India's supply chain vulnerability with Chinese APIs: Industrial policy vs. sophisticated policy design

by Gautam Bambawale, Vijay Kelkar, Raghunath Mashelkar, Ganesh Natarajan, Ajit Ranade, Ajay Shah.

India has a remarkable drugs industry. This involves a high dependence upon Chinese manufacturers of `active pharmaceutical ingredients' (APIs). Given the willingness of the Chinese state to behave in unusual ways in economic engagement (e.g. rare earths), there is a certain supply chain risk that is faced by Indian firms.

Should state power be used in addressing this problem? And if so, how should this be done? How do we avoid the long decades of failure in industrial policy, i.e. the experiments with policy pathways where a government picks winners, with a government that claims to know the correct ways in which production should be organised? Today we saw a fascinating article: Drugmakers cry ‘monopoly’ as Modi govt picks 1 firm each to make over 20 key raw materials by Himani Chandna in The Print. This narrates the story of a 1960s style Indian industrial policy intervention played out poorly.

Our book Checkmate China: Winning through strategic patience and accelerated economic growth is forthcoming from Rupa Publications later this year. A paper based on this book has been released in the public domain and summarises our strategic thinking for India about the China question. In the book, we have a treatment of the API question. This text is excerpted ahead. It represents our attempt at learning from 75 years of failure with industrial policy. This approach would have likely avoided the difficulties described in Himani Chandna's article.

Book excerpt: Designing a government intervention to address the supply chain risk faced by Indian firms that import APIs from China

The Indian drugs industry is a heavy user of Active Pharmaceutical Ingredients (APIs) sourced from China. In an environment where we see China as a bad actor in the global economy, where Chinese nationalism can harm counterparties abroad, this presents a risk to the supply chain. It is easy to design Indian economic nationalism which can combat this. However, as with all aspects of industrial policy, such use of state power raises many concerns. It is difficult for a government agency to know whether a certain industry merits subsidies and whether certain firms merit subsidies. There is a long history, in India, of “infant industry” arguments being used for decades, in which some well-connected Indian firms stay infants and continuously collect fiscal subsidies. Similarly, trade barriers in the form of quantity restrictions are prohibited under the WTO and tariffs are harmful and should best be avoided.

Thus, we face a puzzle: How can state intervention be designed, which can make a difference to India’s China problem with the supply of APIs? Given the failures of industrial policy as it was practiced in previous decades, how can this one sharp problem (supply chain risk faced by Indian pharma companies who rely on Chinese producers of APIs) be addressed by state action? How can this state action be done at the minimum fiscal cost, and while imposing the minimum distortions upon the economy? How can the risk of central planning – of officials determining the outcomes of the market-based competitive process – be avoided?

When faced with supply chain risk with a certain API from China, we should not jump to the conclusion that the answer lies in making the API in India. Perhaps the efficient solution is to import the API from a country other than China. Perhaps the efficient solution is to make it in India. Policy makers cannot assume that India has competitive advantage in making the API, when private persons have thus far chosen to not build such factories in India.

The first step in every policy analysis must be a thorough understanding of the behaviour of the private sector assuming there is zero state intervention. When faced with this new supply chain risk, what are Indian drug companies likely to do out of self interest:

1. Customers of these bulk drugs would be conscious about the business risk that they carry. They would watch the rise of nationalism in China with concern.
2. They would increasingly seek to diversify their sourcing. As an example, we are seeing Fortune 500 companies increasingly reduce the share of China in their global production.
3. One important response by the firms will be to buy APIs from countries other than China, e.g. Taiwan or Japan or Brazil. This is perfectly adequate solution, from the viewpoint of an Indian firm, to the threat of Chinese nationalism. Our problems with Chinese nationalism only imply that we should diversify away from China; this does not justify self-reliance.
4. One element of the process of looking for non-China sourcing is higher demand for firms in India that make APIs, which would kick off a supply response. Ordinarily, this market process will work itself out. But it is a difficult and slow journey. A government program can be designed that addresses this problem, which has a few key features: (a) We do not assume that in the long run India will be a successful producer of APIs, but we consider this possible; (b) The intervention is pre-announced and in a few years, liquidates itself; (c) The intervention imposes zero trade barriers upon imports or exports of APIs or drugs with respect to any country.

This proposed intervention would involve the following steps:

• A government agency would identify the top 50 APIs and the quantities $q = (q1, q2, .. q50)$ which are being imported from China.
• We establish the objective of domestic production that comes up to half of the imports from China over a five year period. This suggests escalation of quantities as: $0.1q, 0.2q, 0.3q, 0.4q, 0.5q$ over a period of five years.
• We put out a binding commitment on the part of the state that the government will run procurement restricted to domestic producers only, where there will be purchases over the next five years of these quantities. The government will commit to placing orders with 3 lowest-cost firms that produce in India, in each year’s bidding. The requirement from a bidder should be that production is done in India. Foreign or Indian firms should be permissible, subject to a restriction against firms controlled by the Chinese state e.g. bar a firm where any one member of the board of directors is an employee of the Chinese state or the CCP.
• These commitments about a rising scale of GOI procurement will create incentives for Indian/foreign firms, located in India, to build knowledge and physical capacity to produce APIs at a large scale.
• The government agency has only one objective: to trigger off economies of scale and competition by producers in India. Once the goods are purchased by the Indian government agency, what is it to do with them? Indian firms might not like to buy these APIs at the purchase price, as the purchase price may well be higher than the world price of these APIs. Once the goods are purchased, this agency would run a global auction to sell the same goods off, at the highest possible price. Indian drug companies could potentially choose to buy these goods, but these purchases would be at an import-parity-pricing price. As a consequence, through this program, the Indian government would be drop shipping the goods, purchased in the make-in-India auction to buyers who came into the sell-from-India auction.

This scheme constitutes a promise to buy from Indian firms, at rising quantities over five years, at the lowest prices that Indian firms are able to muster (3 firms for each product in each year). At first, the price in India will be high. Under this proposal, GOI will instantly turn around and sell off the goods at the highest possible price through a global tender. The gap between the two prices will be the fiscal subsidy that is being put down, to spark off API production in India.

At the end of five years, the domestic firms would be on their own. If the theory of change is correct – that there is a fixed cost of building knowledge and facilities to make APIs – then this is the minimum intervention that gets the job done. If the theory of change is incorrect – that India is not actually a good platform for making APIs – then in five years, this fiscal outgo would end, and India would not be a producer of APIs.

There are many strengths of this design:

1. Private persons face no new coercion, other than the coercion implicit in mobilising tax resources which are the source of government spending on this program.
2. There is no tariff; there is no interference in international trade. This program is layered on top of a free trade system.
3. It is a simple and transparent intervention. What it requires is the bureaucratic capability in the Indian state to do procurement: to run these auctions, to buy APIs in India, and to sell the same goods globally, doing high volumes of non-complex commodities. Indian officials are not asked to form a judgement about what APIs are important, about whether an API can efficiently be made in India, about the technology through which an API can be made, about whether public money should be used to build factories to make APIs.
4. There is a lack of fudge factors where there can be lobbying and negotiations.
5. No central planner should ever assume s/he knows the way forward. This design respects the possibility that India might actually have no place in API production. In this case, at the end of this program, there will be no API manufacturing in India. The program would have wasted taxpayer resources, but it would not distort the economy.

However, there are four main difficulties of this design:

1. For the desired impact upon incentives of private firms who should commit themselves to investing in building large scale API production, the private sector would have to believe that the deeds of the government will match the words of the government over the coming five years. If private persons feel that the Indian state cannot be trusted to stay the course for five years, then the incentive impact of the government program would not materialise.
2. The private sector has to feel safe engaging with government procurement; it has to believe that the procurement will be done correctly, that payments will be made on time, that there will be no investigations by agencies.
3. If this works, at the end of five years, Indian API vendors will lobby to not shut this down. Every policy designed to support an infant industry ends up with entrenched infants who like to wield state power in their favour.
4. While the objective of the program should be to foster Indian or foreign firms who choose to produce in India, there is the possibility that this could be skewed to favour Indian firms.

Analysing Bambawale, et. al., 2021 ("Strategic patience and flexible policies: How India can rise to the China challenge")

by Shubhashis Gangopadhyay.

This is the text of my discussant comments at LEPC 4.1 today, which is a session organised around a talk by Gautam Bambawale presenting the recent paper Bambawale et. al. 2021.

The paper makes a strong and convincing argument for the need to create an ecosystem that fosters growth that is fast and sustainable. It focuses strongly on what needs to be done to ensure Indian citizens a desirable future. This future is envisioned as one where we are in control of our own destiny, China notwithstanding. I am in complete agreement with the need for India to grow economic muscle. I also agree that this will play a large part or, could even be necessary, to thwart China’s adventurism in our neighbourhood. But what I like most about the paper is that the authors’ emphasis is not on diplomacy, or on battle preparedness, or on economics but on the realization that they all need to play their respective parts for India to reach a common goal.

The paper is a “must read” for all. The paper sets the tone for how public discourses need to be carried out --- state the problem, clearly articulate the solution and, explain why the solution will work. A public discourse is not simply the voicing of opinions but also explaining the reasons behind them. Reading it will not only inform, but also improve, the public discourse on this topic. Respecting the spirit in which this paper has been prepared, I will try and add to the discourse initiated by the authors.

