Institutions and economic development in India.

JULY 24, 2021

Divyayudha khire
Meghnad Desai Academy of Economics
 ABSTRACT
Globalisation and liberalisation have paved a way for the development of the
world economies. Some economies have become prosperous in no time and some
countries are still developing while some are still poor. The reason for this disparity
is stated by Acemoglu in his books “Why Are Some Countries Rich and Some Poor”
and he says that the development of a country depends on the quality of institutions
the country has. The analysis in this paper discusses the same issue of “Do
Institutions help in Economic Development” in the context of the most advanced
developing nation which is India. The paper is divided into two parts for analysis
which try to understand the following main questions. 1) Analysis of challenges or
the barriers which hinder the growth of the Indian economy. 2) Do financial and
monetary freedom help in the progress of Indian economy. The analysis uses a
simple econometric method of OLS multiple regression analysis for both the parts
differently. The data is taken from secondary data sources and the analysis takes
place for the years 1995 to 2020.
The paper is divided into following chapters: Chapter I: Literature Review,
Chapter II: Data and Methodology, Chapter III: History of Institutions and Institutions
in India, Chapter IV: Challenges during the development, Chapter V: Econometric
Analysis and Results, Chapter VI: Policy Implications, Chapter VII: Conclusion.

INTRODUCTION
In this increasing complex global economy, every government faces the challenge of
developing one’s own country. The most important and burning question is to explain
“how some countries become rich” and some remain poor. Adam Smith came to the
conclusion that even though in some countries only some people work still they
become rich and the main reason for that is the better quality of organisations and
institutions. So, we can say that better quality of institutions has a positive and
significant impact on growth and human development in the long term. Institutions
have an influence directly on almost all the macro-economic performances of the
economy.
Developing countries often lack in institutions which support the productive
investments and property rights and that can be a problem in solving the problem of
poverty in these countries. In developing countries due to lack of social trust does
not have sufficient level of legal regulations and sanctions to compensate for this
social trust. Lack of this social trust made it quite difficult to encourage
entrepreneurship in Latin America, and limited the opportunities for economic growth
and innovation (Fellner, 2008: 11-24).
As we talk focusing more on India, India has seen a very rapid growth since past two
decades though the major gap between the living standards in the Indian lifestyle
has gone unnoticed. Public institutions have been at forefront and are keeping up
with the demands of rapidly evolving economy.
In this paper we try to answer the question whether institutions are really responsible
and beneficial for the economic development of an economy. To study this, we
divide the analysis in two parts namely:
1. Analysis of challenges or the barriers which hinder the growth of the Indian
economy.
2. Do financial and monetary freedom help in the progress of Indian economy.
The paper is divided into chapters which are: Chapter I: Literature Review, Chapter
II: Data and Methodology, Chapter III: History of Institutions and Institutions in India,
Chapter IV: Challenges in the economic development, Chapter V: Econometric
Analysis and Results, Chapter VI: Policy Implications, Chapter VII: Conclusion.

