Liberalisation without reform


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IN a few months’ time Narasimha Rao’s government will complete its five-year term in office. Before that there will have to be a general election. Therefore, this is an appropriate time for evaluating the successes and the failures of the economic reform initiatives taken up by Rao and his Finance Minister Manmohan Singh four and half years ago. It is important to do so for two different reasons. First, unless a major corruption scandal or a highly divisive issue of ethnic or religious conflict breaks open in an explosive manner between now and the general election, the economic platform of Narasimha Rao and Manmohan Singh will be the major determinant of the fortunes of the ruling party in the coming election.

Secondly, most observers of the Indian political scene seem to believe that no single political party will succeed in obtaining anything near a decisive majority in the general election. The political system will then need to evolve the culture of coalition government. India’s track record in this field is, to say the least, extremely disappointing. In the various possibilities of government formation, what will happen to the reform initiatives? Economic agents, both inside and outside the country, need to take positions regarding the uncertain future. They are doing so; such positioning will influence to a significant extent the future of the economy at least in the short and intermediate runs.

Manmohan Singh and some of his colleagues are claiming, with some justification, that the reform process in India has by now become irreversible: whatever may be the complexion of the new government in New Delhi, the engine of economic reform has gathered sufficient momentum to keep moving. Some people accept this prognosis, although with caution. Others are sitting on the fence. This is only to be expected. Prediction is an extremely hazardous task, particularly when it involves political changes. Who would have predicted twenty years ago that China would emerge as one of the most aggressively outward-looking market economy in the course of the next five years? Ten years ago, could anybody have predicted the sudden collapse of the Soviet Union and the Warsaw pact? When Salinas was going strong with economic reforms in Mexico and was forging a common market with the USA and Canada, nobody predicted the kind of near-collapse that came so suddenly.

Predictions are difficult to make; nevertheless they need to be, and are made all the time either explicitly or implicitly by traders, financiers and producers. Unless one is prepared to put all one’s money on astrological forecasts, there are only two ways of going about making them: One, on the basis of careful analyses of one’s own past performance; and the other, by learning from comparable experience. How would the performance of the Rao government fare in such a scrutiny?



One should be careful in summarizing this performance, spread over diverse areas in a large and complex economy. Any short summary will remain necessarily incomplete and unsatisfactory in many ways. But if one is engaged in predicting the future course of a political economy, one must do so with the help of a few salient observations. I should like to state them as the following:

Manmohan Singh’s biggest success has been in the area of dismantling the regime of discretionary controls over private investments in industries and trade. Except for a handful of industries, the requirement of licensing for investment in new units, or for capacity expansion in old ones, has been eliminated. Similarly, the manner of licensing for capital goods import has been done away with in most areas. MRTP licensing requirements have been relaxed. The office of the controller of capital issues has been abolished. Perhaps the only success of Manmohan Singh in institutional reform has been the creation of SEBI. Here he has acted with enlightened caution by allowing SEBI to evolve its own norms of behaviour in the light of emerging Indian conditions.



The second area where Manmohan Singh has had a considerable measure of success is in liberalising the regime of foreign trade and foreign investment. This is a creditable achievement because he had to fight not only against the well-established belief-system of India’s political classes but also against well-entrenched interest groups nurtured during the long period of protected industrialisation. For long India’s political classes have believed in the desirability of pursuing the ideal of autarky in the name of self-reliance. The owners and managers of highly protected industries had combined with the dispensers of actual-users’ licenses to create in India what Pranab Bardhan describes as ‘state feudalism’. Singh started by replacing quantitative restrictions by tariff and then slowly went on reducing the levels of protective tariffs.

Even now India’s tariff rates are among the highest in the world; but considering the kind of opposition he faced in doing this, the progress is quite impressive. One can understand how strong the opposing forces are only if one sees his failure in liberalising the trade regime for consumer goods. In a trade regime, there is absolutely no justification for distinguishing between consumer goods and producers’ goods. The function of a liberal trade regime is to put pressures of cost and quality consciousness on domestic producers, whether they produce boot-polish, hair oil or electric engines. But even now under the banner of ‘self-reliance’, Indian industrialists can unload whatever they produce on the Indian consumer without fear of losing their business.



The area of failures is also quite large. The spending behaviour of the government and the operational characteristics of the public sector remain largely unreformed. Narasimha Rao’s government has been extremely careful in not hurting the political and bureaucratic vested interests, which have grown over the years around these institutions. For example, everyone recognizes the importance of making public sector undertakings autonomous, which essentially means distancing the management of these undertakings from political and bureaucratic interference. However, politicians do not want to give up these highly lucrative areas of control.

