Photo: Mint
Photo: Mint

Opinion | The need for strong contract enforcement

It is essential for maintaining business confidence, reducing uncertainty and promoting fair play in the economy

According to Milton Friedman, the three primary functions of the government are defence, law and order, and contract enforcement. Unlike the former two, the latter has not received adequate importance in India. 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. Thus, an effective contract enforcement mechanism can in reality reduce flouting of laws and contracts, reducing the need to approach redressal mechanisms.

A sound contract enforcement mechanism is essential for maintaining business confidence, reducing uncertainty and promoting fair play in the economy. This is the reason for its inclusion as a criteria in World Bank’s Doing Business (DB) report. 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. There has been no improvement in absolute terms here either, as the contract enforcement DB score has remained fixed at 41.19.

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. However, the true extent of the problem also includes various indirect costs. These are an outcome of the inefficient choices made by economic agents in an inefficient legal system. Two such cases are inefficient risk-taking and skewed firm structure.

A business must try to maximize its expected returns. 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. However, poor contract enforcement tends to increase the risk and reduce the returns (increased legal costs), thus affecting the overall risk to return ratio. As a result, businesses don’t engage in economically and socially beneficially activity such as innovation. Similarly, the failure of legal mechanisms in guaranteeing loan repayment has resulted in banks bearing greater risks. The outcome is that interest rates are higher and banks are reluctant to lend to socially beneficial sectors such as agriculture and infrastructure.

Poor contract enforcement tends to increase the risk and reduce the returns -

Another issue is that poor legal frameworks tend to promote excessive vertical integration of companies. 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. For example, a power plant that requires high quality coal but can’t ensure its quality from the coal mine would find it profitable to acquire the mine.

To better understand this, let’s take a look at Indian e-commerce. 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. The main difference is that the former two have a ‘hybrid’ model, while the latter two primarily have a ‘marketplace’ model. The hybrid model entails that the companies themselves sell various products (along with other sellers) by integrating logistics, procurement and delivery. In a marketplace model, the companies just manage a platform to facilitate purchase between various sellers and buyers.

The success of an e-commerce company depends on its ability to retain consumers’ trust. For Snapdeal and eBay, this trust has been waning because of frequent reports of fake and poor quality products sold on their websites. A poor contract enforcement system further prevented them from ensuring good quality products from their suppliers. On the other hand, Flipkart and Amazon through their hybrid model have been able to maintain the quality of their own products. To compete with these products, other sellers have also had to improve the quality of their products. Thus, the latter two have succeeded while the others have not been able to.

In this context, an effective legal system provides the necessary level playing ground for smaller firms. This ensures that they are given adequate opportunity to grow and prosper. Meanwhile, a poor legal system tends to centralize industries, wherein the firms tend to integrate with backward and forward linkages. This results in concentration of wealth as consumers prefer capital-intensive large firms over smaller labour-intensive rivals. This reduces employment and perpetuates inequality.

Another effect of a poor contract enforcement mechanisms is the spurt of informal and often illegal channels of dispute resolution. These make use of local leaders and under-the-table dealings to help settle disputes. Keeping aside the issue of biased and poor quality decisions, this also brings undue power into the hands of middlemen and facilitators. This, in turn, creates problems such as increased corruption and the undermining of the rule of law.

These direct and indirect problems and the market inefficiency associated with them underline the need to reform the legal system. Though some measures have recently been undertaken, they fail to address the deeper issue of an overburdened and understaffed judiciary. As highlighted by the Economic Survey, addressing such deep-rooted problems will only be possible through extensive cooperation between the organs of the government—“cooperative separation of powers".

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