Thoughts on economics and liberty

India’s Long March to Capitalism by Joydeep Mukherji (2002)

This article published in India Review many years ago is still relevant

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Will India become a prosperous country? The answer depends to a large extent on whether it becomes more of a market-oriented economy. Since 1991, when the government nearly defaulted on its external debt, India has moved cautiously to remove the most detailed and comprehensive economic controls ever imposed by any country outside the communist world. This article assesses the economic restructuring made during one decade of reform and the prospects for further change. It looks at some of the key building blocks of a market-oriented economy and the obstacles that continue to constrain their full development in India.

Markets are less effective in raising efficiency, economic growth, and personal incomes if they are saddled with weak laws, excessive regulations, and an overbearing, corrupt bureaucracy. Although India’s institutional framework was friendlier to the market compared with many former socialist countries, it has made only limited progress in building the foundations of an efficient market economy over the last decade. Its policies and institutions continue to limit the scope of market forces, compared with most Asian countries. India has glimpsed the prospect of rapid economic growth and poverty reduction through initial economic liberalization, but much of its pre-1991 economic regime remains intact. The following section outlines key elements of a successful market economy, followed by a review of India’s progress in adapting its laws, regulations, and institutions towards it.

March of Capitalism

Capitalism, like charm, is easier to spot than to define. It can be defined loosely as an economic system based largely on private ownership of property and assets. Capitalism requires a market for private firms and individuals to engage in the production and sale of most goods and services. That, in turn, requires institutions and laws that facilitate the allocation of land, labor, and capital, as well as final goods and services, based largely on market forces. Resources are allocated through the mechanism of prices, which transmit transparent economic signals. The quality of the institutional framework influences the efficiency of the transmission mechanism, and its ability to unleash the productive capacity of the economy. It also affects the flexibility of individuals, firms, and owners of assets to respond to opportunities.

The price mechanism works better with fewer restrictions on competition, trade, and investment. Trade barriers, for example, raise the domestic market price of products, reducing the incentive for producers to cut costs. Barriers against domestic competition, or sub-national trade barriers that fragment the local market, further reduce the effectiveness of the market mechanism in raising productivity. Economic efficiency improves when decisionmaking is decentralized to private firms and individuals who have the ability and the incentive to respond effectively to market forces. Government ownership of enterprises typically prevents them from operating fully along commercial lines, allowing them to ignore market signals in favor of political ones.

Market economies depend on “creative destruction,” Joseph Schumpeter’s term for the ability of capitalism to spur growth by constantly undermining existing companies and practices and replacing them with new ones.’ This process is hindered to the extent that barriers exist to both the entry of new firms into an industry and the “exit” of existing firms through bankruptcy, closure, or liquidation. The need for rapid “entry” and “exit” to boost productivity also applies to markets in land, labor, and capital.

Markets cannot be effective without clearly delineated property rights. Price controls, uncertain ownership, and laws artificially restricting their use all undermine the productive capacity of land, labor, and capital. Poor ownership documentation for homes and property prevent owners from getting credit from formal institutions by pledging real estate assets as collateral. The inability to turn physical assets into fungible capital, to unlock the “potential energy” in assets, constrains the productivity of land and blocks many people in developing countries from formal markets for capital.’ Efficient markets depend on the rule of law, with regulations that enhance competition, enforce transparency, and encourage good corporate governance. Opaque financial markets that are prone to corruption perform poorly in allocating money from those who save to those who borrow or raise equity.

This broad description encompasses a wide range of market economies that employ a range of policies in different institutional settings. US capitalism differs from the Taiwanese and Swedish versions but all of them rely primarily on market forces to allocate economic resources and are relatively open to trade and investment flows from other countries.

Creating a market economy is neither returning to humanity’s natural state prior to the original sin of government intervention nor an inevitable tendency in human society. The social and political consequences of enlarging the role of market forces are formidable in any society. It requires a reconfiguration of the role of government to provide goods and services, such as basic education and security, which complement what the market produces. The experience of former Soviet Bloc countries illustrates the importance of history and institutions, as well as political leadership, in creating the framework for a market economy. Some countries, such as the Czech Republic, Hungary, Poland, and Estonia have made great strides in redesigning their economic and social policies to facilitate a market economy while others, such as Belarus, Ukraine, and Russia, have been less successful. China has followed a very different path but has made great progress in restructuring its once state- and collectively run economy over the last two decades. The “non-state” sector of the Chinese economy is now estimated to exceed 50% of its Gross Domestic Product (GDP), just larger than India’s total GDP.’

India’s Economic Transition and its Results

India’s first experience with modern capitalism and a market-oriented economy was politically unfortunate, coming as it did under British rule. The colonial experience created a consensus amongst the country’s political and even business elites that rapid income growth and economic development depended on an active role for the state, especially in directing industrialization. India never abandoned the market completely during its first four decades of independence but heavily circumscribed it with economic planning, a large public sector, and detailed licencing and permits for the heavily regulated private sector. The private sector, quite well-developed by Asian standards in 1947, was allowed to function, but under severely restrictive trade and investment policies stressing autarchy and “self-reliance.” In the words of T.N. Srinivasan, these inward-oriented development policies were the result of “a misidentification of foreign trade with imperialism and of free trade with the failure of colonial authorities to promote industrialization.”‘

The results were poor. During 1950-90, per capita income growth was below 2% per annum, less than half the level of the developing world as a whole, including sub-Saharan Africa. The policy of “import-substitution industrialization,” common then in much of Asia and Latin America, spurred the growth of uncompetitive heavy and capital goods industries sheltered behind high trade barriers. Much of the new industrial sector, including consumer goods firms enjoying a captive domestic market with almost no pressure from imports, suffered from very poor productivity. According to some estimates, total factor productivity growth (the increase in output that exceeds the amount that can be attributed to added use of labor, capital, and other inputs) ranged from negative 0.2% to negative 1.3% per annum during 1959-80.’

The lack of competition, combined with government-directed lending and other types of regulatory support, provided few incentives to boost efficiency and develop new technology. The chronic inability of Indian firms to obtain export earnings resulted in periodic balance of payments crises, forcing the government to impose more restrictions on the economy and clamp down on economic growth. More lastingly, the development strategy of those years created a cancerous bureaucratic system that embedded corruption in all institutions. Many countries followed similar development models in the postwar era but India is unique in having clung to it much longer.

The shortcomings of India’s development model became more apparent to senior policymakers during the 1980s, but political support for economic reorienting was weak. Liberalization initiated by Prime Minister Rajiv Gandhi in the mid-1980s proved to be a false dawn as opponents within his party, as well as outside, managed to stifle it. Reform-minded officials were more successful in 1991, when India faced a balance of payments crisis (dramatically illustrated by the transfer of Indian gold abroad to serve as collateral for emergency loans). In contrast to previous external crises, including as far back as in 1966, reformers were able to seize the moment to change India’s long-standing development strategy based on import-substitution and industrial licencing. The new development strategy after 1991 sought to reverse the steady financial impoverishment of the government and its enterprises, reduce trade barriers, and pursue a more sustainable trajectory for economic growth. The near default on external debt, averted by emergency loans from the International Monetary Fund, triggered a redirection of policy to give the private sector a larger role in both generating savings and investing them.

The results were impressive. Most Indians are wealthier after a decade of economic reform thanks to higher economic growth (see Table 1). GDP growth accelerated to an average of 7.5% during 1994-96, higher than in most developing countries (excluding China) before gradually slumping below 5% by the end of the decade. GDP growth averaged 5.8% during the 1980s, but proved to be unsustainable since it relied mainly on external borrowing and little on reform to boost efficiency (ultimately resulting in a debt crisis). Growth in the early and mid-1990s was based on better and more sustainable policies, including deregulation of industry, commerce, external trade, and investment. Unfortunately, the acceleration of the growth rate and its sounder underpinnings has been reversed in recent years as the pace of reform decelerated.

