Judged against the rigidities of its previous economic regime, India has come a long distance in its economic thinking since July 1991 when, faced with a severe balance of payments crisis, the Government launched a series of IMF-supported macroeconomic and structural reforms. Indeed, significant policy changes have been introduced—fiscal and monetary restraint, partial convertibility of the rupee, abolition of excessive controls over industrial growth, liberalized foreign investment norms, and simplified import regulations. Yet, much more still needs to be done to set in motion a major restructuring of the economy.
India’s economic prospects have been transformed over the past year and a half. In June 1991, the country was in the throes of severe political and balance of payments difficulties. Gross official reserves had fallen to the equivalent of just a few weeks’ imports, inflation—usually quite low—was in double-digits and rising, and industrial growth was faltering for want of crucial imported inputs. Unlike previous episodes of macroeconomic instability, no obviously temporary factor could be blamed: the monsoon rains were normal, and oil prices had quickly receded after the Middle East crisis. Instead, basic questions were raised about the Government’s ability to contain fiscal imbalances and manage the economy, and a deeper confidence crisis set in. With policymaking paralyzed by political turmoil and capital flight, the risk of external default loomed large.
The economic situation has changed dramatically since then. A credible economic stabilization program, centered on controlling the fiscal deficit and setting in motion structural reforms, has made possible a reconstitution of foreign exchange reserves far in excess of the most optimistic expectations. Inflation has declined, and the economy is showing signs of revival. A decisive break with the interventionist policies of the past has been instrumental in turning around public confidence and reversing the economic decline.
Origins of crisis
As in many other countries, India’s balance of payments crisis had its roots in the high and growing fiscal deficits of the 1980s. For nearly forty years, India’s development strategy had rested on a vast regulatory apparatus designed to support a large public sector (including key inputs such as steel, power, transport, and banking), while leaving the production of consumer goods (imports of which were banned) to the private sector. High protection, tight controls over industry and investment, and a legal framework preventing free movement of capital and labor combined to make for generally lackluster growth—a performance starkly at odds with India’s enormous natural, human, and entrepreneurial resources. Nevertheless, despite its reputation for heavy-handed interventionism, it had established a long track record of macroeconomic stability based on generally cautious financial policies. Thus, as the fiscal deficit widened in the latter half of the 1980s (see chart), India was able to draw on its record of stability to finance rising current account deficits, principally through private capital inflows, including a sizable amount of repatriatable deposits from Non-Resident Indians (NRIs).
The period of strong domestic demand was accompanied by a modest and gradual liberalization of investment and trade, as well as substantial real depreciation of the currency—so that exports and output growth picked up markedly in the late 1980s. However, serious structural constraints remained, and inflationary pressures built up. At the same time, the drawdown in foreign exchange reserves and a growing debt burden raised questions about the sustainability of the current account.
Against this background of rapid domestic demand growth and structural rigidities, two successive shocks in the second half of 1990 exposed the fragility of the balance of payments. First, the Middle East conflict did double damage by raising India’s oil import bill and lowering workers’ remittances. At the same time, despite steady depreciation of the currency, export receipts contracted, reflecting a lengthening in lags in the repatriation of export proceeds; import payments, too, were brought forward in anticipation of trade controls and further currency depreciation.
Second, domestic political turmoil resulted in the fall of two successive governments—so that, pending fresh elections, the caretaker government could do little more than resort to stop-gap measures, including an interim budget largely devoid of policy action and a tightening of import controls. Such inaction drained the last dregs of hope that external creditors and the public may still have had about a firm response to the deteriorating economic situation. NRIs began withdrawing their deposits and India’s access to medium-and long-term bank borrowing all but dried up. Notwithstanding substantial recourse to IMF borrowing and tighter import controls, gross official reserves continued to decline steadily. The crisis deepened after the assassination of former Prime Minister Rajiv Gandhi, and by the time the new Government took office in June 1991, readily usable foreign exchange reserves were within weeks of being entirely depleted.
