Why PM Modi should push economic liberalisation now

The best use of his store of political capital is to undertake big ticket economic reforms.

When a small Takshashila team walked around Bangalore’s wholesale markets, Dobbspet town and a few tiny village in the latter’s vicinity as part of our #FootNote initiative, we noticed many people reporting that they were not only inconvenienced but suffered monetary losses, yet supported Narendra Modi’s currency reform (‘demonetisation’) initiative. This is counter-intuitive, except perhaps in the context of religious faith.

To better understand this phenomenon, I conducted a twitter poll earlier this week that sought to investigate to what extent have people conflated their opinion of Prime Minister Modi and his currency reform initiative.

The results, after just over 1800 responses, were as follows:

Obviously, there is no claim that this poll is representative of the entire population of India. It is more likely representative of the forty thousand or so people who follow my twitter handle. Even so, the responses are interesting, and support what we noticed on the #FootNote tour.

Modi-Demonetisation-Poll

What does this mean? As Karthik Shashidhar, our resident quant, remarked, in 87% of the respondents there is an overlap between their opinion of Mr Modi and his policy. In other words, people’s attitude towards him overshadows their opinion of his policy. My colleague Nidhi Gupta, who recently reviewed Christopher Achen and Larry Bartels’ Democracy for Realists (Princeton University Press), that exposes the flaws of democratic systems, noted that in this case too, the notion that people vote on issues does not seem to hold up.

We’ll repeat the poll again in January to see how much the responses change.

In any event, the upshot is that the demonetisation episode shows that Mr Modi enjoys tremendous political capital that he can use to implement the type of structural reforms that would be extremely difficult for other leaders to pull off.

He should not lose the opportunity.

Postscript: Mr Modi’s team conducted their own poll using his smartphone app. Both the framing of the questions and the type of sample suggest that the poll is essentially a device to rally his supporters rather than obtain an objective estimate of public opinion. It would be wrong to assume it reflects what Indians think, just as it would be wrong to use my twitter poll for the same purpose.

Cash crisis, reform and pain

Structural reform does not have to be painful.

It is clear by now that the Modi government’s currency reform, involving replacement of old high-denomination notes with new ones, is inconveniencing people across the country to various extents. The expectation that the inconvenience will last only a few days has given way to fears that it will take longer: weeks, a couple of months, or more. Many economists estimate that the cash shock will cause an economic slowdown and hurt economic growth in the short term. [Mint has a very good economic analysis of the currency reform]

So question obviously is: was the move worth the pain? Are the benefits of a one-time cleanup of unaccounted cash worth the disruption of almost everyone’s daily life and the short-term—albeit irreversible to some innocent businesses and individuals—damage to the economy? It’s too early to tell.*

In the meantime some defenders of the move argue that inconvenience and pain is an essential part of structural reform. This is both inaccurate and disingenuous. This month’s currency exchange is not a structural reform. And structural reforms do not have to come with so much pain for so many people.

Those old enough to recall 1992 will hardly recall any pain or inconvenience. Similarly, it is hard to envisage the people of the country undergoing pain if say, schools no longer required licenses, businesses could be set up and closed down without hassle, tax laws became simpler, or even labour reform allowed easier hiring and firing of people.

Those linking structural reform to pain are doing a disservice to the cause of liberalisation. There is no reason why structural reforms must be painful. If anything, by removing red tape, preventing official harassment and lowering friction, structural reforms will make life a lot less painful—both in the short term and in the long term. Baby, bathwater and so on.

* Postscript: Many have asked me whether this currency reform will be successful. The honest answer is that it is too early to tell.

In fact it is hard to even analyse its impact had everything gone smoothly. The Indian economy is very complex, and we know less about the ‘unorganised’, ‘informal’ economy. Like blood that runs through the body’s veins, money supply affects every sector and over a billion people. It would be flippant and arrogant to claim to be able predict how it will pan out. Further, given that the transition is not going smoothly, what was complex has become even more so.

Complexity, the lack of required level of knowledge and inability to predict outcomes is one reason for governments to be tentative and parsimonious in their actions. This forms the basis of the argument for “small government”, or “minimum government”. The Modi government has wagered against this wisdom.

Only time will tell. Take expert predictions with a pinch of salt.

President Trump. What now for India?

