Economy: Freedom in Fetters

We have failed to free ourselves. Even as India continues to languish in terms of her global competitiveness, liberalisation has failed to deliver even economic freedom to us. BT charts out the four rules of the reforms for the New Millennium.

"We stand today at the edge of the Second Millennium. It is time to seriously debate and decide on the second-generation reforms that we must put in place to make India economically strong, and fully capable of competing successfully in the evolving world order."
Yashwant Sinha, Union Finance Minister, Budget 99

It is also time to grow a second generation of political leaders who stop talking--and start acting on the economy. Endless debates and discussion papers cannot be allowed to obscure the fundamental failure of liberalisation in India. The first generation of the reforms has failed to deliver freedom to the economy. And, on the eve of the Second Millennium, liberalisation has still not been able to liberate us Indians.

That is, once again, the dismal assessment of the Washington-based think-tank, the Heritage Foundation, which, along with the Wall Street Journal, publishes the Index Of Economic Freedom every year. The Liberty Index, as we call it, attempts to measure the extent of government coercion and constraints on the production, distribution, and consumption of goods and services. For the fifth year in a row, India languishes amongst the most unfree nation-states of the world, clubbed along with Ethiopia, Nigeria, and Albania. Based on its performance on 10 factors--rated on a range from 1 (most free) to 5 (repressed)--India has repeated her 1998 composite score of 3.7. That places India 120th among 161 nations--even worse than last year's showing of 117th among 156 nations.

True, the Liberty Index, probably, assigns some unnecessarily low values to India. Take, for instance, the deterioration in our foreign investment scores, which can only be attributed to rising barriers to foreign capital flows. But no new controls or restrictions on foreign investment were imposed in the last year. Or take our rating on wage- and price-controls, which suggests that goods are, largely, doled out to the public through a rationing mechanism. To correct these anomalies, BT recalculated the scores, using the objective criteria specified for each of the 10 factors. Although this exercise bumps up India's score to 3.30--and its rank to 94th--that is still worse than the 85th place we earned in 1995.

Does freedom matter? Yes, for starters, because a freer economy is a more resilient economy. In the early 1980s, when Argentina ranked among the least-free nations in the world, losses from a series of banking crises consumed more than half its Gross Domestic Product (GDP). Now, a more open economy has been able to weather not just the Mexican Meltdown of 1994, but also the series of financial storms that rolled across the globe from Thailand to Russia to Brazil in 1998. Agrees Melanie Kirkpatrick, an Assistant Editor at the Wall Street Journal and the co-author of the Liberty Index: "Economies that rank high on the Index, such as Singapore, have emerged relatively unscathed by the turmoil in the financial markets. In contrast, it is countries with the highest State interference quotient in their financial sector, notably Indonesia and Thailand, that have fared poorly." In a globalised world, no economy can hope to inoculate itself against a fast-spreading financial crisis, but a freer economy will, at least, recover faster.

In the medium term, a freer economy also grows faster. There is a statistically-demonstrable link between changes in freedom and growth. Several cross-country studies indicate that an expansion in freedom boosts growth albeit with a lag. Restrictive policies, on the other hand, retard growth-rates, and may even cause an absolute decline in average real per capita GDP. Points out Surjit Bhalla, 49, President, Oxus Research, and the author of several studies on economic freedom: "The single-largest change in freedom that the world has witnessed occurred in China between 1978 and the mid-1990s." Unsurprisingly, since then, China has been one of the world's fastest-growing economies.

Between 1990 and 1997, India's economic freedom--as measured by another long-term index developed by the Fraser Institute in Canada--improved from 3.8 to 5.3. As a result, growth rates spiked upwards, averaging 6.8 per cent over the last 5 years. Conversely, the stagnancy in scores since 1995, as measured by the Heritage Index, portends a levelling off, and, perhaps, even a decline in long-term growth.

Changes in economic freedom, therefore, provide a summary statistic of the liberalisation process. Judged by that yardstick, our reforms barely merit a grade. Sure, the momentum generated by the first burst in 1991 has enabled India to maintain her position in the face of an expansion in the number of countries included in the Index, but it has not been sufficient to boost our ranking. In fact, other countries that embarked on a stabilisation programme around the same time--Argentina, Peru, and Poland--have raced ahead. As the experience of these countries demonstrates, there can be no universal blueprint, but successful reforms are marked by certain commonalties.

Based on an analysis of the movements of nations up and down the Liberty League in the last 5 years, BT identifies these rules of reforms--the lessons of liberalisation that our policy-makers are gasping to grasp even now.

Every structural adjustment programme kicks off with a trade- and investment-liberalisation programme. Good ones, however, are based on sustained reforms. Consider the case of Peru, which has vaulted up the Liberty Index from the 72nd rank in 1995 to the 41st in 1999. There, the average tariff-rates were reduced from 34 to 9.50 per cent, import licenses for all but a handful of products were eliminated, and virtually every sector of the economy was thrown open to foreign investment. It paid off: after years of decline, GDP growth in Peru shot up to an average of over 6 per cent between 1995 and 1998.