The paper makes an excellent argument for reforming the ecosystem within which economic transactions are planned and executed. To borrow a term from game theory, building up India’s economic muscle is seen as the “dominant strategy” against the challenges posed by China. There is, or can be, very little dispute about the need for India to grow economically.

While agreeing completely with the recommendation in the paper, I would like to modify somewhat the problem statement. For that, I will distinguish between a goal, or an objective, and the strategy to achieve that goal. A winning strategy is determined by the desired objective of the player and the possible responses by her opponent. In other words, a player’s strategy cannot be independent of what the other player is doing or, of the different circumstance in which the game is being played out.

India’s strategy is not an action it should undertake but an enumeration of the set of all contingent actions that India must take. Contingent on what? Contingent on the response that China will undertake for each of the actions we take. The choice of actions could also be contingent on changing circumstances for which China may not be directly responsible. E.g., if we criticize Myanmar’s military government, China may move in and make the Myanmar government hostile to us; on the other hand, if we do not criticize, we may face problems in the Quad.

A player’s strategy is derived, among other things, from the player’s own objective and the threats to that objective posed by the responses of the other players (or competitors) and, the changes brought about in the environment by nature (uncertainty). Simply put, the strategy is derived from the objective and never the objective itself.

There are two reasons why I want to distinguish between a goal and the strategy to attain that goal. First, as stated before, formulating the problem determines the answer we get. The way the paper currently reads, China is the problem and growing economic muscle is necessary to thwart China. And, it is this that makes me nervous. Why? Our policymaking has been mostly in response to a crisis and we slip back to status quo ante as soon as the crisis blows over. As an example, consider the trade liberalization measures undertaken in the post-1991 period (when we faced a foreign exchange crisis), and the roll-backs in more recent years when we are not facing any foreign exchange shortage. Trade liberalization was never seen by our policymakers as necessary for economic growth; it was always seen as a step towards easing the foreign exchange shortage of 1991. Hence, I am afraid that if we do not clearly state that growing economic muscle is an end in itself (and not simply to thwart China’s adventurism), we will go back to our old economically inefficient ways as soon as the China threat is neutralised.

The second reason is a bit more nuanced and depends essentially on what one means by strategy. As the paper points out, correctly, the game will be played over many years giving enough time both, for China to push back on what India is doing and for circumstances to change as global uncertainties are resolved. For example, if we develop manufacturing and/or services to export into Africa, I do not think that China will simply watch us do so and not push back in various ways to defeat India’s purpose. The correct definition of strategy will enable us to consider the following options (say) --- grow through the African market, focus on the Western market, or ASEAN or, diversify in such a way that China has to push back in every market at great harm to itself (push back is always costly to the one doing it). In other words, we must plan our economic growth in such a way that China cannot, or will not, be able to force us to give up our growth plan in the way we have envisaged. Our growth path must be such that in case they want to affect it, it will be costly to them but with minimal repercussions on us.

This approach immediately alerts us to a careful formulation of our goal, along with a deep understanding of what (a) China is trying to achieve and (b) the national interests of our potential partners. This latter is very important and I get a whiff of romanticism in the paper’s suggestion of forming partnership with those who believe in individual freedom, market resourcefulness and the rule of law. The biggest supporters of the free world routinely justified their inactions against apartheid and continue to be in denial while condoning the atrocities of various “friendly” dictatorial regimes! In other words, they are going to partner with India, against China, only if it is in their interest to do so --- not because they have great regard for India’s righteousness. They will support us only when there is an alignment of our interest with theirs. Some years ago when I complained to a high level US official about how their policies in India’s neighbourhood are adversely affecting us, he was quick to point out that he was paid by US taxpayers not to meet India’s aspirations.

It could be dangerous to misread China’s objective. It may appear as an approach relevant to a zero-sum game (very “mercantilist”), when the economic world is uniquely, and definitely, a positive-sum game. So, why is China doing what it is doing? The paper seems to suggest that this is largely an attempt to raise nationalistic fervour within China to distract people from its domestic problems (of a growth slow-down amid growing disparities). If this indeed is the reason then once China gets back on its erstwhile growth path, Chinese adventurism along India’s borders will diminish. Contrast this with the possibility that irritating Indian border forces is a longer term plan. Should our responses in both cases be the same? To play the game properly, we must be able to anticipate China’s game plan. This will only happen through careful and deep investigation of the ground realities in China along with the interplay among its political actors. Not understanding fully China’s objective is where we begin to lose the game! The paper does point out that there are more people studying India in China than Indians studying China. Given our definition of strategy, the importance of correctly reading China’s objective is crucial to determine India’s optimal strategy.

I want to highlight a specific difference between our two systems that differentiates the manner in which we achieve our respective goals. China could get its banks, companies, policymakers and all other groups in their society to do exactly what the central authorities wanted them to do. In India, that is not feasible. This does not put us at a disadvantage as long as we are aware of it and, hence, stop borrowing “best practices” from China or, for that matter, any other country. We are going to rely on the resourcefulness of our people, operating through innovations and investments by the private sector, facilitated through the appropriate institutions implementing market rules. Historically, this approach has been found to be a more sustainable path to economic growth. As the paper correctly points out, this is a huge advantage for India especially if we see the fault lines now opening up in the Chinese system.

India is not a unitary system but a federal one. Indeed, whatever “ease of doing business” policies the central government rolls out, the ultimate hurdles can be taken down by state governments only. Why would various sops to foreign businesses bring in FDI when our own companies, even when they are flush with investible resources, not investing in India? So the first job of this exercise is to move out of Delhi and get the state governments aligned with the nation’s interest and coordinate their strategies. In this context, I must say that I am extremely sceptical of following a SEZ policy in India simply because China did it successfully. Its implementation invariably leads to corruption and crony capitalism, which will lead to umpteen consequential issues which are difficult to handle in a vibrant federal democracy where the rule of law should reign supreme. What China could do with its centralized economic approach and business activities through state-owned enterprises is simply not doable in India.

Our goal of sustained high growth has to be attained in a way that suits the Indian context. Japan, China, South Korea and the Far East, all followed their own paths to reach where they are now. The differences in the paths they followed are more pronounced than the similarities. And that is what we need to understand --- scholarship without thought will simply not do.

Shubhashis Gangopadhyay is a researcher on India and economics.

The treason of the learned

I was reading John Gray in the New Statesman on Mao Zedong:

... the collection has the shortcomings that are to be expected in a book of essays by academic authors. The prose style is mostly stodgy and convoluted, and the contributors seem anxious to avoid anything that might smack of a negative attitude towards the ideas and events they describe. “As a group,” the editor continues, “we are diverse with respect to age, gender, ethnicity and political sympathies.” He is right that, judged by prevailing standards, it is a well-balanced group. All of the relevant disciplines are represented – history, area studies, literature, political science and sociology – and although ten of the 13 contributors teach in the US, the collection is representative of the range of views of China that you will find in universities in much of the world. However, the fact that it reflects the present state of academic opinion is also the book’s most important limitation.

Reading the essays brought together here, you would hardly realise that Mao was responsible for one of the biggest human catastrophes in recorded history. Launched by him in 1958, the Great Leap Forward cost upwards of 45 million human lives. “When there is not enough to eat, people starve to death,” Mao observed laconically. “It is better to let half of the people die so that the other half can eat their fill.” He did not specify how those condemned to perish would be made to accept their fate. Ensuing events provided the answer: mass executions and torture, beatings and sexual violence against women were an integral part of a politically induced famine that reduced sections of the population to eating roots, mud and insects, and others to cannibalism. When Mao ordered an end to the horrific experiment in 1961, it was in order to launch another.

There is a Principal-Agent problem going on with academic authors. You may think that academics should seek the truth and do things that matter, but what most academics do on most days is worry about what journal editors and referees would think about their work if X was done. This generates all kinds of distortions. It's more like the fashion industry than most of us care to admit: will blue look better than black? The journal editors define what is fashionable and hordes scurry after that. It's bad enough in economics (link, link). It's much worse in the humanities where the anchor to empirical evidence is weaker than the weak link to reality that's found in economics.

Gray's article also reminded me of the famous essay by Omar Ali (link, link) on the Indian and Pakistani Left. I often get struck by the odd subset of persons that write on India in the New York Times.

The biggest exchanges in the world

There are two ways to measure turnover: dollar value and number of trades. By dollar value, advanced economies dominate the rankings. But the number of trades is more important than meets the eye. The number of trades is a measure of what's going on : 1000 trades/s is a lot more than 100 trades/s. And, as far as the IT complexity of an exchange is concerned, number of trades is all that matters. For the folks building and running exchanges, or consuming a feed from an exchange, the IT complexity is determined only by the number of trades.

Here's data from the World Federation of Exchanges for the top 10 exchanges by the number of transactions (measured in millions):

Exchange	2012 transactions	2012 rank	2013 transactions	2013 rank	Change (%)
NSE India	1407	1	1449	1	3.04
NYSE Euronext	1375	2	1188	3	-13.59
NASDAQ OMX	1268	3	1151	5	-9.17
Korea Exchange	1219	4	1032	6	-15.38
Shenzen SE	936	5	1289	2	37.82
Shanghai SE	926	6	1153	4	24.61
BSE India	356	7	345	8	-3.07
Tokyo	350	8	599	7	71.39
London	222	9	211	10	-4.87
TMX Group	216	10	235	9	9.15

This shows that NSE was #1 in the world in both 2012 and 2013. With 1449 million transactions spread over roughly 250 days of roughly 20,000 seconds each, this is an average intensity of 290 trades per second. There is no other part of Indian finance where a win of this scale has come about. I used to be nervous about the vulnerability of these achievements, but now the danger has subsided. We have a good equity market and it's now unlikely to get messed up. As the Indian Financial Code gradually falls into place, the equity market will become much better.

