Free Trade and Inclusive Development

By Suranjana Nabar-Bhaduri

One of the central elements in the development of any country is the creation of economic activities that transform the production structure by significantly increasing labor productivity, or the amount of production per worker. By helping to absorb more people into quality employment, the creation of such activities helps to generate a more inclusive and sustainable path of long-run economic growth. While economists and policy-makers accept the necessity of this transformation, there are differing views on the policies that developing countries should follow to achieve this transformation.

Many Western countries and institutions, such as the International Monetary Fund (IMF) and the World Bank, argue that minimizing the role of the State in economic activity, and opening up the economy to external markets is vital to achieving this transformation. But other economists (e.g., Prebisch 1959, Cimoli and Correa 2002, and Ocampo 2005) stress that active industrial and employment generation policies are also essential ingredients for this transformation, and that it is necessary to complement liberalization with such policies.

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An Italian resonance to India's retail liberalization debate

The opposition in Italy to President Mario Monti's decision to liberalize the heavily regulated retail trade bears strong echoes with India's experience with opening retail trade to greater foreign participation. As part of the Save Italy reforms, the government plans to deregulate operating hours for commercial venues and permit shopkeepers everywhere to set their own hours, and sharply reduce the norms that once regulated entrepreneurs trying to set up shop.

Although many consumers cheered, thrilled at the prospect of buying their provisions after hours, small-enterprise associations have denounced the new rules, calling them the death knell for mom-and-pop stores already struggling in Italy’s recessionary economy.

"Small retailers in Italy were already being squeezed by competition with supermarkets, not to mention the slumping economy, and that in Rome alone 10,000 small shops had closed in the past three years, putting about 35,000 people out of work. The government has to rethink this whole thing. Otherwise it is only going to help large chain stores."

These steps are part of reforms to open up closed occupations and promote competition. The closed occupations, with their prohibitive entry barriers, have been responsible for stifling competition and bringing about Italy's current state of economic sclerosis. Stiff opposition in Italy to such reforms is not confined to retail trade but also other similarly regulated professions like taxi drivers and pharmacists. Trade groups of each occupation prefer the status quo and are naturally opposed to all such reforms. They present these reforms as an attempt to defile Italy's cultural identity, traditions and history.

Though in both countries, the major source of opposition to liberalized and deregulated retail trade is the fear of competition from major retail chains driving out the smaller mom-and-pop traders, the underlying concerns are very different. In India, the fear is that, given the large share of population being involved in small hand-to-mouth retail trade (kirana shops), there would be massive labour market dislocation that would undermine the country's social stability. In Italy, the concerns are driven by mom-and-pop traders unwilling to forego their secure and comfortable professions and let large retail chains intrude into their markets.

In simple terms, while in the former, the opposition may have a very compelling economic argument, in the latter case, it is plain anti-competitive.

Why the retail trade issue is more nuanced?

So India has, atleast for now, turned its back on retail trade liberalization. It has been rightly criticized for this decision since the case for liberalization has been widely discussed and is largely obvious.

Alex Tabarrok weighs in with the argument that if it is to improve the standard of living of its people, India needs workers to move from less productive sectors like farming, retail, and so on to other more productive and higher value added industries, and retail trade liberalization hastens this process. I agree with the first point. The second, about retail trade liberalization hastening the process, though may be more contentious and needs a more nuanced appreciation.

It is surprising that Alex does not explore the argument further since he does acknowledge the perils of liberalization - the painful labour market transition and the fact that, atleast immediately, the losers generally outnumber the winners. He simply confines his analysis to a standard line - transitions always involve some pain; creation always involves some destruction; growth always involves change; the alternative, however, is stagnation.

I think this is pretty lazy, even specious, scholarship. Unfortunately, it is also widely prevalent in academic discussions on reforms. There is a reluctance or inability to think through the real world problems that come in the way of pushing through such reforms, especially in democracies. It is all the more surprising since these supporters do identify the potential challenge. But they refuse to think beyond stage one.

The case for any liberalization measure proceeds something like this. First trumpet the benefits of liberalization. Then gain enough support to liberalize regulations. The benefits start to flow, but accompanied by the pains of transition. Then rationalize that any liberalization will have losers, who may even be large in numbers, but "today’s losses and gains are fleeting, the permanent winners are the workers and consumers of the future who will know only the benefits of productivity".

