This is the third piece in the budget series.
, I wrote about why it won’t be easy for the government to get the economy back on track by spending its way out of trouble.
, I wrote about the seven things the government can do in the budget to get the Indian economy out of trouble.
Dear reader, I would suggest you read the first two pieces before diving into this one, just to make sure you get the total perspective on the budget and the current state of the Indian economy.
In the third piece, I look at the things that the government can do, both in the budget and outside it, to get the economy back on track. These are things that can be announced and initiated from February 1 onwards — the day the budget is to be presented. Let’s look at these things pointwise.
1) Economic protectionism has been making a slow comeback over the last few years. The government seems to think that protecting Indian industry from foreign competition is a good idea, to get the economy back on track.
As the late Arun Jaitley put it in his February 2018 budget speech: “In this budget, I am making a calibrated departure from the underlying policy in the last two decades, wherein the trend largely was to reduce the customs duty…To further incentivise the domestic value addition and Make in India in some such sectors, I propose to increase customs duty on certain items…This measure will promote creation of more jobs in the country [emphasis added].”
What’s the logic here? The idea is to make imports expensive by increasing the customs duty on them. Once imports become expensive, people are more likely to buy domestic products. When people buy domestic products, the demand for domestic products will go up. This will push companies to invest and expand and in the process create new jobs. QED.
This is the seen effect of protectionism, or the effect of trying to protect domestic industry by making imports expensive through higher customs duties, insisting on a minimum import price, and so on. But there is an unseen effect as well. Let’s try and understand that.
The question is: why are people buying foreign products? Well, no one is forcing them to do that. But they still are simply buying because they see more value for money in buying products produced overseas. Now, if customs duty is increased on these products, the people will be forced to buy domestic products, which will be more expensive than the foreign products.
When people spend more on buying something, they are likely to cut down on buying something else, given that they earn only so much. So, if one business will benefit, other businesses will bear the cost of this so-called benefit.
Remember, in economics, there is no such thing as a free lunch. Hence, the sales of other businesses will fall, and they will fire people to stay competitive. So, net-net, no new jobs are likely to be created. This is the unseen effect nobody either thinks about or talks about.
While the benefits of protectionism are seen, the drawbacks are not as obvious. Let’s take the example of steel. A few years ago, the government fixed a minimum import price for steel in order to discourage companies from buying cheap Chinese steel. This benefited the Indian steel companies which were under a lot of debt as well.
But this meant that consumers of steel — everyone from car manufacturers to builders — had to pay more, having been forced to buy steel from Indian companies. Of course, they were not going to pay for this from their own pocket. The price was passed on to the end-consumer. You and I paid for the benefit of steel companies. Of course, this cost was not as obvious in comparison to the benefit received by steel companies.
There is a fundamental point in economics that we can learn here. As David Friedman writes in Hidden Order – The Economics of Everyday Life: “If you are or your company will receive almost all of the benefit from some proposed law, you may be willing to invest lots of money and effort seeing to it that the law passes. If the cost of the law is diffused among many people, no one of them will find it in his interest to discover what is being done to him and oppose it. That is one reason why special interests are so successful in benefiting themselves at the cost of the rest of us—even though we outvote them a thousand to one.”
So, the next time you wonder why business lobbies exist, and why they are so successful, you know the answer. Also, this is precisely why protectionism looks good in theory but, as we just saw, it clearly isn’t.
The point in the context of the budget is that the finance minister should resist from increasing customs duty on imported products in this budget. While it may benefit a few companies and sectors in the short-term, it is going to hurt the broader economy in the long-term.
2) Almost all countries that have gone from being a developing country to becoming a developed country have done so on the basis of an export revolution. Indian exports, on the other hand, have been falling over the years.
Take a look at Figure 1, which basically plots Indian exports of goods and services as a proportion of the gross domestic product over the years.
Figure 1. Source: Centre for Monitoring Indian Economy
As is clear from Figure 1, the exports to GDP ratio peaked in 2013-14 at 25.43 percent of the GDP, or a little over one-fourth of the size of the Indian economy. Since then, it has been on a downward trend. In 2019-20, it is expected to be at 18.45 percent of the GDP. This is the lowest since 2004-05, when it was at 17.86 percent.
There are lots of things that need to be set right for Indian companies to be able to compete on the exports front. Everything from land laws to labour laws to tax laws needs an overhauling — not just corporate income tax. Interest rates need to come down as well. These factors are all well-known and have been written about over the years, so I’ll skip them. Other than these factors, there is one other thing that matters and that is the ability to compete globally.
Trade protectionism goes against the entire idea of competition. It ensures there is less competition in the domestic market. And less competition means less choice.
