Summary: Economic Survey (2017-18)- 3 | RBI Grade B Phase 1 Preparation - Bank Exams PDF Download

Indian economic policy: “Precocious, Cleavaged India”

From erstwhile socialist vision to Washington Consensus or standard Asian development model
 

Indian economic policy can be divided into two phases:

First came nearly half a century of socialism, where the guiding principles were economic nationalism and protectionism.

•  During those years, the public sector occupied the commanding heights and thegovernment intruded into even the most micro-decisions of private firms: their investing, producing, and trading.

(Second) This framework was rejected after 1991. India has replaced its erstwhile socialist vision with something resembling the “Washington Consensus”: open trade, open capital, and reliance on the private sector – essentially the same development model that has been tried and proven successful in most countries of Eastern Asia (excluding China).

Reforms along these lines have been adopted by every Indian government over the past quarter century.

For example, in the last two years, the current government has institutionalized a commitment to low inflation in the new monetary policy framework agreement. There has also been a great effort to reduce the costs of doing business and create an environment friendly to investment, both domestic and foreign.

The result of all these reforms over the past 25 years has been a remarkable transformation of India from a largely closed and listless economy to the open and thriving economy that we see today.

Country’s progress have been qualitative and measurable. Consider, for example, four standard measures: openness to trade; openness to foreign capital; the extent to which public sector enterprises dominate commercial activities; and the share of government expenditure in
overall spending.

Compared to other large countries such as China, India, Brazil, the United States, and Japan; India is “above the line”, meaning that it trades far more than would be expected for a country of its size – a stark turnaround from the pre-1991 situation when India was an under-trader. India’s trade-GDP ratio has been rising sharply, particularly over the decade to 2012. The recovery from the global financial crisis in 2008 was also swift. As a result, India’s ratio now surpasses China which is remarkable. India’s FDI has risen sharply over time.

India is pursuing the standard Asian development path. It is open to foreign trade and foreign capital, where the government is not overbearing, either in a micro, entrepreneurship sense or in a macro, fiscal sense.

India has grown at about 4.5 percent per capita for thirty seven years, an impressive achievement. This achievement is particularly remarkable because it has been achieved under a fully democratic political system.
The Indian model of being a perennial democracy after acquiring independence is rare in postwar economic history – and successes are rarely democracies.

The only other countries that have grown as rapidly and been democratic for a comparable proportion of the boom are Italy, Japan, Israel, and Ireland. Other countries that have grown faster for as long have tended to be oil exporters, East Asian countries, and some that recovered after World War II.

Yet, there remains a niggling sense that India is not quite what it appears to be - that, despite all the data, it is not yet following the standard development model.

So, in what ways is India different?

Three lingering features capture the doubt that it has not yet traversed the distance toward some vague and unspecifiable end-point that could be described as desirable or optimal.
 First, there has been a hesitancy to embrace the private sector and to unambiguously protect property rights, combined with continued reliance on the state to undertake activities that are more appropriately left to the private sector.
 Second, state capacity has remained weak as can be seen from poor delivery of essential services.
 And third, redistribution has been simultaneously extensive and inefficient

(These parts has been already discussed earlier)

The above three distinctive features makes Indian development model unique. India’s economic vision has followed a unique pathway to economic success, what might be called “Precocious, Cleavaged India”.

Historically, economic success has followed one of two pathways:
1. Today’s advanced economies achieved their current status over two centuries in which economic and political development progressed slowly but steadily. They did not begin with universal franchise. Voting rights, narrow and restricted to begin with, expanded slowly over time, a process that helped fiscal and economic development by limiting the initial demands on the state during the period when its capacity was weak.

2. The second set of accelerated economic successes mostly in East Asia began authoritarian, explicitly (Korea, China) or de facto (Singapore, Thailand, Taiwan), and gave way to political transformation only after a degree of economic success was achieved. Explicit authoritarianism came in three flavours: military (Korea), party (China), or individual dictatorship (Indonesia).

India, on the other hand, has attempted economic development while also granting universal franchise from the very beginning.
India is amongst a handful of countries—Botswana, Mauritius, Jamaica, Trinidad and Tobago, and Costa Rica—which are perennial democracies.

