How Can Indians Be Happier?

From Financial Express, September 30, 2013

How can Indians be happier? 

 The most obvious aspect of the Bhagwati-Sen debate on Indian economic policy is the question of trade-offs between growth and redistribution. A subtler and deeper issue, central to Amartya Sen’s work, is that of goals. Gross domestic product (GDP, or its cousin, GNI—gross national income) per capita provides a single number, capturing purchasing power, and therefore a sense of the standard of living that people can afford. But this misses many complications, having to do with the imperfections and gaps in the ability of markets to value what we really care about.

The UN Human Development Index (HDI) creates a different numerical measure of well-being, including GDP, but also other dimensions of our lives, such as how healthy and how educated we are. But it is still somewhat arbitrary in its weightings of different outcomes, and it still misses some things that matter to us for our well-being. Can we do better in tracking average well-being?

The World Happiness Report (WHR) is precisely designed to get a better understanding of how well off people are in different countries, and what contributes to their sense of well-being. The data comes from asking people carefully calibrated questions about how they evaluate their own life circumstances, with answers chosen on a numerical scale. “Happiness” may be a fuzzy concept, difficult to pin down, but, on average, people can give an accurate sense of how they view their lives. Different surveys can distinguish between temporary and transitory feelings and emotions on the one hand, and an overall, longer-run evaluation of life conditions.

The latest WHR is the second annual effort in what may be a major step forward in understanding systematically what contributes to our overall well-being. In turn, it may help policymakers do better in setting their priorities and choosing policies. To make this concrete, look at where India stands. First, the facts. In the 2013 WHR, India ranks 111th out of 156 countries surveyed. For comparison, the US is 17th, China is 93rd, Bangladesh is 108th and Pakistan is (a surprising) 81st. The IMF GDP per capita rankings out of 187 countries, on the other hand, are: US (6), China (93), India (133), Pakistan (141) and Bangladesh (154). And the HDI rankings, also for 187 countries, are: US (3), China (101), India (136), Bangladesh (146), Pakistan (146).

Note that, unlike the HDI, the happiness ranking does not directly include GDP/GNI per capita—it is based on asking people directly how well off they feel. Hence, by comparing the happiness ranking with GDP per capita, one can get a better sense of the importance of material conditions. For the world as a whole, and for most regions and countries, GDP per capita is the most important variable in explaining happiness (there is a larger, unexplained residual). But “social support” is a very close second. Social support is measured by yes-no responses to the question, “If you were in trouble, do you have relatives or friends you can count on to help you whenever you need them, or not?” The remaining four important, identifiable variables that seem to explain happiness are, in order: healthy life expectancy, freedom to make life choices, generosity, and perceptions of corruption.

The initial take on the data does not provide anything new or surprising for India: material conditions (GDP per capita) matter, as does health. This is in concordance with our familiar indicators of progress. But there is one interesting nugget: India was significantly less happy in 2010-12 compared to 2005-07, despite being richer. What happened? The measure of perceived social support fell dramatically between the two periods. And this happened in a situation where the perception of social support in South Asia is far lower than in any other region of the world.

The data need further investigation and understanding before policy implications can be drawn from them. But the happiness index and its explanatory variables provide some beginning for possible policy innovations. If India’s lack of social support is a consequence of social fragmentation, low trust or erosion of extended family support structures, will government transfer programmes address it, or are deeper changes needed? Indeed, is government action the place to look for possible improvements in societal structures that will increase perceived well-being? The WHR finds that trust in national government is not correlated with happiness (subjective life evaluations), but that government effectiveness, reflecting aspects of honesty and effective delivery of public services, is strongly correlated with life evaluations.

Perhaps the preliminary lesson of the WHR for India’s policymakers is therefore the following one. Before trying to fix problems that have deeper social causes, stay focused on the basics, these being material well-being as measured by average income and by healthy lives; and before doing anything else, figure out how to make the government itself more honest and effective in whatever it needs to do most.

From Financial Express, September 13, 2013

Getting India back on track

 In my last column (An Indian Spring? FE, August 22, http://goo.gl/hwW9cw), I raised the possibility of India descending into an Egypt-like situation. It probably will not get that bad, since India’s recent history and its societal makeup are sufficiently different. But there is one large commonality—a surplus of young people relative to decent jobs. That basic mismatch between demographics and economic opportunity can drive substantial waves of social unrest. One only has to think back to the early and mid-1970s to realise that India, for all its democratic resilience, is not immune to severe social and political instability. In an earlier column (Can India grow faster again? FE, August 19, http://goo.gl/8E9iwS) I listed some steps that India’s leaders need to take in the medium run: effective vocational training, removing constraints on electric power generation, and more devolution to the states and to cities. But before that, there is a short run crisis facing the country. Here are my thoughts on how to turn things around quickly and effectively. 

The immediate problem is a crisis of confidence. This is partly what has driven the plunge in the rupee, although the strength of the US and European economies has also contributed to the rupee depreciation. The erosion of confidence has been gradual, with multiple instances of government corruption and fiscal and monetary policy mistakes over the last couple of years. Fixing this will not be easy. The measures undertaken so far have smacked of panic: sudden promises of relaxing foreign direct investment caps, a grab bag of import controls, and derailing financial markets to curb “speculators”. All these measures, in my view, simply reaffirm the view that the government is adrift and that troubles will continue. The latter two types of measures also go against the basics of a coherent economic reform strategy, which should be built on promoting well-functioning markets in a global setting. 

With respect to the rupee, the Reserve Bank of India’s (RBI’s) initial response of trying to reduce speculation by making short-term borrowing harder simply sabotaged the working of short-term credit markets, and had no effect on offshore traders. Markets became thinner and more volatile. Instead, if RBI wants to prevent further overshooting downwards of the rupee’s value, it should follow an assertive and transparent (but feasible) intervention policy (something along the lines suggested by Kaushik Basu, announcing a schedule of intervention). Given what has happened, it may be mostly too late. One thing RBI should do is to raise its policy rate, as other emerging economies have been doing. Yes, this could further slow down growth, but the short run benefits of an interest rate hike, in terms of stabilising expectations about inflation and currency depreciation, seem to make this a worthwhile option. Reversing such rate hikes is easy and quick, and they do not have the deleterious impacts of unexpected changes in the rules governing the functioning of markets. 

With respect to the current account deficit, what the government needs to do is to use the opportunity of the rupee depreciation to push exports. The obvious areas are in information technology and related services, tourism, and possibly some kinds of consumer goods (including apparel, health and beauty items, and processed foods). Essentially, India’s products are suddenly a bargain, but some rapid and concerted marketing efforts are required to make sure that rich world consumers take advantage of these bargains. India’s embassies and missions abroad should be going into overtime, working with Indian businesses to seize the opportunity presented by the fallen rupee. Promoting exports, while more work and slower to take effect than restricting imports, will have a much larger medium term benefit. One of the easiest, most immediate opportunities is promoting foreign tourism, since the supply constraints are less problematic. 

On the domestic front, the politics of the looming national election make progress difficult, but if the government were to push harder to reach a grand bargain on the goods and services tax (GST), convincing the array of opposition parties that they will all benefit from a broader, more robust tax system, this would provide the prospect of a corrective on the fiscal front. My reading of some of the crisis of confidence is that it was driven by the government’s attempts to raise revenue through ad hoc, discretionary and retroactive measures, in turn driven by the need to reduce the fiscal deficit. But those policies hurt confidence, growth and government revenues, just the opposite of what was desired. 

The three examples I have suggested are policies that signal that the government is in charge, and is capable of providing leadership to the country. In contrast, most of the governmental responses to the crisis so far have seemed to signal desperation, weakness and lack of control. Much of the recent Indian policy debate has been reduced to finger pointing (evil speculators, heartless global capitalists, incompetent and venal politicians) and crying over spilt milk. It does not have to be so, and India’s leadership has to act as if it is worthy to lead in these challenging times.

