India’s economy is performing poorly, at least compared to its relative dynamism just a few years ago. With a general election to be concluded by the end of May 2014, many are looking to the country’s next government to break India out of its economic doldrums—but that hope may be misplaced. Political scientist Milan Vaishnav spoke with Ila Patnaik, a leading Indian macroeconomist, about the deep roots of India’s current economic crisis and the type of reforms a new government will need to institute to fix these issues.
Vaishnav: India’s economic growth rate recently slumped to a ten-year low. Inflation remains stubbornly high, and twin fiscal and current account deficits are cause for concern. Will India’s economic prospects improve if a new government comes to power in the upcoming general election?
Patnaik: Many observers are optimistic. Several recent reports suggest that India will regain its economic footing once elections are held and a new government is formed.
These reports all emphasize the effect that creating a stable government will have on India’s economy. Of course, the performance of the economy will also depend on the policies and preferences of that new government. For instance, investors are hopeful that a government headed by Narendra Modi, chief minister of Gujarat and the prime ministerial candidate from the opposition Bharatiya Janata Party (BJP), would be more likely to promote economic reforms than the incumbent United Progressive Alliance because Modi is considered more pro-business than the ruling Congress Party.
By contrast, investors are less optimistic about what a new government headed by one of India’s myriad regional parties or the untested anticorruption Aam Aadmi Party would mean for the economy. The country has little experience with such governments at the center, so their economic policies are largely unknown. Furthermore, investors view such “third front” governments as inherently less stable.
Changes in leadership aside, there are significant problems with the Indian economy at the heart of the current slowdown. So I fail to see how India’s economic problems will suddenly disappear, regardless of the election results. To truly make change, future governments would need to resolve some of the country’s deep-seated issues and build state capacity. How they propose to do that, however, is unclear.
Vaishnav: What are these deep-seated problems with the system?
India grew very quickly in the last decade, and institutional change and state capacity have yet to catch up with the country’s now much-higher GDP. Had the economy grown at a slower rate, India could have gradually scaled up its state capacity and reformed its institutional foundations.
India lacks a transparent, systematic, and nondiscretionary policy framework that allows the government to function effectively in many spheres, which means that many government decisions are made on the basis of individual discretion. For example, the state currently issues licenses and permits to firms for their operation on a case-by-case basis, a practice that results in the government choosing—often in an arbitrary and opaque manner—which firms receive clearances and which ones do not. As a result, favoritism and bribery can heavily influence which companies are granted permits. This model worked when India’s economy was smaller and growing slowly, but it no longer functions in the current era of economic dynamism with the number of firms and decisions increasing rapidly.
Democracy is putting pressure on the government to make this decisionmaking system more transparent. Various initiatives have forced the state to make public information about government activities and decisions that was previously hidden. The Right to Information Act, for example, requires the government to respond to citizens’ requests for information about its inner workings.
In the long run, these reforms are both healthy and desirable. Looking to the future, discretionary, opaque ways of making decisions must change for higher growth to be achieved. To continue the previous example, if India had a rules-based system to govern the process of issuing licenses and permits, firms would be allowed to set up their operations only if they met certain clearly specified conditions, such as those regarding environmental norms and health and safety standards. Once firms met these entry conditions, bureaucratic and individual discretion would be kept to a minimum, which would reduce the attendant issues of corruption.
Fixing these problems requires creating new policy frameworks, writing new laws, and then implementing them. These things can’t be done in a day.
Vaishnav: Some assert that India needs a prime minister who operates like a decisive CEO and can whip the bureaucracy into shape, as Modi has done in Gujarat. How much influence do individual leaders have over the direction of India’s economy?
Patnaik: The issue is not necessarily managing bureaucrats’ behavior but rather addressing structural flaws in the system.
Some component of India’s growth slowdown is due to the fact that many top-level bureaucrats are simply not willing to make decisions. India has witnessed a spate of high-profile corruption scandals over the past few years in which ruling politicians have used their discretionary authority to grant licenses and permits to favored firms. In some cases, bureaucrats have been investigated and blamed for these decisions, sometimes many years after the decisions were made. As a result, bureaucrats in key ministries are hesitant to clear important files because multiple investigative agencies have been scrutinizing government decisionmaking, looking for any potential evidence of malfeasance. Bureaucrats are afraid that if they decide to green-light an investment project, for instance, they could be charged with corruption in the future if there are allegations that the firm in question received special treatment.
