Even 25 years after liberalisation, politics remains the biggest stumbling block in the way of economic reforms in India

[Book extract] Political money is the canker that infects much of government functioning. It comes in the way of decisions.

 |   Long-form |   03-08-2017
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No country at India’s stage of development (for example, with more than four-fifth of adults not literate, in 1951) has experimented successfully with full-fledged democracy — universal adult suffrage with a multiparty polity in a federal structure — and achieved peaceful transfer of power, not once but over and over again. Similarly, no fully functioning democracy has successfully attempted market-oriented reforms when its per capita income was as low as India’s was in 1991.

Those living at the edge of subsistence, or below even a minimalist poverty line, are not natural customers for market-oriented reforms, given that markets cannot give weight to the concerns of those without purchasing power. The textbook answer to the problem is that it is the function of politics to take care of the losers in the economy by arranging for capacity-building and/or income transfers, in cash or kind.

But what if the majority consists of losers, and such transfers in a poor economy are not fiscally feasible so that there is no social-safety net? How do politicians, answerable to voters every five years, push ahead with policies that manifestly serve the interests — at least for the foreseeable future — of the minority that is part of the market?

Welcome, therefore, to the political economy of market-oriented reforms, and the complex challenges of pursuing them in a poor country with a democratic system.

What does one mean by "reforms"?

You could legitimately consider a programme that dramatically extends the reach of the banking system to be "reform"— such as the Modi government’s Jan-Dhan initiative, which simplified the opening of a bank account by eradicating the need for an opening balance; or the digitising of land records so that they become more easily accessible.

However, when discussing the political economy of reforms, the focus must necessarily be on those issues that involve choices that create losers as well as winners. The ambit would, therefore, include changing ownership and market structures, taxation and income transfers, incentives and disincentives; most importantly, it would involve changing the way in which prices are set and, consequently, who gets how much of the surplus.

manbd_080317043742.jpgManmohan Singh seized the opportunity in 1991, when the country was teetering on the edge of international bankruptcy, and earned his place in India’s history.

The outcome of all this must be judged on the primary yardsticks of efficiency, income growth and equity. So, while the tasks are technical and have to do with the tools of economics, the choices and outcomes are deeply political.

The logic of incrementalism

When he was criticised in the mid-1990s for going slow on the reforms programme, Manmohan Singh used to quote Bismarck, that politics was the art of the possible. What is defined as "possible" expands quite naturally in an atmosphere of crisis, since every crisis is also an opportunity.

Singh seized the opportunity in 1991, when the country was teetering on the edge of international bankruptcy, and earned his place in India’s history. Since then, though, every government, including Singh’s own, has chosen discretion over the path of valour when it comes to reform, preferring a gradualist, piecemeal approach to more radical agendas. In explanation, Arvind Subramanian, chief economic adviser in the finance ministry, has argued recently that radical reform is possible only in a crisis; the rest of the time, it can only be incremental reform.

That might be true, but crises come in different shapes and forms. One sort has an immediacy about it that demands urgent action, such as shipping gold overseas, as India did in 1991 to ward off international default. But there are other, quiet crises that creep up on you —the scarcity of good jobs; stubbornly low incomes on low-productivity farms that, regardless, are asked to support ever more people; the country falling behind on education and healthcare attainments and, therefore, at risk of losing the demographic dividend presented by a one-time bulge in the working-age population; or the water crisis that is already affecting millions.

Each of these is a big enough issue to be trajectory defining for a society and economy, but none of them has the actionable immediacy that forces itself to the top of any political agenda in a meaningful way. A good example of resisting immediate costs on the premise of long-term payoffs comes from the electricity sector. Building a reliable supply network usually involves pricing reform. But customers facing higher tariffs tend to protest, especially if they are used to enjoying subsidies. And the history of Indian politics is that the votes have gone invariably to those who have promised jam today: subsidised or free power.

The link that underpriced power has with the country’s endemic power shortages is rarely made, or simply ignored. A second challenge comes from taking on organised interests, such as teachers’ unions, because delivering better educational performance will necessarily mean tackling widespread teacher absenteeism. It is natural for politicians to want to sidestep such issues, preferring outcomes that have winners without losers, or at least many more winners than losers.