The listing underlines the well known fact that the electronic limit order book won. There are no market maker exchanges of note any more. This is a serious problem for academic finance as a lot of our intuition is still rooted in the old world of market makers. I see a striking contrast between the importance of market makers in the finance literature and their irrelevance in the real world. The only game in town is the anonymous limit order book market, and academic finance is weak on it.

If you add up the two Chinese exchanges, there is more activity than the two Indian exchanges. In 2012, the two Chinese exchanges added up to 1861 million transactions, which went up sharply (by 31.25%) to 2442 million transactions in 2013. The two Indian exchanges, in contrast, added up to 1762 million transactions in 2012 but grew by only 1.81% to 1793 million transactions in 2013. In 2013, the two Chinese exchanges added up to a trading intensity that was 36% greater than India. If Shenzen and Shanghai keep up their blistering growth, and NSE stays at low growth, then by 2015 or so, NSE will be displaced from the #1 slot. The question mark for China lies in establishing something like the Indian Financial Code and the rule of law.

This ranking implies that NSE is a great lab for doing research. It is now a bigger exchange than the NYSE and NASDAQ by number of transactions. In addition, liquidity in the US is fragmented across numerous trading venues, which makes is much harder to understand what is going on. In contrast, the order flow for spot and derivatives is largely consolidated. If one can marshal data for NSE and BSE there is 100% coverage. There is no OTC trading and no dark pools. In fact, if a stock is not on the stock derivatives list, it is essentially impossible to take a leveraged position on it. This makes India a clean laboratory where the working of an equity market can be understood.

The US is the ideal lab for understanding what happens when liquidity is fragmented; research projects focusing on fragmentation of liquidity should be done using US data.

The heart of the action in modern exchanges is algorithmic trading. I see one world for the really big exchanges where on average there are over 200 trades/s with peaks of over 10,000 trades/s, and another world for all other exchanges. There is one cadre of finance and IT folks, spread all over the world, who are building these hairy systems around the top exchanges. If you setup a conversation on algorithmic trading between the folks in Bombay, New York, Korea and China, they'd have a lot to say to each other. A new world of financial firms is going to emerge, where a common set of finance & IT skills are deployed across the four locations.

A very large number of transactions yields economies of scale. It is not surprising that the charges in India are low by world standards. This is a competitive advantage in the production of transaction services. If India makes the right moves on the policy bottlenecks, a greater fraction of India-related activity will come to India, and India can be a platform for trading global products. The competitive advantage of NSE and the algorithmic firms surrounding NSE comes from a combination of world class transaction intensity but low revenues/trade. This forces exchanges and algorithmic firms in India to be more intelligent.

Macroeconomic and financial policy challenges of China and India: A special issue of the Journal of International Money and Finance

Joshua Aizenman, Kees Koedijk and I co-edited a special issue of the Journal of International Money and Finance, December 2013, which has:

1. Overview: Macroeconomic and financial policy challenges of China and India; Joshua Aizenman, Ajay Shah.
2. Is China or India more financially open; Guonan Ma, Robert N. McCauley.
3. Why do emerging markets liberalize capital outflow controls? Fiscal versus net capital flow concerns; Joshua Aizenman, Gurnain Kaur Pasricha. Summary.
4. The investment technology of foreign and domestic institutional investors in an emerging market; Ila Patnaik, Ajay Shah. Materials.
5. How do foreign investors impact domestic economic activity? Evidence from India and China; Chotibhak Jotikasthira, Christian Lundblad, Tarun Ramadorai.
6. The financing and growth of firms in China and India: Evidence from capital markets; Tatiana Didier, Sergio L. Schmukler. Summary.
7. The financial crisis and Indian banks: Survival of the fittest? Barry Eichengreen, Poonam Gupta.
8. Macro-prudential policies to mitigate financial system vulnerabilities; Stijn Claessens, Swati R. Ghosh, Roxana Mihet.
9. China's financial linkages with Asia and the global financial crisis; Reuven Glick, Michael Hutchison.
10. The growth of a shadow banking system in emerging markets: Evidence from India; Viral V. Acharya, Hemal Khandwala, T. Sabri Oncu.
11. Impact of exchange rate movements on exports: An analysis of Indian non-financial sector firms; Yin-Wong Cheung, Rajeswari Sengupta. Summary.

International financial centres: Peering into the future

I did the SIGFIRM Quarterly Lecture at the University of California in Santa Cruz recently:


Also see: Mumbai as an International Financial Centre, a project led by Percy Mistry.

You may like to subscribe to the NIPFP MF channel on youtube.

Rupee and Real futures at ICE

Intercontinental Exchange has announced cash-settled futures on the Indian Rupee and the Brazilian Real [press release] [Saabira Chaudhuri in the Wall Street Journal]. With this, ICE is the first serious global exchange to start trading in the rupee.

Vimal Balasubramaniam and I have pointed out that the global market for the Indian rupee is adding up to some fairly big numbers. I recently noticed that in 2010, even though China is a much bigger economy than India, rupee trading was 0.9 per cent of global currency trading while RMB trading was at 0.7 per cent. Similarly, it appears that the INR NDF is bigger than the RMB NDF, even though China is a much bigger economy. Something is going right in the growth of the rupee as a big currency by world standards. Rupee trading at ICE would strengthen that process.

The ICE announcement also connects to the issues of global competition for Indian underlyings. The two biggest financial markets in India are Nifty and the rupee. So far, NSE faced serious competition with Nifty futures trading at SGX and CME, but there was no significant rival with the rupee. With the arrival of ICE, the competitive dynamics for the rupee changes, which is a welcome development. NSE now faces genuinely difficult competition from three first-tier rivals: CME, ICE, SGX. At the same time, the outlook for rupee trading in India is hobbled by an array of constraints:

• ICE can pitch for business from non-residents, while NSE cannot, since foreign participation in currency futures is banned. We seem to think that OTC trading of currency forwards requires encouragement from industrial policy operated by RBI.
• ICE is able to start contracts any time it likes on (say) the Brazilian Real while NSE is forbidden from starting any new contracts.
• India has mistakes on tax treatment, lacking residence based taxation, while the world has all this well sorted out.
• India has an array of other policy and regulatory mistakes that hobble local players. The ICE transaction charge is zero. I wonder if litigation will now start at CCI to try to block this.

A process is afoot, at present, through which the Indian financial system is being hollowed out. If this process runs unchecked, RBI and SEBI will be left lording over nothing. There is a need to reverse this  policy framework of reverse protectionism.

I should like to call you all by name

• China: Worse than you ever imagined by Ian Johnson in the New York Review of Books.
• Totalitarianism, Famine and Us by Samuel Moyn in the Nation.
• Stalin's cannibals by Ron Rosenbaum, on Slate.
• The worst of the madness by Anne Applebaum in the New York Review of Books.
• Stalin and Hitler: Mass murder by starvation by Timothy Snyder in the New York Review of Books.
• Kakfa in Beijing by John Garnaut and Sanghee Liu in Foreign Policy.
• Bloc heads by Louis Menand in the New Yorker magazine.
• Yegor Gaidar's story about the dying days of the USSR is fascinating. This is not going to be the endgame of the PRC.
• Requiem, by Anna Akhmatova.

One tangible pathway to fighting corruption: Increasing the disclosure by firms and politicans

While many researchers have started studying corruption, as of yet, the field is remarkably bereft of tangible policy choices that would yield reduced corruption. As I read The other side of reforms by A. K. Bhattacharya in the Business Standard, and Obtaining financial records in China by David Barboza in the New York Times (which describes the modus operandi of the New York Times' remarkable expose of corruption in China at the level of the Prime Minister, also by David Barboza), I thought there is one tangible policy lever through which we can combat corruption: Increase the transparency of companies and increase the transparency of politicians.

Transparency by firms

It is useful to think at two levels: Transparency about the activities of companies created by politicians, and transparency about the activities of the big companies that pay bribes. I am reminded of the Extractive Industries Transparency Initiative. One element of this is an attempt to change the behaviour of repressive regimes (e.g. Russia) by forcing the companies that deal with them (e.g. BP) to behave differently. Even if the politicians are irredeemably bad, we can change things by modifying the incentives of the firms that pay bribes.

In a recent post, Indian capitalism is not doomed, I argued that the markets for labour and capital are exerting pressure on firms, pushing them towards higher ethical standards even under conditions of medium grade enforcement by the State. To the extent that the firms are more transparent, their misdeeds are more likely to be exposed, and then these kinds of pressures will work more effectively.

At present, the MCA-21 database is clumsy and painful, but it's a step forward in one respect: It does yield some information about many companies. This has been of value in tracing the activities of the companies controlled by politicians and their business partners. This process needs to be carried forward in many dimensions:

• At present, the P&L statement of "public" companies is publicly visible in MCA-21. This definition needs to be widened so that the P&L statement for many more companies become publicly visible.
• The disclosure environment for listed companies in India is quite good. There is no quarterly balance sheet; the shareholding pattern statement is misleading; there are a few other blemishes. But the information access for listed companies is vastly greater when compared with what's in MCA-21. Many features of the disclosure regime for listed companies (where the work is led by SEBI) need to go into the disclosure regime for all companies (were the work is done by the Department of Company Affairs).

