Search the Internet          Tips  Sites: Finance, Investment

The true cost of reservation

Perhaps no component of the pre-1991 policy regime has been as resilient as reservation for small industry. It has been hacked away at over the years, with many important commodities being freed from the constraint.

It has been diluted with the concession that units that export more than 50 per cent of their production are exempt. But, when it comes to doing away with entirely, despite what appears to be an overwhelming consensus amongst "impartial" observers, the government is just not willing to pull the plug.

The elimination of quantitative restrictions in 2000 and 2001 covered over 1500 commodities, of which over 600 are on the list of products reserved for small-scale manufacture. Indian producers of these are now competing with international manufacturers with only an average tariff rate of 35 per cent standing between them.

This promises to be an unequal battle, with the eventual outcome that domestic producers of goods, for which there is a large enough domestic market for foreign producers to find attractive, will simply vanish.

Proponents of the status quo on reservations may argue that this is a kind of "back-door" policy reform.

In effect, by eliminating non-competitive small producers in the reserved segments, the new trade regime will render reservations meaningless. So, one might well ask, why go through the inevitable political battle to undo reservations when events are serving to make them redundant anyway?

Actually, this is a fallacious argument because it is based on a flawed premise. That premise is that no domestic producer of the commodities in question would be competitive. But, suppose that the lack of domestic competitiveness is largely a consequence of the fact that production has been constrained to be in small scales.

Suppose that a domestic producer who was able to achieve a scale, however large, that allowed him to bring costs down to a level at which the tariff protection would keep him competitive at least in the local market.

Then, the elimination of inefficient, small producers in no way implies that the fate of the particular industry as a whole is sealed. Presumably, in at least some of these products, larger domestic manufacturers would be able to hold their own against imports.

It is too late to worry about a hypothetical scenario in which reservations had never existed. The only concern is with what is likely to happen if they are eliminated with immediate effect. Potential investors would begin to make the kinds of calculations described above. Can investments be made at scales, which will keep costs low enough to generate adequate returns?

Suppose that there is no sector in which returns are perceived as adequate. Then, the back-door scenario of natural attrition will emerge and it will not make any difference whether reservations are explicitly eliminated or not.

However, if there are at least a few sectors in which reasonable returns can be visualised, then the persistence of reservations is denying the Indian economy an opportunity to make new and competitive investments.

In today's macroeconomic situation, the cost of foregone investment in manufacturing cannot be overemphasised. For over two years now, the industrial sector has been growing at a rate slower than that of GDP overall, which means that its share of GDP has been shrinking.

New investment, which brings with it the heightened prospect of future growth in both production and productivity, has just not been taking place. There are, of course, several well-known reasons for the adverse investment climate - exit barriers, infrastructure bottlenecks and so on - of which reservation is only one.

It may also be fair to say that unless all these problems are effectively addressed, no investment will materialise. But, the fact is that the government is making visible efforts to deal with these problems. It is not doing so on the reservation issue.

Let's imagine a scenario in which, as a result of the successful amendments to labour laws, the passage of the electricity bill and the improvement in the road network, the investment climate noticeably improves.

What options will a potential entrepreneur face then? He will, in all likelihood, begin small, so the choice of sectors is not much of an issue. But, if he is like any entrepreneur I know, he is not going to allow his aspirations to be limited by a policy, which says that he cannot grow beyond a point if he wants to remain in that line of business.

Yes, there are ways around, like multiple entities producing the same product and so on, but they all come at a cost, both financial and in terms of distraction of the entrepreneur's attention.

In my view, a dominant entrepreneurial motivation is growth. In any market economy, most start-up ventures don't survive their first few months. Of the few, which survive, most don't grow beyond the individual capacity of the entrepreneur.

But it is the prospect of being one of the infinitesimally small number that grow into large corporations that drives every one of those ventures. Telling the potential entrepreneur that his growth opportunities in particular activities are restricted even before he gets off the ground is the kiss of death to entrepreneurship.

What you get then, are people whose primary motivation is to commercially exploit all the fiscal and financial benefits that are made available. This is, of course, a perfectly rational and legitimate individual response to the incentives, but from the macroeconomic perspective, it is just not bringing out the best in the economy's entrepreneurial resources.

If we want investment to revive, among other things, we must offer all entrepreneurs the inducement of unlimited growth prospects, knowing fully well that only a handful will ever realise those prospects. The most immediate step required to provide this inducement is the elimination of reservations.

Along with this, the entire system of fiscal and financial benefits that are currently inflicted on small enterprises should be eliminated. It is only then that the true benefits of genuine entrepreneurship will be realised.

This is, of course, not to argue that it also means the end of a systematic policy towards small enterprises. Needless to say, it should look fundamentally different from what exists today. It should have three objectives.

One, it should encourage and facilitate growth, patting the successful entrepreneur on the back as he grows beyond its purview.

Two, it should allow entrepreneurs to spend all their time on doing what they are best at - hatching ideas and converting them into business propositions. It is better for an entrepreneur to be thrown into the deep end without any support system than being transformed into a form-filling corridor-walker.

Three, it should accommodate the high rate of failure inherent in the process by absorbing some of the costs that the entrepreneur may find destructive and a disincentive to future ventures. In short, it should make "entrepreneurship" and not "scale" its central focus.

Powered by

ALSO READ:
More Specials...
The Rediff Budget Special
The Rediff-Business Standard Special
Money