Economic Reforms Lag, but Narendra Modi Still Has Time to Transform India

This article appeared on Forbes on December 27, 2016.

Narendra Modi became India's prime minister in 2014 after his Bharatiya Janata Party won a strong parliamentary majority. Some Indians saw him as India's Ronald Reagan, ready to liberate his nation from overweening regulation. Optimists predicted that India soon would have the world's second largest economy with a middle class population dwarfing those of America and Europe. Once a symbol of international poverty, India would join a more active foreign policy with a larger military and become a true Weltmacht.

More than two years later India remains a country of great potential. India has enjoyed strong economic growth, but that reflects the fall in oil prices as much as domestic factors. Modi's government has made some important reforms, but so far has left unchallenged many destructive economic policies and political abuses which continue to hobble an entrepreneurial people.

Most recently, New Delhi's mismanaged currency "reform" has left many Indians without the cash necessary to conduct business. With bank withdrawals still limited, economists fear that the negative impact on growth will persist into the coming year. No wonder Indians joke, noted Sebastian Mallaby of the Council for Foreign Relations, that "India's prospects look brighter the farther away you are." Modi should launch a deregulatory blitz before concern for future elections drains away his remaining will to act.

India won its independence from Great Britain in 1947, but the ruling India National Congress Party led the new nation into a different kind of dependency. In the name of self-sufficiency, the economy was rule-bound and inward-looking. The state controlled the economy's commanding heights and enshrined envy as the governing principle, with a top income tax rate of 97.75 percent. Business was ruled by an officious, incompetent, and corrupt "permit Raj" under which supplicants required cash or connections to prosper. In 2012 India's bureaucracy still was rated the worst in Asia, an extraordinary mal-accomplishment.

In his recent Cato Institute study Swaminathan S. Anklesaria Aiyar related how in the 1980s it took the current head of a software company one year to get a phone and three years to win permission to import a computer. With production limits set by the government, he wrote, "India was perhaps the only country in the world where improving productivity (and hence exceeding licensed capacity) was a crime." From India's founding to 1983 the poverty ratio remained essentially unchanged, around 60 percent, even as several Asian nations raced into a prosperous future. India even fell behind its neighbor Communist China.

Prime Minister P.V. Narasimha Rao introduced India's first serious reforms in 1991. The Communist governments of Eastern Europe had been swept away, the Soviet Union was nearing its end, and Third World socialism had been discredited. Although Rao justified his policy as a "middle path," for India it was revolutionary. Explained the Atlas Institute's Eric D. Dixon and Tarun Vats: "India began a process of economic reform that has gradually brought freedom, dignity, and prosperity to millions upon millions of individuals. Within a decade, the average income in India had doubled, and nearly 250 million people—about a fifth of the population—have risen out of poverty since then."

Future progress, however, was halting at best. A succession of weak governments mostly talked about reform, taking at most only modest steps. India's economic liberty actually peaked in the mid-2000s. According to the Economic Freedom of the World report in 2014, the latest year for which numbers are available, India ranked a dismal 112 out of 159 nations rated. It did particularly poorly on trade freedom, credit market regulation, regulation generally, and monetary policy.

Concluded Aiyar, India's story is of "government failure, of successful economic reform tainted by institutional erosion. Although many old controls have been abolished, many still continue, and a plethora of new controls have been created in areas relating to the environment, health, tribal areas, and land." This most entrepreneurial people, who have succeeded economically in other nations around the world, continues to be oppressed by their own government. Wrote Dixon and Vats, "People who want to work and build new businesses face an array of obstacles. Hundreds of millions of people in forgotten rural populations struggle to survive in the face of a regulatory regime that doesn't understand their needs or protect their rights."

Yet even modest reforms have yielded significant benefits. Observed Aiyar: "What used to be a poor, slow-growing country now has the third-largest [GDP] in the world with regard to purchasing power parity and is projected to be the fastest-growing major economy in the world in 2016." Even on the more traditional exchange rate GDP measurement this year India passed the United Kingdom to possess the world's sixth largest economy and the International Monetary Fund predicts that rapid economic growth will continue.

That should provide Modi, the chief minister of Gujarat state who ran on the platform of freeing up business, with a strong foundation for transforming the economy. Yet his performance so far has disappointed those who expected much from his government.

Modi proclaimed that "reforms are happening in a big way" with the simple "aim of enabling the people to realize their potential and dreams." But obstacles to progress are many. Parliament meets only infrequently, about 60 days a year, which enhances the effectiveness of the opposition's delaying tactics. The BJP did not win control the Rajya Sabha, or upper chamber, which depends on party control of state governments. The BJP's enthusiasm for reform took a hit last year when it unexpectedly lost elections in the states of Bihar and Delhi.

