THE

INDIA ECONOMY REVIEW

2009
Volume VI | Quarterly Issue: 30th September 2009
www.iipmthinktank.com
www.gidf.org

THE HYPOCRISY OF FREE

MARKETS & MYTH OF
FREE TRADE
RETHINK
INSIDE THIS ISSUE EDIFY
DELINEATE
Murk y Economics
Wo b b l e M ar ke t s
P r o t e c t i o n ’s P r i c e
O p e n Wo r l d
B o u n d To g e t h e r
Rethink And Resurge

A N I I P M T H I N K T A N K
&
G R E A T I N D I A N D R E A M F O U N D A T I O N P R E S E N T A T I O N
 THE GREAT INDIAN DREAM

“A Society where man is at the centre of all activities,

a society where exploitation of man by man has been
abolished, where he is cared for as an in a family, where
“to each according to his need’ is practised, a society where
non bureaucratic National Economic Planning is given due
importance for sustainable optimum growth, where adequate
social safety net is a reality and yet market’s advantages are
fully taken care of for creativity and entrepreneurship, such
a society can be truly described as humane society and the
vision as “Humanism”.
Dr. M K Chaudhuri
The Great Indian Dream, 2003, Macmillan
India,New Delhi

“Let us together dream of a country where poor are not

just merely reduced to statistics but where there are no poor.
Let there be a day when small children are taken to a poverty
museum like science museum where they shiver at the plight
of the way people used to live in the last millennium. Let this
dream take the form of a revolution and as long as our dreams
keep outweighing our memories, India would remain a young
and dynamic nation on this path to global equality. And for
this let the wait not be for eternity. Let us together achieve this
in the next 25 years.”
Prof. Arindam Chaudhuri
The Great Indian Dream, 2003, Macmillan
India,New Delhi
 IIPM: THE FUTURE IS HERE
Since its incorporation (1973), IIPM has been an institution with privileged traditions, in the diversity of its fraternity, its global outlook, its world
class research and its commitment to alternative national economic planning process.

It can be said, without much oversimplification that there are no ‘underdeveloped economies’. There are only ‘under managed’ countries. Japan
140 years was ago was an underdeveloped country by every material measurement. But it very quickly produced management of great competence,
indeed of excellence. The policy inference is that ‘management’ is the prime mover and ‘development’ is the consequence. At IIPM, every one
considers that development is a matter of human energies rather than economic wealth. And the generation and direction of these human energies
is the task of ‘management’. Accordingly, we formed The Great Indian Dream. Unlike any other dream, this is one dream which each one of us
are determined to realise and that too in our own lifetimes. Each bit of cynicism and condemnation from pessimists makes us evolve even stronger
and determined.

All our endeavours and initiative is towards realisation of this dream, where in we produce committed ‘bare foot’ managers and entrepreneurs
who are needed by nation, on an insistent basis. As an educational institute, we aim at initializing a three dimensional personality in IIPMites, viz.
 Pursuit of knowledge in economics and management
 Commitment to economic, social, political and technological upliftment of masses and
 Cultivation of taste for literature, fine arts and etc.
Economists often have limited access to the practical problems facing senior managers, while senior managers often lack the time and motivation
to look beyond their own industry to the larger issues of the global economy. It has set before it the twin tasks: to reorient education and research
towards the needs of both the private and public sectors and to establish the link between the National Economic Planning and the development
of private enterprises in Indian economy. IIPM dares to look beyond, and understands that what we teach today, other adopt tomorrow. IIPM’s
service output (education, research and consulting,) is a unique combination of two distinct disciplines: economics and management. Through
this integration, IIPM helps guide business and policy leaders in shaping the Indian and global economy, bringing together the practical insights of
industry with broader national and global perspectives.
A hall mark of IIPM is that it is armed with the comparative advantage of engaging the committed, passionate and brightest management post
graduates and undergraduates, who pursued the education at IIPM and subsequently joined it, to realise the dream. IIPM alumni, spread across the
globe, holding crucial decision-making positions in the corporate sector, are bonded by the one ideology of making a positive difference, turning
that ideology into a movement itself.
The India Economy Review is another humble initiative towards the realisation of the same and more distinctly, engaging the broader publics
and pertinent stakeholders.

SEARCH, SIEVE, SCHEME...

In economics, like in everyday existence, it is imperative to hear, perceive and consider what others have to say. Each issue of The IER brings
together a selection of important contributions on a particular theme, authored by some of the brightest minds in different areas of Indian economics.
The provocation for publishing these issues arises from the fact that over the years economic journals have become copious, exclusive and expensive.
Most of the journals and a good many of the books have gone beyond the cerebral and financial reach of general students and other scholars. It is
for them that these issues are primarily being raised and debated here.
Much about India is transparent enough. One does not require detailed criteria, cunning calibration or probing analysis to pinpoint India’s
problems and recognise its antecedents. There is in fact much that is perceptible about India. But not everything about India is even if simplistic is
so simple. The learned reader would appreciate the fact that India is like an elephant that looms too large to be grasped within a distinct structure
and paradigm the constituent parts of which would fail to reveal the entirety. Obviously and observably, no suggested solution to any protracted
and complex socio-economic problem will satisfy all sides and stake-holders evenly. Consequently, there exists an enormous diversity in economic
thinking and perspectives, as is also reflected in the viewpoints of different expert contributors in this issue. The intended outcome of this exercise is to
facilitate the invention, improvement, deliberation and dissemination of innovation in economic thinking and national economic planning, insisting
merely on well-grounded, open and unbiased debates, without predetermined outcomes. It is impossible to do justice to the entire field of Indian
economics in a single issue. The topics selected for this issue are those which are of critical and immediate importance to India. Majority of them were
freshly and exclusively written. Encapsulated, it is a constructive attempt aimed at helping India actualise its promises and potential. The editors hope
that this issue of IER proffer the reader a flavour of dynamism and excitement and persuade her/him to participate in the journey towards realising
‘The Great Indian Dream’. At the same time, it illuminates the terrible, practical problems of India and Bharat.

ACKNOWLEDGEMENTS
The IIPM Think Tank likes to thank all the internal faculty who have been instrumental in coordinating with
many authors all across India and according their unstinted support. The assistance of Prof. R.Krishnan (IIPM
Lucknow) Prof. Amlan Ray (IIPM Lucknow), Prof. Tareque Laskar (IIPM Bangalore) and Mr. Robin Thomas
(IIPM Ahmedabad) has been more valuable than, perhaps, they realise. Mr. R. Nagendra Prasad, Senior
Manager at SMG, IIPM Hyderabad, particularly did all that it was possible to do for this issue of IER. Lastly,
Prof. Shyam.S.Pujala (Dean, IIPM Hyderabad) deserves a special mention for his eager and energetic support,
without which this issue would not have been possible.
 CREDITS The First Words And The Last Word
Founder
Dr. M. K. Chaudhuri
Editor-in-Chief Open Economy: A Boon or Bane for India?
Arindam Chaudhuri
Managing Editor
Prasoon.S. Majumdar
Deputy Editor
M.N.V.V.K. Chaitanya
Consulting Editor
Prashanto Banerji Dear Reader,
Research Fellows
Pathikrit Payne Umpteen wasted years, countless useless
Shweta Shukla
Sray Agarwal treaties, innumerable No votes, unnumber-
Akram Hoque
Mrinmoy Dey able broken promises and the growing sen-
Mufaddal Poonawala
Group Design Director
sation of helplessness by all economies (de-
Satyajit Datta
Senior Designer
veloped and developing otherwise). Ever
Prasoon.S Majumdar M.N.V.V.K.Chaitanya
Amit Sharma
Designer
since the beginning of the fi nancial crisis, Managing Editor Deputy Editor
Dinesh Chandelkar, Saurabh Mishra
Parvesh Kumar Swami, Sandeep Sharma
the policymakers around the world exerted
Sujit Singh, Satyakam Banerjee
interested in. In non-thematic section,
Senior Illustrator
strong pressure to enforce the protectionist
Shantanu Mitra
the joint paper authored by Dr. Suresh
Production Manager
trade policy. China, India and other emerg-
Gurudas Mallik Thakur
Chandra Babu and Dr. G. Bhalachandran
Production Supervisors
ing market economies are on the crossroad
Digember Singh Chauhan
stresses that let Indian society lead the
Soumyajeet Gupta
between pursuing free trade policies or im-
rest of humanity towards pro-environ-
Satbir Chauhan posing protectionist trade policies. Against
Chief Marketing Advisor mental-actions and thus paves the way for
Amit Saxena this macroeconomic backdrop, IER invited
Marketing & Sales pollution -free planet. In ‘Sectoral Snap’
Neha Malhotra the participation of academia, industry and
IER Online section dealing with Indian retailing sec-
Neel Verma, Anil Kumar Sheoran, Himanshu Negi, policy-makers to address theory and prac-
Christopher Mani tor, Dr. Mohammad Amin argues that
Principal Offices tice regarding the linkage between develop-
Satbari, Chandan Haula, Chattarpur,
Bhatimines Road, New Delhi - 110074
competition policies that are currently
IIPM Tower, Junction of , 32nd Road & S.V. ment, trade and policy making. An intent
Road, Bandra (W), Mumbai - 400 050 focused exclusively on fi rm-behaviour
IIPM Tower, 419 100ft. Road, Koramangala, is to highlight the criticality of developing
Bangalore - 560 034 should pay more attention to consumer
IIPM Tower, 893/4, Bhandarkar Road, rightful policy decisions in boosting seam-
Deccan Gymkhana, Pune - 411 004 behaviour and consumer attributes that
IIPM Tower, 145, Marshall’s Road,
Egmore, Chennai - 600 008
less flow of trade in all variants and across
IIPM Tower , 19, Inqulab Society, gulbai Tekra,
shape consumer behaviour.
Off C.G. Road, Ahmedabad - 380 015
all markets. Research papers, case studies
IIPM Tower, 6-3-252/2, Erramanzil, Banjara Hills, You can click straight through to each
Hyderabad - 500 082 are invited on all aspects related to these
We are keen to hear from anyone, who would like to one and read it online at our website,
know more about IIPM Publications. You can e-mail on strategic facets. Of special interest are those
shweta.shukla@iipm.edu or alternatively call Ms.Shweta www.iipmthinktank.com.
at 9811895267 papers with specific focus on theoretical
Additional Thinking
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Happy Reading
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focus and development strategies with his-
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Best
www.arindamchaudhuri.com torical perspectives, specifically the opinion
www.thesundayindian.com
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Disclaimer :
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Aditionally, there are some other pieces
Tank retains all trademark right and copyright on all the text
and graphics.
from this periodic issue you might also be M.N.V.V.K. Chaitanya

Cover Design: Satyakam Banerjee
OPEN WORLD: Wobble Markets
Woebegone Government, Wobbly
Markets and the Economic
Management: Rethink, Recast,
and Resurge
K.K. Srivastava 08
OPEN WORLD: India Arriving
India’s Bits-Network
Attracting Investment for
Realizing Development Benefits
Elisabeth Tuerk 16
OPEN WORLD: Naked Economics
Policy Transparency and Evaluation
for Economic Growth in India
Valentin Zahrnt 28
OPEN WORLD: Power and Control
Regulating Markets
in the Post-Crisis World
Shalendra D. Sharma 34
OPEN WORLD: Missing Markets
Market Failure and
the Need for Regulation
Anjan Panday 38
OPEN WORLD:
From Columbus To ConAgra
Trade Liberalisation and Indian Farm
Sector: Understanding the Situation
from Available Evidence
Subrata Dutta 46
OPEN WORLD: Protection’s Price
The Harmful Impact of Protectionism
Rok Spruk 54
OPEN WORLD: Goldilocks
(F)ACT SHEET
Globalization
Open Economy:
A Boon or Bane for India?
Misu Kim & Susmita Mitra 60
OPEN WORLD: Game Theory
A Model of North-South Growth and
Trade as a Differential Game Problem
with an Empirical Illustration
T. Krishna Kumar 68
OPEN WORLD: Bound Together
Evolution of World Trading System
and Future of Free Trade:
A 21st Century Experience
M.S. Goel 76
OPEN WORLD: Murky Economics
Murky Economics—Comparative
Advantage & Free Trade Theory
John Kozy 82
GROWTH ECONOMICS: Stock Taking
The India Story: Served Sunny Side Up
Ketaki Sharma 88
GROWTH ECONOMICS:
What’s This India Business?
Is Rising Share of Services
Inevitable for GDP Growth?
Madhusudan Dutta 92
GROWTH ECONOMICS:
An Elusive Quest
Modern Theories of Growth:
A Critique
Ambar Ghosh & Chanadana Ghosh 100
WELFARE ECONOMICS:
Rethink and Resurge
Employment Guarantee, Not
Employment Subsidy Approach
Suits Indian Conditions
Saumitra Mohan 112
WELFARE ECONOMICS:
Recast and Restructure
Governance and Employment
Generation in Rural Areas:
A Case Study of NREGs in Selected
Districts of West Bengal
Byasdeb Dasgupta & Bipul De 118
WELFARE ECONOMICS: Water Wisdom
NRDWP – A Paradigm Shift in Rural
Drinking Water Supply
Benny George 126
LAW AND ECONOMICS:
Law Growth Nexus
Review of Economic Development
and Legal System: An International
Perspective
Uma Sankaran 132
LAW AND ECONOMICS: Flat World
Free Trade and Free Markets:
A General Law Perspectives
Rabin Majumder 142
ENVRIONMENTAL ECONOMICS:
Silent Spring
Mitigating Environmental Crisis:
Can India Show the Way?
G. Bhalachandran &
Suresh Chandra Babu 146
ENERGY ECONOMICS: Charging Ahead
Wind Energy in India -
Reforms to the Rescue
Ritesh Agarwal & Shiva Agarwal 152
MICRO MACRO: Entrepreneurial Ethos
Mismatch between Entrepreneurial
Intention and Environment - A Survey
in Burdwan District of West Bengal
Soumyendra K. Datta &
Rimu Chaudhuri 158
MICRO MACRO: Social Edge
Microfinance at Turning Point:
Success Factors of Microcredit in
Bangladesh and Its Future Prospects
Tomohito Kanaizuka &
Farhad Hossain 166
SECTORAL SNAP: Retail Roulette
Consumer Behavior and
Competition in Indian Retailing
Mohammad Amin 176
COUNTER CURRENTS: Trust Busting
Crisis in Academic Economics
Amol Agarwal 184
GLOBAL GOVERNANCE: IMF
New Resources for
an Unreformed IMF?
Kunibert Raffer 196
GLOBAL GOVERNANCE: Unbearable
Lightness
The Unbearable Lightness of
Financial Markets
Heiner Flassbeck & Sonia Boffa 202
O P E N WO R L D

Woebegone
Government, Wobbly
Markets and the
Economic Management:
Rethink, Recast, and
Resurge
K.K. Srivastava
Lead Economist, The IIPM Think Tank,
New Delhi

A
stylized assumption is that if the government does
what it must – provide a secure environment – and if
markets have perfect competition then a free market
economy will allocate resources with relative efficiency. Alas,
real world is characterized by existence of common property
resources, public goods, negative externalities, and excessive
market power concentrated in some hands. Government
intervention, becomes necessary to correct market failures.
Besides, in addition to potential for inefficiency a free market
economy essentially deals with the dilemma of economic
inequity. This further adds to government responsibilities.
Markets are considered to be superior to central planning
since they provide more, better and cheaper information for
decision making. They provide a relatively more flexible
system with a great scope for personal adaptation. These
adjustments can be made much faster. And they decentralize
power. In a perfectly competitive market both production
efficiency and allocative efficiency are attained. Thus each firm
produces at least possible cost, all firms within an industry face
the same price and marginal cost, and the marginal cost of

8 THE IIPM THINK TANK


producing each good is equal to its market price. This is the
idealized situation. In real world, almost all the firms face a
negatively sloped demand curve, leading to equilibrium price
being always higher than marginal cost. Market fails, i.e.
allocative inefficiencies emerge. And government gets a
legitimate right to intervene so as to improve – even if not
eliminate altogether – the market efficiency. Though any
student of economics knows about circumstances under which
markets fail, these bear a remention:
One, producers with excess capacity set prices which lead to
inefficient exclusion; two, each economy has common property
resources that belong to none specifically but can be used by
anyone; so these are prone to be overexploited; three, there
exist public goods where nondiminishability and non exclusion
apply; four, people not participating in a market transaction
may still be affected due to the outcome, i.e. they may suffer
negative externalities or enjoy positive ones; five, there exists
the problem of asymmetric information – one party having
unfair advantage over the other because of access to better
information needed for economic decision making; six, some
markets – known as missing markets – may be needed but may
not exist, may be due to uncertainties, adverse selection
possibility, and so on; and, finally, seven,
imperfect competition may lead to an equi-
librium price higher than the marginal Society’s resources
cost. are optimally
Given all of the above the government allocated when
has two options – replace the market with
the social
central planning (as was unsuccessfully
tried in many centrally planned econo-
marginal cost
mies) or may seek to correct the inefficien- equals the social
cies through direct and indirect interven- marginal benefits
tion. To be sure, however, such
interventions are neither costless nor error free; the post
intervention outcome may at times be less desirable than an
inefficient market functioning!
Thus we know that markets work best when goods and
services are available in a finite amount, are diminishable
upon consumption, and non payers are excludable. But
actually some goods and services, say an art gallery, may be
excludable though not diminishable. If these goods are
provided privately then the price will exceed marginal cost and
some people who are willing to pay more than this marginal
cost but less than current price do not use it. This kind of
WO B B L E M A R K E T S
failure is called ofcourse inefficient exclusion. And, to avoid
inefficient exclusion the government itself often provides
them, like a public park. The service is provided free and the
costs are met out of other levies like taxes.
On the other hand common property resources pose
another problem: these are diminishable but non-excludable.
Under the free market provision common property resources
will be used upto a point where the marginal cost of the last
entrant equals the average output of all existing producers.
The socially optimal exploitation though would occur when
the marginal cost of the last user equals the value of the
marginal addition to total output. Result: overexploitation.
While the solution may lie in fixing quota (say, for fishing in
the sea) or licensing, the problem lies in enforcing the restric-
tion which are both difficult and costly to implement. Another
solution suggested is to make them excludable: privatize the
forests, wildlife, etc. so that the private owners will have a
tendency to exploit them efficiently. But equity issues arise:
those who were using them earlier for free perhaps will suffer
a welfare loss. The classic dilemma of equity vs. efficiency.
Public goods are both nondiminishable and non excludable,
i.e. these are produced for collective consumption, say
information. But because public goods are
non excludable, private producers are not
interested in providing them. So products
like weather forecast, fire protection, etc.
are provided by the government, and for
free. So the free rider problem is also
avoided. But the issues of over or under
production is more difficult to settle since
now there is no market for such products.
Talking of externalities, society’s
resources are optimally allocated when
social marginal cost equals social marginal benefits. But in
case of positive externalities the output produced is invariably
less than the socially optimum level while in case of negative
externalities this output exceeds the socially optimal levels.
Naturally, therefore, to achieve optimally production of
output with beneficial externalities needs to be encouraged
while the other kind, with harmful effects, needs to be cut
down from the level that would be produced under free
market conditions.
Most – though not all – externalities arise because of
absence of property rights – I don’t own the air that I pollute
THE INDIA ECONOMY REVIEW 9
O P E N WO R L D
nor does the one who suffers from polluted air. So to the
extent that appropriate property rights can be created, these
externalities can be internalized. Else, we will have to learn to
live with externality.
Asymmetric information of course leads to issues like moral
hazard and adverse selection. Due to moral hazard social costs
are unnecessarily high (a careless but insured driver) while in
case of adverse selection market outcome is less efficient than
when all the participants were equally well informed. One
possible solution could be again state intervention to impose
standards and level to which information has to be compulso-
rily revealed. But in many situations government can’t do
anything to ensure availability of ‘fair’ information to transact-
ing parties (a doctor determines whether by pass surgery is
essential on a heart patient or not, based on the fact may be
that he will be richer by a few lakh rupees?)
Coming to the missing markets, of course markets don’t
exist for public goods or common property resources, but
these don’t exist for products involving uncertainty (i.e. non
insurable events) too. For example, while future markets for
commodities do exist because these are well established and
unchanging, no such markets exists for
most manufactured products. Who knows
after all whether LED will replace CFL in Regulatory
India in next three years or not, when arbitrage infact
CFLs themselves are struggling to replace causes as much
the ordinary light bulbs. Future markets
economic losses to
are missing and there is no way that the
costs and benefits of planned future
the country as do
expenditure on these products can be the poor decisions
equated by today’s transactions. by the Executive
Finally, market power is unequally
distributed; perfectly competitive markets with atomic firms
are mere theoretical constructs. Yet competition must be
encouraged and monopoly practices must be curbed. This can
be done by either influencing the market structure or the
market behaviour. So most governments follow a competition
policy wherein they may try to directly control natural monop-
olies, they may directly control harmful monopoly and
oligopolies, and they may seek to create more competitive
conditions. Thus in case of natural monopolies like say
electricity distribution the government either assumes owner-
ship of the single firm (Delhi Vidyut Board earlier) or priva-
tizes it (BSES, etc) and then regulates it (through DERC).
10 THE IIPM THINK TANK
Since 1980s (in India since 1991) there has been a movement
in many developed and developing nations to deregulate and/
or privatize. This is mainly due to a growing belief among
policy makers than private firms operating in free markets are
more efficient producers and innovators than governments. To
be sure this is not to suggest zero intervention. Remember, we
had quoted seven situations of market failure. In the presence
of many of these it is not necessarily efficient to allow the free
markets to decide all issues of resource allocation. The least
stringent form of government intervention of course seeks to
create conditions of competitions by preventing firms from
merging unnecessarily or colluding to set monopoly prices. In
general competition by preventing firms from merging
unnecessarily or colluding to set monopoly prices. In general
competition policy aims at preventing the firm from ganging
up against hapless consumers.
Argument So Far..and Further
Briefly put, we can say that effective governments define and
protect the rights and obligations of private property. Market
economies seek to coordinate decentralized decisions without
conscious control. In the process they also
determine the distribution of income.
Thirdly, compared with the alternatives,
perfectly functioning markets attempt to
minimize concentration of economic
power. To the extent desirable outcomes
do not occur, the government needs to
intervene – to enhance efficiency and to
come closer to (subjectively defined)
equity goals. Thus even if the markets work
well most times, they seldom work opti-
mally because of the inevitable presence of one or more of
market failures. So the government policy attempts to alleviate
these failures. either by imposing more efficient behaviour by
rules, regulations, and even public production or by internal-
izing externalities.
But while government interventions may have potential to
improve the workings of the markets, this does not mean that
they always get it right. In this regard we need to note five
important facts. First, governments have many objectives to
pursue in addition to efficiency, viz., growth, stability, and
equity; second, growth and equity objectives may actually
conflict with efficiency goal; third, government uses policy
 WO B B L E M A R K E T S

tools like fiscal policy, legal provisions, regulations, as well as
state entrepreneurship to attain the economic objectives;
fourth, these government interventions involve both the direct
cost of administration and indirect costs associated with
interference with the price mechanism; and, fifth, the govern-
ment in practice may have incentives to consciously deviate
from delivering economic efficiency (an impending election
and a soft budget).
Thus the government policies are directed at modifying the
income and wealth distribution that was ordained due to one’s
parent’s abilities, luck, and market for him. But often the goals
of a more equitable distribution conflict with the goals of a
more efficient economy. The government has to at times
protect one person from abusive potential exercised by other
(thus law against child labor) or protect someone from his own
ance costs, and even losses in productivity. Not only this even
indirect external costs are involved such as efficiency losses
that spread throughout the whole economy; these in turn may
be an outcome of the alteration in price signals caused by
government tax and spending policies.
Like we said earlier that the governments intervene to
reduce the imperfections of the market, let’s also candidly
admit that the potential for benefits would exceed costs also in
a world where the government functioned perfectly. Which
ofcourse is like a utopian dream. Government failure – not
achieving some possible gains – can arise because of rigidities
causing a lack of adequate response of rules and regulation to
changing conditions, poorer foresight on the part of govern-
ment regulators compared with private participants in the
market, and government objectives – such as wining the next

Table 1: Functions of the State

Addressing Market Failures Improving Equity

Providing Pure Public Goods
- Defence
Minimal - Law and Order
Functions - Property Rights
- Macroeconomic Management
- Public Health
Externalities Monopoly Regulation
Intermediate - Basic Education - Utility Regulation
Functions - Environment Protection - Anti Competitive Policy
Activist Coordinating Private Activity
Functions - Fostering Markets
- Cluster Initiative
Protecting Poor
- Anti Poverty Pro-
gram
- Disaster Relief
Imperfect Information Social Insurance
- Financial Regulation - Redistributive Pen-
- Consumer Protection sion
- Unemployment
Insurance
Redistribution
- Asset Redistribu-
tion

Source: World Bank: World Development Report, 1997.

self (a potential/actual drug addict). Besides, sometimes the
government may have to invoke social obligations (like
compulsory military enlistment, or vote in the election or at
least have no right to buy one’s way out of jail for an offence
committed!). For achieving all these goals and more the
government has in its toolkit such instruments as taxes,
spending, rules and regulations, as well as state ownership.
But government activity entails incurring of direct external
costs imposed on those directly affected by these policies.
These could be in the form of extra production costs, compli-
election; they conflict with such objectives as improving
economic efficiency.
Having said so, contrary to the popular perception, the role
of the State has increased in the economic management in
recent decades rather than diminishing. Only that this increase
in the State’s influence has shifted the emphasis from the
quantitative to the qualitative, from the sheer size of the State
and the scope of its intervention, to its effectiveness in meeting
people’s needs.
Today’s renewed focus on the State’s role has actually been

THE INDIA ECONOMY REVIEW 11

O P E N WO R L D
inspired by dramatic events in the global economy, which have
fundamentally changed the environment in which States
operate. The global integration of economies and the spread
of democracy have narrowed the scope for arbitrary and
capricious behaviour. Taxes, investment rules, and economic
policies must be ever more responsive to the parameters of a
globalised world economy. Technological change has opened
new opportunities for unbundling services and allowing a
larger sole for market forces. These changes have meant new
and different roles for government no longer as the role
provider, but as facilitator and regulator. All under the triple
influence of liberalization, privatization,
and globalisation. In India too we are
witnessing deregulation in many industries
– banking, insurance, automobiles, civil
aviation, telecom, and so on.
When the economy moves from pro-
tected monopolies to market competition,
in the interim we need strong and effective
regulators. Else, there is likely to be a scope for arbitrary
heavy cost in the form of rent seeking,
reduced efficiency, and compromise with
consumer welfare. And even at the risk of stating the obvious
different industries are at different stages of freedom and
deregulation. So they need different kind of treatments.
Whiffs of Competition in Successive Stages
There exists a continuum from protected monopoly to market
competition. Depending on historical evolution pattern
different industries find themselves in one of the five distinct
Table 2: Evolution of Competition and its Maturing
Stage-1 Stage-2
Solo Player Some Players
Little or no competition Entry cases
- Railways - Electricity
distribution
- Oil and Gas
- Insurance business
Source: Self constructed by the author
Note: The industry placements are in Indian contexts while the stages are applicable generally
12 THE IIPM THINK TANK
stages of this continuum, or even between the two stages.
What one needs to appreciate is that each stage (from
monopoly to dynamic competition) exhibits different charac-
teristics and throws up different challenges. Depending on
the pace at which the particular industry is orienting itself to
fair competition, regulatory task will be customized; we can’t
have standard regulatory process. Hence it is important for
us to understand the unique characteristics associated with
each stage.
Stage-1: The Bliss of Solitude….and the Pains!
This stage exists prior to deregulation.
There are strict government controls, free
Global economic entry is barred, and the customer is devoid
integration and of alternatives. At best there could be a
the spread of regulated oligopoly structure. Naturally
democracy have pricing is distorted with the cost being the
major determinant of final price. At times
narrowed the the government may intervene in matters of
pricing in the interests of social justice; in
& capricious acts such a case the monopoly maintains cross
subsidization scheme to remain in surplus/
profit. Many a time profit may even be treated as a dirty word.
So there is hardly room for, or inclination to, work efficiently.
On the other hand not much surplus is generated so that
CAPEX is constrained. Alternatively, there may be an excessive
bleeding of existing assets. Protected status and lack of incen-
tives kills the scope for innovations. Sure, we witnessed all this,
and more, in insurance industry, airlines business, oil and gas
sector, etc. before 1991.
Stage-3 Stage-4 Stage-5
Several Players Select Few Survivors
Dogfights begin Shake out happens Souls with sustainable
advantage
- Organised Retailing - Automobiles
- Airlines
- Cellulars
- Mutual Funds
 WO B B L E M A R K E T S

Stage-2: You’ve Got Company try even in the context of five forces model of Michael Porter.
The markets may be opened up and pricing freed. To smoothen The industry has consolidated itself, with each player having
the process an independent regulator may be appointed. Private carved out a niche for itself. Costs are squeezed and prices set
players may be allowed but with restriction like equity caps, no under the optimum influence of 3C’s – cost, customer, and
foreign participation, etc. This also means, however, that under competitor. Having earlier ventured adventurously into territo-
the euphoric feeling of a (false/limited) sense of freedom the ries unfamiliar, most incumbents now choose to come back to
players fail to fully appreciate the impending perils of change; their core customers. Market itself is the regulator now; it is
some of them at least are lulled into complacency either because regulation by exception.
they have joined this stage from being earlier in Stage-1 (mo-
nopoly/regulated oligopoly) and have not yet overcome their Stage-5: Darwinism Rules, Truly!
sense of invincibility, or they are new to the industry with little Only competition rules the entire market place. Prices are
appreciation of all the dimensions of the working. Euthanasia flexible under the dynamics of forces of demand and supply.
begins, or is it hara kiri? Proactive companies alone grow; reactionaries have no role once
the revolution has taken place! So the marketplace is ever
Stage-3: Commoditization Reappears evolving to meet the changing needs and preferences of custom-
Due to gradual deregulation competition spreads deep and wide. ers. The competition is more global than local. Regulators retire
Products and services proliferate and customers are spoilt with into oblivion!
alternative offerings at very heavily discounted prices. Currently,
the airline industry, mutual funds industry, and even cement Time to Let Go? Well, Yes and No
industry is in this stage. Individual market shares decline, newer While everyone agrees that market failures, which are as
and more nimble players emerge which first take on the best and ubiquitous as the presence of the market itself, are ground
then the rest, and finances, talent pool, and all resources face enough for the government to intervene with regulations,
crunch situation. While there are more births (new entries), actually the latter are required even when the markets work
numbers of those dying (exiting) in not so distant a future is likely perfectly. Even competition needs to take place within a frame-
to surpass the newborns. work of rules. The protectors of law must remain within the
range of vision, even if they are not required to galvanize into
Stage-4: There is Room for Few Only action at a given point of time. Competition yes, unfair competi-
By now the market is almost completely deregulated; competi- tion no.
tion is formidable. The customers are very well informed and By one estimate, America, the supposed land of the unfet-
know their mind. The select few players who have been able to tered, has nearly 78,000 pages of regulation, and 2.41 lakh
survive have gained critical mass and well ensconced in the indus- employees to ensure their enforcement. A McDonald burger has
to follow 80 different regulation before
Table 3: The Regulator: Ideal vs. Indian a customer bites into it.
But then there is such animal as an
Ideal Indian ideal regulator who is very different
- Statutory backing, with clearly defi ned - Statutory backing, but relevant laws from an Indian incarnation. We have,
powers may remain unamended interalia, regulators for aviation,
- Independent, free from bureaucratic - Dependent, heavy interference
interference broadcasting, cellulars, disinvestment,
- Accountable only to legislative - To Parliament and to the Ministry insurance, petroleum and natural gas,
- Funding from independent sources - Budgetary support ports, power, roads, telecom, and
- Independent secretarial for technical - Relies on Ministry for such support (proposed for) water. However, all of
support
- Transparent functioning. Consultative - Not very transparent, through con- them suffer from certain inherent
discussions sultative weaknesses, the biggest one of which is
th
Source: Business Today (August 7 ,1999): The Dependent Regulator lack of independence.

THE INDIA ECONOMY REVIEW 13

O P E N WO R L D

Regulatory arbitrage infact causes as much economic losses
to the country as do the poor decisions by the Executive or the
misdemeanours of the market players. India has failed on one
hand in regulating capacity building and on the other from a
weak regulatory oversight. Thus instead of appointing compe-
tent and committed professionals, these positions are used for
parking retired bureaucrats and judges. And with shorter
Parliament sessions there remains a very limited scope for
Parliament’s Executive oversight.
Following a predictable pattern the government may
announce setting up of an independent regulatory authority
but it is not notified or constituted for quite sometime (recall
about the authorities for pension regulation or competition).
When appointed these regulators lack independence and
autonomy. Most regulators thus may be dependent and/or
lacking independent powers.
allow interference by the Ministry concerned. For
example, does the Ports Trust Authority set only tariffs
or is it responsible for everything else too? In an ideal
scenario, violated of course in India, in a general policy
framework the regulators are empowered to implement
the rules. Finally, granting operational autonomy helps
insulate the reform process from bureaucratic interfer-
ence.
2. Independent Regulators
Must Have Independent Funding
One who pays the piper calls the tunes. The government
controls the purse strings, and keeps the regulators on a
tight leash. Thus both financial autonomy and financial
incentive to work efficiently are lost. And, to be sure,
independent funding in no way should axiomatically

Table 4:
No Regulation through Active Regulation to Regulation by Exception
State Ownership Privatization Competition
Where Are We
(Railways) (Cellular Industry) (Financial Intermediaries)
- Subsidies - Subsidy cuts - Price competition
What Are the Issues
- Falling effiency - Price increases - Consolidation
Involved
- Inter-connection problems - Customer Choices
- Nothing; there is no regu- - Tariff bsetting - Monitoring of inter-connec-
lator - Fixing inter-connection tion issues
What Are Regulators charges - Dispute resulation
Expected to Do - Disputes regulation - Monitoring competition
- Monitoring of quality, safety - Monitoring of quality, safety
etc. etc.
Source: Self constructed by the author

According to Swati Kamal, while writing in Business
Today, an effective regulatory body is possible only
when at least four rules are followed. What does our
experience in India tell us? Well,
1. Independent Regulators
Must Have Clearly Defined Powers
For this the underlying Act must be worded unambigu-
ously. Yet, in most cases, the provisions have been
ambiguous, ensuring that the foundation itself is shaky.
For example, the CERC Act does not define the rela-
tionship between the CERC and the SERCs, leaving
enough scope for conflict. Besides, ambiguities can
mean a compromise with accountability. Simple audit-
ing of accounts can ensure this.
3. Independent Regulators
Must Be Independently Staffed
Likewise, there is a clear cut interference of the con-
cerned ministry in matters of appointment of the
chairman and members of the body. Worse, they in turn
lack independence in selecting their juniors. To be fair,
however, some degree of independence is being pro-
vided now.
4. Independent Regulators Must Be Able to Deal With

14 THE IIPM THINK TANK


Independent Operators
India has the unique distinction – but dubious at that
– of the same person being in a dual position of being a
regulator and being the regulated (examples, at least
earlier, from telecom, insurance, and so on). Obviously,
when both the operator and the policy maker are same,
friction is bound to occur. Besides, when the incumbent
player/policy maker faces competition (as in case of civil
aviation) the policies will be designed to protect mo-
nopoly status. In India where the government is thus
both service provider and policy maker this linkage
needs to be severed. Why not corporatize the SEBs, for
example?
Conclusion
Indian marketplace is in a transition phase. For a
developing India if we are conceiving a blueprint for
sustaining efficient growth and investments for the next
periods, cracking the problem of an often dysfunctional
system is crucial. Else, we will be condemned to suffer
huge economic losses. There is a need to define and
implement the fundamental rights for citizens as well as
businessmen. And then ensure that no one violates each
others’ rights.
References and Additional Thinking
• B. G. Verghese: Why Honesty Doesn’t Pay (in)
Business world, 24th August, 2009
• Binu Kwatra: The Hidden Costs of Business (in)
Business world, 24th August, 2009.
• Business world editor: The Fundamental Rights of
Business (in) Business world, 24th August, 2009.
• BW editorial team: Time to Rebuild the Nation (in)
Business world, 24th August, 2009.
• Chandrajit Banerjee: Make Hire and Fire Easier (in)
Business world, 24th August, 2009.
• D. Thankappan: Workers Need More Security (in)
Business world, 24th August, 2009.
• ET Editorial Team: Why Markets Need Regulators
(in) The Economic Times, 18th February, 2002.
• Girish Vanvani & Saloni S. Khandelwal: Making the
Right Cut (in) Business world, 24th August, 2009.
• Hari Shanker Subramaniam: Notes on Tax Freedom
(in) Business world, 24th August, 2009.
WO B B L E M A R K E T S
• Harish Salve: Getting it Right (in) Business world,
24th August, 2009.
• J. K. Mitra: The Right Chapter (in) Business world,
24th August, 2009.
• Jagdish N. Sheth, Allvine, Uslay & Dixit: Deregula-
tion and Competition. Response Books (2007).
• Jayant Sinha: Time to Let Go (in) Outlook Business,
19th September, 2009.
• Michael Porter: Competitiveness and Micro – Eco-
nomics (in) Business Today, 22nd September, 1998
• Rajeev Chandrashekhar: Regulatory Dysfunction (in)
Business world, 31st March, 2008.
• Ranbir Roy Choudhury: Doing Business in India (in)
Business Line, 21st September, 2009.
• Rohit Saran: The New Political Economy (in) Busi-
ness Today, February 7th-21st, 1998.
• Rukmani Parthasarthy & Swati Kamal: For the
Reforms (in) Business Today, 22nd September, 1999.
• Rukmani Parthasarthy: Freedom in Fetters (in)
Business Today, 7th April, 1999.
• S. Gopalakrishnan: Cut the Red Tape (in) Business
world, 24th August, 2009.
• Sandeep Biswas: Surviving Deregulation (in) Busi-
ness Standard, 11th December, 2001.
• Sanita Aggarwal: Airport Regulator Pushes for
Financial Autonomy (in) Indian Express, 22nd Sep-
tember, 2009.
• Shalini S. Sharma: Turning Burden into Boom (in)
Business world, 24th August, 2009.
• Sreevalson Menon: Tangled in Red Tape (in) Busi-
ness world, 24th August, 2009.
• Swaminathan S. A. Aiyar: Regulating the Regulators
(in) The Economic Times, 13th February, 2008.
• Swati Kamal: The Dependent Regulator (in) Busi-
ness Today, 7th August, 1999.
• World Bank: World Development Report, 1997 (by)
World Bank, Washington.
• Y.C. Halan: The State and the Corporate (in) The
Financial Express, 6th April, 2002.
• Y.V. Reddy: State and Market (in) Economic &
political Weekly, October 16th-23rd, 1999.
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation).
THE INDIA ECONOMY REVIEW 15
O P E N WO R L D

India’s Bits-Network
Attracting Investment for
Realizing Development
Benefits*

Elisabeth Tuerk
Senior Legal Expert, International
Agreements Section,
UNCTAD DIAE, Geneva

16 THE IIPM THINK TANK


I
n August 2009 India and the Republic of Korea signed a
bilateral agreement containing a chapter with substan-
tive provisions on the promotion and protection of
investment. The agreement also sets out pre-establishment
national treatment.1 Counting both, bilateral trade or
cooperation agreements and bilateral investment treaties
(BITs), the India–Republic of Korea agreement is the 82nd
international investment agreement (IIA) India has signed.
The agreement with the Republic of Korea is also the third
agreement with investment provisions that India has signed
during the last twelve months.2
Over the last years India has become one of the most
active countries in signing IIAs, 3 a development which could
also be a reflection of India’s increasing role as a capital-
exporting country.4 While IIAs can offer
an important tool for realizing the
development benefits expected from Similar to inward
increasing inward and outward invest- FDI, outward
ment, care has to be given to avoid FDI flows also
unintended side-effects of such agree-
experienced a
ments, including the reduction of domes-
tic policy space and unexpected or
jump, from $3 bn.
unwarranted exposure to Investor-State in 2005 to $14.3
Dispute Settlement (ISDS) cases. 5 bn. in 2006
This essay offers a brief sketch of
India’s approach to IIAs. It commences with some back-
ground-information on the country’s FDI trends; it then
looks at the evolution of India’s IIA network over time;
followed by an overview of the country’s BITs (based on the
analysis of twenty two selected BITs).
1. Background: FDI Flows to and from India
In 2008, Indian inward FDI stock reached a substantial
US$ 123.3 billion, while outward FDI stock reached US$
61.8 billion. This turns India into the 24th most important
destination for FDI, and into the world’s 31st largest out-
ward investor.
Inward FDI flows into India had begun to emerge in
significant amounts during the mid-1990s. Though volatile,
inward FDI flows have been on the increase. A sharp jump
occurred in Indian inward FDI flows in 2006, when Indian
inward FDI rose from US$ 7.6 billion in 2005 to US$ 20.3
billion a year later (almost three times higher than 2005). In
that year, the country received more FDI than ever before,
I N D I A A R R I V I N G
equivalent to the country’s total inflows during the period
2003–2005. The year 2008 saw a further rise in inward FDI
flows to US$ 42 billion. Rapid economic growth which has
led to improved investors confidence might be amongst the
many reasons for these developments. Similarly, sustained
growth in income has made the country increasingly
attractive to market seeking FDI. Numerous US and
Japanese TNCs (ranging from GM, IBM, Toyota and
Nissan) and private equity firms were playing an important
role in this context.6
Outward FDI from India emerged at significant levels at
the turn of the century, hence somewhat later than respective
inward FDI. Since 2000, outward FDI flows continued to
increase year-on-year. Similar to inward FDI, outward FDI
flows also experienced a jump between
2005 and 2006, from US$ 3 billion in 2005
to US$ 14.3 billion in 2006, constituting
an almost four times increase just in one
year. Outward FDI flows rose to US$ 17.2
billion the following year.7 So far, the
amount of inward FDI flows/stock has
always been substantially larger than
outward FDI flows/stock.
With the global financial and economic
crisis came a significant decrease in global
FDI flows. However, developing countries are very likely to
be strong engines for FDI growth in the coming rebound.
This is confirmed by UNCTAD’s recent World Investment
Prospects Survey (WIPS) 2009–2011, which places the
so-called BRIC countries (Brazil, the Russian Federation,
India and China) among the top five most favoured destina-
tions for future FDI activities by large TNCs worldwide.8 In
addition to a general economic stimulus package, India
enacted several policy measures dealing with the entry,
facilitation, and operation of FDI9 and India also continued
to sign new BITs. In comparison to other countries, overall
prospects for inward FDI in India are positive.
2. India’s Network of IIAs: Overview and Trends
An IIA is an international agreement – or treaty – between
two or more countries that addresses issues relevant to
cross-boarder investments. The most common types of IIAs
are bilateral investment treaties (BITs) and preferential trade
and investment agreements (PTIAs), with investment
THE INDIA ECONOMY REVIEW 17
O P E N WO R L D

Figure 1: Indian Inward and Outward FDI Stock: 1990–2007, nomic Cooperation Agreement (CECA) of
US$ Million 2005 and the 2009 Comprehensive Economic
Partnership Agreement (CEPA) between India
45000 150000 and the Republic of Korea are examples for the
125000 latter type of agreements.
36000
Compared to other countries, India started
100000 negotiating BITs relatively late, with the conclu-
27000
Flows

sion of its first BIT (with the United Kingdom)

Stock
75000
18000
in March 1994,14 briefly afterwards followed by
50000 a BIT with Russia. In 1995 alone, India signed
9000 seven BITs. With ten new agreements, 1997 was
25000
the year with the largest number of agreements
0 0 concluded, followed by an average of five
1995 1997 1999 2001 2003 2005 2007
agreements per year between 1998 and 2008.15
FDI outflow FDI inflow
Despite the fact that India only signed one
Inward FDI stock Outward FDI stock
agreement in 2004 and no agreement in 2005,
the country is still one of the most active BITs
provisions. Countries may conclude IIAs with a view to negotiators in the world. In 2008, India concluded six new
protecting their investors abroad or with the aim of attracting BITs, continuing an earlier trend with five new BITs in 2006
foreign investors to their economy (e.g., investment promo- and six in 2007.16 In 2009, the country has already signed
tion). Through the protection, increased security and two BITs – with Bangladesh and Mozambique – and one
certainty under international law that an IIAs offers to other IIA (CEPA with the Republic of Korea). India also
investors (companies and individuals) from contracting completed BITs negotiations with Colombia (2009)17 and
parties who invest or set up a business in with Canada (2007).18
other countries party to an agreement, An interesting characteristic of India’s
IIAs can indirectly promote FDI.10 In 2008, India BITs network is the diversity of its partner
Allowing foreign investors to settle concluded six new countries. India has signed BITs with all
disputes with the host country through BITs, continuing regions of the world, albeit with a differ-
international arbitration, rather than only
an earlier trend ent focus over time. During its early years
through the host country’s domestic of BITs negotiations, India signed
routes, is considered an important aspect
with five new BITs agreements mainly with developed
in this context. However, the increasing in 2006 and six in countries in Europe (Germany, Italy,
number of international investment year 2007 Denmark and the Netherlands in 1995).
disputes emerging from such agreements, Today, 24 (30%) of India’s BITs are with
as well as the costs and challenges associated with them (e.g., developed countries. More recently, India has concluded
financial implications, costs of litigation and inconsistent more agreements with other developing countries (five BITs
awards), have given rise to increasing concerns from policy in 2008). Today 38 (51%) of India’s BITs are South-South
makers, academia and affected stakeholders.11 agreements, possibly reflecting both the country’s increasing
By the end of 2008, the total number of BITs worldwide role as an outward investor and an increasing focus on
rose to 2,676 and the total number of IIAs other than BITs strengthening South-South partnerships.
and DTTs amounted to 273.12 To date, India had signed 82 In terms of geographical diversity, much of India’s more
IIAs.13 75 of these agreements are BITs and seven are recent negotiating activity has focused on other Asian
other international agreements containing investment countries. Out of 38 BITs it signed with other developing
provisions. The India–Singapore Comprehensive Eco- countries, 23 (60%) were concluded with Asian countries.

18 THE IIPM THINK TANK

 I N D I A A R R I V I N G

Figure 2: Number of Indian BITs Concluded, Annual and Cumulative, Japan Comprehensive Economic
1994–200919 Partnership Agreement (CECA)23
and the India–GCC FTA.24 Further-
12 80 more India has started negotiations
10 on a CEPA with Canada.25

Cumulative BITs
60
Annual BITs

8
6 40
3. India’s Network of BITs:
4
2
20 A Brief Sketch
0 0 Based on a brief review of twenty
94 9 95 9 96 9 9 7 98 999 0 0 0 0 01 0 02 0 03 0 04 0 05 0 06 0 07 0 08 0 09 two sample BITs signed by India,
19 1 1 1 19 1 2 2 2 2 2 2 2 2 2 2
Years this section aims to sketch some of
Annual BITs Cumulative BITs the key characteristics of the
country’s BITs network.
India has signed nine BITs with West Asia, four BITs with A first threshold crucial for the scope and breadth of a BIT
East Asia, nine BITs with South-east Asia and two with relates to the definitions of “investor” and “investments”.
South Asia. India has also paid considerable attention to These definitions set out the coverage of protected persons
developing countries in other regions. It has signed eleven and assets under the IIA. Most BITs cover foreign direct
BITs with African and four BITs with Latin American investment (FDI) and portfolio investment, but some exclude
countries. India has also signed fourteen BITs with partners the latter. Typically, BITs have used asset-based definitions in
in the transition economies. While so far a notable absentee investor/investment protection agreements (the first genera-
in the range of Indian BITs partners is the United States, tion BITs) and transactional defi nitions in investment
India is in negotiations on a BIT with the United States.20 liberalization agreements. Asset-based definitions basically
Another key characteristic of India’s BITs policy relates imply that the BIT embraces a large scale of assets of
to the country’s concerted move to economic value, virtually without limita-
ratify agreements. By December 2008, tions. The general definition is followed
more than 90 percent of Indian BITs A rather by an illustrative list of the main catego-
were ratified.21 interesting ries of investment to be protected.33 The
In parallel to BITs, India has also characteristic Indian BITs reviewed all include this type
signed other economic cooperation
of India’s BITs of definition.
agreements that contain substantive A second threshold question is whether
investments provisions as well as frame-
network is the the agreement grants post- or also
work agreements that aim at strengthen- diversity of its pre-establishment rights. This question
ing cooperation on investment issues or partner economies relates to the stage in the investment proc-
pave the way for negotiating substantive ess to which the agreement’s protections
investment rules in the future. India has concluded such apply. Under a post-establishment BIT, only investors (and
agreements with a number of regional groupings (e.g., their investments) that have already established inside the
ASEAN, the Gulf Cooperation Council (GCC), MERCO- country are protected. A pre-establishment BIT, in turn,
SUR) as well as individual countries (e.g., Republic of grants rights (e.g., regarding access and establishment,
Korea). In total, India signed seven such IIAs. After initially guarantees of treatment or promises of liberalization) also to
signing an agreement with the European Community (1993), prospective investors. None of the Indian BITs reviewed
India then focused on other developing countries, mainly in contains commitments with regards to pre-establishment
Asia. In addition to the conclusion of one CEPA in the first treatment of foreign investment.34
eight months of 2009, India is currently negotiating a number Another set of key question relates to the type of substan-
of IIAs, including the ASEAN–India FTA;22 the India– tive protections that are offered to those investors that

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O P E N WO R L D
Figure 3: Total Number of Indian BITs Concluded
by Country Group End 2009 (Percent)
19%
31%
30%
5%
15%
Transition Economy
Europe
Africa
Latin America and the Caribbean
Asia and Oceania
qualify for protection under a country’s IIAs. Amongst these
are so-called relative standards (i.e., National Treatment
(NT) and Most-Favoured-Nation (MFN) treatment) as well
as absolute standards (e.g., Fair and Equitable Treatment
(FET)).
National Treatment (NT) in a BIT context implies that the
obligation of contracting parties to grant
investors/investments of the other
contracting party treatment no less With respect to
favorable than the treatment they grant to full protection and
their country’s own investors/investments. security, Indian
The effect is to create a level playing field
government’s
between foreign and domestic investors in
the relevant market.35 The twenty two
approach varies
Indian BITs reviewed grant NT (on a considerably
post-establishment basis). Hence, once across its BITs
they have already established in the India,
foreign investors are guaranteed the same treatment as
domestic investors.
The Most-Favoured-Nation (MFN) standard is another
core element of BITs. It requires a host country to accord
treatment to a covered foreign investor/investments which is
no less favorable than that accorded to an investor/invest-
ment of a third State. The MFN standard offers foreign
investors/investments a guarantee against certain forms of
discrimination by reason of nationality and is therefore also
crucial for establishing a level field.36 Similarly as with NT, all
20 THE IIPM THINK TANK
22 BITs reviewed contain the same basic MFN provisions.
MFN clauses in Indian BITs reviewed all contain two kinds
of exceptions: new obligations cannot be imported from
agreements establishing Regional Economic Integration
Organizations (REIOs) (e.g., ASEAN); and MFN treatment
does not apply to tax measures.
An example of the second type of substantive provisions
typically stipulated in IIAs are the FET standard, the
guarantee of Full Protection and Security or Minimum
Standard of treatments.37 Moreover, BITs frequently deal
with the issue of expropriation or damages to an investment,
determining that – and in what manner – compensation be
paid to the investor in such a situation. These concepts have
been subject to a wide array of interpretations, giving rise to
concerns about the consistency of such interpretations and
the attendant development implications. Since there is no
universally recognized definition of the meaning of some of
these principles, some countries have aimed at detailing the
scope of protection granted to investments by some of these
principles (e.g., minimum standard of treatments).38
With respect to minimum standard of treatments, Indian
BITs have not set themselves such an ambitious rule making
agenda and have stuck with basic provisions such as the
following: "Investments or investors of
each Contracting Party shall at all times
be accorded fair and equitable treat-
ment".39 With respect to full protection
and security, India’s approach varies
considerably across its BITs. Nine of the
twenty two Indian BITs examined provide
for full protection and security, but
thirteen do not offer such a guarantee.
Interestingly, full protection and security
does not appear in the model BIT that
India uses to negotiate with other countries.40
With respect to expropriation,41 in recent years the
question of indirect expropriation or regulatory taking has
come to the forefront. All of India’s BITs reviewed recog-
nize that indirect expropriation that is "measures having
effect equivalent to nationalisation or expropriation",42 is
expropriation. As a response to arbitral awards, some
countries have – over the last years – aimed to clarify BIT
obligations with a view to ensuring that legitimate regulatory
conduct at the national level would not be considered
 I N D I A A R R I V I N G

Figure 4: Indian Economic Cooperation Agreements, 1993–2009

India – European Community Cooperation Agreement between the European Community and the Republic 199326
of India on Partnership and Development
India – ASEAN Framework Agreement on Comprehensive Economic Cooperation Between 200327
the Republic of India and the Association of South East Asian Nations
India – MERCOSUR Framework Agreement between the MERCOSUR and the Republic of India 200328
India – GCC Framework Agreement on Economic Cooperation Between the Republic of 200429
India and the Member States of the Cooperation Council for the Arab States
of the Gulf
India – Chile Framework Agreement to Promote Economic Cooperation Between the 200530
Republic of Chile and the Republic of India
India – Singapore Comprehensive Economic Cooperation Between the Republic of India and 200531
Singapore
India – Korea Comprehensive Economic Partnership Agreement (CEPA) between the 200932
Republic of India and the Republic of Korea

expropriation. India’s approach to international investment
rule making has however so far stopped short of spelling out
in more detail what does and does not qualify as being
'equivalent to expropriation'.43
Finally, most Indian BITs also contain a specific exception
that allows parties to derogate from treaty obligations in the
case of a threat to national security or other emergency
situations.44 Most of the Indian BITs
reviewed refer to "a state of national
emergency", while the recent BIT be- Adequate
tween India and Mozambique explicitly attention to
draws on "the protection of its essential environmental,
security interests" and "circumstances of
social and poverty
extreme emergency".
Besides the above, there are numerous
related issues
other substantive treaty protections that is crucial in the
would merit attention (e.g., the extent to current context
which IIAs rule out performance
requirements, provisions on free transfer of funds, excep-
tions for balance of payments problems). Of key impor-
tance, however, are also procedural issues: dispute settle-
ment under BITs is characterized by the availability of
Investor State Dispute Settlement (ISDS).45 This allows
investors to submit Host State decisions and actions to an
authority – independent from the host country administra-
tive and judicial system – for examination.46 All of India’s
BITs reviewed grant this right.
Over the years, investors have increasingly resorted to the
dispute settlement mechanisms included in BITs, leading to a
growing number of treaty-based ISDS cases brought to
international arbitration.47 This raises considerable chal-
lenges for host countries, including cost-related challenges
(cost of litigation, costs for awards), challenges regarding a
country’s reputation as an attractive FDI destination and
capacity-related challenges, particularly for developing
countries.48 A particular problematique
arise when ISDS cases challenge legiti-
mate domestic policies. It is therefore of
utmost importance that host countries
have the capacity to manage – and to the
extent possible avoid – such ISDS pro-
ceedings. Preventive measures, including
better treaty language and effective
means of dispute avoidance, are impor-
tant in this regard.49
4. Concluding Remarks
With today’s global crisis, and the attendant nosedive of FDI
flows, effective promotion of foreign investment is needed
more than ever, both for developed and developing countries.
Accordingly, there is a call for intensified investment promo-
tion efforts, both as regards inward and outward investment.
This includes the dismantling of visible and hidden invest-
ment obstacles, as well as a special focus on retaining existing
investment in times of crisis.
The worldwide signature of 25 new BITs and six other IIAs

THE INDIA ECONOMY REVIEW 21

O P E N WO R L D

in academia and policy circles. 53

Today’s global economic and environmental crises raise
further questions about the type of policies that are needed
to maximize the potential of FDI to contribute to economic
and social development. Adequate attention to environmen-
tal, social and poverty related issues is crucial in this context
and today’s key question is how IIAs can better deliver on
their potential to contribute a sustainable and equitable
growth – including in the context of a global recovery.
Revisiting some aspects of IIA rule making could offer an
opportunity to address today’s development challenges.

Endnotes
1
2
3
during the first six months of 2009, points to a continued
reliance – in spite of the ongoing global economic and
financial crisis – on the conclusion of IIAs as a means to
4
promote foreign investment so as to finance the recovery and
boost growth and stability. 50 India, with six (BITs) and three
(two BITs and CEPA) IIAs it concluded in 2008 and 2009
respectively, is also part of this trend.
5
BITs negotiations are driven by the expectation that these
agreements play an important role in enhancing the flow of
FDI to signatory countries (e.g., by improving the investment
climate, by reducing regulatory barriers to international
investment, and by providing greater security, certainty and
6
opportunities for investment and investors in signatory
countries). 51 This positive link between IIAs and FDI flows is
stronger when IIAs contain effective and operational
provisions on investment promotion.52
Generally, countries aim to attract FDI with a view to
7
reaping attendant development benefits. This includes
economic and social benefits (e.g., through employment
creation, technology transfer or increasing tax receipts).
While the role of FDI in economic growth and development
8
is widely acknowledged, the exact relationship between FDI
and development and the manner in which FDI contributes
to – or sometimes detracts from – the growth and welfare of
developing countries has been subject to continuous debate
On 7th August, 2009 India signed a Comprehensive
Economic Partnership Agreement (CEPA) with the
Republic of Korea, see http://commerce.nic.in/trade/
INDIA%20KOREA%20CEPA%202009.pdf
Between August 2008 and August 2009, India signed BITs
with Bangladesh and Mozambique.
For official documents on trade and investment agree-
ments by the Republic of India: http://commerce.nic.in/
trade/international_ta.asp?id=2&trade=i
UNCTAD (2009). Recent Developments in International
Investment Agreements (2008–June 2009). IIA MONI-
TOR No. 3 (2009). http://www.unctad.org/en/docs/webdi-
aeia20098_en.pdf
UNCTAD (2003). World Investment Report 2003. FDI
Policies for Development: National and International
Perspectives. United Nations Publications. Sales No. E.03.
II.D.8. New York and Geneva. P. 114 ff. http://www.unctad.
org/en/docs/wir2003_en.pdf
UNCTAD (2007). World Investment Report 2007.
Transnational Corporations, Extractive Industries and
Development. United Nations Publications. Sales No.
E.07.II.D.9. New York and Geneva. P. 43. http://www.
unctad.org/en/docs/wir2007_en.pdf
UNCTAD (2007). World Investment Report 2007.
Transnational Corporations, Extractive Industries and
Development. United Nations Publications. Sales No.
E.07.II.D.9. New York and Geneva. P. 44
UNCTAD (2009). World Investment Prospects Survey.
http://www.unctad.org/Templates/meeting.asp?intItemID=20
68&lang=1&m=17872 See also Pradhan, Jaya Prakash
(2009). Indian FDI falls in global economic crisis: Indian

22 THE IIPM THINK TANK

 I N D I A A R R I V I N G

multinationals tread cautiously. Columbia FDI Perspec-
tives, No. 11, August 17th, 2009.
http://www.vcc.columbia.edu/pubs/documents/IndianOFDI-
Final.pdf
9
UNCTAD (2009). Investment Policy Developments in
G-20 Countries.
http://www.unctad.org/en/docs/webdiaeia20099_en.pdf
10
UNCTAD (forthcoming 2009). The Role of International
Investment Agreements in Attracting Foreign Direct
Investment to Developing Countries. UNCTAD Series on
Issues in International Investment Agreements. United
Nations publication. New York and Geneva.
11
UNCTAD (2009). Report of the Multi-year Expert
Meeting on Investment for Development on its first
session. Held at the Palais des Nations, Geneva, from 10th
- 11th February, 2009. http://www.unctad.org/en/docs/
ciimem3d3_en.pdf
12
For regional and country specific trends in IIA rule
making (BITs and other IIAs) see UNCTAD (2009).
Recent Developments in International Investment
Agreements (2008–June 2009). IIA MONITOR No. 3
(2009). P. 3. http://www.unctad.org/en/docs/webdi-
aeia20098_en.pdf
13
For a comprehensive list of the country’s BITs see Annex-
ure-1 of this article.
14
The first countries that signed a BIT were Germany and
Pakistan in 1959.
15
UNCTAD (2009). Recent Developments in International
Investment Agreements (2008–June 2009). IIA MONI-
TOR No. 3 (2009). P. 3. http://www.unctad.org/en/docs/
webdiaeia20098_en.pdf
16
UNCTAD (2009). Recent Developments in International
Investment Agreements (2008–June 2009). IIA MONI-
TOR No. 3 (2009). P. 3. http://www.unctad.org/en/docs/
webdiaeia20098_en.pdf
17
The BIT with Colombia is called a Bilateral Investment
Promotion and Protection Agreement (BIPA).
http://www.thaindian.com/newsportal/india-news/india-
colombia-to-sign-bipa-to-increase-investment-
flow_100212609.html
18
The BIT with Canada is called a Foreign Investment
Protection and Promotion Agreement (FIPA).
http://w01.international.gc.ca/MinPub/Publication.
aspx?lang=eng&publication_id=385226&docnum=82
19
Data for 2009 is preliminary, including Indian BITs up to
August 2009.
20
The BIT with the United States is called Bilateral Invest-
ment Promotion and Protection Agreement (BIPA). http://
www.bilaterals.org/article.php3?id_article=11154
http://economictimes.indiatimes.com/News/Economy/
Foreign-Trade/India-America-talk-up-bilateral-investments-/
articleshow/4887737.cms
21
On the distinction between the conclusion, signature and
the entry into force of a BIT and on the importance of
ratification, see UNCTAD (2006). The Entry into Force
of Bilateral Investment Treaties (BITs). IIA MONITOR
No. 3 (2006). http://www.unctad.org/en/docs/webitei-
ia20069_en.pdf
22
The negotiations on the ASEAN-India FTA were con-
cluded on 7th September, 2009, but an agreement has not
yet been signed, see http://iitrade.ac.in/news-archive.
asp?news=1026
23
For details, see http://commerce.nic.in/trade/international_
ta_current_details.asp
24
For details, see http://commerce.nic.in/trade/international_
ta_current_details.asp
25
http://w01.international.gc.ca/MinPub/Publication.
aspx?lang=eng&publication_id=386756&docnum=16
26
http://ec.europa.eu/world/agreements/downloadFile.do?fullT
ext=yes&treatyTransId=790
27
http://commerce.nic.in/trade/international_ta_ framework_
asean.asp
28
http://commerce.nic.in/flac/FRAMEWORK%20AGREE-
MENT%20BETWEEN%20THE%20MERCOSUR%20
AND%20India.pdf
29
http://commerce.nic.in/trade/international_ta_ framework_
gcc.asp
30
http://commerce.nic.in/trade/ta/india_chile.pdf
31
http://commerce.nic.in/trade/international_ta_ framework_
ceca.asp
32
http://commerce.nic.in/trade/INDIA%20KOREA%20
CEPA%202009.pdf
33
For a discussion of issues related to the scope and defini-
tion of IIAs, see UNCTAD (forthcoming 2009). Scope
and Definition. UNCTAD Series on Issues in Interna-
tional Investment Agreements. United Nations publica-
tion. New York and Geneva.
34
A typical formulation is found in the India – Mauritius

THE INDIA ECONOMY REVIEW 23

O P E N WO R L D
BIT which refers to the "management, maintenance, use,
enjoyment or disposal of investments" – leaving aside
issues such as "establishment and acquisition". It has to be
noted however, that the recent CEPA investment chapters
that India has concluded with the Republic of Korea
covers the national treatment of foreign investors in the
pre-establishment phase.
35
UNCTAD (2007). Bilateral Investment Treaties
1995-2006: Trends in Investment Rulemaking. P. 33.
http://www.unctad.org/en/docs/iteiia20065_en.pdf
36
UNCTAD (forthcoming 2009). Most-favoured-Nation
Treatment. UNCTAD Series on Issues in International
Investment Agreements. United Nations publication. New
York and Geneva.
37
UNCTAD (2007). Bilateral Investment Treaties
1995-2006: Trends in Investment Rulemaking. P. 28.
http://www.unctad.org/en/docs/iteiia20065_en.pdf
38
For a more detailed discussion see UNCTAD (2007).
Bilateral Investment Treaties 1995-2006: Trends in
Investment Rulemaking. PP. 28-33. http://www.unctad.org/
en/docs/iteiia20065_en.pdf
39
See India–Australia BIT, Art 3.2.
http://www.unctad.org/sections/dite/iia/docs/bits/australia_
india.pdf
40
See Indian Model BIT, particularly Art 3.2.
41
BITs and other international instruments for the protec-
tion of foreign investment virtually always contain
provisions prohibiting the taking of foreign investors’
assets by public authorities, except if done for a public
purpose, on a non-discriminatory basis, against payment
of compensation, and, in many cases, with due process of
law. UNCTAD (2004). Key Terms and Concepts in IIAs:
A Glossary. UNCTAD Series on Issues in International
Investment Agreements. United Nations Publication.
E.04.II.D.31. New York and Geneva. P. 67. http://www.
unctad.org/en/docs/iteiit20042_en.pdf
42
See Indian Model BIT, Art 5.1.
43
Yet, in the CEPA between India and Korea, indirect
expropriation is also dealt with (P. 233). http://commerce.
nic.in/trade/INDIA%20KOREA%20CEPA%202009.pdf
44
For a discussion of issues related to such national security
exceptions, see UNCTAD (2009). The Protection of
National Security in IIAs. United Nations Publication. E.
09.II.D.12. New York and Geneva.
24 THE IIPM THINK TANK
45
UNCTAD (2004). Key Terms and Concepts in IIAs: A
Glossary. UNCTAD Series on Issues in International
Investment Agreements. United Nations Publication.
E.04.II.D.31. New York and Geneva. P. 43. http://www.
unctad.org/en/docs/iteiit20042_en.pdf
46
During the early stages of IIA rule-making, this has been
controversial, as it is a clear break from the Westphalian
model of international public law as governing only the
relationship between states without recourse for private
parties.
47
UNCTAD (2009). Latest Developments in Investor–
State Dispute Settlement. IIA MONITOR No. 1 (2009).
http://www.unctad.org/en/docs/webdiaeia20096_en.pdf
48
UNCTAD (2009). Report of the Multi-year Expert
Meeting on Investment for Development on its first
session. Held at the Palais des Nations, Geneva, from 10th
- 11th February, 2009. P. 6. http://www.unctad.org/en/docs/
ciimem3d3_en.pdf
49
UNCTAD (2009). Report of the Multi-year Expert
Meeting on Investment for Development on its first
session. Held at the Palais des Nations, Geneva, from 10th
- 11th February, 2009. P. 2. http://www.unctad.org/en/docs/
ciimem3d3_en.pdf See also UNCTAD (forthcoming
2009). Exploring Alternatives to Investment Treaty
Arbitration and the Prevention of Investor-State Dis-
putes. United Nations publication. New York and Geneva.
50
Also during 2008, the network of IIAs has continued to
expand: BITs (59) and other IIAs (16) – in sum – a
development that further strengthens and expands the
current international investment regime.
51
UNCTAD (forthcoming 2009). The Role of International
Investment Agreements in Attracting Foreign Direct
Investment to Developing Countries. UNCTAD Series
on Issues in International Investment Agreements.
United Nations publication. New York and Geneva.
52
For the time being, however, IIAs do not contain commit-
ments by capital-exporting countries other than vague
language relating to investment promotion and do not
give any protection to developing countries against
policies restricting outward investment. Investment
insurance and other home country measures encouraging
outward investment are cases in point where continued
international cooperation can be useful.
53
Moran, Theodore H. / Graham, Edward M. / Blomstöm,

Magnus (2005). Does Foreign Direct Investment promote
development? Institute for International Economics.
Washington. http://www.piie.com/publications/chapters_
preview/3810/14iie3810.pdf. UNCTAD (2005). Economic
Development in Africa. Rethinking the Role of Foreign
Direct Investment. http://www.unctad.org/en/docs/gdsaf-
rica20051_en.pdf.
References and Additional Thinking
• Moran, Theodore H. / Graham, Edward M. / Blomstöm,
Magnus (2005). Does Foreign Direct Investment promote
development? Institute for International Economics.
Washington. http://www.piie.com/publications/chapters_
preview/3810/14iie3810.pdf
• Pradhan, Jaya Prakash (2009). Indian FDI falls in global
economic crisis:Indian multinationals tread cautiously.
Columbia FDI Perspectives, No. 11, August 17th, 2009.
http://www.vcc.columbia.edu/pubs/documents/IndianOFDI-
Final.pdf
• UNCTAD (forthcoming 2009). Exploring Alternatives to
Investment Treaty Arbitration and the Prevention of
Investor-State Disputes. United Nations publication. New
York and Geneva
• UNCTAD (forthcoming 2009). Most-favoured-Nation
Treatment. UNCTAD Series on Issues in International
Investment Agreements. United Nations publication. New
York and Geneva.
• UNCTAD (forthcoming 2009). Scope and Definition.
UNCTAD Series on Issues in International Investment
Agreements. United Nations publication. New York and
Geneva.
• UNCTAD (forthcoming 2009). The Role of International
Investment Agreements in Attracting Foreign Direct
Investment to Developing Countries. UNCTAD Series
on Issues in International Investment Agreements.
United Nations publication. New York and Geneva.
• UNCTAD (2009). Investment Policy Developments in
G-20 Countries. http://www.unctad.org/en/docs/webdi-
aeia20099_en.pdf
• UNCTAD (2009). Latest Developments in Investor–
State Dispute Settlement. IIA MONITOR No. 1 (2009).
http://www.unctad.org/en/docs/webdiaeia20096_en.pdf
• UNCTAD (2009). Recent Developments in International
Investment Agreements (2008–June 2009). IIA MONI-
I N D I A A R R I V I N G
TOR No. 3 (2009). http://www.unctad.org/en/docs/webdi-
aeia20098_en.pdf
• UNCTAD (2009). Report of the Multi-year Expert
Meeting on Investment for Development on its first
session. Held at the Palais des Nations, Geneva, from 10th
to 11th February, 2009. http://www.unctad.org/en/docs/
ciimem3d3_en.pdf
• UNCTAD (2009). The Protection of National Security in
IIAs. United Nations Publication. E. 09.II.D.12. New
York and Geneva.
• UNCTAD (2009). World Investment Prospects Survey.
http://www.unctad.org/Templates/meeting.asp?intItemID=2
068&lang=1&m=17872
• UNCTAD (2007). Bilateral Investment Treaties
1995-2006: Trends in Investment Rulemaking. P. 33 http://
www.unctad.org/en/docs/iteiia20065_en.pdf
• UNCTAD (2007). World Investment Report 2007.
Transnational Corporations, Extractive Industries and
Development. United Nations Publications. Sales No.
E.07.II.D.9. New York and Geneva.
http://www.unctad.org/en/docs/wir2007_en.pdf
• UNCTAD (2006). The Entry into Force of Bilateral
Investment Treaties (BITs). IIA MONITOR No. 3 (2006).
http://www.unctad.org/en/docs/webiteiia20069_en.pdf
• UNCTAD (2005). Economic Development in Africa.
Rethinking the Role of Foreign Direct Investment. http://
www.unctad.org/en/docs/gdsafrica20051_en.pdf
• UNCTAD (2004). Key Terms and Concepts in IIAs: A
Glossary. UNCTAD Series on Issues in International
Investment Agreements. United Nations Publication.
E.04.II.D.31. New York and Geneva. http://www.unctad.
org/en/docs/iteiit20042_en.pdf
• UNCTAD (2003). World Investment Report 2003. FDI
Policies for Development: National and International
Perspectives. United Nations Publications. Sales No.
E.03.II.D.8. New York and Geneva. http://www.unctad.org/
en/docs/wir2003_en.pdf
(* This paper was prepared by a team led by Elisabeth Tuerk.
The contributors include Amare Bekele, Hamed El-Kady, Jan
Knoerich, Matthew Levine, Diana Rosert, Astrit Sulstarova
and Elisabeth Tuerk. The views expressed are those of the
authors and do not reflect the views of the UNCTAD secre-
tariat or its member States.)
THE INDIA ECONOMY REVIEW 25
O P E N WO R L D

ANNEXURE - 1

Total Indian BITs (1994–2009)

Partner Country Date of Signature Date of Entry into Force BITs Text Reviewed
Argentina 20-Aug-99 12-Aug-02
Armenia 23-May-03 30-May-06
Australia 26-Feb-99 4-May-00 y
Austria 8-Nov-99 1-Mar-01
Bahrain 13-Jan-04 5-Dec-07
Bangladesh 9-Feb-09
Belarus 26-Nov-02 23-Nov-03
Belgium and Luxembourg 31-Oct-97 8-Jan-01 y
Bosnia and Herzegovina 12-Sep-06 13-Feb-08
Brunei Darussalam 22-May-08 18-Jan-09
Bulgaria 29-Oct-98 23-Sep-99
China 21-Nov-06 1-Aug-07
Croatia 4-May-01 19-Jan-02 y
Cyprus 9-Apr-02 12-Jan-04
Czech Republic 11-Oct-96 6-Feb-98 y
Denmark 6-Sep-95 28-Aug-96 y
Djibouti 19-May-03
Egypt 9-Apr-97 22-Nov-00 y
Ethiopia 5-Jul-07
Finland 7-Nov-02 9-Apr-03
France 2-Sep-97 17-May-00
Germany 10-Jul-95 13-Jul-98
Ghana 18-Aug-02 y
Greece 26-Apr-07 10-Apr-08
Hungary 3-Nov-03 2-Jan-06 y
Iceland 29-Jun-07 16-Dec-09
Indonesia 10-Feb-99 22-Jan-04 y
Israel 29-Jan-96 18-Feb-97
Italy 23-Nov-95 26-Mar-98
Jordan 30-Nov-06 22-Jan-09
Kazakhstan 9-Dec-96 26-Jul-01 y
Korea, Republic of 26-Feb-96 7-May-96
Kuwait 27-Nov-01 28-Jun-03
Kyrgyzstan 16-May-97 10-Apr-98
Lao People’s Democratic Republic 9-Nov-00 5-Jan-03
Libyan Arab Jamahiriya 26-May-07 25-Mar-09
Macedonia, TFYR 17-Mar-08 17-Nov-08

26 THE IIPM THINK TANK

 I N D I A A R R I V I N G

Partner Country Date of Signature Date of Entry into Force BITs Text Reviewed
Malaysia 1-Aug-95 12-Apr-97
Mauritius 4-Sep-98 20-Jun-00 y
Mexico 21-May-07 23-Feb-08
Mongolia 3-Jan-01 29-Apr-02
Morocco 13-Feb-99 22-Feb-01 y
Mozambique 19-Feb-09 y
Myanmar 24-Jun-08 8-Feb-09
Netherlands 6-Nov-95 1-Dec-96 y
Oman 2-Apr-97 13-Oct-00 y
Philippines 28-Jan-00 29-Jan-01
Poland 7-Oct-96 31-Dec-97
Portugal 28-Jun-00 19-Jul-02 y
Qatar 7-Apr-99 15-Dec-99
Romania 17-Nov-97 9-Dec-99
Russian Federation 23-Dec-94 5-Aug-96
Saudi Arabia 25-Jan-06 20-May-08
Senegal 3-Jul-08
Serbia and Montenegro 31-Jan-03 24-Feb-09
Slovakia 25-Sep-06 27-Sep-07
Spain 30-Sep-97 15-Dec-98
Sri Lanka 22-Jan-97 13-Feb-98 y
Sudan 22-Oct-03
Sweden 4-Jul-00 1-Apr-01 y
Switzerland 4-Apr-97 16-Feb-00 y
Syrian Arab Republic 18-Jun-08 22-Jan-09
Taiwan Province of China 17-Oct-02 28-Nov-02
Tajikistan 13-Dec-95 14-Nov-03
Thailand 10-Jul-00 13-Jul-01 y
Trinidad and Tobago 12-Mar-07 7-Oct-07
Turkey 17-Sep-98 18-Nov-07 y
Turkmenistan 20-Sep-95 27-Feb-06
Ukraine 1-Dec-01 12-Aug-03
United Kingdom 14-Mar-94 6-Jan-95 y
Uruguay 11-Feb-08
Uzbekistan 18-May-99 28-Jul-00
VietNam 8-Mar-97 1-Dec-99
Yemen 1-Oct-02 10-Feb-04
Zimbabwe 10-Feb-99

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O P E N WO R L D

Policy Transparency and

Evaluation for Economic
Growth in India
Valentin Zahrnt
Research Associate,
European Centre for International Political
Economy (ECIPE), Belgium

G
ood governance, in its broadest sense, means
selecting the right policy objectives together with the
appropriate instruments to attain them. And it
means implementing the policies efficiently, without waste,
delay or corruption. India wrestles with both challenges, and
this weakness of governance from the commanding heights
down to the lowlands of local administration explains why
India fails to realize its economic potential more fully. This
article addresses the first challenge, that of policy-making. It
argues that India cannot expect improvements in this area as a
byproduct of economic development but needs to strengthen
domestic and international mechanisms for transparency and
policy evaluation.

