Keys to successful reform in India

  • Blog Post Date 09 July, 2014
  • Perspectives
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The new Indian government’s first budget - due to be unveiled this week – will be an important indicator of how forcefully the new PM intends to translate his mandate of putting India’s economy back on track into effective actions. This article contends that both strategy and specifics will be crucial for this budget to effectively kick-start economic reforms.

India’s new Prime Minister, Mr. Modi, won a decisive mandate from an electorate yearning for effective leadership. His government’s first budget, due to be unveiled this week, will be an important indicator of how forcefully Mr. Modi intends to translate this mandate into effective actions that put India’s economy back on track.

The list of required reforms is long and well-known. The new government seems to have a clear understanding of what needs to be done. Of course, despite his clear mandate, Mr. Modi will not have a free hand to impose reforms by decree. He is constrained by a democratic system of government and is accountable to the electorate, and will need to be ready to expend some political capital to overcome opposition to reforms. Both specifics and strategy will be crucial for a successful reform programme.

Fiscal discipline

A key priority is to signal greater fiscal discipline. High levels of public deficits and debt, exacerbated by wasteful subsidies and an inefficient tax system, have created many distortions in markets and contributed to high inflation. Populist sops have also reduced resources available for expenditure on infrastructure, education and other areas that could help long-term productivity.

The government needs to commit to long-term fiscal discipline and buttress that with aggressive moves to reduce fuel subsidies, implement a goods and services tax, and step up the pace of privatisation of state enterprises. These measures would not only improve the fiscal position of the government but also enhance overall economic efficiency by shifting the focus away from purely redistributive policies.

It will also be helpful to signal that the government will not look for easy targets, such as foreign firms, to raise revenues by changing the rules when convenient. In order to promote domestic long-term investment that improves the growth potential of the economy, policy certainty and stability are as important for domestic investors as for foreign ones.

Highlighting broad benefits of reforms

Mr. Modi needs a narrative that highlights the broad benefits of reforms. A major stumbling block to reforms in emerging market economies is the view, often a legitimate one, that such reforms largely benefit the economic and political elite.

This will be relevant for major reforms, such as those to increase labour market flexibility. Rigid labour laws, making it hard to fire workers or shut down loss-making firms, have hurt job growth and the competitiveness of India’s manufacturing sector. It will be important to communicate that freeing up the labour market is essential for generating high-quality job growth that will benefit India’s population rather than just industrialists and entrepreneurs.

The rhetoric surrounding reforms turns out to be particularly crucial in determining their political fate in a democracy. Mr. Modi could build support for his agenda by taking a frontal stand against public corruption, which has not only hurt economic efficiency but also deprived the poor of many benefits from economic growth.

Embracing globalisation

Mr. Modi should also signal a willingness to embrace globalisation with both arms. Reducing barriers to trade in goods and services and easing barriers to foreign investment would create more choices for consumers and more sources of financing for firms.

Increasing openness to foreign trade and capital no doubt has some risks. But when the process of opening-up is managed well, there can be large indirect benefits in terms of catalysing domestic reforms by pushing domestic firms and financial institutions to up their game.

Building credibility on reforms

The budget should provide a downpayment on reforms to help generate momentum. No one expects miracles overnight but actions are as important as words in building credibility on reforms.

Consider the actions of Mr. Raghuram Rajan, the governor of the Reserve Bank of India (RBI). On his first day in office, Mr. Rajan announced a set of financial sector reforms and signaled that more was to come. Soon after, despite protests from industry, he raised policy interest rates. This made it clear that controlling inflation would be the first priority of the central bank and he would not compromise his institution’s effectiveness and credibility by backing off from this objective. This combination - a quick start on implementing reforms and a commitment to deliver on the central bank’s core mandate - fended off market pressures and helped turn around sentiment about the economy’s prospects during a difficult period.

Fighting inflation

The fight against inflation should be a priority of the new government as persistent high inflation can quickly erode its support. It can bolster the RBI’s actions by emphasising supply-side measures that boost investment and productivity. The supply and distribution of food, in particular, needs improvement through reforms of agricultural and land policies. Moreover, changes are needed to government policies that have kept the distribution system, which remains dominated by small shopkeepers and multiple layers of middlemen, inefficient and wasteful.

Financial markets and the formal financial system

The budget should contain a clear message supporting the central bank’s efforts to free up financial markets and develop broader sources of financing, especially corporate bond markets, to meet India’s needs for long-term finance. Another goal enunciated by the RBI is to promote access to the formal financial system. Support from the government for this objective will tie in to the broader message of inclusive reforms as it will help spread the benefits of reforms more broadly through the population.

Concluding remarks

On the national stage, the complexity of the challenges Mr. Modi faces and the level of opposition to reforms will be far higher than at the state level. To be successful, he will need an iron will and a plan of action that involves quickly plucking low-hanging fruit but also getting started on more fundamental reforms. To deliver what India’s electorate is hoping for, a well thought-out strategy will be as important as knowing what needs to be done.

A version of this article has appeared in the Wall Street Journal.

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