The private sector plays a greater role after deregulation. While the rate of investment (measured as a share of total GDP) rose marginally during the decade, its composition changed; around 70% of total

TABLE 1
ECONOMIC PERFORMANCE DURING THE 1990s (%)

1991*199219931994199519961997199819992000
GDP Growth0.85.36.27.87.37.55.06.86.44.0
Current Account-0.6-0.5-0.5-1.1-1.7-1.3-1.4-1.0-1.0-0.5
Deficit/GDP
Domestic Savings/22.922.022.525.025.523.324.722.322.3N.A.
GDP
Private Sector’s Share
of Total Savings
91.393.297.393.292.292.794.3100.0105.0N.A.
Domestic Capital23.423.923.126.127.224.626.223.423.3N.A.
Formation/GDP
Private Sector’s Share
of Total Capital
57.763.256.356.769.560.663.764.970.0N.A.
Formation
Central Gov’t. Budget5.95.77.05.75.14.95.96.45.45.3
Deficit/GDP
State & Central Gov’t.7.47.48.37.16.66.47.38.99.49.1
Deficit/GDP

Note:             Refers to fiscal year ending on March 31 of subsequent year.

Source: World Bank, India: Policies to Reduce Poverty and Accelerate Sustainable Growth, Jan.
31, 2000, Table 8.7, p.118; Reserve Bank of India Annual Report, 2000/2001.

investment now comes from the private sector, compared with 57% a decade earlier. Rising exports, combined with growing foreign direct investment, bolstered the inflow of foreign exchange into the country, with foreign exchange reserves approaching $50 billion in 2001, compared to just $1 billion in June 1991. India’s external current account balance, which includes trade in goods and services but excludes debt and foreign investment, has shown a stable and manageable deficit, in contrast to previous years. A stronger external position allowed India to absorb the negative impact of a doubling in oil import prices in 2000 while increasing its dollar reserves (in contrast to nearly defaulting on its external debt during the last period of high oil prices in 1990/91).

Reform improved the efficiency of India’s economy and raised its low standard of living. The poverty rate fell to 26% in 2000, compared with 36% in fiscal year 1993, according to government data (all references to fiscal years refer to the 12-month period ending on March 31 of the subsequent year). India’s official definition of poverty is extremely spartan but the trend reveals more than the absolute level. The average rate of population growth during the 1990s fell to 1.9% compared with 2.1% in the previous decade, while the percentage of the population above the age of seven classified as literate rose to 65 in 2001 from 52 a decade earlier. According to official figures, the absolute number of illiterate people declined for the first time in Indian history by around 30 million in the last decade.

Despite success elsewhere, India has made limited progress in achieving macroeconomic stability and in building the foundations of an efficient market economy. Success in deregulation stands in stark contrast to the government’s failure to control its budget deficit and contain its rising domestic debt. The country’s growing debt burden (the sum of central and state government debt exceeded 70% of GDP in 2001) threatens its economic stability. High debt diverts public spending to pay for interest, which consumes nearly half of the central government’s total revenues, leaving little for providing basic services such as infrastructure.

Policies and institutions continue to limit the scope of market forces, constraining productivity and economic growth. High trade tariffs and policies reserving the production of many items to small-scale industries pose formidable barriers to competition. Reform has been largely confined to industry and to the service sector, by-passing the vast agricultural sector, which employs most people. Barriers to entry have fallen, but not to exit. Laws for bankruptcy and liquidation remain largely unworkable. The Schumpeterian process of “creative destruction” works poorly in the formal economy, especially in the industrial sector. Much of India’s financial resources, as well as land and machinery, is under-utilized or wasted by inefficient firms enjoying de facto immunity from creditors and protection against corporate takeovers. Government ownership dilutes the ability and the incentive of many large Indian enterprises and banks to respond effectively to market forces. The problem of bad corporate governance is worsened by poor transparency in financial markets, which remain prone to manipulation by small groups of insiders.

Despite a decade of economic reform, India’s pre-reform regime largely persists. The following sections discuss the development of markets in land, labor and capital, followed by a discussion of the level of competition and the role of the public sector.

Building Markets

Land

India’s market in land barely functions. Poor laws often substitute administrative discretion for market forces in setting the price of land and allocating it to different owners and uses, creating artificial shortages. While land ownership is largely in private hands, laws that are inconsistent with economic incentives continue to promote corruption and to artificially raise the costs of undertaking legitimate business operations. Most land ownership is not very clear; formal records are few, incomplete, often out of date, rarely computerized, and easy to tamper with. The process of registering new ownership, as well as changing land use designation, sometimes takes decades. The imposition of high stamp duties on land sales gives a strong incentive to undervalue land when selling .

India’s urban tenancy laws effectively preclude eviction. In tandem with rent controls, they restrict the supply of rental housing in cities, forcing people to rent illegally at higher prices. Such laws deter the development of modern rental housing, forcing a growing share of urban migrants to reside in slums. They also render a large segment of the urban housing and commercial real estate stock difficult to sell or refurbish, and give owners no incentive to maintain it.

Land is a major source of graft. Insiders, typically politicians, bureaucrats, and well-connected businessmen, purchase land based on confidential information prior to public announcements of land acquisition or re-designation from low value to high value uses. Zoning laws rarely change, but actual land use does, especially as the country becomes more urbanized. The growth of “illegal” residential and commercial areas further complicates land use, as the new owners typically lack formal title to the assets they own. Poor records make it difficult to raise funding for projects, as land developers cannot offer clear collateral to lenders.

Efficient markets depend on the ability to undertake legally enforceable transactions with strangers. The weak or unclear ownership rights of the informal sector, or poor enforceability of them, lead people to buy, sell, rent, or lease land (and other assets) with a narrower group of people they know or trust. The informal sector may operate according to market forces, using its own laws and mechanisms for enforcing contracts, but the failure to integrate it with the country’s formal laws and institutions means the failure to unleash its full energy.’ It also means corruption and higher costs, with bribes estimated to account for 10-20% of the income of small companies.

For example, commercial tenants in Delhi have fought for years to prevent the central government from promulgating an amendment to the city’s rental laws facilitating rent increases. Although rent control keeps commercial rents extremely low, the “tenants” claim that they are in fact the real owners of the property that they are supposedly renting. The leasehold rules for the properties do not allow the original holders to either sell or sub-divide their properties. In practice, many of the original holders did both without any documentation. The new owners continue to pay a nominal amount in “rent” to the original leaseholders to maintain the fiction that no sale had occurred.

In another example, legal restrictions prevent bankrupt textile mills located in the heart of Bombay (Mumbai) from selling their extremely valuable land to developers for building new housing and commercial buildings. The proceeds of sale could pay back wages owed to mill employees or loans owed to creditors, while the new construction would generate jobs and boost economic activity in the city. Current owners are unable to recoup the market value of their property. In both these cases, bad laws not only spur illegal activity but also prevent market forces from efficiently allocating land in a manner that generates more wealth.

All urban land in India is subject to an urban land ceiling act, limiting the amount owned by any single proprietor. The act, which allows the government to purchase land from private owners in excess of the ceiling, deters land sales and prevents land consolidation in cities, as well as tying up real estate in the courts. The central government recently repealed the urban land ceiling act, but most states have yet to follow suit (land is largely a state subject). The state of Gujarat abolished its land ceiling act in 1999, facilitating the consolidation of urban land for larger development. In addition, in 1997 it simplified procedures for converting up to 10 hectares of land from agriculture to other uses. The normal procedure for land conversions is opaque and relies on the discretion of local officials.

