If you haven’t read chapter one, read that here first

We follow the standard pattern delineated in chapter one i.e. ‘quotable quotes’, statistics, major themes and recommended reading. Click on the hyperlinks in green to read and revise the topic hyperlinked.

Let’s get started

• A market economy requires unrestricted entry of new firms, new ideas, and new technologies so that the forces of competition can guide capital and labour resources to their most productive and dynamic uses
• But it also requires exit so that resources are forced or enticed away from inefficient and unsustainable uses
• Joseph Schumpeter expounded the concept of “creative destruction,” the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating new ones”

Structural impediments to India’s progress-

Problems of entry i.e. “licence-quota-permit Raj”

It has been largely taken care of by-

• liberalization(delicensing, end of permit quota system) , privatization (Divestment and end of public sector monopoly), Globalization (FDI and reduced tariff) reforms of 1991
• New initiative of across the board FDI liberalization and Start up-Stand up programme aim to further liberalize the entry.

But exit (chakrvyuah) remains the major challenge-

What is this problem of exit and what’s it’s magnitude?

• Inefficient and unsustainable firms are not allowed to wind down their operations and exit from the market
• In a normal economy, old firms would be the ones that were efficient, only then could they survive for that long and hence should be much bigger in size than new firms
• But in India avg 40 year old firm is just 1.5 times larger than a new firm (8 times in US
• Worst part is that a decade back they were 2.5 times larger i.e. inefficient firms are not allowed to exit and they remain small

What are the costs of impeded exit?

#1. Fiscal cost

• Of course, inefficient firms are supported by explicit (bailouts) or implicit (free power, reduced tariff, interest subvention etc) government subsidies
• High subsidies # high borrowings # high fiscal deficit # high debt # high interest cost.
• Add to this the tax revenue forgone, if efficient firms were allowed to take their place i.e. Double whammy of low tax and high subsidies

#2. Economic cost-

• Market economy is supposed to allocate resources/ factors of production (capital and labour) in the most efficient way towards most profitable ventures
• Lack of exit leads to misallocation of resources with enormous costs for a capital starved country such as India
• Overhang of stressed assets on corporate and bank balance sheets reflect same problem (remember twin balance sheet challenges, 4Rs solution discussed in part one) of  difficulty of apportioning costs of past mistakes

#3. Political costs

1. Benefits of impeded exit follows to rich (firms are owned by richie rich naa) # govt charged as pro rich # No political constituency for reform measures (recall debate on land ordinance)
2. No action against willful defaulters # erosion of legitimacy of regulatory institutions such as RBI

Let’s take an example of fertilizer subsidies

• Fiscal cost- .8% of GDP, much of which leaks abroad or to non-agricultural uses, or goes to inefficient producers, or to firms given the exclusive privilege to import.
• But precisely for these reasons it has proved politically impossible to close the inefficient firms or eliminate the canalisation of imports. Rich farmers have internalised the benefits and prevent reforms

What causes an exit problem?

3 Is

#1. Interests – Power of vested interests which is aggravated by certain imbalances or asymmetry

• Concentrated producer interests (a few losers stand to lose by lot) v/s diffused consumer interests (individual benefit small but aggregate benefit large)
• Concentrated interests have more voice, backed by financial power and often democratic political systems tend to give disproportional influence to them (vocal minority v/s silent majority)
• In the case of administrative schemes, vested interests often create a market of their own, planning their actions to benefit from it: put differently, this is a case of supply creating its own demand
• Bureaucratic inertia perpetuates persistence
• 50 percent of schemes are 25 years old. extra vigilance is necessary to ensure that schemes remain relevant and useful over time. And vigilance should probably increase in proportion to the longevity. (for these reasons only concept of ZERO based budgeting was introduced)

Q. List down advantages/ disadvantages of zero based budgeting.

#2. Institutions– Paradoxical situation of both weak and strong institutions delaying exit

Weak institutions –

• Inability to punish willful defaulters (legitimacy of institutions itself is questioned)
• Judiciary- Tareekh pe Tareekh (time and cost overrun)

• Eg. Debt recovery tribunal- share of settled cases is small and declining (4 lakh crore locked up)

Strong institutions so called referee or vigilance institutions– CBI, CVC, CAG, Judiciary combined with the asymmetric incentives for bureaucrats that favours abundant caution and hence the status quo.

