[Editorial Analysis] The need for strong contract enforcement

Mains Paper 3: Economy

Prelims level: E-commerce

Mains level: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment. Inclusive growth and issues arising from it

Context

• 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.

India’s position on e-commerce

• 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.

• 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.

• The 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

• The 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.

• 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.

• The success of an e-commerce company depends on its ability to retain consumers’ trust.

• 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.

• 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.

Conclusion

• 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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