Fixing the Indian Economy

By Derek Scissors
Derek Scissors
Derek Scissors
April 12, 2014 Updated: April 12, 2014

India must address its primary, internal challenges before paying too much heed to foreign concerns.

Despite April’s national elections, there is no point expecting India to soon adopt an ideal program for economic reform. Democracies rarely adopt ideal policies and India, still full of only partly reconstructed socialists, has not entirely made up its mind as to what it wants, much less how to achieve it. Nonetheless, the election offers something of an opportunity.

It does so because both the Bharatiya Janata Party and the Congress appear, at least, to have recognised that market-oriented reform is necessary for economic development to succeed. The question is whether the winning coalition will have the vision, courage, and political capacity to implement decisive reforms, or will again falter in favour of continued statism or short-sighted populism.

A measuring stick for genuine and fundamental reform is therefore valuable. The new government will certainly not achieve a perfect score but how well it does will determine the economic story.

The crucial reforms are familiar to those who watch India, because they have been discussed for years. The most fundamental involves individuals and households: clear land rights. The second concerns firms: the ability to fire workers in the manufacturing sector, vital if India is to properly utilise a huge labour force. The third involves states: reduced barriers between them, such as differential taxation, creating a genuinely unified market. The fourth is national: reducing distortions in the use of capital caused by government action.

An India that fails on all these fronts may crow over its prospects but success will be fleeting. There is a silver lining to years of bad policy, however: only one area is needed for a breakthrough. A single powerful program would directly improve economic performance and, just as important, make ensuing reform in the other areas more likely. If the new government can get the ball rolling, India could fulfil many of the lofty expectations.

Land Ownership

Successful economic development requires clear private ownership of land. Britain was the first country to industrialise in good measure because it was the first to grant property rights. The old Soviet Union failed in good measure because of its disastrous treatment of farmers. China, India’s international economic obsession, started reform by granting a small but unmistakable measure of private control to farmers. This drastically increased agricultural productivity and slashed both poverty and income inequality.

As it was with China, it is now with India: land ownership is the single biggest factor holding back economic development. India’s problem is largely opacity in ownership. Land boundaries are unclear and land rights attenuated, with individuals, local collective bodies such as tribes, state governments, and the national government all claiming rights to make allocation decisions depending on the location and history of the land and the natural resources involved. Basic choices such as what crop to grow entail government action rather than being left to farmers.

Results are ugly. Unclear land rights curb incentives to produce. Remarkably, India has seen per capita food grain availability drop in recent years. This is fundamentally at odds with successful development. Distribution of farm goods is certainly a problem, but so are yields themselves. Indian yields are inferior across the board to Chinese, where China’s are hardly outstanding. Prospects are mixed, at best, due to decreasing water availability. Not coincidentally, another unavoidable outcome of unclear rights is overuse of “common property” like water.

While agriculture remains central to the economy, still accounting for about half of those employed, the harm caused by vague land rights extends further. For most of the last decade, the national government has deferred market-based reform in favour promoting infrastructure spending as an engine for growth.

Public control of such spending inevitably reduces commercial returns, in favour of political gain, as compared to private investment. But heavy public involvement has been rendered unavoidable because land use is almost invariably contested, sometimes bitterly. As a result, most infrastructure programs have performed poorly and some have been sharply curtailed. Rather than increasing as the government hoped, already limited private participation may decrease, in part due to the uncertainty surrounding land acquisition and retention. Successful infrastructure programs cannot substitute for painstaking land rights reform; in fact, they require it.

An unabridged right for individuals to own and sell (or not) land addresses all these problems. India suffers from both mass poverty and rising inequality. Granting full private ownership of land puts assets in the hands of what are usually the poorest people in the country, and is far more effective than the government dole. Land rights will also improve yields, as better farmers value land more highly and purchase from worse farmers. This is the process through which farmers in rich countries have not only served their countries by becoming more productive but have themselves become wealthier in terms of owned assets than non-farmers.

There is a new land acquisition law on the books. Rather than moving toward individual rights to own and sell, the new law enshrines a weak form of collective ownership, freezing the land market in the name of protecting the same people to whom the government refuses to grant basic rights. While collective ownership is codified, legislation clarifying titling – necessary for individual rights – is a low priority and years away. The new government must move toward clearer land rights for individuals or most of the population will remain poor.

