Animal Spirits

Just Do It

Devangshu Datta, a journalist based in Delhi, writes on markets and technology
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Between his first term as Finance Minister in the early 90s, when Manmohan Singh ushered in economic reforms, and his second term now, India has changed dramatically. But Manmohan Singh in 2012 is a different man, with a different boss and political circumstances. There are powerful reasons though why he must push key reforms

The grandeur of Lutyens’ New Delhi is leavened with practicality. Lutyens assumed, reasonably enough, that the Raj’s administrators might want to meet each other without trekking vast distances. The administrative complexes on Raisina Hill are close to each other. There is little physical distance between North Block, where the Finance Ministry is housed, and the Prime Minister’s Office in South Block.

An active 80-year-old could stroll from one complex to the other in under ten minutes. It is quite possible that the 80-year-old now in charge of both these administrative wings will do that, if his security staff and the weather permit. Dr Manmohan Singh likes walking and he is not known to insist on formality.

In the past four years, despite physical proximity, interactions between the two wings had been minimal and had become more formal as the political distance widened. The impending elevation of Pranab Mukherjee to India’s presidency and Dr Manmohan Singh’s taking charge of the finance portfolio, even temporarily, could help bridge that gap.

As in June 1991, Dr Singh takes charge of the Finance Ministry at what seems to be an economic crisis point. He is a great deal older and wearier than in 1991. Ironically, he may also possess much less in the way of actual power to effect change as PM, than he did as Finance Minister. This is because the UPA II believes its rule is secure. Unlike in 1991, there is deep internal resistance to rocking the boat by instituting reforms, with possibly unpredictable consequences.

In another sense, the PM is a prisoner of his own success. In that stint as FM between 1991 and 1996, he authored the first burst of reforms and triggered a pattern of higher economic growth that continues to this day. Things may be bad at the moment in comparative terms. But things are light years better than they were in 1991. That being so, few career politicians see the need to make radical changes.

Still, the fact is that India’s economic surge has stalled. The fiscal deficit as a percentage of GDP is as high as it has been in the 21st century, and may even be the highest since the 1991 crisis. The country’s current account deficit is at its widest since 1991. The forex reserves position has been deteriorating. Inflation has been persistently high for the past three years. Officially, around 9.5 per cent of India’s workforce is unemployed. Defaults and restructuring of loans are at record high levels. The rupee has fallen sharply, and though it has seen a slight bounce of late, is not far from its all-time low.

If the PM does want to channel Keynes and revive the economy’s ‘animal spirits’, as he says he does, he will indeed have to make radical changes to turn things around. He has his work cut out for him, and probably a tight deadline. There is likely to be a Cabinet reshuffle fairly soon and the Congress president may want him to relinquish the finance portfolio well before the 2013-14 Union Budget.

Obviously, if politicians believed that successful reforms guaranteed more votes, they would consider this a good trade-off. But while reforms have improved the condition of hundreds of millions of citizens over the past 20-odd years, the votes of those citizens have not necessarily been in favour of the parties that instituted reforms.

This is why there have actually been only two reform bursts at the Centre in the last 20 years. Both sets were driven by governments that did not expect to survive their full term. Between 1991 and 1993, a minority government led by Narasimha Rao undertook the first key steps.

Economic conditions were desperate in 1991. India was reduced to penury. The fiscal deficit was above 8.5 per cent of GDP. Reserves were down to a couple of weeks’ worth of import cover. The Chandrashekhar Government ended up offering 65 tonnes of gold as security for imports.

The economy responded rapidly to the New Economic Policy announced by Dr Singh in June 1991. By 1994, the Rao Government had also been shored up by the inclusion of the Jharkhand Mukti Morcha in the ruling alliance. The impetus for reform ceased. The Congress lost the 1996 general election.

The next government that showed signs of reformist zeal was the BJP-led NDA in 1999. All its reform measures were mooted and passed as ordinances after the NDA lost a vote of confidence while presenting the Budget. As it happened, feedback from Kargil ensured that the NDA won the next election, and, to its credit, started implementing reforms. Equally crucially, it lost the 2004 polls. India was ‘shining’, but Indian voters wanted change.

