Charting a course for the Indian economy

  • Blog Post Date 05 August, 2015
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Karthik Muralidharan

University of California, San Diego

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Arvind Subramanian

Peterson Institute of International Economics

Karthik Muralidharan (Associate Professor of Economics, University of California, San Diego) speaks with Arvind Subramanian (Chief Economic Adviser, Government of India) on a broad set of issues ranging from the uniqueness of the Indian development model, the political economy of reforms, reducing factor misallocation in the economy, enhancing State capacity, financing India´s infrastructure needs, to the implications of the Fourteenth Finance Commission, improving the design of social welfare programmes, and climate change.

This is the third in the series of I4I Conversations.

Karthik Muralidharan (KM): It is a great privilege to have Arvind at the I4I Conversation Series. The aim of this forum is not to put Arvind on the spot and ask what the government is doing about x or y or z, because those are very much part of a deliberative process that might not always be sharable in the public domain. Rather, this is in the spirit of what Ideas for India and the I4I Conversation Series are about - creating a forum for informed public understanding of complex issues. So Arvind, let me start by asking you to give us an overview of the Indian economy - how we got where we have, with a focus on what has happened in the past year, and your forecast for the most important things going ahead.

Arvind Subramanian (AS): Thanks – it’s great to be here. I do want to take a few minutes to set the Indian development experience and model in a broader context, before I come to the more recent period which I’m sure everyone is interested in. I want to say 3-4 things about the Indian development model, where we are, and how to understand it.

The first and I think the most exciting thing for me as someone who has studied growth across countries from a macro perspective, is that there is something very unique about the Indian development model. I call this the precocious development model, and it has two components. One, political scientists have often observed that India is a complete outlier in having sustained democracy at very low levels of income, low levels of illiteracy, and a highly agrarian economy – that’s one aspect that has implications for economics as well. The second part of the precocious model is that it is not just precocious politics but also precocious economics. There are many ways of explaining this precocious economics model, but I will focus on two ways. Most countries grow by either specialising in/ exploiting their minerals, as in - the old model - or in some cases, exploiting their geography. But most of the post-war growth experiences have come about by becoming manufacturing powerhouses, especially starting with low-skill labour and going up the spectrum. Of course, everyone knows that the Indian development experience, certainly in the last 30-35 years, has been driven by services, and that’s fairly special. The other way of understanding this precocious model is that in some ways India is trying to grow and develop not by worshipping or deifying its comparative advantage but by defying it. We have a lot of unskilled labour but we are not using it; we are using much more of our skilled labour.

For me, the most striking manifestation of this precocious development model is that India actually exports a lot of FDI. If you think of the international pattern of development, countries in our stage of development are meant to get capital, labour and technology, and then export labour-intensive goods. But we have been doing something else, so this is actually a fairly unique development model. It is a work-in-progress; we can’t say if it’s a success or not. Provisionally, in the last 30 years, it hasn´t been doing too badly - 6-6.5% growth rates for 35 years, but with lots of problems and so on. So if India can pull it off in some senses, it would be quite a unique development model - maybe a model for others to follow down the road. So that is something really exciting about Indian development.

The second thing which strikes me is related to India’s precocious politics model. There is a combination of what Lant Pritchett calls a flailing State (some would say, as you have said, that India has weak State capacity) on one hand, but India is also a perennial democracy as it were, on the other. I think democracy has created these pressures to redistribute and spend at levels of development, which the advanced countries reached much later in their development process. This creates a lot of challenges - can you spend well? What kind of spending should you do? We are seeing these tugs to some extent. One manifestation of that is in some ways, you can understand some of what went on in the UPA years: a country or a model that is trying to redistribute without the State having established its credibility and legitimacy by providing essential services. Indira Rajaraman said that even the western world redistributed much later in the process because it had established its credibility to spend. And so we are trying to spend and redistribute without, perhaps, the legitimacy or ability of the State to do it well.

