Economy (Policy and Reforms) by Gargee Sharma

Model Answer

Question #1. Discuss how globalization has led to informalisation of the Indian Economy. Is the increasing pace of informalisation detrimental to the Indian Economy?

Answer.

Globalization refers to the spread of the flow of financial products, goods, technology, information, and jobs across national borders and cultures. In economic terms, it describes an interdependence of nations around the globe fostered through free trade. India embraced globalization with the advent of 1991 economic reforms and opened its borders for global integration. Post globalization despite predictions to the contrary, employment in the informal economy has risen rapidly in India and various forms of non-standard employment have emerged.

Reasons behind globalization leading to informalization of the Indian Economy:

1. Increased automation in labour intensive sector: Due to global integration of economy and seamless technology transfer, India is facing an onslaught of automation through robotics and artificial intelligence creating a job deficit for the labours.
2. Stringent and regressive labour laws: reforms are necessary to afford more flexibility to employers, facilitate the ease of business and attract greater foreign investment. It has also been claimed that changes to the labour law inspection regime are necessary to free employers from the tyranny of inspection raj. Lack of a structured labour policy industries went for contract hiring post LPG reforms which ultimately led to reduction of formal jobs and increase in contractual jobs.
3. Increased competition: The pressure due to increased competition overseas encouraged formal firms to shift formal wage workers to informal employment arrangements without minimum wages, assured work or benefits.
4. Services sector led growth: LPG reforms pushed a phenomenon known as job polarization due to demand of highly and low paid jobs phasing out the mid skilled jobs. Due to rise in the service sector many jobs were outsourced which were fulfilled by the informal sector. Services sector demand highly skilled labors that wasn’t available as per the demand during the inception of the reforms. As a result many sectors lacked skilled manpower and formal jobs were not created.
5. Gender bias: because of transition in the economy and reduction in formal job creation majority of men remained unemployed. Due to the technical education gap majority of women started seeking employment in the informal sector.
6. Concentration of wealth: with few MNCs running around the globe hiring labors in developing and less developed countries on contractual basis and paying employees high salaries in their base countries increases the roots of informalisation in the developing countries.

Reasons why informal sector is detrimental to development:

1. Reduced Productivity: The average informal firm in emerging market and developing economies is only one-quarter as productive as the average firm operating in the formal sector. This is only in part explained by informal firm characteristics such as their younger age, less experience, and smaller size. Moreover, firms in the formal sector that face informal competition are, on average, only three-quarters as productive as those that do not. Better business climates can mitigate some of these productivity differentials.
2. Increasing income disparity: The informal sector challenges economic growth and hinders the abatement of income disparities in developing countries. The prevalence of informal work is also associated with high inequality: workers with similar skills tend to earn less in the informal sector than their formal sector peers, and the wage gap between formal and informal workers is higher at lower skill levels. 
3. Reduced tax base: individuals and firms may choose to remain outside the formal economy to avoid taxes and social contributions or compliance with standards and licensing requirements. individuals may rely on informal activities as a safety net: they may lack the education and skills for formal employment or be too poor to access public and financial services. This reduces overall revenue and thus hinders public investment in infrastructure, economy and social welfare. This hinders the development of an economy.
4. Decreasing rate of economic growth: The high incidence and persistence of informal labor, particularly in emerging market and developing economies, is increasingly recognized as an obstacle to sustainable development. Informal firms do not contribute to the tax base and tend to remain small, with low productivity and limited access to finance. As a result, economic growth in regions or countries with large informal sectors remains below potential.
5. Lack of protection: Informal workers are more likely to be poor than workers in the formal sector, both because they lack formal contracts and social protection and because they tend to be less educated. 
6. Gender Inequality: Informal work is similarly linked with gender inequality. In two out of three low- and lower-middle-income countries, women are more likely than men not only to be in informal employment, but also to be in the most precarious and low-paying categories of informal employment.

Addressing informality requires well-coordinated policies that take into account country-specific conditions. Policy changes that could affect vulnerable groups can be balanced by stronger safety nets, greater labor and product market flexibility, and better access to resources for informal firms. In addition, policies to spur economic development in general can help reduce informality. Specific measures include streamlining of tax codes and enhanced enforcement of revenue collection; easing firm and labor regulations to create a level playing field for both formal and informal participants; as well as greater access to finance and public services to help increase productivity in the informal sector.

Question #2. Do you think monetary policy of the RBI which is based on Inflation targeting has proved to be inefficient and needs reform? Comment.

Answer.

Monetary policy is a set of tools that a nation’s central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation’s banks, its consumers, and its businesses. The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending. RBI is the main decision maker for the country’s financial system and is mandated with ensuring its stability. RBI currently uses inflation targeting as key to monetary policy. 

Monetary policy is set by Monetary Policy Committee of RBI which was set up under the RBI Act of 1934 and was amended by Finance act, 2016 to provide for a statutory and institutionalized framework or maintaining price stability, while keeping in mind the objective of growth. The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.

Functions of monetary policy committee:

• Exchange rate stability – MPC aims at maintaining the relative stability in exchange rate.
• Equal income distribution – MPC fix special provisions for sectors like agriculture, MSME and thus help in bridging the economic inequality.
• Rapid economic growth – MPC influence economic growth by controlling real interest rate and its resultant impact on investment.
• Price stability – MPC helps in controlling both Inflation and Deflation thus maintains price stabilization policy.
• The current mandate of the committee is to maintain 4% annual inflation until 31 March 2021 with an upper tolerance of 6% and a lower tolerance of 2%.

Limitations of Monetary Policy:

• Inflation targeting cannot ensure stability in the economy. For example, it failed to detect financial crisis events like various defaults and non-Performing assets crisis in the economy.
• Inflation targeting in India coincides with a substantial rise in the real policy rate. This has been accompanied by declining borrowing in the formal sector likely affecting investment and thereby growth.
• Monetary policy formation based on inflation targeting cannot ensure employment creation in an economy.
• Inflation in emerging markets such as India is very sensitive to exogenous shocks like global oil prices, a weaker rupee and a poor monsoon. Global Financial crisis of 2008 showed that monetary policy defined by inflation targeting can no longer be treated as the centerpiece of macroeconomic policy.

Measures needed:

• Enabling effective monetary transmission would not only increase the credibility of the Central Bank but also help in strengthening the financial structure.
• Timely transmission of policy rates could be considerably improved if the banking sector’s non-performing assets (NPAs) are resolved more quickly and efficiently.
• Fiscal policy should be the primary tool used by the government in efforts to stabilize the economy. Better policies need to be adopted that target at efficient taxation and government spending should be used to influence the economy in the long run.

The goals of monetary policy are to promote maximum employment, stable prices and moderate long-term interest rates. By implementing effective monetary policy, stable prices can be maintained, thereby supporting conditions for long-term economic growth and maximum employment. RBI should be granted functional independence and the conflict of interest between RBI and government should be avoided by redefining RBI’s role through a recalibrated monetary policy.