THE INDIA ECONOMY REVIEW 2009 www.iipmthinktank.com Volume VI | Quarterly Issue: 30th September 2009 www.gidf.org

THE HYPOCRISY OF FREE MARKETS & MYTH OF FREE TRADE RETHINK INSIDE THIS ISSUE EDIFY Murky Economics DELINEATE Wobble Markets Protection’s Price Open World Bound Together Rethink And Resurge

AN IIPM THINK TANK & GREAT INDIAN DREAM FOUNDATION PRESENTATION THE GREAT INDIAN DREAM

“A Society where man is at the centre of all activities, a society where exploitation of man by man has been abolished, where he is cared for as an in a family, where “to each according to his need’ is practised, a society where non bureaucratic National Economic Planning is given due importance for sustainable optimum growth, where adequate social safety net is a reality and yet market’s advantages are fully taken care of for creativity and entrepreneurship, such a society can be truly described as humane society and the vision as “Humanism”. Dr. M K Chaudhuri The Great Indian Dream, 2003, Macmillan India,New Delhi

“Let us together dream of a country where poor are not just merely reduced to statistics but where there are no poor. Let there be a day when small children are taken to a poverty museum like science museum where they shiver at the plight of the way people used to live in the last millennium. Let this dream take the form of a revolution and as long as our dreams keep outweighing our memories, India would remain a young and dynamic nation on this path to global equality. And for this let the wait not be for eternity. Let us together achieve this in the next 25 years.” Prof. Arindam Chaudhuri The Great Indian Dream, 2003, Macmillan India,New Delhi IIPM: THE FUTURE IS HERE

Since its incorporation (1973), IIPM has been an institution with privileged traditions, in the diversity of its fraternity, its global outlook, its world class research and its commitment to alternative national economic planning process. It can be said, without much oversimplification that there are no ‘underdeveloped economies’. There are only ‘under managed’ countries. Japan 140 years was ago was an underdeveloped country by every material measurement. But it very quickly produced management of great competence, indeed of excellence. The policy inference is that ‘management’ is the prime mover and ‘development’ is the consequence. At IIPM, every one considers that development is a matter of human energies rather than economic wealth. And the generation and direction of these human energies is the task of ‘management’. Accordingly, we formed The Great Indian Dream. Unlike any other dream, this is one dream which each one of us are determined to realise and that too in our own lifetimes. Each bit of cynicism and condemnation from pessimists makes us evolve even stronger and determined. All our endeavours and initiative is towards realisation of this dream, where in we produce committed ‘bare foot’ managers and entrepreneurs who are needed by nation, on an insistent basis. As an educational institute, we aim at initializing a three dimensional personality in IIPMites, viz.  Pursuit of knowledge in economics and management  Commitment to economic, social, political and technological upliftment of masses and  Cultivation of taste for literature, fine arts and etc. Economists often have limited access to the practical problems facing senior managers, while senior managers often lack the time and motivation to look beyond their own industry to the larger issues of the global economy. It has set before it the twin tasks: to reorient education and research towards the needs of both the private and public sectors and to establish the link between the National Economic Planning and the development of private enterprises in Indian economy. IIPM dares to look beyond, and understands that what we teach today, other adopt tomorrow. IIPM’s service output (education, research and consulting,) is a unique combination of two distinct disciplines: economics and management. Through this integration, IIPM helps guide business and policy leaders in shaping the Indian and global economy, bringing together the practical insights of industry with broader national and global perspectives. A hall mark of IIPM is that it is armed with the comparative advantage of engaging the committed, passionate and brightest management post graduates and undergraduates, who pursued the education at IIPM and subsequently joined it, to realise the dream. IIPM alumni, spread across the globe, holding crucial decision-making positions in the corporate sector, are bonded by the one ideology of making a positive difference, turning that ideology into a movement itself. The India Economy Review is another humble initiative towards the realisation of the same and more distinctly, engaging the broader publics and pertinent stakeholders. SEARCH, SIEVE, SCHEME... In economics, like in everyday existence, it is imperative to hear, perceive and consider what others have to say. Each issue of The IER brings together a selection of important contributions on a particular theme, authored by some of the brightest minds in different areas of Indian economics. The provocation for publishing these issues arises from the fact that over the years economic journals have become copious, exclusive and expensive. Most of the journals and a good many of the books have gone beyond the cerebral and financial reach of general students and other scholars. It is for them that these issues are primarily being raised and debated here. Much about India is transparent enough. One does not require detailed criteria, cunning calibration or probing analysis to pinpoint India’s problems and recognise its antecedents. There is in fact much that is perceptible about India. But not everything about India is even if simplistic is so simple. The learned reader would appreciate the fact that India is like an elephant that looms too large to be grasped within a distinct structure and paradigm the constituent parts of which would fail to reveal the entirety. Obviously and observably, no suggested solution to any protracted and complex socio-economic problem will satisfy all sides and stake-holders evenly. Consequently, there exists an enormous diversity in economic thinking and perspectives, as is also reflected in the viewpoints of different expert contributors in this issue. The intended outcome of this exercise is to facilitate the invention, improvement, deliberation and dissemination of innovation in economic thinking and national economic planning, insisting merely on well-grounded, open and unbiased debates, without predetermined outcomes. It is impossible to do justice to the entire field of Indian economics in a single issue. The topics selected for this issue are those which are of critical and immediate importance to India. Majority of them were freshly and exclusively written. Encapsulated, it is a constructive attempt aimed at helping India actualise its promises and potential. The editors hope that this issue of IER proffer the reader a flavour of dynamism and excitement and persuade her/him to participate in the journey towards realising ‘The Great Indian Dream’. At the same time, it illuminates the terrible, practical problems of India and Bharat.

ACKNOWLEDGEMENTS The IIPM Think Tank likes to thank all the internal faculty who have been instrumental in coordinating with many authors all across India and according their unstinted support. The assistance of Prof. R.Krishnan (IIPM Lucknow) Prof. Amlan Ray (IIPM Lucknow), Prof. Tareque Laskar (IIPM Bangalore) and Mr. Robin Thomas (IIPM Ahmedabad) has been more valuable than, perhaps, they realise. Mr. R. Nagendra Prasad, Senior Manager at SMG, IIPM Hyderabad, particularly did all that it was possible to do for this issue of IER. Lastly, Prof. Shyam.S.Pujala (Dean, IIPM Hyderabad) deserves a special mention for his eager and energetic support, without which this issue would not have been possible. CREDITS The First Words And The Last Word Founder Dr. M. K. Chaudhuri Editor-in-Chief Open Economy: A Boon or Bane for India? Arindam Chaudhuri Managing Editor Prasoon.S. Majumdar Deputy Editor M.N.V.V.K. Chaitanya Consulting Editor Prashanto Banerji Dear Reader, Research Fellows Pathikrit Payne Umpteen wasted years, countless useless Shweta Shukla Sray Agarwal treaties, innumerable No votes, unnumber- Akram Hoque Mrinmoy Dey able broken promises and the growing sen- Mufaddal Poonawala Group Design Director sation of helplessness by all economies (de- Satyajit Datta veloped and developing otherwise). Ever Senior Designer Prasoon.S Majumdar M.N.V.V.K.Chaitanya Amit Sharma Designer since the beginning of the fi nancial crisis, Managing Editor Deputy Editor Dinesh Chandelkar, Saurabh Mishra the policymakers around the world exerted Parvesh Kumar Swami, Sandeep Sharma interested in. In non-thematic section, Sujit Singh, Satyakam Banerjee strong pressure to enforce the protectionist Senior Illustrator the joint paper authored by Dr. Suresh Shantanu Mitra trade policy. China, India and other emerg- Production Manager Chandra Babu and Dr. G. Bhalachandran Gurudas Mallik Thakur ing market economies are on the crossroad Production Supervisors stresses that let Indian society lead the Digember Singh Chauhan between pursuing free trade policies or im- Soumyajeet Gupta rest of humanity towards pro-environ- Satbir Chauhan posing protectionist trade policies. Against Chief Marketing Advisor mental-actions and thus paves the way for Amit Saxena this macroeconomic backdrop, IER invited Marketing & Sales pollution -free planet. In ‘Sectoral Snap’ Neha Malhotra the participation of academia, industry and IER Online section dealing with Indian retailing sec- Neel Verma, Anil Kumar Sheoran, Himanshu Negi, policy-makers to address theory and prac- Christopher Mani tor, Dr. Mohammad Amin argues that Principal Offices Satbari, Chandan Haula, Chattarpur, tice regarding the linkage between develop- Bhatimines Road, New Delhi - 110074 competition policies that are currently IIPM Tower, Junction of , 32nd Road & S.V. ment, trade and policy making. An intent Road, Bandra (W), Mumbai - 400 050 focused exclusively on fi rm-behaviour IIPM Tower, 419 100ft. Road, Koramangala, is to highlight the criticality of developing Bangalore - 560 034 should pay more attention to consumer IIPM Tower, 893/4, Bhandarkar Road, rightful policy decisions in boosting seam- Deccan Gymkhana, Pune - 411 004 behaviour and consumer attributes that IIPM Tower, 145, Marshall’s Road, less fl ow of trade in all variants and across Egmore, Chennai - 600 008 IIPM Tower , 19, Inqulab Society, gulbai Tekra, shape consumer behaviour. Off C.G. Road, Ahmedabad - 380 015 all markets. Research papers, case studies IIPM Tower, 6-3-252/2, Erramanzil, Banjara Hills, You can click straight through to each Hyderabad - 500 082 are invited on all aspects related to these We are keen to hear from anyone, who would like to one and read it online at our website, know more about IIPM Publications. You can e-mail on strategic facets. Of special interest are those [email protected] or alternatively call Ms.Shweta www.iipmthinktank.com. at 9811895267 papers with specifi c focus on theoretical Additional Thinking Happy Reading www.iipmthinktank.com www.iipm.edu focus and development strategies with his- www.iipmpublications.com Best www.arindamchaudhuri.com torical perspectives, specifi cally the opinion www.thesundayindian.com www.thedailyindian.com pieces authored by John Kozy, noted socio- www.businessandeconomy.org www.gidf.org economic philosopher, Rok Spruk, doc- www.planmanconsulting.com Printed by: toral candidate from Slovenia and Dr. Elis- Rolleract Press Servies, C-163, Ground Floor, Naraina industrial Area, Phase-I, New Delhi - 16 Disclaimer : abeth Tuerk of UNCTAD. The research All efforts have been taken to ensure the veracity of the information contained in the research, however the IIPM Think Tank expressly paper wrriten by Dr. M.S. Goel records the disclaims any and all warranties, express or implied, including Prasoon.S.Majumdar without limitation warranties of merchantability and fitness for a experience of developing economies in particular purpose, with respect to any service or material. In no event shall the IIPM Think Tank be liable for any direct, indirect, trade negotiations in twenty fi rst century. incidental, punitive, or consequential damages of any kind whatsoever with respect to the and materials, although the reader Aditionally, there are some other pieces may freely use the research and material provided, the IIPM Think Tank retains all trademark right and copyright on all the text and graphics. from this periodic issue you might also be M.N.V.V.K. Chaitanya (F)ACT SHEET

Globalization LAW AND ECONOMICS: Open Economy: Law Growth Nexus A Boon or Bane for India? Review of Economic Development Misu Kim & Susmita Mitra 60 and Legal System: An International OPEN WORLD: Game Theory Perspective A Model of North-South Growth and Uma Sankaran 132 Trade as a Differential Game Problem LAW AND ECONOMICS: Flat World with an Empirical Illustration Free Trade and Free Markets: T. Krishna Kumar 68 A General Law Perspectives OPEN WORLD: Bound Together Rabin Majumder 142 Evolution of World Trading System ENVRIONMENTAL ECONOMICS: and Future of Free Trade: Silent Spring st Cover Design: Satyakam Banerjee A 21 Century Experience Mitigating Environmental Crisis: M.S. Goel 76 Can India Show the Way? OPEN WORLD: Murky Economics G. Bhalachandran & OPEN WORLD: Wobble Markets Murky Economics—Comparative Suresh Chandra Babu 146 Woebegone Government, Wobbly Advantage & Free Trade Theory ENERGY ECONOMICS: Charging Ahead Markets and the Economic John Kozy 82 Wind Energy in India - Management: Rethink, Recast, GROWTH ECONOMICS: Stock Taking Reforms to the Rescue and Resurge The India Story: Served Sunny Side Up Ritesh Agarwal & Shiva Agarwal 152 K.K. Srivastava 08 Ketaki Sharma 88 MICRO MACRO: Entrepreneurial Ethos OPEN WORLD: India Arriving GROWTH ECONOMICS: Mismatch between Entrepreneurial India’s Bits-Network What’s This India Business? Intention and Environment - A Survey Attracting Investment for Is Rising Share of Services in Burdwan District of West Bengal Realizing Development Benefi ts Inevitable for GDP Growth? Soumyendra K. Datta & Elisabeth Tuerk 16 Madhusudan Dutta 92 Rimu Chaudhuri 158 OPEN WORLD: Naked Economics GROWTH ECONOMICS: MICRO MACRO: Social Edge Policy Transparency and Evaluation An Elusive Quest Microfi nance at Turning Point: for Economic Growth in India Modern Theories of Growth: Success Factors of Microcredit in Valentin Zahrnt 28 A Critique Bangladesh and Its Future Prospects OPEN WORLD: Power and Control Ambar Ghosh & Chanadana Ghosh 100 Tomohito Kanaizuka & Regulating Markets WELFARE ECONOMICS: Farhad Hossain 166 in the Post-Crisis World Rethink and Resurge SECTORAL SNAP: Retail Roulette Shalendra D. Sharma 34 Employment Guarantee, Not Consumer Behavior and OPEN WORLD: Missing Markets Employment Subsidy Approach Competition in Indian Retailing Market Failure and Suits Indian Conditions Mohammad Amin 176 the Need for Regulation Saumitra Mohan 112 COUNTER CURRENTS: Trust Busting Anjan Panday 38 WELFARE ECONOMICS: Crisis in Academic Economics OPEN WORLD: Recast and Restructure Amol Agarwal 184 From Columbus To ConAgra Governance and Employment GLOBAL GOVERNANCE: IMF Trade Liberalisation and Indian Farm Generation in Rural Areas: New Resources for Sector: Understanding the Situation A Case Study of NREGs in Selected an Unreformed IMF? from Available Evidence Districts of West Bengal Kunibert Raffer 196 Subrata Dutta 46 Byasdeb Dasgupta & Bipul De 118 GLOBAL GOVERNANCE: Unbearable OPEN WORLD: Protection’s Price WELFARE ECONOMICS: Water Wisdom Lightness The Harmful Impact of Protectionism NRDWP – A Paradigm Shift in Rural The Unbearable Lightness of Rok Spruk 54 Drinking Water Supply Financial Markets OPEN WORLD: Goldilocks Benny George 126 Heiner Flassbeck & Sonia Boffa 202 O PEN WORLD Woebegone Government, Wobbly Markets and the Economic Management: Rethink, Recast, and Resurge K.K. Srivastava Lead Economist, The IIPM Think Tank, New Delhi

stylized assumption is that if the government does what it must – provide a secure environment – and if Amarkets have perfect competition then a free market economy will allocate resources with relative effi ciency. Alas, real world is characterized by existence of common property resources, public goods, negative externalities, and excessive market power concentrated in some hands. Government intervention, becomes necessary to correct market failures. Besides, in addition to potential for ineffi ciency a free market economy essentially deals with the dilemma of economic inequity. This further adds to government responsibilities. Markets are considered to be superior to central planning since they provide more, better and cheaper information for decision making. They provide a relatively more fl exible system with a great scope for personal adaptation. These adjustments can be made much faster. And they decentralize power. In a perfectly competitive market both production effi ciency and allocative effi ciency are attained. Thus each fi rm produces at least possible cost, all fi rms within an industry face the same price and marginal cost, and the marginal cost of

8 THE IIPM THINK TANK W OBBLE MARKETS

producing each good is equal to its market price. This is the failure is called ofcourse ineffi cient exclusion. And, to avoid idealized situation. In real world, almost all the fi rms face a ineffi cient exclusion the government itself often provides negatively sloped demand curve, leading to equilibrium price them, like a public park. The service is provided free and the being always higher than marginal cost. Market fails, i.e. costs are met out of other levies like taxes. allocative ineffi ciencies emerge. And government gets a On the other hand common property resources pose legitimate right to intervene so as to improve – even if not another problem: these are diminishable but non-excludable. eliminate altogether – the market effi ciency. Though any Under the free market provision common property resources student of economics knows about circumstances under which will be used upto a point where the marginal cost of the last markets fail, these bear a remention: entrant equals the average output of all existing producers. One, producers with excess capacity set prices which lead to The socially optimal exploitation though would occur when ineffi cient exclusion; two, each economy has common property the marginal cost of the last user equals the value of the resources that belong to none specifi cally but can be used by marginal addition to total output. Result: overexploitation. anyone; so these are prone to be overexploited; three, there While the solution may lie in fi xing quota (say, for fi shing in exist public goods where nondiminishability and non exclusion the sea) or licensing, the problem lies in enforcing the restric- apply; four, people not participating in a market transaction tion which are both diffi cult and costly to implement. Another may still be affected due to the outcome, i.e. they may suffer solution suggested is to make them excludable: privatize the negative externalities or enjoy positive ones; fi ve, there exists forests, wildlife, etc. so that the private owners will have a the problem of asymmetric information – one party having tendency to exploit them effi ciently. But equity issues arise: unfair advantage over the other because of access to better those who were using them earlier for free perhaps will suffer information needed for economic decision making; six, some a welfare loss. The classic dilemma of equity vs. effi ciency. markets – known as missing markets – may be needed but may Public goods are both nondiminishable and non excludable, not exist, may be due to uncertainties, adverse selection i.e. these are produced for collective consumption, say possibility, and so on; and, fi nally, seven, information. But because public goods are imperfect competition may lead to an equi- non excludable, private producers are not librium price higher than the marginal Society’s resources interested in providing them. So products cost. are optimally like weather forecast, fi re protection, etc. Given all of the above the government allocated when are provided by the government, and for has two options – replace the market with the social free. So the free rider problem is also central planning (as was unsuccessfully avoided. But the issues of over or under tried in many centrally planned econo- marginal cost production is more diffi cult to settle since mies) or may seek to correct the ineffi cien- equals the social now there is no market for such products. cies through direct and indirect interven- marginal benefits Talking of externalities, society’s tion. To be sure, however, such resources are optimally allocated when interventions are neither costless nor error free; the post social marginal cost equals social marginal benefi ts. But in intervention outcome may at times be less desirable than an case of positive externalities the output produced is invariably ineffi cient market functioning! less than the socially optimum level while in case of negative Thus we know that markets work best when goods and externalities this output exceeds the socially optimal levels. services are available in a fi nite amount, are diminishable Naturally, therefore, to achieve optimally production of upon consumption, and non payers are excludable. But output with benefi cial externalities needs to be encouraged actually some goods and services, say an art gallery, may be while the other kind, with harmful effects, needs to be cut excludable though not diminishable. If these goods are down from the level that would be produced under free provided privately then the price will exceed marginal cost and market conditions. some people who are willing to pay more than this marginal Most – though not all – externalities arise because of cost but less than current price do not use it. This kind of absence of property rights – I don’t own the air that I pollute

THE INDIA ECONOMY REVIEW 9 O PEN WORLD

nor does the one who suffers from polluted air. So to the Since 1980s (in India since 1991) there has been a movement extent that appropriate property rights can be created, these in many developed and developing nations to deregulate and/ externalities can be internalized. Else, we will have to learn to or privatize. This is mainly due to a growing belief among live with externality. policy makers than private fi rms operating in free markets are Asymmetric information of course leads to issues like moral more effi cient producers and innovators than governments. To hazard and adverse selection. Due to moral hazard social costs be sure this is not to suggest zero intervention. Remember, we are unnecessarily high (a careless but insured driver) while in had quoted seven situations of market failure. In the presence case of adverse selection market outcome is less effi cient than of many of these it is not necessarily effi cient to allow the free when all the participants were equally well informed. One markets to decide all issues of resource allocation. The least possible solution could be again state intervention to impose stringent form of government intervention of course seeks to standards and level to which information has to be compulso- create conditions of competitions by preventing fi rms from rily revealed. But in many situations government can’t do merging unnecessarily or colluding to set monopoly prices. In anything to ensure availability of ‘fair’ information to transact- general competition by preventing fi rms from merging ing parties (a doctor determines whether by pass surgery is unnecessarily or colluding to set monopoly prices. In general essential on a heart patient or not, based on the fact may be competition policy aims at preventing the fi rm from ganging that he will be richer by a few lakh rupees?) up against hapless consumers. Coming to the missing markets, of course markets don’t exist for public goods or common property resources, but Argument So Far..and Further these don’t exist for products involving uncertainty (i.e. non Briefl y put, we can say that effective governments defi ne and insurable events) too. For example, while future markets for protect the rights and obligations of private property. Market commodities do exist because these are well established and economies seek to coordinate decentralized decisions without unchanging, no such markets exists for conscious control. In the process they also most manufactured products. Who knows determine the distribution of income. after all whether LED will replace CFL in Regulatory Thirdly, compared with the alternatives, India in next three years or not, when arbitrage infact perfectly functioning markets attempt to CFLs themselves are struggling to replace causes as much minimize concentration of economic the ordinary light bulbs. Future markets economic losses to power. To the extent desirable outcomes are missing and there is no way that the do not occur, the government needs to costs and benefi ts of planned future the country as do intervene – to enhance effi ciency and to expenditure on these products can be the poor decisions come closer to (subjectively defi ned) equated by today’s transactions. by the Executive equity goals. Thus even if the markets work Finally, market power is unequally well most times, they seldom work opti- distributed; perfectly competitive markets with atomic fi rms mally because of the inevitable presence of one or more of are mere theoretical constructs. Yet competition must be market failures. So the government policy attempts to alleviate encouraged and monopoly practices must be curbed. This can these failures. either by imposing more effi cient behaviour by be done by either infl uencing the market structure or the rules, regulations, and even public production or by internal- market behaviour. So most governments follow a competition izing externalities. policy wherein they may try to directly control natural monop- But while government interventions may have potential to olies, they may directly control harmful monopoly and improve the workings of the markets, this does not mean that oligopolies, and they may seek to create more competitive they always get it right. In this regard we need to note fi ve conditions. Thus in case of natural monopolies like say important facts. First, governments have many objectives to electricity distribution the government either assumes owner- pursue in addition to effi ciency, viz., growth, stability, and ship of the single fi rm (Delhi Vidyut Board earlier) or priva- equity; second, growth and equity objectives may actually tizes it (BSES, etc) and then regulates it (through DERC). confl ict with effi ciency goal; third, government uses policy

10 THE IIPM THINK TANK W OBBLE MARKETS

tools like fi scal policy, legal provisions, regulations, as well as ance costs, and even losses in productivity. Not only this even state entrepreneurship to attain the economic objectives; indirect external costs are involved such as effi ciency losses fourth, these government interventions involve both the direct that spread throughout the whole economy; these in turn may cost of administration and indirect costs associated with be an outcome of the alteration in price signals caused by interference with the price mechanism; and, fi fth, the govern- government tax and spending policies. ment in practice may have incentives to consciously deviate Like we said earlier that the governments intervene to from delivering economic effi ciency (an impending election reduce the imperfections of the market, let’s also candidly and a soft budget). admit that the potential for benefi ts would exceed costs also in Thus the government policies are directed at modifying the a world where the government functioned perfectly. Which income and wealth distribution that was ordained due to one’s ofcourse is like a utopian dream. Government failure – not parent’s abilities, luck, and market for him. But often the goals achieving some possible gains – can arise because of rigidities of a more equitable distribution confl ict with the goals of a causing a lack of adequate response of rules and regulation to more effi cient economy. The government has to at times changing conditions, poorer foresight on the part of govern- protect one person from abusive potential exercised by other ment regulators compared with private participants in the (thus law against child labor) or protect someone from his own market, and government objectives – such as wining the next

Table 1: Functions of the State

Addressing Market Failures Improving Equity Providing Pure Public Goods Protecting Poor - Defence - Anti Poverty Pro- Minimal - Law and Order gram Functions - Property Rights - Disaster Relief - Macroeconomic Management - Public Health Externalities Monopoly Regulation Imperfect Information Social Insurance Intermediate - Basic Education - Utility Regulation - Financial Regulation - Redistributive Pen- Functions - Environment Protection - Anti Competitive Policy - Consumer Protection sion - Unemployment Insurance Activist Coordinating Private Activity Redistribution Functions - Fostering Markets - Asset Redistribu- - Cluster Initiative tion

Source: World Bank: World Development Report, 1997. self (a potential/actual drug addict). Besides, sometimes the election; they confl ict with such objectives as improving government may have to invoke social obligations (like economic effi ciency. compulsory military enlistment, or vote in the election or at Having said so, contrary to the popular perception, the role least have no right to buy one’s way out of jail for an offence of the State has increased in the economic management in committed!). For achieving all these goals and more the recent decades rather than diminishing. Only that this increase government has in its toolkit such instruments as taxes, in the State’s infl uence has shifted the emphasis from the spending, rules and regulations, as well as state ownership. quantitative to the qualitative, from the sheer size of the State But government activity entails incurring of direct external and the scope of its intervention, to its effectiveness in meeting costs imposed on those directly affected by these policies. people’s needs. These could be in the form of extra production costs, compli- Today’s renewed focus on the State’s role has actually been

THE INDIA ECONOMY REVIEW 11 O PEN WORLD

inspired by dramatic events in the global economy, which have stages of this continuum, or even between the two stages. fundamentally changed the environment in which States What one needs to appreciate is that each stage (from operate. The global integration of economies and the spread monopoly to dynamic competition) exhibits different charac- of democracy have narrowed the scope for arbitrary and teristics and throws up different challenges. Depending on capricious behaviour. Taxes, investment rules, and economic the pace at which the particular industry is orienting itself to policies must be ever more responsive to the parameters of a fair competition, regulatory task will be customized; we can’t globalised world economy. Technological change has opened have standard regulatory process. Hence it is important for new opportunities for unbundling services and allowing a us to understand the unique characteristics associated with larger sole for market forces. These changes have meant new each stage. and different roles for government no longer as the role provider, but as facilitator and regulator. All under the triple Stage-1: The Bliss of Solitude….and the Pains! infl uence of liberalization, privatization, This stage exists prior to deregulation. and globalisation. In India too we are There are strict government controls, free witnessing deregulation in many industries Global economic entry is barred, and the customer is devoid – banking, insurance, automobiles, civil integration and of alternatives. At best there could be a aviation, telecom, and so on. the spread of regulated oligopoly structure. Naturally When the economy moves from pro- democracy have pricing is distorted with the cost being the tected monopolies to market competition, major determinant of fi nal price. At times in the interim we need strong and effective narrowed the the government may intervene in matters of regulators. Else, there is likely to be a scope for arbitrary pricing in the interests of social justice; in heavy cost in the form of rent seeking, & capricious acts such a case the monopoly maintains cross reduced effi ciency, and compromise with subsidization scheme to remain in surplus/ consumer welfare. And even at the risk of stating the obvious profi t. Many a time profi t may even be treated as a dirty word. different industries are at different stages of freedom and So there is hardly room for, or inclination to, work effi ciently. deregulation. So they need different kind of treatments. On the other hand not much surplus is generated so that CAPEX is constrained. Alternatively, there may be an excessive Whiffs of Competition in Successive Stages bleeding of existing assets. Protected status and lack of incen- There exists a continuum from protected monopoly to market tives kills the scope for innovations. Sure, we witnessed all this, competition. Depending on historical evolution pattern and more, in insurance industry, airlines business, oil and gas different industries fi nd themselves in one of the fi ve distinct sector, etc. before 1991.

Table 2: Evolution of Competition and its Maturing

Stage-1 Stage-2 Stage-3 Stage-4 Stage-5 Solo Player Some Players Several Players Select Few Survivors Little or no competition Entry cases Dogfi ghts begin Shake out happens Souls with sustainable advantage - Railways - Electricity - Organised Retailing - Automobiles distribution - Oil and Gas - Airlines

- Insurance business - Cellulars

- Mutual Funds Source: Self constructed by the author Note: The industry placements are in Indian contexts while the stages are applicable generally

12 THE IIPM THINK TANK W OBBLE MARKETS

Stage-2: You’ve Got Company try even in the context of fi ve forces model of Michael Porter. The markets may be opened up and pricing freed. To smoothen The industry has consolidated itself, with each player having the process an independent regulator may be appointed. Private carved out a niche for itself. Costs are squeezed and prices set players may be allowed but with restriction like equity caps, no under the optimum infl uence of 3C’s – cost, customer, and foreign participation, etc. This also means, however, that under competitor. Having earlier ventured adventurously into territo- the euphoric feeling of a (false/limited) sense of freedom the ries unfamiliar, most incumbents now choose to come back to players fail to fully appreciate the impending perils of change; their core customers. Market itself is the regulator now; it is some of them at least are lulled into complacency either because regulation by exception. they have joined this stage from being earlier in Stage-1 (mo- nopoly/regulated oligopoly) and have not yet overcome their Stage-5: Darwinism Rules, Truly! sense of invincibility, or they are new to the industry with little Only competition rules the entire market place. Prices are appreciation of all the dimensions of the working. Euthanasia fl exible under the dynamics of forces of demand and supply. begins, or is it hara kiri? Proactive companies alone grow; reactionaries have no role once the revolution has taken place! So the marketplace is ever Stage-3: Commoditization Reappears evolving to meet the changing needs and preferences of custom- Due to gradual deregulation competition spreads deep and wide. ers. The competition is more global than local. Regulators retire Products and services proliferate and customers are spoilt with into oblivion! alternative offerings at very heavily discounted prices. Currently, the airline industry, mutual funds industry, and even cement Time to Let Go? Well, Yes and No industry is in this stage. Individual market shares decline, newer While everyone agrees that market failures, which are as and more nimble players emerge which fi rst take on the best and ubiquitous as the presence of the market itself, are ground then the rest, and fi nances, talent pool, and all resources face enough for the government to intervene with regulations, crunch situation. While there are more births (new entries), actually the latter are required even when the markets work numbers of those dying (exiting) in not so distant a future is likely perfectly. Even competition needs to take place within a frame- to surpass the newborns. work of rules. The protectors of law must remain within the range of vision, even if they are not required to galvanize into Stage-4: There is Room for Few Only action at a given point of time. Competition yes, unfair competi- By now the market is almost completely deregulated; competi- tion no. tion is formidable. The customers are very well informed and By one estimate, America, the supposed land of the unfet- know their mind. The select few players who have been able to tered, has nearly 78,000 pages of regulation, and 2.41 lakh survive have gained critical mass and well ensconced in the indus- employees to ensure their enforcement. A McDonald burger has to follow 80 different regulation before Table 3: The Regulator: Ideal vs. Indian a customer bites into it. But then there is such animal as an Ideal Indian ideal regulator who is very different - Statutory backing, with clearly defi ned - Statutory backing, but relevant laws from an Indian incarnation. We have, powers may remain unamended interalia, regulators for aviation, - Independent, free from bureaucratic - Dependent, heavy interference interference broadcasting, cellulars, disinvestment, - Accountable only to legislative - To Parliament and to the Ministry insurance, petroleum and natural gas, - Funding from independent sources - Budgetary support ports, power, roads, telecom, and - Independent secretarial for technical - Relies on Ministry for such support (proposed for) water. However, all of support - Transparent functioning. Consultative - Not very transparent, through con- them suffer from certain inherent discussions sultative weaknesses, the biggest one of which is Source: Business Today (August 7th,1999): The Dependent Regulator lack of independence.

THE INDIA ECONOMY REVIEW 13 O PEN WORLD

Regulatory arbitrage infact causes as much economic losses allow interference by the Ministry concerned. For to the country as do the poor decisions by the Executive or the example, does the Ports Trust Authority set only tariffs misdemeanours of the market players. India has failed on one or is it responsible for everything else too? In an ideal hand in regulating capacity building and on the other from a scenario, violated of course in India, in a general policy weak regulatory oversight. Thus instead of appointing compe- framework the regulators are empowered to implement tent and committed professionals, these positions are used for the rules. Finally, granting operational autonomy helps parking retired bureaucrats and judges. And with shorter insulate the reform process from bureaucratic interfer- Parliament sessions there remains a very limited scope for ence. Parliament’s Executive oversight. Following a predictable pattern the government may 2. Independent Regulators announce setting up of an independent regulatory authority Must Have Independent Funding but it is not notifi ed or constituted for quite sometime (recall One who pays the piper calls the tunes. The government about the authorities for pension regulation or competition). controls the purse strings, and keeps the regulators on a When appointed these regulators lack independence and tight leash. Thus both fi nancial autonomy and fi nancial autonomy. Most regulators thus may be dependent and/or incentive to work effi ciently are lost. And, to be sure, lacking independent powers. independent funding in no way should axiomatically

Table 4:

No Regulation through Active Regulation to Regulation by Exception State Ownership Privatization Competition Where Are We (Railways) (Cellular Industry) (Financial Intermediaries) - Subsidies - Subsidy cuts - Price competition What Are the Issues - Falling effi ency - Price increases - Consolidation Involved - Inter-connection problems - Customer Choices - Nothing; there is no regu- - Tariff bsetting - Monitoring of inter-connec- lator - Fixing inter-connection tion issues What Are Regulators charges - Dispute resulation Expected to Do - Disputes regulation - Monitoring competition - Monitoring of quality, safety - Monitoring of quality, safety etc. etc.

Source: Self constructed by the author

According to Swati Kamal, while writing in Business mean a compromise with accountability. Simple audit- Today, an effective regulatory body is possible only ing of accounts can ensure this. when at least four rules are followed. What does our experience in India tell us? Well, 3. Independent Regulators Must Be Independently Staffed 1. Independent Regulators Likewise, there is a clear cut interference of the con- Must Have Clearly Defi ned Powers cerned ministry in matters of appointment of the For this the underlying Act must be worded unambigu- chairman and members of the body. Worse, they in turn ously. Yet, in most cases, the provisions have been lack independence in selecting their juniors. To be fair, ambiguous, ensuring that the foundation itself is shaky. however, some degree of independence is being pro- For example, the CERC Act does not defi ne the rela- vided now. tionship between the CERC and the SERCs, leaving enough scope for confl ict. Besides, ambiguities can 4. Independent Regulators Must Be Able to Deal With

14 THE IIPM THINK TANK W OBBLE MARKETS

Independent Operators • Harish Salve: Getting it Right (in) Business world, India has the unique distinction – but dubious at that 24th August, 2009. – of the same person being in a dual position of being a • J. K. Mitra: The Right Chapter (in) Business world, regulator and being the regulated (examples, at least 24th August, 2009. earlier, from telecom, insurance, and so on). Obviously, • Jagdish N. Sheth, Allvine, Uslay & Dixit: Deregula- when both the operator and the policy maker are same, tion and Competition. Response Books (2007). friction is bound to occur. Besides, when the incumbent • Jayant Sinha: Time to Let Go (in) Outlook Business, player/policy maker faces competition (as in case of civil 19th September, 2009. aviation) the policies will be designed to protect mo- • Michael Porter: Competitiveness and Micro – Eco- nopoly status. In India where the government is thus nomics (in) Business Today, 22nd September, 1998 both service provider and policy maker this linkage • Rajeev Chandrashekhar: Regulatory Dysfunction (in) needs to be severed. Why not corporatize the SEBs, for Business world, 31st March, 2008. example? • Ranbir Roy Choudhury: Doing Business in India (in) Business Line, 21st September, 2009. Conclusion • Rohit Saran: The New Political Economy (in) Busi- Indian marketplace is in a transition phase. For a ness Today, February 7th-21st, 1998. developing India if we are conceiving a blueprint for • Rukmani Parthasarthy & Swati Kamal: For the sustaining effi cient growth and investments for the next Reforms (in) Business Today, 22nd September, 1999. periods, cracking the problem of an often dysfunctional • Rukmani Parthasarthy: Freedom in Fetters (in) system is crucial. Else, we will be condemned to suffer Business Today, 7th April, 1999. huge economic losses. There is a need to defi ne and • S. Gopalakrishnan: Cut the Red Tape (in) Business implement the fundamental rights for citizens as well as world, 24th August, 2009. businessmen. And then ensure that no one violates each • Sandeep Biswas: Surviving Deregulation (in) Busi- others’ rights. ness Standard, 11th December, 2001. • Sanita Aggarwal: Airport Regulator Pushes for References and Additional Thinking Financial Autonomy (in) Indian Express, 22nd Sep- • B. G. Verghese: Why Honesty Doesn’t Pay (in) tember, 2009. Business world, 24th August, 2009 • Shalini S. Sharma: Turning Burden into Boom (in) • Binu Kwatra: The Hidden Costs of Business (in) Business world, 24th August, 2009. Business world, 24th August, 2009. • Sreevalson Menon: Tangled in Red Tape (in) Busi- • Business world editor: The Fundamental Rights of ness world, 24th August, 2009. Business (in) Business world, 24th August, 2009. • Swaminathan S. A. Aiyar: Regulating the Regulators • BW editorial team: Time to Rebuild the Nation (in) (in) The Economic Times, 13th February, 2008. Business world, 24th August, 2009. • Swati Kamal: The Dependent Regulator (in) Busi- • Chandrajit Banerjee: Make Hire and Fire Easier (in) ness Today, 7th August, 1999. Business world, 24th August, 2009. • World Bank: World Development Report, 1997 (by) • D. Thankappan: Workers Need More Security (in) World Bank, Washington. Business world, 24th August, 2009. • Y.C. Halan: The State and the Corporate (in) The • ET Editorial Team: Why Markets Need Regulators Financial Express, 6th April, 2002. (in) The Economic Times, 18th February, 2002. • Y.V. Reddy: State and Market (in) Economic & • Girish Vanvani & Saloni S. Khandelwal: Making the political Weekly, October 16th-23rd, 1999. Right Cut (in) Business world, 24th August, 2009. • Hari Shanker Subramaniam: Notes on Tax Freedom (The views expressed in the article are personal and do not (in) Business world, 24th August, 2009. refl ect the offi cial policy or position of the organisation).

THE INDIA ECONOMY REVIEW 15 O PEN WORLD India’s Bits-Network Attracting Investment for Realizing Development Benefi ts*

Elisabeth Tuerk

Senior Legal Expert, International Agreements Section, UNCTAD DIAE, Geneva

1616 THE IIPM THINK TANK I NDIA ARRIVING

n August 2009 India and the Republic of Korea signed a equivalent to the country’s total infl ows during the period bilateral agreement containing a chapter with substan- 2003–2005. The year 2008 saw a further rise in inward FDI Itive provisions on the promotion and protection of fl ows to US$ 42 billion. Rapid economic growth which has investment. The agreement also sets out pre-establishment led to improved investors confi dence might be amongst the national treatment.1 Counting both, bilateral trade or many reasons for these developments. Similarly, sustained cooperation agreements and bilateral investment treaties growth in income has made the country increasingly (BITs), the India–Republic of Korea agreement is the 82nd attractive to market seeking FDI. Numerous US and international investment agreement (IIA) India has signed. Japanese TNCs (ranging from GM, IBM, Toyota and The agreement with the Republic of Korea is also the third Nissan) and private equity fi rms were playing an important agreement with investment provisions that India has signed role in this context.6 during the last twelve months.2 Outward FDI from India emerged at signifi cant levels at Over the last years India has become one of the most the turn of the century, hence somewhat later than respective active countries in signing IIAs,3 a development which could inward FDI. Since 2000, outward FDI fl ows continued to also be a refl ection of India’s increasing role as a capital- increase year-on-year. Similar to inward FDI, outward FDI exporting country.4 While IIAs can offer fl ows also experienced a jump between an important tool for realizing the 2005 and 2006, from US$ 3 billion in 2005 development benefi ts expected from Similar to inward to US$ 14.3 billion in 2006, constituting increasing inward and outward invest- FDI, outward an almost four times increase just in one ment, care has to be given to avoid FDI flows also year. Outward FDI fl ows rose to US$ 17.2 unintended side-effects of such agree- experienced a billion the following year.7 So far, the ments, including the reduction of domes- amount of inward FDI fl ows/stock has tic policy space and unexpected or jump, from $3 bn. always been substantially larger than unwarranted exposure to Investor-State in 2005 to $14.3 outward FDI fl ows/stock. Dispute Settlement (ISDS) cases.5 bn. in 2006 With the global fi nancial and economic This essay offers a brief sketch of crisis came a signifi cant decrease in global India’s approach to IIAs. It commences with some back- FDI fl ows. However, developing countries are very likely to ground-information on the country’s FDI trends; it then be strong engines for FDI growth in the coming rebound. looks at the evolution of India’s IIA network over time; This is confi rmed by UNCTAD’s recent World Investment followed by an overview of the country’s BITs (based on the Prospects Survey (WIPS) 2009–2011, which places the analysis of twenty two selected BITs). so-called BRIC countries (Brazil, the Russian Federation, India and China) among the top fi ve most favoured destina- 1. Background: FDI Flows to and from India tions for future FDI activities by large TNCs worldwide.8 In In 2008, Indian inward FDI stock reached a substantial addition to a general economic stimulus package, India US$ 123.3 billion, while outward FDI stock reached US$ enacted several policy measures dealing with the entry, 61.8 billion. This turns India into the 24th most important facilitation, and operation of FDI9 and India also continued destination for FDI, and into the world’s 31st largest out- to sign new BITs. In comparison to other countries, overall ward investor. prospects for inward FDI in India are positive. Inward FDI fl ows into India had begun to emerge in signifi cant amounts during the mid-1990s. Though volatile, 2. India’s Network of IIAs: Overview and Trends inward FDI fl ows have been on the increase. A sharp jump An IIA is an international agreement – or treaty – between occurred in Indian inward FDI fl ows in 2006, when Indian two or more countries that addresses issues relevant to inward FDI rose from US$ 7.6 billion in 2005 to US$ 20.3 cross-boarder investments. The most common types of IIAs billion a year later (almost three times higher than 2005). In are bilateral investment treaties (BITs) and preferential trade that year, the country received more FDI than ever before, and investment agreements (PTIAs), with investment

THE INDIA ECONOMY REVIEW 17 O PEN WORLD

Figure 1: Indian Inward and Outward FDI Stock: 1990–2007, nomic Cooperation Agreement (CECA) of US$ Million 2005 and the 2009 Comprehensive Economic Partnership Agreement (CEPA) between India 45000 150000 and the Republic of Korea are examples for the

125000 latter type of agreements. 36000 Compared to other countries, India started 100000 negotiating BITs relatively late, with the conclu- 27000 sion of its fi rst BIT (with the United Kingdom) 75000 Stock Flows 14 18000 in March 1994, briefl y afterwards followed by 50000 a BIT with Russia. In 1995 alone, India signed

9000 seven BITs. With ten new agreements, 1997 was 25000 the year with the largest number of agreements 0 0 concluded, followed by an average of fi ve 1995 1997 1999 2001 2003 2005 2007 agreements per year between 1998 and 2008.15 FDI outfl ow FDI infl ow Despite the fact that India only signed one Inward FDI stock Outward FDI stock agreement in 2004 and no agreement in 2005, the country is still one of the most active BITs provisions. Countries may conclude IIAs with a view to negotiators in the world. In 2008, India concluded six new protecting their investors abroad or with the aim of attracting BITs, continuing an earlier trend with fi ve new BITs in 2006 foreign investors to their economy (e.g., investment promo- and six in 2007.16 In 2009, the country has already signed tion). Through the protection, increased security and two BITs – with Bangladesh and Mozambique – and one certainty under international law that an IIAs offers to other IIA (CEPA with the Republic of Korea). India also investors (companies and individuals) from contracting completed BITs negotiations with Colombia (2009)17 and parties who invest or set up a business in with Canada (2007).18 other countries party to an agreement, An interesting characteristic of India’s IIAs can indirectly promote FDI.10 In 2008, India BITs network is the diversity of its partner Allowing foreign investors to settle concluded six new countries. India has signed BITs with all disputes with the host country through BITs, continuing regions of the world, albeit with a differ- international arbitration, rather than only an earlier trend ent focus over time. During its early years through the host country’s domestic of BITs negotiations, India signed routes, is considered an important aspect with five new BITs agreements mainly with developed in this context. However, the increasing in 2006 and six in countries in Europe (Germany, Italy, number of international investment year 2007 Denmark and the Netherlands in 1995). disputes emerging from such agreements, Today, 24 (30%) of India’s BITs are with as well as the costs and challenges associated with them (e.g., developed countries. More recently, India has concluded fi nancial implications, costs of litigation and inconsistent more agreements with other developing countries (fi ve BITs awards), have given rise to increasing concerns from policy in 2008). Today 38 (51%) of India’s BITs are South-South makers, academia and affected stakeholders.11 agreements, possibly refl ecting both the country’s increasing By the end of 2008, the total number of BITs worldwide role as an outward investor and an increasing focus on rose to 2,676 and the total number of IIAs other than BITs strengthening South-South partnerships. and DTTs amounted to 273.12 To date, India had signed 82 In terms of geographical diversity, much of India’s more IIAs.13 75 of these agreements are BITs and seven are recent negotiating activity has focused on other Asian other international agreements containing investment countries. Out of 38 BITs it signed with other developing provisions. The India–Singapore Comprehensive Eco- countries, 23 (60%) were concluded with Asian countries.

18 THE IIPM THINK TANK I NDIA ARRIVING

Figure 2: Number of Indian BITs Concluded, Annual and Cumulative, Japan Comprehensive Economic 1994–200919 Partnership Agreement (CECA)23 and the India–GCC FTA.24 Further- 12 80 more India has started negotiations 10 25 60 on a CEPA with Canada. 8 6 40 3. India’s Network of BITs: 4 20 Annual BITs Annual A Brief Sketch

2 BITs Cumulative 0 0 Based on a brief review of twenty two sample BITs signed by India, 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Years this section aims to sketch some of Annual BITs Cumulative BITs the key characteristics of the country’s BITs network. India has signed nine BITs with West Asia, four BITs with A fi rst threshold crucial for the scope and breadth of a BIT East Asia, nine BITs with South-east Asia and two with relates to the defi nitions of “investor” and “investments”. South Asia. India has also paid considerable attention to These defi nitions set out the coverage of protected persons developing countries in other regions. It has signed eleven and assets under the IIA. Most BITs cover foreign direct BITs with African and four BITs with Latin American investment (FDI) and portfolio investment, but some exclude countries. India has also signed fourteen BITs with partners the latter. Typically, BITs have used asset-based defi nitions in in the transition economies. While so far a notable absentee investor/investment protection agreements (the fi rst genera- in the range of Indian BITs partners is the United States, tion BITs) and transactional defi nitions in investment India is in negotiations on a BIT with the United States.20 liberalization agreements. Asset-based defi nitions basically Another key characteristic of India’s BITs policy relates imply that the BIT embraces a large scale of assets of to the country’s concerted move to economic value, virtually without limita- ratify agreements. By December 2008, tions. The general defi nition is followed more than 90 percent of Indian BITs A rather by an illustrative list of the main catego- were ratifi ed.21 interesting ries of investment to be protected.33 The In parallel to BITs, India has also characteristic Indian BITs reviewed all include this type signed other economic cooperation of India’s BITs of defi nition. agreements that contain substantive A second threshold question is whether investments provisions as well as frame- network is the the agreement grants post- or also work agreements that aim at strengthen- diversity of its pre-establishment rights. This question ing cooperation on investment issues or partner economies relates to the stage in the investment proc- pave the way for negotiating substantive ess to which the agreement’s protections investment rules in the future. India has concluded such apply. Under a post-establishment BIT, only investors (and agreements with a number of regional groupings (e.g., their investments) that have already established inside the ASEAN, the Gulf Cooperation Council (GCC), MERCO- country are protected. A pre-establishment BIT, in turn, SUR) as well as individual countries (e.g., Republic of grants rights (e.g., regarding access and establishment, Korea). In total, India signed seven such IIAs. After initially guarantees of treatment or promises of liberalization) also to signing an agreement with the European Community (1993), prospective investors. None of the Indian BITs reviewed India then focused on other developing countries, mainly in contains commitments with regards to pre-establishment Asia. In addition to the conclusion of one CEPA in the fi rst treatment of foreign investment.34 eight months of 2009, India is currently negotiating a number Another set of key question relates to the type of substan- of IIAs, including the ASEAN–India FTA;22 the India– tive protections that are offered to those investors that

THE INDIA ECONOMY REVIEW 19 O PEN WORLD

Figure 3: Total Number of Indian BITs Concluded 22 BITs reviewed contain the same basic MFN provisions. by Country Group End 2009 (Percent) MFN clauses in Indian BITs reviewed all contain two kinds of exceptions: new obligations cannot be imported from agreements establishing Regional Economic Integration 19% Organizations (REIOs) (e.g., ASEAN); and MFN treatment 31% does not apply to tax measures. An example of the second type of substantive provisions typically stipulated in IIAs are the FET standard, the 30% 5% guarantee of Full Protection and Security or Minimum 15% Standard of treatments.37 Moreover, BITs frequently deal with the issue of expropriation or damages to an investment, determining that – and in what manner – compensation be paid to the investor in such a situation. These concepts have Transition Economy Europe been subject to a wide array of interpretations, giving rise to Africa Latin America and the Caribbean concerns about the consistency of such interpretations and Asia and Oceania the attendant development implications. Since there is no universally recognized defi nition of the meaning of some of qualify for protection under a country’s IIAs. Amongst these these principles, some countries have aimed at detailing the are so-called relative standards (i.e., National Treatment scope of protection granted to investments by some of these (NT) and Most-Favoured-Nation (MFN) treatment) as well principles (e.g., minimum standard of treatments).38 as absolute standards (e.g., Fair and Equitable Treatment With respect to minimum standard of treatments, Indian (FET)). BITs have not set themselves such an ambitious rule making National Treatment (NT) in a BIT context implies that the agenda and have stuck with basic provisions such as the obligation of contracting parties to grant following: "Investments or investors of investors/investments of the other each Contracting Party shall at all times contracting party treatment no less With respect to be accorded fair and equitable treat- favorable than the treatment they grant to full protection and ment".39 With respect to full protection their country’s own investors/investments. security, Indian and security, India’s approach varies The effect is to create a level playing fi eld government’s considerably across its BITs. Nine of the between foreign and domestic investors in twenty two Indian BITs examined provide the relevant market.35 The twenty two approach varies for full protection and security, but Indian BITs reviewed grant NT (on a considerably thirteen do not offer such a guarantee. post-establishment basis). Hence, once across its BITs Interestingly, full protection and security they have already established in the India, does not appear in the model BIT that foreign investors are guaranteed the same treatment as India uses to negotiate with other countries.40 domestic investors. With respect to expropriation,41 in recent years the The Most-Favoured-Nation (MFN) standard is another question of indirect expropriation or regulatory taking has core element of BITs. It requires a host country to accord come to the forefront. All of India’s BITs reviewed recog- treatment to a covered foreign investor/investments which is nize that indirect expropriation that is "measures having no less favorable than that accorded to an investor/invest- effect equivalent to nationalisation or expropriation",42 is ment of a third State. The MFN standard offers foreign expropriation. As a response to arbitral awards, some investors/investments a guarantee against certain forms of countries have – over the last years – aimed to clarify BIT discrimination by reason of nationality and is therefore also obligations with a view to ensuring that legitimate regulatory crucial for establishing a level fi eld.36 Similarly as with NT, all conduct at the national level would not be considered

20 THE IIPM THINK TANK I NDIA ARRIVING

Figure 4: Indian Economic Cooperation Agreements, 1993–2009

India – European Community Cooperation Agreement between the European Community and the Republic 199326 of India on Partnership and Development India – ASEAN Framework Agreement on Comprehensive Economic Cooperation Between 200327 the Republic of India and the Association of South East Asian Nations India – MERCOSUR Framework Agreement between the MERCOSUR and the Republic of India 200328 India – GCC Framework Agreement on Economic Cooperation Between the Republic of 200429 India and the Member States of the Cooperation Council for the Arab States of the Gulf India – Chile Framework Agreement to Promote Economic Cooperation Between the 200530 Republic of Chile and the Republic of India India – Singapore Comprehensive Economic Cooperation Between the Republic of India and 200531 Singapore India – Korea Comprehensive Economic Partnership Agreement (CEPA) between the 200932 Republic of India and the Republic of Korea expropriation. India’s approach to international investment dispute settlement mechanisms included in BITs, leading to a rule making has however so far stopped short of spelling out growing number of treaty-based ISDS cases brought to in more detail what does and does not qualify as being international arbitration.47 This raises considerable chal- 'equivalent to expropriation'.43 lenges for host countries, including cost-related challenges Finally, most Indian BITs also contain a specifi c exception (cost of litigation, costs for awards), challenges regarding a that allows parties to derogate from treaty obligations in the country’s reputation as an attractive FDI destination and case of a threat to national security or other emergency capacity-related challenges, particularly for developing situations.44 Most of the Indian BITs countries.48 A particular problematique reviewed refer to "a state of national arise when ISDS cases challenge legiti- emergency", while the recent BIT be- Adequate mate domestic policies. It is therefore of tween India and Mozambique explicitly attention to utmost importance that host countries draws on "the protection of its essential environmental, have the capacity to manage – and to the security interests" and "circumstances of social and poverty extent possible avoid – such ISDS pro- extreme emergency". ceedings. Preventive measures, including Besides the above, there are numerous related issues better treaty language and effective other substantive treaty protections that is crucial in the means of dispute avoidance, are impor- would merit attention (e.g., the extent to current context tant in this regard.49 which IIAs rule out performance requirements, provisions on free transfer of funds, excep- 4. Concluding Remarks tions for balance of payments problems). Of key impor- With today’s global crisis, and the attendant nosedive of FDI tance, however, are also procedural issues: dispute settle- fl ows, effective promotion of foreign investment is needed ment under BITs is characterized by the availability of more than ever, both for developed and developing countries. Investor State Dispute Settlement (ISDS).45 This allows Accordingly, there is a call for intensifi ed investment promo- investors to submit Host State decisions and actions to an tion efforts, both as regards inward and outward investment. authority – independent from the host country administra- This includes the dismantling of visible and hidden invest- tive and judicial system – for examination.46 All of India’s ment obstacles, as well as a special focus on retaining existing BITs reviewed grant this right. investment in times of crisis. Over the years, investors have increasingly resorted to the The worldwide signature of 25 new BITs and six other IIAs

THE INDIA ECONOMY REVIEW 21 O PEN WORLD

in academia and policy circles.53 Today’s global economic and environmental crises raise further questions about the type of policies that are needed to maximize the potential of FDI to contribute to economic and social development. Adequate attention to environmen- tal, social and poverty related issues is crucial in this context and today’s key question is how IIAs can better deliver on their potential to contribute a sustainable and equitable growth – including in the context of a global recovery. Revisiting some aspects of IIA rule making could offer an opportunity to address today’s development challenges.

Endnotes 1 On 7th August, 2009 India signed a Comprehensive Economic Partnership Agreement (CEPA) with the Republic of Korea, see http://commerce.nic.in/trade/ INDIA%20KOREA%20CEPA%202009.pdf 2 Between August 2008 and August 2009, India signed BITs with Bangladesh and Mozambique. during the fi rst six months of 2009, points to a continued 3 For offi cial documents on trade and investment agree- reliance – in spite of the ongoing global economic and ments by the Republic of India: http://commerce.nic.in/ fi nancial crisis – on the conclusion of IIAs as a means to trade/international_ta.asp?id=2&trade=i promote foreign investment so as to fi nance the recovery and 4 UNCTAD (2009). Recent Developments in International boost growth and stability.50 India, with six (BITs) and three Investment Agreements (2008–June 2009). IIA MONI- (two BITs and CEPA) IIAs it concluded in 2008 and 2009 TOR No. 3 (2009). http://www.unctad.org/en/docs/webdi- respectively, is also part of this trend. aeia20098_en.pdf BITs negotiations are driven by the expectation that these 5 UNCTAD (2003). World Investment Report 2003. FDI agreements play an important role in enhancing the fl ow of Policies for Development: National and International FDI to signatory countries (e.g., by improving the investment Perspectives. United Nations Publications. Sales No. E.03. climate, by reducing regulatory barriers to international II.D.8. New York and Geneva. P. 114 ff. http://www.unctad. investment, and by providing greater security, certainty and org/en/docs/wir2003_en.pdf opportunities for investment and investors in signatory 6 UNCTAD (2007). World Investment Report 2007. countries).51 This positive link between IIAs and FDI fl ows is Transnational Corporations, Extractive Industries and stronger when IIAs contain effective and operational Development. United Nations Publications. Sales No. provisions on investment promotion.52 E.07.II.D.9. New York and Geneva. P. 43. http://www. Generally, countries aim to attract FDI with a view to unctad.org/en/docs/wir2007_en.pdf reaping attendant development benefi ts. This includes 7 UNCTAD (2007). World Investment Report 2007. economic and social benefi ts (e.g., through employment Transnational Corporations, Extractive Industries and creation, technology transfer or increasing tax receipts). Development. United Nations Publications. Sales No. While the role of FDI in economic growth and development E.07.II.D.9. New York and Geneva. P. 44 is widely acknowledged, the exact relationship between FDI 8 UNCTAD (2009). World Investment Prospects Survey. and development and the manner in which FDI contributes http://www.unctad.org/Templates/meeting.asp?intItemID=20 to – or sometimes detracts from – the growth and welfare of 68&lang=1&m=17872 See also Pradhan, Jaya Prakash developing countries has been subject to continuous debate (2009). Indian FDI falls in global economic crisis: Indian

22 THE IIPM THINK TANK I NDIA ARRIVING

multinationals tread cautiously. Columbia FDI Perspec- 19 Data for 2009 is preliminary, including Indian BITs up to tives, No. 11, August 17th, 2009. August 2009. http://www.vcc.columbia.edu/pubs/documents/IndianOFDI- 20 The BIT with the United States is called Bilateral Invest- Final.pdf ment Promotion and Protection Agreement (BIPA). http:// 9 UNCTAD (2009). Investment Policy Developments in www.bilaterals.org/article.php3?id_article=11154 G-20 Countries. http://economictimes.indiatimes.com/News/Economy/ http://www.unctad.org/en/docs/webdiaeia20099_en.pdf Foreign-Trade/India-America-talk-up-bilateral-investments-/ 10 UNCTAD (forthcoming 2009). The Role of International articleshow/4887737.cms Investment Agreements in Attracting Foreign Direct 21 On the distinction between the conclusion, signature and Investment to Developing Countries. UNCTAD Series on the entry into force of a BIT and on the importance of Issues in International Investment Agreements. United ratifi cation, see UNCTAD (2006). The Entry into Force Nations publication. New York and Geneva. of Bilateral Investment Treaties (BITs). IIA MONITOR 11 UNCTAD (2009). Report of the Multi-year Expert No. 3 (2006). http://www.unctad.org/en/docs/webitei- Meeting on Investment for Development on its fi rst ia20069_en.pdf session. Held at the Palais des Nations, Geneva, from 10th 22 The negotiations on the ASEAN-India FTA were con- - 11th February, 2009. http://www.unctad.org/en/docs/ cluded on 7th September, 2009, but an agreement has not ciimem3d3_en.pdf yet been signed, see http://iitrade.ac.in/news-archive. 12 For regional and country specifi c trends in IIA rule asp?news=1026 making (BITs and other IIAs) see UNCTAD (2009). 23 For details, see http://commerce.nic.in/trade/international_ Recent Developments in International Investment ta_current_details.asp Agreements (2008–June 2009). IIA MONITOR No. 3 24 For details, see http://commerce.nic.in/trade/international_ (2009). P. 3. http://www.unctad.org/en/docs/webdi- ta_current_details.asp aeia20098_en.pdf 25 http://w01.international.gc.ca/MinPub/Publication. 13 For a comprehensive list of the country’s BITs see Annex- aspx?lang=eng&publication_id=386756&docnum=16 ure-1 of this article. 26 http://ec.europa.eu/world/agreements/downloadFile.do?fullT 14 The fi rst countries that signed a BIT were Germany and ext=yes&treatyTransId=790 Pakistan in 1959. 27 http://commerce.nic.in/trade/international_ta_ framework_ 15 UNCTAD (2009). Recent Developments in International asean.asp Investment Agreements (2008–June 2009). IIA MONI- 28 http://commerce.nic.in/fl ac/FRAMEWORK%20AGREE- TOR No. 3 (2009). P. 3. http://www.unctad.org/en/docs/ MENT%20BETWEEN%20THE%20MERCOSUR%20 webdiaeia20098_en.pdf AND%20India.pdf 16 UNCTAD (2009). Recent Developments in International 29 http://commerce.nic.in/trade/international_ta_ framework_ Investment Agreements (2008–June 2009). IIA MONI- gcc.asp TOR No. 3 (2009). P. 3. http://www.unctad.org/en/docs/ 30 http://commerce.nic.in/trade/ta/india_chile.pdf webdiaeia20098_en.pdf 31 http://commerce.nic.in/trade/international_ta_ framework_ 17 The BIT with Colombia is called a Bilateral Investment ceca.asp Promotion and Protection Agreement (BIPA). 32 http://commerce.nic.in/trade/INDIA%20KOREA%20 http://www.thaindian.com/newsportal/india-news/india- CEPA%202009.pdf colombia-to-sign-bipa-to-increase-investment- 33 For a discussion of issues related to the scope and defi ni- fl ow_100212609.html tion of IIAs, see UNCTAD (forthcoming 2009). Scope 18 The BIT with Canada is called a Foreign Investment and Defi nition. UNCTAD Series on Issues in Interna- Protection and Promotion Agreement (FIPA). tional Investment Agreements. United Nations publica- http://w01.international.gc.ca/MinPub/Publication. tion. New York and Geneva. aspx?lang=eng&publication_id=385226&docnum=82 34 A typical formulation is found in the India – Mauritius

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BIT which refers to the "management, maintenance, use, 45 UNCTAD (2004). Key Terms and Concepts in IIAs: A enjoyment or disposal of investments" – leaving aside Glossary. UNCTAD Series on Issues in International issues such as "establishment and acquisition". It has to be Investment Agreements. United Nations Publication. noted however, that the recent CEPA investment chapters E.04.II.D.31. New York and Geneva. P. 43. http://www. that India has concluded with the Republic of Korea unctad.org/en/docs/iteiit20042_en.pdf covers the national treatment of foreign investors in the 46 During the early stages of IIA rule-making, this has been pre-establishment phase. controversial, as it is a clear break from the Westphalian 35 UNCTAD (2007). Bilateral Investment Treaties model of international public law as governing only the 1995-2006: Trends in Investment Rulemaking. P. 33. relationship between states without recourse for private http://www.unctad.org/en/docs/iteiia20065_en.pdf parties. 36 UNCTAD (forthcoming 2009). Most-favoured-Nation 47 UNCTAD (2009). Latest Developments in Investor– Treatment. UNCTAD Series on Issues in International State Dispute Settlement. IIA MONITOR No. 1 (2009). Investment Agreements. United Nations publication. New http://www.unctad.org/en/docs/webdiaeia20096_en.pdf York and Geneva. 48 UNCTAD (2009). Report of the Multi-year Expert 37 UNCTAD (2007). Bilateral Investment Treaties Meeting on Investment for Development on its fi rst 1995-2006: Trends in Investment Rulemaking. P. 28. session. Held at the Palais des Nations, Geneva, from 10th http://www.unctad.org/en/docs/iteiia20065_en.pdf - 11th February, 2009. P. 6. http://www.unctad.org/en/docs/ 38 For a more detailed discussion see UNCTAD (2007). ciimem3d3_en.pdf Bilateral Investment Treaties 1995-2006: Trends in 49 UNCTAD (2009). Report of the Multi-year Expert Investment Rulemaking. PP. 28-33. http://www.unctad.org/ Meeting on Investment for Development on its fi rst en/docs/iteiia20065_en.pdf session. Held at the Palais des Nations, Geneva, from 10th 39 See India–Australia BIT, Art 3.2. - 11th February, 2009. P. 2. http://www.unctad.org/en/docs/ http://www.unctad.org/sections/dite/iia/docs/bits/australia_ ciimem3d3_en.pdf See also UNCTAD (forthcoming india.pdf 2009). Exploring Alternatives to Investment Treaty 40 See Indian Model BIT, particularly Art 3.2. Arbitration and the Prevention of Investor-State Dis- 41 BITs and other international instruments for the protec- putes. United Nations publication. New York and Geneva. tion of foreign investment virtually always contain 50 Also during 2008, the network of IIAs has continued to provisions prohibiting the taking of foreign investors’ expand: BITs (59) and other IIAs (16) – in sum – a assets by public authorities, except if done for a public development that further strengthens and expands the purpose, on a non-discriminatory basis, against payment current international investment regime. of compensation, and, in many cases, with due process of 51 UNCTAD (forthcoming 2009). The Role of International law. UNCTAD (2004). Key Terms and Concepts in IIAs: Investment Agreements in Attracting Foreign Direct A Glossary. UNCTAD Series on Issues in International Investment to Developing Countries. UNCTAD Series Investment Agreements. United Nations Publication. on Issues in International Investment Agreements. E.04.II.D.31. New York and Geneva. P. 67. http://www. United Nations publication. New York and Geneva. unctad.org/en/docs/iteiit20042_en.pdf 52 For the time being, however, IIAs do not contain commit- 42 See Indian Model BIT, Art 5.1. ments by capital-exporting countries other than vague 43 Yet, in the CEPA between India and Korea, indirect language relating to investment promotion and do not expropriation is also dealt with (P. 233). http://commerce. give any protection to developing countries against nic.in/trade/INDIA%20KOREA%20CEPA%202009.pdf policies restricting outward investment. Investment 44 For a discussion of issues related to such national security insurance and other home country measures encouraging exceptions, see UNCTAD (2009). The Protection of outward investment are cases in point where continued National Security in IIAs. United Nations Publication. E. international cooperation can be useful. 09.II.D.12. New York and Geneva. 53 Moran, Theodore H. / Graham, Edward M. / Blomstöm,

24 THE IIPM THINK TANK I NDIA ARRIVING

Magnus (2005). Does Foreign Direct Investment promote TOR No. 3 (2009). http://www.unctad.org/en/docs/webdi- development? Institute for International Economics. aeia20098_en.pdf Washington. http://www.piie.com/publications/chapters_ • UNCTAD (2009). Report of the Multi-year Expert preview/3810/14iie3810.pdf. UNCTAD (2005). Economic Meeting on Investment for Development on its fi rst Development in Africa. Rethinking the Role of Foreign session. Held at the Palais des Nations, Geneva, from 10th Direct Investment. http://www.unctad.org/en/docs/gdsaf- to 11th February, 2009. http://www.unctad.org/en/docs/ rica20051_en.pdf. ciimem3d3_en.pdf • UNCTAD (2009). The Protection of National Security in References and Additional Thinking IIAs. United Nations Publication. E. 09.II.D.12. New • Moran, Theodore H. / Graham, Edward M. / Blomstöm, York and Geneva. Magnus (2005). Does Foreign Direct Investment promote • UNCTAD (2009). World Investment Prospects Survey. development? Institute for International Economics. http://www.unctad.org/Templates/meeting.asp?intItemID=2 Washington. http://www.piie.com/publications/chapters_ 068&lang=1&m=17872 preview/3810/14iie3810.pdf • UNCTAD (2007). Bilateral Investment Treaties • Pradhan, Jaya Prakash (2009). Indian FDI falls in global 1995-2006: Trends in Investment Rulemaking. P. 33 http:// economic crisis:Indian multinationals tread cautiously. www.unctad.org/en/docs/iteiia20065_en.pdf Columbia FDI Perspectives, No. 11, August 17th, 2009. • UNCTAD (2007). World Investment Report 2007. http://www.vcc.columbia.edu/pubs/documents/IndianOFDI- Transnational Corporations, Extractive Industries and Final.pdf Development. United Nations Publications. Sales No. • UNCTAD (forthcoming 2009). Exploring Alternatives to E.07.II.D.9. New York and Geneva. Investment Treaty Arbitration and the Prevention of http://www.unctad.org/en/docs/wir2007_en.pdf Investor-State Disputes. United Nations publication. New • UNCTAD (2006). The Entry into Force of Bilateral York and Geneva Investment Treaties (BITs). IIA MONITOR No. 3 (2006). • UNCTAD (forthcoming 2009). Most-favoured-Nation http://www.unctad.org/en/docs/webiteiia20069_en.pdf Treatment. UNCTAD Series on Issues in International • UNCTAD (2005). Economic Development in Africa. Investment Agreements. United Nations publication. New Rethinking the Role of Foreign Direct Investment. http:// York and Geneva. www.unctad.org/en/docs/gdsafrica20051_en.pdf • UNCTAD (forthcoming 2009). Scope and Defi nition. • UNCTAD (2004). Key Terms and Concepts in IIAs: A UNCTAD Series on Issues in International Investment Glossary. UNCTAD Series on Issues in International Agreements. United Nations publication. New York and Investment Agreements. United Nations Publication. Geneva. E.04.II.D.31. New York and Geneva. http://www.unctad. • UNCTAD (forthcoming 2009). The Role of International org/en/docs/iteiit20042_en.pdf Investment Agreements in Attracting Foreign Direct • UNCTAD (2003). World Investment Report 2003. FDI Investment to Developing Countries. UNCTAD Series Policies for Development: National and International on Issues in International Investment Agreements. Perspectives. United Nations Publications. Sales No. United Nations publication. New York and Geneva. E.03.II.D.8. New York and Geneva. http://www.unctad.org/ • UNCTAD (2009). Investment Policy Developments in en/docs/wir2003_en.pdf G-20 Countries. http://www.unctad.org/en/docs/webdi- aeia20099_en.pdf (* This paper was prepared by a team led by Elisabeth Tuerk. • UNCTAD (2009). Latest Developments in Investor– The contributors include Amare Bekele, Hamed El-Kady, Jan State Dispute Settlement. IIA MONITOR No. 1 (2009). Knoerich, Matthew Levine, Diana Rosert, Astrit Sulstarova http://www.unctad.org/en/docs/webdiaeia20096_en.pdf and Elisabeth Tuerk. The views expressed are those of the • UNCTAD (2009). Recent Developments in International authors and do not refl ect the views of the UNCTAD secre- Investment Agreements (2008–June 2009). IIA MONI- tariat or its member States.)

