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The non-trivial costs of a slow judiciary
Long-term, relationship-specific investments as well as higher-risk contracts are difficult with a weak judicial system
It would not be hyperbole to say that efficient courts are the backbone of the modern, hyper-specialized economy. A sound judiciary is key to enforcing laws and creating trust in the economy, allowing economic exchange between complete strangers by deterring fraud and increasing the incentives for fair play. Unsurprisingly, then, when the justice system breaks down, the consequences are bad.
A slow judiciary with a large number of pending cases reduces trust in the economy and makes people fearful. The Economic Survey 2017-18 has, therefore, made a compelling argument that addressing pendency, delays and backlogs in the appellate and judicial arenas is the next frontier for improving ease of doing business (EODB) in the country.
This is urgent. In the latest EODB report by the World Bank, India ranked a dismal 164 in the category of enforcing contracts. It takes, on average, almost four years to enforce a standard sales agreement in a local court, and costs up to 31% of the claim’s value. This is much higher than the average for South Asia (three years) and China (a year and four months), and has crippling effects on the dispute resolution mechanism of the economy.
India’s poor ranking in enforcing contracts relates directly to its judicial capacity. A slow judiciary forces participants to adopt loss-minimizing strategies that are not always efficient.
The most intuitive result is for the cost structure of the entire economy to go up. For example, landowners have to increase the rent significantly or ask the tenant to deposit a security amount to cover the risk due to the insecurity created by a weak judiciary. Similarly, the interest rates on credit are higher in an economy with poor enforcement, due to the inclusion of a risk premium by the lender.
Second, it deters firms from making relationship-specific investments—investments for products that have lower value in alternative uses than they have in the intended use between the parties involved. For example, a company supplying especially treated ash-less coal to a power generation company has made investments that are less valuable in alternative uses. In such transactions, once the coal supplier has made the initial investment, he is in a vulnerable position should the power company change the terms of the contract. The threat of hold-ups can dissuade efficient investments, and could even rule out exchanges that are potentially valuable.
Firms and industries have developed ways around this problem. In many industries, firms vertically integrate in order to align their incentives in the different stages of production, or sellers require a security amount from the buyer. Integration, however, increases the cost of starting a business and makes the industry less competitive. Vertical integration also reduces the focus on becoming more competitive in their development and achieving economies of scale. Firms also rely on repeat business and reputation norms to discipline the actors, and these norms work fairly well. Lastly, some industries follow private rules and use private tribunals to solve disputes. The diamond traders, for example, punish non-compliance with punishment that could lead to the ostracization of the individual from further practice. But these tribunals are only available to a homogenous group of people, and do not work for most of the complicated exchanges that are characteristic of a modern economy.
Judicial effectiveness varies considerably throughout the country, and this has allowed researchers to measure the impact of a slow judiciary on various outcomes.
In a research paper published in February 2017, Amrit Amirapu demonstrates that the location of a contract-intensive industry—an industry that requires more relationship-specific investments—in a state having faster courts is highly predictive of its future growth: “for an industry in the 75th percentile of contract intensity, an improvement of one standard deviation in court efficiency would imply a higher annual growth rate of gross value added of 0.9 percentage points. This is a very large effect, since the average annual growth rate in the sample is 2% per year. Similar results hold for growth in employment, profits and net entry of factories, where all outcome variables are taken from the Annual Survey of Industries (ASI) and represent the entire formal manufacturing sector from 1999 to 2008.”
Similar research on 25 Indian states and Union territories from 1971 to 1996 found that a weak judiciary (defined by the speed and predictability of the trial outcome) has a negative effect on economic and social development, which leads to: lower per capita income; higher poverty rates; lower private economic activity; poorer public infrastructure; and higher crime rates and more industrial riots.
The problem of pendency has become worse in the last decade as the average percentage of cases under trial in state high courts and lower courts increased from 82.8% to 84.81% in the previous decade. In 1987, the law commission had recommended increasing the number of judges from 10 judges per 10 lakh people then to 50. The figure stood at only 18 in 2016.
The present government has been vocal about improving India’s EODB ranking. Perhaps that should motivate them to heed the recommendations in the Economic Survey.
Does the problem of rising pendency in the judicial system deserve more attention? Tell us at views@livemint.com.
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Business NewsOpinionThe non-trivial costs of a slow judiciary
First Published:30 Jan 2018, 11:00 PM IST
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