Seizing crises as an opportunity: Case for implementing India's long impending economic reforms

It is often said that in every crisis, lies great opportunity. Same is true for this current Covid pandemic. The LPG reforms, which are hailed now and spurred India's growth trajectory in 1990s and 2000s, were nothing but a policy response to Balance of payment (BoP) crisis.

The current Covid crisis has rattled Global economy to levels previously unseen. Even in the Great depression of 1930s, world economy had not seen slowdowns of such levels. According to IMF in the April update of its World Economic Outlook (WEO), Covid-19 pandemic will shrink world output by at least 3% in 2020. In the same report, India’s growth estimate for FY21 was slashed to 1.9% from 5.8%, warning that the “worst recession since the Great Depression” will dwarf the economic damage caused by the GFC. Some economists have argued that as lockdown has brought manufacturing and services to a grinding halt, Indian economy will either remain stagnant or may contract by more than 2 per cent in 2020-21.

Though the complete extent of the slowdown on the economy will only be known later as different countries are in different stages of the pandemic and only a vaccine will reinvigorate global economy’s confidence, it is very clear that global growth, along with India's , will take its biggest hit. However, India will take much longer to recover as we were witnessing prolonged slowdown enabled due to multitude of reasons predating much before the pandemic. It was due to combination of structural and cyclical issues in the economy and expedited due to turmoil in our financial institutions, first banks and then NBFCs. Unless or until the structural issues, which involve long impending reforms across factors of production and industries aren’t undertaken, we won’t see quick recovery in the economy.

State of Indian Economy

Even pre-Covid, Indian economy was witnessing a slowdown with declining growth rate quarter on quarter. In Jan 2020, it reached 4.7% from high of 7.7% in Jan 2018. This was caused primarily due to slowdown in Investments and exports, two major growth engines during the high growth period between 2002-2014. The slowdown in Investments have been caused by slowdown in growth resulting in lesser job creation (some even calling it a jobless growth) and lesser income in the hands of people. This has caused a vicious cycle of lower growth causing lower incomes causing lower savings and lower investment.

India’s gross savings fell to 30.1 per cent of the gross domestic product in fiscal 2019 from the highs of 34.6 per cent in fiscal 2012, and 36 per cent in 2007-08. This is the lowest savings rate since 2003-04, when household savings had dropped to 29%. This has resulted in sharp decline in investments as shown above.

The slowdown post GFC slowed down global growth and that resulted in dip in commodity prices ranging from oil to agri-produces. Though dip in global Oil prices have benefited us close to 1-1.5% of GDP, the decline in agri-commodity prices have hit agricultural incomes badly despite higher aggregate production levels as depicted in the graph below.

Periodic labor force survey 2017-18 had presented a grim picture of the employment in economy. The survey had estimated unemployment rate at 6.1%, the highest in last 42 years (highest since 1977-78). The latest CMIE data, pegs the unemployment rate at 27.1%, estimating that close to 121.5mn people are currently out of work due to Covid and this is only going to increase from here.

The last nail in the coffin has been slowdown in consumption in the economy. The much talked about demographic dividend, for absence of jobs and incomes, has not been able to drive consumption in the economy. The consumption growth has declined for the first time in the history of independent India. For lack of revenues on both tax and non-tax sides (lower GST collection month on month) and lower collection on capital receipts' side due to lower disinvestment than what is targeted year on year, the government has been raising its expenditure every year financing programs primarily through deficits, which is reflected in higher fiscal deficit as below.

In the graph above, we can see that we are already running a very high deficit budget. If we include the off-balance sheet borrowings of NHAI and FCI along with UDAY bonds for power sector, center’s cumulative fiscal deficit is round 6.3%. Adding the 2.5% of the deficit of states, we can see that we have our deficit at around 8.8% of GDP. The higher borrowing by Government has crowded out private investments and because of higher differential between interest rate and growth rate, defaults in bonds is expected to increase. Consequently, Sovereign Government bonds, considered mostly as zero default risk, too don’t appear attractive to Investors because of lower yields and few revenue mobilization sources at their disposal.

When this article is being written, central government has raised its Gross Borrowing target for 2020-21 to Rs 12 Lakh Crore, in light of Covid, from earlier set target of 7.8 lakh crore (Additional 4.2 Lac Crore). This will further put pressure on bond market and further crowd out private investments.