Financial Express, August 22, 2013

An Indian Spring?

In my last column, I ended by suggesting that India can either have a true Indian Spring, with its economy and society blossoming, or instead something that veers toward what has happened in Egypt. What are the factors that will determine where the country goes? First, I want to emphasise that the current economic debate (now and perhaps forever labelled as “Sen vs Bhagwati”) has tended to miss the interaction of economics and politics. Prescriptions are sometimes offered as if by wise philosophers or technocrats, with the only issue being a sorting out of the facts of the growth process, or agreeing on the relative weighting of the welfare of different segments of society. How does politics enter into the evaluation of different policy options? 

The most obvious political process is the use of government transfers to buy votes. Empathy for the poor may matter for many of those involved in the intellectual debates, but a good first approximation to reality is that India’s politicians care most about getting re-elected. The policies that get implemented, in this case, are the ones that maximise the chance of winning the next election. India’s voters have to keep making it clear to politicians that subsidies and transfers are not going to be enough to secure their votes. There have been signs of this shift (rewarding performance over populism) in how Indians vote, and one has to hope this trend will continue.

But politics is also more complicated than that. Take Egypt, where democratic elections failed to lead to a stable, popular government, and the country is close to descending into chaos or repression. The winners of the election lost support not just, or even mainly, because they failed to deliver economic betterment. Instead, they were criticised for undermining the people’s recently-won freedoms. Basically, people want dignity and freedom as well as material improvement.

Economic reform in India has delivered an uneven mix of material and non-material benefits. For example, Dalit entrepreneurs seem to have gained on both fronts. Some of the middle classes have seen material gains, but erosion of their status and of traditional certainties. The upper crust of society has benefited disproportionately. And at the other extreme, many people in rural areas, especially in tribal regions, have seen their exploitation increase. This is a complicated story, with perhaps a couple of clear lessons. First, a majority of the population is frustrated with the corruption of, and exploitation by, those with political and economic power. Second, doling out money to win votes will not work as well as it used to, and will not stop the pot from boiling over. Social conflict in India will increase unless there is a quantum improvement in the quality of governance.

There is also another danger lurking. The growth-redistribution debate has only tangentially addressed India’s macroeconomic and financial sector policies. Here, the spectre of corruption also raises its head in the form of the government’s push to give new banking licences to powerful industrialists. But many of the problems have arisen from failure to execute the basics of macroeconomic management. The central government has not done a good job of managing its fiscal deficit, while the Reserve Bank of India (RBI) has gone backwards in managing inflation and the currency. RBI has failed to control inflation effectively, even as economic growth has not been protected. Government mismanagement of food and oil policies has contributed to the problem. Most recently, RBI’s attempts to control the exchange rate have ranged from pointless to damaging, undoing a longer-term program of creating a deeper and more robust financial system. The danger is that macroeconomic conditions will deteriorate rapidly, dealing a severe blow to the economy that will further increase social conflict.

RBI could have used earlier benign economic circumstances to push financial sector reforms that would have improved the functioning of a range of financial markets, improved financial access, and helped capital to flow to more productive uses. It did a little, but not enough, and the futile attempt to defend the rupee has undone some of the certainties of financial sector policy that should have been maintained. Confidence—a valuable commodity itself—has been eroded.

The incoming governor of RBI has a track record of speaking up for the right policies. Not long ago, he authored a vital report on financial sector reform, covering the issues from top (macroeconomic management) to bottom (financial access at the grassroots of the economy). He does not have to stand for re-election, and he does not have to rely on reappointment for his livelihood or prestige.

Raghuram Rajan has an opportunity to determine the nature of an Indian Spring, both through his immediate decisions on macroeconomic management, and through his shaping of financial sector reform over the next two or three years. What he says and does is what will matter much more for India than the shadings of the Sen-Bhagwati debate. He even has the potential to overcome the economic policy missteps of India’s politicians. Let us see what happens.

Financial Express, August 19, 2013

Can India grow faster again?

India’s slowdown is partly a result of its own policy missteps, and not just global conditions. These factors suggest that India can grow at 8% a year, even in the current economic climate. 

 

India’s growth has slowed dramatically from the global boom years. What can it do to recover? Was the period before the financial crisis just a temporary, lucky window for India, now gone forever? The rich world is saddled with debt. An emerging market slowdown, partly a result of the industrialised countries’ own slowdown, and partly due to internal structural issues in China and elsewhere, is the latest shadow looming over India’s growth prospects. Is the gloom escapable?

There are possibilities for hope. Much as I dislike the idea of Indian exceptionalism, in this case it may be warranted to some extent. Most importantly, India is by far the poorest of the BRIC group, and probably one of the poorest of the more amorphous “emerging market” designation. That means it has more room to grow. It is quite far from having to worry about any so-called “middle-income trap,” that might be an issue for China and Brazil. Secondly, India’s demographics give it an opportunity that does not have to be sabotaged by a global slowdown. Thirdly, India’s slowdown is partly a result of its own policy missteps, and not just global conditions. These factors suggest to me that India can grow at 8% a year, even in the current economic climate. How can this be achieved?

The need to create productive employment at a very large scale is obvious. This is more complicated than just giving away money for rural make-work programmes—that is just a transfer scheme for redistribution-cum-income insurance. India needs to create more new businesses and allow existing ones to expand more easily, and in employment-friendly ways. Clearly, labour market reform is needed, and it is not as difficult as it is made out to be. The core problem is political acceptability, and a grandfathering scheme, where existing employees are protected, but new ones in new firms, or certain classes of old ones, are allowed to be employed under more flexible conditions.

Next, the focus of new business creation should be in second and third tier cities and towns. These are best placed to absorb rural labour most efficiently and flexibly. To make this work, strengthening urban infrastructure at this level is critical—this means empowering urban local governments, increasing their capacity and incentives to raise revenues and build and manage new infrastructure. It also needs continued development of rural roads.

Another way in which India is somewhat different is in its geography. This geography actually makes it easier to develop internal supply chain networks, again provided that the internal infrastructure is in place. Currently, a wholesale review of India’s transportation sector is under way—hopefully its recommendations will be the basis for reform, not just in physical infrastructure for internal movement of goods, but also in the institutional infrastructure of regulation and taxation that often inhibits the development of internal production networks.
India also needs to think about patterns of production. Japan certainly grew by becoming an exporting powerhouse after World War 2, but it also produced for its domestic market. Durable goods industries making appliances and cars for domestic consumers were crucial to Japan’s inclusive growth. India is poorer, bigger and more heterogeneous than Japan. On the other hand, technology has made it easier to set up new industries (smaller-scale factories, for example), to manage production, and even to innovate inside a technology frontier that has itself been pushed out at an incredible rate. The key to inclusive growth is domestic production of consumer goods that are affordable to large numbers of Indian consumers—not just watches and bicycles, but mobile phones, kitchen appliances, energy generating devices and more.

This last point suggests that the idea of Track 1 and Track 2 reforms, so clearly articulated recently by economists Jagdish Bhagwati and Arvind Panagariya, may be dominated by a reform agenda that integrates the need for growth with inclusion, and goes beyond mere redistribution or trickle down.

To support the growth path outlined above, there are three crucial areas where the national government needs to focus, beyond basic health and literacy. First is a large-scale, effective set of vocational training programs: there has been much talk on this front and little achievement. The private sector probably needs to be incentivised to make something happen quickly. Second, the government needs to fix the mess in electric power generation—this is well-documented as a prime constraint on growth. My earlier calculation suggested over a percentage point of growth is lost each year.