Examples of Bad Policy-Making Abound

There is a rough correlation between the level of development
and the efficiency of policy implementation, and the OECD
countries have generally learned to execute their policies
decently well. Efforts to introduce a service culture, to flatten
hierarchies, and to employ information technologies have
further enhanced administrative efficiency in the developed
world during the last decade. But even the most developed
countries continue to commit to policies whose aims are blurry
to the point of being indiscernible, to policies whose objectives

28 THE IIPM THINK TANK


are incongruent, and to policies whose ends contradict any
reasonable vision of the public good. Similarly, examples
abound in OECD countries where policy instruments are, by
their very nature or design, ineffective or even harmful for the
espoused targets. What strikes the observer is that good
policy-making does not come with economic develop-
N A K E D E C O N O M I C S
ment. The case of EU agricultural policy can illustrate this
claim. The EU pays about € 55 billion of farm subsidies per
year, an amount corresponding to more than 40% of its budget.
Furthermore, tariffs on agricultural products average 18%
– over four times more than charges on other goods. All EU
tariffs greater than 100% relate to agricultural products, with
isoglucose hit hardest by a staggering 604% duty. These
policies are disastrous. The benefits are distributed arbitrarily
and unfairly among farmers, helping poor farmers little.
Consumers are harmed through higher food prices, hitting
especially poor households who spend a relatively high propor-
tion of their income on food. At the same time, the agricultural
policies fail to stimulate rural development in disadvantaged
regions, to motivate environmentally friendly farming prac-
tices, or to support food security. What they do achieve is
distortion of the economy and increased vulnerability to
criticism from the EU’s trading partners.
Poor governance practices have contributed to this absurd
outcome. Vice versa, politicians and bureaucrats have become
dependent on the opacity created by their poor governance
practices in order not to be held accountable for the results.
The EU is caught in a trap of bad policy practices and out-
comes. One key mechanism employed to avoid accountability
has been to never seriously define the objectives of the EU’s
agricultural policies. They were briefly enumerated in the 1957
Treaty of Rome and have since then been repeatedly extended
without any sense of precision or prioritization. Other mecha-
nisms include the dispersion of responsibility across numerous
committees; a repelling degree of legislative complexity;
secrecy of data about farm incomes and subsidy recipients;
superficial and politically biased policy evaluation through the
implementing agency, the Directorate-General for Agriculture
and Rural Development; fostering a supportive policy commu-
nity through the commissioning of ‘independent’ studies and
close cooperation with external experts; not publishing sensi-
tive in-house and commissioned analysis; and a monolithic
European Commission discourse with minimal internal dissent
combined with the disciplining of critical external stakeholders.
These opacity mechanisms have worked so well that policies
that endanger EU long-term food security – for instance by
depleting water and soil resources – are commonly justified by
the very need to ensure food security (which is not seriously
threatened in the EU anyway). And the EU’s agricultural
policies are generally credited with providing consumers
THE INDIA ECONOMY REVIEW 29
O P E N WO R L D
healthy food at affordable prices though consumers actually
pay more due to tariffs, production quotas, and export subsi-
dies. The same pattern can be observed in the EU’s policy
against dumped imports. Antidumping measures have little to
do with threats to competition on the EU market stemming
from foreign suppliers striving for excessive market power.
They lack any welfare rationale. Instead, they are deeply
political, driven by industry lobbying and electoral populism.
Once again, bad policies go hand in hand with poor policy-
making: consumer interests are relegated to the backseat,
economy-wide analysis is not undertaken in anti-dumping
procedures, examination of the link between dumping and
damage to the domestic industry is perfunctory, and the
calculations of dumping margins are kept secret.1
The Australian Case
Examining the OECD countries demon-
strates that being a rich democracy is not a
sufficient condition for having sound Anti-dumping
policy-making processes let alone for measures have
making sensible policies. Importantly, this little to do
judgment does not depend on preferences
with threats to
for particular (liberal) policies. The
benchmark is structural weakness, notably
competition and
lacking coherence among objectives and lack any sort of
between objectives and instruments, that welfare rationale
are condemned by experts across the board.
This does not imply that rational policy-making is a hopeless
case. The most important exception – one might say the
world’s showcase for policy transparency and evaluation – is
Australia’s Productivity Commission.2 This body started with a
narrow trade focus and became responsible for analyzing issues
as diverse as railway and shipping services, competition on the
telecommunication market, nursing home subsidies, and cost
recovery by government agencies. Several features of this
institution deserve highlighting.
High-Quality, Comprehensive Analysis: The Productivity
Commission assesses the impact of policy options on economic,
social, and environmental objectives. It also calculates the net
effects of various policies on the sector level. This shows how
some sectors that enjoy protection are harmed even more
strongly by protection of other sectors. Higher input prices or
reduced demand for the sector’s output through protection in
other parts of the economy can overwhelm the more visible
30 THE IIPM THINK TANK
benefits a sector receives from state intervention. Disentan-
gling and netting out the manifold distributional effects of
policies can thus create support for less intrusive and more
efficient solutions.
Transparent and Participative Inquiry Process: The Productiv-
ity Commission invites the public to contribute to its inquiries
through introductory issue papers. It receives submissions,
meets stakeholders, and holds public hearings. Draft reports
are published as well as all subsequent comments. Final
reports are written in an accessible language and actively
disseminated, in line with the objective ‘to promote public
understanding of matters relating to industry, industry
development and productivity’.
Right to Be Heard: The government is free to engage the
Productivity Commission in an inquiry or not, but final inquiry
reports must be tabled in the Parliament within twenty five
sitting days. Furthermore, the Productivity
Commission publishes an annual report
with economy-wide analysis.
Independence: Members are appointed for
up to five years based on qualifications and
experience. Strong safeguards protect them
against being removed from their office.
They accept strict limitations on outside
employment and requirements to disclose
their interests. Furthermore, ministerial
responsibility is assigned to the Treasury, a
ministry with an inherently economy-wide perspective unlikely
to sponsor sectoral interests.
Continuity: The Productivity Commission goes back to the
Tariff Board, established in 1921. Though its affiliation, rights,
resources, and methods have changed considerably over time,
the institution has remained recognizable over time. It could
thus build up its expertise and reputation.
These features must not be perceived in isolation for they
interact in beneficial ways. For instance, the Productivity
Commission’s independence rests not only on the explicit
provisions to this end but also on various other characteristics.
Thanks to its continuity, its high-quality research, and its
transparent and participative inquiry process, the Productivity
Commission has built up public support that shields it from
government infringements in its inquiries and attempts to
undermine its institutional functioning. The Productivity
Commission has thus been able to wield significant influence

on numerous specific policies. It has been widely credited for
its role in Australia's remarkable unilateral liberalization from
the 1970s to the 1990s. More importantly, it has shaped the
public discourse in the long run towards more rational policies
and fostered high expectations regarding the transparency and
scientific soundness of policy-making.
The Lesson for India
The lesson for India is that it cannot rely on a virtuous circle of
economic development and better economic governance. India
needs to actively create sound institutions that enhance
transparency, conduct analysis, and stimulate debate. As
Narayan (2009) notes, ‘An important aspect of the unfinished
[reform] agenda should therefore be wide dissemination of
information and debate about the necessity of reforms …’ This
must not be confounded with activism. India has long been
swamped by committees and councils that
assess policies and propose alternatives.3
These bodies have been placed with the The lesson for
Planning Commission, various ministries, India is that it
and the prime minister; they have white- cann't rely on a
washed failures or laid them bare; they
virtuous circle
have been ignored or supported by the
government. Here and there, they have
of economic
influenced policies. But neither the development and
Economic Advisory Council, nor the better governance
Programme Outcome and Response
Monitoring Division, nor the Programme Evaluation Organiza-
tion have created a culture of evaluation. A multiplicity of
government-dependent and ad-hoc commissions produces
piecework which politicians can discard or reinterpret as
political opportunism dictates.
What is needed is not more evaluation mechanisms but
fewer and better ones. The Australian Productivity Commis-
sion can serve as a model in terms of the kind and quality of
reports, transparency and public participation, independence
and rules of engagement, and institutional stability. The
objective should be to inspire a culture that pervades all of
policy-making, creating expectations that scientific advice will
be duly considered and that policies be justified by the stand-
ards of applied science. In addition to a public but independent
transparency institution, India should also foster private think
tanks that analyze policies and propose alternatives. All this
can be especially powerful in India, a functioning democracy,
N A K E D E C O N O M I C S
where the electorate can punish policy failure. And unlike
many other developing countries, India has the expertise and
capacity to set up such institutions.
Domestic institutions with local ownership and close ties to
local stakeholders and processes must be the cornerstone of a
system for policy transparency and evaluation. Still, India
would be well advised to endorse complementary international
mechanisms. First, an international mechanism can guarantee
that a review of certain quality and coverage is undertaken with
certain frequency. The minimum level of transparency thus
ensured is valuable as there is no guarantee that the Indian
government will establish and maintain sound transparency
mechanisms domestically and entrust them with regular
reviews of all relevant matters. (Even the Productivity Commis-
sion in Australia is at times sidelined by the government on
sensitive issues.)
Second, an international mechanism can
support domestic transparency institutions.
It accustoms governments to tolerate
reviews, stakeholders to contribute to the
review process, and the media to use the
results. Furthermore, international reviews
can report on the quality of domestic
transparency institutions, drawing atten-
tion to persistent shortcomings and acute
governmental encroachments. Such
reporting could include information on the
mandate, resources, and independence of the domestic
mechanisms; on the issues they have covered since the last
international report; and on the integration of their results
into policymaking.
Third, an international mechanism can serve not only as a
backup and prop for domestic institutions but deliver its own,
unique contribution. Namely, it facilitates country comparison
through standardization. An international mechanism can ask
the same questions for all countries, analyze the matter with
consistent methods, and apply a similar standard of rigor in its
conclusions. Information on where the own country stands in
international comparison is a powerful tool to mobilize
stakeholders and influence policy debates.
International Transparency Mechanisms
Several international organizations provide regular reviews of
countries’ economic policies. The World Bank maintains
THE INDIA ECONOMY REVIEW 31
O P E N WO R L D
various measures, such as the Doing Business, the World
Governance, the Logistics Performance, and the World Trade
Indicators. The IMF conducts an annual ‘Article IV Consulta-
tion’, a very uncompromising analysis of a country’s macroeco-
nomic developments and policies. The international transpar-
ency mechanism for economic policies with the greatest
potential, however, is the WTO’s Trade Policy Review Mecha-
nism (TPRM).
According to its mission, ‘the review mechanism enables the
regular collective appreciation and evaluation of the full range
of individual Members’ trade policies and practices and their
impact on the functioning of the multilateral trading system.’
The TPRM was provisionally established in 1989 and was made
definitive in 1995. The Secretariat first sends one or two
questionnaires to the country under review and collects
information from various sources. Members of the Trade Policy
Review Division of the Secretariat then
travel to the country to discuss outstanding
questions with the government and other Regrettably, the
stakeholders. The Secretariat drafts a current Trade
report and sends it to the country under Policy Review
review for verification. The final report,
Mechansim
together with a policy statement from the
country under review, is circulated to the
(TPRM) is beset
member states before the review meeting. with many striking
All documents, including the minutes of the weaknesses
meeting, are made public.
Regrettably, the current TPRM is beset with striking
weaknesses. TPRs are cumbersome to read and clogged with
compendium-style information. They are analytically superfi-
cial and relentlessly uncritical. They differ in their coverage and
approach one from another. The procedures for preparing and
discussing TPRs lack efficiency and public participation. It is
therefore unsurprising that TPRs are deemed to have no
discernible effect on trade policies. Improvement is necessary
in four areas.
Objective: TPRs should be resolutely aimed at shaping
domestic politics rather than informing bureaucrats in Geneva.
TPRs should focus the attention of domestic constituents and
the media on their country’s trade policies. They should make
trade policies comparable across countries and time and
highlight their trade and welfare effects. And they should spell
out their criticism. The latest TPR of India notes, for instance:4
Tenancy laws do not give well-defined rights to tenant
32 THE IIPM THINK TANK
farmers, who make up a significant share of agricultural
producers, and therefore they lack the incentive to develop
the land. Other factors of low productivity include regula-
tion of agricultural markets and the movement of major
crops, which has dissuaded the private sector in general from
investing in the sector, and relatively low levels of research
and development. … The Government's policy of providing
key inputs at subsidized prices has also resulted in a growing
subsidy bill to the detriment of public investment in infra-
structure and research and development.
Such statements should be found more frequently and be
underpinned more systematically with independent analysis. In
this way they could convince readers of the benefits of liberal
reform and serve as a reference in domestic policy debates.
Reports: TPRs should follow a standardized analytical grid.
This would make TPRs easier to read, facilitate comparison
across time and countries, and assure that
reports are complete. It would also secure
consistency in the severity of criticism,
making reports more acceptable to
governments who care about their relative
standing and treatment. Regarding their
content, TPRs should rely much more
strongly on existing analysis that shows the
economy-wide costs of protectionism and
identifies winners and losers on a sectoral
basis. Besides, they should scrutinize not
only trade policies but also policy-making processes. TPRs
should compare actual processes to best practices and summa-
rize available analysis on the quality of policy-making.
Process: The process of how TPRs are prepared, discussed,
and disseminated should be reformed. The drafting of the
Secretariat’s report should be more transparent and allow for
greater stakeholder participation. A further step in the attempt
to transform TPRs from a diplomatic exercise in Geneva into
an event in members’ domestic politics should be to present
and debate TPRs in the country under review. To realize these
more ambitious objectives, the budget of the WTO Secretariat
should be substantially increased.
Frequency: According to current rules, the four countries with
the largest share of world trade are to be reviewed every two
years, the next sixteen every four years, and the rest every six
years. The last reviews of India have been in 2007 and 2002.
This is insufficient to influence domestic politics. TPRs should

be conducted more frequent to deliver up-to-date information
and remain in stakeholders’ minds.
Political Feasibility of TPRM Reform
The political climate is propitious for a strengthening of the
TPRM. The blockade of the Doha Round has demonstrated
the need to address various systemic issues. Since the Uruguay
Round, trade has become increasingly contested at the
domestic level. The ‘club model’ of multilateral cooperation
that isolated the trade ministry from involvement by other
ministries and the general public has come to an end. Convinc-
ing a broader audience of the benefits of free trade – e.g.
through TPRs – is therefore increasingly important if further
liberalization is to succeed.
Accordingly, Pascal Lamy, the WTO’s Director General,
and the Secretariat have been successfully pushing transpar-
ency mechanisms as a complement to negotiations and dispute
settlement. Most notably, they introduced a new review
mechanism of preferential trade agreements,5 and they started
reporting to the Trade Policy Review Body on recent trade
developments associated with the financial crisis. Govern-
ments appear to be slowly learning this lesson, too. The last
five-yearly self-appraisal by the Trade Policy Review Body did
not produce strong conclusions.6 But it showed that major
players (with the EU and Japan in the first place) promote
changes to give the TPRM greater bite. Since then, the
financial and economic crisis has created momentum for
fundamental re-thinking and reform of international institu-
tions. In particular, it has sparked concerns about insufficient
monitoring of trade policies.
The next WTO ministerial meeting, planned for the end of
November 2009 and explicitly dedicated to systemic issues
outside of the Doha Round, offers a venue for initializing
thorough TPRM reform. India has submitted suggestions for
enhancing the WTO’s transparency function: a database
with non-tariff measures shall be established, the Secretariat
shall make ‘factual presentation on developments in various
members’ in the respective working committees, and the
transparency mechanism for regional trade agreements shall
be made permanent.7 These are reasonable proposals, not
very ambitious but enough to position India in the vanguard
of the reform movement. India should go further and
become a champion of transparency in trade policy. This
would be a much more constructive approach to its new
N A K E D E C O N O M I C S
leadership role than the obstruction of multilateral negotia-
tions practiced in the past.
Endnotes
1
See Davis (2009) and Hindley (2009).
2
See Productivity Commission (2003) on the history of the
institution as well as the Productivity Commission Act 1998.
In the meantime, the Australian government was able to
abolish the obligation to seek public advice from the
Productivity Commission before granting new or increased
assistance to any industry. In the wake, the Productivity
Commission was by-passed on important issues in favor of
more controllable bodies.
3
See Arun Shourie’s speech on ‘New Beginnings’ on 8th June,
2009 at http://www.indianexpress.com/news/new-
beginnings/476900/0.
4
WTO (2007), pp. 100.
5
See WTO (2006).
6
See WTO (2008).
7
India (2009).
References and Additional Thinking
• Davis, Lucy. 2009. Anti-dumping Investigation in the EU:
How Does It Work? : ECIPE Working Paper No. 04/2009.
• Hindley, Brian. 2009. Cause-of-injury Analysis in European
Anti-dumping Investigations: ECIPE Working Paper No.
05/2009.
• India. 2009. Strengthening the WTO: Communication from
India: WT/GC/W/605.
• Narayan, S., ed. 2009. The Political Economy of Trade
Reform in Emerging Markets. Edited by P. Draper, P. Alves
and S. Razeen. Cheltenham: Edward Elgar.
• Productivity Commission. 2003. From Industry Assistance
to Productivity: 30 Years of 'The Commission': Productivity
Commission, Canberra.
• WTO. 2006. Transparency Mechanism for Regional Trade
Agreements: WT/L/671.
–. 2007. Trade Policy Review: India - Report by the Secre-
tariat: WT/TPR/S/182/Rev.1.
–. 2008. Third Appraisal of the Operation of the Trade
Policy Review Mechanism: WT/TPR/229.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation.)
THE INDIA ECONOMY REVIEW 33
O P E N WO R L D
Regulating Markets in the
Post-Crisis World
T
here are few precedents for the current global financial
meltdown. Not surprisingly, the crisis has already led to
much soul-searching in both the policy-making and
academic circles. Established orthodoxies are being questioned as
never before, not only to better understand the roots of the crisis,
but also to formulate policies in order to mitigate the current
economic toll and dislocation and prevent future crises. Even as
the dust settles, the process of drawing lessons from the great
global credit crisis of 2008-09 has begun with earnest. While we
do not know all the answers yet, the one unambiguous answer is
34 THE IIPM THINK TANK
that the hands-off American or “Anglo- Saxon” model of regula-
tion or (“regulation-lite”) needs to be replaced with a more
vigorous and effective regulation of financial institutions and
markets. Yet, what will this regulation entail? Of course, the devil
is in the details and there is no consensus on that. The following
sections fill in some of the gaps. It suggests that although greater
regulation is necessary, we must be careful not to cross the line
where regulations become too restrictive and an impediment to
innovation and entrepreneurship.
First, an important caveat should be noted: that the globally

Shalendra D. Sharma*
Professor, Department of Politics,
University of San Francisco
linked financial markets are inherently unstable and prone to
excess. Even as global capital markets allocates money more
efficiently than domestic ones, and helped spread capital and
wealth more widely than ever before (and in the process enabled
millions to better their lives), the financial system is also extremely
fragile – prone to boom and busts. Eichengreen and Bordo have
identified some 139 financial crises between 1973 and 1997 (of
which 44 took place in high-income countries), compared with a
total of only 38 between 1945 and 1971.1 This is because with
globalization, markets have become even more volatile and
unpredictable, and may not always work efficiently due to exter-
nalities, coordination failures, information asymmetries, including
well-placed firms and individuals using their power and privileged
access for private gain.
Thus, although open global financial markets provide tremen-
dous rewards by lowering the cost of capital, it is also clear that
more effective regulation is needed to realize
this potential. After all, financial markets can Unprecedented
only function efficiently when there is pace of change
symmetry of information available to both
makes it difficult,
buyers and sellers. Since effective disclosure
and transparency is fundamental to well-
if not impossible,
functioning markets, a core role of market for regulation and
regulators is to reduce information asym- supervision to
metries. This is essential now because keep pace
financial innovation and integration have
increased the speed and extent to which shocks are being trans-
mitted across asset classes and economies throughout the world.
Yet, regulation and supervision remain largely geared at individu-
al financial institutions and do not adequately factor-in the
systemic and international implications of domestic institutions’
actions. As a result (and as we now know) many highly structured
products were far from transparent and the disclosure of their
originators often lacking. Given these challenges, regulatory
oversight that places constraints on imprudent individual behav-
ior and prevent the build-up of dangerous speculative bubbles
makes sense. This failure has been most vividly and tragically
demonstrated during the current crisis where weak regulatory and
supervisory frameworks in the United States (but, also in other
P O W E R A N D C O N T R O L
advanced economies), failed to prevent excessive risk-taking by
market participants.
The current crisis also underscores that current macro-pruden-
tial tools do not sufficiently take into account business and
financial cycles. This has led to an excessive build up of leverage.
Although a feature that the current crisis shares with previous ones
is the apparent procyclicality of the financial system (with a
build-up of leverage in good times when investors tend to underes-
timate risk, and the subsequent unwinding of this leverage when
conditions deteriorate), this crisis is also unique for the key role of
assets that are held off banks’ balance sheets and the extent to
which credit problems have affected the liquidity of the entire
financial system. This not only means that credit rating agencies
need to more clearly differentiate structured products from more
standard financial instruments in their assessment of risks, market
participants need more information and transparency to better
price risk and reduce uncertainty at times of market disruption.
Thus, it is essential to put into place rules and institutions that
reduce systemic risks and improve financial intermediation without
imposing unnecessary red-tape. In particular, more transparent
capital and liquidity requirements would make financial institu-
tions (especially those that are highly
interconnected) more resilient to risk, and
making accessible data on over-the-counter
derivatives (to migrate those peer-to-peer
transactions to a tradable and public market),
and to introduce minimum capital require-
ments that cover all financial assets and
organizations would be a great help. It also
means that the supervisory and regulatory
frameworks should be more globally coordi-
nated to ensure effective supervision, including more transparent
disclosure and reporting rules. Such an approach would also
provide better information to market participants regarding
assessments of systemic risks.
Yet, this crisis has also underscored that protecting the global
financial system from the recurrent bouts of speculative excesses
and painful contractions is not going to be easy given the interna-
tionalization of markets. The unprecedented pace of change
makes it difficult, if not impossible, for the bureaucratic world of
regulation and supervision to keep pace. While the conventional
view (not surprisingly promoted by politicians) blames deregula-
tion for the current problem, it is important to keep in mind that
the U.S. financial services industry is not without its fair share of
THE INDIA ECONOMY REVIEW 35
O P E N WO R L D
regulations and red-tape. In fact, numerous laws and regulations
are already on the books and a plethora of government agencies,
notably the Securities and Exchange Commission (SEC) in
America and its British equivalent, the Financial Services Author-
ity (FSA), have significant powers to implement and supervise
these rules. Clearly, more bureaucratic red tape is not the answer.
Yet, a regulatory backlash is almost certain to follow the govern-
ment bailout. However, what must be avoided is politically driven
legislation and overregulation. It must be underscored that that a
market system can never be fully tamed and there will always be an
element of risk. To make markets completely safe would mean an
end of innovation and pervasive stagnation.
Rather, targeted supervision in the area of intermediation to
guarantee effective reconciliation of the economic needs of
businesses and individuals for long-term credit on predictable
terms is critical. To the authorities in charge of banking regulations
this means that if a bank is “irresponsible,”
they should require the bank to take immedi- It must be
ate corrective measures, and if it does not,
they must close the bank, and if the bank is
understood that
too large to fail, it should be taken over by the a market system
authorities. This will go a long-way in instilling can never be fully
confidence. Similarly, policymakers must tamed and there
avoid indiscriminate regulations. Rather they will always be an
need to double their efforts to identify the
core market imperfections that gave rise to
element of risk
the incentives for excess risk taking. Strengthening and streamlin-
ing the prudential oversight of financial and capital markets and
enhancing transparency of market instruments and transactions
will go a long way to mitigate problems. Specifically, in the United
States and elsewhere there needs to be greater regulatory oversight
over the nation’s financial system, including strict federal rules for
hedge funds, credit rating agencies and mortgage brokers, as well
as transparency over the use of the complex financial instruments
that helped spawn the current crisis. At a minimum, this must
mean the elimination of conflicts of interest at credit rating
agencies that gave top investment grades to the ultimately shaky
financial instruments.
It was most encouraging when on November 15th, 2008 meeting
of the “Summit on Financial Markets and the World Economy” in
Washington, D.C., the G-20 leaders recognized the serious
challenges facing the global economy, especially the financial
markets, and renewed their commitments to enhance cooperation
to restore global growth based on the market principles of open
36 THE IIPM THINK TANK
trade, transparency and accountability. This was an explicit
recognition on the part of the G-20 that well-regulated financial
markets foster the dynamism, innovation, and entrepreneurship
that are essential for economic growth, employment, and poverty
reduction. The fact that the G-20 agreed to strengthen and
empower institutions like the World Bank and the IMF to aid the
transition and developing countries, especially the poorest “least
developed countries” (LDCs) who are reeling under the crisis they
had no part in creating, further underscores that a global effort is
needed to combat this global crisis.
However, making a commitment is one thing, following through
is another. For example, institutions like the World Bank and the
IMF are to be effective their lending capacity needs to be en-
hanced. In fact, John Lipsky, the IMF’s Deputy Director has called
for a doubling of the Fund’s lending capacity to $500 billion – al-
beit, interestingly a number of developing countries see this
request as too modest and have called for a
tripling of the resources. This may seem
counterintuitive as developing countries have
long accused the IMF of having too much
power and influence. However, this crisis has
made strange bedfellows. Specifically, as the
resultant global credit crunch has literally
dried up private capital flows to developing
countries, monies from agencies like are IMF
and the World Bank is once again in big
demand. Facing a real prospect of being shut out of international
capital markets, for many developing countries, especially the
LDCs, their only option may be the financing from these multilat-
eral financial institutions. Nevertheless, the IMF’s major share-
holders (the rich nations) must make sure that these multilateral
financial organizations do more than simply dole out money, but
be proactive in preventing the build-up of global financial imbal-
ances that has contributed to this crisis (i.e. the huge international
reserves in emerging countries and massive deficits in rich nations).
It is also in the common interest of the G-20 to counter the
growing forces of protectionism and nationalism. Among other
things, this means that the United States, the EU, China, India and
Brazil put aside their largely narrow differences and salvage the
Doha round of trade negotiations. The failure of Doha has the
potential to reduce world trade by $1 trillion, especially if countries
abandon the voluntary tariff restraint. India and to a lesser extent,
China who bear much responsibility for bringing the Doha round
to a abrupt in summer of 2008 by insisting on protecting their

farmers through tariffs will need to be more flexible if Doha is to
be concluded. It also means that the Obama administration, in
charge of the world’s largest economy, end the ambivalence,
indeed, stop sending mixed signals regarding its commitment to
free trade. Acknowledging on one hand the benefits of trade, while
on the other, criticizing free trade is counter-productive when
protectionist sentiments are running high. The U.S. administration
can allay these concerns by declaring unambiguously that any U.S.
government bail-out and subsidies will be WTO-consistent. Failure
to do this, especially with the “Buy American” provisions in the
economic stimulus program has the potential to lead to the kind of
tit-for-tat protectionism that helped deepen the Great Depression.
More substantively, for Doha to progress, the U.S. must make
meaningful reductions in its support of trade distorting agricultural
subsidies. Of course, this is now a challenge as governments
throughout the world are forced to increase support payments to
farmers with the collapse of global commodity
prices. In addition, in the spirit of coopera-
Free markets
tion, governments’ can better coordinate their
stimulus packages. At a minimum, stimulus
will not always
packages must be built around common 'self-correct' and
principles of multilateralism and openness to state intervention
trade, even if they differ in the details. Indeed, is necessary
U.S. backing for a successful end of Doha will
to protect the
not only underscore its commitment to free
trade, an institutionalized rules based trading
capitalist system
system under the WTO will also mitigate the
more subtle tricks, if not, insidious protectionism countries use
such as health and safety standards, including technical barriers,
especially licensing and certification requirements to protect
domestic industries.
Finally, the cost of fighting the crisis has been unprecedented.
Public debt is rising as governments around the world hemorrhag-
ing red ink. The massive stimulus programs coupled with the
upfront costs of financial rescues, including the recapitalization of
banks, guarantees for troubled assets, not to mention the tax
revenues lost from growing unemployment, and falling output
and asset prices means that fiscal deficits will increase. The IMF
expects OECD countries’ combined fiscal deficit to rise to seven
percent of GDP in 2009 (from less than two percent in 2007),
while emerging economies will see their budget surpluses grow
into a deficit of 3 percent of GDP. There is general agreement
that such massive deficit spending is needed to help revive the
economy from recession -- because prolonged recessions can have
P O W E R A N D C O N T R O L
far more serious consequences than the fiscal bailouts designed to
combat them. Nevertheless, public debt can only rise so much
without any implications. In the United States the cost of the
stimulus packages and the bailouts for the financial system has
already resulted in “trillion-dollar deficits.” In the short term, if
the government debt ratios increase sharply it could lead to a
sharp drop in the value of the currency and inflation -- with real
consequences for many who have already seen their nest-eggs
disappear. Over the long-term, it could potentially lead to a
perpetual debt burden on future generations.
John Maynard Keynes, during the depths of the great depression
warned that free markets will not always “self-correct” and
government intervention is necessary to protect the capitalist
system against its own excesses. No doubt, we are witnessing a
crisis of confidence in capitalism forcing champions of laissez-faire
to implement policies and programs that were simply unthinkable
just weeks ago. Who could have imagined
that the government of the United States
would have intervened in markets by bailing-
out private banks through recapitalizations,
or buy assets directly from private firms with
tax-payer dollars and provide blanket
guarantees to bank deposits.
Nevertheless, as Milton Friedman pointed
out long ago: government intervention must
be strictly regulated because over the
long-term markets are far more efficient at
allocating capital than bureaucrats. We can also add that we live in
an economically interconnected. As such, financial crises cannot be
contained within borders and that international cooperation is
essential to address the immediate and long-term challenges posed
by the crisis.
Endnotes and Additional Thinking
1
Eichengreen, Barry and Michael D. Bordo, 2002, “Crises Now
and Then? What Lessons from the Last Era of Financial
Globalization?,” NBER Working Paper No. 8716.
(Author of: China and India in the Age of Globalization: A Com-
parative Political Economy. New York: Cambridge University Press
(2009).http://www.cambridge.org/us/catalogue/catalogue.
asp?isbn=9780521731362 The views expressed in the article are
personal and do not reflect the official policy or position of the
organisation.)
THE INDIA ECONOMY REVIEW 37
O P E N WO R L D

Market
Failure and
the Need for
Regulation

Anjan Panday
Ph.D. candidate <Economics>,
The American University, Washington, DC

Abstract:
During the current global financial crisis, nations around the
world took unprecedented steps in bailing-out failing indus-
tries and rescue the economy. Proponents of market system
advocate liquidating insolvent firms. In reality, though, the
situation was different, especially in the financial industry,
because of the systemic threat to the entire market. The
self-serving market system could not foot-hold during this
time. The housing bubble that predated the current crisis is an
example of market limitation. In this paper, the idea of
market failure is revisited and, for all the reason it deserves,
an effective regulation is argued vital at this time.

Introduction:
The current global financial crisis has opened a floodgate of
discussions on the fragility of largely unregulated financial
sector and the subsequent influence on the broader economy.
Many have drawn analogy of the current crisis as second only

38 THE IIPM THINK TANK

 M I S S I N G M A R K E T S

to the Great Depression of 1930s, something observed once in

a generation. The “Roaring Twenties” came to an end with
the collapse of stock market in 1929 and the years thereafter
witnessed one of the great sufferings and miseries of mankind.
It later became clear that the stock market during the time
was buoyed by speculative investment, often manipulated by
few large participants, in absence of any meaningful regula-
tion in the Wall Street. What started as a stock market crash
quickly spread to the banking sector wiping out savings of
many and had an unprecedented impact on the economy. A
quick fact check of the current crisis holds some resemblance.
In the years since, a number of regulatory frameworks and
institutional setups were put in place with an aim to prevent
market failure and minimize the potential of a catastrophic
crisis1. However, by the end of the millennium, the deregula-
tion phenomenon was sweeping over much of the financial
industry. To a significant extent, the belief on rational agents
and self-regulating market mechanism swayed much of the
policy orientation. The critics, however, have argued that the
first two crises of the 21st century—stock market and real-
estate led—have undermined the market rationality and
points to, inter alia, a lack of sensible regulation behind the
market collapse. There is a near consensus among economists
that some of the fundamental beliefs behind market rationale
failed to hold true. The great confidence on rational agents
and in their judgment demonstrated only perverse result. At
the core is the idea that the market participants often either
fail to recognize their best interest due to several limitations
or are motivated to act otherwise. This microcosmic effect in
aggregation leads to a disruption of market and is demon-
strated through failure in price adjustment.
This paper will revisit the concept of market failure, its role
in current crisis, and a possible intervention in the market
through regulation. To provide balance to the discussion, this
paper will draw on some theoretical notion of market failure
while highlighting the application side of regulatory frame-
work. A brief summary on traditional notion of market
failure and the behavioral dimension is presented. For its
proper role, some of the key deregulation measures will be
discussed. The regulatory aspect will highlight the perverse
incentive problem while arguing for adequate capital provi-
sioning and related preventive measures in the financial
institutions. To conclude, a cautionary note in designing
regulatory system is presented.

THE INDIA ECONOMY REVIEW 39

O P E N WO R L D
2. Market Failure and Causes:
As introduced above, the case for market failure involves some
sort of market distortion that impedes adjustment of prices in
the market. The consequences of failure to adjust prices are
many. This section will briefly present some of the concepts of
market failure.
A traditional notion of market
failure entails obstacle in achieving
efficient production and distribution in
a Pareto optimal sense. Various types
of market imperfections illustrate the
idea of inefficiency in production and
distribution. The immediate ramifica-
tion is on prices of goods and services.
A textbook example of this would be
the case of a monopoly producer or a
monopsony buyer. A large supplier
can alter the market prices favorably
by manipulating production. By
restricting supply, it can effectively
raise the market price above the
competitive equilibrium which
inevitably results in loss of efficiency,
commonly referred as dead-weight loss. In The housing
a similar vein, a large buyer can squeeze bubble that
price below the competitive equilibrium, predated the
again resulting in a dead-weight loss.
current economic
Industry-wide price cartel is the most
commonly observed form of market
crisis is an
imperfection that leads to market ineffi- example of
ciency. As Kenneth Arrow suggested market limitation
market failure often results from the
absence of competitive market.
Another area of ubiquitous discussion on market failure
features the case of externality. When a mutually consenting
transaction between two parties has an adverse consequence
on a third party unrelated to the act, the case of negative
externality is invoked. Environmental degradation due to
industrial pollutant is strongly argued as a cost on general
public. The point is that the private cost fails to incorporate the
societal cost and is not reflected in prices of industrial output.
Market as generally perceived fails to capture cost to society.
In yet another related discussion, the case of public goods is
often cited as an example of market failure. The nonexcludabil-
40 THE IIPM THINK TANK
ity feature of the public good avails benefit to the users without
having to compensate for it.
The idea of market failure has evolved from these conven-
tional notions. Its relevancy in the present crisis pertains to
market distortion whereby prices diverge greatly from its true
or fundamental value, as observed during bubble formation.
The fundamental value is invariably
based on some kind of expected
revenue stream over the life time of
asset. A common characterization of
price changes during bubble formation
entails investors’ reaction today based
merely on the expectation of further
price rise in future. Such expectation,
however, is not grounded on economic
reality. There is a plethora of evidence
to suggest bubble formation in past
crises. Before the crash in 1929, there
was a general feeling of unsustainable
price rise on Wall Street. The same was
true with the dot-com bubble earlier in
this decade. Moreover, prior to the
sub-prime debacle of 2007, there were
alarming calls out on the un-sustainability
of house prices. Author Robert J. Shiller in
his book “The Subprime Solution”
documents the evidence of out-of- sync
prices in the housing market. The bottom
line is that market prices fail to represent
real worth of an asset during bubble.
Finally, the current crisis also illustrated
one more episode of market distortion. It
is clear that the current global crisis is rooted in the US housing
market which exploded after the collapse of sub-prime mort-
gage market. The degree to which crisis in one sector of the
economy diffused to a global scene has been viewed in light of
sophisticated network of interconnected and interwoven
financial system, spread globally. Financial innovation of
roughly two decades offered investors with an array of state-of-
the-art products. The idea of securitization was a breakthrough
for investors as well as borrowers. Transactions in complicated
derivatives and asset-backed securities were thought to provide
investors with comforting choices. However, the level of
sophistication proved costly in that proper asset valuation

mechanism was trampled. Gorton(2008) argues that in course
of repeated packaging of the asset-backed securities, the
system made it virtually impossible to penetrate the chain back-
wards and value the asset based on the underlying mortgaged
property. The crucial information on future payoff was lost as a
result of added complexity. A number of commentators2 have
highlighted the fact that the complexity in the
financial market hampered price discovery
mechanism and contributed to market
arket distortion.
Inadvertently it may be but the market
arket
adjustment was laid dysfunctional..
2.1 Market Limitation:
In the preceding section, we brieflflyy
presented some conditions under
the neo-classical tradition of
characterizing market failures.
The broad distinction is either
the lack of effective competi-
tion or non-existent market. In
a sharp contrast, the behavior-
ists’ explanation alludes to a
more fundamental limitation in human
behavior. According to
As pointed before, the neo-classical argu- Kenneth Arrow,
ment for market adjustment rests on the market failure
idea of rational market guided by self
often results
interest of market participants. A rationally
motivated individual is sufficiently
from the absence
equipped to make best decision in the of competitive
market place. Many believe that this faith markets
in the market formed the intellectual basis
for deregulation in the financial market and an off-hand
approach in the policy orientation of recent decades. In the
aftermath of current crisis, the all too- powerful rational
market argument is perhaps debated vigorously than any time
before. Economists, however, have for long pointed to the
limitation of rational market.
Herbert A. Simon is credited with bringing the notion of
bounded rationality to the forefront. He argued that agents
face uncertainty in decision making and gathering all kind of
information can be prohibitively costly. Therefore, people
often make decision based on “satisficing” rather than deciding
optimally. This limitation in human behavior is well grounded
M I S S I N G M A R K E T S
on behaviorists’ explanation of bubble, panic and other
irrational behavior in the market. They argue that noneconom-
ic factors do motivate decision making, which explain the
anomalies observed in the market. Authors Akerlof and Shiller
(2009) write that panic in the market spreads quickly and
“fear” sets in motion the speed of contagion. They point that
investors' psychology dominates decision making
under panic situatio
situation and it quickly overwhelms the
market. There are evidences of this type of non-
rational behavior
be in past crises3. It is quite
clear that the massive bail-out scheme
offered by the governments’
world-wide, during current
crisis, is driven to a large extent
by the concern to contain the
possible contagion and help
soar-up market confidence.
Prior to the current crisis, a
number of studies tried to
analyze signs of bubble forma-
tion in the US housing market.
C
Case and Shiller(2003) report-
ed—based on the survey of homeowners
response—that there was a strong indica-
tion of bubble in the market4. Further,
Shiller(2008) provides a well thought-out
narrative of bubble formation and inves-
tors’ reaction in run-up to the US housing
crisis. The author argues that humans often
respond in emotion, unpredictably, and
wildly. There is a tendency to exaggerate
good news while downplay bad ones.
Moreover, investors are often biased in their decision. For
instance, home buyers often prefer investing in their home
town/city/state which often locks-out from exploring locations
preferable from the stand point of living comfort. In the run-up
to the housing bubble that predated current crisis, the author
notes that people believed and reacted to “word of mouth
communication”. A price-story-price loop generated feedback
mechanism for further price rise. Investors psyche prevailed
over market rationale. To sum up, there are numbers of factors5
that motivate our psychological perception, in good times or
bad times. And, these factors feature prominently in our
decision making. They often take over market rationality.
THE INDIA ECONOMY REVIEW 41
O P E N WO R L D
Table 1: Total Political Contribution in the USA by Finance/Insurance/Real-Estate Industry
Year Amount USD
1990 60,613,414
1992 117,126,447
1994 103,174,435
1996 175,517,301
1998 155,005,805
Source: opensecrets.org
3. Deregulation and Market Failure:
Based on the discussion so far, a reasonable case for some kind
of market intervention seems indispensable. Insofar to address
market imperfections or the limitations in human decision
making, there is a role for some regulatory mechanism to
ensure market smoothness. In the years
after stock market crash of 1929, a series of
regulatory measures were put in place in As a capital of
the US financial system. The relatively global finance, the
stable period of much of the remaining 20th consequences in
century may be rightfully attributed to the
the US financial
check and balance that these regulations
provided. Some, however, argued against
system continue
what was perceived as too much encroach- to have global
ment in the market during this time. ramifications
Towards the end of the 20th century, the evil
of big government—and to that extent the regulatory set-ups—
had all but put to rest. The period also concur with an era of
greater integration of economies and market worldwide.
Finance and capital flows proved crucial for global economic
growth. As a capital of global finance, the consequences in the
US financial system continue to have global ramifications. A
brief summary of deregulation efforts in the US financial
market is presented as a contextual description relevant in the
current crisis.
In their book, “Bailout Nation”, authors Barry Ritholtz and
Aaron Task discuss three crucial deregulation measures of last
decade that connects importantly to the current crisis. First,
they argue that the repeal of the Glass-Steagall Act, 1933, by
Gramm-Leach-Bailey Act, 1999, expanded the scope of
traditional banking into a much larger center for financial
services. The banks benefitted from economies of scale and
innovations in the financial market while consumers found a
convenient location to meet all of their financial-services need.
42 THE IIPM THINK TANK
Year Amount USD
2000 309,119,703
2002 233,061,144
2004 340,099,037
2006 259,437,470
2008 474,857,391
Sounds a perfect match until the reality of “too-big-to-fail”
type institution6 emerged. Second, in 2000, under intense
pressure of different lobbying groups, the Commodities
Futures Modernization Act was passed. The legislation
provided for almost no regulation of derivative transaction
including the catastrophic Credit Default
Swap (CDS) which the financial institu-
tions had amassed to a critical level during
the current crisis. Third, the Net Capital
Rule that originally allowed for debt to
equity ratio of 12:1 often got higher
reaching up to 40:1, again under the
influence of strong lobby. It is no coinci-
dence that the complex derivative transac-
tions became acceptable norm in the
industry nor is it any accident that the
financial institutions were critically leveraged.
The deregulation-era policy orientation drew upon the
intellectual philosophy of competent market capable of serving
its best interest, especially to maintain safety and soundness of
the system. In the aftermath of the crisis, this argument is
highly contested. Market imperfection resulted, to a large
degree, under the influence of interest groups which were
unable to see their own long-term interest. Table 1 shows exam-
ple of business-politics connection. It is reasonable to doubt if
the business interest had a natural pathway to policymaking
through political contribution.
4. Market Intervention through Regulation:
Designing a workable regulatory framework is perhaps the
biggest challenge that policymakers face. It is well known that
incentivizing corrective action, or, equivalently, promoting
preventive measures, best solves many issues that market fails
to accommodate. In retrospect, it is quite clear that the

deregulation-era policy measures provided little incentive for
check and balance. The incentive system in the financial
industry resulted perverse outcome. Nobel Laureate Paul
Krugman often takes to the point that the pay-and-perform-
ance system in the financial industry promoted more risk taking
behavior. While no one is arguing to restrict the ingenuity and
innovative power of the private market, there is definitely a
realization to bridge the big void left in the regulatory system.
One lesson the current crisis has made clear is the cataclys-
mic nature of risk to the entire system. The fragility of global
financial system was exposed in the events following collapse
of the US sub-prime housing market. A sectoral impact
quickly turned into an industry-wide credit crisis and had a
significant spillover effect on the real economy. The greater
interconnectedness of markets in the new millennium also
meant that the crisis spread quickly to a
global scale. It is in response to this global
nature of crisis that nations world-wide are The pay-and-
coordinating in establishing effective performance
regulatory mechanism and also working in system in the
concert to stimulate economies. The
financial industry
following statement made at the recently
concluded G-20 summit succinctly identi-
promoted more
fies the problem: risk taking
“At the same time, weak underwriting behavior
standards, unsound risk management
practices, increasingly complex and opaque financial products,
and consequent excessive leverage combined to create vulner-
abilities in the system. Policy-makers, regulators and supervi-
sors in some advanced countries, did not adequately appreci-
ate and address the risks building up in financial market…or
take into account the system ramifications of domestic
regulatory actions.”
It is quite clear that the reform measures to stabilize the
financial market will be aimed at preventing the systemic risk
and to avoid situations of panic calls, typical during crisis.
4.1 Pertinent Issues in Regulatory Mechanism:
In discussing practicality of the regulatory system, it is impera-
tive to find appropriate balance between stability and efficien-
cy. Again, the following phrase from the G-20 meeting puts this
squarely in context:
“…while ensuring that regulation is efficient, does not stifle
innovation, and encourages expanded trade in financial
M I S S I N G M A R K E T S
products and services.”
To fully appreciate the various dimension of regulatory
mechanism is out of the scope of this paper. Nonetheless, some
important considerations that the upcoming regulatory system
needs to address are presented.
Mussa (1986) in writing on regulation of depository institu-
tions argued that the safety and soundness of the institution
should be the core objective. In pointing deficiencies of the
existing system, the author notes that the government policies
tended to discourage adequate capital holding. Indeed, the
safety of institutions greatly relies on solvency of its financial
position. The former Fed-chief Alan Greenspan wrote in a
guest article in the Economist magazine that the banking
system needs “much thicker capital cushions” than they had
enjoyed before the crisis.
Second, some of the big banks which
took on a role of multi-service center are
now recognized to pose a systemic threat,
especially with hefty short-term leveraging.
Kenneth Rogoff of Harvard University
writes7 that systemically important banks
need to be placed under stricter control on
short-term borrowing. Others have argued
that there should be some mechanism to
prevent banks from becoming “too big to
fail”. Yet some other view that independ-
ently each of the banks can make the same mistake and
therefore individual entity should be brought under an um-
brella of regulation.
Third, there needs to be some reconciliation to address the
adverse incentive system of rewarding based on short-term
performance, something that has become industry standard in
recent years. The compensation practice in the financial
industry is lately under serious debate given what many view as
a tendency to privatize profit while socialize loss. This has been
true in light of numerous bailout actions by governments in
attempting to prevent free-fall of the economy. While the
financial industry continues to oppose this as infiltration in
their territory, there is a sense of urgency to address the pay
system and streamline the incentive.
Fourth, although proper risk evaluation entails technical
analysis and objective evaluation, there is enough room for
subjective judgment in performance monitoring. Transparency
and accountability are related features of regulation which
THE INDIA ECONOMY REVIEW 43
O P E N WO R L D
complements healthy market operation. To this effect, regula-
tory bodies have a big role to play in remaining vigilant on
activities in market to prevent any fraudulent scheme or
predatory-type lending.
Finally, it is necessary to acknowledge complexity in design-
ing effective regulation. History shows how the interest groups
and lobbying pressure can undermine the effectiveness of the
system. It will be hard to keep the business-politics nexus away.
Besides, managing the regulatory system should not become a
bureaucratic nightmare. In all, regulation should pave for
healthy competition in the market and not become a recipe for
another disaster—i.e., failure of the government.
5. Conclusion:
This paper is an attempt to present a summary of theoretical
notion of market failure, relating the discussion to the current
global financial crisis. It is clear that the crisis originated from a
sector in the US housing market which spread to the domestic
economy and eventually escalated to a global scene. Therefore,
the events in the US financial system are central to the paper
which nonetheless has global ramifications.
The traditional notion of market failure suggests failure in
price adjustment due to some sort of market distortion. This is
different from dominant role of investors’ perception in
decision making during bubble formation. A better under-
standing of the kind of limitation in rational thinking was
offered through behavioral exposition. In analyzing the
deregulation-era policy measures, it became clear that a great
deal of market imperfection resulted under influence of
interest groups.
On the second part of the paper, a case for effective and
efficient regulatory mechanism was argued. Our experience
with market shows that proper regulation complements and
enhances safety and soundness of the system. Although
difficult to achieve, it can stem untoward incidents while
promoting healthy competition. The current crisis made aware
of the risks in the financial system that can potentially threaten
stability of the entire market. Current debate on avoiding
system risk is a right step toward financial market stability.
Some of the key concerns to this effect were discussed.
Endnotes
1
Here, we characterize a major crisis as the one that can
potentially overwhelm the entire industry and is a threat to
44 THE IIPM THINK TANK
overall economy
2
Note that Warren Buffet in 2003 warned complex deriva-
tives as financial weapons of mass destruction.
3
One example the authors cite is the ensuing bank run after
the suspension of currency payments by New York’s
Knickerbocker Trust in 1907.
4
It is indeed noteworthy that many of the studies failed to
provide any conclusive evidence, worthy of necessitating
policy response.
5
Refer Akerlof and Shiller(2009)
6
The authors indicate that some of the US banks have
outgrown to lose efficiency, even becoming too big to
manage.
7
Financial Times article dated August 18th, 2009
References
• Akerlof, George A. and Shiller, Robert J. 2009. “Animal
Spirits: How Human Psychology Drives the Economy, and
Why it Matters for Global Capitalism”, Princeton Univer-
sity Press. Princeton and Oxford.
• Case, Karl E. and Robert J. Shiller.2003. “Is There a Bubble
in the Housing Market? An analysis”, Brooking Paper on
Economic Activity, 2.
• G-20. Declaration. Summit of Financial Markets and the
World Economy. November 15th, 2008
• Gorton, Gary B. 2008. “The Subprime Panic”, NBER
Working Paper Series, Working Paper 14398
• Greenspan, Alan. “Banks Need More Capital”. The
Economist. December 18th, 2008.
• Mussa, Michael. 1986. “Safety and Soundness as an Objec-
tive of Regulation of Depository Institutions: Comment on
Kareken”, The Journal of Business, Vol. 59, No. 1, pp
97-117.
• Ritholtz, Barry and Task, Aaron. 2009. “Bailout Nation”,
John Wiley & Sons, Inc.
• Rogoff, Kenneth. “Why we need to regulate bank sooner,
not later”. Financial Times. August 18th, 2009.
• Shiller, Robert J. 2008. “The Subprime Solution: How
Today’s Global Financial Crisis Happened, and What to Do
about It”, Princeton University Press. Princeton and
Oxford.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation).
O P E N WO R L D

Trade Liberalisation and

Indian Farm Sector:
Understanding the
Situation from
Available Evidence

46
46 THE IIPM THINK TANK

Subrata Dutta
Associate Professor, Sardar Patel Institute of
Economic and Social Research, Ahmedabad
Market Liberalisation with Faulty Price Policy
Let us fi rst try to understand the concern about how agricul-
tural trade liberalisation has often been affecting our food
security issue via the hike in prices. The rise in wheat price
in last few years in India has been mainly the result of trade
liberalisation. It is true that due to rising population growth
supply of wheat fell short of what has been demanded after
2004-05, but in the last seven years significant market
reforms, resulting in increasing the participation of the
private sector in foodgrain trade, have been mostly responsi-
ble for the rise in wheat price. Ramesh Chand (2007) has
analysed the case in a well manner. A number of big compa-
nies (including multinationals), e.g. ITC,
Cargill, Australian Wheat Board,
Britannia, Con Agro, Delhi Flour Mills When the market
and some others, are now operating in price of a grain is
foodgrain trade, holding sizeable stocks higher than theh
and playing with their inventories to
MSP, the PP must
cause increases in price and to take
advantage of the same. In case the
follow the market
government had a reasonable stock it norms and offer
could keep a check on any abnormal market prices
increase in prices. But the government
has a faulty price policy. Every year the minimum support
price (MSP), which remains fi xed for the whole particular
season, is announced and thereafter the government starts
procuring commodities like wheat and rice either at the MSP
or by adding a bonus to the MSP. This fi xed price policy does
not fit in the open market system and thus inhibit the
government in procuring the required quantity of produce.
The procurement either falls short or exceeds what is needed
to be purchased by the government. However, there is
another concept called procurement price (PP), but virtually
in practice the MSP turns out to be the fi xed PP (sometimes
with added bonus, as said earlier). It allows the private sector
to outstrip government agencies by offering a little more
than the procurement price. In such a situation, the govern-
ment becomes a helpless witness since the procurement
F R O M C O L U M B U S TO C O N A G R A
officer cannot pay even a single penny more than what is
already fi xed. According to Chand (2007), this is the sole
reason for the failure of the government to achieve its
procurement target and objective. This practice also puts the
government in an embarrassing situation when it has to meet
its needs through purchasing wheat from the multinationals,
which are hoarding the grains, (or through imports) by
paying high prices than those paid to domestic producers.
Chand (2007) emphasises that there is an urgent need to
follow a dual price system in order to procure grain at
required quantity and thus stabilise the market price of
grain. The government should immediately differentiate
between the MSP and PP and the latter should be higher
than the former while at the same time the PP should also
be kept flexible, meaning, for example, that the PP can be
declared on a weekly basis. The MSP has an objective to
save farmers by ensuring remunerative prices to them for
their produces on the basis of the Commission for Agricul-
tural Costs and Prices (CACP) recom-
mendations while prices fall below the
level fi xed by the CACP. Such MSPs are
fi xed at incentive levels so as to induce
the farmers to make capital investment
for the improvement of their farm and to
motivate them to adopt improved crop
production technologies to step up their
production and thereby their net income.
However, how far these objectives are
met through the MSPs is questionable
and that is why the PP should be given substantial impor-
tance. When the market price of a grain is higher than theh
MSP, the PP should follow the market norms and offer
market prices.
The Crises in Farm Sector
There are a large number of small and marginal farmers in
India. They have been suffering from adverse effects of
uneven liberalisation in international agricultural trade. In
consequence, several small and marginal farmers have
committed suicide in various states in India in last half-a-
decade for the reason that they had been heavily indebted to
the private non-institutional moneylenders and at the same
time they had been unable to get the proper price for their
produces. Rural institutional credit supply failure is clearly
THE INDIA ECONOMY REVIEW 47
O P E N WO R L D

Table 1: Agriculture Subsidies in India during 2000-01 to 2004-05 (Current Price)

(Rs. in Crore)
Item 2000-01 2001-02 2002-03 2003-04 2004-05
1. Fertilizer 13800 12595 11015 11847 16127
2. Electricity* 6056 9342 7354 NA NA
3. Irrigation** 13465 13164 15012 11142 12990
4. Other subsidies given to marginal farmers and
farmers' cooperative societies in the form of seeds, 2686 3041 3133 4018 NA
development of oilseeds, pulses etc.
5. Total 36007 38142 36514 27007 29117
Notes: * Includes all subsidies to Electricity Boards and Corporations. Separate estimates of subsidies on Electricity exclusively provided to agriculture sector are not available.
** The rates for supply of water to farmers are kept low as a matter of policy, resulting in losses to the government irrigation system. The excess of operating costs over the gross
revenue is treated as imputed irrigation subsidy.
NA stands for "not available".
Source: Directorate of Economics and Statistics, Ministry of Agriculture, Government of India.

one of the responsible factors for farmers' misery, but the
most serious concerns are the distortionary tariff and price
policies adopted by the developed countries. The huge
subsidies which are given to the farmers in the developed
countries have been artificially reducing the prices of their
produces and simultaneously destroying the comparative
advantage of the farmers of developing countries. While
the developed countries are protecting their farmers
through conservative measures (by imposing tariffs on
imported agricultural produces and
providing subsidies to their farmers) on
the one hand, they are demanding for, Fertilizer subsidy
and also forcibly implementing, market experienced a
liberalisation in developing countries to downward trend
the larger market. For such forcible
till 2002-03,
implementation of liberalised policies in
developing countries, the developed
except a marginal
countries are taking help from the World increase in the
Bank and the International Monetary year 2003-04
Fund (IMF) on which the developing
countries are dependent for loans. Table 1 presents an
illustration of agricultural subsidies in India from 2000-01
to 2004-05. Fertilizer subsidy experienced a downward
trend till 2002-03, except a marginal increase in 2003-04.
In 2004-05, it has increased significantly due to the fact that
the government realised that sluggish growth in agriculture
was going to hamper the overall GDP growth of the coun-
try. As regards subsidy in power sector, one can hardly
figure out about how much is exclusively going to the
farmers as electricity subsidy since the Ministry of Agricul-
ture itself fi nds lack of clarity in this regard (see the note
just below Table 1). Irrigation subsidy figure is clearly lower
in 2004-05 than that in 2000-01. Seed and other subsidies
have experienced an increasing trend though, the overall
picture is not impressive.
Two opposing schools of thought are found in the litera-
ture on correlation between liberalisation and agriculture
(Vakulabharanam, 2005). One school stresses that there is a
policy bias against agriculture in LDCs, keeping output
prices artificially low (as compared to the
international prices) by maintaining
subsidies on inputs. This school suggests
removal of incorrect price incentives, i.e.
input subsidies, from agriculture and
making agricultural market more open to
global trade. As for example, Khan (2004)
argued that input subsidies led to misuse
or over-use of inputs. However, the
second school of thought offers an
argument, among others, saying that
subsidies that the farmers of developed countries receive are
much significant than that received by the farmers of
developing countries (see, among others, Anderson, 1992;
Tangermann, 2006), thereby resulting in unfair competition
in international market. Bardhan (2006: 1395) argued that,
in exports, the major hurdle the small producers face “is
often due to not more globalisation but less.” In 2000, the
producer subsidy in OECD countries was US$ 330 billion
-- equal to Africa’s entire annual GDP (Albert and Springer-
Heinze, 2006). The protectionist policies of developed

