Not by babanomics

Indian Express, 22nd January 2014

Tax reform is a serious issue. Transaction tax is a bad idea.

In a recent speech, Narendra Modi said that India needs tax reform. The BJP is reportedly evaluating various reform proposals to include in its manifesto. It is important to evaluate these on the basis of both economic theory and international experience.

The most prominent proposal on tax reform is the one supported by Baba Ramdev. He has proposed a tax on all bank transactions. According to the proposal, such a tax will eliminate "black money". Money is considered "black" only when the payment of taxes has been evaded. Under a transaction tax regime, evasion is technologically impossible because the bank will be responsible for the collection and payment of taxes, which will take place electronically. Such a tax is supposed to be simple - with little cost of collection, no filing of tax returns and no possibility for evasion.

By implementing this proposal, it is argued that India can get rid of all the complicated taxes it has at present. There will, however, be no taxation of cash transactions because it will be difficult to implement. To ensure that people do not start transacting in cash alone, it is proposed that Rs 500 and Rs 1000 currency notes should be demonetised.

Why is this not a good idea? Transaction taxes are often referred to as "sand in the wheels". They are meant to discourage certain kinds of transactions. The original "Tobin tax" on currency market transactions was intended to reduce the magnitude of currency trading turnover. Those who argue for transaction taxes do so on the grounds that they will reduce transactions. In other words, it is well understood that when the government starts taxing certain kinds of transactions, people move away from them towards other kinds of transactions. If one method of making payments involves being taxed, people will choose other methods.

Transactions on the street will shift to dollars, gold, bitcoins and other unexpected things. For example, bottles of Tide detergent are reportedly popular as a currency in underworld transactions in the US because they are untraceable. Cigarettes can be used for small transactions. A one cubic centimetre piece of gold weighs 19.1 grams and is worth approximately Rs 56,350. These could be used for larger transactions. This would result in the further decline of the Indian rupee as a trusted vehicle for the storage and transportation of value.

Commentators have highlighted that the international experience of transaction taxes shows that they do not support revenue collection of more than 2 per cent of the GDP, and even this declines over time. Most countries have given up on transaction taxes. Such taxes do not yield the 10 per cent of GDP that even a minimal government, such as the one that Modi is said to want to oversee, will need as revenue.

But lest it be thought that this tax is only dysfunctional in foreign lands, let's take the example of an Indian transaction tax - the stamp duty. If property is bought or sold, a set percentage of the value of the transaction is supposed to be paid as tax. Only if the transaction takes place through the banking system is it recorded, necessitating the payment of the stamp duty. So what do people do? They transact partly in cash. This part of the transaction is unrecorded and therefore the tax on it is not paid. Of course, this is illegal - the amount that is declared as the value of the transaction for the property is less than what it actually is and duty is being evaded. Does the inconvenience of counting, transporting and paying in notes of, say, Rs 500 prevent this cash transaction from taking place? No, it does not. In fact, in the real estate sector, it is difficult not to transact in cash. Tax evasion has become the norm. This has numerous downstream consequences - a network of illegality in real estate, weakness of the property tax, etc. Public finance experts believe that stamp duty should be eliminated to reduce black money in real estate.

Rather than encourage compliance, the stamp duty incentivises people to move away from the formal economy. With the proposed banking transaction tax (BTT), this is likely to become the norm for the bulk of the economy as there will be a "stamp duty" on all transactions routed through the banking system.

The dream of getting rid of myriad tax collectors is a good one - but it requires a great deal of action at the level of state governments, which have their own tax administrations. A constitutional amendment is needed to take away the taxation powers of states. The negotiations of the empowered group of state finance ministers regarding the GST - one of the few truly good ideas in tax policy in India - have been a long saga over the 2004-13 period. How will all state governments ever be persuaded to abolish their taxes in return for a slice of the BTT?

No country in the world has eliminated all taxes and replaced them with a BTT. If a government wishes to reform India's tax system and reduce evasion, there are better ways to do this and simplify the system. The right strategy combines a flat low rate of income tax on individuals with an EET (exempt-exempt-taxed) treatment of savings, a removal of myriad exemptions, a clean and simple GST and the removal of most existing taxes so that we end up with exactly two taxes - an income tax on individuals and a GST on firms. Many expert tax and public finance committees have recommended this based not just on rigorous economic theory, but also on international evidence. Tax reform is an important and serious issue and can have a huge impact on economic conditions in India.