In India, the trade-reforms began with a bang, but quickly ended with a whimper. Between 1990-91 and 1996-97, the average tariff-rates tumbled from 87 to 24 per cent, and the quantitative restrictions on nearly a third of our import-lines were lifted. But, since then, not only has the pace slackened, the direction has been reversed through a series of across-the-board special duties, special additional duties, and, more recently, a 10 per cent surcharge.

In a country which started off with some of the highest tariff-barriers in the world, stalled reforms effectively amount to worse than no reforms. At close to 30 per cent, India's average tariffs are still far higher than those in other emerging markets like Mexico (4 per cent), Malaysia (6.40 per cent), or even China (20 per cent). And despite the fanfare that surrounds the annual lifting of quantitative restrictions on imports by successive Export Import polices, non-tariff barriers still continue to block over 60 per cent of our lines. The only other countries with such a sweeping range of import curbs: Myanmar and North Korea.

Investment policy reforms are also running out of steam. For instance, Budget 99 proposed the expansion of the list of industries that qualify for automatic approval of foreign direct investment. That is not going to mean much to foreign investors as procedural roadblocks have rendered automatic approval far from automatic. Even though the scope of the mechanism has been steadily expanded since 1991, investors continue to route nearly 90 per cent of their inflows through the Foreign Investment Promotion Board (FIPB). Policy-makers may claim a shift to a more rule-based regime but, in practice, the bulk of foreign investment inflows are still governed by bureaucratic discretion--not transparent norms.

Meanwhile, the economic costs continue to mount. As trade reforms braked, so did India's exports growth. Ever since the tariff-rates began to edge back up, the dollar value of our exports has grown slower than world trade. More ominously, foreign investment has begun to contract. Sure, as the Asian contagion spread, investors withdrew en masse from the emerging markets but, if Indonesia is excluded, India still continues to attract less foreign capital than even the crisis-ravaged Asian economies. Eight years after the initiation of external sector reforms, our minuscule share of the global flow of goods and capital is only shrinking.

Balancing the government's books involves both tax and expenditure reforms. Yet, most fiscal stabilisation programmes begin with the former. It is not difficult to fathom why. Slashing unproductively-high tax-rates is a politically-popular move; slashing unproductive subsidies is not. Postponing expenditure reforms minimises the initial opposition, but runs the risk of triggering off further fiscal deterioration. Tax-revenues from improved compliance will materialise only after a lag, which could force the government to pare expenditure on social services in the interim.

Although it should not be undertaken solely to bolster revenues, the outright sale of public sector enterprises will efficiently plug this resources gap. Thanks to a sweeping privatisation programme that encompassed everything from pension plans to nuclear power plants, Argentina was able to dramatically reduce taxes, raise spending on social services--and still eliminate its budget deficit.

India has only been able to reduce taxes, and that too partially. Successive budgets have lowered corporate and personal income-tax rates to levels that are now comparable to those in the most developed economies. While the excise-duty rationalisation by Budget 99 will help clean up a messy slab structure, it will not lower the burden on companies. But, then, tax-reforms in India have always included some form of hike. In order to mop up revenues, successive finance ministers have resorted to across-the-board surcharges and special duties even as they claim to have reduced rates.

Blame the erratic progress of tax-reforms on the disinvestment debacle. Over the last 8 years, the piecemeal sale of shares in public sector enterprises has fetched the exchequer close to Rs 16,000 crore--less than the $4.30 billion (Rs 1,80,600 crore) the Argentinian government received from a one-shot sale of the State-run telecom company, Entel. Worse, these dribbles have not inspired any noticeable improvement in operating efficiency, thus ensuring that loss-making enterprises continue to drain money from public coffers. Only if Sinha delivers on his promise of privatisation--by mixing genuine disinvestment in profit-making enterprises with the strategic sale of loss-making ones--will India begin her long-awaited move up the Liberty Index.

Successful financial reforms are linked to fiscal reforms. Credible fiscal stabilisation begins when financial repression ends. That happens when the government stops providing itself with captive, low-cost finance from the banking system. Such pre-emptions effectively constitute a tax on financial intermediation, and distort the process of resource-allocation. The quickest and the surest way of eliminating this is to privatise the banking system. Hungary, for instance, ensured that its banks were relatively free from government meddling by imposing a ceiling that limited State holdings in banks to 25 per cent.

In India, the Reserve Bank of India has relied on gradual incrementalism. For the last 8 years, successive credit policies have progressively deregulated interest-rates and credit-delivery mechanisms. A cautious, calibrated approach may have avoided financial instability, but it has also made for slow progress. Directed lending, via priority sector advances targets, still amount to 40 per cent of total advances while government pre-emptions through the reserve requirements co-opt 35 per cent of deposits. More fundamentally, the government still owns more than 80 per cent of the banking system, and all the insurance and provident-fund companies.

Predictably, in these segments, the fraction of resources commandeered by the government through a barrage of investment restrictions is even higher. Financial supervision, better accounting practices, and the development of risk-management systems will, no doubt, strengthen the financial institutions. But, as long as a clumsy State apparatus can question every commercial decision, the gains will be limited. The only solution: greater autonomy for, and the eventual privatisation of the financial institutions. Yet, this is not even on the policy agenda today.