Even rarer, India, at independence, was a very poor democracy (as shown in figure below)

At the same time, India was also a highly cleavaged society. Historians have remarked how it has many more axes of cleavage than other countries: language and scripts, religion, region, caste, gender, and class. A country with high levels of poverty and deep social fissures.

A precocious, cleavaged democracy that starts out poor will almost certainly distrust the private sector.

The founders of India wanted to “build the country” by developing industry that would make India economically, as well as politically, independent.

The private sector had conspicuously failed to do this under colonial rule, not only in India but in every other newly independent nation, giving rise to severe doubts as to whether it could ever do so.

In contrast, the example of the Soviet Union, which had transformed itself from an agricultural nation to an industrial powerhouse in a few short decades, suggested that rapid development was indeed possible, if the state would only take control of the commanding heights of the economy and direct resources into priority areas.

Of course, while India adopted planning and a large role for the state sector, it never abolished the private sector unlike the Soviet Union. Instead, it tried to control private businesses through licensing and permits.

Paradoxically, however, this only further discredited the private sector, because the more the state imposed controls, the more the private sector incumbents were seen as thriving because of the controls, earning society’s harsh criticism in the process.

Another important implication of India’s precocious, cleavaged democracy is that India had to redistribute early in the development process, when its state capacity was particularly weak.

India did not invest sufficiently in human capital – for instance, public spending on health was an un unusually low 0.22 per cent of the GDP in 1950-51. This has risen to a little over 1 per cent today, but well below the world average of 5.99 per cent (World Bank, 2014).

The Festering Twin Balance Sheet Problem

The Economic Survey has devoted considerable attention to what it terms India's Twin Balance Sheet problem - overleveraged and distressed companies and the rising NPAs in Public Sector Bank balance sheets. The issue is important because it is holding up private investment in the
country and therefore, growth in all sorts of sectors.

For some time, India has been trying to solve its Twin Balance Sheet problem– using a decentralised approach, under which banks have been put in charge of the restructuring decisions.

But decisive resolutions of the loans, concentrated in the large companies, have eluded successive attempts at reform. The problem has consequently continued to fester: NPAs keep growing, while credit and investment keep falling.

India’s NPA ratio at its current level of 9.1% of the gross loans is higher than any other major emerging market (with the exception of Russia), higher even than the peak levels seen in Korea during the East Asian financial crisis.

What needs to be done?
RBI has over the past few years introduced a number of mechanisms to deal with the stressed asset problem. Three of these mechanisms are particularly notable.

1. For some time, the RBI has been encouraging the establishment of private Asset Reconstruction Companies (ARCs), in the hope that they would buy up the bad loans of the commercial banks. In that way, there could be an efficient division of labour, as banks could resume focusing on their traditional deposit-and-loan operations, while the ARCs could deploy the specialist skills needed to restructure corporate debts.

This strategy, however, has had only limited success. Many ARCs have been created, but they have solved only a small portion of the problem. The problem is that ARCs have found it difficult to recover much from the debtors. Thus they have only been able to offer low prices to banks, prices which banks have found it difficult to accept.

So the RBI has focused more recently on two other, bank-based workout mechanisms.
 

2. In June 2015, the Strategic Debt Restructuring (SDR) scheme was introduced, under which creditors could take over firms that were unable to pay and sell them to new owners.

3. The following year, the Sustainable Structuring of Stressed Assets (S4A) was announced, under which creditors could provide firms with debt reductions up to 50 percent in order to restore their financial viability.

In principle, these schemes taken together might have provided a comprehensive framework for dealing with solvency problems. Their success, however, has been limited; while two dozen firms have entered into negotiations under SDR, only two cases have actually been concluded as of end-December 2016. And only one small case has been resolved so far under S4A.

All of this suggests that it might not be possible to solve the stressed asset problem using the current mechanism, or indeed any other decentralised approach that might materialise in the near future. Instead a centralised approach might be needed.

Therefore, Survey suggests that a centralised Public Sector Asset Reconstruction Company (PARA) be formed to buy the biggest, most complex NPAs and then dispose of them.

How would a PARA actually work?
PARA would purchase specified loans (for example, those belonging to large, over-indebted infrastructure and steel firms) from banks and then work them out, either by converting debt to equity and selling the stakes in auctions or by granting debt reduction, depending on professional assessments of the value-maximizing strategy.