Same old banking

Indian Express, 14nd January 2014

The RBI's mandate-driven approach has constricted financial inclusion

A Reserve Bank of India panel has submitted a report on financial inclusion. It proposes that priority sector lending by banks be raised and that banks be mandated to open accounts for every adult Indian by January 2016. The recommendations do not challenge the RBI's basic approach to financial inclusion. This approach, which has been to mandate banks to undertake financial inclusion, might have spread public sector bank branches in rural areas for some years, helped open bank accounts and directed credit, but it has stopped yielding results. What India needs is a new approach, which encourages competition and innovation, rather than more mandates.

India's approach to financial inclusion has been bank-centric. So far, it has focused on bank nationalisation, continued with government ownership of banks and their recapitalisation. The way to ensure inclusion has been priority sector lending, which mandates that 40 per cent of each bank's lending be to weaker sectors - small-scale industries, agriculture and exports - to which the bank might not have lent otherwise. The RBI panel now recommends raising this share to 50 per cent.

The panel's recommendations are in sync with the RBI's recent guidelines for the grant of licences to new banks. These require that the bank have a plan for financial inclusion and that it open 25 per cent of its branches in unbanked rural areas. This approach is similar to the one that required PSU banks to open rural branches. By once again mandating financial inclusion, this time for private sector licence applications, instead of focusing on competition and innovation, the RBI is essentially doing more of the same.

Financial inclusion may be defined as access to a range of financial services in a convenient, flexible, reliable and continuous manner from formal, regulated financial institutions. Even though access can be ensured by mandates, the quality parameters of access may be compromised in the process. This is seen in the low usage of accounts and the poor asset quality of priority sector portfolios. Such inclusion confuses ends with means. A bank account is meant to fulfil certain functions - simply opening an account is not enough. The panel proposes to make it mandatory for every Indian over the age of 18 to have a bank account.

An often overlooked consequence of the mandate-driven approach to inclusion, as pursued by the RBI, is that the costs of this inclusion are levied on the investors and consumers of banks. The losses from unused bank accounts and poorly performing priority sector assets are eventually borne by the investors and consumers. If the political objective of opening bank accounts is to be met, or lending to certain sectors ensured, it should be transparent as a line item on the government's budget. Instead, it is done through a cross-subsidy that effectively makes other customers pay for the political goals of a government pushing its agenda through banks.

This approach has been accompanied by a neglect of the other drivers of inclusion - competition and innovation. In the last 11 years, the Indian economy has grown rapidly, but no banking licences have been given in this time. The trend has been that once a decade, the RBI decides to give a few licences, but there is no window to get licences during this period. The incumbent banks feel little or no pressure to reach out to unbanked areas and people with their services. This, in turn, necessitates a mandate-driven approach to financial inclusion. Despite decades of RBI mandates, rural customers turn to informal channels and unregulated financial firms.

As part of the RBI's bank-centric approach, there are regulatory and entry barriers to prevent bank-like institutional mechanisms from competing with banks. For example, money market mutual funds, a viable alternative to bank deposits and popular in countries such as the US, are not allowed to issue cheques by the RBI, which also regulates the payments system. This reduces competition to banking. These barriers help generate complacency among banks and curb the extent to which new business models emerge.

The mandate-driven approach to financial inclusion has also been a key hindrance to innovation. The RBI has emphasised specific quantitative targets, such as priority sector lending or opening bank accounts. Lately, appointing customer service providers has been added. A consequence of these mandates is that the rural business departments of banks are too busy trying to meet the targets to spend time and effort in actual innovation that serves the consumers.

A comprehensive change in regulatory philosophy is required to bring about meaningful financial inclusion in India. This would entail a shift from the present bank-centric, mandate-driven approach to an emphasis on competition, innovation and consumer protection as the pillars of regulatory philosophy. The Financial Sector Legislative Reforms Commission has recommended an approach to financial regulation that is based on these three pillars.