Play the ball as it comes to the bat

Peter Thiel, a Silicon Valley billionaire who backed Donald Trump’s candidacy, perhaps best explained the latter’s political appeal. Journalists and analysts, he said, took Mr Trump literally but not seriously, and wanted to know details of how he would implement some of the outrageous ideas he proposed. Ordinary people, on the other hand, took him seriously but not literally, and were persuaded that he intented to take policies in directions that they agreed with; the exact details didn’t matter. In the uncertainties that prevail in Washington and elsewhere on what policies President Trump would pursue, Mr Thiel’s explanation is a very useful signpost.

It would only be conceit for anyone at this stage to predict Trump’s foreign policy positions. Candidate Trump and his core supporters were anti-immigration, anti-Muslim and anti-trade. Mr Trump threatened to pull out of NATO, repudiate free trade agreements, engage Russia’s Vladimir Putin, withdraw the security umbrella from over treaty allies, renegotiate the Iran nuclear deal, deal with ISIS, back Israel and grab the oil in Iraq. And yes, build that wall on the border with Mexico. At this point, it is best to take all these, as Mr Thiel suggests, seriously but not literally.

To the extent that President Trump attempts to throw international regimes, norms and institutions up in the air, New Delhi will encounter opportunities that it must be prepared to seize. This means the level of diplomatic imagination and boldness in the external affairs, commerce and defence ministries must be boosted. India is far better placed today than ever before to take advantage of possible shifts in global order.

Of course there are risks. A world that retreats from free trade will hurt India’s growth and development trajectory. A global recession will shave off significant percentage points from India’s economic growth rate. Throttling of free movement of people — in the US as in Europe — will necessitate painful business and human readjustments, although the result might be more business for India’s outsourcing/offshoring industry. Most of these risks can be managed by proceeding with structural economic reforms, or Reforms 2.0 (yes, I sound like a broken record, but the point is valid and important to make).

The path to success in the world of President Trump is nimbleness, deftness and speed. New Delhi’s diplomats and policymakers will need to see the opportunities early and act faster than others, without being constrained by historical baggage. No pre-determined strokes: see the ball early and play it accordingly.

Related Link: My colleague Pranay Kotasthane has an opinion piece on this in the New Indian Express today.

New currency notes for old

A one-off reduction of unaccounted money must be followed by long-pending structural economic reforms.

Some of the most insightful arguments on the demonetising of high-value currency notes have come from Takshashila associates.

Ajit Ranade has long been a proponent of getting rid of the high-denomination bank notes, pointing out that this will make a big dent in holdings of unaccounted money.

Karthik Shashidhar, on the other hand, has calculated that the exercise will be very costly. In other conversations with some colleagues last night, we noted that the real costs will be even higher, given the higher transaction costs, friction and so on.

[Update] Anupam Manur has a thorough analysis of the demonetisation.

Deepak Shenoy, one of India’s shrewdest analysts of capital markets, has more recent analysis that argues that the Modi government’s move will have short-term negatives but long-term positives. You should read the articles I’ve linked to above.

The Modi government’s move (even if it rightfully ought to be the RBI governor’s move) to demonetize Rs 500 and Rs 1000 notes and replace them after some time with new Rs 500 and Rs 2000 notes will act as a move to massively reduce the existing stock of unaccounted money and counterfeit currency. [Update: There will be new Rs 1000 notes too!] This will generally hurt the people who are sitting on large amounts of cash holdings (mostly for evading tax) and also, temporarily, those who are holding on to some cash, but have no bank accounts. This is significant.

A senior colleague argued that this was an extremely courageous move by Prime Minister Modi, not least because it hurts business communities that have long supported him and the BJP. However, given that this is one of the few moves that makes honest citizens feel good, it is likely to strengthen Mr Modi’s personal popularity. Effects on electoral outcomes have probably been calculated by those whose business it is to do so, and are probably as good as the best (or the worst) guess. There are just too many factors at play when it comes to how people will vote.

Now, if the government (or the RBI) had merely demonetized the big notes, the effect would have been to put permanent brakes on tax evasion and a faster move towards ubiquitous electronic banking. However, since the big notes will be back, the effect will be one-time. In fact, as another colleague pointed out last night, the same mattress will hold twice as much cash if filled with Rs 2000 notes. Also, many cash holders will convert their current holdings into gold, foreign currency or some other assets until they can change it back to cash again. There are limits to how much money they can hide this way, but many middlemen will make healthy commissions by providing such “services”.

