Sequencing Reforms

How dire is the future prospect of the Indian economy with S&P's recent downgrade of the country outlook from ‘stable' to ‘negative'? According to many self styled economists from investment to World Bank, the future is gloomier than ever. As a reader of Businessworld will know, S&P's pronouncements were transpired by a combination of negative factors like shrinkage of GDP (from 8.4 per cent to 6.9 per cent) as well as the inability of the Central Government to cut down budget deficit (5.6 per cent of the GDP as opposed to 4 per cent promised earlier). The soaring trade deficit of $156 billion and failure to reach consensus on reforms in a dysfunctional Parliament were major contributors to S&P's pessimistic estimation about Indian economy as well.

So, given these negative opinions regarding the extent of political gridlock, how concerned should one be for the future of the Indian economy?  Relatively speaking, one should not give too much weight on these views, especially if the benchmark of comparison is western economies. The US is still struggling with jobless recovery as well as political infighting of the worst kind related to the stimulus programme and cutting of budget deficit. UK just slipped into a recession mode with a negative growth rate of 0.2 per cent in the first quarter and recent elections across Europe show how unstable the whole zone is, both on economic and political terms. In this global atmosphere, India's growth rate of 6.9 per cent is certainly not abysmal and the figure could easily inch upwards with a good monsoon or from an unexpected growth rate from a set of states (like 11 per cent growth rate in Bihar or 12 per cent growth in UP)  or from an improved performance in export due to a falling rupee.

But of course, there is no room for complacency either. India can still do much better even with her dysfunctional Parliament. Much hype about the debate on the stalling of reforms stemming from political gridlock is much exaggerated and misplaced. Any functioning democracy always makes pauses on decisions due to heterogeneity of views.  A diverse country such as India is expected to encounter even more dissenting attitude towards new policies with uncertain outcome.  The main problem rather lies on the faulty design, inexact implementation and erroneous sequencing of economic reforms and not just on the nature of coalitional politics. There is always a way out too!. The blame lies squarely with the Government which most of the times fails to take into account the set of constraints — emerging spontaneously in a democratic setup — that forces delays or halts the process of reforms.

Take the example of the recently botched-up attempt by the government to open India's £450-billion retail sector to foreign investors. The reforms meant allowing the foreign companies to buy 51 per cent stake in the country's supermarkets and owning single brand retailers outright. In return, these retailers were asked to commit an investment of £50 million in infrastructure and in buying 30 per cent of the stock from local suppliers. Furthermore, they could do business in cities with more than 1 million population. The plan looks so perfect on paper and was meant to achieve multiple objectives at one shot:  ensure a huge inflow of foreign capital, revive the ailing infrastructure, help poorer framers (via contract farming), benefit consumers with more choice  of consumables within a reasonable price range and promise more tax revenue to the cash-strapped Government.

Yet the whole plan failed miserably and blame was put on the inertia of coalitional politics and individual politicians were singled out for the paralyzing logjam. The irony is that no one bothered to delve into the deeper reasons that gave rise to the current state of policy inaction.  Any reform that replaces a current system with a more  efficient one (like this case) is bound to increase economic growth, relax the budget constraint of the Government via higher tax receipts and make consumers happy through greater choice of products. But such reforms will always create constituencies who stand to lose as a consequence. Take this example again in little detail.  Since every day a huge volume of goods and services are traded in different parts of the country, India has a huge network of intermediaries who function from the pre production (advancing loans to farmers and buying the crop later) and collection of  information about total supplies in the market stage to storing and releasing these products sequentially over time to the retail level.

The market structure of these large chain of activities is segmented regionally and most likely consists of a very few monopoly traders in each region joined by countless number of smaller players. Since much of the  activities  related to trading at different stages do not require much skill (after a network is established), this sector absorbs a huge number of surplus labour. What is going to happen to them after opening up of the sector to the foreign retailers when most of the people in the current system do not have any safety net or social security? How many of such small players are there in the network? How this network system (from pricing of products to their deliveries) would be affected by the introduction of a new system? Not a single research paper exists by economists of any repute that address these important questions because the Government chose not to bother about them and did not commission any studies from any reputable quarter. The people who are at the bottom of the trading spectrum tend to form the vote banks of many smaller regional parties and they just exercise their voice of concern through their local leaders. The bill thus went nowhere. The point of this example is that if a plan of reform is the product of bureaucratic effort exclusively, it loses the sense of ground reality and fails at the stage of implementation because of its inability to allay fears of losers.

Of course, the existence of losers does not mean at all that the Government should eschew the path of reforms. However, it certainly ought to minimize frictions and gather more information about the possible effects and the process itself before giving a shape to a new policy that affects a wide range of people. For the sake of concreteness, a policy prescribing "starting small and then expanding in a phased manner'' could easily resolve many tensions that create obstacles. That is, first start opening up the retail sectors to the states where the opposition is at a minimum and then spread to other places when gains from foreign investment is visibly seen to have exceeded the costs of displacements as part of the old trading network inevitably gets assimilated into the new system over a course of time.

The road to least resistant paths of reform is not singular and it can be followed in many other areas. The introduction of GST which will increase the revenue of the states via unification of the tax code is a good candidate for reforms. If conducted cleverly, this reform could succeed even if it requires amendment of the constitution. Another least contested area of reform is the financial market. The government can give a fillip to developing a market for public debt and tie the process with the development of infrastructure investment via PPP (Private public partnership).

One of the biggest obstacles to maintaining a high growth rate is the current state of infrastructure. Both its creation and maintenances require huge amount of funds. However, creation of institutional architecture and reforms to open market for public debt together with proper structuring of a deal with private enterprises would literally remove the roadblock and enhance the future growth not only through building up connectivity and network, but the new source of financing would help many medium industries who are too big for bank loans but small enough to go to the equity markets. Moreover, such growth enhancing and employment generating reforms are also politically feasible because few would contest them as there are not many immediate losers. 

For a smooth passage of reforms, they must be properly designed and sequenced in such a way that would propel growth via increased efficiency and investment without creating major economic tensions. The Government may benefit a lot if it takes some (but not all) lessons from the Chinese experience. For the first twenty years, China concentrated only on the export, agricultural and infrastructure. The reforms in retail, banking and other problematic areas have not been touched. At the same time, huge expenditure by the Government on the social sector lifted some 500 million people from poverty. Only afterwards, it aimed at opening banking, insurance and retail sectors. It took twenty five years of sustained growth of 10 per cent to make such transition from one type of reforms to another.

Unless the policy makers in the Government realize this and make an effort to unleash reforms that generate less resistance, the future will remain uncertain. Such reforms are plenty and they possibly include, among others, simplification of tax rules, boosting up of infrastructure via PPP and alleviation of finance constraints for medium enterprises by creating newer channels of funding. Reforms, if not carried out with a proper sequence, will deprive India of realizing her true potential for no good reason.

(The writer is a Professor of Finance at Nottingham University and can be reached at Sanjay dot Banerji at nottingham dot ac dot UK)