If private limited companies become more transparent, politicians will try to use trusts and limited liability partnerships for their activities. Improvements in transparency should extend to LLPs, trusts and partnership companies also.

Transparency by politicians

Alongside a push for greater transparency by firms (both the big listed companies and the firms created by politicians), we should be pushing towards greater transparency by politicians. This push towards transparency has begun, and has started yielding some results. It needs to be carried forward. The comprehensive financial lives of MPs, MLAs, and their next of kin should be in the public domain. The transparency regime should kick in when a person wins an election, and should stay in place for atleast 10 years from that starting date. Any company or LLP with shareholding of more than 1% by an MP or an MLA or their next of kin should have to comply with the comprehensive disclosure manual of SEBI for listed companies. Any trust when an MP or an MLA or their next-of-kin is a trustee should have to similarly fall into a high quality disclosure framework.

Privacy is precious

There is a tradeoff between privacy of citizens and corruption control. There is value in protecting the privacy of the business dealings of individuals. Perhaps, at the early stages in the formation of the Republic, where we're grappling with basics of governance, there is a case for violating the privacy of individuals in the quest for improved cleanliness in public life. Over the years, as the State falls into place, a greater push for privacy would be desirable.

The young are getting away from agriculture

Who does agriculture in India? Here's some fascinating evidence, from the CMIE Household Survey for the quarter Apr-May-June 2012. This is a survey of 700,000 individuals in 150,000 households all across India, both urban and rural. Let's look at the share of the working population, in each age group, that's engaged in agriculture:

Age 15-20	19.69
Age 20-25	21.22
Age 25-30	24.70
Age 30-35	28.22
Age 35-40	30.91
Age 40-45	32.76
Age 45-50	34.75
Age 50-55	36.96
Age 55-60	40.02
Overall	31.31

As we see, in the overall dataset, 31.31 per cent of the working population is in agriculture. CMIE shows three categories of this -- `Small farmer', `Organised farmer' and `Agricultural labourer'. I have added up these three categories to make the table above.

That 31.31 per cent of the Indian workforce is in agriculture is fairly well known. What I had not thought about, previously, is the age structure. Will agriculture have a bigger share of young or old workers? We can envisage two competing effects. On one hand, if a family has underemployed young ones who are engaged in agriculture by default, then we'd see a lot of young people in agriculture. On the other hand, if families try hard to get their kids off the farm, and the growth in industry and services in India is successfully absorbing this workforce, then we should see a smaller share with the young.

The evidence above favours the latter story. The share of the overall workforce which is engaged in agriculture is 31.31%. But amongst the old (age 55-60), the share is higher at 40.02%. This share steadily drops as you get to the young. In the class of the working young (i.e. age 15-20 but a part of the working population), just 19.69% are in agriculture.

Perhaps there is greater malleability of human capital with the young: the old may not be able to easily pick up the skills required to participate in the modern world of services and industry. When the shift of a worker into services or industry is accompanied by migration, it adds up to a powerful engine of social and economic modernisation. It is a powerful mega-trend that is reshaping India today.

The agricultural workforce is greying. There are many divides between the old India and the new one. This evidence suggests one more: the old world of agriculture is disproportionately one of the old, while the new worlds of industry and services are disproportionately manned by the young.

This data helps us understand India's demographic dividend. Many people worry that services and manufacturing in India will not absorb the great surge of young people in India. If that was the case, there would be a lot more people in agriculture. Instead, we see only 20% of the young depending on agriculture.

The application of sound economic principles in the field of agriculture will give us a situation where no more than 5% of the workforce is required there. At present, agriculture is using up 31% of the workforce. This gives us a headroom of an additional 25% of the workforce which can move out. This movement would give a one-time improvement in GDP because the per-worker output in industry or services is greater than that seen in agriculture. But these effects are diminished with the young, where the alteration that's feasible is smaller: from 20% to 5%.

For an interesting comparison against China, in 2007, roughly 10% of the workforce was in agriculture in the age group from 16 till 35. By the time you got to the age group of 41-50 (in 2007), roughly 45% were in agriculture.  By 2012, China has reached a point where there is relatively little upside for GDP growth by getting workers out of agriculture. The Indian evidence for 2012 looks similar to China of 2004, so India is perhaps 10 years away from this loss of upside in GDP growth.

Indian capitalism is not doomed

India's problem of crony capitalism

by Ajay Shah.

The rise of modern capitalism in India in the 1990s was at first viewed in optimistic terms. A new breed of companies were born, who seemed to exhibit a new kind of competence, international competitiveness and high ethical standards. We could start putting our old mistrust of corrupt business houses behind us.

These hopes were substantially dashed by the fresh emergence of crony capitalism. Doing business in many areas in India involves an extensive interface with the government. In these areas, the weaknesses of the State generated an opportunity for crooks. At first, the financial system sent massive resources into dubious companies, with an attitude of being blind to anything but profits. When these companies controlled vast resources, and were shown the promise of even bigger valuations to come, they embarked on systematically undermining the State. Through this, we got a feedback loop: The crooks came up where the State was weak, and their activities further undermined the State.

In some cases, we saw rotten companies spring up in one part of the economy where the State was weak, and once these companies were up and running, they turned their attention to related fields and devoted themselves to undermining State institutions in related fields. Through this, the gangrene spread from one area to the next.

In the the early 1990s, we could hope that India would smoothly moving up to the ranks of middle income countries, powered by world class local companies in addition to global companies building operations here. These hopes have substantially receded. The heart of the Indian story is now about the feedback loop between rotten companies and the State. If we manage to bootstrap ourselves out of this, we have a bright future. But will be be able to bootstrap ourselves out of this? Many countries got mired in this `middle income trap': we shouldn't assume that our destiny is rosy.

At first blush, stopping the rotten companies seems infeasible. These are typically efficient and competent firms in a day to day tactical sense. They are staffed with hard-driving amoral people (typically incentivised very strongly using high-powered incentives), who fully understand the weaknesses of the system and attack it. Considerable resources are invested into subverting politicians, bureaucrats, judges and the media. The Indian system is rotten and ripe for attack. It's like computer criminals attacking Microsoft Windows. Resistance is futile. Indian capitalism is doomed.

There is, however, an array of homeostatic forces in place which are generating push back. Some crooked companies have faced enforcement actions by arms of the State. In some cases, India has had good discussions in the public domain which has generated checks and balances. In addition, while many people are devoid of ethics and will support the latest nouveau riche entrepreneur who is throwing cash around, a large number of people get revulsed by the sight of this, and quietly and doggedly refuse to cooperate.

Enforcement in India does not work perfectly. The key point of this blog post is that medium grade enforcement has far reaching implications. The key insight is to look at the way the goals of labour and capital (i.e. investors and employees) are reshaped by medium grade enforcement.

The perspective of the investor

The enforcement push back against rotten firms is yielding results. Many crooked companies have grossly underperformed the index. Some have experienced enforcement actions and have experienced jaw-dropping returns. Some have experienced dogged opposition from pockets of high ethics in the system, which have effectively led to systematic and sustained under-performance of the index over five- and ten-year periods. The stock market has become wary about ethical issues. As Shekhar Gupta says in the Indian Express yesterday:

If you draw a simple chart of the large companies that have lost the most value on the stock markets over the past three years, you'd notice that almost all of these were doing business on the same cusp of politics, finance and natural resources. To that extent, you have to admit that the market has been the first to sense the rot and has applied a stunning self-correction, severely punishing those responsible for it.

There was a time when investors used to be oblivious about ethical standards of portfolio companies. The attitude of the investor in the 1990s used to be I don't want to know how you do business; I will hold my nose since you stink; but as long as you will produce returns, I will happily invest in you. This attitude has been thoroughly broken. The investors who pursued such strategies have often been devastated. Even if you have only 10% invested in a crooked company, if you get -80% returns on it, this generates a -800 basis point returns drag on your overall portfolio performance. As a consequence, portfolio managers have started caring about the ethical standards of portfolio companies.

Enforcement does not have to be 100% perfect for it to impact on the decision making of investors. Even if there is only a 10% chance of getting caught and thus getting -80% returns, that is a big risk from the viewpoint of the investor. From the viewpoint of the investor: Why take the risk? Why not make a thorough analysis of the ethical standards of a company one element of the security selection process?

The problem of freedom of speech

Journalism is printing
what someone else does not want printed.
Everything else is public relations.
-- George Orwell.

India is supposed to be a liberal democracy, and a free press is supposed to write vigorously about misdeeds (link). By and large, this has not worked out as it was meant to be. On one hand, it is quite easy for the bad guys to corrupt the media. Whether this is done through gifts of shares to a media company, or through advertising and sponsorship, it is fairly easy to obtain a supportive media. In addition, defamation is a criminal offence in India: a legacy of colonial law that we have not yet been bright enough to undo. Putting these together, the bad guys have a nice combination of carrot (throwing money at the media) and stick (litigation).

Analysts and financial intermediaries are supposed to make a living out of spotting problems in firms. Here also, there is quite a bit of corruption which impedes speaking freely. Few are willing to go against the latest nouveau riche entrepreneur who is throwing cash around, including his efforts at buying respectability. The mainstream strategy is to participate in the gravy train, and look for ways to part the fool and his money.