Bank accounts will see a lot more transactions as latent account holders begin to transact through banks. This effect too will not be complete, as some might just decide to wait until the new notes arrive, and then lapse back to old habits. Behaviour is very hard to change easily. Until mindsets towards banks, taxes and scruples change, people will continue in the old pattern. It’s a good time to refresh the case for structural reforms: deregulation, getting rid of the license raj (no, it didn’t go away in 1992), tax reform and liberalisation. This will require even more courage on the part of this government (or any government, for that matter).

Will the move hurt confidence in the Indian Rupee? A sober Anupam Manur, Takshashila’s macroeconomics analyst, noted that denominations don’t impact the value of the currency. He doesn’t think the rupee will be hurt. On the other hand, another colleague likened this to Mr Modi’s Tughlaq moment — more politically, perhaps than economically.

The war against corruption and unaccounted money can only be won when economic incentives change, and in turn, change behaviour patterns (and ‘culture’). Disclosure schemes and demonetization of high-denomination currency notes have a salutary, but temporary effect. There is, however, no alternative to Reforms 2.0.

In defence of lobbying

The lobbying industry must be allowed to function transparently within the ambit of the law.

This is an unedited draft of today’s column in Business Standard.

A famous Indian politician was searching for an issue that could energise his party cadre and move the masses. An group of businessmen produced a report on “making India self-contained in her supply” of a particular commodity. It had arguments on the rationale on consumption of the commodity, why it was necessary and why the poor needed it more than the rich. One of the politician’s close associates forwarded the report to the party leadership across the country while his personal secretary echoed the report’s arguments in an op-ed article the subsequent week.

The politician embraced the cause and triggered off a historic agitation, the basis of which, partly at least, was the output of corporate lobbying. The politician was Mohandas Karamchand Gandhi, the industry group was FICCI and the commodity common salt. The historic event in question, of course, is the Salt Satyagraha (see this post for details). It would be hazardous to suggest that a FICCI monograph singularly triggered off Gandhi’s famous march to Dandi. It would, however, be equally hazardous to discount the importance of lobbying on national politics then, as indeed in contemporary times.

The current debate over corporate lobbying conflates two separate issues: one, the legitimate persuasion of politicians on the merits of a certain policy measures and two, the illegal activity of bribing them in pursuit of this goal. The latter is wrong. The former is necessary. We might be in the throes of moral panic, but we should not mix up the two.

Lobbying is inevitable in a modern representative democracy: the more rules you make, the more complex the economy, the more the need for ‘specialists’ to intermediate between citizen, corporation and the state. That’s why we have lawyers, who help individuals and firms navigate the legal system. That’s why we have chartered accountants, who interpret the arcana of tax laws. These intermediaries play an important economic role by specialising in such matters and saving you and I the trouble of mastering law and the tax code when all we want is to go about our business.

Lobbying serves a similar function. It is far more efficient for businesses to hire public affairs specialists and lobbyists rather than involve the management in the byzantine world of Indian politics. If we consider lawyers and chartered accountants as legitimate professionals, why not lobbyists?

One argument against mainstreaming lobbying is that lobbyists risk making democracy a plaything of the rich. Those with deeper pockets will get to unduly influence government policies. This is reasonable in and of itself. However, isn’t it true that richer people can afford better lawyers and bend justice in their favour? Isn’t it true that richer people have smarter accountants who can find ingenious ways to pay less tax? More importantly, isn’t it the case that richer people already influence government policies, but in opaque, shady, dubious or wholly illegal ways? Those who doubt this can contact Mr Kejriwal for details.

Hey wait! What about the Niira Radia controversy? Doesn’t that connect shady corporate lobbying to high corruption? Yes, it does. However, that controversy arose in a country where lobbying is not only unregulated by perceived by many as a dubious activity. Had lobbying been a recognised as a legitimate profession, bound by its own norms and governed by a set of rules—like law and accountancy—we might have been spared some of the scandal.

This is, in fact, a good time to have a public debate over lobbying. Before 1991, most corporates would line up outside government offices as supplicants pleading for licenses, quotas and permits. After 1991 and until the exposure of big corruption scandals of 2010, canny businessmen sought to create legislative loopholes that would allow them to squeeze through, but keep their competitors out. This approach is becoming untenable.

