Economic Survey 2019-20-

Entrepreneurship and Wealth Creation at the Grassroots 39 and physical infrastructure in determining improve access to local markets and such heterogeneity. For instance, the eastern improve entrepreneurial activity. part of India has the lowest literacy rate of However, in terms of prioritization, this about 59.6 per cent according to the census of may not be as crucial as investments in 2011. This is also the region in which formal education. Moreover, increasing the access entrepreneurial activity is the lowest. The to local markets might create other types analysis in this chapter, therefore, suggests of opportunities which might discourage the following policy implications. entrepreneurship. Hence investments in infrastructure especially those undertaken 2.23 First, measures to increase the to increase entrepreneurial activity literacy levels rapidly through the institution should be weighed against how improved of more schools and colleges will spur infrastructure creates other kinds of entrepreneurship and consequently local opportunities that might be consequential wealth creation. Following the successful to a district’s GDDP. contribution of privatization of engineering colleges to India’s software exports (Arora 2.25 Third, policies that foster ease of doing et.al., 2011), governments could also business and flexible labour regulation foster explore the privatization of education to entrepreneurial activity, especially in the augment education capacity at all levels of manufacturing sector. As the manufacturing education. sector has the potential to create the maximum jobs, states must focus on enabling ease of 2.24 Second, better connectivity of doing business and flexible labour regulation villages through tar roads will likely to foster job creation. CHAPTER AT A GLANCE  This chapter examines the content and drivers of entrepreneurial activity at the bottom of the administrative pyramid – over 500 districts in India. The analysis employs comprehensive data on new firm creation in the formal sector across all these districts from the Ministry of Corporate Affairs (MCA)-21 database.  First, using the World Bank’s Data on Entrepreneurship, this chapter confirms that India ranks third in number of new firms created. The same data shows that new firm creation has gone up dramatically in India since 2014. While the number of new firms in the formal sector grew at a cumulative annual growth rate of 3.8 per cent from 2006-2014, the growth rate from 2014 to 2018 has been 12.2 per cent. As a result, from about 70,000 new firms created in 2014, the number has grown by about 80 per cent to about 1,24,000 new firms in 2018.  Second, reflecting India’s new economic structure, i.e. comparative advantage in the Services sector, new firm creation in services is significantly higher than that in manufacturing, infrastructure or agriculture.  Third, grassroots entrepreneurship is not just driven by necessity as a 10 percent increase in registration of new firms in a district yields a 1.8 percent increase in GDDP. Thus, entrepreneurship at the bottom of the administrative pyramid – a district – has a significant impact on wealth creation at the grassroot level. This impact of entrepreneurial activity on GDDP is maximal for the manufacturing and services sectors.

40 Economic Survey 2019-20 Volume 1  Fourth, birth of new firms is very heterogeneous across Indian districts and across sectors. Moreover, it is dispersed across India and is not restricted to just a few cities.  Fifth, literacy and education in the district foster local entrepreneurship significantly. For instance, the eastern part of India has the lowest literacy rate of about 59.6 per cent according to the census of 2011. This is also the region in which new firm formation is the lowest. In fact, the impact of literacy on entrepreneurship is most pronounced when it is above 70 per cent.  Sixth, the level of local education and the quality of physical infrastructure in the district influence new firm creation significantly.  Finally, policies that enable ease of doing business and flexible labour regulation enable new firm creation, especially in the manufacturing sector. As the manufacturing sector has the greatest potential to create jobs for our youth, enhancing ease of doing business and implementing flexible labour laws can create the maximum jobs in districts and thereby in the states.  Literacy, education and physical infrastructure are the other policy levers that district and state administrations must focus on foster entrepreneurship REFERENCES Evans, D.S. and Leighton, L.S., 1989. “The determinants of changes in US self- Arora, A. and Bagde, S., Advantage, R. R. employment, 1968–1987.”. Small Business C., & Based, K. 2011. “Private investment Economics, 1(2), pp.111-119. in human caoital and industrial development: the case of the Indian software industry. Ghani, E., Kerr, W. and O’Connell, S., Dimensions of Economic THEORY and 2011. “Promoting entrepreneurship, growth, Policy: Essays for Anjan Mukherji. and job creation.”. Reshaping Tomorrow, pp.168-201. Arzaghi, M. and Henderson, J.V., 2008. “Networking off madison avenue.”. The Glaeser, E.L. and Kerr, W.R., 2009. Review of Economic Studies, 75(4), pp.1011- “Local industrial conditions and 1038. entrepreneurship: how much of the spatial distribution can we explain?”. Journal Bönte, W., Falck, O. and Heblich, S., 2009. of Economics & Management Strategy, “The impact of regional age structure on 18(3), pp.623-663. entrepreneurship.”. Economic Geography, 85(3), pp.269-287. Meki, M., 2019, September. “Microequity For Microenterprises: Evidence From An Carlino, G.A., Chatterjee, S. and Hunt, Artefactual Field Experiment And Survey.”. R.M., 2007. “Urban density and the rate of In Economic Research Forum Working invention”. Journal of Urban Economics, Papers (No. 1348). 61(3), pp.389-419. Mittelstädt, A. and Cerri, F., 2008. “Fostering Dahl, M. and Sorenson, O., 2007. “Home entrepreneurship for innovation. sweet home: Social capital and location choice.”. Social Science, pp.1-22. OECD, 1998. Fostering entrepreneurship.”. Industries Services and Trade, 16(1), p.277.

Entrepreneurship and Wealth Creation at the Grassroots 41 APPENDIX Table A1: OLS regressions of natural log of GDDP on natural log of new firms. VARIABLES (1) (2) (4) Log of Log of Log of New Firms Formed 3 years back Log of GDDP GDDP GDDP Log of New Firms Formed in Agriculture 3 years 0.03*** 10.96*** back 0.18*** (0.00) (0.05) Log of New Firms Formed in Manufacturing 3 years (0.01) 0.07*** -0.39*** back (0.00) (0.06) 0.07*** -0.68*** Log of New Firms Formed in Services 3 years back (0.00) (0.07) 0.05*** -0.24*** Log of New Firms Formed in Infrastructure 3 years (0.00) (0.06) back 0.04*** 0.22*** Log of New Firms Formed in Other Sectors 3 years (0.01) (0.02) back -0.06*** 11.21*** (0.02) South India (0.04) 0.03 5,591 (0.02) North India 0.87 0.02 Yes (0.03) East India Yes Yes 5,591 West India 0.77 No South India x Log of New Firms Formed 3 years back Yes Yes North India x Log of New Firms Formed 3 years back East India x Log of New Firms Formed 3 years back West India x Log of New Firms Formed 3 years back 10.66*** (0.02) Constant 5,591 0.85 Observations Yes R-squared Yes State Fixed Effects Yes Year Fixed Effects Errors Clustered at District Level *p<0.10, **p<0.05, ***p<0.01

42 Economic Survey 2019-20 Volume 1 Table A2: OLS regressions of natural log of new firms on measures of physical and social infrastructure VARIABLES (1) (2) (3) (4) Natural Log Natural Log of Population Natural Log of New Firms Natural Log of New Natural Log Density per last Census of New Firms Firms Formed - of New Firms Natural Log of Total Formed - Manufacturing Colleges per last Census Formed Agriculture Formed - Percentage of Population 0.16*** Services Literate per last Census 0.18*** 0.09** (0.04) Percentage Villages (0.04) (0.03) 0.69*** 0.24*** Connected by Tar Roads per 0.74*** 0.45*** (0.10) (0.04) last Census (0.09) (0.08) 0.06*** Percentage Villages Having 0.07*** 0.03*** (0.01) 0.72*** Access to Power per last (0.01) (0.01) (0.09) Census Natural Log of Mean 0.02*** 0.01*** 0.08*** Distance from 500K (0.00) (0.00) (0.01) Population Centre 0.00 0.00 0.02*** 0.02*** Constant (0.00) (0.00) (0.01) (0.00) Observations -0.15*** -0.16*** 0.01 0.00 R-squared (0.05) (0.03) (0.00) (0.00) State Fixed Effects Census Fixed Effects -6.11*** -5.96*** -0.18*** -0.16*** Errors Clustered at District (0.67) (0.51) (0.05) (0.05) Level 5,337 5,337 0.53 0.44 -7.47*** -7.92*** *p<0.10, **p<0.05, ***p<0.01 Yes Yes (0.72) (0.67) Yes Yes 5,337 5,337 0.43 0.56 Yes Yes Yes Yes Yes Yes Yes Yes

Pro-Business versus Pro-Crony 03 CHAPTER India’s aspiration to become a $5 trillion economy depends critically on promoting “pro-business” policy that unleashes the power of competitive markets to generate wealth, on the one hand, and weaning away from “pro-crony” policy that may favour specific private interests, especially powerful incumbents, on the other hand. Economic events since 1991 provide powerful evidence supporting this crucial distinction. Viewed from the lens of the Stock market, which captures the pulse of any economy, creative destruction has increased significantly after reform. Before liberalization, a Sensex firm expected to stay in it for 60 years, which decreased to only 12 years after liberalization. Every five years, one-third of Sensex firms are churned out, reflecting the continuous influx of new firms, products and technologies into the economy. Despite impressive progress in enabling competitive markets, pro-crony has destroyed value in the economy. For example, an equity index of connected firms significantly outperformed the market by 7 per cent a year from 2007 to 2010, reflecting abnormal profits extracted at common citizens’ expense. In contrast, the index underperforms the market by 7.5 per cent from 2011, reflecting the inefficiency and value destruction inherent in such firms. Pro-crony policies as reflected in discretionary allocation of natural resources till 2011 led to rent-seeking by beneficiaries while competitive allocation of the same resources post 2014 have put an end to such rent extraction. Similarly crony lending that led to wilful default, wherein promoters have collectively siphoned off wealth from banks, led to losses that dwarf subsidies directed towards rural development. PRO-BUSINESS, CREATIVE we can clearly see an increase in market dynamism in the pro-business India of the DESTRUCTION AND WEALTH post-liberalization period. Figure 1 reveals that after the market reforms of 1991, Sensex CREATION has not only grown, but has grown at an accelerating pace. Whereas crossing the first 3.1 The liberalization of the Indian incremental 5000 points took over 13 years economy in 1991 unleashed competitive and was achieved in 1999, the time taken markets. It enabled the forces of creative to achieve each incremental milestone has destruction, generating benefits that we still substantially reduced over the years. witness today. Using the lens of Indian equity markets as captured in the S&P BSE Sensex,

44 Economic Survey 2019-20 Volume 1 3.2 Broadly, the growth of the Sensex as revival in response to structural reforms and seen in the Figure 1 can be divided into three improvement in global liquidity. Strikingly, in phases after 1999. Phase I from 1999 to 2007 this phase, the Sensex jumped from the 30,000 saw an acceleration in the growth of the Sensex, mark to the 40,000 mark in just two years. with each successive 5000-point mark taking As the Cumulative Abnormal Growth Rates lesser and lesser time to achieve. Phase II from (CAGR) shown in the chart depict clearly, 2007 to 2014 saw a slowdown in the index’s the acceleration in the Sensex was not due to growth. This phase coincides with the global the base effect. In fact, the higher acceleration slowdown in 2008 among other unfavourable stemmed from higher CAGR. events. Phase III began in 2014 and saw a Figure 1: Sensex- Incremental months taken to cross each 5000-point milestone 180 Phase I Phase II Phase III 100% Oct '99 Slowdown Revival 90% Accelerated growth 160 No. of months140 Jun '14 80% CAGR12070% 100 Feb '06 60% 80 50% 60 Apr '17 40% 40 30% 20 Jul '07 Jun '19 20% 10% 0 Dec '07 Jan '18 0% 5000 10000 15000 20000 25000 30000 35000 40000 Sensex milestones (points) Months since last milestone CAGR from previous milestone Source: BSE Note: Time to cross each milestone is defined as the time elapsed between the first time the Sensex closed at the previous milestone and the first time it closed at the present milestone. CAGR is computed over the period from the previous milestone to the current one. Time elapsed is recorded as number of calendar days and converted to months assuming 30 days a month. 3.3 The relationship between pro- the index during its inception in 1986, nearly business policy and creative destruction is all the firms were retained for the majority mirrored in the composition of the Sensex of the next decade. On the other hand, the over the years.1 For the first ten years since constituents of the Sensex of 1997 were the Sensex’s inception in 1986, the firms steadily churned out over the next decade, so that constituted the index barely changed. As that the Sensex of 2006 had barely half the Figure 2 shows, of the firms that constituted firms from the Sensex of 1997. ____________________________________________ 1 Data gathered from BSE and Bloomberg. Full market capitalization is used rather than free-float capitalization for comparability over time, as free-float methodology was initiated only in 2003. Sensex constituents and market capitalization data were obtained from BSE for 1985-2000. Data is available from BSE on the following dates of observation: Dec ‘91, Jun ‘92, Jun ‘93, Nov ‘94, Mar ‘95, Mar ‘96, Mar ‘97, Jun ‘98, Mar ‘99, Mar ‘00. Data for subsequent years obtained from Bloomberg with Sept of each corresponding year as the month of observation, basis the latest available data as of this writing (data for 2019 is as of 3 Sept 2019).