McKinsey & Company, a management consultant firm, estimates that land market distortions cost foregone GDP growth of 1.3% annually.’ The cost of land per square meter compared to per capita GDP is 5-6 times higher in New Delhi and Bombay than in other Asian cities. The proportionately higher prices reflect the artificially reduced supply of land for housing and retailing, undermining competitiveness and reducing living standards.

Labor

The dichotomy between formal laws and actual practice extends from the land to the labor market. India enjoys an elaborate framework of labor laws that “protect” about 10% of the country’s workforce, while the rest subsist in the un-regulated “informal” sector. Nearly half the employees in the formal sector work in the heavily unionized public sector. Firms in the “formal” sector enjoy very little labor flexibility, thanks to numerous central and state laws restricting their ability to redeploy, lay off workers, or resort to contracting out work. For example, current laws force employers to obtain government permission for lay-offs and plant closures if they employ more than 100 workers. In practice, governments do not give permission. The perverse result of such laws, designed to protect employment, is to give employers a strong incentive to replace labor with machinery, in a country with massive unemployment and low wages. Denied the flexibility to reduce their workforce during a downturn, employers are reluctant to hire additional full-time workers during a business upturn.

India was ranked 45th out of 53 countries in terms of labor flexibility in an international survey in 1998.8 Per worker, it loses more days of work due to strikes and lock-outs than most industrialized countries. Its Industrial Disputes Act injects government arbitration into all labor disputes, not just those where negotiations have collapsed, thereby politicizing labor relations and delaying settlements. Worker compensation is influenced as much by politics as economics, with government-appointed pay commissions setting wages for the public sector that are usually matched by many other employers in the formal sector of the economy.

The political sensitivity of labor, and the power of trade unions affiliated to major political parties, kept labor law reform off the political agenda until 2001. Public opposition to changes in labor laws that would facilitate lay-offs remains strong. The lack of welfare or unemployment insurance, as well as the paucity of alternative job opportunities, limits the government’s ability to countenance lay-offs in the formal sector. Nevertheless, private companies, facing greater competition in recent years, have increasingly gained labor flexibility through various means. Many have designed their own voluntary retirement schemes, paying workers to quit. Others resort to greater sub-contracting or ignore the laws, making their own arrangements with their workers.

Public sympathy for unionized workers, especially in the public sector, has been reduced by growing complaints of corruption. The lack of public support for government employees helped the state government of Rajasthan to defeat a strike organized by its workers in 2000. This set-back for organized labor came close on the heels of another unsuccessful strike by employees of the state electricity board in India’s largest state, Uttar Pradesh. Public hostility to the power workers union, increasingly perceived to be corrupt and indifferent to the general public, led even the state opposition parties to avoid supporting the strikers.

The combination of slowly changing public opinion and intense pressure from the business community emboldened the government to introduce flexibility into the formal labor market. In 2000, the government introduced a voluntary retirement scheme for public sector employees. Government-owned banks, which suffer from a double curse of non-performing loans and non-performing staff, began the first major retrenchment in the public sector. Approximately 90,000 out of 860,000 public sector bank workers, or about two-thirds of those who had applied, received a retirement package. Similar schemes have been introduced in other public sector units owned by the central and state governments, gradually cutting their excess labor. The government announced plans in its 2001 budget to introduce legislation to allow firms with less than 1,000 employees (accounting for around 75% of all firms) to retrench labor without seeking official approval. The fierce opposition aroused by the announcement is likely to delay passage of the new legislation for a year or two.

All capitalist countries have labor laws that restrict the behavior of employers in some form or another, but India’s labor market is likely to remain more encumbered, and more inefficient than in most countries. Reform will be slow, given its political sensitivity. The private sector is likely to enjoy greater discretion in hiring and firing over the coming years, regardless of formal changes to the law, while the public sector remains more constrained. The dichotomy between a privileged labor elite enjoying better job protection and benefits and the rest of the workforce will continue. Restrictions on the formal labor market will continue to limit its size, forcing most Indians to work in the unregulated and more precarious informal sector.

Capital

India has made impressive progress in developing markets to raise and allocate the country’s financial savings. The role of market forces has increased faster in capital markets than in land or labor. Lenders, investors, and borrowers enjoy more autonomy in entering into transactions, and market forces play a greater role in setting interest rates, the price of money. However, the government retains a dominant role in the financial system, directing a substantial share of India’s financial resources to borrowers of its choosing. Government ownership of most of the banking system, which handles much of the country’s money, limits its ability to act along commercial lines.

Prior to reform, India’s banking system was a direct part of the government’s spending policies, serving as a captive source of funding the fiscal deficit, as well as key industries. Regulations forced the banks to lend much of their money to government. Over half of the money the banks received through new deposits had to be either devoted to cash reserves held with the Reserve Bank of India, the country’s central bank, or used to buy government debt. Much of the rest had to be lent to borrowers in “priority” sectors defined by the government. The government maintained controls on almost all interest rates, allocating funds based largely on administrative and political criteria.

Economic reform has reduced political control over the allocation of money through the financial system and increased the role of market mechanisms such as interest rates to perform the same function. Almost all controls on interest rates have been lifted and lending rules have been liberalized. The government also relaxed restrictions on Indian companies seeking to borrow abroad. The level of bank deposits legally directed towards the government was reduced by 2001 to around 33% of total deposits. While the banks are still required to lend 40% of their loans to “priority” sectors, the definition of such sectors has been expanded slowly to dilute the impact of the regulation. Competition has increased with the entry of new foreign and private banks. Starting with only 21 in 1991, the number of foreign banks more than doubled during the last decade, while nine new Indian private sector banks began operations. Nevertheless, government-owned commercial banks, with their politicized unions and management, still account for about 80% of the total assets of the banking system (similar to the market share of government-owned institutions in the mutual fund sector).

The financial system has been strengthened by new rules for risk management, tighter disclosure norms, and higher prudential standards. However, the good progress on the regulatory side has not been matched by bank restructuring, which is necessary to make them more efficient by reducing operational costs. The operational habits and practices of public sector banks still resemble those of government departments more than commercial organizations. With little or no penalty for failure, or autonomy for management to make tough business decisions, most public sector banks are slow to adapt to market pressures. For example, in 1993 the Reserve Bank of India entered into annual memorandums of understanding with the 27 nationalized banks to set benchmarks for improved performance. As with similar initiatives elsewhere in the public sector, it failed, in part due to the absence of serious penalties for non-compliance.

Based on a realistic assessment of their asset quality, many public sector banks were insolvent prior to the reforms. According to a study by Standard & Poor’s and Credit Rating Information Service of India Ltd., India’s scheduled commercial banks require between $11-13 billion in new capital to meet the regulatory level of minimum capital, once their balance sheets are adjusted for the actual quality of their assets.’ The recovery value of the security, such as machinery and land, backing the bad loans is very low. Until recently, large borrowers faced little pressure to repay their debts, while lenders, usually public sector banks, had little incentive to pursue politically connected borrowers. India’s debt recovery laws are unworkable and its legal system unprepared to enforce the rights of creditors. Although the government established special debt recovery tribunals in 1993 to alleviate the problem, their track record has been poor.

Political compulsions lead the government to “revive” the weaker banks rather than restructure, sell, or close them. In practice, “reviving” has meant providing periodic financial support to cover losses and prop up the weakest banks without demanding serious changes in their operations in return. The government has announced plans to introduce legislation that would allow it to reduce its ownership in public sector banks to 33% of total shares, down from the now minimum 51% fixed by law. If implemented, along with operational and labor flexibility, this would set the stage for greater efficiency in the financial sector.