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ANNEXURE - 1

Total Indian BITs (1994–2009) Partner Country Date of Signature Date of Entry into Force BITs Text Reviewed Argentina 20-Aug-99 12-Aug-02 Armenia 23-May-03 30-May-06 Australia 26-Feb-99 4-May-00 y Austria 8-Nov-99 1-Mar-01 Bahrain 13-Jan-04 5-Dec-07 Bangladesh 9-Feb-09 Belarus 26-Nov-02 23-Nov-03 Belgium and Luxembourg 31-Oct-97 8-Jan-01 y Bosnia and Herzegovina 12-Sep-06 13-Feb-08 Brunei Darussalam 22-May-08 18-Jan-09 Bulgaria 29-Oct-98 23-Sep-99 China 21-Nov-06 1-Aug-07 Croatia 4-May-01 19-Jan-02 y Cyprus 9-Apr-02 12-Jan-04 Czech Republic 11-Oct-96 6-Feb-98 y Denmark 6-Sep-95 28-Aug-96 y Djibouti 19-May-03 Egypt 9-Apr-97 22-Nov-00 y Ethiopia 5-Jul-07 Finland 7-Nov-02 9-Apr-03 France 2-Sep-97 17-May-00 Germany 10-Jul-95 13-Jul-98 Ghana 18-Aug-02 y Greece 26-Apr-07 10-Apr-08 Hungary 3-Nov-03 2-Jan-06 y Iceland 29-Jun-07 16-Dec-09 Indonesia 10-Feb-99 22-Jan-04 y Israel 29-Jan-96 18-Feb-97 Italy 23-Nov-95 26-Mar-98 Jordan 30-Nov-06 22-Jan-09 Kazakhstan 9-Dec-96 26-Jul-01 y Korea, Republic of 26-Feb-96 7-May-96 Kuwait 27-Nov-01 28-Jun-03 Kyrgyzstan 16-May-97 10-Apr-98 Lao People’s Democratic Republic 9-Nov-00 5-Jan-03 Libyan Arab Jamahiriya 26-May-07 25-Mar-09 Macedonia, TFYR 17-Mar-08 17-Nov-08

26 THE IIPM THINK TANK I NDIA ARRIVING

Partner Country Date of Signature Date of Entry into Force BITs Text Reviewed Malaysia 1-Aug-95 12-Apr-97 Mauritius 4-Sep-98 20-Jun-00 y Mexico 21-May-07 23-Feb-08 Mongolia 3-Jan-01 29-Apr-02 Morocco 13-Feb-99 22-Feb-01 y Mozambique 19-Feb-09 y Myanmar 24-Jun-08 8-Feb-09 Netherlands 6-Nov-95 1-Dec-96 y Oman 2-Apr-97 13-Oct-00 y Philippines 28-Jan-00 29-Jan-01 Poland 7-Oct-96 31-Dec-97 Portugal 28-Jun-00 19-Jul-02 y Qatar 7-Apr-99 15-Dec-99 Romania 17-Nov-97 9-Dec-99 Russian Federation 23-Dec-94 5-Aug-96 Saudi Arabia 25-Jan-06 20-May-08 Senegal 3-Jul-08 Serbia and Montenegro 31-Jan-03 24-Feb-09 Slovakia 25-Sep-06 27-Sep-07 Spain 30-Sep-97 15-Dec-98 Sri Lanka 22-Jan-97 13-Feb-98 y Sudan 22-Oct-03 Sweden 4-Jul-00 1-Apr-01 y Switzerland 4-Apr-97 16-Feb-00 y Syrian Arab Republic 18-Jun-08 22-Jan-09 Taiwan Province of China 17-Oct-02 28-Nov-02 Tajikistan 13-Dec-95 14-Nov-03 Thailand 10-Jul-00 13-Jul-01 y Trinidad and Tobago 12-Mar-07 7-Oct-07 Turkey 17-Sep-98 18-Nov-07 y Turkmenistan 20-Sep-95 27-Feb-06 Ukraine 1-Dec-01 12-Aug-03 United Kingdom 14-Mar-94 6-Jan-95 y Uruguay 11-Feb-08 Uzbekistan 18-May-99 28-Jul-00 VietNam 8-Mar-97 1-Dec-99 Yemen 1-Oct-02 10-Feb-04 Zimbabwe 10-Feb-99

THE INDIA ECONOMY REVIEW 27 O PEN WORLD Policy Transparency and Evaluation for Economic Growth in India

Valentin Zahrnt Research Associate, European Centre for International Political Economy (ECIPE), Belgium

ood governance, in its broadest sense, means selecting the right policy objectives together with the Gappropriate instruments to attain them. And it means implementing the policies effi ciently, without waste, delay or corruption. India wrestles with both challenges, and this weakness of governance from the commanding heights down to the lowlands of local administration explains why India fails to realize its economic potential more fully. This article addresses the fi rst challenge, that of policy-making. It argues that India cannot expect improvements in this area as a byproduct of economic development but needs to strengthen domestic and international mechanisms for transparency and policy evaluation.

Examples of Bad Policy-Making Abound There is a rough correlation between the level of development and the effi ciency of policy implementation, and the OECD countries have generally learned to execute their policies decently well. Efforts to introduce a service culture, to fl atten hierarchies, and to employ information technologies have further enhanced administrative effi ciency in the developed world during the last decade. But even the most developed countries continue to commit to policies whose aims are blurry to the point of being indiscernible, to policies whose objectives

28 THE IIPM THINK TANK N AKED ECONOMICS

are incongruent, and to policies whose ends contradict any ment. The case of EU agricultural policy can illustrate this reasonable vision of the public good. Similarly, examples claim. The EU pays about € 55 billion of farm subsidies per abound in OECD countries where policy instruments are, by year, an amount corresponding to more than 40% of its budget. their very nature or design, ineffective or even harmful for the Furthermore, tariffs on agricultural products average 18% espoused targets. What strikes the observer is that good – over four times more than charges on other goods. All EU policy-making does not come with economic develop- tariffs greater than 100% relate to agricultural products, with isoglucose hit hardest by a staggering 604% duty. These policies are disastrous. The benefi ts are distributed arbitrarily and unfairly among farmers, helping poor farmers little. Consumers are harmed through higher food prices, hitting especially poor households who spend a relatively high propor- tion of their income on food. At the same time, the agricultural policies fail to stimulate rural development in disadvantaged regions, to motivate environmentally friendly farming prac- tices, or to support food security. What they do achieve is distortion of the economy and increased vulnerability to criticism from the EU’s trading partners. Poor governance practices have contributed to this absurd outcome. Vice versa, politicians and bureaucrats have become dependent on the opacity created by their poor governance practices in order not to be held accountable for the results. The EU is caught in a trap of bad policy practices and out- comes. One key mechanism employed to avoid accountability has been to never seriously defi ne the objectives of the EU’s agricultural policies. They were briefl y enumerated in the 1957 Treaty of Rome and have since then been repeatedly extended without any sense of precision or prioritization. Other mecha- nisms include the dispersion of responsibility across numerous committees; a repelling degree of legislative complexity; secrecy of data about farm incomes and subsidy recipients; superfi cial and politically biased policy evaluation through the implementing agency, the Directorate-General for Agriculture and Rural Development; fostering a supportive policy commu- nity through the commissioning of ‘independent’ studies and close cooperation with external experts; not publishing sensi- tive in-house and commissioned analysis; and a monolithic European Commission discourse with minimal internal dissent combined with the disciplining of critical external stakeholders. These opacity mechanisms have worked so well that policies that endanger EU long-term food security – for instance by depleting water and soil resources – are commonly justifi ed by the very need to ensure food security (which is not seriously threatened in the EU anyway). And the EU’s agricultural policies are generally credited with providing consumers

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healthy food at affordable prices though consumers actually benefi ts a sector receives from state intervention. Disentan- pay more due to tariffs, production quotas, and export subsi- gling and netting out the manifold distributional effects of dies. The same pattern can be observed in the EU’s policy policies can thus create support for less intrusive and more against dumped imports. Antidumping measures have little to effi cient solutions. do with threats to competition on the EU market stemming Transparent and Participative Inquiry Process: The Productiv- from foreign suppliers striving for excessive market power. ity Commission invites the public to contribute to its inquiries They lack any welfare rationale. Instead, they are deeply through introductory issue papers. It receives submissions, political, driven by industry lobbying and electoral populism. meets stakeholders, and holds public hearings. Draft reports Once again, bad policies go hand in hand with poor policy- are published as well as all subsequent comments. Final making: consumer interests are relegated to the backseat, reports are written in an accessible language and actively economy-wide analysis is not undertaken in anti-dumping disseminated, in line with the objective ‘to promote public procedures, examination of the link between dumping and understanding of matters relating to industry, industry damage to the domestic industry is perfunctory, and the development and productivity’. calculations of dumping margins are kept secret.1 Right to Be Heard: The government is free to engage the Productivity Commission in an inquiry or not, but fi nal inquiry The Australian Case reports must be tabled in the Parliament within twenty fi ve Examining the OECD countries demon- sitting days. Furthermore, the Productivity strates that being a rich democracy is not a Commission publishes an annual report suffi cient condition for having sound Anti-dumping with economy-wide analysis. policy-making processes let alone for measures have Independence: Members are appointed for making sensible policies. Importantly, this little to do up to fi ve years based on qualifi cations and judgment does not depend on preferences with threats to experience. Strong safeguards protect them for particular (liberal) policies. The against being removed from their offi ce. benchmark is structural weakness, notably competition and They accept strict limitations on outside lacking coherence among objectives and lack any sort of employment and requirements to disclose between objectives and instruments, that welfare rationale their interests. Furthermore, ministerial are condemned by experts across the board. responsibility is assigned to the Treasury, a This does not imply that rational policy-making is a hopeless ministry with an inherently economy-wide perspective unlikely case. The most important exception – one might say the to sponsor sectoral interests. world’s showcase for policy transparency and evaluation – is Continuity: The Productivity Commission goes back to the Australia’s Productivity Commission.2 This body started with a Tariff Board, established in 1921. Though its affi liation, rights, narrow trade focus and became responsible for analyzing issues resources, and methods have changed considerably over time, as diverse as railway and shipping services, competition on the the institution has remained recognizable over time. It could telecommunication market, nursing home subsidies, and cost thus build up its expertise and reputation. recovery by government agencies. Several features of this These features must not be perceived in isolation for they institution deserve highlighting. interact in benefi cial ways. For instance, the Productivity High-Quality, Comprehensive Analysis: The Productivity Commission’s independence rests not only on the explicit Commission assesses the impact of policy options on economic, provisions to this end but also on various other characteristics. social, and environmental objectives. It also calculates the net Thanks to its continuity, its high-quality research, and its effects of various policies on the sector level. This shows how transparent and participative inquiry process, the Productivity some sectors that enjoy protection are harmed even more Commission has built up public support that shields it from strongly by protection of other sectors. Higher input prices or government infringements in its inquiries and attempts to reduced demand for the sector’s output through protection in undermine its institutional functioning. The Productivity other parts of the economy can overwhelm the more visible Commission has thus been able to wield signifi cant infl uence

30 THE IIPM THINK TANK N AKED ECONOMICS

on numerous specifi c policies. It has been widely credited for where the electorate can punish policy failure. And unlike its role in Australia's remarkable unilateral liberalization from many other developing countries, India has the expertise and the 1970s to the 1990s. More importantly, it has shaped the capacity to set up such institutions. public discourse in the long run towards more rational policies Domestic institutions with local ownership and close ties to and fostered high expectations regarding the transparency and local stakeholders and processes must be the cornerstone of a scientifi c soundness of policy-making. system for policy transparency and evaluation. Still, India would be well advised to endorse complementary international The Lesson for India mechanisms. First, an international mechanism can guarantee The lesson for India is that it cannot rely on a virtuous circle of that a review of certain quality and coverage is undertaken with economic development and better economic governance. India certain frequency. The minimum level of transparency thus needs to actively create sound institutions that enhance ensured is valuable as there is no guarantee that the Indian transparency, conduct analysis, and stimulate debate. As government will establish and maintain sound transparency Narayan (2009) notes, ‘An important aspect of the unfi nished mechanisms domestically and entrust them with regular [reform] agenda should therefore be wide dissemination of reviews of all relevant matters. (Even the Productivity Commis- information and debate about the necessity of reforms …’ This sion in Australia is at times sidelined by the government on must not be confounded with activism. India has long been sensitive issues.) swamped by committees and councils that Second, an international mechanism can assess policies and propose alternatives.3 support domestic transparency institutions. These bodies have been placed with the The lesson for It accustoms governments to tolerate Planning Commission, various ministries, India is that it reviews, stakeholders to contribute to the and the prime minister; they have white- cann't rely on a review process, and the media to use the washed failures or laid them bare; they virtuous circle results. Furthermore, international reviews have been ignored or supported by the can report on the quality of domestic government. Here and there, they have of economic transparency institutions, drawing atten- infl uenced policies. But neither the development and tion to persistent shortcomings and acute Economic Advisory Council, nor the better governance governmental encroachments. Such Programme Outcome and Response reporting could include information on the Monitoring Division, nor the Programme Evaluation Organiza- mandate, resources, and independence of the domestic tion have created a culture of evaluation. A multiplicity of mechanisms; on the issues they have covered since the last government-dependent and ad-hoc commissions produces international report; and on the integration of their results piecework which politicians can discard or reinterpret as into policymaking. political opportunism dictates. Third, an international mechanism can serve not only as a What is needed is not more evaluation mechanisms but backup and prop for domestic institutions but deliver its own, fewer and better ones. The Australian Productivity Commis- unique contribution. Namely, it facilitates country comparison sion can serve as a model in terms of the kind and quality of through standardization. An international mechanism can ask reports, transparency and public participation, independence the same questions for all countries, analyze the matter with and rules of engagement, and institutional stability. The consistent methods, and apply a similar standard of rigor in its objective should be to inspire a culture that pervades all of conclusions. Information on where the own country stands in policy-making, creating expectations that scientifi c advice will international comparison is a powerful tool to mobilize be duly considered and that policies be justifi ed by the stand- stakeholders and infl uence policy debates. ards of applied science. In addition to a public but independent transparency institution, India should also foster private think International Transparency Mechanisms tanks that analyze policies and propose alternatives. All this Several international organizations provide regular reviews of can be especially powerful in India, a functioning democracy, countries’ economic policies. The World Bank maintains

THE INDIA ECONOMY REVIEW 31 O PEN WORLD

various measures, such as the Doing Business, the World farmers, who make up a signifi cant share of agricultural Governance, the Logistics Performance, and the World Trade producers, and therefore they lack the incentive to develop Indicators. The IMF conducts an annual ‘Article IV Consulta- the land. Other factors of low productivity include regula- tion’, a very uncompromising analysis of a country’s macroeco- tion of agricultural markets and the movement of major nomic developments and policies. The international transpar- crops, which has dissuaded the private sector in general from ency mechanism for economic policies with the greatest investing in the sector, and relatively low levels of research potential, however, is the WTO’s Trade Policy Review Mecha- and development. … The Government's policy of providing nism (TPRM). key inputs at subsidized prices has also resulted in a growing According to its mission, ‘the review mechanism enables the subsidy bill to the detriment of public investment in infra- regular collective appreciation and evaluation of the full range structure and research and development. of individual Members’ trade policies and practices and their Such statements should be found more frequently and be impact on the functioning of the multilateral trading system.’ underpinned more systematically with independent analysis. In The TPRM was provisionally established in 1989 and was made this way they could convince readers of the benefi ts of liberal defi nitive in 1995. The Secretariat fi rst sends one or two reform and serve as a reference in domestic policy debates. questionnaires to the country under review and collects Reports: TPRs should follow a standardized analytical grid. information from various sources. Members of the Trade Policy This would make TPRs easier to read, facilitate comparison Review Division of the Secretariat then across time and countries, and assure that travel to the country to discuss outstanding reports are complete. It would also secure questions with the government and other Regrettably, the consistency in the severity of criticism, stakeholders. The Secretariat drafts a current Trade making reports more acceptable to report and sends it to the country under Policy Review governments who care about their relative review for verifi cation. The fi nal report, Mechansim standing and treatment. Regarding their together with a policy statement from the content, TPRs should rely much more country under review, is circulated to the (TPRM) is beset strongly on existing analysis that shows the member states before the review meeting. with many striking economy-wide costs of protectionism and All documents, including the minutes of the weaknesses identifi es winners and losers on a sectoral meeting, are made public. basis. Besides, they should scrutinize not Regrettably, the current TPRM is beset with striking only trade policies but also policy-making processes. TPRs weaknesses. TPRs are cumbersome to read and clogged with should compare actual processes to best practices and summa- compendium-style information. They are analytically superfi - rize available analysis on the quality of policy-making. cial and relentlessly uncritical. They differ in their coverage and Process: The process of how TPRs are prepared, discussed, approach one from another. The procedures for preparing and and disseminated should be reformed. The drafting of the discussing TPRs lack effi ciency and public participation. It is Secretariat’s report should be more transparent and allow for therefore unsurprising that TPRs are deemed to have no greater stakeholder participation. A further step in the attempt discernible effect on trade policies. Improvement is necessary to transform TPRs from a diplomatic exercise in Geneva into in four areas. an event in members’ domestic politics should be to present Objective: TPRs should be resolutely aimed at shaping and debate TPRs in the country under review. To realize these domestic politics rather than informing bureaucrats in Geneva. more ambitious objectives, the budget of the WTO Secretariat TPRs should focus the attention of domestic constituents and should be substantially increased. the media on their country’s trade policies. They should make Frequency: According to current rules, the four countries with trade policies comparable across countries and time and the largest share of world trade are to be reviewed every two highlight their trade and welfare effects. And they should spell years, the next sixteen every four years, and the rest every six out their criticism. The latest TPR of India notes, for instance:4 years. The last reviews of India have been in 2007 and 2002. Tenancy laws do not give well-defi ned rights to tenant This is insuffi cient to infl uence domestic politics. TPRs should

32 THE IIPM THINK TANK N AKED ECONOMICS

be conducted more frequent to deliver up-to-date information leadership role than the obstruction of multilateral negotia- and remain in stakeholders’ minds. tions practiced in the past.

Political Feasibility of TPRM Reform Endnotes The political climate is propitious for a strengthening of the 1 See Davis (2009) and Hindley (2009). TPRM. The blockade of the Doha Round has demonstrated 2 See Productivity Commission (2003) on the history of the the need to address various systemic issues. Since the Uruguay institution as well as the Productivity Commission Act 1998. Round, trade has become increasingly contested at the In the meantime, the Australian government was able to domestic level. The ‘club model’ of multilateral cooperation abolish the obligation to seek public advice from the that isolated the trade ministry from involvement by other Productivity Commission before granting new or increased ministries and the general public has come to an end. Convinc- assistance to any industry. In the wake, the Productivity ing a broader audience of the benefi ts of free trade – e.g. Commission was by-passed on important issues in favor of through TPRs – is therefore increasingly important if further more controllable bodies. liberalization is to succeed. 3 See Arun Shourie’s speech on ‘New Beginnings’ on 8th June, Accordingly, Pascal Lamy, the WTO’s Director General, 2009 at http://www.indianexpress.com/news/new- and the Secretariat have been successfully pushing transpar- beginnings/476900/0. ency mechanisms as a complement to negotiations and dispute 4 WTO (2007), pp. 100. settlement. Most notably, they introduced a new review 5 See WTO (2006). mechanism of preferential trade agreements,5 and they started 6 See WTO (2008). reporting to the Trade Policy Review Body on recent trade 7 India (2009). developments associated with the fi nancial crisis. Govern- ments appear to be slowly learning this lesson, too. The last References and Additional Thinking fi ve-yearly self-appraisal by the Trade Policy Review Body did • Davis, Lucy. 2009. Anti-dumping Investigation in the EU: not produce strong conclusions.6 But it showed that major How Does It Work? : ECIPE Working Paper No. 04/2009. players (with the EU and Japan in the fi rst place) promote • Hindley, Brian. 2009. Cause-of-injury Analysis in European changes to give the TPRM greater bite. Since then, the Anti-dumping Investigations: ECIPE Working Paper No. fi nancial and economic crisis has created momentum for 05/2009. fundamental re-thinking and reform of international institu- • India. 2009. Strengthening the WTO: Communication from tions. In particular, it has sparked concerns about insuffi cient India: WT/GC/W/605. monitoring of trade policies. • Narayan, S., ed. 2009. The Political Economy of Trade The next WTO ministerial meeting, planned for the end of Reform in Emerging Markets. Edited by P. Draper, P. Alves November 2009 and explicitly dedicated to systemic issues and S. Razeen. Cheltenham: Edward Elgar. outside of the Doha Round, offers a venue for initializing • Productivity Commission. 2003. From Industry Assistance thorough TPRM reform. India has submitted suggestions for to Productivity: 30 Years of 'The Commission': Productivity enhancing the WTO’s transparency function: a database Commission, Canberra. with non-tariff measures shall be established, the Secretariat • WTO. 2006. Transparency Mechanism for Regional Trade shall make ‘factual presentation on developments in various Agreements: WT/L/671. members’ in the respective working committees, and the –. 2007. Trade Policy Review: India - Report by the Secre- transparency mechanism for regional trade agreements shall tariat: WT/TPR/S/182/Rev.1. be made permanent.7 These are reasonable proposals, not –. 2008. Third Appraisal of the Operation of the Trade very ambitious but enough to position India in the vanguard Policy Review Mechanism: WT/TPR/229. of the reform movement. India should go further and become a champion of transparency in trade policy. This (The views expressed in the article are personal and do not refl ect would be a much more constructive approach to its new the offi cial policy or position of the organisation.)

THE INDIA ECONOMY REVIEW 33 O PEN WORLD Regulating Markets in the Post-Crisis World

here are few precedents for the current global fi nancial that the hands-off American or “Anglo- Saxon” model of regula- meltdown. Not surprisingly, the crisis has already led to tion or (“regulation-lite”) needs to be replaced with a more Tmuch soul-searching in both the policy-making and vigorous and effective regulation of fi nancial institutions and academic circles. Established orthodoxies are being questioned as markets. Yet, what will this regulation entail? Of course, the devil never before, not only to better understand the roots of the crisis, is in the details and there is no consensus on that. The following but also to formulate policies in order to mitigate the current sections fi ll in some of the gaps. It suggests that although greater economic toll and dislocation and prevent future crises. Even as regulation is necessary, we must be careful not to cross the line the dust settles, the process of drawing lessons from the great where regulations become too restrictive and an impediment to global credit crisis of 2008-09 has begun with earnest. While we innovation and entrepreneurship. do not know all the answers yet, the one unambiguous answer is First, an important caveat should be noted: that the globally

34 THE IIPM THINK TANK P OWER AND CONTROL

advanced economies), failed to prevent excessive risk-taking by Shalendra D. Sharma* market participants. Professor, Department of Politics, The current crisis also underscores that current macro-pruden- University of San Francisco tial tools do not suffi ciently take into account business and fi nancial cycles. This has led to an excessive build up of leverage. linked fi nancial markets are inherently unstable and prone to Although a feature that the current crisis shares with previous ones excess. Even as global capital markets allocates money more is the apparent procyclicality of the fi nancial system (with a effi ciently than domestic ones, and helped spread capital and build-up of leverage in good times when investors tend to underes- wealth more widely than ever before (and in the process enabled timate risk, and the subsequent unwinding of this leverage when millions to better their lives), the fi nancial system is also extremely conditions deteriorate), this crisis is also unique for the key role of fragile – prone to boom and busts. Eichengreen and Bordo have assets that are held off banks’ balance sheets and the extent to identifi ed some 139 fi nancial crises between 1973 and 1997 (of which credit problems have affected the liquidity of the entire which 44 took place in high-income countries), compared with a fi nancial system. This not only means that credit rating agencies total of only 38 between 1945 and 1971.1 This is because with need to more clearly differentiate structured products from more globalization, markets have become even more volatile and standard fi nancial instruments in their assessment of risks, market unpredictable, and may not always work effi ciently due to exter- participants need more information and transparency to better nalities, coordination failures, information asymmetries, including price risk and reduce uncertainty at times of market disruption. well-placed fi rms and individuals using their power and privileged Thus, it is essential to put into place rules and institutions that access for private gain. reduce systemic risks and improve fi nancial intermediation without Thus, although open global fi nancial markets provide tremen- imposing unnecessary red-tape. In particular, more transparent dous rewards by lowering the cost of capital, it is also clear that capital and liquidity requirements would make fi nancial institu- more effective regulation is needed to realize tions (especially those that are highly this potential. After all, fi nancial markets can Unprecedented interconnected) more resilient to risk, and only function effi ciently when there is pace of change making accessible data on over-the-counter symmetry of information available to both makes it difficult, derivatives (to migrate those peer-to-peer buyers and sellers. Since effective disclosure transactions to a tradable and public market), and transparency is fundamental to well- if not impossible, and to introduce minimum capital require- functioning markets, a core role of market for regulation and ments that cover all fi nancial assets and regulators is to reduce information asym- supervision to organizations would be a great help. It also metries. This is essential now because keep pace means that the supervisory and regulatory fi nancial innovation and integration have frameworks should be more globally coordi- increased the speed and extent to which shocks are being trans- nated to ensure effective supervision, including more transparent mitted across asset classes and economies throughout the world. disclosure and reporting rules. Such an approach would also Yet, regulation and supervision remain largely geared at individu- provide better information to market participants regarding al fi nancial institutions and do not adequately factor-in the assessments of systemic risks. systemic and international implications of domestic institutions’ Yet, this crisis has also underscored that protecting the global actions. As a result (and as we now know) many highly structured fi nancial system from the recurrent bouts of speculative excesses products were far from transparent and the disclosure of their and painful contractions is not going to be easy given the interna- originators often lacking. Given these challenges, regulatory tionalization of markets. The unprecedented pace of change oversight that places constraints on imprudent individual behav- makes it diffi cult, if not impossible, for the bureaucratic world of ior and prevent the build-up of dangerous speculative bubbles regulation and supervision to keep pace. While the conventional makes sense. This failure has been most vividly and tragically view (not surprisingly promoted by politicians) blames deregula- demonstrated during the current crisis where weak regulatory and tion for the current problem, it is important to keep in mind that supervisory frameworks in the United States (but, also in other the U.S. fi nancial services industry is not without its fair share of

THE INDIA ECONOMY REVIEW 35 O PEN WORLD

regulations and red-tape. In fact, numerous laws and regulations trade, transparency and accountability. This was an explicit are already on the books and a plethora of government agencies, recognition on the part of the G-20 that well-regulated fi nancial notably the Securities and Exchange Commission (SEC) in markets foster the dynamism, innovation, and entrepreneurship America and its British equivalent, the Financial Services Author- that are essential for economic growth, employment, and poverty ity (FSA), have signifi cant powers to implement and supervise reduction. The fact that the G-20 agreed to strengthen and these rules. Clearly, more bureaucratic red tape is not the answer. empower institutions like the World Bank and the IMF to aid the Yet, a regulatory backlash is almost certain to follow the govern- transition and developing countries, especially the poorest “least ment bailout. However, what must be avoided is politically driven developed countries” (LDCs) who are reeling under the crisis they legislation and overregulation. It must be underscored that that a had no part in creating, further underscores that a global effort is market system can never be fully tamed and there will always be an needed to combat this global crisis. element of risk. To make markets completely safe would mean an However, making a commitment is one thing, following through end of innovation and pervasive stagnation. is another. For example, institutions like the World Bank and the Rather, targeted supervision in the area of intermediation to IMF are to be effective their lending capacity needs to be en- guarantee effective reconciliation of the economic needs of hanced. In fact, John Lipsky, the IMF’s Deputy Director has called businesses and individuals for long-term credit on predictable for a doubling of the Fund’s lending capacity to $500 billion – al- terms is critical. To the authorities in charge of banking regulations beit, interestingly a number of developing countries see this this means that if a bank is “irresponsible,” request as too modest and have called for a they should require the bank to take immedi- It must be tripling of the resources. This may seem ate corrective measures, and if it does not, understood that counterintuitive as developing countries have they must close the bank, and if the bank is long accused the IMF of having too much too large to fail, it should be taken over by the a market system power and infl uence. However, this crisis has authorities. This will go a long-way in instilling can never be fully made strange bedfellows. Specifi cally, as the confi dence. Similarly, policymakers must tamed and there resultant global credit crunch has literally avoid indiscriminate regulations. Rather they will always be an dried up private capital fl ows to developing need to double their efforts to identify the element of risk countries, monies from agencies like are IMF core market imperfections that gave rise to and the World Bank is once again in big the incentives for excess risk taking. Strengthening and streamlin- demand. Facing a real prospect of being shut out of international ing the prudential oversight of fi nancial and capital markets and capital markets, for many developing countries, especially the enhancing transparency of market instruments and transactions LDCs, their only option may be the fi nancing from these multilat- will go a long way to mitigate problems. Specifi cally, in the United eral fi nancial institutions. Nevertheless, the IMF’s major share- States and elsewhere there needs to be greater regulatory oversight holders (the rich nations) must make sure that these multilateral over the nation’s fi nancial system, including strict federal rules for fi nancial organizations do more than simply dole out money, but hedge funds, credit rating agencies and mortgage brokers, as well be proactive in preventing the build-up of global fi nancial imbal- as transparency over the use of the complex fi nancial instruments ances that has contributed to this crisis (i.e. the huge international that helped spawn the current crisis. At a minimum, this must reserves in emerging countries and massive defi cits in rich nations). mean the elimination of confl icts of interest at credit rating It is also in the common interest of the G-20 to counter the agencies that gave top investment grades to the ultimately shaky growing forces of protectionism and nationalism. Among other fi nancial instruments. things, this means that the United States, the EU, China, India and It was most encouraging when on November 15th, 2008 meeting Brazil put aside their largely narrow differences and salvage the of the “Summit on Financial Markets and the World Economy” in Doha round of trade negotiations. The failure of Doha has the Washington, D.C., the G-20 leaders recognized the serious potential to reduce world trade by $1 trillion, especially if countries challenges facing the global economy, especially the fi nancial abandon the voluntary tariff restraint. India and to a lesser extent, markets, and renewed their commitments to enhance cooperation China who bear much responsibility for bringing the Doha round to restore global growth based on the market principles of open to a abrupt in summer of 2008 by insisting on protecting their

36 THE IIPM THINK TANK P OWER AND CONTROL

farmers through tariffs will need to be more fl exible if Doha is to far more serious consequences than the fi scal bailouts designed to be concluded. It also means that the Obama administration, in combat them. Nevertheless, public debt can only rise so much charge of the world’s largest economy, end the ambivalence, without any implications. In the United States the cost of the indeed, stop sending mixed signals regarding its commitment to stimulus packages and the bailouts for the fi nancial system has free trade. Acknowledging on one hand the benefi ts of trade, while already resulted in “trillion-dollar defi cits.” In the short term, if on the other, criticizing free trade is counter-productive when the government debt ratios increase sharply it could lead to a protectionist sentiments are running high. The U.S. administration sharp drop in the value of the currency and infl ation -- with real can allay these concerns by declaring unambiguously that any U.S. consequences for many who have already seen their nest-eggs government bail-out and subsidies will be WTO-consistent. Failure disappear. Over the long-term, it could potentially lead to a to do this, especially with the “Buy American” provisions in the perpetual debt burden on future generations. economic stimulus program has the potential to lead to the kind of John Maynard Keynes, during the depths of the great depression tit-for-tat protectionism that helped deepen the Great Depression. warned that free markets will not always “self-correct” and More substantively, for Doha to progress, the U.S. must make government intervention is necessary to protect the capitalist meaningful reductions in its support of trade distorting agricultural system against its own excesses. No doubt, we are witnessing a subsidies. Of course, this is now a challenge as governments crisis of confi dence in capitalism forcing champions of laissez-faire throughout the world are forced to increase support payments to to implement policies and programs that were simply unthinkable farmers with the collapse of global commodity just weeks ago. Who could have imagined prices. In addition, in the spirit of coopera- Free markets that the government of the United States tion, governments’ can better coordinate their would have intervened in markets by bailing- stimulus packages. At a minimum, stimulus will not always out private banks through recapitalizations, packages must be built around common 'self-correct' and or buy assets directly from private fi rms with principles of multilateralism and openness to state intervention tax-payer dollars and provide blanket trade, even if they differ in the details. Indeed, is necessary guarantees to bank deposits. U.S. backing for a successful end of Doha will to protect the Nevertheless, as Milton Friedman pointed not only underscore its commitment to free out long ago: government intervention must trade, an institutionalized rules based trading capitalist system be strictly regulated because over the system under the WTO will also mitigate the long-term markets are far more effi cient at more subtle tricks, if not, insidious protectionism countries use allocating capital than bureaucrats. We can also add that we live in such as health and safety standards, including technical barriers, an economically interconnected. As such, fi nancial crises cannot be especially licensing and certifi cation requirements to protect contained within borders and that international cooperation is domestic industries. essential to address the immediate and long-term challenges posed Finally, the cost of fi ghting the crisis has been unprecedented. by the crisis. Public debt is rising as governments around the world hemorrhag- ing red ink. The massive stimulus programs coupled with the Endnotes and Additional Thinking upfront costs of fi nancial rescues, including the recapitalization of 1 Eichengreen, Barry and Michael D. Bordo, 2002, “Crises Now banks, guarantees for troubled assets, not to mention the tax and Then? What Lessons from the Last Era of Financial revenues lost from growing unemployment, and falling output Globalization?,” NBER Working Paper No. 8716. and asset prices means that fi scal defi cits will increase. The IMF expects OECD countries’ combined fi scal defi cit to rise to seven (Author of: China and India in the Age of Globalization: A Com- percent of GDP in 2009 (from less than two percent in 2007), parative Political Economy. New York: Cambridge University Press while emerging economies will see their budget surpluses grow (2009).http://www.cambridge.org/us/catalogue/catalogue. into a defi cit of 3 percent of GDP. There is general agreement asp?isbn=9780521731362 The views expressed in the article are that such massive defi cit spending is needed to help revive the personal and do not refl ect the offi cial policy or position of the economy from recession -- because prolonged recessions can have organisation.)

THE INDIA ECONOMY REVIEW 37 O PEN WORLD Market Failure and the Need for Regulation

Anjan Panday Ph.D. candidate , The American University, Washington, DC

Abstract: During the current global fi nancial crisis, nations around the world took unprecedented steps in bailing-out failing indus- tries and rescue the economy. Proponents of market system advocate liquidating insolvent fi rms. In reality, though, the situation was different, especially in the fi nancial industry, because of the systemic threat to the entire market. The self-serving market system could not foot-hold during this time. The housing bubble that predated the current crisis is an example of market limitation. In this paper, the idea of market failure is revisited and, for all the reason it deserves, an effective regulation is argued vital at this time.

Introduction: The current global fi nancial crisis has opened a fl oodgate of discussions on the fragility of largely unregulated fi nancial sector and the subsequent infl uence on the broader economy. Many have drawn analogy of the current crisis as second only

38 THE IIPM THINK TANK M ISSING MARKETS

to the Great Depression of 1930s, something observed once in a generation. The “Roaring Twenties” came to an end with the collapse of stock market in 1929 and the years thereafter witnessed one of the great sufferings and miseries of mankind. It later became clear that the stock market during the time was buoyed by speculative investment, often manipulated by few large participants, in absence of any meaningful regula- tion in the Wall Street. What started as a stock market crash quickly spread to the banking sector wiping out savings of many and had an unprecedented impact on the economy. A quick fact check of the current crisis holds some resemblance. In the years since, a number of regulatory frameworks and institutional setups were put in place with an aim to prevent market failure and minimize the potential of a catastrophic crisis1. However, by the end of the millennium, the deregula- tion phenomenon was sweeping over much of the fi nancial industry. To a signifi cant extent, the belief on rational agents and self-regulating market mechanism swayed much of the policy orientation. The critics, however, have argued that the fi rst two crises of the 21st century—stock market and real- estate led—have undermined the market rationality and points to, inter alia, a lack of sensible regulation behind the market collapse. There is a near consensus among economists that some of the fundamental beliefs behind market rationale failed to hold true. The great confi dence on rational agents and in their judgment demonstrated only perverse result. At the core is the idea that the market participants often either fail to recognize their best interest due to several limitations or are motivated to act otherwise. This microcosmic effect in aggregation leads to a disruption of market and is demon- strated through failure in price adjustment. This paper will revisit the concept of market failure, its role in current crisis, and a possible intervention in the market through regulation. To provide balance to the discussion, this paper will draw on some theoretical notion of market failure while highlighting the application side of regulatory frame- work. A brief summary on traditional notion of market failure and the behavioral dimension is presented. For its proper role, some of the key deregulation measures will be discussed. The regulatory aspect will highlight the perverse incentive problem while arguing for adequate capital provi- sioning and related preventive measures in the fi nancial institutions. To conclude, a cautionary note in designing regulatory system is presented.

THE INDIA ECONOMY REVIEW 39 O PEN WORLD

2. Market Failure and Causes: ity feature of the public good avails benefi t to the users without As introduced above, the case for market failure involves some having to compensate for it. sort of market distortion that impedes adjustment of prices in The idea of market failure has evolved from these conven- the market. The consequences of failure to adjust prices are tional notions. Its relevancy in the present crisis pertains to many. This section will briefl y present some of the concepts of market distortion whereby prices diverge greatly from its true market failure. or fundamental value, as observed during bubble formation. A traditional notion of market The fundamental value is invariably failure entails obstacle in achieving based on some kind of expected effi cient production and distribution in revenue stream over the life time of a Pareto optimal sense. Various types asset. A common characterization of of market imperfections illustrate the price changes during bubble formation idea of ineffi ciency in production and entails investors’ reaction today based distribution. The immediate ramifi ca- merely on the expectation of further tion is on prices of goods and services. price rise in future. Such expectation, A textbook example of this would be however, is not grounded on economic the case of a monopoly producer or a reality. There is a plethora of evidence monopsony buyer. A large supplier to suggest bubble formation in past can alter the market prices favorably crises. Before the crash in 1929, there by manipulating production. By was a general feeling of unsustainable restricting supply, it can effectively price rise on Wall Street. The same was raise the market price above the true with the dot-com bubble earlier in competitive equilibrium which this decade. Moreover, prior to the inevitably results in loss of effi ciency, sub-prime debacle of 2007, there were commonly referred as dead-weight loss. In The housing alarming calls out on the un-sustainability a similar vein, a large buyer can squeeze bubble that of house prices. Author Robert J. Shiller in price below the competitive equilibrium, predated the his book “The Subprime Solution” again resulting in a dead-weight loss. current economic documents the evidence of out-of- sync Industry-wide price cartel is the most prices in the housing market. The bottom commonly observed form of market crisis is an line is that market prices fail to represent imperfection that leads to market ineffi - example of real worth of an asset during bubble. ciency. As Kenneth Arrow suggested market limitation Finally, the current crisis also illustrated market failure often results from the one more episode of market distortion. It absence of competitive market. is clear that the current global crisis is rooted in the US housing Another area of ubiquitous discussion on market failure market which exploded after the collapse of sub-prime mort- features the case of externality. When a mutually consenting gage market. The degree to which crisis in one sector of the transaction between two parties has an adverse consequence economy diffused to a global scene has been viewed in light of on a third party unrelated to the act, the case of negative sophisticated network of interconnected and interwoven externality is invoked. Environmental degradation due to fi nancial system, spread globally. Financial innovation of industrial pollutant is strongly argued as a cost on general roughly two decades offered investors with an array of state-of- public. The point is that the private cost fails to incorporate the the-art products. The idea of securitization was a breakthrough societal cost and is not refl ected in prices of industrial output. for investors as well as borrowers. Transactions in complicated Market as generally perceived fails to capture cost to society. derivatives and asset-backed securities were thought to provide In yet another related discussion, the case of public goods is investors with comforting choices. However, the level of often cited as an example of market failure. The nonexcludabil- sophistication proved costly in that proper asset valuation

40 THE IIPM THINK TANK M ISSING MARKETS

mechanism was trampled. Gorton(2008) argues that in course on behaviorists’ explanation of bubble, panic and other of repeated packaging of the asset-backed securities, the irrational behavior in the market. They argue that noneconom- system made it virtually impossible to penetrate the chain back- ic factors do motivate decision making, which explain the wards and value the asset based on the underlying mortgaged anomalies observed in the market. Authors Akerlof and Shiller property. The crucial information on future payoff was lost as a (2009) write that panic in the market spreads quickly and result of added complexity. A number of commentators2 have “fear” sets in motion the speed of contagion. They point that highlighted the fact that the complexity in the investors' psychology dominates decision making fi nancial market hampered price ddiscoveryiscovery uundernder ppanicanic situatisituationo and it quickly overwhelms the mechanism and contributed to marketarket distortion. mmarket.arket. There are evidences of this type of non- Inadvertently it may be but the marketarket rationalrational behaviorbe in past crises3. It is quite adjustment was laid dysfunctional.. clearclear thatthat the massive bail-out scheme offered by the governments’ 2.1 Market Limitation: world-wide, during current In the preceding section, we brieflfl y crisis, is driven to a large extent presented some conditions under by the concern to contain the the neo-classical tradition of possible contagion and help characterizing market failures. soar-up market confi dence. The broad distinction is either Prior to the current crisis, a the lack of effective competi- number of studies tried to tion or non-existent market. In analyze signs of bubble forma- a sharp contrast, the behavior- tion in the US housing market. ists’ explanation alludes to a CCase and Shiller(2003) report- more fundamental limitation in human ed—based on the survey of homeowners behavior. According to response—that there was a strong indica- As pointed before, the neo-classical argu- Kenneth Arrow, tion of bubble in the market4. Further, ment for market adjustment rests on the market failure Shiller(2008) provides a well thought-out idea of rational market guided by self often results narrative of bubble formation and inves- interest of market participants. A rationally tors’ reaction in run-up to the US housing motivated individual is suffi ciently from the absence crisis. The author argues that humans often equipped to make best decision in the of competitive respond in emotion, unpredictably, and market place. Many believe that this faith markets wildly. There is a tendency to exaggerate in the market formed the intellectual basis good news while downplay bad ones. for deregulation in the fi nancial market and an off-hand Moreover, investors are often biased in their decision. For approach in the policy orientation of recent decades. In the instance, home buyers often prefer investing in their home aftermath of current crisis, the all too- powerful rational town/city/state which often locks-out from exploring locations market argument is perhaps debated vigorously than any time preferable from the stand point of living comfort. In the run-up before. Economists, however, have for long pointed to the to the housing bubble that predated current crisis, the author limitation of rational market. notes that people believed and reacted to “word of mouth Herbert A. Simon is credited with bringing the notion of communication”. A price-story-price loop generated feedback bounded rationality to the forefront. He argued that agents mechanism for further price rise. Investors psyche prevailed face uncertainty in decision making and gathering all kind of over market rationale. To sum up, there are numbers of factors5 information can be prohibitively costly. Therefore, people that motivate our psychological perception, in good times or often make decision based on “satisfi cing” rather than deciding bad times. And, these factors feature prominently in our optimally. This limitation in human behavior is well grounded decision making. They often take over market rationality.

THE INDIA ECONOMY REVIEW 41 O PEN WORLD

Table 1: Total Political Contribution in the USA by Finance/Insurance/Real-Estate Industry

YearAmount USDYearAmount USD 1990 60,613,414 2000 309,119,703 1992 117,126,447 2002 233,061,144 1994 103,174,435 2004 340,099,037 1996 175,517,301 2006 259,437,470 1998 155,005,805 2008 474,857,391

Source: opensecrets.org

3. Deregulation and Market Failure: Sounds a perfect match until the reality of “too-big-to-fail” Based on the discussion so far, a reasonable case for some kind type institution6 emerged. Second, in 2000, under intense of market intervention seems indispensable. Insofar to address pressure of different lobbying groups, the Commodities market imperfections or the limitations in human decision Futures Modernization Act was passed. The legislation making, there is a role for some regulatory mechanism to provided for almost no regulation of derivative transaction ensure market smoothness. In the years including the catastrophic Credit Default after stock market crash of 1929, a series of Swap (CDS) which the fi nancial institu- regulatory measures were put in place in As a capital of tions had amassed to a critical level during the US fi nancial system. The relatively global finance, the the current crisis. Third, the Net Capital stable period of much of the remaining 20th consequences in Rule that originally allowed for debt to century may be rightfully attributed to the the US financial equity ratio of 12:1 often got higher check and balance that these regulations reaching up to 40:1, again under the provided. Some, however, argued against system continue infl uence of strong lobby. It is no coinci- what was perceived as too much encroach- to have global dence that the complex derivative transac- ment in the market during this time. ramifications tions became acceptable norm in the Towards the end of the 20th century, the evil industry nor is it any accident that the of big government—and to that extent the regulatory set-ups— fi nancial institutions were critically leveraged. had all but put to rest. The period also concur with an era of The deregulation-era policy orientation drew upon the greater integration of economies and market worldwide. intellectual philosophy of competent market capable of serving Finance and capital fl ows proved crucial for global economic its best interest, especially to maintain safety and soundness of growth. As a capital of global fi nance, the consequences in the the system. In the aftermath of the crisis, this argument is US fi nancial system continue to have global ramifi cations. A highly contested. Market imperfection resulted, to a large brief summary of deregulation efforts in the US fi nancial degree, under the infl uence of interest groups which were market is presented as a contextual description relevant in the unable to see their own long-term interest. Table 1 shows exam- current crisis. ple of business-politics connection. It is reasonable to doubt if In their book, “Bailout Nation”, authors Barry Ritholtz and the business interest had a natural pathway to policymaking Aaron Task discuss three crucial deregulation measures of last through political contribution. decade that connects importantly to the current crisis. First, they argue that the repeal of the Glass-Steagall Act, 1933, by 4. Market Intervention through Regulation: Gramm-Leach-Bailey Act, 1999, expanded the scope of Designing a workable regulatory framework is perhaps the traditional banking into a much larger center for fi nancial biggest challenge that policymakers face. It is well known that services. The banks benefi tted from economies of scale and incentivizing corrective action, or, equivalently, promoting innovations in the fi nancial market while consumers found a preventive measures, best solves many issues that market fails convenient location to meet all of their fi nancial-services need. to accommodate. In retrospect, it is quite clear that the

42 THE IIPM THINK TANK M ISSING MARKETS

deregulation-era policy measures provided little incentive for products and services.” check and balance. The incentive system in the fi nancial To fully appreciate the various dimension of regulatory industry resulted perverse outcome. Nobel Laureate Paul mechanism is out of the scope of this paper. Nonetheless, some Krugman often takes to the point that the pay-and-perform- important considerations that the upcoming regulatory system ance system in the fi nancial industry promoted more risk taking needs to address are presented. behavior. While no one is arguing to restrict the ingenuity and Mussa (1986) in writing on regulation of depository institu- innovative power of the private market, there is defi nitely a tions argued that the safety and soundness of the institution realization to bridge the big void left in the regulatory system. should be the core objective. In pointing defi ciencies of the One lesson the current crisis has made clear is the cataclys- existing system, the author notes that the government policies mic nature of risk to the entire system. The fragility of global tended to discourage adequate capital holding. Indeed, the fi nancial system was exposed in the events following collapse safety of institutions greatly relies on solvency of its fi nancial of the US sub-prime housing market. A sectoral impact position. The former Fed-chief Alan Greenspan wrote in a quickly turned into an industry-wide credit crisis and had a guest article in the Economist magazine that the banking signifi cant spillover effect on the real economy. The greater system needs “much thicker capital cushions” than they had interconnectedness of markets in the new millennium also enjoyed before the crisis. meant that the crisis spread quickly to a Second, some of the big banks which global scale. It is in response to this global took on a role of multi-service center are nature of crisis that nations world-wide are The pay-and- now recognized to pose a systemic threat, coordinating in establishing effective performance especially with hefty short-term leveraging. regulatory mechanism and also working in system in the Kenneth Rogoff of Harvard University concert to stimulate economies. The financial industry writes7 that systemically important banks following statement made at the recently need to be placed under stricter control on concluded G-20 summit succinctly identi- promoted more short-term borrowing. Others have argued fi es the problem: risk taking that there should be some mechanism to “At the same time, weak underwriting behavior prevent banks from becoming “too big to standards, unsound risk management fail”. Yet some other view that independ- practices, increasingly complex and opaque fi nancial products, ently each of the banks can make the same mistake and and consequent excessive leverage combined to create vulner- therefore individual entity should be brought under an um- abilities in the system. Policy-makers, regulators and supervi- brella of regulation. sors in some advanced countries, did not adequately appreci- Third, there needs to be some reconciliation to address the ate and address the risks building up in fi nancial market…or adverse incentive system of rewarding based on short-term take into account the system ramifi cations of domestic performance, something that has become industry standard in regulatory actions.” recent years. The compensation practice in the fi nancial It is quite clear that the reform measures to stabilize the industry is lately under serious debate given what many view as fi nancial market will be aimed at preventing the systemic risk a tendency to privatize profi t while socialize loss. This has been and to avoid situations of panic calls, typical during crisis. true in light of numerous bailout actions by governments in attempting to prevent free-fall of the economy. While the 4.1 Pertinent Issues in Regulatory Mechanism: fi nancial industry continues to oppose this as infi ltration in In discussing practicality of the regulatory system, it is impera- their territory, there is a sense of urgency to address the pay tive to fi nd appropriate balance between stability and effi cien- system and streamline the incentive. cy. Again, the following phrase from the G-20 meeting puts this Fourth, although proper risk evaluation entails technical squarely in context: analysis and objective evaluation, there is enough room for “…while ensuring that regulation is effi cient, does not stifl e subjective judgment in performance monitoring. Transparency innovation, and encourages expanded trade in fi nancial and accountability are related features of regulation which

THE INDIA ECONOMY REVIEW 43 O PEN WORLD

complements healthy market operation. To this effect, regula- overall economy tory bodies have a big role to play in remaining vigilant on 2 Note that Warren Buffet in 2003 warned complex deriva- activities in market to prevent any fraudulent scheme or tives as fi nancial weapons of mass destruction. predatory-type lending. 3 One example the authors cite is the ensuing bank run after Finally, it is necessary to acknowledge complexity in design- the suspension of currency payments by New York’s ing effective regulation. History shows how the interest groups Knickerbocker Trust in 1907. and lobbying pressure can undermine the effectiveness of the 4 It is indeed noteworthy that many of the studies failed to system. It will be hard to keep the business-politics nexus away. provide any conclusive evidence, worthy of necessitating Besides, managing the regulatory system should not become a policy response. bureaucratic nightmare. In all, regulation should pave for 5 Refer Akerlof and Shiller(2009) healthy competition in the market and not become a recipe for 6 The authors indicate that some of the US banks have another disaster—i.e., failure of the government. outgrown to lose effi ciency, even becoming too big to manage. 5. Conclusion: 7 Financial Times article dated August 18th, 2009 This paper is an attempt to present a summary of theoretical notion of market failure, relating the discussion to the current References global fi nancial crisis. It is clear that the crisis originated from a • Akerlof, George A. and Shiller, Robert J. 2009. “Animal sector in the US housing market which spread to the domestic Spirits: How Human Psychology Drives the Economy, and economy and eventually escalated to a global scene. Therefore, Why it Matters for Global Capitalism”, Princeton Univer- the events in the US fi nancial system are central to the paper sity Press. Princeton and Oxford. which nonetheless has global ramifi cations. • Case, Karl E. and Robert J. Shiller.2003. “Is There a Bubble The traditional notion of market failure suggests failure in in the Housing Market? An analysis”, Brooking Paper on price adjustment due to some sort of market distortion. This is Economic Activity, 2. different from dominant role of investors’ perception in • G-20. Declaration. Summit of Financial Markets and the decision making during bubble formation. A better under- World Economy. November 15th, 2008 standing of the kind of limitation in rational thinking was • Gorton, Gary B. 2008. “The Subprime Panic”, NBER offered through behavioral exposition. In analyzing the Working Paper Series, Working Paper 14398 deregulation-era policy measures, it became clear that a great • Greenspan, Alan. “Banks Need More Capital”. The deal of market imperfection resulted under infl uence of Economist. December 18th, 2008. interest groups. • Mussa, Michael. 1986. “Safety and Soundness as an Objec- On the second part of the paper, a case for effective and tive of Regulation of Depository Institutions: Comment on effi cient regulatory mechanism was argued. Our experience Kareken”, The Journal of Business, Vol. 59, No. 1, pp with market shows that proper regulation complements and 97-117. enhances safety and soundness of the system. Although • Ritholtz, Barry and Task, Aaron. 2009. “Bailout Nation”, diffi cult to achieve, it can stem untoward incidents while John Wiley & Sons, Inc. promoting healthy competition. The current crisis made aware • Rogoff, Kenneth. “Why we need to regulate bank sooner, of the risks in the fi nancial system that can potentially threaten not later”. Financial Times. August 18th, 2009. stability of the entire market. Current debate on avoiding • Shiller, Robert J. 2008. “The Subprime Solution: How system risk is a right step toward fi nancial market stability. Today’s Global Financial Crisis Happened, and What to Do Some of the key concerns to this effect were discussed. about It”, Princeton University Press. Princeton and Oxford. Endnotes 1 Here, we characterize a major crisis as the one that can (The views expressed in the article are personal and do not refl ect potentially overwhelm the entire industry and is a threat to the offi cial policy or position of the organisation).

44 THE IIPM THINK TANK O PEN WORLD Trade Liberalisation and Indian Farm Sector: Understanding the Situation from Available Evidence

4646 THETHT HEH E IIPMIIII PMP M THTTHITHINKHHII NKK TANKTTANTAAANN K F ROM COLUMBUS TO CONA GRA

offi cer cannot pay even a single penny more than what is Subrata Dutta already fi xed. According to Chand (2007), this is the sole Associate Professor, Sardar Patel Institute of reason for the failure of the government to achieve its Economic and Social Research, Ahmedabad procurement target and objective. This practice also puts the government in an embarrassing situation when it has to meet its needs through purchasing wheat from the multinationals, Market Liberalisation with Faulty Price Policy which are hoarding the grains, (or through imports) by Let us fi rst try to understand the concern about how agricul- paying high prices than those paid to domestic producers. tural trade liberalisation has often been affecting our food Chand (2007) emphasises that there is an urgent need to security issue via the hike in prices. The rise in wheat price follow a dual price system in order to procure grain at in last few years in India has been mainly the result of trade required quantity and thus stabilise the market price of liberalisation. It is true that due to rising population growth grain. The government should immediately differentiate supply of wheat fell short of what has been demanded after between the MSP and PP and the latter should be higher 2004-05, but in the last seven years signifi cant market than the former while at the same time the PP should also reforms, resulting in increasing the participation of the be kept fl exible, meaning, for example, that the PP can be private sector in foodgrain trade, have been mostly responsi- declared on a weekly basis. The MSP has an objective to ble for the rise in wheat price. Ramesh Chand (2007) has save farmers by ensuring remunerative prices to them for analysed the case in a well manner. A number of big compa- their produces on the basis of the Commission for Agricul- nies (including multinationals), e.g. ITC, tural Costs and Prices (CACP) recom- Cargill, Australian Wheat Board, mendations while prices fall below the Britannia, Con Agro, Delhi Flour Mills When the market level fi xed by the CACP. Such MSPs are and some others, are now operating in price of a grain is fi xed at incentive levels so as to induce foodgrain trade, holding sizeable stocks higher than theh the farmers to make capital investment and playing with their inventories to MSP, the PP must for the improvement of their farm and to cause increases in price and to take motivate them to adopt improved crop advantage of the same. In case the follow the market production technologies to step up their government had a reasonable stock it norms and offer production and thereby their net income. could keep a check on any abnormal market prices However, how far these objectives are increase in prices. But the government met through the MSPs is questionable has a faulty price policy. Every year the minimum support and that is why the PP should be given substantial impor- price (MSP), which remains fi xed for the whole particular tance. When the market price of a grain is higher than theh season, is announced and thereafter the government starts MSP, the PP should follow the market norms and offer procuring commodities like wheat and rice either at the MSP market prices. or by adding a bonus to the MSP. This fi xed price policy does not fi t in the open market system and thus inhibit the The Crises in Farm Sector government in procuring the required quantity of produce. There are a large number of small and marginal farmers in The procurement either falls short or exceeds what is needed India. They have been suffering from adverse effects of to be purchased by the government. However, there is uneven liberalisation in international agricultural trade. In another concept called procurement price (PP), but virtually consequence, several small and marginal farmers have in practice the MSP turns out to be the fi xed PP (sometimes committed suicide in various states in India in last half-a- with added bonus, as said earlier). It allows the private sector decade for the reason that they had been heavily indebted to to outstrip government agencies by offering a little more the private non-institutional moneylenders and at the same than the procurement price. In such a situation, the govern- time they had been unable to get the proper price for their ment becomes a helpless witness since the procurement produces. Rural institutional credit supply failure is clearly

THE INDIA ECONOMY REVIEW 47 O PEN WORLD

Table 1: Agriculture Subsidies in India during 2000-01 to 2004-05 (Current Price) (Rs. in Crore) Item 2000-01 2001-02 2002-03 2003-04 2004-05 1. Fertilizer 13800 12595 11015 11847 16127 2. Electricity* 6056 9342 7354 NA NA 3. Irrigation** 13465 13164 15012 11142 12990 4. Other subsidies given to marginal farmers and farmers' cooperative societies in the form of seeds, 2686 3041 3133 4018 NA development of oilseeds, pulses etc. 5. Total 36007 38142 36514 27007 29117

Notes: * Includes all subsidies to Electricity Boards and Corporations. Separate estimates of subsidies on Electricity exclusively provided to agriculture sector are not available. ** The rates for supply of water to farmers are kept low as a matter of policy, resulting in losses to the government irrigation system. The excess of operating costs over the gross revenue is treated as imputed irrigation subsidy. NA stands for "not available". Source: Directorate of Economics and Statistics, Ministry of Agriculture, Government of India. one of the responsible factors for farmers' misery, but the ture itself fi nds lack of clarity in this regard (see the note most serious concerns are the distortionary tariff and price just below Table 1). Irrigation subsidy fi gure is clearly lower policies adopted by the developed countries. The huge in 2004-05 than that in 2000-01. Seed and other subsidies subsidies which are given to the farmers in the developed have experienced an increasing trend though, the overall countries have been artifi cially reducing the prices of their picture is not impressive. produces and simultaneously destroying the comparative Two opposing schools of thought are found in the litera- advantage of the farmers of developing countries. While ture on correlation between liberalisation and agriculture the developed countries are protecting their farmers (Vakulabharanam, 2005). One school stresses that there is a through conservative measures (by imposing tariffs on policy bias against agriculture in LDCs, keeping output imported agricultural produces and prices artifi cially low (as compared to the providing subsidies to their farmers) on international prices) by maintaining the one hand, they are demanding for, Fertilizer subsidy subsidies on inputs. This school suggests and also forcibly implementing, market experienced a removal of incorrect price incentives, i.e. liberalisation in developing countries to downward trend input subsidies, from agriculture and the larger market. For such forcible till 2002-03, making agricultural market more open to implementation of liberalised policies in global trade. As for example, Khan (2004) developing countries, the developed except a marginal argued that input subsidies led to misuse countries are taking help from the World increase in the or over-use of inputs. However, the Bank and the International Monetary year 2003-04 second school of thought offers an Fund (IMF) on which the developing argument, among others, saying that countries are dependent for loans. Table 1 presents an subsidies that the farmers of developed countries receive are illustration of agricultural subsidies in India from 2000-01 much signifi cant than that received by the farmers of to 2004-05. Fertilizer subsidy experienced a downward developing countries (see, among others, Anderson, 1992; trend till 2002-03, except a marginal increase in 2003-04. Tangermann, 2006), thereby resulting in unfair competition In 2004-05, it has increased signifi cantly due to the fact that in international market. Bardhan (2006: 1395) argued that, the government realised that sluggish growth in agriculture in exports, the major hurdle the small producers face “is was going to hamper the overall GDP growth of the coun- often due to not more globalisation but less.” In 2000, the try. As regards subsidy in power sector, one can hardly producer subsidy in OECD countries was US$ 330 billion fi gure out about how much is exclusively going to the -- equal to Africa’s entire annual GDP (Albert and Springer- farmers as electricity subsidy since the Ministry of Agricul- Heinze, 2006). The protectionist policies of developed

48 THE IIPM THINK TANK F ROM COLUMBUS TO CONA GRA

Table 2: Import Trend of Raw Cotton Lint in India pushed other countries to open up their markets to areas of our [the USA’s] strength … but resisted efforts to make us Year Import Import Value Unit Price of Import reciprocate”. Tangermann (2001) points out that, as regards Quantity (in (in 1000 (in US$ per metric reduction in export subsidies, the EU has created main metric tonne) US$) tonne) problems since their share in total worldwide export subsidy 1990 167 311 1862 on many agricultural products is very high. Naik (2005) 1996 8795 2850 3086 states that the world prices of sugar now are below the costs 2003 241787 333282 1378 of production of some of the most effi cient producers. “In Source: Philip and Jenniah (2006) fact in some cases, such as cotton in India, the effi cient producers are unable to compete in their own domestic countries in agriculture are highly distorting and impose market. Cotton imports in India have increased substantially substantial costs on farmers in developing countries (Ismail, due to the availability of cheap US cotton, as a consequence 2006). Recent estimates by International Food Policy of the subsidies provided by the US to their farmers” (Naik Research Institute (IFPRI) suggest that protectionism and and Singh, 2003: 60). Cotton farming occupies a signifi cant subsidies in industrialised countries cost developing coun- place in the Indian economy as a means of employment to tries about US$ 24 billion in agricultural and agro-industrial over one million farmers in the primary sector. It is also income (cited in Pal, 2006). If all dynamic and spill-over offering direct employment in the textile industry that effects are taken into account, the fi gure will be much signifi cantly contributes to an extent of 14 percent of the higher. In the EU and USA, the subsidy level is very high for country’s industrial production, 30 percent of the country’s wheat, sugar and rice (Naik 2005, Chakraborty and Singh export earning and four percent of the GDP. Let us refer to 2006). Sugar and cotton, along with some other items, which Philip and Jenniah (2006) for the Indian cotton-case in receive the highest level of subsidies in the EU or USA, are liberalised era. Cotton imports were liberalised in 1991. very important export commodities in the world market. With this the monopoly of Cotton Corporation of India was Subsidies on these items are undermining terminated and imports were placed the export potentials of many developing under the open general license, allowing countries. The trade opportunities of The extent of unrestricted imports by private traders. developing countries are being negatively cotton subsidies The import duty was originally set to zero affected both by the domestic support (on prevailing in the and there was a surge in imports in the production or output) and export support global level is late 1990s (see Table 2). On account of in developed countries. Philip and this surge, domestic prices too witnessed Jenniah (2006) argued that the removal close to 13% of a major decline, resulting in incidents of of subsidies by the US, EU and China the total value suicides committed by cotton farmers. would increase the world price of cotton produced in India The situation forced the government to by 18 percent. They also argued that a impose fi ve percent tariff in 2000. Still small change in subsidy could create a phenomenal impact this could not provide cotton farmers with a major remedy. on the cotton production of some countries like the US and As we already said, liberalisation has caused several EU, to the extent of 15 and 32 percent respectively. This, in Indian cotton farmers to commit suicide. Narayanamoorthy turn, would result in supply shifts. Subsidies given in cotton (2006) observed that profi ts have been declining particularly at the global scale averaged US$ 5 billion and the extent of since late 1990s, because of a substantial increase in the cost subsidies prevailing in the global level is close to 13 percent of cultivation. He asserts that farmers need remunerative of the total value of cotton produced in India. US subsidy to prices for their crops because their income from crop cotton farmers is in the form of direct assistance to farmers cultivation is not enough to even cover their consumption through marketing loan assistance and market loss assist- expenditure. Moreover, the farmers have been indebted to ance. Stiglitz (2003: 206) commented that “[T]he U.S. moneylenders, traders etc. for they had taken loans from

THE INDIA ECONOMY REVIEW 49 O PEN WORLD

these non-institutional sources. There is another concern in if Indian dairy producers could initially afford to pay EU cotton farming. Let us refer to the observations of Narayana- tariffs of 144 percent on butter and 76 percent on milk moorthy and Kalamkar (2006). Cotton’s productivity in powder, it could hardly compete in Europe with domestic India is one of the lowest in the world mainly due to attacks producers, half of whose income is derived from subsidies by pests/insects and low coverage of irrigation facility. In (Oxfam, 2002a). At the same time, India’s efforts to export spite of using pesticides, farmers are unable to control the milk and other dairy products to new net dairy-importing bollworm -- the key pest in cotton -- that ravages up to 80 markets in countries in South-East Asia, the Gulf, and the percent of crop output. In India, Bt (which stands for southern Mediterranean are being hampered by unfair Bacillus Thuringiensis) cotton was introduced in March competition from subsidised European dairy exports 2002 for commercial cultivation. This variety can protect (Oxfam, 2002b). On the other hand, as Shah noted, Indian itself from the bollworm. Although the productivity and milk producers are rather worried because an increase in profi t from Bt cotton cultivation is substantially higher than cheap imports of milk products, particularly milk powder, the conventional hybrid cotton varieties, the seed cost of Bt would further adversely affect their milk production by cotton is very high as compared to non-Bt hybrid varieties. lowering the price of the milk they sell. At least as a short term measure, direct subsidy should be Globalisation, on the other hand, has created some provided for Bt cotton seed, but liberalization is standing in positive effects on Indian economy as we have seen that the way of such measure. through the 1990s the share of handi- Shah (2006) analyses the effect of crafts exports in the overall manufactur- WTO on Indian dairy industry. Milk is The share of ing exports of India has risen from two such a product using which (as input) a Indian handicrafts percent to fi ve percent (Leibl and Roy, number of by-products (e.g. butter, differ- exports in 2003). But Basu (2006), while visiting to ent kinds of sweets, ghee, paneer etc.) the overall the village of Jakorta in a remote corner have grown (or even can further grow in of Gujarat and talking to the villagers the future) in the rural agro-industrial manufacturing who were engaged in earning their sector in India. The success of milk exports has risen livelihood largely from handicrafts and producers’ unions/cooperatives, like from 2% to 5% mainly embroidery work on textiles, AMUL, is well-known in India. But let us found “double-edge sword of globalisa- not forget that millions of small farmers who produce tion”. What is that? On the one hand, the villagers had nominal quantity of marketable surplus of milk (only a litre benefi ted in the last decade because of globalisation by or two) are majority in this industry. Landless labourers in selling their products to other countries. On the other hand, India account for 21 percent of the total rural households.1 they feared that their livelihood could get wiped out by Though they do not have any share in the total landholding, competition from some international producers who decide they own 12 percent of the milk produced. At current prices, to export to India. Basu emphasises that the villagers are still the value of livestock products in the country in 2003-04 is poor enough since end of prosperity for them could mean estimated at Rs. 164,509 crores with milk and milk products poverty, destitution and even starvation. The producers accounting for 67 percent. Indian dairy industry has the cannot avoid this double-edge sword of globalisation. potential to capture a considerable part of the world market Another example can be relevant here. While elimination of but, as Shah (2006) argued, currently this industry is subsidies from agriculture in developed countries can benefi t adversely affected by distorted world prices of dairy prod- farmers of countries like India and China, removal of trade ucts due to export subsidies extended by the EU and US. distortions in India and China in the case of groundnut trade Moreover, developing countries cannot participate in would substantially benefi t the African countries through international trade because their products are barred from increasing their export volume and thus income (Beghin et entry into rich countries by trade barriers, restrictive trade al., 2006). Their groundnut needs to be promoted but there policies and stringent health and sanitary standards.2 Even is another concern as well. The issue now becomes more

50 THE IIPM THINK TANK F ROM COLUMBUS TO CONA GRA

complex when we see that many low-income food-defi cit low and medium technology industries, and low skill countries depend on import of food to survive. According to services. One of the reasons of the poor productivity rates the FAO, there are currently 86 low-income food-defi cit of these sectors is the lack of new technologies and manage- countries (for further details, see Grote and Wobst, 2006). ment effi ciencies. Zeng (2005) suggested that dissemination Let us take the example of Senegal in which food production of new technologies and advanced management practices has doubled in absolute terms since 1960 (the year of throughout the rural economy may be of some help in the independence), but, due to the country’s high level of days to come. Zeng argued that small and medium enter- population growth, per capita food production has fallen by prises, especially those in the urban areas and also belong- almost 50 percent. As a result, Senegal is heavily dependent ing to the tertiary sector, have become an increasingly on import of food item, especially broken rice.3 Senegalese important source of job creation. But the majority of the people have developed this consumption pattern probably village enterprises have limited technological and human due to availability of broken rice in suffi cient quantity during resources to become internationally competitive. This is the the colonial and post colonial period. Broken rice is import- headache for China even while the remarkable growth of its ed in order to keep food prices under control and at the same national economy has drawn much attention of the interna- time groundnut is exported as Senegal’s main export product tional community. (Brüntrup et al., 2006). Since currently rice imports account for seven to eight percent of total imports and pose a major Endnotes burden on the country’s trade and foreign exchange balance, 1 Oxfam (2002b) has noted that India has now become the increase in groundnut export alone would not be of great world’s largest dairy producer, producing 84 million help for the country to grow as a whole. As a remedial tonnes of milk. Its dairy sector includes a network of measure, it needs to restrict import and also substantially cooperatives serving more than 10 million farmers in over improve agricultural productivity, and this can change the 80,000 villages. consumption pattern gradually. Only 10 percent of farms 2 Albert and Springer-Heinze (2006) argues that although occupy irrigated land, whereas the rest 90 percent are stringent regulatory requirements contain risks, the rural rainfed, which offer little potential for more intensive producers in developing countries should consider such farming (Brüntrup et al., 2006). Extremely weak agriculture requirements as opportunities which would allow them to sector cannot be a base for economic prosperity. That is why meet rising quality demands of consumers throughout the the industrialisation strategy adopted earlier had yielded world. very little in the internationally competitive environment. It 3 Broken rice is a by-product of rice processing. In the should start from its agriculture and, for that, within WTO international market, broken rice is considered an inferior there should be adequate scope for a country like Senegal product and is therefore much cheaper than whole rice. for adopting conservative rice import policy while at the same time it should take advantage of trade liberalisation References and Additional Thinking and promote their groundnut in other countries. This case • Albert, Helmut and Andreas Springer-Heinze (2006): proves that WTO needs to take a very careful look at the “Value-Added Chains and Agricultural Trade”, Agricul- country specifi c cases while trying to pursue trade liberalisa- ture and Rural Development, Vol. 13, No. 1, pp. 15-17. tion in the world. • Anderson, Kym (1992): “International Dimensions of the Although China has made impressive progress in eco- Political Economy of Distortionary Price and Trade nomic development and improving social well-being, it is Policies.” In Ian Goldin and L. Alan Winters (eds.), Open facing many challenges while liberalising its economy and Economies: Structural Adjustment and Agriculture, pp. after WTO accession. The main challenge is to fi nd employ- 290-310, Cambridge: Cambridge University Press. ment for millions of people who are being displaced from • Bardhan, Pranab (2006): Globalisation and Rural Pov- farm jobs as a result of WTO accession. In China, the erty”, World Development, Vol. 34, No. 8, pp. 1393-1404. majority of the labour force is still in agriculture, traditional • Basu, Kaushik (2006): “Globalisation, Poverty, and

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Inequality: What is the Relationship? What can be • Narayanamoorthy, A. (2006): “Relief Package for Farm- Done?” World Development, Vol. 34, No. 8, pp. 1361- ers: Can It Stop Suicides?” Economic and Political 1373. Weekly, Vol. XLI, No. 31, August, pp. 3353-3355. • Beghin, John, Diop Ndiame, and Holger Matthey (2006): • Narayanamoorthy, A. and S.S. Kalamkar (2006): “Is Bt “Groundnut Trade Liberalisation: Could the South Help Cotton Cultivation Economically Viable for Indian the South? World Development, Vol. 34, No. 6. pp. Farmers? An Empirical Analysis”, Economic and Political 1016-1036. Weekly, Vol. XLI, No. 26, June, pp. 2716-2724. • Brüntrup, Michael, Thao Nguyen, and Christian Kaps • Oxfam (2002a): “Europe’s Double Standards: How the (2006): “The Rice Market in Senegal”, Agriculture and EU should Reform Its Trade Policies with the Developing Rural Development, Vol. 13, No. 1, pp. 22-25. World”, Oxfam Briefi ng Paper 22, Oxfam International. • Chakraborty, Debashis and Yashika Singh (2006): • Oxfam (2002b): “Stop the Dumping! How EU Agricul- “Agricultural Subsidy: The Major Hurdle to Free Trade.” tural Subsidies are Damaging Livelihoods in the Develop- In Dipankar Sengupta, Debashis Chakraborty and Pritam ing World”, Oxfam Briefi ng Paper 31, Oxfam Internation- Banerjee (eds.) Beyond the Transition Phase of WTO: An al. Indian Perspective on Emerging Issues, pp. 75-107, New • Pal, Parthapratim (2006): Development Boxed! Analysing Delhi: Academic Foundation (in association with Centre Box Shifting and Other Issues of Domestic Subsidies in de Sciences Humanities). WTO Agricultural Negotiations, New Delhi: Oxfam. • Chand, Ramesh (2007): "Wheat Import and Price Out- • Philip, Linu Mathew and Aldas Jenniah (2006): The look for 2007-08: Separating the Grain from the Chaff", Indian Cotton Dilemma: Caught in the International Economic and Political Weekly, Vol. XLII, No. 31, August Cotton Mesh, New Delhi: Oxfam. 4, pp. 3196-3199. • Shah, Deepak (2006): Milked Away by Developed • Grote, Ulrike, and Peter Wobst (2006): “What do Libera- Countries: Plight of Indian Dairy Farmers in WTO lised Agricultural Markets mean for food-importing Regime, New Delhi: Oxfam. developing countries?” Agriculture and Rural Develop- • Stiglitz, Joseph (2003): The Roaring Nineties. New York: ment, Vol. 13, No. 1, pp. 18-21. W.W. Norton. • Ismail, Faizel (2006): “Mainstreaming Economic Devel- • Tangermann, Stefan (2006): “The WTO Negotiations: opment in the Trading System.” In Simon J. Evenett and What Interests are the OECD Countries Pursuing?” Agri- Bernard M. Hoekman (eds.) Economic Development & culture and Rural Development, Vol. 13, No. 1, pp. 7-9. Multilateral Trade Cooperation, pp. 213-228, Washington • Tangermann, Stefan (2001): “Agriculture: New Wine in and New York: The World Bank and Palgrave Macmillan New Bottles?” In Klaus Günter Deutsch and Bernhard (a co-publication). Speyer (eds.), The World Trade Organisation Millennium • Leibl, M., and T. Roy (2003): “Handmade in India: Round: Freer Trade in the Twenty-First Century, pp. Preliminary Analysis of Crafts Producers and Crafts 199-212, London and New York: Routledge. Production”, Economic and Political Weekly, Vol. 38, • Vakulabharanam, Vamsi (2005): “Growth and Distress in December 27th. a South Indian Peasant Economy during the Era of • Naik, Gopal (2005): “Expiry of Peace Clause in WTO’s Economic Liberalisation”, Journal of Development Agriculture Agreement: Implications.” In Ramesh Chand Studies, Vol. 41, No. 6, August, pp. 971-997. (ed.), India’s Agricultural Challenges: Refl ections on • Zeng, Douglas Zhihua (2005): “China’s Employment Policy, Technology and Other Issues, pp. 47-77, New Challenges and Strategies after the WTO Accession”, Delhi: Centre for Trade and Development (Centad), World Bank Policy Research Working Paper 3522, established by Oxfam GB. February. • Naik, Gopal and Yashika Singh (2003): “Doha Round Negotiations: Agriculture,” Working Paper No. 217, (The views expressed in the article are personal and do not Indian Institute of Management Bangalore, November. refl ect the offi cial policy or position of the organisation.)