Economic growth, globalisation, the Right to Information (RTI), urbanisation and the penetration of social media have changed the nature of how India’s corporations and governments engage each other. Businesses that try to create and exploit loopholes have a greater chance of being exposed, with the attendant loss to reputation and valuation. Like their counterparts in mature democracies, Indian businesses will have to engage in public affairs in cleaner, more professional, and transparent ways.

This can only happen if we allow the lobbying industry to function within the law. It is far better to regulate it rather than drive it underground. Indian democracy will be better served by placing the lobbying industry in a regulatory environment that requires companies to declare their lobbying activities and expenses, lobbying firms to disclose their activities and lobbyists to adhere to professional codes of practice. This is what the United States does. It’s not a silver bullet, but certainly an improvement over hypocritically persisting with a sanctimonious moral blindfold and pretending to be surprised that odious things happen in our country.

Copyright © 2012. Business Standard. All rights reserved.

Return and reforms

Will Manmohan Singh’s return to the finance ministry result in some reforms?

Pranab Mukherjee, an over-rated, over-respected and over-portfolioed cabinet minister presided over the finance ministry at a time when the results of UPA government’s gross mismanagement of the Indian economy began to show. His remedies worsened the malaise—not only has the economy slowed down, domestic and foreign investors have been given reason to believe that India’s economic managers are not only unserious, but also nearly banana. Retrospective taxation—Mr Mukherjee’s gift to economic policymaking—is an abomination and exemplifies how awfully perverted the UPA government’s thinking has been.

So, with Mr Mukherjee out of the cabinet (and undeservingly heading for Rashtrapati Bhavan) and Manmohan Singh taking over the finance portfolio, what are the prospects for reforms? None at all, argues the astute Swaminathan Anklesaria-Aiyar. Quite a lot, contends Sanjaya Baru. The truth may be in the middle, but despite Mr Baru’s valiant cheerleading, the odds are stacked up in favour of Mr Aiyar’s prognosis.

Samanth Subramanian sought my views for his report in The National. Here is my full response to his questions:

Q. Do you think the PM has the political capital he needs to make bold changes? Do you think, for that matter, that the government will risk making possibly unpopulist changes with the elections less than two years away?

Whether or not there will be any reforms depends on how much Manmohan Singh is willing to face down the Congress party establishment in order to secure his own place in history. It’s not so much about political capital but as he said in his 1991 speech “Sarfaroshi ki tamanna ab hamare dil mein hai/Dekhna hai zor kitna baazu-e-qatil mein hai.” Does he have Sarfaroshi ki tamanna?

Q. How much can any possible economic reforms redeem Manmohan Singh’s otherwise awful leadership of this UPA government?

What Manmohan Singh can do at this stage is revive the narrative of reforms, by setting out a long-term road map and by implementing the ones he can. The signal this will send will help set the economy back on track and hopefully redeem his own record.

Q. If you had to make a short, three-item wish list of reforms you hope he could enact, what would that list be?

Liberalise education, liberalise labour laws and start fixing land acquisition. Toying with fuel subsidies, reversing GAAR etc is mere signaling…the fundamental strengths of the economy can be reinforced only by liberalising education, labour and land acquisition. Playing around with financial markets and FIIs is mere tinkering. He must do what is necessary to revive direct investment, both domestic and foreign.

Everyone loves a good outrage

The reform agenda must be defended from Montek Singh Ahluwalia’s attackers

As far as op-eds go, this one marks a new low from P Sainath. It is not uncommon for him to frame grave issues in a divisive manner by conflating them with unrelated matters—like, for instance, agrarian crises and beauty pageants. This technique seeks to arbitrage outrage, as if decent people cannot be anguished at a tragedy without having to contrast it with an unrelated celebration. But when Mr Sainath links the poverty line, expenses incurred by the Planning Commission chief while traveling on official business overseas, the lavishness with which some tycoons spend their private funds and dubious dealings of crony capitalism, it can’t merely be his usual, unfortunate and misguided conflation.

Make no mistake: Mr Sainath’s hatchet job on Montek Singh Ahluwalia is part of an internal campaign against reform-minded individuals within the UPA government. This week’s manufactured controversy over renovation expenses of toilets in the Planning Commission’s headquarters is another manifestation of the same campaign.