To encourage competition, the RBI should not decide the optimal number of banks for the country. Bank licences should be available on tap, based on reasonable eligibility criteria. The RBI should also permit the emergence of new business models in banking, non-bank lending and payments. An increase in competition should encourage existing banks and newcomers to explore opportunities beyond the markets that have already been served.

The second pillar is allowing innovation to happen. The RBI's present approach prohibits innovation until it is expressly permitted. This approach has led to delayed innovation across all products and processes. For example, the business correspondent model, which enables the delivery of banking services through low cost agents, was introduced more than a decade after it made headway in comparable emerging markets. The RBI must shift to an approach that allows innovation to happen and then responds with proportionate regulations.

Increased competition and innovation must be accompanied by consumer protection, acknowledging the imperfections in financial markets. The idea of financial inclusion must not be limited to getting access. This access must help consumers use finance in beneficial ways, with the regulator protecting them from unfair contracts and terms.

Consumer protection also translates into proportionate regulation to maintain the safety and soundness of financial service providers. A bank or an insurance company must be managed prudently enough to minimise the probability of failure. The failure probability need not be zero, for that would lead to excessive conservatism. Once in a while, when a financial firm fails, it should be resolved in a manner that entails the least pain for the consumers.

India needs a new approach to financial innovation and it is time the RBI realised that more of its mandate-driven approach is not the solution.

Regulator, not planner

Financial Express, 11th January 2014

The UPA's political agenda of inclusive growth through rights and entitlements is now being carried forward by the banking regulator, RBI, which has taken upon itself to give India growth with a human face. The central bank will now seek to become the central planner. The committee on comprehensive financial services for small businesses and low income households, headed by Nachiket Mor, has created a utopian vision of a world where rights and entitlements go even beyond what the National Advisory Committee came up with, to extend to a right to bank accounts and other financial services.

The panel's report lays out a vision that is so precise and detailed that it reeks of central planning. The report has a vision statement around each type of financial service. Coverage targets are given along with dates and timelines extending to the next few years. For example, the panel says every Indian resident above the age of 18 should have a bank account by January 1, 2016. The credit-to-GDP ratio in every district of India is envisaged to grow to 10% by January 01, 2016, then growth at 10% per annum and reach 50% by January 02, 2020. The report says that by January 10, 2016, each district would have a total deposits-and-investments-to-GDP ratio of at least 15%. This ratio would increase every year by 12.5% with the goal that it reaches 65% by January 1, 2020.

Not suprisingly, the panel recommends that RBI issue a circular indicating that no bank can refuse to open an account for a customer who has adequate KYC, which specifically includes Aadhaar. A bank would not have the choice to refuse opening accounts, even if its business model does not permit it to do so. The panel does not say what this inclusion will cost the system. Neither does it say who will pay this additional cost. Will it be the government whose political objectives it seeks to meet, or will it be other customers, the borrowers who will pay higher interest costs and the depositors who will receive less interest? Is it in the interest of bank customers to have these costs imposed on them, or, it is it cross-subsidisation without a political mandate?

The costs imposed are effectively taxes. The opening of accounts and other intrusive, distortionary recommendations flow directly from the utopian vision. In most markets, and especially in financial markets, central planning distorts the incentives in a manner that does more harm than good. It is not RBI's job to pursue this political agenda. The panel has confused RBI's role in the financial system. It seems to have assumed that RBI is not a regulator, but the owner and planner of the entire system. It also seems to have assumed that RBI has some God-given mandate to ensure redistribution from some consumers to some other consumers.

The forum for redistribution is Parliament, which is the place where competing welfare objectives are assessed. If the committee indeed believes that right to banking is such a fundamental right, it should have drafted a 'Right to Banking Bill' and submitted it to the government, with a recommendation to place it in Parliament. Parliament will approve expenditures to pay for the right to food. It needs to do the same with the right to banking. The report builds upon RBI's approach to the financial sector so far. RBI has tried to achieve greater financial inclusion, but with little real success. Priority sector lending targets have existed for decades. In the recent years, RBI has come up with more mandates for banks to open bank accounts, which remain largely unused. RBI has done central planning and redistribution. This report doubles up on that approach.