India's tryst with retail liberalization has resonance with similar structural transformations across other sectors, both in India and elsewhere. The fundamental issues bear striking similarity with the conditions when China liberalized its markets and encouraged foreign investments. The newer firms ended up competing with large and uncompetitive public sector units (PSUs) thereby generating the risk of lay-offs by these PSUs. The US economy too, as Joe Stiglitz pointed out in his New Year essay in Vanity Fair, faces a similar labour market challenge as it transitions from manufacturing to productive services.

In all these cases, the key to successful transformation is the effectiveness in managing the losers or those displaced during the process. Traditionally, academicians and policy makers pay disproportionate attention to the reforms themselves while ignoring the more important issue of getting the mechanics of the transition process right. What needs to be done to rehabilitate those affected by the changes? What are the immediate and medium-term measures?

As democracies become increasingly politically divisive, effective rehabilitation strategies will become even more important if governments are to push through such reforms. China appears to have managed the transition effectively, albeit less efficiently. It kept the large and failing PSUs running with heavy state support. The spectacular economic growth in other sectors helped the government with the resources required to backstop this transition hemorrhage without curtailing the progress of the reforms. Now that the transformation has stabilized, the government is slowly removing its support for the PSUs.

Since the pains associated with the transition invariably comes in the way of the effective implementation of the reforms, it is critical that the mitigation cum rehabilitation plan gets the required focus. However, assuming that governments rarely get the transition plan right, a second best option would be, as the Chinese have done, to let the existing public systems continue to maintain life-support till the transition takes strong roots. While this has its costs, it will mitigate the hardships and ease the reform path.

In India's case, it is important that those likely to be displaced from retail trade be absorbed elsewhere in the labour market. This will not happen by itself and merely through the dynamics of economic growth and resultant job creation. It will require enabling policy frameworks and massive investments in education, especially in the acquisition of vocational skills. It will also require policies that encourage the creation of large enough self-employment opportunities.

Most importantly, it will need a universal social safety system that can atleast partially cushion those losing out from the bitter pain and social dislocation that follow. In any case, this social safety net is an essential pre-requisite for cushioning those most vulnerable from the vagaries of liberalization and increasing integration with the global economy. Unfortunately, the opportunity to establish a comprehensive social safety net is being side-tracked by the obsession with populist, inefficient and even wasteful piece-meal interventions.

The retail liberalization debate

The decision by the Union Government of India to liberalize Foreign Direct Investment (FDI) norms in multi-brand retail trade has sparked off an intense debate about fears of the WalMartization of India and massive job losses in the trading sector.

The liberalized retail norms include 100% FDI in single-brand retail, and 51% in multi-brand retail. Among other conditions, the liberalization would be implemented in million-plus cities in first phase, fresh farm produce cannot be branded and 30% of the inputs have to be sourced from small enterprises, and multi-brand entities will have to bring in an investment of $100 million. Retail constitutes a $430 bn market in India, with organized retail forming just 10% of the total and being confined to the larger cities. It is estimated that 30-40% of fresh produce goes waste and more than half of this can be brought to the market if the proper farm-to-fork infrastructure is in place.

There are primarily five stakeholders in retail market - organized retailers, unorganized retailers, farmers/producers, consumers, and governments. It is easy to rationalize the benefits for governments (infrastructure investments), consumers (choice and better quality of produce), and producers/farmers (better prices). Given the precedence of other markets which have been liberalized, it is safe to argue that organized retailers too will adjust to the changes, improve their productivity, embrace newer technologies and processes, and become more competitive. This means that the concerns about the liberalization of retail trade can be mainly confined to the unorganized retailers. The debate should therefore be focused on its impact on them and what can be done to mitigate it.

There is a need for careful strategic thinking on the details of this liberalization policy with regard to its impact on the unorganized retailers. How do we calibrate the first wave of liberalization, so that it is initially restricted to those areas - places and products - least likely to affect them? What should be the sequence of opening up so as to minimize its adverse consequences? What should be the conditions imposed on the retailers permitted to enter Indian markets? Discussion and analysis of the liberalization that addresses these issues will considerably enrich the debate and is certain to increase the effectiveness of policy making itself.

It is unfortunate that the mainstream debate in electronic and print media on the issue has been dominated by ideological sabre rattling. There has been very little objective empirical analysis of the underlying market trends. For example, given that the central concern is about the impact on unorganized retailers, certain questions follow. What is the share of these retailers in the cities proposed for liberalization in the first phase? Where are the existing unorganized retailers located and who are their customers? Are those located in these areas likely to be swamped by the larger retailers? What is the market share and structure of existing organized retailers in these cities? Who are the typical customers of the organized and unorganized retailers?