Third, and most difficult, the national government needs to overcome its own corruption and inefficiency by devolving responsibility and authority to the states, and from there down to cities. Old fears of national disintegration are no longer valid. Political power at the centre can be just as well sustained through sustained economic betterment, as opposed to short term handouts. Political parties at the national level need to understand that this is possible. A future Indian spring can be a true blossoming, or it can be like the Arab one so far.

Financial Express, August 7, 2013

The great rights debate

 India’s Food Security Bill has intensified a larger debate on where the country should be headed, with respect to questions of the rights of citizens. Naturally I want to weigh in as well. There are several issues, which to my mind are getting combined in ways that reduce the clarity of our thinking. 

First, there is the grand philosophical challenge of what rights are and which ones, at some abstract level, we want to protect and promote in our society. For example, the United States Declaration of Independence called out (though not exclusively) the rights to life, liberty and the pursuit of happiness.

Second, there is the question of how to translate any abstract right into practical rules for society. In the US, the right to liberty was amplified and spelled out in their constitution’s “Bill of Rights,” to include freedom of speech. How that gets put into practice (for example, it is not a right to shout “fire” in a crowded theatre if there is no fire) depends on societal norms, laws, and the interpretation and enforcement of those laws.

Third, there is the issue of the motivations and objectives of those who are pushing for amplifications or extensions of rights in India, including influential people in and outside government.

Let’s not worry too much about the third issue, since the first two are central. Of course, if the current approach to rights is wrong, understanding why it went wrong will be important for changing the process and for selecting new decision makers who can do a better job. Looking at the United Nations Universal Declaration of Human Rights, one can see that we have, in principle, agreed to an expansive set of rights, of varying character and tenor (the right to life versus the right to marry, for example), some of which are derivative of others, and some of which may conflict at times with others. It is also clear that practice in India falls woefully short of many of the ideals laid out in this document.

So, with respect to the first issue, of what rights are, and which ones are desirable, as a first approximation, we have reasonable answers, the result of considerable global intellectual effort and historical experience. The real focus, then, should be on implementation. Of course, everyone falls short of ideals in practice, so the question is how we can do better. The economist’s way of thinking is very useful here—one should establish where we are relative to a “rights frontier,” how to move closer to the frontier, and where we should be on the frontier. The latter involves tradeoffs—should we spend more on subsidised food or on access to clean water? On public health centres in villages or on subsidised health insurance? On better and more equal treatment in the justice system or on maternal and neonatal health?

Of course, we would like to do all these things, but at some level choices have to be made, and one problem with India’s government decision making processes is that they do not support good spending choices in general. How to fix that was the subject of my last column. There is a second level problem once choices have been made. If we want to promote the right to health and well-being (as articulated in the UN Declaration) by focusing on food (rather than housing or medical care), then, is translating that objective into “the right to rice at two rupees a kilo, delivered through the Public Distribution System” the best way to do it? What is surprising is that this question has not been properly addressed by many policy makers and policy advisers. This is disheartening.

Of course, it can be counterproductive to criticise without offering a better alternative. So here is my suggestion, one I have made before. Focus above all on the health and well-being of two years in the life-cycle of every citizen, from conception to their first birthday. Put marginal public resources for the broad right to health and well-being entirely into this targeted group. This includes an integrated approach to food and nutrition, health care, and information and education. This will also have a big impact on gender issues and the rights of women, though in indirect and long-run ways. It is universal and easily targeted at the same time.

For complicated reasons, India does terribly on the interval (-1, +1) in its citizens’ lives. That alone would suggest that the bang for the buck would be highest here. Indian society has too many problems to fix all at once with the resources available. Getting this one piece of our lives right would be an excellent place to start. It will make a lot of other rights easier to attain over the longer run. Articulating citizens’ rights is a good thing. Using resources intelligently to achieve these rights effectively is also good, and ultimately where the proof of the pudding lies.

Financial Express, July 26, 2013

Making government work

 India’s government works very well in some ways (functioning democracy, stability, responsiveness, and so on) but is maddeningly inept in others (improving provision of basic public services, ranging from health and education to water and electricity supplies). Lant Pritchett, formerly of the World Bank, and now at Harvard’s Kennedy School of Government, has coined a new term for this situation. He calls India a “flailing” state: “a nation-state in which the head, that is the elite institutions at the national (and in some states) level remain sound and functional but … this head is no longer reliably connected via nerves and sinews to its own limbs. In many parts of India in many sectors, the everyday actions of the field level agents of the state—policemen, engineers, teachers, health workers—are increasingly beyond the control of the administration at the national or state level.” It may be debatable whether the deterioration is in absolute terms, or relative to expectations and aspirations, but the question is what can be done to change this situation. 

Pritchett’s solution to the problem that so many have identified, and which he has so picturesquely named, is unclear. He suggests that India’s “administrative modernism” is out of step with the country’s politics and society. He argues that political competition focuses on loyalty to identity groups, rather than provision of effective public services. He suggests that India will eventually muddle through with incremental reforms and learning by doing. Here I would like to offer some different perspectives on the problem and the possible solutions.

Ultimately, as Pritchett and others have recognised, a major issue is that of weak accountability of government employees. Accountability can be internal, within an organisation (for example, to one’s boss), or external, such as to citizens as voters. There are a variety of ways in which accountability can be improved. Several years ago, OP Agarwal and TV Somanathan, themselves senior bureaucrats, suggested some structural changes for decision-making within central ministries, including letting more policy implementation be managed below the top level, providing better career incentives for performance by elite bureaucrats, and broadening the input of expertise into policy-making.

The suggested changes can, in fact, be thought of as embodying two fundamental principles, those of decentralisation and competition. Decentralisation allows for better matching of skills and tasks, at least when training is appropriately provided. Competition provides incentives, sometimes pecuniary, but sometimes non-pecuniary, for better effort. The interesting idea here is that relatively small structural changes at the very top may have significant impacts—the decentralisation envisaged is modest, just pushing some decisions one or two levels down the hierarchy. The competition envisaged is also modest—slightly more in the way of performance expectations and appraisals, plus potential and actual competition from outsiders to the bureaucracy.

Such micro reforms can, of course, be copied at the level of each state government, and would need to be. A second set of reforms, which are much more macro in nature, apply the principles of decentralisation and competition at a different scale. I would suggest that India’s so-called flailing state is very much a result of over-centralisation with respect to the different tiers of government. I would argue that more expenditure authority needs to be pushed down to the level of state governments, and from there to local governments, particularly city and town governments. Currently, the states appear to have considerable responsibilities for expenditure, and there is a view that they have failed to meet these responsibilities, necessitating more central government control through transfers with strings attached. I would argue that state governments instead need to be given more autonomy, and that more revenue authority needs to be delegated to state governments, who must then delegate further to local governments. Decentralisation is essential for creating effective external accountability, which in turn will drive internal accountability.

Of course there are issues of inequity, of corruption, and of capacity. However, each of these can be addressed directly. None of these problems is solely associated with decentralisation, and none of them should stand as a necessary difficulty of decentralisation. The initial evidence from India’s massive local government reform supports the idea that accountability and effectiveness can increase with decentralisation, even as mechanisms are needed to deal with the adverse consequences mentioned. And this has happened without giving local governments even a semblance of appropriate revenue authority.

The two suggestions for government reforms presented here—decentralisation and competition within top-level government organisations, and across tiers of government—illustrate the problem with Pritchett’s metaphor. There is not just one brain that controls nerves, sinews and limbs. Government is made of individuals with skills that can be better utilised, and that can be improved. Democratic governments ultimately serve at the pleasure of citizens, and government workers need to make that connection more explicitly. A focus on these possibilities can make government work better more rapidly than the pessimists might believe.

