Relevance: GS Paper III (Indian Economy)
How to make economic growth sustainable?
- There is the need of investment 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.
India’s economic reforms
- 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.
Biggest problem of Indian economy
- 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.
- Banks were pushed by government in the direction of longer-term loans for fixed capital investment, and away from working capital and household loans, but without the development of the needed internal expertise required for assessing the most challenging type of lending.
The IL&FS fiasco
- There has been 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.
Way forward
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:
- 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.
- There is a desperate need for a corporate bond market in India that will allow firms to borrow more directly from savers.
- 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, needs to be eradicated.
Conclusion
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.