Perhaps most important, Modi is no visionary. Mallaby observed: "Having spent a dozen years as chief minister of Gujarat, he seems stuck in the mindset of a provincial executive: he is more interested in projects than in policies; he is a modernizer, not a reformer." Equally important, Modi is more pro-business than pro-market, and a social engineer at heart, backing expanded state control in several areas.

For instance, agriculture is highly controlled, and, said Aiyar, "New price controls have been clamped on seeds and even on royalties paid by seed companies to suppliers of technology." To hold down prices the Modi government targeted "hoarding" and black markets, which actually are symptoms of government failure. New Delhi provided big salary increases to the very public employees who inhibit economic growth.

Moreover, reported The Telegraph (Kolkata) in early 2016: "Over the past year, the Modi government has started to drum up the virtues of creating large state-owned assets in a throwback to a Nehruvian era of creating state monopolies in strategic areas." The opposition Congress Party today actually may be more hostile to public monopolies than is the BJP. What we've seen, suggested Aiyar, is that Indian economic policy was not neoliberalism but "neo-illiberalism."

Which reinforces Times of India blogger Gurcharan Das' claim that "India does well when it bets on its people; it does less well when it bets on its government." Unfortunately, that continues to be the case under Modi.

The government claims to have eliminated 1159 obsolete laws and regulations, but what that means in practice is hard to assess. Modi's most obvious achievements are as a minimalist modernizer. For example, the environmental approval process has been streamlined, though decisions still take 190 days (and the reform actually was developed by the previous government). Sanitation and e-governance have been improved. The government pressed India's poor to open bank accounts, though many are unused. A biometric identification system allows distribution of welfare payments with less "leakage." Central government tax payments to states have been rationalized.

In fact, in assessing the government's first year in office the Times of India opined that "this government's biggest achievement has been its success in injecting optimism in the economy." That may account for the significant, but likely temporary, rise in foreign investment; last year's increase "would be difficult to replicate," warned the Asian Development Bank.

Among Modi's most important changes this year was to eliminate the requirement for minimum capital requirements and government certification to start a business. Amit Chandra of the Centre for Civil Society predicted that this reform would create "a level playing field for all entrepreneurs, big or small." That will reduce one of the reasons so much of India's economic activity is informal, where it is vulnerable to prosecution and extortion.

The government also finally won parliamentary approval of a uniform goods and services tax (GST) intended to replace a complicated collection of regional and national levies. Today trucks average 16 percent of their time waiting at state checkpoints where local taxes are collected. Finance Minister Arun Jaitley said the GST would "facilitate seamless transfer of goods across the country and bring a lot of financial equity," which some economists predicted could add up to a couple points a year to growth. Participants at the Economist-organized "India Summit 2016" viewed this as one of the most "transformational initiatives" in the country's recent history.

However, the government is sacrificing simplicity if not uniformity in implementing the reform. Reported the Economist, "the central government, in negotiations with state authorities, has put forward a schedule of seven different GST slabs ranging from 4% for gold to 26% or more for middle-class goods, with other goods being taxed at 6%, 12% or 18%, and basic goods remaining exempt." Moreover, keeping some rates high, warned the magazine, "will threaten the GST's third big advantage, of bringing business into the formal economy." Even this diminishing reform isn't likely to be implemented by the goal of April 2017. The rather disappointing experience, some observers fear, reduces the likelihood of other tax reforms.

Overall, the Modi government's incomplete reform program has fostered substantial frustration. Mallaby observed simply: "the results have been disappointing." Business Standard (New Delhi) columnist Shankar Acharya, who began with an optimistic view of Modi, concluded late last year: "Economic reforms have clearly lost momentum and there is a sense of drift in economic policy." The Times of India complained that "the government hasn't pressed the pedal hard on reforms" and "implementation of projects" has been slow.

Nevertheless, economic progress is evident as India ascends internationally. New Delhi rose in rankings for "Global Competitiveness" (World Economic Forum), from 71 to 55 to 39 in 2014, 2015, and 2016, respectively. However, in its ease of "Doing Business" (World Bank), India went from 142 in 2015 to 130 in 2016, where it stalled out, remaining at 130 in 2017. (The World Bank reported that little progress was made in starting a business or registering property; access to electricity was much improved, while there had been backsliding in dealing with construction permits.) On the "Corruption Perception Index" (Transparency International) the country went from 85 in 2014 to 75 in 2015; the 2016 rankings have not yet been released.

