Shyam Saran: The perils of India's arbitrage economy

Last Updated: Tue, Nov 20, 2012 20:10 hrs

In my column titled “Muddling along is no longer an option” (October 17, 2012), I had underlined the importance of our governing elite openly embracing economic reforms rather than resorting to “reform through stealth” or “reform through crisis”. A couple of weeks ago, the Congress party leadership took some encouraging – though tentative – steps in this direction, providing long-overdue public support to Prime Minister Manmohan Singh’s recent modest policy measures such as welcoming foreign direct investment and reducing fuel subsidies. This needs to be followed through with graduated steps towards dismantling the “arbitrage economy” that has become entrenched in our country on the back of populist, but ill-administered, entitlement schemes and a badly designed, outdated and inefficient regulatory and bureaucratic system.

Opportunities for arbitrage arise whenever there is a significant gap between administered or regulated prices set by the government and a market price reflecting actual demand and supply of a product or service. The objective may be to make supplies or a service available to only a target section of the population. This is the case with kerosene supplied through the public distribution system (PDS). Or the government may wish to keep costs low in the economy through a subsidy on a strategic product. Thus, the subsidy on diesel is aimed at keeping transportation costs stable. Government regulation may also create arbitrage opportunities, for example, in prohibiting the import and export of goods through border trade points except those in a designated list and in limited quantities. This leads to large-scale contraband trade in the absence of efficient and strict means of enforcement.

The experience of the last several years indicates that whatever the original and laudable social objectives of subsidies or regulations in force may have been, they have mostly not been achieved. On the contrary, they have led to opportunities for large-scale rent-seeking, causing major distortions in resource allocation and investment decisions — and, more seriously, severely undermining national security. Politicians, bureaucrats and civil society all need to be made fully aware of the full costs of persisting with such policies — costs that go far beyond the nominal Budget outlays.

According to the Planning Commission, India’s subsidy bill for 2011-12 was Rs 2.16 lakh crore, or 2.4 per cent of GDP. In its assessment, 58 per cent of this did not reach the targeted groups. It is also estimated that one-third of the grain in PDS is siphoned off and the finance minister claims that the government spends “Rs 3.65 on transferring Rs 1 to the poor”.

If these figures are correct (they are probably underestimates), then there is no justification for our bloated and expanding subsidy bill. It may be better to give Rs 1 to the recipient directly rather than spend Rs 3.65 in order to deliver it to him or her. The money saved could allow more expenditure on priority sectors such as education and public health when current outlays are abysmal.

Let us take the case of kerosene. The current market price in India is, on an average, Rs 44 a litre, but PDS kerosene is being sold at Rs 14. It is estimated that 40 per cent of PDS kerosene is diverted illegally to adulterate more costly transport fuels like petrol and diesel. In addition to the huge loss on account of diversion, adulteration leads to greater wear and tear of engines. It leads to more toxic emissions, negating the considerable investment the government is making to promote cleaner and more efficient fuels for vehicles. Those who are involved in this illegal business are able to earn massive profits. A powerful mafia becomes entrenched to safeguard and perpetuate this lucrative business. This leads to criminality in society and encouragement to corruption in politics and in bureaucracy. It should be recalled how an upright officer was burned to death in Maharashtra because his brave attempt to tackle this mafia. Therefore, it is not only the nominal loss to the public exchequer that we should consider; there is a much greater – though as yet unaccounted – consequential cost to the economy, society and polity.

It may be instructive to look at the result of a pilot project in Alwar (Rajasthan). Here the supply of subsidised kerosene through PDS was replaced by direct cash transfers to the target population. In a brief period, the monthly off-take of kerosene in the district dropped from 80 kilolitres to only 14 kilolitres, or by 80 per cent. This reveals the extent of diversion that has been taking place.

For an example of regulatory arbitrage, let us look at the very restrictive border trade regime with Myanmar. According to the northeast chapter of the Indian Chamber of Commerce and Industry, the daily turnover of legitimate border trade between India and Myanmar is Rs 40 lakh. The actual turnover, including illegal imports of Chinese and Thai goods, is Rs 2 crore, or five times as large. Contraband, by definition, pays no customs or excise revenue to the government. The trade is controlled by a powerful and often violent criminal mafia. The border authorities on our side, whether immigration, customs or paramilitary forces, soon became complicit, given the temptation of significant pay-offs. The result is loss of revenue to the government, the undermining of local industry in the northeast, and a major threat to national security along a very sensitive border. If these costs are taken into account, then the implications of “arbitrage” go far beyond nominal monetary loss.

The “arbitrage economy” also discourages productive investment in the economy. If more money can be earned through exploiting arbitrage opportunities, why take the trouble to invest in manufacturing or legitimate trade? Most recent scams are the result of such rent-seeking.

The winter session of Parliament, which convenes next week, must confront these substantive issues rather than descend into a familiar indulgence in populist tokenism. Political consensus is needed behind a credible plan to dismantle the arbitrage economy, prevent the dangerous erosion of national security, and enable healthy and balanced growth of the Indian economy.


The writer, a former foreign secretary, is currently chairman of RIS and a senior fellow at the Centre for Policy Research, New Delhi

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