Chapter I: - LITERATURE REVIEW AND EMPERICAL STUDIES

Supporting the topic:
Researchers such as North (1988); Rodrick (2002) have shown that economic
institutions are a primary cause of economic growth, according to (Acemoglu &
Robinson; Keefer 2005) institutions that protect property rights, mobilise savings and
make them available for investments are more important for an economy.
Przeworski and Curvale (2007) stated that economic institutions that promote
economic growth are those that observe and quietly process the likely conflicts and
values of interest. These institutions are political institutions and it is important that
they are self-sustaining. Acemoglu et al. (2005) argued that economic institutions are
the one’s which determine long run causes of economic growth. According to him the
traditional neo-classical growth models like Solow (1956), Swan (1956), Cass (1965)
explained the differences between the capital accumulation and these models do
agree that the institutions do exist and are based on the representative agents.
However, these models do not acknowledge that the differences in income and
growth rates are not explained by differences in institutions or variations in
institutions. Acemoglu et al. (2005) further argues that this approach remains within
the neo-classical tradition by using preferences and endowment to explain this long-
run growth. More recent growth models of Romer (1990), Grossman and Helpman
(1991) explain economic growth and technological progress. Though these models
go in tandem with the neo-classical models as Romer says that those countries
which invest more resources in research and innovation is the country which would
grow more faster, which breaks down to the quality of institutions and their ability.
According to (Easterly 2008) economic institutions matter for the economic growth
because they are the incentives which help the key performers of the economy. To
explain it more precisely economic institutions, influence investments in physical and
human capital which means how the wealth is distributed among members of the
economy, technology and production (Acemoglu et al. (2005)).
Pereira and Teles (2009) used an econometric analysis model based on the GMM
and used auto-regressive distributed lag model for 109 countries for a 9-year period,
from 1975 to 2004 with the dependent variable as per-capita GDP; and political
institutions were taken as explanatory or independent variables. The political
institutions were the electoral rules, form of government and political regime. To
know the results of the study the economic variables were controlled and the study
showed that political institutions do matter for recipient democracies and not for
consolidated democracies. The economic growth is already internalised in the
consolidated democracies by their political system whereas, in recipient democracies
there is a need to internalise good political institutions to empower good and
powerful growth of the economy.
Studies not supporting the topic:
Docquier (2014) studied the impact of institutions on economic growth. According to
him past century has come and gone but only few poor countries has caught up with
rich countries. His study was particularly designed to explain convergence across
countries. The periodic data used for the analysis spanned from 1870 to 2010. And
the study found no conclusive evidence of convergence of economic institutions and
convergence of growth among the countries studied.
Chang (2011) says that the state is the main institutions among all the other
institutions which help in the growth and structural change, which is different from
what Acemoglu et al. (2005) and other economist agree. But Chang says that “Good”
institutions like property rights can only help in the changes which are structural but
only then when they are implemented in a proper manner. But he says that even if
the “Good” institutions are enforced upon the economies there is no proper evidence
or any reason why there should be growth, because the growth and structural
changes are very much ambiguous in nature.

Chapter II: - DATA AND METHODOLOGY.

To analyse the two main parts of our paper we do a simple econometric analysis
which is a simple Multivariate OLS Regression. The data used in the paper is taken
from secondary sources and is a cross-sectional data. The time period used is (from
1995 to 2020) which is for 25 years. This data is used to statistically test the
variables and prove our hypothesis that institutions do impact economic growth and
development.
The variables used are explained below:
The variables used are formulated indexes from secondary data sources. For the
first part of our analysis, I have used Gross Domestic Product (GDP) at constant
prices as the variable for economic development and it is the most important variable
as it’s the dependent variable in our analysis. The independent variables used are
two indexes which are Corruption Perspective index (CPI) which is the index
formulated by Transparency International (TI), it is an index which ranks 180
countries by their perceived levels of public sector corruption it uses a scale of zero
to 100, where zero is highly corrupt and 100 is very clean. The data shows that
despite some progress, most countries still fail to tackle corruption. The next variable
is the Economic Freedom index (EFI), this index is given by the Heritage Foundation
and The Wall Street Journal and is an annual guide published to measure the
progress made in economic prosperity. The approach for this index is majorly
inspired by Adam Smith's in The Wealth of Nations, that "basic institutions that
protect the liberty of individuals to pursue their own economic interests result in
greater prosperity for the larger society". The above variables of EPI and CPI will
help us know how the basic challenges affect the economic development.
For the second part of the analysis again we use a multiple regression analysis and
our dependent variable is GDP at constant prices, and the independent variables are
two indexes which are given by the Heritage foundation namely Monetary freedom
which tells us about the stabilisation of prices and to what extent does the
microeconomy affect the prices. This index is formulated on the basis of two main
factors which are 1. Weighted average inflation rate and the price controls put by the
government. The next index is the financial freedom which tells us about the banking
efficiency and also how the financial sector is independent from the government of
the country. It takes areas like government regulation of financial services, degree of
state intervention in banks and other financial firms through direct and indirect
ownership, government influence on the allocation of credit, extent of financial and
capital market development, openness to foreign competition. ** Both these
variables will help us to know how the financial institution perform and do their
independent working help in economic development.