48 THE IIPM THINK TANK


Table 2: Import Trend of Raw Cotton Lint in India pushed other countries to open up their markets to areas of
Year Import Import Value Unit Price of Import
Quantity (in (in 1000 (in US$ per metric
metric tonne) US$) tonne)
1990 167 311 1862
1996 8795 2850 3086
2003 241787 333282 1378
Source: Philip and Jenniah (2006)
countries in agriculture are highly distorting and impose
substantial costs on farmers in developing countries (Ismail,
2006). Recent estimates by International Food Policy
Research Institute (IFPRI) suggest that protectionism and
subsidies in industrialised countries cost developing coun-
tries about US$ 24 billion in agricultural and agro-industrial
income (cited in Pal, 2006). If all dynamic and spill-over
effects are taken into account, the figure will be much
higher. In the EU and USA, the subsidy level is very high for
wheat, sugar and rice (Naik 2005, Chakraborty and Singh
2006). Sugar and cotton, along with some other items, which
receive the highest level of subsidies in the EU or USA, are
very important export commodities in the world market.
Subsidies on these items are undermining
the export potentials of many developing
countries. The trade opportunities of The extent of
developing countries are being negatively cotton subsidies
affected both by the domestic support (on prevailing in the
production or output) and export support
global level is
in developed countries. Philip and
Jenniah (2006) argued that the removal
close to 13% of
of subsidies by the US, EU and China the total value
would increase the world price of cotton produced in India
by 18 percent. They also argued that a
small change in subsidy could create a phenomenal impact
on the cotton production of some countries like the US and
EU, to the extent of 15 and 32 percent respectively. This, in
turn, would result in supply shifts. Subsidies given in cotton
at the global scale averaged US$ 5 billion and the extent of
subsidies prevailing in the global level is close to 13 percent
of the total value of cotton produced in India. US subsidy to
cotton farmers is in the form of direct assistance to farmers
through marketing loan assistance and market loss assist-
ance. Stiglitz (2003: 206) commented that “[T]he U.S.
F R O M C O L U M B U S TO C O N A G R A
our [the USA’s] strength … but resisted efforts to make us
reciprocate”. Tangermann (2001) points out that, as regards
reduction in export subsidies, the EU has created main
problems since their share in total worldwide export subsidy
on many agricultural products is very high. Naik (2005)
states that the world prices of sugar now are below the costs
of production of some of the most efficient producers. “In
fact in some cases, such as cotton in India, the efficient
producers are unable to compete in their own domestic
market. Cotton imports in India have increased substantially
due to the availability of cheap US cotton, as a consequence
of the subsidies provided by the US to their farmers” (Naik
and Singh, 2003: 60). Cotton farming occupies a significant
place in the Indian economy as a means of employment to
over one million farmers in the primary sector. It is also
offering direct employment in the textile industry that
significantly contributes to an extent of 14 percent of the
country’s industrial production, 30 percent of the country’s
export earning and four percent of the GDP. Let us refer to
Philip and Jenniah (2006) for the Indian cotton-case in
liberalised era. Cotton imports were liberalised in 1991.
With this the monopoly of Cotton Corporation of India was
terminated and imports were placed
under the open general license, allowing
unrestricted imports by private traders.
The import duty was originally set to zero
and there was a surge in imports in the
late 1990s (see Table 2). On account of
this surge, domestic prices too witnessed
a major decline, resulting in incidents of
suicides committed by cotton farmers.
The situation forced the government to
impose five percent tariff in 2000. Still
this could not provide cotton farmers with a major remedy.
As we already said, liberalisation has caused several
Indian cotton farmers to commit suicide. Narayanamoorthy
(2006) observed that profits have been declining particularly
since late 1990s, because of a substantial increase in the cost
of cultivation. He asserts that farmers need remunerative
prices for their crops because their income from crop
cultivation is not enough to even cover their consumption
expenditure. Moreover, the farmers have been indebted to
moneylenders, traders etc. for they had taken loans from
THE INDIA ECONOMY REVIEW 49
O P E N WO R L D
these non-institutional sources. There is another concern in
cotton farming. Let us refer to the observations of Narayana-
moorthy and Kalamkar (2006). Cotton’s productivity in
India is one of the lowest in the world mainly due to attacks
by pests/insects and low coverage of irrigation facility. In
spite of using pesticides, farmers are unable to control the
bollworm -- the key pest in cotton -- that ravages up to 80
percent of crop output. In India, Bt (which stands for
Bacillus Thuringiensis) cotton was introduced in March
2002 for commercial cultivation. This variety can protect
itself from the bollworm. Although the productivity and
profit from Bt cotton cultivation is substantially higher than
the conventional hybrid cotton varieties, the seed cost of Bt
cotton is very high as compared to non-Bt hybrid varieties.
At least as a short term measure, direct subsidy should be
provided for Bt cotton seed, but liberalization is standing in
the way of such measure.
Shah (2006) analyses the effect of
WTO on Indian dairy industry. Milk is The share of
such a product using which (as input) a Indian handicrafts
number of by-products (e.g. butter, differ- exports in
ent kinds of sweets, ghee, paneer etc.)
the overall
have grown (or even can further grow in
the future) in the rural agro-industrial
manufacturing
sector in India. The success of milk exports has risen
producers’ unions/cooperatives, like from 2% to 5%
AMUL, is well-known in India. But let us
not forget that millions of small farmers who produce
nominal quantity of marketable surplus of milk (only a litre
or two) are majority in this industry. Landless labourers in
India account for 21 percent of the total rural households.1
Though they do not have any share in the total landholding,
they own 12 percent of the milk produced. At current prices,
the value of livestock products in the country in 2003-04 is
estimated at Rs. 164,509 crores with milk and milk products
accounting for 67 percent. Indian dairy industry has the
potential to capture a considerable part of the world market
but, as Shah (2006) argued, currently this industry is
adversely affected by distorted world prices of dairy prod-
ucts due to export subsidies extended by the EU and US.
Moreover, developing countries cannot participate in
international trade because their products are barred from
entry into rich countries by trade barriers, restrictive trade
policies and stringent health and sanitary standards.2 Even
50 THE IIPM THINK TANK
if Indian dairy producers could initially afford to pay EU
tariffs of 144 percent on butter and 76 percent on milk
powder, it could hardly compete in Europe with domestic
producers, half of whose income is derived from subsidies
(Oxfam, 2002a). At the same time, India’s efforts to export
milk and other dairy products to new net dairy-importing
markets in countries in South-East Asia, the Gulf, and the
southern Mediterranean are being hampered by unfair
competition from subsidised European dairy exports
(Oxfam, 2002b). On the other hand, as Shah noted, Indian
milk producers are rather worried because an increase in
cheap imports of milk products, particularly milk powder,
would further adversely affect their milk production by
lowering the price of the milk they sell.
Globalisation, on the other hand, has created some
positive effects on Indian economy as we have seen that
through the 1990s the share of handi-
crafts exports in the overall manufactur-
ing exports of India has risen from two
percent to five percent (Leibl and Roy,
2003). But Basu (2006), while visiting to
the village of Jakorta in a remote corner
of Gujarat and talking to the villagers
who were engaged in earning their
livelihood largely from handicrafts and
mainly embroidery work on textiles,
found “double-edge sword of globalisa-
tion”. What is that? On the one hand, the villagers had
benefited in the last decade because of globalisation by
selling their products to other countries. On the other hand,
they feared that their livelihood could get wiped out by
competition from some international producers who decide
to export to India. Basu emphasises that the villagers are still
poor enough since end of prosperity for them could mean
poverty, destitution and even starvation. The producers
cannot avoid this double-edge sword of globalisation.
Another example can be relevant here. While elimination of
subsidies from agriculture in developed countries can benefit
farmers of countries like India and China, removal of trade
distortions in India and China in the case of groundnut trade
would substantially benefit the African countries through
increasing their export volume and thus income (Beghin et
al., 2006). Their groundnut needs to be promoted but there
is another concern as well. The issue now becomes more

complex when we see that many low-income food-deficit
countries depend on import of food to survive. According to
the FAO, there are currently 86 low-income food-deficit
countries (for further details, see Grote and Wobst, 2006).
Let us take the example of Senegal in which food production
has doubled in absolute terms since 1960 (the year of
independence), but, due to the country’s high level of
population growth, per capita food production has fallen by
almost 50 percent. As a result, Senegal is heavily dependent
on import of food item, especially broken rice. 3 Senegalese
people have developed this consumption pattern probably
due to availability of broken rice in sufficient quantity during
the colonial and post colonial period. Broken rice is import-
ed in order to keep food prices under control and at the same
time groundnut is exported as Senegal’s main export product
(Brüntrup et al., 2006). Since currently rice imports account
for seven to eight percent of total imports and pose a major
burden on the country’s trade and foreign exchange balance,
increase in groundnut export alone would not be of great
help for the country to grow as a whole. As a remedial
measure, it needs to restrict import and also substantially
improve agricultural productivity, and this can change the
consumption pattern gradually. Only 10 percent of farms
occupy irrigated land, whereas the rest 90 percent are
rainfed, which offer little potential for more intensive
farming (Brüntrup et al., 2006). Extremely weak agriculture
sector cannot be a base for economic prosperity. That is why
the industrialisation strategy adopted earlier had yielded
very little in the internationally competitive environment. It
should start from its agriculture and, for that, within WTO
there should be adequate scope for a country like Senegal
for adopting conservative rice import policy while at the
same time it should take advantage of trade liberalisation
and promote their groundnut in other countries. This case
proves that WTO needs to take a very careful look at the
country specific cases while trying to pursue trade liberalisa-
tion in the world.
Although China has made impressive progress in eco-
nomic development and improving social well-being, it is
facing many challenges while liberalising its economy and
after WTO accession. The main challenge is to fi nd employ-
ment for millions of people who are being displaced from
farm jobs as a result of WTO accession. In China, the
majority of the labour force is still in agriculture, traditional
F R O M C O L U M B U S TO C O N A G R A
low and medium technology industries, and low skill
services. One of the reasons of the poor productivity rates
of these sectors is the lack of new technologies and manage-
ment efficiencies. Zeng (2005) suggested that dissemination
of new technologies and advanced management practices
throughout the rural economy may be of some help in the
days to come. Zeng argued that small and medium enter-
prises, especially those in the urban areas and also belong-
ing to the tertiary sector, have become an increasingly
important source of job creation. But the majority of the
village enterprises have limited technological and human
resources to become internationally competitive. This is the
headache for China even while the remarkable growth of its
national economy has drawn much attention of the interna-
tional community.
Endnotes
1
Oxfam (2002b) has noted that India has now become the
world’s largest dairy producer, producing 84 million
tonnes of milk. Its dairy sector includes a network of
cooperatives serving more than 10 million farmers in over
80,000 villages.
2
Albert and Springer-Heinze (2006) argues that although
stringent regulatory requirements contain risks, the rural
producers in developing countries should consider such
requirements as opportunities which would allow them to
meet rising quality demands of consumers throughout the
world.
3
Broken rice is a by-product of rice processing. In the
international market, broken rice is considered an inferior
product and is therefore much cheaper than whole rice.
References and Additional Thinking
• Albert, Helmut and Andreas Springer-Heinze (2006):
“Value-Added Chains and Agricultural Trade”, Agricul-
ture and Rural Development, Vol. 13, No. 1, pp. 15-17.
• Anderson, Kym (1992): “International Dimensions of the
Political Economy of Distortionary Price and Trade
Policies.” In Ian Goldin and L. Alan Winters (eds.), Open
Economies: Structural Adjustment and Agriculture, pp.
290-310, Cambridge: Cambridge University Press.
• Bardhan, Pranab (2006): Globalisation and Rural Pov-
erty”, World Development, Vol. 34, No. 8, pp. 1393-1404.
• Basu, Kaushik (2006): “Globalisation, Poverty, and
THE INDIA ECONOMY REVIEW 51
O P E N WO R L D
Inequality: What is the Relationship? What can be
Done?” World Development, Vol. 34, No. 8, pp. 1361-
1373.
• Beghin, John, Diop Ndiame, and Holger Matthey (2006):
“Groundnut Trade Liberalisation: Could the South Help
the South? World Development, Vol. 34, No. 6. pp.
1016-1036.
• Brüntrup, Michael, Thao Nguyen, and Christian Kaps
(2006): “The Rice Market in Senegal”, Agriculture and
Rural Development, Vol. 13, No. 1, pp. 22-25.
• Chakraborty, Debashis and Yashika Singh (2006):
“Agricultural Subsidy: The Major Hurdle to Free Trade.”
In Dipankar Sengupta, Debashis Chakraborty and Pritam
Banerjee (eds.) Beyond the Transition Phase of WTO: An
Indian Perspective on Emerging Issues, pp. 75-107, New
Delhi: Academic Foundation (in association with Centre
de Sciences Humanities).
• Chand, Ramesh (2007): "Wheat Import and Price Out-
look for 2007-08: Separating the Grain from the Chaff",
Economic and Political Weekly, Vol. XLII, No. 31, August
4, pp. 3196-3199.
• Grote, Ulrike, and Peter Wobst (2006): “What do Libera-
lised Agricultural Markets mean for food-importing
developing countries?” Agriculture and Rural Develop-
ment, Vol. 13, No. 1, pp. 18-21.
• Ismail, Faizel (2006): “Mainstreaming Economic Devel-
opment in the Trading System.” In Simon J. Evenett and
Bernard M. Hoekman (eds.) Economic Development &
Multilateral Trade Cooperation, pp. 213-228, Washington
and New York: The World Bank and Palgrave Macmillan
(a co-publication).
• Leibl, M., and T. Roy (2003): “Handmade in India:
Preliminary Analysis of Crafts Producers and Crafts
Production”, Economic and Political Weekly, Vol. 38,
December 27th.
• Naik, Gopal (2005): “Expiry of Peace Clause in WTO’s
Agriculture Agreement: Implications.” In Ramesh Chand
(ed.), India’s Agricultural Challenges: Reflections on
Policy, Technology and Other Issues, pp. 47-77, New
Delhi: Centre for Trade and Development (Centad),
established by Oxfam GB.
• Naik, Gopal and Yashika Singh (2003): “Doha Round
Negotiations: Agriculture,” Working Paper No. 217,
Indian Institute of Management Bangalore, November.
52 THE IIPM THINK TANK
• Narayanamoorthy, A. (2006): “Relief Package for Farm-
ers: Can It Stop Suicides?” Economic and Political
Weekly, Vol. XLI, No. 31, August, pp. 3353-3355.
• Narayanamoorthy, A. and S.S. Kalamkar (2006): “Is Bt
Cotton Cultivation Economically Viable for Indian
Farmers? An Empirical Analysis”, Economic and Political
Weekly, Vol. XLI, No. 26, June, pp. 2716-2724.
• Oxfam (2002a): “Europe’s Double Standards: How the
EU should Reform Its Trade Policies with the Developing
World”, Oxfam Briefi ng Paper 22, Oxfam International.
• Oxfam (2002b): “Stop the Dumping! How EU Agricul-
tural Subsidies are Damaging Livelihoods in the Develop-
ing World”, Oxfam Briefi ng Paper 31, Oxfam Internation-
al.
• Pal, Parthapratim (2006): Development Boxed! Analysing
Box Shifting and Other Issues of Domestic Subsidies in
WTO Agricultural Negotiations, New Delhi: Oxfam.
• Philip, Linu Mathew and Aldas Jenniah (2006): The
Indian Cotton Dilemma: Caught in the International
Cotton Mesh, New Delhi: Oxfam.
• Shah, Deepak (2006): Milked Away by Developed
Countries: Plight of Indian Dairy Farmers in WTO
Regime, New Delhi: Oxfam.
• Stiglitz, Joseph (2003): The Roaring Nineties. New York:
W.W. Norton.
• Tangermann, Stefan (2006): “The WTO Negotiations:
What Interests are the OECD Countries Pursuing?” Agri-
culture and Rural Development, Vol. 13, No. 1, pp. 7-9.
• Tangermann, Stefan (2001): “Agriculture: New Wine in
New Bottles?” In Klaus Günter Deutsch and Bernhard
Speyer (eds.), The World Trade Organisation Millennium
Round: Freer Trade in the Twenty-First Century, pp.
199-212, London and New York: Routledge.
• Vakulabharanam, Vamsi (2005): “Growth and Distress in
a South Indian Peasant Economy during the Era of
Economic Liberalisation”, Journal of Development
Studies, Vol. 41, No. 6, August, pp. 971-997.
• Zeng, Douglas Zhihua (2005): “China’s Employment
Challenges and Strategies after the WTO Accession”,
World Bank Policy Research Working Paper 3522,
February.
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation.)
O P E N WO R L D
The Harmful Impact of
Protectionism
Rok Spruk*
Economist, Slovenia
T
here is a general agreement among economists that
free trade is good for the economy. Polls have sug-
gested that more than 90 percent of economists in the
U.S believe free trade is beneficial for the economy and society
as a whole. Ever since the beginning of the financial crisis, the
policymakers around the world exerted strong pressure to
enforce the protectionist trade policy. In the United States,
American Federation of Labor openly opposed free-trade
agreement between the United States and
Columbia. In France, the policymakers
suggested the introduction of carbon tariffs India is at
on countries which refuse to cut carbon the crossroad
emissions. Before the Great Depression of between pursuing
1929, the U.S Congress enacted Smoot-
free trade policies
Hawley Act which sharply raised tariffs on
foreign exports. In spite of hefty rethoric
or imposing
about the benefits of trade protection, the protectionist
cost of trade protection exceeds the benefits trade policies
of trade protection shared by the few. The
beginning of the financial crisis of 2008/2009 that led to the
recession initiated a set of trade policies that promote protec-
tionism. According to IMF; in 2009, emerging market econo-
mies expect 8.8 percent decline in the import of goods and
services and six percent decline in the export of goods and
services. In 2008, imports of goods and services in developing
economies grew by nearly 11 percent. India and other emerging
market economies are on the crossroad between pursuing free
trade policy or imposing protectionist trade policy. The
54 THE IIPM THINK TANK
empirical evidence overwhelmingly supports the notion that
free trade is an economic benefit for the nation, regardless of
country’s level of development. In this article, I discuss the
harmful impact of trade protectionism and why free trade
should be the key priority of economic policies worldwide.
Trade Protection in International Trade
Policymakers imposing policies that restrain trade often point
out the necessity of domestic market protection against foreign
competition. The economic history offers numerous examples
of trade protection. Back in 1930, the U.S Congress adopted
Smoot-Hawley Act which raised tariff rates on over 20,000
imports entering the U.S. The adoption of high tariffs on
imports restrained foreign trade. Between 1929 and 1932, the
world trade diminished by 66 percent. Back in early 2002,
President George W. Bush placed tariffs on
imported steel, arguing it would protect the
U.S steel industry. Immediately after the
enactment of steel tariffs, World Trade
Organization declared tariffs unjustified
and highly protectionist. Before 2002, 30
U.S steelmakers declared bankruptcy, seek-
ing effective tariff rates up to 40 percent.
After steel tariffs were introduced,
European Union announced it would
impose retaliatory tariffs. The economic
effects of imposing tariffs on steel imports were disastrous. In
the long run, empirical evidence suggests, the demand for steel
is highly inelastic, ranging from -0.2 to -0.3. This suggests that,
as the price per unit of steel increased by one percent, the
long-run demand for steel would decrease by -0,2 to -0,3
percent. On the other hand, empirical estimates of price
elasticity of steel supply show that the long-run coefficient of
elasticity does not exceed 3.0 - a very elastic supply, indeed
curve. This suggests that as per unit price of steel increases by
 P R O T E C T I O N ’S P R I C E

THE INDIA ECONOMY REVIEW 55

O P E N WO R L D
one percent, the quantity of supplied steel goes up by three
percent. In the situation of inelastic demand and elastic supply,
the introduction of tariffs on steel imports reduced consumer
surplus. Thus, the effect of tariff levied into higher producer
surplus. The effective tariff rate on steel, which ranged from
eight to 30 percent, reduced the consumption of steel imports
and raised the equilibrium price in the world steel market.
Economists Joseph Francois and Laura M. Baughman estimated
the effects of the introduction of steel tariffs. According to their
estimates, a 10 percent increase in the price of steel, reduced the
employment in steel industry by 0.64 percent. Each saved job
cost the U.S economy 445.497 USD on
average. In December 2002, increase in per
unit price of steel led to 197,000 employment A ten percent
in U.S steel industry. So the question is what increase in the
to choose - higher steel prices and fewer jobs price of steel,
or a vibrant and competitive steel market?
The economic effects of trade protection
reduced the
clearly contradict the notion that protection-
employment in
ism is good for the economy. the steel industry
Back in 1941, Paul A. Samuelson and by 0.64 percent
Wolfgang Stolper formulated Stolper-Samu-
elson theorem. Assuming perfect competition and constant
returns of scale, the theorem states that “a rise in the relative
price of good will lead to the rise in the return to that factor
which is used more intensively in the production of the good, and
conversely, to a fall of the return to the other factor.” The
theorem has important implications for international trade.
Samuelson and Stolper wrote:
“Second only in political appeal to the argument that tariffs
increase employment is the popular notion that the standard of
living of the American worker must be protected against the ruinous
competition of cheap foreign labor… In other words, whatever will
happen to wages in wage good (labor intensive) industry will
happen to labor as a whole. And this answer is independent of
whether the wage good will be exported or imported.”1
The powerful version of Stolper-Samuelson theorem states
that the international trade between two countries leads to the
situation in which at least one factor of production faces a
decline in the real income. The rigorous version of Heckscher-
Ohlin-Samuelson theorem states that international trade is a
consequence of difference in relative factor abundance. It means
that countries abundant with labor will incompletely specialize
in the production of labor-intensive good while countries
56 THE IIPM THINK TANK
abundant with capital will incompletely specialize in the
production of capital-intensive good. The international trade
will, hence, reduce the reward to the scarce factor of production.
Since developed countries are usually capital-abundant, there
are significant pressures from less abundant factor (labor) to
impose tariff protection.
Back in June 2009, American Federation of Labor (AFL)
exerted a significant pressure on Obama Administration not to
enact U.S-Columbia free trade agreement (FTA). The AFL
stated that Columbian government has no respect for labor
rights. The AFL further stated that FTAs contributed to U.S
trade deficit, job losses and lower wages.
However, the real argument for eliminate
the FTA between the U.S and Columbia
came from the opposition of the scarce
factor of production to international trade.
The openness of protected labor-intensive
industries to trade reduces the real reward
to labor in the short run. However, the
reduction in real reward to labor is more
than compensated by a long-run increase in
purchasing power enabled by lower prices of
imports. A research paper by economists Christian Broda and
John Romalis of the University of Chicago investigated the
effects of price dispersion on welfare of U.S consumers. The
authors found that between 1994 and 2005 non-durable inflation
for households in 10th percentile of income distribution was 7.3
percent lower than non-durable inflation for households in the
90th percentile of income distribution. A study by economists
Gary C. Hufbauer and Kimberly A. Elliot estimated the cost of
trade protection in the United States. The authors estimated that
the restriction of foreign imports cost $199,000 for each job in
the textile sector and $1,376,000 in the benzenoid chemical
industry. There is even more additional evidence that free trade
promotes welfare by reducing domestic inflation. Andreas
Fischer and Raphael Auer (2008) showed that import competi-
tion from low-wage countries dampens the US producer price
inflation for manufactured goods by more than two percentage
points annually.
Economic Effects of Trade Liberalization:
Evidence from India
The World Trade Organization (WTO) has recognized India’s
trade liberalization efforts and remaining barriers to trade.

The WTO wrote:
“Recognizing the importance of continuing its economic reform
and especially its trade aspects, India has pushed ahead with
further reductions in the tariff: the overall applied MFN rate fell
from 32.3% to 15.8% between 2001/02 and 2006/07… While
import barriers have been falling, India's export regime continues
to be complex. Export prohibitions and restrictions are largely
unchanged since India's last Review. However, in order to reduce
the anti-export bias inherent in India's import and indirect tax
regime, a number of duty remission and exemption schemes are
in place to facilitate exports.”2
The empirical evidence of the economic
effects of trade liberalization shows that
lower barriers to trade and foreign market India has pushed
access have stimulated regional trade. In ahead with further
studying the effects of trade liberalization reductions in the
on wage inequality Mishra and Kumar
(2005) have estimated that India’s 1991
tariff. The overall
trade liberalization has boosted productiv-
applied MFN rate
ity growth at the firm level and increased fell from 32.3%
wage premiums for skilled and non-skilled to 15.8%
workers. The authors suggest that trade
liberalization has reduced wage inequality. There are, of
course, other features that affected lower wage inequality.
Acharyya (2006) estimated the effects of trade liberalization
on income inequality and poverty. The author emphasized
rising income inequality - measured by the Gini coefficient -
as a result of robust growth in manufacturing imports and
exports. During 1990s, the high-tech manufacturing sector
experienced robust growth in exports. Since high-tech
manufacturing sector is skill-intensive, the shift toward
skill-intensive exports is a plausible explanation of higher
income inequality.
There is another example of the beneficial effect of free
trade. Prior studies by Deaton and Dreze (2002) showed that
urban and rural poverty rates decreased in the periods
between 1993 and 2000. The urban poverty rate fell from 17.8
percent to 12 percent while the rural poverty rate fell from 33
percent to 26.3 percent of the population. In another study of
the effect of trade liberalization on foreign direct investment,
Goldar and Banga (2007) presented their results. They found
that between 1980 and 1998, the effective rate of trade protec-
tion fell from 99.5 percent to 41 percent. Applied tariff rates
and non-tariff barriers declined as well. Using panel data for
P R O T E C T I O N ’S P R I C E
78 industries after the period of trade liberalization and
cross-section data for 2,500 firms in 16 Indian states, they
found that trade liberalization had a favorable effect on FDI
inflows in Indian manufacturing industries and that higher
cross-border trade has attracted higher foreign direct invest-
ment (FDI) into manufacturing industries. They also showed
that regions having great involvement in international trade
are able to attract greater amount of FDI. A study by Topalova
(2004) found that reduced trade protectionism led to higher
levels and growth of firm productivity, having the strongest
effect on private companies.
The Cost of Protectionism
In the annual assessment of economic
freedom, Index of Economic Freedom
critically evaluated India’s trade policy.
It says:
“India's weighted average tariff rate was
14.5 percent in 2005. Large differences
between bound and applied tariff rates,
import and export restrictions, services
market access restrictions, import taxes and
fees, complex and non-transparent regulation, onerous standards
and certifications, discriminatory sanitary and phytosanitary
measures, restrictive licensing, domestic bias in government
procurement, problematic enforcement of intellectual property
rights, export subsidies, inadequate infrastructure, counter-trade
policies, and complex and non-transparent customs add to the
cost of trade.”3
The existence of non-tariff barriers stimulates lobbying
groups who seek profit opportunities by exerting pressure on
policymakers to protect markets by imposing tariffs against
foreign competition. Non-tariff barriers add to the cost of
trade. If tariff and non-tariff barriers persist, trade flows are
diverted while welfare gains from trade are diminished. There
is no better engine of poverty reduction than free trade. High
tariff and non-tariff barriers to trade decrease the real
purchasing power of consumers. It often happens that pres-
sures for tariff protection come from small and influential
lobbying groups. Lobbying for trade protection from foreign
competition results in unproductive rent-seeking activities.
These activities are unproductive because they provide
anticipated profits for those who lobby but do not create any
valuable output for consumers.
THE INDIA ECONOMY REVIEW 57
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Table 1: India’s Major Trade Partners in 2007

Trading Partner Share of Exports (in %) Trading Partner Share of Imports (in %)
European Union 21.7 European Union 14.8
United States 13.8 China 11.2
United Arab Emirates 9.9 Saudi Arabia 7.6
China 6.5 United States 6.5
Singapore 4.4 United Arab Emirates 5.4
Others 43.7 Others 54.5
Source: World Trade Organization, India Trade Profi le (2009)

Pillars of Free-Trade Policy
In recent decades, India’s economy has grown at the robust
pace, averaging over seven percent between 2001 and 2007. In
2009, the economic growth rate is expected to reach 4.5
percent. By 2014, the Indian economy is expected to increase
by eight percent annually. The emergence of India as one of the
leading economic powers in the world is likely to increase its
influence in world markets and, hence, in world trade policy.
Table 1 shows major Indian export and import partners in 2007.
In recent years, India already signed bilateral trade agree-
ments with countries such as Chile, Singapore, Bhutan and Sri
Lanka. It joined and signed regional free trade agreements
such as Asia Pacific Trade Agreement (APTA) and South
Asian Free Trade Agreement (SAFTA). Bilateral and regional
trade agreements are a step in the direction of free trade but,
from a broader perspective, multilateral free trade is superior
to regional and bilateral trade agreements. Multilateral free
trade eliminates all the unnecessary bias that lead to trade
diversion and distorted allocation of resources.
The question that remains is what are the pillars of trade
policy that a fast-growing emerging-market economy should
pursue? Recent Global Enabling Trade Report 2009 by the
World Economic Forum assessed the ease of international
trade around the globe. India ranked 76th out of 121 countries.
The report found that tariff and non-tariff protection increase
the economic cost of trade. Since 1991, India has steadily
deregulated the framework of foreign direct investment. India’s
small and medium-sized companies comprise 35 percent of
exports. Protecting small and medium-sized enterprises by
tariff and non-tariff measures would restrain trade, reduce
incentives to innovate and diminish welfare gains. To remove
all the unnecessary barriers to trade, India’s trade policy should
set the following priorities:
• Elimination of all tariff and non-tariff obstacles to trade
• Ensuring transparency and rigorous enforcement of intellec-
tual property rights
• Ending of export subsidies and import restrictions
• Deregulation of customs procedures
• Elimination of all government barriers to market entry
The economic theory and history teach that trade protection
is an unproductive benefit of the few without the valuable gain
for the rest of the society. If India played the leading role in
eliminating all tariff non-tariff barriers to trade and invest-
ment, encouraging the protection of intellectual property rights
and initiating efforts for multilateral trade liberalization, it
would emerge as one of the leading economic and political
giants sooner than current figures suggest, and inspire other
nations to follow India’s pursuit of free trade and robust
economic performance.
Endnotes and Additional Thinking
1
Stolper, Wolfgang F., Paul A. Samuelson (1941), Protection
and Real Wages, Review of Economic Studies, No. 9, pp.
58-73
2
Country Profile: India, World Trade Organization, August
2009
http://stat.wto.org/CountryProfile/WSDBCountryPFView.
aspx?Language=E&Country=IN
3 Index of Economic Freedom 2009, Heritage Foundation,
Washington D.C
http://www.heritage.org/index/Country/India
(* Rok Spruk's main areas of research include macroeconomics,
international economics and finance. The views expressed in the
write-up are personal and do not reflect the official policy or
position of the organisation.)

58 THE IIPM THINK TANK

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Open Economy:
A Boon or Bane for India?
Misu Kim &
Susmita Mitra
Phd Scholars, Centre for International Trade
and Development, School of International
Studies, Jawaharlal Nehru University (JNU),
New Delhi
I. Introduction
The recent global crisis raised a question on the opinions in favour
of open market and global integration. The high economic growth
rate of India in an open market structure witnessed in the last few
years came to a halt as the financial crisis hit the world. Econo-
mists arguing in favour of free market and withdrawal of protec-
tionism in India started giving a second thought to their opinion.
After more than a decade’s time it cannot be said that opening up
of Indian economy brought miraculous
changes for India. This essay analyses some of
the important macroeconomic indicators like Indian economic
trade, investment, and socio-economic factors liberalisation is
like education, employment, inequality etc. to distinct in the
see why India could not achieve the expected
economic development through open policy.
sense that it was
However, before we focus completely in this
abrupt, and at
area, there is a brief snapshot of the liberali- the same time
sation process of India. externally imposed
II. Imposed and Abrupt Economic Liberalisation
In the early 1960s, India followed protectionist policy as a strategy
of economic growth. At this stage India’s motive was self-sufficient
growth through grand economic theories, such as ‘big push’ theory
and the Mahalanobis model, which played a major role in the
60 THE IIPM THINK TANK
country’s industrial strategy. These strategies were, however,
criticised for high social cost in the form of resource waste and
demand deficiency (Ahluwalia, 1985; Joshi and Little, 1987, and
Dhar, 1989). As a way out, the focus of India’s development
strategy started shifting towards export-led growth from the mid
1980s. Due to this gradual liberalisation process, macroeconomic
imbalances viz. fiscal deficit and balance of payments deficits
increased, which in turn made India vulnerable to shocks. The
sudden increase in oil prices due to the Gulf War in 1990, the drop
in remittances from Indian workers in the Middle East pushed
India in a severe crisis of foreign exchange. To deal with its
external payments problems, the government of India requested
arrangement from the International Monetary Fund (IMF) in
August 1991. The IMF support was conditional on an adjustment
programme featuring structural reforms and trade liberalisation.
Since then, the Indian economy has been undergoing substantial
changes. Almost all the areas have been opened to foreign private
investment; import licensing restrictions on intermediaries and
capital goods have been mostly eliminated; and tariffs have been
significantly reduced. Economic liberalisation
of India is distinct in the sense that it was
abrupt, and at the same time externally
imposed rather than consciously decided.
III. Open Economy in Poor
Domestic Conditions
Since 1991 the Indian government has been
emphasising on export in its economic growth
strategy. If we simply study the aggregate
macroeconomic data, then in the post
liberalisation era, all variables like gross domestic product (GDP),
per capita GDP, economic growth rate, export, import and
investment show an increasing trend in nominal value terms. Does
that really imply that India has achieved economic development
through free trade? Here we will study the other side of the coin.
 G O L D I L O C K S G L O B A L I Z A T I O N

THE INDIA ECONOMY REVIEW 61

O P E N WO R L D

Diagram 1: Export and Import in India

900000

800000

700000

600000
Rupee Crore

500000 Export
Import
400000

300000

200000

100000

0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006QE

Source: Handbook of Statistics on Indian Economy published by the Reserve Bank of India

Diagram 2: Investment in India

1600000

1400000

1200000

Gross Domestic Investment

Rupee Crore

1000000
Gross Foreign Investment

800000

600000

400000

200000

0
1970 1974 1980 1982 1986 1990 1994 1998 2002 2006QE

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India

62 THE IIPM THINK TANK


From the mid 1980s export started rising. However, India being
a developing country needed to import the machines and appli-
ances for the production of the main exportables like gems and
jewellery, pharmaceuticals, chemical and engineering manufac-
tures (WTO: Trade Policy Review, 2007). Thus , with an increase
in export, import also increased as shown in Diagram 1.
Moreover, since import has always exceeded the export, it gave
rise to trade deficit. As the diagram 1 shows, the trade deficit
started roaring after 2004. However, invisible inflow (i.e. income
from the service sector) and foreign investment inflow helped to
maintain the Balance of Payment (BOP) account. From this angle
one can argue that although there has been trade deficit in an
open market for India, the inflow of foreign investment is obvi-
ously a positive side of free trade. However, there are flip-sides of
the story as well.
First of all, if we compare the volume of
the different forms of investment in India,
then foreign investment (the sum of foreign India lacks the
direct investment and portfolio investment) capacity to absorb
is much less compared to the domestic sophisticated
investment (sum of investment from the
technology and
household, private corporate and public
sector) even in the free trade era. As the
still lags behind
Diagram 2 shows, the benefit of foreign other economies
investment can only have a negligible effect in vital spheres
due to its low volume.
Secondly, if we study investments as a share of GDP, then the
Diagram 3 shows that since 1991 (for the entire decade) foreign
investment has been rising but domestic investment has been
falling. It implies that although India is benefited by foreign
investment, it has worked as a substitute to domestic investment
rather than a complement, a process popularly known as
crowding-out effect. For a capital scarce country like India, the
quality of foreign investment also matters along with its
quantity. The worst case could be when foreign investment
enters into the host country just to produce for its domestic
market and in turn displace the local industry (Agrawal and
Shahani, 2005). The Indian retail sector has been observed to
be partially hit by this phenomenon.
Another important question is where and in which form the
foreign investment is taking place. If investment comes in the form
of technology or direct capital to establish a new firm, then it has
positive effects for a labour abundant developing country through
creating new jobs. In contrast, if the investment is in the portfolio
G O L D I L O C K S G L O B A L I Z A T I O N
form (mainly in share markets), then it can have a bubble effect
without having any fundamental change. Unfortunately, in the last
few years foreign portfolio investment has been large, making the
Indian economy more volatile, as shown in Diagram 4. The recent
boom in the share market (before the global crisis period), was
largely a bubble (due to huge inflow of foreign portfolio invest-
ment), which in turn burst in the time of global crisis, when a large
amount of foreign money was withdrawn. This is again a major
drawback of open market.
Thirdly, there is sector-wise disparity regarding the perform-
ance of foreign investment. After economic liberalisation, the
declining trend of primary sector was not reversed by the
increase in foreign investment. The manufacturing sector
experienced temporary growth acceleration after economic
reforms in 1991. However, this trend was reversed from 1995 to
2000, even though foreign investment stocks
continued to rise. Foreign investment boom
was witnessed mainly by the tertiary or
service sector, but limited to a few services
only. However, contrary to the widespread
view that booming foreign investment in the
service sector was driving the miraculous
growth in India in the last few decades,
economists have shown that it was the
growth of the service sector that attracted
foreign investment, not the other way round
(Chakraborty and Nunnenkamp, 2006).
Coming to the reasons behind low foreign investment in India,
it can be argued that the country could not create investment
welcoming environment. Indian infrastructure remained poor
which acted as a deterrent to the investors. Rapid growth in a
globalised environment requires a well-functioning infrastructure,
including electric power, road and railway connectivity, telecom-
munications, air transport, and efficient ports. After nearly two
decades of economic liberalisation, India still lags behind other
developing countries like China, Vietnam, Malaysia etc. in these
vital spheres.
Another reason is that, India lacks the capacity to absorb
sophisticated technology. The volume of foreign investment
depends on various factors, including absorption capacity and
local skills, technological spillovers and linkages between foreign
and local firms, and export orientation of the host economy. The
education system has also not improved in the post-liberalisation
era with India trailing behind the target of 100 percent literacy
THE INDIA ECONOMY REVIEW 63
O P E N WO R L D
Diagram 3: The Share of Domestic and Foreign Investment in GDP
14
12
10
8 Foreign Investment
%
0
1970 1974 1980 1982 1986
Source: Handbook of Statistics on Indian Economy published by the Reserve Bank of India
rate. The number of primary schools (primary implies upto fourth
standard) are relatively high in comparison to the institutions for
higher education.. This is quite natural, but in case of India, the
number of higher education institutes is way too low than what is
required, as shown in Diagram 5.
The prevailing education system in India led to abundance of
unskilled labour compared to educated-skilled labour. Obviously
this acts as a barrier to new technology by multinational compa-
nies. Indian exports are dominated by simple and undifferentiated
products where the main competitive advantage lies in cheap
labour, low level of skill and simple technologies (Lall, 1999). Due
to other constraints also viz. intellectual property protection, India
sometimes has not received up-to-date technology (Athreye and
Kapur, 2001).
As a result of all the above factors, employment scenario in
India did not improve much in the post liberalisation era. Lack of
employment-creating foreign direct investment compared to
portfolio investment, coupled with the crowding out effect on
domestic investment, there has not been much increase in the
demand of employment. On the supply side, the static education
system is not able to produce a strong base of educated and skilled
labour force. As a result, employment in the public and organised
private sectors in India has not increased significantly after
64 THE IIPM THINK TANK
Domestic Investment
1990 1994 1998 2002 2006QE
economic liberalisation as shown in Diagram 6.
However, employment has been particularly created in the
electronics and electrical equipment sector, mainly due to
Information Technology Enabled Services (ITES) and Business
Process Outsourcing (BPO) growth. However, the global crisis
proved the vulnerability of these outsourced jobs. Due to the
international linkages, crisis in source countries can affect these
jobs. This is another disadvantage of global integration faced by
India recently.
Apart from education and employment another important
socio-economic factor is inequality. In India, inequality issue is
very important and controversial. NSS data shows that inequality
has remained more or less similar. Sen and Himanshu (2004)
analyses NSS data in a different way and found that inequality
increased in the 1990s both in the rural and urban areas. The ratio
of poor people shows a downward trend but the absolute number
of poor people increased due to an increase in population.
According to Jha (2002), inequality has increased after economic
liberalisation rather than a decrease. He argued that inequality
widened because labour intensive industry has been sluggish,
whereas capital intensive sector has been prosperous since the
economic reforms. Due to economic liberalisation, economic
growth rate increased, but the level of poverty remained stubborn

Diagram 4: Foreign Investment in India
140000
120000
100000
Rupee Crore
80000
60000
40000
20000
0
2000 2001 2002
Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India
(partially because of higher inequality and stagnation in the
agricultural real wage), although there was some reduction in
urban poverty.
To sum it up, it is very difficult to conclude whether open
market is boon or bane for India.
IV. Lessons from the East Asian Countries
India lacks the platform to exploit the benefit of economic
liberalisation, in contrast, the East Asian governments played a
strong role behind the export-led-growth model. Along with
foreign investment different governments have boosted up domes-
tic investment simultaneously through different channels. The
role of government behind the investment boom process is largely
through increasing the profits, because profits are an incentive for
investment, a source of investment and an outcome of investment
(Akyuz and Gore, 1996). The total process in most of the East
Asian countries worked in the following way:
• Government policies pushed profits over and above the level
that could be attained under free market policies.
• Increase in profits was translated into high savings.
• High rate of domestic savings was transformed into investment
which played a major role in the exceptionally rapid growth of
the East Asian countries.
G O L D I L O C K S G L O B A L I Z A T I O N
FDI
Portfolio
2003 2004 2005 2006 2007
To enhance corporate profits and savings, the East Asian
governments have provided direct assistance to build export
industries and fiscal benefits like tax rebates, tariff exemptions on
imports of raw materials, reduced rates for electricity and
transportation services, export subsidies for exporters. At the
same time different governments made provisions of financial
benefits like loans at lower interest rate for exporters.
These policies pushed up corporate profits above the levels
attainable only under free market conditions. This increased the
savings rate of the region. It was corporate savings in the East
Asian Countries which played a crucial role in investment boom
(Stiglitz, 1999). Apart from pushing the corporate profits, the East
Asian governments also performed well in fundamental policy
areas to increase household savings. By avoiding inflation, they
resisted volatility of real interest rates on deposits and also
guaranteed that the interest rates were largely positive and
generally higher than other developing countries (Page, 1994).
Some governments used different interventionist mechanisms also
to increase savings viz. mandatory provident fund contributions.
However, simply increasing savings does not guarantee that it
will be channelised to investment. For that purpose the East Asian
governments encouraged investment by different means.
• Governments invested in proper infrastructure and created a
THE INDIA ECONOMY REVIEW 65
O P E N WO R L D

Diagram 5: Number of Recognised Educational Institutions

900000

800000 Primary
Upper
700000 Primary
High/
600000 Hr. Sec./
Inter/Pre.
Rupee Crore

500000 Jr.Colleges
Colleges
400000 for General
Education
300000 Colleges for
Professional
200000 Education
University/
100000 Deemed
Univ./Instt.
0 of National
1950 1960 1970 1980 1990 1992 1994 1996 1998 2000 2002 2004 Importance

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India

Diagram 6: Employement in the Public and Private Sector

25 Public Sector
Private Sector
20
Million

15

10

0
1970 1980 1990 2004

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India

crowding in effect for private investment.
• Tax policies in most of the East Asian countries were such that
an investment friendly environment is created.
• Financial policies like credit rationing had a major role.
Thus, government’s fiscal and financial policies increased the
corporate profits which further created a virtuous circle for
investment as Diagram 7 shows:
At the same time most of the East Asian governments have
successfully moulded different policies according to the changing
world scenario as well as the country’s comparative advantage. In
the 1970s, when Hong Kong was loosing its competitiveness in
labour-intensive products, it started diversifying the home
industries by producing and exporting higher quality electronics
goods. In recent times, most of the exports of Hong Kong are

66 THE IIPM THINK TANK


Diagram 7: Virtous Circle
Increase in
corporate
profit
Technological Increase in
advancement savings
Increase in
investment
classified as re-exports. In South Korea, the Fifth Five-Year Plan
(1982-86) moved the emphasis away from heavy and chemical
industries to technology-intensive industries, such as electronics
(televisions, videocassette recorders, and semiconductor-related
products) to serve the increasing demand of the world market. In
the early 1980s, Malaysia expanded its exports from labour-inten-
sive to capital-intensive goods while the Taiwan government
followed a development programme designed to shift its economy
away from labour-intensive industries towards the expansion of
technology-intensive industries. The process can be described as
the ‘prescription according to the disease’.
V. Conclusion
India’s economic liberalisation process was distinct in the sense
that it was the result of external compulsion rather than a con-
scious decision. At that point of time India’s infrastructural base
was not sufficient enough to face the global competition. The
government neither could change the domestic conditions
drastically nor could the country grab the benefits of the open
economy much. If India wants to take up some useful lessons from
the success stories of the East Asian countries, then the first and
foremost lesson should be to build up a strong base of education
and infrastructure. These are the platforms on which India can
build its success. According to Krueger (1990), abundant labour
and a well-functioning labour market facilitated the export sectors
of the East Asian countries. Indian labour market is inflexible and
at the same time education system is such that large population is
not turning into human resource.
G O L D I L O C K S G L O B A L I Z A T I O N
Reference and Additional Thinking
• Agrawal, R. and R. Shahani (2005), “Foreign Investment in
India: Issues and Implications for Globalisation” In: C. Tisdell
(ed.), Globalisation and World Economic Policies: Effects and
Policy Responses of Nations and their Groupings. New Delhi
(Serials Publ.)
• Ahluwalia, M.S. (1985), “Industrial Growth in Indian Manufac-
turing”, Oxford University Press.
• Akyuz, Y. and C. Gore (1996), “The Investment-Profits Nexus
in East Asian Industrialisation”, World Development, Vol. 24,
No. 3.
• Athreye, S. and S. Kapur (2001), “Private Foreign Investment
in India: Pain or Panacea?” The World Economy, Vol. 24, No. 3
• Chakraborty, C. and P. Nunnenkamp (2006), “Economic
Reforms, Foreign Direct Investment and its Economic Effects
in India”, Working Paper No. 1272, the Kiel Institute for the
World Economy (Germany)
• Dhar, P.N. (1989), “Constraint on Growth: Reflections on the
Indian Experience”, Seminar Paper, Institute of Economic
Growth.
• Jha, R. (2000) ‘Reducing Poverty and Inequality in India: Has
Liberalization
• Helped?’, WIDER Working Paper No. 204, UNU/WIDER:
Helsinki.
• Joshi and I.M.D Little (1987), “Indian Macroeconomic
policies”, Economic and Political Weekly, Vol. 22.
• Krueger, A.O. (1990), “Asian Trade and Growth Lessons”, The
American Economic Review, Vol. 80, No. 2.
• Lall, S. (1999), “India's Manufactured Exports: Comparative
Structure and Prospects”, World Development, Vol. 27, No. 10
• Page, J.M (1994), “The East Asian Miracle:” An Introduction”,
World Development, Vol.22, No.4
• Sen and Himanshu (2004), “Poverty and Inequality in India II
– Widening Disparities during the 1990s”, Economic and
Political Weekly, September 5th
• Stiglitz, J. E. (2001), “From Miracle to Crisis to Recovery:
Lessons from Four Decades of East Asian Experience” in
Joseph E. Stiglitz and Shahid Yusuf (eds.), Rethinking the East
Asian Miracle, New York: Oxford University Press, pp.509-26.
• World Trade Organization (2007), Trade Policy Review: India,
Geneva: WTO.
(The views expressed in the article are personal and do not reflect the
official policy or position of the organisation.)
THE INDIA ECONOMY REVIEW 67
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A Model of North-
South Growth and
Trade as a Differential
Game Problem with an
Empirical Illustration
T. Krishna Kumar
Director,
Samkhya Analytica India Pvt. Ltd, Bangalore

I. Introduction
There is considerable literature, mostly theoretical, which
states that free trade is beneficial to all the trading partners.
The theoretical arguments are based on certain assumptions
such as that all countries have access to the same technologi-
cal choices, there are no transportation costs, all goods are
tradable, there is perfect competition in product markets, etc.
Most of these studies examine the autarky situation with a
free trade situation with just two countries, two products, and
two factors of production.1 Some of these results have been
established even under some relaxed conditions such as a
deviation from perfect competition. A case is also made for a
strategic trade policy that takes into account what is good for a
country in question.2
One often wonders what would happen to these results
when some of the assumptions are relaxed. One also would
like to know what quantitative impact a particular trade policy
would have on the overall long-term growth of a particular
economy. In a competitive world market one must also know
what counter strategy another country would adopt. It is

68 THE IIPM THINK TANK


therefore useful to have a quantitative model that is capable of
providing numerical solutions when one plugs in the realistic
values of the parameters associated with growth models of
different countries. In this paper we present such an empirical
quantitative model. Using this model we examine the emerg-
ing outcomes associated with two countries adopting trade
policies such as autarky, free trade, quantitative restrictions
and tariffs. We assume specific dynamic Leontieff production
structures along with linear consumption, export and import
functions in the two countries.
Planning or quantitative policy analysis has been discarded
in recent years under the assumption that every country ought
to follow competition policies and free trade policies, thereby
minimizing the role of the state. Government officials of
different countries are, however, called upon to advise their
governments, and to represent their government's interests in
G A M E TH E O R Y
international forums, on commercial policies. There is a need
to reformulate quantitative economic policy problem to make
it useful in the newly emerging economic environment. The
earlier treatment of the economic policy problem as an
optimization or optimal control problem with a single objec-
tive function is now obsolete. In the newly emerged global
economy with trade liberalizations and capital flows one must
consider a new formulation of the economic policy problem
with multiple objective functions, one for each country. This
leads to a game theoretic formulation. We can model the
economies by a system of differential or difference equations
to capture economic growth. The optimal policy problem then
becomes one of a differential game problem.3
In this paper we take a simple situation by assuming
that the world can be grouped into less industrially
developed countries and industrially advanced countries.
The former are labeled here as the South Country while
the latter are labeled as the North Country. The quantita-
tive economic policy problem of choosing between the
appropriate trade regimes by the two groups of countries
for optimal growth and development is then formulated as
a differential game problem.
The plan of the paper is as follows. Section II provides a
dynamic model for growth and trade. Section III presents an
empirical illustration of the dynamic model and traces the
autarky and free trade solutions. Section IV widens the scope
of the policy problem as a non-cooperative differential game
problem in which the two trading countries have to choose
between a set of alternate trade policies with quantitative
restrictions and import tariffs. Finally section V offers
concluding comments.
II. A Model of North-South Growth and Trade
We assume that there are two nations called North and South,
each being governed by a dynamic Leontieff model with and
without trade links. The model without trade is called Au-
tarky situation and the one with free trade with no quantita-
tive restrictions and tariffs is called the Free Trade situation.4
The specification of the model is as follows:
Let y(t) represent the output of country labeled South in
period 't' while z(t) the output associated with country North.
We then have the following National Income Identity.
y(t)= a. y(t)+b. D y(t) + c(t)+e(t) - m(t) ................................. (1)
THE INDIA ECONOMY REVIEW 69
O P E N WO R L D

Figure 1: The Trajectories of Outputs of the North 'e(t)' is the exports to country North by the South
(Green) and the South (Red) Countries: Under country, and
Autarky Situation 'm(t)' is imports of the South country from the North
country. 5
Similarly, we have the following National Income Identity
for North Country:
40
z(t)=d. z(t)+f. D z(t)+g(t)+m(t)- e(t) .........……………..... (2)
Where,
30 d and f are the current and capital input output coefficients of
the North country, and g(t) is the final demand or consump-
tion function of the North country.6
20 We assume that the consumption or final demand equations
in the two countries are given by:

10 c (t) = c0 + c1 y(t) .................................................................... (3)

g (t) = g0 + g1 z(t) …............................................................... (4)
0 2 4 6 8 10
Year We assume that the export from country South equals the
imports of country North, and vice versa. We assume the
Where: following linear export and import functions:
D is an operator denoting the first order time derivative,
'a' is the current input-output coefficient, e (t) = e0 + e1 z(t)…………………...... (5)
'b' is the incremental capital-output ratio, m (t) = m0 + m1 y(t) ............................ (6)
'c(t)' is the final consumption in period 't',
When we substitute expressions (3)--(6) in equations (1) and
Figure 2: The Trajectories of GNPs of the North
and the South Countries: Case 1 Under Free (2) we get a system of two inhomogeneous differential equa-
Trade Situation tions of the first order that are linked to each other if there is
trade. By assuming an initial condition we can solve these two
equations and determine the dynamic inter-temporal trajec-
tory of the total output or income of each country as a
40 function of time.
We assume that the variables are measured in real terms
measured in, say, billions of US Dollars. We also assume that
30 the exchange rate is flexible to generate zero trade balance for
each country.
We can specify all the parameters of the model and solve
20 the two differential equations.

III. Comparison of Autarky and Free Trade Situations

10 We assume the following numerical values for the parameters
for deriving the empirical results:
0 2 4 6 8 10
Year a=0.10; b=4.0; c0= -10; c1=0.75; e0=0 (autarky), =1.03 ( free

70 THE IIPM THINK TANK

 G A M E TH E O R Y

Table 1: Matrix of Alternate Trade Strategies of North and Assume the following initial conditions:
South Countries
SOUTH y(0)=6,z(0)=10; ……………………... (10)
Free Trade LL LH HL HH Autarky
N Free Trade 1 2 3 4 5 NA The dynamic path of the two countries,
O LL 6 7 8 9 10 NA South and North are given by y(t), and z(t)
R
T LH 11 12 13 14 15 NA respectively as follows:7
H HL 16 17 18 19 20 NA
HH 21 22 23 24 25 NA y(t) = 72.66666667 exp(.03750000000 t) -
Autarky NA NA NA NA NA 26 66.66666667..………………………(11)
Source: Computations made by the author based on assumptions made in the text

z(x)= 209.9999999 exp(.01666666667 t) -

trade); e1=0 (autarky), = 0.20 (free trade) m0=0 (autarky), =
1 (free trade); m1=0 (autarky), =0.35 (free trade); d=0.30;
f=3.0; g0=-10; g1=0.65……………………………… (7)
Autarky Situation:
Assume that there are no exports and imports,
i.e., e(t)=m(t)=0.
The South Country's structure is now characterized by the
following dynamic Leontieff model.
4.0*D y(t)-0.15*y(t)-10=0 ............................................. (8)
The North Country's structure is given by the following
dynamic Leontieff model:
3.0*D z(t) -0.05*z(t)-10=0…..………….…………………
199.9999999 … (12)
These solutions are plotted against time in Figure 1. We
assumed a horizon of 15 years for our comparative analysis
throughout this study. Throughout this paper the trajectory
that starts at 10 refers to the North Country while the one that
starts at 6 refers to the South country. It can be noted that the
divergence between the two countries widens as time goes on.
Free Trade Situation:
Let us now assume that South country's exports are given by e
(t), which constitutes the imports of North Country. Similarly
the imports of South Country and exports of North Country
are given by m (t) as given by equations (5) and (6) with
(9) parameters as specified in (7).

Table 2: Pay-off Bi-Matrix Associated with Alternate Trade Strategies of North and South Countries
NORTH
Free Trade LL LH HL HH Autarky
Free Trade 227.07+ 268.52+ 334.07+ 269.38+ 334.80+ NA
271.16* 237.8 184.89 237.1 184.3
LL 181.96 223.27 289.58 224.04 290.24 NA
S 307.66* 274.42 220.9 273.79 220.36
O
U LH 145.44 186.17 252.37 186.87 252.97 NA
T 337.33* 304.53 251.09 303.96 250.6
H HL 181.54 222.88 289.25 223.65 289.91 NA
308.00* 274.73 221.17 274.1 220.63
HH 145.06 185.82 252.08 186.52 252.67 NA
337.64* 304.82 251.33 304.25 250.85
Autarky NA NA NA NA NA 286.42
223.64
Source: Computations made by the author based on assumptions made in the text

THE INDIA ECONOMY REVIEW 71

O P E N WO R L D
The structure of South Country is now given by:
4.0 D y(t) - .50 y(t) - 9.97 + .20 z(t) = 0 ……..……………
The structure of the North Country is given by:
3.0 D z(t) - .25 z(t) - 10.03 + .35 y(t) = 0 ………………… (14)
The initial conditions are assumed to be the same as those
assumed for the Autarky case, viz. y (0) =6, z (0)=10; It can be
seen from equations (13) and (14) that the growth path of each
country depends on the output of the other country.
The solution for the Free Trade situation is given by:
-8
y(t) = 3.45933019* 10 exp (0.1833333333 t)
+ 84.33157892 exp (0.02499999999 t)
-7
+ .4000000000* 10 exp (0.1583333333 t) - 81.79090915
………………. ........................................................... (15)
z(t) = 168.6631579 exp (0.02499999999 t)
- 4.03588519 exp (0.1833333333 t) - 154.6272728
-8
- .2000000001* 10 exp (-0.1583333333 t)
-7
- .3000000001* 10 exp (0.1583333333 t),
-8
+ .1000000000* 10 exp (-0.1583333333 t) ............... (16)
The Free Trade solutions are plotted against time in Figure
2.
As can be seen from Figures 1 and 2 free trade has benefit-
ed the South country at the expense of, the North Country.
Marginal propensity to export by the North country seem to
reflect the kind of situation that could prevail when a small (in
the sense of GNP) closed economy such as India could be the
South country while a large export-seeking large country such
as United States is the North country.
The usual claim made by the free trade proponents, that
free trade is beneficial to both countries does not seem to be
borne out in this case. We will, however, examine later
whether the countries find free trade to be preferable to
72 THE IIPM THINK TANK
autarky.
If y (t) is the output in US bill $s, is the time discount factor,
(13) and (0,T) is the time horizon then the integral pay-off for the
plan horizon can be written as:
.......................................................... (17)
Optimal growth theory suggests that one must use a Ramsey
type objective function that is a strictly concave function of
consumption. We assume, however, that what is maximized is the
discounted consumption stream. As the consumption function is
linear function of income it is a monotonic isomorphic transfor-
mation of income, and hence the above pay-off function. We find
the numerical values for the integral pay-offs as follows, assum-
ing that the time discount factor is 0.08 and that the plan horizon
is 15 years:
Pay-offs for Autarky Situation in US bill $s: (286.42; 223.64)
Pay-offs for Free Trade Situation in US bill $s: (227.07; 271.16)
Where the first entry refers to the pay-off to the North and the
second entry is the pay-off to the South country.
From this it is obvious that free trade is beneficial to the South
and harmful to the North. As a result of free trade the gain to
the South is 47.52 and the loss to the North is 59.35. The loss to
the North is more than the gain to the South. Which situation
will the two countries choose autarky or free trade? We will
consider a more general situation of a choice by the two coun-
tries of a trade strategy which involves quantitative restrictions
and tariffs.
IV. Choosing Optimal Trade Strategies:
A Differential Game Formulation
It must be admitted that the model described above is very
primitive and highly aggregative.8 Further the question of
trade strategies is made somewhat irrelevant as a result of the
new WTO trade regime. There are certain provisions of WTO
regime that do permit member countries to use discretionary
trade policies. Even violations of the trade regime rules are
subject to disputes and dispute resolution mechanisms that
take time.
In this section we reformulate the import and export functions
with a quantitative restriction dummy variable that shifts the
intercept term and a tariff dummy variable that would shift the

marginal propensities to export and import.
The following are the possible trade strategies that the two
countries are supposed to adopt. Two letters represent the
strategy. The first letter represents the level of quantitative
restrictions (QR) or quotas, and the second letter represents the
level of import tariff (T).
We assume that the quantitative restrictions (QR) imposed by
South reduce the intercept of its import function while the tariff
(T) reduces its slope or the marginal propensity to import. We
assume two levels for each, labeled low (L) and high (H). For the
South country QR low equals downward shift of intercept of the
import function by 0.02, while QR high equals a downward shift
of intercept of the import function by 0.04. When there are no
quantitative restrictions the intercept of the import function of
South is 1.0. When there is Low tariff in the
South country its MPI is 0.30, while a high
tariff gives rise to an MPI of 0.20. When In a competitive
there is no tariff at all the MPI for the South world market one
country is assumed to be 0.35. should also know
The QR imposed by North at low level
what counter
results in an intercept of export function of
the South country of 1.02 while QR at higher
strategy another
level imposed by the North country would economy would
result in an intercept of the South country's adopt eventually
exports of1.01. When there are no quantita-
tive restrictions imposed by the North Country the intercept of
the export function of the South country at 1.03. When there is
low tariff in North the marginal propensity to export of the
South country is 0.15 and when there is high tariff in North the
value of this becomes 0.10.
The matrix of strategy pairs is given below. NA means that
strategy pair is not applicable. There are altogether 26 pairs of
strategies. We specify the following values to the parameters:
a = 0.10, b = 4.0, c0 = -10, c1 = 0.75, e0 =1.03 (N: no QR), e0 =
1.02(N:LQR), 1.01(N:HQR); e1=0.10(N:HT),0.15(N:LT),0.20(
N: no-T); m0 =1(S: noQR), 0.98(S:LQR)), 0.96(S:HQR); m2=
0.20(S:HT), 0.30(S:LT), 0.35(S:no-T); g0 = -10 ; d= 0.30; f = 3.0;
g1= 0.65.
The integral pay-offs for the two countries can be calculated
for each of the 26 combinations of the trade strategies. If we
assume that the two countries play a non-cooperative game then
the optimal trade strategies for the two countries are those that
G A M E TH E O R Y
correspond to the Nash-Equilibrium. For each strategy used by a
country we determine what the best counter strategy of the other
country is. We call these the best response functions. We then
define the Nash Equilibrium as the set of strategies that are best
against the best strategies of the other country.
We present below in Table 2 the integral pay-offs for all the
strategy pairs along with the identification of the best responses
of each country against each of the strategies of the other
country. The numbers in the top refer to the integral pay-offs of
the North Country while the numbers below refer to the integral
pay-offs of the South country. The pay-offs with " * " are the best
response of the South country while the pay-offs with "+" sign
are the best responses of the North Country. The trajectories of
outputs of the South and North countries associated with these
alternate trade strategies are not shown
here. Interested readers can contact the
author for the Appendix to this article that is
not being printed.
From the pay-off bi-matrix it is evident
that Free Trade is the Nash equilibrium
strategy . The two countries would thus
choose free trade as the non-cooperative
solution. However, it can be noted that if
both countries cooperate they can choose
either LH and LH each or HH and HH each
which will give more benefits to the North than the loss to the
South when compared with the Nash equilibrium, The differ-
ence, the gain over the loss is $5.14 billion in LH, LH case, and
$5.29 billion in HH, HH case. This gain can be shared between
the two countries. Thus there can be cooperative solutions that
are better than the non-cooperative solutions.
V. Concluding Remarks
This paper deals with an empirical illustration of the model and
techniques advocated earlier by the author (Kumar (1998). The
model presented here is made deliberately very simple. The
major purpose of the paper is to illustrate the usefulness of
differential game theory for quantitative and empirical analysis
of optimal trade strategies. The computer software can easily be
used for a more realistic and complicated models such as growth
and trade models with more sectors and more countries. Once
we introduce two sectors with consumer goods industries and
capital goods industries we can study the impact of foreign direct
investment on growth and development. This model can also be
THE INDIA ECONOMY REVIEW 73
O P E N WO R L D
improved to incorporate increasing returns to scale.
Endnotes
1 7
For a more detailed discussion of these results one may refer
to an earlier article by the author (Kumar (2003)).
2
One may see Helpman and Krugman (1985), and Krugman
(1999).
3
Nearly forty years ago this author was one among several
economists who formulated the quantitative economic policy
problem of economic growth and development as an optimal
control problem. It was at that time that the author had seen
the work carried out by Rufus Isaac at the Rand Corporation
on Differential Games, which first appeared as Rand
Reports. The author then contemplated on the possibility of
generalization of economic policy problem from a control
problem to a differential game problem with the associated
duality theory. Such a thought was provoked by an excellent
paper of 1961 by Leonid Hurvicz on programming in linear
spaces and the close relationships between game theory and
mathematical programming. There is thus an element of
nostalgia associated with writing this paper. The author
thanks George Papavassilopoulos of University of Southern
California for drawing his attention to some of his own work
on differential games which motivated the author to return to
this topic.
4
The intercept and the slope parameters of the import and
export functions are assumed to be constant in this and the
subsequent sections. In section IV we make them depend on
the trade policies, such as imposing quantitative restrictions
and import tariffs, to trace the implications of a variety of
alternate trade policies.
5
We assume a composite single commodity. Trade is meaning-
ful only if there are at least two commodities. I am grateful to
Panagaria for this comment. It is assumed here that there is
in fact more than one commodity in the two economies and
what are modeled are the aggregate outputs and their growth.
The composite price indices in the two countries differ due to
differing average costs as reflected in the technical coeffi-
cients of the Leontief model. Comparative advantage and
specialization thus become meaningful. One may even say
that the composite commodity of one country is different
from the composite commodity of the other country.
6
The technical coefficients "a", "b", "c", and "d" are assumed to
differ between the countries. This is equivalent to assuming
74 THE IIPM THINK TANK
that the two countries have either unequal access to the latest
technology or that the countries choose different technolo-
gies depending on their respective factor endowments.
We used Maple 5.1 software of Maplesoft, Canada for
obtaining the numerical solution of a system of ordinary
differential equations.
8
The models presented here can be easily generalized to make
them multi-sect oral and non-linear. The reader may see
Kumar (1998) for a generalization of this model to allow for
several sectors.
9
This is intuitive. Free trade solution refers to optimization by
each country under no trade restrictions. As the objective
function itself does not depend on the trade flow an unre-
stricted maximum is larger than a restricted maximum.
References and Additional Thinking
• Helpman, E., and P.R. Krugman (1985), Market Structure
and Foreign Trade: Increasing Returns, Imperfect Competi-
tion, and the International Economy, Brighton, Wheatsheaf.
• Krugman, P.R. (1990), Rethinking International Trade, MIT
Press.
• Kumar, T. Krishna (1998), “ Models of North-South Trade,
Growth, and Development as Differential Game Problems,
in L. Caccetta, K.L. Teo, P.F. Siew, Y.H. Leung, L.S.
Jennings, and V. Rehbock ( Editors) Optimization Tech-
niques and Applications, Vol.1 , pp204-209.(Proceedings of
the 4th International Conference on Optimization: Tech-
niques and Applications, Curtin University of Technology,
Perth, Australia, July 1-3, 1998).
• Kumar, T. Krishna (2003), "On a suitable framework for
designing trade policies of a developing country in an open
global economy" in A.K. Bagchi and M. Chattopadhyaya,
and Ratan Khasnabis ( editors), Economy and the Quality
of Life, Dasgupta and Company, Kolkota, 2003, pp.
190-218.
(It is the birth of the author's granddaughter Saachi that prompt-
ed the author to write an article on a topic that will be of some
relevance and significance to her and her generation. The author
thanks Arvind Panagaria and Gopal Kadekodi for their com-
ments on the first draft, although Panagaria did not agree with
some of the findings and observations made here. The views
expressed in the article are personal and do not reflect the official
policy or position of the organisation).
O P E N WO R L D

Evolution of World
Trading System and
Future of Free Trade: A
st
21 Century Experience
76 THE IIPM THINK TANK
 B O U N D TO G E T H E R

M.S. Goel
Reader, Department of Applied Economics,
JNPG College, University of Lucknow
Introduction:
Trade in goods is one of the oldest human activities. Trade is
as old as the fi rst urban settlements which began to emerge
approximately 6000 years ago in four independent regions of
the world:
•
•
Mesopotamia
Northern China
• India
• Central America
The fi rst records of extensive trading networks in the world
are from Egyptian, Phoenician, Greek and Roman civiliza-
tions. Trade Flourished under the Greek city States e.g.
Athens and Sparta (Around 500 BC) and later on under the
Roman empire (starting around 300 BC).
The 17th Century saw the growth of restrictive policies that
later came to be known as mercantilism. The mercantilist

THE INDIA ECONOMY REVIEW 77

O P E N WO R L D
hold that economic policy should be nationalistic and aim to
secure the wealth and power of the State. The concept was
based on the conviction that national interest are inevitably
in confl ict. In this condition, gain in trade is possible at the
expense of other nation. This thinking led the Governments
to impose price and wages controls, foster national indus-
tries, promote exports of fi nished goods and encourage
imports of raw material.
Industrial Revolution: The
Beginning of Free Trade
The landmark work of Adam Smith and David Ricardo in
the late 18th Century and early 19th
century and also emergence of industrial
revolution laid the foundation stone of Great Britain saw
evolution process of theorizing free trade a great potential
in Great Britain. It saw a great potential in free trade and
in freer trade and also possible domi-
also possible
nance through it in world manufacturing
and trade. The result was announcement
dominance
by British Government to introduce free through it in world
trade as a government policy in 1846 when manufacturing
the British Parliament repealed the Corn
Law (which placed a high tariff on corn imports).
During the next 80 years or so, Great Britain advocated for
trade liberalization while other major trading players have
generally pursued protectionist policies.
The Era of Protectionism: (1913-1950) :
Advent of Great Depression in America in 1929, however,
began to influence the trade policies of Great Britain, United
states and other leading economies. Element of free trade
orientation was gradually vaning and protectionism creeping
into trade policies.
Most people will argue but the records speak that “the
period between 1913 and 1950 is noted by economic histori-
ans as the period with the lowest average economic growth
rate since 1820, and also the only period over at least 250
years, where trade grew at a slower rate than Gross Domestic
Product (GDP).1
Infact this period is marked by Great Depression (1929),
the two world wars and beginning of the end of colonial
rule, which probably did create confusions in the minds of
policy makers of leading economies and trading countries
78 THE IIPM THINK TANK
of that time.
Protectionism was on its high because of severe unem-
ployment, need to revive the industrial activities (particu-
larly in war ravaged economics) and also fall in movement
of foreign capital.
With the exception of U.S.A most other economies,
therefore, opted for protectionist policies.
GATT Foundation:
The Beginning of End of Discrimination
Free trade contains many positive points in it such, as to
help better allocation of resources in the country, improving
wellbeing of the consumers through
larger and diversified supplies of the
commodities and services as well, and
also inducing competitiveness among the
businesses within and outside the
country.
In post world war II era, efforts were
made again to reintroduce the sorts of
free trade into global trading. U.S.A. was
the leading economy at that time and
also advocate of the policy of free trade.
U.S. Congress, therefore, swing into action. As a conse-
quence, under their leadership General Agreement on
Trade and Tariff (GATT) was established in 1947 through
Havana Charter.
GATT had been instrumental in transforming the world
trading system to some extent by helping in eliminating
barriers to trade (see Table-1).
GATT negotiation resulted into reduction of tariffs on
industrial goods of 40 percent countries from an average of
40 percent in the late 1940’s to five percent. Prior to Uruguay
Round 8 about 79 percent of industrial tariff positions in
developing countries and 22 percent in case of developed
countries2 were unbound, which was a cause of instability in
world trading.
After the conclusion of the TOKYO Round in 1979, some
disturbing trends were observed in world trading system.
Firstly; aggressive expansion of Japanese exports in
leading sectors such as automotive and semiconductors
and at the same time keeping the Japanese economy
mostly closed to foreign suppliers and investors by admin-
istrative barriers.
 B O U N D TO G E T H E R

Table 1: GATT/WTO Negotiating Rounds

Round No. and Place/Name Year(s) No. of Parties Subject Covered % Cut in Tariffs
1. Geneva 1947 23 Tariffs 21
2. Annecy 1949 13 Tariffs 2
3. Torquay 1950-195 38 Tariffs 3
4. Geneva 1956 26 Tariffs 4
5. Geneva 1960-1962 45 Tariffs 2
(Dillon Round)
6. Geneva 1964-1967 62 Tariffs and anti-dumping measures 35
(Kennedy Round)
7. Geneva 1973-1979 99 Tariffs, non-tariff measures, multi- 33
(Tokyo Round) lateral , agreements
8. Geneva 1986-1994 117 Tariffs, non-tariff measures, agri- 34
(Uruguay Round) cultural, services, textiles, intellec-
tual property, dispute settlement
Source: Adapted from Various GATT/WTO publications

Secondly; many countries used subtle forms of interven- years of existence.

tion instead of utilizing tariffs and circumvent technical
violation of GATT rules. Growth of Regional Trade: Boon or Bane for
Main achievements of the Uruguay Round may be Developing Countires and Multilateral Trade
summarized in following manner: Multilateral trade in said to be a condition in which a
• Acceptance by developed countries to cut tariffs by country enters into trade with other countries as per the
another 34 percent. rules and regulations formulated by a
• 117 countries joined negotiation multilateral trade agency . Presently
process. Element of free there is world Trade organisation (WTO)
• Reductions in agricultural import trade orientation which is authorized by the member.
barriers. was gradually States to monitor world trade among
• Commitment for better access to
vaning and themselves. WTO is doing a good job. We
developing countries in service sector. still have the memories of the last
• Textiles and clothing sector receiving
protectionism recession of the 1930’s when unilateral
the cut in quantitation restrictions. creeping into actions on tariffs led to a decline of world
The transition from GATT to world trade policies trade by as much as 30 percent in those
Trade Organisation (WTO) in 1995 is days. From all reports, the decline today
thought to be a major driving force in facilitating trade is no longer of that magnitude. The fact that a multilateral
negotiations, bringing stability in world economic order and organisation for trade negotiations exists today is surely a
introducing effective dispute minimizing process in world contributing factor here. 3
trade (see Table-2). However, we notice one striking development taking place
First six years in the life of the WTO suggest its enforce- in the world trading system since mid 1990s that there a
ment mechanisms are having a positive effect. As of 31st surge in the regional trade agreements (RTA) from about 50
December, 2000, 200 trade disputes were brought to the till 1990, the number of RTAs notified to the WTO has
dispute settlement body (DSB). This is a bigger figure than crossed 250 in 2003 and more than 300 RTAs have been
196 cases which were handled by the GATT during its 46 notified to WTO 4 (till march 15 2008).

THE INDIA ECONOMY REVIEW 79

O P E N WO R L D
Table 2: A Comparative Multilateral Framework of the World Trade Under GATT and WTO
The Multilateral Framework in GATT
Industrial Tariffs
· Backstone of the GATT rounds 1 to 7 Tarriffs on indus-
trial goods in developed countries have been progres-
sively reduced from 40% in the late 1940s to 5%
· High proportion of tariffs are ‘unbound’
Agriculture
· High farm subsides and protected markets in United
States and EC lead to overproduction and dumping
Services
· GATT rules do not extend to services Many countries
keep high barries in the services sector.
Intellectual Property
· Standards of protection for patents copyrights, and trade- · Extensive agreements on patents, copyrights and trade-
marks vary widely ineffective enforcement of national
laws becomes a growing source of trade friction
Textiles and Clothing
· Imports of textiles and clothing restricted through bi-
lateral export quotes under the GATT Multi-Fiber Ar-
rangement (MFA)
Source: Adapted from Charles Hill, International Business 2001, McGraw Hill and DEAT Reports
It is notified that this surge in RTAs is largely driven by
developed countries. Since the failure of the Seattle ministe-
rial of WTO in 1999, countries like U.S and European (E.U.)
have initiated negotiation on a large number of bilateral and
RTAS. 5 The world Bank (2005) estimates that about 40
percent of total global trade is done among the regional
trading partners.
The economists like Jagdish Bhagwati, Harry Johnson ,
Bela Blassa ,Arvind Pana gariya do not fully endorse the
RTAs. Harry Johnson claimed that “ many more Regional
Trade Agreements and custom unions would rise in future.
However they would all be expected to break up at a certain
point of time in future.6 Paul Krugman (1993) opines we still
need to ask why such regional blocs are, infact, emerging.
Experience of the past several decades shows that RTA
80 THE IIPM THINK TANK
The multilateral framework in WTO
· Developed Countries to reduce tariffs by 40% to reach a
range between 1.7% (japan) and 4.8% (Canada)
· India, South Korea and Singapore to reduce tariffs by
over 50%
· Developed countries ‘bind’ 99% of tariffs.
· Export subsidies down by 36%
· Production subsidies down by 18%
· New market opportunities for 1.8 m tons of grain and
0.73 m tons of dairy products
· The setting up of GATS, the first multilateral and legally
enforceable agreement on trade and investment in the
services sector.
· Post-Uruguay Round agreements.
· Telecommunications (Feb. 1998)
· Telecommunications (Feb. 1998)
· Financial services (March 1980)
marks benefiting producers of intellectual property and
increasing technology transfer.
· Textiles and clothing restraints under MFA to be phased
out in 4 steps between 01-01-1995- 01-01-2005 benefitting
exports in developing countries.
experiments in the west, as well as in the third world have
proved to be stumbling blocks, providing little gain for
member countries. 7
It is important to note that the provisions of most North-
South RTAs go well beyond the WTO rules and are likely to
impose higher level of restrictions on the developing coun-
tries. 8
Bhagwati and Pana gariya (1996) argue by pushing aggres-
sive trade treaties on a bilateral basis , developed countries
are weakening the power of developing countries in multilat-
eral trade negotiations.
If those are few observations about RTAs and an open
world trading system continues to be our ultimate goal, then
several important questions arise as to whether we should
welcome regional trading agreement as a step.

