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Political economy of reforms in India

Arvind Panagariya

When reforms slow down, two explanations are commonly given: lack of consensus and vested interests. While these are powerful and plausible explanations, they also raise a curious puzzle: why do we observe periods of mega reform punctuated by long spells of inaction?

Surely neither consensus nor vested interests can shift dramatically within a short period to produce the wide swings in the pace of reforms.

Thus, recall that as the 1980s drew to a close, the spurt in reforms during 1985-86 and 1986-87 under Prime Minister Rajiv Gandhi seemed to peter out. Yet, in 1991-92, Prime Minister Narasimha Rao and finance minister Manmohan Singh began to lay down the foundation of systematic reforms. They did away with investment licensing as also with import licensing on capital goods and raw materials, substantially lowered industrial tariffs, opened most industries to foreign investment, dramatically reformed both direct and indirect taxes, substantially cut fiscal deficit, considerably liberalised the financial sector, and made the rupee convertible on the current account.

But by mid-1994, despite clear evidence of significantly improved economic performance, reforms came to a standstill. Congress party lost elections in May 1996 and a series of unstable governments followed. There was some effort to revive the reforms by these governments in areas of taxation, civil aviation, telecommunications and insurance but their success was at best limited.

At this juncture, Prime Minister Atal Bihari Vajpayee and finance minister Yashwant Sinha came to the helm. Defying the conventional wisdom of the day that the consensus for reforms was lacking, they went on to introduce deep and wide-ranging reforms in virtually all areas during six years of their rule. They promulgated the New Telecom Policy, 1999, and introduced some of the toughest reforms in the sector. Those reforms have led to a sharp rise in the tele-density from just 2.8% in 1998-99 to approximately 19% today.

Import licensing on consumer goods, which the trade reform of 1991-92 had ubiquitously left in place, came to an end in April 2001. The top industrial tariff rate was brought down from 45% in March 1999 to 20% in January 2004. The indirect tax system and tax administration were reformed in a major way. The government introduced genuine privatisation with several public sector enterprises transferred into private hands. The Urban Land Ceilings and Regulation Act, 1976 was repealed. The government successfully embarked upon a massive programme of highway construction. A major step towards the reform of the power sector was taken through the Electricity Act, 2003.

On the macroeconomic front, the Vajpayee-Sinha team liberalised most interest rates, introduced greater competition in the banking sector through more liberal entry of domestic and foreign private banks, freed up several external capital account transactions and introduced the Fiscal Responsibility and Budget Management Act. It opened the insurance sector to the private sector with limited foreign investment permitted. Vajpayee-Sinha combine also launched reforms of the civil service pension system and the exit policy though they remain incomplete to-date.

In May 2004, the Vajpayee government lost election and the reforms were once again setback. Outside of international trade, last three years have seen very limited progress in opening up the economy further. Why? Shifts in the consensus and the power of vested interests cannot explain this large shift in the policy stance. We must seek explanation elsewhere.

My own view is that within India’s parliamentary democracy, the leadership at the top plays a decisive role in shaping the policy. A leadership committed to reforms faces resistance from three quarters: opponents among the supporters of the government in Parliament, those sitting in the opposition, and the vested interests that expect to lose from the policy change. A determined leadership can often overcome resistance from all three sources.

Those on the ruling side rarely want to vote themselves out of power. In the beginning of its term, when the present government decided to raise foreign investment caps in telecommunications and in civil aviation, the Left Front parties eventually dropped their opposition rather than bring the government down. They only stood to lose by voting the government out. Chances are better than 50% that they will do the same in the current stand-off on the nuclear issue.
The power of the opposition to stop the reform is even more limited. When disinvestment minister Arun Shourie proposed an ambitious agenda of privatisation in the early 2000s, the opposition accused him of corruption to derail the programme. But a determined Shourie, backed up by an equally determined Vajpayee, could successfully advance his agenda.

Even vested interests, frequently credited with blocking the reforms, have only a limited standing power. If the public views the change favourably, agitators quickly lose its sympathy. The airport workers trying to block the privatisation of Delhi airports in 2006 faced this situation and had to quickly give up their agitation. Indeed, even when the public views a policy change as detrimental to its interests, the free-rider problem in agitation works in favour of the government. The cost of the agitation falls disproportionately on those actively participating but the benefits are diffused. Therefore, a patient government is often able to outlast the agitators. The failure of the public in 2006 to reverse the government’s decision to extend caste-based quotas for admissions to private schools and colleges illustrates this point.

Many observers today hold the Left Front parties responsible for the slowdown in the reforms. While this view has some merit, the bulk of the problem resides within the ruling coalition. While Prime Minister Singh would undoubtedly like to proceed with the reforms, by all indications, the Congress party president Mrs Sonia Gandhi holds his hand back. Faced with similar challenges from within the party during his tenure, Prime Minister Vajpayee confronted his opponents and prevailed. Unfortunately, Prime Minister Singh has not done the same.

(The author is a professor at Columbia University )

Economic Times September 27 2007