Let us examine Mr Sainath’s cleverly framed allegations. His case is that at Mr Ahluwalia’s travel expenses are exorbitant, at an average of $4000 per day abroad. You would think he would give you some comparable data to prove Mr Ahluwalia has been unusually proliferate in spending public funds. Say, for instance, the average daily expenditure when cabinet-ranked Indian officials travel abroad on official business. Or for instance, the average daily expenditure incurred by Mr Ahluwalia’s counterparts from other countries. These would be like-for-like comparisons. Mr Sainath, however, does not do that. He compares these to a income of a person on India’s poverty line. All this proves is that $4000 is much higher than Rs 28. It does not even come close to proving that public funds were misspent, nor does it show that Mr Ahluwalia was unusually liberal with his expense budget. The onus of doing this research is on Mr Sainath, the person making the argument.

How Mukesh Ambani spends his personal wealth is irrelevant to the argument—he is free to spend his money as he pleases, even if it does not suit our tastes—, so is a discussion on cronyism and corruption in IPL. You don’t need to read the Planning Commission’s response to conclude that Mr Sainath’s allegations are sensationalistic nonsense.

But why choose Mr Ahluwalia at all? Mr Sainath’s arguments against profligacy would have been worthy of respect if he had compared the travel expenses of the top officials of government—from President Patil to the lowest ranking minister of state. How much, for instance, does Sonia Gandhi, as chairperson of the National Advisory Council, spend on her foreign trips? Whatever her political role, she’s an official of equivalent rank. How much do the members of the National Advisory Council spend on their foreign and domestic trips? Unless we have some numbers to compare with, we can’t say anything about Mr Ahluwalia’s trips.

What we do know is that Mr Ahluwalia is among the few people known to be advocating economic reforms in the UPA government. Singling him out with a view to making him the lightning rod for public outrage has all the signs of a political hatchet job. The objective is to discredit the reformist agenda by associating it with imaginary wrongdoing. After running the Indian economy to the ground, the socialists that haunt the UPA government’s policymaking are now trying to bury the narrative of reform, liberalisation and markets through subterfuge and intellectual dishonesty.

It’s no different with the renovation expenses of public toilets in Yojana Bhavan, the Planning Commission’s headquarters. One of the earliest reports on this, in the Times of India, again compared toilet renovation expenses with the the poverty line. Few in the mainstream or social media bothered to ascertain the scope of the renovations and compare it with similar renovations conducted in New Delhi’s public and private buildings. The purpose of the revelations was to insinuate wrongdoing on the part of Mr Ahluwalia, rather than to establish whether there was any wrongdoing at all.

Mr Ahluwalia is guilty: of not throwing his credibility on the line to compel the UPA government to launch the second-generation reforms, and to prevent it from engaging in monumental fiscal irresponsibility that has put India’s future at risk. Like his mentor Prime Minister Dr Manmohan Singh, he becomes complicit in the UPA’s misgovernance. He will have to answer these charges both to the nation and to history. This does not mean he’s lavishing public funds on unnecessary foreign excursions, building gold-plated toilets or taking a cut from the renovation contractor.

It is fair for the Opposition parties to politically exploit the situation to their advantage. However, it is in the national interest not to allow a campaign of unfair personal calumny to discredit the reform agenda—or indeed, to prevent Mr Ahluwalia from a chance to redeem his reformist record—to succeed. The Acorn completely agrees with Mint’s editorial defence of Montek Singh Ahluwalia. Mr Ahluwalia has “done far more for the poor than the busybodies and peddlers of poverty porn who are now attacking him.”

Mostly dogmas

More of the same gives you more of the same

One of the positive outcomes of the controversies sparked by General V K Singh is that it has, even if it is ephemerally, triggered a public debate on defence policy. Carrying it forward is important. In today’s Business Standard, Ajai Shukla responds to my arguments for reform in defence procurement.

Mr Shukla raises two broad points. First, that we ought not to throw away indigenisation while reforming the defence public sector; and second, that economic liberalisation that gave us a modern, competitive automotive industry cannot give us a modern, competitive defence industry. Let’s consider them in turn.