Incentives are stacked against decisions to precipitate exit for fear of being seen as favouring corporate interests and hence susceptible to scrutiny, encouraging ever-greening of loans, postponing exit

#3. Ideas/ ideology

• Very difficult to phase out entitlements especially in a country with sizable poverty and inequality and one that is a democracy
• The objective is often laudable but once the policies and programs have been set in place, they are very difficult to reverse
• For instance, minimum support prices (MSPs) were envisioned as an insurance mechanism for farmers, but have become price floors instead, favouring some crops in some regions at the expense of other

How to address the problem

#1. Avoid exit through liberal entry: promote competition via private sector entry rather than change ownership through privatization. Eg. BSNL, MTNL were not privatized but liberal entry to private telcos

Advantage- It bypasses opposition from managers as well as labour interests.

#2. Direct policy action- Frame better laws, align incentives with the objectives

Govt response– a new bankruptcy law (solves weak institution problem), amendment to prevention of corruption act (solves strong referee institution problem), reforms in PPP (Kelkar Committee Report)

#3. Technology and the JAM solution:  Direct Benefit Transfer (DBT) for targeting and protecting the poor while removing distortions

• Brings down human discretion and the layers of intermediaries
• Breaks the old shackles and old ways of doing business

#4. Transparency: Transparently reflect economic as well as social, environmental and health costs and benefits

• Eg. Costs of producing cereals in Punjab and Haryana; declining water table, soil quality degradation, post harvest burning of stalks causing pollution, rich farmers getting benefits
• v/s benefits from pulses; nitrogen fixation, lower import dependency etc.

#5. Exit as an opportunity- It’s not the business of govt to be in business. For eg. loss making Air India

• Opposition from existing managers or employees’ interests;  solution- earmark resources earned from privatization for compensation and retraining;
• credibly ensure that reservation policies will be maintained in the privatized enterprise as well
• convert part of land into land bank and develop industrial clusters or in dense urban areas nurture start ups

A few more points about strong referee institution problems

1. Prevention of corruption act (PCA) definition of corruption does not include words like ‘corruptly’ or ‘wrongfully’ i.e. no requirement of mens rea or guilty intent hence even a benefit conferred inadvertently is sufficient to be prosecuted
2. For example, suppose an honest public servant makes, in good faith, an error of judgment and undervalues an asset which is being disinvested. Obviously that undervaluation causes a pecuniary gain to the buyer of the asset and is not in public interest, he is in way benefited but can still be prosecuted.
3. Misaligned incentive structure– external monitoring in the public sector tends to be skewed towards bad decisions that were taken rather than good decisions that were not taken (i.e. opportunities that were missed).
4. This promotes a culture where avoidance of mistakes is more important than the pursuit of opportunities

Result –

1. The reluctance of government to accept responsibility for its own delays in projects
2. The penchant for departments to appeal even fair and reasonable arbitration awards or lower court judgments
3. The tendency to raise tax disputes based on audit objections even if the tax authority disagrees with the auditor
4. The reluctance of civil servants to sell land or divest public enterprises

Solution:

1. Amendment to prevention of Corruption act (prs bill summary) to prevent prosecution for mere administrative errors,  differentiating cases of graft from those of genuine errors of decision-making 
2. Providing investigative agencies with tools, skills and training to do a proper investigation of modern day financial crime and corruption so that culprits do not go scot free either
3. Reexamine the cost of elaborate but largely ineffective and counterproductive vigilance machinery

What you have to read for yourself

1. All the boxes from the chapter plus bankruptcy box from statistical appendix
2. Open all the hyperlinks. Learn, understand and revise.

Ask all your doubts in the comment section below or in doubts clearing forum . all your suggestions, criticism and feedback are most welcome.

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