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The three stages of crony capitalism

On the path to negligible competition

Update : 21 Nov 2023, 09:56 AM

Crony capitalism, a subject that I started writing on at least four years ago, is now a much-discussed subject in Bangladesh. There is concern that our remarkable economic transformation since independence may be threatened by the rise of cronyism. This concern is not unjustified. In that context, it is useful to understand how crony capitalism evolves over time. In this article, I will talk about three stages of crony capitalism.

Growth-oriented government leaders often emphasize the development of key industries, and also sectors that support industry, such as infrastructure and energy. They see these as being important, perhaps even critical, for achieving their high growth ambitions. As they look around for economic actors who can help implement such ambitious agendas, their gaze often settles on a select group of business companies. These companies may have already done well in different sectors and accumulated considerable capital and business experience. The political leaders feel that such companies can lead the way by investing in ventures considered important for their development agendas. 

Thus, when the government embarks on an important infrastructure building program, such as building major roads, setting up container terminals, laying country-wide fibre optic networks, or substantially increasing power generation capacity, it may award contracts to such companies. Sometimes this may happen through a competitive process, sometimes not. Similarly, large companies operating in the industrial sector may get certain privileges such as tax breaks, or protection from competing imports through high custom duties on such imports. Often, the companies who obtain such privileges have some political link to the government. Even if they don’t initially, they usually acquire this over time. 

A good example of this comes from neighbouring India. Sometime in the mid to late 1990s, the Indian government decided to engage the private sector in a big way in infrastructure and energy development. Gujarat was the state which responded to this policy decision with the most enthusiasm. During the days of Nehruvian socialism, the state was somewhat an outlier with a pro-business stance. Now it pursued this approach with extra vigour. 

The private sector was awarded huge contracts to generate power, develop ports and airports, construct roads and railways and set up refineries. This was underpinned by a set of generous privileges such as subsidized land and credit, income tax concessions and reduced import duties on machinery and other materials. Even when the private sector had deep pockets, it was reluctant to put its own money at stake in infrastructure projects with long gestation periods. Massive amounts of bank debt, especially from state-owned financial institutions, became the norm. Even though on paper this was meant to be a competitive process, in many cases it degenerated into a scheme for granting privileges to a few chosen firms. Thus, were born the Ambanis and the Adanis of India.

LF-Shutterstock

This is the first stage of crony capitalism. At this stage, crony capitalism, even if ethically undesirable, may not have a negative impact on development. In fact, it may have a positive impact if the privileged firms are efficient -- and sometimes they are, at least initially. Such firms can deliver the expected infrastructure or growth in industrial output reasonably fast. The enhanced supply of such goods or services, especially infrastructure and energy, helps other businesses whose activities expand as a result. Thus, there is a multiplier effect on the economy. More jobs are created, aggregate output increases, and export earnings rise.    

Such positive developments endear such companies to the political leaders, who now come to rely on them even more. By now, the cronies have established strong political connections and are able to exert considerable influence on the government. The fact that they have delivered in the first stage helps them in this. So, more contracts are awarded, and more privileges granted. 

As the cronies get these privileges, others, especially those with some political connections, want a share too. The government, realizing the need to keep a broader constituency happy, decides to play along. It thus grants some privileges to a broader set of businesspeople, beyond the smaller coterie of cronies. Thus, an entire industry may get some privileges. It could be an emerging industry such as electronics which is protected from import competition or an established one such as garments which gets cash subsidies to help boost their profits. I call them the privileged class. So, you have three classes within the business community: The cronies, the privileged, and the rest who are having to operate in competitive markets and within a challenging business environment. 

By now, the cronies and the privileged classes have started getting used to privileges. They have started enjoying the fact that they can make huge amounts of money without necessarily having to compete hard. They are getting large infrastructure and energy contracts without competitive bidding. Industrialists producing for the domestic market don’t need to worry about competition from more efficient imports because they are protected by high tariff walls.  For those exporting to a highly competitive export market, the task is made easier through the privileged granting of subsidies or tax breaks.

LF-Vectorstock-safetynet 

In this second stage of crony capitalism, the cronies are no longer as efficient as they might have been in the first stage. They are getting used to an easy life, free of the pressures of competition. The incentive to be efficient has been diluted. The cronies find it more rewarding to invest in strengthening their political connections than in improving productivity. Their interest in coming up with new products or finding new export markets is weakened.  

Nonetheless, the economy continues to grow, drawing upon the advances made in the relatively more efficient first stage of crony capitalism, and also from the less efficient, but nonetheless expanding, supply of infrastructural services and industrial investment in the second phase. The cronies and the privileged classes benefit. But others do too. It is still a win-win situation. 

The government, by now intoxicated with the taste of growth, feels that it has come up with the right model. It is in a self-congratulatory mode. Complacency sets in. But there are others who see things more clearly, discovering fault lines and hidden mine fields. But their words of caution are met with indifference or downright hostility. They are criticized by government functionaries as pathological naysayers who never find anything good with the economy. 

Then comes the third stage of crony capitalism. At this stage, it is a zero-sum game, or close to being one. The interests of the cronies and the privileged are now diametrically opposite to those of the other economic actors in the country. This happens in several ways, but I shall mention just two. 

Firstly, there is a rise in predatory business, a subject I wrote about in an earlier piece.  The cronies, whose ambitions have no limits, are looking for new arenas to invest their money. But they lack the patience to start a business from scratch. They are not inclined to put in the long, painstaking effort needed to grow a business. For them, the easy way is to prey on established businesses using whatever tool they have, including buying out regulatory officers. 

If they succeed, and sadly they often do, we end up with businesses that are no longer efficient or competitive. The answer is simple. People who acquire businesses through predatory means usually lack the incentive or the capacity to make the businesses grow. In fact, even sustaining the business may prove challenging in some cases.   

The second case is the undue influence that cronies have on policy making. A few examples will make this clear. Let us say the cronies are able to exercise their influence and get a freeze on bank interest rates. Since the banks need to earn a profit, they, in turn, keep deposit rates low. This discourages savings and deposits, as a result of which the banks now have less funds to lend. The privileged classes still manage to get loans, and at rates substantially lower than market rates. However, other businesses, who may be more competitive now find it difficult to obtain loans. 

Another example is overvaluation of the exchange rate. This benefits privileged classes who are major importers and lobby to keep the exchange rate overvalued. Such overvaluation harms exports and discourages remittance flows through official channels. A foreign exchange shortage ensues, reserves start falling and the government decides to address this problem by curbing imports. This harms both consumers who suffer from higher prices due to less supply of imported goods in the market, and businesses who are adversely affected by shortages of imported inputs. The granting of privileges to a chosen few starts hurting the others; in some cases, very badly.    

A third example relates to government expenditures. In the third stage of crony capitalism, cronies become greedier and start demanding a high share of government expenditures. As their friends in government accede to such demands, the rest of the population, especially those without much political influence, are crowded out. Expenditures that benefit the poorer sections of society, such as social protection programs, are curtailed to fund the privileges demanded by the cronies. 

Government leaders, once enamoured by the delivery prowess of cronies, may at this stage start having second thoughts about the wisdom of privileged-driven policy decisions. But, by then, it is usually too late, unless such a realization triggers some truly bold actions to rein in the cronies.  

 

Syed Akhtar Mahmood is an economist, previously with an international development agency.

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