In 2009, the Congress-led UPA won a repeat mandate, despite a global slowdown that had impacted growth in 2007-08. Whatever the truth of the matter, the strategists of the UPA firmly believe that entitlements like NREGA (now MNREGA) were hugely instrumental in swinging the vote.

That makes two reformist governments that lost their next election, and one government that offered entitlements and won a repeat mandate. That’s how many politicians see it. One might argue that it was a great performance by the UPA’s regional allies (and correspondingly poor performance of several NDA allies) that buttressed the alliance’s 2009 success. One may offer the counter-examples of state satraps like Nitish Kumar, Naveen Patnaik, Sheila Dikshit and Narendra Modi, who have all won repeat mandates on the basis of reform.

It does not matter. The UPA’s strategists, and most importantly, Mrs Gandhi, seem to believe that entitlements and subsidies are winning electoral stances and reforms are a losing electoral proposition. The Congress High Command has kept ‘reformists’ such as Montek Singh Ahluwalia and C Rangarajan out of active policy-making, and set up the National Advisory Council to implement the UPA manifesto. Pranab-babu also effectively deferred sensitive decisions by taking them through the Group of Ministers (GoM) process where committees could debate these endlessly.

There are perhaps a few political reasons why the UPA II might countenance backing reforms now. One is that reform may be necessary to reduce inflation, which is regarded as a politically sensitive issue. The other is that the Government may now be running out of money at a rate where it finds it difficult to fund its entitlement schemes and subsidies.

Dr Manmohan Singh is a politician and a pretty good one. He has managed to retain his clean image and brand equity despite nine years in the saddle, and only a very effective politician would be able to do that. He is also unquestionably a very smart economist, a rational man.

Where would Dr Singh’s self interest lie? Does he believe that reform is required to win the 2014 election? More importantly, can he sell that position to his boss? Can he walk a tightrope while funding the subsidies he must, and still maintain some fiscal prudence?

Here are some of the important things he’ll need to do:

1 Find ways to rationalise processes of taxes and subsidies in the entire hydrocarbons sector. Indian policy here is stark insanity. The Government controls the retail prices of diesel, kerosene, gas and nitro-fertilisers (nitro fertilisers are derived from petro/gas feedstock). The subsidy prices are set arbitrarily and revised at arbitrary intervals. Price hikes, including hikes in petrol prices, technically decontrolled, were delayed, for example, for months due to the UP Assembly polls.

Government refiners that are forced to market products at those controlled prices suffer huge losses. These losses are partially borne by the Central Government and partially by other public sector undertakings. The Government also subsidises fertilisers. Private refiners like Reliance Industries and Essar are reluctant to get involved in retailing and prefer to sell products abroad. Thus, there’s no competition in the domestic retail sector.

At the same time, the Centre imposes taxes on petro-products. Various states , too, impose taxes on these products. The sector is therefore an accounting nightmare. Since final prices are higher (due to taxes), these prices sometimes feed into inflation.

It’s difficult to look at tax revenues versus subsidies, work out differences, and figure what the net gains and losses to the Government are, in rupee terms. The states always make some money since they don’t fork out any on subsidies, while the Centre usually seems to make money net of subsidies. However, the Centre may have lost money in fiscal 2011-12, since it cut customs duties, lowering its revenues.

India has to import around 80 per cent of its petroleum products. It pays in hard currencies. This causes a massive trade deficit and leads to pressure on its forex reserves if international crude oil prices are high. Nor has the Government worked out a formula to attract more domestic exploration activity. The biggest gas strike in decades—the offshore Krishna Godavari Dhirubhai-6 by Reliance Industries—is mired in controversy with falling output and a dispute over a production sharing contract.

Reforms here would involve simplification of the tax structure and a subsidy structure that’s more directly linked to international prices and revised at regular intervals. The Government also has to find ways to encourage more exploration activity and enable competition at the retail level.