Chapter III: - HISTORY OF INDIAN INSTITUTIONS.

India experienced a turnaround in the late 1980’s. there was an increase in the per
capita income from 1.7 % in 1950 to 3.8 % in 1980. Scholars like De Long and
Williamson and Zagha noted that a full decade before 1991 reforms India’s growth
rate nearly doubled. Indira Gandhi’s government took a more business friendly
stance without making a significant change in the policy which triggered the
productivity and hence benefitted the growth in 1980’s. this particular change may
have brought about changes in the informal institutions and business environment
overall which may have improved the quality of property rights adding further to the
productivity dividends. Liberalisation also has a positive impact on institutions and a
more noticeable when 1991 expropriation risk is compared to that of 1992. The
scores jump from 6.2 to 8.2. This is the line which shows the cress-national results
which shows that liberalisation does lead to improvements in the institutional quality
which ultimately helped in the productivity and growth performance in India over past
three decades. In short, we can say that, after independence India experienced a
slow and sluggish economic growth due to weak regulatory institutions. The
increasing negative impact of near-shifting regulatory institutions on growth and
investments have camouflaged the positive impact of strong property rights and
political institutions.
i
** all the areas are directly taken from the Wikipedia of the Economic Freedom Index.
INSTITUTIONS IN INDIA
Economic institutions:
To propel as a successful economy, a country’s economic development is very
important and that can be achieved by the help of excellent economic or financial
institutions of the country. These institutions have been a long-term funds for the
economy as they are responsible for the provision of varied services and funds for
the running of the country. Another major work done by these institutions is they
provide funds or assistance to all the small and medium firms of the country and help
them to prosper in term reducing the disparity of the regions in the country and
improving the poor and backward areas in tandem with the country’s development.
The Government of India has also therefore formed such economic or financial
institutions to credit various new enterprises and sectors of the economy. They can
be categorised by their geographical limits into All India institutions and State level
institutions. Indian economic institutions are mainly comprised of financial
institutions, financial markets and financial instruments. Financial markets comprise
of the credit market, money market, Government securities market, foreign exchange
market, capital market and insurance market.
Financial institutions are divided into two major categories namely the regulatory
institutions and the intermediaries depending on their job of governing which is done
by the regulators and intermediaries include banking and non-banking institutions.
The major institutions which manage the above-mentioned money market, foreign
exchange and government securities market are managed by the Reserve Bank of
India (RBI) the capital market and the insurance market are managed by the
Securities and Exchange Board of India (SEBI) and Insurance Regulatory and
Development Authority (IRDA) respectively.
Political institutions:
The main political institution is the parliament of India. Some of the functions of the
parliament are making laws, sanctioning government expenditure, etc. some other
major institutions are judiciary and legislature. Political institutions are very important
for the economic growth of the low-income countries. To prosper for these countries
factors like same party in power for longer time, fragmented party system,
government coalition with more than 2 parties, electoral system is more centred to
the same ruling party, etc. are responsible for the hindrance of the country’s
economic growth. The economic growth differs from the type of governments or
political institutions like in the democracy if a political leader is in power for a longer
period a greater economic growth can be achieved, while in the authoritarian
regimes the effect may be reversed. Political polarization also has an adverse impact
on the economic development on both the type of regimes. Like it happened in India
in the 1970’s the political polarisation happened between the congress party and the
Hindu nationalist organisations which impacted the governance and the institutions
slowing down the growth of India. Acemoglu (2009) said that to look into how the
political institutions affect the economic growth of a nation we need to look beyond
the governmental difference (Democracy vs non-Democracy) because only having a
democratic regime won’t help in achieving growth but if a democracy has the support
of good institutions, economic growth can be achieved at a better rate.
Subramanian (2013) in reviewing the work of Acemoglu and Robinson (2012) on
their analysis of the interaction of political and economic institutions in the
development of a country, says that India is an important outlier to the cross-country
relationship between democracy index and GDP per-capita because India is too
economically underdeveloped, given the quality of its institutions India possesses.”
Subramanian at the end of paper concludes that the events in the history of India
does not suit for the above theory given by Acemoglu and Robinson (2012).

