There has been a great deal of excitement about elections lately. First, there were the national elections with their thrilling run-up and decisive outcome. This was followed swiftly by some state elections. Some feel these constant elections—every year one or the other Indian state is in election mode—is a useful check on the power of representatives, forcing accountability and scrutiny of their policies, virtually on a real-time basis. The thinking goes that such accountability must have beneficial effects on policymaking, forcing it to be relevant. However, the costs imposed by constant political uncertainty are large, and possibly greater than the benefits.
There are a number of reasons to worry about the negative effects of political uncertainty on economic performance. The most obvious area of concern is investment. Consider a firm deciding on a relatively long-term investment. Prior to an election, the issues that the firm has to weigh are significantly more complex than at other times. Especially in a policy-sensitive economic environment such as India, even minor variations in policies caused by a change in regime can have important consequences for the return on investment that the firm expects to generate. This means that the option value of waiting before embarking on a new programme of investment around elections is substantially higher. The resulting problem of delay or even abandonment of capital investment only gets worse when there is political corruption or patronage leading to favouritism in bidding contests or the award of contracts.
The direct corporate investment channel isn’t the only one to consider when evaluating the impact of political uncertainty on corporate investment. To better understand other avenues, we need to make a small economics digression. In Keynesian economics, government spending crowds out private investment through effects on the interest rate. You don’t have to believe in Keynes to believe in the substitution effects of government capital for private capital—there is plenty of novel evidence from the US, in which US states to which powerful politicians direct spending, experience significant declines in private-sector capital investments. Government spending shocks appear to generate inflation in labour and capital prices, making corporate investment less remunerative.
How is this connected to electoral uncertainty? There is plenty of evidence to indicate that just prior to state, local, and national elections in India and elsewhere, governments go on a spending bonanza to try to convince the electorate of their competence and generosity. Perversely, if you combine this with the crowding out mechanism, this is bad news for corporate investment, which retreats in the face of these government binges.
How big can these effects be? Brandon Julio and Youngsuk Yook conduct a careful analysis (Political Uncertainty and Corporate Investment Cycles, The Journal of Finance, February 2012). Using national elections from 48 countries over 25 years, they find that corporate investment declines a large and significant 4.8% in the year prior to national elections.
The news gets worse, considering the characteristics of the Indian economy. These effects are biggest in countries with poor governance, those with fewer checks and balances on the exercise of executive authority, those with unstable (read coalition) governments, and in countries which run high budget deficits. The effects are also worse for firms in government-sensitive industries such as transport, aerospace, defence, and telecommunications—all engines for growth in India over the next few decades.
This roughly 5% magnitude estimated across countries is probably much higher in India. Election spending in India tends to come in many forms, most unrecorded—thus potentially increasing the size of the crowding out effect.
Can you think of a firm without government connections in India? Clearly, this is a difficult exercise. Once again, the sheer reach and scale of government operations in India means that many more firms are potentially affected by election cycles.
Perhaps the most important reason to worry about this issue is India’s federal structure. Federalism in India means that we have many more elections—state as well as national. But this isn’t the only reason to be more concerned. India takes federalism seriously, meaning that the relative importance of state policy in our country is greater than that in many others. Perversely, this probably means that the negative effects of electoral uncertainty and political cycles on economic performance are significantly greater in our country.
How can we solve this problem? Clearly, reducing government interference in corporate affairs will help. Aligning the currently asynchronous political cycles across states might also help—one might envision fixed-term parliaments with a window in which elections can be called, accompanied by periodic realignments of electoral cycles across states. This solution might also help with any corporate issues that require harmonization of policies across states—a far bigger issue, for a subsequent article.
Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance.
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