Analysing the 2021 budget

Business Standard, 2 February 2021

The main puzzle of economic policy today is the slow pace of private investment. The budget announcements show progress in some areas. In proposing to privatise PSU banks and increasing the FDI limit on insurance, there is a new willingness to take on problems which had turned into holy cows. There is progress on fiscal transparency, and in putting a halt to the procession of welfarist initiatives and increased tax rates. In other areas, there is less progress. Many customs duties have gone up, which will harm the economy. The initiatives on banks, a new DFI, and bond market liquidity will not help solve the problems of the financial system.

Most GDP growth and jobs emerge from the willingess of private persons to put equity capital and emotional energy into building private organisations. The most important problem of the Indian economy is the loss of dynamism in private investment from 2011 onwards. This is related to the central planning problem (the extent to which the Indian state picks winners, and poses business model risk for private persons), the rule of law problem (the extent to which state actors and personnel have arbitrary power over private persons), the resolution problem (financial and non-financial firms with stressed balance sheets), and the loss of confidence that India was steadily evolving into a mature market economy.

This was the framing within which policy makers applied their minds in recent weeks for drafting the budget announcements, and this is the framing within which we should assess the extent to which our view about the economy has changed as a consequence of these announcements.

Two problems had loomed large as holy cows: FDI in insurance and the privatisation of PSU banks. It is a great step forward that these announcements have come out. For the first time, a finance minister has said that PSU banks will be privatised. There is symbolic value in breaking past these barriers in our minds.

We have to curtail our optimism by recalling that previous announcements about privatisation of Air India or a listing for LIC have resisted implementation. Selling a PSU bank is likely to be harder than selling Air India. In addition, the gains from these reforms are relatively modest. Greater foreign engagement in Indian insurance companies will help, but it's not central to the problem of private investment, and there is a considerable associated pending agenda on insurance regulatory reform that needs to go alongside this. Public sector ownership is not central to the repeated experiences with banking crises in India; the flaws lie in financial law and regulation. As the old saying in finance goes, the one thing worse than a state owned bank is a poorly regulated private bank. The puzzle in Indian financial reform lies in modified laws that change the incentives and processes of financial regulators.

The budget speech makes progress towards the sustainable strategy in infrastructure: of government as the developer which gets an asset up and running, and then sells it to private operating companies. In the logjam of institutional difficulties faced by an infrastructure developer in India, state organisations are the ones best placed to build new assets, after which capital can be recycled by selling these off to private operating firms which have access to the wholesale securities markets.

From 2007 onwards, fiscal transparency of the union government had become an embarrassment, to the point where the CAG was pointing out that documents being laid in Parliament were misleading. There is major progress, last year and this year, in cleaning up this situation. It is quite remarkable to see the food subsidy being brought on-budget.

The budget speech puts a great emphasis on health. There is a discernable shift im emphasis from health care towards public health. Emphasising prevention and not cure is the correct change in course for health policy.

The experience of listening to budget speeches over innumerable years has conditioned us into low expectations; we steel our minds in anticipation of higher taxes and a procession of government subsidy programs with incomprehensible names. This year, we might have expected special effort in buying off farmers with subsidy programs. The budget speech was surprising and refreshing in not having much of this. It was more clear headed and intellectually sound. Putting this fact together with the sentences about insurance and PSU banks, one may discern a certain ideological shift. Ultimately every political leadership in India is accountable for delivering growth and jobs, which are born of private investment. The strategy of taxes and subsidies does not work in the long run.

There are two big areas of concern about the budget. The first is the large number of increased customs duties. India's high growth in the 1991-2011 was critically linked to the steady process of cutting customs duties. Raising customs duties is a strategic mistake. It induces an inferior resource allocation, hampers exporting firms, and creates the wrong incentives for firms.

The second area of concern is the absence of financial reform. The path to solving India's financial crisis lies in addressing the failures of law and regulation. The budget speech pushes solutions from the 1970s and 1980s -- a bad bank, a DFI, and some inchoate government body which will make liquidity for corporate bonds. The institutional memory of financial reform of the 1990s and 2000s would suggest a different line of attack for addressing the financial crisis. We still have no significant pathway to resolving stressed firms, both financial and non-financial, and it is hard to revive growth without doing a lot of resolution.

There is progress, then, on ideological problems (the willingness to challenge the holy cows of insurance FDI and PSU banks, the willingess to step back from the steady ratcheting up of tax rates and of welfarism). These would help pull many minds back from the cynical confidence that Indian economic policy is irredeemably stuck. But there is not yet the intellectual framework of understanding and addressing the central planning problem, the rule of law problem, and the balance sheet problem. It is within these conflicting elements that we have to make the call: Will this generate a turning point in private investment in 2021-22?

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