Four Balance Sheet (FBS) Problem & Indian Financial Sector: An Achilles' heel

India is a bank-based economy unlike USA which is mostly a market based economy. Economic activity is mostly driven by bank lending in India. However, in the recent past fragility in the financial sector, first driven by detection of NPAs due to AQR regime instituted under former Governor Rajan and later India’s own housing lending bubble of NBFCs, have created what Arvind Subramanian and Josh Felman has called Four Balance Sheet problem in their paper India's Great Slowdown.

India's Four balance Sheet problem, which comprise - Twin Balance Sheet 1 and Twin Balance Sheet 2, has primarily happened due to lower revenue mobilization by Government and historical lending under UPA-2 post GFC to boost and stimulate growth. This lending was focused on Capex intensive sectors- predominantly cement, steel, real estate among others. Cyclical reasons wiped out the cash flows for these companies and defaults increased subsequently resulting in higher NPAs. Despite the resolution mechanism insituted under IBC, our banks are currently sitting on NPAs worth 9.5 lakh crore (9.5% of bank assets, excluding 2.5 lakh crore of lending to power sector)

The earlier Twin Balance Sheet of Banks and Corporate (TBS 1.0) has become Four balance sheet issue with TBS 2.0 of Balance sheet issues with NBFC and real estate companies now.They have argued that any economic revival will require revival of lending. However, given the high NPA levels of Bank and near collapse of NBFCs , it will be very difficult to revive economic growth unless completely addressed.

Reform undertaken till now

The economy has hit the rock bottom but that does not mean all gloom and doom as all crises present an opportunity for reform. And Covid is not an exception either. However, the current crises requires implementing long impending reforms in the factor market. Many economists have argued that if we do not build an ecosystem of systemic reforms, it will be very difficult to get an edge in this fast emerging protectionist economy. With more countries looking inwards, our services sector, which contributes around 60% of the economy and has been a major growth engine, will see a major slowdown.

The current government has undertaken some major reform measures in the last six years, as follows-

1. Corporate Tax cuts- These were by far the biggest reforms in Corporate India history. This was a long pending promise of NDA when they had come into power. The rate was drastically reduced from 30% to 25% of PAT. However, the savings to India Inc. has not translated into increase in private investments due to lack of demand in the economy.
2. IBC reforms - Insolvency and bankruptcy code (IBC), was introduced in December 2016, to bring in prompt resolution of long impending NPA problem. However,, IBC has proven to be slower than what was earlier envisaged. The cases which have been resolved have taken on an average 409 days, much more than the law mandated 270 days. On top of that, out of the 12 cases referred by RBI to IBC, only six have been resolved till now. These have prolonged NPA resolution in the country and the growth issue has been lingering for lack of capital.
3. Goods and Services Tax - This has been hailed as the biggest change in our tax regime since independence to unify tax structures across states to create a common market. However, the implementation challenges in it have resulted in lower GST collection year-on-year. This will have huge implications on Central devolution to state under finance commission recommendation as states like Bihar have 75% of the revenue coming from devolution by FCs. However, slowdown in collections have badly hampered state's resources and various programmes. This is only going to aggravate post Covid for center and many more states.

Reform opportunities : Factor market

Though these reforms are laudable, these have not been able to bring systemic reforms in the economy and especially in factor markets. If we have to avoid the middle income trap, we need to build a sustainable manufacturing base in lines with PM's speech yesterday which emphasized on self-reliance and import substitution. The Economic history of South East Asian tiger nations teaches us that unless or until we don't build concrete manufacturing base through sustained effort of decades, we can't overcome middle to low income trap. India is often criticized for having one of the lowest per capita incomes in the world (at levels with South Asian and Sub-Saharan countries) despite a high GDP growth over last post LPG reforms of 1990s.

This can only be addressed by investing heavily in domestic manufacturing which can employ our huge workforce. The current Covid crisis has exposed the vulnerabilities of global supply chains and excessive reliance on a few manufacturing nations. World can hardly afford such lockdowns going forward. Thus, the time is ripe for having institutional reform across the factors of production of Land, Labor, Capital, Entrepreneurship and bring in other institutional reforms to reinvigorate and accelerate our growth journey in next decades.