Similar slow progress with insurance, which was opened to the private sector only in August 2000, should gradually raise the role of market forces in the financial system. Lack of competition (with only two state insurers) and government ownership hindered the growth of the industry. Less than 10% of the population has life insurance. Insurance premiums accounted for only 2.6% of GDP in 1998, compared with 7.4% globally.’ Following the pattern in other politically sensitive sectors, the government capped foreign ownership of insurance companies at 26%. Such restrictions constrain investment in the industry, denying India the full benefits of having foreign firms with deep pockets and expertise. The ownership cap may be raised over time, as in other sectors, when the shortcomings of the policy become more apparent and political opposition to liberalization less vehement.

Liberalization has gone further in the stock market, perhaps the most potent symbol of a capitalist economy. The reduction in government controls over lending and business investment decisions increased the role of stock markets in raising funds and in transferring resources into different firms and industries. Beginning in the early 1990s, the government abolished regulations that set the price of new share issues on the stock market and allowed firms to set their own prices. The establishment of a new Securities and Exchange Board of India to regulate stock markets, along with a new National Stock Exchange run with modern technology and stronger rules of governance, forced India’s other 22 exchanges to raise their standards. Indian stock markets became open to foreign investment, mainly from institutions. The number of listed companies has grown to around 10,000 from below 6,000 in 1990 while market capitalization, the value of all the stocks, has nearly tripled as a share of GDP.

More and more Indian firms have listed their stocks on foreign stock exchanges, tapping wealthier markets with more sophisticated institutional investors. Listing overseas, as well as selling shares to foreign institutional buyers in the Indian markets, has generated greater market discipline, forcing firms to disclose more information about their operations to investors and change their accounting standards to match international practices. Better managed firms, be they in software, banking, or manufacturing, have been able to differentiate themselves from their competitors, thereby gaining access to cheaper funds from a wider pool of investors. Under the heavily regulated pre-reform system, gaining better access to funds depended largely on political lobbying.

Despite considerable progress, Indian stock markets suffer from outdated rules, poor supervision, and corruption. Major scandals erupt every few years, demonstrating the ability of brokers and insiders to manipulate share prices. Resistance to reform comes from powerfully connected stockbrokers who spend lavishly in Delhi to keep their political patrons content. Following a scandal over price rigging in 2001, the government announced plans to convert the broker-run Bombay Stock Exchange into a professionally managed stock-holding corporation. Regulators are also introducing “rolling settlements,” forcing trades to be settled within one day instead of five, reducing the opportunities for speculation and fraud. Unfortunately, the intimate relationship between market insiders is typically weakened only after a major scandal when many people lose lots of money.

Well-developed capital markets in a modern economy force the government to compete openly with others to raise money. The Indian government has moved in that direction during the last decade, increasingly issuing its debt on market terms as banking and debt market reforms lowered the level of “captive” funds it could borrow at artificially low interest rates. The level of subsidy enjoyed by the government through such practices during the pre-reform era has been estimated at around 2.8% of GDP.” The pre-emption of India’s financial savings by government continues, both through the banking system (at reduced levels) and through various small-scale savings schemes and public pension funds that offer attractive tax-free returns to lenders and beneficiaries. About 75% of such funds, which in total account for more than 20% of savings in the financial sector, are lent to state governments and the rest to the central government. The government sets a high interest rate on these funds, thanks to political pressure to please small depositors and pensioners, creating an artificially high floor for other interest rates throughout the economy and hurting all borrowers. Recently, the government has lowered the rates on such schemes and may slowly link them with other interest rates set by the market.

The financial system plays an important role in the capitalist process of creative destruction by denying firms capital or by rewarding good performance with higher market valuations and cheaper funds. India’s financial markets enjoy a much bigger role now, compared to a decade earlier, in allocating money according to commercial criteria, but are still subject to considerable, though diminishing, government influence. Reform has eroded, but not ended, the cozy relationship between government financial institutions and large domestic businesses, typically solidified by generous political contributions from the latter in exchange for lax lending. Government financial institutions, such as the Unit Trust of India and nationalized insurance companies, still own large blocks of the listed shares of major companies, giving politicians an indirect tool for influencing private corporations. However, competition from private financial institutions, especially mutual funds, and growing market transparency, places greater pressure on public sector financial institutions to behave in a more commercial and less political manner. Nearly 8% of Indian households own shares or debentures, a growing political constituency that is likely to favor the de-politicization of financial markets. The introduction of minority private sector and foreign shareholders into most public sector banks has increased pressure to improve performance and adopt more commercial practices. These trends, combined with stronger laws for debt recovery and bankruptcy, are likely to facilitate more corporate takeovers, introducing more accountability for bad management. The role of market forces will increase in the coming years, further separating politics from business. However, reducing government ownership of financial institutions will take many years at best.

Introducing Competition

Goods and Services

The level of competition in the Indian economy has risen impressively over the last decade, but its growth has been lop-sided, with more of its benefits apparent in the lightly regulated and fastest growing service sector (see Table 2). Restrictions on domestic and foreign business have been loosened and the number of industries “reserved” for public sector enterprises has been cut to two (atomic energy and railway transport) from nearly 20. Government licencing for businesses has been cut to only six strategic and socially or environmentally sensitive sectors. Price controls, which undermine the competitive nature of markets, have been lifted for most consumer and capital goods. However, they remain in sensitive sectors such as energy, fertilizers, some drugs, and public transportation. The government is scheduled to lift most controls on petroleum and oil products in 2002, bringing competition to a still sheltered sector of the economy.

The process of dismantling barriers to competition has gone beyond removing licencing requirements for the private sector and monopoly rights enjoyed by public sector enterprises. The government has raised the scope and ownership level of foreign investment in various sectors of the economy, reducing the number of approvals required and delegating more approval authority to the states. The results are impressive, at least in some sectors. For example, employment rose 11% and productivity 256% in the auto industry during fiscal 1992-99 thanks to the end of licencing requirements and the entry of foreign investors.’

The biggest shortcoming in competition policy, however, is the failure to abandon what D. Lal calls the “industrial caste system,” the practice of subjecting different segments of industry to different laws, restrictions, and incentives.’ India still grants a monopoly on the production of nearly 800 items, mainly consumer goods, to small-scale industries. The policy, designed to promote small-scale, labor-intensive manufacturing, restricts the production of mainly light consumer products to firms employing capital and labor beneath very low, arbitrary thresholds set by government (with no regard to the gains that arise from economies of scale). It imposes the judgment of government rather than market forces on the smallest details of managing a business. Restrictions on investment, employment, and production decisions of the private sector create uncompetitive firms prevented from expanding and from acquiring costly but profitable new technologies. In addition, they lead many producers to break the law in order to expand their business. Faced with the loss of subsidized bank loans and tax advantages, as well as the legal right to produce their products, many small-scale firms illegally enlarge their workforce and level of investment in order to attain a more economical scale of operations.

The policy prevents India from developing a competitive export sector in consumer goods, such as toys, clothing, shoes, and leather goods, by nurturing uncompetitive firms using archaic technology. For example, small units in the Gujarati city of Rajkot used to manufacture nearly half a million diesel engines annually based upon British designs introduced into India prior to independence.” Thanks to these restrictions, a typical Indian clothing plant has only 50 machines, compared with 500 in a comparable Chinese plant, and is less competitive.” A recent study suggests that the reservation policy has contributed to India’s poor performance in manufacturing.” Output in the country’s large-scale sector grew at a rate of 9%, in contrast to 6% in the small-scale sector, during the last two decades, a reversal of the pattern in other industrializing countries. Flawed industrial policy is one reason why India has less than 10 million people working in manufacturing, including both small and large scale, compared with over 110 million in China (of which about 50-60 million work in large-scale factories). The reservation policy also hurts agriculture by stunting the growth of food processing industries through limits on investment.