Modi's government proudly points to continuing high growth rates. However, many economists believe that estimates have been inflated because of changed methodology. In August Shilan Shah at Capital Economics figured rates were more likely 5.5 to six percent than seven percent.

Moreover, in September the Asian Development Bank warned that growth had been driven by government spending; private investment was "listless" and manufacturing growth was down this year. In fact, economists at the Reserve Bank of India warned that the nation's growth rate may have peaked as the country relied on an increase in low productivity labor. India's per capita GDP growth dropped in half between just 2011 and 2014, and is well behind that of China. India still has substantial growth potential, but economic reform is necessary to make it real.

Yet today the country remains convulsed by Modi's decision to order the elimination of large bills, 86 percent of the nation's cash, without having replacement currency available. The consequences for this cash-based economy have been predictably chaotic, as people lacked money to conduct business, pay household expenses, provide wedding gifts, get medical treatment, and otherwise handle their affairs. In many areas supply chains broke, companies closed, and firms sent employees to stand in bank lines, thereby bringing "the economy to a halt," as Barun Mitra of the Liberty Institute explained to me. Economist Kenneth Rogoff called the impact "catastrophic." Yet analysts figure it will be weeks before limits on bank withdrawals are lifted and months before the withdrawn currency is fully replaced.

Kalraj Mishra, Minister for Micro, Small, and Medium Enterprises, dismissed business losses as "nominal and temporary," and predicted "industrial momentum will be back" as soon as sufficient currency is restored. However, HSBC's Pranjul Bhandari predicted that the currency debacle would knock as much as a two percent off of growth in the last quarter of 2016 and first quarter of 2017. Goldman Sachs cut its overall growth estimate for 2017 by 1.5 percent.

Unsurprisingly, while "India Summit 2016" acknowledged New Delhi's efforts, participants paid much more attention to the many problems that remained unresolved. For instance, reported the event summary, to promote a mobile-internet services necessary is "sound regulation that makes payment systems easier, enables improvement sin information and communications technology infrastructure and reduces red tape. Complex land and labor laws will also need an overhaul."

The latter is critical. Conference participant Suraj Saharan of logistics start-up Delhivery, which employs thousands of Indians, complained of "insane laws and regulations." Derek Scissors of the American Enterprise Institute warned that such restrictions "essentially guarantee mass underemployment and an India that, unlike its neighbors in East Asia, cannot benefit from global demand for manufactured goods." The requirement that firms with at least 100 employees receive government permission to cut employment causes companies to rely on temporary workers or stay small. Yet the latter denies companies economies of scale.

Alas, the Modi government has done very little in this area. One unnamed BJP official told the Telegraph: "Look, if it's a conflict between a corporate entity and its workers, we have to be on the side of the workers. We are a political party." No matter, apparently, what actually is in the interest of the workers, and everyone else. The only reason laborers do as well as they do today is because of the 1991 reforms.

Moreover, observed Aiyar: "With almost no exceptions, the delivery of government services in India is pathetic, from the police and judiciary to education and health. Unsackable government staff members have no accountability to the people they are supposed to serve, and so callousness, corruption, and waste are common." On most every reformer's wish list is modernizing the sclerotic legal system, with a backlog of 31.5 million cases, some of which take decades to resolve. Education reform is desperately needed: half of government schools teach little since rampant teacher absenteeism discourages student attendance.

Public-sector banks possess 70 percent of total assets, but nearly a fifth of their loans are "stressed." Much more needs to be done to restructure the debt and revamp the entire sector. Explained Mallaby: "Rather than pulling the plug on deadbeat borrowers, banks are drip-feeding them with new loans to cover up the fact that the bankers blundered in lending to them." Sustaining such economic zombies, which mimics Chinese policy, prevents potentially successful firms from getting capital.

Politicians keep electricity prices low. Public power companies lose millions of dollars daily while failing to provide service to a fifth of India's households. Half of manufacturers suffer significant power cuts weekly. Said Archarya: "The electric power sector continues to be crippled by the massive losses and outstanding dues of state electricity boards." The heavily used transportation network is inadequate and poorly maintained. Disproportionate reliance on roads results in higher logistical costs than in countries such as neighboring China. The Modi government has made progress in both areas, but much more needs to be done.

Overall the National Institute of Public Finance and Policy figured that subsidies run an incredible 13.4 percent of GDP. The benefits include, in Aiyar's words, "a bewildering variety of freebies given by various state governments," and many go to the wealthy. Modi said he plans to rationalize and target subsidies rather than end them, yet Acharya noted "little progress."

