Where are the second-generation reforms?

There is a celebratory air in India these days, and not just because of the festive season. As Barack Obama’s visit made eminently clear, India has arrived, at any rate as a destination for American business, if not yet as a geopolitical great power. That, too, may obtain, if we sustain our current pace of economic development. With the growth rate ticking close to double digits, second only to China, and even The Economist newspaper, ever the naysayer, now suggesting that the Indian growth rate could overtake the Chinese, there is a justified sense of satisfaction that India’s gradualist track toward economic reform is beginning to bear fruit. So is it time to pop the champagne corks? Perhaps, not just yet.

A quick recap of history: The initial impetus to the first phase of reform, back in 1991, was a foreign exchange crisis, induced by the First Gulf War and the sharp increase in the price of oil that followed. In a story that has now become famous, Indian leaders at the time, not particularly popular politically, decided that a piecemeal approach to stave off the crisis was not enough, but that what was required was a thorough liberalisation and opening up of the economy. In a bold move that required a look toward the long view, rather than short-term electoral gain, the government, at one fell swoop, virtually eliminated the “License Raj”. It also lowered trade barriers and liberalised the foreign direct investment regime, amongst other key elements of the reform package. It was, indeed, these first generation economic reforms which ushered in the period of rapid economic growth and development that has made India the success story it currently is.

Following the initial reforms, there was a lull, as we were ruled by a series of unstable coalition governments with the Left parties playing a prominent role. They did not then, nor do they now, have any appetite for liberal economic policies. At least, they did not reverse course. The next phase of a muscular and purposeful pursuit of systematic reform came during the BJP-led National Democratic Alliance (NDA) government, starting in the late 1990s and carrying into the new millennium, in which the case for further reform was prodded and pushed by key figures such as Jaswant Singh and Yashwant Sinha.

Indeed, one could well argue that the current Congress-led government is reaping a harvest, the seeds of which were sown by the BJP-led government it ousted in the 2004 general elections. They have been good managers, and have delivered reasonably sound fiscal and monetary policy, that saw India weather the worst of the global financial crisis of three years ago. One should not minimise that accomplishment. However, this does not gainsay the fact that the two most recent Congress-led governments, UPA 1, which ruled from 2004 to 2009, and UPA 2, in power from 2009 to the present, have been unable to carry forward the agenda of next generation economic reforms.

What must be stressed is the necessity of completing the reform agenda. All of the low-hanging fruit have been plucked. Now it is high time to deal with vitally important areas such as labour law reform, privatisation of public sector units (PSUs), elimination of agricultural subsidies, opening up retail and insurance to foreign investment, and the dismantling of what remains of the industrial licensing regime, especially reservation for the small-scale sector. We cannot sustain our high growth rate and cement our economic transformation without this next phase of reforms.

Some may ask, if reform is so vital, how is it that we are growing almost at double digits? Here, I would echo the view of astute observers, such as Arvind Panagariya, who have rightly argued that the current boom in the Indian economy is entirely driven by the dynamic private sector, the high savings rate (almost a third of GDP) which drives investment, and the large domestic market, which gives economic growth a certain momentum of its own. But, it must be underlined that without further reforms, rapid growth in itself will not accomplish the required structural transformation of the economy, and, indeed, may not be sustainable in the long run.

Regrettably, rather than getting on with the job, the current government has been content to pursue an uncontroversial and innocuous agenda, focusing on politically safe issues that no one could argue with, such as improving India’s infrastructure, which is bursting at the seams, things like airports, ports, bridges, highways, and the like, and all of this under the mantra of our time, public-private partnership. Anyone who has recently flown through Delhi’s impressive new airport terminal will agree that this is working well.

But there is much more to ensuring sustainable growth and development than building airports and highways, important though they are. The crux is this: India’s current economic success rests on slender and fragile foundations, which are missing one key ingredient: a large, labour-intensive manufacturing sector. No major economy in history has ever gotten rich without this. India is still a largely agrarian society, excessively dependent on relatively unproductive agriculture. This is attested to by the striking fact that, despite all of our progress in the modern economy, the single largest determinant of year-to-year variations in GDP growth is still variation in rainfall. The bottom line is that hundreds of millions of young people are going to need to move out of the countryside and into the cities in the coming decades, and this will only happen without creating major social unrest if there are manufacturing sector jobs waiting for them. Otherwise, our much vaunted “demographic dividend” will turn into a nightmare instead.

