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India's states harm themselves with wild policy swings

Investors cannot trust that governments will honor contracts

| India

There was concerning news from the south of India in mid-November. The state of Andhra Pradesh has canceled a Singapore-backed project to develop its new capital, Amaravati, into a world-class financial hub. The plan of the previous chief minister, it has fallen foul to his successor from a rival party.

Similarly, Chief Minister Jagan Mohan Reddy has been threatening to revoke solar and wind power purchase agreements if producers refuse to renegotiate rates for energy projects. These agreements were established by his predecessor and guaranteed high prices for the producers. Forcing prices lower will create problems for banks that financed these projects.

Finally, the state government has reserved three quarters of jobs for local young people, which is likely to create a scarcity of workers and drive up wages, deterring investors. Worse, it is prompting other Indian states to consider similar sons of the soil regulations to appease local political constituencies. For instance, Chief Minister of Maharashtra, Uddhav Thackeray who is heading a coalition government wants to reserve four-fifths of jobs in private sector for locals.

This all comes when India's gross domestic product growth rate fell to 4.5% in the July-September and may slip further -- when it needs new investment most.

What this goes to show is that it is every state for itself, and given India's federal nature, it is not easy for New Delhi to rein in states' irresponsible actions. If anyone thinks the states can now push reforms of land, labor and energy and in turn help the country's stuttering economy to grow faster, this myopic news will disappoint them.

State politicians have been self-harming for a while now in the pursuit of populist ends.

In 2008, West Bengal's opposition leader, Mamata Banerjee, agitated against Tata Motors' proposed development of a factory on fertile agricultural land which the state had acquired for it. Tata decided to leave and Ratan Tata, chairman emeritus, said the move had had "a high negative cost" to the company.

After wooing international beer-maker Carlsberg to set up a $25 million brewery, Bihar's state government caused it to shut down in 2017 when Chief Minister Nitish Kumar introduced his ill-advised liquor ban. It was soon followed by the closure of United Breweries, another liquor manufacturer.

Since the ban, illegal alcohol sales have increased and the state government has lost tax revenues -- state excise collection fell from 31.41 billion rupees ($430 million) in 2015-16 to a mere 0.29 billion rupees in 2016-17. Andhra Pradesh is now likely to impose prohibition too.

Power sector reform is another casualty of state-level populism. The loss and theft of electrical power and the tariffs effectively levied on businesses to subsidize favored voter groups such as farmers and households artificially raise electricity costs for everyone else.

Even positive policies, such as Delhi's provision of free transport for women to encourage them into the workforce, cost money and will spark similar demand in other states with worse financial health. At least this might result in economic growth ultimately.

One of the reasons behind the growing reckless populism in Indian states which leads to economic self-harm is the system of political patronage which rewards donors with lucrative contracts. It also means contracts entered into by their predecessors are likely to be canceled on flimsy grounds.

Politicians are expected to reward loyal voter groups such as farmers and poor households. Things become worse in competitive democratic elections, with one party trying to outdo another in blocking reforms or persisting with market-distorting regulations, often with adverse implications for those doing business.

State governments will not stop simply because many of their shortsighted and market-distorting actions bring political benefits, and once a company has put money in it is not easy to pull out without incurring cost. Even if they are in fact canceling an unfair project which benefited a predecessor, not the state, they may well replace it with one of their own.

Given this backdrop, investors need to demand policy certainties and insist on guarantees or provisions for compensation against arbitrary state actions. These include risks arising out of a change in government leading to the cancellation of capital-intensive projects or the forced revision of terms in operational contracts.

Foreign investors can also insist on investment treaties signed between two countries which have a provision for investors to seek compensation through international arbitration for damage caused by unfavorable regulatory changes. These treaties can rein in imprudent state actions.

Some independence from political concerns is needed to stop this cycle of contracts and cancellations. The federal government should ask the finance commission, entrusted with devising a formula to distribute central taxes among states, to consider linking part of this distribution to how well states abide by contracts not tainted by corruption -- especially those signed by previous governments.

Ritesh Kumar Singh is chief economist of Indonomics Consulting and a former assistant director of the Finance Commission of India.

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