1. Land Reforms- Land being a state subject and an emotive issue, has been resistant to reform. Since independence, various reform initiatives have been undertaken. However, those have been insufficient to arise major investor confidence and has been the biggest deterrent in take-off of major manufacturing activities in the countries. Despite Center's ambitious Make in India initiative, manufacturing as percentage of GDP has hovered around 16-18% of GDP. Large manufacturing with economies of scale is land intensive and it requires easier acquisition without harming the interests of farmers or the industrialists. Center had come up with a Land ordinance but it was allowed to lapse in August 2015. Despite that, several other institutional challenges listed below remain, which need to be addressed as below-

• Poor quality of land records- The lack of good records creates uncertainty about land rights and various hindrances. This inhibits agricultural and industrial investment and creates significant impetus for litigation, and leads to financial exclusion of those who cannot prove their right to their property.
• Restrictions on the transferability of land rights - Current restrictions on various activities like leasing, sub-leasing and rental arrangements discourage consolidation of land holdings and give rise to further informality and subsequently, inaccurate land records.
• Non-ease of registering property - While India has made considerable progress on the Ease of Doing Business index in the last few years, it continues to be ranked at 166 on the ease of registering property. This needs to be addressed.
• High volume of property litigations- In a survey, it was found that two-thirds of civil litigations were related to land and property. Litigation is an additional cost borne by the poor for transacting in land and property. The overwhelming number of litigants surveyed had an annual income of less than Rs 3 lakh and had not studied beyond school.

We have made little progress in addressing the above issues. The decade-old National Land Record Modernisation Programme (NLRMP) aimed at improving land records was rechristened as Digital India Land Record Modernization Programme (DILRMP), but fundamentally, the scheme has remained the same despite low-to-middling success across states. However, these land reforms are imperative if we want manufacturing to drive our growth in this decade.

2. Labor Market Reforms - This Covid crisis has exposed the vulnerabilities of migrant labours working in different states. This has also brought to light the draconian labour laws which have prevented investments in their native states most notably Bihar, UP and Odisha and forced them to work outside. Thus it is necessary to bring in labour reforms both at a country level and at state level. Some of the major reform areas in labour are-

• Draconian nature of labour laws - India is home to one of the most draconian labour laws. The labour laws, formed during erstwhile socialist era, prevent liquidity in the labour market. Though these laws were created to deter employee exploitation, these have deterred firms to such an extent that businesses have moved out of these states completely. It imposes draconian provisions like seeking government permission before firing employees, if the number of employees is >99. Such provisions have deterred companies to scale fearing Government action. This disincentive to scale through such laws have curtailed entrepreneurship of scale and helped in creating more 'informal' economy.
• Heterogeneity in Labour laws dissuading investors - Labour in India is in concurrent list where both the center and state can legislate. India currently has 45 central labour laws and about 200 labour laws at the state. If India is to realise its vision of one-nation-one-market, then we need one-nation-one-labour law too. Rajasthan had come up with a comprehensive set of labour reforms and has been lauded. However, center should consider implementing such reforms across nation through a legislative intervention.

Such reforms ought to be undertaken if we have to achieve parity in Cost of doing business with our competitors in South or South East Asia. Most of the BPO outsourcing due to higher wages have already moved out to countries like Vietnam, Philippines. If we have to move manufacturing back leveraging Covid and discontent in countries against China, such labour reforms are imperative. Also workforce needs to be constantly skilled in this fast changing world. On that front, Central government and state governments have undertaken multiple initiatives. However, the curriculum for the same needs to keep pace with the needs of the industry.

When this article is being written, three states namely UP, Gujarat and MP have already amended their labor laws. UP is amending 34 of the applicable 37 laws through an ordinance.

3. Market reforms

For some time, financial sector regulation and supervision has clearly been inadequate. From the lending excesses in public sector banks during the boom; to delays in acknowledging the true size of the problem during 2012-16; to the delayed response to troubles in private sector banks such ICICI and Yes; to the Nirav Modi scandal at a major public sector bank; to the shenanigans at ILFS and other NBFCs (DHFL) and the mutual funds to the collapse of the Punjab and Maharashtra Cooperative Bank—all of these have exposed serious shortcomings at the RBI and government. Thus the time is ripe for implementing major reforms across the financial sector along the lines of FSLRC recommendations made by Justice Srikrishna Committee.