52 THE IIPM THINK TANK O PEN WORLD The Harmful Impact of Protectionism

Rok Spruk* empirical evidence overwhelmingly supports the notion that free trade is an economic benefi t for the nation, regardless of Economist, Slovenia country’s level of development. In this article, I discuss the harmful impact of trade protectionism and why free trade should be the key priority of economic policies worldwide.

Trade Protection in International Trade here is a general agreement among economists that Policymakers imposing policies that restrain trade often point free trade is good for the economy. Polls have sug- out the necessity of domestic market protection against foreign T gested that more than 90 percent of economists in the competition. The economic history offers numerous examples U.S believe free trade is benefi cial for the economy and society of trade protection. Back in 1930, the U.S Congress adopted as a whole. Ever since the beginning of the fi nancial crisis, the Smoot-Hawley Act which raised tariff rates on over 20,000 policymakers around the world exerted strong pressure to imports entering the U.S. The adoption of high tariffs on enforce the protectionist trade policy. In the United States, imports restrained foreign trade. Between 1929 and 1932, the American Federation of Labor openly opposed free-trade world trade diminished by 66 percent. Back in early 2002, agreement between the United States and President George W. Bush placed tariffs on Columbia. In France, the policymakers imported steel, arguing it would protect the suggested the introduction of carbon tariffs India is at U.S steel industry. Immediately after the on countries which refuse to cut carbon the crossroad enactment of steel tariffs, World Trade emissions. Before the Great Depression of between pursuing Organization declared tariffs unjustifi ed 1929, the U.S Congress enacted Smoot- free trade policies and highly protectionist. Before 2002, 30 Hawley Act which sharply raised tariffs on U.S steelmakers declared bankruptcy, seek- foreign exports. In spite of hefty rethoric or imposing ing effective tariff rates up to 40 percent. about the benefi ts of trade protection, the protectionist After steel tariffs were introduced, cost of trade protection exceeds the benefi ts trade policies European Union announced it would of trade protection shared by the few. The impose retaliatory tariffs. The economic beginning of the fi nancial crisis of 2008/2009 that led to the effects of imposing tariffs on steel imports were disastrous. In recession initiated a set of trade policies that promote protec- the long run, empirical evidence suggests, the demand for steel tionism. According to IMF; in 2009, emerging market econo- is highly inelastic, ranging from -0.2 to -0.3. This suggests that, mies expect 8.8 percent decline in the import of goods and as the price per unit of steel increased by one percent, the services and six percent decline in the export of goods and long-run demand for steel would decrease by -0,2 to -0,3 services. In 2008, imports of goods and services in developing percent. On the other hand, empirical estimates of price economies grew by nearly 11 percent. India and other emerging elasticity of steel supply show that the long-run coeffi cient of market economies are on the crossroad between pursuing free elasticity does not exceed 3.0 - a very elastic supply, indeed trade policy or imposing protectionist trade policy. The curve. This suggests that as per unit price of steel increases by

54 THE IIPM THINK TANK P ROTECTION’ S PRICE

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one percent, the quantity of supplied steel goes up by three abundant with capital will incompletely specialize in the percent. In the situation of inelastic demand and elastic supply, production of capital-intensive good. The international trade the introduction of tariffs on steel imports reduced consumer will, hence, reduce the reward to the scarce factor of production. surplus. Thus, the effect of tariff levied into higher producer Since developed countries are usually capital-abundant, there surplus. The effective tariff rate on steel, which ranged from are signifi cant pressures from less abundant factor (labor) to eight to 30 percent, reduced the consumption of steel imports impose tariff protection. and raised the equilibrium price in the world steel market. Back in June 2009, American Federation of Labor (AFL) Economists Joseph Francois and Laura M. Baughman estimated exerted a signifi cant pressure on Obama Administration not to the effects of the introduction of steel tariffs. According to their enact U.S-Columbia free trade agreement (FTA). The AFL estimates, a 10 percent increase in the price of steel, reduced the stated that Columbian government has no respect for labor employment in steel industry by 0.64 percent. Each saved job rights. The AFL further stated that FTAs contributed to U.S cost the U.S economy 445.497 USD on trade defi cit, job losses and lower wages. average. In December 2002, increase in per However, the real argument for eliminate unit price of steel led to 197,000 employment A ten percent the FTA between the U.S and Columbia in U.S steel industry. So the question is what increase in the came from the opposition of the scarce to choose - higher steel prices and fewer jobs price of steel, factor of production to international trade. or a vibrant and competitive steel market? reduced the The openness of protected labor-intensive The economic effects of trade protection industries to trade reduces the real reward clearly contradict the notion that protection- employment in to labor in the short run. However, the ism is good for the economy. the steel industry reduction in real reward to labor is more Back in 1941, Paul A. Samuelson and by 0.64 percent than compensated by a long-run increase in Wolfgang Stolper formulated Stolper-Samu- purchasing power enabled by lower prices of elson theorem. Assuming perfect competition and constant imports. A research paper by economists Christian Broda and returns of scale, the theorem states that “a rise in the relative John Romalis of the University of Chicago investigated the price of good will lead to the rise in the return to that factor effects of price dispersion on welfare of U.S consumers. The which is used more intensively in the production of the good, and authors found that between 1994 and 2005 non-durable infl ation conversely, to a fall of the return to the other factor.” The for households in 10th percentile of income distribution was 7.3 theorem has important implications for international trade. percent lower than non-durable infl ation for households in the Samuelson and Stolper wrote: 90th percentile of income distribution. A study by economists “Second only in political appeal to the argument that tariffs Gary C. Hufbauer and Kimberly A. Elliot estimated the cost of increase employment is the popular notion that the standard of trade protection in the United States. The authors estimated that living of the American worker must be protected against the ruinous the restriction of foreign imports cost $199,000 for each job in competition of cheap foreign labor… In other words, whatever will the textile sector and $1,376,000 in the benzenoid chemical happen to wages in wage good (labor intensive) industry will industry. There is even more additional evidence that free trade happen to labor as a whole. And this answer is independent of promotes welfare by reducing domestic infl ation. Andreas whether the wage good will be exported or imported.”1 Fischer and Raphael Auer (2008) showed that import competi- The powerful version of Stolper-Samuelson theorem states tion from low-wage countries dampens the US producer price that the international trade between two countries leads to the infl ation for manufactured goods by more than two percentage situation in which at least one factor of production faces a points annually. decline in the real income. The rigorous version of Heckscher- Ohlin-Samuelson theorem states that international trade is a Economic Effects of Trade Liberalization: consequence of difference in relative factor abundance. It means Evidence from India that countries abundant with labor will incompletely specialize The World Trade Organization (WTO) has recognized India’s in the production of labor-intensive good while countries trade liberalization efforts and remaining barriers to trade.

56 THE IIPM THINK TANK P ROTECTION’ S PRICE

The WTO wrote: 78 industries after the period of trade liberalization and “Recognizing the importance of continuing its economic reform cross-section data for 2,500 fi rms in 16 Indian states, they and especially its trade aspects, India has pushed ahead with found that trade liberalization had a favorable effect on FDI further reductions in the tariff: the overall applied MFN rate fell infl ows in Indian manufacturing industries and that higher from 32.3% to 15.8% between 2001/02 and 2006/07… While cross-border trade has attracted higher foreign direct invest- import barriers have been falling, India's export regime continues ment (FDI) into manufacturing industries. They also showed to be complex. Export prohibitions and restrictions are largely that regions having great involvement in international trade unchanged since India's last Review. However, in order to reduce are able to attract greater amount of FDI. A study by Topalova the anti-export bias inherent in India's import and indirect tax (2004) found that reduced trade protectionism led to higher regime, a number of duty remission and exemption schemes are levels and growth of fi rm productivity, having the strongest in place to facilitate exports.”2 effect on private companies. The empirical evidence of the economic effects of trade liberalization shows that The Cost of Protectionism lower barriers to trade and foreign market India has pushed In the annual assessment of economic access have stimulated regional trade. In ahead with further freedom, Index of Economic Freedom studying the effects of trade liberalization reductions in the critically evaluated India’s trade policy. on wage inequality Mishra and Kumar tariff. The overall It says: (2005) have estimated that India’s 1991 “India's weighted average tariff rate was trade liberalization has boosted productiv- applied MFN rate 14.5 percent in 2005. Large differences ity growth at the fi rm level and increased fell from 32.3% between bound and applied tariff rates, wage premiums for skilled and non-skilled to 15.8% import and export restrictions, services workers. The authors suggest that trade market access restrictions, import taxes and liberalization has reduced wage inequality. There are, of fees, complex and non-transparent regulation, onerous standards course, other features that affected lower wage inequality. and certifi cations, discriminatory sanitary and phytosanitary Acharyya (2006) estimated the effects of trade liberalization measures, restrictive licensing, domestic bias in government on income inequality and poverty. The author emphasized procurement, problematic enforcement of intellectual property rising income inequality - measured by the Gini coeffi cient - rights, export subsidies, inadequate infrastructure, counter-trade as a result of robust growth in manufacturing imports and policies, and complex and non-transparent customs add to the exports. During 1990s, the high-tech manufacturing sector cost of trade.”3 experienced robust growth in exports. Since high-tech The existence of non-tariff barriers stimulates lobbying manufacturing sector is skill-intensive, the shift toward groups who seek profi t opportunities by exerting pressure on skill-intensive exports is a plausible explanation of higher policymakers to protect markets by imposing tariffs against income inequality. foreign competition. Non-tariff barriers add to the cost of There is another example of the benefi cial effect of free trade. If tariff and non-tariff barriers persist, trade fl ows are trade. Prior studies by Deaton and Dreze (2002) showed that diverted while welfare gains from trade are diminished. There urban and rural poverty rates decreased in the periods is no better engine of poverty reduction than free trade. High between 1993 and 2000. The urban poverty rate fell from 17.8 tariff and non-tariff barriers to trade decrease the real percent to 12 percent while the rural poverty rate fell from 33 purchasing power of consumers. It often happens that pres- percent to 26.3 percent of the population. In another study of sures for tariff protection come from small and infl uential the effect of trade liberalization on foreign direct investment, lobbying groups. Lobbying for trade protection from foreign Goldar and Banga (2007) presented their results. They found competition results in unproductive rent-seeking activities. that between 1980 and 1998, the effective rate of trade protec- These activities are unproductive because they provide tion fell from 99.5 percent to 41 percent. Applied tariff rates anticipated profi ts for those who lobby but do not create any and non-tariff barriers declined as well. Using panel data for valuable output for consumers.

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Table 1: India’s Major Trade Partners in 2007

Trading Partner Share of Exports (in %) Trading Partner Share of Imports (in %) European Union 21.7 European Union 14.8 United States 13.8 China 11.2 United Arab Emirates 9.9 Saudi Arabia 7.6 China 6.5 United States 6.5 Singapore 4.4 United Arab Emirates 5.4 Others 43.7 Others 54.5 Source: World Trade Organization, India Trade Profi le (2009)

Pillars of Free-Trade Policy • Elimination of all tariff and non-tariff obstacles to trade In recent decades, India’s economy has grown at the robust • Ensuring transparency and rigorous enforcement of intellec- pace, averaging over seven percent between 2001 and 2007. In tual property rights 2009, the economic growth rate is expected to reach 4.5 • Ending of export subsidies and import restrictions percent. By 2014, the Indian economy is expected to increase • Deregulation of customs procedures by eight percent annually. The emergence of India as one of the • Elimination of all government barriers to market entry leading economic powers in the world is likely to increase its The economic theory and history teach that trade protection infl uence in world markets and, hence, in world trade policy. is an unproductive benefi t of the few without the valuable gain Table 1 shows major Indian export and import partners in 2007. for the rest of the society. If India played the leading role in In recent years, India already signed bilateral trade agree- eliminating all tariff non-tariff barriers to trade and invest- ments with countries such as Chile, Singapore, Bhutan and Sri ment, encouraging the protection of intellectual property rights Lanka. It joined and signed regional free trade agreements and initiating efforts for multilateral trade liberalization, it such as Asia Pacifi c Trade Agreement (APTA) and South would emerge as one of the leading economic and political Asian Free Trade Agreement (SAFTA). Bilateral and regional giants sooner than current fi gures suggest, and inspire other trade agreements are a step in the direction of free trade but, nations to follow India’s pursuit of free trade and robust from a broader perspective, multilateral free trade is superior economic performance. to regional and bilateral trade agreements. Multilateral free trade eliminates all the unnecessary bias that lead to trade Endnotes and Additional Thinking diversion and distorted allocation of resources. 1 Stolper, Wolfgang F., Paul A. Samuelson (1941), Protection The question that remains is what are the pillars of trade and Real Wages, Review of Economic Studies, No. 9, pp. policy that a fast-growing emerging-market economy should 58-73 pursue? Recent Global Enabling Trade Report 2009 by the 2 Country Profi le: India, World Trade Organization, August World Economic Forum assessed the ease of international 2009 trade around the globe. India ranked 76th out of 121 countries. http://stat.wto.org/CountryProfi le/WSDBCountryPFView. The report found that tariff and non-tariff protection increase aspx?Language=E&Country=IN the economic cost of trade. Since 1991, India has steadily 3 Index of Economic Freedom 2009, Heritage Foundation, deregulated the framework of foreign direct investment. India’s Washington D.C small and medium-sized companies comprise 35 percent of http://www.heritage.org/index/Country/India exports. Protecting small and medium-sized enterprises by tariff and non-tariff measures would restrain trade, reduce (* Rok Spruk's main areas of research include macroeconomics, incentives to innovate and diminish welfare gains. To remove international economics and fi nance. The views expressed in the all the unnecessary barriers to trade, India’s trade policy should write-up are personal and do not refl ect the offi cial policy or set the following priorities: position of the organisation.)

58 THE IIPM THINK TANK O PEN WORLD Open Economy: A Boon or Bane for India?

country’s industrial strategy. These strategies were, however, Misu Kim & criticised for high social cost in the form of resource waste and demand defi ciency (Ahluwalia, 1985; Joshi and Little, 1987, and Susmita Mitra Dhar, 1989). As a way out, the focus of India’s development Phd Scholars, Centre for International Trade strategy started shifting towards export-led growth from the mid and Development, School of International 1980s. Due to this gradual liberalisation process, macroeconomic Studies, Jawaharlal Nehru University (JNU), imbalances viz. fi scal defi cit and balance of payments defi cits New Delhi increased, which in turn made India vulnerable to shocks. The sudden increase in oil prices due to the Gulf War in 1990, the drop in remittances from Indian workers in the Middle East pushed India in a severe crisis of foreign exchange. To deal with its I. Introduction external payments problems, the government of India requested The recent global crisis raised a question on the opinions in favour arrangement from the International Monetary Fund (IMF) in of open market and global integration. The high economic growth August 1991. The IMF support was conditional on an adjustment rate of India in an open market structure witnessed in the last few programme featuring structural reforms and trade liberalisation. years came to a halt as the fi nancial crisis hit the world. Econo- Since then, the Indian economy has been undergoing substantial mists arguing in favour of free market and withdrawal of protec- changes. Almost all the areas have been opened to foreign private tionism in India started giving a second thought to their opinion. investment; import licensing restrictions on intermediaries and After more than a decade’s time it cannot be said that opening up capital goods have been mostly eliminated; and tariffs have been of Indian economy brought miraculous signifi cantly reduced. Economic liberalisation changes for India. This essay analyses some of of India is distinct in the sense that it was the important macroeconomic indicators like Indian economic abrupt, and at the same time externally trade, investment, and socio-economic factors liberalisation is imposed rather than consciously decided. like education, employment, inequality etc. to distinct in the see why India could not achieve the expected sense that it was III. Open Economy in Poor economic development through open policy. Domestic Conditions However, before we focus completely in this abrupt, and at Since 1991 the Indian government has been area, there is a brief snapshot of the liberali- the same time emphasising on export in its economic growth sation process of India. externally imposed strategy. If we simply study the aggregate macroeconomic data, then in the post II. Imposed and Abrupt Economic Liberalisation liberalisation era, all variables like gross domestic product (GDP), In the early 1960s, India followed protectionist policy as a strategy per capita GDP, economic growth rate, export, import and of economic growth. At this stage India’s motive was self-suffi cient investment show an increasing trend in nominal value terms. Does growth through grand economic theories, such as ‘big push’ theory that really imply that India has achieved economic development and the Mahalanobis model, which played a major role in the through free trade? Here we will study the other side of the coin.

60 THE IIPM THINK TANK G OLDILOCKS GLOBALIZATION

THE INDIA ECONOMY REVIEW 61 O PEN WORLD

Diagram 1: Export and Import in India

900000

800000

700000

600000

500000 Export Import 400000 Rupee Crore Rupee 300000

200000

100000

0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006QE

Source: Handbook of Statistics on Indian Economy published by the Reserve Bank of India

Diagram 2: Investment in India

1600000

1400000

1200000

1000000 Gross Domestic Investment Gross Foreign Investment

800000 Rupee Crore Rupee 600000

400000

200000

0 19701974 1980 1982 1986 1990 1994 1998 2002 2006QE

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India

62 THE IIPM THINK TANK G OLDILOCKS GLOBALIZATION

From the mid 1980s export started rising. However, India being form (mainly in share markets), then it can have a bubble effect a developing country needed to import the machines and appli- without having any fundamental change. Unfortunately, in the last ances for the production of the main exportables like gems and few years foreign portfolio investment has been large, making the jewellery, pharmaceuticals, chemical and engineering manufac- Indian economy more volatile, as shown in Diagram 4. The recent tures (WTO: Trade Policy Review, 2007). Thus , with an increase boom in the share market (before the global crisis period), was in export, import also increased as shown in Diagram 1. largely a bubble (due to huge infl ow of foreign portfolio invest- Moreover, since import has always exceeded the export, it gave ment), which in turn burst in the time of global crisis, when a large rise to trade defi cit. As the diagram 1 shows, the trade defi cit amount of foreign money was withdrawn. This is again a major started roaring after 2004. However, invisible infl ow (i.e. income drawback of open market. from the service sector) and foreign investment infl ow helped to Thirdly, there is sector-wise disparity regarding the perform- maintain the Balance of Payment (BOP) account. From this angle ance of foreign investment. After economic liberalisation, the one can argue that although there has been trade defi cit in an declining trend of primary sector was not reversed by the open market for India, the infl ow of foreign investment is obvi- increase in foreign investment. The manufacturing sector ously a positive side of free trade. However, there are fl ip-sides of experienced temporary growth acceleration after economic the story as well. reforms in 1991. However, this trend was reversed from 1995 to First of all, if we compare the volume of 2000, even though foreign investment stocks the different forms of investment in India, continued to rise. Foreign investment boom then foreign investment (the sum of foreign India lacks the was witnessed mainly by the tertiary or direct investment and portfolio investment) capacity to absorb service sector, but limited to a few services is much less compared to the domestic sophisticated only. However, contrary to the widespread investment (sum of investment from the technology and view that booming foreign investment in the household, private corporate and public service sector was driving the miraculous sector) even in the free trade era. As the still lags behind growth in India in the last few decades, Diagram 2 shows, the benefi t of foreign other economies economists have shown that it was the investment can only have a negligible effect in vital spheres growth of the service sector that attracted due to its low volume. foreign investment, not the other way round Secondly, if we study investments as a share of GDP, then the (Chakraborty and Nunnenkamp, 2006). Diagram 3 shows that since 1991 (for the entire decade) foreign Coming to the reasons behind low foreign investment in India, investment has been rising but domestic investment has been it can be argued that the country could not create investment falling. It implies that although India is benefi ted by foreign welcoming environment. Indian infrastructure remained poor investment, it has worked as a substitute to domestic investment which acted as a deterrent to the investors. Rapid growth in a rather than a complement, a process popularly known as globalised environment requires a well-functioning infrastructure, crowding-out effect. For a capital scarce country like India, the including electric power, road and railway connectivity, telecom- quality of foreign investment also matters along with its munications, air transport, and effi cient ports. After nearly two quantity. The worst case could be when foreign investment decades of economic liberalisation, India still lags behind other enters into the host country just to produce for its domestic developing countries like China, Vietnam, Malaysia etc. in these market and in turn displace the local industry (Agrawal and vital spheres. Shahani, 2005). The Indian retail sector has been observed to Another reason is that, India lacks the capacity to absorb be partially hit by this phenomenon. sophisticated technology. The volume of foreign investment Another important question is where and in which form the depends on various factors, including absorption capacity and foreign investment is taking place. If investment comes in the form local skills, technological spillovers and linkages between foreign of technology or direct capital to establish a new fi rm, then it has and local fi rms, and export orientation of the host economy. The positive effects for a labour abundant developing country through education system has also not improved in the post-liberalisation creating new jobs. In contrast, if the investment is in the portfolio era with India trailing behind the target of 100 percent literacy

THE INDIA ECONOMY REVIEW 63 O PEN WORLD

Diagram 3: The Share of Domestic and Foreign Investment in GDP

14

12

10 Domestic Investment 8 Foreign Investment % 6

4

2

0 1970 1974 1980 1982 1986 1990 1994 1998 2002 2006QE

Source: Handbook of Statistics on Indian Economy published by the Reserve Bank of India rate. The number of primary schools (primary implies upto fourth economic liberalisation as shown in Diagram 6. standard) are relatively high in comparison to the institutions for However, employment has been particularly created in the higher education.. This is quite natural, but in case of India, the electronics and electrical equipment sector, mainly due to number of higher education institutes is way too low than what is Information Technology Enabled Services (ITES) and Business required, as shown in Diagram 5. Process Outsourcing (BPO) growth. However, the global crisis The prevailing education system in India led to abundance of proved the vulnerability of these outsourced jobs. Due to the unskilled labour compared to educated-skilled labour. Obviously international linkages, crisis in source countries can affect these this acts as a barrier to new technology by multinational compa- jobs. This is another disadvantage of global integration faced by nies. Indian exports are dominated by simple and undifferentiated India recently. products where the main competitive advantage lies in cheap Apart from education and employment another important labour, low level of skill and simple technologies (Lall, 1999). Due socio-economic factor is inequality. In India, inequality issue is to other constraints also viz. intellectual property protection, India very important and controversial. NSS data shows that inequality sometimes has not received up-to-date technology (Athreye and has remained more or less similar. Sen and Himanshu (2004) Kapur, 2001). analyses NSS data in a different way and found that inequality As a result of all the above factors, employment scenario in increased in the 1990s both in the rural and urban areas. The ratio India did not improve much in the post liberalisation era. Lack of of poor people shows a downward trend but the absolute number employment-creating foreign direct investment compared to of poor people increased due to an increase in population. portfolio investment, coupled with the crowding out effect on According to Jha (2002), inequality has increased after economic domestic investment, there has not been much increase in the liberalisation rather than a decrease. He argued that inequality demand of employment. On the supply side, the static education widened because labour intensive industry has been sluggish, system is not able to produce a strong base of educated and skilled whereas capital intensive sector has been prosperous since the labour force. As a result, employment in the public and organised economic reforms. Due to economic liberalisation, economic private sectors in India has not increased signifi cantly after growth rate increased, but the level of poverty remained stubborn

64 THE IIPM THINK TANK G OLDILOCKS GLOBALIZATION

Diagram 4: Foreign Investment in India

140000

120000

100000 FDI 80000 Portfolio

60000 Rupee Crore Rupee

40000

20000

0 2000 2001 2002 2003 2004 2005 2006 2007

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India

(partially because of higher inequality and stagnation in the To enhance corporate profi ts and savings, the East Asian agricultural real wage), although there was some reduction in governments have provided direct assistance to build export urban poverty. industries and fi scal benefi ts like tax rebates, tariff exemptions on To sum it up, it is very diffi cult to conclude whether open imports of raw materials, reduced rates for electricity and market is boon or bane for India. transportation services, export subsidies for exporters. At the same time different governments made provisions of fi nancial IV. Lessons from the East Asian Countries benefi ts like loans at lower interest rate for exporters. India lacks the platform to exploit the benefi t of economic These policies pushed up corporate profi ts above the levels liberalisation, in contrast, the East Asian governments played a attainable only under free market conditions. This increased the strong role behind the export-led-growth model. Along with savings rate of the region. It was corporate savings in the East foreign investment different governments have boosted up domes- Asian Countries which played a crucial role in investment boom tic investment simultaneously through different channels. The (Stiglitz, 1999). Apart from pushing the corporate profi ts, the East role of government behind the investment boom process is largely Asian governments also performed well in fundamental policy through increasing the profi ts, because profi ts are an incentive for areas to increase household savings. By avoiding infl ation, they investment, a source of investment and an outcome of investment resisted volatility of real interest rates on deposits and also (Akyuz and Gore, 1996). The total process in most of the East guaranteed that the interest rates were largely positive and Asian countries worked in the following way: generally higher than other developing countries (Page, 1994). • Government policies pushed profi ts over and above the level Some governments used different interventionist mechanisms also that could be attained under free market policies. to increase savings viz. mandatory provident fund contributions. • Increase in profi ts was translated into high savings. However, simply increasing savings does not guarantee that it • High rate of domestic savings was transformed into investment will be channelised to investment. For that purpose the East Asian which played a major role in the exceptionally rapid growth of governments encouraged investment by different means. the East Asian countries. • Governments invested in proper infrastructure and created a

THE INDIA ECONOMY REVIEW 65 O PEN WORLD

Diagram 5: Number of Recognised Educational Institutions

900000

800000 Primary Upper 700000 Primary High/ 600000 Hr. Sec./ Inter/Pre. 500000 Jr.Colleges Colleges 400000 for General

Rupee Crore Rupee Education 300000 Colleges for Professional 200000 Education University/ 100000 Deemed Univ./Instt. 0 of National 1950 1960 1970 1980 1990 1992 1994 1996 1998 2000 2002 2004 Importance

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India

Diagram 6: Employement in the Public and Private Sector

25 Public Sector Private Sector 20

15

Million 10

5

0 1970 1980 1990 2004

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India

crowding in effect for private investment. At the same time most of the East Asian governments have • Tax policies in most of the East Asian countries were such that successfully moulded different policies according to the changing an investment friendly environment is created. world scenario as well as the country’s comparative advantage. In • Financial policies like credit rationing had a major role. the 1970s, when Hong Kong was loosing its competitiveness in Thus, government’s fi scal and fi nancial policies increased the labour-intensive products, it started diversifying the home corporate profi ts which further created a virtuous circle for industries by producing and exporting higher quality electronics investment as Diagram 7 shows: goods. In recent times, most of the exports of Hong Kong are

66 THE IIPM THINK TANK G OLDILOCKS GLOBALIZATION

Diagram 7: Virtous Circle Reference and Additional Thinking • Agrawal, R. and R. Shahani (2005), “Foreign Investment in India: Issues and Implications for Globalisation” In: C. Tisdell Increase in (ed.), Globalisation and World Economic Policies: Effects and corporate Policy Responses of Nations and their Groupings. New Delhi profi t (Serials Publ.) • Ahluwalia, M.S. (1985), “Industrial Growth in Indian Manufac- turing”, Oxford University Press. Technological Increase in advancement savings • Akyuz, Y. and C. Gore (1996), “The Investment-Profi ts Nexus in East Asian Industrialisation”, World Development, Vol. 24, No. 3. • Athreye, S. and S. Kapur (2001), “Private Foreign Investment in India: Pain or Panacea?” The World Economy, Vol. 24, No. 3 Increase in investment • Chakraborty, C. and P. Nunnenkamp (2006), “Economic Reforms, Foreign Direct Investment and its Economic Effects in India”, Working Paper No. 1272, the Kiel Institute for the classifi ed as re-exports. In South Korea, the Fifth Five-Year Plan World Economy (Germany) (1982-86) moved the emphasis away from heavy and chemical • Dhar, P.N. (1989), “Constraint on Growth: Refl ections on the industries to technology-intensive industries, such as electronics Indian Experience”, Seminar Paper, Institute of Economic (televisions, videocassette recorders, and semiconductor-related Growth. products) to serve the increasing demand of the world market. In • Jha, R. (2000) ‘Reducing Poverty and Inequality in India: Has the early 1980s, Malaysia expanded its exports from labour-inten- Liberalization sive to capital-intensive goods while the Taiwan government • Helped?’, WIDER Working Paper No. 204, UNU/WIDER: followed a development programme designed to shift its economy Helsinki. away from labour-intensive industries towards the expansion of • Joshi and I.M.D Little (1987), “Indian Macroeconomic technology-intensive industries. The process can be described as policies”, Economic and Political Weekly, Vol. 22. the ‘prescription according to the disease’. • Krueger, A.O. (1990), “Asian Trade and Growth Lessons”, The American Economic Review, Vol. 80, No. 2. V. Conclusion • Lall, S. (1999), “India's Manufactured Exports: Comparative India’s economic liberalisation process was distinct in the sense Structure and Prospects”, World Development, Vol. 27, No. 10 that it was the result of external compulsion rather than a con- • Page, J.M (1994), “The East Asian Miracle:” An Introduction”, scious decision. At that point of time India’s infrastructural base World Development, Vol.22, No.4 was not suffi cient enough to face the global competition. The • Sen and Himanshu (2004), “Poverty and Inequality in India II government neither could change the domestic conditions – Widening Disparities during the 1990s”, Economic and drastically nor could the country grab the benefi ts of the open Political Weekly, September 5th economy much. If India wants to take up some useful lessons from • Stiglitz, J. E. (2001), “From Miracle to Crisis to Recovery: the success stories of the East Asian countries, then the fi rst and Lessons from Four Decades of East Asian Experience” in foremost lesson should be to build up a strong base of education Joseph E. Stiglitz and Shahid Yusuf (eds.), Rethinking the East and infrastructure. These are the platforms on which India can Asian Miracle, New York: Oxford University Press, pp.509-26. build its success. According to Krueger (1990), abundant labour • World Trade Organization (2007), Trade Policy Review: India, and a well-functioning labour market facilitated the export sectors Geneva: WTO. of the East Asian countries. Indian labour market is infl exible and at the same time education system is such that large population is (The views expressed in the article are personal and do not refl ect the not turning into human resource. offi cial policy or position of the organisation.)

THE INDIA ECONOMY REVIEW 67 O PEN WORLD A Model of North- South Growth and Trade as a Differential Game Problem with an Empirical Illustration

T. Krishna Kumar Director, Samkhya Analytica India Pvt. Ltd, Bangalore

I. Introduction There is considerable literature, mostly theoretical, which states that free trade is benefi cial to all the trading partners. The theoretical arguments are based on certain assumptions such as that all countries have access to the same technologi- cal choices, there are no transportation costs, all goods are tradable, there is perfect competition in product markets, etc. Most of these studies examine the autarky situation with a free trade situation with just two countries, two products, and two factors of production.1 Some of these results have been established even under some relaxed conditions such as a deviation from perfect competition. A case is also made for a strategic trade policy that takes into account what is good for a country in question.2 One often wonders what would happen to these results when some of the assumptions are relaxed. One also would like to know what quantitative impact a particular trade policy would have on the overall long-term growth of a particular economy. In a competitive world market one must also know what counter strategy another country would adopt. It is

68 THE IIPM THINK TANK G AME THEORY

therefore useful to have a quantitative model that is capable of international forums, on commercial policies. There is a need providing numerical solutions when one plugs in the realistic to reformulate quantitative economic policy problem to make values of the parameters associated with growth models of it useful in the newly emerging economic environment. The different countries. In this paper we present such an empirical earlier treatment of the economic policy problem as an quantitative model. Using this model we examine the emerg- optimization or optimal control problem with a single objec- ing outcomes associated with two countries adopting trade tive function is now obsolete. In the newly emerged global policies such as autarky, free trade, quantitative restrictions economy with trade liberalizations and capital fl ows one must and tariffs. We assume specifi c dynamic Leontieff production consider a new formulation of the economic policy problem structures along with linear consumption, export and import with multiple objective functions, one for each country. This functions in the two countries. leads to a game theoretic formulation. We can model the Planning or quantitative policy analysis has been discarded economies by a system of differential or difference equations in recent years under the assumption that every country ought to capture economic growth. The optimal policy problem then to follow competition policies and free trade policies, thereby becomes one of a differential game problem.3 minimizing the role of the state. Government offi cials of In this paper we take a simple situation by assuming different countries are, however, called upon to advise their that the world can be grouped into less industrially governments, and to represent their government's interests in developed countries and industrially advanced countries. The former are labeled here as the South Country while the latter are labeled as the North Country. The quantita- tive economic policy problem of choosing between the appropriate trade regimes by the two groups of countries for optimal growth and development is then formulated as a differential game problem. The plan of the paper is as follows. Section II provides a dynamic model for growth and trade. Section III presents an empirical illustration of the dynamic model and traces the autarky and free trade solutions. Section IV widens the scope of the policy problem as a non-cooperative differential game problem in which the two trading countries have to choose between a set of alternate trade policies with quantitative restrictions and import tariffs. Finally section V offers concluding comments.

II. A Model of North-South Growth and Trade We assume that there are two nations called North and South, each being governed by a dynamic Leontieff model with and without trade links. The model without trade is called Au- tarky situation and the one with free trade with no quantita- tive restrictions and tariffs is called the Free Trade situation.4 The specifi cation of the model is as follows: Let y(t) represent the output of country labeled South in period 't' while z(t) the output associated with country North. We then have the following National Income Identity.

y(t)= a. y(t)+b. D y(t) + c(t)+e(t) - m(t) ...... (1)

THE INDIA ECONOMY REVIEW 69 O PEN WORLD

Figure 1: The Trajectories of Outputs of the North 'e(t)' is the exports to country North by the South (Green) and the South (Red) Countries: Under country, and Autarky Situation 'm(t)' is imports of the South country from the North country.5 Similarly, we have the following National Income Identity for North Country: 40 z(t)=d. z(t)+f. D z(t)+g(t)+m(t)- e(t) ...... ……………..... (2) Where, 30 d and f are the current and capital input output coeffi cients of the North country, and g(t) is the fi nal demand or consump- tion function of the North country.6 20 We assume that the consumption or fi nal demand equations in the two countries are given by:

10 c (t) = c0 + c1 y(t) ...... (3)

g (t) = g0 + g1 z(t) …...... (4) 0246810 Year We assume that the export from country South equals the imports of country North, and vice versa. We assume the Where: following linear export and import functions: D is an operator denoting the fi rst order time derivative,

'a' is the current input-output coeffi cient, e (t) = e0 + e1 z(t)…………………...... (5)

'b' is the incremental capital-output ratio, m (t) = m0 + m1 y(t) ...... (6) 'c(t)' is the fi nal consumption in period 't', Figure 2: The Trajectories of GNPs of the North When we substitute expressions (3)--(6) in equations (1) and and the South Countries: Case 1 Under Free (2) we get a system of two inhomogeneous differential equa- Trade Situation tions of the fi rst order that are linked to each other if there is trade. By assuming an initial condition we can solve these two equations and determine the dynamic inter-temporal trajec- tory of the total output or income of each country as a 40 function of time. We assume that the variables are measured in real terms measured in, say, billions of US Dollars. We also assume that 30 the exchange rate is fl exible to generate zero trade balance for each country. We can specify all the parameters of the model and solve 20 the two differential equations.

III. Comparison of Autarky and Free Trade Situations 10 We assume the following numerical values for the parameters for deriving the empirical results: 0246810 Year a=0.10; b=4.0; c0= -10; c1=0.75; e0=0 (autarky), =1.03 ( free

70 THE IIPM THINK TANK G AME THEORY

Table 1: Matrix of Alternate Trade Strategies of North and Assume the following initial conditions: South Countries SOUTH y(0)=6,z(0)=10; ……………………... (10) Free Trade LL LH HL HH Autarky N Free Trade 1 2 3 4 5 NA The dynamic path of the two countries, O LL 6 7 8 9 10 NA South and North are given by y(t), and z(t) R 7 T LH 11 12 13 14 15 NA respectively as follows: H HL 16 17 18 19 20 NA HH 21 22 23 24 25 NA y(t) = 72.66666667 exp(.03750000000 t) - Autarky NA NA NA NA NA 26 66.66666667..………………………(11) Source: Computations made by the author based on assumptions made in the text z(x)= 209.9999999 exp(.01666666667 t) - trade); e1=0 (autarky), = 0.20 (free trade) m0=0 (autarky), = 199.9999999 … (12) 1 (free trade); m1=0 (autarky), =0.35 (free trade); d=0.30; f=3.0; g0=-10; g1=0.65……………………………… (7) These solutions are plotted against time in Figure 1. We assumed a horizon of 15 years for our comparative analysis Autarky Situation: throughout this study. Throughout this paper the trajectory Assume that there are no exports and imports, that starts at 10 refers to the North Country while the one that i.e., e(t)=m(t)=0. starts at 6 refers to the South country. It can be noted that the The South Country's structure is now characterized by the divergence between the two countries widens as time goes on. following dynamic Leontieff model. Free Trade Situation: 4.0*D y(t)-0.15*y(t)-10=0 ...... (8) Let us now assume that South country's exports are given by e The North Country's structure is given by the following (t), which constitutes the imports of North Country. Similarly dynamic Leontieff model: the imports of South Country and exports of North Country are given by m (t) as given by equations (5) and (6) with 3.0*D z(t) -0.05*z(t)-10=0…..………….………………… (9) parameters as specifi ed in (7).

Table 2: Pay-off Bi-Matrix Associated with Alternate Trade Strategies of North and South Countries

NORTH Free Trade LL LH HL HH Autarky Free Trade 227.07+ 268.52+ 334.07+ 269.38+ 334.80+ NA 271.16* 237.8 184.89 237.1 184.3 LL 181.96 223.27 289.58 224.04 290.24 NA S 307.66* 274.42 220.9 273.79 220.36 O U LH 145.44 186.17 252.37 186.87 252.97 NA T 337.33* 304.53 251.09 303.96 250.6 H HL 181.54 222.88 289.25 223.65 289.91 NA 308.00* 274.73 221.17 274.1 220.63 HH 145.06 185.82 252.08 186.52 252.67 NA 337.64* 304.82 251.33 304.25 250.85 Autarky NA NA NA NA NA 286.42 223.64

Source: Computations made by the author based on assumptions made in the text

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The structure of South Country is now given by: autarky. If y (t) is the output in US bill $s, is the time discount factor, 4.0 D y(t) - .50 y(t) - 9.97 + .20 z(t) = 0 ……..…………… (13) and (0,T) is the time horizon then the integral pay-off for the plan horizon can be written as: The structure of the North Country is given by: ...... (17) 3.0 D z(t) - .25 z(t) - 10.03 + .35 y(t) = 0 ………………… (14) Optimal growth theory suggests that one must use a Ramsey The initial conditions are assumed to be the same as those type objective function that is a strictly concave function of assumed for the Autarky case, viz. y (0) =6, z (0)=10; It can be consumption. We assume, however, that what is maximized is the seen from equations (13) and (14) that the growth path of each discounted consumption stream. As the consumption function is country depends on the output of the other country. linear function of income it is a monotonic isomorphic transfor- The solution for the Free Trade situation is given by: mation of income, and hence the above pay-off function. We fi nd the numerical values for the integral pay-offs as follows, assum- -8 ing that the time discount factor is 0.08 and that the plan horizon y(t) = 3.45933019* 10 exp (0.1833333333 t) is 15 years: + 84.33157892 exp (0.02499999999 t) -7 Pay-offs for Autarky Situation in US bill $s: (286.42; 223.64) + .4000000000* 10 exp (0.1583333333 t) - 81.79090915 Pay-offs for Free Trade Situation in US bill $s: (227.07; 271.16) ………………...... (15) Where the fi rst entry refers to the pay-off to the North and the z(t) = 168.6631579 exp (0.02499999999 t) second entry is the pay-off to the South country. - 4.03588519 exp (0.1833333333 t) - 154.6272728 From this it is obvious that free trade is benefi cial to the South -8 and harmful to the North. As a result of free trade the gain to - .2000000001* 10 exp (-0.1583333333 t) the South is 47.52 and the loss to the North is 59.35. The loss to -7 the North is more than the gain to the South. Which situation - .3000000001* 10 exp (0.1583333333 t), will the two countries choose autarky or free trade? We will -8 consider a more general situation of a choice by the two coun- + .1000000000* 10 exp (-0.1583333333 t) ...... (16) tries of a trade strategy which involves quantitative restrictions and tariffs.

The Free Trade solutions are plotted against time in Figure IV. Choosing Optimal Trade Strategies: 2. A Differential Game Formulation As can be seen from Figures 1 and 2 free trade has benefi t- It must be admitted that the model described above is very e d t h e S o u t h c o u n t r y a t t h e e x p e n s e o f , t h e N o r t h C o u n t r y . primitive and highly aggregative.8 Further the question of Marginal propensity to export by the North country seem to trade strategies is made somewhat irrelevant as a result of the refl ect the kind of situation that could prevail when a small (in new WTO trade regime. There are certain provisions of WTO the sense of GNP) closed economy such as India could be the regime that do permit member countries to use discretionary South country while a large export-seeking large country such trade policies. Even violations of the trade regime rules are as United States is the North country. subject to disputes and dispute resolution mechanisms that The usual claim made by the free trade proponents, that take time. free trade is benefi cial to both countries does not seem to be In this section we reformulate the import and export functions borne out in this case. We will, however, examine later with a quantitative restriction dummy variable that shifts the whether the countries fi nd free trade to be preferable to intercept term and a tariff dummy variable that would shift the

72 THE IIPM THINK TANK G AME THEORY

marginal propensities to export and import. correspond to the Nash-Equilibrium. For each strategy used by a The following are the possible trade strategies that the two country we determine what the best counter strategy of the other countries are supposed to adopt. Two letters represent the country is. We call these the best response functions. We then strategy. The fi rst letter represents the level of quantitative defi ne the Nash Equilibrium as the set of strategies that are best restrictions (QR) or quotas, and the second letter represents the against the best strategies of the other country. level of import tariff (T). We present below in Table 2 the integral pay-offs for all the We assume that the quantitative restrictions (QR) imposed by strategy pairs along with the identifi cation of the best responses South reduce the intercept of its import function while the tariff of each country against each of the strategies of the other (T) reduces its slope or the marginal propensity to import. We country. The numbers in the top refer to the integral pay-offs of assume two levels for each, labeled low (L) and high (H). For the the North Country while the numbers below refer to the integral South country QR low equals downward shift of intercept of the pay-offs of the South country. The pay-offs with " * " are the best import function by 0.02, while QR high equals a downward shift response of the South country while the pay-offs with "+" sign of intercept of the import function by 0.04. When there are no are the best responses of the North Country. The trajectories of quantitative restrictions the intercept of the import function of outputs of the South and North countries associated with these South is 1.0. When there is Low tariff in the alternate trade strategies are not shown South country its MPI is 0.30, while a high here. Interested readers can contact the tariff gives rise to an MPI of 0.20. When In a competitive author for the Appendix to this article that is there is no tariff at all the MPI for the South world market one not being printed. country is assumed to be 0.35. should also know From the pay-off bi-matrix it is evident The QR imposed by North at low level what counter that Free Trade is the Nash equilibrium results in an intercept of export function of strategy . The two countries would thus the South country of 1.02 while QR at higher strategy another choose free trade as the non-cooperative level imposed by the North country would economy would solution. However, it can be noted that if result in an intercept of the South country's adopt eventually both countries cooperate they can choose exports of1.01. When there are no quantita- either LH and LH each or HH and HH each tive restrictions imposed by the North Country the intercept of which will give more benefi ts to the North than the loss to the the export function of the South country at 1.03. When there is South when compared with the Nash equilibrium, The differ- low tariff in North the marginal propensity to export of the ence, the gain over the loss is $5.14 billion in LH, LH case, and South country is 0.15 and when there is high tariff in North the $5.29 billion in HH, HH case. This gain can be shared between value of this becomes 0.10. the two countries. Thus there can be cooperative solutions that The matrix of strategy pairs is given below. NA means that are better than the non-cooperative solutions. strategy pair is not applicable. There are altogether 26 pairs of strategies. We specify the following values to the parameters: V. Concluding Remarks This paper deals with an empirical illustration of the model and a = 0.10, b = 4.0, c0 = -10, c1 = 0.75, e0 =1.03 (N: no QR), e0 = techniques advocated earlier by the author (Kumar (1998). The 1.02(N:LQR), 1.01(N:HQR); e1=0.10(N:HT),0.15(N:LT),0.20( model presented here is made deliberately very simple. The N: no-T); m0 =1(S: noQR), 0.98(S:LQR)), 0.96(S:HQR); m2= major purpose of the paper is to illustrate the usefulness of 0.20(S:HT), 0.30(S:LT), 0.35(S:no-T); g0 = -10 ; d= 0.30; f = 3.0; differential game theory for quantitative and empirical analysis g1= 0.65. of optimal trade strategies. The computer software can easily be used for a more realistic and complicated models such as growth The integral pay-offs for the two countries can be calculated and trade models with more sectors and more countries. Once for each of the 26 combinations of the trade strategies. If we we introduce two sectors with consumer goods industries and assume that the two countries play a non-cooperative game then capital goods industries we can study the impact of foreign direct the optimal trade strategies for the two countries are those that investment on growth and development. This model can also be

THE INDIA ECONOMY REVIEW 73 O PEN WORLD

improved to incorporate increasing returns to scale. that the two countries have either unequal access to the latest technology or that the countries choose different technolo- Endnotes gies depending on their respective factor endowments. 1 For a more detailed discussion of these results one may refer 7 We used Maple 5.1 software of Maplesoft, Canada for to an earlier article by the author (Kumar (2003)). obtaining the numerical solution of a system of ordinary 2 One may see Helpman and Krugman (1985), and Krugman differential equations. (1999). 8 The models presented here can be easily generalized to make 3 Nearly forty years ago this author was one among several them multi-sect oral and non-linear. The reader may see economists who formulated the quantitative economic policy Kumar (1998) for a generalization of this model to allow for problem of economic growth and development as an optimal several sectors. control problem. It was at that time that the author had seen 9 This is intuitive. Free trade solution refers to optimization by the work carried out by Rufus Isaac at the Rand Corporation each country under no trade restrictions. As the objective on Differential Games, which fi rst appeared as Rand function itself does not depend on the trade fl ow an unre- Reports. The author then contemplated on the possibility of stricted maximum is larger than a restricted maximum. generalization of economic policy problem from a control problem to a differential game problem with the associated References and Additional Thinking duality theory. Such a thought was provoked by an excellent • Helpman, E., and P.R. Krugman (1985), Market Structure paper of 1961 by Leonid Hurvicz on programming in linear and Foreign Trade: Increasing Returns, Imperfect Competi- spaces and the close relationships between game theory and tion, and the International Economy, Brighton, Wheatsheaf. mathematical programming. There is thus an element of • Krugman, P.R. (1990), Rethinking International Trade, MIT nostalgia associated with writing this paper. The author Press. thanks George Papavassilopoulos of University of Southern • Kumar, T. Krishna (1998), “ Models of North-South Trade, California for drawing his attention to some of his own work Growth, and Development as Differential Game Problems, on differential games which motivated the author to return to in L. Caccetta, K.L. Teo, P.F. Siew, Y.H. Leung, L.S. this topic. Jennings, and V. Rehbock ( Editors) Optimization Tech- 4 The intercept and the slope parameters of the import and niques and Applications, Vol.1 , pp204-209.(Proceedings of export functions are assumed to be constant in this and the the 4th International Conference on Optimization: Tech- subsequent sections. In section IV we make them depend on niques and Applications, Curtin University of Technology, the trade policies, such as imposing quantitative restrictions Perth, Australia, July 1-3, 1998). and import tariffs, to trace the implications of a variety of • Kumar, T. Krishna (2003), "On a suitable framework for alternate trade policies. designing trade policies of a developing country in an open 5 We assume a composite single commodity. Trade is meaning- global economy" in A.K. Bagchi and M. Chattopadhyaya, ful only if there are at least two commodities. I am grateful to and Ratan Khasnabis ( editors), Economy and the Quality Panagaria for this comment. It is assumed here that there is of Life, Dasgupta and Company, Kolkota, 2003, pp. in fact more than one commodity in the two economies and 190-218. what are modeled are the aggregate outputs and their growth. The composite price indices in the two countries differ due to (It is the birth of the author's granddaughter Saachi that prompt- differing average costs as refl ected in the technical coeffi - ed the author to write an article on a topic that will be of some cients of the Leontief model. Comparative advantage and relevance and signifi cance to her and her generation. The author specialization thus become meaningful. One may even say thanks Arvind Panagaria and Gopal Kadekodi for their com- that the composite commodity of one country is different ments on the fi rst draft, although Panagaria did not agree with from the composite commodity of the other country. some of the fi ndings and observations made here. The views 6 The technical coeffi cients "a", "b", "c", and "d" are assumed to expressed in the article are personal and do not refl ect the offi cial differ between the countries. This is equivalent to assuming policy or position of the organisation).

74 THE IIPM THINK TANK O PEN WORLD

Evolution of World Trading System and Future of Free Trade: A 21st Century Experience

76 THE IIPM THINK TANK B OUND TOGETHER

M.S. Goel • Mesopotamia • Northern China Reader, Department of Applied Economics, • India JNPG College, University of Lucknow • Central America The fi rst records of extensive trading networks in the world are from Egyptian, Phoenician, Greek and Roman civiliza- Introduction: tions. Trade Flourished under the Greek city States e.g. Trade in goods is one of the oldest human activities. Trade is Athens and Sparta (Around 500 BC) and later on under the as old as the fi rst urban settlements which began to emerge Roman empire (starting around 300 BC). approximately 6000 years ago in four independent regions of The 17th Century saw the growth of restrictive policies that the world: later came to be known as mercantilism. The mercantilist

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hold that economic policy should be nationalistic and aim to of that time. secure the wealth and power of the State. The concept was Protectionism was on its high because of severe unem- based on the conviction that national interest are inevitably ployment, need to revive the industrial activities (particu- in confl ict. In this condition, gain in trade is possible at the larly in war ravaged economics) and also fall in movement expense of other nation. This thinking led the Governments of foreign capital. to impose price and wages controls, foster national indus- With the exception of U.S.A most other economies, tries, promote exports of fi nished goods and encourage therefore, opted for protectionist policies. imports of raw material. GATT Foundation: Industrial Revolution: The The Beginning of End of Discrimination Beginning of Free Trade Free trade contains many positive points in it such, as to The landmark work of Adam Smith and David Ricardo in help better allocation of resources in the country, improving the late 18th Century and early 19th wellbeing of the consumers through century and also emergence of industrial larger and diversifi ed supplies of the revolution laid the foundation stone of Great Britain saw commodities and services as well, and evolution process of theorizing free trade a great potential also inducing competitiveness among the in Great Britain. It saw a great potential in free trade and businesses within and outside the in freer trade and also possible domi- also possible country. nance through it in world manufacturing In post world war II era, efforts were and trade. The result was announcement dominance made again to reintroduce the sorts of by British Government to introduce free through it in world free trade into global trading. U.S.A. was trade as a government policy in 1846 when manufacturing the leading economy at that time and the British Parliament repealed the Corn also advocate of the policy of free trade. Law (which placed a high tariff on corn imports). U.S. Congress, therefore, swing into action. As a conse- During the next 80 years or so, Great Britain advocated for quence, under their leadership General Agreement on trade liberalization while other major trading players have Trade and Tariff (GATT) was established in 1947 through generally pursued protectionist policies. Havana Charter. GATT had been instrumental in transforming the world The Era of Protectionism: (1913-1950) : trading system to some extent by helping in eliminating Advent of Great Depression in America in 1929, however, barriers to trade (see Table-1). began to infl uence the trade policies of Great Britain, United GATT negotiation resulted into reduction of tariffs on states and other leading economies. Element of free trade industrial goods of 40 percent countries from an average of orientation was gradually vaning and protectionism creeping 40 percent in the late 1940’s to fi ve percent. Prior to Uruguay into trade policies. Round 8 about 79 percent of industrial tariff positions in Most people will argue but the records speak that “the developing countries and 22 percent in case of developed period between 1913 and 1950 is noted by economic histori- countries2 were unbound, which was a cause of instability in ans as the period with the lowest average economic growth world trading. rate since 1820, and also the only period over at least 250 After the conclusion of the TOKYO Round in 1979, some years, where trade grew at a slower rate than Gross Domestic disturbing trends were observed in world trading system. Product (GDP).1 Firstly; aggressive expansion of Japanese exports in Infact this period is marked by Great Depression (1929), leading sectors such as automotive and semiconductors the two world wars and beginning of the end of colonial and at the same time keeping the Japanese economy rule, which probably did create confusions in the minds of mostly closed to foreign suppliers and investors by admin- policy makers of leading economies and trading countries istrative barriers.

78 THE IIPM THINK TANK B OUND TOGETHER

Table 1: GATT/WTO Negotiating Rounds

Round No. and Place/Name Year(s) No. of Parties Subject Covered % Cut in Tariffs 1. Geneva 1947 23 Tariffs 21 2. Annecy 1949 13 Tariffs 2 3. Torquay 1950-195 38 Tariffs 3 4. Geneva 1956 26 Tariffs 4 5. Geneva 1960-1962 45 Tariffs 2 (Dillon Round) 6. Geneva 1964-1967 62 Tariffs and anti-dumping measures 35 (Kennedy Round) 7. Geneva 1973-1979 99 Tariffs, non-tariff measures, multi- 33 (Tokyo Round) lateral , agreements 8. Geneva 1986-1994 117 Tariffs, non-tariff measures, agri- 34 (Uruguay Round) cultural, services, textiles, intellec- tual property, dispute settlement

Source: Adapted from Various GATT/WTO publications

Secondly; many countries used subtle forms of interven- years of existence. tion instead of utilizing tariffs and circumvent technical violation of GATT rules. Growth of Regional Trade: Boon or Bane for Main achievements of the Uruguay Round may be Developing Countires and Multilateral Trade summarized in following manner: Multilateral trade in said to be a condition in which a • Acceptance by developed countries to cut tariffs by country enters into trade with other countries as per the another 34 percent. rules and regulations formulated by a • 117 countries joined negotiation multilateral trade agency . Presently process. Element of free there is world Trade organisation (WTO) • Reductions in agricultural import trade orientation which is authorized by the member. barriers. was gradually States to monitor world trade among • Commitment for better access to vaning and themselves. WTO is doing a good job. We developing countries in service sector. still have the memories of the last • Textiles and clothing sector receiving protectionism recession of the 1930’s when unilateral the cut in quantitation restrictions. creeping into actions on tariffs led to a decline of world The transition from GATT to world trade policies trade by as much as 30 percent in those Trade Organisation (WTO) in 1995 is days. From all reports, the decline today thought to be a major driving force in facilitating trade is no longer of that magnitude. The fact that a multilateral negotiations, bringing stability in world economic order and organisation for trade negotiations exists today is surely a introducing effective dispute minimizing process in world contributing factor here. 3 trade (see Table-2). However, we notice one striking development taking place First six years in the life of the WTO suggest its enforce- in the world trading system since mid 1990s that there a ment mechanisms are having a positive effect. As of 31st surge in the regional trade agreements (RTA) from about 50 December, 2000, 200 trade disputes were brought to the till 1990, the number of RTAs notifi ed to the WTO has dispute settlement body (DSB). This is a bigger fi gure than crossed 250 in 2003 and more than 300 RTAs have been 196 cases which were handled by the GATT during its 46 notifi ed to WTO 4 (till march 15 2008).

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Table 2: A Comparative Multilateral Framework of the World Trade Under GATT and WTO

The Multilateral Framework in GATT The multilateral framework in WTO Industrial Tariffs · Backstone of the GATT rounds 1 to 7 Tarriffs on indus- · Developed Countries to reduce tariffs by 40% to reach a trial goods in developed countries have been progres- range between 1.7% (japan) and 4.8% (Canada) sively reduced from 40% in the late 1940s to 5% · India, South Korea and Singapore to reduce tariffs by · High proportion of tariffs are ‘unbound’ over 50% · Developed countries ‘bind’ 99% of tariffs. Agriculture · High farm subsides and protected markets in United · Export subsidies down by 36% States and EC lead to overproduction and dumping · Production subsidies down by 18% · New market opportunities for 1.8 m tons of grain and 0.73 m tons of dairy products Services · GATT rules do not extend to services Many countries · The setting up of GATS, the fi rst multilateral and legally keep high barries in the services sector. enforceable agreement on trade and investment in the services sector. · Post-Uruguay Round agreements. · Telecommunications (Feb. 1998) · Telecommunications (Feb. 1998) · Financial services (March 1980) Intellectual Property · Standards of protection for patents copyrights, and trade- · Extensive agreements on patents, copyrights and trade- marks vary widely ineffective enforcement of national marks benefi ting producers of intellectual property and laws becomes a growing source of trade friction increasing technology transfer. Textiles and Clothing · Imports of textiles and clothing restricted through bi- · Textiles and clothing restraints under MFA to be phased lateral export quotes under the GATT Multi-Fiber Ar- out in 4 steps between 01-01-1995- 01-01-2005 benefi tting rangement (MFA) exports in developing countries.

Source: Adapted from Charles Hill, International Business 2001, McGraw Hill and DEAT Reports

It is notifi ed that this surge in RTAs is largely driven by experiments in the west, as well as in the third world have developed countries. Since the failure of the Seattle ministe- proved to be stumbling blocks, providing little gain for rial of WTO in 1999, countries like U.S and European (E.U.) member countries. 7 have initiated negotiation on a large number of bilateral and It is important to note that the provisions of most North- RTAS.5 The world Bank (2005) estimates that about 40 South RTAs go well beyond the WTO rules and are likely to percent of total global trade is done among the regional impose higher level of restrictions on the developing coun- trading partners. tries. 8 The economists like Jagdish Bhagwati, Harry Johnson , Bhagwati and Pana gariya (1996) argue by pushing aggres- Bela Blassa ,Arvind Pana gariya do not fully endorse the sive trade treaties on a bilateral basis , developed countries RTAs. Harry Johnson claimed that “ many more Regional are weakening the power of developing countries in multilat- Trade Agreements and custom unions would rise in future. eral trade negotiations. However they would all be expected to break up at a certain If those are few observations about RTAs and an open point of time in future.6 Paul Krugman (1993) opines we still world trading system continues to be our ultimate goal, then need to ask why such regional blocs are, infact, emerging. several important questions arise as to whether we should Experience of the past several decades shows that RTA welcome regional trading agreement as a step.

80 THE IIPM THINK TANK B OUND TOGETHER

Multilateral Trade Negotiations: poor were on the defensive. The rich countries never A 21st Century Experience: realised that a win-lose out come cannot lead to any Strong mechanism of multilateral trade system is regarded conclusion. as the pre-requisite to make globalization work successfully Therefore for new talks to succeed those suspicions must and pave way for free trading among the global economies. be proved wrong. We do need to strengthen the multilateral This becomes even more important in the light of the fact trade regime in the context of rising protectionist sentiments that more than 95 percent of global trade takes places around the globe. among WTO members. But advent of 21st Century brought no relief to developing countries as important issues like Endnotes agriculture subsidy and non-agriculture market access 1 “ International Trade and Investment –An Asia Pacifi c (NAMA) remain unresolved. Perspective,” By John Gionea, published by McGraw Hill This declaration of Doha (November 2001) did fi x 1st Irwin, 2005 p. 154 January, 2005 as the date for completing all but these two 2 Ibid p. 156 issues through negotiations. But talks are still pending 3 WTO talks : Waiting for Godot” an article written by covering other issues as well. Prof. Manoj Pant (J.N.U) published in Economic Times. On the insistence of Government of India (Doha Round) 11th September 09. meet is going to take place in the fi rst week of September 4 “Regional Trade Agreements and Improved Market 2009. According to media reports India is to be blamed for Access in developed Countries: The Evidence Written by creating deadlock. Prof. Parthapratim Pal, published in economic and To negate this impression worldwide, India has taken a political weekly, November 29, 2008 p. 84. bold step to organize the meet and invite the bluff off 5 Ibid p. 84 countries which accused it of having torpedoed the July 6 Quoted from a research paper titled, “ New Institutions 2009, Geneva meet by not agreeing to lower its demand on Asian Monetary Fund, SAFTA, ASEAN, APEC; A new safe guarding it subistence farmers. Infact, it was not India Funeral for New Regionalism in this new Century.” all alone which was steadfast in this issue but china, Brazil Written by Rameshwar Tandon. and eight other counties were also party. 7 Written by Prof. Rameshwar Tandon, published at centre Though India and European union have joined hands in for Japanese economic studies, Maeguariec Univ. playing a lead role in freeing up the global trade but all 8 Opp. Cit. Parthapratim pal p. 91 matters relating to WTO rest on the Capitol Hill, Washing- ton DC. Unless the U.S. President has a fast track authority, References and Additional Thinking no commitments can be made by other parties. • John Gionea (2005) International Trade and Investment, The thinking in the US have always been to focus on Mc Graw Hill Irwin, Australia market access and developments of its own businesses. Thus, • Josiph Stiglitz (2002) Globalisation And its Discontents, in spite of huge opposition by poor countries , it was success- Penguin Books. ful in getting an agreement on intellectual property (TRIP) • Jagdish Bhagwati (2004) In Defence of Globalization, into the text of WTO agreement in 1994-95. Oxford University Press. In historical perspective also, successful Doha Rounds • Economic Survey, Government of India. have witnessed fi libustering tactics used by developed • International Trade Statistics 2008, Geneva WTO (2008). countries to push developing countries to corner. This has • Comprehensive Tariff Data. World Trade organisation, been seen in cancun meet which was dominated by Singa- online via: http:/www. Wto.Org./english/tratop-e/ tariff- pore issue. Thereafter Paris in 2005, Geneva in 2006, data-e.htm. Potsdam in 2007 and Geneva in 2008 saw the WTO talks broke due to intersticing of modalities between farm (The views expressed in the article are personal and do not agreement and industrial good negotiations. In each case refl ect the offi cial policy or position of the organisation.)