Once the loans are off the books of the public sector banks, the government would recapitalise them, thereby restoring them to financial health and allowing them to shift their resources –financial and human – back toward the critical task of making new loans. Similarly, once the financial viability of the over-indebted enterprises is restored, they will be able to focus on their operations, rather than their finances. And they will finally be able to consider new investments.

Over the past three years the RBI has implemented a number of schemes to facilitate resolution of the stressed asset problem. The figure below depicts these schemes. In what follows a brief overview of these schemes is provided.

The 5/25 Refinancing of Infrastructure Scheme:
 

 This scheme offered a larger window for revival of stressed assets in the infrastructure sectors and eight core industry sectors.

 Under this scheme lenders were allowed to extend amortisation periods to 25 years with interest rates adjusted every 5 years, so as to match the funding period with the long gestation and productive life of these projects.

 The scheme thus aimed to improve the credit profile and liquidity position of borrowers, while allowing banks to treat these loans as standard in their balance sheets, reducing provisioning costs.

 However, with amortisation spread out over a longer period, this arrangement also meant that the companies faced a higher interest burden, which they found difficult to repay, forcing banks to extend additional loans (‘evergreening’). This in turn has aggravated the initial problem.

Private Asset Reconstruction Companies (ARCs):
 ARCs were introduced to India under the SARFAESI Act (2002), with the notion that as specialists in the task of resolving problem loans, they could relieve banks of this burden.

 However, ARCs have found it difficult to resolve the assets they have purchased, so they are only willing to purchase loans at low prices. As a result, banks have been unwilling to sell them loans on a large scale.

 Then, in 2014 the fee structure of the ARCs was modified, requiring ARCs to pay a greater proportion of the purchase price up-front in cash. Since then, sales have slowed to a trickle: only about 5 percent of total NPAs at book value were sold over 2014-15 and 2015-16.

Strategic Debt Restructuring (SDR):

 The RBI came up with the SDR scheme in June 2015 to provide an opportunity to banks to convert debt of companies (whose stressed assets were restructured but which could not finally fulfil the conditions attached to such restructuring) to 51 percent equity and sell them to the highest bidders, subject to authorization by existing shareholders.
 An 18-month period was envisaged for these transactions, during which the loans could be classified as performing. But as of end-December 2016, only two sales had materialized, in part because many firms remained financially unviable, since only a small portion of their debt had been converted to equity.
 

Asset Quality Review (AQR):
 Resolution of the problem of bad assets requires sound recognition of such assets. Therefore, the RBI emphasized AQR, to verify that banks were assessing loans in line with RBI loan classification rules. Any deviations from such rules were to be rectified by March 2016.

Sustainable Structuring of Stressed Assets (S4A):
 Under this arrangement, introduced in June 2016, an independent agency hired by the banks will decide on how much of the stressed debt of a company is ‘sustainable’. The rest (‘unsustainable’) will be converted into equity and preference shares. Unlike the SDR arrangement, this involves no change in the ownership of the company.

Since other approaches to resolve the TBS problem had failed or had limited success, the Economic Survey noted that international experience shows that a professionally-run central agency with government backing can overcome the difficulties that have impeded progress.

The twin balance sheet problem is a serious drag on credit growth. The setting up of a centrallyassisted rehabilitation agency will help in taking difficult decisions which the public sector banks are unable to take.

Fiscal Rules: Lessons from the States
India like several other countries, embarked in the mid-2000s on an ambitious project of fiscal consolidation, adopting fiscal rules aimed at curbing fiscal deficits.
The most well-known and best-studied part of this project was the Fiscal Responsibility and Budget Management (FRBM) Act, adopted by the centre in 2003.
This Act was mirrored by Fiscal Responsibility Legislation (FRL) adopted in the states, laws that were no less important than the FRBM, since states account for roughly half the general government deficit.
Most states achieved and maintained the target fiscal deficit level (3 percent of GSDP) and eliminated the revenue deficit soon after the introduction of their Fiscal Responsibility Legislation (FRL).