Pro-Business versus Pro-Crony 45 Figure 2: Percentage of Sensex constituents retained over next decade 100% 90% 80% 70% 60% 50% 40% t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t Constituents retained from 1986 Sensex Constituents retained from 1997 Sensex Source: Bloomberg, BSE Note: Due to slight discrepancy in the month of observation before and after 2001 (due to distinct data sources), consider individual annual churn rates for 2000-02 as approximate; however the aggregated churn over these years is accurate. 3.4 The lack of dynamism in the Ten firms were churned out in the five years constitution of the index in its initial years from 2006 to 2010, eight in 2011-15 and ten was largely representative of the lack in 2016-19. Put differently, every five years, of dynamism in the Indian economy in roughly one-third of the firms in the index are general. However, the years following 1991 replaced. liberalization saw the rapid emergence of new firms, new ideas, new technologies and new 3.6 The figure also indicates the average operating processes, causing a steep revision duration a Sensex constituent remains on of the Sensex in 1996. In 1996, half of the the index. Given that only 5 firms exited the constituents of the index were replaced. After index in the ten-year period 1986-95, had 1996, the Sensex underwent more frequent liberalization not occurred, a firm that entered revisions, owing to the more dynamic nature the index in 1986 could have expected to stay of the now substantially more competitive on the index for the next sixty years! Following Indian market. the 1991 reforms, the average duration a firm spent on the index declined drastically. 3.5 Figure 3 shows the number of firms Currently, a firm is expected to remain on that exited the Sensex in each five-year period the index for only 12 years – one-fifth of the following 1986. Pro-business policy, i.e., expected duration prior to the reforms. liberalization caused a spike in the number of firms churned in the years that immediately 3.7 A pertinent question that arises at followed it, but the churn rate did not decline this stage is whether the churn illustrated to pre-liberalization levels in later years. above was beneficial to the Indian economy.

46 Economic Survey 2019-20 Volume 1 Figure 3: Increasing churn in the Sensex 25 70 60 20 50 15 40 10 30 20 5 10 00 1986-90 1991-95 1996-2000 2001-05 2006-10 2011-15 2016-19 Number of companies Number of years Number of companies that exited the index Average duration spent on the Sensex Source: Bloomberg, BSE Note: Average time spent on Sensex is calculated as the reciprocal of the churn rate in that period. Because of the very low churn in the first two periods, the total churn rate during 1986-95 is used to infer the time spent on the Sensex for these two periods. A monopolist taking the place of another that displaced the incumbents on the Sensex identical monopolist is hardly beneficial. brought with them new ideas, technologies However, in the Indian case, the Sensex does and processes. For an illustration, consider represent a process of creative destruction Table 1 that depicts the major Sensex rather than spurious dynamism. The firms revision of 1996 following market reforms. Table 1: Revision of the constituents of the Sensex index in 1996 Firm Exit Firm Replacement Industry Industry (new in bold) Arvind Mills Consumer Durables & Ballarpur Industries Materials Apparel Bajaj Auto Bharat Forge Materials Ambuja Automobiles & Components Cements GSFC Materials ICICI Materials MTNL Indian Organic Materials Diversified Financials Mukand Iron Telecommunication Services Bombay Dyeing Materials BHEL Capital Goods Century Textiles Consumer Durables & Colgate Apparel Household & Personal Products Consumer Durables & Apparel

Pro-Business versus Pro-Crony 47 Indian Rayon Consumer Durables & IDBI Diversified Financials Apparel Phillips Consumer Durables & Ranbaxy Labs Pharma, Biotech & Life Apparel Sciences Voltas Consumer Durables & Tata Materials Apparel Chemicals Ceat Automobiles & BSES Utilities Components Hindustan Motors Automobiles & HPCL Energy Components Premier Auto Automobiles & SBI Banks Components Kirloskar Cummins Capital Goods IPCL Materials Siemens Pharma, Biotech & Life SAIL Materials Sciences Source: BSE, Bloomberg. Note: Highlighted cells represent new sectors that entered the index for the first time. New sectors like banks and financials entered was witnessing in the wake of liberalization. the index for the first time, eroding the predominance of the manufacturing sector on 3.8 Figure 4 depicts the size of various the index, placing the services sector on the sectors in the Sensex by market capitalization map for the first time, and reflecting the far- over time. Financials and information reaching changes that the Indian economy technology, which were virtually non- existent in the Sensex of the early 1990s, Figure 4: New sectors emerged in the Sensex following liberalization Market capitalization (full) of Sensex₹80,000 Real Estate Billions₹70,000 Health Care ₹60,000 Communication Services 2001₹50,000 Industrials 2002₹40,000 Utilities 2003₹30,000 Materials 2004₹20,000 Consumer Discretionary 2005₹10,000 Consumer Staples 2006 Energy 2007₹0 Information Technology 2008 Financials 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: Bloomberg, BSE

48 Economic Survey 2019-20 Volume 1 are responsible for more than 50 per cent of The initial Sensex of 1986 was dominated by the market share of the Sensex today. It is the Materials and Consumer Discretionary therefore incontrovertible that the churn in sectors, accounting for two-thirds of the the Sensex represents a very real process of firms on the Sensex. Sectors like financials, creative destruction that brought altogether telecommunications and information new technologies, products and services to technology were non-existent in the index consumers. then. With the entry of these new sectors, today’s Sensex is far less concentrated than 3.9 The diversity of sectors in the Sensex the Sensex of the 1980s and 1990s, and steadily increased over time following mirrors the far lower sectoral concentration market reforms, as shown in Figure 5 below. of the Indian economy as a whole. Figure 5: Sectoral concentration of the Sensex decreased post-liberalization as new sectors emerged Percentage of firms in specific sectors 100% 90% Utilities 80% Real Estate 70% Materials 60% Information Technology 50% Industrials Health Care 40% Financials 30% Energy 20% Consumer Staples 10% Consumer Discretionary Communication Services 0% 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Source: Bloomberg, BSE 3.10 India has followed an idiosyncratic status today. growth pattern, wherein the prime mover of the economy has shifted from agriculture 3.11 Today’s Sensex is not only composed to services. Almost 60 per cent of Indian of a larger number of sectors, but is also GDP is attributable to the services sector. As far more democratic in terms of the size of shown by Figure 6, the number of Sensex companies. In 1991, the largest firm on the firms in manufacturing has reduced while index was roughly 100 times the smallest those in services has increased between 1988 in terms of market capitalization. Ten years and 2019. Thus, over the years, the share later, the ratio declined to roughly 75. In of services sector in the total number of 2018, the ratio was only 12. The benefit of companies on the Sensex has changed from liberalizing markets does not end with a one- being negligible in the 1980s to the dominant time drop in the ratio and continues to be felt

Pro-Business versus Pro-Crony 49 even today, as indicated by the decreasing per cent of the market capitalization of the trend in the ratio in Figure 7. Similarly, while Sensex, the largest firm of 2019 contributed the largest firm of 1991 constituted around 20 only 13 per cent. Figure 6: The rise of services in the Sensex % manufacturing and service sector % manufacturing and service sector in firms on the Sensex market capitalization of Sensex 100% 3 16 100% 4% 55% 80% 27 14 80% 96% 45% 60% 60% 40% 40% 20% 20% 0% 2019 0% 2019 1991 1991 Manufacturing Services Manufacturing Services Source: Bloomberg, BSE Figure 7: Decreasing size concentration of firms in the Sensex Highest to lowest firm market Top firm market capitalization as capitalization ratio in Sensex proportion of Sensex full market 305 capitalization 255 25% 205 20% 155 15% 105 10% 55 5% 1991 1995 1999 2003 2007 2011 2015 2019 5 1991 1995 1999 2003 2007 2011 2015 2019 Source: Bloomberg, BSE Note: See earlier footnote about the dates on which market capitalization for each corresponding year is observed. Data for 2019 is as of 3 Sep 2019 3.12 The forces of creative destruction a cause for concern: a potential case of following liberalization in the Indian more concentration or a reversal in creative economy have led to the rise of new destruction in the economy. However, a sectors such as financials and information closer look reveals otherwise. technology. Virtually non-existent in the Sensex of the early 1990s, the share of these 3.13 Firstly, the rising share in market sectors in the total market capitalization has capitalization has been accomplished by a increased over the years, so much so that rise in number of companies rather than a these sectors dominate the Sensex today rise in size of incumbents, suggesting greater (Figure 8). At first glance, this trend indicates competition within these sectors (Figure 9).

50 Economic Survey 2019-20 Volume 1 Figure 8: Increasing Share of IT and Financials Sector in Total Market Capitalization of Sensex Sensex 2001 Sensex 2011 Sensex 2019 19% 31% 55% 81% 45% 69% IT & Financials Others IT and Financials Others IT and Financials Others Source: Bloomberg, BSE Figure 9: Increasing Share of IT and Financials Sector (By Count) in the Sensex Sensex 2001 Sensex 2011 Sensex 2019 20% 23% 43% 57% 80% 77% IT & Financials Others IT & Financials Others IT & Financials Others Source: Bloomberg, BSE 3.14 Secondly, using the Herfindahl Index entrenched firms is being rapidly challenged to analyse degree of competition within the by new, smaller and more agile firms; every two sectors reveals an overall decline in five years, roughly one in three firms in the concentration in both sectors. However, the Indian economy can expect to be challenged IT sector has recently begun to show a slight in a massive way by the forces of creative increasing trend in the Herfindahl index, destruction. Finally, the difference between indicating that there is room to increase the sizes of the largest and smallest firms competition in the sector (Figure 10). are rapidly shrinking, and consequently monopoly power in the economy is declining 3.15 Three key insights emerge from and making way for more competitive the analysis above. First, we can expect markets. Consumers benefit from an increased today’s dominant firms to remain dominant variety of goods and services, lower prices for only one-fifth of the time that their pre- and incessant improvement in the quality of liberalization counterparts did. Second, existing products. sectors once considered mainstays of the Indian economy are being displaced by new 3.16 “There is a common misconception sectors bringing with them new technologies that people who are in favour of a free market and products. The competitive advantage of are also in favour of everything that big

Pro-Business versus Pro-Crony 51 Herfindahl IndexFigure 10: Herfindahl Index of Financials and IT sectors 7000 6000 5000 4000 3000 2000 1000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Financials IT Source: Bloomberg, BSE business does. Nothing could be further from as a “process of industrial mutation that the truth,” wrote Milton Friedman (Friedman incessantly revolutionizes the economic 1999). Pro-crony policy supports incumbent structure from within, incessantly destroying firms but does not necessarily foster the old one, incessantly creating a new one.” competitive markets (Figure 11). On the other hand, policy that fosters competitive markets 3.17 Creative destruction brings new (hereafter pro-business policy) creates a level innovations into the market that serve playing field for businesses to compete. It people better than the old technologies they unleashes the powerful forces of creative displace. It brings new firms into the markets, destruction, which create wealth. Austrian which compete with existing firms and lower economist and creator of the term, Joseph prices for consumers. It brings dynamism Schumpeter, described creative destruction to the marketplace that keeps firms on their Figure 11: Difference between pro-business and pro-crony policy Pro-business •Firms compete on a level playing field •Resource allocation in the economy is efficient •Citizens' welfare is maximized Pro-crony •Some incumbent firms may receive preferential treatment •Resource allocation in the economy may not be efficient •Citizens' welfare may not be maximized

