Pragati Manifesto

Economic Reforms: Time for Structural Change

This section of the Pragati Manifesto is about the four essential economic reforms we need. Read the other pieces here.

In a rumbustious and diverse democracy, it is often difficult to secure consensus to effect deep structural changes. Consequently, economic reforms are postponed till they become absolutely necessary, often till the moments of crisis. Nevertheless, an analyst can not keep waiting forever. The ideation, articulation, critique and discussion of the themes of the future reform must precede the real action, even by decades.

In what follows, I outline four measures that must be implemented before Indian economy makes the transition to a large, middle income economy.

One: PSB Reforms

If there is one sector that is at the heart of the Indian political economy, it is Public Sector Banks (PSBs). Resources controlled by these entities are humongous: State Bank of India (SBI) alone has a balance sheet of around ₹34 trillion. Unfortunately, the scale of mismanagement in these institutions is as enormous as the loan portfolio they manage.

Most of us have read about the egregious operational risk management failures which have resulted in unprecedented frauds in the recent years. Keen observers must be aware of bank recapitalization plans, which represent an example of the socialization of the private losses.

However, even shrewd observers may not be aware that such ‘recaps’ are not isolated events: they are part of a cycle that keeps recurring every ten or fifteen years. While researching the budget documents, I had found that the taxpayers are still bearing the burden of the last recap plan which happened in the late nineties. And even before these liabilities are redeemed, another multi-trillion recapitalization plan has been hatched.

Why do such problems persist 25 years after our economic reforms? The underlying reason of the problem is an enormous conflict of interest. Public sector banks and the banking sector regulator both are de facto responsible to the government of the day. Moreover, the government also provides what is called soft budgetary constraint. It implies that there are no effective checks and balances in the system.

An effective economic reform would entail at least one of the two happening: either the bank regulation should be completely insulated from government interference or the operational management of the PSBs should be taken away from the government. One way of doing the latter would be for the government to divest its control in the PSBs.

Two: Mechanism Design for the Allocation of Resources

Parliamentary democracy is based on the idea that every tax and expenditure proposal must be explicitly permitted, vetted and scrutinised by the parliament. This system puts enormous premium on transparency. However, just as most software programs have inherent bugs which can be exploited by the smart hackers, the financial procedure of the Indian parliament too has a number of exploitable loopholes that could be taken advantage of by the executive. One such loophole is the allocation of resources and regulatory approvals. Unlike the appropriation from the consolidated fund of India, these allocations are discretionary, dated and opaque.

It should not come as a surprise, therefore, that in recent years, allocation of resources (think spectrum and coal) has been the subject of intense public controversy and scandals. Interestingly, much of the public debate is totally oblivious to the many advances in the the auction design literature. Modern auction design offers many non-obvious lessons about how resources should be allocated. The devil often lies in the detail. Auction of spectrum (where no bidder has an insider information about the value) is very different from the auction of a coal or petroleum block (where those owing adjacent blocks often have an informational advantage over other bidders).

India needs to engage sophisticated and professional mechanism designers for the allocation of resources (and even regulatory approvals). At the same time, we also need to have an informed public debate about such issues.  

Three: Autonomous Central Bank

Conventionally, governments are expected to provide public goods and services and correct market failures. To achieve these objectives, a government has two exclusive sources of resource mobilization, namely taxes and money creation. To prevent the abuse of the government’s monopoly power over the creation of money, a number of institutional details have been worked out, the most important among them being the autonomy of the central bank. Cranking up money printing requires a concurrence between the treasury and the central bank. Neither alone is capable of creating money ex nihilio.

However, when the central bank loses its independence, sooner or later the money creation process is going to be subordinated to the goal of deficit financing. While the Indian central bank did enjoy de facto operational independence in the post reform period, its de jure status remains quite weak. Giving the central bank autonomy a legal, if not a constitutional, footing therefore should be part of the economic agenda.

Four: Independent Statistical System

In the last two months, the Boeing 737 was involved in two crashes in Ethiopia and Indonesia respectively, killing all the onboard passengers. While the detailed enquiries are still on, preliminary investigations suggest that the crashes were caused by a malfunctioning sensor.

Why is this news relevant in the discussion of an economic agenda? The reason is that a large, modern economy like India is like a large aircraft in action. It is buffeted by turbulence every now and then, and requires careful handling. To navigate, one must have feedback. Just as a malfunctioning sensor can result in a catastrophic air accident, economic management with imprecise data can have catastrophic consequences. Without a credible and accurate statistical system, policy making is like flying an aircraft without sensors: a disaster waiting to happen.

Think of the computation of GDP for example. Most of us think of it as an academic exercise with no practical implication for the economy. In reality, the nominal GDP figures are used to project future tax collections, and the tax department is given targets on the basis of such figures. When GDP is exaggerated, the tax department will get inflated tax demands and often resort to extortionary manners to achieve them. In the process, corporate investment and employment will suffer.

A robust, professional and independent statistical system is the sine qua non of a complex economy and must rank at the top of any future reform agenda.

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Read the rest of the Pragati Manifesto here.

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About the author

Avinash M Tripathi

Avinash M. Tripathi is an Associate Research Fellow (Economics) at the Takshashila Institution. His research interests include competition policy and financial risk management. He prefers a profound answer to a silly question rather than the other way around.