Signs of economic turnaround in India
Sources: Data provided by Indian authorities; and program projections.
1 Change in wholesale price index.
2 Based on the IMF, Information Notice System (1980=100) Calculation excludes Brazil. For March and June 1992, the exchange rate applied to exports is shown.
The emergency stabilization effort
Within days of assuming office, the new Government announced a two-stage adjustment strategy aimed at restoring public confidence and staunching capital flight.
The first stage consisted of an emergency package of stabilization measures, including a 19 percent devaluation of the currency and the establishment of a de facto dual exchange rate regime (by giving exporters a share of their earnings in the form of a tradable import license). Monetary policy was tightened further and interest rates were raised substantially. The authorities also undertook a large amount of gold-backed external borrowing as a sign of their commitment to meeting all external obligations. Indeed, the pains the authorities went through to avoid default, including harsh across-the-board import compression measures, surprised many who had come to regard debt rescheduling as inevitable.
The second stage coincided with the fiscal year (FY) 1991/92 Budget (April-March) in late July, the central element of which was a credible—and quickly implemented—set of measures to lower the fiscal deficit from about 9 percent of GDP in the previous year to 6½ percent of GDP; with only eight months left in the fiscal year, the politically courageous set of measures represented a sharp contraction in fiscal stimulus.
Just as important, Finance Minister Manmohan Singh’s budget proved to be a watershed in policy orientation, insofar as there was a decisive shift away from economic intervention and a highly gradualist approach to reform. By far the most far-reaching step was the virtual abolition of the complex system of industrial licensing, which had for decades governed the entry, expansion, and diversification of industries. A number of measures were also announced to strengthen competition between the private sector and public enterprises, including a narrowing of the areas reserved exclusively for the public sector. Foreign direct investment was significantly liberalized, from case-by-case consideration to automatic approval of 51 percent foreign equity ownership in a wide range of industries. With a credible and rounded adjustment well under way, and with bilateral donors and the World Bank committed to making available substantial amounts of quick-disbursing assistance—including a $500 million structural adjustment Bank loan—an SDR 1.7 billion stand-by arrangement was approved by the IMF’s Executive Board on October 31, 1992.
Stabilization under the program
With the rebuilding of critically low foreign exchange reserves an overriding short-term objective, the adjustment strategy centered on a near halving of the central government fiscal deficit, which lay at the root of external and internal macroeconomic imbalances. This was to be supported by tight monetary policy and a deepening of the structural reforms that had been announced in July.
The first five months of the program witnessed a remarkable reversal of capital flight and rebuilding of net international reserves, which rose by over $3 billion to bring the foreign exchange cover to three months of imports. To a large extent, the sizable balance of payments surplus in the second half of FY1991/92 reflected the effect of import compression measures taken at the height of the crisis, which lowered the volume of overall imports by over 17 percent; imports of capital goods and other inputs were hit even harder. Exports also suffered, partly because of the shortage of imported inputs, but also as a result of the collapse of trade with the states of the former U.S.S.R. Total trade declined sharply, and the overall current account deficit was nearly halved in FY1991/92.
Balanced against this painful contraction in trade, however, was a major reflow of capital. About $2.5 billion was mobilized from the sale of special bonds denominated in foreign currencies and from an amnesty scheme to encourage the repatriation of assets held abroad. Attractive—for India, costly—interest rates were clearly an important factor here. The larger reason for the reversal of capital flight, however, was the restoration of confidence following up-front structural reforms and fiscal actions in the budget (including politically difficult cuts in fertilizer subsidies and transfers to states).
One side effect of the massive buildup in foreign exchange was a large expansion in broad money. Partly as a result, the rate of inflation did not drop as quickly as had been hoped, although it did fall from its peak of 17 percent in August to about 13 percent by end-March 1992. At the same time, output growth slowed markedly as the squeeze on imported inputs led to a downturn in industrial production. Thus, by the start of FY1992/93, the focus of short-run adjustment shifted from averting external default to lowering inflation further and reviving the economy.