52 Economic Survey 2019-20 Volume 1 toes, always on the lookout for the next big 3.20 Ambit Pvt Ltd, a brokerage, publishes way to serve consumers. It has only one pre- a stock market index of 75 Indian firms that requisite – a pro-business policy stance that they define as “connected”. For our purposes, fosters competitive, unfettered markets. they proxy firms that may benefit from pro- crony policies. Figure 12 compares the 3.18 When creative destruction is fostered, performance of this index to the BSE 500 sectors as a whole will always outperform index over time. individual companies within the sector in creating wealth and maximizing welfare. 3.21 Prior to 2010, it clearly paid a firm Therein lies the motivation for India to pursue and its shareholders if the firm’s promoters pro-business, rather than pro-crony, growth. had “connections”. The index of “connected” firms consistently outperformed the BSE PRO-CRONY AND WEALTH 500 index as these firms systematically DESTRUCTION made more profits than would have been possible in a more competitive economy. 3.19 Pro-crony policies, in contrast to pro- The market priced the current and future business ones, erode wealth in the economy as abnormal profits of these firms. In late 2010, cronyism fosters inefficiencies by inhibiting the Comptroller and Auditor General’s audit the process of creative destruction. Raghuram report on the 2G spectrum allocation named a Rajan and Luigi Zingales stressed the need list of private companies that benefitted from for “saving capitalism from the capitalists” alleged collusions in the allocation of the 2G in their eponymous book, referring to the spectrum. The timing of the report’s release dangers of regulatory capture by private is demarcated on the chart with a vertical interests (Rajan and Zingales 2003). line. Figure 12: Investor wealth generated by connected firms before and after CAG report on the 2G scam 295 245 CAG Report on 2G spectrum 195 145 95 45 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Connected Companies Index BSE500 Index Source: Ambit Capital research, Capitaline, BSE Note: 1) The connected companies index is an aggregate market cap index which has been rebased and is adjusted for demergers, 2) 70 companies with political dependence and connectivity as on Dec’06 as per Ambit analysts.

Pro-Business versus Pro-Crony 53 3.22 The CAG report on the 2G allocations a year on average till 2010. Put differently, appears to have reversed the fortunes for from 2007 to 2010, “connected” firms “connected” firms. The “connected” index realized 7 percentage points higher returns started to underperform the market starting than they would have in a more competitive 2011. In fact, the gap for the investor wealth market. destroyed by “connected” firms is widening over time, which reflects the inability of 3.24 This pre-2010 outperformance of such firms to systematically create value “connected” firms indicates the possible for their investors from extracting rents extent of rents extracted by these firms at based on their political connections (Kishore society’s expense. In contrast, the significant 2016). post-2010 underperformance – following the release of the CAG report – illustrates 3.23 Had an investor invested ` 100 in the fact that such “connected” firms were these “connected” firms at the start 2007, her likely to have been inefficient ones. Between investment would have grown to ` 190 by 2007 and 2016, “connected” firms have the start of 2010. On the other hand, had she earned, on average, 7.5 percentage points invested ` 100 in the BSE500, the investment lower returns than the BSE 500 index per would have grown to ` 150. The “connected” annum. This phenomenon of rent-seeking index yielded an average return of 17.5 per by inefficient, “connected” firms, though cent per annum during this period, whereas unhealthy to the economy, is not unique to the BSE 500 index yielded an average return India. In fact, several global studies reinforce of 10.5 per cent per annum. “Connected” the relationship between such connections firms thus outperformed the broad index and rent-seeking activities when institutional of the stock market by 7 percentage points checks and balances are weak (Box 1). Box 1: Global evidence that political connections lead to rent extraction Several studies from around the globe find that political connections lead to rent extraction. Faccio (2006) examines politically connected firms in 47 countries and finds that around the time that a firm announces that managers or large shareholders are entering politics, there is a positive impact on stock price. The result is consistent with the theory that markets anticipate additional sources of profit for the now politically connected firm despite no change in firm fundamentals. Faccio et al. (2006) study financial distress in politically connected firms in 35 countries and find that distressed politically connected firms are significantly more likely to be bailed out by the government than their non-connected counterparts. Claessens et al. (2008) show that Brazilian firms that provided contributions to (elected) federal deputies experienced higher stock returns than firms that did not make such contributions around the 1998 and 2002 elections. Further, contributing firms substantially increased their bank financing relative to a control group after each election, indicating that access to bank finance is an important channel through which political connections operate. They estimate the economic costs of this rent seeking over the two election cycles to be at least 0.2 per cent of gross domestic product per annum. A recent World Bank study of cronyism in Ukraine finds that the country would grow 1 to 2 per cent faster if all political connections were eliminated (Kahkonen 2018)! Politically connected firms in Ukraine account for over 20 per cent of the total turnover of all Ukrainian companies. The study finds that these politically connected firms (i) are larger than non-connected peers, (ii) pay lower

54 Economic Survey 2019-20 Volume 1 effective tax rates, (iii) are less productive in terms of total factor productivity (TFP), (iv) are less profitable, and (v) grow slower (World Bank 2018). Evidence from Asia China Firth et al. (2009) find that political connections play a role in the allocation of bank loans to Chinese firms. They find that having the state as a minority owner helps firms obtain bank credit. Political connections especially benefit firms located in areas with a less developed banking sector. Deng, Zeng & Zhu (2019) provide evidence that firms in China actively build political connections to alleviate the cost of market frictions. Firms facing severe market frictions are not as financially constrained as they would be expected to be; the key reason is that they possess strong political connections which alleviate these costs. Chan et al. (2012) find that politically connected firms in China display much lesser financing constraints compared to firms without such connections. Chen et al. (2017) find that politically connected underwriters increase the likelihood of clients’ IPO applications being approved by the Chinese Securities Regulatory Commission. Further, consistent with the rent-seeking argument, they document the post-IPO underperformance of such firms, indicating that minority shareholders’ interests may be compromised. Thailand Bunkanwanicha & Wiwattanakantang (2009) find in Thailand that when business owners come to political power, the market valuation of their firms increases dramatically. Business owners in top offices use their policy-decision powers to implement regulations and public policies favorable to their firms. Civilize et al. (2015) undertake a longitudinal study of firms in Thailand and conclude that higher realized stock returns are systematically associated with political connectedness. Consistent with the view that such a relationship provides economic rents, this finding is particularly prominent in more regulated industries. The politically connected premium is higher for higher level political connections and when the political bodies hold an equity stake in the firm. Indonesia Fisman (2001) estimates the value of political connections in Indonesia by looking at how stock prices of firms with differing degrees of political exposure moved when former President Suharto’s health was reported to change. Adverse health reports led politically connected firms to realize lower returns than less dependent firms. Malaysia Johnson & Mitton (2003) find that the imposition of capital controls in Malaysia in 1998 primarily benefitted firms with strong ties to the President, suggesting that capital controls provided a screen behind which firms with political ties leveraged their connections for favours. A study of Malaysian politically connected firms finds that such firms are perceived as being higher risk by the market, audit firms and lenders. Such firms have higher likelihoods of reporting a loss, having negative equity, and being charged higher interest rates by lenders (Bliss and Gul 2012). Vietnam Rand (2017) examines over 2000 Vietnamese SMEs over a 10-year period and finds that political connections decrease the likelihood of a firm being credit-constrained by 4 percentage points. Further, politically connected firms accessing credit face lower cost-of-capital than non-connected SMEs not excluded from formal financial markets. These studies unanimously document a myriad of benefits enjoyed by politically connected firms. These benefits represent direct and indirect forms of rent unduly enjoyed by the connected firm’s shareholders at the expense of unconnected firms and society at large.

Pro-Business versus Pro-Crony 55 3.25 Pro-crony, when compared to pro- DISCRETIONARY ALLOCATION business, policies can create various indirect OF NATURAL RESOURCES costs as well. When opportunities for crony VIS-À-VIS ALLOCATION VIA rent-seeking exist, firms shift their focus AUCTIONS away from growth through competition and innovation towards building political 3.26 In this section, we consider a case relationships, thus undermining the economy’s study from the natural resource allocation capacity for wealth creation (see Box 2). process in India. India has the fifth largest Further, the rents sought by cronies are paid coal reserves in the world behind USA, for by genuine businesses and citizens who Russia, China, and Australia. Coal is the are not receiving any preferential treatment. most important indigenous source of energy Such a transfer of wealth exacerbates income for India; it meets more than half of India’s inequality in the economy, as crony firms energy requirements. Therefore, allocation of leverage their connections to extract a larger such an important natural resource provides share of existing wealth instead of expanding us a nice case study to contrast pro-business the available wealth. and pro-crony policies. Box 2: Political clout and preferential allocation of contracts (2001-13): A case study of road construction in India Many businesses in India use their political clout to obtain preferential allocation of projects and resources from the government. Lehne, Shapiro & Eynde (2016) examine bidding data on more than 88,000 rural roads built under the Pradhan Mantri Gram Sadak Yojana (PMGSY) and juxtapose this data with election results. Using a large sample spanning 8116 candidates in 4058 elections from 2001 to 2013 and employing a regression discontinuity design, the study finds that after close election victories, contractors affiliated to the winning politician are more likely to be awarded road projects. Figure below depicts this result graphically, plotting the change in the share of contractors who have the same name as the winning politician against the politician’s margin of victory in the election. After close election victories, the share of road construction contractors who appear affiliated to the winning politician increases Source: Lehne, Shapiro & Eynde (2016)

56 Economic Survey 2019-20 Volume 1 Further, the authors use Census 2011 data at the village level to check whether roads listed as completed in the PMGSY monitoring data are also captured in the Census data. Several roads recorded as complete in PMGSY monitoring data are missing from the Census, suggesting that these roads were never actually built or completed. Around 26 per cent of roads listed as completed prior to the census in PMGSY data are missing from the 2011 Census data. Preferential allocation of roads increases the likelihood of such “missing” roads by as much as 86 per cent. The figure below depicts this dramatic effect. After close election victories, the share of missing all-weather roads increases when the contractor appears affiliated to the winning politician Source: Lehne, Shapiro & Eynde (2016) The authors find that preferential allocation accounts for an additional 497 missing all- weather roads that would have served roughly 860,000 people. Clearly, PMGSY contracts that seem to have been politically influenced lead to suboptimal economic outcomes. 3.27 Prior to 1993, no specific criteria of the processes adopted in allocation of for the allocation of captive mines existed. coal blocks.2 On 24 September 2014, the Amendments introduced to the Coal Mines Supreme Court of India cancelled 214 of the (Nationalisation) Act 1973 in June 1993 218 allocations made by the Government allowed private companies to carry out of India over a span of 15 years.3 The Coal coal mining for captive use. In July 1992, Mines (Special Provisions) Bill, 2014, and its a screening committee was set up under subsequent rules, were passed in December the chairmanship of the Secretary of Coal 2014, and the Coal Mines (Special Provisions) to consider applications made by various Act, 2015, was included in the Indian mining companies interested in captive mining and legislative framework. The Act ensured that to allocate coal blocks for development. In August 2012, the CAG report on coal any future allocation of coal blocks would block allocations examined the effectiveness solely be through competitive auctions. ________________________________________________ 2 The report can be found here: https://www.cag.gov.in/sites/default/files/audit_report_files/Union_Performance_Commercial_Allocation_Coal_Blocks_and_Production_ Ministry_Coal_7_2012.pdf. 3 Manohar Lal Sharma vs. The Principal Secretary & Ors., Writ Petition No. 120 of 1012. A copy of the order can be accessed here: http:// www.prsindia.org/uploads/media/Coal%20Mines/SC%20order.pdf.