The preferred phrase in the 1990s was "making an omelette without breaking the egg". One could say that populist bribing of voters and protecting the interests of organized groups are the two principal ways in which politics intrudes on economic reforms.

An omelette without breaking the egg

Politicians who are secure about their continuance in office and their constituencies can afford to risk "breaking the egg". But the Indian reality is that no political party since 1989 had won an absolute majority in the Lok Sabha, the lower house of Parliament, until Narendra Modi’s victory in 2014. There is the further complication that the Rajya Sabha, the upper house, is modelled on the US Senate: one-third of its members retire every two years.

The different election cycles for the two houses mean that majorities in one house change faster than in the other. As a consequence, most recent governments that enjoy the confidence of the Lok Sabha have not commanded a majority in the upper house for the bulk of their tenure. Perhaps the best example of what results in an environment of bitterly competitive politics is the case of the goods and services tax, universally considered to be a good thing but blocked by the BJP in the upper house when the Congress ruled, and, in turn, blocked for two years by the Congress after the BJP came to power.

The Bill enabling such a tax was finally passed more than six years after it was introduced. The choices become most political when they involve farmers — numerically large, often financially stressed, and politically assertive. Agro-based industries such as sugar have, therefore, seen the greatest market aberrations and the most frequent and pervasive government intervention, with controls on pricing, distribution and export/import. As for an agricultural input like fertiliser, prices were not raised for a decade, a period in which there was no fresh investment in the industry, leading to a sharp increase in import dependency.

Given these very real political challenges, it is only to be expected that reform measures have been introduced where change has involved little pain because there are few losers; where careful political management has been possible; or where the issue has no political resonance. Where it has not been so, politicians have paid no heed to the economists rooting for market-oriented policy changes.

The hard fact is that all prime ministers have been politically risk-averse. Against this backdrop, consider three examples of successful, and relatively painless, reform. The first goes back to the initial reform thrust that Singh undertook as finance minister in July 1991: the devaluation of the rupee that was combined with a simultaneous slashing of tariff levels. Ordinarily, lower tariff levels would make imports cheaper and expose domestic producers to greater competition from overseas. You would expect, therefore, that such a measure would be opposed by domestic business lobbies.

povertbd_080317043816.jpgThose living at the edge of subsistence, or below even a minimalist poverty line, are not natural customers for market-oriented reforms.

However, the opportunity to drop tariff levels — and for good measure to abolish key export incentives — came because the rupee had been hopelessly overvalued in the run-up to 1991. A three-stage devaluation over two years, 1991 to 1993, dropped the rupee’s exchange rate from Rs 18 to the dollar in 1991, to Rs 31 in 1993. This meant that an imported item that cost $10 (Rs 180) in 1991, but attracted 150 per cent tariff protection, would have had a domestic cost of Rs 450. In 1993, the same item imported at an exchange rate of Rs 31 but attracting only a third of the old duty level (50 per cent), would cost Rs 465.2.

Local producers enjoyed less nominal protection but higher increased effective protection. In actual fact, the average duty on commodities dropped only from 72.5 per cent in 1991–92 to 46.8 per cent in 1993–94, while the peak rate dropped from 150 per cent to 85 per cent.

Thus was tariff reform combined with rupee devaluation to be transformed into painless medicine; the inflation effect of devaluation was reduced through tariff cuts, even as the competitiveness of domestic industry was protected through devaluation, which neutralised the effect of the tariff cuts. Yet, both steps were rightly characterised as reforms. Indeed, Manmohan Singh as finance minister told the author in the early 1990s that he had spent "sleepless nights" to make sure that the extent of tariff cuts would not damage domestic industry.

Take the next two of the business sectors that have been success stories in the post-reform area: aviation and telecom. Both sectors had inefficient, government-owned monopoly operators; both provided services of poor quality; and both had dissatisfied customers looking for change (or choice). Still, the reform undertaken was carefully crafted to mollycoddle the government-owned legacy players.

In aviation, private airlines were initially allowed to fly domestic routes in the guise of air-taxi services — a piece of legal fiction because air taxis do not have flight schedules, whereas the services that were launched did. Ownership was restricted to Indian nationals, resident and non-resident, and there were stipulations on the minimum size of aircraft. Later, foreign companies were allowed to invest — but not if they were in the aviation business — in order to make sure that investment did not come packaged with sector expertise!