Reasons for effective fiscal consolidation:
 FRL was not the sole impetus behind this impressive fiscal performance.
 Acceleration of GDP growth helped boost states’ revenues
 Increased transfers from the Centre because of the 13th Finance Commission recommendations and the surge in central government revenues
 Decline in interest payments on account of the debt restructuring package offered by the centre and increased central CSS expenditure

All these contributed significantly to such consolidation.

Fiscal challenges are mounting because of the Pay Commission recommendations, slowing growth, and rising payments from the UDAY bonds.

Moreover, macro-economic conditions will not be as favorable to states as they were in the mid-2000s. Going forward greater market-based discipline on state government finances will be a major imperative. And, the Centre must take the lead not only in incentivizing fiscal prudence by states but also by acting as a model through its own fiscal management.

Economic Survey attempted to answer two questions:
 To what extent did the FRL really make a difference?
 What are the lessons for future fiscal rules?

Summary of Fiscal Responsibility Legislation (FRL)

The FRL aimed to impose fiscal discipline through a number of mechanisms:
 Fiscal targets were established, which were the same for all states: overall deficit was not allowed to exceed 3 percent of Gross State Domestic Product (GSDP), while the revenue deficit was to be eliminated by 2008/9 (later extended to 2009/10).
 The 12th Finance Commission allowed states to borrow directly from the market
 States were required to publish annual Medium-Term Fiscal Policy reports, which would project deficits over the next three to four years

Assessment of Fiscal Responsibility Legislation (FRL)

:
 Most of the States achieved the fiscal targets. Within the first two years, states on average lowered their deficits to target levels -- 3 percent for fiscal deficit and 0 for revenue deficits – while the primary balance shifted into surplus.
 Therefore, FRL had a significant impact -- both fiscal deficit and revenue deficit fell sharply.
 Another indication that the FRL had a significant impact is that states kept a tight rein on wage and salary expenditure.
 FRLs clearly made an important difference, both in terms of outcomes and behaviour.
 States kept their average fiscal deficit at 2.4 percent of GSDP in the 10 years after the FRL, well below the prescribed ceiling of 3 percent of GSDP.
 And there was also a striking change in behaviour: budget forecasting procedures improved, and there was a more cautious approach to guarantees, a build-up of cash balances, and a reduction in debt.

Lessons for Future Fiscal Rules
 As the fiscal challenges mount for the states going forward because of the Pay Commission recommendations, slowing growth, and mounting payments from the UDAY bonds, there is need to review how fiscal performance can be kept on track.

 Greater market-based discipline on state government finances is imperative -- at present, this is missing. There is a complete lack of correlation between the spread on state government bonds and their debt or deficit positions.

Clothes and Shoes: Can India Reclaim Low Skill Manufacturing?
Creating jobs is India’s central challenge.

Survey indicates that government should pay attention to labor-intensive sectors to meet the challenge of jobs.
The apparel and leather and footwear sectors meet many or all of these criteria and hence are eminently suitable candidates for targeting and policy attention.
 It has good potential to create employment, especially for women
 Opportunities for exports and growth

With China planning to rise labour costs, it is gradually vacating its dominant position (losing market share) in these sectors, affording India an opportunity. To not cede this space to competitors such as Vietnam and Bangladesh will require easing restrictions on labor regulations, negotiating FTAs with major partners such as the EU and UK, and ensuring that the GST rationalizes current tax policy that can discriminate against dynamic sectors.

India has underperformed relative to the East Asian competitors. The Indian underperformance, has been particularly marked in the leather sector. Hence effective targeting and policy attention to clothing and leather apparel sector offers tremendous opportunities for creation of jobs, especially for women.

India is well positioned to take advantage of China’s deteriorating competitiveness because wage costs in most Indian states are significantly lower than in China. The space vacated by China is fast being taken over by Bangladesh and Vietnam in case of apparels; Vietnam and Indonesia in case of leather and footwear. Indian apparel and leather firms are relocating to Bangladesh, Vietnam, Myanmar, and even Ethiopia. The window of opportunity is narrowing and India needs to act fast if it is to regain competitiveness and market share in these sectors. Hence, the urgency, the Survey indicates.

Challenges:
India has potential comparative advantage in terms of cheaper and more abundant labour. But these are nullified by other factors that render them less competitive than their peers in competitor countries.

