Why India is a high-cost economy

The Economic Survey has done well to emphasise the role of domestic factors in India’s economic slowdown. On the face of it, there is also considerable room for consensus on its diagnosis of the present economic scenario.

The stimulus that was used to offset the global economic crisis in 2008 generated a surge in consumption expenditure.

In the face of supply side constraints this led to inflation. The efforts to counter inflationary trends through a tighter monetary policy contributed to a slowdown that has left no sector untouched. It is in responding to this largely accurate diagnosis that the government has let itself and the country down.

REGIONAL STOCK EXCHANGES

At the heart of this response is a belief that all that is needed is to wait out the crisis.

When calculating its numbers, the Budget has simply assumed a higher growth rate than has been achieved in the current year. It has few major initiatives of the kind the slowdown would appear to demand. There is the now predictable demand in the Survey that reforms should be hastened. To suggest that at least some part of the blame for the current slowdown could lie in the specific course of reforms in India would be treated as sacrilege.

And yet it is not difficult to argue that the course of reforms disrupted a direct link between savers and companies that was developing in India in the 1980s. Even a casual glance at the GDP charts would tell us that the growth story began in the mid-1980s.

It was set off by a variety of factors, including a changing savings pattern. By the beginning of that decade, small savings had moved from the post office to banks and was entering the capital market. Companies that had credibility locally could tap these savings directly to get on to a rapid growth path.

With the coming of liberalisation, it was assumed that the greater regulation that the stock market desperately needed could only be provided by centralised control.

And to be attractive to foreign institutional investors, the scale of capital issues was raised well above the reach of the small ambitious company. The entire home-grown regional network of stock exchanges was allowed to die.

The break of this link hurt both the companies as well as the savers. The companies lost a major source of low-cost equity capital. The alternative of borrowing from financial institutions increased their cost of capital.

This would have been particularly true of small-scale industries hoping to use local reputations to become larger players. It is difficult to estimate just how much of a role this drying up of equity capital for small firms played in the lack of rapid growth in the manufacturing sector, but it is a factor that should not be ignored.

INFRASTRUCTURE EFFECT

The shift to companies seeking to operate on a global scale also created a demand for world-class infrastructure. Attractive as this infrastructure is, it does not come cheap. The higher cost infrastructure has an impact on prices.

The principle of the-user-must-pay raises the costs for those using the infrastructure. And there can be an indirect effect on others in the city as well. It is not unknown for infrastructure projects to be made viable by giving them more land than they, strictly speaking, need. The additional demand for land has an impact on the price of housing for all in the city, including the poor.

The fact that the city as a whole pays the higher costs of high-end infrastructure influences the decisions of the poor to stay in the city.

As the cost of living goes up, labour is forced to leave the city, going back to the relatively low-cost environment of the village.

The resultant shortage of labour in the cities leads industry to seek greener pastures elsewhere. And when these alternative sites are outside the country, it further accentuates the slowdown.

SMALL SAVER EXCLUDED

On the household savings side, the main effect was on the credibility of the instruments on offer. Local reputations that provided the credibility for small investors to go by were no longer in the picture. This gap was to be filled by mutual funds. But these funds came with their own problems. Their prices were often not very much less volatile than those of ordinary shares. This hurt their credibility as long-term investments. And as the economy began to slow down, gold was the obvious alternative. In 2012, consumer demand for gold in India grew by a huge 41 per cent in physical terms.

The obvious response to this story must be to work out ways to revive the link between the small saver and the small but ambitious manufacturer.

This would require a number of steps, ranging from setting up incubators to the revival of the old regional stock exchanges with an emphasis on helping manufacturers gain access to small local capital.

But for any of this to happen, the government would have to take a far more critical view of the working of the liberalisation process than the Economic Survey or the Budget has been willing to attempt.

(The author is Professor, National Institute of Advanced Studies, Bangalore.)

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