Pro-Business versus Pro-Crony 57 Use of Related Party Transactions in equipment from related parties are classified Discretionary Allotment of Natural as “Capital Purchases”. Capital purchases Resources offer an ideal mechanism to transfer wealth because they are large one-time non-recurring 3.28 Abraham, Chopra, Subramanian & cash outflows that can serve as an opportune Tantri (2018) find evidence that the form of mask to hide transactions from regulators. coal block allocation has an impact on the Second, operational expenses paid to related value of Related Party Transactions (RPTs) parties are classified as “Revenue expenses.” engaged in by firms that are beneficiaries of Third, operational income from related the coal block allocation. Comparing the RPTs parties are classified as “Revenue income.” in the 3-year period post the allotment against These three RPTs show a marked increase in the 3-year period prior to the allotment, they the three-year period following the receipt find significant differences between the rupee of a coal block through the committee-based value of RPTs undertaken by beneficiaries allocation as compared to the preceding three of the committee-based allotment versus years. No such increase is seen in the case the beneficiaries of the competition-based of auction-based allotment. The other three allotment. main types of RPTs – Capital Sales, Loans and advances given and taken do not show 3.29 Figure 13 graphically depicts the any particular increase in the case of the comparison for RPTs under three heads. First, committee-based allocation. RPTs used for purchasing capital goods/ Figure 13: Impact of coal block allocations on Related Party Transactions Source: Abraham, Chopra, Subramanian & Tantri (2018)

58 Economic Survey 2019-20 Volume 1 firm behaviour is nearly identical to the earlier figures, with capital purchases, revenue RPTs to unlisted/foreign entities and expenses and revenue income showing a tax havens remarkable increase post the receipt of the coal block in the committee-based allotment 3.30 Figure 14 shows RPTs with unlisted/ process, while no such increase is seen foreign entities and related parties that are following competitive auctions. based out of internationally recognised tax havens. Unlisted/foreign entities are either Director compensation and consulting individuals or unlisted domestic enterprises expenses or enterprises incorporated in a foreign jurisdiction. As such entities are harder for 3.31 The authors also find evidence the domestic enforcement authorities to that one-time payments to directors like track, RPTs with such entities are likely to commissions, perquisites and consulting manifest for purposes of opacity. Similarly, expenses increase following the discretionary tax havens are charaterised by opaque allocation. Director commissions increase disclosure regulations and hence serve as an by 12 per cent, director perquisites by 5.7 ideal sink to tunnel corporate wealth away per cent and other consulting expenses by from other stakeholders. As the figure shows, Figure 14 : RPTs to Unlisted/Foreign counterparties and tax havens Source: Abraham, Chopra, Subramanian & Tantri (2018)

Pro-Business versus Pro-Crony 59 7.6 per cent. We find no increase in the case the committee-based allocation from 1993 of salary expenses for normal employees to 2011. There has been a steady decline in suggesting that only the directors benefit post the market share of these firms despite them the discretionary allocation. In the case of getting a windfall gain from the discretionary auctions, we see no such increases. In fact, allocation. The gain of an almost free resource we find that director salaries decrease post should have aided firm productivity and the auction-based allotment. business fundamentals. Instead the market share has fallen over the years - suggesting Firm productivity and performance a case of Dutch disease – firms that got the free resource diverted efforts towards the 3.32 Figure 15 shows the evolution of the tunnelling of the windfall gain instead of average market share of firms that received towards productive business activity. Figure 15: Market share of allottee firms (committee-based allocation) 25 Average Market Share (%) 20 15 10 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Source: Abraham, Chopra, Subramanian & Tantri (2018) 3.33 Indeed, the authors find that total and Plant and Machinery reduces by 51.1 per income declines by 54.9 per cent over a cent. They find no such decline in the case of 3-year period from the date of allocation as competitive auctions. compared to firms that did not receive an allocation, total expenses reduce by 58.7 3.34 Overall, the evidence suggests that per cent and PAT by 37.8 per cent. There discretionary allocation of natural resources also seems to be a loss of productive assets by a committee provides avenues for rent- - total assets reduce by 76.2 per cent and seeking. Subsequently, firm owners divert Land and Building reduces by 48.2 per cent their focus towards tunnelling away these rents rather than furthering productive

60 Economic Survey 2019-20 Volume 1 economic activities. A shift to market-based regulators and state coffers. allocation of resources takes these avenues away, encourages productive economic 3.36 The RBI defines wilful defaulter activity and generates more wealth. as a firm that has defaulted in meeting its repayment obligations even though it has the Riskless Returns: The Case of Wilful capacity to honour these obligations. A firm Default could also be branded a wilful defaulter if it uses the funds for purposes other than what is 3.35 Although the primary tenet of any sanctioned by the lender, siphons the money investment is that high expected rewards out to related parties or removes the assets come with high risk, many Indian firms have used to secure the loan. found a peculiar way to reap rewards without commensurate risk. Many firms enjoy profits 3.37 Every rupee lent to a wilful defaulter in good times but often rely on the state constitutes an erosion of wealth. Money lent or their financiers to bail them out in bad to a genuine business creates assets, which times. A particularly egregious form of such generate profit and employment. On the riskless return is the phenomenon of wilful other hand, money lent to a firm that has no default – a classic case of a one-way gamble intention of investing the proceeds in ex-ante in which “heads, the promoter wins; tails, profitable projects is money wasted. Besides the lender loses”. Wilful default occurs when making cronies rich, it contributes nothing to firms take loans, divert the proceeds out of the economy. the firm for the personal benefit of owners, default on loans and declare bankruptcy, 3.38 Figure 16 and Figure 17 show the thereby expropriating a range of stakeholders wealth that wilful defaulters have taken out – lenders, minority shareholders, employees, of the Indian economy. As of 2018, wilful Figure 16: Aggregate outstanding amount owed by wilful defaulters (` crores) 1,40,000 2002 1,20,000 2003 1,00,000 2004 2005 80,000 2006 60,000 2007 40,000 2008 20,000 2009 2010 0 2011 2012 2013 2014 2015 2016 2017 2018 Source: TransUnion CIBIL Suits Filed database

Pro-Business versus Pro-Crony 61 defaulters owed their respective lenders Figure 18, which compares the amount owed nearly `1.4 lakh crores. The number has by wilful defaulters in 2018 with the Union been steadily rising since the early part of budget allocations towards citizen welfare in the current decade. The defaulters are spread the same year. Had the money siphoned away across several sectors, with manufacturing by wilful defaulters stayed in the economy, firms constituting the largest share. the resulting wealth would have been equivalent in value to that needed to double 3.39 To put in perspective the quantum of the allocation towards health, education wealth eroded by wilful defaulters, consider Figure 17: Split of aggregate outstanding amounts of wilful defaulters by sector 100% Utilities 90% Miscellaneous 80% Diversified 70% Information Technology 60% Communication Services 50% Health Care 40% Industrials 30% Consumer Staples 20% Financials 10% Materials 0% Consumer Discretionary 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: TransUnion CIBIL Suits Filed database, CMIE Prowess database Figure 18: Wealth destroyed by wilful defaulters in comparison to Union BudgetAllocations Thousands of Crores ₹180 136 138 149 169 ₹160 115 ₹140 Railway Food subsidy ₹120 55 70 Rural Willful Health, capex ₹100 MGNREGA Fertilizer ₹80 subsidy ₹60 ₹40 ₹20 ₹0 development defaulters education and outstanding social protection Source: TransUnion CIBIL Suits Filed database, Union budget reports

62 Economic Survey 2019-20 Volume 1 annual report as legally required in India, barely 40 per cent of wilful defaulters do. and social protection, double the allocation towards rural development, or triple the 3.41 Second, promoters at the helm of allocation towards MGNREGA. wilfully defaulting firms pledge, on average, almost 50 per cent of their shareholding to 3.40 Figure 19 depicts three distinguishing lenders. In contrast, the corresponding figures characteristics of wilful defaulters in India. for distress defaulters and non-defaulters First, wilful defaulters tend to be more are 30 per cent and 11 per cent respectively. opaque than both non-defaulters and firms While the pledging of shares prevails in that default out of genuine distress (hereafter advanced economies also, it has taken a distress defaulters). Whereas roughly 60 per peculiar form in India. Promoters, especially cent of non-defaulters and distress-defaulters provide related party disclosures in their Figure 19: Wilful defaulters tend to be opaque about their RPTs, pledge substantial proportions of promoter shares, and advance large loans to related parties Panel A: Comparing Wilful Defaulters and Non-Defaulters Panel B: Comparing Wilful Defaulters and Distress Defaulters Source: CMIE Prowess, TransUnion CIBIL Suits Filed database. Note: A firm is said to have made an RPT disclosure if its annual filing contains an RPT section (even if the firm states it had no transactions that year). Net outstanding loans refers to the total balance of loans given by firms to their related parties, net of loans taken from them. It is expressed as a percentage of the firm’s total assets. Wilful defaulters are those classified as such in the CIBIL Suits Filed database, while distress defaulters are those with a default credit rating at least once in the sample period but those who have not been classified as ‘wilful defaulters’. Non-defaulters are all other firms. Data spans 2002-18

Pro-Business versus Pro-Crony 63 those of wilful defaulter firms, pledge shares initiatives aim to redistribute wealth from the to obtain financing not for external ventures rich to the poor, wilful default achieves the or personal endeavours but for the firm’s opposite. Rich businesses that want to get own projects. Such a practice is suboptimal richer use wilful default as an instrument to for lenders as the value of collateral used to redistribute wealth away from the poor. secure loans should not correlate with the value of the project being funded. When 3.44 Not only that, wilful default if a firm is in distress, the value of pledged unchecked would increase the cost of shares falls. Precisely when it is required to, borrowing for everyone else, including the collateral stops serving its purpose. As genuine businesses with profitable investment promoters have no personal liability beyond opportunities before them. In fact, at high their pledged shares, they care little when the enough credit spreads, adverse selection may pledged shares fall in value as any reduction force genuine borrowers to exit the market in their wealth is offset by rents they have altogether, leaving only cronies in the market already extracted. In many cases, promoters and resulting in a market failure that slows are unconcerned about losing control of the economic growth, employment and wealth company as they may have already siphoned creation capacity. out the extracted rents before the share price collapse. CONCLUSION 3.42 Third, wilful defaulters make large 3.45 While pro-business policies increase loans to related parties. The outstanding competition, correct market failures, or balance of loans given to related parties enforce business accountability, pro-crony for distress defaulters and non-defaulters is policies hurt markets. Such policies may negative, meaning that the average firm in the promote narrow business interests and may sample is a net recipient of loans from related hurt social welfare because what crony parties. Wilful defaulters, on the other hand, businesses may want may be at odds with the are net givers of loans. Peculiarly, they are net same. For example, crony businesses may recipients of external loans and defaulters on lobby the government to limit competition in these loans at the same time that they are net their industry, restrict imports of competing givers of loans to their related parties. This is goods or reduce regulatory oversight. These consistent with a theory of issuing debt only initiatives enhance the lobbying group’s to siphon the proceeds out of the firm for the income but undermine markets and reduce personal benefit of owners and their cronies. aggregate welfare. Thus, pro-crony policy can inadvertently end up being hurtful to 3.43 The cost of such wilful default is businesses in general. borne by the common man. Public sector banks get their equity from taxes paid by 3.46 Pro-business policies, for example, the common man. They get their debt from those that make it easy to start a business, deposits made by the common man. When register property, enforce contracts, obtain unscrupulous firms willfully default, it is the credit, bid for natural resources, get permits, common man who loses. While most policy and resolve insolvency help firms to function effectively and thereby enable competitive

64 Economic Survey 2019-20 Volume 1 markets. Making it easy to do business in alone without regard for other businesses and a jurisdiction furthers the eventual goal of the remaining stakeholders in the economy maximizing social welfare. Reforms aimed may end up benefitting the preferentially in this direction must continue. However, treated firms at the expense of other firms, catering to the needs of crony businesses market efficiency and social welfare. CHAPTER AT A GLANCE  India’s aspiration to become a $5 trillion economy depends critically on promoting “pro- business” policy that unleashes the power of competitive markets to generate wealth, on the one hand, and weaning away from “pro-crony” policy that may favour specific private interests, especially powerful incumbents, on the other hand. Economic events since 1991 provide powerful evidence supporting this crucial distinction.  Viewed from the lens of the Stock market, which captures the pulse of any economy, creative destruction has increased significantly after reform. Before liberalisation, a Sensex firm expected to stay in it for 60 years, which decreased to only 12 years after liberalisation. Every five years, one-third of Sensex firms are churned out, reflecting the continuous influx of new firms, products and technologies into the economy.  Despite impressive progress in enabling competitive markets, pro-crony policies has destroyed value in the economy. For example, an equity index of connected firms significantly outperformed the market by 7 per cent a year from 2007 to 2010, reflecting abnormal profits extracted at common citizens’ expense. In contrast, the index underperforms the market by 7.5 per cent from 2011, reflecting the inefficiency and value destruction inherent in such firms.  Pro-crony policies as reflected in discretionary allocation of natural resources till 2011 led to rent-seeking by beneficiaries while competitive allocation of the same resources post 2014 have put an end to such rent extraction. Similarly crony lending that led to wilful default, wherein promoters have collectively siphoned off wealth from banks, led to losses that dwarf subsidies directed towards rural development. REFERENCES Bertrand, Marianne, Paras Mehta, and Sendhil Mullainathan. 2002. “Ferreting Abraham, Jefferson Kaduvinal, Yakshup Out Tunneling: An Application to Indian Chopra, Krishnamurthy Subramanian, and Business Groups.” The Quarterly Journal of Prasanna Tantri. 2019. “Natural resource Economics 117 (1): 121-148. curse as applied to firms: Evidence from India.” Working Paper. Bliss, Mark A., and Ferdinand A. Gul. 2012. “Political connection and cost of debt: Some B.S., Sunil. 2014. “India’s stock market just Malaysian evidence.” Journal of Banking & confirmed: It really pays to have political Finance 1520-1527. connections.” Quartz India, 19 June. Bunkanwanicha, Pramuan, and Yupana Bae, Kee-Hong, Jun-Koo Kang, and Jin- Wiwattanakantang. 2009. “Big Business Mo Kim. 2002. “Tunneling or value added? Owners in Politics.” The Review of Financial evidence from mergers by korean business Studies 22 (6): 2133–2168. groups.” The journal of finance.