The Right to Fire

Overregulation of Indian business remains pervasive, sometimes to the point of being bizarre. Very large companies have the resources to comply with these regulations, very small companies escape them, but the regulatory burden means there are too few companies in between.

Among many, the first regulation to roll back is the requirement that industrial firms with more than 100 employees cannot freely close or sharply downsize – they must apply for government permission. This is the most vital deregulation because ‘industrial’ includes manufacturing, the sector India must rely on to absorb its famously expanding number of young workers

Half the population, approximately 600 million people, is under the age of 25. At present, the private, organised (read: those paid market wages) sector employs less than three percent of workers, indicating massive scope for expansion.

Beyond the much-discussed size of the labour force, though, the numbers are far more worrisome. In the near term, the situation can reasonably described as dire. Labour force participation is actually declining, having fallen from about 61 percent in 2005 to below 56 percent now. It is frighteningly early in the demographic cycle for this to occur, India right now must be a job creation machine. It is manifestly not.

Epoch Times Photo

Looking down the road, India is a young country by median age but its life expectancy remains low by global standards. The window to take advantage of a huge labour force is not especially long. Education improvements are indispensable but can take decades to show major benefits. This risk is that the hoped-for demographic benefit will become the more typical situation of a demographic threat, where high unemployment causes social and political instability, which then hurts business sentiment and hiring in a vicious cycle.

This is obviously a very dangerous possibility. But there is reason to think India is capable of creating large numbers of jobs. The labour market in services is less restricted than that in manufacturing. Not coincidentally, a number of services subsectors are globally competitive, where almost nothing in manufacturing is. If manufacturing can become more competitive, an aging population in China will remove a prime competitor to serve the global market. Then the sky’s the limit for Indian manufacturing employment, with up to 100 million additional jobs.

As with land reform, greater manufacturing employment will reduce poverty and inequality. Indeed, the two are complements, as redundant farmers fill manufacturing jobs. The requirement of government approval to downsize should simply be thrown out. Ideally, this would occur nationally but it could work to some extent at the state level, as firms would then relocate to the freer areas. There will be obvious political problems either nationally or by state. One way to address them is for the government to continue to oversee employment decisions at a set of state-owned enterprises.

At present, there is nothing more than wistful discussion of new labour laws in manufacturing. The demographic boom is a wonderful opportunity for sustained economic growth but it requires a dynamic manufacturing sector, which can only delivered by increasing private activity. Private industry does not hire if it cannot freely fire. The new government has to move away from assisting existing workers toward assisting new workers, or labour force expansion will end badly.

India Integrating

Building up from the individual and the firm, the next step is India states. This is arguably also the last step, because the economic barriers between states are so high as to undermine the idea that India has a truly national economy. The people need land rights and jobs, India as a nation needs a unified market, which will both strengthen its economy as a whole and give it more weight in international commerce.

The need for a unified market applies to labour – as noted, states have different labour laws and policies. Language and other barriers are high enough; legal and regulatory restrictions must not add to them. States must be as open as possible to migrant workers from other states. Workforce expansion is anticipated to be much heavier in northern states such as Uttar Pradesh than the rest of the country, but migration can prevent dangerously high local unemployment and help expanding labour supply benefit the entire country.

Even more fundamental than the movement of labour is the movement of goods and services (including electricity). States occasionally ban trade with other states, as if they belong to different countries entirely. Agriculture is central in developing economies. But regulatory and transit barriers between states prevent comparative advantage in agriculture production and contribute to wasted farm goods, a tragedy when malnutrition is still so prevalent. The current government recognises the problem but, in a familiar story, action has been lacking.

Overregulation is even worse inter-state than within states. Not only are there too many license requirements and the like in each state but there are different licensing requirements utilising different standards across states.

This lack of standardisation extends to taxes. Remarkably, India does not have a national taxation system. Instead, it has a variety of mismatched state taxes, imposed on goods and services when they cross state lines. There are multiple indirect taxes applied in each state and the kinds of taxes varies across states, in part to ensure that taxes paid in one do not prevent another from grabbing revenue. As such, India is arguably no more integrated than the EU and certainly not comparable to truly national economies such as Japan or Australia.