The other part of this, which is very important and which gets neglected, is taxation - the fiscal contract between citizens and the government is very important for accountability and institutional development. In India, for example, the number of taxpayers in relation to voters in the economy has been about 4-4.5% for a long time. So we still don’t have that fiscal contract and that creates a lot of challenges.

The third thing, which has happened in the last 10 years, is what I would call the Latinisation of Indian macroeconomics (I should clarify that, in some ways, the Latins have moved on). We had become much more vulnerable macroeconomically - high deficits, high inflation, great reliance on foreign capital over time, which has created this volatility. Dani Rodrik has this important idea that if you are going to integrate, you actually need bigger government because there is more volatility and you have to cushion against the shocks. So we have a situation where we have become more volatile macroeconomically, we have become more exposed, and that has created a lot of challenges. The 2013 experience that we had - coming very close to a serious problem - I think was, in some ways, a culmination of the Latinisation of Indian macroeconomics.

The fourth point, I would make in terms of the challenges is as follows: one way to understand India – on the model side and the micro side - is I that we went from socialism with restricted entry to capitalism without exit. This is now a real problem in India. You take power, fertiliser, banks, PPP projects, civil aviation, or even agriculture like rice and sugar - the problem is you can’t get out. Inefficient firms or inefficient production can’t be easily reduced and that poses a really big problem for all the things that you think are desirable. It is a fiscal burden; it affects the economy in so many ways.

Summing up, India has a unique development model and there are at least three challenges. First, the weak State and what politics has done in terms of redistribution and taxation; second, the Latinisation of Indian macroeconomics, and third, we have gone to this capitalism without exit (we can talk about crony capitalism later).

I actually strongly believe that there is going to be a lot of endogenous change in India. I’ll give you a few examples. One – and Karthik, we have discussed this before - is that we talk a lot about what the State has or has not done for education. Educational outcomes are very poor. But I think, to some extent, if you look at what has really driven at least the drive to enrollment and people seeking more education has been the growth pickup over the last 20 years. Just having growth and the particular pattern of growth has increased the demand for education. Outcomes are still a question mark but at least we are not talking now about just supply driving educational outcomes, but also demand driving educational outcomes. This has had a huge impact and is an example of endogenous change.

The other big agent for change in India is going to be competition among states. That is why I am - subject to some caveats - a big fan of the Fourteenth Finance Commission because basically you create not just cooperative federalism but also competitive federalism. It has maybe not gone far enough - it has to embrace cities as well.

Lastly - again a work in progress - I think there are signs that some of this endogenous change can come about because in India, good economics, perhaps slowly, not always, not everywhere, could be becoming good politics. We have seen that in the last 2-3 election cycles, we have seen that in 2014. The great sage and philosopher Donald Rumsfeld said, “You go to battle with the army you have”. So when people in India talk wistfully about the Chinese model and top-down development, it’s almost a silly wistfulness because you know you’re stuck with the system you have.

Are we seeing enough endogenous change from within the system? I think this good economics becoming good politics could be combined with competitive federalism, and could be an endogenous agent of change in India. So on the whole I would say, yes there are challenges, but I’m quite hopeful about endogenous change.

The macroeconomy has turned around quite considerably in the last year or so. Looking ahead, I think growth in the short run is going to be better than last year. Pronab is sitting here so I’m not going to pronounce on the number; he will get angry with me. But all I can say is that growth in 2015-16 is going to be better than growth in 2014-15 by more than 2014-15 was better than 2013-14! Whether that is 7, 6, 7.5 or 8, I will leave it to Pronab to decide; as I say, I don´t fully understand the numbers but I think it is going to be better. And I think yes, change is happening, reforms are happening; we can get into how much has happened, how much has not happened. I don´t actually think that the international environment is going to be a big constraint on us, certainly not in terms of capital/ finance. One thing that does worry me is that our export outcomes have deteriorated quite sharply. It’s happened not just in goods and services. Some of it is external but some of it is also competitive challenge. So we need to keep plugging away.

