Anindito Mukherjee / Courtesy Reuters A construction site in New Delhi, November 20, 2013.

The Promise of Modinomics

How the New Prime Minister Can Bring Back Growth

For the first time in India’s modern history, a non–Congress Party outsider with no prior involvement in running the central government has won an absolute majority in the parliament. But as the euphoria associated with Narendra Modi’s extraordinary election gives way to the duties of the office, the new prime minister must turn to the hard work of delivering the economic promises he made during the campaign. For Modi, that will raise three key questions: Is sustained rapid growth, which is essential for his development and employment plans, even feasible? If it is, what reforms should the government undertake now and in the longer run to achieve it? And what obstacles will he face in carrying out these reforms?

WHAT AILS INDIA?

Until the 2012 fiscal year, the Indian economy had grown at eight percent per year for nearly a decade. That track record busted apart the myth that democracy hinders economic growth -- a common conclusion among many looking at the economic growth of authoritarian China, Singapore, Taiwan, and (in an earlier age) South Korea. Although policy mistakes have resulted in a sharp decline in India’s growth rate to below five percent in the last two fiscal years, sustained policy reform could bring the country near-double-digit growth over the next two decades.

There are three reasons for this. First, throughout the last decade, India’s national savings rate has been consistently at 30 percent of GDP or higher. Those savings guarantee that India has plenty of investible resources to grow the stock of capital, an important ingredient in growth. Second, demographically, India is young, and it is predicted to become even younger, with a healthy growth in population. It will not, therefore, face the labor shortages that have already hit many other economies, including China. In fact, the working population will rise as a proportion of the total population, which, in turn, could lead to a further increase in the savings rate. Finally, with a per-capita income of around only $1,500 per year, India still has vast room to catch up. It remains very far from the global productivity frontier and can grow rapidly as it races toward it.

So renewed Indian growth is possible. But how can the government promote it? That depends on what caused the recent downturn. The outgoing government’s favorite explanation was that the global economy was weak. But closer examination points to domestic factors. In 2007–08, the economy grew 9.3 percent. In September 2008, the Lehman crisis hit. But it only mildly dented the Indian economy, forcing the growth rate down to 6.7 percent during 2008–09. In the following two years, the growth rate quickly returned to a higher level, averaging 8.75 percent. It is only in subsequent years, a period during which little has changed in the global economy, that growth rate has averaged just 4.6 percent.

The key to this sharp decline in growth is paralysis in the central government, which resulted from three factors. First, corruption scandals led to the jailing of several of top-level politicians and bureaucrats. That created gridlock; worried about the risk of being called out for corruption, officials prudentially put off making decisions. Second, the environment ministry inordinately delayed decisions on environmental clearances on projects worth more than a hundred billion dollars, adding to investors’ woes. Finally, an ineffective prime minister’s office slowed things down even more by failing to coordinate across ministries. (Most decisions in India require agreement among two or more ministries.)

BUDGET BREAKDOWN

The new government will need to overcome all three sources of paralysis. It must convince senior officers that they can make legitimate decisions without fear of future prosecution. It should appoint a pragmatic environment minister. (The current minister, although he fulfills that need, is in charge of the ministry only temporarily.) And it will have to build a strong prime minister’s office to ensure that disagreements across ministries do not get in the way of policymaking.

Overcoming the deadlock in New Delhi must be complemented by the creation of healthier partnerships with India’s state government. New Delhi must be readier to sign off on state initiatives to attract investors. And it must also get more serious about evaluating states’ progress in meeting those goals in a timely fashion.

The final budget for 2014–15, which is due for presentation in early July and will replace the interim budget of the previous government, provides the Modi government with several opportunities. The first concerns the fiscal deficit. The interim budget pegs the deficit at 4.1 percent of GDP. But most commentators have argued that the figure was calculated based on overly optimistic assumptions about revenues and expenditures. On the revenue front, the calculation assumes a nominal GDP growth of 13.4 percent, which would translate into net tax revenue growth of 18 percent and proceeds from sales of equity in government-owned enterprises yielding more than $6 billion. On the expenditure side, the calculation assumes that subsidies to the poor will stay at the same level in nominal terms as last year. It also makes inadequate provision for recapitalization of banks. Because of these issues, one of India’s leading banks, Kotak Mahindra, has noted that a “more realistic” deficit would be 4.5 percent of the GDP. The new government must thus ensure that the fiscal deficit does not exceed at 4.1 percent if the calculation in the interim budget is right and 4.5 percent if it is wrong.

The budget must also clearly signal the government’s intention to restart reforms that stalled under the outgoing government, particularly liberalizing trade and lowering the top tariff rate on nonagricultural goods from ten percent to seven -- and possibly even five -- percent. It must also commit to completing the Goods and Services Tax (GST) reform within two years. That will entail replacing all indirect national- and state-level taxes with a uniform value-added tax on all goods and services except for essential items such as food and medicines, which will be exempted, and so-called demerit goods, such as alcohol and tobacco, which will be taxed at higher rates. It should also commit to completing the direct-tax simplification and codification within one year. That would involve clarifying tax rules and eliminating some exemptions, leaving less room for bureaucrats to use their own discretion on tax day. Finally, it must end retrospective taxation, which was introduced in 2012 to force a multinational into paying a tax that, according to a later supreme court ruling, it did not owe under the then-existing laws.