The single most visible action to unify the national market is a common Goods and Services Tax (GST). A common GST would bring many of the advantages of scale that a huge country is supposed to have but India has not enjoyed. A fairly simple and transparent GST would further improve the competitiveness of Indian products internally – greater value to consumers – and externally. Barriers between states can also lead to greater inequality, causing development paths to diverge. Through GSP and other measures aimed at breaking down inter-state barriers, the next Indian government can boost both growth and probably equality without spending a rupee.

The advantages of a unified GST are well understood but implementation has gone nowhere for years. State governments refuse to give up revenue in exchange for economic progress. At the national level, direct compensation of state governments would be far less wasteful and corrupt than existing populist programs but has a lower political profile. If a national GST is impossible in the short term, the program should start with the subset of states that are willing to participate, preferably with as much geographically contiguity as possible.

Capital for All

In rich economies, problems in capital markets are usually the most pressing. India is not rich and land, labour, and basic economic integration are all more important for the new government to address. Nonetheless, it would also be useful if national credit markets, in particular, operated on a more commercial, competitive basis.

Epoch Times Photo

It is a sign of policy weakness that so much emphasis has been placed in the past few years on nominal interest rates. Interest rates are a management tool, not a foundation for growth. At 17 percent in fiscal 2012-3, credit growth has been more than adequate. And borrowing costs are already very low – the inflation-adjusted yield on treasury bills were negative for some time and were barely above two percent in 2013. Among other things, this has helped spur the stock market to new highs.

Since credit conditions are most likely too loose in the aggregate, the constant complaints about ‘high’ rates must be the result of market segmentation, where certain entities can borrow much more easily than others. The solution is not to try, again, to drown the problem in yet more liquidity, but to improve the functioning of markets through greater competition.

State banks account for over 75 percent of bank deposits and manifestly do not operate independently from the government. Promised new banking licenses are a step in the right direction but new banks take many years to become large enough to change market structure and India has already suffered greatly from non-competitive finance.

There’s a more pointed problem, as well. State banks must hold at least 24 percent of assets in government bonds. This makes fiscal deficits partly a function of the dominance of state banks, as these enable the government to borrow, at a negative real interest rate. The goal should therefore be at least partial privatisation of the state banking system. This does not mean selling minority stakes in state banks and leaving their operations entirely unchanged, as is being done on a scattered basis now. It means taking some state banking assets entirely private.

Privatising state banks would improve the national return on capital, cutting waste and boosting growth. It would constrain government borrowing by reducing access to below-market financing. Controlling the budget contributes indirectly to core reforms by taking away the easy political substitute of just spending more. Unless some state banks are privatised, some users of capital will continue to be privileged over others, the government will continue to waste money, and growth will continue to be choked.

The Good News

Privatising state banks, unifying the internal market, liberalising manufacturing labour, and granting individual land rights constitute an absurdly difficult challenge to set before a new government. The goal cannot be to succeed completely in these areas but rather to make visible progress, progress that has been manifestly lacking in the past decade.

Even better, the new government should pick a dimension on which to start, whichever one is deemed most desirable and feasible. An advance in just one area will considerably bolster the national economy, boosting productivity and growth while very possibly simultaneously reducing inequality. This, in turn, will build political support for reform in another area.

Such gains would not only be political. For example, privatising some state banks would mean more capital directed to successful manufacturers, making it easier to remove labour restrictions in the sector. A more unified internal market would boost the return to land, making land rights all the more rewarding for the poor. If progress is made, these reforms will feed off each other.

A last thought: trade and investment have not been mentioned. They have not been mentioned because they are secondary in successful development for a large economy. India must address its primary, internal challenges before paying too much heed to foreign concerns. Multinationals may even find they prefer this set of priorities – actually being able to buy land would encourage many more foreign projects and the other reforms would be quite valuable, as well.

Derek Scissors is a resident scholar at the American Enterprise Institute (AEI), where he studies Asian economic issues and trends. He is also an adjunct professor at George Washington University. This article was originally published at the Pragati.