Financial Express, July 1, 2013

A reform success story for India

 We are used to highlighting the shortcomings of economic reform in India, both in process and outcomes. These shortcomings are particularly apparent now, when the economy is struggling on several fronts: growth, inflation, and the external balance. In this context, it is good to revisit an ongoing success story of Indian economic reform: its tax system. In the last two decades, India has made tremendous strides in terms of reforming income taxes and consumption taxes. These reforms have included improvements in tax policy as well as in administration. The former has helped the latter: rationalising tax policy has made tax administration easier to conduct effectively, but there have been direct improvements as well in the technology of tax administration.

Better tax policy has meant cutting inefficiently high rates, whether in the income tax structure, or in areas such as import tariffs. In the case of consumption taxes, it has meant replacing a complicated tangle of sales taxes and duties, often piled on each other, with a simpler, more transparent value added tax (VAT). As the VAT nomenclature implies, this avoids the problem of taxes being applied to quantities that already include other taxes—a cascading effect that can create unintentionally high rates, and multiple inefficiencies. Better tax administration has been built on the foundation of new information technology systems, which support mechanisms such as deducting income taxes at source for those who pay them, and tracking of purchases and sales required for VAT credits along the value chain. 

The goods and services tax (GST), which is inching toward implementation, represents an important new step in the process of Indian tax reform. The sooner it is put in place, the better for the economy. In particular, there is some reason for thinking that the GST will give the central as well as state governments a firmer, broader revenue base, which is less subject to political distortions than is the income tax: the GST is a VAT, better coordinated than the present system, and applied more broadly and consistently. A key institution in the process of introducing the GST, as it was earlier for introducing the VAT and for managing state sales tax incentives, is the Empowered Committee of State Finance Ministers (EC). This EC met in May, and then, on June 7, its chairmen met with representatives of industry associations and consulting firms, where an EC paper formed the basis for discussion. This discussion paper is a model of clarity, and illustrates how this complicated process of introducing a major overhaul of the tax system is proceeding. There are several facets of the process worth noting.

Technical policy formulation: There is a clear understanding of the technical issues involved in introducing the GST, including changes in revenue receipts at different levels of government, trade-offs involved in specifying tax bases in different ways (based on turnover levels), and mechanisms for administration (especially across different levels of government). One might expect this clarity, given the time it has taken to get where we are, but time has not been a guarantee of quality in other cases of policy formulation. There is also a clear use of technical inputs from the main national source of such expertise, the National Institute for Public Finance and Policy.

Political management: There is a clear understanding of the constitutional issues involved in introducing the GST, of course, but also a polite and pragmatic statement of the needs of the states in terms of some protection against revenue uncertainties that might come with the reform. In this context, the national government appears to have been somewhat lax in its political management of a complex Centre-state issue—the compensation being requested by the states seems to be quite small relative to central tax receipts, or even as a percentage of the fiscal deficit.

Institutional innovation: The creation of a GST Network (GSTN), which will be a non-profit company with ownership shares of the Centre, states, National Securities Depository Limited, and three selected financial institutions. The GSTN will provide a common IT infrastructure to support the introduction and implementation of the GST. As the EC discussion paper elucidates, issues of monitoring and control versus costs of compliance, can all be dealt with effectively with a combination of the right policy framework and a solid information infrastructure.

One hopes that the EC discussion paper, which distils many years of discussion and analysis, marks the end of the process of agreeing on the details of the GST, and the beginning of efforts to make it happen. The GST will be a major milestone in Indian economic reform. Tax reform has not been perfect. There is much left to do. For example, the GST, in coordinating taxes on the same bases (in this case, business sales) may provide a model for reform of the income tax system, allowing States along with the Centre to tax personal incomes. The GST use of information infrastructure might point the way to methods for strengthening property tax systems across India’s creaking, bursting cities, as well as other aspects of local tax systems. Tax reform is important, and it is very much alive in India.

Financial Express, May 31, 2013

India’s China puzzle

 The recent visit to India by China’s new Premier, Li Keqiang, led to a statement of cooperation covering a wide array of topics, and was followed by much sceptical analysis in the Indian media. Aside from history (the harkening back to the 1954 Panchsheel Treaty seems particularly ironic), the recent Chinese actions in Ladakh made the Chinese premier’s goal of trust-building somewhat more difficult to accept on the Indian side. An extreme pessimistic position is that China is engaging in diplomacy that will allow it to pursue its long-term strategic goals, by making promises to India of good things to come from cooperation. The Chinese leader’s visit certainly did seem to come across as a charm offensive, with one Indian academic describing him as “exuding warmth.” The rhetoric of the two population giants cooperating for peace and stability and for economic development is certainly appealing. On the other hand, strategic analyst Brahma Chellaney has termed China’s approach as coercive diplomacy, strengthening its hand on border issues with its incursion, while appearing to be magnanimous in its official diplomacy.

India has no choice but to talk with China. Their geographic proximity and the range of issues where their interests intersect make that imperative. The problem is that the deck is stacked against India in many dimensions: whether it is China’s economic advantage, its military prowess, or its geographic position (particularly with respect to trans-boundary rivers). Cooperation may lead to mutual gains, but how those gains are divided depends on the relative bargaining strengths of the two parties. On almost every dimension, India is in a weak bargaining position. In some cases, as in the boundary dispute, China can almost completely call the shots. India has to change the game it plays.

In analyses of the Chinese premier’s visit, it was certainly well-recognised that China wishes to counter India’s attempts at economic or strategic closeness to the United States, and also, to some extent, to Japan. But it is precisely ties such as these that will give India some leverage in its dealings with China. Indeed, there is a long list of Asian countries with which India should be pursuing closer economic or strategic relations. In dealings with these countries, India has an advantage over China, which has a trust deficit with many of its neighbours, not only with India.

I outlined a strategy for India in two columns last year (August 14 and 22, 2012) that emphasised broader engagement with other countries as alternatives to China, as well as a concerted effort on the domestic front, in areas such as infrastructure. In the joint communiqué this time around, the Indian side encouraged Chinese investment for infrastructure development. But relying too much on the Chinese for India’s critical needs in this sector will be a mistake, precisely because it fails to reduce the asymmetries in bargaining power between the two nations, even if there are mutual gains from cooperation. Increasing India’s economic strength will take time, and physical infrastructure is not the only area in which India is weak relative to China: health and education also stand out as sectors where India lags more than it should. Fixing all of these areas will take time.

One area where the financial resources needed are relatively small (although there may be other, non-financial hurdles) is that of India’s foreign policy institutions, in particular the Indian Foreign Service. If India is to pursue a strategy of global engagement, in which China is just one of many partners—its influence counterbalanced by networks of foreign ties—the size of the IFS and its quality will need to increase. It is well-recognised that the IFS is small relative to India’s size, even allowing for the country’s relative poverty. Brazil and China have larger numbers of diplomatic personnel, and even tiny Singapore has almost as many professional diplomatic personnel (as opposed to support staff) as India.

There are many areas of improvement needed, besides adequate numbers: a 2009 article by Daniel Markey in Asia Policy makes a telling and unfavourable comparison of India’s training of its diplomats with the case of China. Markey also highlights the relative strength of China’s foreign policy think tanks. And the comparison of universities across the two countries only emphasises India’s weakness.

The puzzle for India is that it cannot avoid China, but it is currently ill-equipped to engage with its neighbour in a manner that protects and enhances its own interests. To deal with China, India needs a strategy of broader economic and strategic engagement, but it also needs the means to design and implement that global engagement. To accomplish that, India needs to invest very specifically in the human and organisational capital required for that task. This is not a trivial task, but it does not require the scale of resources directly needed for domestic economic growth. The challenge will be to overcome institutional inertia, but raising the size and status of, and support for, India’s diplomatic corps should be easier than the broader reform of the bureaucracy that is also needed.

