Reallocation of capital and labor market

“In the interest of promoting competitiveness of Indian industry it’s important that domestic enterprises should have the flexibility to reallocate capital and labor swiftly in the response to the changing market conditions.”

The availability of efficient and inexpensive financial and infrastructural service facilitates improvements in international competitiveness of domestic industry. However, if enterprises do not have the flexibility to reallocate capital and labor swiftly in response to the changing domestic and international market conditions, better financial and physical infrastructure in and of itself can only have a limited effect on competitiveness. Unfortunately, labor and bankruptcy laws continue to constrain the flexibility if the enterprises.
Major problems in the financial sector mushroomed during the pre-reform era. The government used financial repression to mobilize savings for priority investments and played a large role in the allocation of funds throughout 1970s. Government owned term lending institutions had no choice except to invest in the approved public and private sector investment project. Commercial banks, the providers of short term working capital, were directed to lend to priority sector. Interest rates on both long term and short term loans were often set low enough so that the real interest rate was negative and the cost of capital was lower than its social opportunity cost in an economy where labor as abundant, capital was scarce, incomes were low. There was very little incentive to use the capital efficiently.
The post-reform in 1991 saw the gradual deregulation of interest rates, recapitalization of public-sector commercial banks, steady improvement in risk-weighted asset ratios, and enforcement of prudential accounting norms. Two government committees appointed in the 1990s made several recommendations for strengthening the banking system, improving the assets quality, and tightening the prudential norms and disclosure requirements. The two committees were as follows:-
The Alexander Committee(Chairman: P.C. Alexander)-The Alexander Committee recommended simplification of import licensing procedure and provided a framework involving a shift in the emphasis from ‘controls’ to ‘development.’
The Abid Hussain Committee (Chairman: Abid Hussain)- The Abid Hussain Committee envisaged “growth led exports” and stressed upon the need for harmonization of foreign trade policies with the other economic policies arguing a phased reduction of effective protection. The Committee also favored announcement of trade policies for longer periods in order to impart degree of continuity and facilitate long-term planning of export business.
LABOR MARKET REFORMS
Indian labor market is characterized by sharp dichotomy. In the changing economic scenario, global as well as national, labor flexibility is viewed as an essential attribute of competitiveness. All over the world efforts are being made to introduce greater flexibility while at the same time protecting the legitimate interests of labor. It must be emphasized that labor flexibility does not mean ‘hire and fire’. There are many aspects of our labor laws where greater flexibility is needed and would be in the interest of labor as a whole in the sense that it would actually generate larger volumes of employment in the organized sector by encouraging employment. A large number of establishments in the unorganized sector remain outside any regulation, while the organized sector has been regulated fairly stringently. It can be reasonably argued that the organized sector has provided too much of job-security for too long, while the unorganized sector has provided too little to too many.
Rapid growth requires continuous adjustment to the changes in the domestic demand, technology, and opportunities for international expansion. A regulatory framework that allows for the mobility of labor and capital away from inefficient uses and into efficient uses is critical.
Two pieces of legislation provide the defining characteristics of the pre-reform regime that was designed to protect the labor’s interest.
1) The pre colonial Trade Union Act of 1925 fragmented the trade union movement by permitting any seven workers to come together and form a trade union eligible for recognition in collective bargaining.
2) The Industrial Disputes Act of 1948 closely follows the defence of India rules formulated by the colonial government during the emergency situation created by the World War II. The legislation provides employment guarantee, restricting employer’s flexibility regarding production techniques as well as placements, transferability, and the allocation of labor. Production units of more than 1000 workers must seek government’s permission for closure.
The regulatory framework, far from promoting social justice, has constrained job growth and exacerbated inequalities among formal and informal sector workers. The protective labor laws, which effectively apply to fewer than 110 percent of the total labor work force of 374 million, have increased inequalities between both the sectors.
We should develop a consensus on the scope of reforming key labor laws including specially the Industrial Disputes Act and the Contract Labor (Regulation and Abolition) Act. These laws make it difficult for the employers to respond flexibly to the changes in demand when necessary and have the net effect discouraging the growth of strong labor absorbing sectors. On the request of state governments, selective exemption from the applicability of the above two laws could be considered for the Special Economic Zones (SEZs) and export oriented units (EOUs) and even in the larger SERs.
The net result of these legislative provisions and judicial interpretations has been to increase hiring costs, require companies to carry surplus labor power, and prevent them from adjusting the workforce in response to the demand fluctuations. Labor in the organized sector of the economy has thus been legislatively transformed into a fixed factor of production at par with fixed capital.
