Business

Doing Business in India, Indian Style

Wharton Business School’s special online portal on India has an article on India’s business environment for SMEs, titled How Some Firms in India Succeed by Bypassing Entrenched Financial and Legal Systems.

India has often been praised for its strong financial and legal systems and its well-regulated stock market. It is argued that these strong formalized systems make India a less risky place to do business.

Yet, it is common knowledge that India’s legal systems are overburdened, overregulated, and corrupt (India ranked 70th on Transparency International’s Corruption Perception Index). And while the stock market functions well for established companies it has not attracted smaller firms, indicating these firms turn elsewhere for growth capital. In spite of these hurdles unlisted, privately held firms, according to the report, are growing faster than the economy, and make up 40% of total value added in manufacturing.

We’ve been told corruption and poor governance are bad for business. Yet India continues to grow. Whence this contradiction?

The Relevance of Extra-Legal Systems

The report offers a fascinating if not novel answer - the absence of legal norms and protections can be filled by other informal systems, particularly those based on cultural, social, or family norms. As the article explains:

The three most important financing channels for these firms during their start-up and growth periods are founders’ family and friends, trade credits and loans from financial institutions, such as state-owned banks and banks specialized in lending to small- and medium-size firms.

The researchers also discovered that informal governance mechanisms based on trust, reputation and relationships are much more important than legal remedies in resolving disputes and enforcing contracts. For example, when asked about the consequences of delay of payments or non-payments and breach of contracts, the respondents ranked loss of future business opportunities, reputation and personal assets as main concerns, while fear of legal remedies was the least important. When asked who would be the best mediator for disputes, 46% said “mutual friends and business partners” and 26% specified a non-government organization like a trade association. Only 20% chose “going to courts.”

The report also addresses just how important an impediment corruption is to economic growth.

Allen stresses that the study should not suggest that corruption is acceptable. But he does conclude — at least when it comes to the issue of economic growth — that corruption does not seem to be a serious impediment. Furthermore, academic researchers and policy makers at institutions like the World Bank should recognize that not all corruption is the same and that different kinds of corruption pose different levels of threat to a well-functioning business environment and a healthy economy.

From an economic viewpoint, corruption is bad because it is a transaction cost or adds to the uncertainties of doing business. Conversely, strong legal systems reduce uncertainties and transaction costs.

Market Transactions - Many Ways to Skin a Cat

This is, unfortunately, a limited and occidental view of the market that fails to account for two factors.

The first is the opportunity cost of corruption. While it is a financial cost, it need not be an additional one. For instance, if a business can pay a bribe to avoid taxes, the cost of operations is actually reduced. Similarly, if bribes are small - for instance to get approvals - the additional cost may not be significant. So, if corruption does not always hold back business, perhaps its link to growth is more tenuous than imagined?

Second, while legal systems introduce certainties they may not be the lowest cost way to conduct market transactions. Instead, if social norms can replace legal ones the costs of transactions may actually be reduced by, for instance, depending on players that introduce no financial costs (such as replacing lawyers by trustworthy family members).

Changing the Emerging Market Viewing Lens

The report is certainly relevant in understanding this significant, but previously unstudied segment of Indian business.

It is, however, most important for western economists and business leaders that too often see emerging economies through a western lens and conclude that the environment is risky. Lack of formal systems is seen as an impediment, and legal unknowns as risks.

Yet, for those that actually operate in these countries there is more than one way to skin a cat. In creating the microcredit movement Yunus showed that the absence of formal laws need not prevent market transactions. This report provides more support for that view. It should, therefore, give western pundits reason to reassess their understanding of emerging markets.

UPDATE: Blokesablogin pointed me to the example of Angadias, a Gujarati community that forms the core of the Indian diamond industry. Very much like the Jewish merchants that dominate New York’s diamond trade, the Angadias illustrate an extreme case of the use of trust-based systems in business transactions for competitive advantage, where these community norms go far beyond the protections any legal system can provide. For those interested, read, How Community Institutions Create Economic Advantage: Jewish Diamond Merchants in New York (in Law & Social Inquiry, by Barak D. Richman).

© 2006 The Discomfort Zone.