Multilateral Trade Negotiations:
A 21st Century Experience:
Strong mechanism of multilateral trade system is regarded
as the pre-requisite to make globalization work successfully
and pave way for free trading among the global economies.
This becomes even more important in the light of the fact
that more than 95 percent of global trade takes places
among WTO members. But advent of 21st Century brought
no relief to developing countries as important issues like
agriculture subsidy and non-agriculture market access
(NAMA) remain unresolved.
This declaration of Doha (November 2001) did fi x 1st
January, 2005 as the date for completing all but these two
issues through negotiations. But talks are still pending
covering other issues as well.
On the insistence of Government of India (Doha Round)
meet is going to take place in the fi rst week of September
2009. According to media reports India is to be blamed for
creating deadlock.
To negate this impression worldwide, India has taken a
bold step to organize the meet and invite the bluff off
countries which accused it of having torpedoed the July
2009, Geneva meet by not agreeing to lower its demand on
safe guarding it subistence farmers. Infact, it was not India
all alone which was steadfast in this issue but china, Brazil
and eight other counties were also party.
Though India and European union have joined hands in
playing a lead role in freeing up the global trade but all
matters relating to WTO rest on the Capitol Hill, Washing-
ton DC. Unless the U.S. President has a fast track authority,
no commitments can be made by other parties.
The thinking in the US have always been to focus on
market access and developments of its own businesses. Thus,
in spite of huge opposition by poor countries , it was success-
ful in getting an agreement on intellectual property (TRIP)
into the text of WTO agreement in 1994-95.
In historical perspective also, successful Doha Rounds
have witnessed fi libustering tactics used by developed
countries to push developing countries to corner. This has
been seen in cancun meet which was dominated by Singa-
pore issue. Thereafter Paris in 2005, Geneva in 2006,
Potsdam in 2007 and Geneva in 2008 saw the WTO talks
broke due to intersticing of modalities between farm
agreement and industrial good negotiations. In each case
B O U N D TO G E T H E R
poor were on the defensive. The rich countries never
realised that a win-lose out come cannot lead to any
conclusion.
Therefore for new talks to succeed those suspicions must
be proved wrong. We do need to strengthen the multilateral
trade regime in the context of rising protectionist sentiments
around the globe.
Endnotes
1
“ International Trade and Investment –An Asia Pacific
Perspective,” By John Gionea, published by McGraw Hill
Irwin, 2005 p. 154
2
Ibid p. 156
3
WTO talks : Waiting for Godot” an article written by
Prof. Manoj Pant (J.N.U) published in Economic Times.
11th September 09.
4
“Regional Trade Agreements and Improved Market
Access in developed Countries: The Evidence Written by
Prof. Parthapratim Pal, published in economic and
political weekly, November 29, 2008 p. 84.
5
Ibid p. 84
6
Quoted from a research paper titled, “ New Institutions
Asian Monetary Fund, SAFTA, ASEAN, APEC; A new
Funeral for New Regionalism in this new Century.”
Written by Rameshwar Tandon.
7
Written by Prof. Rameshwar Tandon, published at centre
for Japanese economic studies, Maeguariec Univ.
8
Opp. Cit. Parthapratim pal p. 91
References and Additional Thinking
• John Gionea (2005) International Trade and Investment,
Mc Graw Hill Irwin, Australia
• Josiph Stiglitz (2002) Globalisation And its Discontents,
Penguin Books.
• Jagdish Bhagwati (2004) In Defence of Globalization,
Oxford University Press.
• Economic Survey, Government of India.
• International Trade Statistics 2008, Geneva WTO (2008).
• Comprehensive Tariff Data. World Trade organisation,
online via: http:/www. Wto.Org./english/tratop-e/ tariff-
data-e.htm.
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation.)
THE INDIA ECONOMY REVIEW 81
O P E N WO R L D

Murky Economics—
Comparative Advantage
& Free Trade Theory

John Kozy*
Retired Professor of Philosophy and Logic

82 THE IIPM THINK TANK


E
conomics is adrift in a sea of murky concepts, one
of which is free trade. This murkiness arises from
two practices common to economists—commis-
sion of what I call the fallacy of excessive generalization
and imprecisely defi ned terms.
Consider the principle of comparative advantage. The
number of problems with this “principle” is legion, and
numerous economists have attempted to amend and extend
it. All the problems and emendations have been discussed
extensively in economic literature. One writer, Steven M.
Suranovic [http://internationalecon.com/Trade/Tch40/T40-0.
php], has reduced comparative advantage to an almost
useless hypothetical claim about merely possible results:
"The usual way of stating the Ricardian model results is
to say that countries will specialize in their comparative
advantage good and trade them to the other country such
that everyone in both countries benefit. Stated this way it is
easy to imagine how it would not hold true in the complex
real world.
A better way to state the results is as follows. The Ricard-
ian model shows that if we want to maximize total output in
the world then, first, fully employ all
resources worldwide; second, allocate Subjunctive
those resources within countries to each expressions
country's comparative advantage
would at least be
industries; and third, allow the countries
to trade freely thereafter.
honest, as they
In this way we might raise the wellbe- would imply that
ing of all individuals despite differences economists were
in relative productivities. In this descrip- unsure of validity
tion, we do not predict that a result will
carry over to the complex real world. Instead we carry the
logic of comparative advantage to the real world and ask
how things would have to look to achieve a certain result
(maximum output and benefits). In the end, we should not
say that the model of comparative advantage tells us
anything about what will happen when two countries begin
to trade; instead we should say that the theory tells us some
things that can happen."
Yes, I know. Mr. Suranovic is just one economist, per-
haps not even a good one. But that’s the point. There is no
precisely defined Principle of Comparative Advantage that
all economists point to; it has been propounded, amended,
extended, revised, and even adorned. Attempts to refute it
M U R K Y E C O N O M I C S
can be likened to shooting at shadows. But the principle
has two features that appear to be universal.
First, to determine that one country has a comparative
advantage over another in the production of a specific
product, a comparison of its costs of production in both
nations is required. Look at what Ricardo writes:
"England may be so circumstanced, that to produce the
cloth may require the labour of 100 men for one year; and if
she attempted to make the wine, it might require the labour
of 120 men for the same time. England would therefore
find it her interest to import wine, and to purchase it by the
exportation of cloth.
To produce the wine in Portugal, might require only the
labour of 80 men for one year, and to produce the cloth in
the same country, might require the labour of 90 men for
the same time. It would therefore be advantageous for her
to export wine in exchange for cloth."
Notice that Ricardo has no idea of how much labor of
how many men is required to produce anything anywhere.
Count the modal verbs. Three ‘mights’ and one ‘may’ which
grammatically should have been another ‘might.’ The two
paragraphs are couched in the subjunc-
tive mood which, in English, implies
unreality, doubt, and uncertainty. Now
“how much labor of how many men” is,
in principle, a simple calculation. It
merely requires some counting. But even
today, can anyone say with certainty how
much labor of how many men is required
to produce rice in any nation?
Perhaps all economists should express
their principles in the subjunctive mood just as Ricardo
does. Such subjunctive expressions would at least be
honest, since they would imply that economists were
uncertain of the validity of their models. But even Ricardo
isn’t consistent. When he writes, “England may be so
circumstanced, that to produce the cloth may require the
labour of 100 men for one year; and if she attempted to
make the wine, it might require the labour of 120 men for
the same time,” he should have concluded that England
might therefore fi nd it her interest to import wine, rather
than England would therefore find it her interest. But
“might find it in her interest” is a weaker conclusion than
“would find it in her interest.” Could free trade be sold to
THE INDIA ECONOMY REVIEW 83
O P E N WO R L D
people by claiming it might lower prices?
Someone is sure to point out that the passage can be
rewritten with conditional sentences that eliminate the
modal verbs. True. Consider these:
"If producing cloth in England requires the labour of 100
men for one year, and if producing wine requires the
labour of 120 men for the same time, it is in England’s
interest to import wine and to purchase it by exporting
cloth.
If producing wine in Portugal requires only the labour of
80 men for one year, and producing cloth requires the
labour of 90 men for the same time, it is in Portugal’s
interest to import cloth and to purchase it by exporting
wine."
The advantage is derived from the increased production
of cloth when the labor of the 120 men
spent on producing wine is transferred
One of the most
to producing cloth. The argument
implies nothing about how much the
difficult aspects of
imported wine will cost. What lowers economic analysis
the price? Applying the law of supply is how to interpret
and demand, which requires a number the conclusions
of assumptions.
of models and
One is that Portugal reciprocates in
this arrangement and devotes its cloth
frameworks
making resources to wine making, and
another is that the demand for wine stays relatively con-
stant. If Portugal chooses not to move its cloth-making
resources to winemaking, the supply of wine doesn’t
increase. What if Portugal simply can’t increase its produc-
tion of wine? Wine, after all, is made from grapes which
don’t grow well everywhere. Then the added English
demand for Portuguese wine increases the demand while
the supply remains constant which raises prices.
Now put a third country into the mix. Suppose Sweden
finds itself in exactly the same position as England.
Sweden stops making wine to produce cloth. Now the
demand for Portuguese wine is even greater. There is
nothing in free trade theory that makes lower prices
necessary or even certain.
Subsequently, economists replaced “how much labor of
how many men “ by “opportunity costs.” But opportunity
costs are much more difficult to compute. Look at how the
concept of opportunity cost is defined: the amount of one
84 THE IIPM THINK TANK
product that must be given up in order to produce one
more unit of another product. But how many phone calls
to an Indian call center must be given up for Indians to
produce one more pound of hak? And how many pounds
of hak must be given up by Americans to get one more call
to an American call center? Is the example facetious? I
think not. How many American made automobiles must
be given up to produce one more two-story home? Who
knows? Does it matter where the automobiles and homes
are built? Would opportunity cost be the same in Califor-
nia and Connecticut or Kerala and Bihar? Would the
opportunity cost be the same if the workers producing
automobiles were unionized and those producing houses
were not or vice versa or both? Can opportunity costs be
manipulated? Economists avoid these questions merely by
making more assumptions.
Opportunity costs are assumed to be
constant; they never change. No limits
on production exist. Full employment
exists in both countries at all times. All
factors of production are mobile within
countries but are immobile between
them. Pricing mechanisms maintain
perfect competition. Can we ask
whether the cloth producers in Portugal
are lazier than the wine producers? No.
Labor is assumed to be equally productive everywhere.
All this assuming is very neat, but it’s a sham. Has anyone
ever seen an analysis of data that shows that the Chinese
have a comparative advantage over the United States in
the production of the plethora of products that Americans
import from China? Why not? If the comparison of how
much labor of how many men is required (or the opportu-
nity costs) can’t be carried out, the principle of compara-
tive advantage has no applications and is entirely useless.
But as useless as it is, economists venerate it. Consider
this passage:
"[O]ne of the most difficult aspects of economic analysis
is how to interpret the conclusions of models. Models are,
by their nature, simplifications of the real world and thus
all economic models contain unrealistic assumptions.
Therefore, to dismiss the results of economic analysis on
the basis of unrealistic assumptions means that one must
dismiss all insights contained within the entire economics

discipline. Surely, this is not practical or realistic. Econom-
ic models in general and the Ricardian model in particular
do contain insights that most likely carry over to the more
complex real world [http://internationalecon.com/Trade/
Tch40/T40-0.php]."
This passage, in its entirety, is a non-sequitur. Even if
models are simplifications of the real world and contain
unrealistic assumptions, it does not follow that one must
dismiss all insights contained within them unless there are
none. After developing the model, a competent model
builder would then analyze it assumption by assumption,
asking what happens if this assumption is false, what
happens if that assumption is false, what happens if the first
and second assumptions are false, and so on until s/he asks
what happens when all of the assumptions are false. Only
then could one see which, if any, insights
are revealed by the model. Why would In cuisine, proof
rejecting all insights contained within
the entire economics discipline not be
is in the pudding.
practical or realistic if there are no valid In economics, the
insights? And to conclude that the proof is in the
Ricardian model contains insights that recipe regardless
most likely carry over to the real world is of how rank the
pure unjustified opinion. How would
anyone ever determine its likelihood?
pudding tastes
Building models on assumptions that may or may not be
true is one thing. Such models may apply to the real world.
But building models on assumptions that can never be
true is another. These models are never applicable to the
real world.
Economists are a curious bunch. In cuisine, the proof is
in the pudding. In economics, the proof is in the recipe
regardless of how rank the pudding tastes. Paraphrasing
Dani Rodrik, when economists are taken to task for
ignoring real world complications, they argue that the
presence of market imperfections does not change the
model’s logic. He’s right, but they change the model’s
outcome, and that’s what’s really important. People don’t
care about theory, and a logical principle, named modus
tollens, affirms that if the consequent of a conditional argu-
ment is false, the antecedent is false. So when economists
apply a model and the predicted results don’t ensue, the
only logical conclusion is that the model’s premises are
surely false.
M U R K Y E C O N O M I C S
Second, the principle of comparative advantage relies on
a generalization so extensive its generalized term has no
denotation. It is a term without meaning.
You see, only winos (alcoholics) drink wine! The rest of
us drink Asti, Beaujolais, Bordeaux, Burgundy, Cabernet
Sauvignon, Chablis, Champagne, Chardonnay, Chianti,
Fynbos, Jerez, Kalecik Karası, Luján de Cuyo, Madeira,
Merlot, Moselle, Pinot Gris, Port, Pouilly Fuisse, Riesling,
Sake, Sangiovese, Sauternes, Sherry, Tempranillo, Valpoli-
cella, Vinhos Verdes and scores of others. Why Ricardo
chose wine is a mystery. Perhaps he was a wino and really
didn’t care about flavor, aroma, dryness, and body. Or
perhaps he chose wine because the English were and still
are not very good at making wine. Would the French be
willing to give up Beaujolais for Port or the Japanese be
willing to swap Sake for Vinhos Verdes?
Someone will say it’s just an example.
But generalize on any product. Automo-
biles, tomatoes, potatoes, chairs, what-
ever. The only products made worldwide
that are identical are factory produced
according to precisely defined specifica-
tions and sometimes even those vary.
These products can be made just as
easily in Chad as in China. There is no
reason to believe that people in Bongor are any less
dexterous than people in Beijing.
Statements like the following are often found in the
literature:
"The magic of comparative advantage is that everyone
has a comparative advantage at producing something. The
upshot is quite extraordinary: Everyone stands to gain from
trade. Even those who are disadvantaged at every task still
have something valuable to offer. Those who have natural
or learned absolute advantages can do even better for
themselves by focusing on those skills and buying other
goods and services from those who produce them at
comparatively low cost. [http://www.econlib.org/library/
Topics/Details/comparativeadvantage.html]"
Now, just ask, how could anyone know the first sentence's
claim? Is it simply impossible that someone somewhere
can’t do anything at all? How can anyone justify a claim
that such an impossibility exists? And how does everyone
stand to gain from trade just because they can buy things at
THE INDIA ECONOMY REVIEW 85
O P E N WO R L D
comparatively (compared to what) low cost? If just one
person loses his income or his life because of trade policy,
the statement about everyone is false. The sentence isn’t
even true if the word ‘gain’ is modified by ‘fi nancial.’
So if it cannot be shown with certainty that one nation
has a comparative advantage over another in the produc-
tion of some product, then no one can be certain that any
predicted benefits from basing trade on a comparative
advantage will ensue. If free trade can’t be based on
comparative advantage, it must be based on some other
kind of real, contrived, assumed, or imagined advantage,
not comparative advantage.
Free trade, when reduced to its simplest form, means
nothing but trade not restricted by protectionist practices.
But “protectionist practices” is another ill-defined, murky
concept. Consider these scenarios:
Two countries, Us and Them, each
produce a product named a domock. Us
is a highly developed nation that has If free trade policy
implemented many economic regula- were implemented
tions to protect its people from injury, worldwide and
exploitation, and fraud. Them is an
underdeveloped nation with no econom-
all protective
ic regulations. Manufacturers in Them
regulations were
can export domocks to Us and sell them over, who would
for one curr each. Manufacturers in Us stand to gain?
can sell domocks for two currs each. So
what can Us do?
Leaving aside the possibility that Us might simply allow
its manufacturers of domocks to go out of business, only
three unique alternatives exist: Us can impose a tariff of
one or more currs on each domock imported (a protection-
ist practice), can subsidize its domock-manufacturers so
they can reduce the price to one curr (another protectionist
practice), or eliminate the protective regulations that cause
the price of domocks to be two currs. Free trade advocates
do not consider this last alternative protectionist, and it is
the alternative they advocate.
But why is the third alternative not just as protectionist as
the first two? All three are done for the same reason and
produce the same result. How can anyone justify calling
the first two protectionist and the third not?
Only one answer to the question exists, and it is trivial.
Free trade is often defined as a trade policy that allows
86 THE IIPM THINK TANK
traders to act without having to deal with governmentally
imposed regulations. Since the fi rst two alternatives
involve regulations and the third does not, the first two are
protectionist and the third is not by definition alone. But
logically, a thing is what it is and not another thing. If some
horticulturalists decide to define orchids as adornments
and not flowers, would orchids no longer be flowers? A
name does not make something what it is; its attributes do.
Remember the adage, if it looks like a duck, squawks like a
duck, and walks like a duck? But if all three alternatives
are essentially the same, free trade theory collapses into
utter nonsense.
In 1913, V. I. Lenin published an article in Pravda titled,
Who Stands to Gain? Regardless of opinions of Lenin or
Leninist-Marxism, this question is a useful analytical tool
when evaluating policy proposals and was stated long
before Lenin by the Romans (cui
prodest?). Unfortunately, it is asked far
too infrequently. If free trade policy
were implemented worldwide and all
protective regulations were eliminated,
who would stand to gain? Merchants cer-
tainly. But what about the rest of us?
Well, suppose Them allows its manu-
facturers to employ child labor. Us then
eliminates it child-labor protections.
Are the children better off just because
they can now purchase domocks for one curr each?
Suppose Them allows its manufacturers to use dangerous
materials. Us then eliminates its restrictions on the use of
dangerous materials. Are people better off being injured
and poisoned just because they can now buy domocks for
one curr? Suppose Them allows its manufacturers to place
workers in dangerous circumstances where many are
maimed and killed. Us then eliminates it regulations on
unsafe workplaces. Are workers better off being injured
and killed just because they can now buy domocks for one
curr? Is anyone even financially better off? So who stands
to gain? Just merchants?
To economists, incredibly, merchants are mostly Mr.
Goodfellows. They don’t lie to and cheat consumers. They
don’t overcharge. They never market products that don’t
work or that don’t work as advertised. They don’t market
products that injure and sometimes kill and hide the fact

that these possibilities were known before the products
were marketed. They don’t write contracts with hidden fees
buried in text that can be read only with microscopes or
that coerce people into repudiating their legal rights. They
never defraud clients, each other, or governments by
submitting claims for work never done on governmental
projects or for governmental programs. They don’t profit-
eer in wartime. They don’t corrupt public officials. In fact,
most are veritable saints, and the few that aren’t, those
rotten apples, are plucked from the barrel of commerce by
the invisible hand, because the market is self-regulating.
But in reality, unregulated business exhibits all the charac-
teristics of a criminal enterprise.
As a logician, if I were asked to prove that the market is
self-regulating, the only effective proof that I could think of
would be to list all the untrustworthy firms whose dishonest
actions were restrained by trustworthy
firms and then show that, at best, no or
just a few untrustworthy firms have The question is
avoided this restraint. But no economist not trade, but how
has ever developed such a proof, which and by whom it
means that either the market isn’t
will be controlled.
self-regulating or that there are so few
trustworthy firms that they lack the
Trojan horses do
power to restrain the untrustworthy. exist and everyone
However, this debate on free trade is is a protectionist
merely a diversion. The process of
globalizing trade that has now gone on for several decades
has nothing to do with comparative advantage or free trade
theory. No nation has abandoned any industries, trans-
ferred the resources to industries making products for
export, and used the exports to pay for the importation of
the products previously made by the abandoned industries.
The so-called "developed" nations, whose governments are
controlled by commercial interests, have merely bought the
idle labor and resources of "underdeveloped" nations for
skimpy sums and paid for them with fiat currencies that
amount to little more than promissory notes. It remains to
be seen whether the nations holding these promissory notes
will ever be able to redeem them for value equal to that
expended on the labor and resources used to manufacture
their exported products. If not, these nations will fi nd that
they have been swindled just as the residents of the United
States, Great Britain, and other nations who have lost their
M U R K Y E C O N O M I C S
homes and savings have. The only confirmed result of
globalized trade is the greatest transfer of wealth from the
least wealthy to the most wealthy in recorded history.
The real issue is independence or dependence. Free
trade advocates are attempting to convince governments
worldwide to relinquish their control over their economies.
It is an attempt by merchants to control all markets. If it
succeeds, national governments will be irrelevant.
The real question that nations must answer is whom do
they want to give control of their economies to? The
alternatives are national governments, which are at least in
some cases and in some sense responsible to their citizens,
or powerful worldwide commercial interests who have to
answer to no government and no people. Nations that were
once colonies of Western imperialist countries should
consider this question carefully. Although the yokes of past
oppression may have been lifted, the
interests that propelled imperial con-
quest were commercial and still exist,
and the agendas have not changed. Only
the methods of conquest have.
Trade between nations will not cease
if free market theory is completely
debunked. Everyone, as I have argued
above, is a protectionist; everyone seeks
to protect something—people their
lives, merchants their profits, consumers
their protections, laborers their jobs, nations their wealth
and power. The question is not trade, but how and by whom
it will be controlled. So I would suggest that the world’s
governments should beware economists bringing promises
of prosperity based on utopian theories on behalf of
merchants. Trojan horses do exist.
(The views expressed in the article are personal. The author is
a retired professor of philosophy and logic who blogs on
social, political, and economic issues. After serving in the U.S.
Army during the Korean War, he spent 20 years as a university
professor and another 20 years working as a writer. He has
published a textbook in formal logic commercially, in aca-
demic journals and a small number of commercial maga-
zines, and has written a number of guest editorials for
newspapers. His on-line pieces can be found on http://www.
jkozy.com/ and he can be emailed from that site's homepage.)
THE INDIA ECONOMY REVIEW 87
G R O W T H E C O N O M I C S

The India Story: Served

Sunny Side Up
88 THE IIPM THINK TANK

Ketaki Sharma
Economist, Reliance Equities International
Pvt Ltd., Mumbai
A
periodic visit to the various shopping malls in the
metros over the past few months reveal a lot about
the changing consumer mindset and is something
that sets my economist mind ticking. Footfalls have increased,
distress discount sales are a thing of the past, business is
thriving, waiting time outside movie ticket counters has gone
up and the great Indian pass-time of eating out has undergone
revival. This, if not a confi rmation, is at least an indicator of
the great India story that everyone has been talking about.
As global liquidity returns and risk appetite improves, there
is bound to be a foreign funds inflow into the emerging
markets – especially India and China. Agreed that hitherto
the emerging markets have been far more volatile than that of
developed countries but the fact remains that they -almost
always- outperform the latter.
Taking a look at Charts 1 and 2, it is Four and a half
obvious that the Morgan Stanley Compos- trillion borrowing
ite Index (MSCI) for Emerging markets
plan of the state
outperforms the index for the world
markets, more so in the recent past.
will ensure that
Within this index for emerging markets, credit remains
India clearly outperforms the others. expensive and
It is my belief that India will continue rates may not fall
to outperform other emerging markets
and will remain one of the most favored destinations for the
FII inflow. What makes me so confident? Read further to
find out!
As Liquidity is Back with a Bang…
The Reserve Bank of India cut rates for the fi rst time in 2008
in October - to fight the lack of liquidity in the system post the
fall of Lehman Brothers.
Post the Lehman crisis (in September), the Reserve Bank of
India has been cutting its policy rates. Since October there has
been a 400 basis point cut in the CRR and similar cuts in the
Repo and the reverse repo. The big idea was to make money
so cheap that lenders find it profitable to lend rather than to
ST O C K TA K I N G
hold onto cash. Thanks to the monetary loosening, we are now
seeing a considerable softening of lending rates. Recently SBI
cut its prime lending rates by 50 bps, while weeks before doing
so it cut its deposit rates, thus creating incentives for individu-
als to remain more liquid. Another indicator of increasing
liquidity is the cooling off of call rates (inter bank lending
rates). Call rates that had peaked to 21% in October, are now
placed within a more healthy range of 0.75% to 3.5%.
On the fiscal front, similar measures have been taken. In
India there have been excise duty cuts and other infrastruc-
ture expenditure undertaken by the government to ensure
that domestic demand does not wither away. Here again,
India is not the only country. China cut its central VAT in
January while the West has a wide social security net that
props up demand.
And Risk Aversion Abates…
G-Sec yields might have fallen from their peak of 8.4% on 7th
September 2008; however they have been more or less stable
at 6.8% level. Loosening of policy rates has also helped abate
risk aversion - this is evident from the fall in 10 year G-Sec
yield. Many might argue that the already
announced four and a half trillion borrow-
ing plan of the government will ensure that
credit remains expensive and that interest
rates may not come down any further.
True, given the borrowing requirements of
the government, it is unlikely that they will
fall further.
India and China are the Most
Attractive Investment Destinations
While the world economy contracts, India & China grow at
five plus level. Both countries combined, India and China
constitute about 40% of the world’s population. The demo-
graphics and sheer size of the population ensure strong
domestic demand. India’s growth story is here to stay. While
monsoon failure remains a risk to India’s GDP growth, my
belief is that India and China have so far outperformed the
rest of the world. And what is the reason behind that strong
belief? Because what we experience today is a demand side
constraint. The populous countries of China and India ensure
domestic demand holds up especially with rising government
spending to buoy infrastructure and farm activities. In the
THE INDIA ECONOMY REVIEW 89
G R O W T H E C O N O M I C S

Chart 1: Morgan Stanley Composite Index for Emerging Markets Versus the World
1400

1200

1000

800

600

400

200

0
Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
MSCI Emerging Market MSCI World Index
Source: Bloomberg

Chart 2: Morgan Stanley Composite Index for Emerging Markets Versus India

900
800
700
600
500
400
300
200
100
0
Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
MSCI India MSCI EM (Index)

Source: Bloomberg

Chart 3: 10 Year G-Sec Yield Falls, Risk Aversion Abates

10.00
9.50
9.00
8.50
8.00
7.50
7.00
6.50
6.00
5.50
Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09
10 year G-Sec
Source: Bloomberg

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 ST O C K TA K I N G

Chart 4: GDP Growth (Year on Year) for January to March 2009

8
6
4
2
0
-2
-4
-6
-8
-10
-12 China India Indonesia Chile USA UK Thailand Japan

Source: Bloomberg

Table 1: Sensex’ Return on Capital vs. GDP One Year Forward

Return on Capital (30 Sensex companies) GDP 1 Year Forward
FY02 16.21 3.7
FY03 22.22 8.4
FY04 15.72 8.3
FY05 25.89 9.3
FY06 21.02 9.7
FY07 22.35 9.1
FY08 20.14 6.7
Correlation: 62.84%
Source: Bloomberg and author's calculation

first quarter, January to March 2009, Chart 4 compares GDP
growth for a few countries. India and China clearly outper-
form their peers.
Taking Stock of the Stock Market…
The Indian stock market is a good indicator of its gross
domestic product, one year forward. Return on Capital is
positively correlated with GDP a year forward (see Table 1). In
simple words, the higher the return on capital in the Stock
market, the better the growth prospects. Since India and
China have outperformed the global markets so far, it is highly
likely that their GDP growth one year forward will outper-
form the rest.
while looking at the India story are the sturdy GDP
numbers, the ability of the Sensex to indicate the same
and the very nature of the Indian market which ensures a
strong domestic demand. As they say in cricket, “Form is
temporary, class is permanent”. Similarly, while there
may be hiccups on the way but the Indian market is
fundamentally an attractive market and has a lot going in
its favour.
References and Additional Thinking
• Bloomberg
• Central Statistical Office, for data on Gross Domestic
Product of India

Conclusion: Sensex, GDP and the Republic of India (The views expressed in the article are personal and do not
Essentially, the three things that one needs to delve into reflect the official policy or position of the organisation).

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Is Rising Share of Services

Inevitable for GDP
Growth?
Madhusudan Dutta
Professor, Sardar Patel Institute of Economics
and Social Research, Ahmedabad

T
he growth of the Indian economy at least over the
last one and a half decades is generally viewed as led
by the tertiary (or, service) sector. Many observers,
while appreciating the rapid growth of services exports in
recent times, take the soaring share of the tertiary sector in
gross domestic product (GDP) to be not very healthy; they
view growth through service expansion to be illusory to a
great extent as services are ephemeral. The implication seems
to be that the service-led growth does not reflect the inherent
strength of the economy. Vestiges of Smithian ideas of
productive and unproductive labour may be traced here.
Adam Smith (1776) considered only material goods to be
capable of generating economic growth through their use as
fi xed capital and wage goods. Rendering of services, however
dignified or important, was considered as unproductive
labour activity.
I find it somewhat uncomfortable to direct arguments in
terms of the service sector as a whole without going ad-
equately into the diverse characteristics of the component
activities lumped together just on the basis of their products
being intangibles. In fact, the classification of activities on
the basis of intangibility of product is only convenient and it
has a historical legacy; but it is not based on any inherent
strength or weakness of the relevant activities. A major part
of the service sector activities are related to the production

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Table 1: Shares in GDP*: Major Sectors Relative GDP shares of the major sectors – pri-
mary, secondary and tertiary – change in the course
Sector Primary Secondary Tertiary Intermediate Final of development in conformity with change in the
Service Service
structure of final demand. The associated change in
1950-51 57.5 14.7 27.8 11.3 16.5 the production process involves not only expansion
1955-56 55.5 16.5 28.1 12.1 16 in scale but also technical progress that includes
1960-61 52.9 18.3 28.8 13 15.8 emergence of new products and also change in the
1965-66 45.1 22.3 32.6 14.9 17.7 structure of production organization. Revolution in
1970-71 46.3 21.6 32.1 14.7 17.4 computing and telecommunications technology has
1975-76 44.2 21.7 34 15.7 18.3 given us several new products and it has changed the
1980-81 39.7 23.7 36.6 17.2 19.4 way work is done making way for greater specializa-
1985-86 36.3 24.8 38.9 18.1 20.8 tion and, so, splintering of activities. Coming into
1990-91 32.2 27.2 40.6 18.8 21.8 prominence of business process outsourcing is an
1995-96 28 28.1 43.9 21.9 22 example of the importance of this trend. Out-
2000-01 23.7 27.8 48.4 23.8 24.6 sourced services should be viewed as an integral
2004-05 20.4 27.3 52.3 26.6 25.7 part of the production process which they serve, as
*At factor cost, 1993-94 prices. they had used to be until they started to be out-
Source: Calculations based on various issues of National Accounts Statistics, CSO.
sourced. But the value-added in such services would
now be shown in the service sector even though the
of material goods; so much so that these services used to be, activities form an integral part of tangible or material produc-
in effect, included in the measure of production used to be tion. There are services like trade and transport which may
given by the erstwhile socialist countries as Net Material also be viewed as part of material production in the broader
Product (NMP). sense of production as stated above. It will be instructive to
take an example.
Classification of Sectors Consider companies like the Indian Oil
and their Dynamics: Rendering of Corporation Ltd. It refines crude petro-
The appellations – primary, secondary and services, however leum and distributes the products to the
tertiary – have historical roots. Primary dignified or consumers. The company thus performs
activities are extractive in nature and these two types of operations: refining, belong-
were supposed to cater to the most basic
important, was ing to the secondary sector and distribu-
needs of subsistence. The secondary activi-
considered as tion of products through trading cum
ties are transformative in nature and these unproductive transportation activity belonging to the
were viewed to be of the next order of labour activity tertiary sector. The company reckons its
importance. Tertiary activities are the performance on the basis of the whole
diverse set of residual activities basically of the nature of gamut of its activities. In order to satisfy the national account-
services; i.e., they do not result in any tangible product. ing classification the two types of operations (in fact, trans-
Though left out of the sphere of production by a considerable portation is also separated from trade) are taken into account
section of opinion for a long time, these services are now very separately. But that cannot blur the integral nature of the two
much considered as part of a country’s GDP. A modern man basic activities – refining and distribution. If the different
would not consider his car or television set to be more impor- activities were not reported separately the whole value added
tant than his education or security. That is reflected in his by the company would be reported in the industry sector
choice for services exerted through his expenditure. The because the company is known as a refiner (transforming
growing share of services in GDP reflects this choice because crude oil into refined oil and related products); that would
production is not sustainable without demand. raise the share of industry in GDP and correspondingly lower

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 W H A T ’S TH I S I N D I A B U S I N E S S ?

Table 2: Shares of Sub-sectors of the Tertiary Sector

Tertiary Shares in the Tertiary Sector
In GDP THR TSC Communication # Banking & DRB Business Service# CSP
Insurance
1950-51 27.8 31 12.2 1.4 3.4 19.8 1.5 33.7
1960-61 28.8 34 13.7 1.7 4.4 16.2 1.3 31.7
1970-71 32.1 33.9 14.6 2.2 5.2 13.1 0.9 33.2
1980-81 36.6 33.3 17 2.6 6.3 11.5 1 31.9
1990-91 40.6 30.9 15.3 2.5 10.3 13.6 1.5 30
1995-96 43.9 31.8 15.8 3.3 12.7 13.3 3 26.4
2004-05 52.3 30 20.6 9.1 12.5 11.6 4.3 25.3
*At factor cost, 1993-94 prices.
# Communication is a part of TSC and Business Services is a part of DRB.
Abbreviations – THR: trade, hotels and restaurants; TSC: transport, storage and communications; CSP: community, social and personal services; DRB: Dwellings, real estate and
business services.
Source: Calculations based on various issues of National Accounts Statistics, CSO.

the share of services without any consequence for the size of financial institutions.
the GDP. All the countries of the world do not have equally
developed national accounting system. Separating different Intermediate and Final Services:
types of activities within a company requires a very well Considering the inter-linkage among activities as discussed
developed accounting tradition. Surely, this makes the above, instead of taking the tertiary sector as a single block it
sectoral shares of different countries non-comparable to should be instructive to divide it into two parts – intermediate
some extent. services and final services. Services that are not directly
In the same way it should not be very difficult to see the associated with material production are public administrative
intimate relationship between finance and services, education and health, dwellings,
the above activities. The more advanced The financial miscellaneous personal services and a part
does the corporate structure become, the services growth of transport, communications and finan-
more intimately do the companies get reflects the growth cial services enjoyed as personal consump-
connected with financial institutions. Thus tion. These services together with service
the development of financial institutions
of other activities exports constitute final demand for
may be viewed as an adjunct to the
that use these services. The rest of the services, account-
development of the industrial structure; services as an ing for a major part of value-added in the
the two developments are synergistic. In intermediate input tertiary sector, are intermediate services
fact, the greater part of what is shown as forming an integral part of the production
output in financial institutions is deducted from the output in process using them. Secondary sector is the dominant source
the productive sectors using the services as an intermediate of their demand.
input. As such, and to that extent, the growth of financial In fact, as the objective of productive activities is catering
services basically reflects the growth of other activities that to final demand a relevant question in understanding the
use these services as an intermediate input. This is unlike the sectoral shares is how the composition of final demand has
growth of final service like personal, social and community changed in the course of development. It is generally
services. Determination of value-added in financial services is expected that with rise in per-capita income relative impor-
basically a question of distribution of value added between tance of services in private and public consumption rises
cooperating sectors. Indeed, there is much uncertainty (Wagner’s law). But whether intermediate services like
regarding the proper treatment of value added by different trade, transport, etc., should grow faster than other activities

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G R O W T H E C O N O M I C S
Table 3: India’s Exports and Imports ( as % of GDP unless otherwise specified)
Period 1971-1981 1981- 1991
Export of Goods and Services 5.29
Export of Services 0.85
Export of Services as % of Total 15.58
Import of Services 0.56
Source: Rakshit (2007)
should depend, among other things, on the evolving sectoral
structure of production.
Sectoral Shares in the Indian Economy:
Table 1 presents the relative shares of the three major sectors
in GDP. The secondary sector includes mining, manufactur-
ing, construction and the utilities electricity, gas and water
supply. We have divided the tertiary sector into two catego-
ries: intermediate and final services. We have used input-
output transactions tables for the Indian economy to compute
intermediate services that include the whole of trade and parts
of transport, communications, finance and
business services used as intermediate
input. The rest are final services, which Intermediate
include Community, Social and Personal services share is
services (CSP) as well as parts of other just above 40%
services treated as final use.
of all services in
It is seen that the share of the tertiary
sector increased by about 13 percentage
1950-51 and it
points in the first four decades after increased to 50%
1950-51 but it rose further up by about 12 in 1995-96
percentage points in only the next one and
a half decades. This is a striking development and naturally it
has caught the attention of observers. The share of the
secondary sector also rose by roughly the same magnitude as
that of the tertiary sector in the first four decades but in the
subsequent period its share remained stagnant. Thus the
tertiary sector captured the whole of the share lost by agricul-
ture (primary sector) in the nineties and thereafter.
Table -2 presents relative shares of sub-sectors of the
tertiary sector. THR (trade, hotels and restaurants) consti-
tutes the largest sub-sector of the tertiary sector since mid-
fifties. Though CSP (it includes public administration and
defence as well as education, health and miscellaneous
services) has remained close to the THR we should keep in
96 THE IIPM THINK TANK
1991-2005 1996-2005 2000-2005
6.29 11.85 13.2 15.1
1.46 3.44 3.59 4.58
23.27 24.21 26.44 29.9
1.02 2.7 2.79 3.36
mind that CSP combines really a group of diverse activities.
THR’s share in the tertiary sector increased during the first
fifteen years but then the share gradually declined. Neverthe-
less, as the tertiary sector itself raised its share all through,
trade’s share in GDP increased, all through from roughly nine
percent to 15 percent; thus the sub-sector was more than half
the size of the secondary sector as a whole most of the time.
Naturally, one will want to know why and how it was so. We
will take up the question below.
Transport, storage and communications (TSC) increased its
share in the tertiary sector very fast during the last ten years,
but this is entirely explained by the growth
of communications service, which grew
particularly fast during the period. The
other growth story that cannot escape
attention is (computer related) business
services. In fact communications and
business services together explained only
four percent of the tertiary sector in
1990-91 but then grew to as much as 13.4
percent of the sector in 2004-05. This
meant that communications and business
services together explain five percentage point (out of
12-point) rise in the GDP share of the tertiary sector during
the last fi fteen years.
Table-1 shows that intermediate services constituted just
above 40 percent of all services in 1950-51. The share in-
creased to around 50 percent in 1995-96 and more or less
stayed there since then. Thus over the first four and a half
decades the growth of intermediate service has been faster
than that of final service. However, if we look at the last one
decade, intermediate and final services almost maintained
parity. The fact that the growth of the tertiary sector is
explained equally by the intermediate (of which industry is the
main source of demand) and final services implies that
 W H A T ’S TH I S I N D I A B U S I N E S S ?

Table 4: Private Final Consumption Expenditure at current prices (Percentage Distribution)

YEAR 1960-61 1970-71 1980-81 1990-91 2000-01 2005-06

1.Food, Beverages & Tobacco 59.5 62.5 58.1 54 47.3 39.4
1.1 Hotels & Restaurants 0.6 0.6 0.8 1 1.4 2.3
2.Clothing & Footwear 5.1 4.9 6.3 6.2 4.6 5
4.Gross Rent,Fuel & Power 21.9 17.3 15.3 13.6 11.4 11.8
5.Furnitures 2.7 3.1 3.3 3.5 3 3.6
6.Health 2.3 2.8 4.4 3.8 7.3 6.5
7.Transport & Communications 2.6 2.9 4.5 9.8 14.2 19.1
8.Recre,Education etc. 2.1 2.5 2.5 3.1 3.6 4.2
Sub-total (rows 6 through 8) 7 8.2 11.4 16.7 25.1 29.8
9.Misc. 5.3 4.7 5.5 6.1 8.6 10.3
Total 100 100 100 100 100 100

Source: CSO, different years, National Accounts Statistics

roughly half of the growth of the service sector is explained activities – outsourcing certain functions and sub-contract-
by the growth of industry at a time when industry generally ing the production of numerous components (think of
failed to raise its relative share in GDP. This is a fundamen- automobiles and electronics goods). Shift from single stage
tal point for understanding the growth of relative share of to multi-stage production process adds to the ‘depth’ of the
the tertiary sector. process. As a result there has been enormous increase in
trade within industries. Of course,
Demand for Intermediate Services: vertical integration is known to be a
A very prominent example of intermedi- Service intensity means of cutting transactions costs but
ate services is distributive trade. Its of the secondary there are limits to such strategies in the
demand is wholly a derived demand, i.e., sector itself face of growing competition and speciali-
demand arising form demand for com-
increased over zation; and the contrary trend is strongly
modities distributed through traders. felt in East-Asian markets. The Indian
Also, transport is intimately related to
time, as can be economy, one presumes, is not free from
trade, so a very large part of the demand verified from the such effects and these effects should
for transport services is derived demand research data affect the intermediate input coefficients
too. Let us take an example. Milk dairy of the relevant sectors.
movement has led to value addition in the processing of What we have talked about trade and transport services is
milk. In the absence of processing, milk would be considered roughly valid regarding demand for a large part of fi nancial
a product of animal husbandry included in the primary services also. The three broad groups involving these
sector, and it would be distributed largely without the services account for roughly three-fourths of value-added in
intermediation of traders. Milk processing has led to rise in the service sector of the Indian economy in recent times
value addition not only in food processing industry but also (Table-2). In order to understand why such services grow so
created demand for trade and transport of processed milk fast we just have to understand that the secondary sector
and milk products. The example being a part of everybody’s uses the above services in the highest intensity. So as the
daily experience, one can readily relate the rise in trade and share of the secondary sector rises the share of these serv-
transport services to the ‘spread’ of industry. ices also rises. Furthermore, service intensity of the second-
At a more sophisticated level we can look at the ongoing ary sector itself increased over time. This can be verified
global integration process. The multi-national companies from the input-output transactions tables for the Indian
strive at reducing their costs by de-verticalizing their economy (not shown here).

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G R O W T H E C O N O M I C S
Structure of Final Demand:
Given the input-output structure, the composition of the fi nal
demand vector determines the composition of output and, so,
the sectoral structure of value added. The final demand vector
may be viewed as having two parts – one endogenous (deter-
mined by disposable income) and the other autonomous.
Income determination requires that, given the autonomous
final demand, the endogenous final demand must be such that
the aggregate final demand vector is just equal to the vector of
net output. To explain the relative share of the tertiary sector
within this structure we look at the changing composition of
final demand.
It is observed from Table-3 that the average of India’s total
exports in the decade of the 80’s was about 6.3 percent of
GDP and this figure rose to 15.1 in the quinquennium ending
in 2004-05. Out of this roughly nine percentage point in-
crease, the contribution of services was more than three
percentage points. Since the share of services in total exports
in the 80’s was less than a quarter of the total, the above
phenomenon implies, and it is observed form the table, that
services’ share in total exports increased subsequently. This is
a very encouraging picture so far as services production is
concerned and it definitely goes some way in explaining the
rising share of the tertiary sector in GDP particularly in view
of the fact that services make relatively little use of industrial
products as intermediate inputs. However, one cannot lose
sight of the fact that import of services also increased fast
during the same period. So, the growth of net export of
services was not as fast. Nevertheless this net export being an
autonomous component of final demand for services, it
constituted a new source of stimulation of GDP growth as well
as a relative growth of the share of the service sector in GDP.
Now, for the induced part of final demand for services, a
very important source of change in the relative importance of
services is rise in per-capita income. When the rise in per-
capita income is accompanied by rise in income inequality the
change in relative share of services may indeed be sharp.
Table-4 gives an idea of this change for the Indian economy
over the period 1960-61 to 2005-06. During this period
private final consumption expenditure (PFCE) on transport
and communications, education, health and recreation
increased from a paltry seven percent to as much as 29.8%.
We note that PFCE on services as a whole increased from
17.8% to 40.6% over the last two decades and a half. But this
98 THE IIPM THINK TANK
impact got a bit softened buy the fall of PFCE as a proportion
GDP at market prices roughly from about 75% to 65%. Even
then it is clear that there was a large shift in fi nal demand from
goods to services. Such shifts in demand from goods to
services inevitably lead to a substantial increase in sectoral
share of services.
Towards a Conclusion:
Our discussion above shows that in the process of growth of
the Indian economy the weight of services in private consump-
tion expenditure increased markedly. Demand for industrial
products also increased rapidly for private consumption as
well as capital formation. This is evidenced by the share of the
secondary sector in GDP. This resulted in growing ‘spread’
and ‘depth’ of industry. The growth of industry led to faster
growth of demand for intermediate services. Thus, on the
whole, the service sector has grown rapidly, through demand
for both final and intermediate services, following the intrin-
sic logic of development.
References and Additional Thinking
• Baumol, W. J. (1967), "Microeconomics of Unbalanced
Growth: The Anatomy of Urban Crisis", American Eco-
nomic Review, Vol.57, June.
• Datta, M (2001), The Significance and Growth of the
Tertiary Sector: Indian Economy – 1950 to 1997,
Kuznets, S.(1971), Economic Growth of National : Total
Output and Production Structure, The Belknap Press of
Harvard University Press, Cambridge, Massachusetts.
• Rakshit, M. (2007), Services-led Growth: the Indian
Experience, Money and Finance, III (1), New Delhi.
• Smith, A. (1776), An Inquiry into the Nature and Causes of
the Wealth of Nations, Cannan, E. (ed), The Modern
Library, New York.
• Wagner, A. (1883), Three Extracts on Public Finance,
Extracts from Finanzwissenschaft, Part I, Third Edition,
Leipzig, reprinted in Classics in the Theory of Public
Finance, Musgrave, R.A. and Peacock, A.T. (eds), 1958,
Macmillan, London.
• World Bank (2004), Sustaining India’s Services Revolution,
Report on the South Asia Region: India.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation).
G R O W T H E C O N O M I C S

Modern Theories of
Growth: A Critique

1 0
100 THE IIPM THINK TANK

Chanadana Ghosh
Economic Research Unit, Indian
Statistical Institute (ISI), Kolkata
Ambar Ghosh
Economics Department, Jadavpur
University, Kolkata
1. Introduction
The objective of the modern theory of growth is to explain the
growth in the trend values of aggregate output and employ-
ment. Its focus is therefore on the long run. It is based on the
Natural Rate Hypothesis (NRH). The NRH states that in the
short run a market economy behaves in accordance with the
Keynesian theory, while the classical theory best describes its
behaviour in the long run. The NRH in its turn is based on the
concept of natural rate of unemployment. It
is defined as the rate of unemployment that In the long run
obtains when demand for and supply of we are in the
labour are equal. But, why should there be
world of the
unemployment in such a situation? The
exponents of the NRH have given two
classical theory,
major reasons, namely, imperfect informa- where output is
tion and imperfect spatial and occupational determined by the
mobility of labour. Even if there are supply side factors
vacancies and an equal number of suitable
unemployed people, firms may not have the information
regarding the availability of suitable candidates and unem-
ployed people may also lack information regarding the avail-
ability of suitable vacancies and both the parties may have to
spend some time searching before the vacancies get filled up.
By the time one set of vacancies gets filled up, another set of
vacancies is created and a new group of people enter the labour
market. This is how unemployment may persist, even when
demand for and supply of labour are equal. Similarly, concen-
trations of unemployment and vacancies may be in different
geographical areas and occupations and hence unemployment
may persist despite matching number of vacancies because of
imperfect mobility of labour. It is assumed that because of shifts
A N E L U S I V E Q U E S T
in aggregate demand for final goods and services the rate of
unemployment is above the natural rate in times of recession
and below it in times of boom so that the trend value of the rate
of unemployment equals the natural rate in every year. In other
words, in the long run, the economy is always in the situation of
full employment. The growth in the trend values of output is
therefore due to growth in the supplies of labour and capital
and also due to technological progress that brings about shifts
in the production function. Accordingly, in the long run we are
in the world of the classical theory, where output is determined
by the supply side factors. The NRH invokes the Keynesian
theory only to explain the deviation of the actual rate of
unemployment from its trend value in every year (or in every
short period, which is a year at the maximum). The NRH thus
neatly compartmentalizes the study of the behaviour of aggre-
gate output and employment into two separate fields: one
analyses the trend values of output and unemployment and the
other focuses on deviations of actual values of aggregate output
and employment from their respective trend values in different
short periods. The former constitutes the long run macroeco-
nomics, while the latter is the subject of short run macroeco-
nomics.
The importance of NRH can therefore
hardly be overestimated in macroeconom-
ics today. Accordingly, it is imperative to
subject it to close scrutiny. The proponents
of NRH point out that no one has ever
observed an economy without unemploy-
ment. However, at the same time they find
it hard to believe that a market economy
never achieves full employment. They
refuse to subscribe to the view that demand deficiency and
involuntary unemployment may be, as held by Keynes and also
by the Keynesians in the hey days of Keynesianism, the natural
state of affairs in a market economy. Instead, they assume that
there exists unemployment even in situations of full employ-
ment and invokes imperfections in information dissemination
and mobility of labour to explain that. They point out that an
economy is always in a state of flux. Not only does the aggregate
demand fluctuate, so also does the composition of aggregate
demand. The shifts in the composition of aggregate demand
engender switch in demand from one kind of labour to another
and also from goods and services produced in one region to
those produced in another region. Following the innovations of
THE INDIA ECONOMY REVIEW 101
G R O W T H E C O N O M I C S
computers, for example, demand switched to computers from
typewriters and thereby to computer operators from typists.
This kind of shifts in demand is referred to as sectoral shifts.
Since sectoral shifts occur all the time in market economies, it is
argued, unemployment is inevitable in such economies because
of imperfections in information dissemination and imperfect
mobility of labour across occupations and regions, even when
aggregate demand for and aggregate supply of labour are equal.
The kind of unemployment that is given rise to by the sectoral
shifts on account of the imperfections noted above is called
frictional unemployment.
The above argument, though seems plausible superficially,
wilts when subjected to close scrutiny. Let us explain. First,
focus on the case of imperfect information alone and ignore
imperfect mobility of labour, i.e., assume for the present that
information is imperfect, but labour is perfectly mobile. Start
from a situation of full employment.
Suppose there takes place a change in the Demand
composition of demand in favour of one
industry at the expense of another. The
deficiency and
favoured sector will recruit and expand, involuntary
while the other sector will downsize. It is unemployment
argued that this will lead to unemployment are chronic
as the contracting sector will release labour, in decentralized
but the expanding sector will take time to
recruit because of lack of information
market economies
regarding the availability of suitable unemployed candidates.
The unemployed workers will also take some time to collect
information regarding the availability of suitable vacancies. This
argument does not seem acceptable. Reasons are the following.
First, in this age of information revolution, there are a large
number ways of advertising vacancies. There are numerous
news papers, TV channels, internet and so on. Information can
be made available and recruitments can be done within a very
short period of time. Second, firms also take time to sack, if they
think that the change is temporary, as it is costly to train new
recruits, to make them adapt to the new environment, to learn
about their skills, sincerity, honesty etc. This phenomenon is
referred to as labour hoarding and it is quite common. Firms
downsize only when they think that the shift is a long term one.
Finally, if sectoral shifts are regular and important, as the
proponents of NRH emphasize, the workers are always under
the threat of losing jobs, while firms are also under the threat of
losing profit because of the delay involved in filling up vacan-
102 THE IIPM THINK TANK
cies. Under these circumstances it is quite natural that institu-
tions and practices will emerge to take care of the problem.
Employment agencies will emerge to place the workers appre-
hending job cuts in firms expecting a favourable turn in de-
mand. Firms of repute are likely to emerge specializing in
supplying suitable candidates to firms immediately on demand.
These firms will act as an intermediary between workers under
the threat of losing jobs and workers about to enter the labour
market on the one hand and the firms seeking to expand and
hire on the other. Hence unemployment given rise to by
imperfections in the information dissemination system does not
stand up to close scrutiny. It should be particularly unaccept-
able to those who believe in the efficacy of the market mecha-
nism. Ironically, it is those very people who harp on the imper-
fections in information dissemination.
Let us now consider the case of imperfect mobility of labour.
Start from a situation of full employment
and consider a shift in demand in favour of
doctors at the expense of engineers, giving
rise to excess demand for doctors and just
the opposite for engineers. If wages and
prices are perfectly flexible, they will adjust
and clear markets for both types of labour.
There will be no unemployment in this case.
However, if wages and prices are rigid,
sectors employing doctors will not expand
because of shortages of doctors, but those employing engineers
will contract. In this case, the impact of the demand shift is
similar to that of a contraction in aggregate demand. Engineers
become involuntarily unemployed – as they are willing to work
at the going wage rate for the engineers and an increase in
aggregate demand will reduce their unemployment. Two points
emerge from the above example. First, sectoral shifts create
unemployment if and only if wages and prices are rigid. The
unemployment is therefore involuntary. Second, if sectoral
shifts are accompanied by price rigidity and give rise to unem-
ployment due to imperfect mobility of labour, they will in no
time snowball into full fledged recessions. The contracting firms
will cut output, but the firms planning expansion will fail to do
so because of paucity of suitable labour. Aggregate income will
therefore fall reducing aggregate demand and thereby inducing
further cut in aggregate output. The contracting firms will lose
and therefore will be in financial difficulty. Default rate will rise
putting the lending institutions in trouble. They will ration

credit more severely. It will reduce demand again. These
contractions will mutually reinforce and cumulate and push the
economy in a recession. From the above it follows that, if
unemployment is due to sectoral shifts, there is rigidity in the
price system. Moreover, if sectoral shifts combine with price
rigidity and imperfect mobility of labour, they generate strong
recessionary forces. If one admits that sectoral shifts, price
rigidities and imperfect mobility of labour are common features
of market economies, as the proponents of the NRH do, one
also concedes that a market economy is normally recession
prone and demand deficiency and involuntary unemployment
are rules rather than exceptions. In other words, the implica-
tion of the assumptions of the proponents of the NRH is that
demand deficiency and involuntary unemployment are chronic
and systemic in decentralized market economies. Sectoral shifts
that generate unemployment are hardly as innocuous as the
proponents of the NRH make us believe.
They have strong destabilizing and contrac-
In a market
tionary impact. Thus, in a market economy
today, it is sensible to regard the observed
economy today,
unemployment as being involuntary - a it is sensible
product of wage rigidity and inadequacy of to regard
aggregate demand. The latter is due to the observed
various factors including sectoral shifts.
unemployment as
Even though the mismatch between the
structure of labour demand and that of
being involuntary
labour supply has been attributed to
sectoral shifts in the above discussion, it can occur even without
any kind of sectoral shifts. It is a general feature of market
economies. Let us explain. Consumption decisions and deci-
sions to invest in physical and human capital in such economies
are taken by individual economic agents independently of one
another in an uncoordinated manner. Individual decision
makers cannot have any idea as to what the total demand would
be for any particular good or for any particular type of labour or
what the total supply would be of any particular type of labour.
The input-output relationships across different sectors of
production and different types of labour change continuously
with innovations of new technology, products etc. Individuals
do not and cannot have information regarding these relation-
ship or their changes. Accordingly, structure of labour demand
that is yielded by the composition of aggregate demand and the
structure of labour supply that arise out of individuals’ invest-
ments in different kinds of human capital can match only
A N E L U S I V E Q U E S T
accidentally. The phenomenon of sectoral shifts makes the
scenario more unpredictable. Moreover, prices and wages are
also normally rigid because of different kinds of market
imperfections. Hence, involuntary unemployment and demand
deficiency are likely to be chronic and systemic in unplanned
market economies.
Let us generalize the above argument. Mismatches in
demands and supplies of the kind discussed above are by no
means confined to labour markets alone. They apply to physical
capital also with equal force. Capital too is imperfectly mobile
across different industries. A steel plant can only produce steel;
it cannot produce power or any other product. A mismatch
between the structure of demand for capital services yielded by
the composition of aggregate demand and the structure of the
supply of capital services is also quite likely to occur in market
economies. Thus, even though aggregate demand for capital
services equals their aggregate supply, there
may be excess demand for one kind of
capital service (such as the ones producing
power or transport) and excess supply of
some other kind (such as the ones produc-
ing consumer durables). If prices are rigid,
as is normally the case, because of oligopo-
listic interdependence in case of private
goods and administered prices in case of
public goods, these mismatches will not get
corrected through movements in prices in
the short run. Let us illustrate with an example. Suppose in a
given period, there occurs in an economy excess demand for
roads, water supply etc and an excess supply of consumer
durables. Prices of the former are non-existent, as they are
public goods. Hence they cannot rise to correct the situation.
Prices of the latter may not fall either because of oligopolistic
interdependence. Hence the situation will give rise to substan-
tial excess capacity in the consumer durables industry saddling
the investors with heavy losses. We can show the problem in a
different way also. Since different sectors of production are
interdependent through input-output relationships, investments
made in different lines of production in any given period have
to synchronize to ensure full utilization of capacity for the
economy as a whole. In the example given above, the capacity
output of the road and water supply sector is too low to enable
the rest of the economy to fully utilize its productive capacity. In
this kind of a situation, serious economic problems will arise
THE INDIA ECONOMY REVIEW 103
G R O W T H E C O N O M I C S

leading to recession. In the sectors having excess supply of
capital, a substantial part of expensive capacities created will
remain unutilized and the investors will incur heavy losses.
They are likely to default on their loan obligations creating
financial difficulties for the banks and other lending institu-
tions. These institutions’ ability to lend will
get restricted. They will also be more
cautious in their lending. This will reduce
credit supply and consequently aggregate
demand, which will further aggravate the
situation pushing the economy into
recession. The kind of problem specified
above is and should be systemic in market
economies since consumption decisions
and decisions to invest in physical and
human capital are made by individual
consumers and investors in an uncoordinated manner and
prices are rigid for reasons already discussed. This problem is
referred to as that of coordination failure. It is called dispro-
portionality crisis by Marx. This is a, if not the, major factor
that makes a market economy recession prone. Alternatively, it
makes demand deficiency a chronic problem in a market
economy. In times of high rate of growth or boom, when
capacities are created at a high rate in different areas of
production in an uncoordinated manner, the problem of
coordination failure makes newly created expensive capacities
idle in different lines of production due to scarcities of certain
specific kinds of labour or shortages of some crucial inputs
badly hurting investors’ morale, even
though there may be sizeable excess
Prices and wages capacity and unemployment on the
are often found aggregate. This has, as we have already
to be inflexible pointed out, adverse financial implications,
downward, but which push the financial institutions on the
back foot aggravating the damage to
they are not so business sentiments. The problem of the
in the upward real sector gets magnified through its
direction in deficits impact on the financial sector. This process
is referred to as that of financial accelerator
– see Bernanke et al.(1998). These mutually reinforcing forces
push the economy into recession much before the state of full
employment is reached. Again, in an economy in recession,
with the increase in the pool of unemployed workers, availabil-
ity of all kinds of workers becomes plentiful; supplies of social
goods improve due to governments’ efforts at stabilizing the
economy and with the easing up of fiscal constraints on public

Table 1 : Y-o-Y Growth rates of India's GDP and Its Components at Constant Prices:

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

GDP 4.0 5.2 3.8 8.4 8.3 9.2 9.7 9.2 7.1
1
Agriculture -0.2 0.8 1.8 10.0 0.0 5.9 3.8 5.1 2.6
Industry 6.4 2.4 6.8 6.0 8.5 8.0 10.6 7.5 4.2
Services 5.7 6.9 7.5 8.8 9.9 11.0 11.2 11.1 9.2
2
(I) -3.5 -2.9 17.0 19.9 19.5 19.4 10.9 16.9 9.7
3
(I – MC) -3.8 -4.0 15.1 19.5 19.1 16.8 9.3 19.0
4
C 3.2 6,2 2.7 5.8 5.2 8.7 7.1 6.5 6.8
5
G 0.9 2.3 -0.4 2.6 2.6 5.4 6.2 7.0 16.8
Exports 18.0 1.5 17.8 10.8 32.3 20.2 21.8 4.6 21.5
6
ELEM 23.9 1.1 17.2 10.4 33.4 22.9 25.6 5.1
Imports 8..2 1.5 17.7 12.6 35.1 27.9 24.4 8.2
Remittances 5.7 22.3 3.8 20.6 -13.3 12.9 10.0 24.1
1
Agriculture includes forestry and fi shing
2
I stands for gross investment
3
(I-MC) stands for gross investment net of import of capital goods
4
C denotes private fi nal consumption expenditure
5
G denotes public fi nal consumption expenditure
6
ELEM stands for exports net of export related imports
Source: CSO

104 THE IIPM THINK TANK

 A N E L U S I V E Q U E S T

expenditure. With idle capacities everywhere, supplies of all
kinds of goods become more abundant too. These improve-
ments in supply side factors again begin to boost business
morale leading to a resurgence in economic activities. The
point of this whole discourse is that price rigidities and mis-
matches between the structures of aggregate demand and
those of capital and labour due to coordination failure are an
integral feature of a market economy. They are systemic and
generate chronic demand deficiency and involuntary unem-
ployment. They are the main reason why booms turn into
recession much before the state of full employment is reached.
Even the current recession in the US ravaging the developed
world has its roots in massive over-investments in the real
estate far in excess of genuine demand for housing. The reason,
again, lay in large scale coordination failure. The increasing
profitability of investment in the housing sector led to tremen-
dous overinvestment in housing precipitating the crash.
It thus seems more sensible to regard the observed unem-
ployment in a market economy as being involuntary. Apart
from the argument spelt out above, there are other factors that
tend to make aggregate demand deficient. People have to save
to fend for old age, infirmity etc. Hence consumption demand
usually falls far short of aggregate output. Investment is highly
risky and people are generally risk averse. Government expend-
iture is subject to severe budget constraints, given governments’
obsession with revenue and fiscal deficits. For these reasons also
demand deficiency may be the norm rather than an exception.
Even casual empiricism shows that nominal prices are fairly
rigid and there is no dearth of supplies of goods and services at
their given prices. If demand deficiency and involuntary
unemployment are chronic, it means that in times of recession
the rate of involuntary unemployment is large and it is small in
times of boom. Besides the factors noted above, there is
another reason why a market economy may fail to achieve full
employment. Usually, there is an asymmetry in the price
adjustment processes. Prices and wages are often found to be
inflexible downward, but they are not so in the upward direction
in the event of shortages. The reason is not far to seek. First

Table 2 : Cross Country Comparisons of Various Economic Indicators

Country Growth Rate Contribution Contribution TFP Growth Per Capita

GDP Capital Labour Rate Growth
Rate
OECD Countries 1960-1995
Canada 0.0369 0.0186 0.0123 0.0057 0.0077
=0.42
UK 0.0221 0.0124 0.0017 0.008 0.0175
=0.37
US 0.0318 0.0117 0.0127 0.0076 0.0201
=0.39
Japan 0.0566 0.0178 0.0125 0.0265 0.0276
=0.43
East Asian Countries 1966-1990

Hong Kong 0.073 0.03 0.02 0.023 0.019

=0.37
Singapore 0.087 0.056 0.029 0.002 0.0279
=0.49
South Korea 0.103 0.041 0.045 0.017 -0.047
=0.30
Taiwan 0.094 0.032 0.036 0.026 -0.0444
=0.26
Source: Estimates of OECD countries are taken from Jorgenson and Yip(2001)
Estimates of East Asian countries are taken from Young (1995) (QJE,110,August,641-680).
The last column is the authors’ own calculations.