The dualistic nature of our economy, with large differences in productivity between agriculture and non-agriculture on the one hand and within the non-agricultural sector between the organized and the unorganized sectors poses problems, especially since the dualism appears to have intensified over the last decade or so. Labor productivity in the organized sector was already 4 times than in unorganized non agriculture in 1993. This ratio has increased to 7 times by 2004. During the same period, the share of the organized sector in total non-agricultural employment declined from 20 to 13 percent.
Both domestic and foreign investors cite rigidity of labor laws as one of the factors affecting the competitiveness of the manufacturing industry, especially the labor intensive sectors. Some of the labor laws may appear to improve the position of labor in the organized sector, but these may also reduce new employment in the organized sector by imposing labor rigidity, especially in the industries where scope for expanding employment is linked to export possibilities and competing producers in other countries benefit from greater labor flexibility.
There are lessons to be learnt from China in the area of labor reforms. China, with a history of extreme employment security, has drastically reformed its labor relations and created a new labor market, in which workers are highly mobile. Although there have been lass layoffs and open unemployment, high rates of industrial growth especially in the coastal regions helped their redeployment. In spite of hardships, workers in China seem to have benefited from wage growth, additional job creation and new opportunities for self employment.
INDUSTRIAL RESTRUCTURING AND BANKRUPTCY LAWS
Post-1991 liberalization has resulted in the removal of barriers to entry into some economic activities. However, in the absence of a speedy legal framework for restructuring or exits, the resource reallocation will be slow, resulting in lower industrial growth and less new employment. The transfer of resources is complicated in India because, unlike in most countries, the procedure for reorganization, bankruptcy, and liquidation are governed by separate laws. The Companies Act of 1956 governs bankruptcy and liquidation, and the judicial proceedings take place in the relevant High Court. Industrial revival and reorganization, however, are covered by the Sick Industrial Companies Act of 1985(SICA), and the authority in this respect is vested with the quasi-judicial Board for Industrial and Financial Restructuring (BIFR).
The existing two-step procedure has been defined in the report of the Prime Minister’s Economic Advisory Council. A sick company (according to the criteria defined in SICA) has to report to BIFR under SICA. BIFR then explores reorganization and restructuring for revival. If the revival is deemed infeasible, closing down the company is recommended and the issue is referred to the relevant High Court under Company act. The High Court then appoints the official liquidator to look into the affairs of the company and to enable the subsequent bankruptcy and liquidation proceedings. The process can often take 20 years or more.
RESERVATION OF PRODUCTION FOR SMALL-SCALE INDUSTRIES
The reservation of the production of certain commodities for small0scale industrial units is another constraint on reallocating resources to efficiently produce exports. Modern small-scale industrial (SSI) units, defined by an investment ceiling (varying over time) on the value of plant and machinery, have been given a variety of promotional concessions to help them overcome genuine handicaps arising from the small-scale of operation.
The additional preferential measures include excise tax concessions, preferred access to government procurement contracts, and subsidized priority credit from the nationalized commercial banks. Several industrial products have been reserved for the SSI units.
These protective concessions penalize efficiency and success by giving firms strong incentives to stay small. The benefits if the concessions outweigh the increase in profitability from a higher scale of operation that would take the units beyond the SSI investment ceiling and make it ineligible for the concessions. Large Indian firms in effect circumvented the reservation policy by moving abroad where there are no reservations and by producing there for exports to India. They also have an incentive to fragment production in several small firms rather than produce in one large firm.
Many of the reserved products, including ready-made garments, are significantly current or potential export items. One victim of this policy, the cotton textile industry was a major exporter competing with Japan in 1950s. The prospective phase-out of the Multi-Fiber Arrangement in 2005 increases the importance of removing the reservation policy. India will lose its share in world markets unless its garment sector can compete effectively with other efficient producers in the world.
A case in point is the poor performance of textiles and garment exports after abolition of quota for textile exports with effect from 1st Jan 2005, exports of textiles and clothing were expected to sky rocket from India. Exports during January-March, 2005 from China are reported to have increased over 500 per cent. However, exports from India are said to have increased by about 1 percent in value terms. Hence there is an urgent need to relax labor laws.
Measures would need to be taken in the 11th Five Year Plan to boost, in particular, labor intensive manufacturing sectors such as food processing, leather products, footwear, and textiles, and service sector such as tourism and construction. The end of the textile import quota regime in industrialized countries offers India a he opportunity to expand textile and garment exports and generate substantial additional employment, provided we can complete with other developing countries.