As Thomas Philippon writes in The Great Reversal — How America Gave Up on Free Markets: “Competition leads to more choices for consumers as businesses cater to different segments of the population and as they try to differentiate their products from those of their competitors.”
How is this linked to the need for greater exports? Competition leads to a greater choice and access to better quality products for the consumer. Encouraging imports leads to greater competition. Before 1991, when imports were discouraged and when import substitution was the norm, companies needed to produce just for the internal market. Almost anything was produced.
For a very long time, car consumers had access to largely two brands: the Ambassador, manufactured by the Birlas at Uttarpara near Kolkata, and the Premier Padmini by the Walchand group at Kurla in Mumbai. Quality wasn’t the greatest facet of these cars. As India kept concentrating on import substitution as a strategy for an inordinately long period of time, most companies never developed the ability to produce quality products that were needed to compete in the international market. Trade protectionism leads to import substitution and it ensures that companies do not develop the ability to compete in the international market.
This is something that Finance Minister Nirmala Sitharaman needs to realise, along with the fact that the global market is much bigger than the domestic market.
3) Take a look at Figure 2, which basically plots the total value of investment projects dropped every year, over the years.
Figure 2. *April to December 2019. Source: Centre for Monitoring Indian Economy
Figure 2 tells us that the value of investment projects being dropped has burgeoned over the years. Typically, the reasons vary from problems in land acquisition owing to unclear land records, difficulties involved in physical possession of land, rehabilitation and resettlement issues, evacuation and logistics constraints, environmental and other clearances, and so and so forth.
It is important for the government to figure out why these projects have been dropped and if some of them can be revived. This should be given top priority.
4) The banking sector has been in trouble over the years. Having said that, between mid-2015 and March 2019, the Reserve Bank of India (RBI) got its act right and forced banks to declare bad loans as bad loans. A bad loan is a loan that has not been repaid for a period of 90 days or more.
All this started with the RBI carrying out an asset quality review of banks in mid-2015, forcing them to recognise bad loans as bad loans. In fact, until then, banks were using various tricks, and were happy to postpone the recognition of bad loans as bad loans. Take a look at Figure 3, which plots the total amount of bad loans of public sector banks, over the years.
Figure 3. Source: Centre for Monitoring Indian Economy and Lok Sabha Starred Question No. 401, answered on July 22, 2019
As can be seen from Figure 3, the total bad loans of public sector banks peaked at Rs 8,95,601 crore in March 2018. By March 2019, this had fallen to Rs 7,89,569 crore.
In the recent past, with different sectors like telecom, real estate, and power getting into trouble, there has been talk about the bad loans of banks deteriorating further. At the same time, the non-banking finance companies have not been in the best of shape. A few of them like IL&FS and Dewan Housing Finance Ltd. have gone bust.
Given this, it is important that the RBI carry out another round of asset quality review, especially in case of NBFCs, where there isn’t much information publicly available.
As Arvind Subramanian and Josh Felman write in their working paper, titled India’s Great Slowdown: What Happened? What’s the Way Out?: “On the financial sector, given the recent credit bubble and the series of problems, involving so many financial institutions, the time is ripe for a second Asset Quality Review (AQR). A regulatory system that failed to spot, let alone head off, the spate of problems from Nirav Modi to Punjab and Maharashtra Cooperative Bank to Dewan Housing and NBFC financing of real estate, and above all the behemoth that we have now discovered ILFS to be, has to work extra hard to regain trust; and transparency about stressed assets will be an essential prerequisite for that effort.”
To cut a long story short, we have had more than a few surprises on the financial front in the last couple of years, and it's best to identify any more problems in advance.
5) The goods and services tax (GST) is the big elephant in the room. In the last piece, I had discussed how it was important to address the operational issues that are making GST difficult to handle for individuals as well as companies.
Along with that, there is the more important issue of multiple rates and how it has made things difficult. Eighty percent of the countries that have introduced GST after 1995 have done so through a single rate system. As Vijay Kelkar and Ajay Shah write in In Service of the Republic: “A simple single-rate GST is easier to implement, as opposed to a complex GST system with multiple rates.”
We did exactly the opposite. There were multiple reasons, one of which was because all state governments had to be taken together on this. As TCA Ranganathan and TCA Srinivasa Raghavan write in All the Wrong Turns:: “The story of GST in India is a good example of how trying to please everybody leaves almost everybody dissatisfied.”
Also, there was a single-minded focus on revenue neutrality, that is, trying to earn an almost similar amount of revenue through GST, as the earlier system. The problem here, as Kelkar and Shah put it was: “The emphasis on revenue neutrality in the GST, in the short run, was a mistake. Government is an important buyer of goods and services, and a low-single-rate GST would yield cost savings for all levels of government.” Over and above this, like in any Indian system, the ultimate system design was fairly complicated.
