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WHEN SINS CATCH UP - Is Indias growth story coming unravelled?
June, 30th 2008

Indias much-touted growth story has unravelled. The stock market index has dropped from 21000 to below 14000 in hardly five months. Growth of industrial production is declining. Foreign fund inflows are dropping. The declining rupee has necessitated massive interventions by the Reserve Bank of India and reduction in foreign exchange reserves. Inflation is galloping. We are are back to prospects of downgrading by rating agencies.

The sins of finance ministers since 1991 are catching up. Fiscal deficit reductions were achieved by cutting expenditures on agriculture, physical and social infrastructure. Deficit figures were fudged, real deficits being much higher. Attempts to cut subsidies were rolled back, as were attempts to improve efficient delivery of subsidized food grains, kerosene and so on, opposed by vested interests in the bureaucracy, the Food Corporation of India and in the trade. Even when inflation was low retail prices of petroleum products were frozen despite crude oil price rises. Defence expenditures were never questioned, even on grounds of efficiency and effectiveness, or corrupt practices. Declining public investment in agriculture led to fall in productivity and agricultural growth, hitting the majority that lives on agriculture. The stifling hold of bureaucratic procedures remained. Infrastructure bottlenecks added to costs.

Before the Vajpayee governments golden quadrilateral scheme, which has since been extended to rural infrastructure, investment in roads was poor. This made for higher freight costs, greater time for deliveries and, so, slower industrial growth. Poor investment in roads was compounded by little investment in railways and ports. This increased the turnaround time for goods sent by rail or ship. It delayed deliveries of many imports and led to higher inventories and higher costs for industry.

The power sector was mismanaged. Emphasis in 1991 was on generation, until the bureaucracy understood that investment in generation would only come when investors were assured of customers who wanted the electricity and would pay its cost. Transmission and distribution were opened to private investment in 1998, but the central public sector transmission monopoly, the Power Grid Corporation, successfully prevented private investment in transmission till 2006 (except for one joint sector project). Electricity distribution was and is mostly with poorly managed state government monopolies. World Bank mantras to un-bundle and corporatize were followed as nostrums, not out of conviction. There is practically no commercial culture in power distribution. Even the present reformist prime minister did not defend the only successful attempt to privatize electricity distribution (in Delhi). The only efficient public sector generator, the National Thermal Power Corporation, never achieved targets to add generation capacity. The private sector had little incentive to invest in electricity because of concerns about payment security and profitable tariffs. Endemic power shortages hamper growth and efficiency and raise costs.

The United Progressive Alliance government has broken through the bottleneck to some extent. The pathbreaking Electricity Act of 2003 could have, with captive generation, open access, merchant power and trading, attracted private investment. It was rendered ineffective by bureaucrats appointed as independent regulators, with the mindset of command and control. Power remains uncertain and inadequate, adding to inefficiencies and costs.

Determining prices of refined products in India by linking them to international prices of refined oil products has allowed huge windfall gains to private oil companies. Gas prices from domestic sources must be linked to costs, not international, manipulated prices, especially for power and fertilizer, whose prices are capped by regulators. Gas for generation will mitigate the pollution from coal. Domestic gas supplies will grow from next year. Gas prices must be regulated, allowing ample return for exploration and production risks and on investment. Future inflation can be mitigated if gas prices are regulated.

By not allowing retail prices of petroleum products to rise in relation to real costs of inputs for years, the government has dug itself a fiscal hole. We should not have related domestic petroleum product prices to international markets, but let retail prices rise when required. Now we have to meet the huge cumulative shortfalls.

We must have a market economy. But sectors like oil, gas and other natural resources, and essentials like medicine, while enabled to earn adequate returns, must be subservient to the needs of a poor people.

Telecommunications is an area of success, thanks to an imaginative secretary, N. Vittal, and a wheeler-dealer minister, Pramod Mahajan, who changed rules, or just bypassed them. From the bottom of the league in telecom density at high tariffs, India is today the fastest growing and cheapest in the world.

Forty years of centralized planning and direction resulted in many procedural and taxation hurdles to investment. Those removed were the easier ones industrial import and export licensing, regulation of companies, varying indirect taxes between states, high import duties, banned imports, share issue price approvals and so on. The difficult ones multitudes of procedures and approvals to set up new production units, environmental clearances, inspectors of factories under different rules, regulation of production, distribution and retailing of medicines, movement of essential commodities, to mention only a few remain.

Value-added tax has been introduced and Central sales tax rates have been cut. India is becoming a common market. Among hurdles, the CST continues as does the need for the buyers and sellers to get thousands of forms on pain of severe penalty. Trucks are stopped at state and city boundaries for inordinate lengths of time, increasing costs for industry.

Procedural bottlenecks take citizens time and attention away from productive endeavour. Many officials do not know all of the numerous procedures, while citizens are quite ignorant of them. So procedural gridlock ensues, adding to the cost and time to complete projects.

Neglect of the social infrastructure, namely health and education, has eroded India's competitive abilities. Economic growth appears to have increased relative inequalities in health and diminished health indicators for many.

Education has suffered governmental neglect for years. The Sarva Shiksha Abhiyan programme is aimed at universal primary education. But teachers are scarce and of poor quality. Higher, technical and professional education is available but of poor standard. While India has competitive potential because of its youthful workforce, poor education is likely to convert the demographic dividend into a liability.

So what did we do wrong? Some of them were skewed priorities, poor governance, poor administration, subversion of institutions like independent regulation, poor investment in essential sectors like agriculture, physical and social infrastructure, failure to understand the market economy in areas like energy, the fudging of deficit figures to look good to international investors, thus building strong inflationary potentials, excessive liberalization of the financial sector in relation to the real economy, consequent highly volatile foreign fund inflows making a casino of our stock markets and excessively strengthening the rupee and so adding liquidity into the system. We did not stimulate growth in the real economy and relied on services for economic growth. The administrative apparatus is inflexible, uncoordinated, venal, inefficient and largely ineffective, so that much government expenditure is wasted.

We must confine subsidies only to the truly deserving poor, while stimulating the real economy of agriculture and industry. Massive investments in physical and social infrastructure must be undertaken to improve efficiencies and reform the administration so that it is accountable for performance. Then we can largely avoid inflation which has always hovered to prevent growth.

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