Chapter IV: CHALLENGES DURING THE DEVELOPMENT

India is one of the fastest growing and developing country in the world, but the major
problem with India is there is a lot of regional disparity and differences in almost all
the sectors of life. We in this section discuss some of the major challenges which
India face and are there any institutions which can help resolve these issues and
provide a supportive hand in the overall development of the nation.
1.Poverty:
Poverty has proven to be a great obstacle in hindering the growth of the country
whether it be India or any other developing countries in the world. According to the
last official count in 2011, 22.5% of India’s population resides below the poverty line
that is their daily income is less than $1.09. Though many people have been lifted
out of poverty since 1980’s it still remains a threat for the growth. Institutions affect
the poverty in many direct and indirect ways. Mostly through government like the
institutions influence governments to take certain policy actions and decisions which
affect the growth and the income of the economy in turn affecting the poor of the
nation. If we look at the type of institution then social institution has a key impact and
the key factor is the social capital which is followed by the social institutional services
like basic health and education, food and accommodation security, etc. All these
social institutions are dependent upon the political institutions like the legislature and
the governance. In our paper we use the index of Economic Freedom which takes
two factors impacting poverty like legal structure, access to sound money as two of
the factors in many in its analysis.
2.Corruption:
The second major point is the increasing corruption in India, according to the recent
data India ranks 86th in 180 countries in the Corruption Perception index 2020. But
even though these organisations estimate the data the actual corruption might be far
bigger. Even the institutions in India which include from Indian Administrative service
up to Judicial Services are involved in the corruption activities making a mockery of
the democracy and India’s democratic government. If we look at our main hypothesis
of does this corruption in institutions affect the economic growth then generally at the
macro-economic level it will have a negative and a direct impact on the development;
but indirectly it will also have an impact on the investment, taxation, public
expenditure, etc. There are many studies and articles which support that corruption’s
impact on growth could be due to the factors associated with the country’s legal and
important institutions which include the political as well as governance quality.
According to (Houston 2007; Méon and Weill 2008) corruption is very dangerous in
countries where the quality of institutions is good and they are effective, it can help in
increasing the productivity and entrepreneurship in countries that do not poses such
effective government institutions.
3.Financial problems
India is a huge nation and due to a large gap between the rich and the poor it faces a
lot of problems in the financial planning which is looked after by the Financial
Institutions. One of the money related issue which India faces very often is the
problem of Inflation. In spite of the target of 4 per cent by RBI which is an important
financial institution in India the inflation rose to 6.93 % in July 2021 and the inflation
has generally remained high since a long time. The absence of credit availability has
dogged India in restricting the development in multiple aspects such as building
comprehensive education models and investing in projects to promote rural
development to reduce poverty. Non-Performing Assets (NPAs) also have an
adverse impact on the development like due to the NPAs the stress increases in the
banking sector which results in less money available to fund various projects
therefore negatively impacting the economy as a whole. If we take the cases of the
public sector banks in India due to the banking the returns are bad to the
shareholder which impacts the money which the Government of India gets as
dividend impacting many developmental projects. Investments are also adversely
impacted which results in unemployment and then poverty. In this paper also we try
to study the impacts of these issues through the two indexes of Monetary freedom
and financial freedom which help in understanding the performance of banks and
financial sector on the development of India.

CHAPTER V: ECONOMETRIC ANALYSIS AND RESULTS.

To understand how the above problems impact the economic growth and
development we do a Multiple Regression Analysis in two parts:

Model 1 Model 2

Type of variable Variable name Variable name

Dependent Variable Gross Domestic Product Gross Domestic Product

(GDP) (GDP)
Independent Variable 1 Economic Freedom Index Monetary Freedom Index
(EFI) (MFI)
Independent Variable 2 Corruption perspective Financial Freedom Index
Index (CPI) (FFI)
 1. We firstly look at the regression analysis of how the Corruption Perspective
Index and the Economic Freedom Index affect the growth variable which is
GDP at constant prices.

