[op-ed snap] The need for strong contract enforcement

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Mains Paper 3: Economy | Effects of liberalization on the economy, changes in industrial policy & their effects on industrial growth

From the UPSC perspective, the following things are important:

Prelims level: Doing business report, Economic survey

Mains level: Need of robust contract enforcement regime in India


Context

Lax contract enforcement in India

  1. According to Milton Friedman, the three primary functions of the government are defence, law and order, and contract enforcement
  2. Unlike the former two, the latter has not received adequate importance in India

Why is contract enforcement important?

  1. A sound contract enforcement mechanism is essential for maintaining business confidence, reducing uncertainty and promoting fair play in the economy
  2. An efficient contract enforcement mechanism not only provides remedies to aggrieved parties but also dissuades violation of the contractual obligations because of the fear of legal fees and court fines
  3. Thus, an effective contract enforcement mechanism can, in reality, reduce the flouting of laws and contracts, reducing the need to approach redressal mechanisms
  4. This is the reason for its inclusion as a criterion in World Bank’s Doing Business (DB) report
  5. Though India’s overall ranking in the report this year improved from 100 to 77, when it comes to the contract enforcement metric, it lags behind at 163 out of 190 nations

Costs of poor contract enforcement

  1. The Economic Survey 2017-18 tried to highlight the impact of this problem by drawing attention to the costs of stalled projects and legal fees
  2. However, the true extent of the problem also includes various indirect costs
  3. These are an outcome of the inefficient choices made by economic agents in an inefficient legal system
  4. Two such cases are inefficient risk-taking and skewed firm structure
  5. A business must try to maximize its expected returns
  6. At the same time, healthy risk-taking behaviour in the economy is necessary to ensure growth, rather than just relying on low-return risk-free alternatives
  7. However, poor contract enforcement tends to increase the risk and reduce the returns (increased legal costs), thus affecting the overall risk to return ratio
  8.  As a result, businesses don’t engage in economically and socially beneficially activity such as innovation
  9. Similarly, the failure of legal mechanisms in guaranteeing loan repayment has resulted in banks bearing greater risks
  10. The outcome is that interest rates are higher and banks are reluctant to lend to socially beneficial sectors such as agriculture and infrastructure
  11. Another issue is that poor legal frameworks tend to promote an excessive vertical integration of companies
  12. According to Nobel Laureate Oliver Hart, when contracts are ineffective, businesses prefer to eliminate the need to deal with other companies by resorting to acquisitions and mergers

Shining example: India’s e-commerce sector

  1. Today, the sector is dominated by the likes of Flipkart and Amazon, while companies such as Snapdeal and eBay have failed to make a lasting impression
  2. The main difference is that the former two have a ‘hybrid’ model, while the latter two primarily have a ‘marketplace’ model
  3. The hybrid model entails that the companies themselves sell various products (along with other sellers) by integrating logistics, procurement and delivery
  4. In a marketplace model, the companies just manage a platform to facilitate purchase between various sellers and buyers
  5. The success of an e-commerce company depends on its ability to retain consumers’ trust
  6. For Snapdeal and eBay, this trust has been waning because of frequent reports of fake and poor quality products sold on their websites
  7. A poor contract enforcement system further prevented them from ensuring good quality products from their suppliers
  8. On the other hand, Flipkart and Amazon through their hybrid model have been able to maintain the quality of their own products
  9. To compete with these products, other sellers have also had to improve the quality of their products
  10. Thus, the latter two have succeeded while the others have not been able to
  11. In this context, an effective legal system provides the necessary level playing ground for smaller firms
  12. This ensures that they are given adequate opportunity to grow and prosper

Effects of poor contract enforcement

  1. A poor legal system tends to centralize industries, wherein the firms tend to integrate with backward and forward linkages
  2. This results in the concentration of wealth as consumers prefer capital-intensive large firms over smaller labour-intensive rivals
  3. This reduces employment and perpetuates inequality
  4. Another effect of poor contract enforcement mechanisms is the spurt of informal and often illegal channels of dispute resolution
  5. These make use of local leaders and under-the-table dealings to help settle disputes
  6. Keeping aside the issue of biased and poor quality decisions, this also brings undue power into the hands of middlemen and facilitators
  7. This, in turn, creates problems such as increased corruption and the undermining of the rule of law

Way forward

  1. These direct and indirect problems and the market inefficiency associated with them underline the need to reform the legal system
  2. Though some measures have recently been undertaken, they fail to address the deeper issue of an overburdened and understaffed judiciary
  3. Addressing such deep-rooted problems will only be possible through extensive cooperation between the organs of the government—“cooperative separation of powers”
Industrial Sector Updates – Industrial Policy, Ease of Doing Business, etc.
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