It took more than a decade before international routes were opened up to domestic private airlines, but came with arbitrary restrictions. The legacy government-owned airline, Indian Airlines, was expected to hold its own in the domestic market, given the strength of an established network. In the event, despite its passenger traffic declining steadily, it made modest profits in most years, helped by the fact that it had a fully amortised fleet of ageing aircraft. Two decades would pass before it was dethroned as the largest domestic carrier.

The transition to a competitive marketplace had happened, but no companies had been privatised, no jobs had been lost, and no one had been forced to give up the safety of public-sector jobs to face the uncertainties and rigours of private-sector employment. What is more, by 2015, India’s domestic aviation market had grown more than tenfold in 25 years, and emerged as the world’s fastest-growing aviation market, clocking over 20 per cent growth.

Intense competition had led to cut-throat fares so low that they invited railway passengers to consider flying as an option. Thus was a success story wrought through the introduction of private-sector competition into a government monopoly, scripted without anyone feeling the pain of reform. Amidst the success, though, public-sector mismanagement continued; in fact, it got worse.

After a disastrous merger of Indian Airlines with the government-owned international carrier Air India, and the ordering of large numbers of new aircraft that led to huge financing costs, the merged Air India began notching up record losses; even then, employees of the hopelessly overmanned airline did not feel the pain.

It has been a similar story in telecom. In 1991, teledensity was hopelessly low (0.6 lines per 100 population, having improved from 0.3 per 100 in 1981); waiting lists for new connections ran to a decade and more. As in aviation, private-sector competition was introduced in a carefully calibrated fashion: new companies could offer local services but were shut out of the then very profitable long-distance traffic; in each telecom area, only two private mobile operators were allowed to compete with the government-owned company.

But that was enough to raise teledensity to more than four per cent in 2002, before lower tariffs, more open competition and explosive growth took it to more than 80 per cent by 2015. The government companies were unable to compete and became marginal players, except in legacy landlines, now the much smaller component of the business. They were also deep in the red, with losses more than equal to revenue in many years. However, there was no pain for employees because the government continued to bankroll the companies.

The bill was only a fraction of the massive revenues that the private telecom companies served up to the government — through spectrum fees, revenue-share prescriptions and taxes on profits. In effect, customers were paying, but mobile telecom tariffs were low by international standards and no one had cause to complain.

The pricing challenge

In contrast to these two cases where painless reform was possible, change has been difficult to introduce where it has meant inflicting pain. This is most notable in the sectors where long-standing pricing distortions have caused subsidies to balloon and wasteful consumption to flourish.

Electricity, for instance, has been an area where politicians have traditionally felt obliged to offer supply at less than cost, especially but not only to farmers. Almost nowhere in the country is the average power tariff at a commercially viable level. Yet, the endemic shortages of electricity forced the government in the 1990s to invite private investment in power generation — investment that had to be offered a reasonable return.

Changes in the law to facilitate this were introduced in 2003. The assumption was that investment in power would be made financially feasible by charging consumers a commercially viable rate, or the subsidy paid by the state government concerned so that the electricity sector remained ring-fenced from political pricing decisions. The results were encouraging, up to a point.

ook_080317043908.jpgIndia Transformed: 25 Years of Economic Reforms Hardcover, Edited by Rakesh Mohan; Penguin Random House India; Rs 699.

In the decade to 2015, half the new generating capacity created was by private companies, and for the first time the country had enough capacity to provide all the power that was demanded by customers; power shortages came down sharply in many states. However, the promised pricing reform did not happen, nor did state governments pay all the subsidy bills as they were obliged to.

The power distribution companies were caught in the middle between suppliers and consumers, with revenue that was lower than the cost. They borrowed from banks and, when that course reached the end of the road, simply limited their buying and distribution of electricity. The result in certain parts of the country was bizarre: generating companies could deliver more electricity but there was no one to buy it, and consumers wanted more power but it wasn’t being supplied.

The central government has tried more than once to incentivise pricing reform, with limited success. As a national average, revenue has tended to fall short of cost by about 25 per cent.

Partial reform clearly has its perils. The trick, of course, is to depoliticise pricing. How to do it has been shown in another energy sector that has been dogged by political pricing — petroleum products.

