In my last column, I argued that a falling rupee is not a major economic problem for India, and neither is a widening current account deficit (https://goo.gl/qdWRXx). Of course, a freefall in the rupee or a massive current account deficit would be more serious. But in any case, they would both still be symptoms of other, underlying issues. I also previously argued that Indian policy needs to focus on long-run growth. As long as short-run fluctuations are not so large or rapid that they are disruptive, then macroeconomic policy should not get derailed by focusing on short-run symptoms.
If we think about the sources of economic growth, then investment is a fundamental variable, whether in people, knowledge bases, institutional capacity or, most obviously, physical capital. The efficiency of the process whereby savings are generated and channelled into productive investment is at the heart of successful and sustained economic growth. This is so obvious that it is easy to take it for granted, but focusing on this point draws attention to India’s biggest economic problem.
Over the more than two decades of reform, India has made considerable progress in removing unnecessary and inefficient controls on international and domestic trade and investment. It has slowly improved the functioning of its tax system, management of public finances, and monetary policy. These all still have room for improvement, but India’s biggest economic problem is in the efficient allocation of capital. Bad loans in the banking sector have been one symptom of this problem.
The latest example is the crisis at Infrastructure Leasing and Financial Services (IL&FS), which has defaulted on some of its debt obligations. What these cases have in common is long-term lending for large projects, which are subject to high risks, because of their scale and their length of gestation. In the case of bank loans, Pronab Sen has argued convincingly (in Ideas for India) that banks were pushed by government in the direction of longer-term loans for fixed capital investment, and away (at least in relative terms) from working capital and household loans, but without the development of the needed internal expertise required for assessing the most challenging type of lending.
Writing about the IL&FS fiasco, which unfolded with remarkable speed, Ila Patnaik (in the Indian Express) has noted the failure of India’s government to create a regulatory framework that would be sufficiently comprehensive to detect incipient problems in systemically important firms such as IL&FS. But there are other contributors as well, to this mess. Clearly, poor corporate governance is a major culprit. This includes financial intermediaries such as banks and non-bank financial companies, but also the firms that do the borrowing. There can always be mistakes in making investment decisions, or unforeseen circumstances that make an ex ante sound decision into a loser. But in India’s case, there also seems to be a too-common problem of skimming funds, whether by business borrowers or politicians who also want their cut. Sometimes the two groups overlap.
So India’s biggest economic problem is incompetence and malfeasance in the allocation of capital. As the economy has liberalised, and the financial sums at stake have grown dramatically, the problem has mushroomed. There are several fixes needed for this problem, and all of them have to be attended to, because the financial system will only be as strong as its weakest link.
Pronab Sen has suggested that Indian banks be given more freedom to tap bond markets for funding longer-term loans. This will allow markets to send better price signals about bank portfolios. Indeed, there is a desperate need for a corporate bond market in India that will allow firms to borrow more directly from savers. And this does not stop at long-term borrowing—working capital and other short-term borrowing can also benefit from new market platforms.
As financial markets are broadened and deepened, the demands on regulators increase, and India needs to step up here as well. India’s financial system regulatory architecture also needs to be broadened and deepened. This involves not just external oversight by regulators, but insistence on strong corporate governance, with greater disclosure and transparency. Auditors and rating agencies also need to step up and do their jobs better. The government can help this along by raising and enforcing standards for these private sector monitoring institutions, as well as encouraging greater competition in these arenas.
At India’s stage of economic and institutional development, kleptocracy in the private and public sector, which is most lucrative for large-scale, long-term investments, is the country’s biggest economic problem.
No country is able to eradicate this problem completely, but those that can contain the problem are the ones that grow the most sustainably. The problem is politically more difficult to solve than improving fiscal policy or monetary policy, and many countries never deal with it adequately. The first step is identifying the problem and prioritising it.
The second step has to be many (a hundred?) small steps of opening financial markets, building regulatory and monitoring institutions, and increasing competition. Short-term fluctuations in the exchange rate, or blips in the current account deficit are a diversion from the important and difficult task of improving the allocation of long-run capital.