In fact, atleast in non-food retailing, the trend towards organized retailing has already moved far ahead in many states. For example in the southern states like Kerala, long the bastion of left-wing parties, the ubiquitous chain of Margin Free shops may have already marginalized the traditional mom-and-pop stores in all but the smaller villages. The widely acclaimed Rythu Bazars in Andhra Pradesh, which seek to offer producers an opportunity to directly market their farm produce, carry within them the seeds of crowding-out middlemen and unorganized retailers of perishables.

In the larger Indian cities, the big box Indian retail chains have already captured a major share of the market from unorganized retailers. Even without foreign competition, the Reliances, Mores, and Food Bazars are already expanding aggressively into neighbourhoods within smaller cities and towns and displacing the unorganized retailers. This trend will only continue apace. However, even with this assault, given the sheer size and diversity of the markets in urban India, neighbourhood mom-and-pop shops, with a long history of personal relationships, are likely to adapt and survive.

There is an important difference between the business models of big box retail chains in India and those in US and Europe. The market for big hyper-markets and malls in India is limited for variety of reasons - cost of space within cities, limited space availability, opportunity cost associated with shopping in these often distant shops etc. In the circumstances, the preferred model of expansion will be through smaller franchises spread out across the city. In this, the domestic organized retailers have already taken the pole position and the entry of foreign retailers will be significant more for the intensified competition among them rather than for the marginalization of small unorganized retailers.

At a purely intuitive level, a carefully calibrated liberalization of retail trade, with the first phase restricted to a handful of big cities, appears to be an excellent strategy. Given the massive size of markets in these cities, it is certain to generate a significant impact on the incentives in the downstream production and procurement segments. The infrastructure investment requirement will mean that it will spur substantial investments in cold storages and go-downs, transport logistics and so on.

Farmers will be able to deal directly with these large procurers (who and their agents can be held accountable), instead of the fragmented and largely invisible intermediaries, and thereby get better prices for their produce. Consumers will benefit by way of choice and better quality. All these developments take place at the back-end of the production-consumption chain. The impact on retailers will be taking place in cities where that impact is already felt and would have deepened, albeit less efficiently and more slowly, with already expanding domestic retailers.

This entry of retailers presents a great opportunity to deploy randomized control trials (RCTs) to a natural setting. For example, given that it would be implemented only in a few cities, it would be possible for researchers to locate or design an RCT setting. The impact of the entry of foreign retailers can be evaluated objectively to arrive at answers to some of the questions raised earlier in the post.

Update 1 (6/12/2011)

Good story in the Times. Barely 6% of India’s $470 billion in retail sales takes place in organized retail stores, in contrast to more than 20% in China, 36% in Brazil, and 85% in the United States.

I also feel that shopping habits may be an important factor in how customers take to retail liberalization. People use the big retail malls for large, monthly or weekly-once, purchases. For a number of reasons, the local kirana shop would be convenient for smaller purchases. How many people in India make bulk purchases? It would be surprise if more than a small share of people would be making such bulk purchases. And these people, with or without foreign retailers, would, in these million-plus cities, by now have already gravitated to the Indian retailers.

The counterfactual problem in public policy

Heads I win, tails you lose! This aphorism could well describe the debate on many intractable public policy issues, those where conclusive answers are difficult to come by. Supporters claim that it would have been worse without the intervention. Critics denounce the intervention as a failure since the problem persists. The challenge with all such issues is the difficulty of establishing the counterfactual. Let me illustrate this dilemma with three examples.

The most famous counterfactual problem of our times is the debate on the impact of expansionary policies implemented in the US in the aftermath of the Great Recession. Conservatives point to the persistent high unemployment rates and weak economic conditions, despite the extraordinary fiscal (more than $ 1 trillion) and monetary expansion (zero bound rates and $2.3 trillion QE), as conclusive proof of the failure of expansionary policies.

They reinforce their argument by pointing to the failure of the now infamous recovery projection, estimating future unemployment rates with and without a stimulus plan, made in January 2009 by Christina Romer and Jared Bernstein, then part of President Barack Obama's team. Their way-off-the-mark estimates suggested that unemployment would approach 9% without a stimulus, but would never exceed 8% with the plan.



In May 2011, using the latest figures available from the BLS, the unemployment rate reached 9.1%. In contrast to the Romer and Bernstein projections which estimated that the unemployment rate would be around 8.1% for May without a recovery plan, or 6.8% with a stimulus plan, the actual rate was 9.1%. The actual unemployment rate has been consistently above Romer and Bernstein’s worse case scenario for the economy – and by a considerable margin. Critics of the stimulus invoke this as proof of its complete failure. After all, though a massive and unprecedented monetary and stimulus was enacted, it appears to have had no impact in terms of improving the economic conditions.