The panel has made the classic central planner's mistake of confusing ends with means. The kind of vision it has enunciated might lead to access in name only, but little functional consequences for the consumers. This is how the government has done things in India for a long time, and it has not worked. The government sets a simplistic goal, even in markets for complex services, and then goes on to centrally plan the process that will lead to the goal. The root of the problem in setting such goals, which inevitably lead to the logical next step: central planning. This is fundamentally different from saying that the government (in this case, the regulator) will fix the problems that might be preventing the market from achieving the desirable outcomes.

The same problematic vision is reflected in the report's treatment of different stylised business models of banking. It outlines certain business models, and then goes on to identify what each can do for financial inclusion. There is nothing wrong in such analysis as long as it is an academic exercise. In the hands of a central planning regulator, this thinking can be a recipe for disaster. It is impossible to foresee what the different business models might achieve. Placing them in cubbyholes, which lead to further restrictions is a bad idea. It would have been much better had the committee recommended that RBI open its doors to different business models, and impose risk-based regulations on each.

There is a strong focus on attaining financial inclusion through extending the reach of banking networks. This 'bank-led' crusade of RBI clearly stems from a gross misunderstanding of the demand-side requirements of financial inclusion and access. India is a heterogeneous country with large variations in people's preferences. Instead of evaluating the efficacy and failures of past financial inclusion efforts, which have also centered on banks, the panel assumes having more banks and more savings accounts will lead to better outcomes.

The panel is not satisfied with merely using banks for purposes of savings and resource mobilisation; it goes a step further and recommends creation of 'payments banks' within banks which enables bundling of 'universal payment services' with 'universal bank accounts'. Global experience, be it from the United States or Kenya, suggests that banks based on legacy systems are both inefficient and unconcerned about delivering low-value payments services to their customers as it does not make much business sense for them. Our own experience with the still-birth and the lack of transactions on the bank account dependent Immediate Payments Service (IMPS) started by the National Payments Corporation of India (NPCI) seems counter-intuitive to the 'payments bank' suggestion made by the report.

In summary, inclusion is a political agenda and the job of the banking regulator is not that of a political authority, but of a regulator that protects consumers and focuses on the safety and soundness of the banking system.

Constricted by law

Indian Express, 2nd January 2014

APMC acts impair the freedoms of farmers and consumers.

Rahul Gandhi has announced that fruit and vegetables will be removed from the list of commodities under the agricultural produce marketing committee (APMC) acts in Congress-ruled states. This is an important move towards the freeing-up of markets, and will bring in competition and remove barriers to entry. It is expected that the de-listing will reduce the prices of fruit and vegetables in the long run and encourage investment in cold-storage facilities and warehouses. If the government wishes to reform agriculture and control food inflation, the reform should not stop here.

APMC acts were passed by states during our socialist past. They restrict whom farmers can sell to, who can get a licence to buy produce, and where trading can take place. This has given rise to a system with substantial barriers to entry in the trade of agricultural products. The freedom of farmers and other citizens to buy or sell as they like has been abrogated - farmers are forced to sell to traders who hold APMC licences at APMC prices.

As with many other state structures in socialist India, APMC regimes rapidly turned into rackets. Hardly 30 per cent of the mandated "open auctions" are actually open or transparent. New licences are mostly given to persons who already have shops and godowns in the prescribed market area. Shops in these areas are limited and are mostly available only to friends and relatives of existing traders. There are no transparent criteria for sale or for getting a licence. There is no time-bound application processing period during which a licence is either granted or refused. A licence is granted for a period of one to five years. Thus, the incentive for long-term investment is diminished. Regulatory capture by local trading communities is said to be the norm. These traders control the entire marketing chain, including credit, inputs, storage etc. Prices are often bundled, and there is a lack of clarity on what the exact price of the produce is, and what the interest on the credit and other items is.

These traders then sell the fruit and vegetables to wholesalers who are also APMC-licenced traders and set prices in the wholesale market. Pricing is a mark-up over costs. Various studies have identified this monopsonistic-monopolistic market structure and the lack of free entry and competition as the reason for large middleman margins. For some products, the farmer gets only 40 per cent of the price paid by the end consumer. This market structure does not permit the entry of new players who want to set up cold chains and invest in other infrastructure, keeping marketing costs high. Sometimes, the marketing cost is itself nearly a fifth of the total price paid by the consumer.