This is a real shame: India should be much better than China in the role of freedom of speech acting as a check against corporations. However, the Indian media has largely caved in the face of carrot and stick: it is largely doing public relations.

At the same time, there is strong demand among investors for skills in identifying the crooks, given that this is an important investment fundamental. The problems of the conventional media and financial firms, which inhibit naming the crooks openly and in the public domain, has created a business opportunity in this space. Supply has come up to fill this demand; a new breed of companies has come up, reflecting this need. Examples of firms with these capabilities include Ambit Capital, Veritas Investment Research, Forensic Asia, and Espirito Santo. Numerous investors are building in this analysis into their portfolio process, and this is helping to channel capital away from dubious companies.

Foreign firms seem to be more prominent in this field of research and analysis from the viewpoint of ethical standards, because they are relatively immune to the problems of intimidation through courts and police in India, and because they are relatively cutoff from the reciprocity that binds everyone in the world of business in India. See Veritas' report on Indiabulls has put in contrast the research by India-based analysts in the Economic Times by Uday Khandeparkar. But even they are not immune to the problems of the Indian legal system. Now we have a new investment tool: sell shares of the companies that embark on such litigation.

The weaknesses of freedom of speech in India have thus emphasised a greater role for information processing and analysis away from Indian shores. I am reminded of what is going on in China, where some of the most important short sellers who are bringing out the misdeeds of Chinese companies are located abroad: it's too dangerous to do the same things within China. We in India are evolving towards a similar structure of information processing.

The perspective of the employee

In the modern world, a vital determinant of the success of an enterprise is the kind of people it is able to attract. Here also, at first, there was a relatively amoral attitude on the part of most young people: I don't want to know how you do business; I will hold my nose since you stink; but as long as you offer me the highest wage, I will join you. But over the years, it has been demonstrated that this is a bad strategy:

• The sight of senior employees going into Tihar Jail has given out powerful messages to everyone in Indian companies that good people should not hang out with crooks.
  
• The second phenomenon is reputational damage. It makes business sense for an individual to engage in fair play. I have been in recruitment conversations where a person is being discussed but his name gets shot down as he has not been careful about the company that he keeps. Birds of a feather flock together. I recently heard a senior person say: ``I knew XXX was a rotten firm when a bunch of corrupt people from SEBI joined it''. Low ethical standards in people and in firms go together; a cloud of mistrust envelops them.
  
• Gradually, as regulators develop and refine the doctrine of `fit and proper' such people will increasingly suffer career damage. We aren't fully there in Indian finance yet, but it will increasingly be the case that a name is shot down for a CEO position because he was part of a team that was caught doing nasty things by SEBI or RBI.
  
• These factors are particularly important for the best and the brightest. If you are the best and the brightest, why would you suffer even epsilon risk of going to jail? Why would you run with crooks if this could hamper your rise to CEO? Why would you suffer reputational damage, and not be able to hold your head high at your class reunion?

These factors are inhibiting the flow of talent to dubious companies. I know of several situations where a person was made an offer, and chatted about this with his friends, and turned it down. It was just too much of a risk to be seen in the wrong company.

Second rate people recruit third rate people. Once a firm is contaminated with a series of low grade staff at senior levels, it becomes increasingly hard to draw in top quality talent, which drags down capabilities all across the board.

I believe this is one of the factors which has generated systematic under-performance in the stock price of dubious companies. It isn't just the case that they are in danger of enforcement actions. It is also the case that on an every day basis, they find it harder to operate well given that they generally fail to recruit as well as their competitors.

How might Indian capitalism develop?

If the crooks had thundered ahead producing super-normal stock market returns, and attracting the best talent, I would have been truly gloomy. What is fascinating about the Indian story is that things have worked out differently. Some dubious companies have cratered with -80% returns over short periods. Others have generated substantial under-performance when compared with the index over 5- and 10-year horizons. The best people are avoiding rotten companies. Putting these together, the bad guys are finding it difficult to obtain both capital and labour, which are seeking out better firms.

Wall Street tells Main Street what to do. At a time when the investors did not care about ethical standards of portfolio companies, and only asked for earnings growth, this sent out powerful signals into the economy (a) Favouring rotten firms and (b) Encouraging rotten entrepreneurs to setup firms so as to harvest the opportunities available by selling shares. We got a precipitous collapse of ethical standards in India in the last decade in India, partly because that is what a financial system that was oblivious to ethical standards was encouraging. Some of the most rotten companies rose to the top. Now that the investors and the employees are seeing things differently, this is sending out signals into the economy (a) Favouring healthy firms and (b) Encouraging healthy entrepreneurs to setup firms so as to harvest the opportunities available by selling shares. We will also see some chameleons turn a new leaf: You will see the oddest of characters preaching purity.

Vishal Kampani pointed out a remarkable fact to me: Some of the biggest successes of the last decade have been the old `Bombay Club' companies. All too often, they have outperformed when compared with the hard-driving unethical nouveau riche entrepreneur. What is going on? I would conjecture that there is a survivorship bias. A large number of different strands of corporate DNA compete. Over the long run, the survivors are those where elements of policy and strategy are of a certain kind. The old rich of the `Bombay Club' are not paragons of virtue, but they have developed certain good practices which are conducive to survival and stock market returns.

I am reminded of the mighty German Wehrmacht in the Second World War. At the level of tactics and operations, it was second to none. In the short run, it generated the most amazing achievements in battle. After the campaigns from September 1939 till December 1941, many contemporary observers thought that Germany was unstoppable. But at the same time, Germany was making profound mistakes at the levels of strategy and policy. No amount of operational art could overcome those fundamental mistakes in strategy and policy.

In similar fashion, we tend to get very impressed by the hard-driving take-no-prisoners nouveau riche entrepreneurs and their hypercharged sidekicks. Their dynamism and willingness to play dirty seems to be unstoppable, particularly given the weaknesses of politicians, bureaucrats, judges and media in India. But it appears that in India, these strengths in tactics and operations have often been unable to overcome fundamental mistakes in strategy and policy. Indian capitalism is not doomed.

The widget illusion

The Economist runs a discussion forum titled The Economist By Invitation. In this, they recently setup a discussion about an opinion piece by Dani Rodrik about the future of manufacturing-led growth in emerging markets. I wrote a response there which is reproduced here.

The role of manufactures

I agree with a small element of Dani Rodrik's argument, but mostly for different reasons. Rodrik says:

Except for a handful of small countries that benefited from natural-resource bonanzas, all of the successful economies of the last six decades owe their growth to rapid industrialization.

I have seen this kind of thinking among some policy makers in India also: that industrialisation is somehow special and good when compared with services. I would question this proposition, that I term `the widget illusion'. What matters to a country is having sophisticated firms that have a high marginal product of labour. We should not care whether this happens in services or in manufacturing. If anything, the opportunity to do it is perhaps better in services.

India is a good example of a country which embarked on its catchup by connecting into globalisation late: from 1991 onwards. It was probably the last country in the world to shed autarkic policies. This has given a remarkable growth acceleration. Sustained growth of 7 per cent is pretty good by world standards. These achievements have been significantly driven by services production in India within global supply chains (whether within production facilities owned by global MNCs who are operating in India, or contracted-out by global MNCs to Indian firms). If your null hypothesis was that industrialisation is essential to growth, then you would not have predicted what happened in India, where manufacturing was hobbled by an array of policy mistakes.

This illustrates the limitations of manufacturing-focused thinking, which seems a bit out of date in today's world economy where most output is services. Agriculture and manufacturing have wilted away in the consumption of the global representative agent: to succeed in the world economy today requires prime attention upon services.

Rodrik says:

Consider India, which demonstrates the limitations of relying on services rather than industry in the early stages of development. The country has developed remarkable strengths in IT services, such as software and call centers. But the bulk of the Indian labor force lacks the skills and education to be absorbed into such sectors. In East Asia, unskilled workers were put to work in urban factories, making several times what they earned in the countryside. In India, they remain on the land or move to petty services where their productivity is not much higher.

As Rodrik points out, there are important gaps between the skills of the great unwashed masses in India versus China, where elementary technical training reached a larger mass of humans. In addition, China did better on core economic policy choices about (a) Removing protectionism; (b) Removing barriers to FDI; (c) Building hard infrastructure; (d) Labour law and (e) Rationalising taxation.

What policy advice would flow from this? India should not have have made these six mistakes in economic policy (low training for the masses, protectionism, barriers to FDI, weak investments into infrastructure, labour law and mistakes in tax policy). At the same time, this does not recommend a bias in favour of manufacturing. It is hard to discern a meaningful choice about emphasising services versus manufacturing in Indian economic policy. Participation in all global production is good. Governments should remove all barriers that inhibit global integration whether in goods or in services - e.g. the six mistakes in Indian policy sketched above.

A paragraph earlier, Rodrik says:

To be sure, some modern service activities are capable of productivity convergence as well. But most high-productivity services require a wide array of skills and institutional capabilities that developing economies accumulate only gradually. A poor country can easily compete with Sweden in a wide range of manufactures; but it takes many decades, if not centuries, to catch up with Sweden's institutions.

I would point out the contradiction: "A poor country can easily compete with Sweden in .. manufactures" but earlier it was asserted that the gaps in Indian skills inhibited India's ability to compete with Sweden in manufactures.

Doing things that push skills and institutional capabilities

I would go further to say that it is good to go after fields which require a wide array of skills and institutional capabilities.