In slow, hesitant stages, the government first stepped out of the picture for the pricing of petrol, then of diesel, leaving both to market forces, with prices to be adjusted every fortnight or month so that each change was no more than a pinprick. The government has also taken the initial steps to reform the pricing of cooking gas and kerosene.

The success of this pricing reform suggests that baby steps, taken at regular intervals, achieve better end results than big, infrequent price revisions. In electricity, however, the regulatory architecture that was to oversee pricing reform — by making it non-political — was undermined and therefore rendered ineffective.

The labour market

If political pricing has been one of the big political stumbling blocks in the way of reform, labour law reform has been an even bigger one. India’s labour laws seek to protect primarily the organised section of the labour market, which is represented by trade unions. But anything up to 90 per cent of India’s workforce is engaged in the unorganised sector, where an unregulated market operates without the intervention of trade unions or the effective application of protective rules, such as minimum-wage stipulations.

Nevertheless, politicians have focused on the smaller corner of the labour market, leaving the bulk of the labour force to its own devices.

To make matters worse, a series of changes in the 1970s and early 1980s made the organised labour market segment even more rigid. Retrenchment and layoffs were made exceedingly difficult, and pulling down shutters required government permission, which rarely, if ever, came. These changes were driven by a concern for the fate of workmen in declining industries, such as large textile-weaving units threatened with cheaper competition from power-loom units in the informal sector, and troubled engineering units in the state of West Bengal, which at the time was marked by militant trade union activity.

It didn’t help, because more than 100 textile mills of Mumbai shut down anyway after a prolonged strike in 1982 and never reopened; large numbers of engineering units in West Bengal also shut down, even after the government took charge of running some of them. At the same time, the tighter laws had the perverse effect of discouraging employment-intensive industries of the kind that flourished in China, making garments, toys and shoes.

Legacy workers in the organised sector were protected after a fashion, but those looking for jobs (unorganised and therefore inchoate) were the losers. Denied the abundant resource of labour at competitive wages to rival East Asia and neighbouring Bangladesh, the country’s manufacturing sector has been stunted, accounting in 2014 for just 16 per cent of GDP — lower than for almost every country in East Asia.

The resulting failure to move workers from farms and into factories has meant that agriculture too has been a stressed sector. It contributes to 16 per cent of GDP but engages half the workforce — yielding, on average, income per worker that is one-sixth of non-agricultural work. Nevertheless, any attempt to reform the labour laws and do no more than restore the status quo ante to pre-1980, is automatically characterised as anti-labour, damned as part of a larger "neo-liberal" scheme, and opposed by the large trade unions that draw their membership mainly from the existing organised sector.

No reformist government has had the courage to break this particular egg to make the desired omelette, that is, rapid growth of productive employment. All of them have been happy to step gingerly around the issue or, as in the case of the Modi government, to pass the buck to state governments, most of which (to no one’s surprise) have focused on other matters.

Politicians’ compulsions

Meanwhile, the political class has its own concerns. Elections cost money, many million rupees to contest a state legislature seat, and hundreds of millions for some parliamentary seats; a typical parliamentary constituency has 1.4 million voters. Almost all of the cash used to fight an election is unaccounted money, contributed either by the political party or garnered by the candidate. The money has to come from somewhere, either extracted from businessmen who pay for favours from the government, or siphoned off in cash from government-spending programmes.

That is one reason why about half the grain supplied by the government at subsidised rates does not reach its intended beneficiaries (the poor); why in public-sector oil-marketing companies the adulteration of diesel with lower-priced kerosene is an organised racket; why billions of rupees spent on irrigation projects create no additional irrigation capacity, as corrupt contractors first bribe ministers and then cheat on the work to be done; and why government-owned banks have financed highway projects at (on average) twice the cost assessed by the National Highway Authority of India.

Business favours can take many forms: of getting government-owned electricity-generating units to back down so that the power-distribution companies have to turn to higher-priced power that is privately generated; of high tariffs imposed on steel imports so that domestic producers improve profit margins; of radio spectrum sold well below the market price to favoured mobile telephone companies; of government-owned airlines vacating profitable flight routes and time slots, which are quickly allotted to private airlines.

