The advantages of incumbency

Incumbency is a dirty word in Indian politics. In a majority of recent elections, incumbent governments have been voted out of office.

But, the recent performance of the Indian economy suggests that, in a different context, incumbency is actually a source of great competitive strength.

This assertion may fly in the face of popular perceptions about the impact of liberalisation on Indian business. These perceptions are based on the huge blows that so many companies who dominated their respective businesses before the opening up took after 1991.

Many large groups, which straddled wide-ranging portfolios until the beginning of the 1990s, are no longer heard of.

Clearly by any yardstick of competitive brutality, the India of the last decade cannot be accused of being a soft environment.

The combined impact of trade liberalisation, domestic delicensing and a more hospitable foreign investment regime was unquestionably devastating on many businesses.

To that extent, the perceptions are quite valid.

But, just as many prominent names from the pre-liberalisation corporate roster have disappeared, it is equally apparent that many of them are still around and dominating their businesses.

In most manufacturing sectors, the top three firms today are typically those which set up shop long before the reforms.

With the exception of a few businesses in which new multinational entrants have gained strong competitive positions, the big guns in Indian manufacturing today were also pretty big guns ten or fifteen years ago.

The destructive power of new competition was clearly not sweeping in its scope. Some companies who succeeded in the old regime did apparently have the skills and resources to re-orient themselves towards the new.

Their ability to maintain their dominant positions in a completely different environment says something about the advantages of incumbency.

There are both internal and external reasons for these advantages. The "quality of management" may be a convenient general label for the internal factors, but there are some specific dimensions on which the incumbency advantages were realised.

One was being able to get rid of the fat in the organisation -- excess manpower, inefficient systems, failing businesses and so on -- without hurting the overall productivity of the organisation.

That the absence of competition induces organisations to accumulate flab is a universal truth. What differentiates between them is their ability to continue to do business while transforming themselves.

An incumbent that transforms successfully has huge advantages over a new entrant who has to build up his entire competitive arsenal from scratch.

Incumbency advantages necessarily imply entry barriers. To the extent that these exist because of the level of efficiency and competitiveness of the incumbent, there is no problem.

But, if the barriers are also the results of policy distortions, which, wittingly or otherwise, favour the incumbent, there are legitimate reasons for concern. This brings me to the external reasons for the incumbency advantage.

The concern is motivated by the perception that broad-based investment in new capacity in Indian industry is not taking place, and hasn't been for some time.

The evidence in support of this perception is quite strong -- the sluggishness in the capital goods sector, the lack of activity in the primary capital market, the overwhelming focus of banks on their retail business and so on.

Many people believe that the drought is at an end, but that is another story. What caused it and what it is costing the economy are questions fundamental to policy.

I would argue that the cause of investment drying up is directly the consequence of policy distortions, which in the context of this article, do discriminate in favour of incumbents.

To keep the story simple, let us focus on two key aspects of this discrimination. The first is job security regulation. On paper, both incumbent and entrant face the same restrictions.

But, in practice, the calculations of the incumbent and the entrant are entirely different. The incumbent is going to reduce his workforce, not hire new people.

He compares the present value of cost savings from his downsized operation to the cost of regulation-mandated severance packages.

This will usually be a relatively favourable comparison with reasonable productivity gains. Also, the package can be funded by selling off assets, which are not contributing. In short, despite the force of the regulations, downsizing is both possible and profitable.

An entrant, on the other hand, looks at his true cost of labour.

Assuming that his efficient scale of operation will bring him into the ambit of job security regulations, his calculations will be as follows. He hires workers based on normal capacity utilisation levels.

At some point, he finds himself below these levels, because of a business cycle, or because his incumbent competitor is dominating him. He has no reserves to finance severance packages, so he has to keep paying wages to underutilised workers.

In effect, his true cost of labour is the wage plus unemployment insurance. In many lines of business, that 'plus' could be the difference between a decision to invest and not to invest.

The second issue is infrastructure. Indian industry has reached a point where a captive power plant is a must for survival.

Although this proposition is subject to empirical validation, I would venture to argue that a high proportion of investment that has actually happened over the last few years has been in the form of incumbent players beefing up their captive infrastructure.

A potential entrant is doubly damned.

If he puts his money into production capacity, leaving himself exposed to public infrastructure, he is straightaway at a competitive disadvantage. If he puts money into captive infrastructure, he is diluting his commitment to capacity and technology.

If one accepts the argument, there are two major reasons for concern. First, an incumbent-dominated growth process is inherently self-limiting.

If the playing field is so skewed against new entrants, sooner or later, the pressure to improve and stay ahead of competition will ease.

Flab will accumulate again. Even if the incumbent most often wins the race, it is the quality and strength of new entrants that ensures that it is a genuine race.

Second, incumbent-dominated growth is generally speaking, and certainly in the Indian context, job-displacing.

Incumbents grow more through rationalising internal resources than by continuous deployment of new resources.

The real engine of job growth is new businesses. If these are deterred in any way, employment is just not going to grow.

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