THE INDIA ECONOMY REVIEW 81 O PEN WORLD Murky Economics— Comparative Advantage & Free Trade Theory

John Kozy* Retired Professor of Philosophy and Logic

82 THE IIPM THINK TANK M URKY ECONOMICS

conomics is adrift in a sea of murky concepts, one can be likened to shooting at shadows. But the principle of which is free trade. This murkiness arises from has two features that appear to be universal. Etwo practices common to economists—commis- First, to determine that one country has a comparative sion of what I call the fallacy of excessive generalization advantage over another in the production of a specifi c and imprecisely defi ned terms. product, a comparison of its costs of production in both Consider the principle of comparative advantage. The nations is required. Look at what Ricardo writes: number of problems with this “principle” is legion, and "England may be so circumstanced, that to produce the numerous economists have attempted to amend and extend cloth may require the labour of 100 men for one year; and if it. All the problems and emendations have been discussed she attempted to make the wine, it might require the labour extensively in economic literature. One writer, Steven M. of 120 men for the same time. England would therefore Suranovic [http://internationalecon.com/Trade/Tch40/T40-0. fi nd it her interest to import wine, and to purchase it by the php], has reduced comparative advantage to an almost exportation of cloth. useless hypothetical claim about merely possible results: To produce the wine in Portugal, might require only the "The usual way of stating the Ricardian model results is labour of 80 men for one year, and to produce the cloth in to say that countries will specialize in their comparative the same country, might require the labour of 90 men for advantage good and trade them to the other country such the same time. It would therefore be advantageous for her that everyone in both countries benefi t. Stated this way it is to export wine in exchange for cloth." easy to imagine how it would not hold true in the complex Notice that Ricardo has no idea of how much labor of real world. how many men is required to produce anything anywhere. A better way to state the results is as follows. The Ricard- Count the modal verbs. Three ‘mights’ and one ‘may’ which ian model shows that if we want to maximize total output in grammatically should have been another ‘might.’ The two the world then, fi rst, fully employ all paragraphs are couched in the subjunc- resources worldwide; second, allocate Subjunctive tive mood which, in English, implies those resources within countries to each expressions unreality, doubt, and uncertainty. Now country's comparative advantage would at least be “how much labor of how many men” is, industries; and third, allow the countries in principle, a simple calculation. It to trade freely thereafter. honest, as they merely requires some counting. But even In this way we might raise the wellbe- would imply that today, can anyone say with certainty how ing of all individuals despite differences economists were much labor of how many men is required in relative productivities. In this descrip- unsure of validity to produce rice in any nation? tion, we do not predict that a result will Perhaps all economists should express carry over to the complex real world. Instead we carry the their principles in the subjunctive mood just as Ricardo logic of comparative advantage to the real world and ask does. Such subjunctive expressions would at least be how things would have to look to achieve a certain result honest, since they would imply that economists were (maximum output and benefi ts). In the end, we should not uncertain of the validity of their models. But even Ricardo say that the model of comparative advantage tells us isn’t consistent. When he writes, “England may be so anything about what will happen when two countries begin circumstanced, that to produce the cloth may require the to trade; instead we should say that the theory tells us some labour of 100 men for one year; and if she attempted to things that can happen." make the wine, it might require the labour of 120 men for Yes, I know. Mr. Suranovic is just one economist, per- the same time,” he should have concluded that England haps not even a good one. But that’s the point. There is no might therefore fi nd it her interest to import wine, rather precisely defi ned Principle of Comparative Advantage that than England would therefore fi nd it her interest. But all economists point to; it has been propounded, amended, “might fi nd it in her interest” is a weaker conclusion than extended, revised, and even adorned. Attempts to refute it “would fi nd it in her interest.” Could free trade be sold to

THE INDIA ECONOMY REVIEW 83 O PEN WORLD

people by claiming it might lower prices? product that must be given up in order to produce one Someone is sure to point out that the passage can be more unit of another product. But how many phone calls rewritten with conditional sentences that eliminate the to an Indian call center must be given up for Indians to modal verbs. True. Consider these: produce one more pound of hak? And how many pounds "If producing cloth in England requires the labour of 100 of hak must be given up by Americans to get one more call men for one year, and if producing wine requires the to an American call center? Is the example facetious? I labour of 120 men for the same time, it is in England’s think not. How many American made automobiles must interest to import wine and to purchase it by exporting be given up to produce one more two-story home? Who cloth. knows? Does it matter where the automobiles and homes If producing wine in Portugal requires only the labour of are built? Would opportunity cost be the same in Califor- 80 men for one year, and producing cloth requires the nia and Connecticut or Kerala and Bihar? Would the labour of 90 men for the same time, it is in Portugal’s opportunity cost be the same if the workers producing interest to import cloth and to purchase it by exporting automobiles were unionized and those producing houses wine." were not or vice versa or both? Can opportunity costs be The advantage is derived from the increased production manipulated? Economists avoid these questions merely by of cloth when the labor of the 120 men making more assumptions. spent on producing wine is transferred One of the most Opportunity costs are assumed to be to producing cloth. The argument constant; they never change. No limits implies nothing about how much the difficult aspects of on production exist. Full employment imported wine will cost. What lowers economic analysis exists in both countries at all times. All the price? Applying the law of supply is how to interpret factors of production are mobile within and demand, which requires a number the conclusions countries but are immobile between of assumptions. of models and them. Pricing mechanisms maintain One is that Portugal reciprocates in perfect competition. Can we ask this arrangement and devotes its cloth frameworks whether the cloth producers in Portugal making resources to wine making, and are lazier than the wine producers? No. another is that the demand for wine stays relatively con- Labor is assumed to be equally productive everywhere. stant. If Portugal chooses not to move its cloth-making All this assuming is very neat, but it’s a sham. Has anyone resources to winemaking, the supply of wine doesn’t ever seen an analysis of data that shows that the Chinese increase. What if Portugal simply can’t increase its produc- have a comparative advantage over the United States in tion of wine? Wine, after all, is made from grapes which the production of the plethora of products that Americans don’t grow well everywhere. Then the added English import from China? Why not? If the comparison of how demand for Portuguese wine increases the demand while much labor of how many men is required (or the opportu- the supply remains constant which raises prices. nity costs) can’t be carried out, the principle of compara- Now put a third country into the mix. Suppose Sweden tive advantage has no applications and is entirely useless. fi nds itself in exactly the same position as England. But as useless as it is, economists venerate it. Consider Sweden stops making wine to produce cloth. Now the this passage: demand for Portuguese wine is even greater. There is "[O]ne of the most diffi cult aspects of economic analysis nothing in free trade theory that makes lower prices is how to interpret the conclusions of models. Models are, necessary or even certain. by their nature, simplifi cations of the real world and thus Subsequently, economists replaced “how much labor of all economic models contain unrealistic assumptions. how many men “ by “opportunity costs.” But opportunity Therefore, to dismiss the results of economic analysis on costs are much more diffi cult to compute. Look at how the the basis of unrealistic assumptions means that one must concept of opportunity cost is defi ned: the amount of one dismiss all insights contained within the entire economics

84 THE IIPM THINK TANK M URKY ECONOMICS

discipline. Surely, this is not practical or realistic. Econom- Second, the principle of comparative advantage relies on ic models in general and the Ricardian model in particular a generalization so extensive its generalized term has no do contain insights that most likely carry over to the more denotation. It is a term without meaning. complex real world [http://internationalecon.com/Trade/ You see, only winos (alcoholics) drink wine! The rest of Tch40/T40-0.php]." us drink Asti, Beaujolais, Bordeaux, Burgundy, Cabernet This passage, in its entirety, is a non-sequitur. Even if Sauvignon, Chablis, Champagne, Chardonnay, Chianti, models are simplifi cations of the real world and contain Fynbos, Jerez, Kalecik Karası, Luján de Cuyo, Madeira, unrealistic assumptions, it does not follow that one must Merlot, Moselle, Pinot Gris, Port, Pouilly Fuisse, Riesling, dismiss all insights contained within them unless there are Sake, Sangiovese, Sauternes, Sherry, Tempranillo, Valpoli- none. After developing the model, a competent model cella, Vinhos Verdes and scores of others. Why Ricardo builder would then analyze it assumption by assumption, chose wine is a mystery. Perhaps he was a wino and really asking what happens if this assumption is false, what didn’t care about fl avor, aroma, dryness, and body. Or happens if that assumption is false, what happens if the fi rst perhaps he chose wine because the English were and still and second assumptions are false, and so on until s/he asks are not very good at making wine. Would the French be what happens when all of the assumptions are false. Only willing to give up Beaujolais for Port or the Japanese be then could one see which, if any, insights willing to swap Sake for Vinhos Verdes? are revealed by the model. Why would In cuisine, proof Someone will say it’s just an example. rejecting all insights contained within is in the pudding. But generalize on any product. Automo- the entire economics discipline not be biles, tomatoes, potatoes, chairs, what- practical or realistic if there are no valid In economics, the ever. The only products made worldwide insights? And to conclude that the proof is in the that are identical are factory produced Ricardian model contains insights that recipe regardless according to precisely defi ned specifi ca- most likely carry over to the real world is of how rank the tions and sometimes even those vary. pure unjustifi ed opinion. How would pudding tastes These products can be made just as anyone ever determine its likelihood? easily in Chad as in China. There is no Building models on assumptions that may or may not be reason to believe that people in Bongor are any less true is one thing. Such models may apply to the real world. dexterous than people in Beijing. But building models on assumptions that can never be Statements like the following are often found in the true is another. These models are never applicable to the literature: real world. "The magic of comparative advantage is that everyone Economists are a curious bunch. In cuisine, the proof is has a comparative advantage at producing something. The in the pudding. In economics, the proof is in the recipe upshot is quite extraordinary: Everyone stands to gain from regardless of how rank the pudding tastes. Paraphrasing trade. Even those who are disadvantaged at every task still Dani Rodrik, when economists are taken to task for have something valuable to offer. Those who have natural ignoring real world complications, they argue that the or learned absolute advantages can do even better for presence of market imperfections does not change the themselves by focusing on those skills and buying other model’s logic. He’s right, but they change the model’s goods and services from those who produce them at outcome, and that’s what’s really important. People don’t comparatively low cost. [http://www.econlib.org/library/ care about theory, and a logical principle, named modus Topics/Details/comparativeadvantage.html]" tollens, affi rms that if the consequent of a conditional argu- Now, just ask, how could anyone know the fi rst sentence's ment is false, the antecedent is false. So when economists claim? Is it simply impossible that someone somewhere apply a model and the predicted results don’t ensue, the can’t do anything at all? How can anyone justify a claim only logical conclusion is that the model’s premises are that such an impossibility exists? And how does everyone surely false. stand to gain from trade just because they can buy things at

THE INDIA ECONOMY REVIEW 85 O PEN WORLD

comparatively (compared to what) low cost? If just one traders to act without having to deal with governmentally person loses his income or his life because of trade policy, imposed regulations. Since the fi rst two alternatives the statement about everyone is false. The sentence isn’t involve regulations and the third does not, the fi rst two are even true if the word ‘gain’ is modifi ed by ‘fi nancial.’ protectionist and the third is not by defi nition alone. But So if it cannot be shown with certainty that one nation logically, a thing is what it is and not another thing. If some has a comparative advantage over another in the produc- horticulturalists decide to defi ne orchids as adornments tion of some product, then no one can be certain that any and not fl owers, would orchids no longer be fl owers? A predicted benefi ts from basing trade on a comparative name does not make something what it is; its attributes do. advantage will ensue. If free trade can’t be based on Remember the adage, if it looks like a duck, squawks like a comparative advantage, it must be based on some other duck, and walks like a duck? But if all three alternatives kind of real, contrived, assumed, or imagined advantage, are essentially the same, free trade theory collapses into not comparative advantage. utter nonsense. Free trade, when reduced to its simplest form, means In 1913, V. I. Lenin published an article in Pravda titled, nothing but trade not restricted by protectionist practices. Who Stands to Gain? Regardless of opinions of Lenin or But “protectionist practices” is another ill-defi ned, murky Leninist-Marxism, this question is a useful analytical tool concept. Consider these scenarios: when evaluating policy proposals and was stated long Two countries, Us and Them, each before Lenin by the Romans (cui produce a product named a domock. Us prodest?). Unfortunately, it is asked far is a highly developed nation that has If free trade policy too infrequently. If free trade policy implemented many economic regula- were implemented were implemented worldwide and all tions to protect its people from injury, worldwide and protective regulations were eliminated, exploitation, and fraud. Them is an all protective who would stand to gain? Merchants cer- underdeveloped nation with no econom- tainly. But what about the rest of us? ic regulations. Manufacturers in Them regulations were Well, suppose Them allows its manu- can export domocks to Us and sell them over, who would facturers to employ child labor. Us then for one curr each. Manufacturers in Us stand to gain? eliminates it child-labor protections. can sell domocks for two currs each. So Are the children better off just because what can Us do? they can now purchase domocks for one curr each? Leaving aside the possibility that Us might simply allow Suppose Them allows its manufacturers to use dangerous its manufacturers of domocks to go out of business, only materials. Us then eliminates its restrictions on the use of three unique alternatives exist: Us can impose a tariff of dangerous materials. Are people better off being injured one or more currs on each domock imported (a protection- and poisoned just because they can now buy domocks for ist practice), can subsidize its domock-manufacturers so one curr? Suppose Them allows its manufacturers to place they can reduce the price to one curr (another protectionist workers in dangerous circumstances where many are practice), or eliminate the protective regulations that cause maimed and killed. Us then eliminates it regulations on the price of domocks to be two currs. Free trade advocates unsafe workplaces. Are workers better off being injured do not consider this last alternative protectionist, and it is and killed just because they can now buy domocks for one the alternative they advocate. curr? Is anyone even fi nancially better off? So who stands But why is the third alternative not just as protectionist as to gain? Just merchants? the fi rst two? All three are done for the same reason and To economists, incredibly, merchants are mostly Mr. produce the same result. How can anyone justify calling Goodfellows. They don’t lie to and cheat consumers. They the fi rst two protectionist and the third not? don’t overcharge. They never market products that don’t Only one answer to the question exists, and it is trivial. work or that don’t work as advertised. They don’t market Free trade is often defi ned as a trade policy that allows products that injure and sometimes kill and hide the fact

86 THE IIPM THINK TANK M URKY ECONOMICS

that these possibilities were known before the products homes and savings have. The only confi rmed result of were marketed. They don’t write contracts with hidden fees globalized trade is the greatest transfer of wealth from the buried in text that can be read only with microscopes or least wealthy to the most wealthy in recorded history. that coerce people into repudiating their legal rights. They The real issue is independence or dependence. Free never defraud clients, each other, or governments by trade advocates are attempting to convince governments submitting claims for work never done on governmental worldwide to relinquish their control over their economies. projects or for governmental programs. They don’t profi t- It is an attempt by merchants to control all markets. If it eer in wartime. They don’t corrupt public offi cials. In fact, succeeds, national governments will be irrelevant. most are veritable saints, and the few that aren’t, those The real question that nations must answer is whom do rotten apples, are plucked from the barrel of commerce by they want to give control of their economies to? The the invisible hand, because the market is self-regulating. alternatives are national governments, which are at least in But in reality, unregulated business exhibits all the charac- some cases and in some sense responsible to their citizens, teristics of a criminal enterprise. or powerful worldwide commercial interests who have to As a logician, if I were asked to prove that the market is answer to no government and no people. Nations that were self-regulating, the only effective proof that I could think of once colonies of Western imperialist countries should would be to list all the untrustworthy fi rms whose dishonest consider this question carefully. Although the yokes of past actions were restrained by trustworthy oppression may have been lifted, the fi rms and then show that, at best, no or interests that propelled imperial con- just a few untrustworthy fi rms have The question is quest were commercial and still exist, avoided this restraint. But no economist not trade, but how and the agendas have not changed. Only has ever developed such a proof, which and by whom it the methods of conquest have. means that either the market isn’t will be controlled. Trade between nations will not cease self-regulating or that there are so few if free market theory is completely trustworthy fi rms that they lack the Trojan horses do debunked. Everyone, as I have argued power to restrain the untrustworthy. exist and everyone above, is a protectionist; everyone seeks However, this debate on free trade is is a protectionist to protect something—people their merely a diversion. The process of lives, merchants their profi ts, consumers globalizing trade that has now gone on for several decades their protections, laborers their jobs, nations their wealth has nothing to do with comparative advantage or free trade and power. The question is not trade, but how and by whom theory. No nation has abandoned any industries, trans- it will be controlled. So I would suggest that the world’s ferred the resources to industries making products for governments should beware economists bringing promises export, and used the exports to pay for the importation of of prosperity based on utopian theories on behalf of the products previously made by the abandoned industries. merchants. Trojan horses do exist. The so-called "developed" nations, whose governments are controlled by commercial interests, have merely bought the (The views expressed in the article are personal. The author is idle labor and resources of "underdeveloped" nations for a retired professor of philosophy and logic who blogs on skimpy sums and paid for them with fi at currencies that social, political, and economic issues. After serving in the U.S. amount to little more than promissory notes. It remains to Army during the Korean War, he spent 20 years as a university be seen whether the nations holding these promissory notes professor and another 20 years working as a writer. He has will ever be able to redeem them for value equal to that published a textbook in formal logic commercially, in aca- expended on the labor and resources used to manufacture demic journals and a small number of commercial maga- their exported products. If not, these nations will fi nd that zines, and has written a number of guest editorials for they have been swindled just as the residents of the United newspapers. His on-line pieces can be found on http://www. States, Great Britain, and other nations who have lost their jkozy.com/ and he can be emailed from that site's homepage.)

THE INDIA ECONOMY REVIEW 87 G ROWTH ECONOMICS

The India Story: Served Sunny Side Up

88 THE IIPM THINK TANK S TOCK TAKING

hold onto cash. Thanks to the monetary loosening, we are now Ketaki Sharma seeing a considerable softening of lending rates. Recently SBI Economist, Reliance Equities International cut its prime lending rates by 50 bps, while weeks before doing Pvt Ltd., Mumbai so it cut its deposit rates, thus creating incentives for individu- als to remain more liquid. Another indicator of increasing liquidity is the cooling off of call rates (inter bank lending rates). Call rates that had peaked to 21% in October, are now periodic visit to the various shopping malls in the placed within a more healthy range of 0.75% to 3.5%. metros over the past few months reveal a lot about On the fi scal front, similar measures have been taken. In Athe changing consumer mindset and is something India there have been excise duty cuts and other infrastruc- that sets my economist mind ticking. Footfalls have increased, ture expenditure undertaken by the government to ensure distress discount sales are a thing of the past, business is that domestic demand does not wither away. Here again, thriving, waiting time outside movie ticket counters has gone India is not the only country. China cut its central VAT in up and the great Indian pass-time of eating out has undergone January while the West has a wide social security net that revival. This, if not a confi rmation, is at least an indicator of props up demand. the great India story that everyone has been talking about. As global liquidity returns and risk appetite improves, there And Risk Aversion Abates… is bound to be a foreign funds infl ow into the emerging G-Sec yields might have fallen from their peak of 8.4% on 7th markets – especially India and China. Agreed that hitherto September 2008; however they have been more or less stable the emerging markets have been far more volatile than that of at 6.8% level. Loosening of policy rates has also helped abate developed countries but the fact remains that they -almost risk aversion - this is evident from the fall in 10 year G-Sec always- outperform the latter. yield. Many might argue that the already Taking a look at Charts 1 and 2, it is Four and a half announced four and a half trillion borrow- obvious that the Morgan Stanley Compos- trillion borrowing ing plan of the government will ensure that ite Index (MSCI) for Emerging markets plan of the state credit remains expensive and that interest outperforms the index for the world rates may not come down any further. markets, more so in the recent past. will ensure that True, given the borrowing requirements of Within this index for emerging markets, credit remains the government, it is unlikely that they will India clearly outperforms the others. expensive and fall further. It is my belief that India will continue rates may not fall to outperform other emerging markets India and China are the Most and will remain one of the most favored destinations for the Attractive Investment Destinations FII infl ow. What makes me so confi dent? Read further to While the world economy contracts, India & China grow at fi nd out! fi ve plus level. Both countries combined, India and China constitute about 40% of the world’s population. The demo- As Liquidity is Back with a Bang… graphics and sheer size of the population ensure strong The Reserve Bank of India cut rates for the fi rst time in 2008 domestic demand. India’s growth story is here to stay. While in October - to fi ght the lack of liquidity in the system post the monsoon failure remains a risk to India’s GDP growth, my fall of Lehman Brothers. belief is that India and China have so far outperformed the Post the Lehman crisis (in September), the Reserve Bank of rest of the world. And what is the reason behind that strong India has been cutting its policy rates. Since October there has belief? Because what we experience today is a demand side been a 400 basis point cut in the CRR and similar cuts in the constraint. The populous countries of China and India ensure Repo and the reverse repo. The big idea was to make money domestic demand holds up especially with rising government so cheap that lenders fi nd it profi table to lend rather than to spending to buoy infrastructure and farm activities. In the

THE INDIA ECONOMY REVIEW 89 G ROWTH ECONOMICS

Chart 1: Morgan Stanley Composite Index for Emerging Markets Versus the World

1400

1200

1000

800

600

400

200

0 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 MSCI Emerging Market MSCI World Index

Source: Bloomberg

Chart 2: Morgan Stanley Composite Index for Emerging Markets Versus India

900 800 700 600 500 400 300 200 100 0 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 MSCI India MSCI EM (Index)

Source: Bloomberg

Chart 3: 10 Year G-Sec Yield Falls, Risk Aversion Abates

10.00 9.50 9.00 8.50 8.00 7.50 7.00 6.50 6.00 5.50 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 10 year G-Sec

Source: Bloomberg

90 THE IIPM THINK TANK S TOCK TAKING

Chart 4: GDP Growth (Year on Year) for January to March 2009

8 6 4 2 0 -2 -4 -6 -8 -10

-12 China India Indonesia Chile USA UK Thailand Japan

Source: Bloomberg

Table 1: Sensex’ Return on Capital vs. GDP One Year Forward Return on Capital (30 Sensex companies) GDP 1 Year Forward FY02 16.21 3.7 FY03 22.22 8.4 FY04 15.72 8.3 FY05 25.89 9.3 FY06 21.02 9.7 FY07 22.35 9.1 FY08 20.14 6.7 Correlation: 62.84%

Source: Bloomberg and author's calculation

fi rst quarter, January to March 2009, Chart 4 compares GDP while looking at the India story are the sturdy GDP growth for a few countries. India and China clearly outper- numbers, the ability of the Sensex to indicate the same form their peers. and the very nature of the Indian market which ensures a strong domestic demand. As they say in cricket, “Form is Taking Stock of the Stock Market… temporary, class is permanent”. Similarly, while there The Indian stock market is a good indicator of its gross may be hiccups on the way but the Indian market is domestic product, one year forward. Return on Capital is fundamentally an attractive market and has a lot going in positively correlated with GDP a year forward (see Table 1). In its favour. simple words, the higher the return on capital in the Stock market, the better the growth prospects. Since India and References and Additional Thinking China have outperformed the global markets so far, it is highly • Bloomberg likely that their GDP growth one year forward will outper- • Central Statistical Offi ce, for data on Gross Domestic form the rest. Product of India

Conclusion: Sensex, GDP and the Republic of India (The views expressed in the article are personal and do not Essentially, the three things that one needs to delve into refl ect the offi cial policy or position of the organisation).

THE INDIA ECONOMY REVIEW 91 G ROWTH ECONOMICS Is Rising Share of Services Inevitable for GDP Growth?

Madhusudan Dutta Professor, Sardar Patel Institute of Economics and Social Research, Ahmedabad

he growth of the Indian economy at least over the last one and a half decades is generally viewed as led T by the tertiary (or, service) sector. Many observers, while appreciating the rapid growth of services exports in recent times, take the soaring share of the tertiary sector in gross domestic product (GDP) to be not very healthy; they view growth through service expansion to be illusory to a great extent as services are ephemeral. The implication seems to be that the service-led growth does not refl ect the inherent strength of the economy. Vestiges of Smithian ideas of productive and unproductive labour may be traced here. Adam Smith (1776) considered only material goods to be capable of generating economic growth through their use as fi xed capital and wage goods. Rendering of services, however dignifi ed or important, was considered as unproductive labour activity. I fi nd it somewhat uncomfortable to direct arguments in terms of the service sector as a whole without going ad- equately into the diverse characteristics of the component activities lumped together just on the basis of their products being intangibles. In fact, the classifi cation of activities on the basis of intangibility of product is only convenient and it has a historical legacy; but it is not based on any inherent strength or weakness of the relevant activities. A major part of the service sector activities are related to the production

92 THE IIPM THINK TANK W HAT’ S THIS INDIA BUSINESS?

THE INDIA ECONOMY REVIEW 93 G ROWTH ECONOMICS

Table 1: Shares in GDP*: Major Sectors Relative GDP shares of the major sectors – pri- mary, secondary and tertiary – change in the course Sector Primary Secondary Tertiary Intermediate Final of development in conformity with change in the Service Service structure of fi nal demand. The associated change in 1950-51 57.5 14.7 27.8 11.3 16.5 the production process involves not only expansion 1955-56 55.5 16.5 28.1 12.1 16 in scale but also technical progress that includes 1960-61 52.9 18.3 28.8 13 15.8 emergence of new products and also change in the 1965-66 45.1 22.3 32.6 14.9 17.7 structure of production organization. Revolution in 1970-71 46.3 21.6 32.1 14.7 17.4 computing and telecommunications technology has 1975-76 44.2 21.7 34 15.7 18.3 given us several new products and it has changed the 1980-81 39.7 23.7 36.6 17.2 19.4 way work is done making way for greater specializa- 1985-86 36.3 24.8 38.9 18.1 20.8 tion and, so, splintering of activities. Coming into 1990-91 32.2 27.2 40.6 18.8 21.8 prominence of business process outsourcing is an 1995-96 28 28.1 43.9 21.9 22 example of the importance of this trend. Out- 2000-01 23.7 27.8 48.4 23.8 24.6 sourced services should be viewed as an integral 2004-05 20.4 27.3 52.3 26.6 25.7 part of the production process which they serve, as *At factor cost, 1993-94 prices. they had used to be until they started to be out- Source: Calculations based on various issues of National Accounts Statistics, CSO. sourced. But the value-added in such services would now be shown in the service sector even though the of material goods; so much so that these services used to be, activities form an integral part of tangible or material produc- in effect, included in the measure of production used to be tion. There are services like trade and transport which may given by the erstwhile socialist countries as Net Material also be viewed as part of material production in the broader Product (NMP). sense of production as stated above. It will be instructive to take an example. Classifi cation of Sectors Consider companies like the Indian Oil and their Dynamics: Rendering of Corporation Ltd. It refi nes crude petro- The appellations – primary, secondary and services, however leum and distributes the products to the tertiary – have historical roots. Primary dignified or consumers. The company thus performs activities are extractive in nature and these important, was two types of operations: refi ning, belong- were supposed to cater to the most basic ing to the secondary sector and distribu- needs of subsistence. The secondary activi- considered as tion of products through trading cum ties are transformative in nature and these unproductive transportation activity belonging to the were viewed to be of the next order of labour activity tertiary sector. The company reckons its importance. Tertiary activities are the performance on the basis of the whole diverse set of residual activities basically of the nature of gamut of its activities. In order to satisfy the national account- services; i.e., they do not result in any tangible product. ing classifi cation the two types of operations (in fact, trans- Though left out of the sphere of production by a considerable portation is also separated from trade) are taken into account section of opinion for a long time, these services are now very separately. But that cannot blur the integral nature of the two much considered as part of a country’s GDP. A modern man basic activities – refi ning and distribution. If the different would not consider his car or television set to be more impor- activities were not reported separately the whole value added tant than his education or security. That is refl ected in his by the company would be reported in the industry sector choice for services exerted through his expenditure. The because the company is known as a refi ner (transforming growing share of services in GDP refl ects this choice because crude oil into refi ned oil and related products); that would production is not sustainable without demand. raise the share of industry in GDP and correspondingly lower

94 THE IIPM THINK TANK W HAT’ S THIS INDIA BUSINESS?

Table 2: Shares of Sub-sectors of the Tertiary Sector

Tertiary Shares in the Tertiary Sector In GDP THR TSC Communication # Banking & DRB Business Service# CSP Insurance 1950-51 27.8 31 12.2 1.4 3.4 19.8 1.5 33.7 1960-61 28.8 34 13.7 1.7 4.4 16.2 1.3 31.7 1970-71 32.1 33.9 14.6 2.2 5.2 13.1 0.9 33.2 1980-81 36.6 33.3 17 2.6 6.3 11.5 1 31.9 1990-91 40.6 30.9 15.3 2.5 10.3 13.6 1.5 30 1995-96 43.9 31.8 15.8 3.3 12.7 13.3 3 26.4 2004-05 52.3 30 20.6 9.1 12.5 11.6 4.3 25.3

*At factor cost, 1993-94 prices. # Communication is a part of TSC and Business Services is a part of DRB. Abbreviations – THR: trade, hotels and restaurants; TSC: transport, storage and communications; CSP: community, social and personal services; DRB: Dwellings, real estate and business services. Source: Calculations based on various issues of National Accounts Statistics, CSO. the share of services without any consequence for the size of fi nancial institutions. the GDP. All the countries of the world do not have equally developed national accounting system. Separating different Intermediate and Final Services: types of activities within a company requires a very well Considering the inter-linkage among activities as discussed developed accounting tradition. Surely, this makes the above, instead of taking the tertiary sector as a single block it sectoral shares of different countries non-comparable to should be instructive to divide it into two parts – intermediate some extent. services and fi nal services. Services that are not directly In the same way it should not be very diffi cult to see the associated with material production are public administrative intimate relationship between fi nance and services, education and health, dwellings, the above activities. The more advanced The financial miscellaneous personal services and a part does the corporate structure become, the services growth of transport, communications and fi nan- more intimately do the companies get reflects the growth cial services enjoyed as personal consump- connected with fi nancial institutions. Thus of other activities tion. These services together with service the development of fi nancial institutions exports constitute fi nal demand for may be viewed as an adjunct to the that use these services. The rest of the services, account- development of the industrial structure; services as an ing for a major part of value-added in the the two developments are synergistic. In intermediate input tertiary sector, are intermediate services fact, the greater part of what is shown as forming an integral part of the production output in fi nancial institutions is deducted from the output in process using them. Secondary sector is the dominant source the productive sectors using the services as an intermediate of their demand. input. As such, and to that extent, the growth of fi nancial In fact, as the objective of productive activities is catering services basically refl ects the growth of other activities that to fi nal demand a relevant question in understanding the use these services as an intermediate input. This is unlike the sectoral shares is how the composition of fi nal demand has growth of fi nal service like personal, social and community changed in the course of development. It is generally services. Determination of value-added in fi nancial services is expected that with rise in per-capita income relative impor- basically a question of distribution of value added between tance of services in private and public consumption rises cooperating sectors. Indeed, there is much uncertainty (Wagner’s law). But whether intermediate services like regarding the proper treatment of value added by different trade, transport, etc., should grow faster than other activities

THE INDIA ECONOMY REVIEW 95 G ROWTH ECONOMICS

Table 3: India’s Exports and Imports ( as % of GDP unless otherwise specifi ed)

Period 1971-1981 1981- 1991 1991-2005 1996-2005 2000-2005 Export of Goods and Services 5.29 6.29 11.85 13.2 15.1 Export of Services 0.85 1.46 3.44 3.59 4.58 Export of Services as % of Total 15.58 23.27 24.21 26.44 29.9 Import of Services 0.56 1.02 2.7 2.79 3.36 Source: Rakshit (2007) should depend, among other things, on the evolving sectoral mind that CSP combines really a group of diverse activities. structure of production. THR’s share in the tertiary sector increased during the fi rst fi fteen years but then the share gradually declined. Neverthe- Sectoral Shares in the Indian Economy: less, as the tertiary sector itself raised its share all through, Table 1 presents the relative shares of the three major sectors trade’s share in GDP increased, all through from roughly nine in GDP. The secondary sector includes mining, manufactur- percent to 15 percent; thus the sub-sector was more than half ing, construction and the utilities electricity, gas and water the size of the secondary sector as a whole most of the time. supply. We have divided the tertiary sector into two catego- Naturally, one will want to know why and how it was so. We ries: intermediate and fi nal services. We have used input- will take up the question below. output transactions tables for the Indian economy to compute Transport, storage and communications (TSC) increased its intermediate services that include the whole of trade and parts share in the tertiary sector very fast during the last ten years, of transport, communications, fi nance and but this is entirely explained by the growth business services used as intermediate of communications service, which grew input. The rest are fi nal services, which Intermediate particularly fast during the period. The include Community, Social and Personal services share is other growth story that cannot escape services (CSP) as well as parts of other just above 40% attention is (computer related) business services treated as fi nal use. of all services in services. In fact communications and It is seen that the share of the tertiary business services together explained only sector increased by about 13 percentage 1950-51 and it four percent of the tertiary sector in points in the fi rst four decades after increased to 50% 1990-91 but then grew to as much as 13.4 1950-51 but it rose further up by about 12 in 1995-96 percent of the sector in 2004-05. This percentage points in only the next one and meant that communications and business a half decades. This is a striking development and naturally it services together explain fi ve percentage point (out of has caught the attention of observers. The share of the 12-point) rise in the GDP share of the tertiary sector during secondary sector also rose by roughly the same magnitude as the last fi fteen years. that of the tertiary sector in the fi rst four decades but in the Table-1 shows that intermediate services constituted just subsequent period its share remained stagnant. Thus the above 40 percent of all services in 1950-51. The share in- tertiary sector captured the whole of the share lost by agricul- creased to around 50 percent in 1995-96 and more or less ture (primary sector) in the nineties and thereafter. stayed there since then. Thus over the fi rst four and a half Table -2 presents relative shares of sub-sectors of the decades the growth of intermediate service has been faster tertiary sector. THR (trade, hotels and restaurants) consti- than that of fi nal service. However, if we look at the last one tutes the largest sub-sector of the tertiary sector since mid- decade, intermediate and fi nal services almost maintained fi fties. Though CSP (it includes public administration and parity. The fact that the growth of the tertiary sector is defence as well as education, health and miscellaneous explained equally by the intermediate (of which industry is the services) has remained close to the THR we should keep in main source of demand) and fi nal services implies that

96 THE IIPM THINK TANK W HAT’ S THIS INDIA BUSINESS?

Table 4: Private Final Consumption Expenditure at current prices (Percentage Distribution)

YEAR 1960-61 1970-71 1980-81 1990-91 2000-01 2005-06 1.Food, Beverages & Tobacco 59.5 62.5 58.1 54 47.3 39.4 1.1 Hotels & Restaurants 0.6 0.6 0.8 1 1.4 2.3 2.Clothing & Footwear 5.1 4.9 6.3 6.2 4.6 5 4.Gross Rent,Fuel & Power 21.9 17.3 15.3 13.6 11.4 11.8 5.Furnitures 2.7 3.1 3.3 3.5 3 3.6 6.Health 2.3 2.8 4.4 3.8 7.3 6.5 7.Transport & Communications 2.6 2.9 4.5 9.8 14.2 19.1 8.Recre,Education etc. 2.1 2.5 2.5 3.1 3.6 4.2 Sub-total (rows 6 through 8) 7 8.2 11.4 16.7 25.1 29.8 9.Misc. 5.3 4.7 5.5 6.1 8.6 10.3 Total 100 100 100 100 100 100

Source: CSO, different years, National Accounts Statistics roughly half of the growth of the service sector is explained activities – outsourcing certain functions and sub-contract- by the growth of industry at a time when industry generally ing the production of numerous components (think of failed to raise its relative share in GDP. This is a fundamen- automobiles and electronics goods). Shift from single stage tal point for understanding the growth of relative share of to multi-stage production process adds to the ‘depth’ of the the tertiary sector. process. As a result there has been enormous increase in trade within industries. Of course, Demand for Intermediate Services: vertical integration is known to be a A very prominent example of intermedi- Service intensity means of cutting transactions costs but ate services is distributive trade. Its of the secondary there are limits to such strategies in the demand is wholly a derived demand, i.e., sector itself face of growing competition and speciali- demand arising form demand for com- increased over zation; and the contrary trend is strongly modities distributed through traders. felt in East-Asian markets. The Indian Also, transport is intimately related to time, as can be economy, one presumes, is not free from trade, so a very large part of the demand verified from the such effects and these effects should for transport services is derived demand research data affect the intermediate input coeffi cients too. Let us take an example. Milk dairy of the relevant sectors. movement has led to value addition in the processing of What we have talked about trade and transport services is milk. In the absence of processing, milk would be considered roughly valid regarding demand for a large part of fi nancial a product of animal husbandry included in the primary services also. The three broad groups involving these sector, and it would be distributed largely without the services account for roughly three-fourths of value-added in intermediation of traders. Milk processing has led to rise in the service sector of the Indian economy in recent times value addition not only in food processing industry but also (Table-2). In order to understand why such services grow so created demand for trade and transport of processed milk fast we just have to understand that the secondary sector and milk products. The example being a part of everybody’s uses the above services in the highest intensity. So as the daily experience, one can readily relate the rise in trade and share of the secondary sector rises the share of these serv- transport services to the ‘spread’ of industry. ices also rises. Furthermore, service intensity of the second- At a more sophisticated level we can look at the ongoing ary sector itself increased over time. This can be verifi ed global integration process. The multi-national companies from the input-output transactions tables for the Indian strive at reducing their costs by de-verticalizing their economy (not shown here).

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Structure of Final Demand: impact got a bit softened buy the fall of PFCE as a proportion Given the input-output structure, the composition of the fi nal GDP at market prices roughly from about 75% to 65%. Even demand vector determines the composition of output and, so, then it is clear that there was a large shift in fi nal demand from the sectoral structure of value added. The fi nal demand vector goods to services. Such shifts in demand from goods to may be viewed as having two parts – one endogenous (deter- services inevitably lead to a substantial increase in sectoral mined by disposable income) and the other autonomous. share of services. Income determination requires that, given the autonomous fi nal demand, the endogenous fi nal demand must be such that Towards a Conclusion: the aggregate fi nal demand vector is just equal to the vector of Our discussion above shows that in the process of growth of net output. To explain the relative share of the tertiary sector the Indian economy the weight of services in private consump- within this structure we look at the changing composition of tion expenditure increased markedly. Demand for industrial fi nal demand. products also increased rapidly for private consumption as It is observed from Table-3 that the average of India’s total well as capital formation. This is evidenced by the share of the exports in the decade of the 80’s was about 6.3 percent of secondary sector in GDP. This resulted in growing ‘spread’ GDP and this fi gure rose to 15.1 in the quinquennium ending and ‘depth’ of industry. The growth of industry led to faster in 2004-05. Out of this roughly nine percentage point in- growth of demand for intermediate services. Thus, on the crease, the contribution of services was more than three whole, the service sector has grown rapidly, through demand percentage points. Since the share of services in total exports for both fi nal and intermediate services, following the intrin- in the 80’s was less than a quarter of the total, the above sic logic of development. phenomenon implies, and it is observed form the table, that services’ share in total exports increased subsequently. This is References and Additional Thinking a very encouraging picture so far as services production is • Baumol, W. J. (1967), "Microeconomics of Unbalanced concerned and it defi nitely goes some way in explaining the Growth: The Anatomy of Urban Crisis", American Eco- rising share of the tertiary sector in GDP particularly in view nomic Review, Vol.57, June. of the fact that services make relatively little use of industrial • Datta, M (2001), The Signifi cance and Growth of the products as intermediate inputs. However, one cannot lose Tertiary Sector: Indian Economy – 1950 to 1997, sight of the fact that import of services also increased fast Kuznets, S.(1971), Economic Growth of National : Total during the same period. So, the growth of net export of Output and Production Structure, The Belknap Press of services was not as fast. Nevertheless this net export being an Harvard University Press, Cambridge, Massachusetts. autonomous component of fi nal demand for services, it • Rakshit, M. (2007), Services-led Growth: the Indian constituted a new source of stimulation of GDP growth as well Experience, Money and Finance, III (1), New Delhi. as a relative growth of the share of the service sector in GDP. • Smith, A. (1776), An Inquiry into the Nature and Causes of Now, for the induced part of fi nal demand for services, a the Wealth of Nations, Cannan, E. (ed), The Modern very important source of change in the relative importance of Library, New York. services is rise in per-capita income. When the rise in per- • Wagner, A. (1883), Three Extracts on Public Finance, capita income is accompanied by rise in income inequality the Extracts from Finanzwissenschaft, Part I, Third Edition, change in relative share of services may indeed be sharp. Leipzig, reprinted in Classics in the Theory of Public Table-4 gives an idea of this change for the Indian economy Finance, Musgrave, R.A. and Peacock, A.T. (eds), 1958, over the period 1960-61 to 2005-06. During this period Macmillan, London. private fi nal consumption expenditure (PFCE) on transport • World Bank (2004), Sustaining India’s Services Revolution, and communications, education, health and recreation Report on the South Asia Region: India. increased from a paltry seven percent to as much as 29.8%. We note that PFCE on services as a whole increased from (The views expressed in the article are personal and do not refl ect 17.8% to 40.6% over the last two decades and a half. But this the offi cial policy or position of the organisation).

98 THE IIPM THINK TANK G ROWTH ECONOMICS Modern Theories of Growth: A Critique

1001 0 THET HEH IIPMIII PM THITHTTHINKHHINKK TANKTANK A N ELUSIVE QUEST

in aggregate demand for fi nal goods and services the rate of Chanadana Ghosh unemployment is above the natural rate in times of recession Economic Research Unit, Indian and below it in times of boom so that the trend value of the rate Statistical Institute (ISI), Kolkata of unemployment equals the natural rate in every year. In other words, in the long run, the economy is always in the situation of full employment. The growth in the trend values of output is Ambar Ghosh therefore due to growth in the supplies of labour and capital Economics Department, Jadavpur and also due to technological progress that brings about shifts University, Kolkata in the production function. Accordingly, in the long run we are in the world of the classical theory, where output is determined by the supply side factors. The NRH invokes the Keynesian theory only to explain the deviation of the actual rate of unemployment from its trend value in every year (or in every 1. Introduction short period, which is a year at the maximum). The NRH thus The objective of the modern theory of growth is to explain the neatly compartmentalizes the study of the behaviour of aggre- growth in the trend values of aggregate output and employ- gate output and employment into two separate fi elds: one ment. Its focus is therefore on the long run. It is based on the analyses the trend values of output and unemployment and the Natural Rate Hypothesis (NRH). The NRH states that in the other focuses on deviations of actual values of aggregate output short run a market economy behaves in accordance with the and employment from their respective trend values in different Keynesian theory, while the classical theory best describes its short periods. The former constitutes the long run macroeco- behaviour in the long run. The NRH in its turn is based on the nomics, while the latter is the subject of short run macroeco- concept of natural rate of unemployment. It nomics. is defi ned as the rate of unemployment that In the long run The importance of NRH can therefore obtains when demand for and supply of we are in the hardly be overestimated in macroeconom- labour are equal. But, why should there be world of the ics today. Accordingly, it is imperative to unemployment in such a situation? The subject it to close scrutiny. The proponents exponents of the NRH have given two classical theory, of NRH point out that no one has ever major reasons, namely, imperfect informa- where output is observed an economy without unemploy- tion and imperfect spatial and occupational determined by the ment. However, at the same time they fi nd mobility of labour. Even if there are supply side factors it hard to believe that a market economy vacancies and an equal number of suitable never achieves full employment. They unemployed people, fi rms may not have the information refuse to subscribe to the view that demand defi ciency and regarding the availability of suitable candidates and unem- involuntary unemployment may be, as held by Keynes and also ployed people may also lack information regarding the avail- by the Keynesians in the hey days of Keynesianism, the natural ability of suitable vacancies and both the parties may have to state of affairs in a market economy. Instead, they assume that spend some time searching before the vacancies get fi lled up. there exists unemployment even in situations of full employ- By the time one set of vacancies gets fi lled up, another set of ment and invokes imperfections in information dissemination vacancies is created and a new group of people enter the labour and mobility of labour to explain that. They point out that an market. This is how unemployment may persist, even when economy is always in a state of fl ux. Not only does the aggregate demand for and supply of labour are equal. Similarly, concen- demand fl uctuate, so also does the composition of aggregate trations of unemployment and vacancies may be in different demand. The shifts in the composition of aggregate demand geographical areas and occupations and hence unemployment engender switch in demand from one kind of labour to another may persist despite matching number of vacancies because of and also from goods and services produced in one region to imperfect mobility of labour. It is assumed that because of shifts those produced in another region. Following the innovations of

THE INDIA ECONOMY REVIEW 101 G ROWTH ECONOMICS

computers, for example, demand switched to computers from cies. Under these circumstances it is quite natural that institu- typewriters and thereby to computer operators from typists. tions and practices will emerge to take care of the problem. This kind of shifts in demand is referred to as sectoral shifts. Employment agencies will emerge to place the workers appre- Since sectoral shifts occur all the time in market economies, it is hending job cuts in fi rms expecting a favourable turn in de- argued, unemployment is inevitable in such economies because mand. Firms of repute are likely to emerge specializing in of imperfections in information dissemination and imperfect supplying suitable candidates to fi rms immediately on demand. mobility of labour across occupations and regions, even when These fi rms will act as an intermediary between workers under aggregate demand for and aggregate supply of labour are equal. the threat of losing jobs and workers about to enter the labour The kind of unemployment that is given rise to by the sectoral market on the one hand and the fi rms seeking to expand and shifts on account of the imperfections noted above is called hire on the other. Hence unemployment given rise to by frictional unemployment. imperfections in the information dissemination system does not The above argument, though seems plausible superfi cially, stand up to close scrutiny. It should be particularly unaccept- wilts when subjected to close scrutiny. Let us explain. First, able to those who believe in the effi cacy of the market mecha- focus on the case of imperfect information alone and ignore nism. Ironically, it is those very people who harp on the imper- imperfect mobility of labour, i.e., assume for the present that fections in information dissemination. information is imperfect, but labour is perfectly mobile. Start Let us now consider the case of imperfect mobility of labour. from a situation of full employment. Start from a situation of full employment Suppose there takes place a change in the Demand and consider a shift in demand in favour of composition of demand in favour of one deficiency and doctors at the expense of engineers, giving industry at the expense of another. The rise to excess demand for doctors and just favoured sector will recruit and expand, involuntary the opposite for engineers. If wages and while the other sector will downsize. It is unemployment prices are perfectly fl exible, they will adjust argued that this will lead to unemployment are chronic and clear markets for both types of labour. as the contracting sector will release labour, in decentralized There will be no unemployment in this case. but the expanding sector will take time to market economies However, if wages and prices are rigid, recruit because of lack of information sectors employing doctors will not expand regarding the availability of suitable unemployed candidates. because of shortages of doctors, but those employing engineers The unemployed workers will also take some time to collect will contract. In this case, the impact of the demand shift is information regarding the availability of suitable vacancies. This similar to that of a contraction in aggregate demand. Engineers argument does not seem acceptable. Reasons are the following. become involuntarily unemployed – as they are willing to work First, in this age of information revolution, there are a large at the going wage rate for the engineers and an increase in number ways of advertising vacancies. There are numerous aggregate demand will reduce their unemployment. Two points news papers, TV channels, internet and so on. Information can emerge from the above example. First, sectoral shifts create be made available and recruitments can be done within a very unemployment if and only if wages and prices are rigid. The short period of time. Second, fi rms also take time to sack, if they unemployment is therefore involuntary. Second, if sectoral think that the change is temporary, as it is costly to train new shifts are accompanied by price rigidity and give rise to unem- recruits, to make them adapt to the new environment, to learn ployment due to imperfect mobility of labour, they will in no about their skills, sincerity, honesty etc. This phenomenon is time snowball into full fl edged recessions. The contracting fi rms referred to as labour hoarding and it is quite common. Firms will cut output, but the fi rms planning expansion will fail to do downsize only when they think that the shift is a long term one. so because of paucity of suitable labour. Aggregate income will Finally, if sectoral shifts are regular and important, as the therefore fall reducing aggregate demand and thereby inducing proponents of NRH emphasize, the workers are always under further cut in aggregate output. The contracting fi rms will lose the threat of losing jobs, while fi rms are also under the threat of and therefore will be in fi nancial diffi culty. Default rate will rise losing profi t because of the delay involved in fi lling up vacan- putting the lending institutions in trouble. They will ration

102 THE IIPM THINK TANK A N ELUSIVE QUEST

credit more severely. It will reduce demand again. These accidentally. The phenomenon of sectoral shifts makes the contractions will mutually reinforce and cumulate and push the scenario more unpredictable. Moreover, prices and wages are economy in a recession. From the above it follows that, if also normally rigid because of different kinds of market unemployment is due to sectoral shifts, there is rigidity in the imperfections. Hence, involuntary unemployment and demand price system. Moreover, if sectoral shifts combine with price defi ciency are likely to be chronic and systemic in unplanned rigidity and imperfect mobility of labour, they generate strong market economies. recessionary forces. If one admits that sectoral shifts, price Let us generalize the above argument. Mismatches in rigidities and imperfect mobility of labour are common features demands and supplies of the kind discussed above are by no of market economies, as the proponents of the NRH do, one means confi ned to labour markets alone. They apply to physical also concedes that a market economy is normally recession capital also with equal force. Capital too is imperfectly mobile prone and demand defi ciency and involuntary unemployment across different industries. A steel plant can only produce steel; are rules rather than exceptions. In other words, the implica- it cannot produce power or any other product. A mismatch tion of the assumptions of the proponents of the NRH is that between the structure of demand for capital services yielded by demand defi ciency and involuntary unemployment are chronic the composition of aggregate demand and the structure of the and systemic in decentralized market economies. Sectoral shifts supply of capital services is also quite likely to occur in market that generate unemployment are hardly as innocuous as the economies. Thus, even though aggregate demand for capital proponents of the NRH make us believe. services equals their aggregate supply, there They have strong destabilizing and contrac- In a market may be excess demand for one kind of tionary impact. Thus, in a market economy capital service (such as the ones producing today, it is sensible to regard the observed economy today, power or transport) and excess supply of unemployment as being involuntary - a it is sensible some other kind (such as the ones produc- product of wage rigidity and inadequacy of to regard ing consumer durables). If prices are rigid, aggregate demand. The latter is due to the observed as is normally the case, because of oligopo- various factors including sectoral shifts. unemployment as listic interdependence in case of private Even though the mismatch between the goods and administered prices in case of structure of labour demand and that of being involuntary public goods, these mismatches will not get labour supply has been attributed to corrected through movements in prices in sectoral shifts in the above discussion, it can occur even without the short run. Let us illustrate with an example. Suppose in a any kind of sectoral shifts. It is a general feature of market given period, there occurs in an economy excess demand for economies. Let us explain. Consumption decisions and deci- roads, water supply etc and an excess supply of consumer sions to invest in physical and human capital in such economies durables. Prices of the former are non-existent, as they are are taken by individual economic agents independently of one public goods. Hence they cannot rise to correct the situation. another in an uncoordinated manner. Individual decision Prices of the latter may not fall either because of oligopolistic makers cannot have any idea as to what the total demand would interdependence. Hence the situation will give rise to substan- be for any particular good or for any particular type of labour or tial excess capacity in the consumer durables industry saddling what the total supply would be of any particular type of labour. the investors with heavy losses. We can show the problem in a The input-output relationships across different sectors of different way also. Since different sectors of production are production and different types of labour change continuously interdependent through input-output relationships, investments with innovations of new technology, products etc. Individuals made in different lines of production in any given period have do not and cannot have information regarding these relation- to synchronize to ensure full utilization of capacity for the ship or their changes. Accordingly, structure of labour demand economy as a whole. In the example given above, the capacity that is yielded by the composition of aggregate demand and the output of the road and water supply sector is too low to enable structure of labour supply that arise out of individuals’ invest- the rest of the economy to fully utilize its productive capacity. In ments in different kinds of human capital can match only this kind of a situation, serious economic problems will arise

THE INDIA ECONOMY REVIEW 103 G ROWTH ECONOMICS

leading to recession. In the sectors having excess supply of capacities are created at a high rate in different areas of capital, a substantial part of expensive capacities created will production in an uncoordinated manner, the problem of remain unutilized and the investors will incur heavy losses. coordination failure makes newly created expensive capacities They are likely to default on their loan obligations creating idle in different lines of production due to scarcities of certain fi nancial diffi culties for the banks and other lending institu- specifi c kinds of labour or shortages of some crucial inputs tions. These institutions’ ability to lend will badly hurting investors’ morale, even get restricted. They will also be more though there may be sizeable excess cautious in their lending. This will reduce Prices and wages capacity and unemployment on the credit supply and consequently aggregate are often found aggregate. This has, as we have already demand, which will further aggravate the to be inflexible pointed out, adverse fi nancial implications, situation pushing the economy into downward, but which push the fi nancial institutions on the recession. The kind of problem specifi ed back foot aggravating the damage to above is and should be systemic in market they are not so business sentiments. The problem of the economies since consumption decisions in the upward real sector gets magnifi ed through its and decisions to invest in physical and direction in deficits impact on the fi nancial sector. This process human capital are made by individual is referred to as that of fi nancial accelerator consumers and investors in an uncoordinated manner and – see Bernanke et al.(1998). These mutually reinforcing forces prices are rigid for reasons already discussed. This problem is push the economy into recession much before the state of full referred to as that of coordination failure. It is called dispro- employment is reached. Again, in an economy in recession, portionality crisis by Marx. This is a, if not the, major factor with the increase in the pool of unemployed workers, availabil- that makes a market economy recession prone. Alternatively, it ity of all kinds of workers becomes plentiful; supplies of social makes demand defi ciency a chronic problem in a market goods improve due to governments’ efforts at stabilizing the economy. In times of high rate of growth or boom, when economy and with the easing up of fi scal constraints on public

Table 1 : Y-o-Y Growth rates of India's GDP and Its Components at Constant Prices:

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 GDP 4.0 5.2 3.8 8.4 8.3 9.2 9.7 9.2 7.1 Agriculture1 -0.2 0.8 1.8 10.0 0.0 5.9 3.8 5.1 2.6 Industry 6.4 2.4 6.8 6.0 8.5 8.0 10.6 7.5 4.2 Services 5.7 6.9 7.5 8.8 9.9 11.0 11.2 11.1 9.2 ( I )2 -3.5 -2.9 17.0 19.9 19.5 19.4 10.9 16.9 9.7 (I – MC)3 -3.8 -4.0 15.1 19.5 19.1 16.8 9.3 19.0 C4 3.2 6,2 2.7 5.8 5.2 8.7 7.1 6.5 6.8 G5 0.9 2.3 -0.4 2.6 2.6 5.4 6.2 7.0 16.8 Exports 18.0 1.5 17.8 10.8 32.3 20.2 21.8 4.6 21.5 ELEM6 23.9 1.1 17.2 10.4 33.4 22.9 25.6 5.1 Imports 8..2 1.5 17.7 12.6 35.1 27.9 24.4 8.2 Remittances 5.7 22.3 3.8 20.6 -13.3 12.9 10.0 24.1

1 Agriculture includes forestry and fi shing 2 I stands for gross investment 3 (I-MC) stands for gross investment net of import of capital goods 4 C denotes private fi nal consumption expenditure 5 G denotes public fi nal consumption expenditure 6 ELEM stands for exports net of export related imports Source: CSO

104 THE IIPM THINK TANK A N ELUSIVE QUEST

expenditure. With idle capacities everywhere, supplies of all from the argument spelt out above, there are other factors that kinds of goods become more abundant too. These improve- tend to make aggregate demand defi cient. People have to save ments in supply side factors again begin to boost business to fend for old age, infi rmity etc. Hence consumption demand morale leading to a resurgence in economic activities. The usually falls far short of aggregate output. Investment is highly point of this whole discourse is that price rigidities and mis- risky and people are generally risk averse. Government expend- matches between the structures of aggregate demand and iture is subject to severe budget constraints, given governments’ those of capital and labour due to coordination failure are an obsession with revenue and fi scal defi cits. For these reasons also integral feature of a market economy. They are systemic and demand defi ciency may be the norm rather than an exception. generate chronic demand defi ciency and involuntary unem- Even casual empiricism shows that nominal prices are fairly ployment. They are the main reason why booms turn into rigid and there is no dearth of supplies of goods and services at recession much before the state of full employment is reached. their given prices. If demand defi ciency and involuntary Even the current recession in the US ravaging the developed unemployment are chronic, it means that in times of recession world has its roots in massive over-investments in the real the rate of involuntary unemployment is large and it is small in estate far in excess of genuine demand for housing. The reason, times of boom. Besides the factors noted above, there is again, lay in large scale coordination failure. The increasing another reason why a market economy may fail to achieve full profi tability of investment in the housing sector led to tremen- employment. Usually, there is an asymmetry in the price dous overinvestment in housing precipitating the crash. adjustment processes. Prices and wages are often found to be It thus seems more sensible to regard the observed unem- infl exible downward, but they are not so in the upward direction ployment in a market economy as being involuntary. Apart in the event of shortages. The reason is not far to seek. First

Table 2 : Cross Country Comparisons of Various Economic Indicators

Country Growth Rate Contribution Contribution TFP Growth Per Capita GDP Capital Labour Rate Growth Rate OECD Countries 1960-1995 Canada 0.0369 0.0186 0.0123 0.0057 0.0077 =0.42 UK 0.0221 0.0124 0.0017 0.008 0.0175 =0.37 US 0.0318 0.0117 0.0127 0.0076 0.0201 =0.39 Japan 0.0566 0.0178 0.0125 0.0265 0.0276 =0.43 East Asian Countries 1966-1990

Hong Kong 0.073 0.03 0.02 0.023 0.019 =0.37 Singapore 0.087 0.056 0.029 0.002 0.0279 =0.49 South Korea 0.103 0.041 0.045 0.017 -0.047 =0.30 Taiwan 0.094 0.032 0.036 0.026 -0.0444 =0.26

Source: Estimates of OECD countries are taken from Jorgenson and Yip(2001) Estimates of East Asian countries are taken from Young (1995) (QJE,110,August,641-680). The last column is the authors’ own calculations.