These are not deals and scandals carefully hidden in cupboards, along with other skeletons; indeed, they are the stuff of political allegations hurled across the floor in Parliament and state legislatures, and of committee reports and inquiry findings. Much of it, therefore, is common knowledge. The colour of political money taints government decisions, puffs up project costs and leads to suboptimal outcomes in every conceivable way.

Political money is the canker that infects much of government functioning. It comes in the way of decisions to reduce the role of government, to privatise, to remove counterproductive controls and expand the role of markets, that is, the very stuff of reforms.

Naturally, politics is only nominally about ideology or maximising welfare. While Indian politics has retained the formal structures of Westminster democracy, its substance harks back increasingly to older, more indigenous, traditions and practices. Other than the Bharatiya Janata Party, which is Hindu revivalist, and the communist parties, which are programme-driven, every other party in India’s multihued political spectrum has become the extension of a single politician or political family — starting, of course, with the Congress.

Even parties that started out with clear ideologies, such as the socialists, and those that represented subnational identities have tended to become dominated by single families. This is feudalism in Westminster raiment, with some leading political families counting in their fold parliamentarians and state legislators who are into the third or fourth generation — the Congress’s Nehru–Gandhis, the Thackerays of the Shiv Sena, the Dravida Munnetra Kazhagam’s (DMK’s) Karunanidhi–Maran clan, the Scindias and others.

Some political dynasties have emerged in surprisingly little time with billions of rupees in private wealth (such as Jagan Reddy, son of a former Congress chief minister). Many politicians have diversified their activities and become wealthy businessmen in their own right —nascent Indian oligarchs, if you will, since their political clout is useful for business. Some, such as the Marans and the aforementioned Jagan Reddy, have become media barons too.

Indeed, individual parliamentarians have declared assets that outdo the entire British Cabinet. It is impossible to understand the political economy of India’s reforms, its limited scope and ambitions, without first understanding the reality of Indian party politics, the dynasties at its heart, and how the feudals have made the state their handmaiden. India’s politicians make sure that they extract their pound of flesh from the economy.

Broad support for shallow reform

This political feudalism is mated to a modern sector of the economy and a growing middle class that apply counter-pressure points. Industry and trade have to function, and some semblance of law and order has to be maintained. The English-language media, including business publications, call for more market-oriented reforms, while the cleaner elements in the business world look for an end to corruption and cronyism. Civil-society organisations work at the grass roots to expose malfeasance and misfeasance, and the courts are independent.

At the same time, urbanisation reduces the role of caste- and community-oriented identity politics, because city dwellers tend to be more interested in issues such as clean air and proper water supply and, therefore, are less likely to simply vote according to their caste or community markers. The result of the interplay of these different forces is the stop-go, piecemeal, partial reform that India has seen since 1991. Where reform has been more comprehensive, it is because even though the changes faced resistance in political circles where old ways of thinking persisted, such resistance had no political resonance with voters.

The sweeping industrial reforms of 1991 that ended most of the curbs on investment were welcomed in the circles that were affected because it had become increasingly obvious that the old controls were counterproductive. Slow change had begun a few years earlier, building up to the comprehensive delicensing of 1991 that became possible in an atmosphere of crisis management. Similarly, the steady dropping of income-tax rates was popular among taxpayers, even as the progressive reform of the indirect tax system (fewer tax rates, then a shift to value-added taxation) made life easier for businesses across the board.

It is not that there was no resistance to change — many in the ruling Congress party were critical of the deviations from past orthodoxies. But the fact that there was no broader political resistance to the changes became evident when, in the 1996 elections, the reforms did not figure as an issue; they had not yet touched the lives of enough people. Even eight years later, in 2004, when the ruling BJP campaigned on the basis of a "Shining India", it was rejected by voters who found the rival Congress focus on the "aam aadmi" (common man) more convincing.

The benefits of reforms were still to percolate deep enough to win votes. In economic terms, though, the freeing up of the private sector laid the foundation for faster economic growth. Private corporate profits as a share of GDP doubled to eight per cent between the 1990s and the first decade of the new century. As a consequence, the ratio of fixed-capital formation to GDP surged from a range-bound 20–23 per cent of GDP in the 1980s and 1990s, to more than 30 per cent in the new century, taking up with it the rate of economic growth.

