Irrational exuberance

September 17, 2012 01:24 am | Updated November 16, 2021 11:09 pm IST

The stock market and large sections of the media have reacted with predictable euphoria to last week’s bold economic announcements, hoping that the latest reform measures will revive the ‘animal spirits’ of entrepreneurs and reverse the slowdown in growth. There is no doubt that Prime Minister Manmohan Singh is telling global investors he is willing to take decisive action on contentious economic issues. As policy, however, the individual announcements do not amount to much on the macroeconomic plane. For instance, the stiff hike in the retail prices of diesel will inflict severe pain on the economy by driving up inflation, which is already at unacceptably high levels. Households will have to bear the burden of higher fuel charges and prices for other goods. Of course, the justification for the fuel hike is that it will, to an extent, rein in subsidies and help repair government finances. But this kind of shock therapy is not the most effective or rational way of sorting out the fisc, or indeed the financial health of the oil-marketing companies.

Despite widespread opposition, the government has permitted foreign direct investment in multi-brand retail, subject to a cap of 51 per cent on the share of foreign equity. Companies like Walmart and countries like the United States have lobbied aggressively for the doors of the Indian retail sector to be thrown open. By including this policy in the recent slew of liberalisation measures — even at the risk of losing some of its political legitimacy — the Congress is sending a message to international capital. However, since India’s quasi-federal structure complicates matters, the decision on whether to actually allow FDI in retail has been left to the State governments. As expected, many State governments have already said they have no intention of permitting FDI into this sector. Thus, signalling the commitment to reform seems more important than actually ensuring FDI entry into retail. The assumption seems to be that foreign investors would still respond positively, contributing to growth in output and employment somewhere, even if not in retail. However, growth has fallen and organised sector employment stagnated even though most areas are already open to foreign investors. The government’s optimism is, therefore, clearly misplaced.

Even within the retail trade, the government’s claim that FDI is good for the nation is difficult to defend. The success of large retail cannot be based only on the expansion of the retail space, but requires acquiring a share of the existing space occupied by small retailers. NSSO data for 2009-10 indicate that the occupational category consisting largely of the wholesale and retail trade employed 44 million Indians. The displacement of a substantial number of these workers is inevitable. Since the economies of scale and scope that size delivers in organised retailing are expected to reduce costs by raising labour productivity, the expansion of large retail will not compensate for this employment loss. Further, once cost reduction leads to displacement of traditional retailers, big players dominating the space would be in a position to increase retail margins, with implications for prices paid by consumers. Finally, cost reduction is ensured at the expense of the producers as well. When a few buyers dominate the retail trade, the prices paid to competing small suppliers, especially in agriculture, are depressed. The margin above production costs implicit in the retail price shifts in favour of the retailers at the expense of producers and consumers. Of course, such adverse outcomes would follow from increased domestic investment in organised retail as well. But the entry of foreign firms with deep pockets would hasten the rise to dominance of large retail and amplify the adverse consequences.

Turning to the other big headline, the decision to permit foreign airlines to take a 49 per cent stake in a domestic carrier may not benefit those who need such investment the most. Investment in tottering airlines can come only on very onerous terms to existing shareholders or, as was seen during the early days of private airlines in India, from murky sources. Whether in airlines or retail, then, the expectation of large, stable dollar inflows through foreign direct investment in these sectors may not materialise fast enough to make a difference to the economy’s near- or even medium-term growth prospects. It is evident, therefore, that the immediate hopes of the government are being pinned on the renewed push towards public sector disinvestment. The Congress is hoping that the sale of PSU shares will bring in revenue, boost the equity market and signal ‘reform’ to a corporate sector whose faith in the party is slowly flagging. Here too, the danger is that bright and cheerful signals may not be enough to turn things around. What the economy needs today is not the red herring of reform in retail but actual economic governance on the ground. Poor roads and ports and erratic power supply hurt the competitiveness of Indian manufacturing and are the main reason why the sector has slowed down. The ability for companies to earn easy resource rents from spectrum, gas, coal and iron ore is another. Tackling these problems requires strong, decisive leadership; unless the UPA is prepared to provide some, the applause it is getting from the investor community today will not add up to anything durable.

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