Figure 1
RESULTS: -
When we do a multiple regression analysis, we need to check whether there is any
Heteroscedasticity or and Multi-collinearity in the data before doing the regression.
To check for Heteroscedasticity, I did the traditional BP that is the Breusch–Pagan
test where we check the p-value of the model which is 0.0164 which is > 0.05 so
there is no heteroscedasticity and hence we can reject the null hypothesis which
states that there is no homoscedasticity. Then to check whether there is any
multicollinearity in the data we conduct another test known as VIF test. If we look at
the results of the test, the VIF for both the variables EFI_Score and CPI_Score is
1.640887 and 1.640887 respectively which is between 1 and 5 but its more closely to
1 so there is low or moderate multicollinearity between these variables which means
that we can use the data for forming our model.
After looking at results in (Figure 1) above we come to know that both the variables
are significant which justifies our claim that the Economic Freedom Index (EFI) and
Corruption Perspective Index does impact the economic development or growth.
EFI_Score is significant at the 0.01% significance level while CPI_Score is significant
at the 0.001% significant level. The overall p-value of the model is also very low
which makes our model better. The R2 is 0.7556 and the Adjusted R2 is 0.7343 and
we can see that overall, our model is explaining about 73% of variation in the
dependent variable of Gross Domestic Product.

ii
Note: The CPI score is more the better.
 2. Next, we identify the impact financial institutions have on the growth. For this
too we use Multiple Regression analysis with GDP being the dependent
variable which depicts the growth and financial freedom Index and Monetary
freedom Index as the independent variables.

Figure 2
RESULTS: -
After checking for the heteroscedasticity through the BP test I got the value as
0.0902 which is > 0.05 so there is no heteroscedasticity. Next after doing the VIF to
check the multicollinearity the values were 1.039611 and 1.039611 for Financial
Freedom and Monetary Freedom respectively which are closer to 1 and importantly
between 1 to 5 so the data has very low correlation and hence can be used for our
analysis.
Figure 2 tells us that both the variables are significant at less that 0.05 %
significance level and also have very low p-values and hence we can claim that
these two indexes which represent the financial institution of the economy does
impact the growth patterns. Like the Monetary Freedom looks at the inflation levels
and price controls; the higher the score the better the country’s development. So, if
there is a 1-unit change in the Monetary Freedom Index the GDP increases by 0.08
units. And for the Financial freedom Index a 1-unit change in it increases the GDP by
0.21 units. Also, the Adjusted R2 is 0.6633 and we can see that overall, our model is
explaining about 66% of variation in the dependent variable of Gross Domestic
Product. Overall, our models support our hypothesis we stated in the introduction
above.
After looking at the above regression analysis of the various Institutional Indexes we
can say that in the first model the corruption and the economic freedom (includes
poverty) indexes score des affect the economic development and also in the second
model the better the financial and banking institutions work the better will be the
score of the indexes and the better it will help the economy to grow and develop.
CHAPTER VI: POLICY IMPLICATIONS
If India wants to grow or develop as a nation it needs to adopt certain policy changes
in various sectors. In the current era of digitalisation and technology if India is
thinking of starting new-start-ups in the field of technology to compete with world and
achieve economic growth ;Some of my policy recommendations are if India is going
to go with the above entrepreneurial approach of economic development ,it needs to
make some changes by starting to provide opportunities for (1) education of skills
focused specifically at developing entrepreneurial skills, (2) provision of finances to
these entrepreneurial efforts, and (3) creating a network of potential entrepreneurs
and their experienced leaders. The political institutions which are headed by the
government could play an important role in helping provide these opportunities.
Financial Institutions can also help by providing some tax regulations and
appropriate regulatory policies so that people can link their entrepreneurial efforts
and economic development on the nation together.
Social institutions can play an important part in shaping the growth by helping
improve the infrastructure, minimising the gap between the rural and urban India and
improving the quality of education and training which can be a vital cog in the
economic development of India.
Another major policy change to stimulate the economic growth is what India has
recently started to adapt which is encouraging the business creation and FDI in the
country. Most of the companies in the developed economies are prospering because
there are less regulatory and taxation barriers. So financial institutions can be helpful
in this problem as they can regulate the tax reforms and reduce the regulations for
the economy to achieve development. A stable banking sector is very important for
the economic growth of the country; hence India should try to improve its return of
assets (RAO) for the economic growth in the future. Also, in order to achieve higher
growth rate, it is advisable for the financial institutions to increase on the lending
capacity and the investment activities.
Some other policy recommendations:
1. Improvement in the social marginal productivity.
2. Increase in the private savings.
3. Introduction of the demand and supply-side policies.
4. Improve the quality and protection of the property rights as it will incentivise
the people to invest in human and physical capital.
5. Enhancement of the political institutions ‘s legacy and effectiveness through
social institutions.
Overall, India should focus on improving the institutional quality which includes
enhancing rule of law and regulation, securing property rights and reducing
inequality and poverty, reducing uncertainty.
CHAPTER VII: CONCLUSION