The government's approach to reform has been to try to change the APMC acts. In 2003, the Central government circulated a model APMC act and asked the states to adopt it. Sixteen states changed their acts accordingly, though only six notified the new rules under their act. The model APMC act does not solve the problem. Though it allows contract farming, it does not free up entry and exit into trading. It does not allow different business models to spring up. Some states allegedly adopted a few elements of the new act because there was a fiscal incentive to do so. The one state to strike a happy note in this bleak landscape is Bihar, which repealed its APMC act in 2006.

While the structure of this market is badly designed, it has not changed over the last decade. Then why has food inflation surged? Part of the answer lies in the change in consumption. The demand for non-cereals - particularly protein, fruits and vegetables - has increased with the increase in household incomes. When income rises, households do not just eat more rice and wheat. They graduate to a better diet and nutrition. Part of the answer also lies in the higher labour costs of production. The labour intensity of the production of non-cereals is higher than that of cereals. Estimates suggest that while it typically takes 55 man-days per hectare for the production of wheat, it takes 124 for onion, 110 for cabbage and 195 for tomatoes. Wage costs have also been rising since 2008.

While the increase in the prices of cereals because of the rise in minimum support prices has got a lot of media attention, the increase in the prices of fruit and vegetables has been relatively neglected. It's sometimes assumed that the supply has not responded to the rising demand. However, an examination of the data reveals that the production of non-cereals like eggs, meat, fish, fruit and vegetables has risen quite rapidly. It is not as if the market economy has not responded. The question is: at what price is the new production willing to come in?

The combination of high costs, a market structure with mark-up prices and the lack of suitable storage facilities has given rise to high and volatile prices. This is why removing these food items from the purview of the APMCs becomes important. This will foster entry, investment and competition in this key weak-link of Indian agriculture: the processes from the farm to the fork.

While it is good that fruit and vegetables will be removed from APMC lists, there is no reason to keep other agricultural items on them. For example, why should the freedom of the producers and consumers of dal be impaired? This calls the entire edifice of the APMCs into question. Why should all Congress-ruled states not match Bihar's modernisation by repealing their APMC acts?

Another element of the five-point programme announced by Gandhi is the use of the Essential Commodities Act (ECA) to attack hoarders. This flies against what is being attempted by bringing private players into the fruit and vegetable markets. The ECA does not permit private traders to hold food above certain quantities or for more than a certain number of days. The state usually does not have storage capacity. If private traders are allowed into trading and storage, food price volatility could decrease. The ECA has often been used arbitrarily to impose restrictions on the trade and holding of food. What we require is economic freedom and a competitive market. This will yield higher productivity in agriculture and lower prices for consumers, and requires getting rid of the APMC acts and the ECA.

Looking like a recovery

Financial Express, 20th December 2013

There are a few signs of recovery in the Indian business cycle. These include an improvement in sales and profits of non-oil, non-financial companies and increase in the dollar value of exports. The growth in dollar value of exports has slowed down in the latest available data but now that the rupee is more competitive and the US economy is recovering, if firms have the needed business environment and infrastructure, we can see further improvements and a pick up in the business cycle.

One measure of business cycle conditions in India is to look at the quarterly GDP data. Figure 1 shows the seasonally-adjusted qoq growth of real GDP at factor cost. This data shows that the last quarter (July-September 2013) is showing an upturn.

Figure 1:

However, this data includes agriculture and government spending. Agriculture has many fluctuations, but these are related to weather rather than business-cycle conditions. If an upturn in seen in agriculture then, while it does influence demand and therefore non-agricutural output, the direct effect of the monsoon on crops is not part of the cyclical upturn. If the government spends more, say because of a hike in government salaries due to the implementation of pay commission recommendations, GDP due to government services goes up. This component also can have an indirect effect on demand and cyclical conditions, but the additional spending by the government should not constitute a reason to believe that the cycle has turned. We, therefore, look at non-agricultural, non-government GDP (figure 2). This shows an upturn in the last quarter.

Figure 2:

We then look at business cycle conditions by aggregating the performance of firms. Figure 3 shows aggregate sales of all non-oil, non-finance listed firms in India. The data showed qoq growth of seasonally-adjusted nominal sales. Oil companies are kept out as the administered price of diesel and kerosene will affect their nominal sales values. Finance is kept out as the definition of sales is not fully compatible with that of other services and goods. Since the figure is nominal its interpretation should be mindful of inflation. But if the WPI is not rising, then looking at these growth rates is meaningful. The figure shows that the growth rate of sales has now been rising for four quarters in a row. This is in contrast to the situation in the last two years when sales growth continued to decline quarter after quarter.