Pro-Business versus Pro-Crony 65 Chan, Kenneth S., Vinh Q.T. Dang, and Isabel Friedman, Milton. 1999. “Policy Forum: K.M. Yan. 2012. “Chinese firms’ political “Milton Friedman on business suicide”.” connection, ownership, and financing CATO Institute. 1 March. https://www.cato. constraints.” Economics Letters 164-167. org/policy-report/marchapril-1999/policy- forum-milton-friedman-business-suicide. Chen, Donghua, Yuyan Guan, Tianyu Zhang, and Gang Zhao. 2017. “Political connection IIFL Wealth. 2019. IIFL Wealth-Hurun India of financial intermediaries: Evidence from Rich List: Here are India’s richest in 2019; China’s IPO market.” Journal of Banking Mukesh Ambani tops charts 8th year in a row. and Finance 15-31. 25 September. Accessed December 15, 2019. https://www.iiflwealth.com/newsroom/ Cheung, Yan-Leung, P Raghavendra Rau, and in_the_news/iifl-wealth-hurun-india-rich- Aris Stouraitis. 2006. “Tunneling, propping, list-here-are-indias-richest-2019-mukesh- and expropriation: evidence from connected ambani. party transactions in hong kong.” Journal of Financial Economics. Johnson, Simon, and Todd Mitton. 2003. “Cronyism and capital controls:evidence Civilize, Sireethorn, Udomsak Wongchoti, and from Malaysia.” Journal of Financial Martin Young. 2015. “Political Connection Economics 351-382. and Stock Returns: A Longitudinal Study.” The Financial Review 89-119. Kahkonen, Satu. 2018. What Is the Cost of Crony Capitalism for Ukraine? 15 March. Claessens, Stijn, Erik Feijen, and Luc Laeven. https://www.worldbank.org/en/news/ 2008. “Political connections and preferential opinion/2018/03/15/what-is-the-cost-of- access to finance: The role of campaign crony-capitalism-for-ukraine. contributions.” Journal of Financial Economics 554–580. Kant, Krishna. 2016. 1991 to 2016: How the Sensex has transformed in 25 years. 27 July. Deng, Kebin, Haijian Zeng, and Yushu Zhu. Accessed November 5, 2019. https://www. 2019. “Political connection, market frictions rediff.com/business/report/how-the-sensex- and financial constraints: evidence from has-transformed-in-25-years/20160727.htm. China.” Accounting & Finance 2377–2414. Khanna, Tarun, and Yishay Yafeh. 2007. Faccio, Mara. 2006. “Politically Connected “Business groups in emerging markets: Firms.” The American Economic Review 96 Paragons or parasites.” Journal of Economic (1): 369-386. literature. Faccio, Mara, Ronald W. Masulis, and John Kishore, Roshan. 2016. “Does black money J. McConnell. 2006. “Political Connections boost economic growth?” Livemint, 18 and Corporate Bailouts.” The Journal of November. Finance 2597-2635. Lehne, Jonathan, Jacob N. Shapiro, and Oliver Firth, Michael, Chen Lin, Ping Liu, and Vanden Eynde. 2018. “Building connections: Sonia M.L. Wong. 2009. “Inside the black Political corruption and road construction in box: Bank credit allocation in China’s private India.” Journal of Development Economics sector.” Journal of Banking & Finance 1144- 62-78. 1155. Onder, Zeynep, and Süheyla Ozyildirim. Fisman, Raymond. 2001. “Estimating 2011. “Political Connection, Bank Credits the Value of Political Connections.” The and Growth: Evidence from Turkey.” The American Economic Review 1095-1102. World Economy 1042-1065.

66 Economic Survey 2019-20 Volume 1 Rand, John. 2017. “Are politically connected firms less constrained in credit markets?” Rajan, Raghuram G., and Luigi Zingales. UNU-WIDER Working Paper 2017/200. 2003. Saving Capitalism from the Capitalists. New Jersey: Princeton University Press. Romer, Paul M. 2000. “Should the Government Subsidize Supply or Demand Rajan, Raghuram. 2014. Saving Credit (Talk in the Market for Scientists and Engineers?” by Dr. Raghuram G. Rajan, Governor, Reserve NBER Working Paper Series. Bank of India at the Third Dr. Verghese Kurien Memorial Lecture at IRMA, Anand on World Bank. 2018. Crony Capitalism in November 25, 2014). 25 November. https:// Ukraine: Impact on Economic Outcomes. www.rbi.org.in/scripts/BS_SpeechesView. Washington, D.C.: World Bank Group. aspx?Id=929.

Undermining Markets: When 04 Government Intervention Hurts More Than It Helps CHAPTER {k.k'k% d.k'k'pSo fo|ke~ vFkZa p lk/;sr~A {k.ks u\"Vs dqrks fo|k d.ks u\"Vs dqrks /ue~AA Every moment one should learn, from every bit one should earn. If you waste a second you can’t get knowledge and if you waste a bit u can’t get money. Government intervention, sometimes though well intended, often ends up undermining the ability of the markets to support wealth creation and leads to outcomes opposite to those intended. This chapter analyses four examples of anachronistic government interventions, though many more abound. First, frequent and unpredictable imposition of blanket stock limits on commodities under Essential Commodities Act (ECA) neither brings down prices nor reduces price volatility. However, such intervention does enable opportunities for rent-seeking and harassment. For instance, imposition of stock limits on dal in 2006-Q3, sugar in 2009- Q1 and onions in September 2019 spiked up the volatility of the wholesale and retail prices instead of smoothening them – in contrast to its objective of easing pressure on prices. Around 76000 raids under ECA were conducted during 2019. Assuming a minimum of 5 persons involved in a raid, considerable administrative effort goes into enforcement of ECA. As the conviction rate, however, is abysmally low and raids have no impact on prices, the ECA only seems to enable rent-seeking and harassment. The Act is anachronistic as it was passed in 1955 in an India worried about famines and shortages; it is irrelevant in today's India and must be jettisoned. Second, the regulation of prices of drugs through the DPCO 2013, has led to increase in the price of a regulated pharmaceutical drug vis-à-vis that of a similar drug whose price is not regulated. Our analysis shows that the increase in prices was witnessed for more expensive formulations than for cheaper ones and those sold in hospitals rather than retail shops, reinforcing that the outcome is opposite to what DPCO aims to do - making drugs affordable. The evidence across different commodities (pulses, sugar, onions and drugs) - not just onions or sugar where cartelisation is often suspected - and episodes spanning different time periods (2006-19) suggests that the ineffectiveness of ECA stems from unnecessary government intervention that undermines markets. Third, government policies in the foodgrain markets has led to the emergence of Government as the largest procurer and hoarder of foodgrains – adversely affecting competition in these markets. This has led to overflowing of buffer stocks with FCI, burgeoning food subsidy burden, divergence between demand and supply of cereals and acted as a disincentive towards crop diversification. Fourth, analysis of debt waivers given by States/Centre shows that full waiver beneficiaries consume less, save less, invest less and are less productive after the waiver when compared to the partial beneficiaries. The share of formal credit decreases for full beneficiaries when compared to partial beneficiaries, thereby defeating the very purpose of the debt waiver provided to farmers.

68 Economic Survey 2019-20 Volume 1 The chapter makes the case that each department and ministry in the Government must systematically examine areas where the Government needlessly intervenes and undermines markets. Note that the chapter does not argue that there should be no Government intervention. Instead, interventions that were apt in a different economic setting may have lost their relevance in a transformed economy. Eliminating such instances of needless Government intervention will enable competitive markets and thereby spur investments and economic growth. 4.1 Though India has made significant India ranks in the bottom half. The Index progress in enhancing economic freedom for of Economic Freedom, which is brought firms and its citizens, it still counts among out by the Heritage Foundation, and the the shackled economies in the world. In Global Economic Freedom Index, which is the global indices of economic freedom, brought out by the Fraser Institute, measure Figure 1: Relative Economic Freedom in India Source: Index of Economic Freedom, 2019 accessed at https://www.heritage. org/index/ economic freedom as the freedom of choice 4.2 Economic freedom enhances wealth enjoyed by individuals in acquiring and creation by enabling efficient allocation using economic goods and resources. In the of entrepreneurial resources and energy to Index of Economic Freedom, India was productive activities, thereby promoting categorized as ‘mostly unfree’ with a score economic dynamism. This is manifested in of 55.2 in 2019 ranking the Indian economy the close correlation of the ranks in the two 129th among 186 countries, i.e., in the referred indices of economic freedom with bottom 30 per cent of countries (Figure 1). per capita GDP of the countries (Figure 2). In the component pertaining to “investment The low rank in economic freedom makes freedom”, which measures the ease of flow of it evident that India chains opportunities investment capital both internally and across for wealth creation by shackling economic the country’s borders, India scores a low freedom for its citizens. Figures 3-6 show 40.0 on a scale of 0-100 (repressed) against the cross-country correlation of the index the world average of 58.5. In the Index of of economic freedom with the density Global Economic Freedom too, India ranks of registration of new business, the ease 79th among 162 countries with 108th rank in of doing business indicators, number of business regulation. patents applied in a country, the number of

Undermining Markets 69 Figure 2: Correlation of Indices of Economic Freedom with Per Capita GDP 100 90 Index of Economic Freedom 80 70 60 50 40 India 30 20000 40000 60000 80000 100000 120000 140000 0 GDP Per Capita (PPP) 90 80 Global Economic Freedom Index 70 60 50 India 40 30 20 20000 40000 60000 80000 100000 120000 140000 0 GDP Per Capita (PPP) Source: Index of Economic Freedom accessed at https://www. heritage.org/index/ and Global Economic Freedom Index accessed at https://www.fraserinstitute.org/ Figure 3: Correlation of IEF with density of new business registration 25 New Business Density (2018) 20 15 10 5 0 40.0 45.0 50.0 55.0 60.0 65.0 70.0 75.0 80.0 85.0 90.0 Index of Economic Freedom (2019) Source: Ease of Doing Business Database and Index of Economic Freedom accessed at https://www.heritage.org/index/ Note: The new business entry density is defined as the number of newly registered corporations per 1,000 working-age people (those ages 15–64). Units of measurement are private, formal sector companies with limited liability.