Indian policymakers increasingly acknowledge the damage done by small-scale reservations but have been cautious in introducing reforms. The list of items reserved for the sector has been gradually pruned, with garments and toys liberalized in 2001. Ironically, the removal of import quotas (but not tariff barriers) in 2001 has gently exposed small-scale producers to competition from abroad but not from larger scale domestic producers.

The legacy of several decades of restrictive industrial policies is difficult to remove in medium- and large-scale industry as well, much of which remains uncompetitive. Many “infant industries” nurtured by the government behind high trade barriers and indirect subsidies have become “senile industries” today. Much of large and medium-sized industry still depends as much on competing in the corridors of power, in Delhi and in state capitals, as in the marketplace. India has made more progress in “privatizing” government decisionmak ing than in privatizing government-owned enterprises, thanks to the growing power of large business interests who “invest” heavily in politicians and bureaucrats and seek a lucrative return through favorable policies.

Businesses are still subject to the “inspector raj,” the practice of bureaucratic harassment under the guise of inspections. The average manufacturing company in the formal sector receives up to 5 inspection visits by officials during the course of a year, about two-thirds of them from the central government, while an average unregistered, smaller unit may receive about 30 such visits. Setting up a new industrial unit may take up to 30 different approvals.” Such practices drive economic activity into the informal economy to escape the burden of bureaucracy and regulations, imposing a heavy cost on the economy beyond the loss of tax revenues.

Competition inevitably leads some firms into bankruptcy, which is still legally difficult to do in India. It remains nearly impossible for unprofitable firms to shed workers legally, though many do so illegally. Loss-making or insolvent enterprises cannot easily close or be rehabilitated by market forces, thanks to unworkable bankruptcy and liquidation laws. More than half of company liquidation cases before the courts are more than a decade old. Laws shield owners from creditors seizing their assets. With little pressure on existing owners to close their business or sell, new owners cannot buy assets cheaply and attempt to make a profit from them, an essential feature of a market economy. Loss-making companies remain open forever as “sick” firms, suffering from an economic ailment unique to India. According to the Reserve Bank of India, there were nearly 300,000 “sick” firms as of March 1999.18

The quality of corporate governance is poor, despite some recent improvement. Poor accounting and disclosure standards, as well as weak scrutiny from public sector creditors, allow business owners to mislead investors and minority shareholders. For example, the combination of corruption, poor lending skills in public sector banks, and weak creditor rights, gives a strong incentive for business promoters to “over-borrow” from banks and minimize, if not completely forgo, investing their own funds into the business. Legal and institutional weaknesses have made it easy for borrowers to siphon money from their business ventures into other companies that they control if that particular business fails to prosper. With little or none of his own money at risk, the business promoter can effectively shift the entire risk of the venture to the lenders. Should the business fail, the promoter can hide behind the cumbersome procedures of India’s Board of Industrial and Financial Reconstruction (BIFR), a slow-moving bureaucracy that is supposed to determine the prospects for reviving insolvent firms. In practice, however, the BIFR, and other laws, prevent creditors from seizing assets or closing the business, allowing the promoter to enjoy his “sickness.”

Recent banking sector reform has begun to address part of this problem, especially as market pressures force banks to improve their lending practices. Various “expert” committees have proposed steps to strengthen bankruptcy laws, typically through setting up new tribunals and quasi-judicial bodies to oversee the “rehabilitation” of sick units. For political reasons, the government has tried to keep the entire process within the hands of the bureaucracy, which is subject to political pressure, and away from market forces.

By failing to allow industrial “sickness” to be resolved through either “death” or takeover by new owners, India clings to bankrupt firms and existing owners, management, and technologies while subsidizing them through the banks. The failure to allow market forces to “destroy” existing economic structures hinders the development of new industries and the redeployment of resources to new purposes, the good side of capitalism’s creative destruction. Fierce political resistance to exit policy is likely to delay reform for many years.

Despite these obstacles, the momentum behind deregulation should increase in the coming years. The positive impact of slowly increasing competition, both from abroad and within, has injected greater economic dynamism in recent years. Competition has forced some of India’s sluggish and cosseted private firms to restructure their operations. One result has been a growing number of mergers and acquisitions. A new code for companies seeking to take over other companies was introduced in 1997 and the first successful hostile takeover was done in 1998.

Deregulation has led to private firms now accounting for around half the traffic in domestic air travel, while the former monopoly public sector airline languishes with poor results. Government-owned ports now face new competition from new ports developed by private and foreign investors in the states of Gujarat and Andhra Pradesh. The auto industry, once dominated by two companies, now has nearly a dozen firms producing a wider range of better quality vehicles. Similar changes have transformed the consumer electronics and many other sectors. The growing political impact of success stories, such as IT, which is driven largely by market forces and is least regulated, augurs well for other sectors. Similar success is likely in the pharmaceutical sector, which is now moving from producing bulk drug products towards developing new products based on research that utilizes India’s ample pool of skilled labor.

The benefits of competition have appeared in the availability of a wider range and better quality of goods in the consumer market place. At a more abstract level, competition has increased the efficiency of investment. According to the RBI, the incremental capital output ratio, a measure of the amount of capital invested each year compared with the increase in total output, fell from 4.4 in 1990 to 3.4 in 1998.19 This was largely due to better productivity in the service sector, which uses less capital and has accounted for over half the growth in GDP in recent years. The World Bank estimates that total factor productivity grew about 1.3-1.5% annually for the period 1979-97. The same measure is estimated to have grown at a higher rate of 2.4-2.8% during 1994-96, indicating an increase in later years due to reform.’

Agriculture

India’s reforms have largely concentrated on the industrial and service sectors, unlike China, which began with agriculture. Indian agriculture remains subject to detailed controls and restrictions similar to those imposed on industry prior to 1991. As a result, while India’s manu­facturers now enjoy easier access to national and international markets, its farmers do not.’ Creating a national market in most agricultural products, putting agriculture on the same footing as industry and services, will be a protracted process. The delay in liberalizing agriculture prevents most Indians from directly enjoying the benefits of reform.

Agriculture suffers from a horrible physical infrastructure, including poor roads to markets, clogged irrigation systems, and poor storage facilities. All levels of government impose controls over prices and the movement of crops. Restrictions on private investment, such as in dairies, further depress growth prospects. Many states force farmers to sell their crops to designated markets, typically dominated by traders who handsomely bribe government officials for the privilege. A recent attempt by the US multinational Cargill to buy wheat directly from farmers in Punjab, India’s richest agricultural state, was blocked by lobbying from such market middle-men. The result, not surprisingly, is low farm incomes, very little value added in production, poor quality products, high spoilage and losses, and very little agro-industry.

Political pressure to address these problems is increasing. The government, in its annual Economic Survey in 2001, announced plans to gradually decontrol agriculture, removing restrictions on production, storage, transport, and the processing of products and inputs. Several minor steps have already been taken. For example, the portion of their crop that sugar growers are forced to sell to mills at a controlled price fell to 15% in February 2001 from 40% in 1979. Restrictive central govern­ment legislation on rice milling, cold storage, and ginning factories has been repealed. Most importantly, the government announced in 2001 its intention to remove the Essential Commodities Act, a severely restrictive law that forbids the movement of several farm products across state lines. As with labor laws, fierce opposition to the reform is likely to delay implementation for a few years. Many of the restrictions on agriculture are at the state level, where the commitment to reform is uneven.

The success of past efforts to boost production has, ironically, saddled India with some typical “rich world” problems in agriculture. The expansion of irrigation and the use of high procurement prices have boosted grain output to record levels in recent years. The government has purchased growing quantities of grain from farmers at a high, politically determined price but has been unable to sell much of it through a leaky public distribution system targeted at poor consumers. As a result, a record level of grains now rots or feeds rats in government storage depots while almost half the population remains under-nourished.

