Economic Survey Vol.1 Ch.3: Pro Business versus Pro-Crony

Pro-business policies are those policies that foster competitive markets create a level playing field for businesses to compete. The pro-crony policy supports incumbent firms but does not necessarily foster competitive markets

Pro-crony policies, in contrast to pro-business ones, erode wealth in the economy as cronyism fosters inefficiencies by ‘inhibiting the process of creative destruction’. These policies may promote narrow business interests and hurt social welfare.

The Survey takes liberalization of the Indian Economy in 1991 as an example of Pro-business policy thus acting as an illustration of the impact of Pro-business policy on wealth creation. Liberalisation enabled creative destruction and generated benefits. Here ‘churning process’ of the stock market is taken as an identifier for creative destruction. 

• In the initial years of Sensex (during its inception), there was a lack of dynamism in the index that could be proved by looking at the firms that constituted the index. However, the years following 1991 liberalization saw the rapid emergence of new firms, new ideas, new technologies and new operating processes, causing a steep revision of the Sensex in 1996.
• After 1996, the Sensex underwent more frequent revisions, owing to the more dynamic nature of a substantially more competitive Indian market.
• The figure shows the number of firms that exited (moved out) the Sensex in each five-year period following 1986:

• Liberalization caused a spike in the number of firms churned in the years that immediately followed it, but the churn rate did not decline to pre liberalization levels in later years.
• The figure also indicates the average duration a Sensex constituent remains on the index. Following the 1991 reforms, the average duration a firm spent on the index declined drastically. Currently, a firm is expected to remain on the index for only 12 years – one-fifth of the expected duration prior to the reforms.

• Pro Business policies bring innovation, dynamism to the markets and encourage competition.
• When creative destruction is fostered, sectors as a whole will always outperform individual companies within the sector in creating wealth and maximizing welfare. Therein lies the motivation for India to pursue pro-business, rather than pro-crony, growth. 

• Pro-crony policies, in contrast to pro-business ones, erode wealth in the economy as cronyism fosters inefficiencies by inhibiting the process of creative destruction.
• Prior to 2010, if the firm’s promoters had “connections”( firms that may benefit from pro-crony policies), it clearly paid a firm and its shareholders.
• “Connected” firms outperformed the broad index of the stock market by 7 percentage points a year on average till 2010. This pre-2010 outperformance of “connected” firms indicates the possible extent of rents extracted by these firms at society’s expense.
• In contrast, the significant post-2010 underperformance – following the release of the CAG report – illustrates the fact that such “connected” firms were likely to have been inefficient ones

The Economic Survey explains how political connection used in gaining the allocation of resources affects the economy. It gives the example of coal mines allocation.

• Coal block allocation: Prior to 1993, no specific criteria for allocation of captive mines existed. It was changed through Amendments in Coal Mines (Nationalization) Act, 1973 which allowed private players to carry out coal mining for captive use.
• In August 2012, the CAG report on coal block allocations examined the effectiveness of the processes adopted in the allocation of coal blocks. On 24 September 2014, the Supreme Court of India cancelled 214 of the 218 allocations made by the Government of India over a span of 15 years.
• The Coal Mines (Special Provisions) Bill, 2014, and its subsequent rules were passed in December 2014, and the Coal Mines (Special Provisions) Act, 2015, was included in the Indian mining legislative framework. The Act ensured that any future allocation of coal blocks would solely be through competitive auctions.

• Wilful default occurs when firms take loans, divert the proceeds out of the firm for the personal benefit of owners, default on loans and declare bankruptcy, thereby expropriating a range of stakeholders – lenders, minority shareholders, employees regulators, and state coffers.
• Every rupee lent to a wilful defaulter constitutes an erosion of wealth. Money lent to a genuine business creates assets, which generate profit and employment.
• On the other hand, money lent to a firm that has no intention of investing the proceeds in ex-ante profitable projects is money wasted. Besides making cronies rich, it contributes nothing to the economy.
• As of 2018, wilful defaulters owed their respective lenders nearly 1.4 lakh crores. This amount is the almost equal budget allocation for health, education and social protection or 2.5 times the allocation towards MGNREGA, as shown below in figure

Distinguishing characteristics of wilful defaulters in India

• Wilful defaulters tend to be more opaque than both non-defaulters and firms that default out of genuine distress.
• Promoters at the helm of wilfully defaulting firms pledge, on average, almost 50 %of their shareholding to lenders. In contrast, the corresponding figures for distress defaulters and non-defaulters are 30 %and 11% respectively.
• Wilful defaulters make large loans to related parties. The outstanding balance of loans given to related parties for distress defaulters and non-defaulters is negative, meaning that the average firm in the sample is a net recipient of loans from related parties. Wilful defaulters, on the other hand, are net givers of loans. Peculiarly, they are net recipients of external loans and defaulters on these loans at the same time that they are net givers of loans to their related parties.

Conclusion

While pro-business policies increase competition, correct market failures, or enforce business accountability, pro-crony policies hurt markets. Such policies may promote narrow business interests and may hurt social welfare because what crony businesses may want may be at odds with the same. For example, crony businesses may lobby the government to limit competition in their industry, restrict imports of competing goods or reduce regulatory oversight