Column: Reforming factor markets

Written by Sajjid Z Chinoy | Updated: Jun 20 2014, 05:32am hrs
In many ways the recent election was historic, with record turnout and the first single-party government in a generation, defying what political and social scientists have been saying for years: that Indias pluralism would translate into coalition governments till the eye can see. But despite that, political capital is not infinite, given that the government needs to work closely with the states and build alliances in the Upper House. Therefore, the government will have to carefully pick its hits in the first year.

Yesterday we focused on the need to tackle food inflation and the importance of jumpstarting coal production and debottlenecking land constrains to drive the capex cycle. Today we focus on something even more fundamentallabour reformsand conclude with the opportunities and risks posed by the upcoming budget and monsoon.

The motivation for revisiting labour laws is obvious. There are concerns that India has recently experienced jobless growth. One explanation for this is that despite having an abundance of unskilled labourIndias comparative advantageIndian firms have expanded largely in capital-intensive sectors (engineering goods, pharmaceuticals) or used excessively capital-intensive technologies in other sectors, resulting in a sub-optimally low utilisation of labour. Labour laws are deemed a key culprit. By making firing, and therefore hiring, difficult and introducing other rigidities they have essentially bid-up the relative cost of labour, and induced firms into operating at sub-optimally high (from a societal perspective) capital-intensive technologies.

Professors Jagdish Bhagwati and Arvind Panagariya effectively demonstrate how the textile industry, for example, is littered with small firms in India because labour laws have constricted expansion, and therefore from realising economies of scale, increasing productivity and competing on the world stage. Almost 93% of workers in the labour-intensive textile industry are employed in firms employing 49 workers or lessin large part due to labour laws. In contrast, more than half of Chinas textile workers work in firms with over 200 employees!a far cry from Chinas size distribution (Page 134, Indias Tryst With Destiny, by Jagdish Bhagwati and Arvind Panagariya).

But a glimmer of hope is finally emerging. Recently, the Rajasthan government amended three important lawsIndustrial Disputes Act, Factories Act and Contract Labour Actto make hiring and firing of employees more flexible. However, the laws fall on the concurrent list and need Presidential (not legislative) approval. If they do secure it, this could serve as a powerful demonstration effect to other states, who may also be induced into liberalising laws for fear of losing investment to states that reform.

The first budget: Opportunities and trade-offs

Next months budget will be the new governments first major policy statement, providing an opportunity to lay out its vision. But it also involves trade-offs, and therefore will reveal what the governments near-term priorities are.

On the face of it, the budget involves two, potentially conflicting objectives. First, it will be important to persevere with fiscal consolidation. To its credit, the previous government reined in the deficit the last two yearsachieving a 1.2% of GDP cyclically-adjusted consolidationin a period of low growth and populated with elections. This, in turn, was a critical prerequisite to restoring macroeconomic stability. Its important that this signal be sustained.

But simultaneously, its equally important to jumpstart the capex cycle by boosting public investment and recapitalising public sector banks. Civilian capex off the budget has fallen to worrying levels. With balance sheets in infrastructure still stretched and banks still handicapped by elevated NPAs and restructured loans, creating some capex momentum through public investment is critical.

So how does the budget simultaneously achieve, say, a 0.5% of GDP boost to public investment and simultaneously consolidate by 0.4% of GDP, as per the interim budget There is some space to rationalise urban subsidies but an aggressive rationalisation of rural subsidies or welfare programmes will be tricky given a sub-par monsoon.

The key, therefore, is disinvestment. The sharp rally in recent weekswith PSU equity prices rallying 55% in the last six weeksprovides an ideal opportunity for the government to accelerate its disinvestment programme and use those proceeds for infrastructure investment. As the chief minister of Gujarat, the Prime Minister has indicated a preference for making PSUs more autonomous and professional. But market discipline is another equally-effective mechanism of reaching those objectives.

Eventually, of course, the government has to find a way to achieve closure on the goods and services tax (GST), the most important fiscal reform of our time. By truly making India a common market, it will drive allocative efficiency and boost productivity growth. However, the GST will be a harder legislative slog, because it entails a Constitutional Amendment and requires a two-thirds majority in each house of Parliamentwhich the NDA lacksapart from 50% of state Assemblies. So, the government will need to build a national consensus to push through the GST.

The first test: Poor rainfall

The first real risk for the new government is a deficient monsoon. Recently, the MET indicated that there is a 71% chance of a sub-normal or deficient monsoon. Simultaneously, the likelihood of an El Nino, though mild for now, is pegged at 70%. The last time India suffered from an El Nino in 2009, the similarities were eery. The METs first two forecast of the monsoon were 95% and 93% of its long-term averageexactly what they have predicted this year. As it turned out, actual rainfall was only 79%.

A deficient monsoon would impart a stagflationary shock to the economy. Agricultural production would suffer and drag down rural incomes and consumption. Simultaneously, food prices would be pressureddepending on the severity of the shock and the nimbleness of the policy response. In 2009, for example, food inflationwhich was already at 10% in the year leading to the deficient monsoonsurged to 17% the year after. Moreover, given the wage-price spiral in the rural economy, this pushed up wages and resulted in a more generalised inflation spiral. And there will be fiscal implications, too. Automatic stabilisers like MGNREGA will kick-in, growthand therefore tax collectionswill suffer, and it will be harder to rationalise rural subsidies. But how effectively the government responds will be critical to dampening or propagating the initial impulse.

Putting it all together

The out-turn of the elections offers

Indias new government a unique opportunity to push through the next generation of reforms. But political capital is not infinite, and it is hoped and expected that the government will put its weight in the first year behind one or two key areas (food inflation, land, coal) rather than trying to be all things to all people.

The early signs are very encouraging. The government has sounded all the right noises and appears ready to tackle the big problems. But July will present the first real tests for the new governmenta budget with trade-offs and a potentially-deficient monsoon. That said, we could be at the cusp of a structural-break in policymaking. Stay tuned.

(Concluded)

Co-authored with Toshi Jain, JP Morgan

Chinoy is chief India economist, JP Morgan