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Institutions and Economy~II

In the last decade or so, there has been a renewed urge to implement the reform process. India has reaffirmed its policy to follow fiscal prudence, with a new time path for reducing the national fiscal deficit to 3 per cent of GDP.


In the last decade or so, there has been a renewed urge to implement the reform process. India has reaffirmed its policy to follow fiscal prudence, with a new time path for reducing the national fiscal deficit to 3 per cent of GDP.

The industrial policy continues to be liberal with a strengthened emphasis on “ease of doing business”. Openness in foreign trade, a liberal environment to attract FDI, opening up of new areas such as defence and raising the equity cap on insurance have been some of the marked features of the strengthened reform process.

The emphasis on Capex, surge in public investment, investments in logistics through “Gatishakti” and other infrastructure such as roads, drinking water and housing have been a hallmark of the budget of 22- 23. Another significant move has been in the area of digital IT infrastructure and in the introduction of a biometric system of Aadhar to facilitate the receipt of direct financial benefits. The introduction of the Goods and Services Tax is a major reform of the domestic indirect taxes that would enable India to have a state-of-the-art domestic indirect tax system; the Insolvency and Bankruptcy code is expected to expedite the process of debt recovery and create incentives for bankers, are the large ticket reforms pushed by a government that means business.

The inclusive intent of the Government is evidenced in the Right to Education act and in the National Digital Health Mission as well as the National Medical commission. With a willing dispensation pushing through the process of reforms and economic policy resurgence, India is truly poised to take off as one of the largest global economic players in days to come.

Against this backdrop, it would be of interest to study the alternate model of the widely acclaimed model of East Asian development, with its focus on Japan and China, and its impact on one of India’s neighbouring countries, Sri Lanka. Gao (2002), in “Economic ideology and Japanese industrial policy” observed that neither Neoclassical, Keynesian nor Marxist theories could explain Japan’s rapid development in the 1980s.

China’s development that followed is somewhat comparable in the context of structural similarities or procedural differences in China’s reforms and opening-up policy. Studies on the applicability of K Akamatsu’s “flying geese model” to explain the East Asian economic renaissance as conducted by Gill and Kharas in 2007 have found that the main differences in the Japanese model of development as compared to that of China lay in their divergent attitudes towards the market and resultant institutional arrangements, particularly with reference to capital formation, international market relations, degree of technical innovation, resource and trade dependence.

The institutional parameters that urged the Japanese paradigm were the system of private property and a market economy, the theoretical constructs of capitalism. To sustain a continuous growth of per capita income, however, long-run governmental intervention in the market was called for particularly in the need to provide the much-needed market economic stimulus. Similarly, the government’s effective role was most visible in the Chinese socialist market economic system. These admit the relevance of effective governance in the East Asian development paradigm.

The next institutional factor that stands out in the East Asian development model is the role of the bureaucracy. In Japan, a team of talented elite bureaucracy was formed to operate in a system meant to guarantee innovation and performance. The officials were responsible for identifying and selecting the industrial structural policies, formulating industrial rationalization policies and monitoring performance to ensure efficiency. Johnson (1982), in his book “MITI and the Japanese miracle: The growth of industrial policies” aptly observes that the “Japanese model of bureaucracy distinguishes the right to rule from the right to govern”. Another important institutional parameter, namely Industrial policy was set in the background of the state as a minimal system. The state, while supporting the market economy, would provide redistribution by imposing constraints on parliamentary democracy. Such industrial policy extracts the economic effects from industrialization, the ability to coordinate production and the expansion of national productivity from industry to the economy. While Japan’s industrial policy followed a strategy of technology-intensive industries, China, in comparison, followed a strategy to encourage labour-intensive industrialization.

The paradigm of Japanese development was successfully emulated by other third-world countries especially in Southeast Asia and in Latin America some of whose growth stories have even surpassed that of Japan. One such country in South Asia, Sri Lanka, soon after its independence, ranked high on economic and social indices, higher than even Taiwan and South Korea. As times and policies changed, such an advantage gradually eroded. The Sri Lankan government embarked on a halfhearted policy of economic liberalization in the late 1960s but took much longer than other Asian economies to implement import substitution policies, and fundamentally failed to change its economic performance.

Three factors intervened in a change in the economic policy orientation of the island nation, namely, criticism of the inward-looking economic policy, the impact of the East Asian development model and conditionality imposed by the World Bank and other aid agencies. In 1977, the new government came into power changing the economic strategy and a liberalized economic structure was established in the process of its integrating with the global economy. Market mechanisms started to be the key players in this country, ignoring its large agricultural sector that was earlier contributing to 20 per cent of the GDP, in overt reliance on export-led industrialization and an exaggerated emphasis on a fragile sector such as tourism.

Hence, while other countries following the East Asian developmental paradigm have escaped the development dilemma and have emerged as developed countries, Sri Lanka, despite so many decades of liberalization and open market policy continues to remain a developing economy. Yan He (2020), in his research paper “The Developmental Government and Economic Development in Sri Lanka” finds that government intervention, bureaucracy and industrial policy provide “a novel explanation for Sri Lanka’s economic growth and regime change over the past fifteen years”.

Yan would observe that the island nation has enough historical evidence and supportive institutional conditions for governmental interventions in its economic development and that Sri Lanka’s experience between 2005 and 2019 reveals that strongman politics is indeed an effective governance model which was a key factor in driving its economic growth. Such charisma also facilitated in maintaining a stable environment for development and in creating an efficient administrative apparatus.

Nevertheless, as the following years would show us, the deficiency of this strategy is obvious, posing a crisis to the legitimacy of the very regime, ultimately losing the confidence of the electorate despite improvement in the economic performance in the preceding years. Paradoxically, the coalition government that followed, widely hailed as a victory for democracy, was unable to stay in power for more than one term.

The institutional and organizational shortcomings of the bureaucracy rendered the administration largely dysfunctional. Familial politics and nepotism put the concepts of fairness and efficiency in question and have led to pronounced inequalities, threatening the very viability of the regime. In its purported attempts at promoting efficiency in policy implementation, the bureaucracy only succeeded in restricting reform and innovation. Sri Lanka’s economic policymaking has also impeded realistic growth prospects.

Despite liberalizing the entry of FDI in infrastructure development, the industrial policy, in its over-simplified form, has failed to take off and the island nation, having failed to take advantage of its export processing zones, has continued to depend on exaggerated export-led industrialization and over-dependence on imports even for the basic necessities. Sri Lanka, unlike Japan in the 1980s, failed to reap the benefits of industrial upgrades, technological innovation, or the skilling of its human resources. Its over-dependence on imports restrained it from taking advantage of the economies of scale. The policies also failed to be inclusive and most of the islanders failed to access the benefits of the economic growth trajectory, in whatever form.

According to Yan, where effective strongman politics prevail, despite bureaucratic imbalance and oversimplified economic policies, the economy gains momentum. Where such strongman politics is absent, coupled with a weak bureaucracy and simplified policy making, economic decline is inevitable, and this is the lesson learnt from our studies in economic development in Sri Lanka. Institutions, therefore, strongly influence the economic development of countries in determining the framework in which economic exchanges occur.

An effective government, a well-formulated legal structure, an efficient bureaucracy as well as pragmatic and dynamic policy implementation are, inter alia, the important institutional factors which have enabled countries to “develop”; whereas in the absence of such institutional support, countries have been relegated to the realm of “developing”, a developmental dilemma that they failed to overcome.