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Table 3: Saving Ratio and Per Capita Income in India (1950-51 – 2006-07) recession and fi rms have insuffi cient demand for their products. A 1950s 1960s 1970s 1980s 1990s 1991-92 – 1997-98 – 2003-04 - unilateral cut in wages in such a 1996-97 2002-03 2006-07 situation and the consequent adverse s1 9.7 12.3 17.2 19 23 22.7 24.1 32.7 response of the workers may be 2 y 6737 7888 8880 10691 14761 14012 17812 22776 enormously costly to the fi rms. Any 1 s represents gross domestic savings as percentage of GDP kind of supply failure in such a 2 y represents per capita GNP at factor cost at constant 1993-94 prices. It is measured in Rupees (crore). Source: CSO scenario may lead to a sizeable loss in market share and this loss may far consider the prices of produced goods and services. Markets of outweigh the gain due to the wage cut. There are also minimum these goods are oligopolistic. When there is excess capacity in wage legislations setting fl oors to money wages. In the event of the fi rms, no fi rm risks cutting its price unilaterally, as it will labour shortages, however, fi rms can offer higher money wages lead to a price war saddling all the fi rms with losses. When all without the adverse consequence noted above. This explains the fi rms in an industry engage in competitive price cuts, it has asymmetry in the price adjustment mechanism. This asymmetry ruinous implications for them all. But in times of shortages, coupled with the problem of coordination failure may check fi rms may unilaterally raise their prices, as there is no risk of output expansion in times of boom much before full employ- losing customers to the rivals, since every producer is capacity ment is attained. Let us explain. Capital structure and labour constrained. In case of labour, as Keynes pointed out, money structure, as we have already explained, are far from balanced wages do not fall in the face of unemployment on account of in market economies, given the lack of coordination among the workers’ resistance. Worker unions resist such cuts. Firms may individual decision makers and that of information. Hence, as also consider it imprudent to cut wages despite workers’ aggregate demand rises relative to productive capacity, short- resistance unilaterally to earn the infamy of being a bad ages of various kinds of goods and labour begin to crop up employer. If a fi rm gets singled out as a bad employer, it will not putting upward pressure on prices. This is the standard trade- be able to retain or get to recruit the best of the workers and off between infl ation and unemployment that the traditional thereby will lose out in competition. Unemployment and Phillips curve captures. Since the government and the central recession go hand in hand. In times of unemployment, there is bank do not want the rate of infl ation to rise beyond some tolerable levels, they may adopt contrac- Table 4: Average Annual Growth Rate (%) of Gross Domestic Product tionary programmes much before the full Average Annual Growth PPP per capita Rank employment level of output is reached. Rate (%) of GDP GNP ($) This may also be one of the reasons why a Country 1990 -2000 2000-2004 2004 2004 market economy never attains full Low Income Countries 4.7 5.5 2258 employment. In this case, even though Middle Income Countries 3.8 4.7 6644 prices move in the upward direction, it High Income Countries 2.7 2 31009 cannot do so fully to adjust the pattern of China 10.6 9.4 5890 108 demand to that of supply owing to government intervention. Vietnam 77.22700149 Once we accept that demand defi cien- Ireland 7.5 5.1 32930 8 cy is chronic, a position which seems to India 66.23120144 be much more sensible and logical than United States 3.5 2.5 39820 3 the NRH, the sharp division between the United Kingdom 2.7 2.3 31430 14 short run and long run analyses in Japan 1.3 0.9 29810 18 macroeconomics dissolves altogether. France 21.52946020The focus shifts to the year-on-year Source: World Development Indicators 2006, The World Bank growth rates, which have to be explained

106 THE IIPM THINK TANK A N ELUSIVE QUEST

using the short run models only. output will be determined by the growth in their productive The above observations throw the area of growth wide open. capacity due to investments in earlier periods. Note that It need not necessarily be the exclusive preserve of long run productive capacity in agriculture depends crucially on public macroeconomics that focuses solely on the supply side factors. investment in major irrigation in dry land areas, fl ood control It may be better to study growth by focusing on the year-on-year facilities in areas prone to fl ooding, inventions of better seeds, growth using the Keynesian models. The short run Keynesian farming practices etc. The last two in India also depends model determines Y or Yt . Given Yt-1 , it determines a growth crucially upon public investment in agricultural R&D. Thus rate as well. Growth rates in a market economy fl uctuate a great Keynesian economics does not apply fully to Indian macro deal, but they do so within limits. Growth rates usually follow a economy. When GDP is demand driven, its growth can be cyclical pattern. Periods of high growth rates are followed by explained in terms of growth in the autonomous components of those of low ones and vice versa. Consider, for example, the aggregate demand, namely, investment, government consump- fi gures in Table 1, which shows that India was in recession tion and export. From the data in Table 1 one can compute the during 2000-01 to 2002-03. However, this phase was followed by growth rates of these components of aggregate demand. But the a period of high growth from 2003-04 to sum of these growth rates, as one can easily 2007-08. The growth rate slumped a little check, cannot explain fully the growth again in 2008-09. Thus the growth rate The neoclassical performance of GDP in India during the neither goes on rising steadily over time nor theory of growth period under consideration – see in this does it keep on falling monotonically, even states that a context Rakshit( 2009 ). though the average or the trend growth rate market economy We shall now critically assess the major may show a tendency to rise, as is the case in theories of long run growth based on the India. These fl uctuations in year-on-year in the long run NRH. In fact, we shall discuss the pioneer- growth rates are best explained using the eventually attains ing work of Solow (1956) and the endog- short-run models. It should be noted in this steady state enous growth theory that it gave rise to and context that in India both demand and evaluate the results they yield. The model supply constraints operate at the same time and this makes the Solow(1956) developed is referred to as the Solow model or the study of growth much more complicated. Let us elaborate. Even neoclassical theory of growth. casual empiricism shows that in India prices of privately provided nonagricultural goods are highly rigid and there is no 2. The Neoclassical Theory of Growth dearth of these goods at these rigid prices. Hence outputs of The Solow model states that a market economy in the long run these goods are demand driven. However, there are many eventually attains steady state. In the steady state per capita publicly provided goods in India, which are supplied either free growth rates of capital and output are equal to the rate of of charge or at non-remunerative administered prices, and technological progress, which we denote by m. The value of m is there are marked shortages of these goods. These goods include exogenously given in the model. In the out of steady state power, potable water, roads, water from major irrigation situations, however, per capita growth rate becomes a function projects etc. Outputs of these goods are capacity constrained. not only of m but also of the economy’s saving ratio, the rate of Output of the agricultural sector is also given in the short run. depreciation and the rate of growth of population, denoted by s, This is because agriculture is a nature process; production δ and n respectively. Like m, they are all parameters in the requires a pre-specifi ed period of time; and there is no scope Solow model. for adjusting output during the time that elapses between one Let us now examine whether or how one can apply these sowing season to the next. To explain growth in India’s GDP in results of the Solow model to explain the long run growth a given year, one has to therefore undertake a disaggregated performance of a country. In this context, two alternative study. Growth in the privately provided non-agricultural goods assumptions are possible. One may assume, for example, that in has to be explained in terms of growth in their demand, while the long run an economy is always in steady state. If this the growth in the publicly provided goods and agricultural assumption is made, per capita growth rate of GDP in the long

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run must equal the rate of technological progress. This implies scale and factors of production are paid in accordance with that the rate of growth of the trend values of GDP should their marginal productivities. For simplicity, suppose that the exceed the trend rate of growth of the labour force by the rate aggregate production function is Cobb-Douglas and it is given of technological progress. Surprisingly, none of the major by . Note that the power of each factor gives the empirical studies carried out so far make this assumption. share of its income in GDP, when the price of each factor equals Obviously, Solow model cannot explain long run growth its marginal productivity. Taking logarithm of both sides of the performance if the above assumption is made. In fact, data Cobb-Douglas production function specifi ed above and given in Table 2 do not give any prima facie support to the result differentiating them with respect to time, we get of the Solow model. It shows that countries with high per capita ...... (1) growth may have low total factor productivity (TFP) growth, From (1) it follows that the part of the growth in GDP that is which is a measure of the rate of technological progress, and due to growth in capital and labour is given by . vice versa. Thus UK with a per capita growth of 1.75 percent The remaining part of the growth in GDP, , had a TFP growth rate of 0.8 percent, while US with a higher is due to growth in A, . , which is referred to as Solow residu- per capita growth of 2.01 percent recorded a lower TFP growth al or total factor productivity growth, is usually regarded as a rate of 0.76 percent. The result becomes all the more startling measure of technological progress. The above discussion when we fi nd that South Korea and Taiwan with negative per suggests a method of measuring . Suppose one wants to capita growth rates of -4.7 percent and -4.4 percent had TFP measure the rate of technological progress in an economy in a growth rates of 1.7 percent and 2.6 percent respectively. Hong given decade. One can do so by estimating the average growth Kong, whose per capita growth rate of 1.9 percent was close to rates of GDP, capital and labour and the average shares of that of UK registered a substantially higher TFP growth rate of capital and labour during the decade and then by computing 2.3 percent. Thus the data do not seem to support the result of for the given decade. This method of the Solow model, if we assume that the economies in the long estimating the rate of technological progress is far from satisfac- run are more or less in steady state all the time, i.e., the trend tory for reasons that we shall explain shortly. (Barro and values of the endogenous variables of the Solow model refl ect Sala-I-Martin (2004) refers to the above measure of technologi- more or less their steady state values always. cal progress as the primal measure. They have discussed a dual Alternatively, one may assume that the economies even in the measure also. But the latter is based on the same set of assump- long run are usually out of steady state. When an economy is tions as the former.) not in steady state, its growth rate, as follows from the Solow Let us now explain why the above method of measuring the model and as we have mentioned above, is determined by the rate of technological progress is fl awed. It is so because it parameters of the Solow model. Even though all the empirical assumes that the markets are perfectly competitive and factors studies in the mainstream growth theory assume the economies are paid in accordance with their marginal productivities. to be out of steady state, none of them has tried to verify this Obviously, almost all the markets in modern developed result. This is surprising in view of the fact that the Solow model economies today are oligopolistic. In countries like India also, dominated growth literature for nearly three decades. We have this is true except for the markets of agricultural goods, which dwelt on this issue later in the concluding section. From the are competitive. Thus, most of the producers earn super above it follows that the rate of technological progress is an normal profi t. This means that return on capital far exceeds its important determinant of the rate of growth of GDP in Solow marginal productivity. model in both steady state and out of steady state situations. It is in fact not necessary to resort to marginal productivity Hence we shall discuss below how the rate of technological theory of factor pricing to develop a measure of technological progress is measured in the mainstream growth theory. progress. The theory is patently false. Mark-up pricing rule in The rate of technological progress is measured on the basis of oligopolistic industries is regarded as the norm by many writers, a number of assumptions, which are extremely hard to accept. see, for example Kalecki(1954). Under this rule, price is set by The mainstream macroeconomists assume that there exists an applying a fi xed mark-up to the average variable cost of aggregate production function that displays constant returns to production. For the economy as a whole, the average variable

108 THE IIPM THINK TANK A N ELUSIVE QUEST

cost consists only of labour cost. If the requirement of labour capita output especially in the long run. An increase in per per unit of output is , the average price of goods and services capita output raises individuals’ capacity to save and thereby under the mark-up pricing rule is given by tends to step up s. It also tends to lower n. It also tends to make ...... (2) more resources available to the government per capita, which in where the average price of goods and services, the fi xed turn improves per capita supplies of public goods such as average mark-up and the average money wage rate. In (2), drainage, protection from natural calamities, public administra- is historically and exogenously given. It is to be estimated tion, defence etc. leading to a fall in δ. Obviously, in this kind of from the data on costs and prices. Given the diffi culty of a scenario, the Solow model ceases to hold. It has been claimed estimating demand functions and the complexities thrown on it that in the long run the saving function is proportional. How- by oligopolistic market structures and the price rigidity that the ever, Indian data do not support this. As we fi nd from Table 3, oligopolistic interdependence entails, the application of a saving ratio has increased steadily over time along with per historically given mark-up to the average variable cost to set up capita income. Thus the Solow model breaks down altogether at the price seems to be eminently sensible and therefore rational. least in the context of the India economy. From (2) it follows that the share of labour in GDP = ...... (3) and share of profi t or 3. Endogenous Growth Theory capital in The mainstream growth theory since the mid-eighties tried to extend the Solow model by endogenising the rate of technologi- GDP = ...... (4) cal progress. In other words, they tried to formulate theories that explain the value of m of the Solow model. Pioneering Equations (3) and (4) determine factor shares in terms of the attempts in this regard were made by Lucas(1988) and average mark-up, . It also suggests a measure of technological Romer(1986,1990). The growth theory that they developed is progress. Since labour is much more variable than capital, referred to as the endogenous theory of growth. It is a vast labour requirement per unit of output may literature, which is still growing at a fast be regarded as a technology-determined rate. The endogenous growth theory that variable. So the rate of decline in l, i.e., the The Endogenous took off phenomenally from the pioneering rate of increase in the average productivity growth theory studies of Lucas and Romer broadened the of labour, may be taken to be an index of broadened the set set of determinants of the per capita growth the rate of technological progress. This is of determinants rate of a country. It traced the per capita quite a satisfactory measure of technologi- growth rate to a whole host of factors such cal progress in an economy with an insignifi - of the per capita as the educational attainment and state of cant agricultural sector. This is because in growth rate of health of the people, the share of resources the non-agricultural sector diminishing an economy devoted to R&D, the rule of law, democ- return to labour is not much pronounced racy, openness of the economy etc. The and this makes the labour requirement per unit of output more general problem with the endogenous growth theory is that all or less constant corresponding to any given technology. Since the different determinants of per capita growth rate that this there are usually restrictions on hiring and fi ring of labour and literature identifi es are increasing functions of per capita also on account of the phenomena such as labour hording and income. Accordingly, they assume highest levels in the devel- sectoral shifts, it may be sensible to use the trend values of l for oped countries, which, however, grow at substantially lower measuring the rate of technological progress. rates than many much poorer economies. Table 4 shows that the Finally, it is extremely diffi cult to accept the Solow model as a average annual growth rates of GDP during 1990-2000 and theory of long run growth. In this model, per capita output or 2000-2004 were the highest in the low income countries, second the rate of growth of per capita output is an endogenous highest in the middle income countries and lowest in the high variable. However, it is hard to imagine the parameters of the income countries. It also shows that China ranked 108 on the Solow model such as s, δ, n etc. as being independent of per basis of per capita income in 2004 recorded highest growth

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during the given periods followed by Vietnam ranked 149. The see Table 4 in this context - there is prima facie no evidence to third highest growth rate was recorded by Ireland ranked 8th, that effect. but the fourth highest growth rate was recorded by India ranked These studies also claim that they have found evidences for 144th. The richest countries such as the US, UK, Japan and conditional convergence even though not for absolute conver- France ranked 3rd, 14th. 18th and 20th respectively recorded quite gence (see Barro and Sala-I-Martin(2004) in this context). In modest growth rates. The endogenous growth theory therefore other words, they have found that if all other variables are held prima facie does not stand up to close empirical scrutiny. In constant, an increase in per capita income tends to lower the what follows we shall dwell on the empirical studies that have per capita growth rate and vice versa. The meaning of this result been made on the endogenous growth theory. is the following. If, for example, in India, per capita income rises alone in the long run and all other explanatory variables remain 4. Empirical Results and Concluding Remarks unchanged, the long run growth rate in India will tend to fall. Empirical studies on the mainstream growth theory, which The mainstream growth theorists regard this result as an includes the Solow model and the endogenous growth theory, evidence of conditional convergence. This means that every focus on three issues in the main, namely, growth accounting, country tends to move towards its respective steady state. As we explanation of cross-country differences in the long run rates of have already pointed out, this kind of exercise hardly makes any growth and convergence. Growth accounting assumes that sense. The notions of conditional convergence follow from the there are three sources of growth, viz, rate of growth of capital, Solow model. Since saving rate, rate of growth of population rate of growth of labour and technological progress. It seeks to and the rate of depreciation are all functions of the per capita decompose the growth rate of GDP into the contributions of income in the long run, the model breaks down altogether. In these three sources (see, for example, Barro fact, tastes and preferences change drasti- and Sala-I-Martin(2004)). We have already cally in the long run. They change with explained the problems with this kind of If all other changes in individuals’ surroundings and exercise. The other studies are cross-section variables are environment that accompany growth in studies and they seek to explain cross-coun- held constant, an income. Under these conditions, the try differences in growth rates. To that end increase in per endogenous growth models also cease to they regress long run per capita growth hold and the steady states that they derive rates of different countries on a whole host capita income become meaningless. This is the basic of factors in addition to per capita output as tends to lower the problem of developing a long run theory of explanatory variables such as educational per capita growth growth. To quote Keynes, “in the long run attainment, infant mortality rate, life we are all dead”. expectancy, rule of law, degree of democracy etc. Note that per If we look at the aggregative group-wise raw data, we fi nd capita income must be an important determinant of all these that, as we pointed out earlier, the long run growth rate varies factors. The higher the per capita output, the greater is the inversely with the degree of development – see Table 4. This is ability of the people to spend on education, health and less is in sharp contrast with the predictions of the endogenous growth likely to be the incidence of crime. Again, the higher the per theory. If we focus on more disaggregated country-wise data, capita output, the greater is the taxable capacity of the people please refer Table 4, we fi nd that many of the richest of the and therefore the larger is the amount of resources at the nations persistently grow faster than many of the poorest command of the government leading to greater provision of nations, while some poor nations grow at a much faster rate public goods such as public administration, health care, than many of the richest nations. Actually, countries with high education, potable water, sanitation etc. per capita. For both per capita income have many advantages, which the others do the reasons, the richer a country the greater is likely to be the not have. Governments have larger resources per capita, which values of the explanatory variables mentioned above. Accord- enables them to supply better and more public goods per capita. ingly, per capita growth rate should be the highest in the richest This implies better infrastructure, better administration, greater of the nations. Unfortunately, as we have already pointed out – protection of life and assets and better quality of human capital

110 THE IIPM THINK TANK A N ELUSIVE QUEST

leading to higher productivity of capital. People can also spend gain in importance with the rise in per capita income and fall in more on education and health contributing to the quality of the rate of growth of population. Rate of growth of consump- human capital. The rich nations can also afford to engage in tion in developed countries accordingly depends crucially upon R&D on a larger scale, given the superior fi nancial might of the rate of arrival of new and superior quality consumption their fi rms and their greater access to quality manpower. All goods in the market. In richer countries therefore growth in these factors create a solid base for high rates of growth from consumption demand and, therefore, that in investment are the supply side. In other words, all the explanatory variables largely innovation driven. The growth rates are accordingly low. identifi ed by the mainstream growth theory for explaining per New investment does not add to capacity much. It leads to capita growth rate assume highest values in the richest of the better products and makes a part of the existing productive nations. Accordingly, if the mainstream growth theory is true, capacity obsolete. For these reasons growth rates in rich per capita growth rate should the highest in the richest of the countries may be low. The mainstream growth theory’s predic- nations. Despite this, some poor economies grow at much faster tions go wrong as they focus only on the supply side factors and rates than the rich ones – please refer Table 4. Obviously, this ignore the demand side factors completely. cannot be explained by the mainstream growth theory, as it focuses on the supply side factors alone. Even in the long run, References and Additional Thinking demand side factors remain crucially important. Hence, the • Barro, R.J. and Sala-i-Martin, X.(2004). Economic Growth, following may be a much more sensible explanation of the Prentice Hall, India cross-country differences in the growth performances. Poorer • Bernanke, B, Gartler M and Gilchrist, M. (1998). The countries have much greater urgency to grow fast to remove fi nancial accelerator in a quantitative business cycle frame- poverty, to catch up with the rich to cope with the international work, NBER Working Paper 6455 competition and even for self defence. This induces many of the • Jorgenson, D.W. and Yip,E.(2001). Whatever happened to governments in developing countries to play active roles in productivity growth? In E.R.Dean, M.J.Harper and C. promoting growth. Moreover, in poor countries most of the Hulten, eds., New Development in Productivity Analysis, people have little protection against the elements of nature, Chicago University Press diseases etc. They hardly have enough to eat. To stay in power • Kalecki, M.(1954). Theory of Economic Dynamics: An Essay even in totalitarian regimes on a sustained basis, support of on Cyclical and Long-Run Changes in Capitalist Economy, these people is crucial. Competition among politicians for Allen & Unwin power therefore brings the development issues in the forefront • Lucas,R.E.Jr.(1988). On the mechanics of economic devel- for garnering support. Hence government plays an important opment, Journal of Monetary Economics, 22, July role in promoting development in these countries. Govern- • Rakshit, M.(2009). India amidst the Global Financial Crisis, ments’ policies range from direct public investment in different Economic and Political Weekly, Vol.44, No.13, March28 sectors to subsidization of saving and investment. This contrib- – April 03 utes to sustaining a high rate of growth in demand for goods • Romer, P,M.(1986). Increasing returns and long run growth, and services. In the developed countries, since per capita Journal of Political Economy, 94, October income is much higher, the urgency of growth is much less. • Endogenous Technological Change, Journal of Political Moreover, most of these countries are against large and Economy, 98, October, Part II infl uential governments. They recommend minimization of • Solow, R., M.(1956). A contribution to the theory of eco- government intervention in economic matters. For these nomic growth, Qurterly Journal of Economics, 70, February reasons governments in these countries do little to directly • Young, A.(1995). The tyranny of numbers: confronting the stimulate growth. Growth in consumption is likely to slacken statistical realities of the East Asian growth experience, with development. The constraint that income puts on con- Quarterly Journal of Economics, 110, August. sumption eases with the increase in per capita income. But factors such as the physical capacity to consume, the time (The views expressed in the article are personal and do not refl ect available for consumption etc. also act as constraints and they the offi cial policy or position of the organisation.)

THE INDIA ECONOMY REVIEW 111 W ELFARE ECONOMICS

Employment Guarantee, Not Employment Subsidy Approach Suits Indian Conditions

112 THE IIPM THINK TANK R ETHINK AND RESURGE

Illustration : Shantanu Mitra

work for minimum number of days on pre-decided subsist- Saumitra Mohan ence wages. It is with this objective that the National Rural Additional District Magistrate (General), Employment Guarantee Scheme (NREGS) was launched in Burdwan, West Bengal all the districts of this country. This follows on the back of various employment generation and food for work pro- grammes including Integrated Rural Development Pro- liberal welfare state tries to ensure equitable gramme (IRDP), Community Development Programme distribution of the development pie by resorting to (CDP) and Swarnajayanti Jawahar Rojgar Yozna (SJRY). A myriad ways of redistributive allocation of values NREGS is actually predicated on the experiences and among its citizens. One of such measures include employment knowledge gained during implementation of all these guarantee schemes for the toiling masses to ensure them previous schemes.

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Since then, many observers have come up with suggestions Rojgar Guarantee Scheme. The author bemoans the fact that and proposals for further fi ne-tuning of this fl agship employ- the business enterprises do not only have to pay higher taxes, ment guarantee programme. This author read with interest an but also have to pay higher wages. The author believes that if article recently which espoused the idea to provide employ- Prof. Phelps’ suggestion is accepted then the taxes paid by ment subsidies to employers instead of providing guaranteed businesses are recouped by receiving employment subsidies. jobs through state-run employment generation programmes The net outgo on wages shall be reduced due to subsidies like the NREGS. The underlying assumption of the said thus received. proposition was the belief that such an approach would create While the author’s suggestion for subsidy to labour-inten- jobs more effi ciently and effectively than done by the present sive industries does make some sense, but going whole hog for employment guarantee scheme. Prof. Phelps’ proposed alternative defi nitely does not, more so Nobel Laureate Prof. Edmund Phelps was quoted in the in the Indian context. To begin with the beginning, notwith- said write-up as saying, “Although such programmes have standing the supposed failure of the employment guarantee been substantial in Europe and the US, the working poor scheme in the developed countries, they still have not been remain as marginalized as ever. Indeed, social spending has able to replace the same with the ‘employment subsidy’ worsened the problem because it reduces work incentives and, approach as advocated by many including Prof. Phelps. thus, creates a culture of dependency and alienation from the This is notwithstanding the fact that such employment commercial economy, undermining labour guarantee schemes have been in force for force participation, employability and Social spending over fi fty years in most of these devel- employee loyalty.” has worsened the oped countries. Prof. Phelps’ proposal is Proposing an alternative, Prof. Phelps fraught with loopholes and complexities says, “The best remedy is a subsidy for problem because and prone to more corruption than one low-wage employment, paid to employers it reduces work thinks. Moreover, it also does not for every full-time low wage worker they incentives and promise to increase the job opportuni- hire and calibrated to the employee’s wage thus creates ties for the jobless as has been proved to cost to the fi rm. The higher the wage cost, dependency be practicably possible by the present the lower the subsidy, until it has tapered employment guarantee scheme, the off to zero. With such wage subsidies, many implementational hitches and competitive forces would cause employers to hire more glitches notwithstanding. workers, and the resulting fall in unemployment would cause First and foremost problem with this approach is the moral most of the subsidy to be paid out as direct or indirect labour hazard of passing off the extant employment in a fi rm to claim compensation. People could benefi t from the subsidy only by wage subsidies falsely and dishonestly. The employers led by engaging in productive work.” petty and comprador bourgeoisie, in stead of creating new It is believed that the employment generated through this employment, would try to ingenuously cheat the system for alternative scheme that Prof. Phelps proposes, shall be an claiming the subsidies. After all, we don’t necessarily have a asset for the economy instead of a burden. Prof. Bharat data-base of employed manpower of all such fi rms and Jhunjhunwala of IIM, Bangalore believes that the present industries. And such a data-base, even if created and main- approach provides for taxes to be imposed mainly on urban tained, may not be completely sacrosanct. Our experience business enterprises while money is spent in rural areas. The tells us as to how such data-base is often tinkered and tam- urban businesses have to bear the tax burden while the pered with, often to the advantage of the high and mighty. benefi ts are reaped by faraway villages. The business sector So, any system of working out compensatory subsidies for suffers on account of higher wage rates. The availability of employers by establishing contrived linkages to employment some employment in the villages acts as a disincentive for generation is going to be very complex and is also likely to workers to move from labour-surplus to labour-scarce areas involve a lot of scope for discretion and subjectivity for the because some employment is available locally under the bureaucracy than the extant system. There is defi nitely no

114 THE IIPM THINK TANK R ETHINK AND RESURGE

need to compensate big businesses for higher taxes levied on workers shall either lead to shut-down of enterprises in the them as there are already multiple government schemes and urban areas or relocation of many of them to the rural areas is incentives for performing enterprises and businesses. Moreo- also unfounded. At a time when we are talking of liberaliza- ver, even after paying those taxes, they are still left with decent tion and globalization, we defi nitely should have no reason to profi t margins to go shopping the world over for acquiring think of the industries who shut down as a result of having to many of the renowned companies even in times of recession. pay higher wages to the workers, more so when multiple Over the years, our tax and incentives structure have come to government incentives are available. The enterprises need to be comparable with the best in the world. learn to survive the cut-throat competition in the market. The assumed fear that such employment guarantee scheme They always have the option of shaping up or shipping out. actually encourages mediocrity and dependence on govern- Moreover, such an apprehension remains far fetched as the ment is far from the truth. The present system is an incentive- pool of low wage workers shall still be larger in this unreason- based transparent system where a more productive worker can ably populous country despite local availability of guaranteed earn more if she/he gives more output and her/his wages shall employment in the villages as there still are many push and correspondingly be higher compared to others whose output pull factors which drive people to the urban areas. As such, is less. The fear that villages unduly gain at the expense of there is no reason to panic. towns is unwarranted, to say the least. The fact remains that Still, if some of them decide to move to low-wage areas towns are always better endowed in terms which are likely to be under-developed, it of basic services and facilities than those The current is all the better as that would lead to found in the villages. The employment employment infrastructural and capacity development guarantee scheme not only ensures of such areas and further improvement of assured employment for a household guarantee quality of life there which eventually may throughout the year (considering hundred approach does see rise in labour costs in those areas as days for each adult member of a family not reduce labour well. The cycle may go on till all parts of including the handicapped), it also force participation the country are more or less equitably envisages creation of basic infrastructures and employability developed. The government can actually in the countryside. think of giving incentives for relocation It is believed that the progressive or establishment of new industries creation and availability of such infrastructures and employ- including labour-intensive ones in the backward and under- ment opportunities in the countryside shall discourage people developed areas. from migrating to the urban areas where basic infrastructures The belief that the current employment guarantee approach and services are already feeling pressure of increasing reduces labour force participation and employability of a population. It shall also bridge the gap between rural and worker is also not true. The experience from all over the urban areas in terms of socio-economic indicators which are country tells us that labour force participation in the economy quite uneven at the moment. It is believed that wages in the has only increased as a result of operation of such a scheme urban areas shall go up consequent to reduced emigration and and as a result, per capita income has also gone up. The reduced availability of workers from the rural area. With less multiplier effect of such a rise has been perceptible in the workers competing for more works, the real wages in urban relatively high economic growth rates and other development areas shall go up which would continue to attract a minimal indicators of our economy, recession notwithstanding. number of workers from the countryside as per changing Besides, an employment guarantee scheme is also immune to demand and supply curve. The increased wages for urban the negative impacts of a recession. While the government workers shall be in keeping with the increased expenses shall have more reason to persist with such employment required for urban living eventually enabling them to lead a guarantee schemes in diffi cult times like recession, the better life than has been possible otherwise. employers, fi nding reduced demand and market for their The apprehension that reduced availability of low wage products, would shut down overnight rendering all the

THE INDIA ECONOMY REVIEW 115 W ELFARE ECONOMICS

workers under their dispensation jobless. been extended to the entire country, is itself a big achievement Again, contrary to the belief, the employability of a worker is of sorts. also not compromised because of in-built incentive structure The belief that the alternative proposal is corruption proof in such employment guarantee schemes as the worker learns to compared to the present one is also not true as already pointed be more hard working to earn higher wages by giving better out above because of the element of discretion and subjectivity output and by being more productive. The various training inherent therein. The extant scheme because of the transpar- programmes given to people under the said scheme and under ent system of job-card, fi xed responsibility to provide jobs many other schemes do give the workers a choice to decide for within fi fteen days of receipt of an application demanding work themselves as to what do they intend to do. The dovetailing or to pay unemployment allowance in case of failure of the and convergence of many such cognate schemes and pro- same and the provision of social audit is much better placed to grammes further could yield better results with better value do the needful. The provision of job cards, public hanging of allocations among the hoi polloi. The cascading multiplier Muster Roll, public notice of details of an on-going works and effects and resultant pay offs for the country as a whole is Muster Rolls and a participatory social and fi nancial audit of bound to be better and greater than commonly understood. all the aspects of the schemes ensure better transparency and The supposed acquisition of newer skills under the employ- accountability than any other scheme. The Right to Informa- ment subsidy approach is quite problematic and is more at the tion plugs the loopholes and fi lls the gaps, if any left anywhere. level of assumption than a reality. The belief that the innocent, Yes, one does feel that there is lot of scope for further ignorant and gullible workers would get better jobs and acquire improvement of the scheme. One is sure that as more feedback better skills as per their choice and aptitude moving from one from the fi eld is received and fed into the system to further industry to another for job-shopping is misplaced and fraught fi ne-tune it, the extant scheme shall respond better to the tasks with danger. The danger emanates from the feared exploita- and objectives it is supposed to realize. To give some credit to tion of workers by these enterprises who are likely to take Prof. Phelps, his proposal can be tried on an experimental advantage of their helplessness and non-possession of requisite basis in selected areas as a pilot project rather than completely skills by paying low wages and forcing them to work in unhy- replacing the extant scheme. After all, it is too early to pro- gienic and undignifi ed working conditions. nounce a judgement on the success and failure of the same. Most of these enterprises are not likely to be enlightened And in any case, an ingenuous and creative mix of the two enough to do a charity by employing an ignoramus and conceptions rather than an exclusive reliance on any of the one inexperienced worker to teach him/her newer skills to employ can always be a better idea. One hopes that NREGS would him/her later. However, the spirit of the proposal here is well evolve with time in keeping with the objective of realizing and taken and one does feel that the scope and ambit of such ensuring growth with equity and justice. employment guarantee scheme needs to be further broadened Also, with the failure of the invincible capitalist system of and diversifi ed. It could also be creatively fi ne-tuned to offer economic development as represented by the Washington better wages and better opportunities to the people. But one Consensus, it is all the more accepted and acknowledged that has to give the scheme some time to evolve naturally and be we can no longer depend on market forces for taking up social more promising and better suited to the requirements of the responsibilities. Rolling back the state completely is no longer employment-seeking workers. an option. The state has to be there as a regulator and disci- After all, the Constitutional Right to Work, as envisaged in plining force with minimal responsibilities of maintaining law the fourth chapter of the Indian Constitution detailing and order, dispensing justice and building an equitable society. directive principles of state policy, which took fi ve decades to So, the ‘employment subsidy’ approach, as dependent on be translated into a reality, is likely to be some more time to be private enterprises, is just not acceptable in preference to the better customized to the requirements and needs of the target employment guarantee approach. people. The very fact that NREGS, after being launched selectively in some districts of the country for guaranteed (The views expressed in the article are personal and do not refl ect employment in the rural areas throughout the year, has now the offi cial policy or position of the organisation.)

116 THE IIPM THINK TANK W ELFARE ECONOMICS Governance and Employment Generation in Rural Areas: A Case Study of NREGS in Selected Districts of West Bengal

Act has been universalized w.e.f. 1st April 2008 and now Byasdeb Dasgupta covers the entire country. The individuals needing unskilled Head, Department of Economics, work for survival must be aware of the NREGS, the eligibility University of Kalyani, West Bengal requirements for work, the procedure for registration, getting a job card, wage rates etc. The NREGS makes a provision for compensation and treat- ment in case of injury and some on-site facilities like safe Bipul De drinking water, care for small children, periods of rest and a Lecturer, Sonamukhi College, fi rst aid box. It bans contractors and restricts the use of labour Bankura, West Bengal displacing machines. It requires that the wage component should be at least 60 percent of the expenditure in any project. It tries to create much needed rural assets through watershed development, water conservation and harvesting methods, irrigation works, forestry, land development, fl ood control, NREGS and its Financing construction of roads etc. [CSE, 2008; PACS, 2006] The National Rural Employment Guarantee Act (NREGA) These investments can lead to improvements in agricultural was passed unanimously in the Lok Sabha on 23rd August productivity, water security and creation of livelihood oppor- 2005. It guarantees 100 days of unskilled work at the mini- tunities. But NREGA provides the guarantee at the level of mum wage to each household which can not eradicate poverty the household and not that of the individual. Therefore the but it can reduce severe distress if implemented effectively. It rights of women get subsumed under those of the household came into force in 200 districts on 2nd February 2006 and was (though the act requires that at least one third of the benefi ci- then extended to an additional 130 districts in the fi nancial aries should be women). year 2007-08 (113 districts were notifi ed w.e.f. 1st April 2007 The Central government will bear the following costs: and 17 districts in Uttar Pradesh w.e.f. 15th May 2007). The • The entire cost of wages for unskilled manual workers,

118 THE IIPM THINK TANK R ECAST AND RESTRUCTURE

• 75 percent of the cost of material and wages for skilled and role of the Panchayats as the principal agents of implementa- semi skilled workers, tion and empowers citizens to play an active role in the • Administrative expenses as may be determined by the implementation of the scheme through Gram Sabhas, Social central government. These will include the salary and Audit, use of Right to Information Act (RTI), participatory allowances of Programme Offi cers and their support staff planning and other activities. and work site facilities, • Administrative expenses of the central Employee Guaran- Objective of the Study tee Council. After three years of implementation it is the time to judge the The State government will bear the following costs: effi cacy of the scheme in terms of several aspects like jobs • 25 percent of the cost of material and wages for skilled and demanded and provided, household participation rate based semi skilled workers, on the employment demanded, gender wise proportion of • Unemployment allowance payable in case the State person days of employment generated, caste wise proportion government cannot provide wage employment within 15 of the total person days of employment generated, estimates days of application. This allowance acts as a penalty every of the proportion of work completed to total works taken up time the State is unable to provide work. and the proportion of total funds spent under NREGA. • Administrative expenses of the State Employee Guarantee Council. Status of NREGA Implementation in Major [Source: NREGA Operational Guidelines 2008] Districts of W.B. The important aspect of NREGS is that it recognizes the National Rural Employment Guarantee Act was passed by

Illustration : Shantanu Mitra

THE INDIA ECONOMY REVIEW 119 W ELFARE ECONOMICS

Table 1: Employment Generated during the Year 2008-2009 up to the Month of March 2009

[1] [2] [3] [4] [5] [6] Districts Employment De- Employment Pro- Person Days of Employment Pro- Average Person manded by HH vided to HH Employment Pro- vided as a Percent Days Generated (in lakhs) (in lakhs) vided of Employment Per HH (in lakhs) Demanded (4/3) (3/2)

24 Pgs North 1.16955 1.13678 12.37190 0.97198068 10.8832844 24 Pgs South 0.77470 0.77325 9.35412 0.99812831 12.0971484 Bankura 1.22834 1.19917 19.03979 0.9762525 15.8774736 Birbhum 2.86099 2.81015 23.57875 0.98222993 8.39056634 Burdwan 4.50177 4.43213 54.57808 0.98453053 12.3141875 Coochbeher 0.10738 0.09331 0.70197 0.86897001 7.52298789 Darjeeling 0.20470 0.18648 2.44036 0.9109917 13.0864436 Dinajpur (D) 0.19137 0.18686 2.63722 0.97643309 14.1133469 Dinajpur (U) 0.01130 0.00997 0.08887 0.88230088 8.91374122 Hooghly 1.20038 1.17597 13.41062 0.97966477 11.4038794 Howrah 0.04979 0.04872 0.35850 0.97850974 7.35837438 Jalpaiguri 1.19202 1.10526 9.72354 0.92721599 8.79751371 Maldah 0.06983 0.06938 0.86309 0.99355578 12.4400404 Murshidabad 0.70559 0.69541 6.16522 0.98557236 8.86559008 Nadia 0.97162 0.96052 7.I5836 0.98857578 7.45258818 Paschim Midnapur 1.73470 1.66179 20.21487 0.95796968 12.1645154 Purba Midnapur 1.38219 1.34035 15.90327 0.9697292 11.8650129 Purulia 0.10389 0.10076 1.22481 0.96987198 12.1557166 TOTAL 18.46011 17.98626 199.81334

Source: www.nrega.nic.in (Till March 2009) Note: bold letter represents the fi rst phase districts

Parliament in 2005. It became operational in West Bengal demanded and provided. The performance as shown in from February 2006. In the fi rst phase NREGA was Table 2, has not been uniform across the districts. implemented in 10 districts (South 24 Parganas, Bankura, Offi cial record shows that till May 2009, out of 1.84 Birbhum, Dakhhin and Uttar Dinajpur, Jalpaiguri, Maldah, million people demanding jobs 1.79 million were provided Murshidabad, Paschim Midnapur, Purulia) followed by with jobs which generated almost 200 million person days another seven districts (North 24 parganas, Burdwan, and around 10.87 person days per family which is far away Coochbihar, Darjelling, Hooghly, Puaba Midnapur, Nadia) from the envisaged 100 days. Bankura is showing the maxi- from 1st April 2007 and one more district from 1st April mum average person days of employment i.e. 15 and at 2008 (at Howrah). least seven districts are showing less than 10 average person days of employment. 1. Jobs Demanded and Provided The record also shows that demand for employment was The NREGS has primarily been evaluated in terms of jobs almost met (at 99%) in South 24 Parganas and Maldah.

120 THE IIPM THINK TANK R ECAST AND RESTRUCTURE

Table 2: NREGS Participation Rate

[1] [2] [3] [4] Districts No of Rural HH in NREGS Employment Demanded by Participation Rate (in lakhs) HH (in lakhs) (3/2) * 100 24 Pgs North 542954 116955 21.5404988 24 Pgs South 602185 77470 12.8648173 Bankura 454901 122834 27.0023588 Birbhum 590605 286099 48.4416827 Burdwan 750130 450177 60.0131977 Coochbeher 325971 10738 3.29415807 Darjeeling 71171 20470 28.7617147 Dinajpur Dakshin 234678 19137 8.15457776 Dinajpur Uttar 411711 1130 0.27446437 Hooghly 453041 120038 26.4960566 Howrah 147944 4979 3.36546261 Jalpaiguri 574648 119202 20.7434812 Maldah 381065 6983 1.83249577 Murshidabad 865466 70559 8.15271773 Nadia 579487 97162 16.766898 Paschim Midnapur 699991 173470 24.7817472 Purba Midnapur 547776 138219 25.2327594 Purulia 362458 10389 2.86626313

Only in two districts like Uttar Dinajpur and Coochbihar potential correlation between governance in a state and the demand for employment was met at less than 90%. the need for employment generation through such schemes. 2. Participation Rate An attempt can be made to estimate the 3. Gender Aspect of NREGS NREGS household participation rate The NREGS is designed primarily based on employment demanded by The NREGS along the lines on Maharashtra EGS rural households in 18 districts as a generated fewer (MEGS). Women were the major proportion of the total number of rural than the one-third benefi ciaries of the MEGS as the households in districts in which the female person scheme guaranteed work for all those NREGS was being implemented. Table who demand it. Table 3 shows that 2 shows the results. The household days stipulated NREGS generated fewer than the participation rates are highest in Burd- by the Act in 11 one-third female person days stipulated wan (60 percent) followed by Birbhum districts out of 19 by the Act in 11 districts out of 19. The (48.44 percent) and lowest in Uttar proportion of person days of work Dinajpur (0.22 percent). The participation ratets in seven generated for women was satisfactory in Darjeeling (48.9 districts are less than 10%. percent) followed by Jalpaiguri (40.19 percent). Districts These two parameters ‘participation rate’ and ‘jobs like Bankura (35.57 percent), Burdwan (34.84 percent), demanded and provided’ raise the questions regarding a Uttar Dinajpur (36.71 percent), Purulia (37.04), Purba

THE INDIA ECONOMY REVIEW 121 W ELFARE ECONOMICS

Table 3: Gender Wise Proportion of Person Days of Table 4: Caste Wise Proportion of Person Days of Employment Generated (in percentage) Employment Generation (in percentage)

[1] [2] [3] [1] [2] [3] [4] Districts Women Men Districts SC ST Others 24 Pgs North 5.72 94.28 24 Pgs North 24.38 5.87 69.75 24 Pgs South 9.77 90.23 24 Pgs South 43.63 3.16 53.21 Bankura 35.57 64.43 Bankura 55.39 19.78 24.83 Birbhum 24.7 75.3 Birbhum 44.3 11.32 44.38 Burdwan 34.84 65.16 Burdwan 47.84 17.52 34.64 Coochbeher 20.76 79.24 Coochbeher 48.45 3.32 48.23 Darjeeling 55.38 21.11 23.52 Darjeeling 48.9 51.1 Dinajpur Dakshin 27.09 18.72 54.19 Dinajpur Dakshin 26.44 73.56 Dinajpur Uttar 45.29 8.95 45.76 Dinajpur Uttar 36.71 63.29 Hooghly 51.86 10.57 37.56 Hooghly 26.41 73.59 Howrah 39.46 0.08 60,45 Howrah 8.69 91.31 Jalpaiguri 43.06 31.1 25.84 Jalpaiguri 40.19 59.81 Maldah 30.47 12.05 57.48 Maldah 20.43 79.57 Murshidabad 14.7 4.78 80.52 Murshidabad 10.59 89.41 Nadia 27.25 3.7 69.05 Nadia 13.99 86.01 Paschim Midnapur 27.25 3.7 69.05 Paschim Midnapur 25.52 74.48 Purba Midnapur 29.88 23.73 46.4 Purba Midnapur 32.35 67.65 Purulia 19.98 0.89 79.13 Purulia 37.04 62.96 Purulia 27.41 30.92 41.68 Source: www.nrega.nic.in (Till March 2009) Source: www.nrega.nic.in (Till March 2009) Note: Bold letter represents the fi rst phase districts Note: Bold letter represents the fi rst phase districts

Midnapur (32.35) can manage the target. Women have percent) followed by Darjeeling (55.38 percent) and been active participants in few districts where Self Help Hooghly (51.86 percent). Groups have been made the imple- menting agencies for developing land 5. Proportion of Works Completed to of BPL/SC/ST households under Land, especially Works Taken Up NREGA which has increased not only non-irrigable Estimates of the proportion of works their self confi dence but has enhanced land was a basic completed to total works taken up under their status. requirement to NREGA are shown in Table 5. Offi cial data shows that nine districts lead with 4. Caste Aspect of NREGS provision jobs fi gures of more than 50 percent—Uttar Table 4 shows the caste wise proportion under the NREG Dinajpur (87.63 percent), Jalpaiguri of the total person days generated scheme (69.76 percent), Murshidabad (68.26 under NREGA. The proportion of percent), Darjelling (65 percent), Purba person days of employment availed by SC/ST benefi ciar- Midnapur (64.29 percent), Burdwan (64.27 percent), ies is more than 30 percent in 11 districts with the pro- Birbhum (55.89 percent), South 24 Parganas (55.65 per- portion being more than 50 percent in three districts out cent), Bankura (52.42 percent). For the rest of the districts of 18. The proportion is highest in Bankura (55.39 the proportion of works completed to total works taken up

122 THE IIPM THINK TANK R ECAST AND RESTRUCTURE

Table 5: NREGS—Proportion of Works Completed to Works Taken Up

[1] [2] [3] [4] Districts Total Works Taken Up Works Completed Proportion Of Works Completed (In percentage) 24 Pgs North 6652 2817 42.348166 24 Pgs South 3980 2215 55.6532663 Bankura 7473 3940 52.7231366 Birbhum 10022 5601 55.8870485 Burdwan 18312 11770 64.2747925 Coochbeher 2765 1317 47.6311031 Darjeeling 498 324 65.060241 Dinajpur Dakshin 695 317 45.6115108 Dinajpur Uttar 1415 1240 87.6325088 Hooghly 3893 1510 38.7875674 Howrah 637 185 29.0423862 Jalpaiguri 6108 4261 69.7609692 Maldah 1649 593 35.9611886 Murshidabad 2814 1921 68.2658138 Nadia 1934 994 51.39607 Paschim Midnapur 1649 593 35.9611886 Purba Midnapur 13865 8915 64.2985936 Purulia 5848 1864 31.874145 Total 99778 54125 54.2454248 is between 29 percent to 47 percent. clearly seems to lag behind other states in terms of actual job provision or the average number of days provided with 6. Proportion of Total Funds Spent job per family. Of the total 88 lakh job card holders in the Data shows in Table 6 that the propor- state around 21 lakh have been provided tion of total funds spent is highest in with employment cumulatively till date. Dakkhin Dinajpur (93 percent) fol- West Bengal One of the major reason for this lowed by Purba Midnapur (86 percent) seems to lag lacunae or shortfall was paucity of and lowest in Nadia (32 percent). The behind other funds as also lack of demand for jobs, state average is 71 percent of total fund states in terms of this being an entirely demand driven was spent till March 2009. There are scheme unlike previous employment nine districts above the state average average number schemes. The state even faced a severe out of 18. of days provided crunch of funds in the last two years, with job per family which primarily meets the wage needs, Concluding Observations said the source. Despite the fact that all the 18 districts in the state have The main reasons were unequal and illogical distribution been covered under the National Rural Employment of funds, besides frequent case of siphoning of funds or Guarantee Scheme (NREGS) and more than 88 lakh job money laundering which caused some districts like Birb- cards have been distributed so far in the state, West Bengal hum, Purulia, Jhargram, with good scope for the scheme

THE INDIA ECONOMY REVIEW 123 W ELFARE ECONOMICS

Table 6: NREGS—Expenditures

Districts Total Fund (in crores) Expenditure (in crores) Proportion of Total Fund Spent 24 Pgs North 86.23 63.16 0.73246 24 Pgs South 39.80 29.46 0.740201 Bankura 94.39 80.65 0.854434 Birbhum 131.89 85.45 0.647888 Burdwan 147.90 148.12 1.001487 Coochbeher 59.21 60.20 1.01672 Darjeeling 10.67 5.56 0.521087 Dinajpur Dakshin 17.70 16.48 0.931073 Dinajpur Uttar 31.10 16.57 0.532797 Hooghly 52.12 33.57 0.644091 Howrah 10.32 5.51 0.533915 Jalpaiguri 126.73 71.77 0.566322 Maldah 71.74 23.46 0.327014 Murshidabad 93.68 51.60 0.550811 Nadia 71.74 23.46 0.327014 Paschim Midnapur 123.84 106.01 0.856024 Purba Midnapur 59.11 50.88 0.860768 Purulia 59.27 42.87 0.7233 Total 1287.44 914.78 0.710542 falling short of funds and some districts sitting on extra road construction, drought proofi ng, plantation of trees, cash. This was primarily because the funds from the mostly non-agricultural-based jobs, with a huge require- Centre would go directly to the district offi ces in the hands ment for non-irrigated land. Rajasthan and Madhya of the district program coordinator who looked after the Pradesh rank high in the implementation of this scheme disbursal of funds. The State P&RD department had no due to land availability. say on the disbursal inspite of knowing which districts required it. References and Additional Thinking Districts like Purulia, Bankura, Birbhum, Jhargram, • Krishnaraj, M., D. Pandey and A. Kanchi (2004), “Does part of West Medinipur, had huge potential as far as the NREGS Require Restructuring for Poverty Alleviation scheme was concerned because of availability of land which and Gender Equality”, Economic and Political Weekly, suited the types of job provided under the scheme. Infact, 39 (17): 1741-47; 24th April. Bankura ranked highest in terms of average number of • Menon, S (2008), “Right to Information Act and NRE- days provided with jobs per family last year, which was GA: Refl ection on Rajasthan”, MPRA Paper No:7351 around 41 days compared to the state's average of 25 days • Siddharta and Anish Vanik (2008), “CAG Report on per family. NREGA: Fact and Fiction”, Economic and Political Land, especially non-irrigable land was a basic require- Weekly, 43(25): 39-47; 21st-27th June ment to provide jobs under this scheme. The jobs provided under this scheme in the state at a minimal wage of Rs 75 (The views expressed in the article are personal and do not per day were mainly water conservation jobs, land levelling, refl ect the offi cial policy or position of the organisation).

124 THE IIPM THINK TANK W ELFARE ECONOMICS NRDWP – A Paradigm Shift in Rural Drinking Water Supply

Benny George Consultant (M&E), Department of Drinking Water Supply, Government of India, New Delhi

Government of India has been striving to provide drinking water security in the rural areas since independence. Incorporating the wisdom accrued over decades through the implementa- tion of water supply programmes, Government of India has launched a new programme – NRDWP – on 1st April 2009. Though it comes with a whiff of fresh thinking and bold measures to safeguard the interests of the weaker sections of the society, a great deal of its success hinges on its effective implementation.

Introduction Availability of drinking water in right quality and quantity is one of the prerequisites for a healthy life. Human Development Report – 2006 states that delivering clean water, remov- ing wastewater and providing sanitation are three of the most basic foundations for human progress. United Nations Committee on Economic, Social and Cultural Rights declared that “The human right to water entitles every- one to suffi cient, safe, acceptable, physically accessible and affordable water for personal

126 THE IIPM THINK TANK W ATER WISDOM

and domestic use” (UNDP 2006). Water is no more an abundant resource. India with 2.4% of Government of India has been striving to achieve the goal of the world's total area has 16% of the world's population; but providing safe drinking water to the people of India. Till the has only four percent of the total available fresh water. Cur- end of the 10th Five Year Plan, almost Rs. 70,000 Crore had rently, the total water use (including ground water) is 634 been invested by Central and State Governments in providing BCM, of which 83% is for irrigation. The demand for water is drinking water in the rural areas (Table 1). Eleventh Plan projected to grow to 813 BCM by 2010, 1093 BCM by 2025 and Central outlay for the rural water supply sector stands at Rs. 1447 BCM by 2050, against utilisable quantum of 1123 BCM 39,490 crore. (Planning Commission 2007a). Despite making huge investments for ensuring drinking The rapid extraction of ground water has led to its over water security in rural areas, we still have some more distance exploitation in the country. In 15% of the Blocks, annual to cover. As per UNICEF and WHO (2008), only 86 percent extraction of ground water exceeds annual recharge and in rural population in India had access to ‘improved’ water supply four percent of Blocks it is more than 90% of recharge (Plan- in 2006. ning Commission 2007b). Such a scenario does not augur well for drinking water supply as about 80% of rural drinking water 2. ARWSP supply programmes are ground water based1. To accelerate the pace of coverage of problem villages, the Another issue of major concern is global warming and its Government of India introduced the Accelerated Rural Water fallout on drinking water security. Using the General Circula- Supply Programme (ARWSP) in 1972–73 to assist States and tion Models, weather experts have predicted that global UTs with 100% grants-in-aid to implement drinking water warming will intensify the hydrologic cycle; more intense supply schemes in such villages. rainfall will occur in fewer spells; fl oods and droughts both will become more intense; the fl oods will be more frequent; the 2.1 Components: rainfall will shift towards winter; and there To ensure that all aspects of rural water may be a signifi cant reduction in the mass supply are adequately addressed, ARWSP In the Eleventh of glaciers, resulting in increased fl ows in was broken into different components. Five-Year Plan, the initial few decades but substantially Those components, funds earmarked for Central outlay for reduced fl ows thereafter (Ibid). them, interventions to be made and the the rural water ‘Slipped back’ habitations have been a funding pattern are given in Table 2. scourge of rural water supply programmes supply sector in India2. Magnitude of this problem can 2.2 Coverage Norms: stands at Rs. be gauged from the fact that, of the 1. 40 lpcd of drinking water for human beings 39,490 crores 6,03,639 habitations to be covered under 2. 30 lpcd of additional water for cattle in the Bharat Nirman Programme, 3,31,604 areas under the DDP habitations (54.93 percent) were slipped back (http://ddws.gov. 3. One hand pump or stand post for every 250 persons, and in/popups/BNPcummulative.pdf, accessed on 10th March, 2009). 4. Availability of water source within a distance of 1.6 Km in In the wake of increasing water stress and aging physical plains and 100 m elevation in hilly areas. infrastructure, slipping back is likely to pose major challenges. Against this backdrop, NRDWP has been launched in the 3. National Rural Drinking Water Programme country on 1st April, 2009 as a game changer, which heralds a (NRDWP) paradigm shift to move away from single source coverage of India has come a long way in providing drinking water to its habitations to universal access to safe drinking water on a rural population. However, life has changed so much since the sustained manner for all rural people (NRDWP, Framework for early days of ARWSP. Then the core strategy was aimed at Implementation 2008-2012 is available at http://www.ddws.gov. building physical infrastructure and institutional mechanisms in/popups/FinalRWSGuideLines.pdf, accessed on 16th March, to supply water which was abundant in nature. 2009). The Programme seeks to provide every individual

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Table 1: Plan-wise Expenditure Incurred on Providing Rural Drinking Water

PERIOD ARWSP STATE SHARE Allocation Release Exp. Reported Provision Exp. Reported 1st Plan (1951-56) N.A 3.00 2nd Plan (1956-61) Not applicable as ARWSP 28.00 30.00 was introduced rd 3 Plan (1961-66) from 1972-73 67.00 48.00 Annual Plans (1966-69) N.A N.A 4th Plan (1969-74) N.A 34.10 34.10 131.00 208.00 5th Plan (1974-79) 98.2 157.17 157.17 481.00 348.00 Annual Plan 1979-80 N.A 58.20 58.58 N.A N.A 6th Plan (1980-85) 1056.52 895.38 880.55 1407.66 1530.17 7th Plan (1985-90) 1922.35 1905.64 1931.21 2525.41 2471.53 Annual Plan 1990-91 423 410.54 391.58 646.33 595.85 Annual Plan 1991-92 758 644.49 505.68 744.49 692.54 8th Plan (1992-97) 4230 4139.74 3739.16 5458.63 5084.44 9th Plan (1997-02) 8563.95 8454.57 8032.85 12268.01 10773.11 10th Plan(2002-07) 16195.01 16254.43 12486.37 17892.80 15102.42

Source: Department of Drinking Water Supply, Government of India. residing in rural areas with adequate water for drinking, by the Government of India. cooking and other basic needs on a sustainable basis by Components of NRDWP, funds earmarked for them, reviving traditional systems and promoting conjunctive use of interventions to be made and the funding pattern are given in surface water, ground water and rain water. Table 3.

3.1 NRDWP Components 3.2 Criteria for Allocation of Funds NRDWP retains all the components and the coverage norms Criteria for allocation of funds to the States under ARWSP of ARWSP. Yet, there are radical changes in funds earmarked and NRDWP are featured in Table 4. Under ARWSP, 15 and funding patterns. For instance, under ARWSP, around 68 percent weightage was given to NC / PC habitations, which has percent funds were earmarked for coverage of habitations. been widely regarded as a reward for inaction on the part of Refl ecting the fast changing ground realities and priorities, the State Governments. Moreover, it allegedly goaded States to NRDWP earmarks only 38 percent of the funds for the over-report the incidence of slippage. Putting a fi rm lid on the purpose. However, only fi ve percent of the funds allocated for scope for such perverted incentives, NRDWP does not factor ARWSP (coverage) (which in turn was around 68 percent of in the number of NC / PC habitations while allocating funds to the total allocation made for ARWSP) was earmarked for the States. However, in order to incentivize community sustainability. So, the actual allocation for the sustainability ownership and management of water supply systems, NRDWP component was just around 3.4 percent of the total funds under gives 10 percent wieghtage to States where assets are trans- ARWSP. In a major departure, NRDWP earmarks 20 percent ferred to Panchayati Raj Institutions. of the total funds for this component, which refl ects the high priority accorded by the Government of India to check 3.3 Innovative Steps slippages. Apart from that, under ARWSP, funding pattern of Government of India needs to be complimented for a few more the sustainability component was 50:50 between the Central ground-breaking steps, besides the ones discussed already, and the State Governments. Under NRDWP, it is fully funded initiated under the NRDWP. The most signifi cant ones are

128 THE IIPM THINK TANK W ATER WISDOM

Table 2: ARWSP Components

Component Funds Earmarked Purpose Funding Pattern For restoration of water supply 100% GoI funding Natural Calamity 5% suffered on account of any kind of natural calamity DDP Areas 5% For drinking water supply in DDP 100% GoI funding blocks / areas Support Activities / Programme 2% For various support activities relat- 100% GoI funding ing to rural water supply Sub-Mission on Water Quality Up to 20% For addressing quality problems in 75:25 GoI and State the affected habitations -Up to 15% for operation and Up to 5% of total funds Normal Rest of the funds maintenance, and for sustainability - Remaining amount for coverage - 50:50 GoI and State

Source: Ministry of Rural Development 2008. listed below. fresh thinking into planning and implementation of rural 1. Recognition of the Demand for Basic Drinking Water Needs as drinking water supply programmes, NRDWP provides for a Fundamental Right: NRDWP Framework for Implementa- engaging State Technical Agencies and National Experts tion 2008-12 categorically states that water is a socio-econom- Groups for preparation of projects, technical scrutiny and ic good and the demand for basic drinking water needs is a evaluation of rural water supply schemes. fundamental right (Page 25). It goes on to add that drinking water supply cannot be left to market forces as it does not 3.4 Areas of Concern recognize the importance of providing livelihoods supply to 1. Implementation Mechanism at the State Level: all, nor does it ascribe an appropriate value to health of the Brisco and Malik (2006) observe that staffi ng levels of water people. It further states that the commodifi cation of water will supply agencies in India are 10 times international norms, and shift the focus to profi ts to be made from a scarce resource most public funds are spent feeding the administrative rather than human rights to water for livelihood (Page 9). machinery, not maintaining the stock of infrastructure or 2. Drinking Water Security at the Household Level: Hitherto, providing services. Though the NRDWP intends to restruc- coverage had been measured in terms of habitations and ture State Rural Water Supply Implementing Agencies population (which was arrived at by multiplying the habita- (NRDWP Framework for Implementation 2008-12, Section tions covered with corresponding population). The NRDWP 12.5, page 28), it remains to be seen as to how effective this Framework for Implementation 2008-12 states that installa- exercise would be. In this context, it may be worth recalling tion of a water supply system in a habitation does not confer the words of Prof. Wangari Maathai, 2004 Nobel Peace Prize the ‘Fully Covered’ status on it unless every house hold in the winner, that water crisis is a crisis of governance: man-made, habitation has been fully covered with potable water in with ignorance, greed and corruption at its core (Transparency suffi cient quantity (Page 11). Moreover, NRDWP provides for International 2008). appointing village level workers – Jal Surakshaks – to Multiplicity of agencies at the State level is likely to do more generate data on coverage at household level (page 62). That harm than good. Besides introducing Technical Agencies at the Government is serious about the whole exercise is the State level, yet another agency – Water and Sanitation refl ected in its making provisions for paying a regular salary Support Organisation (WSSO) – has been created at the State to Jal Surakshaks. level. WSSO will have a tough time fi guring out its boundaries 3. Creation of Technical Agencies: To breathe innovation and as the space is already crowded with a host of other players

THE INDIA ECONOMY REVIEW 129 W ELFARE ECONOMICS

Table 3: NRDWP Components

Component Funds Earmarked Purpose Funding Pattern Coverage 38% Coverage of habitations 50:50 GoI and Stateµ

Water Quality 20% For addressing quality problems 50:50 GoI and Stateµ Sustainability 20% To achieve drinking water security through en- 100% GoI suring sustainability of sources and systems O&M 10% For the O&M of water supply systems 50:50 GoI and Stateµ DDP Areas 5% For providing drinking water in DDP areas 100% GoI Natural Calamity 5% For restoration of water supply suffered on ac- 100% GoI count of natural calamity Support 2% For activities relating to IEC, HRD, Computer- 100% GoI ization (MIS), water quality monitoring, R&D, CCDUs, etc.

µ 90:10 for N-E States and J&K Source: National Rural Drinking Water Programme, Framework for Implementation 2008-2012 such as SWSM, SWSC and CCDU, besides having SLSSC and of 50) and in 10 percent cases, a hand pump is shared by four PHED / nodal agency for the implementation of water supply households or less. Such over-provisioning of services exists in programmes at the State level. other states as well (with the exception of Karnataka) and is particularly noticed in the case of Tamil Nadu (Ibid). There is 2. Absence of Effective Planning: an urgent need to address this issue. Importance of planning in ensuring drinking water security at Though the Framework for Implementation talks about the household level cannot be over-emphasised in a country preparing Village Action Plans (VAPs) and District Water with so much diversity in terms of agro climatic conditions and Security Plans based on VAPs (Page 33), it appears that it is a hydro geological parameters. On the one hand, we grapple statement of intent, not a pre-requisite for funding. Enduring with the seemingly insurmountable problems of slippages and drinking water security can be achieved only if context specifi c water quality. On the other, there are clear signs of over-provi- systems are put in place based on parameters such as source of sioning by schemes in many parts of States such as Uttar water (surface vs ground), type (hand pump vs piped water Pradesh and Tamil Nadu (World Bank 2008). supply [single village scheme vs multi-village scheme]), inter- Oft repeated reasons for slippages are sources going dry, and intra-village confl icts (caste and political), affordability poor O&M and systems outliving its utility. Of these, the fi rst (willingness and ability to pay), etc. Absence of comprehensive two could be addressed to some extent with proper planning. planning is a recipe for over provisioning and further slippages. For instance, a large piped water supply scheme based on ground water is doomed to failure if it is set up in a place with 3. Over Dependence on Civil Society Organisations: already depleted ground water resources. Similarly, it goes NRDWP envisages the civil society organizations to play a without saying that a water supply system which is high on prominent role in planning, community mobilisation, imple- O&M is ill-suited for a village with poor willingness and / or mentation and operation and maintenance of water supply capacity to pay. programmes. Even as I appreciate the critical role that such Signifi cant wastage of resources arises from over-provision- organizations can play in bringing about drinking water ing by some schemes, defunct schemes, and the existence of security in our villages, I strongly believe that we need to be multiple schemes. In Uttar Pradesh more than half of the hand mindful of their limitations as well. The civil society argument pumps are shared by 10 or less households (as against a norm has now been around for about 25 years. The problems of the

130 THE IIPM THINK TANK W ATER WISDOM

Table 4: Criteria for Fund Allocation under ARWSP and NRDWP sections of the society, a great deal of its success depends on its effective implementa- S. No Criteria Weightage (in %) tion. We should not forget that a programme ARWSP NRDWP is as good as its implementation. 1 Rural population 40 60 2 Not Covered / Partially Covered villages 15 0 Endnotes 3 Quality affected villages 10 0 1 Page 46, NRDWP Framework for Imple- 4 Rural population managing rural drinking 010mentation 2008-12. water supply schemes 2 Slipped back refers to the situation wherein a 5 States under DPAP, HADP and special cat- 35 30 Fully Covered habitation slips back in to the egory Hill States in terms of rural areas status of either Partially Covered or Not Total 100 100 Covered, owing to either decline in supply Source: Ministry of Rural Development 2008 and NRDWP Framework for Implementation 2008-2012 level or water quality problems or both. world remain as intractable, even as the numbers of agents who References and Additional Thinking seek to negotiate the ills of the human condition have expand- • Anonymous (2009): “Central Government may be Over- ed exponentially. In popular imagination, the State still seems stating Spending on Aam Aadmi”, Times of India, 23rd to occupy a central position. And it is clear that there are February 2009, New Delhi. certain problems that only the State can resolve, and should be • Brisco, John and R.P.S. Malik (2006): India’s Water resolving (Chandhoke 2009). Economy – Bracing for a Turbulent Future, World Bank, To put things in perspective, the forgoing contention may be New Delhi. juxtaposed with some observations made by the CAG recently. • Chandhoke, Neera (2009): “Putting civil Society in Its It observes that over Rs. 51,000 Crore allocated for the fl agship Place”, Economic and Political Weekly, 44(7), PP 12-16. anti-poverty and development schemes in 2007-08 was trans- • Ministry of Rural Development (2008): Annual Report ferred to the bank accounts of NGOs, autonomous bodies and 2007-08, Government of India, New Delhi. district authorities. However, the Government has told the • Planning Commission (2007a): Ground Water Manage- CAG that it was not aware of the actual expenditure by those ment and Ownership – Report of the Expert Group, New organizations. The CAG goes on to say that as the money is Delhi. kept outside government accounts, it is beyond the purview of • Planning Commission (2007b): Report of the Steering any checks and balances of the Government of India (Anony- Committee on Water Resources for Eleventh Five Year mous 2009). So, it may be a better idea to pay more attention to Plan (2007-2012), New Delhi. reviving the government machinery than placing too much • Transparency International (2008): Global Corruption hope on civil society organizations to redeem the situation, Report 2008 - Corruption in the Water Sector, Cambridge only to be disillusioned, yet again, with the passage of time. University Press, Cambridge, UK. • UNDP (2006): Human Development Report 2006 - Be- 4. Conclusions yond scarcity: Power, Poverty and the Global Water Crisis, Considerable amount of resources have gone into the New York. provision of drinking water in the rural areas of India and • UNICEF and WHO (2008): Progress on Drinking Water the outcome is encouraging. To address the changing and Sanitation, New York. realities of life, Government of India has launched a new • World Bank (2008): Review of Effectiveness of Rural programme, incorporating the wisdom accrued over Water Supply Schemes in India, New Delhi. decades through the implementation of water supply programmes. Though it comes with a whiff of fresh thinking (The views expressed in the article are personal and do not refl ect and bold measures to safeguard the interests of the weaker the offi cial policy or position of the organisation).

THE INDIA ECONOMY REVIEW 131 L AW AND ECONOMICS Review of Economic Development and Legal System: An International Perspective

“Criminal law, while it has major non-economic functions, also services to deter theft and some forms of economic fraud. Civil law has economic aspects centrally in its concerns. Contract law can be said to be mainly for the governance of economic activity; laws of tort and liability pertain to contracts as well as not-contractual relationships, both mainly in the economic sphere” – Dixit A.K. (2004)

Introduction Economic development is one of the main objectives of all economies in the modern world. Achieving this objective depends on the macro economic factors like investment, exchange rate, infl ation, etc. In addition to that, economic development is also affected by micro economic institutions like property rights, contract enforcement etc. These are institutional environment which facilitates micro economic decisions. Kohling (2000) assumed indirect correlation between economic activities and legal system i.e., the judiciary itself has no impact on productive factors, but through individual decision-making, it can infl uence eco- nomic relevant decisions. In short, these micro economic institutions are mainly related to the country’s legal system1. Role played by the institutions for achieving economic development is growing steadily. Among the institutions, judicial system plays an important role in the economic Uma Sankaran Research Scholar, Centre for Development Studies (CDS), Trivandrum

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References and Additional Thinking quences of a Weak Judiciary”, Centre for Development • Acemoglu D, Johnson S, Robinson A. J. (2001), “ The Research, University of Bonn, Germany, November. Colonial Origins of Comparative Development: An • Maria Dakolias (2003), “The Role of the Judiciary for Empirical Investigation”, The American Economic Economic and Social Development”, November 14th, Review, Vol. 91, No. 5, Dec., pp. 1369-1401 2003 Speech to the EU Judiciaries Representatives The • Banerjee A and Iyer L History (2005), “Institutions, and Hague, The Netherlands Economic Performance: The Legacy of Colonial Land • Pinheiro, Armando Castelar (1996), “Judicial System Tenure Systems in India” The American Economic Performance and Economic Development” October. Review, Vol. 95, No. 4, Sep., pp. 1190-1213 • Pistor, Katharina and Philip A., Wellons (1999), “The • Barro J., Robert (1991), “Economic Growth in a Cross role of law and legal institutions in Asian economic Section of Countries”, The Quarterly Journal of Eco- development : 1960-1995”, Asian Development Bank, nomics, May, Vol. 106, No. 2, pp. 407-443 Executive Summary. • Chemin, Matthieu (2004), “Does the Quality of the • Posner A., Richard (1998), “Creating a Legal Framework Judiciary Shape Economic Activity? Evidence from for Economic Development”, World Bank Research India”, Department of Economics, LSE, October. Observer, 13(1), February, 1-11, (Ed.) Hans-Bernd - (2007), “Does Judicial Quality Shape Economic Activ- Shafer and Angara V. Raja, “Law and Economic Devel- ity? Evidence from a Judicial Reform in India”, Cahier de opment”. recherche/Working Paper 07-25, September • Rabiyath, Siddik (2007), “Litigation, Disposal Effi ciency • Cross, B., Frank (2002) “Law and Economic Growth”, and Pendency: A Comparative Analysis of Kerala and Texas Law Review, 80 (7), June, 1737-75, (Ed.) Hans- Andhra Pradesh”, M.Phil., dissertation, University of Bernd Shafer and Angara V. Raja, “Law and Economic Hyderabad. Development”. • Santhakumar V. (2003), “Citizens’ actions for protecting • Davis E., Kevin and Trebilcock J., Michael (2001), “Legal the environment in developing countries: an economic Reforms and Development”, Third World Quarterly, analysis of the outcome with empirical cases from India”, 22(1), 21-36, (Ed.) Hans-Bernd Shafer and Angara V. Environment and Development Economics 8: 505-528, Raja, “Law and Economic Development”. Cambridge University Press. • Demsetz Harold (1967), “Toward a Theory of Property • Scully W., Gerald (1988), “The Institutional Framework Rights”, American Economic Review, 57 (2), May, and Economic Development” The Journal of Political 347-59, (Ed.) Posner A., Richard and Parisi Fransesco, Economy, Jun., Vol. 96, No. 3, pp. 652-662 “Economic Foundations of Private Law”. • Visaria, Sujata (2006), “Legal Reform and Loan Repay- • Douglass C. North (1991), “Institutions”, The Journal of ment: The Microeconomic Impact of Debt Recovery Economic Perspectives, Winter, Vol. 5, No. 1, pp. 97-112 Tribunals in India”, April. - (1996), “Institutions, Institutional Change and Econom- • World Bank (2002), World Development Indicators. ic Performance”, Cambridge University Press. • Xavier, Francis Rathinam (2007), “Law, Institutions and • Feld P., Lars and Vogit, Stefan (2003), “Economic Finance: Time Series Evidence from India”, German Growth and Judicial Independence: Cross Country Working Papers in Law and Economics, Paper 4. Evidence using a new set of Indicators”, CESifo Working Paper No. 906, April. (The views expressed in the article are personal and do not • Ginsburg Tom (2000), “Review: Does Law Matter for refl ect the offi cial policy or position of the organisation. The Economic Development? Evidence from East Asia”, Law earlier version of this paper was presented in Centre for & Society Review, Vol. 34, No. 3., pp. 829-856. Development Studies. Here the author acknowledges Dr. • Klerman, Daniel, “Legal Infrastructure, Judicial Inde- Shanthakumar, Dr. Sunil Mani, and other participants who are pendence, and Economic Development” all given valuable comments to the author and a special thanks • Kohling, K.C., Wolfgang (2000), “The Economic Conse- goes to Alice Sebastian and Krishna Reddy Chittedi.)

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performance and development of market economies tions which is implementing the rule of the law. [Pinheiro - 1996, World Bank - 2002]. It does so in many ways: Kohling (2000) argues that a country’s government can the judiciary is the mechanism whereby disputes on the infl uence the economy negatively through a weak adminis- allocation of rights mainly property rights, disputes between tration. Inappropriate mechanisms that lack checks and private parties, private and public parties are decided balances create corrupt government. Therefore judiciary is according to norms and rules of the society. Consequently, the appropriate body to exercise control over such a corrupt institutions help to reduce uncertainty by providing a administration. Thus, an unbiased judiciary is essential for structure to everyday life [North - 1996]. Posner (1998) economic development. Hence law is not only considered as mentioned that legal machinery in its ideal form consists of a dispute resolution system but also considered as an competent, ethical, and well-paid professional judges, important instrument of economic development. lawyers, police or other functionaries who administer rules Economic theory supports the idea of judicial independ- that are well designed for promotion. It is necessary because ence and high quality courts facilitate economic growth [Feld effi cient legal system depends on the effi cacy of the institu- and Vogit - 2003]. Effi cient, independent, and impartial courts enforce contracts and protect property. This encour- ages investment which is essential for economic develop- ment. It is therefore important to study the economic implications of the legal system in the context of developing countries. In those countries, law enforcement is poor because the general institutional structure is weak. This paper has a dual objective. First, to review the theoretical arguments that helps to understand how effi cient judicial system helps to attain economic growth. Second, to review literature which explain the relationship between judicial system and economic performance. Special attention is given to studies with empirical content related to India.

What is Well-Functioning Judicial System? Before going into the analysis of the theoretical and empiri- cal literature, which explains the relationship between legal system and economic development, it is necessary to under- stand the well-functioning judicial system and the ways it can affect economic development. A well-functioning judicial system should have the follow- ing properties such as low cost access, transparency, fairness, predictability, and timely outcomes which help to promote business and commercial activities through protecting property rights of the individuals [Maria Dakolias (2003), Pinheiro (1996)]. Kohling (2000) identifi ed three preconditions for institu- tions to be effi cient: (i) the respective institutions are well defi ned; (ii) all necessary information is verifi able; and (iii) the absence of cost for transferring or securing of property rights. According to him ineffi ciencies usually emerge due to information asymmetries or incomplete information as not

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all contingencies can be foreseen, and therefore the respec- institutions, a weak judiciary can affect the performance of tive solutions cannot be included a priori in contracts. all other institutions.

What Ways Legal System Theoretical Background of Can Promote Economic Growth? Legal Institutions and Development: Piheiro (1996) mentioned that in the supply side growth, This section theoretically analyses the importance of legal well-functioning judiciaries can promote growth through institutions for reducing uncertainty and transaction cost the following channels: Technological progress, investment, which encourages economic activities in the economy. and effi ciency. Institutions are humanly devised constraints that structure political, Technological Progress Institutions are economic, and social interaction. They Well-functioning legal system may humanly devised consist of both informal constraints (sanc- stimulate growth by protecting intellec- constraints (formal tions, taboos, customs, traditions, and tual property rights and in this way and informal) that codes of conduct), and formal rules fostering technological progress and (constitutions, laws, property rights). absorption. It can encourage domestic structure political, These institutions provide the incentive fi rms to invest in Research and Develop- economic, and structure of an economy; as that structure ment (R&D). This leads to wider diffu- social interactions evolves, it shapes the direction of eco- sion of knowledge, including not only nomic change towards growth, stagna- spillovers, but also the transmission of sound managing, tion, or decline [North – 1991]. marketing and fi nancing practices. ‘New Institutional Economists’ argued that economic development requires many kinds of investment such as Investment physical capital, human capital etc. Investment will occur if By stimulating a more rapid accumulation of factors of investors can be confi dent that they will attain their profi ts. production, well-functioning judicial system can encour- Investment will undermine if the government or a private age investment in both physical and human capital party expropriates the investment or profi t [North - 1996]. If through secure property rights. Particularly private agents no mechanisms such as governmental or non-governmental will only make long-term and highly specialized invest- exist to prevent theft, then any person can wait for others to ments if they are secure that the contract activities will be create property or produce output and then steal it; this properly enforced. usually makes less effort to creating property or the product oneself [Dixit – 2004]. Effi ciency Ginsburg (2000) quoted North view of “How effectively Dysfunctional judicial system can limit growth by stimulat- agreements are enforced is the single most important ing ineffi cient use of resources and technology through high determinant of economic performance”. Feld and Vogit risk and large transaction cost. And it can reduce economy’s (2003), summarizes the institutions importance to reduce effi ciency by consumption of scarce resources. uncertainty and how it helps to improve the investment Cross (2002), quoted Lon Fuller stressed point that which is essential for growth. property and contract rights are vital to growth, a legal Among the many functions of government, the reduction of system must restrain the “rigidities of property and con- uncertainty is of paramount importance. But the law will tracts” so that the society can “direct its resources toward only reduce uncertainty if the citizens can expect the letter of their most effective use.” Therefore the effi ciency of the the law to be followed by government representatives. An judiciary is important not only for themselves, but also for all independent judiciary could thus also be interpreted as a other institutions for promoting long-term investment and device to turn promises – e.g. to respect property rights and contracts. As the judiciary enforces and monitors all other abstain from expropriation – into credible commitments...