Financial Express, May 27, 2013

Managing India’s manufacturing

  In my last column, I suggested that the quality of management may be a critical stumbling block to increasing the size of India’s manufacturing sector. The clues I gave last time came from studies supported by the National Manufacturing Competitiveness Council. But there is still more evidence, from different academic studies. For example, Nicholas Bloom and John van Reenen, in a study published in 2010, found that Indian firms with strong management practices are comparable to the best US firms on this dimension. However, there is a thick tail of badly-run (by their measure of management practices) Indian firms, which often neglect basic tasks such as collecting and analysing data, setting clear performance targets, and linking pay to performance. 

In another study, Bloom and different set of co-authors performed a controlled experiment with a sample of Indian textile firms, and found that the treatment firms improved productivity by 17% over the control group, by implementing specific improvements in operations. The focus was mostly on the basics of operations, such as the organisation of the factory floor, how parts were stored or moved around, how inventories were logged and stored, how machinery was maintained, and so on. In the experiment, the advice came from high-priced consultants (whose services were paid for by the researchers), but the improvements were not rocket science, and did not seem to require expertise at the level of a modern business school graduate. Finally, in a study I did last year with Shruti Sharma, looking at the productivity effects of investments in information technology in Indian manufacturing plants, we found results consistent with the hypothesis that the quality of management mattered for determining these impacts. 

Ultimately, the pressure to remove inefficiencies in manufacturing has to come from competition: last week I noted that inefficient firms still made high profits, and that also seemed to be the case with the sample of textile firms studied by Bloom and his co-authors. But this does not foreclose the possibility that removing constraints on management quality will make things better. Certainly, if and when regulatory and business environment constraints on Indian manufacturing get relaxed, the availability of appropriately skilled management will be critical. 

How is this availability to be achieved? India has certainly expanded graduate management education very rapidly. However, there are problems of quality in many of the new institutions. Even in the best management schools in India, the focus is very much on fast tracks to success, typically through focusing on finance or marketing or general management. Just as in the United States, classic roll-up-your-sleeves, shop-floor management is quite neglected in India. However, for the US, the issues are different: focusing on finance and marketing has taken away from high-end innovation. This is why many Silicon Valley firms still shy away from hiring MBAs, and prefer to train their managers with customized in-house courses. Such courses are difficult for smaller firms to afford, though, and will not provide the large-scale solution that India needs. 

Indian manufacturing, if my reading of the evidence is right, needs basic managerial training, and lots of it – not just for fast-track executives, but for every level from factory supervisors on up. The implication is that not all of this training has to be in the form of MBA degrees or equivalents. Indeed, short certificate courses are probably best suited for many of the skill gaps that lead to basic inefficiencies on the shop floor. Given the shortage of faculty, the solution is going to have to include development of online materials that can be accessed by large numbers. 

One can envisage this effort originating at the level of individual industries, since manufacturing processes can be quite specific to the nature of the product. Of course, there are many management techniques that are more generic, such as basic accounting or inventory tracking. The Indian information technology industry is well known for training its workers, most of whom are skilled professionals, and for using global standards of certification. In their case, they were able to generate the cash flow needed for internally supporting such efforts, but some kind of tax credits may be a good idea for manufacturing. 

One hopeful example is the Munjal Global Manufacturing Institute, at the Indian School of Business’s Mohali (Punjab) campus. This is being developed in collaboration with the Massachusetts Institute of Technology, and will probably be aimed at the high end of the market, but it may provide a role model for mid-market offerings. The key is for industry to be involved in shaping the curriculum and working with faculty (preferably including ex-managers), so that the connection to shop floor challenges remains strong. 

Programs that pull in experienced manufacturing managers from around the world to share their knowledge will also be more valuable. Of course, creating and delivering such programs has its own management challenges and constraints, but a start has to be made, otherwise national policy goals will remain pipe dreams.

Indian Manufacturing: Getting to 25 Percent

Financial Express, May 16, 2013

Indian Manufacturing: Getting to 25 Percent


India’s manufacturing sector has played an unusual role in the national growth experience, compared to many other developing countries. In 1950-51, manufacturing was about 9% of GDP. By 1979-80, this ratio came very close to 15%, but thereafter has barely increased. In this context, the National Manufacturing Policy’s (NMP) goal of increasing manufacturing’s share to 25% by 2022 is ambitious indeed. 

One of the motivations for focusing on manufacturing growth is, of course, its potential to generate employment for the unskilled or semi-skilled. South Korea provides a striking example, having increased the manufacturing sector’s share of employment from 1.5% in 1960 to 26.9% in 1990. The NMP states, in fact, that “over the next decade, India has to create gainful employment opportunities for a large section of its population, with varying degrees of skills and qualifications. This will entail creation of 220 million jobs by 2025 in order to reap the demographic dividend.” 

Recent assessments about achieving this goal are pessimistic. The Economist magazine titles its article on the subject with “What a waste: How India is throwing away the world’s biggest economic opportunity.” This article goes on to list the well-known case for reforms in labour markets, infrastructure, education and governance, and there is no need to go over them here. With respect to manufacturing, it is also helpful to understand the state of play at the ground level. 

In 2002, Pankaj Chandra and Trilochan Sastry summarised the findings of the previous year’s National Manufacturing Survey (NMS), which focused on the organised manufacturing sector, representing less than 1% of the country’s firms at the time, but employing 19% of its industrial workers and contributing almost 75% of gross value added. They concluded, “Manufacturing strategy of most firms is still not addressing certain fundamental issues of competition: need to change product mix rapidly, need to introduce new products based on indigenous R&D, need to use process innovation and quality improvement process to reduce cost of operations and consequently price of product.” They also noted the lack of spending on R&D, and the relatively small numbers of employees with advanced degrees, as well as pervasive supply chain weaknesses. 

In 2009, Pankaj Chandra analysed the next NMS, which was conducted in 2007. Supply chain management remained a key weakness in the later survey, and investments in R&D remained low, despite perceptible benefits to innovation. The firms surveyed indicated a focus on quality, and of trying to achieve that through process improvement, but large scale and low cost were not major goals of the surveyed managers. Chandra’s report also argued that management weaknesses contributed to lack of innovation, as well as to inefficiencies in plant location and supply chains. 

My own reading of the evidence presented suggested that there was under-investment in both physical and human capital, reflecting high financial costs as well as an unfriendly policy environment. At the same time, Indian manufacturing firms were able to make strong profits in this period, despite their inefficiencies, suggesting a lack of adequate competition in manufacturing. In other words, a lack of competitiveness was partly traceable to a lack of competition. 

A 2010 joint study by the National Manufacturing Competitiveness Council (NMCC) and the National Association of Software and Services Companies (NASSCOM) focused more specifically on information technology use, but it made several similar points as the two NMS studies, with newer survey data to back them up. It concluded, “ICT adoption levels in manufacturing firms were primarily influenced by their management team. More than three-fourth of the companies especially in the micro and small firms category are strongly influenced by the owner/management team for their ICT investments.” 

All of these analyses point to a somewhat neglected aspect of the deficiencies of Indian manufacturing, namely the lack of adequate specific human capital in management. The NMCC-NASSCOM report focuses on increasing IT adoption in Indian manufacturing, but its general recommendations for a systemic approach are more generally applicable. The key is broad participation from many parts of the business ecosystem. The report emphasizes the potential role that can be played by national and local industry associations in developing best-practice business process re-engineering guidelines to cope with the organisational changes that are often needed to benefit from investment in innovations. Human capital development to overcome lack of appropriate skills can be addressed through improving the quality of government provided training programs, and tax incentives for firms to spend on this training. In fact, the latter approach of incentivising the private sector might be the most efficient. 

The bottom line is that creating employment requires having enough people with the skills to manage employees in situations of competition and innovation. There are many larger issues of economic reform, across the board, which affect productivity and employment. Indian managers operate in a difficult environment. It is a long haul to change that environment, but a more immediate impact may come from promoting managerial skill development.

