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An unshakable optimism about the long-term destiny of India's economy is counter-productive at moments of crisis.

Optimism is not a sin. But it cannot be the foundation for a country’s entire economic strategy. Sadly, that is what appears to be the case in India — and unless decision makers swiftly revise their assumptions about the future, any optimism will begin to be quite unfounded.

The problem is this: We have long been accustomed to assume that, in the long run, things will work out for the Indian economy. It has many things going for it: A young population, strong consumption demand, a large market, a labour cost advantage. But these very advantages have bred complacency and, worse, arrogance. A belief in our own destiny, in the economy’s inevitable rise to upper-middle income status, undercuts any attempt to introduce urgent structural reform.

These advantages are slowly turning into hurdles. A young population that is under-employed means that welfarism rather than growth will become the dominant paradigm. Labour that is cheap is under-skilled and therefore unable to compete in the world markets. Strong consumption demand underlay years of acceptable GDP growth. But to be sustained, growth needs investment and productivity increases. Consumption cannot keep growth going forever. Worse, even, is the arrogance of size. We believe that our domestic market is so large that we do not need exports. We believe that it is attractive enough that investment from the rest of the world is inevitable, even if we create an unwelcoming atmosphere for such investors. It seems to have escaped us that even China, with a larger population, could only grow through accessing world markets. Are we going to short-change ourselves, by producing only for one-fifth of the world, while China produces for the remaining four-fifths? Is our economy condemned to being a quarter of China’s?

unshakable optimism about the long-term destiny of India’s economy is a particularly pernicious myth at moments such as we find ourselves in now, when there is both a cyclical slowdown and structural constraints on growth. For the government, there is often a trade-off between short- and long-term effects of policy. For example, high government spending might revive demand with short-term benefits, but it might also have poor long-term effects by ensuring the state continues to dominate the pool of savings at the cost of the more productive private sector. To insulate India’s external account in the long term, we might want to reduce our transport system’s dependence on imported fuel; but in the short term, pushing electrification and fuel efficiency is hurting the automobile sector. Structurally, it might be in India’s interest to allow less efficient public sector banks to wither away; but if the concern is reviving lending in the short term, then instead the government will wish to prop them up somehow. For long-term growth, one priority would be reducing the size of the government’s wage bill in such a way that it can use tax revenue more efficiently. But if we wish to ensure consumption in the short term is resuscitated, then no action can be taken on that front. If the optimism-driven belief is the short term is what really matters because the long term will take care of itself, then such structural reform will inevitably be de-prioritised. We have long been told that India reforms only in an emergency. But the truth seems to be that India reforms only enough to escape an emergency.

Thus there is insufficient urgency when it comes to structural reform. There is also insufficient urgency about fixing the root causes of the investment slowdown. It is believed that recovering demand will result in the overcapacity problem being solved, and thus investment will return. But ending overcapacity is a necessary and not a sufficient condition for an investment revival. Correcting the impression of grave political risks to investment is even more important. The government has begun reaching out to concerned voices in industry and elsewhere to allay their fears about “tax terrorism”. Some welcome reforms to tax administration have been promised. But the words and action will not have an impact without a sustained change in both political rhetoric and the institutions and legal framework that control tax officials. Capacity in the legal system also needs to be built up; international arbitration needs to be treated with less contempt; and bilateral investment treaties need to be signed that protect foreign investors. Expectations about the Indian economy’s future are so sky-high in India that it is difficult for officials to believe that not all investors may share it. Even if they do see India as the only bright spot for global growth, it is all too easy for investors, particularly foreign investors, to suffer catastrophic capital loss in India even in a growing economy. Instead of reassuring them about their fears through institutional reform, they are instead lectured about the need to invest in India. We then are so concerned about round-tripping and capital drain that we constrain the arrival of capital counter-productively. One observer of the Indian economy described how foreign investors are treated thus: “In China they are greeted with a red carpet; in India with red tape.”

The simple fact is that the recipe for growth has changed. We still need to be competitive, to produce for markets beyond our own, to seek productivity gains rather than incentivising low-value assembly. If we produce for our own consumption alone, we will be stuck in a low-value-added, low-wage equilibrium — and constantly subject to external shocks, since our dependence on imported energy is not going anywhere for some time. We cannot ignore all the ingredients of this recipe and still assume that the product is going to taste good. Things may still turn out all right for the Indian economy, but not if complacency and unfounded optimism win the battle against realism.

This commentary originally appeared in Business Standard.

Mihir Swarup Sharma (ORF)
6 September 2019

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