I am reminded of Ricardo Hausmann's `Good Cholesterol' argument about financial globalisation as opposed to mere FDI. When a poor country operates in an institutional vacuum, foreign investors are uncomfortable, and the only thing that can happen is FDI. To obtain financial flows, the country has to build institutions: laws, regulators, property rights, and so on. This is a good thing! A country that gets to FDI and gets stuck there should ponder what is going wrong. In similar fashion, no country aspires to have low-wage production; every country wants to understand the secret sauce through which a part of the labour force can earn high wages by world standards.

As a country rises out of poverty, it is essential to build up skills and institutional capabilities. If policy makers hinder services and/or favour manufacturing, there is a greater chance of being stuck in low skills and low institutional capabilities. I am not proposing industrial policy in favour of services. I am only proposing the absence of industrial policy; we should avoid a `widget illusion' and foster more global integration without trying to push towards one industry or another.

In India, with 7 per cent growth, GDP doubles every decade. As a thumb-rule, I feel that a comprehensive transformation of skills and institutions is required across each doubling of GDP, which is roughly each decade for India. A country that is stuck in low-skill manufacturing will find it difficult to achieve the reinvention of this `soft infrastructure' of the mind. If policy makers tried to push a country towards doing low end grunge work, it would be harder to obtain these repeated transformations of institutions and the furniture of the mind, which would lead to growth decelerations.

As an example, in the article New wave of deft robots is changing global industry, John Markoff says:

Foxconn has not disclosed how many workers will be displaced or when. But its chairman, Terry Gou, has publicly endorsed a growing use of robots. Speaking of his more than one million employees worldwide, he said in January, according to the official Xinhua news agency: ``As human beings are also animals, to manage one million animals gives me a headache.''

The project of economic development requires sophisticated interactions between firms and workers. The laws, human rights and management practices that are required when dealing with humans are different from those required when running a firm with `one million animals'. I would hence argue that it is limiting for a country to focus on the political, legal and institutional requirements to produce a la Foxconn. It is better to confront the complexities of high skill, high wage production, and to build the environment for this to happen: in the political and legal system, in management practices of firms, and in the power structure embedded in a conversation between two citizens who are co-workers within a firm. Services production is a valuable learning ground where the complex management practices that involve high skill humans can be learned.

The new world of manufacturing

Rodrik correctly points out that manufacturing has become more sophisticated in recent years. This has some fascinating dimensions:

• The rapid improvements in capabilities and declining costs of robots.
• The rise of open source design coupled with 3-d printers. If a 3-d printer in the US fabricates a part close to its usage in an assembly line, while the labour-intensive design work ("services") that controls the 3-d printer is done in India, does this entail manufacturing or services work in India?
• The world economy is likely to be in a low interest rate environment for a long time, which will encourage capital intensity worldwide (robots, 3-d printers), thus blunting the value of low wages.

Momentous changes are afoot, which challenge our traditional notions of manufacturing versus services. To some extent, we are even seeing some manufacturing go back to the US.

Things that might `go wrong'

Finally, Rodrik talks about reduced willingness in the West to tolerate unfair tactics like the Chinese exchange rate regime. I would generally consider this to be a good thing, both for developing countries and for the world. In any case, the Asian `Bretton Woods II' episode seems to be subsiding. As an example of the disenchantment with exchange rate distortions: From 2004 to 2007, India debated exchange rate rigidity, and walked away from it. The links between undistorted exchange rates and growth have not been adequately emphasised in the discourse. A developing country builds up inferior skills and institutional capabilities by exporting under a subsidised exchange rate: it is better to force firms to confront the market price and achieve the productivity required to participate in globalisation when facing an undistorted price vector.

He worries about a rise in protectionism in the West, but we have to admit that the 2008-2012 experience has been pretty good in this regard: by and large the West has not succumbed into protectionism. In 2008, all of us worried about Smoot-Hawley. Today, things seem to be be going well.

Conclusion

In summary, I would argue that we should avoid a `widget illusion'. There is nothing special about manufacturing or industrialisation: as long as people in India get high wage jobs, this is good. Getting there requries deep integration into the world economy, which includes policy battlefronts such as:

• Openness to the Internet
• Use of English
• Inbound and outbound FDI
• The array of cross-border financial services that are the enablers of complex globalised production of both goods and services
• Globalisation-compatible tax policy on both trade and finance
• The absence of either protectionism or mercantalism
• Fostering high quality human skills, and
• Infrastructure.

To the extent that globalised production of goods and services happens in areas which involve high skills and complex institutional development, this is a bonus, since any high growth country needs a rapid pace of reinvention of laws and institutions.

Most of this is the old orthodoxy. Policy makers worldwide are generally focused on these issues, as they should be. From the 1960s onwards, dirigisme has generally subsided, with the twilight of policies like fixed exchange rates, industrial policy, capital controls, protectionism, etc. These key lessons remain intact in the 21st century.

A tale of two economies and two currencies

by Percy S. Mistry, in the Financial Express.

A fortnight's visit to China in April, to understand better the progress it has made with public and corporate governance, was startling in its revelations. Having been to China years earlier, to advise the State Commission on Reform of the Economic System (Ti-Gai-Wei) in 1988-1994, it was amazing to realise in retrospect that, over the last two decades, much of the advice given then, had actually been taken and applied.

That was in sharp contrast to experience in India. The advice provided there -- e.g. through the Mistry Report and innumerable interactions with MoF and RBI over the years - was applauded by the private financial system for which it was intended (less so by public financial institutions which need to be privatised). But such advice was taken and implemented by MoF and RBI only grudgingly and at the margins of insignificance in terms of impact.

What was most strikingly apparent during the visit was the resolution and purposefulness with which China and its institutions are governed. That applies to public institutions and agencies at various levels of central, provincial and municipal governance, state-owned enterprises (SOEs), and the rapidly growing number of private Chinese companies; whether domestically owned or joint ventures with multinationals involving both public and private partners. It was no surprise to confirm that China is much better governed at central, state and municipal levels than India; where public governance is deteriorating by the day. But, that Chinese companies now seem better and more responsibly governed than their Indian counterparts came as a rude shock!

The impression of corporate and public governance in China now being well ahead of India (and a lot of what now mistakenly passes for the 'developed world' as well) emerges despite the occurrence of the Bo Xi Lai/Gu Kai Lai affairs that were unfolding at the time. One almost got the sense of careful orchestration and stage management of these 'affairs' by two competing factions for influence within the ruling Politburo and its supporting Standing Committee as the future leadership/management team that takes over in October was being put in place.

To be sure the case is invariably made that such resolution and purpose is usually (or can only be) exemplified by a totalitarian state like China, rather than a democratic state like India. After all, China is unhindered by the cumbersome processes of democracy. It has yet to provide many of the personal and human freedoms/rights provided in much of the world and in large emerging countries like India. Yet, despite the correctness of this perception, one cannot help but feel that blaming the Opposition, parliamentary process and democracy, as GoI invariably does routinely (to explain its incompetence and loss of nerve for losing the plot on macroeconomic management), stretches the excuse a bit too far.

One wondered after the China visit whether India is the world's largest democracy as it always claims, or whether it is the world's largest abuse of democracy. Abuse: because of the make-up and mind-set of its parliamentarians and political class, and because of the characteristics of the poor and destitute electorate that engenders, propagates and perpetuates at each election such a dysfunctional polity with such destructively counterproductive tendencies, habits and behaviors.

China still has to cross the Rubicon of political democratisation and full extension of human rights taken for granted elsewhere. Until it does so, the world is right to be sceptical (if not perturbed) about its inexorable ascendancy into a position of global hegemonic power. But one gets the sense (almost with certainty) that China -- in its own imitable way and in its own time unhurried and unbowed by external pressures -- will develop a 'democratic' or 'quasi-democratic' model that suits its purpose and characteristics.

Learning hard lessons from Russia, where it is clear in retrospect that economic and political liberalisation were carried out in the wrong sequence and in the wrong manner, China will do so without destabilising itself in the way that Russia did. The Chinese leadership has no desire to repeat what happened in Russia - i.e. the emergence, after a period of total confusion during the Yeltsin era, of a KGB-controlled/inspired kleptocracy under Putin's leadership. That kleptocracy has now replaced the econo-political apparatus (and power) of the former communist state. Russia's situation has evolved in a manner that, if one thinks about carefully, has some disturbing indirect parallels with 'liberalization' in the Indian case.

The Indian public-private kleptocracy (a peculiarly Indian type of PPP) that has emerged in India post-1991 reforms, has not involved the membership of a repressive state intelligence apparatus, as in Russia. India has never had an intelligence apparatus worthy of the name or of any note. The only threat it poses (hopefully but not assuredly) is to Pakistan. That too is an ineffectual, minuscule threat given how poorly Indian intelligence (if that is not an oxymoron) is organised, funded and conducted. But, the Indian kleptocracy that has emerged after 1991 has certainly involved core relationships between established Indian political dynasties and large corporate houses (especially newer ones) that emerged after the Emergency.

Those corrosive relationships have become deep-rooted and taken hold in various avatars at central and state levels. At each of these levels they involve different business houses and different political dynasties; some of which have become organised medium-scale businesses in their own right, specialising in unique forms of rent extraction.