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citizens will develop a longer time horizon which will lead to als can voluntarily organise their transactions2, without legal more investment in physical capital but also to a higher institutions i.e., they may substitute co-operation for law, in degree of specialization... that manner can reap their profi ts. These informal substi- In the marketplace transaction can be concluded as two tutes, includes arbitration and reputation, for the legal bundles of property rights are exchanged. A bundle of rights enforcement and protection of property and contract rights often connects with a physical commodity or services, but [Posner - 1998]. that value of the rights determines the value of what is However such kind of an informal framework may limit exchanged [Demsetz -1967]. Market economy can not have transactions within one family members or ethnicity [Cross effi cient exchanges in the presence of high transaction costs - 2002]. Small number of players fi nds it worthwhile to and externalities [Rabiyath – 2007]. Transaction costs are cooperate when they play repeatedly and when they possess higher when law is uncertain [Scully – 1988]. In the small complete information about the other player’s past perform- economy i.e. closed economy transaction costs are low; ance. But cooperation is diffi cult to sustain when the game is because of the face to face transactions. But when the econo- not repeated, when information on the other players is my or market begins to grow transaction costs will sharply lacking and when there are large numbers of players [North increase due to complex production system. In this complex – 1991]. As a consequence, shortage of new fi rms and people system production costs are high through specialization and with new ideas and entrepreneurship, and an inability to division of labour. This requires safeguard of property rights enter into long-term contracts can prevent the adoption and across national boundaries so that capital markets (as well as development of complex technologies. In addition that other kinds of exchange) can take place with credible institutions need not and generally has not prohibited the commitment on the part of the players. Therefore it de- norms and private arrangements such as arbitration agree- mands the effective institutions which can reduce transac- ments, but considerably expands the scope of contracting tion costs through reducing the asymmetric information. choices [Cross – 2002]. Obviously transaction costs are a critical determinant of In short, there are two schools of thought: one belongs to economic performance. Ultimately, institution's effective institutional economics which is giving importance for enforcement determines the cost of transactions. In other formal institutions and another school which is for informal words, effective institutions can raise the institutions. It is therefore not clear from benefi ts of cooperative solutions or the The shortage of a theoretical standpoint how much costs of defection [North – 1991]. empirical research institutions are important for economic is a problem development. This lacuna needs to be Non-Legal Rules that affects the fi lled with empirical evidence which or Informal Rules shows the relationship between legal While institutional economists consider entire field of system and economic development. the effective value of legal institutions institutional and property rights, non-institutional economics Review of Literature: economists are argued that the actual International Perspective need for such institutions may be exaggerated. Judicial Institutions are so ingrained with social, economic, legal, and independence and good courts are not necessary for invest- political life that it is diffi cult to isolate the impact of one ment, there are other mechanisms which can enforce institution such as legal, on economic performance. There- contracts and protect property. Contracts can be enforced by fore the shortage of empirical research is a problem that reputation, without recourse to the courts. When parties affects the entire fi eld of institutional economics. In spite of deal with each other repeatedly contracts may be respected that, the following empirical literature tries to provide the because people fear of their good reputation. Similarly, the relationship between judicial system and economic develop- government can protect property through policies against ment. There is renewed interest among economists in the expropriation disputes [Klerman]. In other words, individu- question of what are the fundamental factors for the large

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difference in income per capita across countries? Though mortality rates or where they could not settle safely, they there are multiple answers for this question, differences in created extractive states or did not protect private property institutional framework and property rights have received rights. The study used regression method and model in- considerable attention in recent years. One of the impor- cludes economic outcome (per capita GDP) and institution- tant studies in this context was by Scully (1988). The study al variable (protection against expropriation) for a sample of tried to explain the impact of the choice of institutional 64 countries. The study found that early institutions persist- framework on effi ciency and growth of economies. The ed to the present; therefore settler mortality rates do not study used linear multiple regression analysis and the have direct effect on income today other than through their model incorporated economic variables (viz. real per capita infl uence on institutions. However, this study analyzed gross domestic product and capital-labour ratio) and whether the settlement of institutions during the coloniza- institutional variables (viz. political, civil, and economic tion have any impact on present day institutions, it is impor- liberty) for 115 market economies for the period 1960 to tant to study whether any specifi c historical institution 1980. The study found that politically open societies, which followed during the colonization period have impact on subscribe to the rule of law, to private property, and to the present day economic performance. market allocation of resources, grow at three times the rate Banerjee and Iyer (2005) attempted to compare the and are two and one-half times as effi cient as societies in present-day economic performance of different districts of which these freedoms are circumscribed. India, which were placed under different land revenue However, most of the countries are facing political system by British colonial rulers. The study showed that instability rather than liberty. Therefore, Barro (1991) differences in historical property rights institutions lead to studied the impact of political instability on economic continued differences in economic outcomes, i.e., areas in growth for 98 countries in the period 1960-1985. The study which property rights of land were historically given to used regression technique for analyzing the impact of landlords have signifi cantly lower agricultural investments revolutions and coups, and per million population of and productivity in the post-independence period than areas political assassinations on per capita growth. The study in which given to the cultivators. showed that both these variables are negatively affecting While property rights or choice of institutions are consid- investment and economic growth via ered as important for economic growth, adversely infl uence the property rights. the qualities of these institutions are also The limitation of this study is that, it Differences in equally important. In this aspect an doesn’t explain how these variables are historical property interesting study done by Feld and Vogit adversely affecting property rights, rights institutions (2000) analyzed the relationship between because political assassination may lead to continued economic growth and judicial independ- happen for several purposes. ence (JI). The study introduced two While institutional framework is differences in indicators of JI such as de jure and de considered as an important instrument many economic facto. Whereas de iure JI can be derived for explaining differences in income outcomes from the legal documents, de facto JI is between countries there is a little doubt the independence enjoyed by judges and about that whether history has any role in determining the justices does not suffi ce to write in legal documents. The shape of present-day institutions and the economic perform- study used econometric model which incorporated economic ance of the countries? In this context an interesting study variables (viz. real GDP per capita, private and public was conducted by Acemoglu et al. (2001). It argued that investment etc.) and JI variables such as accessibility of the differences in colonial experience could be a source of court, appointment procedure of judges, constitutional differences in institutions. The study analyzed the European specifi cation of the court’s procedures, tenure of judges and colonization; Europeans adopted different strategies their salaries etc. for de jure and length of the members of associated with institutions. In places where they faced high the high court, court’s budget etc. for de facto for a sample

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of 57 countries between 1980 and 1998. This study found crime constitutes a competitive disadvantage which limits that de jure JI does not have any impact on economic growth the degree of an area’s attractiveness for potential foreign and de facto JI positively infl uences economic growth. The investors. After controlling the relevant economic vari- limitation of this study is associated with the collected data ables, this study found that the extortion of money and the for de facto. This study defi nes JI as judges can expect their number of accused persons, which are proxies for organ- decisions to be implemented regardless of other government ized crimes negatively affects FDI infl ows. But the limita- branches upon whom implementation depends. For analyz- tion associated with this study is that, it doesn’t address the ing de facto this study collected data through questionnaire impact of organized crime on domestic investment. If (via e-mail). If respondents answered domestic investment itself is affected by socially desired answer for this question3 these types of crimes, then there is no then the results may be questionable. Presence of point to expect foreign investment. Economists have also analyzed the crime constitutes One of the main criticisms of cross- importance of law for economic growth in a competitive country empirical study is that, cross context of liberalization or market disadvantage, country regression are based on unrealis- orientation, because in recent years most tic assumptions such as equal growth path of the countries liberalized their econo- limiting the area’s and equal weighting of countries and also mies for integrating with the rest of the potential for suffer omitted variable bias and sample world. So it is important to study, in the attracting FDI selection bias [Barro - 1991]. And to open market regime, how legal system is control for a range of factors that infl u- important for economic growth. In this aspect an important ences economic performance cannot be as convincingly study conducted by Pistor and Wellons (1999) analyzed the controlled for in cross country data [Chemin – 2007]. relationship between law and economic development Therefore, it is necessary to study the country specifi c experience with Asia. The study covered six East Asian empirical studies which explain the relationship between economies for the years of 1960-1995. The study found that legal system and economic growth. by mid 1980s all economies moved from state-led economic policy to market-oriented solutions, law became important. The Indian Case: Therefore, it concluded that law mattered for economic India seems to be an interesting testing ground to analyze development in the period after the policy shift. An impor- the relationship between legal system and economic devel- tant question regarding this study conclusion is that, if law is opment; it is one of the developing countries that witnessed important for economic development after the policy shift dramatic deregulations in various sectors during the 1990s. means, before that whether law does not matter for econom- These efforts need a complementary reform in legal sector ic growth or is this study accepting the non-institutionalist also. Postner (1998) suggests that legal reform is an impor- view? This study doesn’t answer these questions. tant process for poor countries, but the focus of such reforms Apart from property rights and law effi ciency one should be on creating substantive and procedurally effi cient important aspect which is missed in the theoretical argu- rules of contract and property than on creating a fi rst-class ment is how weak legality, which arises from the violation judiciary. The Indian judiciary operates at three levels: a of laws, can affect investment and economic growth. An unique Supreme Court at the federal level; High Courts in interesting study in this perspective done by Daniele and each state; and, at lower levels, district judges for civil cases Marani (2008) analyzed the impact of organized crime on and session judges for criminal cases. India operates under a Foreign Direct Investment (FDI) in Italy. The study found common law system which implies that the actions of High that in Italy compared to northern part, southern part Court judges set precedents for the functioning of subordi- attracts very less FDI. Italy is rooted presence of organized nate courts in Indian state4. Judicial effi ciency and speed in criminal organizations (viz. camorra, mafi a, sacra corona India seems to be the greatest problem with courts in India, unita etc.) So the study hypothesized that the presence of dominating all other problems such as fairness, predictability

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and access to the judiciary [Chemin – 2004]. Pendency in ratio of allowed appeals from High Court to Supreme India has been growing four percent in High Courts and 3.6 Court). The study concluded that a weak judiciary has a percent in the Subordinate Courts in the period 1999-2005 negative effect on economic development which leads to as against a mere of 1.29 percent in US Courts for the period lower per capita income, higher poverty rates, lower private 1990-1998. Average duration for disposal in India is 5-10 economic activity, poorer public infrastructure, higher crime years where as it is only one year in US [Rabiyath – 2007]. In rates, and industrial riots. Here it should be noted that the a study of citizens’ action against environment damage weakness of this study is that, it identifi ed predictability Santhakumar (2003) mentioned that delay in court decisions through allowed appeals from High Courts to Supreme will create social loss via more pollution if Court, in India appeals to the Supreme citizens’ action is against existing fi rms or Court is only for matter of law not for affect production if it is against new fi rms. Pendency has matter of fact and this study is concerned For reducing pendency in Indian been growing weakness of the High Courts only. This courts, which is one of the notable at 4% in High kind of studies mainly suffer from the problems, several measures have been Courts and 3.6% limitation that it doesn’t make any introduced in the last decade like Lok distinction between economically rel- Adalat5, Debt Recovery Tribunals in the Subordinate evant cases and others. It may thus be (DRT)6, and Code of Civil Procedure of Courts in the over estimating the pendency in Indian 1908 Amendment Act7 of 2002 etc. It is period 1999-2005 High Courts. therefore important to study how these Chemin (2004) analyzed how the case legal reforms or procedural laws helps to increase the quality pendency rate in state courts in India affects the contracting of judiciary and to improve economic development of the behaviour of 170,000 small non-agricultural informal fi rms country. Though there are different dimensions of the from the 55th round of the National Sample Survey of 2000. empirical literature available in the case of cross-country The study used Probit regression technique and after analysis, country specifi c literature are limited particularly controlling the state-level (through state domestic product, related to India. In the next section we attempt to review the literacy rates, state expenditure etc.), fi rm-level variables available empirical literature on India. (through indebtedness, fi nancial sources, labour productivity In this section we review the empirical studies which have etc.), sector-specifi c effects, and panchayats and rural attempted to examine the impact of pending cases on planning commissions information, the study found that the economic growth and effects of legal reforms, which is speed slow judiciary, which is measured by ratio of pending cases at up the disposals of cases, on economic growth in India. time period ‘t’ to the pending cases at ‘t-1’ plus cases fi led, Regarding pending cases, the fi rst question raised in our implies more breaches of contract, discourages fi rms from mind is that whether pending cases affects economic growth undertaking specialized investment, impedes the access of or not. One of the important studies in this context done by fi rms to formal fi nancial institutions, and favours ineffi cient Kohling (2000) examined the economic consequences of a family-owned fi rms. weak judiciary on the economic growth using data on 25 However, for reducing pendency Indian courts intro- Indian states and union territories for the period 1971 to duced various legal reforms to speed up the disposal of 1996. The study used cross-regional time-series regression cases. Thus it is interesting to study whether these legal and the model includes economic variables such as per reforms really helps to increase the speed of the disposal of capita income, agricultural production, private sector cases and if it is so, how it helps to improve the economic development, capital formation, poverty rates, etc. and growth. One of the important studies in the context was by judicial variables such as speed of the judiciary or average Visaria (2006). The study analysed the Recovery of Debts years of backlogs in the High Court (viz. ratio of pending due to Banks and Financial Act, 1993 (Debt Recovery cases at the beginning of the year to cases decided within Tribunal Act), a judicial reform which aimed at accelerating that year) and predictability of the High Court rate (viz. banks' recovery of Non-Performing Assets (NPAs) through

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speed up the legal process. The study used difference-in- GDP and Legal Development (procedural law and regula- differences strategy based on two sources of variation (the tory reforms as they matter for the speed and the quality of monetary threshold for claims to be eligible for these redress), Financial Regulation (statutory liquidity ratio and tribunals and the staggered introduction of tribunals across other interest rate controls) and Index of Institutional Indian states) and showed that the establishment of Development (a ratio of broad money net of currency in tribunals reduces delinquency in loan repayment by circulation to broad money) indicies. This study identifi ed between three and 11 percent. Furthermore, new loans that a single co-integrating vector in all of the specifi cations sanctioned after DRT establishment are charged interest indicating that there is a long run relationship among the rates that are lower by 1.4-2 percentage points. variables considered. The result shows that legal, institution- Chemin (2007) investigates the impact of judicial reform, al developments positively affect fi nancial sector with enacted in 2002 Amendment Act to the Civil procedure considerable feedback and economic growth with less Code of 1908 in order to make litigation more effi cient, on feedback and fi nancial regulation has a negative impact on fi rms contracting behaviour and economic performance of fi nancial sector growth. The interesting aspect in this study is 5,20,000 small informal non-agricultural fi rms from 2000 and that the studies which we reviewed above showed one way 2002 rounds of National Sample Survey. The study used the relationship i.e., improvement of the judicial quality leads to spatial variation in the implementation of judicial reform increased economic activities, but this study is expressing and found that this reform decreased the number of cases two way relationship which is development of fi nancial pending per judge in lower courts. For analyzing fi rms sector demands the legal development. behaviour the study used regression technique and after From the above studies we can understand that law and controlling state and sector specifi c effects, the study found governing institutions are clearly relevant for economic that a speedier judiciary leads to decrease in the breaches of growth. contract, encouraged investment, facilitated access to fi nance, and expanded rental markets. The drawback of this Scope for Further Research: study is that it controlled alternative dispute resolution In the case of cross country studies it deals with different system such as fast-track courts and Lok Adalats, but in rural aspects of legal system such as political or property rights, areas people still depends on panchayats policies, judicial independence etc., but for solving their disputes. This study does in the case of empirical studies from not control this alternative informal Though pendency India directly or indirectly deals with dispute solution system and fi rm specifi c is the potential quality of judiciary which is delay in court effects. Nevertheless, this study explains problem in Indian decision or backlog of pendency in judicial reform positively infl uencing courts, there are Indian courts and how it affects the economic behaviour of fi rms. economic growth. Some studies deals Xavier (2007) analysed the long run other problems with judicial reforms which are also relationship between fi nance and growth like corruption related to pendency cases in Indian court, through the determinants of fi nancial and instability how the judicial reform helps to increase sector growth such as legal and institu- the speed of the judiciary, and how it tional developments and fi nancial regulation in India. helps to promote the economic growth of the country. With During 1990’s India introduced various legal reform, these one dimension studies it is diffi cult to articulate, for Securitization and Reconstruction of Financial Assets and practical purposes what laws and implementing organiza- Enforcement of Security Interests Act (SRFAESI Act), Debt tions are most effective at enhancing economic growth and Recovery Tribunals Act etc. It is expected that these innova- what actions preventing such growth. Though pendency is tions in the procedural law would facilitate fi nancial sector the potential problem in Indian courts, there are other development. The study analyzed these effects in the VAR problems such as legal corruption, political instability, legal system, incorporated following variables such as per capita process (much procedures to approach courts will increase

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transaction costs), implementation of law, implementation At the same time non-institutional economists who are institutions etc. But empirical studies from India do not arguing that the importance of legal institutions are address these issues. exaggerated, individuals themselves can organize institu- Another important issue is that legal institutions do not tions and in that manner they can attain their profi ts and play a wholly autonomous role in development; their contracts can be enforced through reputation. But this is effectiveness depends on the effectiveness of a number of possible only in the closed or primitive society. When other institutions. Therefore it is important to study legal society expands or it becomes complex market economies it systems as well as other institutions such as Government needs proper institutions which enforce private property upon which the effi ciency of judicial system depend simul- rights and contracts. Therefore, it is important to under- taneously. stand the relationship between legal system and economic In India sector specifi c studies are also limited for e.g. development with the help of empirical studies. Kohling (2000) render specifi c look at the agriculture sector This paper reviews the Cross-country and Indian empiri- and he found that in India thirty percent of the civil claims cal studies which are exploring the relationship between related to land ownership, rent, and other related issues. legal system and economic development. India is one of the Therefore increasing the quality of the judiciary facilitates a developing countries facing the potential problem of large higher agricultural production and reduces the long-term backlogs in its courts. In order to solve that Indian courts poverty rates through long-term investments. Though some introduced some legal reforms to speed up the disposal of of the studies which we reviewed show the fi nancial sector cases. These are expected to improve economic develop- development and growth, these deals with the banking ment via supporting the liberalization of the economy. sector reforms only. In recent years India’s services sector is Therefore, India is the interesting ground to test the experiencing faster growth than other sectors. These relationship between legal system and economic growth. studies do not talk about how legal reform helps services Though in India not much empirical studies available in sector, except fi nancial sector, to achieve this growth as different dimensions, the studies which we reviewed most of the services sectors are in informal sectors. It is illustrate the importance of the quality of the judiciary on important to study how legal system or reform relates economic development. Therefore, with the help of services sector growth particularly in the informal sector. literatures this study concluded that there is a direct In other words, these studies use the variables which are relationship between legal system and economic develop- representing the characteristics of legal institutions and ment in India. they do not concentrate much on which type of institutions play the most important roles in development. Though Endnotes legal institutions are important for economic growth, it is 1 I will use the words judicial system and legal system only part of the legal system. These studies do not address interchangeably in what follows the issue of relationship between legal system and econom- 2 The best example is diamond business. ic development. Therefore, in that context additional 3 “In how many cases has one of the other government researches are required to explore the relationship between branches remained inactive when its action was neces- law and economic development. sary for a decision to become effective?” 4 Chemin - 2004 Summary and Conclusion 5 Lok Adalat is dispute resolution mechanism which In theory, according to New Institutional Economists, follows the methods of conciliation and mediation are institutions particularly legal or formal institutions are employed to settle cases before goes into the court. important for achieving property rights which encourages 6 Banks and fi nancial institutions can recover their non- investment that is essential for economic growth, because performing loans through DRT quickly. investment will occur only if investors are confi dent that 7 It encourages out-of-court dispute settlement such as they can reap their profi ts. arbitration, conciliation, mediation etc.

140 THE IIPM THINK TANK L AW AND ECONOMICS Free Trade and Free Markets: A General Law Perspectives

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tion and effect of WTO to regulate trades with greater Rabin Majumder restriction to free trade is something which needs detail Advocate & Attorney, discussion. On the private front, concept of Anti-trust, NuDelhiLawFora, Law Firm, New Delhi insider-trade, unfair trade practice, corruption, smuggle, that suggest rampage of non-free trade practices and so as the legal provisions and its applications. The ambit of laws immensely enlarged with traditionally domestic focused legal systems to transnational reach. In Indian context, much hyped "free"-ship in "free mar- kets" and “free trade" is, in effect, a manipulated freedom of the high and mighty which calculatedly prevents equality which otherwise essentially hits by basic features of the A. Introduction Constitution of India besides other substantive laws prevail- Commodity exchange or bartering to hunters’ fl esh trade ing from time to time. As some sections rightly observed, for produce to even fresh fruits producers’ practice for trade is not the same as democracy since ability to access to vegetable to mediums such as stone, metal, and later coins markets (read “free markets” through “free trade”), do not and paper money to trading papers of shares, bills, promis- obviously presume free and fair elections. In short, inequal- sory notes, and all kinds of future instrument to high-end ity looms large by way of camoufl aged-tyranny backed by technology into a paperless society for trading the intangi- legal sanction affecting 'aam aadmi' of India. Law here bles have been in the transitions with some yet not-so- seems rendered ineffective. strong legal regimes in India, until recently. The oldest The wide spread acquisition of lands by the “land-sharks” development is revocation of the slavery backed by the Governments and inap- law leaning towards humane treatment propriate applications of prevailing land of every such activity to improve stand- A free-trade acquisition laws is an glaring example of ard of living and promote freedom to policy does not doing away with democratic legal allow human dignity which became the necessarily imply process through policy shifts which can mantra of legal systems globally affect- that the state not be challenged in any court of law and ing that of India. such illegality and inequality is often Free markets myths, even the self abandons all overlooked by way a “suitable” compen- regulated free Laissez-faire (welfare) policy and sation packages often sanctioned by the market in vogue in mid-19th century, legal controls Courts rendering the theory of fair simply did not fair well, not even market- practices meaningless. forces-would-balance off any bad elements-through com- Legal regimes are ones although engulf the system yet petitive market mechanism theory. Even Adam Smith, the policy overshadows the substantive legal provisions making most famous proponent of British laissez-faire ideology, did the legal environment further weak. Secondly, foreign not believe free market in its strict sense. However, govern- trade policy envisages that a trade policy cannot be fully ment activity in public utility works was engaged in regula- comprehensive in all its details which would naturally tion of foreign commerce to safeguard few selected home require modifi cation from time to time based upon the industries resulting in creation of free trade zones of inevitable changing dynamics of international trade. For NAFTA, AFTA, APEC, APEC plus Three and plus Five, example. by way of partnership with business and industry EU, through EEZ to STPI to SEZ etc. which have never as in PPP models. been freed by excluding non members to the markets. This is also evident in the Free Trade Agreement (FTA) signed B. Hypocrisy of Free Trade between India with many other trading nations. The evolu- It has been observed that ever since the beginning of

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economic liberalization in 1991, a plethora of new industri- and pitfalls and so also has its own myths. Proponents of alization policies have been unveiled and the government is free-ship of trade and commerce in free market concept are continuing to do so. Having laid the policy framework that like a coin having two sides i.e. one way they are neo-liberal allows private control over community resources – water, and on the other, orthodox. Some Western economists biodiversity, forests, seeds, other markets and resources – provide cogent arguments as to why developing nations successive governments have laid the foundations of an should go against such ‘manufactured’ wisdom and plump “exit policy” for farmers. Be that as it may, some general for development models that best suit their goals. and area specifi c laws have been put in place to shape the Ironically, for countries like India, related trade laws are legal environment clearer and effective to deal with focused and tailor-made keeping in mind what so called changed scenario internationally at national level, in order “Good Samaritans” and their dictat desire us to do, no to “free” trade. wonder what their action is, people in India follow through what is preached before it and that becomes new beginning Big Brother WTO for India which is in essence skipping industrialization and Gradually, the heat at the grassroots began to sweep into the increase in domestic laws problems and also evolution and political system. Primarily because of this heat generated benefi t of only service sector (which according to some is a within the country, India’s stand at the WTO has hardened dangerous game, having direct effect on core economy over the years wherein India’s negotiators have so far kept concept for which India is known to the world.) And new law national interests in mind. Opposition to the WTO has also takes over overnight without any other or further discussion galvanised newer protests, i.e., against with “universal” applicability. SEZs, land acquisitions and FDI in food, A structured economic concept suited retail, etc. Sensing troubles, within the By allowing for a particular system is made “univer- country, the Indian government has had private control sally” applicable with modulated legal to bring in a new rehabilitation policy for over community provisions to give required shape. WTO those so displaced. resources, dispute settlement mechanism is one of The continuing WTO deadlock has those kinds, to name a few. And often it given India the impetus to re-orient trade governments has been seen that India adapt such legal policies from multilateral to bilateral infact laid an 'exit culture which was until recently un- agreements. India began exploring the policy' for farmers known. Competition laws are of that possibility of entering into comprehensive kind. People at power elevate people on economic partnership agreements (EPAs) with, inter alia, roads to understand that new laws are the ones which can including the ASEAN members. And that India is also not be ignored and has to be assimilated with like latter’s seeking trans-continental FTAs. A bilateral trade agree- bread-n-butter. ment with the EU is on the roll. India is also gearing up to Probably, India has mastery over injecting the new legal start preferential trade agreements with BRIC countries and concept every now and then it is asked to. A copy-paste the Southern African Customs Union. It may be noted that culture is in vogue in legislative process of making of new specifi c commitments pertaining to national laws so as to laws. The laws relating to intellectual property rights; make strong, transparent disciplines on government pro- foreign direct investments, rules and regulations have been curement procedures, rules of origin and effective enforce- so framed that the benefi t only those other india as a nation. ment of domestic labor and environmental laws are being It is frightening to note if countries like India violate these put in place. rules to protect its sovereignty and food security, etc., the nation is threatened with trade sanctions and economic C. Myths Generally isolation. But if the propounder of such scheme makes an Every system of laws has obvious strength for which it is exception, it is economically so justifi ed (and legally too). brought forth and also has its corresponding inherent lacuna Its new kind of international legal tools whereby exploita-

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tion worldwide is sanctioned and is made tenable. In one tee the rule of law. India is a free-market democracy with a such occasion concerning American Rice, Inc., a U.S. legal and regulatory framework that rewards free enterprise, District Court leisurely legitimatized bribery by a U.S entrepreneurship and risk taking. India is a free-market company to a foreign offi cial to reduce the company's tax democracy with a robust, well-developed legal and adminis- burden or customs duties etc. in abroad, thereby paving the trative system. The Indian legal system has been derived way for future legal protection of those in the Western originally from that of the UK and is considered at par with countries to seek legal protection for their wrong doings that of any developed economy. Accounting standards in elsewhere whereby the accused could have been tried and India are similar to those followed internationally. convicted if found guilty in domestic legal systems. This is a clear case of ousting the jurisdiction of Indian sovereignty E. Conclusion over choice and application of its own laws. It is often said that the ‘Rules of the Game’ helps facilitate Corporate Good Governance, happily celebrated by the economic process, in which the rule and law and economies like India, seems only to be the hallmark India property rights are components. Economically, the most alone. Thus India has made free inroads for market econo- important feature of the rules of the game is clearly defi ned my assimilating again the those laws alien to domestic property rights and a rule of law that recognizes them. demands and legal status. Legally speaking, it creates bundle of rights to enjoy and The problems India faces today is legislative efforts are litigate. Property rights are essential features of the free also market-driven now-a-days and people specifi c. Mere market economy because they encourage market coordina- adoption of such international laws as tion and create comparative advantage. municipal laws is strategically dangerous In fact, a market economy is based upon especially in technology driven laws. In fact, a market private property rights – rights associ- economy is based ated to specifi c individuals in the form of D. Market Economy in India & Laws upon private legal ownership. Induction of market-driven economy property rights This is secured by the rule of law, which (read free market) in India raised a few encourages wealth, and prevents the eyebrows amongst academics having dual and this inturn is subjection of people to the tyranny and interests in economy and law. The secured by the exploitation of others. However, free ‘roll-back’ by the State would affect social rule of law trade assumes a state of perfect competi- security provisions otherwise guaranteed tion to achieve comparative advantage, by the Constitution of India which in turn entails inequality the policy permits trading partners mutual gains from trade and thus, have dangerous elements of altering basic struc- of goods and services. ture theory of the Constitution. This would essentially also A free-trade policy does not necessarily imply that the weaken the community-feeling and the extended family government abandons all policy and legal control, but rather concept which is core bondage of India’s family institutions that it refrains from actions specifi cally designed to hinder and thus may cause a massive law and order problems. international trade which might arise from tariff barriers, On the other hand, some opine that free market econo- currency restrictions, and import quotas, etc. The extent to my in India must not be viewed so negatively which needs which free trade benefi ts economic development amidst any to live and sustain on the strengths of Indian socio-cultur- kinds of legal systems in place is unknown which may be al-political values. It may be noted that role of the State is examined from time to time by domestic legal tools prevail- quite crucial in India in comparison with respect to ing at the given time. market liberalization. India is a fast-growing economy with a dynamic and (The views expressed in the article are personal and do not robust fi nancial system. Being a democracy ensures a stable refl ect the offi cial policy or position of the organisation. The policy environment and its independent institutions guaran- author can be contacted at [email protected])

THE INDIA ECONOMY REVIEW 145 E NVRIONMENTAL ECONOMICS

146 THE IIPM THINK TANK S ILENT SPRING Mitigating Environmental Crisis: Can India Show the Way?

dawn of industrial revolution, advanced countries preferred the G. Bhalachandran path of unlimited growth. As early as in 1960s, the cost-benefi t Department of Economics, Sri Sathya Sai analysis of such growth process revealed that the cost of University, Prasanthinilayam economic growth in terms of environmental damage was quite alarming4. The environmental concern for development process was fi rst revealed by R.Carson, in her Silent Spring5. She Suresh Chandra Babu warned the advanced countries that their growth-path had Senior Fellow and Program Leader, resulted in large depletion of natural resources and caused International Food Policy Research Institute chemical contamination of the world environment, resulting in (IFPRI), Washington D.C. an ecological imbalance. Many critics condemned the unlimited growth strategy and poised for the limits to growth. Barry Commoner, a biologist by Introduction profession, proved with empirical evidence that the present Several aggregate economic and non-economic forces positively course of environmental degradation had challenged the contribute to the development process of an economy which ecological system and would destroy the Earth’s capacity to aims at the promotion of socio-economic welfare of its citizens. support her living beings6. A mathematical model developed by Generally, development means uninhibited economic growth1. Dennis Meadows and his team, predicted a catastrophic One can argue that such a development is acceptable only if it is collapse of the world ecological and economic system under a achieved through ethical means. In other words, the concept of wrong footing of unlimited growth strategy. This Limits to development is value-centric, inclusive of human costs and Growth Strategy derived its fi ndings on fi ve major parameters, sacrifi ces, accountable, transparent and subject to critical viz., population, natural resources, food availability per capita, examination2. To put it simply, development bereft of human industrial output per capita and environmental pollution. This values3 is not only unsustainable but also positively dangerous. model showed the mode of development from 1960 to the The process of economic development involves enormous projected year of 2100 AD and revealed that the over exploita- quantity of production, distribution, and consumption of goods tion of resources would end up in a halt of the currently pursued and services. The process of production, in turn, depends on aggressive path of development. Many great thinkers of the availability and the use of factors of production. It means, different fi elds concurred with the contention of this model, there will be a continuous derived demand for natural resourc- since it has proved once again in 2004 that their propositions are es, consists of renewable and non-renewable gifts of nature, prophetic with thirty years of additional data and world compu- human capital and man-made capital. Population and its ter models7.The critics8 of this model were optimistic to point characteristics set the magnitudes and quality of consumption out that of society. The manner in which the factors of production is a) there are many natural resources which would not disappear used, decides the contours of economic development. Since the forever

THE INDIA ECONOMY REVIEW 147 E NVRIONMENTAL ECONOMICS

b) this model never thought of the concepts of reuse and man’s ability to pollute was well within the nature’s capacity to recycling and clean up. Hence, pollution was not a threat to the world c) the alternative approach of cleaner technology, more fuel community and the planet earth. effi ciency, lesser use of raw materials with improved technol- Great civilizations in Greece, Rome, Mesopotamia, China ogy and lesser waste production were not thought of. and India revealed refi nements in handling issues of different The Sustainable Development Hypothesis9, on the other nature and each one’s culture saw to it that there was no trace of hand, conceived and suggested by the team led by Gro Brunt- environmental degradation. Indian Culture, which is the sole land of Norway as an alternative development strategy, clearly living ancient culture of the world as of today, has hardly underlined the nature of relationship between economic referred about environmental degradation in the past in any of development and environment. It directed the world commu- its vast literature available at present. There are records of nity to follow that pattern of development which takes care of natural disasters and catastrophes in it; but the environmental the welfare of the present generation with an assurance to the degradation caused by human civilization was unknown in future generation, a life that is at least as comfortable as that of ancient India. the present generation. This approach has made many people in As indicated earlier, industrial revolution had changed the economically developed countries to raise questions like; what mind-set of the capitalistic countries. Amazing scientifi c good is great material wealth if it comes at the cost of large- discoveries of the western world have had deep impact on scale disruptions of the eco-systems by human life and nature in general11. Their up which we are nourished? Recent develop- by the bootstraps approach aroused the ments in climate change debate are an What good is productive forces and paved the way for example. Sporadic efforts have been made material wealth mass production. This is diagonally oppo- by the international bodies to step up if it comes at the site of Gandhian dictum: Production by the awareness about sustainable development. cost of disruptions masses. At present, even in India, the Unfortunately, the response is dishearten- traditional approach to industrial produc- ing. What is required currently is an of the eco-systems tion by the artisans and through guild awareness in the world community, that by which we are system was given a go-bye and large-scale man’s life is interdependent on the life of nourished? production by machines; employing every other on the planet and the quest for thousands of workers and using large sustainable development is the most urgent need of the hour. quantities of inputs and capital with a view to catering the demands of far-off markets were encouraged. Naturally, levels History, Economics and Environment of pollution had to rise up. This happened to be beyond the History reminds one not only of the glory of the past but also nature’s capacity of ‘cleaning-up-process’. The net result is the offers valuable inputs from the experience of the forefathers unabating environmental pollution at present. Another corol- one can obtain to handle many of tough issues of today. Even to lary factor to this is the rise in the growth of world population in understand the full gravity of the environmental problems, the general and the improvement in the life-expectancy years of the historical perspective of the study of a problem is useful. For the population of industrialized countries in particular. As a result, sake of experiment, when one turns the pages of history, right the rise in demand for goods and services has become phenom- from the dawn of the Mohenjdaro-Harappa civilization up until enal and the derived demand for inputs from nature is also the industrial revolution in the eighteenth century, one can’t increased manifolds. The interplay of the demand-supply forces fi nd any record of environmental degradation10. Pollution of the of these has added fuel to fi re. present magnitude had never been experienced on the planet Finally, even the very existence of the species on the planet till then. One of the main causes was that population was small; earth has been put on stake. At present, the easiest option on account of this, wants were limited; the level of production available to contain this problem is to refer to the wisdom which and consumption was low; and the pollutants generated were the ancient culture of human civilization could offer to mend cleaned by nature in the routine processes. In other words, our ways and means and correct our paths of development.

148 THE IIPM THINK TANK S ILENT SPRING

What Can Indian Culture Teach Us? was a means to the end. This paved the way for equitable The unlimited growth model of industrialized countries empha- distribution by preventing the over exploitation by any section of sizes rapid growth keeping in view of higher standard of living. society. In a nutshell, the ancients in India made it clear to every But this has led to the irresponsible and continuous exploitation one in society that Sustainable Development (Dharma) was of natural resources and environment beyond the threshold of holistic as well as universal and the approach to it should never resilience of the eco-system. be a piecemeal. This is the cue for the modern society around Indian culture views the eco-system in its entirety which is the world to emulate, follow and adapt for its benefi t in the represented by the fi ve hydrological constituents12. The develop- present as well as future. ment strategy of a country or world at large can’t disturb the equilibrium in the hydro-dynamic integrated system. But, the Operationalizing Indian Thoughts for western paradigm for development has not cared for it. As a Environmental Protection result, this has accentuated various dormant and active geo- In the beginning, people around the globe had seen protection morphic processes on the earth and caused imbalance in the of environment was essential for the human survival and natural eco-system. The Indian culture does not allow the development. The other living creatures including plants, squandering of natural wealth of any kind. It also emphasizes animal species and natural resources in the world were valued that the development path ensures the needs of the present for their ‘utility value’ to the human survival, development and generation without compromising the ability satisfaction. But the truth is that every of the future generation to meet their own living being and life forms have some needs. Moreover, it stands for policies, which Indian culture inherent value in themselves and there is enables future generations to have as much views the eco- an interconnectedness among all of them wealth / benefi ts as the present generation system in its for the welfare of the planet Earth itself. receives. In other words the present genera- entirety which is This concept promotes the notion of tion is not entitled to be over exploitive and environmental ethics. generate debts for the future generation. represented by the People in (so called) modern civilized This is what the ancients in India called five hydrological society are of the opinion that human Dharma13 and it implies fairness to future. constituents beings are the most intelligent of all living The concept of sustainable development species and they are empowered to fl oated by the report entitled, Our Common Future echoes the manipulate and exploit the natural world in any manner they same message that was conceived and made as the way of life of deem fi t. Moreover, they feel that those species which have a people in ancient India. use value for their survival and comfort need their protection Another interesting fact one can observe from the ancient and patronage16. But this is a disastrously wrong perception Indian literature is that their society was encouraged to use and practice. more of renewable resources than of non-renewable resources14. Here comes the ancient wisdom of India as a handy tool to The reason one could infer is that the price mechanism works have the right attitude towards the life and environment around. well with regard to man made goods where as the same principle The ancients in India practiced and preached integrated human does not work when nature / environment has to be priced. It is and environmental ethics, which directed the human beings to because that environment is beyond a price. Hence the ancients hold the responsibility for the stewardship of protection of all in India assigned a pride place of worship to nature. They living species17. This notion of interconnectedness is the way and trained the society to judiciously use one’s own conscience to means for getting the globe out of the morass of misconception trade off between ecology and economic development. Another and mismanagement of the world environment. This ethical added advantage was that they had perfect understanding of the principle has to reach every citizen of the world in right perspec- difference between the private and social cost of resource tive and each one has to practice it for the benefi t of global exploitation15. Hence, they took utmost care to preserve the welfare. It is possible only when the spirit of universal love holds natural resources to the possible extent, which in their opinion the key of every thought, word and deed of people of all

THE INDIA ECONOMY REVIEW 149 E NVRIONMENTAL ECONOMICS

countries without any exception. If humanity as a whole indicates puts man in rightful role as the custodian of nature and not its this ethics, then the concept of sustainable development (as exploiter. Moreover it elevates his spirit and fi nds himself one conceived and practiced in ancient India) can become a reality, with it20. For this, the elders of civic society have a major role to even today. For this purpose a strong political will, forward play in inspiring their children and young generations. looking socio-politico-economic institutions and people with Ahimsa or Non-violence towards life, living beings and nature, universal value system are the prerequisites. is a cardinal principle and basic philosophy for which India It is worth recollecting here the vision of Mahatma Gandhi – a stands for, even today. This was a way of life in ancient India; but reformed India – which is based on sound environmental reiterated for the benefi t of society by Mahavira, the Buddha, management principles of the ancient India. All these principles and recently by Mahatma Gandhi and Bhagawan Sri Sathya Sai are now considered the integral part of sustainable, long – term Baba. Many modern thinkers in the west have begun to see the development. As a part of his experiment with truth, Gandhiji intrinsic value in Indian culture and support it as the basic for had designed a suitable life-style for himself, when these con- human development. The discussion here emphasizes that cepts were not part of general thinking, with a view to revealing modern society has to evolve a scientifi c as well as utilitarian to the rest of the world that the injunctions of Indian culture approach in exploring nature without causing any damage to it. were not only idealistic but also practical. He fi rmly believed that One has to be aware here that any harm done unto nature will be the world could support people’s needs but not to their greed. retaliated by it with immeasurable force21. The world now is at the cross roads because In India, the time has come to consolidate it is fi nding diffi cult to yield to the demand the values which lead to an effective process and pressure of industrially advanced Modern society of decision making and right action for the economies on one side and could not feed has to evolve weal of humanity. The Indian constitution the poverty-ridden population of less-devel- a scientific emphasizes this process succinctly22. This oped countries on the other side. Foreseeing and utilitarian expects that every individual in the society this, Gandhiji wanted that every citizen in must become environmental–sensitive and India to practice a sustainable life-style that approach in pro–environmental actions have to move cares for the earth and promotes the quality exploring nature from the domain of individuals to that of a of human life simultaneously. without damage community and later to society at large. For Mahatma Gandhi’s famous concept of this purpose, a force of pro-environmental Trusteeship can be well extended to drive home that humans are lobbying can be constituted to infl uence governments to enforce the trustees of nature, species and environment around them. laws that can bind every citizen for the pro-environmental Indian culture asserts that human beings are just one small cog in outcomes that include not only material resources but also many the wheel of life on earth. In other words, each living being, a valuable services. plant or animal, has a right to life as a part of the earth’s commu- It is not out of context to stress here that it is obligatory on the nity. This message has to reach every nook and corner of this part of the present generation to do its best to protect many of country through the process of Environmental education at all our ancient structures of archaeological importance including levels of learning. The direction of the Hon’ble Supreme Court of temples. These were constructed by the ancients of this land, not India made this mandatory and the University Grants Commis- only to speak of their glory, architectural ability, their engineer- sion has taken it religiously and steps are being taken to make it ing marvel and their refi ned evolution of the spirit but also to action oriented18. At the societal level, two basic values have to be support the future generation as the priceless environmental inculcated by governments, corporations, media, institutions and assets. They protect the people in times of calamity, but most people in their life-style. One, valuing the nature as a mother. often, they prevent environmental damages to a large extent.23 This principle has been upheld by all the scriptures of this venerable Land19. This has been forgotten now. This value Conclusions kindles the conservation-awareness in man. Second, appreciating Humans are a miniscule part of nature’s complex web of life. the beauty of Nature. If one’s heart is given to nature, this value Nature upholds the value of unity in diversity. Man, who is

150 THE IIPM THINK TANK S ILENT SPRING

endowed with a sixth sense, has to become the trustee of the immemorial in India, has no equivalent in any other tongue. earth’s magnifi cent life-forms, not its destroyer. Indian But, it encompasses and synthesizes all the healthy, profound culture is unique for being idealistic and practical in several principles and practices, the concept of Sustainable Develop- respects. It has many striking values and tips for the modern ment stands for. society to become pro-environmental and trim its ways and 14 See, Arjun Das, Economic Philosophy of Ancient India, means for sustainable development. Hence, this paper Agam Kala Prakashan, 1986, pp. 29-31. stresses that let Indian society lead the rest of humanity 15 See, Kautilya’s Arthashastra, Book II, Ch. 12 towards pro-environmental-actions and thus paves the way 16 For eg. People living in advanced countries look at a cow as a for pollution -free planet. source of milk or meat. 17 Each one lives for the other and all collectively for the welfare Endnotes and Additional Thinking of mankind – This is the conscious prayer of every son of the 1 Jeremy Seabrook, The Meaning of Sustainability, in Chan- soil in ancient India, quoted in all sacred texts. See, V. dreyee Das and Dipankar Ghosh(ed), Eye on Development, Sivarama Sharma (ed) Srimad Valmiki Ramayana, Chowka- Sampark, 2006, p.207. hamba Vidya Bhavan, 1982, 3ed., p.5. 2 See, Des Gasper, The Ethics of Development, Vistaar, 2004, 18 Arun Nigavekar, Forward, in Ercach Bharucha, Text Book of pp 14-16 Environmental Studies, University Press, 2005,p. VII 3 According to Bhagawan Sri Sathya Sai Baba, the universally 19 See, Laxmi Mall Singhvi, Environmental Wisdom in Ancient acceptable human values are Truth, Righteousness, Peace, India, www.ecomall.com, site visited on March 20, 2009. Love and Non-Violence. See, Bhagawan Sri Sathya Sai Baba, 20 King Pari, a legendary philanthropist of Tamil Sangam era Thought for The Day, Sri Sathya Sai Book Trust, 1993 p.K.2.S. (300 BC to 300 AD), once happened to travel with his 4 A.K.Ghosh, Sustainable Development: Is it achievable, in daughters, Angavai and Sangavai, in his chariot, through a for- C.D. Ghosh, op.cit, p.76. est. There, they stumbled upon a huge jasmine creeper spread 5 See for more details, R .Carson, The Silent Spring, Houghton across the road, since someone had cut off its prop-tree. The Miffl in, 1962. King’s benevolent heart melted. He asked his daughters to 6 See, Barry Commoner, The Closing Circle, Alfred A. Knopf, unchain the horses from the chariot and he himself led the New York, 1972. chariot to leave it for the creeper to use it as its prop. He could 7 See, (a) Dennis Meadows et.al, A Report for the Club of do such an act since he saw himself in the jasmine creeper. Romes: Project on the Predicament of Mankind, Universe This is the highest stage of the evolution of a man. That is why; Books, New York, 1972. (b) Donella Meadows et.al., Limits to Pari’s name is synonymous with philanthropy in Tamil land. Growth: The 30-year Update, Chelsea Green Publishing co., See, Kapilar, Purananooru, verse 201, Varthamanan Pathip- U.S.A., 2004. pagam, Part-II Chennai, 1999, p.5. 8 See, William Nordhaus, ‘World Dynamics: Measurement 21 There is a scientifi c base to prove that in all natural calamities without data’, Economic Journal,83;pp.1156-83,1973. the humanity suffers, there is a human element at work. See, 9 See, G .Bruntland, Our Common future-A climate for change, John D Carmack, Is God responsible for the Good or Bad, Oxford, 1987. www.helium.com, site visited on March 27th, 2009. 10 Gautam Gupta, Environment, Ecology and Economy, in R.N. 22 See, Article 48 A and Article 51 A(g), indiacode.nic.in Bhattacharya, Environmental Economics: An Indian Perspec- 23 When tsunami stuck the eastern coast of Tamilnadu, on tive, Oxford, 2001, p. 17. December 26th, 2004, none of the temples on the eastern coast 11 B.M. Sanyal, Sustainable Development: Certain Critical including the Rameswaram temple located in an island was Observations, in Chandraya Das and Dipankar Ghosh (ed), affected. See, Chennai and Tamilnadu, in www.google.com , op.cit., p.89. site visited on March 27th, 2009. 12 They are soil/earth; water; wind; ether/atmosphere and fi re/ energy (The views expressed in the article are personal and do not refl ect 13 The concept of dharma which has been in vogue from time the offi cial policy or position of the organisation).

THE INDIA ECONOMY REVIEW 151 E NERGY ECONOMICS Wind Energy in India - Reforms to the Rescue

useful form of energy, such as electric- ity, using wind turbines. Oil prices were highly volatile during the last fi ve years and we witnessed oil prices reaching USD 147 per barrel and then falling to nearly USD 30 per barrel, all in a span of one year. During the oil shock of 1970s, economies realized the impor- tance of alternate source of energy and started investing in renewable sources of energy like solar energy, wind energy, hydro-power etc. However generating energy from renewable sources was costlier in early years and real thrust for installing renewable energy sources really started in 1990s. Amongst all the sources, wind power registered the high- est amount of growth (Table 1) and investment owing to low investment Introduction costs and high IRR. During the last twenty years, very few oil and gas discoveries have At the end of 2008, worldwide installed capacity of wind- happened and proven reserves are falling. In order to reduce their powered generators was 121.2 gigawatts (GW) (Chart 1). In dependency on oil, many countries are trying to increase energy 2008, wind power produced about 1.5% of worldwide electric- generation from renewable energy sources. However generating ity usage; and is growing rapidly, having doubled in the three power using renewable energy sources is costly and government years between 2005 and 2008. Several countries have achieved subsidies and incentives are critical for the viability of renewable relatively high levels of wind power penetration, such as 19% energy projects. In this article we will fi rst discuss why wind energy of stationary electricity production in Denmark, 11% in Spain has witnessed higher growth as compared to other renewable and Portugal, and seven percent in Germany and the Republic energy sources. Then we will discuss the incentives provided by of Ireland in 2008. As of May 2009, eighty countries around India and various state governments. In the end we will discuss the world were using wind power on a commercial basis. where regulatory changes and reforms are needed in India in order to attract investors and to enhance the transparency. Growth Drivers For Wind Energy 1. Cost competitive – Cost per KWH of wind generation Wind Power is Gaining Popularity decreased from US$ 0.38 in early 80s to present US$ Wind power is generated by converting wind energy into a 0.03-0.06, at excellent wind sites

152 THE IIPM THINK TANK C HARGING AHEAD

a. Global electricity consumption expected to double Ritesh Agarwal between 2002 & 2030 Analyst, b. Wind Energy’s contribution expected to increase from ASK Group, Mumbai 0.2% in 2002 to three percent in 2030

Wind Energy in India India currently accounts for nearly eight percent of total Shiva Agarwal global wind energy installed capacity. The installed capacity Indian School of Business, Hyderabad was only 200 MW in 2000 which increased to nearly 9600 MW by 2008. Although India registered impressive growth in installed capacity, it lagged countries like China which 2. Environmental awareness / government initiatives gave greater emphasis on energy security. India was fourth a. Kyoto protocol – CO2 emission to reduce by 5.2% of globally by installed capacity in 2007 and lost its fourth 1990s levels, by 2012 place to China in 2008 which nearly doubled its installed b. Renewable energy targets – EU – 20% by 2020, India capacity (Table 2). – 10% by 2012, China – 10% by 2020 3. Energy Security – High volatility in oil / gas prices and Incentives and Subsidies depleting oil / gas reserves Provided by Indian Government 4. Increasing electricity demand Indian government and various state governments pro-

Table 1: Comparison of Various Renewable Energy Sources Technology Increase in Energy Turn Key Current Energy Cost Potential Future Production, Investment Energy Cost 1997-2001 Costs (2001 US$ (percent per year) per Kilowatt) Biomass Energy Electricity ~ 2.5 500-6000 3-12 ¢/kWh 4-10 ¢/kWh Heat ~ 2 170-1000 1-6 ¢/kWh 1-5 ¢/kWh Ethanol ~ 2 (8-25 $/GJ (6-10 $/GJ Bio-diesel ~ 1 15-25 $/GJ) 10-15 $/GJ) Wind Electricity ~ 30 850-1700 4-8 ¢/kWh 3-10 ¢/kWh Solar Photovoltaic Electricity ~ 30 5000-18000 25-160 ¢/kWh 5 or 6-25 ¢/kWh Solar Thermal Electricity ~ 2 2500-6000 12-34 ¢/kWh 4-20 ¢/kWh Low-temperature Solar Heat ~ 10 300-1700 2-25 ¢/kWh 2-10 ¢/kWh Hydro Energy Large ~ 2 1000-3500 2-10 ¢/kWh 2-10 ¢/kWh Small ~ 3 700-8000 2-12 ¢/kWh 2-10 ¢/kWh Geothermal Energy Electricity ~ 3 800-3000 2-10 ¢/kWh 1 or 2-8 ¢/kWh Heat ~ 10 200-2000 0.5-5 ¢/kWh 0.5-5 ¢.kWh Marine Energy Tidal 0 1700-2500 8-15 ¢/kWh 8-15 ¢/kWh Wave - 2000-5000 10-30 ¢/kWh 5-10 ¢/kWh Tidal Stream/Current - 2000-5000 10-25 ¢/kWh 4-10 ¢/kWh OTEC - 8000-20000 15-40 ¢/kWh 7-20 ¢/kWh

Source: World Energy Assessment Report 2004, Update

THE INDIA ECONOMY REVIEW 153 E NERGY ECONOMICS

Chart 1: Wind Energy Installed Capacity project attracts a 100% income tax holiday for the income generated from the project World Total Installed Capacity (MW) for 10 consecutive years among fi rst 15 years 200.00 of operation. 190.000

180.00 3. Equity / Loan Ratio:

160.00 152.000 The project involves approx. 30% Equity and 70% Loan Funding. Various PSUS and 140.00 private banks provide funding for wind 121.188 *Prediction 120.00 power projects.

100.00 93.927 Incentives and Benefi ts Provided by 80.00 74.151 State Governments 59.024 60.00 Table 3 describes the incentives and benefi ts 47.693

39.295 given by various state governments .

40.00 31.181 24.322 18.039 13.700 Limitations

20.00 9.667 7.480 1. Wind machines must be located where 0 strong, dependable winds are available most 1998 1999 1997 2001 2003 2005 2002 2007 2008 2004 2006 2000 of the time 2010* 2009*

Source: World Wind Energy Report 2008, WWEA 2. Winds do not blow strongly enough to produce power all the time, therefore energy from wind vide lucrative benefi ts to investors looking to invest in machines is considered "intermittent," that is, it comes and wind energy and wind turbine generators (WTG). Follow- goes. Therefore, electricity from wind machines must have ing are some of the benefi ts provided by Indian govern- a back-up supply from another source ment – 3. As wind power is "intermittent," utility companies can use it for only part of their total energy needs 1. 80% Income Tax Accelerated Depreciation : 4. Wind towers and turbine blades are subject to damage from 80% depreciation can be claimed in the fi rst year of high winds and lighting. Rotating parts, which are located installation itself, if the project is commissioned on or high off the ground can be diffi cult and expensive to repair before 30th September in a fi nancial year; and 40% 5. Electricity produced by wind power sometimes fl uctuates in depreciation in case the project is commissioned on or voltage and power factor, which can cause diffi culties in after 1st October in a fi nancial year. The catalyst saves linking its power to a utility system income tax outfl ow in current business in a year. (Section 32 – Depreciation: Income Tax Act, 1961) Pain Points in Investing in Wind Energy in India An investor, investing in WTG post September, can claim Before discussing the pain points and needed regulatory depreciation as follows – reforms in India, we need to understand that the entire sector 40%: 2009-2010 is driven by private players and government’s role is limited 48%: 2010-2011 to providing subsidies and incentives. There is an autono- 10%--2011-2012 mous body called “Center for Wind Energy Technology” 2% --2012-2013 under Ministry of New and Renewable Energy (MNRE). However C-WET is not a regulatory body like SEBI but it is 2. Tax Holiday under Section 80 I (A): more like a standardization and certifi cation body. C-WET’s According to income tax act Section 80 I(A), a wind energy responsibilities include setting the minimum quality stand-

154 THE IIPM THINK TANK C HARGING AHEAD

Table 2: Global Wind Energy Installed Capacity

Position Country Total Capacity Added Capacity Growth Position Total Total Total 2008 Installed End 2008 Rate 2007 Capacity Capacity Capacity 2008 2008 Installed Installed Installed End 2007 End 2006 End 2005 [MW] [MW] % [MW] [MW] [MW] 1 USA 25170.0 8531.2 49.7 2 16818.8 11603.0 9149.0 2 Germany 23902.8 1655.4 7.4 1 22247.4 20622.0 18427.5 3 Spain 16740.3 1595.2 10.5 3 15145.1 11630.0 10027.9 4 China 12210.0 6298.0 106.5 5 5912.0 2599.0 1266.0 5 India 9587.0 1737.0 22.1 4 7850.0 6270.0 4430.0 6 Italy 3736.0 1009.9 37.0 7 2726.1 2123.4 1718.3 7 France 3404.0 949.0 38.7 8 2455.0 1567.0 757.2 8 United Kingdom 3287.9 898.9 37.6 9 2389.0 1962.9 1353.0 9 Denmark 3160.0 35.0 1.1 6 3125.0 3136.0 3128.0 10 Portugal 2862.0 732.0 34.4 10 2130.0 1716.0 1022.0

Source: World Wind Energy Report 2008, WWEA ards of equipments, and approving the wind farm sites etc. This price is quoted by the manufacturer as a whole and this In essence, the investor willing to invest in a wind turbine is “negotiated” with the investor. Although C-WET certifi es generator has to rely entirely on private players after the the minimum quality standard, it does not specify the project is commissioned. Table 4 is a sample summary sheet maximum charges for the equipment. If government sets a provided by a leading wind power player maximum price for a particular size of to a potential investor. A cursory look at WTG then the investors get a reliable esti- the Table 4 reveals that the only signifi - The C-WET is mate of the initial costs.Manufacturers cant parameter known with certainty to not a regulatory may argue that depending on the technol- the investor is tariff rate. Rest all the body like SEBI. ogy and quality, more power may be signifi cant factors are not in control of an It is more like a generated. The pricing may include investor and the investor has to depend on clauses that excess power generation than the company / lending bank. We will now standardization the set benchmark may entitle the manu- discuss the problems associated with all and certification facturer to share revenue. However this the parameters / factors and will discuss agency leads to another problem of getting the how regulatory reforms can improve the benchmark for average power generation. investment environment in India. Please note that the parameters will directly impact the investment results if Generation (KWH) parameters are changed. At present, manufacturers quote this fi gure primarily depending on their own estimates and calculations. How- Price / WTG ever government agencies need to estimate the wind speed This is the total initial investment (including debt and equity) and generation for a particular location so that investors needed to commission a WTG. The cost comprises equip- have a realistic estimate of the potential power generation. ment costs, land leasing, erection and commissioning This expected potential will also help in setting the price for charges, processing fees, basic infrastructure setting up etc. the equipments.

THE INDIA ECONOMY REVIEW 155 E NERGY ECONOMICS

Table 3: State Wise Description of Various Parameters

Description Gujarat Karnataka Madhya P. Maharashtra Rajasthan Tamil Nadu Tariff Rate Rs. 3.37 Rs. 3.40 Rs. 4.03 - 3.36 Rs. 3.50 Rs. 4.28 Rs. 2.90 Sale to Board Escalation Nil Nil Reduction of 15p/yr for 13 yr Nil Nil on Tariff 17p/yr up to 3.36 and con- stant after that PPA Period 20 years 10 years 20 years 13 years 20 years 20 years Penalty on Rs. 0.10 / Rs. 0.40 / Rs. 0.27 / Rs. 0.25 / Nil Rs. 1.00 / KVARH Reactive KVARH KVARH KVARH KVARH Power Drawn Third Party Permitted Permitted Permitted Permitted Permitted Permitted Sale Wheeling 4% 5% 2% 20-30% 10% 5% Charges Banking Surplus genera- Permitted in Not permitted Permitted in Permitted Permitted in same tion is purchased same fi nancial same fi nancial in same cal- fi nancial year by GUVNL@ year year endar year Rs. 3.37 Banking Nil 2% Not applicable Nil Nil 5% Charges Source: Ministry of New and Renewable Energy (MNRE), New Delhi

Interest Rates worked out depending on the past experiences in wind power There is no set policy according to which loan is provided to generation and future expected cash fl ows from the location. the investors. At present, various PSU and private banks give loans against the WTG according to their own perceived risks Plant Load Factor and understanding. Moreover the loan is The quoted plant load factor is usually usually not fi xed but fl oating which only 21-25% in India. However global experi- enhances the uncertainty in net cash The Government ence shows that this high load factor is not infl ows for the investor. It is understand- needs to possible for all the time. This factor varies able that risks vary from state to state incentivize according to environment which is not in amongst different wind farm locations but the banks to investor’s / manufacturer’s control. risks for a particular wind farms is same Plant load factor is calculated as the for all the WTG installed in the wind rationalize the ratio of (actual amount of power produced farm. In a gist, the risks that all the WTG interest rates on over time) and (Power that would have installed at a location are same (discount- high priority basis produced if turbine operated at maximum ing technical problems as of now). output 100% of the time). While calculat- At present, some banks offer loans at PLR + some risk ing this ratio, we need to account for time when wind speed is premium and this PLR varies from bank to bank. Moreover less than optimum speed; scheduled / unscheduled mainte- PLR also changes according to economic conditions and nance; production losses; dirty or corrosive blades, grid line banks’ policies. According to us, government needs to theft etc. After accounting for the entire factors, realized load incentivize the banks to rationalize the interest rates. We factor is typically less than 25%. propose that a range of risk premium for a state should be An investor cannot calculate the load factor owing to the

156 THE IIPM THINK TANK C HARGING AHEAD

Table 4: Summary Sheet For Investing in A Wind stock churning, various charges and performance etc to the Turbine Generator (WTG) investors on a periodic basis. Sr. No. Parameter 600 kW WTG We propose that the corresponding fi gures for load factor, 1 Size of the Project(MW) 0.6 power generation, down time etc should be disclosed to all the 2 No. of WTGs (600 kW each) 1 investors in a wind farm. 3 Price of the Project (Rs. Lacs) 421 4 Price / WTG (Rs. Lacs) 421 Payment Collection 5 Generation (KWH) 16 The power purchase agreement (PPA) is signed between the 6Losses 7%investor and the state electricity board. The State Electricity 7 O & M (Rs. Lacs per year) 7 Board (SEB) is supposed to pay the investor within 45 days. 8Escalation7.50%However collecting the money from the SEB is problematic 9 Free O & M (yr.) 1 and time consuming. Maharashtra SEB has introduced Real Time Gross Settlement (RTGS) payment system so that 10 Tariff (Rs. / unit) 3.48 timely payment can be done. Extending RTGS to all the states 11 Tariff Escalation (Rs. / unit) 0.02 can certainly lessen the woes of the investors. 12 Tariff Escalation (Rs. / unit) 0.01 13 Interest Rate 13.00% Conclusion 14 Loan Term (yr.) 7 India has set itself ambitious targets in renewable energy 15 Moratorium (yr.) 1 generation and government has indeed provided a host of 16 Plant load factor (PLF) 24.70% subsidies and benefi ts. Wind energy is relatively cheap and various states have extended lucrative benefi ts to the Sr. No. INVESTMENT - RESULTS investors. However a lot of work has to be done in order to 1Payback1.08standardize the investment process; government needs to 2 Cumulative Infl ow/ MW 673.65 instill transparency so that more investors may diversify 3 I R R (20 Yr.) 21% their portfolio taking exposure to renewable energy sources like wind energy. Bold indicates most signifi cant factors for the investor Source : A leading Indian wind energy company References and Additional Thinking limited data at his disposal and his own capability to estimate • World Wind Energy Association (February 2009). the power generation. An investor faces loss when the wind is "World Wind Energy Report 2008". Report. http://www. less than the estimated wind and also faces loss if there is high wwindea.org/home/images/stories/ velocity and power transmission is limited by the grid capacity. worldwindenergyreport2008_s.pdf. Retrieved 24th There is a need to formalize a policy according to which the August, 2009 manufacturer should quote the realized load factor from the • Wind Power: Capacity Factor, Intermittency, and what farm instead of only estimated load factor. This may be happens when the wind doesn’t blow? Retrieved 24th diffi cult if a new farm is developed, however manufacturers August, 2009 can be asked to give quotes for various possible scenarios. • MNRE Website http://mnes.nic.in/ • C-WET website http://www.cwet.tn.nic.in/ Transparency and Disclosures • Global wind energy council (GWEC) statistics Although this factor is not mentioned in the table above, we • European wind energy association (EWEA) statistics believe that this is one of the most important factors to instill • Various investor interviews confi dence in investors. Some cues to enhance the transpar- ency can be borrowed from SEBI. According to SEBI regula- (The views expressed in the article are personal and do not tions, mutual fund houses have disclose their stock holdings, refl ect the offi cial policy or position of the organisation.)