70 Economic Survey 2019-20 Volume 1 Figure 4: Correlation of Economic Freedom with Ease of Doing Business Resolving Insolvency Score Enforcing Contracts Score Ease of Trading Across Borders Score Ease of Paying Taxes Score Protecting Minority Investors Score Ease of Getting Credit Score Ease of Registering Property Score Ease of Getting Electricity Score Ease of Dealing with Construction Permits… Ease of Starting a Business Score Ease of Doing Business Overall Score 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Correlation with Index of Economic Freedom 2019 Source: Ease of Doing Business Database and Index of Economic Freedom accessed at https://www.heritage.org/index/ Figure 5: Correlation of Indices of Economic Freedom with Patents Applied and Patents Granted Source: NBER patent data and Index of Economic Freedom accessed at https://www.heritage.org/index/ Figure 6: Correlation of Indices of Economic Freedom with Index of Innovation Source: World Intellectual Property Organization (WIPO) database and Index of Economic Freedom accessed at https://www.heritage.org/index/

Undermining Markets 71 patents granted in a country and the index of for sale compared to what people want. When innovation respectively. Thus, it is clear that the price is too low, it causes consumers to economic freedom affects several aspects of want more of the product than producers wealth creation significantly. have available. In both cases, serious welfare loss results because not enough of the good 4.3 While there is a case for Government is sold. The wasted chance to create both intervention when markets do not function producer and consumer welfare from such properly, excessive intervention, especially sales leads to ‘deadweight loss’ - income when markets can do the job of enhancing that is lost forever. In addition to creating citizens’ welfare perfectly well, stifles deadweight loss, an artificially high price economic freedom. Government can affect transfers profits from consumers to producers markets either through direct participation and creates opportunities for rent seeking (as a market maker or as a buyer or supplier and an artificially low price leads to transfer of goods and services), or through indirect of profits from producers to consumers and participation in private markets (for example, leads to low incentive to invest further and through regulation, taxation, subsidy or other aggravates the scarcity of the product. influence). Any Government intervention of the first kind, however, affects the dynamic 4.4 As we illustrate in this chapter, the interaction of supply and demand in markets Indian economy is replete with examples and thereby determination of ‘equilibrium’ where Government intervenes even if there is market prices. When the price is too high, no risk of market failure, and in fact, in some there is an excessive amount of the product instances its intervention has created market Box 1: Essential Commodities Act, 1955 Essential Commodities Act (ECA), 1955 was enacted to control the production, supply and distribution of, and trade and commerce in, certain goods considered as essential commodities. The Act itself does not lay out Rules and Regulations but allows the States to issue Control Orders related to dealer licensing, regulate stock limits, restrict movement of goods and requirements of compulsory purchases under the system of levy. The Act also provides for action to confiscate the stock seized; to suspend/ cancel licences, if any and impose punishments like imprisonment. The Act also gives the power to fix price limits, and selling the particular commodities above the limit will attract penalties. Most of the powers under the Act have been delegated by the Central Government to the State Governments with the direction that they shall exercise these powers. Food and civil supply authorities in States execute the provisions of the Act. The major commodity groups included in the Act are (i) Petroleum and its products, including petrol, diesel, kerosene, Naphtha, solvents etc (ii) Food stuff, including edible oil and seeds, vanaspati, pulses, sugarcane and its products like, khandsari and sugar, rice paddy (iii) Raw Jute and jute textiles (iv) Drugs- prices of essential drugs are still controlled by the DPCO (v) Fertilisers- the Fertiliser Control Order prescribes restrictions on transfer and stock of fertilizers apart from prices (vi) Onion and Potato (vii) Seeds of food crops, fruits and vegetables, cattle fodder, Jute seeds and Cotton seeds

72 Economic Survey 2019-20 Volume 1 holding limit. The purported aim of this Act is to ensure affordability of essential commodities failures. This may be partly due to the legacy for the poor by restricting hoarding. It is an of post-independence economic policies overarching legislation regulating agricultural which the country followed. However, as the marketing and production. role of markets has been recognized globally, it is only natural that markets are allowed 4.6 The ECA, however, affects the efficient to work to enable quick wealth creation and development of agricultural markets by thereby economic growth. creating market distortions (Figure 7). As agriculture is a seasonal activity, it is ESSENTIAL COMMODITIES essential to store produce for the off-season ACT (ECA), 1955 to ensure smoothened availaibility of a product at stable prices throughout the year. 4.5 The Essential Commodities Act (ECA), Therefore, producers face an inherent trade- 1955 controls the production, supply and off between building an inventory in the distribution of, and trade and commerce in, harvest season and drawing down inventory certain goods such as vegetables, pulses, in the lean season. ECA interferes with this edible oils, sugar etc., which are treated as mechanism by disincentivising investments essential commodities. Under the Act, the in warehousing and storage facilities due powers to implement the provisions of the Act to frequent and unpredictable imposition of are delegated to the States. When the price of stock limits. As stockholding limits apply to any of these essential commodities rises, the the entire agriculture supply chain, including regulator can impose stockholding limits on wholesalers, food processing industries and the commodity, restrict movement of goods, retail food chains, the Act does not distinguish and mandate compulsory purchases under the between firms that genuinely need to hold system of levy. Consequently, all wholesalers, distributors, and retailers dealing in the product must reduce their inventories to comply with the Figure 7: Agricultural Market distortions due to ECA Weakens Market Reduced producer development of distortions from profit Agricultural value- stock limits under Reduced incentive chain ECA to invest in storage Inhibits development of vibrant commodity derivative markets Increased price volatility - reduced consumer welfare - Opposite of what ECA is intended for

Undermining Markets 73 stocks owing to the nature of their operations, opposite of what it is intended for. and firms that might speculatively hoard stocks. Further, this reduces the effectiveness 4.7 This market distortionary impact is of free trade and flow of commodities from clearly evident from several experiences. The surplus areas to markets with higher demand. ineffectiveness of stock limits in controlling ECA also affects the commodity derivative price volatility, as described above, is not markets as traders may not be able to deliver restricted to a specific commodity or a specific on the exchange platform the promised time period. The figure below indicates the quantity, owing to stock limits. The Act standard deviation of prices of pulses and distorts markets by increasing uncertainty and sugar, on which stock limits were notifioed discouraging the entry of large private sector in 2006-Q3 and 2009-Q1 respectively. These players into agricultural-marketing. These limits had limited success in containing the market distortions further aggravate the price volatility of prices, even two to three years volatility in agricultural commodities- the after the imposition (see Figure 8a and 8b). Standard deviation of daily pricesFigure 8a: Volatility in Retail prices ofProduction shock Standard deviation of daily pricesFigure 8b: Volatility in Retail prices ofProduction Shock Qtr4-2004 Dal even after stock limits underStock limit Sugar even after stock limits underStock limit imposed ECA were imposed in 2006 - Q3imposed ECA were imposed in 2009 - Q1 3 Rice 2.5 Salt Gram dal Sugar 2.5 2 2 1.5 1.5 1 1 0.5 0.5 0 0 Qtr3-2005 Qtr4-2007 Qtr2-2007 Qtr2-2006 Qtr1-2008 Qtr1-2007 Qtr4-2008 Qtr3-2009 Qtr2-2010 Qtr1-2011 Qtr4-2011 Source: Computed from data available from Source: Computed from data available from Deparment of Consumer Affairs (DCA) Deparment of Consumer Affairs (DCA) 4.8 The recent experience with rise in onion of onions was adversely affected leading to prices illustrate the same phenomenon. There lower market arrivals and upward pressure are three harvesting seasons in India for the on onion prices. This kharif crop usually onion crop viz., Kharif (October-December), caters to the demand during the period from Late Kharif (January-March) & Rabi (March- October to December till fresh produce from May). There is a period from around May to late kharif crop comes in the market. In view September in the year wherein the demand of a sustained increase in onion prices, stock for onions has to be met by the stocks kept by limits under the ECA were imposed across the traders/wholesalers. Due to heavy rains the country on September 29, 2019 (the limits in August-September, 2019, the kharif crop equaled 100 quintals on retail traders and 500

74 Economic Survey 2019-20 Volume 1 effect on the volatility of the wholesale and retail prices for onions after September, 2019 quintals on wholesale traders which were (Figure 8c). The lower stock limits must have subsequently reduced to 20 quintals and 250 led the traders and wholesalers to offload quintals respectively). The stock limits were most of the kharif crop in October itself which imposed to control the price rise of onions led to a sharp increase in the volatility from by facilitating the release of stocks in the November, 2019 onwards. The volatility in market and preventing hoarding by traders retal prices mirrors that in wholesale prices. to enhance supply in the market. However, the imposition of stock limits has had no Figure 8c: Volatility in Retail and Wholesale prices of Onion in 2019 even after stock limits were imposed under ECA Wholesale Retail Standard deviation of prices Standard Deviation of prices Production shock Production Shock Stock Limits Imposed Stock Limits Imposed 30 30 25 25 20 20 15 15 10 10 55 00 01-Apr 01-Apr 22-Apr 22-Apr 13-May 13-May 03-Jun 03-Jun 24-Jun 24-Jun 15-Jul 15-Jul 05-Aug 05-Aug 26-Aug 26-Aug 16-Sep 16-Sep 07-Oct 07-Oct 28-Oct 28-Oct 18-Nov 18-Nov 09-Dec 09-Dec 30-Dec 30-Dec Potato Onion Potato Onion Source: Computed from data available from Department of Consumer Affairs (DCA) Note: Both onion and potato are covered under ECA but Stock Limits were imposed on onion since 29th September, 2019 and not on potato 4.9 This effect of the imposition of stock The increasing wedge between wholesale limits is also evident in the trend of the and retail prices reinforces that ECA reduces wedge between the wholesale and retail welfare of consumers. In the long term, the prices of pulses and onion (Figure 9a and 9b). Act disincentivizes development of storage In the case of onions, the wedge has shown infrastructure thereby leading to increased a sharp increasing trend from November, volatility in prices following production/ 2019 onwards as most of the kharif crop, consumption shocks – the opposite of what it which itself was lower, would have had to is intended for. The evidence across different be offloaded in the market in October itself. commodities and different time periods - not Absent government intervention through just onions or sugar where cartelisation is often ECA, traders would store a part of their suspected - suggests that the ineffectiveness produce to ensure smooth availaibility of a of ECA stems from unnecessary government product at stable prices throughout the year. intervention that undermines markets.

Undermining Markets 75 Figure 9a: Increasing wedge between Retail and Wholesale prices of gram dal (pulse) even after ECA is imposed Wedge (retail - wholesale price in ₹/kg 3.5 Production shock Gram dal Rice Stock limit 3 imposed 2.5 ECA is ineffective 2 in stabilising retail prices 1.5 1 0.5 Qtr4-2004 Qtr2-2005 Qtr4-2005 Qtr2-2006 Qtr4-2006 Qtr2-2007 Qtr4-2007 Qtr2-2008 Qtr4-2008 Source: Computed from data available from Department of Consumer Affairs (DCA). Note: Both rise and pulses are covered under ECA, and stock limits were imposed on pulses on 28th August, 2006. Stock limits were imposed on rice also in 2008, at the end of the period considered in this chart. Figure 9b: Increasing wedge between Retail and Wholesale prices of Onion in 2019 even after ECA is imposed Wedge (Retail price-Wholesale price) 10 Stock Limits for onion (₹/quintal) Production Shock for onion Onion Potato 8 6 4 2 01-May 01-Jun 01-Jul 01-Aug 01-Sep 01-Oct 01-Nov 01-Apr Source: Computed from data available from Department of Consumer Affairs (DCA). Note: Both onion and potato are covered under ECA but Stock Limits were imposed on onion since 29th September, 2019 and not on potato

76 Economic Survey 2019-20 Volume 1 Figure 10a: Correlation of raids conducted under ECA with wedge between retail and wholesale onion prices Consumer States 1.0 Producer States 1.5 0.8 Log10(Wedge) 1.0 0.6 0.5 0.4 0.0 1234 234 Log10(Raids) Figure 10b: Correlation of raids conducted under ECA with volatility of retail and wholesale onion prices Consumer States Producer States Log10(volatility) 1.00 1.0 0.75 0.5 0.50 1 2 3 4 0.25 234 Log10(Raids) Source: Compiled from data available from Department of Consumer Affairs (DCA) 4.10 Under the ECA, states are required to no impact on both the wedge between retail enforce the adherence to any stock limits and wholesale onion prices and volatility in specified under the Act. Given that around these prices in consumer or producer states, 76000 raids were conducted during 2019 thereby raising concerns on their effectiveness and assuming that a minimum of 5 persons (Figure 10). are involved in a raid, a considerable administrative effort is utilized for the 4.11 Our analysis shows that in states that are enforcement of the Act. Our analysis shows primarily consumer of essential commodities, that such raids conducted by States have had there is a negative relationship between the