Still, the reforms have remained partial, influenced to varying degrees by the existence of different interest groups, leading to the wisecrack that India has a "broad consensus for shallow reform". Domestic businesses do not want a completely open economy that allows unbridled competition from foreign players, and this is one reason why average tariff levels, though much lower than before, remain higher than in most other countries.

Upper-caste and middle-class interests speak to greater investment in university rather than government-school education; neglect of the latter affects mostly the poor, since wealthier parents turn to private schools. Organised labour, occupying high-wage islands, does not want the reform of labour laws that will take away some of their protections and privileges. And landed interests want a continuation of the inefficiencies that reside in the electricity and fertiliser subsidies, and state-guaranteed procurement of grain, since they are the primary beneficiaries of the largesse.

In poorly administered cities, public transport suffers from relative neglect, while the small minority that commutes in cars occupies the bulk of available road space. There remains, even now, plenty of scope for reforms that don’t need to break the egg. Technology presents one set of options: the digitisation of land records gives citizens access to them without the mediation of officials who hold out greasy palms; a biometric identity system makes it possible to replace clumsy subsidy programmes with better-targeted cash transfers.

The scope for reforms also expands with the proliferation of success stories: no one would have failed to notice how much better the new private airports are than their government-run predecessors, with the ones in Delhi and Mumbai routinely featuring in the lists of the best-run airports around the world. A similar reform may now be attempted at the country’s major railway stations, a more demanding task since these are used by millions every day.

Then, new institutions of governance are being created, such as the Competition Commission, autonomous regulators who set the rules for different business sectors (such as telecom or insurance), and the National Stock Exchange that has displaced the older, broker-dominated Bombay Stock Exchange, which reformed in the face of competitive pressure. Tax policies have been streamlined and modernised; while change is not complete, the system is unrecognisable from what existed in 1991 — as is financial-sector regulation.

The greater role played by overseas investors, portfolio as well as direct investment, has created its own pressure points for better governance, including in the corporate sector. The growing roles of international arbitration and of bilateral investment treaties have acted as restraints on arbitrary authority; notable exceptions tend to hit the headlines and create their own pressures.

Good, but not good enough

In a way, all this explains the nature, scope and limitations of India’s quarter-century record of incremental reforms. They have seemed slow and inadequate at any particular point of time, but in their totality, they have had a significant cumulative impact. As is said, a photograph of India taken at any moment in time shows a messy picture; but over time, a moving picture shows how much has changed.

The lowest-hanging fruit were plucked in 1991–93, but there has been a real, though unspectacular, broadening and deepening of reforms since then: the generation of greater surpluses leading to the slow cranking up of investment in (among other things) physical infrastructure; the steady improvement in health indicators; the expansion of the social-safety net through the employment-guarantee programme and government-provided medical insurance; and the sharp increase in enrolment rates for higher education.

All this and more has led to the higher economic growth rates of the last couple of decades, with an annual average of seven per cent since 1994.

While creditable, this is short of the 8–10 per cent that was achieved in the rapid-growth phases of East Asian countries such as Japan, South Korea, Taiwan and China, and points to what a less incomplete reform might have achieved by now. If the growth rate had averaged nine per cent over 20 years, per capita income would have been 45 per cent higher, with a consequential improvement in the employment situation, a sharp reduction in the numbers of the poor and better human-development indicators.

The truth, therefore, is that the pace of reform has not been fast enough. India’s fundamental challenges are to create the millions of jobs each year that will keep its burgeoning population of working-age youngsters productively engaged, and to hold out for them the promise of a better future.

These call for a still higher rate of economic growth, a much better quality of governance, a rapid end to extreme poverty, political decisiveness and a readiness for change that in their entirety are unlikely to materialise in the given circumstances of the country’s political economy.

The multiple realities of its political economy mean that India’s reformers will continue to wrestle with the art of the possible, in an environment of suboptimality, even as it probably continues for the foreseeable future to be the world’s fastest-growing large economy.

(Excerpted with permission from Penguin Random House India.)

Also read: C Rangarajan on India's road to economic transition - the 1991 liberalisation


TN Ninan TN Ninan

The writer is a senior economic journalist and author, who has served as Editor, The Economic Times and Business Standard, among others.

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