Taken together, they have resulted in Indian corruption becoming an organised mega-industry post-1972, from the localised handloom cottage industry that it was in the 1952-72 era. That mega-industry has its own codes, institutions, intermediaries, processes and lexicon (peti and khokha). It has resulted in a unique form of crony capitalism, favouring those business houses in India that originated mahacorruption and have since become its principal beneficiaries.

Indeed, such corruption has become embedded in the Indian economic system. It is so essential to the 'functioning' of its post-1991 quasi-market, improperly liberalised economy -- where the grant of licenses and inexplicable asymmetries in regulation play such a key role in introducing anti-market distortions and subsequent market failures -- that one now sees the visible damage being done to the functioning of the economy as ham-handed attempts are made to root it out.

One could make a good case that, in part, the slowing down of the Indian economy, and the rapid decline in corporate investment following the 2G-scam, is the result not only of macro-economic mismanagement and poor judgement by the FM/MoF, but also because corruption can no longer be relied upon by corporate houses to get things done in the way they once were. If the people (politicians, bureaucrats, regulators and police) a corporate house 'buys' -- through corruption in the political and bureaucratic systems, to retain its strategic and tactical advantages over its competitors in its main markets - can no longer be relied upon to deliver the goods, then what is the point of taking risks that simply cannot be managed?

Corruption is not only an Indian phenomenon. It occurs in China; possibly to a greater extent. Its totalitarian regime has not expunged it, although it pretends to have. Petty corruption at lower levels of officialdom is neither as pervasive nor as predatory as it is in India. But at the upper reaches it certainly seems omnipresent. Indeed most Chinese (in the public and private sectors) suspect that members of the Politburo and Standing Committee are engaged in concealed corruption on a scale that might make Indian corruption seem amateurish.

Corruption in China arises (and is fuelled) from pervasive state ownership of large public manufacturing, exporting, service and transport enterprises, of public construction companies that have benefitted from massive public spending on infrastructure (of which 10-15% of all contracts is allegedly accounted for by kick-backs), from public ownership of the banking system, and over $3 trillion in reserves that are increasing by 10% annually. On that amount of reserves, over $1-2 billion a day can easily be salted away via accounting errors and omissions and through improperly accounted-for effects of supposed daily exchange rate fluctuations or mark-to-market losses on sovereign bond purchases.

Rumored public estimates of proceeds transferred abroad by the top leadership in China invariably range from $100-150 billion over the last five years. If one extrapolates from that figure the proceeds of corruption at lower levels of governance (especially at municipal levels where the granting of land leases is the major source of leakage), figures of around $1 trillion over the last 5-10 years do not appear as outlandish as they might.

Certainly the ostentatious wealth displayed by Chinese political and business families abroad lends substance and credence to these estimates, in the same way that the lavish life-styles and expenditures of expatriate Russians in London give credence to its own kleptocratic state.

Yet, despite the functioning of both the Chinese and Indian economies being profoundly affected by corruption (of different sorts) the growth and resilience of the Chinese economy does not appear to have been as adversely affected by it as has been the case in India. Instead, quite the reverse! The Chinese economy is displaying extraordinary resilience in the face of externally generated headwinds that are slowing down its dynamic export machine. All the talk about hard and soft landings for the Chinese economy seem moot after the April visit. China has managed to orchestrate a reasonably soft landing with growth slowing to < 8% levels with China switching gradually to a domestic-consumption led rather than export-led growth strategy.

But it takes time for a super-tanker the size of China with its $6-7 trillion economy to change course and reverse gears. The single most effective instrument to induce and accelerate such a change - i.e. opening its capital account and floating its currency to result in more rapid market-driven appreciation of the Chinese Yuan (CNY) or Renminbi - has been eschewed as a policy tool to bring about more rapid switching.

Over the last two years the strength and resilience of the Chinese economy, in the face of the worst global economic and financial crises the world has experienced in nearly a century, have been remarkable, as reflected in its continued build-up of reserves. These now amount to over $3.2 trillion -- despite the impact of the post-Lehman financial crash of 2008 and the rapid deterioration in the economic circumstances of its two largest export markets: i.e. the US and EU. This massive build-up of surplus capital, which it seems unable to use for its own needs, has led China to open its currency market through administrative measures.

The April visit suggested that China is deeply concerned about using exchange rate adjustment as a policy tool, fearing that doing so would destabilise its labour and wage markets. After all the key Chinese imperative to ensure its success as an exporting power has been to manage (manipulate?) its exchange and wage rates so as to import jobs from, and export goods to, the rest of the world for as long as the rest of the world permitted China to get away with it.

And, so far, the rest of the world has done that. In the process, China has built up gargantuan reserves which are likely to grow at 10-20% annually even if its trade account comes into balance. Such unprecedented, large global reserves and the way in which they are managed -- perversely reflecting the limitations and dysfunctionality of China's state-owned financial system -- now pose an economic and political threat to the rest of the world. A continued build up reserves at the same rate as before would be intolerable.

Consequently, China has arrived at the stage where it has no option but to liberalise its currency market and export capital a little more easily in one way or another. It is choosing to do so through administrative measures such as bilateral CNY swaps rather than via traditional open market measures. These measures lead to a number of interesting interim possibilities before full and traditional capital and currency market liberalisation is undertaken.

Until this month, China had focused CNY swaps in local currencies of major emerging market trading partners, and not with developed market partners such as the US and EU. But, a couple of weeks ago, China announced that it would do CNY:JPY swaps with Japan, a developed and large trading partner. Partial capital account liberalisation is also being attempted through gradual opening of the CNY (dim-sum) bond-market in Hong Kong. That market has taken off faster than the Chinese authorities seem comfortable with.

What are the implications of the latest Chinese measure to introduce CNY:JPY swaps? They are not likely to be significant immediately as few internationally traded contracts are denominated in either CNY or JPY.The same arrangement for CNY:USD or CNY:EUR would have been more globally significant and led to CNY internationalisation more quickly.

However, the question raises some interesting possibilities where China-Japan, China-Asean and Japan-Asean trade is concerned. Triangulation on trade and trade-related long term investment among these three large trading blocs/players (more if one includes Korea and Taiwan) holds out interesting possibilities for the growth of Asian markets in regional currency trades and derivative hedges.

Also, Japanese multinationals are major investors in Chinese export production, which is linked to their own export production for global markets, in innumerable and intricate ways. If the CNY:JPY arrangements stabilise the influence of currency fluctuations on such bilateral and pass-through trade then the CNY will benefit and internationalise faster.

How rapidly the CNY becomes an international currency like the USD depends initially on how the Asian/Asean markets perceive movements in the CNY and JPY in the short, medium and long term. As a long-term hold, the CNY seems more attractive than the JPY. The Japanese yen is intrinsically a weak currency issued by a very heavily indebted country that is dying slowly demographically, and is a waning global economic power in relative terms. The opposite is the case for China and the CNY. But long-term currency holds are for investors not traders. And China is denying the world full market access to probably the most significant currency numeraire for long-term investment over the next 30 years.

In the short and medium term, it is difficult to predict what will happen to the value of the CNY relative to other currencies (especially USD, EUR and JPY) because of administrative intervention. If currency markets were left alone the CNY would appreciate significantly against all three; despite the arguments being made that the CNY has found its real effective equilibrium rate and does not need appreciation.

Anyone who believes that does not understand currency markets. Right now the JPY is an international currency that seems to be overvalued, taking Japan's underlying fundamentals and economic prospects into account. Yet it is widely held in global central bank reserves though used to a more limited extent than should be the case for Japan's trade contracts with its various trading partners which, unfortunately, are still denominated more in USD than in JPY.

The Chinese authorities could of course internationalise the CNY faster and more efficiently by opening up their capital markets in a phased fashion; making the CNY at first (up to 2016) a partially and then (2017 and beyond) a fully convertible currency. They are doing it instead in a clumsy, administratively burdensome fashion in the belief that going that route will result in more 'control' over the pace of internationalization.

A key concern is that this administrative approach (akin to the route that Indian bureaucrats invariably prefer in the bizarre belief that their control results in better outcomes, despite evidence to the contrary) will lead to a series of significant anomalies. They will create distortions of the kind that usually arise with administrative intervention and an aversion to letting markets do what they do best -- i.e. price discovery. Those anomalies and distortions could damage the world at a time when the global economy is still quite fragile.

Yet the CNY is heading towards becoming a global currency, perhaps second in importance to the USD over the next 20 years and even more important than the USD thereafter. That process is as inexorable as it is inevitable. Indeed that outcome has been delayed too long. For the world's second largest economy, and its second largest trading economy, to continue having a closed capital account, and a non-convertible currency with a fiat-determined price, is an intolerable eccentricity that has damaged the world and provides an unfair structural advantage to China. Oddly, China has been permitted by the world trading community to play by its own rules to its own advantage (and to the detriment of the rest of the world) for too long by asserting the right to control the most significant price affecting its trade with the rest of the world i.e. the price of its own currency.

In an open economy global trading model, world trading patterns, and consequently global investment patterns, as well as global production location and market share, are all supposed to be determined/equilibrated (i.e. with trade, current and capital account surpluses and deficits -- or imbalances -- being sorted out) by markets and not by administrative interventions; with market forces being left to adjust all prices, including currency prices, that affect global trade.

When China respects the notion that market prices should determine the prices of all inputs and outputs that make up the cost of its production, but then asserts the right to control a key price (i.e. the price of its currency), which in turn affects the price of imports from China by other countries, it violates a fundamental precept of the open economy global trading model. The sustained violation of that principle for two decades has in large part been responsible for bringing the global economy to its knees, while allowing China to accumulate extreme reserve surpluses that now pose a fundamental political and economic threat to the rest of the world.