Governments in most countries, advanced or poor, intervene in agriculture to influence prices, sustain farm incomes, and temper the influence of market forces. The shortcoming in Indian policy is neither government intervention nor attempts to influence prices. Instead, it is the failure to develop a national market for agriculture to boost specialization, productivity, and attract more investment. Production remains in private hands but laws and regulations have failed to harness market forces to improve incomes and encourage private investment into agro-industry. Moreover, the low level of public investment in agriculture has kept many farmers physically isolated from markets, denying them opportunities for growth.

Linkage with External Markets

India’s history of being colonized by a private stock-holding multinational, the East India Company, lends greater political sensitivity even now to opening its economy to external trade and investment. The degree of competition within the Indian economy is inextricably linked to the level of trade barriers, which has fallen considerably in recent years but remains much higher than in most countries. The weighted average tariff for imports was reduced to around 30% by the end of the decade from 128% in 1991, but is still four times higher than the global average.’ Non-tariff barriers to imports, such as licensing requirements and quotas, were gradually reduced, with the last quotas abolished in April 2001.

Lower trade barriers have exposed Indian firms to greater competition from imports, forcing them to improve quality and cut costs. That, along with lower import costs for producers, has made Indian industry more competitive, helping it earn more foreign exchange for the country. Export earnings have grown faster than import payments in recent years (exports covered nearly 75% of imports on average during the 1990s, up from 62% during fiscal period 1980-91). Total trade, including services, approached 30% of GDP by the end of the decade, compared with 24% in fiscal period 1993 as lower trade barriers increased India’s integration with the global economy (see Table 2). Draconian controls on foreign exchange were reduced significantly, with Indians now allowed to buy dollars for imports as well as for travel overseas. Market forces increasingly determine the value of India’s currency.

Trade liberalization has progressed in tandem with lower barriers for capital inflows, though not outflows. Annual foreign direct investment into India has averaged around $2.5 billion in recent years, more than 20 times its level in the pre-reform years (see Table 3). While impressive by India’s own standards, such inflows are much lower than those to China ($40-45 billion) or Brazil (around $30 billion). Portfolio investment, mainly purchases of Indian stocks, has risen to around $3 billion annually since fiscal 1993 and is estimated to account for around 15% of the market capitalization (the number of shares times their price) of Indian stock exchanges. The government’s decision to gradually raise the cap on such foreign holdings to 49% of the stocks of Indian companies in 2001 should continue this trend.

TABLE 2
GROWTH RATES (%)

1980-901990-99
Industry76.7
Agriculture3.13.8
Services6.97.7
Exports of Goods & Services5.911.3

Nurtured for decades behind high trade barriers, and still shackled by policy restrictions not applied to their overseas competitors, India’s private sector remains ambivalent about external liberalization in practice (while generally supporting it in principle). It has lobbied the government to retain caps on the level of foreign ownership, restricting foreign firms and forcing them to enter joint ventures with domestic partners that may not otherwise make business sense. A gradual relaxation of foreign ownership caps, as well as business differences, have led many foreign firms to start new wholly owned subsidiaries in India. In response, Indian business has lobbied to keep the practice of forcing foreign firms to obtain a “no objection certificate” from their existing Indian partner before establishing a fully owned venture in the same field. Domestic industry finds such practices, which constrain foreign investment and economic growth, to be effective tools for either blocking new competition or extracting more money from their foreign partners.

A growing political consensus on the need to boost foreign investment inflows is likely to overcome many of these obstacles over the coming years. Foreign investment, as well as out-sourcing of work by foreign firms, could help India develop an export sector based in services in the manner that China and southeast Asia developed one based on goods in earlier decades. India’s comparative success in the service sector is likely to continue, thanks to ample local talent, easy access to global markets, and fewer physical and regulatory obstacles compared with industry and agriculture. The successful experience of the last decade has changed political attitudes about foreign investment in some sectors. For example, the US company General. Electric now employs more people in India than in America, mainly in service sector jobs, without facing local hostility.

TABLE 3

NET FOREIGN DIRECT INVESTMENT AS % OF GDP
(1996-2000)

India0.6%
Brazil3.2%
China3.7%
Egypt1.1%
Malaysia3.4%
Mexico2.6%

 

Source: Sovereign Risk Indicators, June 2000, Standard & Poor’s

Public Sector Enterprises and Privatization

The scale and role of the public sector, including both government bodies and government-owned commercial enterprises, differ widely in modern market-oriented economies. The scale of India’s public sector may not appear excessive but its role is more politicized and pervasive than in most countries. The public sector accounts for about 15% of non-agricultural employment and about 40% of the country’s stock of industrial capital. The output of public sector enterprises accounts for less than 15% of GDP but the enterprises are plagued with poor labor and capital productivity.

According to recent estimates, labor productivity is three times higher in private sector telecommunications firms, and more than five times higher in private sector retail banks, than in their public sector counterparts.’ Public sector electricity companies suffer about three times more power losses than private firms. Unreformed public sector enterprises, along with bad governance and low accountability, pose major obstacles to creating a more efficient, market-oriented economy run along commercial lines.

Politicians treat the public sector as their fiefdom, a source of patronage and a means for enacting populist policies to garner votes. Public sector bodies providing services like water, power, roads, and sanitation are devoid of any commercial orientation. Plagued with a poor work ethic, over-staffing, and with no incentives for better performance, public sector enterprises suffer from very low cost recovery. They consume growing levels of subsidies from the government, especially at the state level, weakening India’s public finances.

The failure of public sector enterprises to provide basic infrastructure services, such as reliable electric power, constrains economic growth. State electricity boards lose 30-40% of their power due to theft, as well as transmission and distribution losses, generating a negative 18% return on their capital (prior to subsidies from their owners). Around half of centrally owned public sector enterprises lose money. In total, they earn their shareholder a modest return of around 4% of its investment, or about one-third the government’s own cost of funding. Much of that profit emerges from a handful of energy and telecommunications firms that benefit from regulations restricting competition.

The resulting fiscal problem constrains the pace of economic reform, while poor infrastructure hinders the private sector and raises the costs of doing business. For example, many large private firms, as well as most of the high technology sector, generate their own electricity at considerable cost to overcome the public sector’s inability to deliver power reliably. The failure to build rural roads and village schools limits the ability of India’s poorest people to gain access to markets. While public sector reform involves reducing the size of the payroll in government and in its enterprises, the real benefit is the provision of better services and the elimination of useless controls and wasteful procedures.

Reform has introduced competition into markets dominated by the public sector, such as airlines, telecommunications, and banking. In 1999, the country’s first private sector airport started in Cochin in partnership with the state government. The government subsequently announced plans for new private sector airports in Bangalore, Hyderabad, and Goa, as well as privatizing services in other airports. Some public enterprises have responded well to competition while other have been either unable, or unwilling, to adapt to new conditions. The government has begun the difficult process of converting its departmental undertakings into modern corporate bodies that can operate along commercial lines. In 2000, it converted the over-manned Department of Telecommunications into a corporation, giving its employees a 70% bonus, 400,000 free phones and with them free phone calls, and job guarantees in the event that the entity is privatized. In 2001, it announced plans to turn major government-owned ports into corporate organizations, starting with Ennore port near Madras (Chennai) and eventually reaching the large ports in Bombay. The measures, strongly resisted by unions and sometimes by management, will take time. Other governmental undertakings, such as Indian Railways, the largest employer outside the government, remain blissfully insulated from market forces.

The government’s strategy for the public sector is stated clearly in its Economic Survey in 2001: “It is necessary to get the government out of the business of production and enhance its presence and performance in the provision of public goods.”” The failure to privatize public sector enterprises has been one of the major shortcomings of the last decade of reform. The central government began the decade with 240 enterprises and 27 banks under its ownership but managed, by the end of 2001, to sell only a handful of them. The total proceeds from the small-scale privatizations undertaken during fiscal period 1991-99 reached a paltry Rs.186 billion, almost equal to the net outflow of resources from the government to the public sector during just three years (1996-99) in the form of fresh injections of equity, new loans, and waived interest on existing loans (and net of dividends to the government).’