The argument, as I explicitly state in my article, “is not say indigenisation is an unworthy goal. Rather, it is to suggest that the longstanding approach to indigenisation has not only met with limited success but also that the same goal can be achieved using different means.” Mr Shukla shows how reliance on foreign technology causes problems of denial, interoperability and sabotage. The answer, however, is not a “sharper focus on indigenisation” which can easily become wrapping paper for the reform-resistant status quo. No amount of tinkering with the structure and management of India’s defence PSUs can make them competitive enough to provide for our defence requirements.

In fact, the Mr Shukla’s own points support my argument that PSUs have captured our defence procurement policy. “DPSUs,” he writes “notably BEL and BEML, have undermined indigenisation by serving as fronts for the back-door induction of foreign technology through partnerships with foreign vendors.” The political economy of the Indian public sector enterprises will not make them do any better if they are given a sharper focus or placed under a different ministry.

Next, the argument that the defence industry as a whole is different from the automotive (or any other industry) is untenable. Beyond the point that the defence industry has fewer customers than other industries, they are all made of the same people, have the same economic incentives, draw capital from the same economy, react to competition in similar ways and so on. It is unfathomable why Mr Shukla should consider this naïve. Of course, you can’t expect a private sector defence industry to emerge if the government creates disincentives for it, or if it refuses to purchase from it, as happens today. I recall similar charges of naiveté being thrown about when telecommunications, banking and insurance sectors were liberalised. People deeply involved in an industry feel that their industry is different. Well, it’s not. The laws of economics apply to defence as much as they do to the vada pav industry.

Similarly, it is not at all strange to see arguments that free trade or entry of foreign players will weaken the domestic private sector. That is an argument that has been made since Nehruvian times, much to the detriment of the nation. Sadly, it continues to be made despite being proven wrong. Did allowing foreign automobile manufacturers, telecom companies or insurance providers hurt our car makers, telcos or insurance companies? The reality is quite to the contrary. You can have a debate on whether or not Indian consumers should be allowed to purchase from multi-brand retail chains owned by foreigners. But how can you have a debate on whether the Indian armed forces should be prevented from having the best possible equipment to protect us?

The danger with the kind of attempted middle-ground approaches suggested by Mr Shukla is that they end up as a cover for inaction. The onus is on those who prefer mild variations of the status quo to explain why persisting with policies that have failed us for decades will suddenly begin delivering promised results now.

The dogmas that undermine our defence

Reforming defence procurement, mindset first

This the unedited version of my op-ed in today’s Business Standard.

Why is it that on the one hand India is the world’s biggest arms buyer, and on the other, the outgoing army chief has complained that we are short of basic war-fighting equipment like tank ammunition and field guns? Why is it that our defence procurement takes years to complete and can be halted or reversed by allegations of corruption? Is corruption so rampant within the top echelons of our armed forces that the both the army chief and defence minister could shrug off a brazen attempt to bribe the general in his office? How come the defence ministry has spurned and blacklisted vendors from countries whose geopolitical interests are aligned to ours?

It is easy to treat these issues as merely the failings of individuals and the shortcomings of the latest procurement rules. It is easy to park the unholy affair under the general head of how corruption is undermining our nation. To do so would be to ignore the underlying causes of why things have some to such a pass.

The first is the dogmatic pursuit of indigenisation, a mindset that pervades the defence establishment. It has resulted both in policy capture by public sector unit (PSU) network and introduced layers of complexity in procurement rules. Ordinarily, as end users, the armed forces would want the best possible equipment for the rupee, but they too are prisoners of a narrative that involves the pursuit of a chimerical indigenisation. For in New Delhi, it is still nearly heretical to suggest that an enemy killed by a foreign-made bullet is as dead as an enemy killed by a partly-indigenous bullet.

This is not say indigenisation is an unworthy goal. Rather, it is to suggest that the longstanding approach to indigenisation has not only met with limited success but also that the same goal can be achieved using different means. Back in the 1970s and 1980s the government couldn’t produce an indigenous passenger car no matter how many it purchased from Hindustan Motors and Premier Automobiles. It was only after the liberalisation of the economy and the entry of foreign competitors that Tata Motors, Mahindra and others could produce automobiles that are not only indigenous but also in the same league as their foreign competitors. The route to effective indigenisation, therefore, is counter-intuitive. We must open our defence sector to foreign investors so that Indian industry can acquire the capabilities to produce the equipment our armed forces need.

