Addressing the Bigger Concerns in Indian Economy

What is the issue?

A freefall in the rupee or a massive current account deficit would be symptoms of some other underlying serious issues.

Where should the focus be?

• Among the sources of economic growth, investment is a fundamental variable.
• These may include people, knowledge bases, institutional capacity or the obvious physical capital itself.
• The efficiency of the process of savings generation and channelizing them into productive investment is crucial for sustained economic growth.
• This is often taken for granted, but focusing on this draws attention to India’s biggest economic problem.

How has India performed in this regard?

• Since the 1991 reform period, India has made considerable progress in facilitating investment.
• It has removed 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.
• But there are still some serious issues that hamper the sustainable growth.

What are the persistent problems?

• Allocation of capital - India’s biggest economic problem is the inefficient allocation of capital.
• Bad loans in the banking sector have been one symptom of this problem.
• E.g. the latest Infrastructure Leasing and Financial Services (IL&FS) crisis, which defaulted on some of its debt obligations.
• The common factor in these cases is the long-term lending for large projects.
• These are subject to high risks, because of their scale and their length of gestation.
• Banks - Banks were, in fact, pushed by government in the direction of longer-term loans for fixed capital investment.
• They were diverted away (at least in relative terms) from working capital and household loans.
• Worryingly, this happened in banks without the internal expertise required for assessing the most challenging type of lending.
• Government - The Indian government failed to create a regulatory framework.
• This would have detected the incipient problems in systemically important firms such as IL&FS.
• Corporate governance - Poor corporate governance is a major cause to this whole capital allocation mess.
• This includes financial intermediaries such as banks and non-bank financial companies and also the firms that do the borrowing.
• In India, there seems to be a common problem of skimming funds (form of tax evasion), by business borrowers and politicians.

What could be done?

• Markets - Indian banks should 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.
• There is a dire need for a corporate bond market in India that will allow firms to borrow more directly from savers.
• This does not stop at long-term borrowing, but other short-term borrowing can also benefit from new market platforms.
• Regulators - As financial markets are broadened and deepened, the demands on regulators increase.
• India’s financial system regulatory architecture also needs to be enhanced.
• This involves not just external oversight by financial regulators but also 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 facilitate this by raising and enforcing standards for the private sector monitoring institutions.
• The challenge now is moving beyond improving fiscal policy or monetary policy and addressing the political component too.

Source: Financial Express