Next, it is important to improve the quality of expenditures. Two steps in particular are necessary. First, the government must cut subsidies to the middle class more aggressively than what the interim budget proposes. Petrol and diesel subsidies must be eliminated entirely within the current calendar year. Cooking gas subsidies should be reduced from 12 cylinders per year to six. The budget must also rebalance the composition of expenditures. In particular, it should shift toward capital expenditures -- spending on highways, rural roads, ports, and electrical transmission and distribution lines. Overall, capital expenditures must rise from 1.76 percent of the GDP in the interim budget to two percent.

Beyond getting the deficit right, the Modi government must immediately address the health of public-sector banks, which suffer from exceedingly high levels of restructured and nonperforming loans. The government has three options: recapitalizing the banks using public funds, diluting government equity in the banks by pushing the banks to raise equity from the market, or closing some of the weakest banks or merging them with stronger banks. Given the fiscal constraints, it is unlikely that sufficient public funds will be available to rely on recapitalization alone. Nor would that be desirable, since the other two steps offer the opportunity to introduce additional banking sector reforms. The second option would create pressure for banking efficiency. And the third would promote consolidation of an industry that currently consists of one gigantic public sector bank and numerous much smaller banks.

Finally, the government must also use the budget to show its seriousness about giving the states greater legislative and fiscal power. To this end, it should commit to giving states timely permission to amend the laws within the purview of the Concurrent List of the Constitution, which consists of areas in which both the center and state can legislate. Normally, central laws in these areas take precedence over state laws, but the constitution allows the center to permit states to override its laws. The commitment would open the door for speedy labor and land-acquisition reform.

ON TRACK

Once the budget is complete, Modi must turn his attention to longer-term reforms. In our recent book, Why Growth Matters, CFR Senior Fellow Jagdish Bhagwati and I classified reforms into two categories: Track I and Track II. Track I reforms are those aimed at accelerating and sustaining employment-friendly growth, and Track II reforms are aimed at expanding social spending and making it more effective at combating poverty, illiteracy, and poor health.

Track I reforms require, first and foremost, the reform of India’s labor laws. Highly rigid labor laws have made entrepreneurs terrified of hiring workers. Large corporations in India have systematically avoided entering low-skilled and labor-intensive sectors such as apparel, footwear, and electronics assembly -- in all of which China excels. Rather, they have chosen to invest in capital-intensive or skills-intensive industries, such as auto and auto parts, heavy machinery, chemicals, pharmaceuticals, telecommunications, and software. Even when operating in these sectors, they choose the most capital- and skilled-labor-intensive technologies and prefer hiring contract workers when they need low-skilled labor.

As a result, in the most labor-intensive economic sector, clothing and accessories, India’s exports have been less in absolute terms than those of Bangladesh, a smaller country, for many years. They have now fallen below even tiny Vietnam. When compared to a country of its own size, China, India comes nowhere close: China exports more than ten times as much clothing and accessories. With nearly 500 million workers who are overwhelmingly unskilled or low skilled, this poor performance has meant that millions of workers are left without decent jobs. Instead, they have ended up in informal jobs in small shops or the domestic service and local transportation industries, receiving low pay.

Labor laws relating to industrial disputes, trade unions, apprenticeship, pensions, provident fund, and insurance have been the major obstacles to the entry of large formal-sector firms into low-skilled labor-intensive industries. Their effect has been reinforced by the absence of proper bankruptcy laws that would allow firms to close rapidly in case of failure. For example, in some case, firms with 100 or more workers are not permitted to make layoffs. There are plenty of horror stories about formal-sector firms existing for two years and then taking 20 years to wind down their operations.

With such onerous bankruptcy laws, firms hesitate to enter the formal sector in the first place. The result is a stagnant formal sector and a large and ever-growing informal sector. In the next five years, then, the Modi administration will need to think seriously about reforming India’s labor laws and introducing mechanisms that permit the smooth exit of failing firms.

The government also needs to accelerate the development of highways, railways, and electricity. The previous government slowed down investment in these areas even as the economy grew at eight percent. The result is a huge deficit in infrastructure. Apart from building more and better infrastructure, the new government will need update its policies toward those sectors. Railways, currently state-run, should be broken up into four or five independent corporations. Those corporations could then compete for passengers and freight contracts. In the electricity sector, it is time to free up distribution companies and regulatory commissions in the states from political interference. In addition, modernization and economic transformation will also require the movement of workers from rural areas into urban industries and services. Cities, then, will also need cheap rental housing. Otherwise, the slums will only grow larger. India will also need to build many, many new cities.