THE INDIA ECONOMY REVIEW 157 M ICRO MACRO Mismatch between Entrepreneurial Intention and Environment - A Survey in Burdwan District of West Bengal

158 THE IIPM THINK TANK E NTREPRENEURIAL ETHOS

Hofer(1991) - an entrepreneur is defi ned as one who Soumyendra K. Datta perceives a profi t opportunity and undertakes an organiza- Professor, Department of Economics, tion to initiate newer product and technology to achieve Burdwan University, Burdwan the objective with some degree of risk. These three factors like initiative to launch something new, drive to attain certain objective and fulfi l certain Rimu Chaudhuri unsatisfi ed need and taking of risk are supposed to be the Research Student, Department of Economics, three main corner stones, based on which entrepreneur- Burdwan University, Burdwan ship can be said to blossom. The blossoming of the process of entrepreneurship is usually supposed to be conditioned by the demographic, psychological factors and the mental make up to accept challenges, attain a specifi c goal, motivational attitude to create new ventures etc. Introduction These are refl ected in the intention of a person to achieve The spate of events in recent years in the wave of globaliza- something new. tion and liberalization have brought forth severe uncertain- ties in the industrial sphere. Unpredictable shift in demand Small Industries- pattern and corresponding need to adjust production Congenial to Flourishing Entrepreneurship capacity, fl exibility in labour market and rapid changes in In order for the small sector to help incite the quality of technology - all have posed great problem to a smooth entrepreneurial attainment, it is necessary that aforesaid development of the large scale sector. The large scale quality be present in the individual seeking employment in sector run mostly on the method of the small scale sector. Now there are mass production, produce customized The concept of many people in our country who seek product, use lumpy capital and capital entrepreneurship some subsistence or just above subsist- intensive technology. Besides this, the is too complex to ence type of employment in the small recent events have unquestionably led to informal sector involving petty trade or shrinking employment opportunities be explained services. Usually they do not create and changes in job orientation. Added to by a single organization and hardly have any this has been a lack of co-ordination in set of factors or substantial money to take any drive to skill formation and job prospects. The other variables launch on a profi table venture. However relative lack of adaptability of large in the small industrial set up, be it sector to a rapidly changing circumstances and inability to formal or informal, there is often enough scope for a absorb a rising labour force has in recent times brought fl ourishing of entrepreneurial spirit. into prominence the adjustive and complementary role of It is usually assumed that the small scale sector can small sector in the development of the country. Accord- quickly respond to changes in demand pattern adjustive to ingly the aspect of self- employment through fl ourishing of fl exible use of labour and capital and can relatively easily entrepreneurial development in small scale sector has develop along the sub-contracting mode of production. acquired great importance in recent period and requires Multi-skilled worker and multi-purpose capital is said to be incisive analysis. the corner stone in the development of small sector. However innovative development in the small scale sector Key to Entrepreneurship presupposes adequate skill formation in the relevant However, the concept of entrepreneurship is too complex labour group, aptitude and orientation to take risk and to be explained by a single set of factors. Combining the mental and psychological upbringing to face the challenges defi nition of Schumpeter(1934), Korzner(1985), Bygrave & in uncertain market prospect. Aptitude and orientation to

THE INDIA ECONOMY REVIEW 159 M ICRO MACRO

Table 1: State Wise Origin of the Entrepreneurs take risk as manifest in the attribute of entrepreneurial intention is often shaped and governed by a combination of Statewise origin No of entrepreneurs external factors clubbed as entrepreneurial environment. It Marwari & Gujrati 40 encompasses a host of overall economic, cultural, social Bihari 6 and political dimension that promote or even sometimes Punjabi 3 discourage entrepreneurial propensity of an individual. Bengalee 11 Source: Compiled from data based on personal interview with the entrepreneurs Entrepreneurial Environment : A Driving Force Gnyawali and Foget grouped the entrepreneurial environ- ment into fi ve dimensions- government policies and Table 2: Motivational Background producers(import/export restrictions, entry barrier, etc);

Family Friends VRS No Job Risk -loving socio-economic conditions (public attitude towards entrepreneurship, presence of experienced entrepreneurs, Non-Bengalee 47 - - - 2 etc); entrepreneurial and business skill (entrepreneurial Bengalee 4 - 1 5 1 training programmes, availability of information etc); Source: Compiled from data based on personal interview with the entrepreneurs fi nancial support to business (venture capital, low cost loans, etc); and non-fi nancial support to business (coun- Table 3: Academic Background seling and support services, entrepreneurial networks, etc). The authors review the existing literature on environment Academic Qualifi cation No of Entrepreneurs for entrepreneurship and list the empirical evidence for the Engineer 2 factors that they consider infl uential in promoting entre- Non-technical graduate 40 preneurial activity. Thus entrepreneurial environment Under Graduate 14 mediate the relationship between entrepreneurial intention Non-Matric 4 and entrepreneurial resourcefulness. However, there is Source: Compiled from data based on personal interview with the entrepreneurs often observed to exist a mismatch between entrepreneuri- al intention and entrepreneurial environment that dampen Table 4: Technological Inclination of the the spirit of entrepreneurial resourcefulness. Entrepreneur Quintessence of Entrepreneurial Resourcefulness Technology in Use No. of Entrepreneurs Entrepreneurial resourcefulness mean the ability to New technology used 33 identify opportunities in the environment and regulate and Old technology used 27 direct behaviour to successfully cope with the task of R and D NIL creating and managing an organisation to pursue the Source:Compiled from data based on personal interview with the entrepreneurs opportunity. Following the concept of Kanungo and Misra,

Table 5: Technical Aspects of the Surveyed Entrepreneurs

Level of Investment No of entrepreneurs Years of existence of Labour skill Single as Types of product the enterprise well as multiple Rs10.5 – 25.5 lakh 9 <10 years Both type Multiple Rs 25.5 - 50.5 lakh 8 12- 14 years Both type Multiple Rs 50.5 lakh – 1 crore 4 25 years Both type Multiple Rs 1 crore and above 39 >40 years Both type Multiple

Source: Compiled from data based on personal interview with the entrepreneurs

160 THE IIPM THINK TANK E NTREPRENEURIAL ETHOS

Table 6: Results of the GET Test

Characteristics With or above average frequency Percentage of such entrepreneurs Need for achievement 10 16.67 Need for autonomy/independence 30 50 Creative tendency 10 16.67 Moderate/ calculated risk taking 45 75 Drive and determination 8 13.33 Source: Compiled from data based on personal interview with the entrepreneurs entrepreneurial resourcefulness can be said to comprise This sector exhibits ample scope for lessening the unem- three generic competencies – cognitive, affective and ployment problem in our country, if proper motivation and action oriented. Cognitive competency refers to the leadership quality is manifest among the potential youth in effective management of thought processes, beliefs and a vibrant entrepreneurial environment. In our country, expectations. Six components of cognitive competence are despite several fi ve year plans, the unemployment situation identifi ed which contribute to entrepreneurial resourceful- is still persistent with frightening magnitude. Also there ness. These are – ability to analyse and make sense of large exists various kinds of imperfections and ineffi ciency in volumes of information, ability to take risk, innovativeness, the market functioning that hinders the prospect of newer ability to perceive and make sense of equivocal realities, jobs. In such a scenario, nurturing of small scale entrepre- tolerance for equivocality and uncertainty, high effort- out- neurship may at least partially solve the present unemploy- come expectancy. ment problem. Affective competence refers to the management of emotional arousal. Five kinds of affective competence are Present Industrial Features of the Study Region identifi ed for entrepreneurs - ability to control feelings of The above argument is pertinent to the global problem of withdrawal and depression, competitive desire to excel, unemployment as far as Indian economy is concerned as a ability to persevere, high central life whole. In our study as already alluded to, interest, dissatisfaction with status quo. we seek to analyse the potential of Action oriented competence is the Affective entrepreneurial development in a local management of intentions and action competence perspective. The Kulti-Asansol-Barakar orientations. Four main components are refers to the region in the Burdwan district of West identifi ed - ability to take charge and management of Bengal has long been famous as the core lead employees, ability to infl uence industrial belt of the state. external agencies, ability to fi nd, mar- emotional arousal Notable major industries in the region shal and control resources, ability to and there are had been establish strong networks. five variants 1. Chittaranjan Locomotive works, Chittaranjan Motivations of the Study 2. Hindustan Cables, Rupnarayanpur In this backdrop it seems imperative to study the prospect 3. Indian Iron and Steel Company, Burnpur and potential of promotion of entrepreneurial opportuni- 4. Indian Iron and Steel Company, Kulti ties in a region which has a glorious history of industrial 5. Cycle Corporation of India, Asansol development. Kulti-Asansol-Barakar region in West 6. Damodar Valley Corporation , Mython Bengal is one such region which might serve as a source of 7. Eastern Coalfi elds ltd, Asansol nurturing and promoting entrepreneurial qualities among 8. J.K Paper Mill, J.K. Nagar potential risk taking entrants in the small industrial sector. 9. Raniganj Paper Mill, Raniganj

THE INDIA ECONOMY REVIEW 161 M ICRO MACRO

10. Burn Standard Company ltd, Burnpur entrepreneurship should be considered as the mix of 11. Disergarh Power Supply Corporation, Disergarh intention, drive and capacity to undertake continuous 12. Chinakuri Power Station , Chinakuri. process of change in accordance with risk calculated 13. Alumunium Factory , Asansol. prospects of market demand. The selected entrepreneurs 14. A large number of mining companies are mostly engaged in activities like steel casting, fi re However the present situation is a bit different as most of bricks, machinery, parts and components, consultancy, these major industries in the region have closed down and trading etc. some are marked as sick industries. The aforesaid phenom- enon has left many skilled workers jobless and many have Findings Related to Demographic, retired with VRS. In the absence of any emerging alterna- Educational and Motivational Aspects tive employment opportunities, small scale entrepreneurial The origin of the entrepreneurs pertaining to the state they fl ourishing can somehow mitigate the joblessness scenario belong to, has been classifi ed in Table 1. in this predominantly industrial region. This can take place The striking feature of the entrepreneurial pattern in through two ways- (a) the existing small scale entrepre- the region is that most of the entrepreneurs are non-Ben- neurs are motivated to expand their market by diversifying galee and it is further dominated by Marwari and Gujrati. the quality and type of their product. This might require It is startling to fi nd that the Bengalees are far behind in employment of more workers to produce the output taking entrepreneurship as a career in their home state. targeted at the market and employment of skilled person- The classifi cation of motivational support the entrepre- nel at the R&D sector to devise ways and means for the neurs received from in building their career leads to required diversifi cation, (b) on the other Table 2. hand fl ourishing of an entrepreneurial The data in Table 2, suggests that environment can allure more and more There exists non-Bengalees are motivated mostly by skilled workers to the option of taking an little scope for their families. Most often in such cases entrepreneurial drive by setting up absorbing further the entrepreneurs joined in their family independent small industry. employment in run enterprise which were started by their ancestors. The corresponding Objective and the existing small Yule’s co-effi cient of association be- Methodology of the Study scale industries in tween family and non-Bengalees is The objective of the study is to focus on the region rather high at the value 0.952. The whether the existing small industrial continued functioning of an enterprise entrepreneurial spirit in the region is conductive to promo- from the past and its competitive existence in the present, tion and development of such an entrepreneurial environ- marks the fact that adoption of an entrepreneurial career ment as would to some extent mitigate the unemployment by the non-Bengalees appear to be devoid of any great among the skilled / semi skilled population. perceived risk. So the very attribute of the risk taking is With the purpose in view, 60 small entrepreneurs were almost dissociated from these so-called entrepreneurs. In interviewed in the concerned locality. Data were collected the case of Bengalees, however, motivation emerged from a to refl ect on the demographic and educational background, variety of factors like family, no-job, VRS scheme, risk nature of technology, risk perception etc. Further a ques- taking attribute etc. The academic background of the tionnaire in line with General Entrepreneurship Test entrepreneurs as evident from Table 3, suggests a great lack (GET) was also devised to elicit the psychological inclina- of forward looking vision and an indifference regarding the tion of the said sixty industrialists to undertake entrepre- importance of R&D expenses for continuing adoption and neurial drive. The test is meant to serve as a psychological implementation of improved technology. measure of entrepreneurial spirit or inclination among the Table 3, reveals that most of the entrepreneurs in the respondents. In this context , it needs to be stressed that surveyed region are not well-educated, having little knowl-

162 THE IIPM THINK TANK E NTREPRENEURIAL ETHOS

edge of technical education in their fi eld of entrepreneur- neurs, supposed to be necessary to have a dynamic, ship. This is likely to adversely affect their ability and vision innovative view for promotional efforts of the enterprise, is to have a dynamic view of the future and associated drive tested under several attributional headings. For instance to undertake innovative efforts. This is important since frequencies corresponding to the following sections of movement and mobility have an integral part in the march attributes formed by several sub- attributes with the of human history all over the world. Human advancement needed optimal and average scores are documented in swings between two poles of movement and settlement. Table 6. Education is one of the factors that infl uence dynamism in Table 6 reveals that excepting the fourth category, in vision, spirit and drive. It enlarges one’s thinking ability terms of all the attribute characters, the entrepreneurs do and horizon of understanding. not have the requisite scores in the corresponding category that might strongly refl ect on their enterprising spirit and Attitude to Technology tendency for a development oriented outcome. Majority of The fact that comparatively inadequate education of the so called entrepreneurs did not pass the test for being entrepreneurs has a negative bearing on the forward dubbed as persons with entrepreneurial acumen and vision. looking vision is evident from Table 4. It is to be noted that only eight entrepreneurs passed all the Table 4 shows, that 33 entrepreneurs have shown inclina- tests and satisfy the criteria of possessing the requisite tion to adopt newer techniques but almost half of the attributes expected of an entrepreneur. This also indicates number still go on using old fashioned techniques and that true intention refl ecting a person’s attention towards a unfortunately none of the sample entrepreneurs undertake specifi c goal in order to achieve something is not mani- any R&D expenditure to upgrade their fested in the psychological attitude of existing methods. This is suggestive of a the interviewees. static view of their future promotional Comparatively Flourishing of entrepreneurial efforts. Other technical aspects of the inadequate resourcefulness requires a matching of surveyed entrepreneurs can be consid- education has a positive entrepreneurial intention with ered from Table 5. negative bearing positive entrepreneurial environment. Table 5 reveals that, relatively larger Any deviation from the above combina- investment in small scale industries have on the forward tion may be viewed as a mismatch been made in enterprises which have looking vision of between entrepreneurial intention and continued to exist for relatively longer entrepreneurs environment. A sound environment in years. These are mostly family run enter- combination with positive drive is prises from the past. Although the industries produce necessary for fructifi cation of entrepreneurial resourceful- multiple products to avoid risk, in many cases this has been ness and concomitant ripples in the society in terms of happening from the decision of their ancestors. Newer vari- more and more people opting for the entrepreneurial eties are hardly introduced. In this context it may be noted career. Entrepreneurial resourcefulness can be defi ned as that the age of the entrepreneurs vary from 29 years to 45 the ability to identify opportunities in the environment years, the modal age group being 37-40 years. This indi- and regulate and direct behaviour to successfully cope cates that most of them have inherited the enterprises from with the task of creating and managing an organization to their earlier generation but lack the drive expected from pursue the opportunity. This may be viewed as the culmi- them. The lack of forward looking entrepreneurial attitude nation of adoption of successful entrepreneurial activities is also vindicated by the results of GET test as devised by in a region. Durham University, U.K. A View of Entrepreneurial Results of the GET Test Environment in the Region The psychological orientation of the so-called entrepre- An entrepreneurial environment, as already referred to,

THE INDIA ECONOMY REVIEW 163 M ICRO MACRO

implies a combination of socio-cultural, economic and they visualize the potential entrants as possible contenders. political factors that infl uence an individual’s ability and Hence the drive should emerge from NGOs or even from proclivity (either positively or negatively) to initiate entre- Government sponsored agencies to launch programmes preneurial activities in a region. The survey conducted that might activate the entrepreneurial vivacity in the among the entrepreneurs regarding their perception of adjoining region. The provision of loans on easy terms and entrepreneurial environment yields a mixed kind of with little complexity need immediately be introduced for information that is tilted towards a bleak view of the potential entrants in small sector. Again entrepreneurship environment. There is a network or common forum for the training institutes need to be established in every major small scale industries to discuss and solve their mutual industrial belt with suffi cient advertisement for the future problems. It acts as a representative for the small scale prospect of its users. Entrepreneurship as a career has not industries in the region. The forum gives a positive re- yet gained currency in our society. This needs to be re- sponse for the dissemination and encouragement of versed. For this purpose, introduction of an entrepreneur- entrepreneurship in the region but has hardly any vision or ship course at school as well as at college level can hardly drive to achieve it. It has never taken any initiative to await any further delay. Only then some tangible effect disseminate its prospects among potential entrants. It also might be achieved in lessening the problem of unemploy- does not have any information about whether entrepre- ment through the fl ourishing of entrepreneurial resource- neurship training programmes / institutes are available in fulness in our society. the surrounding region. There exists good scope for obtaining loan on easy terms for bigger industries in the References and Additional Thinking region but small industries are not so fortunate, they have • Balasubrahmanya, M.H. 2003.Technological Innova- to face various problems. The industries however can tions in Small Enterprises- A Comparative Study of Ban- obtain counseling or support service from the forum. The galore and North- East England, EPW, May 24th. forum strongly felt that goverment policies were not • Bhide, Sheela.2000. Development Of Small Scale conducive to their fl ourishing; specially they felt that the Industries – A Collaborative Approach, EPW, Novem- VAT was inimical to their growth. These views are refl ec- ber 25th. tive of the fact that the entrepreneurial environment in the • ICSI .1996 .Herald, Vol 7, Nov 4. study area is rather dampening of the entrepreneurial • ICSI .1997. Herald, Vol 8, Nov 7. intention or spirit surrounding the region. • Kanungo, R.N & S. Misra. 1992.‘Managerial Resource- fulness: A Reconceptualization of Management Skills’, Way Forward to Avoid the Present Gloom Human Relations, 35-12. The aforesaid analysis reveals that there exists little scope • Misra, Sasi & E.Sendil Kumar.2000. Resourcefulness: for absorbing further employment in the existing small ‘A Proximal Conceptualization of Entrepreneurial scale industries in the region. Although they produced Behaviour’, The Journal of Entrepreneurship, vol 9,no 2. multiple products to avoid risks, there was not any drive to • Mukherjee, Robin., Pranab .K. Das & Uttam K diversify their quality and hardly any research and develop- Bhattacharya.1999.‘Small Scale Industries In West ment initiative. So the potential of absorbing skilled Bengal, 1971-97-Data Analysis For Study Of Growth’, technicians, personnel in the existing small scale sector has EPW, November 27th. rather been bleak in the region. Besides this, the entrepre- • Nath , V. 2000. Entrepreneurship By Region & Caste-A neurial environment in the region has been mostly discour- Survey , EPW, November 25th. aging for the potential entrants. Although the existing • Streefkerk, Hein .1997.Gujrati Entrepreneurshp, EPW, entrepreneurs stated in the affi rmative regarding the Vol 32. No-7. February 15th-21st. importance of fl ourishing of entrepreneurial spirit in the region, from the core of their heart they have not taken any (The views expressed in the article are personal and do not initiative to disseminate it across the locality. Besides this, refl ect the offi cial policy or position of the organisation.)

164 THE IIPM THINK TANK M ICRO MACRO Microfi nance at Turning Point: Success Factors of Microcredit in Bangladesh and Its Future Prospects

Illustration : Shantanu Mitra

166 THE IIPM THINK TANK S OCIAL EDGE

Introduction Tomohito Kanaizuka Based on the unique concept of utilising the abilities of the ODA Loan Program Specialist, poor for improvement of their own lives, the scheme of micro- Japan International Cooperation Agency fi nance has been continuously expanding its outreach for (JICA), Tokyo, Japan approximately 30 years. In these 30 years, microfi nance has grown from only a tiny economic experiment to a major public policy of poverty alleviation and has reached more Farhad Hossain than 133 million people in developing countries around the Lecturer, Institute for Development Policy and world (Microcredit Summit Campaign (MSC), 2007). Further- Management (IDPM), School of Environment more, quite surprisingly, microfi nance is still growing its and Development, University of Manchester, outreach at a remarkably rapid rate every year1. It is undoubt- Manchester, United Kingdom edly one of the most important schemes of today’s poverty reduction initiatives. However, despite the extremely high popularity of the microfi nance movement and its positive impact to the lives of the poor, Hulme and Moore (2007) explained that the idea of enabling and empowering the poor by providing them with small loans was actually considered as ‘disastrous policy’ when movement was started in the late 1970s in Bangladesh. Furthermore, even after microfi nance established itself as a widely accepted policy of poverty alleviation, it continued to receive heavy criticism with regards to high interest rates, exploitation of women, loan repayment, unchanging poverty levels and failure to cater effectively to the target groups in addition to the numerous accolades (Mallick, 2002; Brau and Woller, 2004). As there are such criticisms, it still remains unclear what are the real success factors of microfi nance, which made it possible to become such an extremely successful scheme. Moreover, the future of the microfi nance scheme has rarely been considered. In order to explore these important themes, the authors have separately visited Bangladesh in July and in December 2007 and conducted a thorough evaluation of the operation of Grameen Bank and socio-economic environment of Bangladesh that surrounds Grameen Bank. Based on empirical fi ndings from these two fi eld visits reinforced by insights from relevant literature, this paper will fi rst look at the background of how microfi nance emerged. Second, the paper will explore the unique characteristics which differenti- ate microfi nance from other poverty-reduction initiatives and enable the microfi nance scheme to grow and be self-sustaina- ble. Third, the paper will explore and identify success factors of the scheme. Finally, this paper will attempt to determine the future of the scheme by considering how socio-economic

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changes would infl uence the success factors identifi ed in the has signifi cantly decreased3, a substantial number of people previous section. still remains poor. According to World Bank (2008), ‘it has been estimated that in 2001, 1.1 billion people had consump- II. Review of Origin and tion levels below $1 a day and 2.7 billion lived on less than $2 Potential of Microfi nance Scheme a day.’ This suggests that there has not been any scheme Origin of Microfi nance which has succeeded to fundamentally change the situation The source of poverty is not traced back to a single root; of developing countries. Although there is also no guaran- people become poor for various reasons such as civil war, tee that microfi nance can change the situation radically, it corruption, natural disasters, lack of basic education and so has two signifi cantly different characteristics that may allow forth. Among the different sources of poverty, Yunus identi- it to do so in the future. fi ed the lack of access to formal fi nancial services as a critical The fi rst characteristic is that, as previously mentioned, cause of poverty. In developing countries, the majority of the microfi nance utilizes the ability of the poor themselves for poor usually do not have any access to formal banking the purpose of improving their lives. In microfi nance, MFI services and have to depend on usurers who charge extremely lends seed or operating capital to the poor often without (often illegally) high interest rates on loans. Yunus and Jolis any collateral, credit history or steady income, for their described the disastrous situation of the poor who borrow proposed income-generating activities (Kota, 2007). Unlike money from money-lenders as follows: such activities as giving of commodities (food, clothes, ‘…in all cases it is extremely diffi cult for the borrower to medicines, etc.), which would only satisfy the immediate extricate him- or herself from the burden of the loan. Usually the needs of benefi ciaries, or provision of education and borrower will have to borrow again just to repay the prior loan, training, which requires time before one becomes able to and ultimately the only way out is death… Unless the poor can use the acquired knowledge and skills, the provision of such be liberated from the bondage of the money-lender, no economic capital funds brings benefi ciaries both immediate and programme can arrest the steady process of alienation of the long-term benefi ts. In order to reduce poverty, it is neces- poor.’ (Yunus and Jolis, 1998: 8) sary for the poor to acquire the skills and build the founda- In the societies of Bangladesh and other low-income tion to sustain their lives on their own on a permanent basis; developing countries where the unemployment rate is substan- microfi nance is a scheme which helps to equip the poor with tially high2, the creation of a job by such skills and foundations. In fact, it is starting a new business is one of a few Microfinance reported by Hulme and Moore (2007) effective ways to overcome poverty. utilizes the ability that there are up to half a million people However since the poor do not have access in Bangladesh alone who successfully to the fi nancial services, they are not able of the poor escape from the poverty every year as the to gain the seed capital to start up their themselves for result of effective use of microfi nance. business and as a result, it becomes an the purpose The second, yet probably more impor- unrealistic option for them to pursue. of improving tant, characteristic of microfi nance is From his fi ndings, Yunus concluded that a their lives that MFIs usually maintain and expand critical source of poverty stems from the their activities by utilizing the contribu- lack of access to the fi nancial services, and he developed the tions recollected from their own benefi ciaries (Felder-Kuzu, mechanism of microfi nance, a scheme of enabling and 2005). Unlike conventional methods of poverty alleviation empowering people through the provision of small-sized whose implementation almost always requires resources fi nancial services with affordable commission charges. provided from donors (and therefore out of the control of the poor), this characteristic has given MFIs a solid basis for Potential of Microfi nance Scheme expansion. Indeed, microfi nance has been growing at In the domain of poverty reduction, although enormous remarkably rapid rate. According to MSC (2007), the total effort has been spent and the proportion of the poor people number of clients reached by MFIs has grown from 13

168 THE IIPM THINK TANK S OCIAL EDGE

millions by the end of 1996 to 133 million by the end of any activity can be easily destructed by the government, the 2006 and numbers of MFIs reported to MSC also grew fact that Grameen Bank has always kept a friendly relation- from 618 to 3,3164. From these fi gures, it can be seen that ship with the government ruled by cabinets of different the number of clients of MFIs has grown by a remarkable political parties contributes signifi cantly to the remarkable 120 million people at the rate of ten-fold in only a decade. It success of the scheme. is important to mention that number of clients, 133 million people, does not include the clients’ families who would Well-designed Strategies also be assisted by the funds provided by MFIs. MSC (2007) Unlike conventional banking operations which can expect estimates 464.4 million people who have consumption level certain amount of profi ts from each loan, profi ts from of $1 or less are currently being helped by MFIs and that microfi nance loans are generally also ‘micro’ by their makes up approximately 40 percent of world’s poor popula- nature. Because of such conditions, it is critically important tion who falls into that category. This signifi cantly high rate for an MFI to implement highly effi cient and effective of growth and considerably wide outreach of the scheme management. From the fi eld studies, various techniques suggests that microfi nance has the potential of reaching all adopted by MFIs in order to realize low-cost management the poor in the world. In fact, Yunus reported in his Nobel were observed. Following are some of the strategies used by lecture in 2006 that 80 percent of poor families in Bangla- Grameen Bank which are widely used by various MFIs: desh have been reached by microfi nance and it is expected that 100 percent of them would be reached by 2010 (Nobel Group-lending: Among various techniques adopted by the Foundation, 2006). Microfi nance has great potential to scheme, group-lending was observed as Bangladeshi MFIs’ reach a signifi cant proportion of the poor population common lending strategy, which contributes to their around the world. effi cient management. By looking at peer-selection and peer-monitoring, two important mechanisms enacted as a III. Success Factors of Microfi nance part of the group-lending strategy, this paper will explore In the previous section, two unique characteristics of how group-lending contributes to the effi cient management microfi nance were reviewed. Now, critical factors that made of microfi nance. microfi nance a successful scheme will be identifi ed and explored based on fi ndings Peer-selection: For MFIs to secure sound from the authors’ fi eld studies to 464.4 million operation, it is necessary to screen out Grameen Bank in Bangladesh and also people who have bad borrowers who would not appropri- relevant literature. consumption level ately repay their debts. Peer-selection is a technique applied in the fi eld, which Political Endorsement of one dollar or enables an MFI to cost-effectively avoid When one tries to implement a large- less are currently such bad borrowers. Ghatak (1999) scale scheme, which would affect the being helped explained the mechanism of peer-selec- well-being of a signifi cant number of by MFIs tion as follows: While gathering local people, it is necessary to obtain support information about potential borrowers is from the government. It was extremely lucky for Yunus that costly for an MFI, local prospective borrowers already he could gain continuous support from the government by know about each other’s projects. By contracting to self- fully utilizing his personal network with high rank govern- formed groups of these prospective borrowers, MFIs can ment offi cials. He was able to obtain government support deliberately induce borrowers to select their groups in a way from the stage the scheme was only a small experiment in a that exploits this local information. village until the experiment turned into a government regulated special bank (Grameen Bank) and now provides Peer-monitoring: Likewise to peer-selection, although it is services to 7.4 million people (Grameen Bank, 2008). While important for securing sound repayment, monitoring the

THE INDIA ECONOMY REVIEW 169 M ICRO MACRO

activities of the borrowers is a costly business for MFIs. A offi cers to develop such strategies have signifi cantly contrib- useful tactic for transferring some of the monitoring costs uted to making the microfi nance scheme a major poverty to the borrowers is peer-monitoring. It is used as a part of alleviation policy today. the group-lending scheme. By designing the rules of loaning funds in such a way that one’s own loan activities positively Favourable Socio-Economic Conditions or adversely affect the loan activities of other borrowers in In addition to the two important success factors presented one’s group, MFIs deliberately induce borrowers to monitor earlier, it was observed through the fi eld studies that each other’s use of their loans. relatively poor socio-economic conditions of Bangladesh, In addition to these two mechanisms, there was another which are not necessarily good for their citizens, ironically commonly used strategy observed in the fi eld, which is serve as important success factors of microfi nance. Two important in terms of low-cost management of the microfi - important elements of the social and economic conditions nance scheme. which contribute to the success of microfi nance will be explored below. Group Meeting: Another important method of saving operational cost is the weekly group meeting. This is Ample Supply of Competitive Employees designed as a mutually benefi cial system for both MFIs and Based on Poor Employment Conditions: their benefi ciaries. Group meetings usually take place in During the fi eld surveys in Bangladesh, extremely tough the vicinity of where benefi ciaries reside. By requiring working conditions of Grameen Bank’s branch workers borrowers to calculate their weekly were observed. Regular working hours instalments and discuss applications for are already long, but during the rainy new loans among their group members Ironically, season they are even longer. Yunus and prior to the weekly meeting, MFIs can relatively poor Jolis (1999) mentioned that the average pre-sort their business concerns and socio-economic working hours for local branch employ- quickly perform their functions. In the conditions serve ees are 12 hours from 7:00 A.M. to 7:00 case of Grameen Bank, it was observed P.M. with one hour break. During the that a skilful manager collected and as important authors’ visits, it was observed that staff registered weekly instalments, accepted success factors stayed in the offi ce often until midnight and evaluated new loan applications, and of microfinance due to the infl uence of rainy seasons. transmitted inquiries from the bank to Moreover, from an interview with a 50 borrowers all in one hour. If considering that most of the senior principal offi cer of Grameen Bank, Ansaruzzaman borrowers do not have any transportation means, the fact (2007), it was discovered that while the staff have to stay they can complete all these business in one hour without long hours, no overtime allowance is paid to them as they travelling far on foot contributes to the reduction of their are required to agree on an annual salary contract upon work as well. their employment. However, according a local branch Although group-lending and group meeting are typical manager Bhuyan (2007), Grameen Bank’s working condi- strategies that are adopted by many MFIs that can consid- tions are actually still much superior to conditions at other erably help them reduce their operational costs, they are employers in the country, and in fact, Grameen Bank is an still not the strategies that are universally adopted by all exceptionally popular destination for work. In Bangladesh MFIs. In fact, strategies adopted by MFIs vary MFI to MFI where a high degree of corruption exists5 and the supply of depending on the environment within which each MFI jobs is extremely limited, obtaining a decent job is some- operates. However although strategies adopted by MFIs thing extraordinarily diffi cult. Yunus and Jolis (1999) vary a lot, their aim of reducing the cost as low as possible is mentioned job applicants must pay bribes which may be up common. There is no doubt that innovative strategies like to twenty times the monthly salary the job would bring, the ones introduced above and the efforts of microfi nance simply to obtain the job. These extremely severe employ-

170 THE IIPM THINK TANK S OCIAL EDGE

ment conditions have made Grameen Bank salaries (which a woman’s position in a family is awfully fragile; a man can is equivalent to government employee with additional divorce his wife simply by telling her so three times (Yunus retirement benefi ts) competitive. Additionally, recruitment and Jolis, 1999) and indeed, they are often abandoned by conditions that do not require application fees and enforce- their husband (Tusboi, 2006). While it is extremely diffi cult ment of strong policies against bribes make Grameen Bank for a divorced woman to fi nd a job because of the high positions remarkably attractive. Upon such favourable constraints of purdah, the family of the divorced woman hiring conditions for employers, Grameen Bank succeeded may not allow her to come back in many cases as they to hire more than 20,000 high-profi le employees6 (Grameen cannot afford to feed an extra mouth. Because of such Bank, 2007) but there is no doubt that the commitment of extreme situations, married women in Bangladesh generally such capable and dedicated staff signifi cantly contributes to live highly oppressed lives under the fear of being aban- the high-performance of Grameen Bank. As the socio- doned by their husband. For those women, microfi nance is economic environment affects not only Grameen Bank but an important and rare opportunity for them to improve also all the organizations in the country, it can be expected their position in the family; in Bangladesh, the provision of that all other MFIs in Bangladesh have benefi ted consider- a microfi nance loan is a rare privilege usually entitled only ably from the unfortunate socio-economic condition, to women, not men. Regarding the provision of microfi - though favourable for employers. nance loans to women, Yunus and Jolis (1999: 88) men- tioned ‘Being poor in Bangladesh is tough for everyone, but Dedicated Commitment of Borrowers being a poor woman is the toughest of all. When she is given Based on Severe Gender Inequality: the smallest opportunity, she struggles The second socio-economic condition, Being poor in extra hard to get out of poverty.’ Arsheda, which works favourably for MFIs in Bangladesh a village borrower interviewed by the Bangladesh, is severe gender inequality is tough for author, mentioned that she was also a in the country. In Bangladesh, there are everyone, but powerless woman totally ignored by her many customs that considerably limit the family before she enrolled in microfi - scope of activities in which women can being a poor nance, but she gained respect and trust engage; under such conditions, men keep woman is the from everyone as she succeeded in her their dominating power over women. toughest of all cattle raising business and became only Among the different customs, there are literate person in the family. Arsheda two major ones that tremendously affect women’s lives. The said being trusted and respected by others are the most fi rst one is called purdah. Purdah is a set of norms that important values in her life, and the excitement from this exclude women from public spaces by enforcing restricted motivated her to overcome the diffi culties of repaying debt. mobility, giving them specifi c gender labour roles, and It is certainly important to remember that the desperate prescribing legitimate behaviours (Newaz, 2001). The extent efforts made by literally millions of struggling women are of activities regulated by purdah is extremely wide so that the driving forces underlying the outstanding achievements women often need to ask for their husband’s permission of microfi nance. even to go to their neighbours (Tsuboi, 2006). Dowry is another custom, which adversely affects women’s lives. IV. Analysis of Success Factors Dowry is a signifi cant value of property or money brought and Future Prospects of Microfi nance by bride to her husband and his family, which often deter- The main success factors of microfi nance scheme were mines the prospect of the wife’s position in the family reviewed in the previous section. However as society is (Newaz, 2001). Dowry is considered a detrimental custom ever-changing, the importance of each success factor also for women’s status in the family because it often becomes a changes. In this section, the paper will attempt to forecast source of domestic violence and in the worst case becomes the future prospects of microfi nance by analyzing the even a cause for murdering the bride (Tsuboi, 2006). In fact, success factors as related to changes in the environment and

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society in which microfi nance is performed. and their wages will be raised. Although these additional costs must be fi nanced from the interest payment of bor- Changes in Importance of Political Endorsement: rowers, it would not be possible to do so if such costs A good example of changes in the importance of the become more than borrowers can afford. In the case of success factors is the changing importance of political Grameen Bank, General Manager Shahjahan (2007) endorsement for the microfi nance scheme. At the very identifi ed two major countermeasures to prepare for this beginning of microfi nance scheme when it was only a small possibility. The fi rst measure is computerization of branch experiment, fi nancial and legal support from the govern- accounts. By computerizing branch accounts, Grameen ment were critically important. However in the current Bank is trying to make their operation more effective while operation, Yunus has secured a solid legal background and reducing the number of people required for operation. also a strong fi nancial basis, which allows the bank to According to Grameen Bank (2008), almost all the branch fi nance 100 percent of its loans from collected deposits accounts (2,418 out of 2,481) have already been computer- (Yunus, 2007). As a result, the relative importance of ized. Another measure is early retirement program. At political endorsement has drastically decreased. In the Grameen Bank, if an employee works for 10 years, that present operation, Grameen Bank and many other MFIs employee will be entitled for early retirement and be able to in Bangladesh have become strong enough to operate on leave the bank with a considerable amount of retirement their own as long as the government is not too destructive benefi t7. Shahjahan (2007) explained that about 25 percent for them. of employees take this option. A policy like this one seems to give Grameen Bank greater control Changes in Socio-economic Conditions over their human resources as they can and Their Infl uence to the Strategies: MFIs based on effectively control the size of the organi- As mentioned above, political support is conventional zation by manipulating the retirement no longer a big issue for the current group-lending policy and the number of employees to operation of microfi nance in Bangladesh. strategies will face be recruited. These are just a few This is because MFIs have grown and examples of the measures taken by a become able to support their activities serious problems leading MFI in Bangladesh; further without receiving governmental assist- if they keep using studies are required in order to fi nd out ance. However unlike government old strategies what preparations are taken by other support, there are other factors such as MFIs. However one thing is sure at this socio-economic conditions, which are out of the control of point; each MFI must establish suitable measures for MFIs. Regarding such factors, it is necessary to consider themselves as it is reasonable to expect that improvement in how these external factors would change in the future and employment conditions would occur in Bangladesh at some how these changes would infl uence the scheme. This paper point in the future. will look at the infl uence of potential changes in two socio-economic conditions and how these changes would Possible Effects of the Changes in Gender Inequality: affect the strategies adopted by MFIs. Regarding the gender inequality issue, there is some evidence which indicates that gender equality is being Possible Effects of the Changes in Employment Conditions: promoted in Bangladesh. For example, in the area of There is unfortunately no evident sign which foretells that education, currently there are even more female students employment conditions in Bangladesh would be signifi cant- enrolled than male students (1.03 of female/male ratio) and ly improved in the near future. Nevertheless, it is important as a result, the gap in literacy rate between the two genders to consider this possibility because it would greatly affect has been quickly diminishing8 (UNDP, 2007). The Bangla- the future operation of microfi nance. If employment deshi government also has been taking extra effort to conditions are improved, both the cost of staff recruitment increase women’s participation in their parliament. Accord-

172 THE IIPM THINK TANK S OCIAL EDGE

ing to UNDP (2007), the Bangladeshi government added 45 manage each branch and the interest rate charged to each seats in their parliament exclusively for women in 2004 and borrower would need to be increased as a result. However, as a result, the share of the seats occupied by women in the if the interest rate is too high, it would no longer possible for parliament was increased from two percent in 2003 (UNDP, poor clients to borrow money from MFIs. On the other 2003) to 15 percent in 2007 (UNDP, 2007). These are just a hand, if MFIs tried to merge branches in order to increase few examples but there are many more examples of the the number of people per branch, it would become diffi cult promotion of gender equality in Bangladesh. for borrowers to come to the weekly meetings and become Unlike improvement in employment conditions, which no longer feasible for them to use microfi nance. In addition, increases the management cost, promotion of gender as the number of people who need microfi nance loans will equality does not necessarily infl uence microfi nance be decreased, it would become harder for potential borrow- scheme in a negative way. This is because regardless of ers to fi nd suitable group members as well. All of these women’s position in the family, their fi nancial situation situations mean that MFIs based on conventional strategies remains the same and the need for microfi nance remains. of group-lending will face serious problems which would For that reason, although improved position of women in not allow them to operate further if they will keep using the family would reduce the degree of their commitment to these strategies without making further improvement. microfi nance as they would no longer be as desperate as Improvement in strategies seems to be an absolutely they are now, it also could be expected that commitment of necessary condition for the future of microfi nance. men to microfi nance would be increased. A separate study would be necessary to V. Conclusion evaluate the effect of promotion of Promotion Microfi nance is a unique method of gender equality on microfi nance. of gender alleviating poverty with the concept of equality does empowering people with their own Evaluation of Effectiveness of not necessarily abilities. In microfi nance, even the Current Strategies in the Future: influence MF maintenance and expansion of the As reviewed earlier, the strength of scheme is usually done based on the microfi nance comes from the fact that scheme in a contributions collected from the benefi - microfi nance scheme is managed by negative way ciaries. These characteristics of self- utilizing the power of the poor them- sustainability and self-expansion have selves. In microfi nance, various strategies are adopted in given the microfi nance an outstanding power of expanding order to make it possible for MFIs to run the scheme using its outreach. Currently 40 percent of world poor who live the tiny amount of interest charges collected from the under the consumption level of $1 per day are expected to borrowers. It was reviewed that group-lending is an effec- be benefi ting from the scheme (MSC, 2007). tive method of economizing the management costs adopted Through the results of recent fi eld studies conducted in by different MFIs. However, it may become diffi cult to use 2007 and literature reviews, this paper has concluded that such a method in the near future in Bangladesh. As men- political support, which provided legal and fi nancial basis, tioned earlier, Yunus said that microfi nance could reach was a critical success factor of the microfi nance scheme almost 100 percent of the poor families in Bangladesh by during its initial stage. Regarding the current operation of 2010 (Nobel Foundation, 2006). Whether or not that would microfi nance, this paper provided two key success factors. become reality is still unknown however the possibility has The fi rst factor was well-designed strategies adopted by signifi cant meaning. Microfi nance may reach a peak at MFIs. In microfi nance, by defi nition, MFIs can expect which point there may be no way it could expand further. As only a ‘micro’ profi t from each benefi ciary but they still more people escape from poverty and quit being clients of have to grow from these tiny earnings. This paper ex- MFIs, the number of benefi ciaries which belong to each plained how the strategies based on group-lending branch may decrease. At that point, it will cost more to enabled MFIs to run their activities cost-effi ciently, so

THE INDIA ECONOMY REVIEW 173 M ICRO MACRO

that they could expand their activities from these small Endnotes incomes. The second success factor was favourable 1 The number of poorest clients reached by the all the socio-economic conditions (for MFIs). It was explained MFIs reported to MSC in the world was increased by 22 that severe employment conditions in Bangladesh enabled percent in average for past fi ve years (2001-2006) MFIs to recruit and use quality staff at relatively low cost. according to the data from MSC 2007 On the other hand, it was also explained that harsh gender 2 According to Bangladesh Bureau of Statistics (2007), inequality exists in Bangladesh makes microfi nance loans unemployment rate (including underemployment) for one of the rare opportunities for women to improve their 2005-2006 was 28.7 percent. status in the family, thus raising their commitment to 3 According to World Bank (as quoted by United Nations repaying their loans. Development Programme 2005), proportion of the Socio-economic conditions in one country and the people who live under $1 per day in the world was effectiveness of the strategies implemented by MFIs are decreased from 40.4 percent in 1981 to 20.7 percent in changeable over an extended period of time. In this paper, 2001. the future prospect of the microfi nance scheme was 4 These fi gures merely represent the data of MFIs evaluated by analyzing the success factors of current micro- reached by MSC. There is high possibility that there are fi nance operations. From the analysis, it was concluded more MFIs and people reached by them but not yet that changes in socio-economic conditions would have recognized by MSC. Please refer to MSC (2007) for the considerable impact over the future of microfi nance, and details of the data. therefore changes or improvements to the current strate- 5 Transparency International (2006) ranked Bangladesh gies must be developed in order for microfi nance to remain 156th among 163 countries listed in Corruption Percep- a successful scheme of poverty alleviation in the future. tion Index 2006. The Corruption Perception Index is an In the past, reaching all the poor in the world was the internationally accredited index released every year by fl agship target of microfi nance. Although it still has a long Transparency International which ‘ranks more than 150 way until microfi nance reaches this target, on a national countries by their perceived levels of corruption, as level in Bangladesh, it is close to becoming a reality. It determined by expert assessments and opinion surveys’ seems highly possible that microfi nance would reach its (Transparency International n.d.: n.p.). For more peak in Bangladesh in near future because of the scheme’s information, please refer to http://www.transparency. high growth rate. Reaching the peak will mean that there org/policy_research/surveys_indices/cpi. will be fewer prospective new clients for MFIs in the 6 According to Yunus and Jolis (1999), Grameen Bank country and the number of benefi ciaries will decrease. The requires applicants for branch manager to have a number of clients served per branch would decrease and master’s degree with the average grades of B or better the cost of managing a branch per person would increase. and applicants for center (the lowest unit of fi eld opera- That would also mean fewer potential clients in a village tion) to have at least two years of college education with and more diffi culty in fi nding group members for prospec- average grades of B or better in college and high school. tive clients. All of these situations lead to the conclusion 7 According to Shahjahan, approximately $10,000 is the that MFIs based on conventional group-lending strategies amount to be paid for young center managers who will face serious problems if they will keep using these started to work at 18 years old. strategies without making further improvement. The 8 Female/ male youth literacy ratio was increased from moment microfi nance reaches its peak will occur in a 0.71 in 2005 (UNDP 2005) to 0.9 in 2007 (UNDP relatively short period of time and it will be the critical 2007). turning point of the microfi nance scheme. For the future of all the poor in the world, further innovation on the strate- References and Additional Thinking gies of microfi nance is eagerly desired and continuous • Bangladesh Bureau of Statistics (2007) Key Findings of attention must be paid for such efforts of innovation. Labour Force Survey 2005-2006, Bangladesh Bureau of

174 THE IIPM THINK TANK S OCIAL EDGE

Statistics [Online], Available: http://www.bbs.gov.bd/ • Tsuboi, Hiromi (2006) Do You Know Grameen Bank? dataindex/labour_%20force05-06.pdf [Accessed: 23rd [Grameen Ginko o Shitte Imasuka], (Tokyo: Toyo January, 2008] Keizai Sinhou). • CIA (2008) The World Fact Book: Bangladesh, Central • United Nations Development Programme (UNDP) Intelligence Agency [Online], Available: https://www. (2007) Human Development Report 2006 Beyond cia.gov/library/publications/the-world-factbook/geos/ Scarcity: Power, Poverty and the Global Water Crisis bg.html#People [Accessed: 24th January, 2008] (New York: Palgrave Macmillan). • Daley-Harris, Sam (2007) State of the Microcredit • United Nations Development Programme (UNDP) Summit Campaign Report 2007, (Washington D.C.: (2005) Human Development Report 2005 International Microcredit Summit Campaign). Cooperation at Crossroads: Aid, Trade and Security in • Felder-Kuzu, Naoko (2005) Making Sense: Microfi - an Unequal World (New York: UNDP). nance and Microfi nance Investments [Nyumon Microfi - • United Nations Development Programme (UNDP) nance], (Tokyo: Diamond). (2003) Human Development Report 2003 Millennium • Ghatak, Maitreesh (1999) Group Lending, Local Development Report Goals: A Compact among Nations Information and Peer Selection. Journal of Develop- to End Human Poverty (New York: Oxford University ment Economics 60(1999), pp. 27-50. Press). • Grameen Bank (2008) Grameen Bank Monthly Up- • World Bank (2008) Understanding Poverty: What is dates in US$: December, 2007, Grameen Bank, Dhaka. Poverty?, World Bank [Online], Available: http://go. • Grameen Bank (2007) Past Ten Years at a Glance worldbank.org/RQBDCTUXW0, [Accessed: 9th (1997-2006), Grameen Bank [Online], Available: http:// January, 2008] www.grameen-info.org/bank/tenyearGBus$.html • Yunus, Muhammad and Alan Jolis (1998) Banker to the [Accessed: 17th January, 2008] Poor (Dhaka: University Press). • Hulme, David and Moore, Karen (2007) Why has • Yunus, Muhammad (2007) Grameen Bank at a Glance Microfi nance been a Policy Success in Bangladesh? in: (Dhaka: Grameen Bank). Bebbington, Anthony and McCourt, Willy (eds) Devel- • Ansaruzzaman, Md.: Senior Principal Offi cer, opment Success: Statecraft in the South, (New York: Grameen Bank, International Department (2007) Palgrave Macmillan), pp.105-139. Personal Interview, Dhaka, 14th, 15th and 22nd July, 2007. • Kota, Ian (2007) Microfi nance: Banking for the Poor. • Arsheda: Grameen Bank borrower (2007), Personal Finance and Development 44(2), pp. 44-5. Interview, Fegunasher, Bangladesh, 9th July, 2007 • Newaz, Ware (2001) NGO Credit Programmes and • Baiddya, Ashim: Fieldworker, Grameen Bank, Panchk- Empowerment of Rural Women: Experience from hola Branch, Madaripur (2007) Personal interview, Bangladesh, in: Farhad Hossain and Zahidur Rahman Madaripur, Bangladesh, 23rd December, 2007. (eds) Microfi nance and Poverty: Contemporary Per- • Bhuyan, Harun-or-Rashid: Branch Manager, Fegunash- spectives, (Tampere: University of Tampere Depart- er Shirajdikhan Branch, Grameen Bank (2007) Fegu- ment of Administrative Science and Service Centre for nasher, Bangladesh, 9th-12th and 19th July, 2007. Development Co-operation), pp 115-37. • Biswas, Pabitra: Fieldworker, Grameen Bank, Panchk- • Transparency International (2006) CPI Table, Trans- hola Branch, Madaripur (2007) Personal interview, parency International [Online], Available: http://www. Madaripur, Bangladesh, 23rd December 2007. transparency.org/news_room/in_focus/2006/ • Shah, Mozahid: Manager, Grameen Bank, Panchkhola cpi_2006__1/cpi_table [Accessed: 17th August, 2007] Branch, Madaripur (2007) Personal interview, Mad- • Transparency International (n.d.) CPI, Transparency aripur, Bangladesh, 25th December 2007. International [Online], Available: http://www.transpar- ency.org/policy_research/surveys_indices/cpi, [Ac- (The views expressed in the article are personal and do not cessed: 20th August, 2007] refl ect the offi cial policy or position of the organisation).

THE INDIA ECONOMY REVIEW 175 S ECTORAL SNAP Consumer Behavior and Competition in Indian Retailing

176 THE IIPM THINK TANK R ETAIL ROULETTE

Mohammad Amin 1. Introduction: Overview and Data Description Private Sector Development Specialist, It is commonly believed that India has one of the highest Enterprise Analysis Unit, Financial and Private density of retail stores in the world and therefore competition Sector Development, The World Bank Group, in the retail industry is hardly an issue. Another common belief Washington, D.C. is that competition in an industry depends on the number of fi rms and fi rm-behavior with consumer behavior being largely irrelevant. However, beliefs and perceptions can be notoriously misleading and confi rmatory evidence using hard data is always welcome. Unfortunately, hard data on structure of retailing in India (or any developing country) is extremely rare. This is surprising given that the retail sector in India is the second largest sector (after agriculture) providing about 10% of the formal jobs, and contributing over a quarter of the value added in all services sectors and 14% to the national GDP. The sector has also shown strong growth in recent years, with an average annual growth rate of 7.3% over the 1990s compared with 5.9% in the 1980s and 4.3% during 1950-1979.1 These numbers tell the story in the formal sector. But an estimated 95% of the sector’s activity takes place in the informal sector that is not accounted for in the offi cial fi gures. This article uses data on 1,948 retail stores in India and collected by the World Bank’s Enterprise Surveys in 2005 (data described in detail below). Using these data, we explore a number of issues relating to the level of competition in retailing and fi nd some surprising results. First, competition in the sector is low by international standards and also when compared with the same in the Indian manufacturing sector. Second, larger and richer metropolitan cities that have been the main hub of Indian retailing show signifi cantly less competition than the relatively smaller cities. Third, contrary to the popular belief that competition is all about how fi rms behave, we fi nd strong evidence that consumer behavior is an equally important determinant of the level of competition. Specifi cally, house- hold’s shopping time opportunity cost as proxied by the number of non-workers per household in the city has a very large effect on the level of competition. The fi nding is particularly impor- tant for India that is witnessing a rapid decline in the number of non-workers driven in part by the ongoing economic boom. Fourth, we look at another popularly held belief that competi- tion in retailing is greater in the poorer cities. The rationale for this is that poorer households value a Rupee of savings more than the rich and hence they are likely to search more inten- sively increasing the level of competition. Our results show that

THE INDIA ECONOMY REVIEW 177 S ECTORAL SNAP

Figure 1. Percentage of Firms Facing Signifi cant Competition important or very important on the question. The survey also provides information Retailers (India) 38.2 on a number of store Retailers (Eastern Europe 71 characteristics such as its and Central Asia age, fl oor area, fi nancial Manufacturing (India) 82 condition, annual sales, etc. We use these rich data to 0 20 40 60 80 check for the robustness of Percentage of fi rms/stores reporting the main results. competition as fairly important or important

Source: Enterprise Surveys and Business Environment and Enterprise Performance Survey (BEEPS, 2005). 2. Low Level of Competition in Indian the negative income-competition relationship in India disap- Retailing pears when we account for the number of non-workers across Figures 1 and 2 show some important fi ndings on the competi- rich vs. poor cities. The fi nding casts doubt on the supposed tion variable: explanation of the income-competition link. Last, we provide • First, 38.2% of the retailers in India face signifi cant competi- some evidence on the likely effect of competition on effi ciency tion (Figure 1). The comparable fi gure for registered of the retail stores in India. Policy implications of the main manufacturing fi rms in India equals 82% (Enterprise fi ndings are discussed. Surveys, 2005) and 71% for retailers in 27 Eastern Europe Our main data source is a stratifi ed random sample of 1,948 and Central Asian countries (Business Environment and retail stores (Enterprise Surveys) located in 16 major states and Enterprise Performance Survey (BEEPS) 2005 conducted by 41 large cities of India. Roughly, 64% of the stores in the the World Bank and EBRD). In short, competition in Indian sample are traditional stores, 26% consumer durable stores retailing seems low even though the country boasts of one of and the rest 10% are modern format stores. In one question, the highest density of retail stores in the world. the respondents were asked how important competition from • Second, the metropolitan cities of Bangalore, Chennai, other retailers is for the prices of the store’s main products. Delhi, Hyderabad, Kolkata and Mumbai have traditionally The response was recorded as not at all important, slightly been the retailing hubs of the country and also the main important, fairly important and very important. We defi ne a benefi ciaries of the ongoing retailing boom. Yet, competition store facing “signifi cant competition” if it reports fairly in these cities is signifi cantly lower than in the remaining cities (Figure 2). Figure 2. Percentage of Indian Retailers Facing Signifi cant Competition • Third, contrary to popular belief, the level of Metropolitan Cities 31.9 competition amongst Non-Metropolitan Cities 40 traditional stores (small Small Stores 33 stores selling grocery items) Large Stores 45.2 is signifi cantly less than Kozhikode 5.7 amongst large stores Madurai 100 (selling consumer durable 020406080 100 and other items and often Percentage of Indian retailers reporting part of a larger shopping competiton as fairly important or important complex). One reason for Source: Enterprise Surveys. Metropolitan cities include Bangalore, Chennai, Hyderabad, Kolkata, Mumbai and New Delhi. Small stores this could be that smaller include tranditional stores selling grocery items. Large stores are large-sized stores selling various consumer items and usually part of a larger shopping complex. stores are better able to

178 THE IIPM THINK TANK R ETAIL ROULETTE

Figure 3. Percentage Change Over 1991-2001 in the Number of Adult Non-Workers per Household

10

5

0 Uttar Pradesh Madhya Pradesh Maharashtra Rajasthan

-5 Andhra Pradesh Tamil nadu Gujrat Bihar All states (average) Orissa

-10 Karnataka West Bengal Punjab Kerala Haryana -15 number of non-workers per household % change between 2001 and 1991 in the -20

Source: Census of India, 1991 and 2001. Percentage changes in the fi gure above equal the number of adult non-workers per household in 2001 minus the same in 1991 and expressed as a percentage of the 1991 values of the variable.

segment the market by providing personalized retailing “… traditional competition policy will not suffi ce to render the services to their customers. industry competitive and that, in such cases, quite different policy • Fourth, competition varies signifi cantly across cities with a measure may well be more effective in enhancing competition. In a low of 5.7% stores in Kozhikode and a high of 100% in nutshell, consumer behavior and policy towards consumers matter Madurai reporting competition as fairly signifi cantly for industry performance.” important or important. Policy makers and practitioners are also Competition beginning to realize the importance of 3. The Importance of Consumer seems low even consumer behavior. For example, Stephen Behavior for Retailing though the Byers, Secretary of State in the United The traditional view of competition is that country boasts of Kingdom notes that competition depends on the number of “Active consumers who are prepared to fi rms and their behavior. Consequently, one of the highest check and shop around to ensure they get a competition policies are almost exclusively density of retail good deal are a key driving force in helping to focused on preventing monopolies, preda- stores in the world create truly competitive markets.” (Stephen tory pricing and collusion by fi rms. How- Byers, Secretary of State, UK; Department of ever, the simple idea that consumer behavior is also important Trade and Industry, 2000) for competition in consumer industries such as retailing, A good example of what the above quotes imply is a recent electricity distribution and personal fi nance is at the heart of a study by Giulietti et al. (2005) on the deregulation of the small but growing literature. This literature calls for greater natural gas supply market in the U.K. This study fi nds that the emphasis in competition policies on consumer behavior as incumbent (monopolist) continued to enjoy signifi cant market opposed to the number of fi rms or fi rm-behavior. For example, power even after complete deregulation (free entry) and that Waterson (2003) notes that the cost of deregulation outweighed the benefi t. According to

THE INDIA ECONOMY REVIEW 179 S ECTORAL SNAP

Figure 4: Competition and Non-Workers that the ongoing economic boom is likely to make increasingly bigger demand on 50 household’s time (evidence 45 provided below). A key question here is whether time 40 cost of households matters for 35 the level of competition in 30 Indian retailing. In this article we proxy for 25 the time cost of households by 20 the number of non-workers 15 per household in the city (henceforth, non-workers). 10

fairly important or The prediction is that more 5 non-workers imply lower time 0 cost for households and Percentage of stores reporting competition as Percentage 1234therefore more intensive Non-workers per household in the city search and hence more (Quartiles, higher values imply more non-workers) competition in the city. As Source: Enterprise Surveys and Census of India (1991). The horizontal axis shows the number of non-workers per household in the city grouped by their quartile values. A higher quartile indicates more non-workers. might be expected, non-work- ers have shown a sharp decline the study, the main reason for the failure of the deregulation over the last few years, most probably due to the economic effort was the perception among consumers that the cost of boom starting early 1990s. Figure 3 provides evidence on this searching and switching to a new supplier would be more than using data from Census of India (1991, 2001). Between 1991 the associated benefi t. However, the perceived cost was much and 2001 and averaged over the 14 major states of India, higher than the true cost. Therefore, the study recommends non-workers declined by 7.2%. The decline was as sharp as correcting consumer perceptions through, for example, an 18.6% in Haryana, 12.7% in Kerala and over 10% in Punjab, information subsidy, as a key ingredient for the success of the Karnataka and West Bengal. Only two states (Uttar Pradesh deregulation exercise. and Madhya Pradesh) witnessed an increase of less than fi ve percent. 4. What Shapes Consumer Behavior? There is very little by way of hard research 5. Relationship between Non-Work- on what shapes consumer behavior and Competition varies ers and Competition in Large therefore the level of competition in significantly across Indian Cities consumer industries of the developing cities with a low In a recent study, Amin (2008a) looks at world. One possibility is that the intensity of 5.7% stores in this relationship between non-workers and with which consumers search for best prices competition in Indian retailing in detail and and deals depends on their shopping time Kozhikode and a we discuss below the main fi ndings from opportunity cost (henceforth, time cost). high of 100% this study. For expositional convenience, When the time cost is low, consumers can in Madurai we use graphical illustrations below while devote more effort and time searching, the formal econometric results are avail- driving up the level of competition. The issue of time cost and able in the stated study. competition in retailing is important in the Indian context given The fi ndings of the study are along predicted lines. Irrespec-

180 THE IIPM THINK TANK R ETAIL ROULETTE

Figure 5: Competition and Children A number of tests were performed to guard against such possibilities. To begin 45 with, we controlled for a number of city and store 40 characteristics and found that 35 the non-workers and competi- 30 tion relationship discussed above remained robust to the 25 controls. Specifi cally, city level 20 controls included the level of 15 literacy, per capita expendi- ture using NSSO data (closest 10

fairly important or available proxy for city level 5 incomes), sex ratio (a proxy 0 for overall development), Percentage of stores reporting competition as Percentage 1234number of children per Children per household in the city household (discussed in detail (Quartiles, higher values imply more children) below), duration of power outages faced by retailers, total employment in retailing tive of the set of controls, non-workers and the percentage of as a percentage of city population (retailer density), fi xed stores facing signifi cant competition in the city are strongly and effects for metropolitan vs. non-metropolitan cities, city-popu- positively correlated. Without any other controls, a move from lation, etc. Controls for fi rm characteristics included fl oor area the city with the least number of non-workers (2.01 in Noida) to of the shop, age of the store, whether the store is part of a the city at the 25th percentile value of non-workers (2.59 in large chain or not, store-type fi xed effects (traditional, Bhubaneswar) increases the number of stores facing signifi cant consumer durable or modern format store), measures of fi nan- competition by as much as 9.8 percentage points (Figure 4). cial access of the store, etc. This is a large effect given that only 38.2% of the stores in the Some of the controls mentioned above were also found to full sample report facing signifi cant competition. We also be important for explaining the level of competition. For checked for the non-workers and competition relationship example, retailer density had a large positive effect on compe- separately for the set of traditional stores (small stores selling tition; power outages in the neighboring stores a negative grocery items) and the rest (consumer durable stores and effect while outages in one’s own stores increased the level of modern format stores). The relationship was slightly stronger competition faced by the store in question; and traditional for the former but not by much. stores were less likely to face signifi cant competition than the One could argue that cities with more non-workers may rest. In contrast, there was virtually no effect of literacy rates, happen to be more competitive because of other correlated income levels, and age, size and fi nancial access of the store on characteristics and not because non-workers search more the level of competition. intensively. For example, cities with more non-workers are also the relatively poorer cities (confi rmed in the data). It is possible 6. Overall Development of Cities and Competition that poorer households search more intensively not because An interesting contrast is provided by comparing how non- they have more non-workers but because a Rupee of savings workers and the number of children per household in the city (through more intensive search) means more to them relative (henceforth, children) affect the level of competition. One to the richer agents. possibility is that both, non-workers and children are reasonably

THE INDIA ECONOMY REVIEW 181 S ECTORAL SNAP

good proxy measures of overall development. Hence, if for the level of development. non-workers is simply a proxy for overall development then children and non-workers should affect the level of competi- 7. Income and Competition tion in the same direction. In contrast, if our claim of A commonly held view is that the utility from a Rupee of non-workers as a proxy for the time cost of shopping is savings (through more intensive search) is higher for the poor correct then we should expect non-workers and children to compared with the rich. What this implies is greater search affect competition in opposite directions. The reason for this effort and therefore more competition in the relatively poorer is that having more children in the household increases cities. However, this idea has not been rigorously tested, household’s time cost of shopping, lowering search efforts especially in the context of a developing country. and hence the level of competition in the city. As discussed Our results show that there is indeed a negative relationship above, the prediction with more non-workers is just the between income and competition but this relationship virtually opposite: more non-workers imply lower time cost leading to disappears once we account for differences in the number of more intensive search and therefore greater competition. non-workers across rich vs. poor cities. The result casts doubt Figure 5 shows the relationshirelationshipp onon the susupposedpposed exexplanationplana ation of the incoincome-competition bebetweentween chchildrenildren aandnd tthehe levlevelel of relationshiprelationnship (that the poor search more intensively because ccompetition.omppete ittioi n. CClearly,learly, tthehe rerelationshiplationship theythey value a Rupee of savings more thanthan the rich). Rather, is negative in contrcontrastasst to the ppositiveositive greatergreater competitioncompetition in the ppooreroorer cities ccould be due to the fact one we found in FiFiguregure 4. The childrenchildren-- thatthat the poorer cities have more non-workersnon-wo and therefore ccompetitionompetition rerelationshiplationship iiss sslightlylightly weaweakk moremore time to ddevoteevote to searcsearchinghing for bebests prices. If this is iinn Figure 5 but bebbecomescomes much stronger indeed true, and more research is requiredrequir to ascertain it, the whenwhenn we accountaccount for differences in the policypolicy iimplicationmplication is sisimplymply to lower shshoppingop cost in the number of non-wornon-workerskers across cities. relativelyrelatively ricricherher cities tthrough,hrouugh, for exaexample,m longer store hours, This strong and negative relationshiprelationship betterbetter dissemination of information on pprices, greater use of isis robust to differences in various internet for shopping,shoopping, etc. citycity andand store characteristicscharacteristics suchsuch as thethe onesones discusseddisccusses d above.above. In 8. CompetitionCompetition and ProductivitProductivityy iin Indian Retailing short,shhoro t, non-workersnon-workerss and children To get a sense of how importantimpoortant the aboabovev fi ndings are, some havehave separate,separate, independentindependent andandn connectionconnecctit on neeneedsds to be mamadede bebetweentwt een ttheh level of competition contrasting effects on thethee level ofof aandnd effi ciency in retailing. At a broad lelevel,v the literature offers competition and so it is highly a number of insights on the competitiocompetition-effin ciency relationship. unlikelyunlikely thatthat theythey are a mere pproxyroxy TThehe generagenerall bebelieflief is tthathat comcompetitionpetition is good for effi ciency. The fear of being wipedwiped out by the competitorscompetito forces fi rms to cut costs. Amin (2008b) uses the same data as discussed above and fi nndsds tthathat increaseincreasedd comcompetitionpetitiono hhasas a vverye large positive effect oonn labor pproductivityroductivity of the stores. EstiEstimatesm suggest that iincreasingncreasing competition from its lowest level (traditional(traditional stores in GGhaziabad) to the highest level (modern format stores in MaduraiMadurai)) is likely to increase the efeffifi ciencyciency ofof the former stores by as muchmuch as 87%87% of the current level. These are largelar gains and could havehave a signifisignifi cant impact on the overalloverall economy.econ R ETAIL ROULETTE

9. Policy Implications and Conclusion tion on behalf of distributors of branded goods. This list The number of non-workers in India is likely to witness signifi - covers stores in forty one cities across India for three major cant declines in the near future as the booming economy industry segments: Fast Moving Consumer Goods (FMCG) attracts more would be non-workers into the fold of the labor stores (traditional stores), consumer durable stores and the force. With fewer non-workers, the time cost of shopping will modern format stores. The sample was stratifi ed according increase forcing consumers to search less intensively for best to segment-specifi c criteria. FMCG stores were stratifi ed prices and deals. This article argues that as a result of declining based on turnover, number of salesmen, number of FMCG non-workers, competition in Indian retailing may see a secular product and the presence of cooling equipment. Consumer drop. The likely effect of lower competition on retailing durable and modern format stores were stratifi ed based on effi ciency is shown to be potentially large. The impact of these turnover. The sample size was determined so as to minimize changes on the overall economy cannot be neglected given that the standard error in the sample variables, given the avail- the retail sector in India is second only to agriculture in terms of able resources for each surveying stratum. Once the sample its size. size was determined, the sample was allocated to strata using Two broad policy implications follow from the fi ndings above. Neymann’s allocation rule. More information about the First, one cannot take the level of competition in Indian survey and methodology is available at www.enterprisesur- retailing for granted, especially in the larger and richer cities. veys.org. By international standards, competition in India’s retail sector 3 The difference in the level of competition between metropolitan is on the lower end. Second, competition policies that are cities and the rest is signifi cant at less than fi ve percent level. currently focused exclusively on fi rm-behavior should pay more attention to consumer behavior and consumer attributes that References and Additional Thinking shape consumer behavior. Some attributes such as non-workers • Amin, M. (2008a), “Competition and Demographics,” Policy may not be directly amenable to competition policies. However, Research Working Paper 4514, World Bank, Washington even in such cases indirect policy measures can help alleviate DC. Available at http://www.enterprisesurveys.org/Research- part of the problem. For example, cities with fewer non-workers Papers/. or where non-workers are decreasing at a rapid rate can be • Amin, M. (2008b), “Competition and Labor Productivity in targeted with better e-commerce facilities, longer operating India’s Retail Stores,” mimeograph available at www. hours for retail stores, lower entry barriers and better dissemi- enterprisesurveys.org. nation of information on product prices. We hope that the • Amin, M. (2008c), “Retailing in India: Assessing the Invest- present work will encourage more research on these issues. ment Climate,” India Economy Review, Sept. 2008: 188-197. Available at http://works.bepress.com/mohammad_amin/4/. Endnotes • Department of Trade and Industry (2000), Switching 1 Cities in the sample include (in alphabetical order): Suppliers, London: The Stationery Offi ce. Ahmedabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh, • Fan, C. S., C. Lin and D. Treisman (2009), “Political Decen- Chennai, Coimbatore, Cuttack, Delhi, Dhanbad, Faridabad, tralization and Corruption: Evidence From Around the Ghaziabad, Greater Mumbai, Guntur, Gurgaon, Gwalior, World,” Journal of Public Economics, 93(1-2): 14-34. Hubli-Dharwad, Hyderabad, Indore, Jaipur, Jamshedpur, • Giulietti, M., C. Price and M. Waterson (2005), “Consumer Kanpur, Kochi, Kolkata, Kota, Kozhikode, Lucknow, Choice and Competition Policy: A Study of the UK Energy Ludhiana, Madurai, Mangalore, Mysore, Nagpur, Nashik, Markets,” Economic Journal, 115: 949-968. Noida, Patna, Pune, Surat, Vadodara, Vijayawada and • Waterson, M. (2003), “The Role of Consumers in Competi- Vishakhapatnam. tion and Competition Policy,” International Journal of 1 These estimates are based on National Accounts Statistics Industrial Organization, 21: 129-150. and taken from Gordon and Gupta (2004). 2 The sampling frame for the survey was the list of retail stores (The views expressed in the article are personal and do not refl ect regularly interviewed by AC Nielson for inventory verifi ca- the offi cial policy or position of the organisation).