India's Security: Food, Water and Energy

Financial Express, May 14, 2013

India's Security: Food, Water and Energy

The conventional notion of national security refers to a country’s capability to defend itself against, or to deter, military aggression. The central idea of security, though, is protection against downside risk, and that concept applies to a range of variables, though all of them ultimately feed into material well-being. In the modern world, risks come not just from deliberate attacks, but also from withdrawal of access (e.g., to goods, resources or technology) and simply from the forces of nature. 


What is the state of India’s security in this broader perspective? This is the right question to ask, rather than the more headline-grabbing one of India’s superpower status. A report from the London School of Economics a year ago asked the question “India: The Next Superpower?” seemingly as a straw man to criticise all that is wrong with India internally. Recently, The Economist magazine cautioned that India is about to become the world’s fourth military power, but lacks a plan to live up to this status. These are useful but fragmentary inputs into the question of India’s security. 

A better starting point is the perspective provided by Professor Upmanu Lall of Columbia University. For several years now, he has been explaining the water-energy-food nexus, and its implications for material security. Essentially, without an integrated and focused approach to water, energy and food security, India will face severe challenges in the near future. While the links between these three things are common across the globe, India’s situation is especially dangerous, for two reasons—one beyond the country’s control, the other very much a function of policy failures. 

The first reason for India’s exceptional security challenge in water, energy and food is a relative lack of natural endowments in water and energy resources. Per capita water availability in India is much lower than in other large, populous countries. Its ability to generate energy from domestic fossil fuels is also relatively poor. On the other hand, India has addressed its past food security problems by relying on water and energy-intensive agricultural techniques to increase yields. In regions such as Punjab, these techniques are leading to ecological disaster, which will destroy food security. 

The problem is not so much with the techniques, as with completely irrational and destructive pricing of water and electricity: an enormous and avoidable policy failure. Free electricity to farmers has led to excessive groundwater depletion, bringing underground aquifers close to irreversible collapse. The water that is pumped is also not priced, being treated as a free good by farmers. The problem is not just in Punjab. Professor Lall has been describing similar problems in states such as Gujarat and Andhra Pradesh, with different cropping patterns and different participation in the central government’s food procurement system. Hence, while foodgrain procurement policy is partly to blame, and is particularly a problem in Punjab, the deeper problem is an almost complete lack of attention to the provision of sensible incentives for the use of water and electricity. Areas in Gujarat are depleting groundwater unsustainably to grow vegetables and dairy fodder, for example. 

Of course, there is more to India’s energy security than the wasting of scarce electricity for excessive groundwater pumping. Development of renewable energy sources, as a way of cutting down on problematic fossil fuels, is an area where India is lagging, relative to where it needs to be. And the management and development of fossil fuel resources for energy production in India is also well known to be inefficient. Food security policy, too, has other dimensions, including deficiencies in pricing, infrastructure, and marketing. 

Still, there is something particularly striking about policies that threaten to simultaneously destroy food and water security, while making a significant dent in energy security. I have not been able to find a clear discussion of these security issues at the national policy level, where it belongs. Professor Lall’s voice comes from a base in American academia, and he is well positioned to discuss, as he has in public forums, the potential technological and institutional solutions that might emerge from the US or other developed countries, for more efficient agricultural water use, in particular. But there has to be a receptive situation in India for such solutions to be evaluated, adapted and implemented. 

India’s policymakers are certainly right to worry about its global status, military security, macroeconomic stability, and so on. A country the size of India is going to matter more as it continues on its economic growth path. But it is easy to lose sight of problems that are accumulating in multiple locations, mostly in barely visible ways, as a result of decades of poorly chosen policies. The biggest threat to India’s security may be the looming problems in water availability and food production, and the associated drain on energy resources, from current policies. Ignoring this threat will not just risk India’s possible superpower status, but its very being.

Financial Express, April 11, 2013

Rebuilding Punjab

 The state of Punjab in India represents an important case study of development gone awry. Partition in 1947, which wreaked havoc on the region, was followed by surprisingly rapid recovery and progress. An infrastructure of roads and market towns was created in the 1950s, followed by the Green Revolution of the 1960s, which saw Punjab become the breadbasket of India. Punjab became the richest state in India, measured by per capita income.

More recently, Punjab’s growth has lagged the rest of India, and it has slipped down the league table of states. This is not worrisome in itself, since the state’s growth has not stopped, and it remains one of India’s better-off states. The bigger worry is looming ecological disaster that will harm Punjab irretrievably, and with it, the whole nation of India.

Last month, Inderjit N Kaur and I organised a conference on rebuilding Punjab at UC Santa Cruz. Participants such as Rajinder Sidhu of Punjab Agricultural University emphasised the criticality of the groundwater situation in Punjab, with rapidly falling water tables, and the distortionary policies, such as free power for farmers, that have accelerated the problem. Upmanu Lall of Columbia University noted that drinking water pollution has also become alarming, so a health disaster will accompany the desertification that comes with groundwater depletion. Lakhwinder Singh of Punjabi University discussed a range of issues, including poor governance, falling investment, monopolistic middlemen, poor educational outcomes, and lack of adequate modern infrastructure, with many of these points coming out in presentations by Dr Sidhu as well.

Pritam Singh of Oxford-Brookes University and Jugdep Chima of Hiram College brought out the complexities of interactions among economics, politics and society, and there was often agreement that state-level politicians have been failing on the job. Poor revenue effort, high fiscal deficits and corruption have been taking their toll on the economy. There were mixed views on the legacy of the militancy and repression of the 1980s and 1990s, which still looms large in many lives. In a separate analysis, Swaminathan Aiyar has dismissed this history as an excuse or explanation for the current crisis of Punjab, preferring to focus on the more recent failings of state governance, but perhaps the two are connected. At the conference, Pritam Singh argued that the lack of an effective opposition party in Punjab has hampered the workings of normal politics as a mechanism for responding to constituent needs and wants.

It is certainly plausible to argue that the political economy of the Green Revolution model has trapped Punjab in an unsustainable and undesirable equilibrium of depleting its natural resources and neglecting its human resources, to keep growing grain for the country’s public distribution system. The seeds of the Punjab crisis, which included issues of water needs amplified by adoption of new varieties and cropping patterns of wheat and rice, perhaps were sown along with the technological innovations of the 1960s.

Swaminathan Aiyar, in his work that emphasises economic freedom and a reform agenda firmly rooted in allowing more room for markets to flourish, pushes for fiscal consolidation and a better environment for doing business. On the other hand, some of the perspectives at the conference emphasised the role of the government in providing the infrastructure and complementary inputs for private sector success. Aiyar notes the distortions of markets in the current Punjab economic system, but perhaps not enough the crisis of drug use and similar problems of societal values. One only has to look at the US to see that economic growth does not automatically translate into a society with greater general well-being.

One of the goals of the conference was to examine the larger, more global, cultural, societal and historical factors that feed into the current state of Punjab’s economy and polity. Pashaura Singh of UC Riverside, Gurinder Mann of UC Santa Barbara, Harpreet Singh of Harvard, Van Dusenbery of Hamline, Supreet Kaur of Columbia, and Inderjit Kaur of UC Santa Cruz discussed various aspects of these factors, and the role of the Sikh diaspora, in particular received some attention. How one creates a social vision, aligns the interests of the leaders and the led, and creates space and momentum for change were all questions that were raised, if not fully answered.

Answers are urgently needed, though. The sense of the conference discussions was that there is no more scope for muddling through—Punjab has to go up or else it will go way down. This is a small state in India, one that often gets lost in the shuffle of national policymaking, but the repercussions of a collapse of Punjab’s economy will have huge implications for India. Already, it is clear that the national food policy is inefficient and even destructive. It should be clear that changing that policy will benefit energy and water security as well. The national government should be making the Punjab economy a national priority.

