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Has India’s economy under-performed relatively to its institutions?

December 20, 2011

Douglass North defines institutions as “the humanly devised constraints that structure political, economic and social interaction.” Their primarily role in economy is to “reduce the transaction and production costs” and allow potential gains in trade. This capacity of reducing transactions costs translates nowadays into various performance factors measuring the “institutions quality”. Performance of institutions has become a hot subject, particularly
within development institutions concerned with their aid effectiveness. Several indices have been developed including factors such as severity of corruption, bureaucratic efficiency, the rule of law, and the predictability of policy making.

In India’s case, when comparing economic performance and institutions quality, I have not found any results supporting that India’s economy has underperformed relatively to its institutions. Assuming the opposite would imply that institutions in India are performing well, while its economic performance is lagging behind. This simply does not match the reality reflected by various observations. Institutions’ quality in India is in fact average to low, scoring approximately the same as Kenya on indices like the CPIA or the Global Integrity Index.

We can easily confirm the result by extending the comparison to a proxy formed by a sample of countries with similar quality scores to India, calculating their average growth and comparing it to the economic erformance of India.

Observations show, on the contrary, that the economy is over performing the institutions. In fact, businesses in India are finding ways to overcome these very institutional inefficiencies. In its special report on India, the Economist point out this phenomenon:” A weak state has given rise to a new kind of economy[…] It makes sense for businesses to sprawl because the Indian state is still pathetically weak. Infrastructure is so awful that companies often build their own. Courts are slow and sometimes corrupt, so contracts are hard to enforce and banks and businesspeople are inclined to stick with companies they know and trust. Fewer new firms have broken into the big league since 2003 and those that have done so have tended to be good at working the political machine.”

It appears in fact that institutions are not functioning as well as required by high-growth businesses.  Companies are therefore doing their best to “adapt” to these underperforming institutions. An interesting measure of this “gap” is provided by the “the Government-Business Efficiency Gap 2011”, that shows a business efficiency over-performing governmental one by seven points in India.

Furthermore, a report by Goldman Sachs on India’s future points out the great “2050 potential of India” and the ten crucial keys to “unlock” it. Governance is unsurprisingly mentioned as the first key factor to improve, confirming that the current institutional situation is alarming. Lack of accountability and centralized inefficient public services mostly explain the lack of results. “Some observers attribute India’s governance problems to its democracy”, say the authors.“We think it is the malpractice of democracy—or the ‘democracy deficit’—that is the cause of the problem.[..] If the system of governance were to respond, it would set in train a virtuous cycle. Thus, the need is for increased democracy, not less.”

India is achieving satisfying growth despite dysfunctional institutions. However, these institutions are a big achievement in themselves and should be considered as an advantage when compared to countries like China or Vietnam where traditions of democracy and accountability is still to be implemented. On the long run, this advantage can turn into a huge differentiator for a sustainable high growth, if matched with successful reforms.

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