THE INDIA ECONOMY REVIEW 105

G R O W T H E C O N O M I C S

Table 3: Saving Ratio and Per Capita Income in India (1950-51 – 2006-07) recession and firms have insufficient
demand for their products. A
1950s 1960s 1970s 1980s 1990s 1991-92 – 1997-98 – 2003-04 - unilateral cut in wages in such a
1996-97 2002-03 2006-07
situation and the consequent adverse
s1 9.7 12.3 17.2 19 23 22.7 24.1 32.7
response of the workers may be
y2 6737 7888 8880 10691 14761 14012 17812 22776 enormously costly to the firms. Any
1
2
s represents gross domestic savings as percentage of GDP kind of supply failure in such a
y represents per capita GNP at factor cost at constant 1993-94 prices. It is measured in Rupees (crore).
Source: CSO scenario may lead to a sizeable loss
in market share and this loss may far
consider the prices of produced goods and services. Markets of outweigh the gain due to the wage cut. There are also minimum
these goods are oligopolistic. When there is excess capacity in wage legislations setting floors to money wages. In the event of
the firms, no firm risks cutting its price unilaterally, as it will labour shortages, however, firms can offer higher money wages
lead to a price war saddling all the firms with losses. When all without the adverse consequence noted above. This explains the
firms in an industry engage in competitive price cuts, it has asymmetry in the price adjustment mechanism. This asymmetry
ruinous implications for them all. But in times of shortages, coupled with the problem of coordination failure may check
firms may unilaterally raise their prices, as there is no risk of output expansion in times of boom much before full employ-
losing customers to the rivals, since every producer is capacity ment is attained. Let us explain. Capital structure and labour
constrained. In case of labour, as Keynes pointed out, money structure, as we have already explained, are far from balanced
wages do not fall in the face of unemployment on account of in market economies, given the lack of coordination among the
workers’ resistance. Worker unions resist such cuts. Firms may individual decision makers and that of information. Hence, as
also consider it imprudent to cut wages despite workers’ aggregate demand rises relative to productive capacity, short-
resistance unilaterally to earn the infamy of being a bad ages of various kinds of goods and labour begin to crop up
employer. If a firm gets singled out as a bad employer, it will not putting upward pressure on prices. This is the standard trade-
be able to retain or get to recruit the best of the workers and off between inflation and unemployment that the traditional
thereby will lose out in competition. Unemployment and Phillips curve captures. Since the government and the central
recession go hand in hand. In times of unemployment, there is bank do not want the rate of inflation to rise beyond some
tolerable levels, they may adopt contrac-
Table 4: Average Annual Growth Rate (%) of Gross Domestic Product tionary programmes much before the full
Average Annual Growth PPP per capita Rank employment level of output is reached.
Rate (%) of GDP GNP ($) This may also be one of the reasons why a
Country 1990 -2000 2000-2004 2004 2004 market economy never attains full
Low Income Countries 4.7 5.5 2258 employment. In this case, even though
Middle Income Countries 3.8 4.7 6644 prices move in the upward direction, it
High Income Countries 2.7 2 31009 cannot do so fully to adjust the pattern of
China 10.6 9.4 5890 108 demand to that of supply owing to
government intervention.
Vietnam 7 7.2 2700 149
Once we accept that demand deficien-
Ireland 7.5 5.1 32930 8
cy is chronic, a position which seems to
India 6 6.2 3120 144
be much more sensible and logical than
United States 3.5 2.5 39820 3
the NRH, the sharp division between the
United Kingdom 2.7 2.3 31430 14
short run and long run analyses in
Japan 1.3 0.9 29810 18
macroeconomics dissolves altogether.
France 2 1.5 29460 20 The focus shifts to the year-on-year
Source: World Development Indicators 2006, The World Bank growth rates, which have to be explained

106 THE IIPM THINK TANK


using the short run models only.
The above observations throw the area of growth wide open.
It need not necessarily be the exclusive preserve of long run
macroeconomics that focuses solely on the supply side factors.
It may be better to study growth by focusing on the year-on-year
growth using the Keynesian models. The short run Keynesian
model determines Y or Yt . Given Yt-1 , it determines a growth
rate as well. Growth rates in a market economy fluctuate a great
deal, but they do so within limits. Growth rates usually follow a
cyclical pattern. Periods of high growth rates are followed by
those of low ones and vice versa. Consider, for example, the
figures in Table 1, which shows that India was in recession
during 2000-01 to 2002-03. However, this phase was followed by
a period of high growth from 2003-04 to
2007-08. The growth rate slumped a little
again in 2008-09. Thus the growth rate The neoclassical
neither goes on rising steadily over time nor theory of growth
does it keep on falling monotonically, even states that a
though the average or the trend growth rate
market economy
may show a tendency to rise, as is the case in
India. These fluctuations in year-on-year
in the long run
growth rates are best explained using the eventually attains
short-run models. It should be noted in this steady state
context that in India both demand and
supply constraints operate at the same time and this makes the
study of growth much more complicated. Let us elaborate. Even
casual empiricism shows that in India prices of privately
provided nonagricultural goods are highly rigid and there is no
dearth of these goods at these rigid prices. Hence outputs of
these goods are demand driven. However, there are many
publicly provided goods in India, which are supplied either free
of charge or at non-remunerative administered prices, and
there are marked shortages of these goods. These goods include
power, potable water, roads, water from major irrigation
projects etc. Outputs of these goods are capacity constrained.
Output of the agricultural sector is also given in the short run.
This is because agriculture is a nature process; production
requires a pre-specified period of time; and there is no scope
for adjusting output during the time that elapses between one
sowing season to the next. To explain growth in India’s GDP in
a given year, one has to therefore undertake a disaggregated
study. Growth in the privately provided non-agricultural goods
has to be explained in terms of growth in their demand, while
the growth in the publicly provided goods and agricultural
A N E L U S I V E Q U E S T
output will be determined by the growth in their productive
capacity due to investments in earlier periods. Note that
productive capacity in agriculture depends crucially on public
investment in major irrigation in dry land areas, flood control
facilities in areas prone to flooding, inventions of better seeds,
farming practices etc. The last two in India also depends
crucially upon public investment in agricultural R&D. Thus
Keynesian economics does not apply fully to Indian macro
economy. When GDP is demand driven, its growth can be
explained in terms of growth in the autonomous components of
aggregate demand, namely, investment, government consump-
tion and export. From the data in Table 1 one can compute the
growth rates of these components of aggregate demand. But the
sum of these growth rates, as one can easily
check, cannot explain fully the growth
performance of GDP in India during the
period under consideration – see in this
context Rakshit( 2009 ).
We shall now critically assess the major
theories of long run growth based on the
NRH. In fact, we shall discuss the pioneer-
ing work of Solow (1956) and the endog-
enous growth theory that it gave rise to and
evaluate the results they yield. The model
Solow(1956) developed is referred to as the Solow model or the
neoclassical theory of growth.
2. The Neoclassical Theory of Growth
The Solow model states that a market economy in the long run
eventually attains steady state. In the steady state per capita
growth rates of capital and output are equal to the rate of
technological progress, which we denote by m. The value of m is
exogenously given in the model. In the out of steady state
situations, however, per capita growth rate becomes a function
not only of m but also of the economy’s saving ratio, the rate of
depreciation and the rate of growth of population, denoted by s,
δ and n respectively. Like m, they are all parameters in the
Solow model.
Let us now examine whether or how one can apply these
results of the Solow model to explain the long run growth
performance of a country. In this context, two alternative
assumptions are possible. One may assume, for example, that in
the long run an economy is always in steady state. If this
assumption is made, per capita growth rate of GDP in the long
THE INDIA ECONOMY REVIEW 107
G R O W T H E C O N O M I C S
run must equal the rate of technological progress. This implies
that the rate of growth of the trend values of GDP should
exceed the trend rate of growth of the labour force by the rate
of technological progress. Surprisingly, none of the major
empirical studies carried out so far make this assumption.
Obviously, Solow model cannot explain long run growth
performance if the above assumption is made. In fact, data
given in Table 2 do not give any prima facie support to the result
of the Solow model. It shows that countries with high per capita
growth may have low total factor productivity (TFP) growth,
which is a measure of the rate of technological progress, and
vice versa. Thus UK with a per capita growth of 1.75 percent
had a TFP growth rate of 0.8 percent, while US with a higher
per capita growth of 2.01 percent recorded a lower TFP growth
rate of 0.76 percent. The result becomes all the more startling
when we find that South Korea and Taiwan with negative per
capita growth rates of -4.7 percent and -4.4 percent had TFP
growth rates of 1.7 percent and 2.6 percent respectively. Hong
Kong, whose per capita growth rate of 1.9 percent was close to
that of UK registered a substantially higher TFP growth rate of
2.3 percent. Thus the data do not seem to support the result of
the Solow model, if we assume that the economies in the long
run are more or less in steady state all the time, i.e., the trend
values of the endogenous variables of the Solow model reflect
more or less their steady state values always.
Alternatively, one may assume that the economies even in the
long run are usually out of steady state. When an economy is
not in steady state, its growth rate, as follows from the Solow
model and as we have mentioned above, is determined by the
parameters of the Solow model. Even though all the empirical
studies in the mainstream growth theory assume the economies
to be out of steady state, none of them has tried to verify this
result. This is surprising in view of the fact that the Solow model
dominated growth literature for nearly three decades. We have
dwelt on this issue later in the concluding section. From the
above it follows that the rate of technological progress is an
important determinant of the rate of growth of GDP in Solow
model in both steady state and out of steady state situations.
Hence we shall discuss below how the rate of technological
progress is measured in the mainstream growth theory.
The rate of technological progress is measured on the basis of
a number of assumptions, which are extremely hard to accept.
The mainstream macroeconomists assume that there exists an
aggregate production function that displays constant returns to
108 THE IIPM THINK TANK
scale and factors of production are paid in accordance with
their marginal productivities. For simplicity, suppose that the
aggregate production function is Cobb-Douglas and it is given
by . Note that the power of each factor gives the
share of its income in GDP, when the price of each factor equals
its marginal productivity. Taking logarithm of both sides of the
Cobb-Douglas production function specified above and
differentiating them with respect to time, we get
................................... (1)
From (1) it follows that the part of the growth in GDP that is
due to growth in capital and labour is given by .
The remaining part of the growth in GDP, ,
is due to growth in A, . , which is referred to as Solow residu-
al or total factor productivity growth, is usually regarded as a
measure of technological progress. The above discussion
suggests a method of measuring . Suppose one wants to
measure the rate of technological progress in an economy in a
given decade. One can do so by estimating the average growth
rates of GDP, capital and labour and the average shares of
capital and labour during the decade and then by computing
for the given decade. This method of
estimating the rate of technological progress is far from satisfac-
tory for reasons that we shall explain shortly. (Barro and
Sala-I-Martin (2004) refers to the above measure of technologi-
cal progress as the primal measure. They have discussed a dual
measure also. But the latter is based on the same set of assump-
tions as the former.)
Let us now explain why the above method of measuring the
rate of technological progress is flawed. It is so because it
assumes that the markets are perfectly competitive and factors
are paid in accordance with their marginal productivities.
Obviously, almost all the markets in modern developed
economies today are oligopolistic. In countries like India also,
this is true except for the markets of agricultural goods, which
are competitive. Thus, most of the producers earn super
normal profit. This means that return on capital far exceeds its
marginal productivity.
It is in fact not necessary to resort to marginal productivity
theory of factor pricing to develop a measure of technological
progress. The theory is patently false. Mark-up pricing rule in
oligopolistic industries is regarded as the norm by many writers,
see, for example Kalecki(1954). Under this rule, price is set by
applying a fixed mark-up to the average variable cost of
production. For the economy as a whole, the average variable
 A N E L U S I V E Q U E S T

cost consists only of labour cost. If the requirement of labour capita output especially in the long run. An increase in per
per unit of output is , the average price of goods and services capita output raises individuals’ capacity to save and thereby
under the mark-up pricing rule is given by tends to step up s. It also tends to lower n. It also tends to make
......(2) more resources available to the government per capita, which in
where the average price of goods and services, the fixed turn improves per capita supplies of public goods such as
average mark-up and the average money wage rate. In (2), drainage, protection from natural calamities, public administra-
is historically and exogenously given. It is to be estimated tion, defence etc. leading to a fall in δ. Obviously, in this kind of
from the data on costs and prices. Given the difficulty of a scenario, the Solow model ceases to hold. It has been claimed
estimating demand functions and the complexities thrown on it that in the long run the saving function is proportional. How-
by oligopolistic market structures and the price rigidity that the ever, Indian data do not support this. As we find from Table 3,
oligopolistic interdependence entails, the application of a saving ratio has increased steadily over time along with per
historically given mark-up to the average variable cost to set up capita income. Thus the Solow model breaks down altogether at
the price seems to be eminently sensible and therefore rational. least in the context of the India economy.
From (2) it follows that the share of labour in
GDP = ...........(3) and share of profit or 3. Endogenous Growth Theory
capital in The mainstream growth theory since the mid-eighties tried to
extend the Solow model by endogenising the rate of technologi-
GDP = ...................(4) cal progress. In other words, they tried to formulate theories
that explain the value of m of the Solow model. Pioneering
Equations (3) and (4) determine factor shares in terms of the attempts in this regard were made by Lucas(1988) and
average mark-up, . It also suggests a measure of technological Romer(1986,1990). The growth theory that they developed is
progress. Since labour is much more variable than capital, referred to as the endogenous theory of growth. It is a vast
labour requirement per unit of output may literature, which is still growing at a fast
be regarded as a technology-determined rate. The endogenous growth theory that
variable. So the rate of decline in l, i.e., the The Endogenous took off phenomenally from the pioneering
rate of increase in the average productivity growth theory studies of Lucas and Romer broadened the
of labour, may be taken to be an index of broadened the set set of determinants of the per capita growth
the rate of technological progress. This is
of determinants rate of a country. It traced the per capita
quite a satisfactory measure of technologi- growth rate to a whole host of factors such
cal progress in an economy with an insignifi-
of the per capita as the educational attainment and state of
cant agricultural sector. This is because in growth rate of health of the people, the share of resources
the non-agricultural sector diminishing an economy devoted to R&D, the rule of law, democ-
return to labour is not much pronounced racy, openness of the economy etc. The
and this makes the labour requirement per unit of output more general problem with the endogenous growth theory is that all
or less constant corresponding to any given technology. Since the different determinants of per capita growth rate that this
there are usually restrictions on hiring and firing of labour and literature identifies are increasing functions of per capita
also on account of the phenomena such as labour hording and income. Accordingly, they assume highest levels in the devel-
sectoral shifts, it may be sensible to use the trend values of l for oped countries, which, however, grow at substantially lower
measuring the rate of technological progress. rates than many much poorer economies. Table 4 shows that the
Finally, it is extremely difficult to accept the Solow model as a average annual growth rates of GDP during 1990-2000 and
theory of long run growth. In this model, per capita output or 2000-2004 were the highest in the low income countries, second
the rate of growth of per capita output is an endogenous highest in the middle income countries and lowest in the high
variable. However, it is hard to imagine the parameters of the income countries. It also shows that China ranked 108 on the
Solow model such as s, δ, n etc. as being independent of per basis of per capita income in 2004 recorded highest growth

THE INDIA ECONOMY REVIEW 109

G R O W T H E C O N O M I C S
during the given periods followed by Vietnam ranked 149. The
third highest growth rate was recorded by Ireland ranked 8th,
but the fourth highest growth rate was recorded by India ranked
144th. The richest countries such as the US, UK, Japan and
France ranked 3rd, 14th. 18th and 20th respectively recorded quite
modest growth rates. The endogenous growth theory therefore
prima facie does not stand up to close empirical scrutiny. In
what follows we shall dwell on the empirical studies that have
been made on the endogenous growth theory.
4. Empirical Results and Concluding Remarks
Empirical studies on the mainstream growth theory, which
includes the Solow model and the endogenous growth theory,
focus on three issues in the main, namely, growth accounting,
explanation of cross-country differences in the long run rates of
growth and convergence. Growth accounting assumes that
there are three sources of growth, viz, rate of growth of capital,
rate of growth of labour and technological progress. It seeks to
decompose the growth rate of GDP into the contributions of
these three sources (see, for example, Barro
and Sala-I-Martin(2004)). We have already
explained the problems with this kind of If all other
exercise. The other studies are cross-section variables are
studies and they seek to explain cross-coun- held constant, an
try differences in growth rates. To that end
increase in per
they regress long run per capita growth
rates of different countries on a whole host
capita income
of factors in addition to per capita output as tends to lower the
explanatory variables such as educational per capita growth
attainment, infant mortality rate, life
expectancy, rule of law, degree of democracy etc. Note that per
capita income must be an important determinant of all these
factors. The higher the per capita output, the greater is the
ability of the people to spend on education, health and less is
likely to be the incidence of crime. Again, the higher the per
capita output, the greater is the taxable capacity of the people
and therefore the larger is the amount of resources at the
command of the government leading to greater provision of
public goods such as public administration, health care,
education, potable water, sanitation etc. per capita. For both
the reasons, the richer a country the greater is likely to be the
values of the explanatory variables mentioned above. Accord-
ingly, per capita growth rate should be the highest in the richest
of the nations. Unfortunately, as we have already pointed out –
110 THE IIPM THINK TANK
see Table 4 in this context - there is prima facie no evidence to
that effect.
These studies also claim that they have found evidences for
conditional convergence even though not for absolute conver-
gence (see Barro and Sala-I-Martin(2004) in this context). In
other words, they have found that if all other variables are held
constant, an increase in per capita income tends to lower the
per capita growth rate and vice versa. The meaning of this result
is the following. If, for example, in India, per capita income rises
alone in the long run and all other explanatory variables remain
unchanged, the long run growth rate in India will tend to fall.
The mainstream growth theorists regard this result as an
evidence of conditional convergence. This means that every
country tends to move towards its respective steady state. As we
have already pointed out, this kind of exercise hardly makes any
sense. The notions of conditional convergence follow from the
Solow model. Since saving rate, rate of growth of population
and the rate of depreciation are all functions of the per capita
income in the long run, the model breaks down altogether. In
fact, tastes and preferences change drasti-
cally in the long run. They change with
changes in individuals’ surroundings and
environment that accompany growth in
income. Under these conditions, the
endogenous growth models also cease to
hold and the steady states that they derive
become meaningless. This is the basic
problem of developing a long run theory of
growth. To quote Keynes, “in the long run
we are all dead”.
If we look at the aggregative group-wise raw data, we find
that, as we pointed out earlier, the long run growth rate varies
inversely with the degree of development – see Table 4. This is
in sharp contrast with the predictions of the endogenous growth
theory. If we focus on more disaggregated country-wise data,
please refer Table 4, we find that many of the richest of the
nations persistently grow faster than many of the poorest
nations, while some poor nations grow at a much faster rate
than many of the richest nations. Actually, countries with high
per capita income have many advantages, which the others do
not have. Governments have larger resources per capita, which
enables them to supply better and more public goods per capita.
This implies better infrastructure, better administration, greater
protection of life and assets and better quality of human capital

leading to higher productivity of capital. People can also spend
more on education and health contributing to the quality of
human capital. The rich nations can also afford to engage in
R&D on a larger scale, given the superior financial might of
their firms and their greater access to quality manpower. All
these factors create a solid base for high rates of growth from
the supply side. In other words, all the explanatory variables
identified by the mainstream growth theory for explaining per
capita growth rate assume highest values in the richest of the
nations. Accordingly, if the mainstream growth theory is true,
per capita growth rate should the highest in the richest of the
nations. Despite this, some poor economies grow at much faster
rates than the rich ones – please refer Table 4. Obviously, this
cannot be explained by the mainstream growth theory, as it
focuses on the supply side factors alone. Even in the long run,
demand side factors remain crucially important. Hence, the
following may be a much more sensible explanation of the
cross-country differences in the growth performances. Poorer
countries have much greater urgency to grow fast to remove
poverty, to catch up with the rich to cope with the international
competition and even for self defence. This induces many of the
governments in developing countries to play active roles in
promoting growth. Moreover, in poor countries most of the
people have little protection against the elements of nature,
diseases etc. They hardly have enough to eat. To stay in power
even in totalitarian regimes on a sustained basis, support of
these people is crucial. Competition among politicians for
power therefore brings the development issues in the forefront
for garnering support. Hence government plays an important
role in promoting development in these countries. Govern-
ments’ policies range from direct public investment in different
sectors to subsidization of saving and investment. This contrib-
utes to sustaining a high rate of growth in demand for goods
and services. In the developed countries, since per capita
income is much higher, the urgency of growth is much less.
Moreover, most of these countries are against large and
influential governments. They recommend minimization of
government intervention in economic matters. For these
reasons governments in these countries do little to directly
stimulate growth. Growth in consumption is likely to slacken
with development. The constraint that income puts on con-
sumption eases with the increase in per capita income. But
factors such as the physical capacity to consume, the time
available for consumption etc. also act as constraints and they
A N E L U S I V E Q U E S T
gain in importance with the rise in per capita income and fall in
the rate of growth of population. Rate of growth of consump-
tion in developed countries accordingly depends crucially upon
the rate of arrival of new and superior quality consumption
goods in the market. In richer countries therefore growth in
consumption demand and, therefore, that in investment are
largely innovation driven. The growth rates are accordingly low.
New investment does not add to capacity much. It leads to
better products and makes a part of the existing productive
capacity obsolete. For these reasons growth rates in rich
countries may be low. The mainstream growth theory’s predic-
tions go wrong as they focus only on the supply side factors and
ignore the demand side factors completely.
References and Additional Thinking
• Barro, R.J. and Sala-i-Martin, X.(2004). Economic Growth,
Prentice Hall, India
• Bernanke, B, Gartler M and Gilchrist, M. (1998). The
financial accelerator in a quantitative business cycle frame-
work, NBER Working Paper 6455
• Jorgenson, D.W. and Yip,E.(2001). Whatever happened to
productivity growth? In E.R.Dean, M.J.Harper and C.
Hulten, eds., New Development in Productivity Analysis,
Chicago University Press
• Kalecki, M.(1954). Theory of Economic Dynamics: An Essay
on Cyclical and Long-Run Changes in Capitalist Economy,
Allen & Unwin
• Lucas,R.E.Jr.(1988). On the mechanics of economic devel-
opment, Journal of Monetary Economics, 22, July
• Rakshit, M.(2009). India amidst the Global Financial Crisis,
Economic and Political Weekly, Vol.44, No.13, March28
– April 03
• Romer, P,M.(1986). Increasing returns and long run growth,
Journal of Political Economy, 94, October
• Endogenous Technological Change, Journal of Political
Economy, 98, October, Part II
• Solow, R., M.(1956). A contribution to the theory of eco-
nomic growth, Qurterly Journal of Economics, 70, February
• Young, A.(1995). The tyranny of numbers: confronting the
statistical realities of the East Asian growth experience,
Quarterly Journal of Economics, 110, August.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation.)
THE INDIA ECONOMY REVIEW 111
W E L F A R E E C O N O M I C S

Employment Guarantee,
Not Employment Subsidy
Approach Suits Indian
Conditions
112 THE IIPM THINK TANK

Saumitra Mohan
Additional District Magistrate (General),
Burdwan, West Bengal
A
liberal welfare state tries to ensure equitable
distribution of the development pie by resorting to
myriad ways of redistributive allocation of values
among its citizens. One of such measures include employment
guarantee schemes for the toiling masses to ensure them
R E T H I N K A N D R E S U R G E
Illustration : Shantanu Mitra
work for minimum number of days on pre-decided subsist-
ence wages. It is with this objective that the National Rural
Employment Guarantee Scheme (NREGS) was launched in
all the districts of this country. This follows on the back of
various employment generation and food for work pro-
grammes including Integrated Rural Development Pro-
gramme (IRDP), Community Development Programme
(CDP) and Swarnajayanti Jawahar Rojgar Yozna (SJRY).
NREGS is actually predicated on the experiences and
knowledge gained during implementation of all these
previous schemes.
THE INDIA ECONOMY REVIEW 113
W E L F A R E E C O N O M I C S
Since then, many observers have come up with suggestions
and proposals for further fine-tuning of this flagship employ-
ment guarantee programme. This author read with interest an
article recently which espoused the idea to provide employ-
ment subsidies to employers instead of providing guaranteed
jobs through state-run employment generation programmes
like the NREGS. The underlying assumption of the said
proposition was the belief that such an approach would create
jobs more efficiently and effectively than done by the present
employment guarantee scheme.
Nobel Laureate Prof. Edmund Phelps was quoted in the
said write-up as saying, “Although such programmes have
been substantial in Europe and the US, the working poor
remain as marginalized as ever. Indeed, social spending has
worsened the problem because it reduces work incentives and,
thus, creates a culture of dependency and alienation from the
commercial economy, undermining labour
force participation, employability and
Social spending
employee loyalty.”
Proposing an alternative, Prof. Phelps
has worsened the
says, “The best remedy is a subsidy for problem because
low-wage employment, paid to employers it reduces work
for every full-time low wage worker they incentives and
hire and calibrated to the employee’s wage
thus creates
cost to the firm. The higher the wage cost,
the lower the subsidy, until it has tapered
dependency
off to zero. With such wage subsidies,
competitive forces would cause employers to hire more
workers, and the resulting fall in unemployment would cause
most of the subsidy to be paid out as direct or indirect labour
compensation. People could benefit from the subsidy only by
engaging in productive work.”
It is believed that the employment generated through this
alternative scheme that Prof. Phelps proposes, shall be an
asset for the economy instead of a burden. Prof. Bharat
Jhunjhunwala of IIM, Bangalore believes that the present
approach provides for taxes to be imposed mainly on urban
business enterprises while money is spent in rural areas. The
urban businesses have to bear the tax burden while the
benefits are reaped by faraway villages. The business sector
suffers on account of higher wage rates. The availability of
some employment in the villages acts as a disincentive for
workers to move from labour-surplus to labour-scarce areas
because some employment is available locally under the
114 THE IIPM THINK TANK
Rojgar Guarantee Scheme. The author bemoans the fact that
the business enterprises do not only have to pay higher taxes,
but also have to pay higher wages. The author believes that if
Prof. Phelps’ suggestion is accepted then the taxes paid by
businesses are recouped by receiving employment subsidies.
The net outgo on wages shall be reduced due to subsidies
thus received.
While the author’s suggestion for subsidy to labour-inten-
sive industries does make some sense, but going whole hog for
Prof. Phelps’ proposed alternative definitely does not, more so
in the Indian context. To begin with the beginning, notwith-
standing the supposed failure of the employment guarantee
scheme in the developed countries, they still have not been
able to replace the same with the ‘employment subsidy’
approach as advocated by many including Prof. Phelps.
This is notwithstanding the fact that such employment
guarantee schemes have been in force for
over fifty years in most of these devel-
oped countries. Prof. Phelps’ proposal is
fraught with loopholes and complexities
and prone to more corruption than one
thinks. Moreover, it also does not
promise to increase the job opportuni-
ties for the jobless as has been proved to
be practicably possible by the present
employment guarantee scheme, the
many implementational hitches and
glitches notwithstanding.
First and foremost problem with this approach is the moral
hazard of passing off the extant employment in a fi rm to claim
wage subsidies falsely and dishonestly. The employers led by
petty and comprador bourgeoisie, in stead of creating new
employment, would try to ingenuously cheat the system for
claiming the subsidies. After all, we don’t necessarily have a
data-base of employed manpower of all such firms and
industries. And such a data-base, even if created and main-
tained, may not be completely sacrosanct. Our experience
tells us as to how such data-base is often tinkered and tam-
pered with, often to the advantage of the high and mighty.
So, any system of working out compensatory subsidies for
employers by establishing contrived linkages to employment
generation is going to be very complex and is also likely to
involve a lot of scope for discretion and subjectivity for the
bureaucracy than the extant system. There is definitely no

need to compensate big businesses for higher taxes levied on
them as there are already multiple government schemes and
incentives for performing enterprises and businesses. Moreo-
ver, even after paying those taxes, they are still left with decent
profit margins to go shopping the world over for acquiring
many of the renowned companies even in times of recession.
Over the years, our tax and incentives structure have come to
be comparable with the best in the world.
The assumed fear that such employment guarantee scheme
actually encourages mediocrity and dependence on govern-
ment is far from the truth. The present system is an incentive-
based transparent system where a more productive worker can
earn more if she/he gives more output and her/his wages shall
correspondingly be higher compared to others whose output
is less. The fear that villages unduly gain at the expense of
towns is unwarranted, to say the least. The fact remains that
towns are always better endowed in terms
of basic services and facilities than those
The current
found in the villages. The employment
guarantee scheme not only ensures
employment
assured employment for a household guarantee
throughout the year (considering hundred approach does
days for each adult member of a family not reduce labour
including the handicapped), it also
force participation
envisages creation of basic infrastructures
in the countryside.
and employability
It is believed that the progressive
creation and availability of such infrastructures and employ-
ment opportunities in the countryside shall discourage people
from migrating to the urban areas where basic infrastructures
and services are already feeling pressure of increasing
population. It shall also bridge the gap between rural and
urban areas in terms of socio-economic indicators which are
quite uneven at the moment. It is believed that wages in the
urban areas shall go up consequent to reduced emigration and
reduced availability of workers from the rural area. With less
workers competing for more works, the real wages in urban
areas shall go up which would continue to attract a minimal
number of workers from the countryside as per changing
demand and supply curve. The increased wages for urban
workers shall be in keeping with the increased expenses
required for urban living eventually enabling them to lead a
better life than has been possible otherwise.
The apprehension that reduced availability of low wage
R E T H I N K A N D R E S U R G E
workers shall either lead to shut-down of enterprises in the
urban areas or relocation of many of them to the rural areas is
also unfounded. At a time when we are talking of liberaliza-
tion and globalization, we definitely should have no reason to
think of the industries who shut down as a result of having to
pay higher wages to the workers, more so when multiple
government incentives are available. The enterprises need to
learn to survive the cut-throat competition in the market.
They always have the option of shaping up or shipping out.
Moreover, such an apprehension remains far fetched as the
pool of low wage workers shall still be larger in this unreason-
ably populous country despite local availability of guaranteed
employment in the villages as there still are many push and
pull factors which drive people to the urban areas. As such,
there is no reason to panic.
Still, if some of them decide to move to low-wage areas
which are likely to be under-developed, it
is all the better as that would lead to
infrastructural and capacity development
of such areas and further improvement of
quality of life there which eventually may
see rise in labour costs in those areas as
well. The cycle may go on till all parts of
the country are more or less equitably
developed. The government can actually
think of giving incentives for relocation
or establishment of new industries
including labour-intensive ones in the backward and under-
developed areas.
The belief that the current employment guarantee approach
reduces labour force participation and employability of a
worker is also not true. The experience from all over the
country tells us that labour force participation in the economy
has only increased as a result of operation of such a scheme
and as a result, per capita income has also gone up. The
multiplier effect of such a rise has been perceptible in the
relatively high economic growth rates and other development
indicators of our economy, recession notwithstanding.
Besides, an employment guarantee scheme is also immune to
the negative impacts of a recession. While the government
shall have more reason to persist with such employment
guarantee schemes in difficult times like recession, the
employers, finding reduced demand and market for their
products, would shut down overnight rendering all the
THE INDIA ECONOMY REVIEW 115
W E L F A R E E C O N O M I C S
workers under their dispensation jobless.
Again, contrary to the belief, the employability of a worker is
also not compromised because of in-built incentive structure
in such employment guarantee schemes as the worker learns to
be more hard working to earn higher wages by giving better
output and by being more productive. The various training
programmes given to people under the said scheme and under
many other schemes do give the workers a choice to decide for
themselves as to what do they intend to do. The dovetailing
and convergence of many such cognate schemes and pro-
grammes further could yield better results with better value
allocations among the hoi polloi. The cascading multiplier
effects and resultant pay offs for the country as a whole is
bound to be better and greater than commonly understood.
The supposed acquisition of newer skills under the employ-
ment subsidy approach is quite problematic and is more at the
level of assumption than a reality. The belief that the innocent,
ignorant and gullible workers would get better jobs and acquire
better skills as per their choice and aptitude moving from one
industry to another for job-shopping is misplaced and fraught
with danger. The danger emanates from the feared exploita-
tion of workers by these enterprises who are likely to take
advantage of their helplessness and non-possession of requisite
skills by paying low wages and forcing them to work in unhy-
gienic and undignified working conditions.
Most of these enterprises are not likely to be enlightened
enough to do a charity by employing an ignoramus and
inexperienced worker to teach him/her newer skills to employ
him/her later. However, the spirit of the proposal here is well
taken and one does feel that the scope and ambit of such
employment guarantee scheme needs to be further broadened
and diversified. It could also be creatively fine-tuned to offer
better wages and better opportunities to the people. But one
has to give the scheme some time to evolve naturally and be
more promising and better suited to the requirements of the
employment-seeking workers.
After all, the Constitutional Right to Work, as envisaged in
the fourth chapter of the Indian Constitution detailing
directive principles of state policy, which took five decades to
be translated into a reality, is likely to be some more time to be
better customized to the requirements and needs of the target
people. The very fact that NREGS, after being launched
selectively in some districts of the country for guaranteed
employment in the rural areas throughout the year, has now
116 THE IIPM THINK TANK
been extended to the entire country, is itself a big achievement
of sorts.
The belief that the alternative proposal is corruption proof
compared to the present one is also not true as already pointed
out above because of the element of discretion and subjectivity
inherent therein. The extant scheme because of the transpar-
ent system of job-card, fi xed responsibility to provide jobs
within fifteen days of receipt of an application demanding work
or to pay unemployment allowance in case of failure of the
same and the provision of social audit is much better placed to
do the needful. The provision of job cards, public hanging of
Muster Roll, public notice of details of an on-going works and
Muster Rolls and a participatory social and financial audit of
all the aspects of the schemes ensure better transparency and
accountability than any other scheme. The Right to Informa-
tion plugs the loopholes and fills the gaps, if any left anywhere.
Yes, one does feel that there is lot of scope for further
improvement of the scheme. One is sure that as more feedback
from the field is received and fed into the system to further
fine-tune it, the extant scheme shall respond better to the tasks
and objectives it is supposed to realize. To give some credit to
Prof. Phelps, his proposal can be tried on an experimental
basis in selected areas as a pilot project rather than completely
replacing the extant scheme. After all, it is too early to pro-
nounce a judgement on the success and failure of the same.
And in any case, an ingenuous and creative mix of the two
conceptions rather than an exclusive reliance on any of the one
can always be a better idea. One hopes that NREGS would
evolve with time in keeping with the objective of realizing and
ensuring growth with equity and justice.
Also, with the failure of the invincible capitalist system of
economic development as represented by the Washington
Consensus, it is all the more accepted and acknowledged that
we can no longer depend on market forces for taking up social
responsibilities. Rolling back the state completely is no longer
an option. The state has to be there as a regulator and disci-
plining force with minimal responsibilities of maintaining law
and order, dispensing justice and building an equitable society.
So, the ‘employment subsidy’ approach, as dependent on
private enterprises, is just not acceptable in preference to the
employment guarantee approach.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation.)
W E L F A R E E C O N O M I C S

Governance and
Employment Generation
in Rural Areas:
A Case Study of NREGS in
Selected Districts of West
Bengal
Act has been universalized w.e.f. 1st April 2008 and now
Byasdeb Dasgupta covers the entire country. The individuals needing unskilled
Head, Department of Economics, work for survival must be aware of the NREGS, the eligibility
University of Kalyani, West Bengal requirements for work, the procedure for registration, getting
a job card, wage rates etc.
The NREGS makes a provision for compensation and treat-

Bipul De
Lecturer, Sonamukhi College,
Bankura, West Bengal
NREGS and its Financing
The National Rural Employment Guarantee Act (NREGA)
was passed unanimously in the Lok Sabha on 23rd August
2005. It guarantees 100 days of unskilled work at the mini-
mum wage to each household which can not eradicate poverty
but it can reduce severe distress if implemented effectively. It
came into force in 200 districts on 2nd February 2006 and was
then extended to an additional 130 districts in the fi nancial
year 2007-08 (113 districts were notified w.e.f. 1st April 2007
and 17 districts in Uttar Pradesh w.e.f. 15th May 2007). The
ment in case of injury and some on-site facilities like safe
drinking water, care for small children, periods of rest and a
first aid box. It bans contractors and restricts the use of labour
displacing machines. It requires that the wage component
should be at least 60 percent of the expenditure in any project.
It tries to create much needed rural assets through watershed
development, water conservation and harvesting methods,
irrigation works, forestry, land development, flood control,
construction of roads etc. [CSE, 2008; PACS, 2006]
These investments can lead to improvements in agricultural
productivity, water security and creation of livelihood oppor-
tunities. But NREGA provides the guarantee at the level of
the household and not that of the individual. Therefore the
rights of women get subsumed under those of the household
(though the act requires that at least one third of the benefici-
aries should be women).
The Central government will bear the following costs:
• The entire cost of wages for unskilled manual workers,

118 THE IIPM THINK TANK


• 75 percent of the cost of material and wages for skilled and
semi skilled workers,
• Administrative expenses as may be determined by the
central government. These will include the salary and
allowances of Programme Officers and their support staff
and work site facilities,
• Administrative expenses of the central Employee Guaran-
tee Council.
The State government will bear the following costs:
• 25 percent of the cost of material and wages for skilled and
semi skilled workers,
• Unemployment allowance payable in case the State
government cannot provide wage employment within 15
days of application. This allowance acts as a penalty every
time the State is unable to provide work.
• Administrative expenses of the State Employee Guarantee
Council.
[Source: NREGA Operational Guidelines 2008]
The important aspect of NREGS is that it recognizes the
Illustration : Shantanu Mitra
R E C A S T A N D R E S T R U C T U R E
role of the Panchayats as the principal agents of implementa-
tion and empowers citizens to play an active role in the
implementation of the scheme through Gram Sabhas, Social
Audit, use of Right to Information Act (RTI), participatory
planning and other activities.
Objective of the Study
After three years of implementation it is the time to judge the
efficacy of the scheme in terms of several aspects like jobs
demanded and provided, household participation rate based
on the employment demanded, gender wise proportion of
person days of employment generated, caste wise proportion
of the total person days of employment generated, estimates
of the proportion of work completed to total works taken up
and the proportion of total funds spent under NREGA.
Status of NREGA Implementation in Major
Districts of W.B.
National Rural Employment Guarantee Act was passed by
THE INDIA ECONOMY REVIEW 119
W E L F A R E E C O N O M I C S

Table 1: Employment Generated during the Year 2008-2009 up to the Month of March 2009

[1] [2] [3] [4] [5] [6]

Districts Employment De- Employment Pro- Person Days of Employment Pro- Average Person
manded by HH vided to HH Employment Pro- vided as a Percent Days Generated
(in lakhs) (in lakhs) vided of Employment Per HH
(in lakhs) Demanded (4/3)
(3/2)

24 Pgs North 1.16955 1.13678 12.37190 0.97198068 10.8832844

24 Pgs South 0.77470 0.77325 9.35412 0.99812831 12.0971484
Bankura 1.22834 1.19917 19.03979 0.9762525 15.8774736
Birbhum 2.86099 2.81015 23.57875 0.98222993 8.39056634
Burdwan 4.50177 4.43213 54.57808 0.98453053 12.3141875
Coochbeher 0.10738 0.09331 0.70197 0.86897001 7.52298789
Darjeeling 0.20470 0.18648 2.44036 0.9109917 13.0864436
Dinajpur (D) 0.19137 0.18686 2.63722 0.97643309 14.1133469
Dinajpur (U) 0.01130 0.00997 0.08887 0.88230088 8.91374122
Hooghly 1.20038 1.17597 13.41062 0.97966477 11.4038794
Howrah 0.04979 0.04872 0.35850 0.97850974 7.35837438
Jalpaiguri 1.19202 1.10526 9.72354 0.92721599 8.79751371
Maldah 0.06983 0.06938 0.86309 0.99355578 12.4400404
Murshidabad 0.70559 0.69541 6.16522 0.98557236 8.86559008
Nadia 0.97162 0.96052 7.I5836 0.98857578 7.45258818
Paschim Midnapur 1.73470 1.66179 20.21487 0.95796968 12.1645154
Purba Midnapur 1.38219 1.34035 15.90327 0.9697292 11.8650129
Purulia 0.10389 0.10076 1.22481 0.96987198 12.1557166
TOTAL 18.46011 17.98626 199.81334

Source: www.nrega.nic.in (Till March 2009)

Note: bold letter represents the fi rst phase districts

Parliament in 2005. It became operational in West Bengal
from February 2006. In the first phase NREGA was
implemented in 10 districts (South 24 Parganas, Bankura,
Birbhum, Dakhhin and Uttar Dinajpur, Jalpaiguri, Maldah,
Murshidabad, Paschim Midnapur, Purulia) followed by
another seven districts (North 24 parganas, Burdwan,
Coochbihar, Darjelling, Hooghly, Puaba Midnapur, Nadia)
from 1st April 2007 and one more district from 1st April
2008 (at Howrah).
1. Jobs Demanded and Provided
The NREGS has primarily been evaluated in terms of jobs
demanded and provided. The performance as shown in
Table 2, has not been uniform across the districts.
Official record shows that till May 2009, out of 1.84
million people demanding jobs 1.79 million were provided
with jobs which generated almost 200 million person days
and around 10.87 person days per family which is far away
from the envisaged 100 days. Bankura is showing the maxi-
mum average person days of employment i.e. 15 and at
least seven districts are showing less than 10 average
person days of employment.
The record also shows that demand for employment was
almost met (at 99%) in South 24 Parganas and Maldah.

120 THE IIPM THINK TANK

 R E C A S T A N D R E S T R U C T U R E

Table 2: NREGS Participation Rate

[1] [2] [3] [4]

Districts No of Rural HH in NREGS Employment Demanded by Participation Rate
(in lakhs) HH (in lakhs) (3/2) * 100
24 Pgs North 542954 116955 21.5404988
24 Pgs South 602185 77470 12.8648173
Bankura 454901 122834 27.0023588
Birbhum 590605 286099 48.4416827
Burdwan 750130 450177 60.0131977
Coochbeher 325971 10738 3.29415807
Darjeeling 71171 20470 28.7617147
Dinajpur Dakshin 234678 19137 8.15457776
Dinajpur Uttar 411711 1130 0.27446437
Hooghly 453041 120038 26.4960566
Howrah 147944 4979 3.36546261
Jalpaiguri 574648 119202 20.7434812
Maldah 381065 6983 1.83249577
Murshidabad 865466 70559 8.15271773
Nadia 579487 97162 16.766898
Paschim Midnapur 699991 173470 24.7817472
Purba Midnapur 547776 138219 25.2327594
Purulia 362458 10389 2.86626313

Only in two districts like Uttar Dinajpur and Coochbihar potential correlation between governance in a state and
the demand for employment was met at less than 90%. the need for employment generation through such
schemes.
2. Participation Rate
An attempt can be made to estimate the 3. Gender Aspect of NREGS
NREGS household participation rate The NREGS is designed primarily
based on employment demanded by The NREGS along the lines on Maharashtra EGS
rural households in 18 districts as a generated fewer (MEGS). Women were the major
proportion of the total number of rural than the one-third beneficiaries of the MEGS as the
households in districts in which the
NREGS was being implemented. Table
female person scheme guaranteed work for all those
who demand it. Table 3 shows that
2 shows the results. The household
days stipulated NREGS generated fewer than the
participation rates are highest in Burd- by the Act in 11 one-third female person days stipulated
wan (60 percent) followed by Birbhum districts out of 19 by the Act in 11 districts out of 19. The
(48.44 percent) and lowest in Uttar proportion of person days of work
Dinajpur (0.22 percent). The participation ratets in seven generated for women was satisfactory in Darjeeling (48.9
districts are less than 10%. percent) followed by Jalpaiguri (40.19 percent). Districts
These two parameters ‘participation rate’ and ‘jobs like Bankura (35.57 percent), Burdwan (34.84 percent),
demanded and provided’ raise the questions regarding a Uttar Dinajpur (36.71 percent), Purulia (37.04), Purba

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Table 3: Gender Wise Proportion of Person Days of Table 4: Caste Wise Proportion of Person Days of
Employment Generated (in percentage) Employment Generation (in percentage)

[1] [2] [3] [1] [2] [3] [4]

Districts Women Men Districts SC ST Others
24 Pgs North 5.72 94.28 24 Pgs North 24.38 5.87 69.75
24 Pgs South 9.77 90.23 24 Pgs South 43.63 3.16 53.21
Bankura 35.57 64.43 Bankura 55.39 19.78 24.83
Birbhum 24.7 75.3 Birbhum 44.3 11.32 44.38
Burdwan 34.84 65.16 Burdwan 47.84 17.52 34.64

Coochbeher 20.76 79.24 Coochbeher 48.45 3.32 48.23

Darjeeling 55.38 21.11 23.52
Darjeeling 48.9 51.1
Dinajpur Dakshin 27.09 18.72 54.19
Dinajpur Dakshin 26.44 73.56
Dinajpur Uttar 45.29 8.95 45.76
Dinajpur Uttar 36.71 63.29
Hooghly 51.86 10.57 37.56
Hooghly 26.41 73.59
Howrah 39.46 0.08 60,45
Howrah 8.69 91.31
Jalpaiguri 43.06 31.1 25.84
Jalpaiguri 40.19 59.81
Maldah 30.47 12.05 57.48
Maldah 20.43 79.57
Murshidabad 14.7 4.78 80.52
Murshidabad 10.59 89.41 Nadia 27.25 3.7 69.05
Nadia 13.99 86.01 Paschim Midnapur 27.25 3.7 69.05
Paschim Midnapur 25.52 74.48 Purba Midnapur 29.88 23.73 46.4
Purba Midnapur 32.35 67.65 Purulia 19.98 0.89 79.13
Purulia 37.04 62.96 Purulia 27.41 30.92 41.68
Source: www.nrega.nic.in (Till March 2009) Source: www.nrega.nic.in (Till March 2009)
Note: Bold letter represents the fi rst phase districts Note: Bold letter represents the fi rst phase districts

Midnapur (32.35) can manage the target. Women have
been active participants in few districts where Self Help
Groups have been made the imple-
menting agencies for developing land
of BPL/SC/ST households under
NREGA which has increased not only
their self confidence but has enhanced
their status.
4. Caste Aspect of NREGS
Table 4 shows the caste wise proportion
of the total person days generated
under NREGA. The proportion of
person days of employment availed by SC/ST beneficiar-
ies is more than 30 percent in 11 districts with the pro-
portion being more than 50 percent in three districts out
of 18. The proportion is highest in Bankura (55.39
percent) followed by Darjeeling (55.38 percent) and
Hooghly (51.86 percent).
5. Proportion of Works Completed to
Land, especially Works Taken Up
non-irrigable Estimates of the proportion of works
land was a basic completed to total works taken up under
requirement to NREGA are shown in Table 5. Official
data shows that nine districts lead with
provision jobs figures of more than 50 percent—Uttar
under the NREG Dinajpur (87.63 percent), Jalpaiguri
scheme (69.76 percent), Murshidabad (68.26
percent), Darjelling (65 percent), Purba
Midnapur (64.29 percent), Burdwan (64.27 percent),
Birbhum (55.89 percent), South 24 Parganas (55.65 per-
cent), Bankura (52.42 percent). For the rest of the districts
the proportion of works completed to total works taken up

122 THE IIPM THINK TANK

 R E C A S T A N D R E S T R U C T U R E

Table 5: NREGS—Proportion of Works Completed to Works Taken Up

[1] [2] [3] [4]
Districts Total Works Taken Up Works Completed Proportion Of Works Completed
(In percentage)
24 Pgs North 6652 2817 42.348166
24 Pgs South 3980 2215 55.6532663
Bankura 7473 3940 52.7231366
Birbhum 10022 5601 55.8870485
Burdwan 18312 11770 64.2747925
Coochbeher 2765 1317 47.6311031
Darjeeling 498 324 65.060241
Dinajpur Dakshin 695 317 45.6115108
Dinajpur Uttar 1415 1240 87.6325088
Hooghly 3893 1510 38.7875674
Howrah 637 185 29.0423862
Jalpaiguri 6108 4261 69.7609692
Maldah 1649 593 35.9611886
Murshidabad 2814 1921 68.2658138
Nadia 1934 994 51.39607
Paschim Midnapur 1649 593 35.9611886
Purba Midnapur 13865 8915 64.2985936
Purulia 5848 1864 31.874145
Total 99778 54125 54.2454248

is between 29 percent to 47 percent. clearly seems to lag behind other states in terms of actual
job provision or the average number of days provided with
6. Proportion of Total Funds Spent job per family. Of the total 88 lakh job card holders in the
Data shows in Table 6 that the propor- state around 21 lakh have been provided
tion of total funds spent is highest in with employment cumulatively till date.
Dakkhin Dinajpur (93 percent) fol- West Bengal One of the major reason for this
lowed by Purba Midnapur (86 percent) seems to lag lacunae or shortfall was paucity of
and lowest in Nadia (32 percent). The behind other funds as also lack of demand for jobs,
state average is 71 percent of total fund
states in terms of this being an entirely demand driven
was spent till March 2009. There are scheme unlike previous employment
nine districts above the state average
average number schemes. The state even faced a severe
out of 18. of days provided crunch of funds in the last two years,
with job per family which primarily meets the wage needs,
Concluding Observations said the source.
Despite the fact that all the 18 districts in the state have The main reasons were unequal and illogical distribution
been covered under the National Rural Employment of funds, besides frequent case of siphoning of funds or
Guarantee Scheme (NREGS) and more than 88 lakh job money laundering which caused some districts like Birb-
cards have been distributed so far in the state, West Bengal hum, Purulia, Jhargram, with good scope for the scheme

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W E L F A R E E C O N O M I C S

Table 6: NREGS—Expenditures

Districts Total Fund (in crores) Expenditure (in crores) Proportion of Total Fund
Spent
24 Pgs North 86.23 63.16 0.73246
24 Pgs South 39.80 29.46 0.740201
Bankura 94.39 80.65 0.854434
Birbhum 131.89 85.45 0.647888
Burdwan 147.90 148.12 1.001487
Coochbeher 59.21 60.20 1.01672
Darjeeling 10.67 5.56 0.521087
Dinajpur Dakshin 17.70 16.48 0.931073
Dinajpur Uttar 31.10 16.57 0.532797
Hooghly 52.12 33.57 0.644091
Howrah 10.32 5.51 0.533915
Jalpaiguri 126.73 71.77 0.566322
Maldah 71.74 23.46 0.327014
Murshidabad 93.68 51.60 0.550811
Nadia 71.74 23.46 0.327014
Paschim Midnapur 123.84 106.01 0.856024
Purba Midnapur 59.11 50.88 0.860768
Purulia 59.27 42.87 0.7233
Total 1287.44 914.78 0.710542

falling short of funds and some districts sitting on extra
cash. This was primarily because the funds from the
Centre would go directly to the district offices in the hands
of the district program coordinator who looked after the
disbursal of funds. The State P&RD department had no
say on the disbursal inspite of knowing which districts
required it.
Districts like Purulia, Bankura, Birbhum, Jhargram,
part of West Medinipur, had huge potential as far as the
scheme was concerned because of availability of land which
suited the types of job provided under the scheme. Infact,
Bankura ranked highest in terms of average number of
days provided with jobs per family last year, which was
around 41 days compared to the state's average of 25 days
per family.
Land, especially non-irrigable land was a basic require-
ment to provide jobs under this scheme. The jobs provided
under this scheme in the state at a minimal wage of Rs 75
per day were mainly water conservation jobs, land levelling,
road construction, drought proofing, plantation of trees,
mostly non-agricultural-based jobs, with a huge require-
ment for non-irrigated land. Rajasthan and Madhya
Pradesh rank high in the implementation of this scheme
due to land availability.
References and Additional Thinking
• Krishnaraj, M., D. Pandey and A. Kanchi (2004), “Does
NREGS Require Restructuring for Poverty Alleviation
and Gender Equality”, Economic and Political Weekly,
39 (17): 1741-47; 24th April.
• Menon, S (2008), “Right to Information Act and NRE-
GA: Reflection on Rajasthan”, MPRA Paper No:7351
• Siddharta and Anish Vanik (2008), “CAG Report on
NREGA: Fact and Fiction”, Economic and Political
Weekly, 43(25): 39-47; 21st-27th June
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation).

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NRDWP – A Paradigm
Shift in Rural Drinking
Water Supply
Benny George
Consultant (M&E),
Department of Drinking Water
Supply, Government of India,
New Delhi

Government of India has been striving to

provide drinking water security in the rural areas
since independence. Incorporating the wisdom
accrued over decades through the implementa-
tion of water supply programmes, Government
of India has launched a new programme –
NRDWP – on 1st April 2009. Though it comes
with a whiff of fresh thinking and bold measures
to safeguard the interests of the weaker sections
of the society, a great deal of its success hinges
on its effective implementation.

Introduction
Availability of drinking water in right quality
and quantity is one of the prerequisites for a
healthy life. Human Development Report –
2006 states that delivering clean water, remov-
ing wastewater and providing sanitation are
three of the most basic foundations for human
progress. United Nations Committee on
Economic, Social and Cultural Rights declared
that “The human right to water entitles every-
one to sufficient, safe, acceptable, physically
accessible and affordable water for personal

126 THE IIPM THINK TANK


and domestic use” (UNDP 2006).
Government of India has been striving to achieve the goal of
providing safe drinking water to the people of India. Till the
end of the 10th Five Year Plan, almost Rs. 70,000 Crore had
been invested by Central and State Governments in providing
drinking water in the rural areas (Table 1). Eleventh Plan
Central outlay for the rural water supply sector stands at Rs.
39,490 crore.
Despite making huge investments for ensuring drinking
water security in rural areas, we still have some more distance
to cover. As per UNICEF and WHO (2008), only 86 percent
rural population in India had access to ‘improved’ water supply
in 2006.
2. ARWSP
To accelerate the pace of coverage of problem villages, the
Government of India introduced the Accelerated Rural Water
Supply Programme (ARWSP) in 1972–73 to assist States and
UTs with 100% grants-in-aid to implement drinking water
supply schemes in such villages.
2.1 Components:
To ensure that all aspects of rural water
supply are adequately addressed, ARWSP In the Eleventh
was broken into different components. Five-Year Plan,
Those components, funds earmarked for Central outlay for
them, interventions to be made and the
the rural water
funding pattern are given in Table 2.
supply sector
2.2 Coverage Norms: stands at Rs.
1. 40 lpcd of drinking water for human beings 39,490 crores
2. 30 lpcd of additional water for cattle in
areas under the DDP
3. One hand pump or stand post for every 250 persons, and
4. Availability of water source within a distance of 1.6 Km in
plains and 100 m elevation in hilly areas.
3. National Rural Drinking Water Programme
(NRDWP)
India has come a long way in providing drinking water to its
rural population. However, life has changed so much since the
early days of ARWSP. Then the core strategy was aimed at
building physical infrastructure and institutional mechanisms
to supply water which was abundant in nature.
WAT E R W I S D O M
Water is no more an abundant resource. India with 2.4% of
the world's total area has 16% of the world's population; but
has only four percent of the total available fresh water. Cur-
rently, the total water use (including ground water) is 634
BCM, of which 83% is for irrigation. The demand for water is
projected to grow to 813 BCM by 2010, 1093 BCM by 2025 and
1447 BCM by 2050, against utilisable quantum of 1123 BCM
(Planning Commission 2007a).
The rapid extraction of ground water has led to its over
exploitation in the country. In 15% of the Blocks, annual
extraction of ground water exceeds annual recharge and in
four percent of Blocks it is more than 90% of recharge (Plan-
ning Commission 2007b). Such a scenario does not augur well
for drinking water supply as about 80% of rural drinking water
supply programmes are ground water based1.
Another issue of major concern is global warming and its
fallout on drinking water security. Using the General Circula-
tion Models, weather experts have predicted that global
warming will intensify the hydrologic cycle; more intense
rainfall will occur in fewer spells; floods and droughts both will
become more intense; the floods will be more frequent; the
rainfall will shift towards winter; and there
may be a significant reduction in the mass
of glaciers, resulting in increased flows in
the initial few decades but substantially
reduced flows thereafter (Ibid).
‘Slipped back’ habitations have been a
scourge of rural water supply programmes
in India2. Magnitude of this problem can
be gauged from the fact that, of the
6,03,639 habitations to be covered under
the Bharat Nirman Programme, 3,31,604
habitations (54.93 percent) were slipped back (http://ddws.gov.
in/popups/BNPcummulative.pdf, accessed on 10th March, 2009).
In the wake of increasing water stress and aging physical
infrastructure, slipping back is likely to pose major challenges.
Against this backdrop, NRDWP has been launched in the
country on 1st April, 2009 as a game changer, which heralds a
paradigm shift to move away from single source coverage of
habitations to universal access to safe drinking water on a
sustained manner for all rural people (NRDWP, Framework for
Implementation 2008-2012 is available at http://www.ddws.gov.
in/popups/FinalRWSGuideLines.pdf, accessed on 16th March,
2009). The Programme seeks to provide every individual
THE INDIA ECONOMY REVIEW 127
W E L F A R E E C O N O M I C S

Table 1: Plan-wise Expenditure Incurred on Providing Rural Drinking Water

PERIOD ARWSP STATE SHARE

Allocation Release Exp. Reported Provision Exp. Reported
st
1 Plan (1951-56) N.A 3.00
nd
2 Plan (1956-61) Not applicable as ARWSP 28.00 30.00
rd
was introduced
3 Plan (1961-66) from 1972-73 67.00 48.00
Annual Plans (1966-69) N.A N.A
th
4 Plan (1969-74) N.A 34.10 34.10 131.00 208.00
th
5 Plan (1974-79) 98.2 157.17 157.17 481.00 348.00
Annual Plan 1979-80 N.A 58.20 58.58 N.A N.A
th
6 Plan (1980-85) 1056.52 895.38 880.55 1407.66 1530.17
th
7 Plan (1985-90) 1922.35 1905.64 1931.21 2525.41 2471.53
Annual Plan 1990-91 423 410.54 391.58 646.33 595.85
Annual Plan 1991-92 758 644.49 505.68 744.49 692.54
th
8 Plan (1992-97) 4230 4139.74 3739.16 5458.63 5084.44
th
9 Plan (1997-02) 8563.95 8454.57 8032.85 12268.01 10773.11
th
10 Plan(2002-07) 16195.01 16254.43 12486.37 17892.80 15102.42
Source: Department of Drinking Water Supply, Government of India.

residing in rural areas with adequate water for drinking, by the Government of India.
cooking and other basic needs on a sustainable basis by Components of NRDWP, funds earmarked for them,
reviving traditional systems and promoting conjunctive use of interventions to be made and the funding pattern are given in
surface water, ground water and rain water. Table 3.

3.1 NRDWP Components 3.2 Criteria for Allocation of Funds

NRDWP retains all the components and the coverage norms
of ARWSP. Yet, there are radical changes in funds earmarked
and funding patterns. For instance, under ARWSP, around 68
percent funds were earmarked for coverage of habitations.
Reflecting the fast changing ground realities and priorities,
NRDWP earmarks only 38 percent of the funds for the
purpose. However, only five percent of the funds allocated for
ARWSP (coverage) (which in turn was around 68 percent of
the total allocation made for ARWSP) was earmarked for
sustainability. So, the actual allocation for the sustainability
component was just around 3.4 percent of the total funds under
ARWSP. In a major departure, NRDWP earmarks 20 percent
of the total funds for this component, which reflects the high
priority accorded by the Government of India to check
slippages. Apart from that, under ARWSP, funding pattern of
the sustainability component was 50:50 between the Central
and the State Governments. Under NRDWP, it is fully funded
Criteria for allocation of funds to the States under ARWSP
and NRDWP are featured in Table 4. Under ARWSP, 15
percent weightage was given to NC / PC habitations, which has
been widely regarded as a reward for inaction on the part of
the State Governments. Moreover, it allegedly goaded States to
over-report the incidence of slippage. Putting a firm lid on the
scope for such perverted incentives, NRDWP does not factor
in the number of NC / PC habitations while allocating funds to
the States. However, in order to incentivize community
ownership and management of water supply systems, NRDWP
gives 10 percent wieghtage to States where assets are trans-
ferred to Panchayati Raj Institutions.
3.3 Innovative Steps
Government of India needs to be complimented for a few more
ground-breaking steps, besides the ones discussed already,
initiated under the NRDWP. The most significant ones are

128 THE IIPM THINK TANK


Table 2: ARWSP Components
Component Funds Earmarked
Natural Calamity 5%
DDP Areas 5%
Support Activities / Programme 2%
Sub-Mission on Water Quality Up to 20%
Normal Rest of the funds
Source: Ministry of Rural Development 2008.
listed below.
1. Recognition of the Demand for Basic Drinking Water Needs as
a Fundamental Right: NRDWP Framework for Implementa-
tion 2008-12 categorically states that water is a socio-econom-
ic good and the demand for basic drinking water needs is a
fundamental right (Page 25). It goes on to add that drinking
water supply cannot be left to market forces as it does not
recognize the importance of providing livelihoods supply to
all, nor does it ascribe an appropriate value to health of the
people. It further states that the commodification of water will
shift the focus to profits to be made from a scarce resource
rather than human rights to water for livelihood (Page 9).
2. Drinking Water Security at the Household Level: Hitherto,
coverage had been measured in terms of habitations and
population (which was arrived at by multiplying the habita-
tions covered with corresponding population). The NRDWP
Framework for Implementation 2008-12 states that installa-
tion of a water supply system in a habitation does not confer
the ‘Fully Covered’ status on it unless every house hold in the
habitation has been fully covered with potable water in
sufficient quantity (Page 11). Moreover, NRDWP provides for
appointing village level workers – Jal Surakshaks – to
generate data on coverage at household level (page 62). That
the Government is serious about the whole exercise is
reflected in its making provisions for paying a regular salary
to Jal Surakshaks.
3. Creation of Technical Agencies: To breathe innovation and
WAT E R W I S D O M
Purpose Funding Pattern
For restoration of water supply 100% GoI funding
suffered on account of any kind of
natural calamity
For drinking water supply in DDP 100% GoI funding
blocks / areas
For various support activities relat- 100% GoI funding
ing to rural water supply
For addressing quality problems in 75:25 GoI and State
the affected habitations
-Up to 15% for operation and Up to 5% of total funds
maintenance, and for sustainability
- Remaining amount for coverage
- 50:50 GoI and State
fresh thinking into planning and implementation of rural
drinking water supply programmes, NRDWP provides for
engaging State Technical Agencies and National Experts
Groups for preparation of projects, technical scrutiny and
evaluation of rural water supply schemes.
3.4 Areas of Concern
1. Implementation Mechanism at the State Level:
Brisco and Malik (2006) observe that staffi ng levels of water
supply agencies in India are 10 times international norms, and
most public funds are spent feeding the administrative
machinery, not maintaining the stock of infrastructure or
providing services. Though the NRDWP intends to restruc-
ture State Rural Water Supply Implementing Agencies
(NRDWP Framework for Implementation 2008-12, Section
12.5, page 28), it remains to be seen as to how effective this
exercise would be. In this context, it may be worth recalling
the words of Prof. Wangari Maathai, 2004 Nobel Peace Prize
winner, that water crisis is a crisis of governance: man-made,
with ignorance, greed and corruption at its core (Transparency
International 2008).
Multiplicity of agencies at the State level is likely to do more
harm than good. Besides introducing Technical Agencies at
the State level, yet another agency – Water and Sanitation
Support Organisation (WSSO) – has been created at the State
level. WSSO will have a tough time figuring out its boundaries
as the space is already crowded with a host of other players
THE INDIA ECONOMY REVIEW 129
W E L F A R E E C O N O M I C S

Table 3: NRDWP Components

Component Funds Earmarked Purpose Funding Pattern

Coverage 38% Coverage of habitations 50:50 GoI and Stateµ

Water Quality 20% For addressing quality problems 50:50 GoI and Stateµ
Sustainability 20% To achieve drinking water security through en- 100% GoI
suring sustainability of sources and systems
O&M 10% For the O&M of water supply systems 50:50 GoI and Stateµ
DDP Areas 5% For providing drinking water in DDP areas 100% GoI
Natural Calamity 5% For restoration of water supply suffered on ac- 100% GoI
count of natural calamity
Support 2% For activities relating to IEC, HRD, Computer- 100% GoI
ization (MIS), water quality monitoring, R&D,
CCDUs, etc.

µ
90:10 for N-E States and J&K
Source: National Rural Drinking Water Programme, Framework for Implementation 2008-2012

such as SWSM, SWSC and CCDU, besides having SLSSC and
PHED / nodal agency for the implementation of water supply
programmes at the State level.
2. Absence of Effective Planning:
Importance of planning in ensuring drinking water security at
the household level cannot be over-emphasised in a country
with so much diversity in terms of agro climatic conditions and
hydro geological parameters. On the one hand, we grapple
with the seemingly insurmountable problems of slippages and
water quality. On the other, there are clear signs of over-provi-
sioning by schemes in many parts of States such as Uttar
Pradesh and Tamil Nadu (World Bank 2008).
Oft repeated reasons for slippages are sources going dry,
poor O&M and systems outliving its utility. Of these, the first
two could be addressed to some extent with proper planning.
For instance, a large piped water supply scheme based on
ground water is doomed to failure if it is set up in a place with
already depleted ground water resources. Similarly, it goes
without saying that a water supply system which is high on
O&M is ill-suited for a village with poor willingness and / or
capacity to pay.
Significant wastage of resources arises from over-provision-
ing by some schemes, defunct schemes, and the existence of
multiple schemes. In Uttar Pradesh more than half of the hand
pumps are shared by 10 or less households (as against a norm
of 50) and in 10 percent cases, a hand pump is shared by four
households or less. Such over-provisioning of services exists in
other states as well (with the exception of Karnataka) and is
particularly noticed in the case of Tamil Nadu (Ibid). There is
an urgent need to address this issue.
Though the Framework for Implementation talks about
preparing Village Action Plans (VAPs) and District Water
Security Plans based on VAPs (Page 33), it appears that it is a
statement of intent, not a pre-requisite for funding. Enduring
drinking water security can be achieved only if context specific
systems are put in place based on parameters such as source of
water (surface vs ground), type (hand pump vs piped water
supply [single village scheme vs multi-village scheme]), inter-
and intra-village conflicts (caste and political), affordability
(willingness and ability to pay), etc. Absence of comprehensive
planning is a recipe for over provisioning and further slippages.
3. Over Dependence on Civil Society Organisations:
NRDWP envisages the civil society organizations to play a
prominent role in planning, community mobilisation, imple-
mentation and operation and maintenance of water supply
programmes. Even as I appreciate the critical role that such
organizations can play in bringing about drinking water
security in our villages, I strongly believe that we need to be
mindful of their limitations as well. The civil society argument
has now been around for about 25 years. The problems of the

130 THE IIPM THINK TANK


Table 4: Criteria for Fund Allocation under ARWSP and NRDWP sections of the society, a great deal of its
S. No Criteria Weightage (in %)
ARWSP
1 Rural population 40
2 Not Covered / Partially Covered villages 15
3 Quality affected villages 10
4 Rural population managing rural drinking 0 10
water supply schemes
5 States under DPAP, HADP and special cat- 35
egory Hill States in terms of rural areas
Total 100
Source: Ministry of Rural Development 2008 and NRDWP Framework for Implementation 2008-2012
world remain as intractable, even as the numbers of agents who
seek to negotiate the ills of the human condition have expand-
ed exponentially. In popular imagination, the State still seems
to occupy a central position. And it is clear that there are
certain problems that only the State can resolve, and should be
resolving (Chandhoke 2009).
To put things in perspective, the forgoing contention may be
juxtaposed with some observations made by the CAG recently.
It observes that over Rs. 51,000 Crore allocated for the flagship
anti-poverty and development schemes in 2007-08 was trans-
ferred to the bank accounts of NGOs, autonomous bodies and
district authorities. However, the Government has told the
CAG that it was not aware of the actual expenditure by those
organizations. The CAG goes on to say that as the money is
kept outside government accounts, it is beyond the purview of
any checks and balances of the Government of India (Anony-
mous 2009). So, it may be a better idea to pay more attention to
reviving the government machinery than placing too much
hope on civil society organizations to redeem the situation,
only to be disillusioned, yet again, with the passage of time.
4. Conclusions
Considerable amount of resources have gone into the
provision of drinking water in the rural areas of India and
the outcome is encouraging. To address the changing
realities of life, Government of India has launched a new
programme, incorporating the wisdom accrued over
decades through the implementation of water supply
programmes. Though it comes with a whiff of fresh thinking
and bold measures to safeguard the interests of the weaker
WAT E R W I S D O M
success depends on its effective implementa-
tion. We should not forget that a programme
NRDWP
is as good as its implementation.
60
0
Endnotes
0 1
Page 46, NRDWP Framework for Imple-
mentation 2008-12.
2
Slipped back refers to the situation wherein a
30
Fully Covered habitation slips back in to the
status of either Partially Covered or Not
100
Covered, owing to either decline in supply
level or water quality problems or both.
References and Additional Thinking
• Anonymous (2009): “Central Government may be Over-
stating Spending on Aam Aadmi”, Times of India, 23rd
February 2009, New Delhi.
• Brisco, John and R.P.S. Malik (2006): India’s Water
Economy – Bracing for a Turbulent Future, World Bank,
New Delhi.
• Chandhoke, Neera (2009): “Putting civil Society in Its
Place”, Economic and Political Weekly, 44(7), PP 12-16.
• Ministry of Rural Development (2008): Annual Report
2007-08, Government of India, New Delhi.
• Planning Commission (2007a): Ground Water Manage-
ment and Ownership – Report of the Expert Group, New
Delhi.
• Planning Commission (2007b): Report of the Steering
Committee on Water Resources for Eleventh Five Year
Plan (2007-2012), New Delhi.
• Transparency International (2008): Global Corruption
Report 2008 - Corruption in the Water Sector, Cambridge
University Press, Cambridge, UK.
• UNDP (2006): Human Development Report 2006 - Be-
yond scarcity: Power, Poverty and the Global Water Crisis,
New York.
• UNICEF and WHO (2008): Progress on Drinking Water
and Sanitation, New York.
• World Bank (2008): Review of Effectiveness of Rural
Water Supply Schemes in India, New Delhi.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation).
THE INDIA ECONOMY REVIEW 131
L A W A N D E C O N O M I C S

Review of Economic
Development and
Legal System: An
International Perspective
“Criminal law, while it has major non-economic functions,
also services to deter theft and some forms of economic fraud.
Civil law has economic aspects centrally in its concerns.
Contract law can be said to be mainly for the governance of
economic activity; laws of tort and liability pertain to contracts
as well as not-contractual relationships, both mainly in the
economic sphere” – Dixit A.K. (2004)

Introduction
Economic development is one of the main objectives of all
economies in the modern world. Achieving this objective
depends on the macro economic factors like investment,
exchange rate, inflation, etc. In addition to that, economic
development is also affected by micro economic institutions
like property rights, contract enforcement etc. These are
institutional environment which facilitates micro economic
decisions. Kohling (2000) assumed indirect correlation
between economic activities and legal system i.e., the
judiciary itself has no impact on productive factors, but
through individual decision-making, it can influence eco-
nomic relevant decisions. In short, these micro economic
institutions are mainly related to the country’s legal system1.
Role played by the institutions for achieving economic
development is growing steadily. Among the institutions,
judicial system plays an important role in the economic

Uma Sankaran
Research Scholar, Centre for Development
Studies (CDS), Trivandrum

132 THE IIPM THINK TANK


References and Additional Thinking
• Acemoglu D, Johnson S, Robinson A. J. (2001), “ The
Colonial Origins of Comparative Development: An
Empirical Investigation”, The American Economic
Review, Vol. 91, No. 5, Dec., pp. 1369-1401
• Banerjee A and Iyer L History (2005), “Institutions, and
Economic Performance: The Legacy of Colonial Land
Tenure Systems in India” The American Economic
Review, Vol. 95, No. 4, Sep., pp. 1190-1213
• Barro J., Robert (1991), “Economic Growth in a Cross
Section of Countries”, The Quarterly Journal of Eco-
nomics, May, Vol. 106, No. 2, pp. 407-443
• Chemin, Matthieu (2004), “Does the Quality of the
Judiciary Shape Economic Activity? Evidence from
India”, Department of Economics, LSE, October.
- (2007), “Does Judicial Quality Shape Economic Activ-
ity? Evidence from a Judicial Reform in India”, Cahier de
recherche/Working Paper 07-25, September
• Cross, B., Frank (2002) “Law and Economic Growth”,
Texas Law Review, 80 (7), June, 1737-75, (Ed.) Hans-
Bernd Shafer and Angara V. Raja, “Law and Economic
Development”.
• Davis E., Kevin and Trebilcock J., Michael (2001), “Legal
Reforms and Development”, Third World Quarterly,
22(1), 21-36, (Ed.) Hans-Bernd Shafer and Angara V.
Raja, “Law and Economic Development”.
• Demsetz Harold (1967), “Toward a Theory of Property
Rights”, American Economic Review, 57 (2), May,
347-59, (Ed.) Posner A., Richard and Parisi Fransesco,
“Economic Foundations of Private Law”.
• Douglass C. North (1991), “Institutions”, The Journal of
Economic Perspectives, Winter, Vol. 5, No. 1, pp. 97-112
- (1996), “Institutions, Institutional Change and Econom-
ic Performance”, Cambridge University Press.
• Feld P., Lars and Vogit, Stefan (2003), “Economic
Growth and Judicial Independence: Cross Country
Evidence using a new set of Indicators”, CESifo Working
Paper No. 906, April.
• Ginsburg Tom (2000), “Review: Does Law Matter for
Economic Development? Evidence from East Asia”, Law
& Society Review, Vol. 34, No. 3., pp. 829-856.
• Klerman, Daniel, “Legal Infrastructure, Judicial Inde-
pendence, and Economic Development”
• Kohling, K.C., Wolfgang (2000), “The Economic Conse-
L A W G R O W T H N E X U S
quences of a Weak Judiciary”, Centre for Development
Research, University of Bonn, Germany, November.
• Maria Dakolias (2003), “The Role of the Judiciary for
Economic and Social Development”, November 14th,
2003 Speech to the EU Judiciaries Representatives The
Hague, The Netherlands
• Pinheiro, Armando Castelar (1996), “Judicial System
Performance and Economic Development” October.
• Pistor, Katharina and Philip A., Wellons (1999), “The
role of law and legal institutions in Asian economic
development : 1960-1995”, Asian Development Bank,
Executive Summary.
• Posner A., Richard (1998), “Creating a Legal Framework
for Economic Development”, World Bank Research
Observer, 13(1), February, 1-11, (Ed.) Hans-Bernd
Shafer and Angara V. Raja, “Law and Economic Devel-
opment”.
• Rabiyath, Siddik (2007), “Litigation, Disposal Efficiency
and Pendency: A Comparative Analysis of Kerala and
Andhra Pradesh”, M.Phil., dissertation, University of
Hyderabad.
• Santhakumar V. (2003), “Citizens’ actions for protecting
the environment in developing countries: an economic
analysis of the outcome with empirical cases from India”,
Environment and Development Economics 8: 505-528,
Cambridge University Press.
• Scully W., Gerald (1988), “The Institutional Framework
and Economic Development” The Journal of Political
Economy, Jun., Vol. 96, No. 3, pp. 652-662
• Visaria, Sujata (2006), “Legal Reform and Loan Repay-
ment: The Microeconomic Impact of Debt Recovery
Tribunals in India”, April.
• World Bank (2002), World Development Indicators.
• Xavier, Francis Rathinam (2007), “Law, Institutions and
Finance: Time Series Evidence from India”, German
Working Papers in Law and Economics, Paper 4.
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation. The
earlier version of this paper was presented in Centre for
Development Studies. Here the author acknowledges Dr.
Shanthakumar, Dr. Sunil Mani, and other participants who are
all given valuable comments to the author and a special thanks
goes to Alice Sebastian and Krishna Reddy Chittedi.)
THE INDIA ECONOMY REVIEW 141

performance and development of market economies
[Pinheiro - 1996, World Bank - 2002]. It does so in many ways:
the judiciary is the mechanism whereby disputes on the
allocation of rights mainly property rights, disputes between
private parties, private and public parties are decided
according to norms and rules of the society. Consequently,
institutions help to reduce uncertainty by providing a
structure to everyday life [North - 1996]. Posner (1998)
mentioned that legal machinery in its ideal form consists of
competent, ethical, and well-paid professional judges,
lawyers, police or other functionaries who administer rules
that are well designed for promotion. It is necessary because
efficient legal system depends on the efficacy of the institu-
L A W G R O W T H N E X U S
tions which is implementing the rule of the law.
Kohling (2000) argues that a country’s government can
influence the economy negatively through a weak adminis-
tration. Inappropriate mechanisms that lack checks and
balances create corrupt government. Therefore judiciary is
the appropriate body to exercise control over such a corrupt
administration. Thus, an unbiased judiciary is essential for
economic development. Hence law is not only considered as
a dispute resolution system but also considered as an
important instrument of economic development.
Economic theory supports the idea of judicial independ-
ence and high quality courts facilitate economic growth [Feld
and Vogit - 2003]. Efficient, independent, and impartial
courts enforce contracts and protect property. This encour-
ages investment which is essential for economic develop-
ment. It is therefore important to study the economic
implications of the legal system in the context of developing
countries. In those countries, law enforcement is poor
because the general institutional structure is weak.
This paper has a dual objective. First, to review the
theoretical arguments that helps to understand how efficient
judicial system helps to attain economic growth. Second, to
review literature which explain the relationship between
judicial system and economic performance. Special attention
is given to studies with empirical content related to India.
What is Well-Functioning Judicial System?
Before going into the analysis of the theoretical and empiri-
cal literature, which explains the relationship between legal
system and economic development, it is necessary to under-
stand the well-functioning judicial system and the ways it can
affect economic development.
A well-functioning judicial system should have the follow-
ing properties such as low cost access, transparency, fairness,
predictability, and timely outcomes which help to promote
business and commercial activities through protecting
property rights of the individuals [Maria Dakolias (2003),
Pinheiro (1996)].
Kohling (2000) identified three preconditions for institu-
tions to be efficient: (i) the respective institutions are well
defined; (ii) all necessary information is verifiable; and (iii)
the absence of cost for transferring or securing of property
rights. According to him inefficiencies usually emerge due to
information asymmetries or incomplete information as not
THE INDIA ECONOMY REVIEW 133
L A W A N D E C O N O M I C S
all contingencies can be foreseen, and therefore the respec-
tive solutions cannot be included a priori in contracts.
What Ways Legal System
Can Promote Economic Growth?
Piheiro (1996) mentioned that in the supply side growth,
well-functioning judiciaries can promote growth through
the following channels: Technological progress, investment,
and efficiency.
Technological Progress Institutions are
Well-functioning legal system may humanly devised
stimulate growth by protecting intellec- constraints (formal
tual property rights and in this way
and informal) that
fostering technological progress and
absorption. It can encourage domestic
structure political,
firms to invest in Research and Develop- economic, and
ment (R&D). This leads to wider diffu- social interactions
sion of knowledge, including not only
spillovers, but also the transmission of sound managing,
marketing and financing practices.
Investment
By stimulating a more rapid accumulation of factors of
production, well-functioning judicial system can encour-
age investment in both physical and human capital
through secure property rights. Particularly private agents
will only make long-term and highly specialized invest-
ments if they are secure that the contract activities will be
properly enforced.
Efficiency
Dysfunctional judicial system can limit growth by stimulat-
ing inefficient use of resources and technology through high
risk and large transaction cost. And it can reduce economy’s
efficiency by consumption of scarce resources.
Cross (2002), quoted Lon Fuller stressed point that
property and contract rights are vital to growth, a legal
system must restrain the “rigidities of property and con-
tracts” so that the society can “direct its resources toward
their most effective use.” Therefore the efficiency of the
judiciary is important not only for themselves, but also for all
other institutions for promoting long-term investment and
contracts. As the judiciary enforces and monitors all other
134 THE IIPM THINK TANK
institutions, a weak judiciary can affect the performance of
all other institutions.
Theoretical Background of
Legal Institutions and Development:
This section theoretically analyses the importance of legal
institutions for reducing uncertainty and transaction cost
which encourages economic activities in the economy.
Institutions are humanly devised
constraints that structure political,
economic, and social interaction. They
consist of both informal constraints (sanc-
tions, taboos, customs, traditions, and
codes of conduct), and formal rules
(constitutions, laws, property rights).
These institutions provide the incentive
structure of an economy; as that structure
evolves, it shapes the direction of eco-
nomic change towards growth, stagna-
tion, or decline [North – 1991].
‘New Institutional Economists’ argued that economic
development requires many kinds of investment such as
physical capital, human capital etc. Investment will occur if
investors can be confident that they will attain their profits.
Investment will undermine if the government or a private
party expropriates the investment or profit [North - 1996]. If
no mechanisms such as governmental or non-governmental
exist to prevent theft, then any person can wait for others to
create property or produce output and then steal it; this
usually makes less effort to creating property or the product
oneself [Dixit – 2004].
Ginsburg (2000) quoted North view of “How effectively
agreements are enforced is the single most important
determinant of economic performance”. Feld and Vogit
(2003), summarizes the institutions importance to reduce
uncertainty and how it helps to improve the investment
which is essential for growth.
Among the many functions of government, the reduction of
uncertainty is of paramount importance. But the law will
only reduce uncertainty if the citizens can expect the letter of
the law to be followed by government representatives. An
independent judiciary could thus also be interpreted as a
device to turn promises – e.g. to respect property rights and
abstain from expropriation – into credible commitments...