2 Reforms in the power sector. Last year, India added huge amounts of generation capacity. However, thermal plant load factors dropped because of coal shortages. Domestic coal in India is supplied by an inefficient government monopoly, Coal India, which consistently underperforms and is unwilling to be held to fuel supply agreements.

State power distribution companies suffer transmission and distribution losses in the range of over 30 per cent. This means that one in three units generated is never billed. As a result, state power units are running at huge losses. They cannot afford to pay for power even when surplus power is available.

No investor wants to touch the conventional power sector because several projects are stuck, largely due to a combination of three factors—fuel linkage issues, environmental clearances and land acquisition problems.

3 India badly needs to reform its tax codes and administration. India is one nation, but it is 20 odd tax zones. Each state charges different rates of excise and octroi, etcetera, on various goods. Contrast this with Europe, where over a dozen nations have a unified tax zone. It costs more in terms of paperwork and taxes to move a truckload of goods from Madhya Pradesh to Maharashtra than it does to transport goods from Poland to Ireland. If you rid the system of this complexity, inter-state trade would automatically jump.

The direct tax code in terms of income tax paid by individuals or businesses is also very complex. It has a raft-

load of exemptions and a raft-load of peculiar provisions. In addition, the revenue service has enormous powers of discretion, which translate into incentives for large-scale corruption at the level of assessing officers.

There are also, of course, the Centre’s retrospective amendments to the Income Tax 1961, and the General Anti-Avoidance Rules (GAAR), which were proposed in the Budget for 2012-13. Clarifications here have huge bearings on future forex inflows, both in terms of foreign direct investment (FDI) and portfolio investments.

Changes in the Direct Tax Code (DTC) and a new Goods & Services Tax (GST) have been proposed and postponed many times. The GST will require the approval of states. It would be administered something like the value-added-tax, with the Finance Commission allocating a share of revenue to each state. VAT has worked well but state-Centre relationships are always delicate and major legislation will be needed to push the GST through.

Dr Singh appears to have started work here. A draft of GAAR has been released. Clarifications on the retrospective amendment have been issued. However, he’ll have to light many fires under many seats to get the DTC and GST hammered out by 2013. This is unlikely to happen.

4 It would be a help if the Government could ensure better coordination between the Ministry of Environment and Forests (MoEF), which issues environmental clearances, and various ministries that award large projects. Instead of seeking MoEF clearances post-award, matters would be speeded up if the concerned ministry (Power, Ports & Shipping, Roads, Aviation, etcetera) were to thrash out the required norms and environmental clearances before it issues a Request for Qualification and starts the award process. As things stand, the fear of delays on this front has made investors reluctant to commit funding. There has also been a lot of blame-gaming with operators, concerned ministries and the MoEF all passing the buck with regard to the responsibility for delays in projects that have been held up.

5 A major reason why projects get delayed is the nightmare of land acquisition. The Government uses legislation dating back to the 19th century. A sarkari representative acquires land, often evoking a privilege called ‘Eminent Domain’. The same representative sets the price to be paid as compensation. The same representative then changes the certificate of land use so that agricultural land can be used for industrial or residential purposes. At such a stroke of the pen, the value of this land multiplies. The farmer whose land has been forcibly acquired is unhappy and inclined to express displeasure loudly and publicly.

There are many potential ways around this. One is to change the valuation process so that valuations are independent and reflect commercial reality more closely. Another is to stop using ‘Eminent Domain’ for commercial projects. A third is to offer farmers long-term upsides in terms of annuities as well as upfront payments. One can disagree about what process will work better, but the Land Acquisition Act indisputably requires reforms.

With an estimated Rs 600,000 crore stuck in various infrastructure projects, the faster the abovementioned bottlenecks are eased, the better. Overall, too, the reforms listed above have all been on the pending list for years. Land Acquisition bills have been drafted, tinkered with and put on the backburner. Electricity reforms started in 2003. The NDA Government suggested the decontrol of petro-pricing back in 2000. The DTC and GST have endlessly been fiddled with and postponed. Only one of them—changes in the tax codes—pertains directly to the Finance Ministry. But if Dr Manmohan Singh actually wants to get reforms moving again, he is better placed than anyone else to try making the others happen.