There are some big institutional reforms that are happening, like the GST (goods and services tax) and the whole DBT (direct benefit transfer)/ JAM (Jan Dhan Yojana, Aadhaar, Mobile Money) vision. Those are really game changers, if we can get them done right. So between competitive federalism, good economics being good politics, a few institutional game-changing reforms - I’m certainly bullish enough to want to do this job with hopefully more energy or as much energy as you have, Karthik!

[13:32] KM: I think that was a great review of how we got to where we are. Let me bring us back to the last 12 months. If you were to highlight the 2-3 big enabling changes that have taken place in this time that are setting the stage for some of the cautious optimism that you describe, what would those be? And then if you could just chalk out, perhaps, the 1-2 year plan on some of those big-ticket items - the GST, the JAM agenda, and some of the other things that you have laid out.

AS: A big change has been the macro stabilisation. Oil prices have helped, but we have also contributed to the decline in inflation – the RBI (Reserve Bank of India) has also done that. To the extent that price inflation was coming through from agriculture and Minimum Support Prices, the government has contributed by moderating them and keeping them manageable. So the macro side is looking less vulnerable than it did a couple of years ago.

In terms of the 2-3 big-ticket reforms - where the big actions have been taken: the fact that spectrum and coal were auctioned cleanly and transparently sets the model in terms of what the government is seeking to do on governance reform. Gold has been liberalised – which people don’t realise – is actually a governance reform. All the deregulation that has taken place on the energy side is another part of it. On the real sector side, a lot of opening to FDI has happened.

In terms of institutional reforms, GST will hopefully get a passage soon and actually start being implemented in April. The JAM is being done for salaries and pensions to some extent. We’ve had this cooking gas experiment which has been quite successful. Prabhat Barnwal has done some work on this, as has Siddharth George. We have seen tremendous gains and are now looking to extend it to other commodities. However, the lessons from cooking gas don´t easily travel to other sectors and the policy design has to be right. But this whole JAM vision is really an institutional change, which is important for the following reasons. Firstly, apart from the fiscal savings - which is the smallest part of it - if the government can do something well, it legitimises the State and builds State capacity. It chips away at the cynicism about government and the delegitimisation of government that takes place. If we can do that, we can also allow the price system to function better; there are efficiency gains to be reaped from that. If you look at the Economic Survey, it’s amazing that for many goods and services, consumers and producers still don´t face market prices. Above all, any democratic government wants to protect the vulnerable and the poor and this (direct transfers) is really the best, most efficient way of doing so. So I think the JAM agenda is going to be really important as an institutional reform.

The interesting thing is that not only have oil prices been deregulated but people have noticed that the government has stuck to its commitment. International prices have gone up to some extent after the low, and pump prices have adjusted accordingly, unlike the earlier era, when the whole thing collapsed. So I think as long as prices don´t go too far – say, if it goes to 100, then all bets are off all over the world, not just in India - but I think the deregulation commitment can be maintained.

The Fourteenth Finance Commission has been a big game changer in terms of unleashing competitive federalism.

On the short-term macro side, we made a strong pitch that the government needed more public investment because of the state of corporate sector balance sheets. The government has allocated more, to some extent, by saying that we’ll delay the fiscal consolidation targets. So all these things add up to something we can build on and work more towards. Of course, the big challenge is the exit problem. There are lots of things related to exit - banks, PPP, corporate sector. That’s going to be one big challenge going forward. Otherwise, in terms of governance, institutions, macro and real sector, I see enough having taken place that if we persist with this, there could be meaningful change and higher growth.