Draft Indian Financial Code - The draft Code formulated by FSLRC is a non-sectoral, principles-based law bringing together laws governing different sectors of the financial system. It addresses nine components, which the FSLRC believes any financial legal framework should address. Some of which are -

• Unified Consumer protection Agency- Create a single unified Financial Redressal Agency (FRA) to serve any aggrieved consumer across sectors.
• Easing Capital controls- India has liberalized its capital account in recent years to attract foreign money in the absence of a large domestic savings pool. Foreigners can now buy and sell stocks without any limits, but there is a cap on how much they can invest in rupee bonds. India has eased restrictions on foreign direct investments in sectors such as retail, manufacturing and coal mining recently. That’s expected to encourage companies from Apple Inc and BHP Group PLC to invest more in Asia’s third-largest economy. However, this regime needs to be further relaxed given comfortable levels of reserves.
• Mechanism for enforcement of Contracts, trading and check on market abuse- : The draft Code establishes the legal foundations for contracts, property and securities markets. This needs to be immediately adopted to ease the doing of business in the country further.
• Public debt management: We run a very high public Debt to GDP budget. Our current public debt to GDP has reached around 70% of GDP. This excess borrowing by state, crowds out private investment. This current level is much higher than 40% Debt to GDP which is envisaged to be achieved by 2024-25 under FRBM targets. The draft Code establishes a specialised framework for public debt management with a strategy for long run low-cost financing. The FSLRC proposes a single agency to manage government debt. 

Unified Regulator- The draft Code sought to move away from the current sector-wise regulation to a system where the RBI regulates the banking and payments system and a Unified Financial Agency subsumes existing regulators like SEBI, IRDA, PFRDA and FMC, to regulate the rest of the financial markets. 

These market reforms will go a long away in securing our economy against the constant frauds and market failures.

4. Other Institutional reforms

• Justice Delivery mechanism- Foreign investment in India is affected by an under-supported judiciary. While jumping up nearly 14 spots in the EoDB 2020 rankings, it still takes an average of nearly four years to enforce a contract in India. In 2016, it was estimated that judicial delays cost India around 0.5% of its GDP annually--Rs 50,387 crore ($7.5 billion). It is required to overhaul our Judicial mechanism so that cases don't linger in courts for ever. It is also required to adopt technologies at scale for faster disposal of cases.
• Police Reforms- Administration of police in an efficient manner is imperative to create a law and order which citizenry and Investors trust. According to a PRS report on Police reforms in India, State police forces had 24% vacancies (about 5.5 lakh vacancies) in January 2016. Hence, while the sanctioned police strength was 181 police per lakh persons in 2016, the actual strength was 137 police personnel only. Crime per lakh population has increased by 28% over the last decade (2005-2015). However, convictions were secured only in 47% of the cases registered under IPC. This poor state of our policing has taken down public and investor confidence in law and order in the country. Investors need to feel secure and ought to have trust in law and order of the sovereign land. State Government should accelerate the filling of vacancies, strengthen their capacities so as to get the investor confidence back.

Conclusion

The noted historian Yuval Harari argues that emergencies or pandemics expedite processes and enables Governments to undertake measures which they won’t take otherwise. Indian economy has been trying to undertake many reforms for long in the past. However, they could not be undertaken due to multitude of reasons ranging from lack of political will to threat of protests. Hence the time is currently ripe to put in place those long impending economic reforms which will ensure a smoother recovery and lay the foundations for stable growth going forward. However, that will require concerted actions and major institutional reforms across levels and institutions.

These reforms discussed have been articulated numerous number of times by previous commissions but could not be implemented. This has stymied our growth potential, led to more informalisation of the economy and has created bottlenecks in the very fundamentals of our economy. The present government has shown the wherewithal to take tough decisions whenever required and Covid presents an opportunity to make these long impending reforms. These reforms will not only go a long way in securing fast paced economic growth but institutionalization of these will also ensure we bucking the middle income trap and strongly emerging as economic leaders in a post covid world order.

The views Expressed are personal

Sources:

1. https://www.hks.harvard.edu/sites/default/files/centers/cid/files/publications/faculty-working-papers/2019-12-cid-wp-369-indian-growth-diagnosis-remedies-final.pdf
2. https://theprint.in/opinion/land-reform-a-game-changer-that-narendra-modi-government-has-overlooked/178104/
3. https://tradingeconomics.com/india/gdp-growth
4. https://www.ft.com/content/19d90308-6858-11ea-a3c9-1fe6fedcca75
5. https://www.indiaspend.com/india-spends-only-0-08-of-gdp-on-judiciary-crippling-reforms/
6. https://www.prsindia.org/sites/default/files/parliament_or_policy_pdfs/Police%20Reforms%20in%20India.pdf
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