Supporters of the stimulus in turn point to other statistics to put forward their claims about how the stimulus created employment, supported the poorest, propped up aggregate demand, and helped local governments. They argue that in the absence of the stimulus measures, the counterfactual, the economy would have plunged into a full-blown depression.

Further, economists like Paul Krugman have consistently held that the actually enacted stimulus policies have been severely deficient and have been advocating much larger doses of expansion to mitigate the high unemployment rate. In the absence of the required magnitude of expansion, they claim, it is unfair and incorrect to blame the expansionary policies for the economy languishing.

Such counterfactual problems are pervasive in economic policy making. This is especially so given the impossibility of localizing and quantifying the impact of specific policy interventions. In the circumstances, if the intervention fails to yield the desired result, critics will denounce it as a failure. Supporters will find that establishing the counterfactual, the scenario in the absence of the stimulus, is fraught with insurmountable difficulties.

Another example of such analysis is the debate about the benefits of metro-rail in New Delhi. Critics argue that despite the massive investments in the Metro, the Delhi traffic remains as bad as ever, even worse. This argument is made on the assumption that the Delhi Metro was set up with the objective of lowering traffic congestion in the city. Now that the final outcome shows no signs of traffic improvement, they argue, the Metro project has failed.

Supporters naturally point that without the Metro Delhi would been uninhabitable. They argue that the Metro has taken 1.7 million people out of the roads, and thereby ensuring that those many people stay out of city roads. They argue that the success of the Metro is a function of how many people it is able to attract and how fast its network expands. The persistent congestion is only a reflection of the fact that the Delhi traffic has been growing at a pace faster than even the growth in the Delhi Metro traffic.

Such criticisms are commonplace with infrastructure investments. They most often fail to produce tangible and immediate impact, and leaves all stakeholders unsatisfied. When the power deficit is a few gigawatts, the commissioning of a few hundred megawatts of power generation capacity has limited impact on the load-shedding situation. Similar situation arises with even major new water and sewerage treatment capacity expansion, since the requirements are massive. The problem is most acute with transportation, since traffic always appears to worsen. In the absence of any salient impact, municipal councils have no incentive to sanction scarce resources in such sectors.

Finally, the left-wing critics of economic liberalization in India point to the persisting high poverty rates and social deprivation and blame it on the neo-liberal policies of the past two decades. They argue that these policies have exacerbated social tensions, widened economic inequality, dismantled social and economic protections and therefore weakened the nation economically.

This too is a classic counterfactual problem. There are two issues here. One, serious commentators question the nature and extent of liberalization undertaken by successive governments, claiming that they have been too little and limited in scope and piecemeal and stop-start. In the absence of, leave alone the full breadth and scope, atleast even some reasonably acceptable level of liberalization, they argue, how can we blame liberalization for the current state of affairs?

Second, they argue that in the absence of this limited economic liberalization, the economy would have been in doldrums. They point to the undoubted macroeconomic gains of recent years as proof of this. How do we know what would have the state of affairs in the absence of the liberalization policies? See Ananth's excellent take on the critics of economic liberalization, including on other dimensions.

In all three cases - stimulus measures in the US, Metro railways in New Delhi, and economic liberalization in India - there is a classic cognitive bias at work, availability bias. People observe salient outcomes - the poor state of the economy, despite the stimulus spending; poor state of Delhi traffic, despite the Metro; and the persistent high poverty levels, despite economic liberalization - and conclude that these interventions failed to achieve the outcome. However, the reality clearly (albeit less so clearly in case of stimulus) points to all having had considerable effect in mitigating the respective problems, though the exact magnitude of their impacts is difficult to quantify.

Then there is another issue here. In all three cases, the opponents frame the debate by equating the particular intervention with the text-book case of the underlying concept. Accordingly, for example, they define the stimulus as was implemented in the US was the classic Keynesian stimulus, and therefore its apparent failure to get the economy out of the recession is conclusive evidence of the failing of the underlying Keynesian concept itself.

Similarly, critics' definition of the success of metro rail as measured by the resultant reduction in congestion rate, means that an actual increase in congestion is taken as proof of its failure. For neo-liberal critics, Manmohanomics is the embodiment of economic liberalization and since it did not "eliminate poverty", as promised, it has failed!