[18:53] KM: That’s great. So let me use that as a chance to transition to much more specific issues. One thing you did not mention, which I think the government deserves a lot of credit for, is the monetary policy framework. I remember you talking about how earlier there was a political consensus that inflation was politically bad, but then there was this time in the past 10-15 years when we seem to have accepted a permanently higher level of inflation, and this was something we were all worried about. So this is actually a big game changer, because it is committing credibly to restricting the government’s ability to inflate away debt. How did this actually come about? What are the costs that you might worry about? Because now that you´ve tied your hands on this, the concern is that the fiscal space gets limited in terms of perhaps running deficits that you think might be warranted for investment reasons. How did this come about in terms of agreeing on the monetary policy framework, and what might be the trade-offs involved?

AS: When Raghuram Rajan took over as RBI Governor, the Urijit Patel Committee Report came out, which recommended inflation targeting. There is some dispute whether it was inflation targeting or flexible inflation targeting - and we need to talk about that to some extent. As you said, the experience of high inflation, I think provoked enough people into recognising that this is a problem going forward and that we need some institutional constraints on that. On this, the RBI and the government have been on one page. In fact, the monetary policy framework was actually announced in the August budget last year, and this budget, we had the first agreement with the RBI. Going forward, this is going to be a part of the monetary landscape, because both government and the RBI have a common commitment to inflation reduction. The strong belief is that when you have high inflation, there is no tradeoff between inflation and growth, and that’s the theory behind it.

Now, going to the second part of your question, the point is whether we going to have a rigid inflation targeting framework or something more flexible. That is a discussion we are going to have going forward. I don´t think the fear that the government is going to inflate away its debt is a serious concern, certainly not at this stage. Maybe, down the road, that might happen. The irony is that we are in this situation because we did inflate away our debt over the last 15-20 years. Our debt to GDP (Gross Domestic Product) ratio has come down. Initially that happened because we grew very rapidly, but then we had high growth and high inflation, so debt has come down beautifully for India in that sense. It is the kind of inflation that I think the US and Europe are salivating about. Going forward, prudent fiscal and macro management is a shared commitment of the government and RBI, and so in that sense, inflation targeting merely codifies that and we will stick to it.

[22:06] KM: Perfect. So let me point to what seems like, to everyone, a pretty fundamental constraint right now, which is that India needs major investments in infrastructure. But, for the reasons that you described, there are commitments to categories of spending. I think most of today’s developed countries invested in public goods before they invested in redistribution. We are kind of in a place where the redistributions commitments are in place and therefore, this severely restrict the fiscal space available for these investments that we know we need. What is interesting is that from a basic capital budgeting perspective, as long as the IRR (internal rate of return) of an investment is positive, you should be willing to borrow for it. But then the bond markets won’t let you do that beyond 3% or 4% or whatever the fiscal targets are. So what are the options to create fiscal space for these infrastructure investments? What are the conventional options, and how out-of-the-box can we get on that?

AS: First, even if you look at the latest budget, the constraint on public investment in India, today at least, is not resources but just the ability to spend, spend well and spend quickly. That’s why in the short run, I have no fears at all that public investment is going to be constrained by lack of fiscal resources. In some ways, I am more anxious that we actually implement what have budgeted for. Partly, it’s because the ability to spend, generally, is not great. There are a few pockets that can spend well like NTPC (National Thermal Power Corporation Ltd.), railways, highways, roads and so on. But it is not easy to do that especially when the legal institutional environment is such that the CBI (Central Bureau of Investigation) and CVC (Central Vigilance Commission) are watching out for bad spending. There is a natural caution in the bureaucracy, which further limits how much you can spend. So, I don´t worry about the resource problem in the short run. In the medium term - I have a slightly strong view on our model of understanding the macro savings-investment picture. In India, I have been surprised by how enthralled we are with what I would call the Ragnar Nurkse-Rosenstein-Rodan Lewis kind of framework. To me, it’s surprising that in the last five years there has been this notion that this is the investment, we need so much saving; where will the savings come from? In fact, the East Asian experience tells you that savings actually rise to meet investment, and investment doesn´t become that much of a constraint on growth. Even if you look at our own experience in India, our savings shot up enormously during the boom period and it’s not as if we had to run huge current account deficits. The big current account deficits happened when we started decelerating for all kinds of different reasons. So while we need to devote time to getting better intermediation of domestic savings - to saying do we need more innovative sources of finance - I think my first-order concern in the short run is with implementation capacity and the natural caution that actually deters public investment. In the medium term, I worry less about this because the East Asian experience, whether it’s China, or Korea or Japan earlier, certainly shows that savings endogenously increase as you grow. In a sense what I´m saying is that there is a certain kind of finance fetish that I don´t completely buy.

