Friday, November 28, 2014

Before the 'second generation reforms’ / Pratap Bhanu Mehta

As expectations for reform soar, it is important to remind ourselves of the nature and magnitude of the challenge. There is much talk about second-generation reforms. But as one smart government official quipped: Forget second-generation reforms, India needs minus-one generation reforms. We don’t even know what we are facing. Political stability, the RBI’s determined effort to fight inflation (despite big business engaging in ideological obfuscation) and changing international circumstances have altered the mood. But the underlying rot is deep. Its surface has yet to be scratched. Too much energy is being expended on reforms that are besides the point, rather than on credible fundamentals.
Just imagine this. Structural regulatory uncertainty continues to affect about a quarter of India’s economy in sectors like mining, natural resources, any investment involving land. This has large indirect effects. There is always some uncertainty and dispute in an economy. But structural regulatory uncertainty basically means that a pricing mechanism has irrevocably broken down. You can have either a market mechanism or an administered price mechanism. The problem is that we do not have either that is credible.
Prime Minister Narendra Modi was right to say in Australia that reform by stealth does not work. What it ended up creating was institutions that had neither the old certainties of state-set prices in areas like coal, nor fully developed markets. Add to this the fact that the legal landscape has now become incredibly complicated: The coal judgment, for example, does not just raise questions about the method of giving mining licences; it has implications for federalism and who should be issuing them. But we underestimate this fact. The regulatory web is now so tangled that you don’t quite know what will happen if you pull at one string. This history of regulatory reform in India, with a few exceptions, has ended up muddying the landscape rather than clarifying it.
Two of the most critical sectors for the economy, health and education, exhibit these characteristics. The single biggest mistake of the right to education, for instance, was to muddy the distinction between public and private. Instead of saying let the public do its job and the private its function, we now have a regulatory system than distorts both irretrievably. And now it is proving near impossible to set the system right. The health sector is a combination of laissez faire and half-baked regulatory interventions. And each attempt to reform the system makes it more vulnerable. There is no reliable measure of inflation in these two sectors either, which probably has a greater effect on the rest of the economy than we realise.
All factors of production still face pricing and structural uncertainty. Add to this the quiet chaos in the financial system. The Indian banking system was not good at assessing projects or pricing risk. Or rather, what it was good at was assessing risk in the context of a closed loop of crony capitalism, where you could count on renegotiated contracts, unscrutinised gold-plating and government patronage. But there are two problems. The first is whether there will be a banking culture that can price risk and promote innovation. The jury is out on this one. The second is this: The lines of credit look more like electricity wires in a standard Indian city — so tangled that you don’t know what you will short circuit if you try and straighten and clean them up.
What will be needed for reforms under the circumstances of such regulatory mess? The first thing is a war against casualness. The besetting sin of government now is casualness more than venality. It thinks it can wing regulatory reform. The finance minister glibly concedes that the land acquisition bill was passed in a moment of populist casualness. Is there any evidence that any proposed reforms to this act will not also be equally casual in the other direction? After all, it is the same lot now trying to reverse course.
The government is underestimating the degree to which, some exceptions apart, the bureaucracy has atrophied — to the point that you cannot expect nuance or thoroughness from most departments. The one thing you could count on the IAS for — saving you from legal trouble — is no longer a virtue that exists. We don’t see the support scaffolding in place. Second, in none of these sectors is there a clear and precise articulation with appropriate nuance of the problem you are trying to fix. This is especially so in the land debate, where we are pretending as if we fully understand what we are trying to fix.
There is also a corresponding casualness in talk of taxes, deficits and so forth. Containing deficits is important. But you cannot restore growth dynamism without increased public investment. There is a deep disjuncture between the finance minister’s talk of lowering tax burdens and tight fiscal deficits on one hand, and the prime minister’s infrastructure dreams on the other. The government has not made a credible case for how it proposes to square the circle. More public investment in a broken system of rules creates its own problems, but the intellectual groundwork for it needs to be done.
The second challenge in this. Unfortunately, economies don’t come with a clean slate. There are too many sunk costs in different sectors. And creating new competencies takes time. Under such circumstances, the path to a new equilibrium is messy: it often involves cutting deals so that the costs of the new path are minimised. Banks will have to sit down with those in their debt and, in many cases, cut deals. Your problem is this: Will the forms of legal, political and public scrutiny allow for some sensible deals or will these get stuck in the logjam of recrimination? Which bankers will feel empowered to sign on them?
Tocqueville’s warning, that governments feel vulnerable when they try to reform, is still apt. Crafting reform requires recognising the depth of the rot. But rather than creating a climate for nuance, the depth of the rot often emboldens calls for more of a slash-and-burn exercise, especially when the state has low credibility. This is why governments still find it hard to come clean. After Modi’s call, what is preventing the government from producing an analytically sound, honest and credible white paper on the rot in several sectors — infrastructure, power, banking, credit, possibly land, and even the growth framework? Reform by stealth is not easy to give up in a system where you can be, for good reason, damned if you do and damned if you don’t.

The writer is president, Centre for Policy Research, Delhi, and a contributing editor for ‘The Indian Express’ 

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