Financial Express, March 21, 2013

A view from Silicon Valley

 Silicon Valley, a short distance from where I teach, is aptly viewed as one of the most important symbols of India’s success. This is paradoxical, of course, because the success of Indians in the Valley (as it is often known locally, with an implicit sense of uniqueness) has come at a cost to India—the talent that thrives here has been lost, in some sense, to India. On the other hand, the success of Indians here in the Valley has served as a powerful signal to those who did not migrate, of what knowledge, talent and hard work can achieve. Just as importantly, it has signaled to non-Indians what might be possible in India, in the right circumstances. 

Every year, for several years now, I have participated in a panel in the Valley that discusses India’s Budget in the context of the country’s economic prospects. My fellow panelists and the entire audience are representative of the area’s ecosystem—smart, well-educated, experienced entrepreneurs and financiers, with global perspectives. Their views on India are worth noting. Here is what I took away from their remarks earlier this month. 

It was unsurprising that the businesspeople expressed dissatisfaction with the current state of the laws governing the use of land and of labour. These are well-known, long-standing issues that successive Indian governments have not managed to come to grips with. What struck me, though, was a sentiment that, even worse than inefficient or overbearing regulation, uncertainty about policy has been a major recent problem. The prime example of this, of course, is the General Anti-Avoidance Rule (GAAR), proposed in last year’s Budget to general consternation. The postponement of GAAR, and a promise to rethink provisions that have been criticised as poorly drafted, have created a period of prolonged uncertainty, which can act as a major deterrent to investment. There was appreciation of the current finance minister’s outreach to foreign investors, but a clear sense that ultimately, it is the certainty of the rules in place that matter, not just wooing through words. 

A closely-related concern that I heard expressed was that India’s rules for business also lack clarity. This, too, is an old problem, but one that has been growing worse in a more complex economic world. Transfer pricing was raised as a major issue in this context. There is a connection to GAAR here too, and national government concerns about tax avoidance through transfer price manipulation are common across many countries. The point here, though, was that poorly written rules unnecessarily increase litigation and other administrative costs: businesses have to pre-emptively spend on trying to get clarification in advance, or they have to bear risks of lawsuits, or both. 

On the positive side, panelists and audience members emphasised that Indian-Americans in senior positions in high tech companies have made a difference in those companies’ strategies towards India. The importance of personal knowledge and networks has been recognised of course, and the Indian Consul General in San Francisco plays an important and visible role in nurturing some dimensions of these, but my outsider (and possibly not fully informed) view is that India’s government could do more to deepen and systematise these networks of Indian-born leaders of high tech companies, to benefit India’s economy. 

As it is, I got the sense from other remarks that India’s political leaders often still do not understand how business at its best can work, and the importance of innovation in its many dimensions, including technology transfer and adaptation, as well as indigenous research and development. One venture capitalist in the discussion remarked that greenfield foreign direct investment (FDI) remains relatively low. Another noted the lack of coordination across ministries. Another observation was on the arbitrariness of some kinds of FDI restrictions, such as those governing e-commerce. One senior investor and entrepreneur suggested that the push for a semi-conductor manufacturing plant did not make sense, either in generating employment or being a fruitful avenue for spurring innovation. 

One can debate these kinds of specific issues, which have to do with the innovation and employment potential of various technologies or combinations of technologies. What is perhaps missing for India is a systematic dialogue with Silicon Valley. The US-India Business Council, which co-sponsored the panel at which I spoke, is certainly systematic in its efforts to build business ties across the two nations. But it represents the interests of its members. There are other institutional linkages as well, such as a sister city initiative between San Francisco and Bangalore. But my sense is that there is room to create a richer interaction that is more balanced in representing various interests, and does more to integrate academic and business knowledge, to further investment and innovation in India by leveraging the tremendous human capital of Silicon Valley. What institutional form that interaction takes would have to be thought through, but the need and potential are both present.

Financial Express, March 8, 2013

Betting on India

 At my university, I help run a new initiative that focuses on finance, and we just hosted a visiting speaker, a prominent statistician known for some innovative algorithms for analysing data. He is also apparently a lifelong—and successful—bettor on horse racing.

He was asking me about India’s economic prospects and, in formulating my answer, it struck me that the metaphor from his passion is apt: it is time to bet on India.

Why do I now think so? For the past few months, I have been gloomy about India’s policy paralysis and missteps. Indeed, many of the core problems are still there. But there is evidence that India has turned the corner. The place to begin is with the Economic Survey of India. (By the way, our visitor to UC Santa Cruz has been a long time colleague of India’s present Chief Economic Advisor). The first two chapters of the Survey lay out India’s current situation and long term growth prospects with unprecedented clarity. The quality of the overall analysis itself is cause for optimism. If this analysis truly begins to guide policy, India will be getting on the right track.

The Economic Survey predicts growth of 6.1-6.7% in the coming fiscal year. This is conditional on a decent monsoon, moderating inflation and reasonable global growth. Barring problems on these fronts, the prediction seems a reasonable one. Even a moderate improvement in growth can make a big difference to confidence at this stage. This growth projection feeds into the numbers used for budget estimates, so it is a critical number.

In addition to the factors mentioned, economic policy decisions will also be crucial. This brings me to the Union Budget.

Writing a few days after the Budget has the advantage of being able to see a slew of more immediate reactions. Most of the reactions were positive, from mildly so to enthusiastic. Some comments were simply based on relief that there were no new government giveaways of the scale and kind that have strained the fisc in recent years. Indeed, the budget was circumspect in this regard, with the need to reassure investors, both foreign and domestic, that the government is serious about managing its finances. A major negative comment was driven by the view that the revenue projections are wildly over-optimistic. If they do not pan out, the budgeted expenditure would be veer into unsustainable territory. But in the current year, it was the ability to pull back on expenditure (especially plan expenditure) that allowed the government to rein in the fiscal deficit despite lower than projected growth and revenues.

This kind of pulling back is not the best way to achieve fiscal consolidation, but my guess is that the coming year will be better. First, the GST keeps getting closer, and the steps that lead to it also have positive impacts. Second, if growth does recover next year, that should help revenues. Third, my overall sense of the tax proposals is that they contain few gimmicks and nothing like the major misstep of last year. They pay attention to principles such as maintaining broad bases for taxation. There are a few proposals here and there that will enhance revenues without too much distortion. The revenue side may well provide good news in the coming year.

On the expenditure side, the main welcome feature of the Budget, as noted, is the restraint shown in expanding transfers or subsidies. This restraint may come under pressure as the general election nears, but for now, it is the official position. The quality of expenditure remains problematic, and one misses the promises of a few years ago to monitor outcomes and test the effectiveness of public expenditure, but perhaps that should be outside the budget in any case.

Tax expenditures seem to be a strong feature of the budget, with several policies intended to spur investment in manufacturing. Similarly pro-growth are measures to streamline regulation of areas such as foreign investment. Indeed, the finance minister has promised more measures along these lines through non-legislative actions outside the Budget’s legislative process.

Overall, then, my sense of this Budget was that it is one of the better ones I have seen, in terms of avoiding silly policy measures, taking a host of small steps in the right direction, and most of all, being intellectually consistent with the rigorous analysis of the Economic Survey. It is still possible that political calculations of the worst kind will derail the possibility of progress. But I am betting that the ruling political elite have realized how far things were going wrong. They have also been given a clear picture of why they have been going wrong (the Economic Survey is again an excellent summary source, presented with clarity and directness), and seem to be betting themselves that they can do better politically by performing rather than pandering. If this is right, then it is time to bet on India once again.

Financial Express, February 27, 2013

Current account deficit worries

 In recent weeks, the Governor of the Reserve Bank of India, Duvvuri Subbarao, has twice highlighted the nation’s current account deficit (CAD) as a cause for concern. The CAD is basically the difference between what is earned on selling goods and services to foreigners and what India pays for foreign goods and services, and it has recently hit record levels—over 5% of GDP. The CAD is typically offset by foreign capital coming into India. Why should a high CAD be a cause for worry? 

