Financial sector reforms have to be governed by the goal of increasing the flow of funds to productive and efficient firms, those which can create good jobs by investing well.
Development cannot occur without increasing the productivity of labour, and that is what creating “good” jobs means. To achieve this on a large enough scale to make a sustained difference for India’s population, new firms have to enter and existing ones grow, in labour-intensive manufacturing. This can include not only traditional labour-intensive products, such as apparel, leather products and toys, but also (at least the assembly stages of producing) electronics items, which can include medical devices and sensors, as well as communication and computing devices.
Being able to export such goods promotes quality standards and allows for greater economies of scale. This is part of the logic for coastal economic zones (CEZs), discussed in my recent columns. There, I also noted the need to invest in labour, enhancing what economists call human capital. CEZs involve a kind of public private partnership in creating economic regions that are insulated from the institutional and infrastructure failures or shortcomings of the rest of the country. The idea is that geographic concentration can allow this to be achieved in ways that are not possible for the country as a whole.
CEZs become a kind of “growth pole,” a term coined by French economist Francois Perroux many decades ago, although he thought of it in abstract terms, not connected to geography. I first heard of the idea from Mrinal Datta-Chaudhuri, when he headed the Delhi School of Economics, and regularly threw out important ideas during tea and coffee breaks, as well as in lectures. Growth poles also are related to ideas of forward and backward linkages, and, in their geographic version, to economies of agglomeration, which come from local spillovers of knowledge and experience.
We have known of these ideas for decades, and seen them successfully implemented in China, so what have been the obstacles in India? Poor governance and policy barriers to the creation and growth of firms have been part of the problem. CEZs can help on these fronts. Another obstacle is a natural one in a poor country, and almost defines being poor—a lack of capital. Among the early industrialisers in East Asia, high savings rates supported high investment rates.
In China’s case (and also in some other East Asian successes), foreign investment also played a role, along with high domestic savings. A rule of thumb might be that double-digit growth requires investment rates pushing towards 40%. In the early years of this millennium, India seemed to be moving in this direction, and double-digit growth seemed attainable. Since then, after the financial crisis, savings and investment rates have fallen, and growth rates have as well.
What happened? We know that banks made many loans that were probably not well-justified, and we now have a serious problem of non-performing or distressed assets on banks’ balance sheets, and corresponding problems in corporate sector balance sheets. This has inhibited new lending and new investment. The government has slowly (maybe too slowly?) dealt with the problem, by creating a plan to recapitalise public sector banks (the source and home of the major part of the lending disaster), and introducing new laws and regulatory mechanisms for managing insolvencies and bankruptcies of distressed firms.
A recent analysis by Rajeswari Sengupta and Anjali Sharma of IGIDR suggests that an ordinance on implementing bankruptcies may be too restrictive, being driven by morality rather than commercial considerations. One does not want to encourage future moral hazard, but the current situation calls for flexibility. In particular, forcing firms into liquidation rather than restructuring may destroy valuable organisational capital. The trick is to allow efficient firms to develop and flourish, whether they are reorganised or built anew.
Perhaps, the bigger problem is in the financial sector itself. If firms that are likely to use capital poorly can keep getting funding and survive, they crowd out those that could be long-run creators of good jobs. If public sector banks cannot be privatised, and are unlikely to become more efficient in their lending and monitoring, part of the answer may be allowing more private sector banks to form, and allowing them to grow faster. Other sources of finance are also important. Foreign direct investment can bring in capital bundled with knowhow.
Better technology platforms for financing of smaller enterprises, whether for startups or ongoing firms, can overcome shortages of capital that hinder the vast majority of Indian firms. The stock market in India was revamped almost overnight over two decades ago, allowing efficient trading of shares of listed firms. But this is a tiny part of the financial sector. More policy attention and rapid reform is needed for creating better channels of capital allocation.
On the savings side, the recent report of the Ramadorai committee on household finances ought to be a landmark guide for policy reforms that will help channel household savings into financial instruments, and ultimately into productive investment by firms, rather than being unduly concentrated in gold and real estate. Financial sector reforms cannot be restricted to CEZs, so require more political will. CEZs are designed to bypass political obstacles. The key idea here is that financial sector reforms have to be governed by the goal of increasing the flow of funds to productive and efficient firms, those which can create good jobs by investing well. This seems to require more and more urgent attention than it may be receiving.
The writer is Professor of Economics University of California, Santa Cruz. Views are personal.