Privatization has lagged. Economist Mohan Guruswamy of the Center for Policy Alternatives complained: "No one wants to take hard decisions because they're worried about winning elections." Even after Modi's triumph, he explained, "The notion of liberal economics has never sunk in in India. There is still a distrust of private capital and foreign capital, and a consensus on state control of industries that cuts across parties. People still want a lifetime of employment, a lifetime of assured income."

The Los Angeles Times reported on government-owned Hindustan Photo Films, which no longer produces anything but has lost hundreds of millions of dollars in recent years taking out loans to pay its staff. More than a decade ago the central government decided to close the obsolescent film-maker, but the company lives on. Reported the Times: "Even today, as India becomes the fastest-growing major economy, the public sector still dominates major industries such as oil and mining, and the number of state-owned enterprises has risen by 70% since 1990."

Corruption remains a serious problem. However, Modi responded in November by withdrawing most of India's money. Cash deposited in banks that had not been previously accounted for is subject to a 50 to 85 percent confiscation rate. Complained Barun Mitra, the move was "the single biggest assault on private bank accounts, on the presumption that everyone is corrupt unless they can prove their innocence."

Yet the cause of corruption is not cash. Rather, Dixon and Vats noted that the "informal status" of businesses "has often made them subject to vast public-sector corruption, bribe solicitations, raids, confiscations, and evictions." Modi should have concentrated on deregulation and legalization of the gray, or informal, economy, which employs an incredible 90 percent of India's workforce. Aiyar pointed out that "areas that were comprehensively liberalized [in the past] saw the disappearance of corruption." The other problem, noted Reason magazine's Shikha Dalmia, is that tax rates "are way higher than what people think their government is worth" and Modi has yet to remedy that imbalance.

The prime minister still has time to act, but more state elections approach and the national poll must be held by 2019. As the latter nears he is even less likely to make major changes, sacrificing his nation's great potential. Acharya worried: "economic reforms seem to be on the slow train, while good old fiscal populism is alive and flourishing. Against the background of a slowing world economy and slumping exports, this does not bode well for India's economic growth and job-creation."

Unfortunately, the economy is not the only issue requiring Modi's attention. Hindu nationalism has expressed itself more violently after the BJP's triumph. Most recent have been mob attacks on Muslims, including some allegedly involved in transporting or eating beef. Christians, a much smaller religious minority, also routinely suffer violence at the hands of Hindu radicals. Observed the U.S. Commission on International Religious Freedom: "Despite the country's status as a pluralistic, secular democracy, India has long struggled to protect minority religious communities or provide justice when crimes occur, which perpetuates a climate of impunity."

Although the Modi government has not directly encouraged such outbursts, in last year's Bihar election the BJP pandered to religion and caste. Moreover, Modi was implicated in anti-Muslim riots when chief minister of Gujarat and as premier has said little about sectarian violence against India's most vulnerable populations. Such attacks hurt all Indians by discouraging foreign investment, offending the concerned and scaring the nervous.

Perhaps Modi's greatest success has come internationally. He appears to prefer the global stage to the grubby battle for domestic reform. Nevertheless, a more prosperous economy would improve India's international standing. Better relations with China and Pakistan could help reduce commercial barriers in a region which lags in economic integration. And the incoming Trump administration, which appears set on confrontation with Beijing, may welcome closer ties with India. Increased trade and investment would benefit both nations. The Washington Post observed that "Two decades of India's information-technology success and the large pool of English-speaking engineers have created a fertile ground for e-commerce companies and innovative tech start-ups. The number of angel investors and venture capital funds is mushrooming."

India is poised at the cusp of international greatness. But this entrepreneurial people continue to be hampered by enervating regulations and bureaucracies. If Modi wants to secure his legacy and, more important, liberate his people, he should implement decisive and far-reaching reforms. Argued Aiyar, "to become a high-income country, India must liberalize the economy much further, improve governance, and raise the quality of its institutions." This means choosing tough solutions over tempting panaceas. Parth Shah of the Centre for Civil Society listed some of the choices for me: free markets versus "pro-business cronyism," institutional reform versus government plans, and liberty versus "imposed discipline/moral purity."

Some Indian officials act like their nation's success, which includes surpassing China's economic growth and becoming a global power, is guaranteed by manifest destiny. However, warned Alok Sheel, an economic adviser to the Indian state of Kerala, "unless India successfully introduces productivity reforms and opens its markets, this 'destiny' will remain a pipe dream."

The 21st Century could be the Indian Century, rather than another American Century or the Chinese Century. But India's ascendance requires courageous political reforms by the Modi government now, not by some hypothetical reform administration years or decades in the future. To miss the opportunity today may be to miss much more for years to come.

Doug Bandow