Figure 3:

We next look at profit margins, or, the net profit (after tax) as a ratio of net sales of non-oil, non-finance listed firms

(figure 4). Conditions for investment are created only after firms see an increase in their profit margins. Here we see that in the last two quarters, profit margins have stopped declining. The data suggests that it is still too soon to say if profit margins have started recovering. We should wait and watch what happens to margins for at least two more quarters before drawing such a conclusion.

Figure 4:

What might have driven these improvements in the firm indicators? While investment indicators have stopped worsening, they are still to show a steady improvement that would be enough to push up sales. Many project clearances have been given, but most of those do not appear to have translated into action on the ground yet. It seems that a serious driver of the improvement is the improvement in exports. Figure 5 shows yoy and the three-month centered moving average of annualised month-on-month change in seasonally-adjusted merchandise exports measured in dollars. This showed a sharp increase and then a sudden slump in export growth.

Figure 5:

Looking forward, can we expect the recovery to continue? The latest US jobs data is further indicating an improvement in business cycle conditions in the US. In the period before the financial crisis, Indian business cycles were highly correlated with global ones. After the crisis, it was felt that the two had decoupled as India continued to grow when the world was slowing down. The same happened with many other emerging economies. However, lately, we have come to understand that the fiscal and monetary stimulus that was able to keep growth from falling in emerging economies has now lost most of its impact. Now that these economies have slowed down and large deficits and inflation have started hurting these economies, the question of decoupling is being revisited. So if the US economy recovers and Indian exports do well, we may expect to see the upturn continuing.

However, there are three caveats. First, infrastructure such as power can pose a constraint to further growth. While textile and leather exports have picked up they could, at some point, hit constraints posed by power availability and port capacity. This suggests that if exports growth has to continue then infrastructure issues would need to be solved. In the immediate future, there may be space capacity and we might see a sudden pick up in exports, but it may become difficult to sustain these unless those constraints are addressed.

Second, if the real exchange rate appreciates, Indian exports could lose competitiveness. This could happen because of an appreciation of the rupee or an increase in the inflation rate. Indeed, very roughly, if the inflation differential between India and the US is 8%, then an annual depreciation of the rupee of about 8% would keep the real exchange rate between the rupee and the dollar where it is today.

Third, finance may pose a constraint as many companies, especially infrastructure companies have damaged balance sheets. Banks have rising NPAs and until the financial health of companies and banks improves, fast recovery will be difficult.

In summary, we are seeing small signs of an improvement in business cycle conditions in India. Looking ahead at the next quarter, these are likely to continue. At the same time, if some of the projects that have obtained clearances start operations, there may be further signs of a cyclical upturn.

Cereal offenders

Indian Express, 17th December 2013

Food inflation owes largely to agricultural markets being regulated by outdated laws.

The RBI governor, Raghuram Rajan, has a difficult task this week. He has to decide whether to keep interest rates constant or raise them - bearing in mind the possible taper of the US Fed's bond buying programme, a decline in industrial production and a rise in inflation. The sharp increase in consumer price-based inflation, to more than 11 per cent, has significantly added to the RBI's headache. The increase in inflation is mainly due to the nearly 15 per cent increase in food prices. This has been led by a 61 per cent increase in the price of vegetables. There are structural problems in agricultural markets, which continue to be regulated by old laws and require licences. Entry into these markets is not free and they remain uncompetitive. The rising demand for food has been met not by an increased supply but by a rise in prices instead.

The demand for vegetables, meat, milk, fish and other food items has been rising with rapid GDP growth and a rise in incomes. Rural demand has increased since 2008 as a result of the MGNREGA and rising rural wages. As income levels increase, the first change in people's consumption basket is in food items. Indian households start consuming more high protein products and fresh vegetables. This phenomenon is discernible in household consumption data. The share of cereals in total food consumption has declined as incomes have increased.