[26:36] KM: Maybe I was channelling Mr. Suresh Prabhu, who was here at the IPF (India Policy Forum) about a week ago. I think perhaps it’s because his Ministry has the capacity to spend, but seems to need to look for off-budget resources to fund some of these large capital expenses. He talked about going to the LIC (Life Insurance Corporation of India), for example.

I think you’re exactly right - there is this financial intermediation problem. This then gets me to the next big item, which is that how do we get the banking system unblocked and how do we get it to start lending again? And there is a whole range of sub-questions I have in there, but clearly it seems like this is a big bottleneck right now.

AS: Allow me a digression into Indian economic history here. If you were to ask me what were the two egregious economic sins we committed in our past - planning was de rigueur in those days, import substitution was de rigueur, so in real time, those were not major mistakes or bad choices. The two big mistakes we made in our history were the industrial policy resolution, and bank nationalisation. The reason is that while in all the other cases we tried to protect Indian industry against competition (import substitution, public sector etc.), in this case we actually taxed and expropriated domestic investors. So in that sense, this was a very costly mistake.

In term of reform going forward, we had a chapter in the Economic Survey which Rohit Lamba and others helped write. Allow me a small digression into kind of the ‘Mckinsey way’ of talking about these things; I call this the four Ds of bank reforms. First, if you look at the banking system, we actually practice financial repression very seriously. We were doing it on the liability side, but we do this on our asset side as well with our priority sector lending and the statutory liquidity ratio. I think we need to address those going forward. That’s the first thing that improves intermediation generally. Second, we need to differentiate - we don´t have public sector banks in India; we have public sector banks and public sector banks and public sector banks. We do need to differentiate how we approach this. Even any recapitalisation strategy should differentiate across banks. For example, there are clearly some categories of banks which you want to shrink, where maybe even the regulator can shrink; maybe some mergers and so on; some where you aggressively need to recapitalise; and some in which governance reform should be undertaken. So the whole one-size-fits-all does not work in banking. Third, we must diversify sources of financing - whether its many more banks, many more types of banks, payment banks - our licensing has to become much more broad. And of course, we have to gradually begin to develop our bond markets. In some ways, it’s possible that the way to get out of the problem is to grow the non-banking sector, rather than to frontally shrink the public sector. The last is to dis-enter, exit is very difficult from this. We need to get better bankruptcy laws. We need much more creative quasi-political exit mechanisms. This may even address the overhang problem we are experiencing. Because clearly, the legal mechanism for exit that we have right now is not effective and needs to be reformed going forward. That’s the way I see banking reform - the 4 Ds - and we have got to work on all of them.

[30:54] KM: To the extent that everybody, at some level, implicitly knows that this is going to take an infusion of taxpayer money - there’s just no getting away from that - how do we design this, so we don´t watch this movie again? What are the options, given that this is a time-tested, repeated path?