In addition, the government must restart efforts to privatize public-sector enterprises, especially those engaged in such activities as manufacturing fertilizers, chemicals, and electronic and engineering goods. It makes particularly little sense to hold on to the enterprises that have been absorbing massive public revenues with little to show for it. But there is also a case to privatize profitable enterprises; research sponsored by the Program on Indian Economic Policies at Columbia University has shown that enterprises such as Bharat Aluminum Co., Ltd., and Hindustan Zinc, Ltd., which were privatized during the last BJP-led coalition government, have performed much better than those that were chosen for privatization but were not fully privatized.

Finally, successive governments have neglected to introduce any reforms whatsoever in higher education. As a result, higher education in India is governed by the same education policies that it created in the 1950s. The United Kingdom, whose framework India borrowed, reformed its system more than 20 years ago. The government’s first step, then, should be to end its own bureaucratic stranglehold on the university system. It should abolish such government bodies as the University Grants Commission, which set and enforce standards for all Indian universities, and replace them with lighter regulatory bodies. These could set some basic norms. Any institution that can meet them should be allowed university status. Institutions must also be free to set their own tuition and teacher salaries.

HEALTH IS WEALTH

Alongside Track I, the government should also reform Track II policies, aimed at addressing the food security, employment, education, health, and wellness of the Indian public.

In previous years, rapid growth, which brought extra revenue, allowed the government to expand social spending. Unfortunately, that money has not been put to good use, mostly due to the poor design of social programs. Both the National Rural Employment Guarantee Act (NREGA) program and the food security program lose massive amounts of money to waste and corruption each year. Ideally, those programs should be replaced with cash transfers, which are shown to be more efficient. But since politics may not favor an outright switch to cash transfers, the government could give the bottom half of households that receive aid the option to choose between 10,000 rupees (almost $170) per year (to be given to the senior-most woman of the household) and access to NREGA and subsidized food. In all likelihood, most households will opt for cash. This will empower the households and help the government wind down the massive state-run distribution chains for subsidized goods and jobs.

There are Track II reforms for elementary education as well. The Right to Education Act of 2009 set norms for funding, teachers, and buildings and other physical infrastructure for each school. But the act set no expectations for learning. It also outlawed board examinations for students and mandated automatic promotions of pupils all the way up to the eighth grade. Because of that, the performance of teachers cannot be measured. In addition, teacher absenteeism is rampant. As a result, systematic surveys by Pratham, an Indian nongovernmental organization, show a sharp decline in the language and mathematical skills of children in public schools.

The problems in Indian public schools might be fixable, or they might not be. Either way, it is worth giving poor parents the same option that the richer parents have: access to private schools. It is sensible to start with education vouchers, which the parent can use for the school of his or her choice. If public schools can provide a decent education, the voucher money will flow right back to the government. If not, children will flee public schools and the government and teachers there might be forced to reconsider their lackadaisical attitudes.

As growth is restored and money begins to flow, the government will also need to address health policy in a major way, namely through its sanitation and vaccination programs. It will need to increase provision of modern toilet facilities. And Indian cities will need to do better job of waste management, drainage, and cleaning of sewage. These are activities that require state intervention since their benefits become automatically available to all without consumers, regardless of whether those consumers pay, and are therefore not profitable for private firms to undertake.

Perhaps not surprisingly, the government has performed very poorly in providing medical services to the public. Despite decades of efforts and investments to build up sub-centers, primary health centers, and community health centers in rural areas, 80 percent of patients who need outpatient care and 55 percent who need inpatient care go to private providers. And here, too, then the private sector needs to be given a greater role: the government should give poor households the money for day-to-day outpatient health care and insurance for episodic illnesses involving large expenditures, mainly surgeries requiring hospitalization.

MODI’S MANDATE

Modi wants to be transformational and intends to be in office for multiple terms. With him, India has an unusual opportunity to transform itself. If it can grow at ten percent per year over the next two decades -- an entirely feasible ambition -- by 2030 it will be the world’s third-largest economy. By then, it would have also brought prosperity and modern amenities to a very large section of its population.

But the road to reform is not without obstacles. At least three roadblocks are worth noting. First, many within the BJP who now hold ministerial posts shared the previous government’s general economic philosophy. They voted for nearly all legislation that the government passed. In other words, the new prime minister will need to bring them on board.

Second, Modi’s coalition lacks a majority in the Rajya Sabha, the Indian Parliament’s upper house. Therefore, it will have to skillfully negotiate with the Congress Party and other parties to pass major legislations. It also has two other options for pressing forward legislation. First, in areas covered by the Concurrent List of the Constitution, such as labor and land, it can transfer powers to reform laws to the states. Second, it can bring legislation to a joint meeting of both houses of the parliament. According to the Indian constitution, in such joint sessions, parliamentarians can pass laws with a simple majority.

Finally, India’s judiciary has lately become very active. It, too, could throw barriers in the way of reforms. In part, that activism has resulted from the failures of the past executive to do his minimal duties. With a renewed focus on efficiency in the executive branch, judicial activism may decline on its own. But that is by no means certain, and the government may have to negotiate its way with the judges as it proceeds with reforms.

Either way, the new government’s forthcoming budget will be the first sign of whether the world’s largest democracy intends to take advantage of this historic opportunity or squander it yet one more time.

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