At the same time, after the global financial crisis, world commodity price inflation has decreased. Inflation in tradables, mainly manufactured goods, has been low. Consequently, households have to spend a smaller share of their income on non-food items. Relatively cheaper non-food items means that the share of disposable income available for the purchase of food has gone up. This has further increased the demand for food.

As we know, Indian agriculture is entirely private. If there was free entry into markets and they were competitive, we could expect a better supply response to the increase in demand. In cereals, some of the food inflation is due to higher minimum support prices. MSPs have risen faster than before because the export of cereals is now allowed and, since 2011, world prices are taken into account in their determination. But this does not explain the rise in the prices of vegetables, meat, etc, which are outside the purview of MSPs.

A second explanation is that the MSP system for cereals creates a pro-cereal bias in policy and production. The price system as well as the subsidies for inputs focus on cereals. This reduces the relative risk of growing them. Even though the price for non-cereals - cash crops, vegetables, etc - may be higher, their risk-adjusted returns are lower.

A third explanation often heard for the high food inflation is hoarding. It is argued that traders hoard food to push up prices. But this only explains the rise in the prices of non-perishables. Products like meat and fish, whose prices have also been rising, cannot be stored without cold storage facilities. They are more likely to go bad than see an increase in prices if they are hoarded. Also, hoarding may cause some price volatility but it cannot explain the persistently high inflation for five to seven years in a row.

The lack of a supply response can also be explained by the absence of free and competitive markets, and by laws that do not allow a customer to buy directly from the farmer without a licenced mandi trader as the go-between. On one hand, the Essential Commodities Act does not allow private persons to hold inventories of agricultural goods that are on the list of essential commodities because it assumes traders are speculators, black-marketeers and hoarders. On the other, the agricultural produce marketing committee acts do not allow people to transact without them.

The APMC acts were created in the Sixties and Seventies by various states to promote agricultural marketing. But these and the Essential Commodities Act created several barriers to the development of free and competitive agricultural markets. A licence for trade in agricultural products requires owning a shop/ godown. This has led to the monopoly of licenced traders. It is a major entry barrier for new entrepreneurs who, attracted by the high returns, may want to enter the market. But the licensing system prevents entry and thus competition. Some market yards were established many years ago and these do not have the space for the construction of new shops and godowns. No new licences are available in such a situation. Traders, commission agents and other functionaries organise themselves into associations, which generally do not easily allow the entry of new players. The law hinders both food processing and direct organised retail tie-ups with farmers.

Though the question of agricultural marketing reform has been under discussion for nearly a decade, no action has been taken. In 2003, the Central government, after holding consultations with state governments, and trade and industry representatives, formulated a model APMC act. This was circulated among the states. But until January 2013, only 16 states had amended their acts, and only six had notified the amended rules.

The lack of cold storage capacities and strong supply chains are a serious cause for concern. To be rectified, investment is required. But the inadequacy of public infrastructure such as roads, power supply, etc constrain profitable investment. The thousands of crores that are spent on food storage in India actually go towards storing cereals and building warehouses for the Food Corporation of India or for the public distribution system. Even according to the most lenient estimates, the leakages here are more than 50 per cent.

Central legislation dealing with essential commodities has been liberalised to remove the controls on the movement, storage and marketing of agricultural goods and abolish the licensing system. The number of commodities covered under the act has been reduced from 54 to seven. However, in order to contain the inflationary pressure on the prices of essential commodities, the government has been imposing stock limits on paddy, rice, pulses, sugar, edible oils, edible oil seeds as and when required. At times, as we saw recently, when Mamata Banerjee announced restrictions on the trade of potatoes, even state governments have been imposing restrictions. The ad-hoc approach to the imposition of controls on stock limits and the movement of produce goes against the spirit of reforms, and hinders investment and free trade in the country.

What 2014 won't change

Indian Express, 26th November 2013

There are no more stroke-of-the-pen economic reforms, no shortcuts

That a change in government in 2014 will bring back the higher rate of GDP growth that we experienced a few years ago is an increasingly popular view. While there may be an upturn in exports, due to the recent depreciation of the rupee and the pick up in the US economy, and some improvement in domestic investment, sustaining a high rate of growth requires longer-term solutions. These solutions are not difficult, but could take some time to put in place. In the meanwhile, GDP growth may still pick up a little in 2014-15. There are two components of the slowdown: the trend growth rate and business cycle conditions. While the business cycle conditions may improve in the coming months, the trend growth rate remains a problem.