Jeff Sachs, about 20 years ago, famously said, “State-owned hotels irritate me, State-owned firms annoy me, State-owned banks terrify me”, precisely for the reason that it is a misallocation of resources across the whole economy. It feels like we are in a little bit of chicken-and-the-egg with respect to banks where at one level, the government feels that the asset values are so depressed that this is not the right time to exit. But then, you’re never going to get that valuation as long as you have the political economy of public sector bank lending. So, when you talk about differentiation, why not bite the bullet on say, one bank? If you are able to bite the bullet on one bank and say that you will bring equity down below 50%, then you will get to see how much the market gives you a control premium, or rather a de-control premium. That kind of lets you just de-risk the process of taking this on – pick one guy and see what happens.

AS: That’s great advice and it certainly should be a part of the menu of options. However, it runs against the exit problem. Let me give you a sense of the political challenger, without disagreeing with what you are saying. A sector that I have been studying a little bit with my colleagues is fertiliser. In fertiliser, for example, we have this perverse system – you can’t make it up - where the more inefficient you are, the more the subsidies you get. The interesting thing is that some of these very inefficient firms are actually not very employment-intensive. But it’s not easy to do, and I am not going to try and second guess my political masters in terms of what is easy and what is not. But the reason I say this is that when you think about your solution for the public sector banks, that problem is kind of magnified n-fold. So that’s where we stand, and it is going to be a difficult thing going forward.

[33:46] KM: On my smartcards work with Sandip Sukhtankar, Santhosh Mathew, who was our discussant last year (and who is here today), said that the deeper question is not whether smartcards reduced corruption, but why was it allowed to be implemented well when political rents were being shut down. I feel that the basic economic roadmap of what needs to happen is almost so obvious to many of us, that the highest value-add then comes from thinking through which are the winnable political battles, and finding ways in which you can get some of these things through. For what it’s worth - again based on some of the insights from Santhosh’s remarks on our work - it seems that there are two or three ways to cut through the political economy gridlock. One is that reforms happen in sectors where the rents are controlled by the opposition party. Given this diversity in banks and this diversity in where those rents are, that might be something that one could consider putting on the table.

AS: I think that is a very good thought – I would like to go into a digression related to that. Crony capitalism in India is well known; I think it is older than capitalism itself. What is really interesting about India is that the markets for the ‘cronier’ and the ‘cronied’ are both contestable. On the crony side, one man is in favour today but the other man can be in favour tomorrow. But equally, the guy who is in the government and doing the crony-ing changes because of politics. One constraint on my misbehavior as a politician today, is that tomorrow I’ll be out of office and in opposition and therefore, liable to all this. That is an aspect of crony capitalism that I think is quite interesting. But more seriously, yes - there are some political constraints that we have to keep pushing and pushing as unacceptable. We may not win that battle. But there are other constraints, where we have to see how we overcome the opposition. One way is what you said; the other way is reform by stealth. The third way is to act where you find the minimum resistance. The fourth, is sharing the gains that materialise from eliminating the rents. For example, if we want to push kerosene and food by doing this through the PDS (public distribution system), maybe we have to incentivise the states - give them a share of the gains. Maybe we have to give the PDS shops a share of the gains as well. There are various ways and I think that’s what makes the economist’s job so interesting and so challenging. Because as you said, the big items that need to be done are well known.

[37:40] KM: So let me add one more possible approach to this. As economists, we think that certain status-quo situations are inefficient. This means that the rent seeking is probably captured by relatively few people in this classic Mancur Olson ‘concentrated costs, diffused benefits’ kind of world. Kaushik Basu said that in many, many settings the problem is just ossified, bad ideas. One approach that might be promising in sector after sector is to do an incidence analysis of some of our most distortionary subsidies, whether its fertiliser or free electricity, and to plot out how regressive that is. The basic political economy of this is that if you have a highly regressive subsidy, then the median or average amount of that is going to be something that is covered by the 80th percentile. So you could take the stock of your subsidy, say free electricity, and repackage this as saying, ‘a certain number of free units for everybody’. You spend less than that, you sell at the graded price; you spend beyond that, you pay the market price. But the key thing is, if you were to put that proposal to vote, you suddenly have an 80% majority in favour of your reform