The notion that we can defy this iron law and get rich instead by focusing on high-tech services is a dangerous delusion. A large, export-oriented, labour-intensive manufacturing sector was the driver of growth in East Asia and is the formula for China’s success. We must emulate this model. Yet, the critical failure to liberalise and rationalise labour laws in India (most notably the notorious Industrial Disputes Act, 1947) is without doubt the principal reason why manufacturing has not taken off, and is not likely to, anytime soon. After all, if you cannot fire workers, why would you hire them in the first place?

Take another contentious area: privatisation of PSUs. When UPA 1 came to power in 2004, they effectively froze the disinvestment part of the reform agenda. Now, under UPA 2, there have been only very tentative steps toward renewing this process, and certainly no wholehearted embrace. Rather, the divestment that is taking place, such as the recent public offering in Coal India Limited, is fiscally driven, by the need to raise more cash for the exchequer, and does not demonstrate a commitment to reform this highly inefficient sector, with its arcane system of notified prices and consequent rationing. A secure energy supply is integral to the development of manufacturing, but the much needed restructuring and liberalisation of the power sector in general, and of electricity-generating capacity in particular, has also gone begging.

So what is going on? When the Congress party in UPA 1 freed itself from reliance on the Left in late 2008, over the wedge issue of the civil nuclear deal with the United States, and then trounced them, as well as the BJP, in the 2009 general elections, they came back to power with a bigger majority, reincarnated as UPA 2, without the need to rely on leftist allies. Yet, reforms are not even remotely on its agenda. Most pundits predicted the opposite. A few prescient commentators, such as Shankar Acharya and Arvind Panagariya, got it right, and recognized as early as 2004 the lack of commitment to economic reform not only within UPA 1 but critically within the Congress itself. That is the reason that UPA 2 has not pursued reform: it has not been embraced by Congress itself.

Arguing that they could not reform in UPA 1 due to reliance on the Left has now been revealed as the hollow excuse it always was. As another astute analyst, Ashutosh Varshney, wrote in 2006: “Congress party strategists have independently come to the conclusion that the party’s social base requires a programmatic focus on the lower and middle echelons of society.” In other words, the party’s own electoral interests inveigh against aggressively pursuing further reforms, as the presumed beneficiaries are the urban middle classes, mostly upper-caste Hindus, who predominantly vote for the BJP.

The more thoughtful, and candid, members of the current government admit as much. Jairam Ramesh has said on numerous occasions that a vigorous pursuit of further reform requires what he aptly terms a “politically durable consensus”, which evidently is lacking within Congress. In terms of electoral calculus, he could be right. The Congress’s short- and medium-term political interests may well be harmed by re-igniting the reform process. It is a safer bet to squeeze slightly higher growth out of the cogs of the exiting system, and coast along for the next few years.

In the long run, this would be a mistake of cataclysmic proportions. Surely the time is now, with the economy booming and a general election still almost four years away, to grasp the nettle and get on with the job. The failure to do so reflects an “original sin” of the first phase reforms in 1991. They were undertaken in an ambiente of crisis, and the case for reform was never properly articulated by Congress. That original sin has now come back to haunt them.

On the other side of the aisle, now would be the time for the BJP to shelve its Hindutva agenda, which is not a vote-winner in any case, and once again put the economy at the top of its political manifesto. That formula worked fabulously for them when they were last in power, and it can work again. While political parties have to be opportunistic to some extent, they also need to stand firm on principle, if they are to remain credible. Unfortunately, on furthering the economic reform agenda that they themselves did so much to strengthen, the BJP strayed too far from principle, and are pursuing electoral gains that thus far have proved illusory.

There is truth in the old parliamentary adage that where you stand depends on where you sit, but this should not be applied to a principled defence of economic reform, which was, and could once again be, at the core of the BJP’s platform. The BJP, quite simply, needs to move beyond its election defeat in 2004, in which it was out-strategised by Congress. The 2009 election defeat was merely a footnote. It must build a new manifesto for 2014 which makes clear that economic development is not just for the urban middle and upper classes, who are already beneficiaries, but for everyone. That could be a winning ticket.

A reinvigorated BJP, committed to completing the reform agenda, may also have the salutary effect of inducing Congress to be a little less smug and complacent about their re-election chances, and get them to focus seriously on the economy again. Doing so will require that they vanquish the old Nehruvian socialists still in their midst. That way, when the next election comes around, Indians will have the choice to vote for a party—either one—which actually believes in economic reform, and then gets on with the job. We should keep the champagne on ice until that happens.

12 Replies to “Where are the second-generation reforms?”

  1. sujeetpillai

    Great article. Structural inflation is quite a high component of India’s inflation today.

    I’m not sure however the UPA-I and UPA-II have has focused on building Indian infrastructure. The Delhi Terminal is one of the rare examples. National Highways, ports, etc have largely been ignored.

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