Undermining Markets 77 Figure 11: Correlation of Prosecution with wedge between retail and wholesale prices of onion 1.25 y = 0.55 0.066 x 1.00 Log10 Wedge 0.75 0.50 0.25 −4 −3 −2 −1 0 Log10 1 Prosecutions Raids Source: Compiled from data available from Department of Consumer Affairs (DCA) probability of being caught (reflected by for maintaining a strategic buffer of the ratio of prosecution to raids) and wedge aforementioned commodities for subsequent between retail and wholesale prices. This calibrated release to moderate price volatility shows that ECA is only effective when it is and discourage hoarding and unscrupulous executed properly (Figure 11). As per the speculation. This needs to be strengthened reports received from the State Governments/ further as it supplements the market forces UT Administrations, the conviction rate rather than substitute them which the ECA under the Act is abysmally low at 2-4 per does. cent on an average. As on 16.12.2019 which is the latest available from DCA, total raids 4.13 The ECA was enacted at a time when conducted in 2019 under ECA were 76,033 speculative hoarding and black marketing but number of persons convicted were only was a threat as agricultural markets were 2941, which equals only 3.8 per cent of the fragmented and transport infrastructure total raids conducted. This indicates that was poorly developed. But the Act, while the raids under ECA may be only leading penalising speculative hoarding, also ends up to harassment of traders, thereby adversely penalising the much desirable consumption- affecting the role of trade in the marketing of smoothing that storage provides. With the the given commodity. agricultural markets in India increasingly becoming more integrated and competitive, 4.12 A beginning was made by setting up the utility of the Act is dubious and is of the Price Stabilization Fund (PSF) in incompatible with development of an 2014-15 to help regulate the price volatility integrated competitive national market for of important agri-horticultural commodities food. The anti-hoarding provisions of ECA like onion, potatoes and pulses. It provides discourage open reporting of stock holdings, storage capacities, trading and carry forward

78 Economic Survey 2019-20 Volume 1 4.15 To examine carefully the impact of the DPCO order on the price and quantity of positions. There is no aggregated data of the essential drugs, we undertake the following total private storage capacity available in the comparison. Consider Glycomet (Metformin) country, which would enable policymakers to and Glimiprex-MF (Glimepiride+Metformin) assess the impact of any production shocks on both of which are used for controlling high the prices. Besides discouraging investment blood sugar. Glycomet came under price in modern methods of storage and in market control in DPCO, 2013 while Glimiprex- intelligence, the lack of information on MF did not. Therefore, a comparison of the trades makes it harder for market participants before-after change in price and quantity to make accurate forecasts for the future. consumed for Glycomet vis-à-vis that for Supporting development of commodity Glimiprex-MF controls for the effect of all futures markets would help efficient discovery other confounding factors such as demand of market expected future prices, which can and supply of drugs in this category. This provide a better basis for private storage comparison, therefore, estimates the pure decisions and avoid ‘peaks’ and ‘troughs’ in effect of the DPCO order. Figure 12 shows prices. Development of effective forecasting that the price of Glycomet actually increased mechanisms, stable trade policies, and more than that for Glimiprex-MF after increasing integration of agricultural markets DPCO, 2013. It, however, had no effect on can serve the purpose of stabilising prices the quantity consumed, which is consistent of agricultural markets more efficiently than with pharmaceutical drugs being an essential government fiat imposed through ECA. commodity for which the demand is inelastic, or insensitive, to the changes in price. DRUG PRICE CONTROLS UNDER ECA 4.16 Our estimates also show that the prices of drugs that came under DPCO, 4.14 Given the important task of ensuring 2013 increased on average by ` 71 per mg access to essential lifesaving drugs and to of the active ingredient. For drugs that avoid poor households from falling into were unaffected by DPCO, 2013, the prices poverty, Governments often resort to price increased by ` 13 per mg of the active controls for drugs. In India, the Government ingredient. The difference-in-difference has historically relied on price controls estimate in prices was 58 per mg of the active to regulate the prices of pharmaceutical ingredient, which was statistically significant drugs through the National Pharmaceutical at 5 per cent (Figure 13). The difference- Pricing Authority (NPPA) and Drug (Prices in-difference in quantities was statistically Control) Order (DPCO). The National List indistinguishable from zero. of Essential Medicines (NLEM), prepared by Ministry of Health and Family Welfare, is 4.17 To parse out the effect of the DPCO a list of medicines considered essential and order, we separate formulations by those high priority for India’s health needs. It is that are sold primarily through retail outlets based on aspects like prevalence of disease and those that are primarily sold through in the population, safety and efficacy of the hospitals. The prices of formulations that medicine, and current affordability. DPCOs came under DPCO, 2013 and that were are issued by the Government, in exercise of mostly sold at hospitals increased by `99 the powers conferred under section 3 of the per mg. In the case of formulations mostly ECA to ensure that the medicines listed under sold in hospitals that were unaffected by NELM are available at a reasonable price to DPCO, 2013, the prices increased by only the general public. 25 per mg (Figure 14). Thus, the difference-

Undermining Markets 79 Figure 12: Effect of DPCO, 2013 on Prices of Glycomet (regulated) vs Glimiprex-MF (unregulated) 2.2 4.5 Price per tablet of Glycomed in INR 2 Glycomet under 4 Price per tablet of Glimiprex in INR price Control 1.8 3.5 1.6 3 1.4 Glimiprex-MF not under price control 1.2 2.5 12 2009 2010 2011 2012 2013 2014 2015 Units in 000's of Glycomet 60000 4500 Units in 000's of og Glimiprex-MF 4000 Glimiprex-MF 55000 not under price control 50000 45000 3500 Glycomet under 40000 Price Control 3000 35000 2500 30000 25000 2000 2009 2010 2011 2012 2013 2014 2015 Source: IMS Health, Survey Calculations Box 2: Drugs Prices Control Order (DPCO) The Drugs Prices Control Order (DPCO) is an order issued under Sec. 3 of Essential Commodities Act (ECA), 1955 that seeks to regulate the prices of pharmaceutical drugs. The DPCO, among other things, specifies the list of drugs that come under the price ceiling and the formula for calculating the ceiling price. The National List of Essential Medicines (NLEM) lists the pharmaceutical drugs that fall under price control. The DPCO, 2013 for instance, contains 680 scheduled drug formulations spread across 27 therapeutic groups whose prices are regulated. National Pharmaceutical Pricing Authority (NPPA) is responsible for fixing and revising the prices of pharmaceutical products as well as the enforcement of the DPCO. The Government of India has amended the DPCO several times and most recently in 2013. Until 2013, DPCO specified the price ceiling using the cost-based pricing method in which the ceiling price was calculated as a multiple of the cost that it took producers to promote and distribute a pharmaceutical drug. This multiple referred to as the Maximum Allowable Post-manufacturing Expenses (MAPE) was set at 50 per cent for formulations imported into India and at 100 per cent for indigenously manufactured formulations. In 2013, for the first time, India transitioned from cost-based pricing to market-based pricing. Under the market-based pricing method, the Government determines the ceiling prices as the maximum mark-up that a retailer can charge over the reference price, which is the simple average of the prices of the all the brands with market share of greater than or equal to 1 per cent based on market data provided by IMS Health, a market research firm. The order capped the maximum mark-up to 16 per cent for all formulations specified in the NLEM.

80 Economic Survey 2019-20 Volume 1 Box 3: Methodology of Difference-in-differences - Explained Difference-in-differences (DiD) is a statistical technique used to estimate the effect of a specific intervention or treatment (such as a passage of law, enactment of policy, or large-scale program implementation). The technique compares the changes in outcomes over time between a population that is affected by the specific intervention (the treatment group) and a population that is not (the control group). DiD is typically used to mitigate the possibility of any extraneous factors affecting the estimated impact of an intervention. This is accomplished by differencing the estimated impact of the treatment on the outcome in the treatment group and the estimated impact of the treatment on the control group. Figure 13: Effect of DPCO, 2013 on Prices and Quantities consumed of regulated drugs 120 12000 100 10000 80 8000 60 6000 Prices of a mg in 1995 INR Quantiy in 000's mg. 40 4000 20 2000 0 0 Formulations that came underprice Formulations that never came Formulations that came underprice Formulations that never came control in 2013 underprice control control in 2013 underprice control Before 2013 After 2013 Before 2013 After 2013 Source: Survey Calculations Note: Data comprising of 1751 formulations and 49893 brands was used from IMS Health. Averages are computed over all the drugs that were unaffected by DPCO, 2013 separately for the period before 2013 and for the period after 2013 in-difference estimate for formulations sold retail outlets increased by a meagre `0.23 per primarily through hospitals was `74 per mg. mg during the same period. However, in the case of formulations unaffected by DPCO, In contrast, the prices of drugs that came under 2013 and mostly sold by retail chemists, DPCO, 2013 and primarily sold through

Undermining Markets 81 Figure 14: Effect of DPCO, 2013 on Prices and Quantities consumed of formulations sold at hospitals vs retail outlets 160 8 Prices of a mg in 1995 INR140 7 Prices of a mg in 1995 INR 120 6 100 5 80 4 60 3 40 2 20 1 0 Formulations that never came 0 Formulations that never came underprice control underprice control Formulations that came underprice Formulations that came underprice control in 2013 control in 2013 Before 2013 After 2013 Before 2013 After 2013 Source: Survey Calculations the prices increased by about `1.72 per mg. 4.18 Our estimates also show that the DPCO, Thus, the difference-in difference estimate 2013 order increased prices by about 21 per cent for formulations primarily sold through retail for the cheaper formulations (i.e, those that were outlets was `(-)1.49 per mg. This shows that in the 25th percentile of the price distribution). the DPCO, 2013 appears to have increased However, in the case of costly formulations the prices of drugs mostly sold through (i.e., those that were in the 99th percentile), hospitals but decreased it mildly in the the increase was about 2.4 times (Figure 15). case of drugs sold through the retail chemists. The effect of DPCO, 2013 in increasing prices This effect of price controls on drugs is was, therefore, more potent for more expensive expected because the enforcement of the formulations than for cheaper ones – reinforcing DPCO orders would be easier in the case of the effect opposite to what it was instituted for i.e., making drugs affordable. retail outlets when compared to hospitals. No. of times increase in prices Figure 15: The effect of DPCO 2013 on prices by percentile (of prices) 1200 1000 800 600 400 200 0 0 10 20 30 40 50 60 70 80 90 100 Percentile pre DPCO price Source: Survey Calculations