citizens will develop a longer time horizon which will lead to
more investment in physical capital but also to a higher
degree of specialization...
In the marketplace transaction can be concluded as two
bundles of property rights are exchanged. A bundle of rights
often connects with a physical commodity or services, but
that value of the rights determines the value of what is
exchanged [Demsetz -1967]. Market economy can not have
efficient exchanges in the presence of high transaction costs
and externalities [Rabiyath – 2007]. Transaction costs are
higher when law is uncertain [Scully – 1988]. In the small
economy i.e. closed economy transaction costs are low;
because of the face to face transactions. But when the econo-
my or market begins to grow transaction costs will sharply
increase due to complex production system. In this complex
system production costs are high through specialization and
division of labour. This requires safeguard of property rights
across national boundaries so that capital markets (as well as
other kinds of exchange) can take place with credible
commitment on the part of the players. Therefore it de-
mands the effective institutions which can reduce transac-
tion costs through reducing the asymmetric information.
Obviously transaction costs are a critical determinant of
economic performance. Ultimately, institution's effective
enforcement determines the cost of transactions. In other
words, effective institutions can raise the
benefits of cooperative solutions or the The shortage of
costs of defection [North – 1991]. empirical research
is a problem
Non-Legal Rules
or Informal Rules
that affects the
While institutional economists consider
entire field of
the effective value of legal institutions institutional
and property rights, non-institutional economics
economists are argued that the actual
need for such institutions may be exaggerated. Judicial
independence and good courts are not necessary for invest-
ment, there are other mechanisms which can enforce
contracts and protect property. Contracts can be enforced by
reputation, without recourse to the courts. When parties
deal with each other repeatedly contracts may be respected
because people fear of their good reputation. Similarly, the
government can protect property through policies against
expropriation disputes [Klerman]. In other words, individu-
L A W G R O W T H N E X U S
als can voluntarily organise their transactions2, without legal
institutions i.e., they may substitute co-operation for law, in
that manner can reap their profits. These informal substi-
tutes, includes arbitration and reputation, for the legal
enforcement and protection of property and contract rights
[Posner - 1998].
However such kind of an informal framework may limit
transactions within one family members or ethnicity [Cross
- 2002]. Small number of players finds it worthwhile to
cooperate when they play repeatedly and when they possess
complete information about the other player’s past perform-
ance. But cooperation is difficult to sustain when the game is
not repeated, when information on the other players is
lacking and when there are large numbers of players [North
– 1991]. As a consequence, shortage of new firms and people
with new ideas and entrepreneurship, and an inability to
enter into long-term contracts can prevent the adoption and
development of complex technologies. In addition that
institutions need not and generally has not prohibited the
norms and private arrangements such as arbitration agree-
ments, but considerably expands the scope of contracting
choices [Cross – 2002].
In short, there are two schools of thought: one belongs to
institutional economics which is giving importance for
formal institutions and another school which is for informal
institutions. It is therefore not clear from
a theoretical standpoint how much
institutions are important for economic
development. This lacuna needs to be
filled with empirical evidence which
shows the relationship between legal
system and economic development.
Review of Literature:
International Perspective
Institutions are so ingrained with social, economic, legal, and
political life that it is difficult to isolate the impact of one
institution such as legal, on economic performance. There-
fore the shortage of empirical research is a problem that
affects the entire field of institutional economics. In spite of
that, the following empirical literature tries to provide the
relationship between judicial system and economic develop-
ment. There is renewed interest among economists in the
question of what are the fundamental factors for the large
THE INDIA ECONOMY REVIEW 135
L A W A N D E C O N O M I C S
difference in income per capita across countries? Though
there are multiple answers for this question, differences in
institutional framework and property rights have received
considerable attention in recent years. One of the impor-
tant studies in this context was by Scully (1988). The study
tried to explain the impact of the choice of institutional
framework on efficiency and growth of economies. The
study used linear multiple regression analysis and the
model incorporated economic variables (viz. real per capita
gross domestic product and capital-labour ratio) and
institutional variables (viz. political, civil, and economic
liberty) for 115 market economies for the period 1960 to
1980. The study found that politically open societies, which
subscribe to the rule of law, to private property, and to the
market allocation of resources, grow at three times the rate
and are two and one-half times as efficient as societies in
which these freedoms are circumscribed.
However, most of the countries are facing political
instability rather than liberty. Therefore, Barro (1991)
studied the impact of political instability on economic
growth for 98 countries in the period 1960-1985. The study
used regression technique for analyzing the impact of
revolutions and coups, and per million population of
political assassinations on per capita growth. The study
showed that both these variables are negatively affecting
investment and economic growth via
adversely influence the property rights.
The limitation of this study is that, it Differences in
doesn’t explain how these variables are historical property
adversely affecting property rights, rights institutions
because political assassination may
lead to continued
happen for several purposes.
While institutional framework is
differences in
considered as an important instrument many economic
for explaining differences in income outcomes
between countries there is a little doubt
about that whether history has any role in determining the
shape of present-day institutions and the economic perform-
ance of the countries? In this context an interesting study
was conducted by Acemoglu et al. (2001). It argued that
differences in colonial experience could be a source of
differences in institutions. The study analyzed the European
colonization; Europeans adopted different strategies
associated with institutions. In places where they faced high
136 THE IIPM THINK TANK
mortality rates or where they could not settle safely, they
created extractive states or did not protect private property
rights. The study used regression method and model in-
cludes economic outcome (per capita GDP) and institution-
al variable (protection against expropriation) for a sample of
64 countries. The study found that early institutions persist-
ed to the present; therefore settler mortality rates do not
have direct effect on income today other than through their
influence on institutions. However, this study analyzed
whether the settlement of institutions during the coloniza-
tion have any impact on present day institutions, it is impor-
tant to study whether any specific historical institution
followed during the colonization period have impact on
present day economic performance.
Banerjee and Iyer (2005) attempted to compare the
present-day economic performance of different districts of
India, which were placed under different land revenue
system by British colonial rulers. The study showed that
differences in historical property rights institutions lead to
continued differences in economic outcomes, i.e., areas in
which property rights of land were historically given to
landlords have significantly lower agricultural investments
and productivity in the post-independence period than areas
in which given to the cultivators.
While property rights or choice of institutions are consid-
ered as important for economic growth,
the qualities of these institutions are also
equally important. In this aspect an
interesting study done by Feld and Vogit
(2000) analyzed the relationship between
economic growth and judicial independ-
ence (JI). The study introduced two
indicators of JI such as de jure and de
facto. Whereas de iure JI can be derived
from the legal documents, de facto JI is
the independence enjoyed by judges and
justices does not suffice to write in legal documents. The
study used econometric model which incorporated economic
variables (viz. real GDP per capita, private and public
investment etc.) and JI variables such as accessibility of the
court, appointment procedure of judges, constitutional
specification of the court’s procedures, tenure of judges and
their salaries etc. for de jure and length of the members of
the high court, court’s budget etc. for de facto for a sample

of 57 countries between 1980 and 1998. This study found
that de jure JI does not have any impact on economic growth
and de facto JI positively influences economic growth. The
limitation of this study is associated with the collected data
for de facto. This study defines JI as judges can expect their
decisions to be implemented regardless of other government
branches upon whom implementation depends. For analyz-
ing de facto this study collected data through questionnaire
(via e-mail). If respondents answered
socially desired answer for this question3
then the results may be questionable. Presence of
Economists have also analyzed the crime constitutes
importance of law for economic growth in a competitive
context of liberalization or market
disadvantage,
orientation, because in recent years most
of the countries liberalized their econo-
limiting the area’s
mies for integrating with the rest of the potential for
world. So it is important to study, in the attracting FDI
open market regime, how legal system is
important for economic growth. In this aspect an important
study conducted by Pistor and Wellons (1999) analyzed the
relationship between law and economic development
experience with Asia. The study covered six East Asian
economies for the years of 1960-1995. The study found that
by mid 1980s all economies moved from state-led economic
policy to market-oriented solutions, law became important.
Therefore, it concluded that law mattered for economic
development in the period after the policy shift. An impor-
tant question regarding this study conclusion is that, if law is
important for economic development after the policy shift
means, before that whether law does not matter for econom-
ic growth or is this study accepting the non-institutionalist
view? This study doesn’t answer these questions.
Apart from property rights and law efficiency one
important aspect which is missed in the theoretical argu-
ment is how weak legality, which arises from the violation
of laws, can affect investment and economic growth. An
interesting study in this perspective done by Daniele and
Marani (2008) analyzed the impact of organized crime on
Foreign Direct Investment (FDI) in Italy. The study found
that in Italy compared to northern part, southern part
attracts very less FDI. Italy is rooted presence of organized
criminal organizations (viz. camorra, mafia, sacra corona
unita etc.) So the study hypothesized that the presence of
L A W G R O W T H N E X U S
crime constitutes a competitive disadvantage which limits
the degree of an area’s attractiveness for potential foreign
investors. After controlling the relevant economic vari-
ables, this study found that the extortion of money and the
number of accused persons, which are proxies for organ-
ized crimes negatively affects FDI inflows. But the limita-
tion associated with this study is that, it doesn’t address the
impact of organized crime on domestic investment. If
domestic investment itself is affected by
these types of crimes, then there is no
point to expect foreign investment.
One of the main criticisms of cross-
country empirical study is that, cross
country regression are based on unrealis-
tic assumptions such as equal growth path
and equal weighting of countries and also
suffer omitted variable bias and sample
selection bias [Barro - 1991]. And to
control for a range of factors that influ-
ences economic performance cannot be as convincingly
controlled for in cross country data [Chemin – 2007].
Therefore, it is necessary to study the country specific
empirical studies which explain the relationship between
legal system and economic growth.
The Indian Case:
India seems to be an interesting testing ground to analyze
the relationship between legal system and economic devel-
opment; it is one of the developing countries that witnessed
dramatic deregulations in various sectors during the 1990s.
These efforts need a complementary reform in legal sector
also. Postner (1998) suggests that legal reform is an impor-
tant process for poor countries, but the focus of such reforms
should be on creating substantive and procedurally efficient
rules of contract and property than on creating a first-class
judiciary. The Indian judiciary operates at three levels: a
unique Supreme Court at the federal level; High Courts in
each state; and, at lower levels, district judges for civil cases
and session judges for criminal cases. India operates under a
common law system which implies that the actions of High
Court judges set precedents for the functioning of subordi-
nate courts in Indian state4. Judicial efficiency and speed in
India seems to be the greatest problem with courts in India,
dominating all other problems such as fairness, predictability
THE INDIA ECONOMY REVIEW 137
L A W A N D E C O N O M I C S
and access to the judiciary [Chemin – 2004]. Pendency in
India has been growing four percent in High Courts and 3.6
percent in the Subordinate Courts in the period 1999-2005
as against a mere of 1.29 percent in US Courts for the period
1990-1998. Average duration for disposal in India is 5-10
years where as it is only one year in US [Rabiyath – 2007]. In
a study of citizens’ action against environment damage
Santhakumar (2003) mentioned that delay in court decisions
will create social loss via more pollution if
citizens’ action is against existing firms or
affect production if it is against new firms. Pendency has
For reducing pendency in Indian been growing
courts, which is one of the notable at 4% in High
problems, several measures have been
Courts and 3.6%
introduced in the last decade like Lok
Adalat5, Debt Recovery Tribunals
in the Subordinate
(DRT)6, and Code of Civil Procedure of Courts in the
1908 Amendment Act7 of 2002 etc. It is period 1999-2005
therefore important to study how these
legal reforms or procedural laws helps to increase the quality
of judiciary and to improve economic development of the
country. Though there are different dimensions of the
empirical literature available in the case of cross-country
analysis, country specific literature are limited particularly
related to India. In the next section we attempt to review the
available empirical literature on India.
In this section we review the empirical studies which have
attempted to examine the impact of pending cases on
economic growth and effects of legal reforms, which is speed
up the disposals of cases, on economic growth in India.
Regarding pending cases, the first question raised in our
mind is that whether pending cases affects economic growth
or not. One of the important studies in this context done by
Kohling (2000) examined the economic consequences of a
weak judiciary on the economic growth using data on 25
Indian states and union territories for the period 1971 to
1996. The study used cross-regional time-series regression
and the model includes economic variables such as per
capita income, agricultural production, private sector
development, capital formation, poverty rates, etc. and
judicial variables such as speed of the judiciary or average
years of backlogs in the High Court (viz. ratio of pending
cases at the beginning of the year to cases decided within
that year) and predictability of the High Court rate (viz.
138 THE IIPM THINK TANK
ratio of allowed appeals from High Court to Supreme
Court). The study concluded that a weak judiciary has a
negative effect on economic development which leads to
lower per capita income, higher poverty rates, lower private
economic activity, poorer public infrastructure, higher crime
rates, and industrial riots. Here it should be noted that the
weakness of this study is that, it identified predictability
through allowed appeals from High Courts to Supreme
Court, in India appeals to the Supreme
Court is only for matter of law not for
matter of fact and this study is concerned
weakness of the High Courts only. This
kind of studies mainly suffer from the
limitation that it doesn’t make any
distinction between economically rel-
evant cases and others. It may thus be
over estimating the pendency in Indian
High Courts.
Chemin (2004) analyzed how the case
pendency rate in state courts in India affects the contracting
behaviour of 170,000 small non-agricultural informal firms
from the 55th round of the National Sample Survey of 2000.
The study used Probit regression technique and after
controlling the state-level (through state domestic product,
literacy rates, state expenditure etc.), firm-level variables
(through indebtedness, financial sources, labour productivity
etc.), sector-specific effects, and panchayats and rural
planning commissions information, the study found that the
slow judiciary, which is measured by ratio of pending cases at
time period ‘t’ to the pending cases at ‘t-1’ plus cases filed,
implies more breaches of contract, discourages firms from
undertaking specialized investment, impedes the access of
firms to formal financial institutions, and favours inefficient
family-owned firms.
However, for reducing pendency Indian courts intro-
duced various legal reforms to speed up the disposal of
cases. Thus it is interesting to study whether these legal
reforms really helps to increase the speed of the disposal of
cases and if it is so, how it helps to improve the economic
growth. One of the important studies in the context was by
Visaria (2006). The study analysed the Recovery of Debts
due to Banks and Financial Act, 1993 (Debt Recovery
Tribunal Act), a judicial reform which aimed at accelerating
banks' recovery of Non-Performing Assets (NPAs) through

speed up the legal process. The study used difference-in-
differences strategy based on two sources of variation (the
monetary threshold for claims to be eligible for these
tribunals and the staggered introduction of tribunals across
Indian states) and showed that the establishment of
tribunals reduces delinquency in loan repayment by
between three and 11 percent. Furthermore, new loans
sanctioned after DRT establishment are charged interest
rates that are lower by 1.4-2 percentage points.
Chemin (2007) investigates the impact of judicial reform,
enacted in 2002 Amendment Act to the Civil procedure
Code of 1908 in order to make litigation more efficient, on
firms contracting behaviour and economic performance of
5,20,000 small informal non-agricultural firms from 2000 and
2002 rounds of National Sample Survey. The study used the
spatial variation in the implementation of judicial reform
and found that this reform decreased the number of cases
pending per judge in lower courts. For analyzing firms
behaviour the study used regression technique and after
controlling state and sector specific effects, the study found
that a speedier judiciary leads to decrease in the breaches of
contract, encouraged investment, facilitated access to
finance, and expanded rental markets. The drawback of this
study is that it controlled alternative dispute resolution
system such as fast-track courts and Lok Adalats, but in rural
areas people still depends on panchayats
for solving their disputes. This study does
not control this alternative informal Though pendency
dispute solution system and firm specific is the potential
effects. Nevertheless, this study explains problem in Indian
judicial reform positively influencing
courts, there are
economic behaviour of firms.
Xavier (2007) analysed the long run
other problems
relationship between finance and growth like corruption
through the determinants of financial and instability
sector growth such as legal and institu-
tional developments and financial regulation in India.
During 1990’s India introduced various legal reform,
Securitization and Reconstruction of Financial Assets and
Enforcement of Security Interests Act (SRFAESI Act), Debt
Recovery Tribunals Act etc. It is expected that these innova-
tions in the procedural law would facilitate financial sector
development. The study analyzed these effects in the VAR
system, incorporated following variables such as per capita
L A W G R O W T H N E X U S
GDP and Legal Development (procedural law and regula-
tory reforms as they matter for the speed and the quality of
redress), Financial Regulation (statutory liquidity ratio and
other interest rate controls) and Index of Institutional
Development (a ratio of broad money net of currency in
circulation to broad money) indicies. This study identified
that a single co-integrating vector in all of the specifications
indicating that there is a long run relationship among the
variables considered. The result shows that legal, institution-
al developments positively affect financial sector with
considerable feedback and economic growth with less
feedback and financial regulation has a negative impact on
financial sector growth. The interesting aspect in this study is
that the studies which we reviewed above showed one way
relationship i.e., improvement of the judicial quality leads to
increased economic activities, but this study is expressing
two way relationship which is development of financial
sector demands the legal development.
From the above studies we can understand that law and
governing institutions are clearly relevant for economic
growth.
Scope for Further Research:
In the case of cross country studies it deals with different
aspects of legal system such as political or property rights,
policies, judicial independence etc., but
in the case of empirical studies from
India directly or indirectly deals with
quality of judiciary which is delay in court
decision or backlog of pendency in
Indian courts and how it affects the
economic growth. Some studies deals
with judicial reforms which are also
related to pendency cases in Indian court,
how the judicial reform helps to increase
the speed of the judiciary, and how it
helps to promote the economic growth of the country. With
these one dimension studies it is difficult to articulate, for
practical purposes what laws and implementing organiza-
tions are most effective at enhancing economic growth and
what actions preventing such growth. Though pendency is
the potential problem in Indian courts, there are other
problems such as legal corruption, political instability, legal
process (much procedures to approach courts will increase
THE INDIA ECONOMY REVIEW 139
L A W A N D E C O N O M I C S
transaction costs), implementation of law, implementation
institutions etc. But empirical studies from India do not
address these issues.
Another important issue is that legal institutions do not
play a wholly autonomous role in development; their
effectiveness depends on the effectiveness of a number of
other institutions. Therefore it is important to study legal
systems as well as other institutions such as Government
upon which the efficiency of judicial system depend simul-
taneously.
In India sector specific studies are also limited for e.g.
Kohling (2000) render specific look at the agriculture sector
and he found that in India thirty percent of the civil claims
related to land ownership, rent, and other related issues.
Therefore increasing the quality of the judiciary facilitates a
higher agricultural production and reduces the long-term
poverty rates through long-term investments. Though some
of the studies which we reviewed show the financial sector
development and growth, these deals with the banking
sector reforms only. In recent years India’s services sector is
experiencing faster growth than other sectors. These
studies do not talk about how legal reform helps services
sector, except financial sector, to achieve this growth as
most of the services sectors are in informal sectors. It is
important to study how legal system or reform relates
services sector growth particularly in the informal sector.
In other words, these studies use the variables which are
representing the characteristics of legal institutions and
they do not concentrate much on which type of institutions
play the most important roles in development. Though
legal institutions are important for economic growth, it is
only part of the legal system. These studies do not address
the issue of relationship between legal system and econom-
ic development. Therefore, in that context additional
researches are required to explore the relationship between
law and economic development.
Summary and Conclusion
In theory, according to New Institutional Economists,
institutions particularly legal or formal institutions are
important for achieving property rights which encourages
investment that is essential for economic growth, because
investment will occur only if investors are confident that
they can reap their profits.
140 THE IIPM THINK TANK
At the same time non-institutional economists who are
arguing that the importance of legal institutions are
exaggerated, individuals themselves can organize institu-
tions and in that manner they can attain their profits and
contracts can be enforced through reputation. But this is
possible only in the closed or primitive society. When
society expands or it becomes complex market economies it
needs proper institutions which enforce private property
rights and contracts. Therefore, it is important to under-
stand the relationship between legal system and economic
development with the help of empirical studies.
This paper reviews the Cross-country and Indian empiri-
cal studies which are exploring the relationship between
legal system and economic development. India is one of the
developing countries facing the potential problem of large
backlogs in its courts. In order to solve that Indian courts
introduced some legal reforms to speed up the disposal of
cases. These are expected to improve economic develop-
ment via supporting the liberalization of the economy.
Therefore, India is the interesting ground to test the
relationship between legal system and economic growth.
Though in India not much empirical studies available in
different dimensions, the studies which we reviewed
illustrate the importance of the quality of the judiciary on
economic development. Therefore, with the help of
literatures this study concluded that there is a direct
relationship between legal system and economic develop-
ment in India.
Endnotes
1
I will use the words judicial system and legal system
interchangeably in what follows
2
The best example is diamond business.
3
“In how many cases has one of the other government
branches remained inactive when its action was neces-
sary for a decision to become effective?”
4
Chemin - 2004
5
Lok Adalat is dispute resolution mechanism which
follows the methods of conciliation and mediation are
employed to settle cases before goes into the court.
6
Banks and financial institutions can recover their non-
performing loans through DRT quickly.
7
It encourages out-of-court dispute settlement such as
arbitration, conciliation, mediation etc.
L A W A N D E C O N O M I C S

Free Trade and Free

Markets: A General Law
Perspectives

142 THE IIPM THINK TANK


Rabin Majumder
Advocate & Attorney,
NuDelhiLawFora, Law Firm, New Delhi
A. Introduction
Commodity exchange or bartering to hunters’ flesh trade
for produce to even fresh fruits producers’ practice for
vegetable to mediums such as stone, metal, and later coins
and paper money to trading papers of shares, bills, promis-
sory notes, and all kinds of future instrument to high-end
technology into a paperless society for trading the intangi-
bles have been in the transitions with some yet not-so-
strong legal regimes in India, until recently. The oldest
development is revocation of the slavery
law leaning towards humane treatment
of every such activity to improve stand- A free-trade
ard of living and promote freedom to policy does not
allow human dignity which became the necessarily imply
mantra of legal systems globally affect-
that the state
ing that of India.
Free markets myths, even the self
abandons all
regulated free Laissez-faire (welfare) policy and
market in vogue in mid-19th century, legal controls
simply did not fair well, not even market-
forces-would-balance off any bad elements-through com-
petitive market mechanism theory. Even Adam Smith, the
most famous proponent of British laissez-faire ideology, did
not believe free market in its strict sense. However, govern-
ment activity in public utility works was engaged in regula-
tion of foreign commerce to safeguard few selected home
industries resulting in creation of free trade zones of
NAFTA, AFTA, APEC, APEC plus Three and plus Five,
EU, through EEZ to STPI to SEZ etc. which have never
been freed by excluding non members to the markets. This is
also evident in the Free Trade Agreement (FTA) signed
between India with many other trading nations. The evolu-
F L A T WO R L D
tion and effect of WTO to regulate trades with greater
restriction to free trade is something which needs detail
discussion. On the private front, concept of Anti-trust,
insider-trade, unfair trade practice, corruption, smuggle,
that suggest rampage of non-free trade practices and so as
the legal provisions and its applications. The ambit of laws
immensely enlarged with traditionally domestic focused
legal systems to transnational reach.
In Indian context, much hyped "free"-ship in "free mar-
kets" and “free trade" is, in effect, a manipulated freedom of
the high and mighty which calculatedly prevents equality
which otherwise essentially hits by basic features of the
Constitution of India besides other substantive laws prevail-
ing from time to time. As some sections rightly observed,
trade is not the same as democracy since ability to access to
markets (read “free markets” through “free trade”), do not
obviously presume free and fair elections. In short, inequal-
ity looms large by way of camouflaged-tyranny backed by
legal sanction affecting 'aam aadmi' of India. Law here
seems rendered ineffective.
The wide spread acquisition of lands by the “land-sharks”
backed by the Governments and inap-
propriate applications of prevailing land
acquisition laws is an glaring example of
doing away with democratic legal
process through policy shifts which can
not be challenged in any court of law and
such illegality and inequality is often
overlooked by way a “suitable” compen-
sation packages often sanctioned by the
Courts rendering the theory of fair
practices meaningless.
Legal regimes are ones although engulf the system yet
policy overshadows the substantive legal provisions making
the legal environment further weak. Secondly, foreign
trade policy envisages that a trade policy cannot be fully
comprehensive in all its details which would naturally
require modification from time to time based upon the
inevitable changing dynamics of international trade. For
example. by way of partnership with business and industry
as in PPP models.
B. Hypocrisy of Free Trade
It has been observed that ever since the beginning of
THE INDIA ECONOMY REVIEW 143
L A W A N D E C O N O M I C S
economic liberalization in 1991, a plethora of new industri-
alization policies have been unveiled and the government is
continuing to do so. Having laid the policy framework that
allows private control over community resources – water,
biodiversity, forests, seeds, other markets and resources –
successive governments have laid the foundations of an
“exit policy” for farmers. Be that as it may, some general
and area specific laws have been put in place to shape the
legal environment clearer and effective to deal with
changed scenario internationally at national level, in order
to “free” trade.
Big Brother WTO
Gradually, the heat at the grassroots began to sweep into the
political system. Primarily because of this heat generated
within the country, India’s stand at the WTO has hardened
over the years wherein India’s negotiators have so far kept
national interests in mind. Opposition to the WTO has also
galvanised newer protests, i.e., against
SEZs, land acquisitions and FDI in food,
retail, etc. Sensing troubles, within the By allowing
country, the Indian government has had private control
to bring in a new rehabilitation policy for over community
those so displaced.
resources,
The continuing WTO deadlock has
given India the impetus to re-orient trade
governments
policies from multilateral to bilateral infact laid an 'exit
agreements. India began exploring the policy' for farmers
possibility of entering into comprehensive
economic partnership agreements (EPAs) with, inter alia,
including the ASEAN members. And that India is also
seeking trans-continental FTAs. A bilateral trade agree-
ment with the EU is on the roll. India is also gearing up to
start preferential trade agreements with BRIC countries and
the Southern African Customs Union. It may be noted that
specific commitments pertaining to national laws so as to
make strong, transparent disciplines on government pro-
curement procedures, rules of origin and effective enforce-
ment of domestic labor and environmental laws are being
put in place.
C. Myths Generally
Every system of laws has obvious strength for which it is
brought forth and also has its corresponding inherent lacuna
144 THE IIPM THINK TANK
and pitfalls and so also has its own myths. Proponents of
free-ship of trade and commerce in free market concept are
like a coin having two sides i.e. one way they are neo-liberal
and on the other, orthodox. Some Western economists
provide cogent arguments as to why developing nations
should go against such ‘manufactured’ wisdom and plump
for development models that best suit their goals.
Ironically, for countries like India, related trade laws are
focused and tailor-made keeping in mind what so called
“Good Samaritans” and their dictat desire us to do, no
wonder what their action is, people in India follow through
what is preached before it and that becomes new beginning
for India which is in essence skipping industrialization and
increase in domestic laws problems and also evolution and
benefit of only service sector (which according to some is a
dangerous game, having direct effect on core economy
concept for which India is known to the world.) And new law
takes over overnight without any other or further discussion
with “universal” applicability.
A structured economic concept suited
for a particular system is made “univer-
sally” applicable with modulated legal
provisions to give required shape. WTO
dispute settlement mechanism is one of
those kinds, to name a few. And often it
has been seen that India adapt such legal
culture which was until recently un-
known. Competition laws are of that
kind. People at power elevate people on
roads to understand that new laws are the ones which can
not be ignored and has to be assimilated with like latter’s
bread-n-butter.
Probably, India has mastery over injecting the new legal
concept every now and then it is asked to. A copy-paste
culture is in vogue in legislative process of making of new
laws. The laws relating to intellectual property rights;
foreign direct investments, rules and regulations have been
so framed that the benefit only those other india as a nation.
It is frightening to note if countries like India violate these
rules to protect its sovereignty and food security, etc., the
nation is threatened with trade sanctions and economic
isolation. But if the propounder of such scheme makes an
exception, it is economically so justified (and legally too).
Its new kind of international legal tools whereby exploita-

tion worldwide is sanctioned and is made tenable. In one
such occasion concerning American Rice, Inc., a U.S.
District Court leisurely legitimatized bribery by a U.S
company to a foreign official to reduce the company's tax
burden or customs duties etc. in abroad, thereby paving the
way for future legal protection of those in the Western
countries to seek legal protection for their wrong doings
elsewhere whereby the accused could have been tried and
convicted if found guilty in domestic legal systems. This is a
clear case of ousting the jurisdiction of Indian sovereignty
over choice and application of its own laws.
Corporate Good Governance, happily celebrated by
economies like India, seems only to be the hallmark India
alone. Thus India has made free inroads for market econo-
my assimilating again the those laws alien to domestic
demands and legal status.
The problems India faces today is legislative efforts are
also market-driven now-a-days and people specific. Mere
adoption of such international laws as
municipal laws is strategically dangerous
especially in technology driven laws. In fact, a market
economy is based
D. Market Economy in India & Laws upon private
Induction of market-driven economy
property rights
(read free market) in India raised a few
eyebrows amongst academics having dual
and this inturn is
interests in economy and law. The secured by the
‘roll-back’ by the State would affect social rule of law
security provisions otherwise guaranteed
by the Constitution of India which in turn entails inequality
and thus, have dangerous elements of altering basic struc-
ture theory of the Constitution. This would essentially also
weaken the community-feeling and the extended family
concept which is core bondage of India’s family institutions
and thus may cause a massive law and order problems.
On the other hand, some opine that free market econo-
my in India must not be viewed so negatively which needs
to live and sustain on the strengths of Indian socio-cultur-
al-political values. It may be noted that role of the State is
quite crucial in India in comparison with respect to
market liberalization.
India is a fast-growing economy with a dynamic and
robust fi nancial system. Being a democracy ensures a stable
policy environment and its independent institutions guaran-
F L A T WO R L D
tee the rule of law. India is a free-market democracy with a
legal and regulatory framework that rewards free enterprise,
entrepreneurship and risk taking. India is a free-market
democracy with a robust, well-developed legal and adminis-
trative system. The Indian legal system has been derived
originally from that of the UK and is considered at par with
that of any developed economy. Accounting standards in
India are similar to those followed internationally.
E. Conclusion
It is often said that the ‘Rules of the Game’ helps facilitate
the economic process, in which the rule and law and
property rights are components. Economically, the most
important feature of the rules of the game is clearly defi ned
property rights and a rule of law that recognizes them.
Legally speaking, it creates bundle of rights to enjoy and
litigate. Property rights are essential features of the free
market economy because they encourage market coordina-
tion and create comparative advantage.
In fact, a market economy is based upon
private property rights – rights associ-
ated to specific individuals in the form of
legal ownership.
This is secured by the rule of law, which
encourages wealth, and prevents the
subjection of people to the tyranny and
exploitation of others. However, free
trade assumes a state of perfect competi-
tion to achieve comparative advantage,
the policy permits trading partners mutual gains from trade
of goods and services.
A free-trade policy does not necessarily imply that the
government abandons all policy and legal control, but rather
that it refrains from actions specifically designed to hinder
international trade which might arise from tariff barriers,
currency restrictions, and import quotas, etc. The extent to
which free trade benefits economic development amidst any
kinds of legal systems in place is unknown which may be
examined from time to time by domestic legal tools prevail-
ing at the given time.
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation. The
author can be contacted at nudelhilawfora@gmail.com)
THE INDIA ECONOMY REVIEW 145
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146 THE IIPM THINK TANK


Mitigating Environmental
Crisis: Can India
Show the Way?
G. Bhalachandran
Department of Economics, Sri Sathya Sai
University, Prasanthinilayam
Suresh Chandra Babu
Senior Fellow and Program Leader,
International Food Policy Research Institute
(IFPRI), Washington D.C.
Introduction
Several aggregate economic and non-economic forces positively
contribute to the development process of an economy which
aims at the promotion of socio-economic welfare of its citizens.
Generally, development means uninhibited economic growth1.
One can argue that such a development is acceptable only if it is
achieved through ethical means. In other words, the concept of
development is value-centric, inclusive of human costs and
sacrifices, accountable, transparent and subject to critical
examination2. To put it simply, development bereft of human
values3 is not only unsustainable but also positively dangerous.
The process of economic development involves enormous
quantity of production, distribution, and consumption of goods
and services. The process of production, in turn, depends on
the availability and the use of factors of production. It means,
there will be a continuous derived demand for natural resourc-
es, consists of renewable and non-renewable gifts of nature,
human capital and man-made capital. Population and its
characteristics set the magnitudes and quality of consumption
of society. The manner in which the factors of production is
used, decides the contours of economic development. Since the
S I L E N T S P R I N G
dawn of industrial revolution, advanced countries preferred the
path of unlimited growth. As early as in 1960s, the cost-benefit
analysis of such growth process revealed that the cost of
economic growth in terms of environmental damage was quite
alarming4. The environmental concern for development
process was first revealed by R.Carson, in her Silent Spring5. She
warned the advanced countries that their growth-path had
resulted in large depletion of natural resources and caused
chemical contamination of the world environment, resulting in
an ecological imbalance.
Many critics condemned the unlimited growth strategy and
poised for the limits to growth. Barry Commoner, a biologist by
profession, proved with empirical evidence that the present
course of environmental degradation had challenged the
ecological system and would destroy the Earth’s capacity to
support her living beings6. A mathematical model developed by
Dennis Meadows and his team, predicted a catastrophic
collapse of the world ecological and economic system under a
wrong footing of unlimited growth strategy. This Limits to
Growth Strategy derived its findings on five major parameters,
viz., population, natural resources, food availability per capita,
industrial output per capita and environmental pollution. This
model showed the mode of development from 1960 to the
projected year of 2100 AD and revealed that the over exploita-
tion of resources would end up in a halt of the currently pursued
aggressive path of development. Many great thinkers of
different fields concurred with the contention of this model,
since it has proved once again in 2004 that their propositions are
prophetic with thirty years of additional data and world compu-
ter models7.The critics8 of this model were optimistic to point
out that
a) there are many natural resources which would not disappear
forever
THE INDIA ECONOMY REVIEW 147
E N V R I O N M E N T A L E C O N O M I C S
b) this model never thought of the concepts of reuse and
recycling and
c) the alternative approach of cleaner technology, more fuel
efficiency, lesser use of raw materials with improved technol-
ogy and lesser waste production were not thought of.
The Sustainable Development Hypothesis9, on the other
hand, conceived and suggested by the team led by Gro Brunt-
land of Norway as an alternative development strategy, clearly
underlined the nature of relationship between economic
development and environment. It directed the world commu-
nity to follow that pattern of development which takes care of
the welfare of the present generation with an assurance to the
future generation, a life that is at least as comfortable as that of
the present generation. This approach has made many people in
economically developed countries to raise questions like; what
good is great material wealth if it comes at the cost of large-
scale disruptions of the eco-systems by
which we are nourished? Recent develop-
ments in climate change debate are an What good is
example. Sporadic efforts have been made material wealth
by the international bodies to step up if it comes at the
awareness about sustainable development.
cost of disruptions
Unfortunately, the response is dishearten-
ing. What is required currently is an
of the eco-systems
awareness in the world community, that by which we are
man’s life is interdependent on the life of nourished?
every other on the planet and the quest for
sustainable development is the most urgent need of the hour.
History, Economics and Environment
History reminds one not only of the glory of the past but also
offers valuable inputs from the experience of the forefathers
one can obtain to handle many of tough issues of today. Even to
understand the full gravity of the environmental problems, the
historical perspective of the study of a problem is useful. For the
sake of experiment, when one turns the pages of history, right
from the dawn of the Mohenjdaro-Harappa civilization up until
the industrial revolution in the eighteenth century, one can’t
find any record of environmental degradation10. Pollution of the
present magnitude had never been experienced on the planet
till then. One of the main causes was that population was small;
on account of this, wants were limited; the level of production
and consumption was low; and the pollutants generated were
cleaned by nature in the routine processes. In other words,
148 THE IIPM THINK TANK
man’s ability to pollute was well within the nature’s capacity to
clean up. Hence, pollution was not a threat to the world
community and the planet earth.
Great civilizations in Greece, Rome, Mesopotamia, China
and India revealed refinements in handling issues of different
nature and each one’s culture saw to it that there was no trace of
environmental degradation. Indian Culture, which is the sole
living ancient culture of the world as of today, has hardly
referred about environmental degradation in the past in any of
its vast literature available at present. There are records of
natural disasters and catastrophes in it; but the environmental
degradation caused by human civilization was unknown in
ancient India.
As indicated earlier, industrial revolution had changed the
mind-set of the capitalistic countries. Amazing scientific
discoveries of the western world have had deep impact on
human life and nature in general11. Their up
by the bootstraps approach aroused the
productive forces and paved the way for
mass production. This is diagonally oppo-
site of Gandhian dictum: Production by the
masses. At present, even in India, the
traditional approach to industrial produc-
tion by the artisans and through guild
system was given a go-bye and large-scale
production by machines; employing
thousands of workers and using large
quantities of inputs and capital with a view to catering the
demands of far-off markets were encouraged. Naturally, levels
of pollution had to rise up. This happened to be beyond the
nature’s capacity of ‘cleaning-up-process’. The net result is the
unabating environmental pollution at present. Another corol-
lary factor to this is the rise in the growth of world population in
general and the improvement in the life-expectancy years of the
population of industrialized countries in particular. As a result,
the rise in demand for goods and services has become phenom-
enal and the derived demand for inputs from nature is also
increased manifolds. The interplay of the demand-supply forces
of these has added fuel to fire.
Finally, even the very existence of the species on the planet
earth has been put on stake. At present, the easiest option
available to contain this problem is to refer to the wisdom which
the ancient culture of human civilization could offer to mend
our ways and means and correct our paths of development.

What Can Indian Culture Teach Us?
The unlimited growth model of industrialized countries empha-
sizes rapid growth keeping in view of higher standard of living.
But this has led to the irresponsible and continuous exploitation
of natural resources and environment beyond the threshold of
resilience of the eco-system.
Indian culture views the eco-system in its entirety which is
represented by the five hydrological constituents12. The develop-
ment strategy of a country or world at large can’t disturb the
equilibrium in the hydro-dynamic integrated system. But, the
western paradigm for development has not cared for it. As a
result, this has accentuated various dormant and active geo-
morphic processes on the earth and caused imbalance in the
natural eco-system. The Indian culture does not allow the
squandering of natural wealth of any kind. It also emphasizes
that the development path ensures the needs of the present
generation without compromising the ability
of the future generation to meet their own
needs. Moreover, it stands for policies, which Indian culture
enables future generations to have as much views the eco-
wealth / benefits as the present generation system in its
receives. In other words the present genera-
entirety which is
tion is not entitled to be over exploitive and
generate debts for the future generation.
represented by the
This is what the ancients in India called five hydrological
Dharma13 and it implies fairness to future. constituents
The concept of sustainable development
floated by the report entitled, Our Common Future echoes the
same message that was conceived and made as the way of life of
people in ancient India.
Another interesting fact one can observe from the ancient
Indian literature is that their society was encouraged to use
more of renewable resources than of non-renewable resources14.
The reason one could infer is that the price mechanism works
well with regard to man made goods where as the same principle
does not work when nature / environment has to be priced. It is
because that environment is beyond a price. Hence the ancients
in India assigned a pride place of worship to nature. They
trained the society to judiciously use one’s own conscience to
trade off between ecology and economic development. Another
added advantage was that they had perfect understanding of the
difference between the private and social cost of resource
exploitation15. Hence, they took utmost care to preserve the
natural resources to the possible extent, which in their opinion
S I L E N T S P R I N G
was a means to the end. This paved the way for equitable
distribution by preventing the over exploitation by any section of
society. In a nutshell, the ancients in India made it clear to every
one in society that Sustainable Development (Dharma) was
holistic as well as universal and the approach to it should never
be a piecemeal. This is the cue for the modern society around
the world to emulate, follow and adapt for its benefit in the
present as well as future.
Operationalizing Indian Thoughts for
Environmental Protection
In the beginning, people around the globe had seen protection
of environment was essential for the human survival and
development. The other living creatures including plants,
animal species and natural resources in the world were valued
for their ‘utility value’ to the human survival, development and
satisfaction. But the truth is that every
living being and life forms have some
inherent value in themselves and there is
an interconnectedness among all of them
for the welfare of the planet Earth itself.
This concept promotes the notion of
environmental ethics.
People in (so called) modern civilized
society are of the opinion that human
beings are the most intelligent of all living
species and they are empowered to
manipulate and exploit the natural world in any manner they
deem fit. Moreover, they feel that those species which have a
use value for their survival and comfort need their protection
and patronage16. But this is a disastrously wrong perception
and practice.
Here comes the ancient wisdom of India as a handy tool to
have the right attitude towards the life and environment around.
The ancients in India practiced and preached integrated human
and environmental ethics, which directed the human beings to
hold the responsibility for the stewardship of protection of all
living species17. This notion of interconnectedness is the way and
means for getting the globe out of the morass of misconception
and mismanagement of the world environment. This ethical
principle has to reach every citizen of the world in right perspec-
tive and each one has to practice it for the benefit of global
welfare. It is possible only when the spirit of universal love holds
the key of every thought, word and deed of people of all
THE INDIA ECONOMY REVIEW 149
E N V R I O N M E N T A L E C O N O M I C S
countries without any exception. If humanity as a whole indicates
this ethics, then the concept of sustainable development (as
conceived and practiced in ancient India) can become a reality,
even today. For this purpose a strong political will, forward
looking socio-politico-economic institutions and people with
universal value system are the prerequisites.
It is worth recollecting here the vision of Mahatma Gandhi – a
reformed India – which is based on sound environmental
management principles of the ancient India. All these principles
are now considered the integral part of sustainable, long – term
development. As a part of his experiment with truth, Gandhiji
had designed a suitable life-style for himself, when these con-
cepts were not part of general thinking, with a view to revealing
to the rest of the world that the injunctions of Indian culture
were not only idealistic but also practical. He firmly believed that
the world could support people’s needs but not to their greed.
The world now is at the cross roads because
it is finding difficult to yield to the demand
and pressure of industrially advanced Modern society
economies on one side and could not feed has to evolve
the poverty-ridden population of less-devel- a scientific
oped countries on the other side. Foreseeing
and utilitarian
this, Gandhiji wanted that every citizen in
India to practice a sustainable life-style that
approach in
cares for the earth and promotes the quality exploring nature
of human life simultaneously. without damage
Mahatma Gandhi’s famous concept of
Trusteeship can be well extended to drive home that humans are
the trustees of nature, species and environment around them.
Indian culture asserts that human beings are just one small cog in
the wheel of life on earth. In other words, each living being, a
plant or animal, has a right to life as a part of the earth’s commu-
nity. This message has to reach every nook and corner of this
country through the process of Environmental education at all
levels of learning. The direction of the Hon’ble Supreme Court of
India made this mandatory and the University Grants Commis-
sion has taken it religiously and steps are being taken to make it
action oriented18. At the societal level, two basic values have to be
inculcated by governments, corporations, media, institutions and
people in their life-style. One, valuing the nature as a mother.
This principle has been upheld by all the scriptures of this
venerable Land19. This has been forgotten now. This value
kindles the conservation-awareness in man. Second, appreciating
the beauty of Nature. If one’s heart is given to nature, this value
150 THE IIPM THINK TANK
puts man in rightful role as the custodian of nature and not its
exploiter. Moreover it elevates his spirit and finds himself one
with it20. For this, the elders of civic society have a major role to
play in inspiring their children and young generations.
Ahimsa or Non-violence towards life, living beings and nature,
is a cardinal principle and basic philosophy for which India
stands for, even today. This was a way of life in ancient India; but
reiterated for the benefit of society by Mahavira, the Buddha,
and recently by Mahatma Gandhi and Bhagawan Sri Sathya Sai
Baba. Many modern thinkers in the west have begun to see the
intrinsic value in Indian culture and support it as the basic for
human development. The discussion here emphasizes that
modern society has to evolve a scientific as well as utilitarian
approach in exploring nature without causing any damage to it.
One has to be aware here that any harm done unto nature will be
retaliated by it with immeasurable force21.
In India, the time has come to consolidate
the values which lead to an effective process
of decision making and right action for the
weal of humanity. The Indian constitution
emphasizes this process succinctly22. This
expects that every individual in the society
must become environmental–sensitive and
pro–environmental actions have to move
from the domain of individuals to that of a
community and later to society at large. For
this purpose, a force of pro-environmental
lobbying can be constituted to influence governments to enforce
laws that can bind every citizen for the pro-environmental
outcomes that include not only material resources but also many
valuable services.
It is not out of context to stress here that it is obligatory on the
part of the present generation to do its best to protect many of
our ancient structures of archaeological importance including
temples. These were constructed by the ancients of this land, not
only to speak of their glory, architectural ability, their engineer-
ing marvel and their refined evolution of the spirit but also to
support the future generation as the priceless environmental
assets. They protect the people in times of calamity, but most
often, they prevent environmental damages to a large extent.23
Conclusions
Humans are a miniscule part of nature’s complex web of life.
Nature upholds the value of unity in diversity. Man, who is

endowed with a sixth sense, has to become the trustee of the
earth’s magnificent life-forms, not its destroyer. Indian
culture is unique for being idealistic and practical in several
respects. It has many striking values and tips for the modern
society to become pro-environmental and trim its ways and
means for sustainable development. Hence, this paper
stresses that let Indian society lead the rest of humanity
towards pro-environmental-actions and thus paves the way
for pollution -free planet.
Endnotes and Additional Thinking
1
Jeremy Seabrook, The Meaning of Sustainability, in Chan-
dreyee Das and Dipankar Ghosh(ed), Eye on Development,
Sampark, 2006, p.207.
2 18
See, Des Gasper, The Ethics of Development, Vistaar, 2004,
pp 14-16
3 19
According to Bhagawan Sri Sathya Sai Baba, the universally
acceptable human values are Truth, Righteousness, Peace,
Love and Non-Violence. See, Bhagawan Sri Sathya Sai Baba,
Thought for The Day, Sri Sathya Sai Book Trust, 1993 p.K.2.S.
4
A.K.Ghosh, Sustainable Development: Is it achievable, in
C.D. Ghosh, op.cit, p.76.
5
See for more details, R .Carson, The Silent Spring, Houghton
Mifflin, 1962.
6
See, Barry Commoner, The Closing Circle, Alfred A. Knopf,
New York, 1972.
7
See, (a) Dennis Meadows et.al, A Report for the Club of
Romes: Project on the Predicament of Mankind, Universe
Books, New York, 1972. (b) Donella Meadows et.al., Limits to
Growth: The 30-year Update, Chelsea Green Publishing co.,
U.S.A., 2004.
8 21
See, William Nordhaus, ‘World Dynamics: Measurement
without data’, Economic Journal,83;pp.1156-83,1973.
9
See, G .Bruntland, Our Common future-A climate for change,
Oxford, 1987.
10
Gautam Gupta, Environment, Ecology and Economy, in R.N.
Bhattacharya, Environmental Economics: An Indian Perspec-
tive, Oxford, 2001, p. 17.
11
B.M. Sanyal, Sustainable Development: Certain Critical
Observations, in Chandraya Das and Dipankar Ghosh (ed),
op.cit., p.89.
12
They are soil/earth; water; wind; ether/atmosphere and fire/
energy
13
The concept of dharma which has been in vogue from time
S I L E N T S P R I N G
immemorial in India, has no equivalent in any other tongue.
But, it encompasses and synthesizes all the healthy, profound
principles and practices, the concept of Sustainable Develop-
ment stands for.
14
See, Arjun Das, Economic Philosophy of Ancient India,
Agam Kala Prakashan, 1986, pp. 29-31.
15
See, Kautilya’s Arthashastra, Book II, Ch. 12
16
For eg. People living in advanced countries look at a cow as a
source of milk or meat.
17
Each one lives for the other and all collectively for the welfare
of mankind – This is the conscious prayer of every son of the
soil in ancient India, quoted in all sacred texts. See, V.
Sivarama Sharma (ed) Srimad Valmiki Ramayana, Chowka-
hamba Vidya Bhavan, 1982, 3ed., p.5.
Arun Nigavekar, Forward, in Ercach Bharucha, Text Book of
Environmental Studies, University Press, 2005,p. VII
See, Laxmi Mall Singhvi, Environmental Wisdom in Ancient
India, www.ecomall.com, site visited on March 20, 2009.
20
King Pari, a legendary philanthropist of Tamil Sangam era
(300 BC to 300 AD), once happened to travel with his
daughters, Angavai and Sangavai, in his chariot, through a for-
est. There, they stumbled upon a huge jasmine creeper spread
across the road, since someone had cut off its prop-tree. The
King’s benevolent heart melted. He asked his daughters to
unchain the horses from the chariot and he himself led the
chariot to leave it for the creeper to use it as its prop. He could
do such an act since he saw himself in the jasmine creeper.
This is the highest stage of the evolution of a man. That is why;
Pari’s name is synonymous with philanthropy in Tamil land.
See, Kapilar, Purananooru, verse 201, Varthamanan Pathip-
pagam, Part-II Chennai, 1999, p.5.
There is a scientific base to prove that in all natural calamities
the humanity suffers, there is a human element at work. See,
John D Carmack, Is God responsible for the Good or Bad,
www.helium.com, site visited on March 27th, 2009.
22
See, Article 48 A and Article 51 A(g), indiacode.nic.in
23
When tsunami stuck the eastern coast of Tamilnadu, on
December 26th, 2004, none of the temples on the eastern coast
including the Rameswaram temple located in an island was
affected. See, Chennai and Tamilnadu, in www.google.com ,
site visited on March 27th, 2009.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation).
THE INDIA ECONOMY REVIEW 151
E N E R G Y E C O N O M I C S
Wind Energy in India -
Reforms to the Rescue
Introduction
During the last twenty years, very few oil and gas discoveries have
happened and proven reserves are falling. In order to reduce their
dependency on oil, many countries are trying to increase energy
generation from renewable energy sources. However generating
power using renewable energy sources is costly and government
subsidies and incentives are critical for the viability of renewable
energy projects. In this article we will first discuss why wind energy
has witnessed higher growth as compared to other renewable
energy sources. Then we will discuss the incentives provided by
India and various state governments. In the end we will discuss
where regulatory changes and reforms are needed in India in
order to attract investors and to enhance the transparency.
Wind Power is Gaining Popularity
Wind power is generated by converting wind energy into a
152 THE IIPM THINK TANK
useful form of energy, such as electric-
ity, using wind turbines. Oil prices were
highly volatile during the last five years
and we witnessed oil prices reaching
USD 147 per barrel and then falling to
nearly USD 30 per barrel, all in a span
of one year. During the oil shock of
1970s, economies realized the impor-
tance of alternate source of energy and
started investing in renewable sources
of energy like solar energy, wind energy,
hydro-power etc. However generating
energy from renewable sources was
costlier in early years and real thrust for
installing renewable energy sources
really started in 1990s. Amongst all the
sources, wind power registered the high-
est amount of growth (Table 1) and
investment owing to low investment
costs and high IRR.
At the end of 2008, worldwide installed capacity of wind-
powered generators was 121.2 gigawatts (GW) (Chart 1). In
2008, wind power produced about 1.5% of worldwide electric-
ity usage; and is growing rapidly, having doubled in the three
years between 2005 and 2008. Several countries have achieved
relatively high levels of wind power penetration, such as 19%
of stationary electricity production in Denmark, 11% in Spain
and Portugal, and seven percent in Germany and the Republic
of Ireland in 2008. As of May 2009, eighty countries around
the world were using wind power on a commercial basis.
Growth Drivers For Wind Energy
1. Cost competitive – Cost per KWH of wind generation
decreased from US$ 0.38 in early 80s to present US$
0.03-0.06, at excellent wind sites
 C H A R G I N G A H E A D

Ritesh Agarwal a. Global electricity consumption expected to double

between 2002 & 2030
Analyst, b. Wind Energy’s contribution expected to increase from
ASK Group, Mumbai 0.2% in 2002 to three percent in 2030

Wind Energy in India

Shiva Agarwal India currently accounts for nearly eight percent of total
global wind energy installed capacity. The installed capacity
Indian School of Business, Hyderabad was only 200 MW in 2000 which increased to nearly 9600
MW by 2008. Although India registered impressive growth
in installed capacity, it lagged countries like China which
2. Environmental awareness / government initiatives gave greater emphasis on energy security. India was fourth
a. Kyoto protocol – CO2 emission to reduce by 5.2% of globally by installed capacity in 2007 and lost its fourth
1990s levels, by 2012 place to China in 2008 which nearly doubled its installed
b. Renewable energy targets – EU – 20% by 2020, India capacity (Table 2).
– 10% by 2012, China – 10% by 2020
3. Energy Security – High volatility in oil / gas prices and Incentives and Subsidies
depleting oil / gas reserves Provided by Indian Government
4. Increasing electricity demand Indian government and various state governments pro-

Table 1: Comparison of Various Renewable Energy Sources

Technology Increase in Energy Turn Key Current Energy Cost Potential Future
Production, Investment Energy Cost
1997-2001 Costs (2001 US$
(percent per year) per Kilowatt)
Biomass Energy
Electricity ~ 2.5 500-6000 3-12 ¢/kWh 4-10 ¢/kWh
Heat ~2 170-1000 1-6 ¢/kWh 1-5 ¢/kWh
Ethanol ~2 (8-25 $/GJ (6-10 $/GJ
Bio-diesel ~1 15-25 $/GJ) 10-15 $/GJ)
Wind Electricity ~ 30 850-1700 4-8 ¢/kWh 3-10 ¢/kWh
Solar Photovoltaic Electricity ~ 30 5000-18000 25-160 ¢/kWh 5 or 6-25 ¢/kWh
Solar Thermal Electricity ~2 2500-6000 12-34 ¢/kWh 4-20 ¢/kWh
Low-temperature Solar Heat ~ 10 300-1700 2-25 ¢/kWh 2-10 ¢/kWh
Hydro Energy
Large ~2 1000-3500 2-10 ¢/kWh 2-10 ¢/kWh
Small ~3 700-8000 2-12 ¢/kWh 2-10 ¢/kWh
Geothermal Energy
Electricity ~3 800-3000 2-10 ¢/kWh 1 or 2-8 ¢/kWh
Heat ~ 10 200-2000 0.5-5 ¢/kWh 0.5-5 ¢.kWh
Marine Energy
Tidal 0 1700-2500 8-15 ¢/kWh 8-15 ¢/kWh
Wave - 2000-5000 10-30 ¢/kWh 5-10 ¢/kWh
Tidal Stream/Current - 2000-5000 10-25 ¢/kWh 4-10 ¢/kWh
OTEC - 8000-20000 15-40 ¢/kWh 7-20 ¢/kWh
Source: World Energy Assessment Report 2004, Update

THE INDIA ECONOMY REVIEW 153

E N E R G Y E C O N O M I C S

Chart 1: Wind Energy Installed Capacity project attracts a 100% income tax holiday
for the income generated from the project
World Total Installed Capacity (MW)

190.000
for 10 consecutive years among first 15 years
200.00 of operation.

152.000
180.00
3. Equity / Loan Ratio:
160.00 The project involves approx. 30% Equity and

121.188
70% Loan Funding. Various PSUS and
140.00
private banks provide funding for wind
*Prediction

93.927
120.00 power projects.

74.151
100.00
59.024 Incentives and Benefits Provided by
80.00 State Governments
47.693
39.295

60.00 Table 3 describes the incentives and benefits

31.181
24.322

given by various state governments .

18.039
13.700

40.00
9.667
7.480

20.00 Limitations
1. Wind machines must be located where
0
strong, dependable winds are available most
1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009*

2010*
of the time
Source: World Wind Energy Report 2008, WWEA
2. Winds do not blow strongly enough to
produce power all the time, therefore energy from wind
vide lucrative benefits to investors looking to invest in machines is considered "intermittent," that is, it comes and
wind energy and wind turbine generators (WTG). Follow- goes. Therefore, electricity from wind machines must have
ing are some of the benefits provided by Indian govern- a back-up supply from another source
ment – 3. As wind power is "intermittent," utility companies can use it
for only part of their total energy needs
1. 80% Income Tax Accelerated Depreciation : 4. Wind towers and turbine blades are subject to damage from
80% depreciation can be claimed in the fi rst year of high winds and lighting. Rotating parts, which are located
installation itself, if the project is commissioned on or high off the ground can be difficult and expensive to repair
before 30 th September in a fi nancial year; and 40% 5. Electricity produced by wind power sometimes fluctuates in
depreciation in case the project is commissioned on or voltage and power factor, which can cause difficulties in
after 1st October in a fi nancial year. The catalyst saves linking its power to a utility system
income tax outflow in current business in a year. (Section
32 – Depreciation: Income Tax Act, 1961) Pain Points in Investing in Wind Energy in India
An investor, investing in WTG post September, can claim Before discussing the pain points and needed regulatory
depreciation as follows – reforms in India, we need to understand that the entire sector
40%: 2009-2010 is driven by private players and government’s role is limited
48%: 2010-2011 to providing subsidies and incentives. There is an autono-
10%--2011-2012 mous body called “Center for Wind Energy Technology”
2% --2012-2013 under Ministry of New and Renewable Energy (MNRE).
However C-WET is not a regulatory body like SEBI but it is
2. Tax Holiday under Section 80 I (A): more like a standardization and certification body. C-WET’s
According to income tax act Section 80 I(A), a wind energy responsibilities include setting the minimum quality stand-

154 THE IIPM THINK TANK

 C H A R G I N G A H E A D

Table 2: Global Wind Energy Installed Capacity

Position Country Total Capacity Added Capacity Growth Position Total Total Total
2008 Installed End 2008 Rate 2007 Capacity Capacity Capacity
2008 2008 Installed Installed Installed
End 2007 End 2006 End
2005
[MW] [MW] % [MW] [MW] [MW]
1 USA 25170.0 8531.2 49.7 2 16818.8 11603.0 9149.0
2 Germany 23902.8 1655.4 7.4 1 22247.4 20622.0 18427.5
3 Spain 16740.3 1595.2 10.5 3 15145.1 11630.0 10027.9
4 China 12210.0 6298.0 106.5 5 5912.0 2599.0 1266.0
5 India 9587.0 1737.0 22.1 4 7850.0 6270.0 4430.0
6 Italy 3736.0 1009.9 37.0 7 2726.1 2123.4 1718.3
7 France 3404.0 949.0 38.7 8 2455.0 1567.0 757.2
8 United Kingdom 3287.9 898.9 37.6 9 2389.0 1962.9 1353.0
9 Denmark 3160.0 35.0 1.1 6 3125.0 3136.0 3128.0
10 Portugal 2862.0 732.0 34.4 10 2130.0 1716.0 1022.0
Source: World Wind Energy Report 2008, WWEA

ards of equipments, and approving the wind farm sites etc. This price is quoted by the manufacturer as a whole and this
In essence, the investor willing to invest in a wind turbine is “negotiated” with the investor. Although C-WET certifies
generator has to rely entirely on private players after the the minimum quality standard, it does not specify the
project is commissioned. Table 4 is a sample summary sheet maximum charges for the equipment. If government sets a
provided by a leading wind power player maximum price for a particular size of
to a potential investor. A cursory look at WTG then the investors get a reliable esti-
the Table 4 reveals that the only signifi- The C-WET is mate of the initial costs.Manufacturers
cant parameter known with certainty to not a regulatory may argue that depending on the technol-
the investor is tariff rate. Rest all the body like SEBI. ogy and quality, more power may be
significant factors are not in control of an
It is more like a generated. The pricing may include
investor and the investor has to depend on clauses that excess power generation than
the company / lending bank. We will now
standardization the set benchmark may entitle the manu-
discuss the problems associated with all and certification facturer to share revenue. However this
the parameters / factors and will discuss agency leads to another problem of getting the
how regulatory reforms can improve the benchmark for average power generation.
investment environment in India. Please note that the
parameters will directly impact the investment results if Generation (KWH)
parameters are changed. At present, manufacturers quote this figure primarily
depending on their own estimates and calculations. How-
Price / WTG ever government agencies need to estimate the wind speed
This is the total initial investment (including debt and equity) and generation for a particular location so that investors
needed to commission a WTG. The cost comprises equip- have a realistic estimate of the potential power generation.
ment costs, land leasing, erection and commissioning This expected potential will also help in setting the price for
charges, processing fees, basic infrastructure setting up etc. the equipments.

THE INDIA ECONOMY REVIEW 155

E N E R G Y E C O N O M I C S

Table 3: State Wise Description of Various Parameters

Description Gujarat Karnataka Madhya P. Maharashtra Rajasthan Tamil Nadu

Tariff Rate Rs. 3.37 Rs. 3.40 Rs. 4.03 - 3.36 Rs. 3.50 Rs. 4.28 Rs. 2.90
Sale to Board
Escalation Nil Nil Reduction of 15p/yr for 13 yr Nil Nil
on Tariff 17p/yr up to
3.36 and con-
stant after that
PPA Period 20 years 10 years 20 years 13 years 20 years 20 years
Penalty on Rs. 0.10 / Rs. 0.40 / Rs. 0.27 / Rs. 0.25 / Nil Rs. 1.00 / KVARH
Reactive KVARH KVARH KVARH KVARH
Power Drawn
Third Party Permitted Permitted Permitted Permitted Permitted Permitted
Sale
Wheeling 4% 5% 2% 20-30% 10% 5%
Charges
Banking Surplus genera- Permitted in Not permitted Permitted in Permitted Permitted in same
tion is purchased same financial same financial in same cal- financial year
by GUVNL@ year year endar year
Rs. 3.37
Banking Nil 2% Not applicable Nil Nil 5%
Charges
Source: Ministry of New and Renewable Energy (MNRE), New Delhi

Interest Rates worked out depending on the past experiences in wind power
There is no set policy according to which loan is provided to generation and future expected cash flows from the location.
the investors. At present, various PSU and private banks give
loans against the WTG according to their own perceived risks Plant Load Factor
and understanding. Moreover the loan is The quoted plant load factor is usually
usually not fi xed but floating which only 21-25% in India. However global experi-
enhances the uncertainty in net cash The Government ence shows that this high load factor is not
inflows for the investor. It is understand- needs to possible for all the time. This factor varies
able that risks vary from state to state incentivize according to environment which is not in
amongst different wind farm locations but
risks for a particular wind farms is same
the banks to investor’s / manufacturer’s control.
Plant load factor is calculated as the
for all the WTG installed in the wind
rationalize the ratio of (actual amount of power produced
farm. In a gist, the risks that all the WTG interest rates on over time) and (Power that would have
installed at a location are same (discount- high priority basis produced if turbine operated at maximum
ing technical problems as of now). output 100% of the time). While calculat-
At present, some banks offer loans at PLR + some risk ing this ratio, we need to account for time when wind speed is
premium and this PLR varies from bank to bank. Moreover less than optimum speed; scheduled / unscheduled mainte-
PLR also changes according to economic conditions and nance; production losses; dirty or corrosive blades, grid line
banks’ policies. According to us, government needs to theft etc. After accounting for the entire factors, realized load
incentivize the banks to rationalize the interest rates. We factor is typically less than 25%.
propose that a range of risk premium for a state should be An investor cannot calculate the load factor owing to the

156 THE IIPM THINK TANK

 C H A R G I N G A H E A D

Table 4: Summary Sheet For Investing in A Wind stock churning, various charges and performance etc to the
Turbine Generator (WTG) investors on a periodic basis.
Sr. No. Parameter 600 kW WTG We propose that the corresponding figures for load factor,
1 Size of the Project(MW) 0.6 power generation, down time etc should be disclosed to all the
2 No. of WTGs (600 kW each) 1 investors in a wind farm.
3 Price of the Project (Rs. Lacs) 421
4 Price / WTG (Rs. Lacs) 421 Payment Collection
5 Generation (KWH) 16 The power purchase agreement (PPA) is signed between the
6 Losses 7% investor and the state electricity board. The State Electricity
7 O & M (Rs. Lacs per year) 7 Board (SEB) is supposed to pay the investor within 45 days.
8 Escalation 7.50% However collecting the money from the SEB is problematic
9 Free O & M (yr.) 1 and time consuming. Maharashtra SEB has introduced Real
Time Gross Settlement (RTGS) payment system so that
10 Tariff (Rs. / unit) 3.48
timely payment can be done. Extending RTGS to all the states
11 Tariff Escalation (Rs. / unit) 0.02
can certainly lessen the woes of the investors.
12 Tariff Escalation (Rs. / unit) 0.01
13 Interest Rate 13.00%
Conclusion
14 Loan Term (yr.) 7
India has set itself ambitious targets in renewable energy
15 Moratorium (yr.) 1 generation and government has indeed provided a host of
16 Plant load factor (PLF) 24.70% subsidies and benefits. Wind energy is relatively cheap and
various states have extended lucrative benefits to the
Sr. No. INVESTMENT - RESULTS investors. However a lot of work has to be done in order to
1 Payback 1.08 standardize the investment process; government needs to
2 Cumulative Inflow/ MW 673.65 instill transparency so that more investors may diversify
3 I R R (20 Yr.) 21% their portfolio taking exposure to renewable energy sources
like wind energy.
Bold indicates most significant factors for the investor
Source : A leading Indian wind energy company

References and Additional Thinking

limited data at his disposal and his own capability to estimate
the power generation. An investor faces loss when the wind is
less than the estimated wind and also faces loss if there is high
velocity and power transmission is limited by the grid capacity.
There is a need to formalize a policy according to which the
manufacturer should quote the realized load factor from the
farm instead of only estimated load factor. This may be
difficult if a new farm is developed, however manufacturers
can be asked to give quotes for various possible scenarios.
Transparency and Disclosures
Although this factor is not mentioned in the table above, we
believe that this is one of the most important factors to instill
confidence in investors. Some cues to enhance the transpar-
ency can be borrowed from SEBI. According to SEBI regula-
tions, mutual fund houses have disclose their stock holdings,
• World Wind Energy Association (February 2009).
"World Wind Energy Report 2008". Report. http://www.
wwindea.org/home/images/stories/
worldwindenergyreport2008_s.pdf. Retrieved 24th
August, 2009
• Wind Power: Capacity Factor, Intermittency, and what
happens when the wind doesn’t blow? Retrieved 24th
August, 2009
• MNRE Website http://mnes.nic.in/
• C-WET website http://www.cwet.tn.nic.in/
• Global wind energy council (GWEC) statistics
• European wind energy association (EWEA) statistics
• Various investor interviews
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation.)