This cannot be achieved by offsets that require foreign suppliers to spend part of the contract price in India. Offsets might re-inject part of the defence expenditure into the domestic economy but will not result in the transfer of knowledge, skills and human capital that are essential for India to build a modern defence industry. The most effective way to get there is to open doors for foreign direct investment in defence manufacturing. Capping the foreign equity at 26% has attracted few investors. Instead of arguing over another arbitrary level at which to set the cap, we should do away with it altogether.

The second is the equally dogmatic anti-middleman mindset. Going by the statements of the defence minister, it would appear that middlemen—like their lobbyist cousins—are uniformly evil and therefore ought to be banned outright. Yet middlemen are not the cause of corruption. Rather, both middlemen and corruption are the twin offspring of the same parent—complex procurement rules.

The more complex a set of rules, the more the need for ‘specialists’ to help navigate through them. The reason lawyers and chartered accountants exist is because the law and the tax code are complex. Middlemen exist because they perform a useful economic role. There’s nothing intrinsically wrong or immoral about them. It is our rules that make them so, driving underground a genuine economic activity.

Why do we have complex procurement rules? Because we have overcrowded them with multiple, sometimes conflicting objectives. Changing our approach to indigenisation as argued earlier can simplify them to some extent. Even so, it is unlikely that they can be simplified enough to eliminate the need for agents. That is why instead of prohibiting middlemen in defence procurement, a far better policy would be to create a regulatory framework under which they can operate legitimately.

Agents could be required to declare their past and current affiliations, and disclose relevant family connections. Former defence officers and their civilian counterparts could be required to serve out a cooling off period before getting into the business. The policy objective ought to be to align—to the extent possible—the economic incentives of the middlemen to the organisational interests of the armed forces. We don’t have to like lawyers and chartered accountants in order for us to let them discharge their economic roles. Why should it be any different with middlemen?

The final cause of the mess in our defence procurement is that we often ignore the geopolitical consequences of our purchases. Awarding the tender to the lowest bidder might be the best method to resurface parade grounds but not for billion dollar purchases of equipment. To treat both purchases the same way would be to lose strategic leverage that comes from being able favour a country which can give us something else that we need. Blacklisting companies from friendly powers exposes us to purchases from less friendly ones.

The biggest argument for indigenisation is that reliance on foreign suppliers is risky because supplies can be withheld in order to coerce us. That risk can be mitigated if we procure military equipment from countries with which we have extensive economic ties, and vice versa. Reducing the incongruence between our top trading partners and our top arms suppliers ought to be an important policy goal.

The ghost of Bofors continues to haunt our defence procurement. Avoiding stepping on the dung on the road is now more important than getting to the destination. As the defence minister admitted in parliament, the pace of modernisation is slow because every allegation of corruption is investigated. This leaves us with the unfortunate implication that that anyone, from an inimical foreign power to a disgruntled equipment vendor, can apply brakes on the modernisation process. The ghost must be exorcised by liberalising the defence manufacturing sector and getting rid of the superstition that passes off as strategy.

Copyright © 2012. Business Standard. All rights reserved.

Liability-shiability absurdity

Liberalise the nuclear power industry!

It is painfully hard to watch the ongoing drama over civil nuclear liability. So much is the political class—from the UPA government to the opposition BJP—engrossed in lawyerly detail, so much has the Congress party abandoned the idea of economic reforms which Manmohan Singh was once famous for, that the biggest policy issue is not even being debated.

That issue is the full liberalisation of the nuclear power sector. There is no good reason why only state-owned (or majority state-owned) enterprises should operate the engines that make electricity from uranium. Instead of quibbling over whether or not to limit liability to operators or to extend it to their suppliers, the political class and the strategic analysts who advise them should be setting their sights on amending the Atomic Energy Act to liberalise the sector and allow for a neutral regulator to supervise them.

During the thick of the debate over the India-US nuclear deal, this blog had argued that liberalising the nuclear power industry is necessary, and that the nuclear deal is an opportunity to accomplish that task. Instead, both the government and the opposition have tied themselves in a legalistic bind over the irrelevant issue of supplier liability.

Irrelevant? Largely, yes. Because in a liberalised environment, all the government needs to do is hold the operator liable, and leave it to the operator to decide how it wants to cover its liabilities.

Related Link: PRS Legislative Research’s M R Madhavan’s brief on the civil nuclear liability bill, in Pragati