Shock therapy works. Largely because there is no time for resistance to reforms to build. At one stroke, Poland freed 90 per cent of its prices and abolished all its trading monopolies. After an initial decline in output in 1990-91, its growth-rates bounced back to average 6 per cent between 1994 and 1997. Initially, inflation rates zoomed to 148 per cent in 1990, but fell to 13 per cent over the next 5 years.

In stark contrast, the Government of India's span of control has shrunk but slowly. Steel- and cement-prices have been decontrolled; yet, the government can still impose a floor-price on steel imports. Fertiliser prices have been partially deregulated, but subsidies are provided on the sale of decontrolled fertilisers. The Administered Price Mechanisms for coal, sugar, and petroleum products are being gradually dismantled, but the government continues to fix the prices of foodgrains, medicines, electricity, water, and other utilities. The results of its still-tight grip over the market mechanism: a flourishing black market, distorted investment patterns, and an artificially-low inflation rate.

Such gradual phase-outs make for low inflation, vital in a poor economy with no social security net. Unfortunately, cross-country experience indicates that, unless an independent regulatory authority with statutory status is set up to oversee the process, gradualist reforms will fast dwindle into policy inertia. Independent regulatory authorities have been set up in India but only in name, as the government has been loath to surrender control. Witness the bitter battles between the Telecom Regulatory Authority of India and the Department of Telecommunications, which have only succeeded in putting telecom investments on hold.

While this impedes investment in some sectors--notably, infrastructure--others are subject to heavy-handed regulation. Even after the dismantling of a labyrinthine system of industrial licensing, a mass of clearances and endless procedural requirements continues to constrict investment-flows. Frequent inspections multiply opportunities for harassment and graft. The controls may have gone, but India Inc. still has to live with a control-oriented administrative regime.

For India, the benefits from a liberalisation-mix consisting of limited stabilisation programmes and selected structural reforms have petered out, leaving her close to the bottom of the standings. Sure, the blame for this pathetic performance does not lie solely with the Vajpayee Administration, but none of its policies is likely to raise our score in the New Millennium. So, forget about the committee to debate the second-generation of reforms. A country that is still trapped in the first-generation of reforms will never have a place in the evolving world order. And that's the real freedom score today.

THE METHODOLOGY

The factors based on which a score between 1 and 5 on each parameter has been awarded:

I. Government Intervention

1. Government consumption under 10% of GDP; virtually no public sector enterprises
2. Government consumption between 11% and 25% of GDP; aggressive privatisation programme
3. Government consumption between 26% and 35% of GDP; stalled privatisation programme
4. Government consumption between 36% and 45% of GDP; many public sector enterprises
5. Government consumption over 46% of GDP; industry is mostly government-owned

II. Trade Policy

1. Average Tariff Rate (ATR) under 4%; very low non-tariff barriers
2. ATR between 5% and 9%; low non-tariff barriers
3. ATR between 10% and 14%; moderate non-tariff barriers
4. ATR between 15% and 19%; high non-tariff barriers
5. ATR above 20%; high non-tariff barriers

III. Monetary Policy

1. Inflation under 6%
2. Inflation between 7% and 13%
3. Inflation between 14% and 20%
4. Inflation between 21% and 30%
5. Inflation over 30%

IV. Taxation

1. Flat Income-Tax (IT) of 10% or less; very low Corporate Tax
2. Top IT below 40%, or average IT below 10%; flat Corporate Tax below 25%
3. Top IT below 35%, or average IT below 15%; flat Corporate Tax between 26% and 35%
4. Top IT between 36% and 50%, or average IT between 15%
5. Top IT above 35%, or average IT between 20% and 25%; top Corporate Tax above 46%

V. Foreign Investment

1. All industries open; incentives provided
2. Restrictions on investment in public utilities and companies vital to national security
3. Several restrictions, but with the existence of codes
4. Investment allowed only on case-by-case basis
5. Not permitted

VI. Property Rights

1. No expropriation; government guarantees private policy
2. Government guarantee exists; lax enforcement
3. Expropriation possible; some property rights exist
4. Property ownership limited to personal items; expropriation likely; legal system in shambles
5. All property State-owned

VII. Banking Policy

1. Very few government controls
2. Few controls on foreign banks; barriers to domestic expansion
3. Strict credit controls; barriers on expansion
4. Banking controlled by government, corruption present
5. Government control almost total; financial system in chaos

VIII. Wage & Price Controls

1. All prices and wages market-determined
2. Some utility prices determined by the government; minimum wages may exist
3. Mixture of market- and government-fixed prices
4. Wage and price controls on most jobs and products; rationing
5. Wages and prices controlled by government

IX. Regulation

1. Simple and uniform regulations; no corruption
2. Simple licensing; some strict regulations
3. Complicated licensing; haphazard regulations; no bribes
4. Government sets production quotas; complicated licensing procedures; some corruption
5. New business discouraged; bribes mandatory

X. Black Market

1. Under 10% of GDP
2. Between 11% and 15% of GDP
3. Between 16% and 20% of GDP
4. Between 21% and 30% of GDP
5. Over 30% of GDP