17 March 2015

Modi’s free market reforms in India have stalled

By

The new Indian government has now been in office for 10 months. It has presented an interim budget, which merely marked time and its first fully owned budget at the end of February. Despite the high hopes engendered by Mr. Modi’s rhetoric about turning back the statist policies of the previous Congress led governments which had led India to stagflation by the end of their tenure in May 2014, the budget itself was by and large a damp squib.

The Economic Survey accompanying the budget had presented a decent analysis of the economy’s ailments and exhortations for a new course. However, it had also claimed, erroneously in my view, that as India did not face an economic crisis (which it did and still does), ‘big bang’ reforms could not be undertaken and only incremental changes were possible because of unstated political compulsions. I have always favored ‘big bang’ reforms when a reformist government attains power on a large electoral wave. Structural reforms have immediate losers and future winners. The longer reforms are postponed, obstructionist losers have more time to coalesce, well before there is a constituency of winners benefitting from the changes.

The Modi government’s failure to have a well thought out program to be implemented as soon as it came to power is proving costly. It knew that it lacked a majority in the upper house (Rajya Sabha), where bills which can be passed with the government’s overwhelming majority in the lower house (Lok Sabha) also need to pass. Given the decimation of the Congress party, and Modi’s rhetorical skills, it would have been worth trying to pass the major reforms in its first parliamentary session. Even if they failed in the Rajya Sabha, they would have been a clear marker of the government’s reform agenda and the opposition to them could have been unmasked and been made a political issue, when the opposition was still traumatized by its massive defeat. It would also have countered the growing impression that the government is unwilling to make any meaningful change to the past dirigiste economic regime.

Instead the government chose to live in the hope, that as representation in the Rajya Sabha is based on party strengths in State legislatures, in time -with forthcoming elections in some major states (like Bihar, W. Bengal and Uttar Pradesh) – the BJP would be able to translate its overwhelming national mandate in these states also into victories in their State legislatures. But with the trouncing in the Delhi elections in February by the populist Aam Admi Party (AAP) which the BJP had beaten in the national elections, this hope is belied.

It is now reluctant to undertake even the modest reforms which its Economic Survey 2015 had advocated when it was written in January. Nothing underlines this better than the speech Mr. Modi made in the Lok Sabka about MGNREGA (the rural employment program) the day before the budget was presented. Taunting his opponents, he said his political sense “tells me never to remove MGNREGA because it is an example of six decades of failure of the Congress party; it has to pay people to dig ditches”. Yet in the budget the allocation to the program was marginally increased.

There was no reduction or transformation of the other subsidies (eg. food, fertilizers, electricity, and water) whose deleterious and regressive effects were ably analyzed in the Economic Survey. The only reduction was for petroleum products because of the fall in the oil price. There has been no further movement, apart from the rhetorical, in using the unique digital identity card (Aadhar), mobile telephones linked to new bank accounts for direct transfer of subsidies to provide better targeting and reduction of leakages.

Nevertheless, there is a change from the past mindset where these purported welfare subsidies were provided in kind rather than through cash transfers, which bodes well for the future. The Chinese economic miracle was based in part on Deng Tsiao Ping’s breaking China’s ‘iron rice bowl’. The Indian economy has been handicapped by its seeking to establish and extend its own ‘iron rice bowl”. India’s populist politics will not allow this to be broken. But it can be improved by making it less leaky, and there is wide recognition and acceptance by the government about what needs to be done.

Modi had realized the importance of promoting labour intensive industrialization in India. Hence his “Make in India” slogan. Two of the other major drivers of China’s economic miracle were the creation of a free labour market with the freedom to hire and fire, and a unilateral liberalization of foreign trade- the largest since Britain’s Repeal of the Corn Laws. These made it possible for it to utilize its most abundant resource –unskilled labour- and transform itself into the workshop of the world. Indian manufacturing has been hamstrung by not full heartedly embracing either.

Modi had recognized India’s failure to promote labour intensive industrialization. This has been hindered by colonial era labour laws (see my The Hindu Equilibrium, 2005) which created an industrial labour aristocracy of ‘insiders’ who have kept out the massive number of  semi-skilled workers willing to work for lower wages, as ‘outsiders’ in the manufacturing sector. As the Economic Survey 2012-13 (Box 2.4) showed, most of the enterprises (80%) in the labour intensive apparel industry employed less than 8 workers as compared to China where firms with over 200 workers predominated, largely because in India if an enterprise employs more than 10 workers it progressively hits more and more cost raising labour laws.

With the political difficulty in passing national legislation to rescind these archaic laws, the new government used a constitutional provision which allows states (with permission from the national government) to change these laws. A BJP governed state, Rajasthan has done this, but surprisingly other BJP ruled states have not been prodded to do the same. If this were done, a free market corridor could be created from Gurgaon (near Delhi) to Mumbai.

The other aspect hampering the ‘Make in India’ campaign is India’s failure to whole heartedly follow China’s example of complete trade liberalization, so that with many industrial inputs subject to various tariffs with none on the final outputs, many manufactured products face negative effective protection. Instead of dealing with this by unifying Indian tariffs to a low uniform rate, the Budget proposes a complex fiddling with the tariff structure.

The same continuing discretionary dirigiste mindset is discernible in the draconian law promised to incarcerate Indians holding foreign bank accounts and assets which are purportedly based on tax evasion. This will just raise the dowries that new entrants to the revenue services will demand, because of the new avenues for corruption opened up with the draconian discretion this bill will provide.

The budget was right in increasing public sector investment in infrastructure particularly in the railways, as the past form of financing through public private partnerships (PPP) has led to a large number of stalled projects and non-performing assets in the banking system. The private firms were landed with the implementation risk associated with obtaining various licenses and permissions, which affected their ability to complete their projects and service their debts. They will be unable to finance the massive infrastructure investment India needs.

The alternative route of foreign financing is still being poisoned by the Congress government’s bill to allow retrospective taxation of foreign investors to overcome the Supreme Court judgment against the tax authorities. The budget failed to rescind this bill. However, the proposed introduction of a bankruptcy bill will hopefully allow the cleaning up of the many ‘sick’ units in both the industrial, infrastructure and banking sectors. There is a lukewarm embrace of the alternative of financing infrastructure through the proceeds from privatizations of the large number of public enterprises, many of which are loss making. Its reluctance to privatize the massively inefficient and loss making national airline (Air India) is a sign that it is not going to adopt Thatcherite privatization policies wholesale.

The most encouraging development is the government’s acceptance of the Finance Commission’s recommendation for transferring about 60% of the taxes collected by the central government to the states. The resulting competitive federalism through tax devolution should allow states to compete in creating the growth promoting environment that national governments in the past, and it seems even today, are unable or unwilling to create.

As regards the likely future growth rate of India given its improved macro economic outlook and the possible structural reforms, any answer is clouded by the recent reworking of the national accounts by the statistical authorities. This has led to an unbelievable rise in the growth rates for 2013 and 2014, which the government’s own Economic Survey and many observers don’t find credible.

Thus despite the many heady forecasts of India being on the road to Chinese style double digit growth rates in the near future, the IMF’s recent forecast of growth hovering around 6% (on the old national income base) for the rest of the decade seems more likely. Thus, despite the hype and good intentions of the new government, India will, at best, continue to ‘hasten slowly’!

Deepak Lal is Professor Emeritus of International Development Studies, UCLA

This article is an exclusive for CapX, and is available for syndication. Please contact editors@capx.co to discuss details.