A great churning

Business Standard, 17 September 2017

High and low productivity firms manage to coexist in India when low productivity firms cheat on compliance. To the extent that a sound GST improves compliance, many low productivity firms will exit. A sound GST will also disrupt many vertically integrated firms and we will see more trades between specialised industries. The banking crisis has slowed down the traditional ways of evergreening that keep zombie firms aloft. RBI reforms, IBC and the resolution corporation will help shift capital from weak firms to healthy firms. These factors suggest that a large restructuring of the economy is underway. This is a daunting scale of churning in the economy. Done right, this will give a new wave of GDP growth. Implementation teams in government hold the key.

Three forces are now reshaping the Indian economy.

GST impact upon tax compliance

Under normal conditions, competition in markets induces creative destruction. Weak firms exit. This improves the supply of labour and capital to healthy firms at lower prices. It also improves the pricing power of healthy firms. When capitalism works, the exit of weak firms improves the profitability of healthy firms.

This is not what we see in India. High productivity high compliance firms coexist with low productivity low compliance firms. The low productivity firms survive by violating health/safety/environment regulations, and cheating on taxes. This harms overall productivity and GDP. The self-enforcing nature of the GST will reduce cheating on taxes. Many firms will be forced to either raise productivity or exit.

GST impact upon vertically integrated firms

In India, we have traditionally had taxation of transactions. In the delicate jargon of public finance, all transaction taxes are `bad taxes'. If production is organised as firm A making engines and firm B making cars, then the taxation of transactions results in double taxation. This encourages vertical integration: automobile companies would prefer to make their own engines. However, the essence of high productivity is specialisation. A sophisticated economy is one in which there are a large number of highly specialised firms who trade with each other.

The GST reduces the extent of taxation of transactions and thus reduces the artificial incentive for vertical integration. Many firms have gone through great pain in recent decades to achieve vertical integration. These firms will encounter difficulties when India achieves more specialised industries that trade intensively with each other.

Better functioning of financial markets

The third element is about zombie firms. In an ideal world, when it is clear that a firm does not work, it should be rapidly dissolved. In India, these walking dead have been kept alive by injections of capital from banks. This process is coming under increasing stress. Any one operational creditor who is not paid on time can trigger the IBC. Any one employee who is not paid a salary on time can trigger the IBC. Any one financial creditor can trigger the IBC. Once any one person initiates the IBC proceeding, it becomes impossible for banks to keep up the facade of a standard asset.

High productivity firms will be able to bring in enough equity capital and run a tight finance operation so as to make all payments on time. Low productivity firms will stumble. This will give more exit of low productivity firms.

A Joint Parliamentary Committee of Parliament is examining the law that creates the `Resolution Corporation' (RC) envisaged by Justice Srikrishna's Financial Sector Legislative Reforms Commission (FSLRC). This will improve the pace of exit of zombie financial firms, and thus bring greater discipline upon the use of financial capital in the economy.

Reallocation is a slow and difficult process

These are valuable and positive features of the outlook for India. However, these changes will not be easy.

These three forces add up to a large scale churning of the economy. Each of the three will impact upon the length and breadth of the country, upon firms large and small. This will require new conceptions of the boundary of the firm, and of processes and technologies within firms. These changes call for building new kinds of organisational capital in all firms.

As an example, there will be opportunities for high productivity firms to grow dramatically. These firms may be able to buy going concerns or assets that come up for sale through the IBC. These firms will see an economy with lower wages, cheaper capital and higher product prices. Their challenge will be in reshaping themselves to harness these opportunities.

I am reminded of the pain associated with `internal devaluation' that often affects countries with managed exchange rates. Even with ideal policy implementation, there will be a slow and painful process of reconstructing Indian capitalism and reallocating resources.

The task for policy makers

Policy makers need to focus on five elements of implementation, so as to avoid layering additional pain on top of a difficult time.

  1. A sound GST is one with a single rate, a low rate, a comprehensive base, a unified and capable administration.
  2. The bankruptcy reform requires nine inputs: fixing the mistakes in the 2016 law, building IBBI into a high performance organisation, sound regulations, three new private competitive industries for information utilities (IUs), insolvency professionals (IPs) and insolvency professional agencies (IPAs), a capable NCLT and DRT, solve mistakes in regulation which shape how financial firms use the levers of IBC, and solve mistakes in regulation which hamper the pool of buyers for distressed assets.
  3. RBI reforms are required to put banking regulation and supervision on a sound footing, which will improve the allocative efficiency of banking.
  4. The Resolution Corporation requires enacting a sound law. After the FSLRC report of 2013, the Ministry of Finance had setup a `Task Force on the Establishment of the Resolution Corporation' led by M. Damodaran, in 2014. They have written an implementation plan for the construction of the Resolution Corporation. This plan needs to be put into motion, so that a high performance organisation is built rapidly.
  5. An array of non-bank financing alternatives need to be activated, so as to alleviate the slow growth of bank financing.

If good implementation teams are put into these five areas, India will translate this phase of structural change into stunning growth. If weak implementation persists, this great churning will turn into a decade long stagnation. The hour is very late, and the choice between triumph or tragedy knocks at our door.

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