The Apparel and Leather sectors face a set of common challenges:
 Logistics: The costs and time involved in getting goods from factory to destination are greater than those for other countries.

 Labor regulations: There are strict regulations for overtime wage payment as the Minimum  Wages Act 1948 mandates payment of overtime wages at twice the rate of ordinary rates of wages of the worker.

 Tax & tariff policy: In both apparel and footwear sectors, tax and tariff policies create distortions that impede India gaining export competitiveness. High tariffs on yarn and fiber increase the cost of producing clothing.

 Disadvantages emanating from the international trading environment compared to competitor countries: The global demand for footwear is shifting away from leather footwear and towards non leather footwear. India’s share of leather footwear exports in the world market is more than double the share of non-leather footwear. Efforts are required to promote non-leather footwear to be able to effectively capture world market
share.

 Discrimination in export markets: India’s competitor exporting nations for apparels and leather and footwear enjoy better market access by way of zero or at least lower tariffs in the two major importing markets, namely, the United States of America (USA) and European Union (EU).

For example:
 In the EU, Bangladesh exports enter mostly duty free (being a Less Developed Country (LDC)), while Indian exports of apparels face average tariffs of 9.1 per cent.
 Vietnam could also attract zero tariffs once the EU – Vietnam Free Trade Agreement (FTA) comes into effect.
 In the US, India faces tariff of 11.4 percent. Ethiopia, which is an emerging new competitor in apparels and leather, enjoys duty free access in US, EU and Canada.
Therefore, an FTA with EU and UK will help.

Policy response and Conclusions:
Several measures form part of the package approved by the Government for textiles and apparels in June 2016. Their rationale is to address the challenges described above.

1. Apparel exporters will be provided relief to offset the impact of state taxes embedded in exports, which could be as high as about 5 per cent of exports. Similar provisions for leather exporters would be useful.

2. Textile and apparel firms will be provided a subsidy for increasing employment. This will take the form of government contributing the employers’ 12 per cent contribution to the Employee Provident Fund (EPF) (the Government is already committed to contributing 8.3 per cent; so the new measure will be additional to that).

3. Negotiations are on the way for new Free Trade Agreements with the European Union (EU) and the United Kingdom (UK).

4. Introduction of the Goods and Service Tax (GST) offers an excellent opportunity to rationalize domestic indirect taxes so that they do not discriminate in the case of apparels against the production of clothing that uses man-made fibers; and in the case of footwear against the production of non-leather based footwear.

5. Number of labour law reforms are implemented to overcome obstacles to employment creation in these sectors.

Thus, more FTAs, GST-induced tax rationalization, and labour law reform would add considerably to the job creation potential of the clothing and footwear sectors.

Some important policy actions
Persons with Disability:

Urbanisation: Cities as Dynamos

Urbanisation will pose considerable challenges for municipalities over the coming decades.
The first task is empowering ULBs financially.

 The analysis shows that municipalities that have generated more resources have been able to deliver more basic services. The states should, therefore, empower cities to levy all feasible taxes.

 Municipalities also need to make the most of their existing tax bases. There is a need to adopt the latest satellite based techniques to map urban properties. The Government should leverage the Indian Space Research Organization (ISRO)/National Remote Sensing Agency (NRSA) to assist ULBs in implementing GIS mapping of all properties in the area of a ULB. Property tax potential is large and can be tapped to generate additional revenue at city level.

Data and transparency also plays an important role
 MoUD should give greater priority to compile and publish comprehensive data on ULBs and urban sector. Perhaps, grants to ULBs should be more tightly linked to comprehensive and updated data disclosure and transparency by ULBs.

 NITI Aayog should compile comparative indices of municipalities’ performance annually based on the actual accountability and administrative capacity to deliver the core public services.

Competition between states is becoming a powerful dynamic of change and progress, and that dynamic must extend to competition between states and cities and between cities. Cities that are entrusted with responsibilities, empowered with resources, and encumbered by accountability can become effective vehicles for competitive federalism and, indeed, competitive sub-federalism to be unleashed.

Note:
 Chapter 10 and Chapter 11 of the Economic Survey should be read comprehensively.