THE INDIA ECONOMY REVIEW 183 C OUNTER CURRENTS Crisis in Academic Economics

Amol Agarwal Economist based at Mumbai

184 THE IIPM THINK TANK T RUST BUSTING

one of the main reasons for the severity of the crisis. However, the crisis. Monetary Policy has tried to lower rates and fi scal ECB looks at monetary targets extensively but failed to see the policy has tried to support falling private demand and invest- crisis. Bank of Japan also looks at these targets but has failed just ment. However, an expansionary fi scal policy leads to higher like ECB. fi scal defi cits and pushes interest rates higher. This becomes a The question is how do we make money and credit variables dilemma for policymakers and confuses fi nancial markets (see more relevant for monetary policies? our report for details- Interest Rate Dilemma for Policymak- • Zero Interest Rate Policy (ZIRP): Fed and other Central banks ers and Markets, 3rd July, 2009). The research needs to solve have shown in this crisis, that zero interest rates are not a this dilemma which has become quite a serious concern for constraint for central banks at all. They have continued to the economies as high interest rates would prolong the expand their balance sheets buying assets from fi nancial markets. economic recovery. However, the issue of effectiveness of these asset purchase programs still remains. We still do not know whether Central Financial Globalisation bank intervention has led to desired benefi t in the fi nancial If role of money and fi scal policy has made a comeback, the role markets. Some economists suggest it has helped and others of capital fl ows has once again come into question. Just like disagree. There will be plenty of research on this matter in fi nancial liberalization, there is no empirical evidence for capital future. However, we can say one thing with some certainty. The account liberalization but is still advocated by most economists. economists made us believe that monetary policy can still be The usual basis for capital account liberalization is that it would effective under ZIRP. In this crisis we have seen monetary policy lead to effi cient allocation of capital and in turn help capital- can be expanded even at Zero Interest Rates. Riksbank even starved economies prosper. However, both empirical and lowered its deposit rate (overnight deposit rate) to negative practical evidences do not justify this claim (see our report for a 0.25% in its July monetary policy meeting. discussion- Capital fl ows in India and other Hence, now even zero interest rates are not developing economies: Are they truly really a bound. However, the question of IMF which had benefi cial? dated 2008). The policymakers effectiveness still remains. The monetary always advised in emerging economies often expressed transmission is weak in a fi nancial crisis not to use dissatisfaction with capital fl ows but were leading to substantial lags in monetary policy fiscal policy are not heard. As there was limited empirical to show desired results. evidence, economists came up with other increasingly ideas to justify capital account liberalization Public Finance Economics calling for more (they provide collateral benefi ts; see Fiscal Policy has made a splendid comeback fiscal expansion Financial Globalisation: A Reappraisal by in this crisis. Just like monetary numbers, Kenneth Rogoff et al). fi scal policy’s role was in oblivion. Fiscal Policy was hardly Now, because of this crisis we are seeing some changes in discussed and researched before this crisis. The macroeconomic economic thinking. IMF has long been a torchbearer for opening models hardly included fi scal policy instruments for guiding up capital infl ows. In a recent report (Initial Lessons of the policies. As a result, little is known about the role fi scal policy Crisis, 2009), IMF economists remark: can play in business cycles. Surely, the lesson is not that capital fl ows should be sharply With this crisis, the role of fi scal policy is going has changed curtailed. But this crisis, as well as many episodes before it, like never before. The leading institutions like IMF which had shows the potential dangers of large capital infl ows. Such infl ows always advised not to use fi scal policy are increasingly calling for can lead to excessive risk taking and to exposure of domestic more fi scal expansion. The depth of the crisis has challenged the fi nancial institutions, households, fi rms, to exchange rate risk. view that monetary policy can be effective under severe reces- They can lead to sharp appreciations, often followed by abrupt sion (discussed above). reversals and strong effects on balance sheets. They can put However, there are questions on fi scal policy as well. In this pressure on demand, and on output. Monetary policy may work crisis both monetary and fi scal policy have been used to ease poorly in this context, as the attempt to slow down activity

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infl ation – seems ill suited to understanding the origins of the manage sustained growth. The economists have been advising crisis or designing measures to solve it.” developing world to have institutions like developed economies. Marcus Miller and Joseph Stiglitz, March 2009. However, in this crisis it is the developed economies that have In another paper (The Financial Crisis and the Systemic Failure performed worst. of Academic Economics by David Colander et al, 2009), the Further, there is confusion as to whether free markets are authors say: same as unregulated markets. We think this debate was settled The economics profession appears to have been unaware of the that markets works best with institutions in place. However, long build-up to the current worldwide fi nancial crisis and to something else seems to be happening in fi nancial markets. have signifi cantly underestimated its dimensions once it started There were institutions (regulators) but either they completely to unfold. In our view, this lack of understanding is due to a failed or market participants knew how to sideline them. Daron misallocation of research efforts in economics. We trace the Acemoglu, leading economist of Institutional School in his deeper roots of this failure to the profession’s insistence on recent paper said (The Crisis of 2008: Structural Lessons for and constructing models that, by design, disregard the key elements from Economics, 2009): driving outcomes in real-world markets. The economics Forgetting the institutional foundations of markets, we mistak- profession has failed in communicating the limitations, enly equated free markets with unregulated markets. Although we weaknesses, and even dangers of its preferred models to the understand that even unfettered competitive markets are based public. This state of affairs makes clear the need for a major on a set of laws and institutions that secure property rights, reorientation of focus in the research economists undertake, as ensure enforcement of contracts, and regulate fi rm behavior and well as for the establishment of an ethical code that would ask product and service quality, we increasingly abstracted from the economists to understand and communicate the limitations and role of institutions and regulations supporting market transac- potential misuses of their models. tions in our conceptualization of markets. Now let us look at a few areas of econom- ics where the concerns are being raised. The importance Financial Economics of finance There are many questions, which fi nancial Development Economics to economic economists need to answer. Some of them Before the crisis, most economies had a growth has are: phase of high growth and low volatility • Finance as a Model of Growth: The earlier (called Great Moderation). The economies also frequently theories of development concentrated on followed variety of Growth models to been ignored labor, capital, institutions etc as the factors generate economic growth. by economists for growth and development. The leading Some of these models are: works hardly include fi nance as a factor for • Export driven (China, Korea, Germany, East Europe etc), growth. Frederick Mishkin in a lecture (JMCB-FDIC Lecture, • Financial Services driven (Iceland, UK, US etc) September 22nd, 2005) remarked: • Investment driven (India etc), The importance of fi nance to economic growth has also fre- • Natural Resource driven (Middle East Economies, Russia, quently been ignored by economists. For example, the leading Chile etc), undergraduate textbook on economic growth, Weill (2005) does • Agriculture exports driven (Australia, New Zealand etc). not discuss the link between fi nance and growth at all. The crisis has impacted all economies and their models of The main reason was initial fi nance theories like Modgillani growth via different channels (see our report for a preview - Miller theorems and Effi cient Market Hypothesis (developed by How the US originated crisis impacted other economies, 12th Eugene Fama and Kenneth French). These were based on the November, 2008). The question open to economists is as assumption that markets are effi cient and there are no frictions economies globalize further, what growth model should an (more on this later). But if these theories were correct then there economy choose? Growth Economics usually suggests that if an was very little reason for fi nancial markets to exist. However, economy has proper institutions in place, it will be able to later development showed that there were imperfections in the

186 THE IIPM THINK TANK T RUST BUSTING

Table 1: Blame Game

Economist/ Institutions Reasons for Crisis Blame Policymakers who Blamed Others William White & BIS Nature of Financial Markets, Alan Greenspan Claudio Borio Monetary Policy

Kenneth Rogoff IMF Capital fl ows (Ken Rogoff), Role Alan Greenspan / of incentives (Raghuram Rajan US Treasury Jean Claude Trichet ECB Under-pricing of risk Financial Market Participants Mervyn King Bank of England Capital fl ows IMF

Source: Speeches and Statements of the noted persons important role to play in policies. ECB and BoE are directly the crisis has posed to economists and economic thinking. This is responsible for their economies and both Trichet and King not an exhaustive list and other issues could arise in future cite their own research which showed imbalances were (infact number of questions over poverty, aid, welfare etc are developing. However, it all stops there with none seem to have being raised). The crisis is still taking shape and affecting all had the will to do anything to resurrect the imbalances. IMF walks of economic life. These issues were visited in previous and BIS case is still understood as they can only infl uence poli- crisis but have been ignored by economic research. The previous cies but not make them (However, this still raises the question crises were limited to developing countries and as a result were of their effectiveness). ignored by economists putting all the reasons under the common But what about ECB and BoE? Why didn’t they do anything in label – Poor institutional framework. With the crisis impacting their own economies? Why did they choose the policies sug- developed economies more severely, the label cannot be the gested by Alan Greenspan? There is a huge criticism on Alan same. Hopefully, economists would work on the above areas. Greenspan and his free-market policies but atleast he followed Moreover, economic policy and ideas seems to be increas- what he believed in (In his testimony to the Committee of ingly driven more by powerful economists than quality of a Oversight and Reform (October 23rd,2008) Greenspan also research idea. Many economists are opining these days via agreed that his belief was not really right). However, the beliefs personal blogs and other media channels. The arguments and of Greenspan do not imply Bank of England and ECB should opinions on both sides are so convincing that it does not have also made the same policies. The fallouts of the crisis could provide a clear path for policymakers. The opinions are usually have been minimized if these key policymakers had backed their backed by research (own and others) and references and as a concerns more strongly. result one is never sure which is the right path and thinking. Apart from the above, there have been comments by other Economics has always been a debatable subject but we really economists that their views were not heard (Like John Geanako- need more clarity in times of crisis. All this has come at a time plos above). Some economists have dubbed above discussed when we are made to believe that economic thinking has really ideas as “Jackson Hole ideas” (monetary policy for price advanced and most of the issues are addressed. Well, the crisis stability, fi scal policy role is limited etc) which usually gained has opened up the fi eld of economics and shows we have still approval by leading US economists in the annual Kansas City not answered the basic questions. Fed Symposium held at Jackson Hole, Wyoming. How do economists change this power equation? (The views expressed in the article are personal and do not refl ect the offi cial policy or position of the organisation. The author Concluding Thoughts maintains a blog on economic research - http://mostlyeconomics. The above analysis is an attempt to categorise the key questions wordpress.com/)

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he ongoing crisis is not just a collapse in economies and few points in our earlier papers and this paper is an attempt to fi nancial markets. The biggest impact of crisis has not summarise all the previously raised issues and point to some new Tbeen on fi nancial markets or economies but on eco- ones as well. nomic thinking. All crises end at some point of time. Lawrence Summers in a speech at Brookings (13th March, 2009) said “.... A Few Quotes there is onr ineluctable lesson of the history of fi nancial crisis: they Willem Buiter, a former Member of Monetary Policy Com- all end”. mittee of the Bank of England titles an article (www.voxeu. Before the crisis there were numerous economic thoughts, com, 6th March, 2009) as "The unfortunate uselessness of which need to be reviewed as the crisis has taken shape. Moreo- most 'state of the art' academic monetary economics". In this ver, leading economists are highly perplexed and are not sure article he says how much of monetary economics is useless for how to summarize this crisis with their economic theories and practical purposes. beliefs. They are calling current economic thinking irrelevant Standard macroeconomic theory did not help foresee the crisis, and asking for a change in economic thinking. nor has it helped understand it or craft solutions. This columns This paper reviews a few areas of economics that need to be argues that both the New Classical and New Keynesian com- reassessed. It also highlights a few areas which till now were plete markets macroeconomic theories not only did not allow considered hallowed but are found wanting. We have covered a the key questions about insolvency and illiquidity to be an- swered. They did not allow such questions to be asked. A new paradigm is needed. David Blanchfl ower outgoing MPC Member of Bank Of England in a speech (24th March, 2009) said: As a monetary policy maker I have found the ‘cutting edge’ of current macroeconomic research totally inadequate in helping to resolve the problems we currently face. I am far from alone in these views. To take a couple of observations: “New classical and new Keynesian research has had little impact on practical macroeconomists who are charged with the messy task of conducting actual monetary and fi scal policy.” Gregg Mankiw, 2006 “In fact “modern macro” has been notable for paying very little rigorous attention to data. …... I am left with the feeling that there is nothing in the empirical performance of these models that could come close to overcoming a modest scepticism. And more certainly, there is nothing to justify reliance on them for serious policy analysis.” Nobel Laureate Robert Solow, 2008 “There is a danger that the macroeconomic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against infl ation. The central banks are prepared to fi ght the last war. But are they prepared to fi ght the new one against fi nancial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful.” Paul De Grauwe, 2008. “The widely used DSGE paradigm – designed to help control

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I propose here instead to show how those propositions bear on leverage declines (deleveraging). This simple and powerful idea current concerns about overleveraging – concerns that in some was not really accepted amidst researchers. In his own words: quarters actually border on hysteria. In particular I will argue, “After it was fi nally published, as “Liquidity, Default, and fi rst, that the highly visible losses and defaults on junk bonds do Crashes” in the conference volume in 2003, I gave that Seattle not mean that overleveraging did in fact occur; second, paradoxi- paper at every major university. It was exactly about the liquidity cal as it may sound, that increased leveraging by corporations cycle, but it didn’t really catch on,” Geanakoplos recalled last does not imply increased risk for the economy as a whole; third, week. The time for it wasn’t ripe. The Asian fi nancial crisis had that the fi nancial distress being suffered by some highly leveraged been contained. No lender lost a dollar when LTCM failed. The fi rms involves mainly private, not social costs; and fi nally, that consequences of the dot.com crash had been confi ned mainly to the capital markets have built-in controls against overleveraging the stock market. For the next seven years, business as usual - controls, moreover, very much in evidence at the moment. resumed. “This time they are more interested.” Recent efforts by our regulators to override these built-in market • Financial Regulation: There is a tome of research being mechanisms by destroying the junk bond market and by written on this subject. Every regulator is taking a relook at imposing additional direct controls over leveraged lending by the spectrum of fi nancial regulation in their own economies. banks will thus have all the unintended consequences normally On a quick look across the various tomes, most of the associated with such regulatory interventions. That the current suggestions coming forward are quite common: emphasis on the evils of overleveraging may be misplaced does - More inclusive fi nancial regulation; no light touch regulation not mean, of course, that all is well. My message is not: “Relax. - Macroprudential regulation Be happy. And, don’t worry.” Worry we should, in the U.S. at - A Financial Resolution framework least, but about the serious problems confronting us, such as our - A special entity to manage non-depository fi nancial institu- seeming inability to bring government tions (has come from Fed offi cials after AIG spending under rational control or to halt fallout) the steady deterioration of our once-vaunt- The role leverage - Some measures to make bank balance- ed system of public education. Let us not plays in one’s sheets less procyclical - Leverage ratio/ waste our limited worrying capacity on financial decisions some cap on leverage, increase provisions second-order and largely self-correcting is pretty basic but during boom times, a capital insurance problems like fi nancial leveraging. scheme that leads to shoring up capital in It would have been very interesting to get has been ignored times of stress. Merton Miller’s views in this crisis. The issue by financial Apart from capital insurance scheme most of leverage is again haunting the policymak- economics of the suggestions have been discussed ers and fi nancial markets. earlier in each crisis. Why weren’t they Hence, the issue of leverage arises in times of crisis but is implemented? There is plenty of research on fi nancial stability ignored soon after the crisis is over. Even much of the sugges- and crisis but the lessons are hardly applied. The recent crisis is tions in times of crisis which talk about minimizing leverage also a result of complacency on the part of fi nancial regulators. are ignored in future papers. It seems research is as procyclical There was this belief that self-regulation is the best form of as leverage. fi nancial regulation. As a result, research and discussion on Recently, John Geanakoplos (Yale University) paper on fi nancial regulation has moved to form (single regulator Vs. leverage cycle has become very popular. His idea is that leverage multiple regulator, rule based Vs. principles based) etc) than the too has a cycle. His broad idea is that till now we assume in a real issue of managing fi nancial stability. loan market, demand and supply only determine the interest rate There are some additional thoughts on the macroprudential on loans. He adds apart from interest rate it also determines the fi nancial regulation which merit serious discussion. Lord Turner leverage (or collateral) with the loan. In good times, lenders in a speech (29th March, 2009) said: don’t require collateral leading to a higher leverage. In bad The Review sets out eight sets of recommendation for regulatory times, the lenders demand more collateral and as a result reform. ……Fourth, the importance of macro-prudential

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fi nancial market and the various fi nancial fi rms actually played a opened up their fi nancial markets. They invited foreign banks role in minimizing these very imperfections. Fed Chairman, Ben to set bases and soon Western Europe Banks were the major Bernanke in his speech (15th June, 2007) explains: banks in the East European economies. As crisis deepened, the The blossoming of work on asymmetric information and exports of these economies slowed leading to problems in principal-agent theory, led by Nobel laureates Joseph Stiglitz and paying off the loans to foreign banks. As a result foreign banks George Akerlof and with contributions from many other were not able to give credit worsening the crisis. Further, these researchers, gave economists the tools to think about the central foreign loans became a problem for their home regulators. role of fi nancial markets in the real economy. For example, the Austrian Banks have lent huge amount of loans to these classic 1976 paper by Michael Jensen and William Meckling economies and is under severe pressure. So, both models showed that, in a world of imperfect information and principal- became a problem. One, UK model which invited foreign banks agent problems, the capital structure of the fi rm could be used as to set bases in their economies and then offer services around a tool by shareholders to better align the incentives of managers the globe and two, the East Europe model which invited with the shareholders’ interests. Thus was born a powerful and foreign banks to lend to domestic companies. fruitful rejoinder to the Modigliani- Miller neutrality result and, • Are Financial Markets Effi cient? Answering this question is more broadly, a perspective on capital structure that has had like dealing with fi re. After this crisis, the economists are divided enduring infl uence. in two camps. One says fi nancial markets are anything but Since then there has been numerous research analyzing how effi cient and are cyclical in nature with booms followed by busts. fi nancial systems help in developing an economy. The research If they were effi cient we should not be seeing this crisis at all has not just looked at how fi nance helps economic activity but (read Turner review for a critique). The second camp says also social aspects like poverty, hunger etc. markets are effi cient as the crisis shows that excesses do get The role of fi nance took a different shape corrected albeit with a lag. in few economies. Few economies like UK, The second camp is right in saying Iceland, Hong Kong etc became fi nancial It is indeed markets are effi cient as they have self-cor- services driven economies. The economies quite ironical rected. However, market effi ciency only started depending increasingly on their that perverse matters if markets correct in a shorter span ability to attract large fi nancial fi rms and incentives are of time. We cannot have a situation where becoming preferred markets for raising years of excesses are corrected in a matter of fi nancial resources. This model soon became being seen as few days. The EMH theory has discussed very popular as these economies grew really the major causes effi ciency mainly from an information well. So much so, some developing econo- of the crisis perspective but not from this time angle. If mies also decided to develop an interna- markets correct in four years of time can we tional fi nance center/region (India, Dubai etc). call them effi cient? However, it was a period of low fi nancial market volatility and Another issue of EMH which has been completely ignored is all was good. In this crisis this growth model has been completely incentives in fi nancial system. It is quite ironical that perverse opened up. The policymakers have realised the problem with incentives are being seen as the major causes of the crisis. In an this approach. The recent Turner report for UK fi nancial system effi cient market the question of incentives does not arise at all. was quite a change from precrisis days, when asll was considered The theory says markets have priced everything and people good with this growth model. UK Government also released a cannot generate profi ts unless they have private/insider informa- report on Status of UK as a International Finance Centre after tion. To prevent this holding of private information we have the crisis. regulators. Now, the leading fi nancial centers have always The problem was not just limited to fi nancial driven econo- marketed themselves as effi cient fi nancial markets. How is it that mies. Large number of East European economies had re- in these effi cient fi nancial market centers, fi nancial fi rms make formed during this crisis and had become export-driven so much profi ts? Moreover, we expect with better technology economies. They did not have a proper banking system and so markets have become more effi cient overtime but the profi ts

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continue to rise. This aspect of effi ciency has been completely research to prevent TBTF but has not gained ground. And all ignored by fi nancial economics. these economists cannot be dubbed as socialist variety. They add • Too Big to Fail: “A large non-fi nancial fi rm can fail but a large that in order for markets to function properly, we need to do fi nancial fi rm cannot fail”. This principle has been followed by away with TBTF. Then only we can have a market discipline. regulators but has reached its zenith and deserves a re-look. The This crisis would lead more thinking on this matter. As said reason behind this principle is that a large fi nancial fi rm is above, this crisis is going to change quite a few ideas. counterparty in many transactions and leads to a run on the • Corporate Governance: This is another branch of fi nancial other fi rms leading to a collapse of the entire system. We have economics that gained huge ground. The corporate boards were seen this come true with bankruptcy of Lehman Brothers and made the center of governance of fi rms. However, what we have collapse of other large fi nancial fi rms. instead witnessed is that these were instead cozy clubs in leading However, not letting a fi nancial fi rm fail makes the managers fi nancial fi rms. The focus was on short-term incentives and not complacent and they know their mistakes would always be really asking questions over the health of the fi rm. The central socialized. This leads to much higher risks and a much bigger principle of corporate governance was having independent crisis in future. Andrew Haldane of Bank of England, in an directors on the board. These are usually people of high acumen excellent review on UK’s risk management noted: and stature and collectively failed to see the huge risks the fi rms A few years ago, ahead of the present crisis, the Bank of England were carrying. and the FSA commenced a series of seminars with fi nancial It is important to note that it is this growth of corporate fi rms, exploring their stress-testing practices. The fi rst meeting of governance which made regulators complacent. Corporate that group sticks in my mind. We had asked fi rms to tell us the Governance was seen as a robust model of self-regulation and it sorts of stress which they routinely used for their stress-tests. A was felt that the quality of board will ensure that the fi rm is on quick survey suggested these were very right track. The board turned out to be more modest stresses. We asked why. Perhaps complacent (perhaps due to TBTF) and we disaster myopia – disappointing, but The focus was are all seeing the results now. perhaps unsurprising? Or network externali- on short-term • Role of Leverage: The role leverage plays ties –we understood how diffi cult these were incentives and not in one’s fi nancial decisions is pretty basic but to capture? really asking right somehow has been ignored by fi nancial No. There was a much simpler explanation economics. Despite numerous crisis showing according to one of those present. There questions over it is mostly high leverage that compounds was absolutely no incentive for individuals the overall health problems, it has been ignored by policymak- or teams to run severe stress tests and show of the firm ers and fi nancial economics research. Much these to management. First, because if there of the research is still based on M-M theory were such a severe shock, they would very likely lose their bonus that debt does not matter or is irrelevant. Merton Miller’s Nobel and possibly their jobs. Second, because in that event the Prize Lecture in 1990 was titled as “Leverage”. At that time authorities would have to step-in anyway to save a bank and Leveraged Buyouts were seen as the new devil that led to many others suffering a similar plight. failures then. Miller remarked: This statement from a policymaker is pretty disappointing and That Franco Modigliani and I should be credited with inventing sums up the state of affairs in fi nancial markets. Simon Johnson these takeovers is doubly ironic since the central message of our (ex-Chief Economist of IMF) has created quite a stir by calling M&M Propositions was that the value of the fi rm was inde- these TBTF fi rms as Financial Oligarches. Recently, quite a few pendent of its capital structure. Subject to one important policymakers have expressed that if banks are too large but are qualifi cation to be duly noted below, you couldn’t hope to insolvent they should be allowed to fail. Thomas Hoeing, enhance shareholder value merely by leveraging up. Investors President of Kansas City Fed has been a leading advocate of this would not pay a premium for corporate leverage because they measure. This is quite a reversal from the previous thinking on could always leverage up their own holdings by borrowing on TBTF. Minneapolis Fed President Gary Stern has written a lot of personal account.

188 THE IIPM THINK TANK C OUNTER CURRENTS

hence they are reacting. But this is the case for rising asset power of voice is not enough. Warnings are unlikely to be prices as well. Justin Lin (Chief Economist World Bank) in a effective when people are being asked to change behaviour which paper The Impact of the Financial Crisis on Developing seems to them highly profi table. So it is not entirely clear how the Countries, 2008) says: Bank will be able to discharge its new statutory responsibility if Throughout the US dot-com and housing price bubbles, the we can do no more than issue sermons or organise burials. Federal Reserve continued to adhere to its view that its mandate A simple focus on price stability is not likely to work anymore. was to pursue price stability and full employment, not to defl ate It is not that Central Banks do not look at fi nancial stability. The asset price bubbles. But amid the wreckage caused by the second Central Banks publish reports on fi nancial stability regularly but burst bubble in a decade, it is clear that this view needs to be all this is done passively. A more active approach and constant rethought. If the Fed is not able to keep these bubbles from endeavor, just like in the case of price stability is needed. infl ating, it will not be able to achieve its other objectives. There US and UK Governments have released reports to reform are reasonable questions about just how effective monetary their fi nancial systems and regulation. The report focuses on authorities will be in preventing asset-price bubbles, but it is no giving the Central bank more powers. The debates are ongoing longer reasonable not to rethink the issue carefully. in these respective economies and we will know the actual status • Guardians of Financial Stability and Role in Financial only when they are implemented. owever, initial reactions of Regulation: A linked point to the two above issues is the role of economists on the proposed reform is mixed. central banks in fi nancial regulation and stability. The regulatory • Role of Money and Credit Makes a Comeback? There has structure to manage fi nancial system is too diverse. In some been a really strange development in central banking. Their countries central banks are responsible to manage and supervise principles are based on Monetary Economics but money the banks and another authority to manage the capital markets hardly plays any role in central bank’s decisions! These days (like India), in some economies there are most central banks only use the interest multiple authorities managing the banks rates to infl uence demand conditions in (USA) and in some economies there is a These days most the economy. single authority regulating the fi nancial central banks Earlier, central banks used growth in system and Central banks only look at price only use the money stock to monitor infl ation. But stability (UK). interest rates to because of fi nancial innovation it became After this crisis, there is little doubt that diffi cult to maintain monetary growth and central banks need to be at the center of influence demand infl ation. Hence, instead of money the fi nancial regulation and need to manage conditions in central banks started to use interest rates. fi nancial stability along with price stability. the economy But the focus on interest rates was taken to Mervyn King, Governor Bank of England in one extreme with complete ignorance to a now-famous speech said: developments in monetary numbers. The role of money was just The Bank of England has a new statutory responsibility for limited to a casual mention in the central bank’s press release. fi nancial stability. Bank Rate is the instrument we deploy to Only ECB maintained its focus on monetary targets and still achieve monetary stability, and should be used exclusively for bases its decisions on the monetary pillar along with the econom- that purpose. To achieve fi nancial stability the powers of the ic pillar. The ECB watchers criticized ECB for their focus on Bank are limited to those of voice and the new resolution powers. monetary targets when they had become irrelevant. They added The Bank fi nds itself in a position rather like that of a church that ECB was using monetary targets just to emulate Bundes- whose congregation attends weddings and burials but ignores the bank (Germany’s Central Bank is considered to be successful at sermons in between. Like the church, we cannot promise that monetary targeting; however, it is still under debates) and bad things won’t happen to our fl ock – the prevention of all needed to do away with money. fi nancial crises is in neither our nor anyone else’s power, as a This crisis brings the role of growth in money and especially study of history or human nature would reveal. And experience credit back in the limelight. The central banks had been ignoring suggests that attempts to encourage a better life through the the substantial rise in credit in lineup to the crisis. This is seen as

192 THE IIPM THINK TANK C OUNTER CURRENTS

need is intellectual challenge to conventional wisdom. Because just looked at the issue minus the operational details. where we did do macro-prudential analysis, it often still failed to • Financial Innovation: We had looked at this issue in details in see the emerging problems. our previous report – Time to reassess Financial Innovation Each edition of the IMF Global Financial Stability Report is (dated 13th February, 2009). In sum, fi nancial innovation has full of macro-prudential analysis. But in April, 2006 it said this just focused on risk management function of fi nancial system (Exhibit 16): and has ignored the other functions. "There is a growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather Monetary Economics/Central Banking: than warehousing such risk on their balance sheets, has helped Dr. YV Reddy, former RBI Governor in an address at Singapore make the banking and overall fi nancial system more resilient". (Hindu Business Line, 11th October, 2008) said: The improved resilience may be seen in fewer bank failures and “An outcome of the crisis, according to Dr Reddy, is the “histori- more consistent credit provision: consequently the commercial cally signifi cant redefi ning of the concept of the central bank”. banks may be less vulnerable today to credit or economic shocks’ This statement neatly sums up the challenges for central banks Which was not just wrong – but 180° wrong. So how do we ahead. This crisis has asked many questions from central banks. ensure that we don’t in ten years’ time get it wrong again, going In most of our research reports on the ongoing crisis we have along with a dominant conventional wisdom? Market prices are posed numerous questions for central banks. Let us just summa- subject to self-reinforcing herd effects: policymakers and policy rise them. intellectuals can be subject to intellectual herd effects; and there • Infl ation Managers: The complacency was not limited to is no failsafe way to offset this human tendency to collective fi nancial regulators/supervisors. The biggest complacency was error. But we need as best possible to embed challenge into our seen in central banking. The recent thinking backed by substan- institutions. tial research was that central banks should Bernanke in a speech (22nd August, 2008) focus only on price stability. As long as had said: The complacency prices are stable, all other economic Some caution is in order, however, as this was not limited variables will be stable as well – growth, more comprehensive approach would be to financial fi nancial markets etc. The usual policy technically demanding and possibly very regulators. advise for central banks in developing costly both for the regulators and the fi rms economies was to just pursue price stability they supervise. It would likely require at The biggest and rest would follow. Before the crisis, this least periodic surveillance and information- complacency was view held very well. gathering from a wide range of nonbank in central banking However, the crisis struck at times when institutions. International regulatory coordi- infl ation was relatively stable. In addition, nation, already quite extensive, would need to be expanded most of the fi re-fi ghting was left for central banks. In order to further. justify their moves to protect fi nancial systems, the Central Macroprudential supervision also presents communication Banks started pointing to their ignored objective to look at issues. For example, the expectations of the public and of fi nancial systems (payment systems etc). The ignored objective fi nancial market participants would have to be managed became the most important objective. To prevent fi nancial carefully, as such an approach would never eliminate fi nancial collapse, central banks reduced rates substantially and did it crises entirely. Indeed, an expectation by fi nancial market frequently. The sharp easing was appalling in the beginning of participants that fi nancial crises will never occur would create its the crisis as the infl ation was at record high levels. The infl ation own form of moral hazard and encourage behavior that would lowered later much to the relief of central banks but questions make fi nancial crises more, rather than less, likely. over this sudden switch need to be answered. Can Central banks Hence, it seems only normative analysis has been done on cut rates at times when infl ation is at record high levels? macroprudential fi nancial regulation. There is not much of a What is also not understood properly is the asymmetric thought on how to make it workable. Once again research has response of central banks. At times of high infl ation, the usual

190 THE IIPM THINK TANK C OUNTER CURRENTS

through higher interest rates may make domestic assets even The DSGE models actually have the same features that we more attractive. have noted as a problem above. The DSGE models assume the Thus, the crisis raises two issues. The fi rst is the need to revisit fi nancial markets to be effi cient and thus accord a minimal role when and how to react to large imbalances, through macroeco- to fi nancial markets. It also does not have a role for fi scal policy, nomic and structural policies that affect saving and investment. money or credit. Some models have started to account for As elsewhere, an attitude of benign neglect has proven to be a fi nancial frictions but are very limited. These models despite mistake. The second is the potential role for prudential measures their limitations have been used actively by monetary policy- to reduce systemic risk associated with large capital infl ows—e.g., makers. The leading central banks have their own versions of through constraints on the foreign exchange exposure of domestic DSGE models. institutions and other borrowers. As these models don’t include the main factors seen in this Some other economists who were leading advocates of crisis, it is time to redo these models. The linkages between fi nancial globalization have also reviewed their models. They economy and fi nancial markets have become very strong and now say that economies need to have certain thresholds to have to be incorporated in the models. However, no economic qualify before they completely open to capital fl ows (see this model can help predict a crisis. The economists should remem- paper- Thresholds in the Process of International Financial ber not to over-rely on models and avoid complacency. Integration by Ayhan Kose et al). This is exactly what the policymakers of developing economies were saying after their Economic Theories/Policies - experiences with capital fl ows. However, it found no takers and Infl uenced by Personalities? the problem was limited to ineffi cienbt institutions and policies This point is not about any specifi c branch of economics but in developing economies. about economists in general. The question that comes to mind is if there were so many concerns with current Economic Models economic thinking why didn’t economists One of the main criticisms of Willem Buiter If there were so correct them? and Paul de Grauwe (quoted in the begin- many concerns The more one reads into economists ning) is centred on the models used by with current account on the current crisis the more one Central banks for their policies. These economic gets the feeling that current economic models are known as Dynamic Stochastic thinking is more driven by personalities/ General Equilibrium Models (DSGE). Paul thinking, then why economists behind the theory. How else can de Grauwe adds: didn’t economists you explain these developments/errors? We Modern macroeconomics as embodied in correct them? had discussed this issue in our previous Dynamic Stochastic General Equilibrium report (Crisis 2007-?: Policymaking at the models (DSGE) is based on the paradigm of the utility maximiz- crossroads?, 2009). However, at that time we had looked at the ing individual agent who understands the full complexity of the issue from a different angle. In summary, the crisis has seen a world. Since all individuals understand the same “Truth”, number of blame games being played. The market participants modern macroeconomics has taken the view that it suffi ces to have blamed the regulators for not acting fast enough, the model one “representative individual” to fully represent reality. regulators blame the market participants and we have other Thus as a consumer the agent continuously maximizes an economists blaming a bit of both. Recent statements from key intertemporal utility function and is capable of computing the policymakers and policy infl uencers suggest they had raised fl ags implications of exogenous shocks on his optimal consumption about the bubble and impending crisis (via their research, plan, taking full account of what these shocks will do to the plans statements etc) but no one listened. of the producers. Similarly, producers compute the implications We had pointed to recent statements/speeches from leading of these shocks on their present and future production plans economists/policymakers that had played the blame game. Table taking into account how consumers react to these shocks. Thus 1 summarises the results. in such a model coordination failures cannot arise. IMF and BIS are independent institutions but have an

194 THE IIPM THINK TANK C OUNTER CURRENTS

hence they are reacting. But this is the case for rising asset power of voice is not enough. Warnings are unlikely to be prices as well. Justin Lin (Chief Economist World Bank) in a effective when people are being asked to change behaviour which paper The Impact of the Financial Crisis on Developing seems to them highly profi table. So it is not entirely clear how the Countries, 2008) says: Bank will be able to discharge its new statutory responsibility if Throughout the US dot-com and housing price bubbles, the we can do no more than issue sermons or organise burials. Federal Reserve continued to adhere to its view that its mandate A simple focus on price stability is not likely to work anymore. was to pursue price stability and full employment, not to defl ate It is not that Central Banks do not look at fi nancial stability. The asset price bubbles. But amid the wreckage caused by the second Central Banks publish reports on fi nancial stability regularly but burst bubble in a decade, it is clear that this view needs to be all this is done passively. A more active approach and constant rethought. If the Fed is not able to keep these bubbles from endeavor, just like in the case of price stability is needed. infl ating, it will not be able to achieve its other objectives. There US and UK Governments have released reports to reform are reasonable questions about just how effective monetary their fi nancial systems and regulation. The report focuses on authorities will be in preventing asset-price bubbles, but it is no giving the Central bank more powers. The debates are ongoing longer reasonable not to rethink the issue carefully. in these respective economies and we will know the actual status • Guardians of Financial Stability and Role in Financial only when they are implemented. owever, initial reactions of Regulation: A linked point to the two above issues is the role of economists on the proposed reform is mixed. central banks in fi nancial regulation and stability. The regulatory • Role of Money and Credit Makes a Comeback? There has structure to manage fi nancial system is too diverse. In some been a really strange development in central banking. Their countries central banks are responsible to manage and supervise principles are based on Monetary Economics but money the banks and another authority to manage the capital markets hardly plays any role in central bank’s decisions! These days (like India), in some economies there are most central banks only use the interest multiple authorities managing the banks rates to infl uence demand conditions in (USA) and in some economies there is a These days most the economy. single authority regulating the fi nancial central banks Earlier, central banks used growth in system and Central banks only look at price only use the money stock to monitor infl ation. But stability (UK). interest rates to because of fi nancial innovation it became After this crisis, there is little doubt that diffi cult to maintain monetary growth and central banks need to be at the center of influence demand infl ation. Hence, instead of money the fi nancial regulation and need to manage conditions in central banks started to use interest rates. fi nancial stability along with price stability. the economy But the focus on interest rates was taken to Mervyn King, Governor Bank of England in one extreme with complete ignorance to a now-famous speech said: developments in monetary numbers. The role of money was just The Bank of England has a new statutory responsibility for limited to a casual mention in the central bank’s press release. fi nancial stability. Bank Rate is the instrument we deploy to Only ECB maintained its focus on monetary targets and still achieve monetary stability, and should be used exclusively for bases its decisions on the monetary pillar along with the econom- that purpose. To achieve fi nancial stability the powers of the ic pillar. The ECB watchers criticized ECB for their focus on Bank are limited to those of voice and the new resolution powers. monetary targets when they had become irrelevant. They added The Bank fi nds itself in a position rather like that of a church that ECB was using monetary targets just to emulate Bundes- whose congregation attends weddings and burials but ignores the bank (Germany’s Central Bank is considered to be successful at sermons in between. Like the church, we cannot promise that monetary targeting; however, it is still under debates) and bad things won’t happen to our fl ock – the prevention of all needed to do away with money. fi nancial crises is in neither our nor anyone else’s power, as a This crisis brings the role of growth in money and especially study of history or human nature would reveal. And experience credit back in the limelight. The central banks had been ignoring suggests that attempts to encourage a better life through the the substantial rise in credit in lineup to the crisis. This is seen as

192 THE IIPM THINK TANK G LOBAL GOVERNANCE New Resources for an Unreformed IMF?

assive crises can be excellent news, as the present recommended to Southern Countries (SCs) were carried to US Crisis proves, which resulted from deregulat- their logical extreme. Deregulation went as far as to encour- Ming and liberalising the fi nancial sector. Al- age practices such as "liar" or "NINJA" (No Income No Job though much larger, it is a crisis like other neoliberal crises or Assets) loans that can only be explained by the fact that earlier in Chile, Mexcio, East Asia or the Savings & Loan securitised debt was quickly sold on and regulatory checks Crisis in the USA. Those policies the IMF forced on or were not applied. Lenders were off the hook after cashing

196 THE IIPM THINK TANK IMF

from SDR 70 billion (2002) to some SDR 15.5 billion (end Kunibert Raffer 2006) as well as income shortfalls projected to surpass 40% Associate Professor, during 2008-10 (Torres 2007, p.9), this Crisis saved the IMF Department of Economics, once again, also making it more powerful. After the demise University of Vienna, Vienna, Austria of Bretton Woods, the IMF should have been dissolved. The Southern debt crisis of the early 1980s saved it, allowing the IMF to usurp the task of “debt manager” after having egged SCs on to borrow. Again, an international debt crisis the IMF had helped come about saved it in 2008. Iceland broke the ice. On 24th October, 2008 an IMF their fees. package totalling $2.1 billion was announced under the The basis of the crash was again the Robichek (now rather Fund's fast-track emergency fi nancing mechanism. A Greenspan) doctrine: markets know best and should not be Stand-By Arrangement for Hungary was approved in "overregulated". The government should not interfere as it November. The G20 decided to increase the IMF's role and can only make things worse. Historically one of the fi rst fi nancial base substantially. This neoliberal crisis has again cases, Chile's military dictatorship provided an ideal precon- put the neoliberal Fund back into business. In March 2009, dition to implement neoliberal ideas, producing the fi rst the IMF "overhauled" its lending structure, also establishing neoliberal fi nancial crash. State enterprises were privatised, a Flexible Credit Line (FCL). When the fi rst country, public expenditure was reduced and the economy opened up. Mexico, availed herself of the FCL, IMF First Deputy As the market knows best banking supervision was cut down, Managing Director John Lipsky spoke of "a historic occa- as in the US recently. Moral backing came from the Bretton sion", "the largest fi nancial arrangement in the Fund’s Woods Institutions, especially from the IMF. The IMF's history", and "the consolidation of a major step in the process Director of the Western Hemisphere, E. of reforming the IMF and making its Walter Robichek, assured Latin Ameri- lending framework more relevant to cans that exchange and other risks would The IMF was member countries’ needs." (IMF Survey presumably be taken into account as granted more online, April 17th, 2009). The IMF in private fi rms can be expected to be power without particular was saved by the Crisis trig- careful. Private borrowers (as opposed to any meaningful gered by those neoliberal policies it governments) were very unlikely to recommends. Money is rolling in from the overborrow, even with offi cial guarantees. reform, and may leading economies. Apparently due to Briefl y, private, voluntary transactions now continue criticism of her surpluses meanwhile even were the private sector’s own business as before called one main reason of the US Crisis, and presumably Pareto optimal. This China signalled her intention to invest up view is sometimes called the Robichek doctrine. The to US$50 billion in notes issued by the Fund in June 2009. "Chilean miracle" turned into a catastrophe in 1982, GDP The worst result, though, is that the IMF was granted fell by over 14%. The government was forced to socialise more power without any meaningful reform, and may now private losses, another parallel to the present US Crisis. continue as before. Reform proposals abound, especially These international crises had positive effects on the IMF. with the IMF they have become some kind of cottage The perpetrator was called in to save its victim; the alcoholic industry. It is all the more surprising that the most urgent was put in charge to guard the bar. Recently, though, richer problem has practically eschewed attention: making the IMF SCs had become able to free themselves from the IMF's grip. obey its own statutes and the principles it preaches - applying Early repayments to the Fund started to threaten its exist- good governance and the Rule of Law to itself. "Reform" is ence. On the brink of bankruptcy due to early repayments limited to a few basis points of voting being shifted between and a corresponding shrinking of its outstanding claims regions, one tangible though economically irrelevant

THE INDIA ECONOMY REVIEW 197 G LOBAL GOVERNANCE

outcome. It might be quite nice if China has a few votes more general resources of the Fund.” than Belgium instead of a few votes less, but this will hardly By fi nancing large and sustained outfl ows in East Asia and change things fundamentally. in other countries, the IMF clearly and openly violated its Open violations of its statutes have caused substantial own Articles of Agreement, infl icting considerable damage damage to SCs, and increased IMF-income. IMF-fl ops have on its member countries. Although the IMF may but is not created IMF-jobs. This paper argues that any "reform" obliged to request controls and declare members ineligible, remains meaningless as long as the IMF is allowed to its statutes clearly show that it is not supposed to press for continue to breach its own statutes and to infl ict heavy liberalisation of capital movements in the way it actually did. damages on its Southern members and clients with impunity, Clearly, Asian countries had not only the right to control fi nancial and institutional gain. capital outfl ows in 1997, as the IMF had to admit when Malaysia courageously exercised it (Raffer and Singer 2001, Capital Controls - A Membership Right p.157), the Fund's forcing members to fi nance large and Although the IMF's Articles of Agreement clearly stipulate sustained outfl ows by speculators is defi nitely a violation of the right to capital controls, even explicitly restricting the the IMF's own constitution. Routinely, short term specula- use of Fund resources to fi nance speculative outfl ows, the tors have been bailed out in breach of the Fund's statutes. IMF has made its Southern members resist from exercising The intentions of its statutes are clear. Rather than forcing their membership right and fi nanced such outfl ows. It foisted or even encouraging members to keep capital accounts open, high interest rates and keeping capital accounts open onto the Fund is meant to request controls from members not members in distress, at great costs to imposing such controls as appropriate them and violating its own statutes. Routinely, short themselves It may even sanction them. Art. VI(3) establishes the right of term speculators However, when it comes to protecting the members to “exercise such controls as are rights of developing members, legal necessary to regulate international have been bailed regulations and obligations are appar- capital movements, but no member may out in breach of ently insignifi cant. Art. VI(1)(b)(ii) allows exercise these controls in a manner which the International members to meet outfl ows “out of a will restrict payments for current transac- Monetary Fund's member's own resources, but members tions”. Art. XXX(d) defi nes these as “not statutes undertake that such capital movements for the purpose of transferring capital”, will be in accordance with the purposes including “Payments of moderate (emph. KR) amount of of the Fund.” Members are even encouraged not to fi nance amortization of loans or for depreciation of direct invest- large and sustained outfl ows. Current transactions can be ments”, or “moderate remittances for family living expenses”. restricted with the Fund's approval. Although this defi nition is somewhat opaque, even restrict- In plain English, members have always had the right to ing fl ows such as amorisations is a member's right. stop amortisations. In 1997-8 there was no obligation to Not only has any member the right to control capital fl ows, fi nance outfl ows fully, nor is there an economic need to keep but the IMF is not allowed to fi nance outfl ows as it did in extremely high reserves against capital account crises, as Asia 1997-8. Pursuant to Art. VI(1)(a), a several Asian countries do now to shield against having to “member may not use the Fund's general resources to call in the IMF again. They do so at great costs. Exercising meet a large and sustained outfl ow of capital except as their statutory rights would be cheaper and not expose them provided in Section 2 of this Article [this refers exclusively to the blame of contributing to "global imbalances", thus to reserve tranche purchases ] and the Fund may request a being “responsible” for the present US-made crisis. member to exercise controls to prevent such use of the general resources of the Fund. If, after receiving such a Falsely Claiming Preferred Creditor Status request, a member fails to exercise appropriate controls, Although the status of preferred creditor is alien to the the Fund may declare the member ineligible to use the statutes of the IMF, the impression has quite successfully

198 THE IIPM THINK TANK IMF

been created over decades that its claims are entitled to during the subsequent year" was done "to give preference in preferential treatment. This perception is completely repayment to lenders other than the Fund." He argues that unfounded and at odds with the truth, both regarding the the intention of deleting this calculation and with it Schedule IMF and multilateral development banks. In fact, IFIs have B, paragraph three from the statutes by the Second Amend- undone their founders’ intention, reversing it into its ment "was not to repudiate the underlying thought that it was opposite. De facto preference of the IMF and other benefi cial to eencourage bank lending by giving banks multilaterals has made debt reductions moreore andand otothersh a preference in repayment" (ibid., diffi cult as other, bona fi de creditors must p.8p.814). Unfortunately, this initial intent was accept larger haircuts. blurredb when conditionality was intro- The IMF knows that it enjoys no legal duced, rather than making the IMF or contractual preferred creditor status, fi nancially accountable as indicated by as can be read on its very own homepage economic reason, and legally and (Boughton 2001, p.820). When prob- ethically proper. lems with SCs unable to service their One has to concur with Martha (1990, debts to the IMF in time could no longer p.814) that the IMF’s statute contains "a be ignored around 1988, it was tried to fi ndd presumptionp against a preferred creditor arguments in favour of preference. But thee sstatus",tat and that "general international law fact that the IMF has no legal or contractualual containscontain no compulsory standard of conduct status as a preferred creditor could not be requiring the preferential treatment of denied. Supporting their institution’s drive It might be any external creditor, including the for undue preference, its "Executive quite nice if China Fund" (ibid., p.825). However the IMF Directors stressed the ... need ... in has no explicit statutory obligation to practice ... to treat the Fund as a preferred has a few votes grant debt relief, which can again be creditor." In September 1988, the Interim more explained by its initial role as a helper Committee endorsed this position and than Belgium without conditionality. Important "urged all members, within the limits of instead of a multilateral development banks violate their laws, to treat the Fund as a preferred few votes less their own constitutions by not giving creditor." (ibid, p.821, emphasis added) members in default relief as stipulated. The qualifi cation "within the limits of their laws" shows that Preference as interpreted by the multilaterals and the Paris even this IMF-organ could not bring itself to demand Club creditor cartel and forced onto the South includes abso- unconditional preference for the Fund from its own mem- lute exemption of multilateral claims. This is done in open bers. The Committee accepted that national laws may forbid breach of their own statutes by multilateral development such treatment. In contrast to the impression the IMF tries banks whose statutes foresee appropriate relief mechanisms to create, there is no legal hindrance to treating it like any explicitly (cf. Raffer 2008; fc, Chapter 13). These member- other creditor. Therefore, the IMF’s SDRM-proposal ship rights are just denied to SCs. attempted to obtain de jure preferred status for IFIs in an Forced by external auditors, the IMF started to provide extremely self-serving way. for non-payment by building up loan loss provisions. This Before the Second Amendment, the IMF’s Articles of means that borrowers have paid for the eventuality of Agreement "contained a provision suggesting that others default. Nevertheless they have continuously been refused would have preference on the Fund" (Martha 1990, p.825). the relief they had already fi nanced with the "argument" The author refers to Schedule B, paragraph three on the that the Fund were preferred and could not survive losses. calculation of monetary reserves on which repurchase It has charged its clients for the event of default, but also obligations were based. It seems logical that the exclusion of claims it cannot use these reserves for the very purpose holdings "transferred or set aside for repayments of loans they were established for. This is like an insurance com-

THE INDIA ECONOMY REVIEW 199 G LOBAL GOVERNANCE

pany charging necessary fees but refusing to cover dam- infl icted by gravest negligence or even wilfully by the Fund, ages once they occur. Unlike the Fund no insurance more damage created by it leads necessarily to larger company could get away with such behaviour, not even if involvement of the IMF as a "trouble shooter". Its fl ops the client were from the South. Legal double standards create more IMF-jobs, and increase its importance. This is may exist, but not everywhere. an intolerable moral hazard situation, unless one agrees to double standards based on nationality. The only exception of Paying for Unlawfully Infl icted Damage the generally accepted principle that someone infl icting While statutes of other IFIs contain mechanisms of legal damage unlawfully must compensate their victims is unfor- redress – most clearly so in the cases of the IBRD and IDA - tunately development co-operation, the last sphere where the IMF clearly differs. Art. IX(3) of its Articles of Agree- damage can still be infl icted with impunity and even fi nan- ment grants it total immunity “except to the extent that it cial and "reputational" gain. If normal accountability expressly waives its immunity for the purpose of any pro- standards applied to Southern debtors there would in all ceedings or by the terms of any contract”. Obviously, this is likelihood be no multilateral debt problem. explained by the fact that initially the Fund was to help mem- The IMF may advise (or force, as skeptics may formulate) ber countries to overcome short-term dollar/gold-parity SCs to implement programmes that it had "known to be problems by unconditional short-term drawings (=loans). It counterproductive ... or that had proved to be 'ineffective would be diffi cult to perceive any need for legal procedures and unsustainable everywhere they had been tried'41”. (IMF and redress in the case of an emergency 2004, p.91). Footnote 41 further clarifi es helper unconditionally giving money, that the IMF was fully aware of proven except cases such as money paid to Evaluating the ineffectiveness and unsustainability: "As dictators fully knowing that large parts Fund’s role in expressed by FAD [the IMF’s Fiscal would routinely be embezzled (as did the Argentina, its own Affairs Department] at the time" (ibid., IBRD in Suharto's Indonesia). Probably internal controllers p.55).This does not result in damage such eventuality made the IMF’s founders compensation but in increased earnings insert this waiver to provide for proper found many and more control over the client. A quick legal dispute settlement. When condition- cases of grave and effi cient solution would in compari- ality became enshrined in the IMF's negligence son have reduced earnings. The differ- statutes in 1969, the appropriate change ence may be illustrated by Stiglitz’s regarding immunity was not made for whichever reason, (2000) famous story "of one unfortunate incident when team although its founders would doubtlessly have stipulated the members copied large parts of the text for one country's possibility of legal redress as they did with the IBRD if they report and transferred them wholesale to another", leaving had approved conditional drawing. Arguably, this was the the initial name in some places. Any private consultant fi rst step to establish legal double standards globally. Never- would be liable to pay damage compensation. In most theless, the IMF may not only submit to arbitration or countries penal consequences would not be unlikely. courts, but contractual clauses stipulating this remain Evaluating the Fund’s role in Argentina, its own internal expressly allowed. Nothing in its statutes prevents the Fund controllers found many cases of grave negligence, if not from applying civilised legal standards. On the contrary, the worse (IMF 2004). In addition to applying policies fully existence of this waiver seems an encouragement to do so if aware that these were counterproductive, Argentina’s and when appropriate. programme did not “address the now clear overvaluation of By not availing itself of this option when and where the exchange rate". Another "critical error" (ibid., p.46) in appropriate, the IMF has knowingly created a system 2001 was, that there was no suffi ciently clear understanding incompatible with the very idea of the market economy, good what to do should the approach fail. The Board supported "a governance, or the Rule of Law. As members are always program that Directors viewed as deeply fl awed" (ibid., p.50). forced to repay fully, also when avoidable damages are The "September 2001 augmentation suffered from a number

200 THE IIPM THINK TANK IMF

of weaknesses in program design, which were evident at the out enforcing this self-evident necessity any other reform time. If the debt were indeed unsustainable, as by then well will remain fairly useless. One may fl out one version of one’s recognized by IMF staff, the program offered no solution to statute as well as any other if allowed to do so. that problem" (ibid., pp.54f). In a footnote the IEO corrobo- rates this last point by quoting a "memorandum to manage- Reference and Additional Thinking ment dated July 26th, 2001", stating that IMF "staff estimates • Boughton. James M (2001), Silent Revolution: The that a haircut of between 15 and 40 percent is required". International Monetary Fund 1979–1989, Washington, Instead, new loans were granted to Argentina. The IMF not DC: IMF; Chapter 16 also at www.imf.org/external/pubs/ only "failed to use the best analytical tools" (ibid, p.66), but ft/history/2001/ch16.pdf (12/08/2009) "[a]vailable analytical tools were not used to explore poten- • IMF, IEO (2004) Report on the Evaluation of the Role of tial vulnerabilities in suffi cient depth" (ibid., p.67). It goes the IMF in Argentina, 1991–2001, at http://www.imf.org/ without saying that the IMF was as usual unduly "optimistic" external/np/ieo/2004/arg/eng/pdf/report.pdf (10/08/2009) in its forecasts, as the report documents. This is just a small • Martha, Rutsel Silvestre J. (1990) "Preferred Creditor selection from a limited part of the period evaluated in one Status under International Law: The Case of the Interna- country. May this suffi ce to show that, if the IMF were a tional Monetary Fund", International and Comparative consultancy fi rm and Argentina its client, the plaintiff’s Law Quarterly 39(4), pp 801ff. lawyers would have a feast. But the IMF is not a consultant • Raffer, Kunibert (2004) "International Financial Institu- and Argentina had to pay for programmes that (as the IMF tions and Financial Accountability", Ethics & Interna- did know, according to its own documents) contributed to tional Affairs 18(2), pp.61ff; or http://www.cceia.org/ her ruin. The IMF got more interest income from Argentina resources/journal/18_2/articles/5019.html (08/08/2009) than it would have got if it had refrained from such strate- • Raffer, Kunibert (2008) "Bretton Woods Institutions and gies. One cannot but concur with the Statement of the the Rule of Law”, Economic & Political Weekly Argentine Governor: “Recognising errors is, however, just XLIII(38), 20-26 September, pp.49ff; or http://homepage. the fi rst step in a healthy self-criticism exercise. The second univie.ac.at/kunibert.raffer/KR-acc.pdf (08/08/2009) step is bearing responsibility for failures, namely sharing the • Raffer, Kunibert (fc) Debt Management for Development burden of redressing their consequences” (ibid., Annex) as - Protection of the Poor and the Millennium Development allowed by the IMF’s statutes. Equal treatment of all Goals, forthcoming at Edward Elgar, Cheltenham (UK)/ creditors in the case of a country's incapability to pay fully Northampton (US) would be a fi rst yet important step to provide incentives for • Raffer, Kunibert and HW Singer (2001) The Economic good institutional governance and for applying due care. North-South Divide: Six Decades of Unequal Develop- Furthermore, arbitration and courts could be used to ment. Cheltenham (UK)/Northampton (US): Elgar provide decent legal relief (see Raffer 2004; fc). The IMF’s [paperback eds: 2002; 2004]. statutes authorise it to behave properly by waiving its • Stiglitz, Joseph (2000) "What I Learned at the World immunity in such scandalous cases. Economic Crisis: The Insider," New Republic, 17 April, pp.56ff; or http://www.mindfully.org/WTO/Joseph- Conclusion Stiglitz-IMF17apr00.htm (12/08/2009) More voice and representation of the South within the IMF • Torres, Hector R (2007) "Reforming the International is necessary and fair. But all present reform proposals will go Monetary Fund – Why its legitimacy is at stake", The nowhere unless one forces the IMF to obey its own statutes. Journal of International Economic Law 10(3), pp.1ff, A seven percent shift of voting in the IMF is doubtlessly a http://www.networkideas.org/featart/aug2007/fa10_Hec- well justifi ed demand, but making the IMF obey its statutory tor_Torres.htm (12/08/2009). obligations even if and when these safeguard rights of SCs is much more important. Obeying one’s own statutes is the (The views expressed in the article are personal and do not cornerstone of the Rule of Law and good governance – with- refl ect the offi cial policy or position of the organisation.)

THE INDIA ECONOMY REVIEW 201 G LOBAL GOVERNANCE The Unbearable Lightness of Financial Markets

information, and instantly change to refl ect new information. Heiner Flassbeck In this manner, the markets always gets the prices right and Director, Division on Globalization assets are always traded at their “fair value”. In this theory, and Development Strategies, fi nancial markets, even more than goods markets, allocate United Nations Conference on resources in an effi cient way and regulation is unnecessary. Trade and Development (UNCTAD), In a different theoretical setting, however, the most impor- Geneva tant lesson of the recent global crisis is that fi nancial markets hardly do "get the prices right". In this view, the information processing of fi nancial markets results systematically in over- Sonia Boffa shooting or undershooting and in misallocation of resources. As Associate Economic Affairs Offi cer, all market participants react in a more or less uniform manner United Nations Conference on to new information or "new shocks", the winding or unwinding Trade and Development (UNCTAD), of their exposure to risk takes place almost in unison. Geneva This has never been better demonstrated than by the current crisis, where fi nancial markets for very different types of assets and in all major countries inancial markets have a long history of speculative were hit almost simultaneously. As Figure 1 bubbles and crashes. From the 1622 currency bubble of shows, the fi nancial shockwave submerged F the Holy Roman Empire, the Tulip mania in 1637 and the stock and bond markets in many countries, South Sea Bubble of 1720, through the Railway mania in 1840s, ex-change rates of some emerging- the Poseidon Bubble in 1970s and the dot-com bubble in 2000 up market currencies and primary to the recent real state bubble1, fi nancial markets seems not to commodity mar-kets all at the fi nd a safe and calm haven but to create the basis for a new storm same time. The same strong as soon as the last one has settled. Surprisingly, despite the correlation can be seen for the previous and the present over-shooting and undershooting of fi rst quar-ter of 2009, with a fi nancial markets, the strong belief that markets "are getting the nearly parallel in-crease prices right" is only rarely as fundamentally questioned as one among totally different could have expected in the light of the shocks? assets that are The Effi cient Market Hypothesis (EMH), supposedly the traded on most widely accepted theory in economics over the last fi ve decades, is still seen as the cornerstone of the whole neoclassi- cal macroeconomic edifi ce. The EMH claims that, in an effi cient market, the prices of traded assets (e.g., bonds, currencies, stocks, or property) refl ect all available

202 THE IIPM THINKK TANKTANK U NBEARABLE LIGHTNESS

fi nancial markets or on markets with a high degree of fi nanciali- zation. The extremely high correlation of the day-to-day price movements in so many different markets can only be ex-plained by a common force like fi nancial specula- tion, which moves all the prices in the same direction despite their different fundamentals. Take, for example, the currency market. High infl ation countries are the main target for short-term capital fl ows because they usually offer high interest rates. In doing so, "investors" can gain large profi ts by carrying money from countries with low interest rates to those with high interest rates. At a macro level, this “carry trade” causes an appreciation of the

THET HEH ININDIAN DID I A EECECONOMYC ONOONNON O MMYY REVIEWRER EEVIIEWW 2030 G LOBAL GOVERNANCE

recipient country currency despite its fundamental need to farmers may sell their future harvest through such a contract in depreciate to stabilize trade fl ows. The long lasting real apprecia- order to be sure about the price and avoid bad surprises at the tion of high yielding currencies is a clear signal of the ability of time of the harvest. The farmer may indeed accept what seems to speculative fl ows to drive prices in the “wrong direction”. be a rather low price to hedge the risk of a much lower price later. On commodity markets fi nancial "investors" have been very In this sense, Thalesian futures market are driven by a reasonable active since the early 1990s as a strategy to diversifying portfolios kind of speculation, where a more risk adverse person is hedging through exposure to commodities as a new asset class. When their its risk with a person that it is less risk adverse. involvement took on new proportions in the aftermath of the What happens when futures contracts are traded in purely dot-com crash in 2000 and started a meteoric rise in early 2005 fi nancial markets without producers of the commodities being prices were clearly distorted2. The parallel development of involved? Trading a futures contract of commodities, like trading commodity prices and fi nancial investment on commodity futures stocks or currencies, implies the anticipation of the future price of markets is a fi rst indicator for the role of large-scale speculative the traded asset. The farmer after having planted its crop may activities in distorting commodity prices (UNCTAD, TFR 2009). have an idea of the future supply, its quality and the local demand Among economists, however, scepticism prevails with regard to for such a quality that allows him to estimate roughly the present the link between speculation and commodity price development value of his coming harvest. However, in a truly global market and and this scepticism is based on the effi cient market hypothesis long before the food stuff is planted, for example olives for the (EMH). EMH believers still sustain that if harvest in 2010, no one has a clear idea about speculators were driving market prices above the outcome in terms of the fi nal price. fundamental levels, consumer will demand The policy The main difference between the less than producer are supplying. The result lesson is simple: thale-sian futures market and the fi nancial would be visible inventories of speculators. macroeconomic fu-tures markets nowadays is the impossi- As the evidence on inventories is inconclusive prices are too bility of an acquisition of reliable informa- the traditional view declines the role of tion in the latter about prices in the future. speculation. However, reality may be more important to be In fact, pricing in fi nancial futures markets complex than this simple model. left to the vagaries is no longer based on some knowledge of of these markets the concrete supply and demand but it is Speculation in Commodity Prices: based on "more sophisticated” techniques Spot Prices and Future Expectations and procedures. But even with these techniques like deep First, there is no doubt that the most basic form of speculation, digging analysis of supply and scientifi c studies of future hedging, can play a useful role in markets with volatile prices: demand (like "The Chinese or Indian demand for oil or food”) Thales was a poor philosopher from Miletus who forecasted the the information is not more accurate; the state of objective olive harvest would be exceptionally good the next autumn. uncertainty prevails. But another nexus may come into play: As Confi dent in his prediction, he made agreements with local olive the futures market normally is a highly active, very visible and press owners to deposit his money with them to guarantee him centralized market, the farmer and the hedger may prefer to exclusive use of their olive presses when the harvest was ready. set their price according to the futures "markets view" instead Thales successfully negotiated low prices because the harvest was of relying on their own judgment (especially when the forward in the future and no one knew whether the harvest would be price in that market is higher than the one the farmer had plentiful or poor and because the olive press owners were willing to expected). Then the futures markets becomes a vital source for hedge against the possibility of a poor yield. When the harvest-time information about spot prices and may indeed force both, the came, he let them out at any rate he pleased, and made a large producer and the hedger, to adjust accordingly. quantity of money. It is exactly in this way in which information, unrelated to the A futures contract of this kind is a standardized contract to buy fundamentals of the concrete market drives many different or sell a specifi ed asset at a certain date in the future, at a fi nancial prices into the same direction over remakably long time pre-determined price. In agri-cultural markets, risk averse spans. The rumor about a recovery of the global economy is more

204 THE IIPM THINK TANK U NBEARABLE LIGHTNESS

important than any “fundamental” in driving the prices up or judgment of the other speculators. This phenomenon systemati- down. Then the futures markets dominate the price formation in cally encourages the emergence of price bubbles if the herds the spot markets and not the other way around, as traditional infl uenced by certain bits of information are large enough. If this theory suggests. Remains the question about fi nal demand: what is the case fi nancial markets systematically "get the prices wrong" will consumers do to protect against the volatility of the fi nancially since betting on ever-rising prices appears to be a rather risk-free determined prices? The simple answer is that in most cases they and high-return business for an extended period of time. have no choice. They continue to satisfy their needs irrespective As long as the “madness of the crowds" prevails, the individual of the price and take the implied overall income effect that is judgement on the fair value of an asset is useless. In this sense, implied by the price moves as good or bad luck respectively. fi nancial markets have a lot in common with the historical Spanish Overall, fi nancial markets are not compa-rable to the ideal tradition of encierros (running with the bulls): since you have to atomistic market of economics textbooks. In an atomistic market, run in the same direction, the best strategy is to be far ahead and each seller's and buyers size is too small relative to the market as a out in front of the bull and exit in the right moment. And this is whole to infl uence prices. Moreover, each seller and each buyer in exactly what each speculator tries to do: to move fi rst because only the ideal market comes with an independent set of information moving fi rst guarantees the biggest gains. But in doing so, "the concerning his or her individual supply and demand. In fi nancial unbearable lightness of fi nancial mar-kets" leads the whole markets, the uniformity of the available information provokes economic system into an unsustainable situation. If farming were herding and highly correlated movements in to be organized like the stock market, a and across markets with the power of farmer would sell his farm in the morning infl uencing the futures market and the future In the great events when it rains, only to buy it back in the spot prices of all traded assets. of man’s history, afternoon when the sun comes out.3 in the unwinding In reality, the future equilibrium price is Herd Behaviour and the of the complex absolutely unknown. Financial investors Irrelevance of Fundamentals even ignoring available information about The EMH claim that relevant new informa- fates of nations, fundamentals can guess the price that tion induces the economic agents to update justice is not proves to be the right one eventually. their expectations appropriately doesn’t solve so simple Relying on what other market participants the general information problem. Which may believe and/or the prediction about kind of information is driving the expectations of market partici- others views on the average value of a share, a commodity or a pants? Are expectations driven by individual needs, by individual currency is suffi cient for temporary success. In such a frame- preferences, or by individual strategic targets of companies? Obvi- work, speculation destabilizes, instead of stabilizing, the prices ously, none of them is relevant. Fundamentals like these are not of the targeted assets. important anymore in modern fi nancial markets. The market participants in a fi nancial market are much more concerned with Policy Conclusions guessing how certain "news" will infl uence the behaviour of other The events of recent months have revealed a huge misallocation fi nancial market participants and consequently with betting on an of resources and a destruction of enormous values driven by outcome that can be expected if many participants' expectations fi nancial markets. The policy lesson is simple: macroeconomic are infl uenced by the same piece of information. prices are too important to be left to the vagaries of these Keynes introduced in 1936 the example that investment markets. However, if the failure has shattered the naïve belief that strategies in such markets resemble a beauty contest; where unfettered fi nancial liberalisation and de-liberate non-interven- guessing the result is mainly driven by trying to second guess tion of governments will not only maximize the benefi t of some which the prettiest woman for other observers is, instead of players but also the social benefi t, the crisis offers an opportunity judging the true beauty of the ladies. In the same way, the for a new start. Governments, supervisory bodies and interna- “fundamental” value of a particular asset is less relevant for the tional institutions have a vital role to play to allow the society at guessing market participant than his expectations about the large to reap the potential benefi ts of a system of decentralized

THE INDIA ECONOMY REVIEW 205 G LOBAL GOVERNANCE

Evolution of Prices in Selected Markets and Countries, June 2008-July 2009 (Index numbers, 2 nd June 2008 = 100) Equity markets Commodity Market 140 140

120 120

100 100

80 80

60 60

40 40

20 20 03/07/2009

0 0 03/07/2009 02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 Budapest Stock Exch Index (Hungary) Jakarta Composite Index (Indonesia) S&P GSCI Cotton Offi cial Close Index FTSE/JSE Africa All Shr (South Africa) S&P GSCI Soybeans Offi cial Close Index Bolsa Index (Mexico) S&P GSCI Brent Crude Offi cial Close Index NIKKEI225 (Japan) S&P GSCI Copper Offi cial Close Index

National Bond Marketa National Bond Marketa 140 140 120 120 100 100 80 80 60 60 40 40 20 20 0 03/07/2009

02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 0 03/07/2009 United States 02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 New Zealand Germany Australian Dollar to Japanese Yen United Kingdom New Zealand Dollar to Japanese Yen Japan Brazilian Real to Japanese Yen

Source: UNCTAD Secretariat Calculations, based on Bloomberg. a Yields on 10-year bonds.

206 THE IIPM THINK TANK U NBEARABLE LIGHTNESS

decision makers. Only consistent and forceful interventions by tive activities that have been responsible for the distortion in institutions with knowledge about systemic risk can transform a national and international price relations have to be tackled at system of markets for goods, for services and fi nance into a the same time to avoid speculative arbitrage. The tragedy of the functioning entity. The neo-liberal laissez faire of the last twenty modern forms of speculation is their very short half-value period: years has dramatically failed its fi nal test. the more people on the globe concentrate on the speculation in Interventions in fi nancial markets that are part of the global certain markets and the more effective they are, the quicker the economy ask for cooperation and coordination of national results will be contradicted by economic reality because the real insti-tutions and for specialized institutions with a multilateral economic system can no longer bear the burden of largely mandate to supervise national action. In midst of the crisis this is distorted prices and exchange rates. even more important than in normal times. The tendency of A coherent and effective approach can only be found at the many governments to grant to fi nancial markets the role of international level and with the inclusion of as many coun-tries as referee or judge over the success of policy adjustments has to be possible. A broad international agreement about the distortive rejected energetically. For example, it is indispensible to stabilize effects of large scale speculation in different areas on trade and exchange rates by direct and coordinated government interven- investment is absolutely crucial to create the framework for a tion instead of letting the market fi nd the bottom line and trying globalization that has the potential to de-liver rising living to “convince” fi nancial markets about the credibility of the standards for all. However, the effects of the improvement in government of the depreciating currency through pro-cyclical terms of material wealth have to be miti-gated by a strategy to policies like public expenditure cuts or interest rate hikes. minimize the cost of higher living standards for the natural In the same vain, the problem of newly issued government environment and the global climate to be sustainable. bonds at “penalty” rates that are demanded by the “markets” can be tackled. The paradox that the same market participants Endnotes that have driven governments of many countries into a 1 Kindleberger has listed 42 bubbles in the history of economics. disastrous budgetary and current account situation ask for 2 The number of futures and option contracts outstanding on “risk premia” because they do not trust these governments any commodity exchanges worldwide increased more than fi vefold more and fear government default, has to be answered by the between 2002 and mid-2008. global community of governments in a strong and dedicated 3 Keynes quote attributed by Hutton (2008). manner. Very rarely only the governments of the negatively affected countries are to be blamed alone for failure and References and Additional Thinking governments of the unaffected countries very rarely are • Aristotle, Politics, trans. Benjamin Jowett, vol. 2, The Great without any guilt. Hence, global solidarity and not a blame Books of the Western World, ed. Robert Maynard Hutchins game is the imperative of the day. As Keynes once put it: “In (Chicago: University of Chicago Press, 1952) book 1, chap. 11, the great events of man’s history, in the unwinding of the p. 453. complex fates of nations, justice is not so simple.” • Hutton, Will, "Will the real Keynes stand up, not this sad A global answer should follow the same principle: If everybody caricature?", Guardian, November 2nd, 2008. defaults nobody defaults. Only if some countries try to avail • Keynes, John Maynard The economic consequences of the themselves of the opportunity to get cheaper credit at the peace, Volume II of the Collected writings of John Maynard expense of others, the “markets” have a choice and can de-mand Keynes published for the Royal Economic Society in 1971, a “risk premium” from the more vulnerable ones. If every page 142. country and every government acknowledges that the global • Kindleberger, Charles P. (2000) Manias, Panics, and Crashes: crisis is foremost a systemic crisis, i. e., due to the failure of the A History of Financial Crisis, 4th edn. New York: John Wiley global community to govern the globalized economy properly, & Sons. the solution of a global bond that can be used by all countries at fi xed exchange rates is less utopian than it sounds. (The views expressed in the article are personal and do not refl ect In the same spirit of cooperation all different sorts of specula- the offi cial policy or position of the organisation.)

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An IIPM Intelligence Unit Publication | 210 August-October 2005 PRAISE FOR IER

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“Undoubtedly, it is of exceptional quality and amongst the best “I am much impressed by the content and quality of the journal that I have seen in my interaction with similar organisations in differ- Indian Economic Review and the wide range of issues it covers. ent countries. I merely wanted to write to you and congratulate you The editors indeed fully deserve the title of ‘think tank’!” and your institution on an extremely well researched and presented Dr. V.M.Madiman Rao, Institute for Social and Economic Change, endeavour... I have taken the liberty of putting the copies that I had Bangalore

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