In the post-Bretton Woods world, China is the most egregiously anomalous case of a country (misusing the developing country argument) becoming as significant as it is in the world economy without being obliged to open its capital account and make its currency convertible. All the other rising economies in the 1960s and 1970s (Germany, Japan and several smaller European economies), 1980s and 1990s (Korea, Singapore, Taiwan, some Asean and most Latin American economies) made their currencies convertible and opened their capital accounts.

They did not suffer any of the kind of damage that China claims it would suffer if it did the same. Essentially what China seems to be asserting through its currency management policy is the divine, inalienable right to import jobs from, and export manufactures to, the rest of the world indefinitely by manipulating the price of its currency. That cannot be permitted to continue given the devastating impact such a policy has had on the rest of the world. The CNY must be internationalised sooner rather than later in a market-oriented manner.

If that is so for the CNY then what is the future of the INR? As the next largest emerging global economy after China shouldn't the INR follow a similar trajectory? Until last year many astute commentators envisaged the INR taking its own place in the world, following the CNY as an increasingly significant trading currency. They thought at first that the INR would become a littoral/regional (2015-2020) trading currency and later (2020 onwards) a globally significant trading and reserve currency.

But the dreadful mess that the UPA-2 coalition and central government have made of the Indian economy over the last 24 months, and the shattering of confidence in India on the part of both domestic and foreign investors, has been an object lesson in confirming that India seems incapable of coping with success for any length of time. India seems instead to be more inured at coping with prolonged failure. It seems to know how to cope with that better attitudinally.

Therefore the INR is unlikely to emulate the CNY as a global trading or reserve currency for quite some time yet. Instead the INR is now seen as a temporally if not structurally weak currency that can barely hold its own value, leave alone become a serious trading or reserve currency in the foreseeable future.

Contrary to assertions by the FM, PM, RBI and UPA-2 leaders, none of the wounds that India is suffering from, and have inflicted on the INR, have much to do with negative global influences or Europe. At most those factors may have had only a marginal impact on growth and inward investment. The damage done has been mostly self-inflicted.

The really devastating impact of MoF/FM misjudgement and malfeasance has been on overall investment and in not relieving mounting supply-side constraints sooner. The FM in particular has played a leading role in convincing investors in India and around the world that India is no longer worth investing in. That impression has been reinforced by aggressive but injudicious posturing by the FM/MoF, goaded by their tax hawks, about the 'losses' India suffers from its DTAs with supposed tax-havens (such as Mauritius) and its contradictory if not absurd positions on applying GAAR retrospectively; and attracting the derision of the world at large.

Immense damage has been caused by this failure of judgement, obtuseness and obstinacy in the vindictive vendetta that has been conducted against Vodafone in particular, and foreign firms in general, on the capital gains tax issue. No mention is made at all about the tax gains (direct and indirect) as well as employment gains that have been derived from inward FDI and about the losses that would be incurred if such FDI flows ceased - as they now seem to be doing.

If GoI/MoF were so concerned about revenue losses to the exchequer, from FDI that escapes capital gains taxation, the PM and FM would have done better to look more closely at their neighbours in parliament and state legislatures. They could apply more vigorously and impartially laws on assets disproportionate to income. That approach would provide them with a triple-whammy. It would deal holistically with the phenomena of black money, corruption and tax evasion/avoidance, all at the same time. The revenue raising possibilities from that source would make Vodafone look trivial by comparison.

Had GoI/MoF done that they would have drawn more effective public attention to the generation of black money which official India is exerting every sinew to evade doing in the most clumsy fashion, knowing that to take serious action on that issue would be to indict virtually the entire political class in the country and bring in to the black money net most corporate leaders as well.

The egregious and severely damaging misjudgements on the tax issue, and the mismanagement of the Indian macro- economy since the change of leadership of the Finance Ministry in 2009, have introduced the kind of uncertainty into investment decisions that now make banana-republics and places like Rwanda and Congo seem almost sagacious in comparison with India.

How could this have happened? The answers seem obvious in retrospect. The political and bureaucratic leadership of the post-2009 Finance Ministry appears to have been childishly naive and clueless about how finance or economics actually work. All of India, and corporate sycophants dependent on the state-owned banking system for liquidity and long-term loan largesse, have been worshipping a false god -- as we seem to do relentlessly. Look at how we worship supposed corporate titans with feet of clay. It would be funny if it were not so tragic that one needs to screw up a country before one becomes an eligible candidate for that country's Presidency!!

Compounding the problem of gross malfeasance in short-selling India as an attractive long-term investment destination, GoI's top leadership appears to have as little clue about what leadership or good governance is all about. The other big beasts in the Cabinet (i.e. the Ministers of Home, Defence and External Affairs) all seem to be in the wrong jobs that play to their weaknesses rather than their strengths. As a consequence, GoI and India have lost all credibility at home and abroad. The impression they convey is of gross incompetence and surprising insouciance.

Being clueless seems widespread and endemic. It goes beyond characterising what now seems to be a sorry excuse for a crippled government that needs to be put out of its misery. At the top political leadership level in the UPA, Madam Sonia and Master Rahul Gandhi also appear to have no clue about anything, if the results of recent state elections are to be judged dispassionately.

They and their sycophants in the leadership of the Congress Party (simply a monarchy in drag) still believe in an India that should be managed politically by hand-outs, subsidies and populist sops that break the Union and state budgets. They do not yet believe in sustainable long-term development generating growth of >8% for the next few decades based on productive public and private investment of between 30-35% of GDP. Nor do they believe in reducing poverty through productive and meaningful private employment generation rather than on NREGA type income subsidies and hand-outs. They would rather that, at election time, the poor voted for them out of gratitude for hand-outs, than because employment was generated by private companies investing in the economy that could not be visibly attributed directly to them.

Their attitudes and supposed 'leadership' make proper macro-economic management by anyone almost impossible. They still do not believe in continuing with structural reforms that widen the distance between the polity and the economy, thus limiting the amount of damage the former can do to the latter through negligence, false ideologies about how the poor can be helped, populism and plain economic ignorance.

They do not believe that significant reforms are needed, along with an urgent programme of ambitious privatisation, beginning with Air India, extending to state-owned companies in telecoms, transport, minerals, natural resources, manufacturing, services (such as transport and tourism) and most of all privatising the state-owned financial system. It is through the SOBs that many of the weaknesses of the Indian economy are aggravated and exacerbated. The SOBs are also the conduit for exercising the kind of political influence that results in the kleptocratic quasi-market economy that has emerged in India post-1991; through an inimical but pervasive public-private partnership (PPP) between political dynasties and large business houses.

Taken together, the top leaderships in MoF, GoI and UPA -- individually and collectively -- are the PROBLEM, not the solution. Once that diagnosis is accepted, a cure can be found. Until then one can but hope that the next election brings more succour to India than is the case now.

What needs to be done urgently is to revive domestic and foreign investment and growth in the Indian economy. Given the rapidly deteriorating state of public finances, a widening current account deficit, a collapsing Indian rupee, and the entrenchment of structural inflation, which it will take prolonged tightness of monetary policy to control, GoI's room for manoeuvre is limited. But there are options to be exercised. The first is to revive confidence in government on the part of domestic and foreign investors. For that to happen, the MoF's obsession with imaginary tax losses has to be dropped in favour of more investor-friendly policies that attract inward foreign investment in large amounts. If that happens, it will spur domestic investment concomitantly.

A start can be made by putting the Insurance and Pensions Bills immediately before parliament with GoI doing whatever it must with its allies and opposition parties to get these passed. If the cap on FDI in insurance were lifted from 26% to 49% in the next few months it would result in a significant inflow of FDI. That would spill over through linkages into private corporate capital investment as well as investment in infrastructure. Both are needed urgently to relieve the supply-side bottlenecks that have been built up in the economy over the years and which are now responsible for structural inflation becoming embedded.

Similarly, the counterproductive debates and hold-ups on limiting FDI in retail (single and multi-brand) and on moving more urgently with privatising Air-India need to be ended. No national interest is served by imposing constraints and limits in any of these areas.

As far as Air India is concerned, it is now obvious to every Indian that continued public investment in that hopeless airline is a waste of public money. It benefits no one, least of all the poor, to run a state-owned airline simply for the personal convenience of the political class.

The same could be said for BSNL, MTNL, Coal India and all the SOBs. GoI ought to commit itself to privatising all SOEs by no later than 2025 in a phased manner. State governments need to follow suit rapidly in privatising the plethora of inefficient state-level public enterprises they own as well.

Those steps might indicate to the world that GoI/MoF is serious about undoing the immense damage it has done to India and its image as an investment destination since 2009. Unless that is done, with an ambitious far-reaching reform and privatisation agenda which convinces domestic and global investors that GoI really does mean business, then the Indian economy will continue to languish with prolonged sub-par performance. If that happens fiscal performance will worsen, inflation will remain too high, and growth will remain too low.

A financial crisis will ensue. The INR will continue to decline in value internally through high inflation, and externally against other currencies, putting at risk and perhaps even reversing all the achievements of the 1991 reforms.

It would be a sad legacy for a beleaguered and exhausted PM to leave, with the best of intentions but the worst of performance (and corruption) records, as he exits a stage he has played a lead role on for nearly a decade.