Chakravyuha Challenge of the Indian Economy

The economic survey 2015-16 has a full chapter on the Chakravyuha Challenge of the Indian economy. This is a summary of that chapter.

What is the Chakravyuha Challenge of the Indian economy?

After independence, Indian economy adopted socialism with limited entry. Since the early 1980s, the Indian economy has made remarkable progress in increasing entry: industrial licensing has been dismantled, public sector monopolies have been diluted, some public sector assets have been privatised, foreign direct investment has been considerably liberalised, and trade barriers have been reduced. However, a market economy requires not just unrestricted entry of new firms, new ideas, and new technologies but it also requires exit so that resources are forced or enticed away from inefficient and unsustainable uses. In India, there has been less progress in relation to exit. Thus, Indian economy is characterized by “marketism” without exit. This is called Chakravyuha Challenge of the Indian economy.

What are the challenges of entry?

Focusing on the exit problem does not mean that the challenges of entry have been fully addressed. The Government’s reform agenda, including liberalising FDI and launching the Start-up India and Entrepreneurship initiatives are noteworthy endeavours to further facilitate entry.

What are the sectors facing the Chakravyuha Challenge?

The case studies suggest that the Chakravyuha challenge is more a feature of the relatively traditional sectors of the economy. The challenge is not just restricted to the public sector and manufacturing but the private sector and agriculture are also facing the exit challenge.

How severe is the exit problem?

The severity of the problem can be measured based on the size of firms in India. In principle, productive and innovative firms should expand and grow, forcing out the unproductive ones. So surviving firms should be much larger than new ones. In the US the average 40-year old plant is 8 times larger (in terms of employment) than a new one. Established Mexican firms are twice as large as new firms. But in 2010 India the average 40 year old plant was only 1.5 times larger than a new one.

What are costs of impeded exit?

The lack of exit creates at least three types of costs: fiscal, economic (or opportunity), and political.

What are fiscal costs?

Due to the exit issue, the government has to support the inefficient firms. This support—in the form of explicit subsidies (for example bailouts) or implicit ones (tariffs, loans from state banks)—represents a cost to the economy. There is interest cost if the government borrows to finance the foregone revenue.

What are economic costs?

Economic losses result from resources and factors of production not being employed in their most productive uses. In a capital scarce country such as India, misallocation of resources can have significant costs. The other consequence of exit problem is a reduced flow of new investment, dampening medium term growth.

What are political costs?

The lack of exit can also have considerable political costs for governments attempting to reform the economy. The exit problem often benefits the rich and influential in the form of support for “sick” firms. This can give the impression that governments favour large corporates. Similarly, if wilful defaulters cannot be dealt with appropriately, the legitimacy of a market economy and the regulating institutions can themselves be called into question.

Why is there an Exit Problem?

In India, the exit problem arises because of three types of reasons, what might be called the three I’s: Interests, Institutions, and And Ideas/Ideology.

Interests

The first and perhaps most powerful reason for lack of exit is the power of vested interests. One good example of interest groups blocking reform comes from introducing JAM for MGNREGA expenditure. In the case of administrative schemes, vested interests often create a market of their own, planning their actions to benefit from it.

Institutions

In India, the problem arises from a combination of both weak and strong institutions. Examples of weak institutions are legal procedures that increase the costs—time and financial costs—of exit. One example of weak institutions is simply the inability to punish wilful defaulters: if demonstrable wrongdoing goes unpunished, the legitimacy of all institutions is called into question.

Ideas/ideology

All around the world, it is very difficult to phase out entitlements. Democracy favour redistribution for the numerous poor. Once the programs and policies have been put in place, it is very difficult to reverse them. For example, Minimum support prices (MSPs) were envisioned as an insurance mechanism for farmers, but have become price floors instead, favouring some crops in some regions at the expense of others.

What are the ways to address the exit problem?

There are at least five possible ways.

• Firstly, by promoting competition via private sector entry rather than change of ownership from public to private. For example, liberal entry of more banks and different types of banks and entry into capital markets is an option to reduce the role of inefficient public sector banks.
• Secondly, Direct policy action through better laws like the Insolvency and Bankruptcy Code 2015, reforming the Prevention of Corruption Act. Institutions need to be made stronger but flexible by empowering bureaucrats and reducing their vulnerability.
• Thirdly, Use of technology to remove persistent distortions by bringing down human discretion and layers of intermediaries. JAM and DBT are examples for using technology to solve exit problem.
• Fourthly, Increasing transparency and highlighting social costs and benefits of various schemes and entitlements.
• Fifthly, Showcasing exit as an opportunity towards a newer and better tomorrow.