For example, if the policy framework governing the coal sector said a committee would decide the allocation of coal-mining licenses, without setting out clear rules for the distribution of those licenses in advance, the committee members would retain an extraordinary amount of discretion and open themselves up to accusations of corruption and favoritism. Until the larger policy is clarified, bureaucrats will not make any decisions for fear of backlash. Determining the most appropriate and effective policy framework for a given sector will require an evaluation of that sector and its development, market structures, and market failures.
Sustained growth in India therefore depends not merely on a strong or decisive leader but on better institutions, increased state capacity, and stronger rule of law. India needs a transparent, rules-based economic framework.
Vaishnav: The upcoming election could bring the Congress-led United Progressive Alliance back to power, but that looks increasingly unlikely. A BJP government seems to be a more likely outcome. What might a BJP economic policy look like?
Patnaik: It is difficult to predict what a BJP economic policy would be because there is considerable debate within the party between pro-market and protectionist factions. During its years as an opposition party, the BJP has not behaved in a way that is clearly in favor of the market. For instance, the party has opposed implementing a goods and services tax and easing foreign direct investment limits in retail, insurance, and pensions—and those are reversals of past policy positions.
In addition, while in opposition the BJP has supported costly entitlement programs that the country cannot afford at its stage of development. Indeed, over the last decade, the BJP has supported welfare schemes and subsidies to the same degree as the Congress Party. These entitlement programs have established an entrenched system of subsidies, price guarantees, and central provisioning.
These policies constitute a substantial shift from the far more pro-market policies that the BJP pursued when it led the National Democratic Alliance government from 1999 to 2004. When the BJP was in power, its pro-market stance benefitted pro-growth investment.
With Modi’s leadership, the BJP needs to clearly state its economic vision and ideology. To date, party leaders have largely spoken in generalities.
Take, for example, the BJP’s opposition to greater foreign direct investment in retail. Does that indicate that the party does not want India to open up further to foreign investment, or is it merely—as I think many BJP supporters are hoping—political posturing?
Vaishnav: There’s always the option that a “third front” government will come to power that is led by a regional party and supported by either the BJP or Congress. If India were to get such an unwieldy coalition government led by a powerful state chief minister, such as Tamil Nadu’s Jayalalithaa or Bihar’s Nitish Kumar, would that be bad news for the Indian economy?
Patnaik: No, I don’t think it would be bad news.
In the past, regional parties have understood that economic reforms and growth are good for them, so they haven’t opposed reforms. Many chief ministers, such as Naveen Patnaik of Odisha, have governed well even though they are not in the national limelight.
In fact, it might be easier for a coalition of regional parties than for either a BJP- or a Congress-led government to negotiate with state leaders to get support for reforms that are under discussion. Regional party leaders, many of whom have exclusively focused on their own states for their entire careers, may be better positioned than officials from national parties to win state support for reforms that require close cooperation between state and central governments.
The goods and services tax, for example, requires such cooperation because the constitution affords the central government the power to tax goods and gives state governments the authority to tax a number of services, including trade and transport. India aims to move to a common tax rate and administrative system for tax collection, which will require cooperation between the states as well as between the states and the central government. It may also require a constitutional amendment if the power to tax services is to be given to the center.
Vaishnav: Is it possible that India’s economy could rebound significantly even without enacting major reforms?
Patnaik: To a degree. There are already some signs of a cyclical upturn due to a better external environment.
Over the last thirty years, India’s average growth rate has been about 6.2 percent even without reforms. There have been up and down cycles, but that is the long-term trend growth rate. Today, India is on the downside of the cycle, with growth below 5 percent.
Some rebound is likely as the U.S. economy improves. But it is important for India to undertake legal and regulatory reform, adopt the rule of law, improve its courts, and build capacity if growth is going to be sustained.
Vaishnav: Without action on these deep-seated, structural problems with the Indian economy, it is difficult to see how any government could achieve higher growth. Which issues should the next government prioritize?
Patnaik: The top priorities for any government should be building state capacity, improving governance through institutional change, and enforcing the rule of law.
Interactions between private firms and the government today are marked by discretionary powers in the hands of everyone from petty bureaucrats right up to the minister in charge. A firm often has no choice but to interact with multiple government interlocutors. To get land for a company, businessmen may have to pay a bribe. Then to set up a water connection, electricity connection, environmental clearances, and so on, they must secure permissions from other government officials—which may mean more bribes. This system is particularly harmful to the investment climate.
There are no silver bullets here. Tackling these issues is a very big project. But the present system, based as it is on transactional, discretionary interaction with the state, needs to change. Many countries have successfully transformed similar systems after seeing them lead to a rise in crony capitalism and rent seeking. The next government must do what it can to help push India toward similar progress.