Financial Daily from THE HINDU group of publications
Tuesday, Aug 23, 2005
India astride a supply side revolution
Sumit K. Majumdar
There has been a substantial change in the mindset of entrepreneurs in India. More companies are being started and new experiments in entrepreneurship are being dared.
Communities once associated with anti-entrepreneurship have now been transformed.
For instance, at a recent seminar in Chennai, a group of chartered accountants, who, ordinarily, would have been satisfied to work in a public sector enterprise, displayed a hitherto unexpected desire to establish firms that would provide financial services to a global market.
The change within
What has changed? The entrepreneurial spirit seems to have hit India. The supply side revolution has arrived. The table shows patterns in the number of private companies established in India, and their nominal paid-up capital, over almost half a century. These numbers tell an interesting story.
In the period immediately after the launch of the commanding heights doctrine, there were about 25,000 private companies with a paid-up capital of less than Rs 2,000 crore. Even during the days of the licence raj, the number of companies had grown to over 100,000 and the average paid-up capital during this period was over Rs 8,000 crore.
By the beginning of the 21st century, there were over half a million private companies. The growth has been extraordinary. At the beginning of the liberalisation period, the average paid-up capital was about Rs 20,000 crore and a decade later it was almost Rs 250,000 crore.
To be sure, there a number of dodgy companies that make up numbers. Nevertheless, the Table shows a trend of a growth in entrepreneurial experimentation.
In the last decade, the transformation brought about by the 1991 liberalisation enabled Indian enterprise to shed the baggage of history, the British raj, and the licence raj, and move ahead. One hopes and that industry is responsive to the opportunities provided by globalisation.
An expanding industry will be able to expand India's share of world trade beyond one per cent, and, in doing so, import items required by the industrial sector. This will boost the scale of domestic production and consumption.
Cost of capital
So why does the cost of capital matter? Axiomatically, low cost capital is a major incentive for entrepreneurs. In the mid- to late-1990s, the cost of capital was so high that entrepreneurs had to abandon their dreams. The cost of money was in double digits, and the economy had not scaled up at all. As a result, producers could hardly reap benefits of economies of size and make profits. It seemed that what the government gave with one hand, in terms of raised expectations, it took away, by way of a monetary policy, with the other.
Perhaps there was a misunderstanding of what drives entrepreneurship. Quite simply, it is the profit motive, and that means keeping costs lower than revenues. Where, therefore, the cost of money equals a third to a fifth of revenues, the profit equation turns negative. And there is no incentive for activity.
One will never know how many ideas were jettisoned on account of a dear money policy during the late 1990s. One will also perhaps not know, though surely simulations can be designed and run, what the loss of growth was to the nation as a result of the cost of capital being so high. It would have been substantial.
Fortunately, all that is in the past. The Indian entrepreneur is resilient. Just as the 1991 liberalisation was a tipping point, so too was the 1998 Pokhran II explosions. Since then, a realistic cost of money policy has unleashed waves of growth in housing, automobiles and consumer durables such as refrigerators and televisions. There has been a boom in consumer spending.
Why does all this matter? The economy is growing every day. Indian firms are increasing the scale of their operations. One of the key drivers of productivity gains economies of scale is being triggered.
A famous economist said that the division of labour is limited by the extent of the market. Well, the Indian market will no longer be a limiting factor. As it grows, there will be ample opportunities for labour, so that scale economies are feasible.
All of this implies one thing for the future. And that is, making of efficiency gains will be axiomatic. The real level of costs will come down and so will the real level of prices. In other words, inflation will not be a worry. Once that happens, the supply side revolution will have taken off in India.
As more entrepreneurs are motivated, by the market and by the ability to raise capital cheaply, the economy can start achieving the enormous productivity benefits that countries such as the US, Japan, Korea and Taiwan enjoyed after they industrialised. China might be doing the same at a faster rate than India.
Of course, once the supply side revolution happens, and it is in the process of taking place, it is up to the Government to make sure that it recovers its fiscal requirements. That, given the quality of the bureaucracy, is somewhat doubtful. Second, if sums are recovered for the exchequer, it is incumbent on the government to make doubly sure that these sums are not blown through profligate spending. That, unfortunately, is even more doubtful.
Supply-side economics got a bad name in the 1980s in the US not because entrepreneurs did not respond to incentives. They did and also met their fiscal obligations to the government. There was wealth generation. After all, the 1980s is when the dark memories of the 1970s stagflation in the US were finally exorcised.
What the Reagan Administration, however, did was to far well beyond its fiscal recoveries. It was rent seeking gone mad. The slogan, that greed is good, was taken at face value. Nevertheless, there had been wealth creation. Perhaps, the same syndrome affects India. But it is more tolerable if it happens within a context of substantial wealth generation.
Do current policies make sense?
The recent policies of the Reserve Bank of India to hold interest rates steady, rather than raise them with the aim of slowing down inflationary pressures in the economy, is wise and mature, and perhaps reflective of its policy-makers' concern for entrepreneurs.
There is a level of business friendliness, and recognition by the gubernatorial place-holder that entrepreneurship is the key driver of economic progress. If industrial progress is to be made, then cost levels necessarily need to be low and declining. A cheap money policy can achieve this outcome. This speaks of courage to recognise the reality of the future. Incumbency is an asset, as it might perhaps have not been a decade ago.
The policies compare well with the those in the US and the UK. In both these countries, the cheap money policy has triggered a supply side revolution, though no one calls it as such. The positive growth figures of gross domestic product in both these countries speak for the success of this policy.
What is most telling is the implicit notion that entrepreneurship and efficiency spells growth and these are best motivated by a cheap money policy.
Entrepreneurship, efficiency and growth are the key components of the supply side revolution in India, as indeed they are the hallmarks of supply side revolutions elsewhere. It is well worth providing the incentives that make this happen.
(The author is Professor of Technology Strategy, University of Texas, Dallas. Feedback can be sent to firstname.lastname@example.org)
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