The main benefit of privatization would be to staunch the flow of resources to loss-making enterprises and shift much of Indian industry into the private sector, permitting new owners to undertake investment and modernization. It would also enhance competition in many sectors, such as petroleum, energy, telecommunications, and banking. Opposition to privatization comes from politicians, bureaucrats, unions, and public sector management, and sometimes from domestic businesses that fear new competition. Opinion polls indicate that most Indians oppose the sale of non-performing public sector units.” This may not be surprising, as most political leaders continue to advocate the benefits of the public sector while few speak fervently in favor of privatization, at least in public. Opposition from domestic competitors has been credited with the failure to sell airlines. Powerful domestic firms sometimes persuade the government to amend the terms of privatization to weaken the new management’s powers in order to reduce the prospects for successful sale. Tactics include offering a low stake in the privatized venture to leave ample room for continued government interference, and placing numerous operational restrictions on the new owners (such as forbidding lay-offs) that effectively diminish the value of the enterprise.

Despite these obstacles, India’s privatization program is likely to stumble forward in the coming years, driven by financial necessity as cash-strapped governments look for quick money. Some states, such as Gujarat, Andhra Pradesh, and Karnataka have been bolder about privatization than the central government. Over time, this will usher in greater competition and increase the role of market forces in economic decisionmaking.

The problems of the public sector extend beyond its enterprises into the government itself. The quality of governance is poor throughout India. Corruption, lack of accountability, and a very slow pace of decisionmaking based on archaic procedures developed over a century ago result in poor policies. The failure to modernize the bureaucracy deters both domestic and foreign investment even as formal rules are liberalized. For example, a Rs.10 billion project between Carnegie Mellon University in Pennsylvania and the Indian government to build a modern, country-wide broadband data network collapsed after two years of delays, largely due to bureaucratic in-fighting, despite high-profile political support.” “The system and procedures are such that there is hardly any allocation of responsibility or accountability for delays and slack behavior, with the result that blame can never be attributed to individuals or small groups, or even to organizations.”” Such delays are not new, as shown in the description by Lord Curzon, Britain’s Viceroy in India in 1901, of the path of a proposal to re-draw India’s state borders: “Round and round, like a diurnal revolution of the earth, went the file, stately, solemn, sure, and slow; and now, in due season, it has completed its orbit, and I am invited to register the concluding stage.”” The main innovation since Curzon’s time has been the need for “speed money” to induce officials to move the file to the next official.

Corruption has been facilitated by a legal system that is impressive in theory but failing in practice. Many laws are outdated, too complex, contradictory, or simply inappropriate for a market economy. The country’s long-established legal system fails to deliver justice for most people, especially those who are poor or who lack political connections. With a back-log of around 27 million cases, the average case languishes 20 years in the courts. India’s conservative, increasingly corrupt, and self-serving legal establishment has successfully resisted attempts to change the status quo, including computerization of court records.

Corruption exacts more than a tax on business; it distorts the process of decisionmaking and affects the path of economic reform. It diverts money into the pockets of private individuals instead of providing resources to institutions that can develop India’s infrastructure. For example, many Indians chose not to have long-distance services available on their home telephone, preferring to use neighborhood public call offices, in order to avoid being saddled with fraudulent bills from corrupt telephone company employees. Increasing the price of the subsidized electricity provided to most Indians, absent a restructuring of the electricity boards, would only raise political protests as people rightly perceive that the added revenue will go to corrupt officials. Most electricity losses result from theft that is facilitated by bribery.

For example, the state of Delhi, India’s richest, suffers one of the highest loss rates, as its mainly upper-middle class residential customers pilfer power with impunity. Aspirants to posts in the electricity distribution grid typically make large donations to senior officials and politicians to get appointed and subsequently recoup their “investment” through collecting bribes from consumers. Not surprisingly, all state electricity boards are bankrupt (in Maharashtra, India’s most industrialized state, the electricity board gives subsidized power to 98% of its customers). Their total losses exceed 1% of GDP.

Taking Stock and Future Prospects

The development of India’s market economy has been slow and uneven, with most people still largely excluded from the tools and opportunities that such an economy offers. Reform has removed many barriers to competition, but has failed to ease the entry of more people, and their businesses, into the formal economy. India’s experience shows that it is easier to liberalize regulated or closed sectors of the economy than to rejuvenate and reform decayed public institutions. The country has failed to strengthen public institutions that are responsible for providing basic services like health care, education, law and order, and for creating an environment conducive to private investment and growth.

Reform has been limited by the ability of “insiders” in regulated sectors and public institutions to preserve their privileges. India’s political class and its bureaucrats have fought to maintain their discretionary control over as much of the economy as possible. Self-interest, more than diminishing anti-market ideology, explains much of the resistance to economic liberalization. The pace of change has also been constrained by fear of unemployment, income and regional disparities, and general insecurity about foreign investment. The ghost of the East India Company, though less frightful than before, has not been laid to rest in the eyes of all Indians.

Similar factors constrain the pace of reform in other Asian, Latin American, and former Communist countries, but they have been exacerbated in India by the poor implementation and design of many reform measures. India’s governing institutions are managed by generalist elites who jealously exclude “outsiders” in creating and implementing policies, occasionally calling upon retired bureaucrats to give “expert” opinion. A recent government taskforce on Information Technology proved to be the exception that proves the rule by drawing upon industry specialists.

The Indian state’s domestic credibility and ability to influence public opinion in matters of policy is diminishing, due in part to corruption and its failure to deliver an adequate level of services. The weakening of the state has allowed powerful interest groups to subvert or block its initiatives, as well as encouraged elements of the bureaucracy to undermine measures that threaten to erode its discretionary authority. Reducing corruption depends largely on greater deregulation of economic activity, reducing the discretionary powers of officials and politicians. It also depends on election finance reform. Unofficial estimates suggest that national elections alone may cost up to $500 million, most of it raised illegally.

The slow pace of reform over the last decade also reflects the ambiguity of India’s political leadership, cutting across all parties, towards reform and market economics, as well as their reluctance to alienate groups that benefit from the old economic model. As in many countries, economic reform was thrust upon India’s reluctant political leadership because of a crisis. “The fact that reform has been driven by bankruptcy more than ideology has consequences. Politicians have moved towards the market more in confused sorrow than ideological triumph.””

Non-economic issues of caste, religion, and regionalism dominated India’s political agenda for much of the last decade, while a series of weak coalition governments pursued hesitant economic liberalization. Economic liberalization has coincided with a deepening of the roots of Indian democracy through greater mobilization of poorer and lower status groups. Almost every one of India’s nearly two score political parties is, or has recently been, in power at some level of government and none has rejected the general thrust of liberalization. Most major parties, however, are internally divided over the pace and extent of liberalization. This, along with the legacy of India’s previous ideological moorings, may explain why its political leadership has not been as vigorous in publicly promoting reform as its counterparts in many other countries, both democracies and dictatorships.

The political task of advocating reform is more imperative in a democratic country where an elite cannot impose change and where electoral considerations affect every political decision. India’s political culture has not allowed any leader to repeat former Chinese leader Deng Xiaoping’s pragmatic maxim that the color of the cat does not matter as long as it catches the mice. Nor can Indian politicians proclaim, like Deng, that “it is good to get rich” in front of a largely poor electorate accustomed to socialist rhetoric from increasingly corrupt leaders.