82 Economic Survey 2019-20 Volume 1 interests of producers and consumers alike. 4.19 Our analysis of the ECA clearly shows 4.22 Subsequent to this mandate, the that stock limits and price controls under Government has emerged as the single the Act lead to sub-optimal outcomes which largest procurer and hoarder of foodgrains. are actually opposite to what the Act is Government procures around 40-50 per cent mandated to achieve. The Act interferes with of the total markets surplus of rice and wheat the functioning of the markets and provides emerging as the dominant buyer of these grains incentives which are detrimental to wealth (Figure 16). In some States like Punjab and creation thereby adversely affecting both Haryana, this share of purchase by Government social welfare and economic development. reaches as high as 80-90 per cent (Figure 12). ECA needs to be repealed and replaced by A record procurement of 44.4 million tonnes of market freiendly interventions like price rice and 34 million tonnes of wheat was done stabilization funds, Direct Benefit Transfers in 2018-19. Thus the government, as the single (DBT) of support to consumers, incentives largest buyer of rice and wheat, is virtually a to innovations, increasing market integration monopsonistinthedomesticgrainmarketandisa and smooth flow of goods and services. dominant player crowding out private trade. This disincetivizes the private sector to undertake GOVERNMENT INTERVENTION long-term investments in procurement, storage IN GRAIN MARKETS and processing of these commodities. 4.20 In the grain markets in India, Government 4.23 These procurement operations largely has sought to achieve food security while support the MSPs that are designed to ensuring remunerative prices to producers be indicative prices for producers at the and safeguarding the interest of consumers beginning of the sowing season and floor by making supplies available at affordable prices as an insurance mechanism for farmers prices. In trying to achieve this, the state from any fall in prices. However, the secular controls input prices such as those of fertilizer, increasing trend in these prices have served water, and electricity, sets output prices, to give a signal to farmers to opt for the crops undertakes storage and procurement through which have an assured procurement system. an administrative machinery, and distributes Figure 17 clearly shows that an increase in cereals across the country through the PDS. MSP translates into farmers offering their produce for the open-ended procurement 4.21 The Food Corporation of India by the Government. This also indicates that (FCI) was set up in 1965 under the Food market prices do not offer remunerative Corporations Act, 1964 with the primary duty options for the farmers and MSPs have, in to purchase, store, move/transport, distribute effect, become the maximum prices rather and sell foodgrains and other foodstuffs. The than the floor price – the opposite of the aim main objectives of FCI are (a) procurement it is intended for. of foodgrains from farmers at Minimum Support Prices (MSP) announced by the 4.24 Given the obligations under the Government; (b) distribution of foodgrains Targeted Public Distribution System (TPDS) to consumers through PDS, particularly the earlier and now under the National Food vulnerable sections of society at affordable Security Act (NFSA), 2013 that covers upto prices; and (c) maintenance of buffer stock 75 per cent of the rural population and 50 of foodgrains for food security and price per cent of the urban population to receive stability. Thus, it is mandated to serve the

Undermining Markets 83 Figure 16: Government – Single Largest Procurer of Rice and Wheat 60 100 93.0 83.0 Government procures 40-50% of Market Surplus 80 50 60 Procurement as a % of Market Surplus 90.1 87.7 TE 2010-11 TE 2011-12 TE 2012-13 TE 2013-14 TE 2014-15 TE 2015-16 TE 2016-17 TE 2017-18 TE 2018-19 Procurement as a % of Marketed surplus (TE- 2018-19) 40 40 20 30 0 Rice Wheat Wheat Rice Punjab Haryana Source: FCI, DACF&W Figure 17: Increasing MSPs leading to Higher Procurements 2000 Wheat 1750 Paddy 1500 1250 Secular Increasing trend in 1000 MSPs 750 Minimum Support Price (Rs/Quintal) 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 Wheat Rice 44 Log (Procurement) 3.5 Log (Procurement) 3.5 e = 0.48 3 e = 0.70 3 2.5 2 2.5 6.2 6.4 6.6 6.8 7 7.2 7.4 7.6 7.8 6.6 6.8 7.0 7.2 7.4 7.6 7.8 8.0 Log (MSP) Log (MSP) Source: DACF&W and DFPD

84 Economic Survey 2019-20 Volume 1 subsidized foodgrains, Government has also (Figure 18). The current peak comprises 45.8 emerged as the single largest hoarder of rice million tonnes of wheat (against a buffer and wheat. As against the buffer stock norm norm of 27.58 million tonnes) and 28.4 of 41.1 million tonnes of rice & wheat (as on million tonnes of rice (against a buffer norm 1 July of each year), total Central Pool stocks of 13.5 million tonnes). were at 74.3 million tonnes on 1 July, 2019 Figure 18: Trend in Buffer Stocks with FCI 90 74.3 80 80.5 70 Million Tonnes 60 50 Wheat NORM 40 30 20 Rice 10 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: FCI Note: Stocks and norms are as on 1st July of the year 4.25 Accounting for the fact that the the operations and development of adequate economic cost of FCI for acquiring, storing infrastructure in storage and warehousing. and distributing foodgrains is about 40 per cent more than the procurement price, 4.26 These policies have led to burgeoning the current mix of policies of assured burden of food subsidy which largely covers procurement (at MSPs), storage (through the procurement cost of FCI (difference a monopolist administrative government between the MSP and the Central issue organistion) and distribution under TPDS prices (CIP) of foodgrains under PDS) have contributed to building up of a high and distribution and carrying costs of FCI. cost foodgrain economy. Figure 19 shows Given fiscal constraints, there is always a that the inefficiency of FCI (estimated by trade-off between allocating money through the wedge between Economic Cost excl subsidies and increasing investments. Figure Distribution Cost and average wholesale 20 clearly shows that the growth in public prices) increases with the increasing level of investments in agriculture is negatively stocks. It is evident that if foodgrain markets correlated to increases in food subsidy are opened for active participation of private outlay. As investments are the crucial input players with Government as an equal player to increase in productivity, the increasing (and not as a monopsonist in procurement focus on subsidies is harming the growth and monopolist in storage and distribution), of agricultural sector in the long-run. This competition would lead to more efficiency in imbalance between subsidies and investments needs to be urgently corrected for sustainable

Undermining Markets 85 Figure 19: Increasing Inefficiency of FCI with Stocks (for Wheat) 250 (Economic Cost-Distribution Costs)- 200 Wholesale Prices (P/Quintal) 150 100 50 100 150 200 250 300 350 400 450 500 Level of Stocks (Lakh Tonnes) Source: Analysis based on data from FCI, DCA Figure 20: Inverse correlation between Change in outlays of food subsidy and Public Investments in Agriculture % Change in GCF 30 25 -15 -10 20 5 10 15 20 25 30 35 15 10 % change in Subsidy 5 0 -5 -5 0 -10 -15 Source: Compiled from Union Budget Documents, data from National Statistics Office (NSO) growth in Indian agriculture and overall from 2004-05 to 2011-12 (latest estimates inclusive growth. available). Further, the share of cereals declines steadily as MPCE level increases, 4.27 Above trends need to be juxtaposed from about 19 per cent for the bottom decile with the trends in consumer expenditure and class of rural India to about 5-6 per cent for thereby demand of cereals. NSS 73rd round on the top decile class, and from 15 per cent for consumer expenditure shows that the share the bottom decile class of urban India to under of cereals in Monthly Per Capita Expenditure 3 per cent for the top decile class. This is in (MPCE) has fallen by about 33 per cent in line with decreasing consumption of food and rural India and about 28 per cent in urban India increasing expenditure on non-food items as

86 Economic Survey 2019-20 Volume 1 farmers are deriving their signals, not from the demand patterns (reflected in the actual market incomes rise. Figure 21 shows the declining prices) but from the Government policies share of cereals in cosumer expenditure while of procurement and distribution policies for the production of rice and wheat has reached grains. Thus, the intervention of Government new records. This trend of decreasing demand has led to a disconnect between demand and for cereals and increasing supply of cereals supply of grains in foodgrain markets. shows that the production pattern is not synchronized with the demand patterns. The Figure 21: Trends in Consumption and Production of Cereals in India Source: DACF&W and NSS 68th Round Note: Cereals consist of Rice, Wheat and Coarse cereals wherein Rice and Wheat comprise more than 80 per cent of total production of cereals Data for Consumption is available only till 2011-12 4.28 It is evident from the analysis above that 4.29 The farmers need to be be empowered there has been a paradigm shift on food (cereal) through direct investment subsidies and cash front between the time when FCI was created transfers, which are crop neutral and do not and today. India has moved from being a interefere with the cropping decisions of the food scarce country to a food surplus country farmer. The coverage of NFSA needs to be with a substantial increase in production and restricted to the bottom 20 per cent and the has emerged as a net exporter of cereals. The issue prices for others could be linked to the Government policies of assured procurement procurement prices.Abetter alternative would and distribution gave the right incentives to be giving income transfers to consumers increase production at that time. The current through Direct Benefit Transfers (DBT). It foodgrain economy is, however, riddled with may be noted here that internationally, there various economic inefficiencies described is a move towards conditional cash transfers above. These policies, therefore, need to (CCTs), aimed at tackling problems of food move on now to incentivize diversification insecurity and poverty and for nudging people and environmentally sustainable production. towards improved health and education levels

Undermining Markets 87 (Box 4). Therefore, the foodgrains policy agricultural marketing, trade (both domestic needs to be dynamic and allow switching and foreign) and distribution policies need to from physical handling and distribution of be aligned so that farmers receive the correct foodgrains to cash transfers/food coupons/ signals for diversification into remunerative smart cards. At the macro level, the and sustainable production. Box 4: Examples of Successful Conditional Cash Transfer Schemes Country Year Modalities Impact 2003 Brazil: • Covers 25 per cent of total population • 80 per cent of benefits went Bolsa Famil- • Eligible beneficiaries below income to identified beneficiaries ia level of • Decline in households that are $60 and further identified through house- food inadequate hold surveys • Decrease in number of • Size of transfer – R$15-95 children malnourished • Access payments through banks, lottery • Increase in food consumption offices, retail stores using debit card • Over 60 per cent transactions • Conditions – Minimum 85 per cent at- made through non-bank agen- tendance and compulsory attending of cies health checkups for women and chil- dren • Cost of scheme – 0.5 per cent of GDP Mexico: 1997 • Focus on geographically poor regions. • 60 per cent of benefits went to Opor- Households identified in these regions poorest 20 per cent of the pop- tuni using marginal index ulation dades • Covers 20 per cent of total Population • 12 per cent decrease in inci- dence of illnesses • Cost of scheme – 0.4 per cent of GDP • Increase in enrollment of chil- • Size of transfer – 235 pesos (average) dren into schools and reduc- tion in dropout rates • Payments made bimonthly • Increase in likelihood of • Benefits can be withdrawn from women deciding on how ben- bank branches and authorized efits to be spent non-financial agencies • Conditions – Minimum attendance re- quirement and mandatory health check ups Philip- 2007 • Covers 20 per cent of total popu- • 20 million Filipinos benefited pines: lation Pantawid • Program has led to a poverty Pamilyang • Beneficiaries identified through reduction of 1.4 percentage Pilipino Household surveys points per year Program • Cost of scheme – 0.5 per cent of • 10.18 million children cur- GDP rently benefit from CCT • Conditions- Minimum atten- • Drastic decrease in alcoholism dance requirement and mandato- in 4Ps households (spending ry health check -ups, participate on vices was lower by 39 per in monthly community-based cent) Family Development Sessions. Source: World Bank FAQ (2017), ICRIER(2017)

88 Economic Survey 2019-20 Volume 1 4.31 The consequences of government intervention in credit markets in India have DEBT WAIVERS been examined by several carefully crafted research studies (Kanz (2016), Gine´ and Kanz 4.30 Government intervention in credit (2017), Mukherjee, Subramanian, and Tantri markets, in the form of full or partial, (2018), Tantri (2018)). Unlike simple pre- and conditional or unconditional, debt relief has post- event comparisons or opinions largely become increasingly common at the state based on anecdotes, these studies compare the level in India. The phenomenon of granting actual outcomes with carefully constructed debt waivers to farmers just before or after an representation of the counter-factual. In other election, which was to fulfill the promise words, the attempt is to compare what actually made in the election manifesto, had died transpired after a government intervention down in the early nineties. However, this with what would have happened had there phenomenon has become widespread after been no such intervention, which represents the large-scale farm debt waiver announced the counter-factual. Therefore, causal claims by the union government in 2008. This was made by these studies are reliable for policy followed byannouncement ofwaiversinstates purposes. such as Andhra Pradesh, Telangana, Uttar Pradesh, Madhya Pradesh, Rajasthan, Punjab, 4.32 When arguing the benefits of debt Maharashtra, and others. Figure 22 shows waivers on farmers, proponents postulate the scale of these waivers as a proportion of that borrowers suffer from the problem of state/central budgets. Given the prevalence “debt overhang”. This refers to a situation of government intervention in the form of where all current income gets used up in farm debt relief in India, it is important to understand its consequences on both the beneficiaries and the credit market in general. Figure 22: Loan Waiver Allocation as a per cent of State/Central Budget 25 21 Debt Waivers as a % of State/Central Budget2014 16 17 13 12 12 Har 1987 GOI 199015 10 9 TN 2006 GOI 2008 34 Mah 2009 Kar 2012 UP 2012 AP 2014 Tel 2014 TN 2016 UP 2017 Pun 2017 Mah 2017 Kar 2017 Raj 2017 Kar 2018 10 10 66 53 1 0 Source: Adapted from Phadnis and Gupta (2018)