THE INDIA ECONOMY REVIEW 157

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Mismatch between
Entrepreneurial Intention
and Environment -
A Survey in Burdwan
District of West Bengal

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Soumyendra K. Datta
Professor, Department of Economics,
Burdwan University, Burdwan
Rimu Chaudhuri
Research Student, Department of Economics,
Burdwan University, Burdwan
Introduction
The spate of events in recent years in the wave of globaliza-
tion and liberalization have brought forth severe uncertain-
ties in the industrial sphere. Unpredictable shift in demand
pattern and corresponding need to adjust production
capacity, flexibility in labour market and rapid changes in
technology - all have posed great problem to a smooth
development of the large scale sector. The large scale
sector run mostly on the method of
mass production, produce customized The concept of
product, use lumpy capital and capital entrepreneurship
intensive technology. Besides this, the
is too complex to
recent events have unquestionably led to
shrinking employment opportunities
be explained
and changes in job orientation. Added to by a single
this has been a lack of co-ordination in set of factors or
skill formation and job prospects. The other variables
relative lack of adaptability of large
sector to a rapidly changing circumstances and inability to
absorb a rising labour force has in recent times brought
into prominence the adjustive and complementary role of
small sector in the development of the country. Accord-
ingly the aspect of self- employment through flourishing of
entrepreneurial development in small scale sector has
acquired great importance in recent period and requires
incisive analysis.
Key to Entrepreneurship
However, the concept of entrepreneurship is too complex
to be explained by a single set of factors. Combining the
definition of Schumpeter(1934), Korzner(1985), Bygrave &
E N T R E P R E N E U R I A L E T H O S
Hofer(1991) - an entrepreneur is defined as one who
perceives a profit opportunity and undertakes an organiza-
tion to initiate newer product and technology to achieve
the objective with some degree of risk.
These three factors like initiative to launch something
new, drive to attain certain objective and fulfi l certain
unsatisfied need and taking of risk are supposed to be the
three main corner stones, based on which entrepreneur-
ship can be said to blossom. The blossoming of the
process of entrepreneurship is usually supposed to be
conditioned by the demographic, psychological factors and
the mental make up to accept challenges, attain a specific
goal, motivational attitude to create new ventures etc.
These are reflected in the intention of a person to achieve
something new.
Small Industries-
Congenial to Flourishing Entrepreneurship
In order for the small sector to help incite the quality of
entrepreneurial attainment, it is necessary that aforesaid
quality be present in the individual seeking employment in
the small scale sector. Now there are
many people in our country who seek
some subsistence or just above subsist-
ence type of employment in the small
informal sector involving petty trade or
services. Usually they do not create
organization and hardly have any
substantial money to take any drive to
launch on a profitable venture. However
in the small industrial set up, be it
formal or informal, there is often enough scope for a
flourishing of entrepreneurial spirit.
It is usually assumed that the small scale sector can
quickly respond to changes in demand pattern adjustive to
flexible use of labour and capital and can relatively easily
develop along the sub-contracting mode of production.
Multi-skilled worker and multi-purpose capital is said to be
the corner stone in the development of small sector.
However innovative development in the small scale sector
presupposes adequate skill formation in the relevant
labour group, aptitude and orientation to take risk and
mental and psychological upbringing to face the challenges
in uncertain market prospect. Aptitude and orientation to
THE INDIA ECONOMY REVIEW 159
M I C R O M A C R O

Table 1: State Wise Origin of the Entrepreneurs take risk as manifest in the attribute of entrepreneurial
intention is often shaped and governed by a combination of
Statewise origin No of entrepreneurs external factors clubbed as entrepreneurial environment. It
Marwari & Gujrati 40 encompasses a host of overall economic, cultural, social
Bihari 6 and political dimension that promote or even sometimes
Punjabi 3 discourage entrepreneurial propensity of an individual.
Bengalee 11
Source: Compiled from data based on personal interview with the entrepreneurs Entrepreneurial Environment : A Driving Force
Gnyawali and Foget grouped the entrepreneurial environ-
ment into five dimensions- government policies and
Table 2: Motivational Background
producers(import/export restrictions, entry barrier, etc);
Family Friends VRS No Job Risk -loving socio-economic conditions (public attitude towards
entrepreneurship, presence of experienced entrepreneurs,
Non-Bengalee 47 - - - 2
etc); entrepreneurial and business skill (entrepreneurial
Bengalee 4 - 1 5 1
training programmes, availability of information etc);
Source: Compiled from data based on personal interview with the entrepreneurs
financial support to business (venture capital, low cost
loans, etc); and non-financial support to business (coun-
Table 3: Academic Background seling and support services, entrepreneurial networks, etc).
The authors review the existing literature on environment
Academic Qualification No of Entrepreneurs
for entrepreneurship and list the empirical evidence for the
Engineer 2
factors that they consider influential in promoting entre-
Non-technical graduate 40
preneurial activity. Thus entrepreneurial environment
Under Graduate 14
mediate the relationship between entrepreneurial intention
Non-Matric 4 and entrepreneurial resourcefulness. However, there is
Source: Compiled from data based on personal interview with the entrepreneurs
often observed to exist a mismatch between entrepreneuri-
al intention and entrepreneurial environment that dampen
Table 4: Technological Inclination of the the spirit of entrepreneurial resourcefulness.
Entrepreneur
Quintessence of Entrepreneurial Resourcefulness
Technology in Use No. of Entrepreneurs
Entrepreneurial resourcefulness mean the ability to
New technology used 33
identify opportunities in the environment and regulate and
Old technology used 27
direct behaviour to successfully cope with the task of
R and D NIL creating and managing an organisation to pursue the
Source:Compiled from data based on personal interview with the entrepreneurs opportunity. Following the concept of Kanungo and Misra,

Table 5: Technical Aspects of the Surveyed Entrepreneurs

Level of Investment No of entrepreneurs Years of existence of Labour skill Single as Types of product
the enterprise well as multiple
Rs10.5 – 25.5 lakh 9 <10 years Both type Multiple
Rs 25.5 - 50.5 lakh 8 12- 14 years Both type Multiple
Rs 50.5 lakh – 1 crore 4 25 years Both type Multiple
Rs 1 crore and above 39 >40 years Both type Multiple
Source: Compiled from data based on personal interview with the entrepreneurs

160 THE IIPM THINK TANK


Table 6: Results of the GET Test
Characteristics
Need for achievement
Need for autonomy/independence
Creative tendency
Moderate/ calculated risk taking
Drive and determination
Source: Compiled from data based on personal interview with the entrepreneurs
entrepreneurial resourcefulness can be said to comprise
three generic competencies – cognitive, affective and
action oriented. Cognitive competency refers to the
effective management of thought processes, beliefs and
expectations. Six components of cognitive competence are
identified which contribute to entrepreneurial resourceful-
ness. These are – ability to analyse and make sense of large
volumes of information, ability to take risk, innovativeness,
ability to perceive and make sense of equivocal realities,
tolerance for equivocality and uncertainty, high effort- out-
come expectancy.
Affective competence refers to the management of
emotional arousal. Five kinds of affective competence are
identified for entrepreneurs - ability to control feelings of
withdrawal and depression, competitive desire to excel,
ability to persevere, high central life
interest, dissatisfaction with status quo.
Action oriented competence is the
management of intentions and action
orientations. Four main components are
identified - ability to take charge and
lead employees, ability to influence
external agencies, ability to find, mar-
emotional arousal
shal and control resources, ability to
establish strong networks.
Motivations of the Study
In this backdrop it seems imperative to study the prospect
and potential of promotion of entrepreneurial opportuni-
ties in a region which has a glorious history of industrial
development. Kulti-Asansol-Barakar region in West
Bengal is one such region which might serve as a source of
nurturing and promoting entrepreneurial qualities among
potential risk taking entrants in the small industrial sector.
E N T R E P R E N E U R I A L E T H O S
With or above average frequency Percentage of such entrepreneurs
10 16.67
30 50
10 16.67
45 75
8 13.33
This sector exhibits ample scope for lessening the unem-
ployment problem in our country, if proper motivation and
leadership quality is manifest among the potential youth in
a vibrant entrepreneurial environment. In our country,
despite several five year plans, the unemployment situation
is still persistent with frightening magnitude. Also there
exists various kinds of imperfections and inefficiency in
the market functioning that hinders the prospect of newer
jobs. In such a scenario, nurturing of small scale entrepre-
neurship may at least partially solve the present unemploy-
ment problem.
Present Industrial Features of the Study Region
The above argument is pertinent to the global problem of
unemployment as far as Indian economy is concerned as a
whole. In our study as already alluded to,
we seek to analyse the potential of
Affective entrepreneurial development in a local
competence perspective. The Kulti-Asansol-Barakar
refers to the region in the Burdwan district of West
management of Bengal has long been famous as the core
industrial belt of the state.
Notable major industries in the region
and there are had been
five variants 1. Chittaranjan Locomotive works,
Chittaranjan
2. Hindustan Cables, Rupnarayanpur
3. Indian Iron and Steel Company, Burnpur
4. Indian Iron and Steel Company, Kulti
5. Cycle Corporation of India, Asansol
6. Damodar Valley Corporation , Mython
7. Eastern Coalfields ltd, Asansol
8. J.K Paper Mill, J.K. Nagar
9. Raniganj Paper Mill, Raniganj
THE INDIA ECONOMY REVIEW 161
M I C R O M A C R O
10. Burn Standard Company ltd, Burnpur
11. Disergarh Power Supply Corporation, Disergarh
12. Chinakuri Power Station , Chinakuri.
13. Alumunium Factory , Asansol.
14. A large number of mining companies
However the present situation is a bit different as most of
these major industries in the region have closed down and
some are marked as sick industries. The aforesaid phenom-
enon has left many skilled workers jobless and many have
retired with VRS. In the absence of any emerging alterna-
tive employment opportunities, small scale entrepreneurial
flourishing can somehow mitigate the joblessness scenario
in this predominantly industrial region. This can take place
through two ways- (a) the existing small scale entrepre-
neurs are motivated to expand their market by diversifying
the quality and type of their product. This might require
employment of more workers to produce the output
targeted at the market and employment of skilled person-
nel at the R&D sector to devise ways and means for the
required diversification, (b) on the other
hand flourishing of an entrepreneurial
environment can allure more and more There exists
skilled workers to the option of taking an little scope for
entrepreneurial drive by setting up absorbing further
independent small industry.
employment in
Objective and the existing small
Methodology of the Study scale industries in
The objective of the study is to focus on the region
whether the existing small industrial
entrepreneurial spirit in the region is conductive to promo-
tion and development of such an entrepreneurial environ-
ment as would to some extent mitigate the unemployment
among the skilled / semi skilled population.
With the purpose in view, 60 small entrepreneurs were
interviewed in the concerned locality. Data were collected
to reflect on the demographic and educational background,
nature of technology, risk perception etc. Further a ques-
tionnaire in line with General Entrepreneurship Test
(GET) was also devised to elicit the psychological inclina-
tion of the said sixty industrialists to undertake entrepre-
neurial drive. The test is meant to serve as a psychological
measure of entrepreneurial spirit or inclination among the
respondents. In this context , it needs to be stressed that
162 THE IIPM THINK TANK
entrepreneurship should be considered as the mix of
intention, drive and capacity to undertake continuous
process of change in accordance with risk calculated
prospects of market demand. The selected entrepreneurs
are mostly engaged in activities like steel casting, fi re
bricks, machinery, parts and components, consultancy,
trading etc.
Findings Related to Demographic,
Educational and Motivational Aspects
The origin of the entrepreneurs pertaining to the state they
belong to, has been classified in Table 1.
The striking feature of the entrepreneurial pattern in
the region is that most of the entrepreneurs are non-Ben-
galee and it is further dominated by Marwari and Gujrati.
It is startling to find that the Bengalees are far behind in
taking entrepreneurship as a career in their home state.
The classification of motivational support the entrepre-
neurs received from in building their career leads to
Table 2.
The data in Table 2, suggests that
non-Bengalees are motivated mostly by
their families. Most often in such cases
the entrepreneurs joined in their family
run enterprise which were started by
their ancestors. The corresponding
Yule’s co-efficient of association be-
tween family and non-Bengalees is
rather high at the value 0.952. The
continued functioning of an enterprise
from the past and its competitive existence in the present,
marks the fact that adoption of an entrepreneurial career
by the non-Bengalees appear to be devoid of any great
perceived risk. So the very attribute of the risk taking is
almost dissociated from these so-called entrepreneurs. In
the case of Bengalees, however, motivation emerged from a
variety of factors like family, no-job, VRS scheme, risk
taking attribute etc. The academic background of the
entrepreneurs as evident from Table 3, suggests a great lack
of forward looking vision and an indifference regarding the
importance of R&D expenses for continuing adoption and
implementation of improved technology.
Table 3, reveals that most of the entrepreneurs in the
surveyed region are not well-educated, having little knowl-

edge of technical education in their field of entrepreneur-
ship. This is likely to adversely affect their ability and vision
to have a dynamic view of the future and associated drive
to undertake innovative efforts. This is important since
movement and mobility have an integral part in the march
of human history all over the world. Human advancement
swings between two poles of movement and settlement.
Education is one of the factors that influence dynamism in
vision, spirit and drive. It enlarges one’s thinking ability
and horizon of understanding.
Attitude to Technology
The fact that comparatively inadequate education of
entrepreneurs has a negative bearing on the forward
looking vision is evident from Table 4.
Table 4 shows, that 33 entrepreneurs have shown inclina-
tion to adopt newer techniques but almost half of the
number still go on using old fashioned techniques and
unfortunately none of the sample entrepreneurs undertake
any R&D expenditure to upgrade their
existing methods. This is suggestive of a
static view of their future promotional Comparatively
efforts. Other technical aspects of the inadequate
surveyed entrepreneurs can be consid- education has a
ered from Table 5.
negative bearing
Table 5 reveals that, relatively larger
investment in small scale industries have
on the forward
been made in enterprises which have looking vision of
continued to exist for relatively longer entrepreneurs
years. These are mostly family run enter-
prises from the past. Although the industries produce
multiple products to avoid risk, in many cases this has been
happening from the decision of their ancestors. Newer vari-
eties are hardly introduced. In this context it may be noted
that the age of the entrepreneurs vary from 29 years to 45
years, the modal age group being 37-40 years. This indi-
cates that most of them have inherited the enterprises from
their earlier generation but lack the drive expected from
them. The lack of forward looking entrepreneurial attitude
is also vindicated by the results of GET test as devised by
Durham University, U.K.
Results of the GET Test
The psychological orientation of the so-called entrepre-
E N T R E P R E N E U R I A L E T H O S
neurs, supposed to be necessary to have a dynamic,
innovative view for promotional efforts of the enterprise, is
tested under several attributional headings. For instance
frequencies corresponding to the following sections of
attributes formed by several sub- attributes with the
needed optimal and average scores are documented in
Table 6.
Table 6 reveals that excepting the fourth category, in
terms of all the attribute characters, the entrepreneurs do
not have the requisite scores in the corresponding category
that might strongly reflect on their enterprising spirit and
tendency for a development oriented outcome. Majority of
the so called entrepreneurs did not pass the test for being
dubbed as persons with entrepreneurial acumen and vision.
It is to be noted that only eight entrepreneurs passed all the
tests and satisfy the criteria of possessing the requisite
attributes expected of an entrepreneur. This also indicates
that true intention reflecting a person’s attention towards a
specific goal in order to achieve something is not mani-
fested in the psychological attitude of
the interviewees.
Flourishing of entrepreneurial
resourcefulness requires a matching of
positive entrepreneurial intention with
positive entrepreneurial environment.
Any deviation from the above combina-
tion may be viewed as a mismatch
between entrepreneurial intention and
environment. A sound environment in
combination with positive drive is
necessary for fructification of entrepreneurial resourceful-
ness and concomitant ripples in the society in terms of
more and more people opting for the entrepreneurial
career. Entrepreneurial resourcefulness can be defi ned as
the ability to identify opportunities in the environment
and regulate and direct behaviour to successfully cope
with the task of creating and managing an organization to
pursue the opportunity. This may be viewed as the culmi-
nation of adoption of successful entrepreneurial activities
in a region.
A View of Entrepreneurial
Environment in the Region
An entrepreneurial environment, as already referred to,
THE INDIA ECONOMY REVIEW 163
M I C R O M A C R O
implies a combination of socio-cultural, economic and
political factors that influence an individual’s ability and
proclivity (either positively or negatively) to initiate entre-
preneurial activities in a region. The survey conducted
among the entrepreneurs regarding their perception of
entrepreneurial environment yields a mixed kind of
information that is tilted towards a bleak view of the
environment. There is a network or common forum for the
small scale industries to discuss and solve their mutual
problems. It acts as a representative for the small scale
industries in the region. The forum gives a positive re-
sponse for the dissemination and encouragement of
entrepreneurship in the region but has hardly any vision or
drive to achieve it. It has never taken any initiative to
disseminate its prospects among potential entrants. It also
does not have any information about whether entrepre-
neurship training programmes / institutes are available in
the surrounding region. There exists good scope for
obtaining loan on easy terms for bigger industries in the
region but small industries are not so fortunate, they have
to face various problems. The industries however can
obtain counseling or support service from the forum. The
forum strongly felt that goverment policies were not
conducive to their flourishing; specially they felt that the
VAT was inimical to their growth. These views are reflec-
tive of the fact that the entrepreneurial environment in the
study area is rather dampening of the entrepreneurial
intention or spirit surrounding the region.
Way Forward to Avoid the Present Gloom
The aforesaid analysis reveals that there exists little scope
for absorbing further employment in the existing small
scale industries in the region. Although they produced
multiple products to avoid risks, there was not any drive to
diversify their quality and hardly any research and develop-
ment initiative. So the potential of absorbing skilled
technicians, personnel in the existing small scale sector has
rather been bleak in the region. Besides this, the entrepre-
neurial environment in the region has been mostly discour-
aging for the potential entrants. Although the existing
entrepreneurs stated in the affirmative regarding the
importance of flourishing of entrepreneurial spirit in the
region, from the core of their heart they have not taken any
initiative to disseminate it across the locality. Besides this,
164 THE IIPM THINK TANK
they visualize the potential entrants as possible contenders.
Hence the drive should emerge from NGOs or even from
Government sponsored agencies to launch programmes
that might activate the entrepreneurial vivacity in the
adjoining region. The provision of loans on easy terms and
with little complexity need immediately be introduced for
potential entrants in small sector. Again entrepreneurship
training institutes need to be established in every major
industrial belt with sufficient advertisement for the future
prospect of its users. Entrepreneurship as a career has not
yet gained currency in our society. This needs to be re-
versed. For this purpose, introduction of an entrepreneur-
ship course at school as well as at college level can hardly
await any further delay. Only then some tangible effect
might be achieved in lessening the problem of unemploy-
ment through the flourishing of entrepreneurial resource-
fulness in our society.
References and Additional Thinking
• Balasubrahmanya, M.H. 2003.Technological Innova-
tions in Small Enterprises- A Comparative Study of Ban-
galore and North- East England, EPW, May 24th.
• Bhide, Sheela.2000. Development Of Small Scale
Industries – A Collaborative Approach, EPW, Novem-
ber 25th.
• ICSI .1996 .Herald, Vol 7, Nov 4.
• ICSI .1997. Herald, Vol 8, Nov 7.
• Kanungo, R.N & S. Misra. 1992.‘Managerial Resource-
fulness: A Reconceptualization of Management Skills’,
Human Relations, 35-12.
• Misra, Sasi & E.Sendil Kumar.2000. Resourcefulness:
‘A Proximal Conceptualization of Entrepreneurial
Behaviour’, The Journal of Entrepreneurship, vol 9,no 2.
• Mukherjee, Robin., Pranab .K. Das & Uttam K
Bhattacharya.1999.‘Small Scale Industries In West
Bengal, 1971-97-Data Analysis For Study Of Growth’,
EPW, November 27th.
• Nath , V. 2000. Entrepreneurship By Region & Caste-A
Survey , EPW, November 25th.
• Streefkerk, Hein .1997.Gujrati Entrepreneurshp, EPW,
Vol 32. No-7. February 15th-21st.
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation.)
M I C R O M A C R O

Microfinance at Turning
Point: Success Factors of
Microcredit in Bangladesh
and Its Future Prospects
Illustration : Shantanu Mitra

166 THE IIPM THINK TANK


Tomohito Kanaizuka
ODA Loan Program Specialist,
Japan International Cooperation Agency
(JICA), Tokyo, Japan
Farhad Hossain
Lecturer, Institute for Development Policy and
Management (IDPM), School of Environment
and Development, University of Manchester,
Manchester, United Kingdom
S O C I A L E D G E
Introduction
Based on the unique concept of utilising the abilities of the
poor for improvement of their own lives, the scheme of micro-
finance has been continuously expanding its outreach for
approximately 30 years. In these 30 years, microfi nance has
grown from only a tiny economic experiment to a major
public policy of poverty alleviation and has reached more
than 133 million people in developing countries around the
world (Microcredit Summit Campaign (MSC), 2007). Further-
more, quite surprisingly, microfinance is still growing its
outreach at a remarkably rapid rate every year1. It is undoubt-
edly one of the most important schemes of today’s poverty
reduction initiatives.
However, despite the extremely high popularity of the
microfinance movement and its positive impact to the lives of
the poor, Hulme and Moore (2007) explained that the idea of
enabling and empowering the poor by providing them with
small loans was actually considered as ‘disastrous policy’ when
movement was started in the late 1970s in Bangladesh.
Furthermore, even after microfinance established itself as a
widely accepted policy of poverty alleviation, it continued to
receive heavy criticism with regards to high interest rates,
exploitation of women, loan repayment, unchanging poverty
levels and failure to cater effectively to the target groups in
addition to the numerous accolades (Mallick, 2002; Brau and
Woller, 2004).
As there are such criticisms, it still remains unclear what are
the real success factors of microfinance, which made it
possible to become such an extremely successful scheme.
Moreover, the future of the microfi nance scheme has rarely
been considered. In order to explore these important themes,
the authors have separately visited Bangladesh in July and in
December 2007 and conducted a thorough evaluation of the
operation of Grameen Bank and socio-economic environment
of Bangladesh that surrounds Grameen Bank. Based on
empirical findings from these two field visits reinforced by
insights from relevant literature, this paper will fi rst look at
the background of how microfinance emerged. Second, the
paper will explore the unique characteristics which differenti-
ate microfinance from other poverty-reduction initiatives and
enable the microfinance scheme to grow and be self-sustaina-
ble. Third, the paper will explore and identify success factors
of the scheme. Finally, this paper will attempt to determine
the future of the scheme by considering how socio-economic
THE INDIA ECONOMY REVIEW 167
M I C R O M A C R O
changes would influence the success factors identified in the
previous section.
II. Review of Origin and
Potential of Microfinance Scheme
Origin of Microfinance
The source of poverty is not traced back to a single root;
people become poor for various reasons such as civil war,
corruption, natural disasters, lack of basic education and so
forth. Among the different sources of poverty, Yunus identi-
fied the lack of access to formal financial services as a critical
cause of poverty. In developing countries, the majority of the
poor usually do not have any access to formal banking
services and have to depend on usurers who charge extremely
(often illegally) high interest rates on loans. Yunus and Jolis
described the disastrous situation of the poor who borrow
money from money-lenders as follows:
‘…in all cases it is extremely difficult for the borrower to
extricate him- or herself from the burden of the loan. Usually the
borrower will have to borrow again just to repay the prior loan,
and ultimately the only way out is death… Unless the poor can
be liberated from the bondage of the money-lender, no economic
programme can arrest the steady process of alienation of the
poor.’ (Yunus and Jolis, 1998: 8)
In the societies of Bangladesh and other low-income
developing countries where the unemployment rate is substan-
tially high2, the creation of a job by
starting a new business is one of a few Microfinance
effective ways to overcome poverty.
However since the poor do not have access
utilizes the ability
to the financial services, they are not able
of the poor
to gain the seed capital to start up their themselves for
business and as a result, it becomes an the purpose
unrealistic option for them to pursue. of improving
From his findings, Yunus concluded that a
critical source of poverty stems from the
their lives
lack of access to the financial services, and he developed the
mechanism of microfinance, a scheme of enabling and
empowering people through the provision of small-sized
financial services with affordable commission charges.
Potential of Microfinance Scheme
In the domain of poverty reduction, although enormous
effort has been spent and the proportion of the poor people
168 THE IIPM THINK TANK
has significantly decreased3, a substantial number of people
still remains poor. According to World Bank (2008), ‘it has
been estimated that in 2001, 1.1 billion people had consump-
tion levels below $1 a day and 2.7 billion lived on less than $2
a day.’ This suggests that there has not been any scheme
which has succeeded to fundamentally change the situation
of developing countries. Although there is also no guaran-
tee that microfinance can change the situation radically, it
has two significantly different characteristics that may allow
it to do so in the future.
The first characteristic is that, as previously mentioned,
microfinance utilizes the ability of the poor themselves for
the purpose of improving their lives. In microfinance, MFI
lends seed or operating capital to the poor often without
any collateral, credit history or steady income, for their
proposed income-generating activities (Kota, 2007). Unlike
such activities as giving of commodities (food, clothes,
medicines, etc.), which would only satisfy the immediate
needs of beneficiaries, or provision of education and
training, which requires time before one becomes able to
use the acquired knowledge and skills, the provision of such
capital funds brings beneficiaries both immediate and
long-term benefits. In order to reduce poverty, it is neces-
sary for the poor to acquire the skills and build the founda-
tion to sustain their lives on their own on a permanent basis;
microfinance is a scheme which helps to equip the poor with
such skills and foundations. In fact, it is
reported by Hulme and Moore (2007)
that there are up to half a million people
in Bangladesh alone who successfully
escape from the poverty every year as the
result of effective use of microfinance.
The second, yet probably more impor-
tant, characteristic of microfinance is
that MFIs usually maintain and expand
their activities by utilizing the contribu-
tions recollected from their own beneficiaries (Felder-Kuzu,
2005). Unlike conventional methods of poverty alleviation
whose implementation almost always requires resources
provided from donors (and therefore out of the control of
the poor), this characteristic has given MFIs a solid basis for
expansion. Indeed, microfinance has been growing at
remarkably rapid rate. According to MSC (2007), the total
number of clients reached by MFIs has grown from 13

millions by the end of 1996 to 133 million by the end of
2006 and numbers of MFIs reported to MSC also grew
from 618 to 3,3164. From these figures, it can be seen that
the number of clients of MFIs has grown by a remarkable
120 million people at the rate of ten-fold in only a decade. It
is important to mention that number of clients, 133 million
people, does not include the clients’ families who would
also be assisted by the funds provided by MFIs. MSC (2007)
estimates 464.4 million people who have consumption level
of $1 or less are currently being helped by MFIs and that
makes up approximately 40 percent of world’s poor popula-
tion who falls into that category. This significantly high rate
of growth and considerably wide outreach of the scheme
suggests that microfinance has the potential of reaching all
the poor in the world. In fact, Yunus reported in his Nobel
lecture in 2006 that 80 percent of poor families in Bangla-
desh have been reached by microfi nance and it is expected
that 100 percent of them would be reached by 2010 (Nobel
Foundation, 2006). Microfinance has great potential to
reach a significant proportion of the poor population
around the world.
III. Success Factors of Microfinance
In the previous section, two unique characteristics of
microfinance were reviewed. Now, critical factors that made
microfinance a successful scheme will be
identified and explored based on findings
from the authors’ field studies to 464.4 million
Grameen Bank in Bangladesh and also people who have
relevant literature.
consumption level
Political Endorsement of one dollar or
When one tries to implement a large- less are currently
scale scheme, which would affect the being helped
well-being of a significant number of by MFIs
people, it is necessary to obtain support
from the government. It was extremely lucky for Yunus that
he could gain continuous support from the government by
fully utilizing his personal network with high rank govern-
ment officials. He was able to obtain government support
from the stage the scheme was only a small experiment in a
village until the experiment turned into a government
regulated special bank (Grameen Bank) and now provides
services to 7.4 million people (Grameen Bank, 2008). While
S O C I A L E D G E
any activity can be easily destructed by the government, the
fact that Grameen Bank has always kept a friendly relation-
ship with the government ruled by cabinets of different
political parties contributes significantly to the remarkable
success of the scheme.
Well-designed Strategies
Unlike conventional banking operations which can expect
certain amount of profits from each loan, profits from
microfinance loans are generally also ‘micro’ by their
nature. Because of such conditions, it is critically important
for an MFI to implement highly efficient and effective
management. From the field studies, various techniques
adopted by MFIs in order to realize low-cost management
were observed. Following are some of the strategies used by
Grameen Bank which are widely used by various MFIs:
Group-lending: Among various techniques adopted by the
scheme, group-lending was observed as Bangladeshi MFIs’
common lending strategy, which contributes to their
efficient management. By looking at peer-selection and
peer-monitoring, two important mechanisms enacted as a
part of the group-lending strategy, this paper will explore
how group-lending contributes to the efficient management
of microfinance.
Peer-selection: For MFIs to secure sound
operation, it is necessary to screen out
bad borrowers who would not appropri-
ately repay their debts. Peer-selection is a
technique applied in the field, which
enables an MFI to cost-effectively avoid
such bad borrowers. Ghatak (1999)
explained the mechanism of peer-selec-
tion as follows: While gathering local
information about potential borrowers is
costly for an MFI, local prospective borrowers already
know about each other’s projects. By contracting to self-
formed groups of these prospective borrowers, MFIs can
deliberately induce borrowers to select their groups in a way
that exploits this local information.
Peer-monitoring: Likewise to peer-selection, although it is
important for securing sound repayment, monitoring the
THE INDIA ECONOMY REVIEW 169
M I C R O M A C R O
activities of the borrowers is a costly business for MFIs. A
useful tactic for transferring some of the monitoring costs
to the borrowers is peer-monitoring. It is used as a part of
the group-lending scheme. By designing the rules of loaning
funds in such a way that one’s own loan activities positively
or adversely affect the loan activities of other borrowers in
one’s group, MFIs deliberately induce borrowers to monitor
each other’s use of their loans.
In addition to these two mechanisms, there was another
commonly used strategy observed in the field, which is
important in terms of low-cost management of the microfi-
nance scheme.
Group Meeting: Another important method of saving
operational cost is the weekly group meeting. This is
designed as a mutually beneficial system for both MFIs and
their beneficiaries. Group meetings usually take place in
the vicinity of where beneficiaries reside. By requiring
borrowers to calculate their weekly
instalments and discuss applications for
new loans among their group members Ironically,
prior to the weekly meeting, MFIs can relatively poor
pre-sort their business concerns and socio-economic
quickly perform their functions. In the
case of Grameen Bank, it was observed
conditions serve
that a skilful manager collected and
as important
registered weekly instalments, accepted success factors
and evaluated new loan applications, and of microfinance
transmitted inquiries from the bank to
50 borrowers all in one hour. If considering that most of the
borrowers do not have any transportation means, the fact
they can complete all these business in one hour without
travelling far on foot contributes to the reduction of their
work as well.
Although group-lending and group meeting are typical
strategies that are adopted by many MFIs that can consid-
erably help them reduce their operational costs, they are
still not the strategies that are universally adopted by all
MFIs. In fact, strategies adopted by MFIs vary MFI to MFI
depending on the environment within which each MFI
operates. However although strategies adopted by MFIs
vary a lot, their aim of reducing the cost as low as possible is
common. There is no doubt that innovative strategies like
the ones introduced above and the efforts of microfinance
170 THE IIPM THINK TANK
officers to develop such strategies have significantly contrib-
uted to making the microfinance scheme a major poverty
alleviation policy today.
Favourable Socio-Economic Conditions
In addition to the two important success factors presented
earlier, it was observed through the field studies that
relatively poor socio-economic conditions of Bangladesh,
which are not necessarily good for their citizens, ironically
serve as important success factors of microfinance. Two
important elements of the social and economic conditions
which contribute to the success of microfinance will be
explored below.
Ample Supply of Competitive Employees
Based on Poor Employment Conditions:
During the field surveys in Bangladesh, extremely tough
working conditions of Grameen Bank’s branch workers
were observed. Regular working hours
are already long, but during the rainy
season they are even longer. Yunus and
Jolis (1999) mentioned that the average
working hours for local branch employ-
ees are 12 hours from 7:00 A.M. to 7:00
P.M. with one hour break. During the
authors’ visits, it was observed that staff
stayed in the office often until midnight
due to the influence of rainy seasons.
Moreover, from an interview with a
senior principal officer of Grameen Bank, Ansaruzzaman
(2007), it was discovered that while the staff have to stay
long hours, no overtime allowance is paid to them as they
are required to agree on an annual salary contract upon
their employment. However, according a local branch
manager Bhuyan (2007), Grameen Bank’s working condi-
tions are actually still much superior to conditions at other
employers in the country, and in fact, Grameen Bank is an
exceptionally popular destination for work. In Bangladesh
where a high degree of corruption exists5 and the supply of
jobs is extremely limited, obtaining a decent job is some-
thing extraordinarily difficult. Yunus and Jolis (1999)
mentioned job applicants must pay bribes which may be up
to twenty times the monthly salary the job would bring,
simply to obtain the job. These extremely severe employ-

ment conditions have made Grameen Bank salaries (which
is equivalent to government employee with additional
retirement benefits) competitive. Additionally, recruitment
conditions that do not require application fees and enforce-
ment of strong policies against bribes make Grameen Bank
positions remarkably attractive. Upon such favourable
hiring conditions for employers, Grameen Bank succeeded
to hire more than 20,000 high-profile employees6 (Grameen
Bank, 2007) but there is no doubt that the commitment of
such capable and dedicated staff significantly contributes to
the high-performance of Grameen Bank. As the socio-
economic environment affects not only Grameen Bank but
also all the organizations in the country, it can be expected
that all other MFIs in Bangladesh have benefited consider-
ably from the unfortunate socio-economic condition,
though favourable for employers.
Dedicated Commitment of Borrowers
Based on Severe Gender Inequality:
The second socio-economic condition, Being poor in
which works favourably for MFIs in Bangladesh
Bangladesh, is severe gender inequality is tough for
in the country. In Bangladesh, there are
many customs that considerably limit the
everyone, but
scope of activities in which women can
being a poor
engage; under such conditions, men keep woman is the
their dominating power over women. toughest of all
Among the different customs, there are
two major ones that tremendously affect women’s lives. The
first one is called purdah. Purdah is a set of norms that
exclude women from public spaces by enforcing restricted
mobility, giving them specific gender labour roles, and
prescribing legitimate behaviours (Newaz, 2001). The extent
of activities regulated by purdah is extremely wide so that
women often need to ask for their husband’s permission
even to go to their neighbours (Tsuboi, 2006). Dowry is
another custom, which adversely affects women’s lives.
Dowry is a significant value of property or money brought
by bride to her husband and his family, which often deter-
mines the prospect of the wife’s position in the family
(Newaz, 2001). Dowry is considered a detrimental custom
for women’s status in the family because it often becomes a
source of domestic violence and in the worst case becomes
even a cause for murdering the bride (Tsuboi, 2006). In fact,
S O C I A L E D G E
a woman’s position in a family is awfully fragile; a man can
divorce his wife simply by telling her so three times (Yunus
and Jolis, 1999) and indeed, they are often abandoned by
their husband (Tusboi, 2006). While it is extremely difficult
for a divorced woman to find a job because of the high
constraints of purdah, the family of the divorced woman
may not allow her to come back in many cases as they
cannot afford to feed an extra mouth. Because of such
extreme situations, married women in Bangladesh generally
live highly oppressed lives under the fear of being aban-
doned by their husband. For those women, microfi nance is
an important and rare opportunity for them to improve
their position in the family; in Bangladesh, the provision of
a microfinance loan is a rare privilege usually entitled only
to women, not men. Regarding the provision of microfi-
nance loans to women, Yunus and Jolis (1999: 88) men-
tioned ‘Being poor in Bangladesh is tough for everyone, but
being a poor woman is the toughest of all. When she is given
the smallest opportunity, she struggles
extra hard to get out of poverty.’ Arsheda,
a village borrower interviewed by the
author, mentioned that she was also a
powerless woman totally ignored by her
family before she enrolled in microfi-
nance, but she gained respect and trust
from everyone as she succeeded in her
cattle raising business and became only
literate person in the family. Arsheda
said being trusted and respected by others are the most
important values in her life, and the excitement from this
motivated her to overcome the difficulties of repaying debt.
It is certainly important to remember that the desperate
efforts made by literally millions of struggling women are
the driving forces underlying the outstanding achievements
of microfinance.
IV. Analysis of Success Factors
and Future Prospects of Microfinance
The main success factors of microfinance scheme were
reviewed in the previous section. However as society is
ever-changing, the importance of each success factor also
changes. In this section, the paper will attempt to forecast
the future prospects of microfinance by analyzing the
success factors as related to changes in the environment and
THE INDIA ECONOMY REVIEW 171
M I C R O M A C R O
society in which microfinance is performed.
Changes in Importance of Political Endorsement:
A good example of changes in the importance of the
success factors is the changing importance of political
endorsement for the microfinance scheme. At the very
beginning of microfinance scheme when it was only a small
experiment, financial and legal support from the govern-
ment were critically important. However in the current
operation, Yunus has secured a solid legal background and
also a strong fi nancial basis, which allows the bank to
finance 100 percent of its loans from collected deposits
(Yunus, 2007). As a result, the relative importance of
political endorsement has drastically decreased. In the
present operation, Grameen Bank and many other MFIs
in Bangladesh have become strong enough to operate on
their own as long as the government is not too destructive
for them.
Changes in Socio-economic Conditions
and Their Influence to the Strategies: MFIs based on
As mentioned above, political support is conventional
no longer a big issue for the current group-lending
operation of microfinance in Bangladesh.
This is because MFIs have grown and
strategies will face
become able to support their activities
serious problems
without receiving governmental assist- if they keep using
ance. However unlike government old strategies
support, there are other factors such as
socio-economic conditions, which are out of the control of
MFIs. Regarding such factors, it is necessary to consider
how these external factors would change in the future and
how these changes would influence the scheme. This paper
will look at the influence of potential changes in two
socio-economic conditions and how these changes would
affect the strategies adopted by MFIs.
Possible Effects of the Changes in Employment Conditions:
There is unfortunately no evident sign which foretells that
employment conditions in Bangladesh would be significant-
ly improved in the near future. Nevertheless, it is important
to consider this possibility because it would greatly affect
the future operation of microfinance. If employment
conditions are improved, both the cost of staff recruitment
172 THE IIPM THINK TANK
and their wages will be raised. Although these additional
costs must be financed from the interest payment of bor-
rowers, it would not be possible to do so if such costs
become more than borrowers can afford. In the case of
Grameen Bank, General Manager Shahjahan (2007)
identified two major countermeasures to prepare for this
possibility. The first measure is computerization of branch
accounts. By computerizing branch accounts, Grameen
Bank is trying to make their operation more effective while
reducing the number of people required for operation.
According to Grameen Bank (2008), almost all the branch
accounts (2,418 out of 2,481) have already been computer-
ized. Another measure is early retirement program. At
Grameen Bank, if an employee works for 10 years, that
employee will be entitled for early retirement and be able to
leave the bank with a considerable amount of retirement
benefit7. Shahjahan (2007) explained that about 25 percent
of employees take this option. A policy like this one seems
to give Grameen Bank greater control
over their human resources as they can
effectively control the size of the organi-
zation by manipulating the retirement
policy and the number of employees to
be recruited. These are just a few
examples of the measures taken by a
leading MFI in Bangladesh; further
studies are required in order to fi nd out
what preparations are taken by other
MFIs. However one thing is sure at this
point; each MFI must establish suitable measures for
themselves as it is reasonable to expect that improvement in
employment conditions would occur in Bangladesh at some
point in the future.
Possible Effects of the Changes in Gender Inequality:
Regarding the gender inequality issue, there is some
evidence which indicates that gender equality is being
promoted in Bangladesh. For example, in the area of
education, currently there are even more female students
enrolled than male students (1.03 of female/male ratio) and
as a result, the gap in literacy rate between the two genders
has been quickly diminishing8 (UNDP, 2007). The Bangla-
deshi government also has been taking extra effort to
increase women’s participation in their parliament. Accord-

ing to UNDP (2007), the Bangladeshi government added 45
seats in their parliament exclusively for women in 2004 and
as a result, the share of the seats occupied by women in the
parliament was increased from two percent in 2003 (UNDP,
2003) to 15 percent in 2007 (UNDP, 2007). These are just a
few examples but there are many more examples of the
promotion of gender equality in Bangladesh.
Unlike improvement in employment conditions, which
increases the management cost, promotion of gender
equality does not necessarily influence microfinance
scheme in a negative way. This is because regardless of
women’s position in the family, their financial situation
remains the same and the need for microfi nance remains.
For that reason, although improved position of women in
the family would reduce the degree of their commitment to
microfinance as they would no longer be as desperate as
they are now, it also could be expected that commitment of
men to microfinance would be increased.
A separate study would be necessary to
evaluate the effect of promotion of Promotion
gender equality on microfinance. of gender
equality does
Evaluation of Effectiveness of not necessarily
Current Strategies in the Future:
As reviewed earlier, the strength of
influence MF
microfinance comes from the fact that scheme in a
microfinance scheme is managed by negative way
utilizing the power of the poor them-
selves. In microfinance, various strategies are adopted in
order to make it possible for MFIs to run the scheme using
the tiny amount of interest charges collected from the
borrowers. It was reviewed that group-lending is an effec-
tive method of economizing the management costs adopted
by different MFIs. However, it may become difficult to use
such a method in the near future in Bangladesh. As men-
tioned earlier, Yunus said that microfi nance could reach
almost 100 percent of the poor families in Bangladesh by
2010 (Nobel Foundation, 2006). Whether or not that would
become reality is still unknown however the possibility has
significant meaning. Microfinance may reach a peak at
which point there may be no way it could expand further. As
more people escape from poverty and quit being clients of
MFIs, the number of beneficiaries which belong to each
branch may decrease. At that point, it will cost more to
S O C I A L E D G E
manage each branch and the interest rate charged to each
borrower would need to be increased as a result. However,
if the interest rate is too high, it would no longer possible for
poor clients to borrow money from MFIs. On the other
hand, if MFIs tried to merge branches in order to increase
the number of people per branch, it would become difficult
for borrowers to come to the weekly meetings and become
no longer feasible for them to use microfinance. In addition,
as the number of people who need microfi nance loans will
be decreased, it would become harder for potential borrow-
ers to find suitable group members as well. All of these
situations mean that MFIs based on conventional strategies
of group-lending will face serious problems which would
not allow them to operate further if they will keep using
these strategies without making further improvement.
Improvement in strategies seems to be an absolutely
necessary condition for the future of microfi nance.
V. Conclusion
Microfinance is a unique method of
alleviating poverty with the concept of
empowering people with their own
abilities. In microfinance, even the
maintenance and expansion of the
scheme is usually done based on the
contributions collected from the benefi-
ciaries. These characteristics of self-
sustainability and self-expansion have
given the microfinance an outstanding power of expanding
its outreach. Currently 40 percent of world poor who live
under the consumption level of $1 per day are expected to
be benefiting from the scheme (MSC, 2007).
Through the results of recent field studies conducted in
2007 and literature reviews, this paper has concluded that
political support, which provided legal and financial basis,
was a critical success factor of the microfinance scheme
during its initial stage. Regarding the current operation of
microfinance, this paper provided two key success factors.
The first factor was well-designed strategies adopted by
MFIs. In microfinance, by definition, MFIs can expect
only a ‘micro’ profit from each beneficiary but they still
have to grow from these tiny earnings. This paper ex-
plained how the strategies based on group-lending
enabled MFIs to run their activities cost-efficiently, so
THE INDIA ECONOMY REVIEW 173
M I C R O M A C R O
that they could expand their activities from these small
incomes. The second success factor was favourable
socio-economic conditions (for MFIs). It was explained
that severe employment conditions in Bangladesh enabled
MFIs to recruit and use quality staff at relatively low cost.
On the other hand, it was also explained that harsh gender
inequality exists in Bangladesh makes microfi nance loans
one of the rare opportunities for women to improve their
status in the family, thus raising their commitment to
repaying their loans.
Socio-economic conditions in one country and the
effectiveness of the strategies implemented by MFIs are
changeable over an extended period of time. In this paper,
the future prospect of the microfi nance scheme was
evaluated by analyzing the success factors of current micro-
finance operations. From the analysis, it was concluded
that changes in socio-economic conditions would have
considerable impact over the future of microfi nance, and
therefore changes or improvements to the current strate-
gies must be developed in order for microfi nance to remain
a successful scheme of poverty alleviation in the future.
In the past, reaching all the poor in the world was the
flagship target of microfinance. Although it still has a long
way until microfinance reaches this target, on a national
level in Bangladesh, it is close to becoming a reality. It
seems highly possible that microfi nance would reach its
peak in Bangladesh in near future because of the scheme’s
high growth rate. Reaching the peak will mean that there
will be fewer prospective new clients for MFIs in the
country and the number of beneficiaries will decrease. The
number of clients served per branch would decrease and
the cost of managing a branch per person would increase.
That would also mean fewer potential clients in a village
and more difficulty in finding group members for prospec-
tive clients. All of these situations lead to the conclusion
that MFIs based on conventional group-lending strategies
will face serious problems if they will keep using these
strategies without making further improvement. The
moment microfinance reaches its peak will occur in a
relatively short period of time and it will be the critical
turning point of the microfinance scheme. For the future of
all the poor in the world, further innovation on the strate-
gies of microfinance is eagerly desired and continuous
attention must be paid for such efforts of innovation.
174 THE IIPM THINK TANK
Endnotes
1
The number of poorest clients reached by the all the
MFIs reported to MSC in the world was increased by 22
percent in average for past five years (2001-2006)
according to the data from MSC 2007
2
According to Bangladesh Bureau of Statistics (2007),
unemployment rate (including underemployment) for
2005-2006 was 28.7 percent.
3
According to World Bank (as quoted by United Nations
Development Programme 2005), proportion of the
people who live under $1 per day in the world was
decreased from 40.4 percent in 1981 to 20.7 percent in
2001.
4
These figures merely represent the data of MFIs
reached by MSC. There is high possibility that there are
more MFIs and people reached by them but not yet
recognized by MSC. Please refer to MSC (2007) for the
details of the data.
5
Transparency International (2006) ranked Bangladesh
156th among 163 countries listed in Corruption Percep-
tion Index 2006. The Corruption Perception Index is an
internationally accredited index released every year by
Transparency International which ‘ranks more than 150
countries by their perceived levels of corruption, as
determined by expert assessments and opinion surveys’
(Transparency International n.d.: n.p.). For more
information, please refer to http://www.transparency.
org/policy_research/surveys_indices/cpi.
6
According to Yunus and Jolis (1999), Grameen Bank
requires applicants for branch manager to have a
master’s degree with the average grades of B or better
and applicants for center (the lowest unit of field opera-
tion) to have at least two years of college education with
average grades of B or better in college and high school.
7
According to Shahjahan, approximately $10,000 is the
amount to be paid for young center managers who
started to work at 18 years old.
8
Female/ male youth literacy ratio was increased from
0.71 in 2005 (UNDP 2005) to 0.9 in 2007 (UNDP
2007).
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S O C I A L E D G E
• Tsuboi, Hiromi (2006) Do You Know Grameen Bank?
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• United Nations Development Programme (UNDP)
(2005) Human Development Report 2005 International
Cooperation at Crossroads: Aid, Trade and Security in
an Unequal World (New York: UNDP).
• United Nations Development Programme (UNDP)
(2003) Human Development Report 2003 Millennium
Development Report Goals: A Compact among Nations
to End Human Poverty (New York: Oxford University
Press).
• World Bank (2008) Understanding Poverty: What is
Poverty?, World Bank [Online], Available: http://go.
worldbank.org/RQBDCTUXW0, [Accessed: 9th
January, 2008]
• Yunus, Muhammad and Alan Jolis (1998) Banker to the
Poor (Dhaka: University Press).
• Yunus, Muhammad (2007) Grameen Bank at a Glance
(Dhaka: Grameen Bank).
• Ansaruzzaman, Md.: Senior Principal Officer,
Grameen Bank, International Department (2007)
Personal Interview, Dhaka, 14th, 15th and 22nd July, 2007.
• Arsheda: Grameen Bank borrower (2007), Personal
Interview, Fegunasher, Bangladesh, 9th July, 2007
• Baiddya, Ashim: Fieldworker, Grameen Bank, Panchk-
hola Branch, Madaripur (2007) Personal interview,
Madaripur, Bangladesh, 23rd December, 2007.
• Bhuyan, Harun-or-Rashid: Branch Manager, Fegunash-
er Shirajdikhan Branch, Grameen Bank (2007) Fegu-
nasher, Bangladesh, 9th-12th and 19th July, 2007.
• Biswas, Pabitra: Fieldworker, Grameen Bank, Panchk-
hola Branch, Madaripur (2007) Personal interview,
Madaripur, Bangladesh, 23rd December 2007.
• Shah, Mozahid: Manager, Grameen Bank, Panchkhola
Branch, Madaripur (2007) Personal interview, Mad-
aripur, Bangladesh, 25th December 2007.
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation).
THE INDIA ECONOMY REVIEW 175
S E C T O R A L S N A P

Consumer Behavior and

Competition in Indian
Retailing

176 THE IIPM THINK TANK


Mohammad Amin
Private Sector Development Specialist,
Enterprise Analysis Unit, Financial and Private
Sector Development, The World Bank Group,
Washington, D.C.
R E T A I L R O U L E T T E
1. Introduction: Overview and Data Description
It is commonly believed that India has one of the highest
density of retail stores in the world and therefore competition
in the retail industry is hardly an issue. Another common belief
is that competition in an industry depends on the number of
firms and firm-behavior with consumer behavior being largely
irrelevant. However, beliefs and perceptions can be notoriously
misleading and confirmatory evidence using hard data is always
welcome. Unfortunately, hard data on structure of retailing in
India (or any developing country) is extremely rare. This is
surprising given that the retail sector in India is the second
largest sector (after agriculture) providing about 10% of the
formal jobs, and contributing over a quarter of the value added
in all services sectors and 14% to the national GDP. The sector
has also shown strong growth in recent years, with an average
annual growth rate of 7.3% over the 1990s compared with 5.9%
in the 1980s and 4.3% during 1950-1979.1 These numbers tell
the story in the formal sector. But an estimated 95% of the
sector’s activity takes place in the informal sector that is not
accounted for in the official figures.
This article uses data on 1,948 retail stores in India and
collected by the World Bank’s Enterprise Surveys in 2005 (data
described in detail below). Using these data, we explore a
number of issues relating to the level of competition in retailing
and find some surprising results. First, competition in the sector
is low by international standards and also when compared with
the same in the Indian manufacturing sector. Second, larger
and richer metropolitan cities that have been the main hub of
Indian retailing show significantly less competition than the
relatively smaller cities. Third, contrary to the popular belief
that competition is all about how firms behave, we find strong
evidence that consumer behavior is an equally important
determinant of the level of competition. Specifically, house-
hold’s shopping time opportunity cost as proxied by the number
of non-workers per household in the city has a very large effect
on the level of competition. The finding is particularly impor-
tant for India that is witnessing a rapid decline in the number of
non-workers driven in part by the ongoing economic boom.
Fourth, we look at another popularly held belief that competi-
tion in retailing is greater in the poorer cities. The rationale for
this is that poorer households value a Rupee of savings more
than the rich and hence they are likely to search more inten-
sively increasing the level of competition. Our results show that
THE INDIA ECONOMY REVIEW 177
S E C T O R A L S N A P

Figure 1. Percentage of Firms Facing Significant Competition important or very important

on the question. The survey
also provides information
Retailers (India) 38.2
on a number of store
Retailers (Eastern Europe characteristics such as its
71
and Central Asia age, floor area, financial
Manufacturing (India) 82 condition, annual sales, etc.
We use these rich data to
0 20 40 60 80 check for the robustness of
Percentage of firms/stores reporting the main results.
competition as fairly important or important

Source: Enterprise Surveys and Business Environment and Enterprise Performance Survey (BEEPS, 2005). 2. Low Level of
Competition in Indian
the negative income-competition relationship in India disap- Retailing
pears when we account for the number of non-workers across Figures 1 and 2 show some important findings on the competi-
rich vs. poor cities. The finding casts doubt on the supposed tion variable:
explanation of the income-competition link. Last, we provide • First, 38.2% of the retailers in India face significant competi-
some evidence on the likely effect of competition on efficiency tion (Figure 1). The comparable figure for registered
of the retail stores in India. Policy implications of the main manufacturing firms in India equals 82% (Enterprise
findings are discussed. Surveys, 2005) and 71% for retailers in 27 Eastern Europe
Our main data source is a stratified random sample of 1,948 and Central Asian countries (Business Environment and
retail stores (Enterprise Surveys) located in 16 major states and Enterprise Performance Survey (BEEPS) 2005 conducted by
41 large cities of India. Roughly, 64% of the stores in the the World Bank and EBRD). In short, competition in Indian
sample are traditional stores, 26% consumer durable stores retailing seems low even though the country boasts of one of
and the rest 10% are modern format stores. In one question, the highest density of retail stores in the world.
the respondents were asked how important competition from • Second, the metropolitan cities of Bangalore, Chennai,
other retailers is for the prices of the store’s main products. Delhi, Hyderabad, Kolkata and Mumbai have traditionally
The response was recorded as not at all important, slightly been the retailing hubs of the country and also the main
important, fairly important and very important. We define a beneficiaries of the ongoing retailing boom. Yet, competition
store facing “significant competition” if it reports fairly in these cities is significantly lower than in the remaining
cities (Figure 2).
Figure 2. Percentage of Indian Retailers Facing Significant Competition • Third, contrary to
popular belief, the level of
Metropolitan Cities 31.9 competition amongst
Non-Metropolitan Cities 40 traditional stores (small
Small Stores 33 stores selling grocery items)
Large Stores 45.2 is significantly less than
Kozhikode 5.7
amongst large stores
Madurai 100
(selling consumer durable
0 20 40 60 80 100 and other items and often
Percentage of Indian retailers reporting part of a larger shopping
competiton as fairly important or important
complex). One reason for
Source: Enterprise Surveys. Metropolitan cities include Bangalore, Chennai, Hyderabad, Kolkata, Mumbai and New Delhi. Small stores this could be that smaller
include tranditional stores selling grocery items. Large stores are large-sized stores selling various consumer items and usually part of a
larger shopping complex. stores are better able to

178 THE IIPM THINK TANK

 R E T A I L R O U L E T T E

Figure 3. Percentage Change Over 1991-2001 in the Number of Adult Non-Workers per Household

10
% change between 2001 and 1991 in the
number of non-workers per household

0
Uttar Pradesh

Madhya Pradesh

Maharashtra

Rajasthan
-5
Andhra Pradesh

Tamil nadu

Gujrat

Bihar

All states (average)

-10

Orissa

Karnataka

West Bengal

Punjab

Kerala

Haryana
-15

-20

Source: Census of India, 1991 and 2001. Percentage changes in the figure above equal the number of adult non-workers per household in 2001 minus the
same in 1991 and expressed as a percentage of the 1991 values of the variable.

segment the market by providing personalized retailing “… traditional competition policy will not suffice to render the
services to their customers. industry competitive and that, in such cases, quite different policy
• Fourth, competition varies significantly across cities with a measure may well be more effective in enhancing competition. In a
low of 5.7% stores in Kozhikode and a high of 100% in nutshell, consumer behavior and policy towards consumers matter
Madurai reporting competition as fairly significantly for industry performance.”
important or important. Policy makers and practitioners are also
Competition beginning to realize the importance of
3. The Importance of Consumer seems low even consumer behavior. For example, Stephen
Behavior for Retailing though the Byers, Secretary of State in the United
The traditional view of competition is that
country boasts of Kingdom notes that
“Active consumers who are prepared to
competition depends on the number of
firms and their behavior. Consequently,
one of the highest check and shop around to ensure they get a
competition policies are almost exclusively density of retail good deal are a key driving force in helping to
focused on preventing monopolies, preda- stores in the world create truly competitive markets.” (Stephen
tory pricing and collusion by firms. How- Byers, Secretary of State, UK; Department of
ever, the simple idea that consumer behavior is also important Trade and Industry, 2000)
for competition in consumer industries such as retailing, A good example of what the above quotes imply is a recent
electricity distribution and personal finance is at the heart of a study by Giulietti et al. (2005) on the deregulation of the
small but growing literature. This literature calls for greater natural gas supply market in the U.K. This study finds that the
emphasis in competition policies on consumer behavior as incumbent (monopolist) continued to enjoy significant market
opposed to the number of firms or firm-behavior. For example, power even after complete deregulation (free entry) and that
Waterson (2003) notes that the cost of deregulation outweighed the benefit. According to

THE INDIA ECONOMY REVIEW 179

S E C T O R A L S N A P

Figure 4: Competition and Non-Workers that the ongoing economic

boom is likely to make
increasingly bigger demand on
50
household’s time (evidence
Percentage of stores reporting competition as

45 provided below). A key

question here is whether time
40
cost of households matters for
fairly important or important

35 the level of competition in

30 Indian retailing.
In this article we proxy for
25
the time cost of households by
20 the number of non-workers
15 per household in the city
(henceforth, non-workers).
10
The prediction is that more
5 non-workers imply lower time
0 cost for households and
1 2 3 4 therefore more intensive
Non-workers per household in the city
search and hence more
(Quartiles, higher values imply more non-workers)
competition in the city. As
Source: Enterprise Surveys and Census of India (1991). The horizontal axis shows the number of non-workers per household in the
city grouped by their quartile values. A higher quartile indicates more non-workers. might be expected, non-work-
ers have shown a sharp decline
the study, the main reason for the failure of the deregulation over the last few years, most probably due to the economic
effort was the perception among consumers that the cost of boom starting early 1990s. Figure 3 provides evidence on this
searching and switching to a new supplier would be more than using data from Census of India (1991, 2001). Between 1991
the associated benefit. However, the perceived cost was much and 2001 and averaged over the 14 major states of India,
higher than the true cost. Therefore, the study recommends non-workers declined by 7.2%. The decline was as sharp as
correcting consumer perceptions through, for example, an 18.6% in Haryana, 12.7% in Kerala and over 10% in Punjab,
information subsidy, as a key ingredient for the success of the Karnataka and West Bengal. Only two states (Uttar Pradesh
deregulation exercise. and Madhya Pradesh) witnessed an increase of less than five
percent.
4. What Shapes Consumer Behavior?
There is very little by way of hard research 5. Relationship between Non-Work-
on what shapes consumer behavior and Competition varies ers and Competition in Large
therefore the level of competition in significantly across Indian Cities
consumer industries of the developing cities with a low In a recent study, Amin (2008a) looks at
world. One possibility is that the intensity
of 5.7% stores in this relationship between non-workers and
with which consumers search for best prices competition in Indian retailing in detail and
and deals depends on their shopping time
Kozhikode and a we discuss below the main findings from
opportunity cost (henceforth, time cost). high of 100% this study. For expositional convenience,
When the time cost is low, consumers can in Madurai we use graphical illustrations below while
devote more effort and time searching, the formal econometric results are avail-
driving up the level of competition. The issue of time cost and able in the stated study.
competition in retailing is important in the Indian context given The findings of the study are along predicted lines. Irrespec-

180 THE IIPM THINK TANK

 R E T A I L R O U L E T T E

Figure 5: Competition and Children A number of tests were

performed to guard against
such possibilities. To begin
Percentage of stores reporting competition as

45 with, we controlled for a

number of city and store
40
characteristics and found that
fairly important or important

35 the non-workers and competi-

30 tion relationship discussed
above remained robust to the
25
controls. Specifically, city level
20 controls included the level of
15 literacy, per capita expendi-
ture using NSSO data (closest
10
available proxy for city level
5 incomes), sex ratio (a proxy
0 for overall development),
1 2 3 4 number of children per
Children per household in the city
household (discussed in detail
(Quartiles, higher values imply more children)
below), duration of power
outages faced by retailers,
total employment in retailing
tive of the set of controls, non-workers and the percentage of as a percentage of city population (retailer density), fixed
stores facing significant competition in the city are strongly and effects for metropolitan vs. non-metropolitan cities, city-popu-
positively correlated. Without any other controls, a move from lation, etc. Controls for firm characteristics included floor area
the city with the least number of non-workers (2.01 in Noida) to of the shop, age of the store, whether the store is part of a
the city at the 25th percentile value of non-workers (2.59 in large chain or not, store-type fixed effects (traditional,
Bhubaneswar) increases the number of stores facing significant consumer durable or modern format store), measures of finan-
competition by as much as 9.8 percentage points (Figure 4). cial access of the store, etc.
This is a large effect given that only 38.2% of the stores in the Some of the controls mentioned above were also found to
full sample report facing significant competition. We also be important for explaining the level of competition. For
checked for the non-workers and competition relationship example, retailer density had a large positive effect on compe-
separately for the set of traditional stores (small stores selling tition; power outages in the neighboring stores a negative
grocery items) and the rest (consumer durable stores and effect while outages in one’s own stores increased the level of
modern format stores). The relationship was slightly stronger competition faced by the store in question; and traditional
for the former but not by much. stores were less likely to face significant competition than the
One could argue that cities with more non-workers may rest. In contrast, there was virtually no effect of literacy rates,
happen to be more competitive because of other correlated income levels, and age, size and financial access of the store on
characteristics and not because non-workers search more the level of competition.
intensively. For example, cities with more non-workers are also
the relatively poorer cities (confirmed in the data). It is possible 6. Overall Development of Cities and Competition
that poorer households search more intensively not because An interesting contrast is provided by comparing how non-
they have more non-workers but because a Rupee of savings workers and the number of children per household in the city
(through more intensive search) means more to them relative (henceforth, children) affect the level of competition. One
to the richer agents. possibility is that both, non-workers and children are reasonably

THE INDIA ECONOMY REVIEW 181

S E C T O R A L S N A P
good proxy measures of overall development. Hence, if
non-workers is simply a proxy for overall development then
children and non-workers should affect the level of competi-
tion in the same direction. In contrast, if our claim of
non-workers as a proxy for the time cost of shopping is
correct then we should expect non-workers and children to
affect competition in opposite directions. The reason for this
is that having more children in the household increases
household’s time cost of shopping, lowering search efforts
and hence the level of competition in the city. As discussed
above, the prediction with more non-workers is just the
opposite: more non-workers imply lower time cost leading to
more intensive search and therefore greater competition.
Figure 5 shows the relationship
between children and the level of
comp
competition.
pet
e ittio
i n. Clearly, the relationship
is negative in contras
contrastst to the positive
one we found in Figure 4. The children-
competition relationship iss slightly weak
in Figure 5 but be b
becomes
comes much stronger
when n we account for differences in the
number of non-workers across cities.
This strong and negative relationship
is robust to differences in various
city and store characteristics such
as the ones discussed
disccusse
s d above. In
short,
sh
hor
o t, non-workerss and children
have separate,
sep
eparate, independent and n connection
contrasting effects on thee level of
competition and so it is highly
unlikely that they are a mere proxy
for the level of development.
7. Income and Competition
A commonly held view is that the utility from a Rupee of
savings (through more intensive search) is higher for the poor
compared with the rich. What this implies is greater search
effort and therefore more competition in the relatively poorer
cities. However, this idea has not been rigorously tested,
especially in the context of a developing country.
Our results show that there is indeed a negative relationship
between income and competition but this relationship virtually
disappears once we account for differences in the number of
non-workers across rich vs. poor cities. The result casts doubt
on the supposed explan
explanation income-competition
a ation of the inco
relationship
relationnship (that the poor search more intensively because
they value a Rupee of savings more than the rich). Rather,
greater competition in the poorer cities ccould be due to the fact
that the poorer cities have more non-workers
non-wo and therefore
more time to devote to searching for bes best prices. If this is
indeed true, and more research is required
requir to ascertain it, the
policy implication is simply to lower shop
shopping cost in the
relatively richer cities throu
through,
ugh, for exam
example, longer store hours,
better dissemination of information on p prices, greater use of
internet for shopping,
sho
opping, etc.
8. Competition and Productivity iin Indian Retailing
To get a sense of how impo
important
ortant the abov
above findings are, some
connec cti
t on needs to be made betw
between
t een ththe level of competition
level, the literature offers
and efficiency in retailing. At a broad lev
competition-efficiency relationship.
a number of insights on the competition
The general belief is that competition is good for efficiency. The
fear of being wiped out by the competitors
competito forces firms to cut
costs. Amin (2008b) uses the same data as discussed above and
finds
finds that increased competitiono has a ve very large positive effect
on labor productivity of the stores. Estim
Estimates suggest that
increasing competition from its lowest level
(traditional stores in GGhaziabad) to the
highest level (modern format stores
in Madurai) is likely to increase the
efficiency of the former stores by as
much as 87% of the current level.
These are large
lar gains and could
have a significant impact on the
overall economy.
econ

9. Policy Implications and Conclusion
The number of non-workers in India is likely to witness signifi-
cant declines in the near future as the booming economy
attracts more would be non-workers into the fold of the labor
force. With fewer non-workers, the time cost of shopping will
increase forcing consumers to search less intensively for best
prices and deals. This article argues that as a result of declining
non-workers, competition in Indian retailing may see a secular
drop. The likely effect of lower competition on retailing
efficiency is shown to be potentially large. The impact of these
changes on the overall economy cannot be neglected given that
the retail sector in India is second only to agriculture in terms of
its size.
Two broad policy implications follow from the findings above.
First, one cannot take the level of competition in Indian
retailing for granted, especially in the larger and richer cities.
By international standards, competition in India’s retail sector
is on the lower end. Second, competition policies that are
currently focused exclusively on firm-behavior should pay more
attention to consumer behavior and consumer attributes that
shape consumer behavior. Some attributes such as non-workers
may not be directly amenable to competition policies. However,
even in such cases indirect policy measures can help alleviate
part of the problem. For example, cities with fewer non-workers
or where non-workers are decreasing at a rapid rate can be
targeted with better e-commerce facilities, longer operating
hours for retail stores, lower entry barriers and better dissemi-
nation of information on product prices. We hope that the
present work will encourage more research on these issues.
Endnotes
1
Cities in the sample include (in alphabetical order):
Ahmedabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh,
Chennai, Coimbatore, Cuttack, Delhi, Dhanbad, Faridabad,
Ghaziabad, Greater Mumbai, Guntur, Gurgaon, Gwalior,
Hubli-Dharwad, Hyderabad, Indore, Jaipur, Jamshedpur,
Kanpur, Kochi, Kolkata, Kota, Kozhikode, Lucknow,
Ludhiana, Madurai, Mangalore, Mysore, Nagpur, Nashik,
Noida, Patna, Pune, Surat, Vadodara, Vijayawada and
Vishakhapatnam.
1
These estimates are based on National Accounts Statistics
and taken from Gordon and Gupta (2004).
2
The sampling frame for the survey was the list of retail stores
regularly interviewed by AC Nielson for inventory verifica-
R E T A I L R O U L E T T E
tion on behalf of distributors of branded goods. This list
covers stores in forty one cities across India for three major
industry segments: Fast Moving Consumer Goods (FMCG)
stores (traditional stores), consumer durable stores and the
modern format stores. The sample was stratified according
to segment-specific criteria. FMCG stores were stratified
based on turnover, number of salesmen, number of FMCG
product and the presence of cooling equipment. Consumer
durable and modern format stores were stratified based on
turnover. The sample size was determined so as to minimize
the standard error in the sample variables, given the avail-
able resources for each surveying stratum. Once the sample
size was determined, the sample was allocated to strata using
Neymann’s allocation rule. More information about the
survey and methodology is available at www.enterprisesur-
veys.org.
3
The difference in the level of competition between metropolitan
cities and the rest is significant at less than five percent level.
References and Additional Thinking
• Amin, M. (2008a), “Competition and Demographics,” Policy
Research Working Paper 4514, World Bank, Washington
DC. Available at http://www.enterprisesurveys.org/Research-
Papers/.
• Amin, M. (2008b), “Competition and Labor Productivity in
India’s Retail Stores,” mimeograph available at www.
enterprisesurveys.org.
• Amin, M. (2008c), “Retailing in India: Assessing the Invest-
ment Climate,” India Economy Review, Sept. 2008: 188-197.
Available at http://works.bepress.com/mohammad_amin/4/.
• Department of Trade and Industry (2000), Switching
Suppliers, London: The Stationery Office.
• Fan, C. S., C. Lin and D. Treisman (2009), “Political Decen-
tralization and Corruption: Evidence From Around the
World,” Journal of Public Economics, 93(1-2): 14-34.
• Giulietti, M., C. Price and M. Waterson (2005), “Consumer
Choice and Competition Policy: A Study of the UK Energy
Markets,” Economic Journal, 115: 949-968.
• Waterson, M. (2003), “The Role of Consumers in Competi-
tion and Competition Policy,” International Journal of
Industrial Organization, 21: 129-150.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation).
THE INDIA ECONOMY REVIEW 183
C O U N T E R C U R R E N T S

Crisis in Academic
Economics
Amol Agarwal
Economist based at Mumbai

184 THE IIPM THINK TANK


one of the main reasons for the severity of the crisis. However,
ECB looks at monetary targets extensively but failed to see the
crisis. Bank of Japan also looks at these targets but has failed just
like ECB.
The question is how do we make money and credit variables
more relevant for monetary policies?
• Zero Interest Rate Policy (ZIRP): Fed and other Central banks
have shown in this crisis, that zero interest rates are not a
constraint for central banks at all. They have continued to
expand their balance sheets buying assets from financial markets.
However, the issue of effectiveness of these asset purchase
programs still remains. We still do not know whether Central
bank intervention has led to desired benefit in the financial
markets. Some economists suggest it has helped and others
disagree. There will be plenty of research on this matter in
future. However, we can say one thing with some certainty. The
economists made us believe that monetary policy can still be
effective under ZIRP. In this crisis we have seen monetary policy
can be expanded even at Zero Interest Rates. Riksbank even
lowered its deposit rate (overnight deposit rate) to negative
0.25% in its July monetary policy meeting.
Hence, now even zero interest rates are not
really a bound. However, the question of IMF which had
effectiveness still remains. The monetary always advised
transmission is weak in a financial crisis not to use
leading to substantial lags in monetary policy
fiscal policy are
to show desired results.
increasingly
Public Finance Economics calling for more
Fiscal Policy has made a splendid comeback fiscal expansion
in this crisis. Just like monetary numbers,
fiscal policy’s role was in oblivion. Fiscal Policy was hardly
discussed and researched before this crisis. The macroeconomic
models hardly included fiscal policy instruments for guiding
policies. As a result, little is known about the role fiscal policy
can play in business cycles.
With this crisis, the role of fiscal policy is going has changed
like never before. The leading institutions like IMF which had
always advised not to use fiscal policy are increasingly calling for
more fiscal expansion. The depth of the crisis has challenged the
view that monetary policy can be effective under severe reces-
sion (discussed above).
However, there are questions on fiscal policy as well. In this
crisis both monetary and fiscal policy have been used to ease
TR U S T B U S T I N G
the crisis. Monetary Policy has tried to lower rates and fiscal
policy has tried to support falling private demand and invest-
ment. However, an expansionary fiscal policy leads to higher
fiscal deficits and pushes interest rates higher. This becomes a
dilemma for policymakers and confuses financial markets (see
our report for details- Interest Rate Dilemma for Policymak-
ers and Markets, 3rd July, 2009). The research needs to solve
this dilemma which has become quite a serious concern for
the economies as high interest rates would prolong the
economic recovery.
Financial Globalisation
If role of money and fiscal policy has made a comeback, the role
of capital flows has once again come into question. Just like
financial liberalization, there is no empirical evidence for capital
account liberalization but is still advocated by most economists.
The usual basis for capital account liberalization is that it would
lead to efficient allocation of capital and in turn help capital-
starved economies prosper. However, both empirical and
practical evidences do not justify this claim (see our report for a
discussion- Capital flows in India and other
developing economies: Are they truly
beneficial? dated 2008). The policymakers
in emerging economies often expressed
dissatisfaction with capital flows but were
not heard. As there was limited empirical
evidence, economists came up with other
ideas to justify capital account liberalization
(they provide collateral benefits; see
Financial Globalisation: A Reappraisal by
Kenneth Rogoff et al).
Now, because of this crisis we are seeing some changes in
economic thinking. IMF has long been a torchbearer for opening
up capital inflows. In a recent report (Initial Lessons of the
Crisis, 2009), IMF economists remark:
Surely, the lesson is not that capital flows should be sharply
curtailed. But this crisis, as well as many episodes before it,
shows the potential dangers of large capital inflows. Such inflows
can lead to excessive risk taking and to exposure of domestic
financial institutions, households, firms, to exchange rate risk.
They can lead to sharp appreciations, often followed by abrupt
reversals and strong effects on balance sheets. They can put
pressure on demand, and on output. Monetary policy may work
poorly in this context, as the attempt to slow down activity
THE INDIA ECONOMY REVIEW 193
C O U N T E R C U R R E N T S
inflation – seems ill suited to understanding the origins of the
crisis or designing measures to solve it.”
Marcus Miller and Joseph Stiglitz, March 2009.
In another paper (The Financial Crisis and the Systemic Failure
of Academic Economics by David Colander et al, 2009), the
authors say:
The economics profession appears to have been unaware of the
long build-up to the current worldwide financial crisis and to
have significantly underestimated its dimensions once it started
to unfold. In our view, this lack of understanding is due to a
misallocation of research efforts in economics. We trace the
deeper roots of this failure to the profession’s insistence on
constructing models that, by design, disregard the key elements
driving outcomes in real-world markets. The economics
profession has failed in communicating the limitations,
weaknesses, and even dangers of its preferred models to the
public. This state of affairs makes clear the need for a major
reorientation of focus in the research economists undertake, as
well as for the establishment of an ethical code that would ask
economists to understand and communicate the limitations and
potential misuses of their models.
Now let us look at a few areas of econom-
ics where the concerns are being raised. The importance
of finance
Development Economics to economic
Before the crisis, most economies had a
growth has
phase of high growth and low volatility
(called Great Moderation). The economies
also frequently
followed variety of Growth models to been ignored
generate economic growth. by economists
Some of these models are:
• Export driven (China, Korea, Germany, East Europe etc),
• Financial Services driven (Iceland, UK, US etc)
• Investment driven (India etc),
• Natural Resource driven (Middle East Economies, Russia,
Chile etc),
• Agriculture exports driven (Australia, New Zealand etc).
The crisis has impacted all economies and their models of
growth via different channels (see our report for a preview -
How the US originated crisis impacted other economies, 12th
November, 2008). The question open to economists is as
economies globalize further, what growth model should an
economy choose? Growth Economics usually suggests that if an
economy has proper institutions in place, it will be able to
186 THE IIPM THINK TANK
manage sustained growth. The economists have been advising
developing world to have institutions like developed economies.
However, in this crisis it is the developed economies that have
performed worst.
Further, there is confusion as to whether free markets are
same as unregulated markets. We think this debate was settled
that markets works best with institutions in place. However,
something else seems to be happening in financial markets.
There were institutions (regulators) but either they completely
failed or market participants knew how to sideline them. Daron
Acemoglu, leading economist of Institutional School in his
recent paper said (The Crisis of 2008: Structural Lessons for and
from Economics, 2009):
Forgetting the institutional foundations of markets, we mistak-
enly equated free markets with unregulated markets. Although we
understand that even unfettered competitive markets are based
on a set of laws and institutions that secure property rights,
ensure enforcement of contracts, and regulate firm behavior and
product and service quality, we increasingly abstracted from the
role of institutions and regulations supporting market transac-
tions in our conceptualization of markets.
Financial Economics
There are many questions, which financial
economists need to answer. Some of them
are:
• Finance as a Model of Growth: The earlier
theories of development concentrated on
labor, capital, institutions etc as the factors
for growth and development. The leading
works hardly include finance as a factor for
growth. Frederick Mishkin in a lecture (JMCB-FDIC Lecture,
September 22nd, 2005) remarked:
The importance of finance to economic growth has also fre-
quently been ignored by economists. For example, the leading
undergraduate textbook on economic growth, Weill (2005) does
not discuss the link between finance and growth at all.
The main reason was initial finance theories like Modgillani
Miller theorems and Efficient Market Hypothesis (developed by
Eugene Fama and Kenneth French). These were based on the
assumption that markets are efficient and there are no frictions
(more on this later). But if these theories were correct then there
was very little reason for financial markets to exist. However,
later development showed that there were imperfections in the
 TR U S T B U S T I N G