Has India's trend growth rate slowed down? Long-term trend growth rates of economies, such as a 30-year average growth rate, have been one of the least understood and most unpredictable variables in the field of economics. The accumulation of capital, human capital, institutions, rule of law, infrastructure, political systems, and productivity growth change in ways little understood by economists even today. Their impact on long-term growth remains even less understood.

Scandals in the allocation of spectrum, coal blocks and land, and projects that have been stalled due to environmental clearances have certainly worsened the medium-term growth rate. But if these factors affect the long-term trend it implies that India does not have the institutions it needs to solve these problems. Despite all the gloom and doom, this is a view that is hard to find. One of the characteristics of Indian democracy is that even though it takes time to build the state's capacity, which is one of the biggest challenges that needs to be surmounted in order to deal with the issues of the day, it is not impossible to do so.

Recent problems have highlighted the limitations of the Indian state's capacity. For example, stalled projects are a major reason for the slowdown in investment today, which is in turn responsible for slower growth. But the growth in investment can only become smooth if there is a serious change in the way in which firms interact with the government. The state's capacity needs to be enhanced and it needs to move away from the old systems that were designed to function under the licence-permit raj.

For example, had proper legal, regulatory and policy frameworks been in place for the protection of the environment, so many projects would not have been stalled. The fast pace of GDP growth meant that there were suddenly several projects where the trade-offs between growth and environmental protection became pressing. Due to the lack of set standards and regulatory mechanisms, each project had to, on a case-by-case basis, be cleared by local, state and Central bureaucrats, many of whom did not understand the basis on which a clearance was to either be given or withheld. The number of projects stuck in the pipeline became greater. It is the lack of a policy framework that scares bureaucrats from clearing projects today.

With the right institutions, there would have been no need for a Central body to clear stalled projects. Many clearances have been given by the Cabinet Committee on Investment. Others will also be given. But does this mean that the problem is solved? That in the future, projects will not get stuck? Unlikely. Without a change in the legal and regulatory framework, India cannot thunder ahead at a 10 per cent growth rate for 30 years like China has done. The demands for transparent and non-discretionary systems for the allocation of resources like land, spectrum, mines and contracts, for well-designed regulatory frameworks, and for clearly defined policies are likely to increase in the coming years. But building the state's capacity is unlikely to be a quick process. Indeed, if it were, then it is less likely to provide us with frameworks that can pass the test of time.

What is this process of change and why might it take so long? The process of financial sector reform is an illustrative example. First, we faced a problem. Slowly evidence started to build up that the problem was not an isolated incident. Then the media, think tanks and academics analysed the data and identified deeper problems. This was followed by committee reports, which involved broad consultations and offered recommendations. In the case of the financial sector, committees such as the Raghuram Rajan committee, the Percy Mistry committee and the U.K. Sinha committee helped form the consensus on the reforms needed. Many changes were made and often legal hurdles came in the way. The government then set up the Financial Sector Legislative Reforms Commission (FSLRC) to review the existing laws. The process of writing a draft law involved studying all the existing laws relating to finance. A full-time 30-person research team of economists and lawyers at the NIPFP supported the commission. After consulting more than 170 people, creating various working groups that analysed specific problems and many long meetings of the commission, a broad consensus was formed on most issues.

The FSLRC submitted its report after the designated two years. The process of legal change will take at least another two to three years. The setting up of the new regulators and the framing of the relevant rules under the new laws are likely to take even longer. Hundreds of regulators, lawyers and judges will need to familiarise themselves with the new legal framework. Companies will need to reinvent themselves.

In the case of financial reform, one can argue that there is at least some consensus. In other areas, the problems are more recent and there is no clarity on what needs to be done. The process of change will therefore take longer. As it should.

India has seen the slow and gradual build-up of the state's capacity. There are no more stroke-of-the-pen reforms left, there are no shortcuts. Hopefully, we will be lifted out of the present downturn thanks to an upturn in the global economy. But we will need to build frameworks to create a healthy interaction between firms and the state. Today's system was designed for a command and control economy. That will hopefully change over the next few years and keep India's trend growth rate high.