In the above study, an attempt was made to establish a link between the institutions
and the economic development with respect to India by using various indexes. The
major focus of the study including the regression analysis being on the financial
institutions and economic institutions there was a need to establish a theoretical
relationship between the institutions and economic growth. We came to know that
economic\ financial institutions serve as a bedrock for the growth of the nation. Once
there are solid economic institutions in a country, other approximate determinants of
growth fall in place. The study also reviewed some of the empirical literature that
established the impact of economic\financial institutions on economic growth in
several countries.
The study applied some indexes like Economic Freedom Index to know how
economically free are the people of the country, then the Corruption Perspective
Index measuring the corruption in the nation, Financial Freedom Index helped in
knowing the situation of the banking and other financial institutions (viz SEBI, IRDA)
of India and lastly the Monetary Freedom Index which told us about the inflation,
price controls and the money flow in the system. Though the scores are not most
perfect but they do help in understanding the impact of institutional functioning. The
results of the regression were pretty significant and the most influencing factor or
variable was the Financial Freedom Index as if India works on its NPA and banking
sector problems it should be on a perfect track of achieving economic development
In the end a discrimination cannot be made between the developed nations and
developing nations instead they should be bifurcated on the basis of good or weak
institutions which have an impact on the economic performance and the
development thereafter. But institutional regulations which are necessary to increase
economic performance may differ in developed and developing countries. For this
reason, institutional structure reforms done with the motivation to increase
competitiveness between the countries caused by globalization phenomenon may
not reach its purpose, and legal regulations issued to this end may just stay as
decisions made on paper. Social Institutions also have a major impact on the
development and they were will and are going to be at the epicentre of the
development of the economy.
After the COVID-19 outbreak importance of the institutions has increased to a
greater extent and all the major institutions and governmental bodies are responsible
for the growth of India after the set-back in the development and growth which India
faced in the year 2020. A major risk was on the financial institutions as the second
wave of COVID-19 started approaching, but as the apex institution RBI announced
some relief measures it provided some relief to other banking and finance
institutions. Special refinance facilities were provided to select all India financial
institutions (AIFIs), while a special liquidity facility for mutual funds (SLF-MF) was
introduced to ease redemption pressures. This pandemic has also hampered the
reduction of poverty temporarily which was on course; and this outbreak could be
more vulnerable and will have a significant impact on the poor households. Some of
the impacts on political institutions were that the Rajya Sabha elections were
postponed due to the pandemic.
Through this paper we have tried to asses the quality of institutions and why do they
matter, quality institutions in this modern era drives the economic progress through
technology and adopting new innovations to achieve growth. So good political
institutions and inclusive economic institutions well supported by financial institutions
causes to ensure the distribution of economic benefits throughout the society and
thereby improve the quality of life of the people and slowly and eventually economy
is developed. And hence lastly, we can say that to achieve a long-term growth and
catch-up with some of the developed economies of the world “Good” Institutions are
the golden steps to success.
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