Table 1: Blame Game

Economist/ Institutions Reasons for Crisis Blame

Policymakers who
Blamed Others
William White & BIS Nature of Financial Markets, Alan Greenspan
Claudio Borio Monetary Policy

Kenneth Rogoff IMF Capital flows (Ken Rogoff), Role Alan Greenspan /
of incentives (Raghuram Rajan US Treasury
Jean Claude Trichet ECB Under-pricing of risk Financial Market
Participants
Mervyn King Bank of England Capital flows IMF
Source: Speeches and Statements of the noted persons

important role to play in policies. ECB and BoE are directly
responsible for their economies and both Trichet and King
cite their own research which showed imbalances were
developing. However, it all stops there with none seem to have
had the will to do anything to resurrect the imbalances. IMF
and BIS case is still understood as they can only influence poli-
cies but not make them (However, this still raises the question
of their effectiveness).
But what about ECB and BoE? Why didn’t they do anything in
their own economies? Why did they choose the policies sug-
gested by Alan Greenspan? There is a huge criticism on Alan
Greenspan and his free-market policies but atleast he followed
what he believed in (In his testimony to the Committee of
Oversight and Reform (October 23rd,2008) Greenspan also
agreed that his belief was not really right). However, the beliefs
of Greenspan do not imply Bank of England and ECB should
have also made the same policies. The fallouts of the crisis could
have been minimized if these key policymakers had backed their
concerns more strongly.
Apart from the above, there have been comments by other
economists that their views were not heard (Like John Geanako-
plos above). Some economists have dubbed above discussed
ideas as “Jackson Hole ideas” (monetary policy for price
stability, fiscal policy role is limited etc) which usually gained
approval by leading US economists in the annual Kansas City
Fed Symposium held at Jackson Hole, Wyoming. How do
economists change this power equation?
Concluding Thoughts
The above analysis is an attempt to categorise the key questions
the crisis has posed to economists and economic thinking. This is
not an exhaustive list and other issues could arise in future
(infact number of questions over poverty, aid, welfare etc are
being raised). The crisis is still taking shape and affecting all
walks of economic life. These issues were visited in previous
crisis but have been ignored by economic research. The previous
crises were limited to developing countries and as a result were
ignored by economists putting all the reasons under the common
label – Poor institutional framework. With the crisis impacting
developed economies more severely, the label cannot be the
same. Hopefully, economists would work on the above areas.
Moreover, economic policy and ideas seems to be increas-
ingly driven more by powerful economists than quality of a
research idea. Many economists are opining these days via
personal blogs and other media channels. The arguments and
opinions on both sides are so convincing that it does not
provide a clear path for policymakers. The opinions are usually
backed by research (own and others) and references and as a
result one is never sure which is the right path and thinking.
Economics has always been a debatable subject but we really
need more clarity in times of crisis. All this has come at a time
when we are made to believe that economic thinking has really
advanced and most of the issues are addressed. Well, the crisis
has opened up the field of economics and shows we have still
not answered the basic questions.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation. The author
maintains a blog on economic research - http://mostlyeconomics.
wordpress.com/)

THE INDIA ECONOMY REVIEW 195


T
he ongoing crisis is not just a collapse in economies and
financial markets. The biggest impact of crisis has not
been on financial markets or economies but on eco-
nomic thinking. All crises end at some point of time. Lawrence
Summers in a speech at Brookings (13th March, 2009) said “....
there is onr ineluctable lesson of the history of financial crisis: they
all end”.
Before the crisis there were numerous economic thoughts,
which need to be reviewed as the crisis has taken shape. Moreo-
ver, leading economists are highly perplexed and are not sure
how to summarize this crisis with their economic theories and
beliefs. They are calling current economic thinking irrelevant
and asking for a change in economic thinking.
This paper reviews a few areas of economics that need to be
reassessed. It also highlights a few areas which till now were
considered hallowed but are found wanting. We have covered a
TR U S T B U S T I N G
few points in our earlier papers and this paper is an attempt to
summarise all the previously raised issues and point to some new
ones as well.
A Few Quotes
Willem Buiter, a former Member of Monetary Policy Com-
mittee of the Bank of England titles an article (www.voxeu.
com, 6th March, 2009) as "The unfortunate uselessness of
most 'state of the art' academic monetary economics". In this
article he says how much of monetary economics is useless for
practical purposes.
Standard macroeconomic theory did not help foresee the crisis,
nor has it helped understand it or craft solutions. This columns
argues that both the New Classical and New Keynesian com-
plete markets macroeconomic theories not only did not allow
the key questions about insolvency and illiquidity to be an-
swered. They did not allow such questions to be asked. A new
paradigm is needed.
David Blanchflower outgoing MPC Member of Bank Of
England in a speech (24th March, 2009) said:
As a monetary policy maker I have found the ‘cutting edge’ of
current macroeconomic research totally inadequate in helping to
resolve the problems we currently face. I am far from alone in
these views. To take a couple of observations:
“New classical and new Keynesian research has had little impact
on practical macroeconomists who are charged with the messy
task of conducting actual monetary and fiscal policy.”
Gregg Mankiw, 2006
“In fact “modern macro” has been notable for paying very little
rigorous attention to data. …... I am left with the feeling that
there is nothing in the empirical performance of these models
that could come close to overcoming a modest scepticism. And
more certainly, there is nothing to justify reliance on them for
serious policy analysis.”
Nobel Laureate Robert Solow, 2008
“There is a danger that the macroeconomic models now in use in
central banks operate like a Maginot line. They have been
constructed in the past as part of the war against inflation. The
central banks are prepared to fight the last war. But are they
prepared to fight the new one against financial upheavals and
recession? The macroeconomic models they have today certainly
do not provide them with the right tools to be successful.”
Paul De Grauwe, 2008.
“The widely used DSGE paradigm – designed to help control
THE INDIA ECONOMY REVIEW 185

I propose here instead to show how those propositions bear on
current concerns about overleveraging – concerns that in some
quarters actually border on hysteria. In particular I will argue,
first, that the highly visible losses and defaults on junk bonds do
not mean that overleveraging did in fact occur; second, paradoxi-
cal as it may sound, that increased leveraging by corporations
does not imply increased risk for the economy as a whole; third,
that the financial distress being suffered by some highly leveraged
firms involves mainly private, not social costs; and finally, that
the capital markets have built-in controls against overleveraging
- controls, moreover, very much in evidence at the moment.
Recent efforts by our regulators to override these built-in market
mechanisms by destroying the junk bond market and by
imposing additional direct controls over leveraged lending by
banks will thus have all the unintended consequences normally
associated with such regulatory interventions. That the current
emphasis on the evils of overleveraging may be misplaced does
not mean, of course, that all is well. My message is not: “Relax.
Be happy. And, don’t worry.” Worry we should, in the U.S. at
least, but about the serious problems confronting us, such as our
seeming inability to bring government
spending under rational control or to halt
the steady deterioration of our once-vaunt- The role leverage
ed system of public education. Let us not plays in one’s
waste our limited worrying capacity on financial decisions
second-order and largely self-correcting
is pretty basic but
problems like financial leveraging.
It would have been very interesting to get
has been ignored
Merton Miller’s views in this crisis. The issue by financial
of leverage is again haunting the policymak- economics
ers and financial markets.
Hence, the issue of leverage arises in times of crisis but is
ignored soon after the crisis is over. Even much of the sugges-
tions in times of crisis which talk about minimizing leverage
are ignored in future papers. It seems research is as procyclical
as leverage.
Recently, John Geanakoplos (Yale University) paper on
leverage cycle has become very popular. His idea is that leverage
too has a cycle. His broad idea is that till now we assume in a
loan market, demand and supply only determine the interest rate
on loans. He adds apart from interest rate it also determines the
leverage (or collateral) with the loan. In good times, lenders
don’t require collateral leading to a higher leverage. In bad
times, the lenders demand more collateral and as a result
TR U S T B U S T I N G
leverage declines (deleveraging). This simple and powerful idea
was not really accepted amidst researchers. In his own words:
“After it was finally published, as “Liquidity, Default, and
Crashes” in the conference volume in 2003, I gave that Seattle
paper at every major university. It was exactly about the liquidity
cycle, but it didn’t really catch on,” Geanakoplos recalled last
week. The time for it wasn’t ripe. The Asian financial crisis had
been contained. No lender lost a dollar when LTCM failed. The
consequences of the dot.com crash had been confined mainly to
the stock market. For the next seven years, business as usual
resumed. “This time they are more interested.”
• Financial Regulation: There is a tome of research being
written on this subject. Every regulator is taking a relook at
the spectrum of financial regulation in their own economies.
On a quick look across the various tomes, most of the
suggestions coming forward are quite common:
- More inclusive financial regulation; no light touch regulation
- Macroprudential regulation
- A Financial Resolution framework
- A special entity to manage non-depository financial institu-
tions (has come from Fed officials after AIG
fallout)
- Some measures to make bank balance-
sheets less procyclical - Leverage ratio/
some cap on leverage, increase provisions
during boom times, a capital insurance
scheme that leads to shoring up capital in
times of stress.
Apart from capital insurance scheme most
of the suggestions have been discussed
earlier in each crisis. Why weren’t they
implemented? There is plenty of research on financial stability
and crisis but the lessons are hardly applied. The recent crisis is
also a result of complacency on the part of financial regulators.
There was this belief that self-regulation is the best form of
financial regulation. As a result, research and discussion on
financial regulation has moved to form (single regulator Vs.
multiple regulator, rule based Vs. principles based) etc) than the
real issue of managing financial stability.
There are some additional thoughts on the macroprudential
financial regulation which merit serious discussion. Lord Turner
in a speech (29th March, 2009) said:
The Review sets out eight sets of recommendation for regulatory
reform. ……Fourth, the importance of macro-prudential
THE INDIA ECONOMY REVIEW 189

financial market and the various financial firms actually played a
role in minimizing these very imperfections. Fed Chairman, Ben
Bernanke in his speech (15th June, 2007) explains:
The blossoming of work on asymmetric information and
principal-agent theory, led by Nobel laureates Joseph Stiglitz and
George Akerlof and with contributions from many other
researchers, gave economists the tools to think about the central
role of financial markets in the real economy. For example, the
classic 1976 paper by Michael Jensen and William Meckling
showed that, in a world of imperfect information and principal-
agent problems, the capital structure of the firm could be used as
a tool by shareholders to better align the incentives of managers
with the shareholders’ interests. Thus was born a powerful and
fruitful rejoinder to the Modigliani- Miller neutrality result and,
more broadly, a perspective on capital structure that has had
enduring influence.
Since then there has been numerous research analyzing how
financial systems help in developing an economy. The research
has not just looked at how finance helps economic activity but
also social aspects like poverty, hunger etc.
The role of finance took a different shape
in few economies. Few economies like UK,
Iceland, Hong Kong etc became financial It is indeed
services driven economies. The economies quite ironical
started depending increasingly on their that perverse
ability to attract large financial firms and
incentives are
becoming preferred markets for raising
financial resources. This model soon became
being seen as
very popular as these economies grew really the major causes
well. So much so, some developing econo- of the crisis
mies also decided to develop an interna-
tional finance center/region (India, Dubai etc).
However, it was a period of low financial market volatility and
all was good. In this crisis this growth model has been completely
opened up. The policymakers have realised the problem with
this approach. The recent Turner report for UK financial system
was quite a change from precrisis days, when asll was considered
good with this growth model. UK Government also released a
report on Status of UK as a International Finance Centre after
the crisis.
The problem was not just limited to financial driven econo-
mies. Large number of East European economies had re-
formed during this crisis and had become export-driven
economies. They did not have a proper banking system and so
TR U S T B U S T I N G
opened up their financial markets. They invited foreign banks
to set bases and soon Western Europe Banks were the major
banks in the East European economies. As crisis deepened, the
exports of these economies slowed leading to problems in
paying off the loans to foreign banks. As a result foreign banks
were not able to give credit worsening the crisis. Further, these
foreign loans became a problem for their home regulators.
Austrian Banks have lent huge amount of loans to these
economies and is under severe pressure. So, both models
became a problem. One, UK model which invited foreign banks
to set bases in their economies and then offer services around
the globe and two, the East Europe model which invited
foreign banks to lend to domestic companies.
• Are Financial Markets Efficient? Answering this question is
like dealing with fire. After this crisis, the economists are divided
in two camps. One says financial markets are anything but
efficient and are cyclical in nature with booms followed by busts.
If they were efficient we should not be seeing this crisis at all
(read Turner review for a critique). The second camp says
markets are efficient as the crisis shows that excesses do get
corrected albeit with a lag.
The second camp is right in saying
markets are efficient as they have self-cor-
rected. However, market efficiency only
matters if markets correct in a shorter span
of time. We cannot have a situation where
years of excesses are corrected in a matter of
few days. The EMH theory has discussed
efficiency mainly from an information
perspective but not from this time angle. If
markets correct in four years of time can we
call them efficient?
Another issue of EMH which has been completely ignored is
incentives in financial system. It is quite ironical that perverse
incentives are being seen as the major causes of the crisis. In an
efficient market the question of incentives does not arise at all.
The theory says markets have priced everything and people
cannot generate profits unless they have private/insider informa-
tion. To prevent this holding of private information we have
regulators. Now, the leading financial centers have always
marketed themselves as efficient financial markets. How is it that
in these efficient financial market centers, financial firms make
so much profits? Moreover, we expect with better technology
markets have become more efficient overtime but the profits
THE INDIA ECONOMY REVIEW 187
C O U N T E R C U R R E N T S
continue to rise. This aspect of efficiency has been completely
ignored by financial economics.
• Too Big to Fail: “A large non-financial firm can fail but a large
financial firm cannot fail”. This principle has been followed by
regulators but has reached its zenith and deserves a re-look. The
reason behind this principle is that a large financial firm is
counterparty in many transactions and leads to a run on the
other firms leading to a collapse of the entire system. We have
seen this come true with bankruptcy of Lehman Brothers and
collapse of other large financial firms.
However, not letting a financial firm fail makes the managers
complacent and they know their mistakes would always be
socialized. This leads to much higher risks and a much bigger
crisis in future. Andrew Haldane of Bank of England, in an
excellent review on UK’s risk management noted:
A few years ago, ahead of the present crisis, the Bank of England
and the FSA commenced a series of seminars with financial
firms, exploring their stress-testing practices. The first meeting of
that group sticks in my mind. We had asked firms to tell us the
sorts of stress which they routinely used for their stress-tests. A
quick survey suggested these were very
modest stresses. We asked why. Perhaps
disaster myopia – disappointing, but The focus was
perhaps unsurprising? Or network externali- on short-term
ties –we understood how difficult these were incentives and not
to capture?
really asking right
No. There was a much simpler explanation
according to one of those present. There
questions over
was absolutely no incentive for individuals the overall health
or teams to run severe stress tests and show of the firm
these to management. First, because if there
were such a severe shock, they would very likely lose their bonus
and possibly their jobs. Second, because in that event the
authorities would have to step-in anyway to save a bank and
others suffering a similar plight.
This statement from a policymaker is pretty disappointing and
sums up the state of affairs in financial markets. Simon Johnson
(ex-Chief Economist of IMF) has created quite a stir by calling
these TBTF firms as Financial Oligarches. Recently, quite a few
policymakers have expressed that if banks are too large but are
insolvent they should be allowed to fail. Thomas Hoeing,
President of Kansas City Fed has been a leading advocate of this
measure. This is quite a reversal from the previous thinking on
TBTF. Minneapolis Fed President Gary Stern has written a lot of
188 THE IIPM THINK TANK
research to prevent TBTF but has not gained ground. And all
these economists cannot be dubbed as socialist variety. They add
that in order for markets to function properly, we need to do
away with TBTF. Then only we can have a market discipline.
This crisis would lead more thinking on this matter. As said
above, this crisis is going to change quite a few ideas.
• Corporate Governance: This is another branch of financial
economics that gained huge ground. The corporate boards were
made the center of governance of firms. However, what we have
instead witnessed is that these were instead cozy clubs in leading
financial firms. The focus was on short-term incentives and not
really asking questions over the health of the firm. The central
principle of corporate governance was having independent
directors on the board. These are usually people of high acumen
and stature and collectively failed to see the huge risks the firms
were carrying.
It is important to note that it is this growth of corporate
governance which made regulators complacent. Corporate
Governance was seen as a robust model of self-regulation and it
was felt that the quality of board will ensure that the firm is on
right track. The board turned out to be more
complacent (perhaps due to TBTF) and we
are all seeing the results now.
• Role of Leverage: The role leverage plays
in one’s financial decisions is pretty basic but
somehow has been ignored by financial
economics. Despite numerous crisis showing
it is mostly high leverage that compounds
problems, it has been ignored by policymak-
ers and financial economics research. Much
of the research is still based on M-M theory
that debt does not matter or is irrelevant. Merton Miller’s Nobel
Prize Lecture in 1990 was titled as “Leverage”. At that time
Leveraged Buyouts were seen as the new devil that led to many
failures then. Miller remarked:
That Franco Modigliani and I should be credited with inventing
these takeovers is doubly ironic since the central message of our
M&M Propositions was that the value of the firm was inde-
pendent of its capital structure. Subject to one important
qualification to be duly noted below, you couldn’t hope to
enhance shareholder value merely by leveraging up. Investors
would not pay a premium for corporate leverage because they
could always leverage up their own holdings by borrowing on
personal account.
C O U N T E R C U R R E N T S
hence they are reacting. But this is the case for rising asset
prices as well. Justin Lin (Chief Economist World Bank) in a
paper The Impact of the Financial Crisis on Developing
Countries, 2008) says:
Throughout the US dot-com and housing price bubbles, the
Federal Reserve continued to adhere to its view that its mandate
was to pursue price stability and full employment, not to deflate
asset price bubbles. But amid the wreckage caused by the second
burst bubble in a decade, it is clear that this view needs to be
rethought. If the Fed is not able to keep these bubbles from
inflating, it will not be able to achieve its other objectives. There
are reasonable questions about just how effective monetary
authorities will be in preventing asset-price bubbles, but it is no
longer reasonable not to rethink the issue carefully.
• Guardians of Financial Stability and Role in Financial
Regulation: A linked point to the two above issues is the role of
central banks in financial regulation and stability. The regulatory
structure to manage financial system is too diverse. In some
countries central banks are responsible to manage and supervise
the banks and another authority to manage the capital markets
(like India), in some economies there are
multiple authorities managing the banks
(USA) and in some economies there is a These days most
single authority regulating the financial central banks
system and Central banks only look at price only use the
stability (UK).
interest rates to
After this crisis, there is little doubt that
central banks need to be at the center of
influence demand
financial regulation and need to manage conditions in
financial stability along with price stability. the economy
Mervyn King, Governor Bank of England in
a now-famous speech said:
The Bank of England has a new statutory responsibility for
financial stability. Bank Rate is the instrument we deploy to
achieve monetary stability, and should be used exclusively for
that purpose. To achieve financial stability the powers of the
Bank are limited to those of voice and the new resolution powers.
The Bank finds itself in a position rather like that of a church
whose congregation attends weddings and burials but ignores the
sermons in between. Like the church, we cannot promise that
bad things won’t happen to our flock – the prevention of all
financial crises is in neither our nor anyone else’s power, as a
study of history or human nature would reveal. And experience
suggests that attempts to encourage a better life through the
192 THE IIPM THINK TANK
power of voice is not enough. Warnings are unlikely to be
effective when people are being asked to change behaviour which
seems to them highly profitable. So it is not entirely clear how the
Bank will be able to discharge its new statutory responsibility if
we can do no more than issue sermons or organise burials.
A simple focus on price stability is not likely to work anymore.
It is not that Central Banks do not look at financial stability. The
Central Banks publish reports on financial stability regularly but
all this is done passively. A more active approach and constant
endeavor, just like in the case of price stability is needed.
US and UK Governments have released reports to reform
their financial systems and regulation. The report focuses on
giving the Central bank more powers. The debates are ongoing
in these respective economies and we will know the actual status
only when they are implemented. owever, initial reactions of
economists on the proposed reform is mixed.
• Role of Money and Credit Makes a Comeback? There has
been a really strange development in central banking. Their
principles are based on Monetary Economics but money
hardly plays any role in central bank’s decisions! These days
most central banks only use the interest
rates to influence demand conditions in
the economy.
Earlier, central banks used growth in
money stock to monitor inflation. But
because of financial innovation it became
difficult to maintain monetary growth and
inflation. Hence, instead of money the
central banks started to use interest rates.
But the focus on interest rates was taken to
one extreme with complete ignorance to
developments in monetary numbers. The role of money was just
limited to a casual mention in the central bank’s press release.
Only ECB maintained its focus on monetary targets and still
bases its decisions on the monetary pillar along with the econom-
ic pillar. The ECB watchers criticized ECB for their focus on
monetary targets when they had become irrelevant. They added
that ECB was using monetary targets just to emulate Bundes-
bank (Germany’s Central Bank is considered to be successful at
monetary targeting; however, it is still under debates) and
needed to do away with money.
This crisis brings the role of growth in money and especially
credit back in the limelight. The central banks had been ignoring
the substantial rise in credit in lineup to the crisis. This is seen as
C O U N T E R C U R R E N T S
need is intellectual challenge to conventional wisdom. Because
where we did do macro-prudential analysis, it often still failed to
see the emerging problems.
Each edition of the IMF Global Financial Stability Report is
full of macro-prudential analysis. But in April, 2006 it said this
(Exhibit 16):
"There is a growing recognition that the dispersion of credit risk
by banks to a broader and more diverse group of investors, rather
than warehousing such risk on their balance sheets, has helped
make the banking and overall financial system more resilient".
The improved resilience may be seen in fewer bank failures and
more consistent credit provision: consequently the commercial
banks may be less vulnerable today to credit or economic shocks’
Which was not just wrong – but 180° wrong. So how do we
ensure that we don’t in ten years’ time get it wrong again, going
along with a dominant conventional wisdom? Market prices are
subject to self-reinforcing herd effects: policymakers and policy
intellectuals can be subject to intellectual herd effects; and there
is no failsafe way to offset this human tendency to collective
error. But we need as best possible to embed challenge into our
institutions.
Bernanke in a speech (22nd August, 2008)
had said: The complacency
Some caution is in order, however, as this was not limited
more comprehensive approach would be to financial
technically demanding and possibly very
regulators.
costly both for the regulators and the firms
they supervise. It would likely require at
The biggest
least periodic surveillance and information- complacency was
gathering from a wide range of nonbank in central banking
institutions. International regulatory coordi-
nation, already quite extensive, would need to be expanded
further.
Macroprudential supervision also presents communication
issues. For example, the expectations of the public and of
financial market participants would have to be managed
carefully, as such an approach would never eliminate financial
crises entirely. Indeed, an expectation by financial market
participants that financial crises will never occur would create its
own form of moral hazard and encourage behavior that would
make financial crises more, rather than less, likely.
Hence, it seems only normative analysis has been done on
macroprudential financial regulation. There is not much of a
thought on how to make it workable. Once again research has
190 THE IIPM THINK TANK
just looked at the issue minus the operational details.
• Financial Innovation: We had looked at this issue in details in
our previous report – Time to reassess Financial Innovation
(dated 13th February, 2009). In sum, financial innovation has
just focused on risk management function of financial system
and has ignored the other functions.
Monetary Economics/Central Banking:
Dr. YV Reddy, former RBI Governor in an address at Singapore
(Hindu Business Line, 11th October, 2008) said:
“An outcome of the crisis, according to Dr Reddy, is the “histori-
cally significant redefining of the concept of the central bank”.
This statement neatly sums up the challenges for central banks
ahead. This crisis has asked many questions from central banks.
In most of our research reports on the ongoing crisis we have
posed numerous questions for central banks. Let us just summa-
rise them.
• Inflation Managers: The complacency was not limited to
financial regulators/supervisors. The biggest complacency was
seen in central banking. The recent thinking backed by substan-
tial research was that central banks should
focus only on price stability. As long as
prices are stable, all other economic
variables will be stable as well – growth,
financial markets etc. The usual policy
advise for central banks in developing
economies was to just pursue price stability
and rest would follow. Before the crisis, this
view held very well.
However, the crisis struck at times when
inflation was relatively stable. In addition,
most of the fire-fighting was left for central banks. In order to
justify their moves to protect financial systems, the Central
Banks started pointing to their ignored objective to look at
financial systems (payment systems etc). The ignored objective
became the most important objective. To prevent financial
collapse, central banks reduced rates substantially and did it
frequently. The sharp easing was appalling in the beginning of
the crisis as the inflation was at record high levels. The inflation
lowered later much to the relief of central banks but questions
over this sudden switch need to be answered. Can Central banks
cut rates at times when inflation is at record high levels?
What is also not understood properly is the asymmetric
response of central banks. At times of high inflation, the usual
C O U N T E R C U R R E N T S
through higher interest rates may make domestic assets even
more attractive.
Thus, the crisis raises two issues. The first is the need to revisit
when and how to react to large imbalances, through macroeco-
nomic and structural policies that affect saving and investment.
As elsewhere, an attitude of benign neglect has proven to be a
mistake. The second is the potential role for prudential measures
to reduce systemic risk associated with large capital inflows—e.g.,
through constraints on the foreign exchange exposure of domestic
institutions and other borrowers.
Some other economists who were leading advocates of
financial globalization have also reviewed their models. They
now say that economies need to have certain thresholds to
qualify before they completely open to capital flows (see this
paper- Thresholds in the Process of International Financial
Integration by Ayhan Kose et al). This is exactly what the
policymakers of developing economies were saying after their
experiences with capital flows. However, it found no takers and
the problem was limited to inefficienbt institutions and policies
in developing economies.
Economic Models
One of the main criticisms of Willem Buiter If there were so
and Paul de Grauwe (quoted in the begin- many concerns
ning) is centred on the models used by with current
Central banks for their policies. These
economic
models are known as Dynamic Stochastic
General Equilibrium Models (DSGE). Paul
thinking, then why
de Grauwe adds: didn’t economists
Modern macroeconomics as embodied in correct them?
Dynamic Stochastic General Equilibrium
models (DSGE) is based on the paradigm of the utility maximiz-
ing individual agent who understands the full complexity of the
world. Since all individuals understand the same “Truth”,
modern macroeconomics has taken the view that it suffices to
model one “representative individual” to fully represent reality.
Thus as a consumer the agent continuously maximizes an
intertemporal utility function and is capable of computing the
implications of exogenous shocks on his optimal consumption
plan, taking full account of what these shocks will do to the plans
of the producers. Similarly, producers compute the implications
of these shocks on their present and future production plans
taking into account how consumers react to these shocks. Thus
in such a model coordination failures cannot arise.
194 THE IIPM THINK TANK
The DSGE models actually have the same features that we
have noted as a problem above. The DSGE models assume the
financial markets to be efficient and thus accord a minimal role
to financial markets. It also does not have a role for fiscal policy,
money or credit. Some models have started to account for
financial frictions but are very limited. These models despite
their limitations have been used actively by monetary policy-
makers. The leading central banks have their own versions of
DSGE models.
As these models don’t include the main factors seen in this
crisis, it is time to redo these models. The linkages between
economy and financial markets have become very strong and
have to be incorporated in the models. However, no economic
model can help predict a crisis. The economists should remem-
ber not to over-rely on models and avoid complacency.
Economic Theories/Policies -
Influenced by Personalities?
This point is not about any specific branch of economics but
about economists in general. The question that comes to mind is
if there were so many concerns with current
economic thinking why didn’t economists
correct them?
The more one reads into economists
account on the current crisis the more one
gets the feeling that current economic
thinking is more driven by personalities/
economists behind the theory. How else can
you explain these developments/errors? We
had discussed this issue in our previous
report (Crisis 2007-?: Policymaking at the
crossroads?, 2009). However, at that time we had looked at the
issue from a different angle. In summary, the crisis has seen a
number of blame games being played. The market participants
have blamed the regulators for not acting fast enough, the
regulators blame the market participants and we have other
economists blaming a bit of both. Recent statements from key
policymakers and policy influencers suggest they had raised flags
about the bubble and impending crisis (via their research,
statements etc) but no one listened.
We had pointed to recent statements/speeches from leading
economists/policymakers that had played the blame game. Table
1 summarises the results.
IMF and BIS are independent institutions but have an
C O U N T E R C U R R E N T S
hence they are reacting. But this is the case for rising asset
prices as well. Justin Lin (Chief Economist World Bank) in a
paper The Impact of the Financial Crisis on Developing
Countries, 2008) says:
Throughout the US dot-com and housing price bubbles, the
Federal Reserve continued to adhere to its view that its mandate
was to pursue price stability and full employment, not to deflate
asset price bubbles. But amid the wreckage caused by the second
burst bubble in a decade, it is clear that this view needs to be
rethought. If the Fed is not able to keep these bubbles from
inflating, it will not be able to achieve its other objectives. There
are reasonable questions about just how effective monetary
authorities will be in preventing asset-price bubbles, but it is no
longer reasonable not to rethink the issue carefully.
• Guardians of Financial Stability and Role in Financial
Regulation: A linked point to the two above issues is the role of
central banks in financial regulation and stability. The regulatory
structure to manage financial system is too diverse. In some
countries central banks are responsible to manage and supervise
the banks and another authority to manage the capital markets
(like India), in some economies there are
multiple authorities managing the banks
(USA) and in some economies there is a These days most
single authority regulating the financial central banks
system and Central banks only look at price only use the
stability (UK).
interest rates to
After this crisis, there is little doubt that
central banks need to be at the center of
influence demand
financial regulation and need to manage conditions in
financial stability along with price stability. the economy
Mervyn King, Governor Bank of England in
a now-famous speech said:
The Bank of England has a new statutory responsibility for
financial stability. Bank Rate is the instrument we deploy to
achieve monetary stability, and should be used exclusively for
that purpose. To achieve financial stability the powers of the
Bank are limited to those of voice and the new resolution powers.
The Bank finds itself in a position rather like that of a church
whose congregation attends weddings and burials but ignores the
sermons in between. Like the church, we cannot promise that
bad things won’t happen to our flock – the prevention of all
financial crises is in neither our nor anyone else’s power, as a
study of history or human nature would reveal. And experience
suggests that attempts to encourage a better life through the
192 THE IIPM THINK TANK
power of voice is not enough. Warnings are unlikely to be
effective when people are being asked to change behaviour which
seems to them highly profitable. So it is not entirely clear how the
Bank will be able to discharge its new statutory responsibility if
we can do no more than issue sermons or organise burials.
A simple focus on price stability is not likely to work anymore.
It is not that Central Banks do not look at financial stability. The
Central Banks publish reports on financial stability regularly but
all this is done passively. A more active approach and constant
endeavor, just like in the case of price stability is needed.
US and UK Governments have released reports to reform
their financial systems and regulation. The report focuses on
giving the Central bank more powers. The debates are ongoing
in these respective economies and we will know the actual status
only when they are implemented. owever, initial reactions of
economists on the proposed reform is mixed.
• Role of Money and Credit Makes a Comeback? There has
been a really strange development in central banking. Their
principles are based on Monetary Economics but money
hardly plays any role in central bank’s decisions! These days
most central banks only use the interest
rates to influence demand conditions in
the economy.
Earlier, central banks used growth in
money stock to monitor inflation. But
because of financial innovation it became
difficult to maintain monetary growth and
inflation. Hence, instead of money the
central banks started to use interest rates.
But the focus on interest rates was taken to
one extreme with complete ignorance to
developments in monetary numbers. The role of money was just
limited to a casual mention in the central bank’s press release.
Only ECB maintained its focus on monetary targets and still
bases its decisions on the monetary pillar along with the econom-
ic pillar. The ECB watchers criticized ECB for their focus on
monetary targets when they had become irrelevant. They added
that ECB was using monetary targets just to emulate Bundes-
bank (Germany’s Central Bank is considered to be successful at
monetary targeting; however, it is still under debates) and
needed to do away with money.
This crisis brings the role of growth in money and especially
credit back in the limelight. The central banks had been ignoring
the substantial rise in credit in lineup to the crisis. This is seen as
G L O B A L G O V E R N A N C E

New Resources for an

Unreformed IMF?
M
assive crises can be excellent news, as the present
US Crisis proves, which resulted from deregulat-
ing and liberalising the fi nancial sector. Al-
though much larger, it is a crisis like other neoliberal crises
earlier in Chile, Mexcio, East Asia or the Savings & Loan
Crisis in the USA. Those policies the IMF forced on or
recommended to Southern Countries (SCs) were carried to
their logical extreme. Deregulation went as far as to encour-
age practices such as "liar" or "NINJA" (No Income No Job
or Assets) loans that can only be explained by the fact that
securitised debt was quickly sold on and regulatory checks
were not applied. Lenders were off the hook after cashing

196 THE IIPM THINK TANK


Kunibert Raffer
Associate Professor,
Department of Economics,
University of Vienna, Vienna, Austria
their fees.
The basis of the crash was again the Robichek (now rather
Greenspan) doctrine: markets know best and should not be
"overregulated". The government should not interfere as it
can only make things worse. Historically one of the fi rst
cases, Chile's military dictatorship provided an ideal precon-
dition to implement neoliberal ideas, producing the fi rst
neoliberal fi nancial crash. State enterprises were privatised,
public expenditure was reduced and the economy opened up.
As the market knows best banking supervision was cut down,
as in the US recently. Moral backing came from the Bretton
Woods Institutions, especially from the IMF. The IMF's
Director of the Western Hemisphere, E.
Walter Robichek, assured Latin Ameri-
cans that exchange and other risks would The IMF was
presumably be taken into account as granted more
private fi rms can be expected to be power without
careful. Private borrowers (as opposed to
any meaningful
governments) were very unlikely to
overborrow, even with official guarantees.
reform, and may
Briefly, private, voluntary transactions now continue
were the private sector’s own business as before
and presumably Pareto optimal. This
view is sometimes called the Robichek doctrine. The
"Chilean miracle" turned into a catastrophe in 1982, GDP
fell by over 14%. The government was forced to socialise
private losses, another parallel to the present US Crisis.
These international crises had positive effects on the IMF.
The perpetrator was called in to save its victim; the alcoholic
was put in charge to guard the bar. Recently, though, richer
SCs had become able to free themselves from the IMF's grip.
Early repayments to the Fund started to threaten its exist-
ence. On the brink of bankruptcy due to early repayments
and a corresponding shrinking of its outstanding claims
IMF
from SDR 70 billion (2002) to some SDR 15.5 billion (end
2006) as well as income shortfalls projected to surpass 40%
during 2008-10 (Torres 2007, p.9), this Crisis saved the IMF
once again, also making it more powerful. After the demise
of Bretton Woods, the IMF should have been dissolved. The
Southern debt crisis of the early 1980s saved it, allowing the
IMF to usurp the task of “debt manager” after having egged
SCs on to borrow. Again, an international debt crisis the
IMF had helped come about saved it in 2008.
Iceland broke the ice. On 24th October, 2008 an IMF
package totalling $2.1 billion was announced under the
Fund's fast-track emergency fi nancing mechanism. A
Stand-By Arrangement for Hungary was approved in
November. The G20 decided to increase the IMF's role and
fi nancial base substantially. This neoliberal crisis has again
put the neoliberal Fund back into business. In March 2009,
the IMF "overhauled" its lending structure, also establishing
a Flexible Credit Line (FCL). When the fi rst country,
Mexico, availed herself of the FCL, IMF First Deputy
Managing Director John Lipsky spoke of "a historic occa-
sion", "the largest fi nancial arrangement in the Fund’s
history", and "the consolidation of a major step in the process
of reforming the IMF and making its
lending framework more relevant to
member countries’ needs." (IMF Survey
online, April 17th, 2009). The IMF in
particular was saved by the Crisis trig-
gered by those neoliberal policies it
recommends. Money is rolling in from the
leading economies. Apparently due to
criticism of her surpluses meanwhile even
called one main reason of the US Crisis,
China signalled her intention to invest up
to US$50 billion in notes issued by the Fund in June 2009.
The worst result, though, is that the IMF was granted
more power without any meaningful reform, and may now
continue as before. Reform proposals abound, especially
with the IMF they have become some kind of cottage
industry. It is all the more surprising that the most urgent
problem has practically eschewed attention: making the IMF
obey its own statutes and the principles it preaches - applying
good governance and the Rule of Law to itself. "Reform" is
limited to a few basis points of voting being shifted between
regions, one tangible though economically irrelevant
THE INDIA ECONOMY REVIEW 197
G L O B A L G O V E R N A N C E
outcome. It might be quite nice if China has a few votes more
than Belgium instead of a few votes less, but this will hardly
change things fundamentally.
Open violations of its statutes have caused substantial
damage to SCs, and increased IMF-income. IMF-flops have
created IMF-jobs. This paper argues that any "reform"
remains meaningless as long as the IMF is allowed to
continue to breach its own statutes and to infl ict heavy
damages on its Southern members and clients with impunity,
fi nancial and institutional gain.
Capital Controls - A Membership Right
Although the IMF's Articles of Agreement clearly stipulate
the right to capital controls, even explicitly restricting the
use of Fund resources to fi nance speculative outflows, the
IMF has made its Southern members resist from exercising
their membership right and fi nanced such outflows. It foisted
high interest rates and keeping capital accounts open onto
members in distress, at great costs to
them and violating its own statutes. Routinely, short
Art. VI(3) establishes the right of
members to “exercise such controls as are
term speculators
necessary to regulate international
have been bailed
capital movements, but no member may out in breach of
exercise these controls in a manner which the International
will restrict payments for current transac- Monetary Fund's
tions”. Art. XXX(d) defi nes these as “not
for the purpose of transferring capital”,
statutes
including “Payments of moderate (emph. KR) amount of
amortization of loans or for depreciation of direct invest-
ments”, or “moderate remittances for family living expenses”.
Although this defi nition is somewhat opaque, even restrict-
ing flows such as amorisations is a member's right.
Not only has any member the right to control capital flows,
but the IMF is not allowed to fi nance outflows as it did in
Asia 1997-8. Pursuant to Art. VI(1)(a), a
“member may not use the Fund's general resources to
meet a large and sustained outflow of capital except as
provided in Section 2 of this Article [this refers exclusively
to reserve tranche purchases ] and the Fund may request a
member to exercise controls to prevent such use of the
general resources of the Fund. If, after receiving such a
request, a member fails to exercise appropriate controls,
the Fund may declare the member ineligible to use the
198 THE IIPM THINK TANK
general resources of the Fund.”
By fi nancing large and sustained outflows in East Asia and
in other countries, the IMF clearly and openly violated its
own Articles of Agreement, infl icting considerable damage
on its member countries. Although the IMF may but is not
obliged to request controls and declare members ineligible,
its statutes clearly show that it is not supposed to press for
liberalisation of capital movements in the way it actually did.
Clearly, Asian countries had not only the right to control
capital outflows in 1997, as the IMF had to admit when
Malaysia courageously exercised it (Raffer and Singer 2001,
p.157), the Fund's forcing members to fi nance large and
sustained outflows by speculators is defi nitely a violation of
the IMF's own constitution. Routinely, short term specula-
tors have been bailed out in breach of the Fund's statutes.
The intentions of its statutes are clear. Rather than forcing
or even encouraging members to keep capital accounts open,
the Fund is meant to request controls from members not
imposing such controls as appropriate
themselves It may even sanction them.
However, when it comes to protecting the
rights of developing members, legal
regulations and obligations are appar-
ently insignificant. Art. VI(1)(b)(ii) allows
members to meet outflows “out of a
member's own resources, but members
undertake that such capital movements
will be in accordance with the purposes
of the Fund.” Members are even encouraged not to fi nance
large and sustained outflows. Current transactions can be
restricted with the Fund's approval.
In plain English, members have always had the right to
stop amortisations. In 1997-8 there was no obligation to
fi nance outflows fully, nor is there an economic need to keep
extremely high reserves against capital account crises, as
several Asian countries do now to shield against having to
call in the IMF again. They do so at great costs. Exercising
their statutory rights would be cheaper and not expose them
to the blame of contributing to "global imbalances", thus
being “responsible” for the present US-made crisis.
Falsely Claiming Preferred Creditor Status
Although the status of preferred creditor is alien to the
statutes of the IMF, the impression has quite successfully

been created over decades that its claims are entitled to
preferential treatment. This perception is completely
unfounded and at odds with the truth, both regarding the
IMF and multilateral development banks. In fact, IFIs have
undone their founders’ intention, reversing it into its
opposite. De facto preference of the IMF and other
multilaterals has made debt reductions more ore
difficult as other, bona fide creditors must
accept larger haircuts.
The IMF knows that it enjoys no legal
or contractual preferred creditor status,
as can be read on its very own homepage
(Boughton 2001, p.820). When prob-
lems with SCs unable to service their
debts to the IMF in time could no longer
be ignored around 1988, it was tried to fi ndd
arguments in favour of preference. But thee
fact that the IMF has no legal or contractualual
status as a preferred creditor could not be
denied. Supporting their institution’s drive It might be
for undue preference, its "Executive
Directors stressed the ... need ... in
quite nice if China
practice ... to treat the Fund as a preferred has a few votes
creditor." In September 1988, the Interim more
Committee endorsed this position and than Belgium
"urged all members, within the limits of instead of a
their laws, to treat the Fund as a preferred
creditor." (ibid, p.821, emphasis added)
few votes less
The qualification "within the limits of their laws" shows that
even this IMF-organ could not bring itself to demand
unconditional preference for the Fund from its own mem-
bers. The Committee accepted that national laws may forbid
such treatment. In contrast to the impression the IMF tries
to create, there is no legal hindrance to treating it like any
other creditor. Therefore, the IMF’s SDRM-proposal
attempted to obtain de jure preferred status for IFIs in an
extremely self-serving way.
Before the Second Amendment, the IMF’s Articles of
Agreement "contained a provision suggesting that others
would have preference on the Fund" (Martha 1990, p.825).
The author refers to Schedule B, paragraph three on the
calculation of monetary reserves on which repurchase
obligations were based. It seems logical that the exclusion of
holdings "transferred or set aside for repayments of loans
IMF
during the subsequent year" was done "to give preference in
repayment to lenders other than the Fund." He argues that
the intention of deleting this calculation and with it Schedule
B, paragraph three from the statutes by the Second Amend-
ment "was not to repudiate the underlying thought that it was
beneficial to eencourage bank lending by giving banks
and oth
others a preference in repayment" (ibid.,
p.8
p.814). Unfortunately, this initial intent was
blurred
b when conditionality was intro-
duced, rather than making the IMF
fi nancially accountable as indicated by
economic reason, and legally and
ethically proper.
One has to concur with Martha (1990,
p.814) that the IMF’s statute contains "a
presumption
p against a preferred creditor
stat
status", and that "general international law
contains
contain no compulsory standard of conduct
requiring the preferential treatment of
any external creditor, including the
Fund" (ibid., p.825). However the IMF
has no explicit statutory obligation to
grant debt relief, which can again be
explained by its initial role as a helper
without conditionality. Important
multilateral development banks violate
their own constitutions by not giving
members in default relief as stipulated.
Preference as interpreted by the multilaterals and the Paris
Club creditor cartel and forced onto the South includes abso-
lute exemption of multilateral claims. This is done in open
breach of their own statutes by multilateral development
banks whose statutes foresee appropriate relief mechanisms
explicitly (cf. Raffer 2008; fc, Chapter 13). These member-
ship rights are just denied to SCs.
Forced by external auditors, the IMF started to provide
for non-payment by building up loan loss provisions. This
means that borrowers have paid for the eventuality of
default. Nevertheless they have continuously been refused
the relief they had already fi nanced with the "argument"
that the Fund were preferred and could not survive losses.
It has charged its clients for the event of default, but also
claims it cannot use these reserves for the very purpose
they were established for. This is like an insurance com-
THE INDIA ECONOMY REVIEW 199
G L O B A L G O V E R N A N C E
pany charging necessary fees but refusing to cover dam-
ages once they occur. Unlike the Fund no insurance
company could get away with such behaviour, not even if
the client were from the South. Legal double standards
may exist, but not everywhere.
Paying for Unlawfully Inflicted Damage
While statutes of other IFIs contain mechanisms of legal
redress – most clearly so in the cases of the IBRD and IDA -
the IMF clearly differs. Art. IX(3) of its Articles of Agree-
ment grants it total immunity “except to the extent that it
expressly waives its immunity for the purpose of any pro-
ceedings or by the terms of any contract”. Obviously, this is
explained by the fact that initially the Fund was to help mem-
ber countries to overcome short-term dollar/gold-parity
problems by unconditional short-term drawings (=loans). It
would be difficult to perceive any need for legal procedures
and redress in the case of an emergency
helper unconditionally giving money,
except cases such as money paid to Evaluating the
dictators fully knowing that large parts Fund’s role in
would routinely be embezzled (as did the Argentina, its own
IBRD in Suharto's Indonesia). Probably
such eventuality made the IMF’s founders
internal controllers
insert this waiver to provide for proper
found many
legal dispute settlement. When condition- cases of grave
ality became enshrined in the IMF's negligence
statutes in 1969, the appropriate change
regarding immunity was not made for whichever reason,
although its founders would doubtlessly have stipulated the
possibility of legal redress as they did with the IBRD if they
had approved conditional drawing. Arguably, this was the
fi rst step to establish legal double standards globally. Never-
theless, the IMF may not only submit to arbitration or
courts, but contractual clauses stipulating this remain
expressly allowed. Nothing in its statutes prevents the Fund
from applying civilised legal standards. On the contrary, the
existence of this waiver seems an encouragement to do so if
and when appropriate.
By not availing itself of this option when and where
appropriate, the IMF has knowingly created a system
incompatible with the very idea of the market economy, good
governance, or the Rule of Law. As members are always
forced to repay fully, also when avoidable damages are
200 THE IIPM THINK TANK
infl icted by gravest negligence or even wilfully by the Fund,
more damage created by it leads necessarily to larger
involvement of the IMF as a "trouble shooter". Its flops
create more IMF-jobs, and increase its importance. This is
an intolerable moral hazard situation, unless one agrees to
double standards based on nationality. The only exception of
the generally accepted principle that someone infl icting
damage unlawfully must compensate their victims is unfor-
tunately development co-operation, the last sphere where
damage can still be infl icted with impunity and even fi nan-
cial and "reputational" gain. If normal accountability
standards applied to Southern debtors there would in all
likelihood be no multilateral debt problem.
The IMF may advise (or force, as skeptics may formulate)
SCs to implement programmes that it had "known to be
counterproductive ... or that had proved to be 'ineffective
and unsustainable everywhere they had been tried'41”. (IMF
2004, p.91). Footnote 41 further clarifies
that the IMF was fully aware of proven
ineffectiveness and unsustainability: "As
expressed by FAD [the IMF’s Fiscal
Affairs Department] at the time" (ibid.,
p.55).This does not result in damage
compensation but in increased earnings
and more control over the client. A quick
and efficient solution would in compari-
son have reduced earnings. The differ-
ence may be illustrated by Stiglitz’s
(2000) famous story "of one unfortunate incident when team
members copied large parts of the text for one country's
report and transferred them wholesale to another", leaving
the initial name in some places. Any private consultant
would be liable to pay damage compensation. In most
countries penal consequences would not be unlikely.
Evaluating the Fund’s role in Argentina, its own internal
controllers found many cases of grave negligence, if not
worse (IMF 2004). In addition to applying policies fully
aware that these were counterproductive, Argentina’s
programme did not “address the now clear overvaluation of
the exchange rate". Another "critical error" (ibid., p.46) in
2001 was, that there was no sufficiently clear understanding
what to do should the approach fail. The Board supported "a
program that Directors viewed as deeply flawed" (ibid., p.50).
The "September 2001 augmentation suffered from a number

of weaknesses in program design, which were evident at the
time. If the debt were indeed unsustainable, as by then well
recognized by IMF staff, the program offered no solution to
that problem" (ibid., pp.54f). In a footnote the IEO corrobo-
rates this last point by quoting a "memorandum to manage-
ment dated July 26th, 2001", stating that IMF "staff estimates
that a haircut of between 15 and 40 percent is required".
Instead, new loans were granted to Argentina. The IMF not
only "failed to use the best analytical tools" (ibid, p.66), but
"[a]vailable analytical tools were not used to explore poten-
tial vulnerabilities in sufficient depth" (ibid., p.67). It goes
without saying that the IMF was as usual unduly "optimistic"
in its forecasts, as the report documents. This is just a small
selection from a limited part of the period evaluated in one
country. May this suffice to show that, if the IMF were a
consultancy fi rm and Argentina its client, the plaintiff’s
lawyers would have a feast. But the IMF is not a consultant
and Argentina had to pay for programmes that (as the IMF
did know, according to its own documents) contributed to
her ruin. The IMF got more interest income from Argentina
than it would have got if it had refrained from such strate-
gies. One cannot but concur with the Statement of the
Argentine Governor: “Recognising errors is, however, just
the fi rst step in a healthy self-criticism exercise. The second
step is bearing responsibility for failures, namely sharing the
burden of redressing their consequences” (ibid., Annex) as
allowed by the IMF’s statutes. Equal treatment of all
creditors in the case of a country's incapability to pay fully
would be a fi rst yet important step to provide incentives for
good institutional governance and for applying due care.
Furthermore, arbitration and courts could be used to
provide decent legal relief (see Raffer 2004; fc). The IMF’s
statutes authorise it to behave properly by waiving its
immunity in such scandalous cases.
Conclusion
More voice and representation of the South within the IMF
is necessary and fair. But all present reform proposals will go
nowhere unless one forces the IMF to obey its own statutes.
A seven percent shift of voting in the IMF is doubtlessly a
well justified demand, but making the IMF obey its statutory
obligations even if and when these safeguard rights of SCs is
much more important. Obeying one’s own statutes is the
cornerstone of the Rule of Law and good governance – with-
IMF
out enforcing this self-evident necessity any other reform
will remain fairly useless. One may flout one version of one’s
statute as well as any other if allowed to do so.
Reference and Additional Thinking
• Boughton. James M (2001), Silent Revolution: The
International Monetary Fund 1979–1989, Washington,
DC: IMF; Chapter 16 also at www.imf.org/external/pubs/
ft/history/2001/ch16.pdf (12/08/2009)
• IMF, IEO (2004) Report on the Evaluation of the Role of
the IMF in Argentina, 1991–2001, at http://www.imf.org/
external/np/ieo/2004/arg/eng/pdf/report.pdf (10/08/2009)
• Martha, Rutsel Silvestre J. (1990) "Preferred Creditor
Status under International Law: The Case of the Interna-
tional Monetary Fund", International and Comparative
Law Quarterly 39(4), pp 801ff.
• Raffer, Kunibert (2004) "International Financial Institu-
tions and Financial Accountability", Ethics & Interna-
tional Affairs 18(2), pp.61ff; or http://www.cceia.org/
resources/journal/18_2/articles/5019.html (08/08/2009)
• Raffer, Kunibert (2008) "Bretton Woods Institutions and
the Rule of Law”, Economic & Political Weekly
XLIII(38), 20-26 September, pp.49ff; or http://homepage.
univie.ac.at/kunibert.raffer/KR-acc.pdf (08/08/2009)
• Raffer, Kunibert (fc) Debt Management for Development
- Protection of the Poor and the Millennium Development
Goals, forthcoming at Edward Elgar, Cheltenham (UK)/
Northampton (US)
• Raffer, Kunibert and HW Singer (2001) The Economic
North-South Divide: Six Decades of Unequal Develop-
ment. Cheltenham (UK)/Northampton (US): Elgar
[paperback eds: 2002; 2004].
• Stiglitz, Joseph (2000) "What I Learned at the World
Economic Crisis: The Insider," New Republic, 17 April,
pp.56ff; or http://www.mindfully.org/WTO/Joseph-
Stiglitz-IMF17apr00.htm (12/08/2009)
• Torres, Hector R (2007) "Reforming the International
Monetary Fund – Why its legitimacy is at stake", The
Journal of International Economic Law 10(3), pp.1ff,
http://www.networkideas.org/featart/aug2007/fa10_Hec-
tor_Torres.htm (12/08/2009).
(The views expressed in the article are personal and do not
reflect the official policy or position of the organisation.)
THE INDIA ECONOMY REVIEW 201
G L O B A L G O V E R N A N C E

The Unbearable Lightness

of Financial Markets

Heiner Flassbeck information, and instantly change to reflect new information.

In this manner, the markets always gets the prices right and
Director, Division on Globalization assets are always traded at their “fair value”. In this theory,
and Development Strategies, financial markets, even more than goods markets, allocate
United Nations Conference on resources in an efficient way and regulation is unnecessary.
Trade and Development (UNCTAD), In a different theoretical setting, however, the most impor-
Geneva tant lesson of the recent global crisis is that financial markets
hardly do "get the prices right". In this view, the information

Sonia Boffa processing of financial markets results systematically in over-

shooting or undershooting and in misallocation of resources. As
Associate Economic Affairs Officer, all market participants react in a more or less uniform manner
United Nations Conference on to new information or "new shocks", the winding or unwinding
Trade and Development (UNCTAD), of their exposure to risk takes place almost in unison.
Geneva This has never been better demonstrated than by the
current crisis, where financial markets for very
different types of assets and in all major countries

F
inancial markets have a long history of speculative were hit almost simultaneously. As Figure 1
bubbles and crashes. From the 1622 currency bubble of shows, the financial shockwave submerged
the Holy Roman Empire, the Tulip mania in 1637 and the stock and bond markets in many countries,
South Sea Bubble of 1720, through the Railway mania in 1840s, ex-change rates of some emerging-
the Poseidon Bubble in 1970s and the dot-com bubble in 2000 up market currencies and primary
to the recent real state bubble1, financial markets seems not to commodity mar-kets all at the
find a safe and calm haven but to create the basis for a new storm same time. The same strong
as soon as the last one has settled. Surprisingly, despite the correlation can be seen for the
previous and the present over-shooting and undershooting of first quar-ter of 2009, with a
financial markets, the strong belief that markets "are getting the nearly parallel in-crease
prices right" is only rarely as fundamentally questioned as one among totally different
could have expected in the light of the shocks? assets that are
The Efficient Market Hypothesis (EMH), supposedly the traded on
most widely accepted theory in economics over the last five
decades, is still seen as the cornerstone of the whole neoclassi-
cal macroeconomic edifice. The EMH claims that, in an
efficient market, the prices of traded assets (e.g., bonds,
currencies, stocks, or property) reflect all available

202 THE IIPM THINK TANK

 U N B E A R A B L E L I G H T N E S S

financial markets or on markets with a high degree of financiali-

zation. The extremely high correlation of the day-to-day price
movements in so many different markets can only be
ex-plained by a common force like financial specula-
tion, which moves all the prices in the same
direction despite their different fundamentals.
Take, for example, the currency market.
High inflation countries are the main target
for short-term capital flows because they
usually offer high interest rates. In doing
so, "investors" can gain large profits by
carrying money from countries with low
interest rates to those with high interest
rates. At a macro level, this “carry
trade” causes an appreciation of the

THE INDIA ECONOMY REVIEW 203

0
G L O B A L G O V E R N A N C E
recipient country currency despite its fundamental need to
depreciate to stabilize trade flows. The long lasting real apprecia-
tion of high yielding currencies is a clear signal of the ability of
speculative flows to drive prices in the “wrong direction”.
On commodity markets financial "investors" have been very
active since the early 1990s as a strategy to diversifying portfolios
through exposure to commodities as a new asset class. When their
involvement took on new proportions in the aftermath of the
dot-com crash in 2000 and started a meteoric rise in early 2005
prices were clearly distorted2. The parallel development of
commodity prices and financial investment on commodity futures
markets is a first indicator for the role of large-scale speculative
activities in distorting commodity prices (UNCTAD, TFR 2009).
Among economists, however, scepticism prevails with regard to
the link between speculation and commodity price development
and this scepticism is based on the efficient market hypothesis
(EMH). EMH believers still sustain that if
speculators were driving market prices above
fundamental levels, consumer will demand The policy
less than producer are supplying. The result lesson is simple:
would be visible inventories of speculators. macroeconomic
As the evidence on inventories is inconclusive
prices are too
the traditional view declines the role of
speculation. However, reality may be more
important to be
complex than this simple model. left to the vagaries
of these markets
Speculation in Commodity Prices:
Spot Prices and Future Expectations
First, there is no doubt that the most basic form of speculation,
hedging, can play a useful role in markets with volatile prices:
Thales was a poor philosopher from Miletus who forecasted the
olive harvest would be exceptionally good the next autumn.
Confident in his prediction, he made agreements with local olive
press owners to deposit his money with them to guarantee him
exclusive use of their olive presses when the harvest was ready.
Thales successfully negotiated low prices because the harvest was
in the future and no one knew whether the harvest would be
plentiful or poor and because the olive press owners were willing to
hedge against the possibility of a poor yield. When the harvest-time
came, he let them out at any rate he pleased, and made a large
quantity of money.
A futures contract of this kind is a standardized contract to buy
or sell a specified asset at a certain date in the future, at a
pre-determined price. In agri-cultural markets, risk averse
204 THE IIPM THINK TANK
farmers may sell their future harvest through such a contract in
order to be sure about the price and avoid bad surprises at the
time of the harvest. The farmer may indeed accept what seems to
be a rather low price to hedge the risk of a much lower price later.
In this sense, Thalesian futures market are driven by a reasonable
kind of speculation, where a more risk adverse person is hedging
its risk with a person that it is less risk adverse.
What happens when futures contracts are traded in purely
financial markets without producers of the commodities being
involved? Trading a futures contract of commodities, like trading
stocks or currencies, implies the anticipation of the future price of
the traded asset. The farmer after having planted its crop may
have an idea of the future supply, its quality and the local demand
for such a quality that allows him to estimate roughly the present
value of his coming harvest. However, in a truly global market and
long before the food stuff is planted, for example olives for the
harvest in 2010, no one has a clear idea about
the outcome in terms of the final price.
The main difference between the
thale-sian futures market and the financial
fu-tures markets nowadays is the impossi-
bility of an acquisition of reliable informa-
tion in the latter about prices in the future.
In fact, pricing in financial futures markets
is no longer based on some knowledge of
the concrete supply and demand but it is
based on "more sophisticated” techniques
and procedures. But even with these techniques like deep
digging analysis of supply and scientific studies of future
demand (like "The Chinese or Indian demand for oil or food”)
the information is not more accurate; the state of objective
uncertainty prevails. But another nexus may come into play: As
the futures market normally is a highly active, very visible and
centralized market, the farmer and the hedger may prefer to
set their price according to the futures "markets view" instead
of relying on their own judgment (especially when the forward
price in that market is higher than the one the farmer had
expected). Then the futures markets becomes a vital source for
information about spot prices and may indeed force both, the
producer and the hedger, to adjust accordingly.
It is exactly in this way in which information, unrelated to the
fundamentals of the concrete market drives many different
financial prices into the same direction over remakably long time
spans. The rumor about a recovery of the global economy is more

important than any “fundamental” in driving the prices up or
down. Then the futures markets dominate the price formation in
the spot markets and not the other way around, as traditional
theory suggests. Remains the question about final demand: what
will consumers do to protect against the volatility of the financially
determined prices? The simple answer is that in most cases they
have no choice. They continue to satisfy their needs irrespective
of the price and take the implied overall income effect that is
implied by the price moves as good or bad luck respectively.
Overall, financial markets are not compa-rable to the ideal
atomistic market of economics textbooks. In an atomistic market,
each seller's and buyers size is too small relative to the market as a
whole to influence prices. Moreover, each seller and each buyer in
the ideal market comes with an independent set of information
concerning his or her individual supply and demand. In financial
markets, the uniformity of the available information provokes
herding and highly correlated movements in
and across markets with the power of
influencing the futures market and the future In the great events
spot prices of all traded assets. of man’s history,
in the unwinding
Herd Behaviour and the of the complex
Irrelevance of Fundamentals
The EMH claim that relevant new informa-
fates of nations,
tion induces the economic agents to update justice is not
their expectations appropriately doesn’t solve so simple
the general information problem. Which
kind of information is driving the expectations of market partici-
pants? Are expectations driven by individual needs, by individual
preferences, or by individual strategic targets of companies? Obvi-
ously, none of them is relevant. Fundamentals like these are not
important anymore in modern financial markets. The market
participants in a financial market are much more concerned with
guessing how certain "news" will influence the behaviour of other
financial market participants and consequently with betting on an
outcome that can be expected if many participants' expectations
are influenced by the same piece of information.
Keynes introduced in 1936 the example that investment
strategies in such markets resemble a beauty contest; where
guessing the result is mainly driven by trying to second guess
which the prettiest woman for other observers is, instead of
judging the true beauty of the ladies. In the same way, the
“fundamental” value of a particular asset is less relevant for the
guessing market participant than his expectations about the
U N B E A R A B L E L I G H T N E S S
judgment of the other speculators. This phenomenon systemati-
cally encourages the emergence of price bubbles if the herds
influenced by certain bits of information are large enough. If this
is the case financial markets systematically "get the prices wrong"
since betting on ever-rising prices appears to be a rather risk-free
and high-return business for an extended period of time.
As long as the “madness of the crowds" prevails, the individual
judgement on the fair value of an asset is useless. In this sense,
financial markets have a lot in common with the historical Spanish
tradition of encierros (running with the bulls): since you have to
run in the same direction, the best strategy is to be far ahead and
out in front of the bull and exit in the right moment. And this is
exactly what each speculator tries to do: to move first because only
moving first guarantees the biggest gains. But in doing so, "the
unbearable lightness of financial mar-kets" leads the whole
economic system into an unsustainable situation. If farming were
to be organized like the stock market, a
farmer would sell his farm in the morning
when it rains, only to buy it back in the
afternoon when the sun comes out.3
In reality, the future equilibrium price is
absolutely unknown. Financial investors
even ignoring available information about
fundamentals can guess the price that
proves to be the right one eventually.
Relying on what other market participants
may believe and/or the prediction about
others views on the average value of a share, a commodity or a
currency is sufficient for temporary success. In such a frame-
work, speculation destabilizes, instead of stabilizing, the prices
of the targeted assets.
Policy Conclusions
The events of recent months have revealed a huge misallocation
of resources and a destruction of enormous values driven by
financial markets. The policy lesson is simple: macroeconomic
prices are too important to be left to the vagaries of these
markets. However, if the failure has shattered the naïve belief that
unfettered financial liberalisation and de-liberate non-interven-
tion of governments will not only maximize the benefit of some
players but also the social benefit, the crisis offers an opportunity
for a new start. Governments, supervisory bodies and interna-
tional institutions have a vital role to play to allow the society at
large to reap the potential benefits of a system of decentralized
THE INDIA ECONOMY REVIEW 205
G L O B A L G O V E R N A N C E

Evolution of Prices in Selected Markets and Countries, June 2008-July 2009

(Index numbers, 2 nd June 2008 = 100)
Equity markets Commodity Market
140 140

120 120

100 100

80 80

60 60

40 40

20 20
03/07/2009

0 0
03/07/2009
02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009
Budapest Stock Exch Index (Hungary)
Jakarta Composite Index (Indonesia) S&P GSCI Cotton Official Close Index
FTSE/JSE Africa All Shr (South Africa) S&P GSCI Soybeans Official Close Index
Bolsa Index (Mexico) S&P GSCI Brent Crude Official Close Index
NIKKEI225 (Japan) S&P GSCI Copper Official Close Index

National Bond Marketa National Bond Marketa

140
140
120
120
100
100
80
80
60
60
40
40
20
20
0
03/07/2009

02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 0 03/07/2009

United States 02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009

New Zealand
Germany Australian Dollar to Japanese Yen
United Kingdom New Zealand Dollar to Japanese Yen
Japan Brazilian Real to Japanese Yen
Source: UNCTAD Secretariat Calculations, based on Bloomberg. a Yields on 10-year bonds.

206 THE IIPM THINK TANK


decision makers. Only consistent and forceful interventions by
institutions with knowledge about systemic risk can transform a
system of markets for goods, for services and finance into a
functioning entity. The neo-liberal laissez faire of the last twenty
years has dramatically failed its final test.
Interventions in financial markets that are part of the global
economy ask for cooperation and coordination of national
insti-tutions and for specialized institutions with a multilateral
mandate to supervise national action. In midst of the crisis this is
even more important than in normal times. The tendency of
many governments to grant to financial markets the role of
referee or judge over the success of policy adjustments has to be
rejected energetically. For example, it is indispensible to stabilize
exchange rates by direct and coordinated government interven-
tion instead of letting the market find the bottom line and trying
to “convince” financial markets about the credibility of the
government of the depreciating currency through pro-cyclical
policies like public expenditure cuts or interest rate hikes.
In the same vain, the problem of newly issued government
bonds at “penalty” rates that are demanded by the “markets”
can be tackled. The paradox that the same market participants
that have driven governments of many countries into a
disastrous budgetary and current account situation ask for
“risk premia” because they do not trust these governments any
more and fear government default, has to be answered by the
global community of governments in a strong and dedicated
manner. Very rarely only the governments of the negatively
affected countries are to be blamed alone for failure and
governments of the unaffected countries very rarely are
without any guilt. Hence, global solidarity and not a blame
game is the imperative of the day. As Keynes once put it: “In
the great events of man’s history, in the unwinding of the
complex fates of nations, justice is not so simple.”
A global answer should follow the same principle: If everybody
defaults nobody defaults. Only if some countries try to avail
themselves of the opportunity to get cheaper credit at the
expense of others, the “markets” have a choice and can de-mand
a “risk premium” from the more vulnerable ones. If every
country and every government acknowledges that the global
crisis is foremost a systemic crisis, i. e., due to the failure of the
global community to govern the globalized economy properly,
the solution of a global bond that can be used by all countries at
fixed exchange rates is less utopian than it sounds.
In the same spirit of cooperation all different sorts of specula-
U N B E A R A B L E L I G H T N E S S
tive activities that have been responsible for the distortion in
national and international price relations have to be tackled at
the same time to avoid speculative arbitrage. The tragedy of the
modern forms of speculation is their very short half-value period:
the more people on the globe concentrate on the speculation in
certain markets and the more effective they are, the quicker the
results will be contradicted by economic reality because the real
economic system can no longer bear the burden of largely
distorted prices and exchange rates.
A coherent and effective approach can only be found at the
international level and with the inclusion of as many coun-tries as
possible. A broad international agreement about the distortive
effects of large scale speculation in different areas on trade and
investment is absolutely crucial to create the framework for a
globalization that has the potential to de-liver rising living
standards for all. However, the effects of the improvement in
terms of material wealth have to be miti-gated by a strategy to
minimize the cost of higher living standards for the natural
environment and the global climate to be sustainable.
Endnotes
1
Kindleberger has listed 42 bubbles in the history of economics.
2
The number of futures and option contracts outstanding on
commodity exchanges worldwide increased more than fivefold
between 2002 and mid-2008.
3
Keynes quote attributed by Hutton (2008).
References and Additional Thinking
• Aristotle, Politics, trans. Benjamin Jowett, vol. 2, The Great
Books of the Western World, ed. Robert Maynard Hutchins
(Chicago: University of Chicago Press, 1952) book 1, chap. 11,
p. 453.
• Hutton, Will, "Will the real Keynes stand up, not this sad
caricature?", Guardian, November 2nd, 2008.
• Keynes, John Maynard The economic consequences of the
peace, Volume II of the Collected writings of John Maynard
Keynes published for the Royal Economic Society in 1971,
page 142.
• Kindleberger, Charles P. (2000) Manias, Panics, and Crashes:
A History of Financial Crisis, 4th edn. New York: John Wiley
& Sons.
(The views expressed in the article are personal and do not reflect
the official policy or position of the organisation.)
THE INDIA ECONOMY REVIEW 207
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sion, Kolkata
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Economic Review…it is undoubtedly a mammoth task of pulling to-
gether divergent perspectives on the critical issues of the nation…”
Dr. Parth.J.Shah, Centre for Civil Society, New Delhi
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questions, answers and solutions...promises to usher in a potentially
better, if not necessarily newer, dawn of economic policies that radiates
the power to dispel the current darkness of socio-economic and socio
political confusion... the review exudes qualified optimism about country’s
prospects.”
Mr. S.R.Kasbekar Senior Editor, The Financial Express, Mumbai
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III, is very impressive and the material is very good. I send all of you
involved with it, my heartiest congratulations and wish you all the best.”
The Lord Paul, The Rt. Hon. Lord Paul of Marylebone
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that I have seen in my interaction with similar organisations in differ-
ent countries. I merely wanted to write to you and congratulate you
and your institution on an extremely well researched and presented
endeavour... I have taken the liberty of putting the copies that I had
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got along in the WTO library.”
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ment.”
Dr. V.L.Chopra, Member, Planning Commission, New Delhi
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and employment. I would like to compliment all the authors as well as
the editorial team for bringing out such a valuable publication.”
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but also to ignite thinking among the readers, I think you have suc-
ceeded very well indeed.”
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it well reflects the high standards of the IIPM.”
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a lot of solid analysis...kudos to those who are bringing it out.”
Mr. B.S.Raghavan, IAS(Retired), ex-US Congressional Fellow, ex-Policy
Adviser to UN(FAO), ex-Adviser to International Commission on Peace and
Development, ex-Director, Politician and Security Policy Planning, Government
of India
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Indian Economic Review and the wide range of issues it covers.
The editors indeed fully deserve the title of ‘think tank’!”
Dr. V.M.Madiman Rao, Institute for Social and Economic Change,
Bangalore
 PRAISE FOR IER
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2007 on India’s Policy Deficit: Planning for Change. I appreciate the
initiative taken by the IIPM Think Tank in this area.”
Dr. Indira Hirway, Centre for Development Alternatives, Ahmedabad
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Mr. Mihir.R.Bhatt, Honorary Director, All India Disaster Mitigation Institute,
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Ahmedabad
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tion...IER which is committed to enhance public awareness of policy
issues in economics and management and to engineer solutions that
will fulfil the Great Indian Dream.”
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Enterprises (India), New Delhi
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certainly offers a good non-ideological mix from leading authors.”
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AG, Zurich
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very interesting ... IER has an interesting mix of articles and the photos
and layout are also very well done.”
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led by Dr. M. K. Chaudhuri and Prof. Arindam Chaudhuri deserve
the appreciation from every one who has a vision and dream for a
new innovative India. Hope your effort will become a path finder for
innovative research workers.”
Dr. Gouri Pada Dutta, Chairman, Subject Committee (Health), State Plan-
ning Board, West Bengal, Kolkata
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mies tread on the path of globalization and economic liberalization.
Your efforts at adding the human face to some very core management
areas are indeed commendable.”
Mr. Bharti Ali, Co-Director, HAQ: Centre for Child Rights, New Delhi
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nonetheless. I would also like to congratulate you and your team for
truly high-quality editions of IER that are of the prime importance to
the future of India’s thriving economy.”
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ence for leading policy makers/planners in India. In fact, I can say that
all your volumes are packed with information/ideas for development
workers. I wish you all the best in your new assignment.”
Dr. G.Poyya Moli, Member, CEM, IUCN & Member, SEAC & SHCC, Govt of
Puducherry, Reader, Department of Ecology & Environmental Sciences, Pondicherry
University, Pondicherry
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been able to cover in this publication. Thank you for this spectacular
piece of work.”
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and is very useful both for reference and research.”
Dr. Prabha Panth, Professor of Economics, Osmania University, Hyderabad
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that you have many new names from new institutions.”
Dr. PadmaPrakash, Editor, eSocialSciences