The RBI Governor highlighted several concerns. At the G20 Finance Ministers’ meeting, he said, “There are a number of risk factors for inflation. The most important is the current account deficit.” A few days earlier, he had stated, “We would not worry if the widening CAD is on account of the import of capital goods, but here it is high on account of the import of oil and gold. The other concern is the way we are financing it. We are financing our CAD through increasingly volatile flows. Instead, we should ideally be getting as much of FDI as possible to finance the CAD.”

What is the possible reasoning behind the Governor’s statements? It is useful to begin with some basic accounting. Macroeconomic balances imply that the CAD is equal to the difference between domestic savings and investment plus the government deficit. Hence, an increasing CAD can reflect a higher fiscal deficit, an increasing shortfall of domestic savings, or both. In India’s case, it has been both. Domestic private savings have fallen as a percentage of GDP, and the fiscal deficit has gone up. It is important to realise that the CAD is a symptom of more basic factors that deserve attention. A high CAD is not bad in itself: it just signals possible underlying problems.

The problems are poorly managed government spending and taxes, high inflation (and high inflation expectations), and a strong perception that government policies are unfavourable for future growth. The last is based on policy inaction as well as evidence of corruption. These problems deserve focus, not the CAD per se.

Turning to the RBI Governor’s statements, why should the CAD be a risk factor for inflation? If the economy were overheating, and pulling in foreign investment for that reason, this statement might make sense—again, the CAD would be a symptom not a cause. But that does not seem to be the problem, unless India’s potential growth rate has fallen more than policymakers admit. If foreigners were unwilling to finance the CAD, and the Indian rupee had to depreciate, pushing up the domestic price of inelastic imports such as oil, that could fuel inflation in the short run (though not in the long run, unless the RBI made a monetary accommodation). But interestingly, after a temporary pause, foreign investment into India has been strong.

Subbarao’s second point was that foreign investment is of the wrong kind, “volatile” portfolio flows instead of FDI. A related concern was that the CAD itself is of poor quality—fuelled by imports of gold and oil rather than capital goods. This leads back to poor inflation management (people are buying gold as an inflation hedge) and poor economic management (lack of an effective energy policy and lack of confidence for private industrial investment in India). His main point, though, seemed to be that portfolio flows are volatile and therefore bad.

To the extent that portfolio flows bring in foreign capital, they are as good as FDI—domestic firms receiving foreign portfolio flows may be encouraged or enabled to make real investments themselves. If this link is absent, it points again to poor domestic economic conditions. Foreign portfolio flows could be contributing to an asset bubble, but volatility seems to be a red herring. My ongoing research with Ila Patnaik and Ajay Shah suggests that such flows do not create wild swings in the domestic stock market, or harm domestic investors at the expense of foreigners. Separately, I have not seen concrete evidence that domestic stock market movements have much impact on India’s real economy.

In fact, any kind of equity investment involves risk sharing, and in that sense it is good for the recipient. At worst, foreigners exit and the currency depreciates: India can still pay its bills. Problems arise much more if the CAD is financed by borrowing on terms fixed in foreign currency, especially at short maturities—that can create a crisis. The real issue, therefore, is what is happening to India’s external debt stock, and its maturity composition. This is where RBI should be focusing, in addition to domestic monetary policy. Unnecessarily worrying about volatility of portfolio flows (or of the exchange rate) is just a distraction. Meanwhile, the biggest problems lie beyond RBI’s control: in the government’s management of revenue raising, spending, and the conditions for private sector investment. FDI is good, but so is domestic investment. The national government needs to do its job better. If it does, the CAD will take care of itself.

Financial Express, February 14, 2013

India’s inflation puzzle

India has been struggling with high inflation for over two years. The Reserve Bank of India (RBI) gradually raised its policy interest rate and has held it relatively firm, with only two small cuts coming recently. Meanwhile, economic growth has slowed dramatically. It has been asserted that RBI’s policy has contributed significantly to the growth slowdown. It has also been argued that monetary policy is ineffective in India, given structural rigidities and incomplete markets in the country’s economy. Fiscal policy and commodity prices have also been under the spotlight. What do we really know? 

A couple of weeks ago, Deepak Mohanty, an executive director of RBI, gave a speech in which he tackled India’s inflation puzzle. I will outline what he said, and then assess the arguments. Mr Mohanty first pointed out that India’s recent inflation surge and its persistence did not line up well with either its own history or what has been happening contemporaneously in the rest of the world. World inflation rose somewhat with the recovery from the Great Recession, but then moderated, while India’s inflation climbed to double digits. In India, moreover, a sharp growth slowdown seemed to do nothing to bring inflation down.

Mr Mohanty traces the start of India’s inflation spike to rises in the global prices of food, crude oil and other commodities. He refers to an unidentified analysis that pass-through of global price shocks to domestic prices increased in this recent period, and notes that corporate finance data are consistent with this increased pass-through. The depreciation of the rupee made the pass-through of external inflation that much worse. Mr Mohanty goes on to note the substantial increase in demand for higher-protein foods. He further documents the rise in real wages in rural India. He highlights the fiscal stimulus that coincided with the recession, and asserts that “higher fiscal expansion also impedes efficacy of monetary policy transmission.” Finally, Mr Mohanty emphasises that long-term inflation expectations rose in this period.

In examining the conduct of monetary policy as inflation spiked, Mr Mohanty emphasises that rises in interest rates trailed inflation, so that, starting from historically low interest rates, the real policy rate remained negative: “Thus, monetary policy was still accommodative though the extent of accommodation was gradually closing.” While all the other points made by Mr Mohanty have been widely recognised and detailed, it seems to me that this feature of recent monetary policy conduct has not received enough attention. Another important point that he highlights is that RBI’s estimate of India’s potential output growth rate has been reduced from 8.5% to 7%.

The story above is plausible, and draws on many analysts’ judgements. I have not been able to identify a publicly available structural model of the Indian economy that would allow one to say that the explanations above are the right ones, or to quantify their different contributions to India’s recent inflation experience. Formal, comprehensive empirical modelling is always a nice check on judgements that are necessarily fragmented and somewhat subjective. In the absence of a model, let me offer some additional thoughts, which may undercut the notion that India’s recent inflation experience should have been puzzling.

First, the monetary policy tightening was actually slow and even hesitant. There may have been good political and economic reasons for this, including fears about derailing an uncertain recovery, but RBI was neither choking off inflation nor growth in an assertive manner. Furthermore, RBI was not doing a good job of managing inflation expectations—interest rate hikes sometimes came with statements doubting if they would be effective. Sharper, faster interest rate hikes and confident statements would have worked. There is no puzzle in the experience.

Second, focusing on rising individual prices or on accommodative fiscal policy are both misleading. Yes, there can be short-term cost-push effects, and government deficits add to aggregate demand. But economic theory tells us that inflation is fundamentally a monetary phenomenon, having to do with the aggregate price level. The so-called fiscal theory of the price level, according to the best theoretical economic research that I have found, can tell us something about transmission channels, but not about long-run inflation.

Third, the growth slowdown has more to do with domestic political events that started to destroy India’s growth potential, more than RBI has estimated. The level of uncertainty for the private sector jumped. It is also true, I think, that government deficits have crowded out private investment directly. So fiscal policy has hurt potential growth. Global uncertainties and anaemic recoveries, especially in Europe, but also in the United States, have also worked to reduce potential output growth in India.

In sum, monetary policy was too timid, and failed to use the power of the word to complement actions; domestic economic management was dysfunctional in ways that reduced potential growth, while failing to account for structural changes in the economy; and global economic conditions exacerbated domestic policy shortcomings. This is a story with clear lessons and no puzzle.