infrastructure, etc.
The other crucial thing the government needs to do in order to sustain growth is to control inflation. Inflation has always been partly demand-driven and partly structural, due to elements like supply bottlenecks. In India, in the last few years, it is the structural part which is almost always driving inflation, particularly food inflation. While the Reserve Bank of India (RBI) and monetary policy can ensure that inflation does not lead to hyperinflation, unless we solve the problem in the food sector, we will continue to have high inflation rates. Hence, interest rates will not be able to come down, which will hamper growth.
In order to solve this problem, the government has to think out of the box. First, it has to have a clear idea about which part of the food chain is really responsible for inflation. It is widely discussed that while farmers are not getting adequate returns from the prices they get, consumers pay a high price in the retail market. The government needs to put in place a system which collects data on a real-time basis about various stages of the agricultural pricing process, right from the farm up to the retail market, so that we can identify where the problem lies. Once there is an adequate understanding of this phenomenon, the government can take appropriate measures to minimise it. These measures will have to involve the enabling of more competition at some level of the wholesale business, after the produce leaves the farm, but before it reaches the retail market.
Reviving growth and checking inflation is the primary mandate that the people of India have given to this government. It has to be understood, though, that there is no magic wand to achieve these goals. It will take time to put in place some of the institutional changes that are necessary for a return to high and sustained growth rates. If the government succeeds in putting these changes in place and reviving growth, it would have successfully dealt with its biggest challenge.
(Sabyasachi Kar is Associate Professor of the Institute of Economic Growth, New Delhi and an honorary visiting fellow at the University of Manchester.)