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Reviving growth and checking inflation is the primarymandate that the people have given to the government. It has to be understoodthough that there is no magic wand to achieve these goals, and it will taketime to put in place some of the institutional changes that are necessary for areturn to high and sustained growth rates

 

After a historic electoral battle, Indian voters have given their mandateand a new government is now in office. The government has promised the peoplethat it will deliver on good governance and inclusive development. However, anumber of challenges lie ahead, the biggest of them, without doubt, being thestate of the economy. To use a term that has increasingly been employed in thiscontext, the economy is in a state of paralysis. So what are the most importantsteps that the government needs to take to help the economy recover from thisparalytic state? To answer this, it is important to understand how the currentstate of affairs came about.

In the first slew of economic reforms and liberalisation in 1993, thetraditional industrial and services sectors within the economy gained a lot offreedom that they had never enjoyed earlier. Before 1993, the major constraintsthese sectors faced were legal and policy constraints like the industriallicensing policy, tariff and quota restriction on import of raw materials andintermediate goods, etc. The 1993 reforms removed most of these constraints.This led to the first growth boom in India, with the average per capita growthrate of the economy going up from less than two per cent to more than four percent per year.

Then came the second growth boom in 2004 with per capita growth ratesincreasing to more than six per cent per year. This boom happened partly due tosome of the traditional sectors continuing to do well and also because of a newkind of growth momentum from some specific sectors minerals, construction, realestate and telecom. The momentum in the minerals sector came from exports, asglobal demand and the price of minerals were very high during this period. Inthe real estate and the telecom sectors, growth resulted directly fromincreased middle class incomes due to the first growth boom. The impetus inconstruction was the result of conscious policy decisions of the governmentthat wanted to push for big infrastructure projects.

Interestingly, the growth momentum in all these sectors was based on aclose relationship between the political class and big private investors. Themineral sector, which was earlier completely under the public sector andcatering largely to domestic demand, was consciously opened up to big privateinvestment and exports. The real estate sector, previously made up almostentirely of small players, saw a number of large private investments duringthis period. In the telecom sector, the nature of the market ensured that onlybig players could participate. Even in the construction sector, some of the bigprojects like airports needed huge investment and big businesses.

Undoubtedly, these sectors needed to be developed for sustained andcontinuing growth in India. The problem was that policymakers thought that theset of reforms made in and after 1993 would be sufficient to regulate this newkind of growth. On hindsight, we now know that there were very significantregulatory failures in these sectors during the second growth boom. We alsounderstand that the reforms of the 1990s, which focussed on removingconstraints on activity, were insufficient to provide broad-based, corruption-freegrowth in these sectors. Each of these sectors needed a different governancestructure and set of regulations, which were not put in place before thesectors started growing at a very rapid rate. We also know that the regulatoryfailures during the second growth boom led to a very strong institutional andpolitical backlash since 2010.

This backlash manifested itself in several ways. Since 2010, the mediabegan raising issues of corruption and crony capitalism in these sectors. Next,civil society got involved and voiced its opinion on the need for alternativeregulatory and anti-corruption institutions like the Lokpal. Finally, thecourts passed orders and rulings that criticised the decisions made by thegovernment in these sectors. All this led to what is now being called theparalysis.

In fact, the paralysis manifested itself in the activity of two importantagents of the economic growth bureaucrats and private investors. Once thecourts gave adverse rulings on the decisions taken by some bureaucrats, thebureaucracy as a whole became jittery about taking decisions, sometimesdeferring to them to the extent that projects simply ground to a halt. Privateinvestors, on the other hand, found out that formal and informal understandingsthat they had entered into with the political class were not as secure as theyhad thought them to be, especially in the face of court cases and popularpolitical uprisings like the one in Singur. This uncertainty that crippled boththe bureaucracy and private investors led to the collapse of investment andgrowth rates.

So, what should the new government do to bring back growth? The first thingthat it needs to do is to move the economy out of this paralytic state.Clearly, the approach has to attempt to rejuvenate both the bureaucracy and theprivate investor. Here, the government has indicated that it intends to do thison a priority basis, but these are complex institutional problems and havingthe right intent may not be enough, unless the nature of the problem is wellunderstood.

Take the case of the bureaucracy. The government needs to ensure that thebureaucracy does not become a part of any deal-making with the business classwhich can lead to decisions that are not in the best interests of the country.This means that there needs to be strong penalties for any malpractice bybureaucrats. However, if the government adopts an approach that stronglypenalises the bureaucracy for any outcome that is less than satisfactory, thenthis may lead to a very risk-averse bureaucracy, which also hampers vibrantdecision-making. In effect, the government needs to put in place a system whichcan differentiate between the deliberate malpractice of the bureaucracy andpoor decisions that it may occasionally take even with the best of intentions.

The crony-capitalism associated with the second growth boom resulted in allsorts of informal deals between the political and the business class, whichinitially raised investor confidence in this period, but later led to abreakdown in confidence when the deals were challenged by ‘accountabilityinstitutions’ like the Comptroller and Auditor General of India (CAG), theCentral Bureau of Investigation (CBI) and the courts. Any future relationshipbetween the political class and the business elite has to be based on formalrather than informal deals. This will not only help investments become lesscostly due to a fall in transaction costs but also assure investors that thesedeals will not be reneged in future. Ultimately, only that can bring backinvestor confidence. In practical terms, this means that sectors which areprone to high rents and crony capitalism need to have more appropriateregulatory mechanisms. This will encourage investment and growth withoutcausing future political backlash. Once these sectors are taken care of, theinvestment climate will no longer be held hostage to investor paralysis. It isthen that the government can shift focus to structural factors likeinfrastructure, etc.

The other crucial thing that the government needs to do in order to sustaingrowth is to control inflation. Inflation has always been partly demand-drivenand partly structural, due to elements like supply bottlenecks. In India, inthe last few years, it’s the structural part which is almost always drivinginflation, particularly food inflation. While the Reserve Bank of India (RBI)and monetary policy can ensure that inflation does not lead to hyperinflation,unless we solve the problem in the food sector, we will keep on having highinflation rates. Hence, interest rates will not be able to come down, hamperinggrowth.

In order to solve this problem, the government has to think out of the box.First, it has to have a clear idea about which part of the food chain is reallyresponsible for inflation. It is widely discussed that while farmers are notgetting adequate returns from the prices they get, consumers pay a high pricein the retail market. The government needs to put in place a system whichcollects data on a real-time basis about various stages of the agriculturalpricing process, right from the farm up to the retail market, so that we canidentify where the problem lies. Once there is an adequate understanding ofthis phenomenon, the government can take appropriate measures to minimise it. Thesemeasures will have to involve the enabling of more competition at some level ofthe wholesale business, after the produce leaves the farm, but before itreaches the retail market.

Reviving growth and checking inflation is the primary mandate that the peopleof India have given to this government. It has to be understood though thatthere is no magic wand to achieve these goals, and it will take time to put inplace some of the institutional changes that are necessary for a return to highand sustained growth rates. If the government succeeds in putting these changesin place and reviving growth, it would have successfully dealt with its biggestchallenge.

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