The role of market forces will increase in the Indian economy over the coming years, despite the many obstacles listed above. Economic issues are becoming more prominent in political debate and more leaders, such as Prime Minister Vajpayee, publicly argue the case for deeper liberalization. Competition between India’s states also drives liberalization. More states are experimenting with industrial and other policies to attract investment and promote growth. States such as Andhra Pradesh, Karnataka, Uttar Pradesh, and Gujarat have entered into loan agreements with international development banks to restructure their bankrupt power utilities, improve their physical infrastructure, and improve the delivery of basic services such as education and health care. While some of these programs will fail, a few states will make progress. Laggard state governments will come under public pressure to copy the success of the more dynamic ones, thanks to growing literacy and access to India’s vibrant media.

The success of various local experiments with new legal, regulatory, and institutional arrangements to boost efficiency will also sustain reform in the coming years. For example, cities like Hyderabad, Rajkot, Surat, Pune, Nasik, and Tirupur have begun to outsource municipal services to private firms. Several parts of the country, typically advanced enclaves of new industries started during the liberalization era, are experimenting with new models of urban development that avoid some of the shortcomings and economic disincentives plaguing most urban real estate markets.

For example, many new centers of economic growth now allow private developers to build a large sub-division of housing and office space, instead of relying on the public sector and limiting the scale of individual private ownership. Such arrangements, in places like the Delhi suburb of Gurgaon, give sufficient scale for corporate developers to enter the real estate market with an incentive to provide good quality housing in order to establish a reputation and gain more business. New private sector commercial banks, driven by profits more than politics, undertake proper due diligence before extending mortgages to home-buyers in these enclaves. The arrangements introduce market-driven, countervailing private interests that scrutinize the behavior of other players in the market to minimize the scope for corruption and waste. The gradual introduction of computerized land records in many parts of the country, along with experiments with new land tenure and rental laws, should slowly raise productivity in the economy through more efficient use of resources. Unfortunately, the impact of such new enclaves of creativity, though growing, has not reached the level where it can transform the rest of the economy.

The economic growth impulse from the first round of micro-economic liberalization in the early 1990s has been exhausted even as macro-economic problems, such as government debt and budget deficits, increase alarmingly. An economic crisis in 1991 allowed Indian policymakers to unleash market-oriented reform over the opposition of strong ideological and vested interests. It is not clear if a second burst of market-oriented reform can be stimulated in the course of normal affairs or if it depends on a similar macro-economic crisis to overcome political resistance.

The unfinished agenda of market-oriented reform is vast, providing sufficient scope for the government to boost India’s growth rate even as it undertakes budgetary austerity to contain its growing fiscal deficits. The stimulus to private sector economic activity resulting from institutional and administrative reform to enlarge the scope of competition and create better functioning markets in land, labor, and capital could more than compensate for the contractionary impact on growth from tighter fiscal policy. According to some estimates, improving regulations and removing barriers to competition could boost India’s GDP growth rate by more than 2% annually.’

India’s development model after independence relied on a public sector elite using the instruments of the state to generate and allocate resources. Today, the public sector, bureaucrats, and politicians are seen as obstacles to faster development. The hope for progress rests increasingly on people and institutions in the private sector as well as on the energy of the growing middle class. The ability of the private sector, driven by market forces, to meet the challenge is limited, however, by the many obstacles outlined in this paper.

Economic liberalization in India is being driven by domestic impulses, not foreign creditors. India’s democratic federal system has slowed the pace of implementation but also distributed the reform impulse widely and deeply into the country’s fabric, ensuring that it will continue regardless of external trends and periodic setbacks. The Indian road towards a prosperous, modern, capitalist economy will be a long one. More than a few accidents lie ahead.

NOTES

 

60 India Review

  1. See Hernando De Soto, The Mystery of Capital (New York: Basic Books, 2000), for a general discussion of this theme.
  2. For China see World Bank, China 2020: Development Challenges in the New Century (Washington, DC: World Bank, 1997) and for Eastern Europe see Helena Hessel, Rating the Transition Economies – 2001, Standard & Poor’s Creditweek, April 16, 2001, as well as European Bank for Reconstruction and Development, Transition Report 2000 (London, 2000).
  3. N. Srinivasan, Eight Lectures on India’s Economic Reforms (New Delhi: Oxford University Press, 2000), p.223.
  4. Deepak Lal, Unfinished Business: India in the World Economy (New Delhi: Oxford University Press, 1999), p.22, Table 1.9. This compares with positive 5.7% in Korea, 2% in Turkey and 3.1% in Japan.
  5. Hernando De Soto, The Mystery of Capital (New York: Basic Books, 2000), p.210.
  6. The McKinsey Quarterly, India – From Emerging to Surging, Number 4, Emerging Markets, 2001, chapter 1.
  7. Reference to Global Competitiveness Report in Daniel Kanda, Patricia Reynolds, and Christopher Towe, “Structural Reform in India,” in Tim Callen, Patricia Reynolds, and Christopher Towe, eds., India at the Crossroads: Sustaining Growth and Poverty Reduction (Washington DC: International Monetary Fund, 2001), p.184.
  8. Standard & Poor’s Creditweek, “Indian Banking System’s Capital Shortfall,” Jan. 10, 2001.
  9. Reserve Bank of India (RBI), Report on Currency and Banking 1999-2000, 2001, chapter IV, p.27.
  10. Paul Cashin, Nilss Olekalns, and Ratna Sahay, “Tax Smoothing, Financial Repression, and Fiscal Deficits in India,” in Callen et al., , India at the Crossroads, p.57.
  11. The McKinsey Quarterly, India – From Emerging to Surging, chapter on “Barriers to Productivity Growth.”
  12. Lal, Unfinished Business, vi.
  13. Narasimham, “Anything that’s protected gets stifled,” Economic Times, Dec. 15, 2000.
  14. The McKinsey Quarterly, India – From Emerging to Surging, chapter
  15. Rakesh Mohan, “Small Scale Industry Policy in India: A Critical Evaluation,” National Council of Applied Economic Research, New Delhi,
  16. Ravindra H. Dholakia, “Liberalization in Gujarat: Review of Recent Experience,” Economic and Political Weekly, 26-Sept. 2, 2000, p.3124, Also see Sebastian Morris, ed., India Infrastructure Report 2001 (New Delhi: Oxford University Press, 2000).
  17. Government of India, Economic Survey 2000-2001, March 2001, p.146.
  18. Reserve Bank of India (RBI), Annual Report 1999-2000,2000, 18.
  19. World Bank, India: Policies to Reduce Poverty and Accelerate Sustainable Growth, 31, 2000, p.128.
  20. The domestic market for most goods is not quite open and free as state taxes and regulations effectively fragment the market and encourage wasteful duplication of
  21. Kanda et al., “Structural Reform in India,” 181.
  22. The McKinsey Quarterly, India – From Emerging to Surging, Exhibit
  23. Government of India, Economic Survey 2000-2001, March 2001, p.24.
  24. Ranganathan, “What Ails Privatization in India?” Economic Times, May 16, 2001.
  25. Poll undertaken by India Today-MARL reported in The News Today, 5, 2001.
  26. “Carnegie Dumps Sankhya Vahini,” The Telegraph, 19, 2001.
  27. Amita Gupta and Sebastian Morris, “How Much More of this Infliction? The Case of the Ahmedabad-Vadodara Expressway,” in Sebastian Morris, ed., India Infrastructure Report (New Delhi: Oxford University Press, 2001), p.77.
  28. John Keay, India: A History (New York: Atlantic Monthly Press, 2000), 463.
  29. Swaminathan Aiyar, “India’s Economic Prospects: The Promise of Services,” April 1999 (Center for the Advanced Study of India, Occasional Paper Number 9, University of Pennsylvania).
  30. The McKinsey Quarterly, India – From Emerging to Surging, Exhibit 1.

Sanjeev Sabhlok

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