The class of officers in the PSUs has evolved over time into a mirror-image of the cadre-based services in the civil administration such as the IAS, IPS and IRS. They have similar norms of institutional behaviour regarding hiring, promotions and remuneration. Civil servants from cadre-based services move back and forth between civil administration and public sector management. This makes it impossible to use the concept of a ‘firm’ or a ‘company’ in the public sector as one does in the economic organisation of a market economy. The avenues of promotion for an officer require a larger domain for horizontal and vertical mobility. Other forms of rewards (or punishment) essential for managers of a firm in a market economy go against the ethos and the collective interests of the officer class in the system of state feudalism.



This is why nationalised banks and financial institutions cannot be made autonomous. But if this is not done, politicians and bureaucrats cannot be prevented from making decisions regarding loan disbursements. So long as politicians and bureaucrats retain the right to make decisions (directly or indirectly) in these matters, nationalised banks cannot develop as credible and competent institutions required to perform economically sound risk-sharing functions in a market economy. But the existence of such credible and competent financial institutions is crucially important for the healthy development of a market economy.

Some people think that it is possible to bypass the need for reforming the public sector by allowing private investors – domestic and foreign – free entry into these sectors. For certain kinds of activities such a strategy can work, although at considerable social costs. For example, private sector banks, electric power companies (generators and distributors), and telecom services can be encouraged to enter in their respective fields to supplement the services provided by the existing public sector undertakings. But these profit-seeking corporations will certainly take away from the inefficient public sector undertakings the entire profitable segment of the market by offering a better quality of service. The government, in turn, will be unable to close down the public sector units, which will become increasingly less viable. The flow of funds from the government’s budget to these loss-making units will have to go on increasing correspondingly, with perilous consequences in terms of the government’s ability to maintain macro-economic stability.

There is another set of consequences, which follow from our inability to reform the public sector. In the working of many of these businesses, there is always an element of cross-subsidization. Suppliers of a service usually make profits from rich customers. This, in turn, enables them to cater to customers with lower ability to pay at prices barely above the marginal costs. Usually, the quality of services provided by chronically loss-making firms go on declining. (Any long-standing user of DTC services in Delhi will testify to this. Any old employee of DTC will also be able to give reasons for this phenomenon.) Therefore, it is safe to say that the less well-to-do citizens of India will have to pay a disproportionately high price for the inevitable deterioration in the health-status of the unreformed public sector.



There are also some sectors of the economy (perhaps not many), where the removal of the entry-barriers to profit-seeking entrepreneurs may not be socially desirable. In these activities there is no alternative to reforming inefficient public enterprises. The health insurance industry in the USA is a good example of this pathology. Thirty years ago, non-profit organizations like the Blue Cross and Blue Shield provided health insurance to people in America. Then came deregulation and for-profit insurance companies entered this business. They offered attractive packages to customers in the profitable segments of the market and lured customers away from non-profit organizations. In order to survive, Blue Cross and Blue Shield changed their business strategy to become attractive to those customers. The inevitable result was the enormous increase in the number of people who could not afford health insurance on those terms. The government had to move in to improve the situation. The net outcome was an enormous increase in health care costs along with decreased access to health care and a rise in government expenditure.



To avoid any misunderstanding, let me state clearly that I am not against privatisation. In fact, I believe that there is enormous scope for privatisation in India’s public sector. But as yet, that does not seem to be a part of the agenda for economic reform of the central government. The divestment of small quantities of shares of PSUs, currently practised by the Government of India should not be confused with privatisation, because the essence of privatisation is the transfer of management and control from government to the private entrepreneur. The holding of some shares of Oil India by financial institutions does not make it a private company, just as the holding of a minority of shares of the Tata Iron and Steel Company by state-owned institutions does not make TISCO a public sector enterprise.

The government is unloading some PSU shares in the capital market, because they find it the most convenient (that is, least inflationary) method of financing the otherwise uncontrollable current expenditures of the government. Of course, this means the diversion of household savings from productive investment to current consumption of the government. In other words, Indian citizens are forced to sacrifice income and employment opportunities in the future in order to fulfil the present appetite of their government.

It is important to emphasize that this is not the outcome of any particular flaw in the behaviour of Narasimha Rao and his colleagues in the ruling party. The attitude towards the spending of public funds is enthusiastically shared by the overwhelming majority of our elected representatives belonging to the various political parties. Career politicians fight – and fight bitterly – in their pursuit of power, but they act in harmony to enhance their individual and collective economic interests. Recently, they voted to allocate a few thousand crores of rupees to themselves to be spent in their respective constituencies. Stories are now filtering in from district headquarters that officials are facing enormous pressures for diverting as much of this money as possible to the election funds of incumbents in the forthcoming general election.



Thus, it seems Narasimha Rao and his finance minister had a mixed bag of successes and failures in reforming the economic system during the last four and a half years. So what does one make of Manmohan Singh’s claim that the engine of reform has gathered sufficient momentum to move on, irrespective of the outcome of the coming election? In two important respects, I share his optimism, in some I remain sceptical.