As Ranganathan and Raghavan write: “The input tax credit system, far from being a seamless chain in the entire supply process has become a morass of paperwork and exceptions.” Also, our obsession with sin taxes hasn’t helped.
Nevertheless, as Kelkar and Shah put it: “It is always possible to layer…sin taxes on top of the basic GST…Individual state governments can choose how they wish to think about alcohol taxation. A carbon tax can potentially be layered on top of the GST. A state like Sikkim, which prizes environmental protection, may impose a sin tax on plastic consumption. We should decouple our thinking between two distinct problems: a single-rate GST and a collection of non-VATable sin taxes.”
Now, two-and-a-half years after GST was launched, the time is actually right to move towards a simpler single rate GST, without exceptions. This will be easier to implement and, at the same time, the government will collect more tax.
As Kelkar and Shah write: “A single 10 percent rate applied on 70 percent of the economy yields 7 percent of the GDP as tax revenue, and even if we actually obtain a part of this, we are broadly okay.”The time is right for a rethink. The trouble is that politicians and bureaucrats rarely like admitting they made a mistake and overhaul any system they have been trying to build.
6) Take a look at Figure 4 which basically plots the proportion that agriculture, forestry and fishing form of the overall Indian economy.
Figure 4. Source: Centre for Monitoring Indian Economy
The size of agriculture, forestry and fishing in the Indian economy has been falling over the years. In 2000-01 this stood at 21.6 percent. In 2019-20, this is expected to fall to 14.9 percent. Having said that, agriculture still employs a bulk of India’s workforce. In 2019, 43.2 percent of India’s workforce was still employed in agriculture.
So, 43.2 percent of India’s workforce will produce less than 15 percent of the country’s economic output this year. This suggests that there is a huge disguised unemployment in agriculture, which means that the sector employs many more people than actually required. Hence people need to be moved away from agriculture to other professions.
What also does not help is the fact that Indian agriculture is not very productive due to a whole host of problems, including small plot sizes (which have been divided across generations).
This is not to say that the proportion of the workforce dependent on agriculture hasn’t come down over the years. It has. In 2000, 59.6 percent of the population was dependent on agriculture. It has come down to 43.2 percent since then. Nevertheless, the sector still has huge disguised unemployment.
One way to tackle this is to move people employed in agriculture away from it. This cannot be done forcefully. It can only be done if low-skilled and semi-skilled jobs are created in other sectors, in particular, construction and real estate. The history of economic development shows that this is how people are moved away from agriculture. The trouble is that the real estate sector in India is down in the dumps.
The only way the sector can revive is if home prices fall. But that hasn’t happened. One reason for this lies in the fact that state governments and state-level politicians are too addicted to the money — both legal and illegal — they earn from real estate.
As Ram Singh writes in a research article titled Inefficiency and Abuse of Compulsory Land Acquisition — An Enquiry into the Way Forward, “the formal and informal (kickback) costs of these clearances [to build a real estate project]”, especially the change in land usage permissions, “are said to be a significant component of the project costs”. In fact, for real estate companies, as well as small and medium enterprises, these costs are as big as the cost of the land itself.
In a recent piece, Vishal Bhargava quotes redevelopment advisor and expert Nayan Dedhia, as of Mumbai, that often, a whopping 30-42 percent of a project cost goes towards taxes (state and central), levies and premium charges.
In this scenario, it is not a surprise that real estate prices remain where they are. So, unless state governments go around slashing these charges, the revival of this sector — and thus, the creation of jobs — remains very difficult.
7) The final suggestion for the government is that it do no harm. Recently, the commerce minister Piyush Goyal made a rather flippant remark suggesting that Amazon getting $1 billion into India wasn’t really a big deal because the company was basically funding its losses.
Well, the fact of the matter is that the company is choosing to fund the losses and not shut down and leave India.
It needs to be mentioned here that any country wanting to do well on the export front, other than being competitive, also needs to be a part of global supply chains being built by multinational companies. As the World Trade Report for 2013 points out: “A central feature of this…age of globalisation is the rise of multinational corporations and the explosion of foreign direct investment…Upwards of two-thirds of world trade now takes place within multinational companies or their suppliers – underlining the growing importance of global supply chains.”
A global supply chain is not going to be built by the local neighbourhood kirana shop owner. For that India needs companies like Amazon. And given that India remains a capital starved economy, we should be welcoming this funding of losses.
To conclude, these are seven more things that the government needs to look at in order to revive and build a robust Indian economy.
This is the third piece in a four-part series, funded by our NL Sena members. You can help fund this series by joining NL Sena today.