I think the achievement of Finance Minister Manmohan Singh in dismantling the regime of investment licensing is irreversible. He has succeeded in convincing almost everyone that this licensing regime has been counter-productive in the past and that it cannot ever be relied on to serve useful social goals. So, entrepreneurs, the existing as well as potential ones, are unlikely to face the kind of entry barriers they did in the past. This should certainly eliminate a lot of rent seeking and consequent inefficiencies in the private industrial sector of the economy.

His achievements in the field of reforming the regime of foreign trade and foreign investments will remain somewhat vulnerable. But it is important to note that this vulnerability will arise from organized pressures from the captains of industries in the private sector and less from the ideological hostility of India’s political classes.



Many Indian industrialists are beginning to develop coherent ideas regarding the so-called ‘level playing field’, which they believe should contain certain slopes and bumps to make the games played in India more entertaining. How far they succeed in convincing the groundsmen (read political bosses) is yet to be seen. Fortunately for us, there is a fast-growing sector of new entrepreneurs in new economic activities who are capable of mounting counter-pressures for eliminating such slopes and bumps.

Where, I think, Manmohan Singh has done a remarkable job during the last four years is in educating his countrymen about the desirability of pursuing economic progress in an open-economy framework. This is no mean achievement, if one realises that economic nationalism has been the most influential political religion in India during the last one hundred years. It should not have surprised anybody when last year saw the RSS and BJP rush in, swadeshi flag in hand, to occupy the turf they saw being vacated by the Congress and CPM.

I know how powerful this flag is from an experience in 1985, when I had to give a public lecture in a university in eastern India. My lecture was on trade and development and I talked about the desirability of a being in a position to take advantage of favourable foreign trade opportunities. Immediately after my talk, an old gentleman got up and said that I should be ashamed of myself for propagating these ideas, particularly because my grandfather had gone to jail in 1905 after burning all his English-made clothes. He was loudly applauded by the audience.

I tried to tell him and the audience that I was a product of my grandfather’s beliefs, that I shared his goal of making India economically prosperous and self-reliant. I also said that my grandfather was an intelligent man. If he were alive I could convince him that the time had come to move away from that old symbolism of economic nationalism and adopt a newer, more effective strategy of development in today’s world. There were not many takers for my views. But in 1995, the climate of opinion in the country has dramatically changed, although many vote-hungry politicians of today continue to organise noisy marches to the altar of the icon of yester-years. For this change of climate, which will have a lasting impact of the political economy of India, we must be grateful to Manmohan Singh.



As I mentioned earlier, the Rao government has shown a remarkable degree of reluctance to initiate institutional reforms, which should have gone hand-in-hand with liberalisation. I have also mentioned the reluctance to reform the public sector and suggested some of the reasons for that. For example, after the submission of the Report of the Narasimha Committee on Financial Sector Reform in November 1991, it was widely believed that the reorganization of the nationalised banks was imminent. But soon it appeared that the government was even reluctant to talk about it.

There is another area of institutional reform which is recognized by everybody to be crucial for the success of the liberalisation programme. This is the area of the laws and procedures governing the methods of manpower-use in commerce, industry and governance. It is recognized everywhere that the system of complete job security and automatic promotion destroys all incentives for better performance and learning. Such a system not only makes industry and commerce inefficient and sluggish, it prevents the regulatory agencies of the government, responsible for monitoring and directing the private sector, from becoming alert and effective.

The government seems reluctant to make even the least effort to reform this area. It is well-known that a proposal for a minor modification of the Industrial Disputes Act has been doing the rounds of the Law Ministry, Labour Ministry and the Prime Minister’s Office for the last four years. Yet no one seems to have the courage to bring it before Parliament.

How likely is it then that the situation will improve after the general election? It is a mistake to think that it is a simple matter of the arithmetic of the majority of the ruling party in the Lok Sabha. After all, Rajiv Gandhi had an overwhelming majority during his tenure in office and his enthusiasm for economic reform was no less than Narasimha Rao’s. Yet Rao, who came to office as the head of a minority government, had far greater success than Rajiv Gandhi. So it is really a matter of commitment and leadership cutting across party lines.

Even optimists should not expect any significant improvement in these areas in the near future. Whether the climate improves over time will depend on the learning process of the career politicians. For example, if we see that in the coming general election, parties are not promising bonanzas to the electorate at the cost of nationalised banks, the State Electricity Boards, the Food Corpora tion of India and other public sector economic institutions (as they did in the past), then there is cause for hope and optimism. Otherwise the engine of liberalisation, without the assistance of necessary institutional reforms, will fail to reach its destination.


* Reproduced from ‘India 1995’, Seminar 437, January 1996.