In this respect, the FY1992/93 budget aims at a further reduction in the fiscal deficit to 5 percent of GDP, principally through expenditure reduction. By September 1992, inflation had fallen to about 7.5 percent, less than half the rate the year before, while industrial activity and imports had picked up. The current budget places most of the emphasis on continued expenditure reduction, especially cuts in subsidies, and higher petroleum prices; revenues are projected to rise moderately, despite significant cuts in import tariffs, reflecting the anticipated rebound in imports following the elimination of all direct controls imposed during the previous two years. Although fiscal variables were evolving roughly as planned, broad money growth remained high—once again, as a result of an unsterilized increase in foreign exchange reserves.
In addition to the liberalization of trade noted above, a number of other reforms were set in motion at the time of the budget—most prominently, the move to partial convertibility of the rupee. Thus, myriad quantitative restrictions on nonconsumer goods imports were eliminated, and importers were allowed to purchase foreign exchange in a newly established dual foreign exchange market; exporters were allowed to convert 60 percent of their earnings at this free market exchange rate, the remaining 40 percent being surrendered to the central bank at the official exchange rate (mainly to finance fertilizer and petroleum imports). Contrary to initial fears, the free foreign exchange market has been remarkably orderly, with the premium stable at 15-20 percent over the official rate.
A number of actions were taken in the area of financial sector reform. Foremost among these was the sharp cutback in the cash reserve ratio and the statutory liquidity requirement (which obliges banks to hold government securities at below-market rates of interest); at the margin, the share of bank deposits impounded by such requirements fell from over 63 percent to 45 percent of new bank deposits. Further, the interest subsidy to “preferred” sectors was reduced, while deposit interest rates were liberalized. Steps were also taken to strengthen bank supervision and to phase in risk-weighted capital adequacy standards based on the Basle Committee on Banking Supervision (established by ten leading industrial countries under the auspices of the Bank for International Settlements); the financing of banks’ recapitalization needs remains one of the key challenges for the medium term. In May 1992, the financial sector was shaken by news of fraud on the expanding Bombay Stock Exchange involving illegal channeling of bank resources to the stock market. While the authorities see this as an argument for speeding up reforms, the impact of the scandal on the pace of financial sector reform remains to be seen.
The agenda ahead
Clearly, India has come a long way since the program of fiscal consolidation and structural reform was initiated in July 1991. But the Government recognizes that much remains to be done. A medium-term adjustment program is now being drawn up, aimed at deepening the reforms and reversing the legacy of protectionism and direct controls.
Three areas will be particularly important.
• Further trade liberalization and moves toward current account convertibility are planned. This would entail substantial cuts in average tariff rates, the elimination of quantitative trade restrictions (most consumer goods imports are still banned), and the unification of the dual exchange rate system.
• The program will aim at improving the quality of fiscal adjustment. Specifically, while the central government will focus on shifting the burden of adjustment from capital spending and maintenance to current spending, the process of fiscal adjustment also will be extended to the level of the states and public enterprises; tax reform—most importantly, a broadening of the tax base—also will be crucial, especially if planned cuts in tariff rates are not to be compromised by revenue considerations.
• To ensure that the reallocation of resources envisaged by the reform program is not hampered, an exit policy is being developed to allow the closure and restructuring of unviable firms both in the public and private sectors (government laws and regulations currently prevent timely exit of loss-making firms). A nascent social safety net—among other things, to provide compensation and retraining for displaced public sector workers—is being supported by the World Bank and should become operational shortly.
Taken as a whole, the program would drastically alter relative prices and set in motion a major economic restructuring—not just of production, but also of income, including the enormous economic rents associated with India’s regulated system. In such a large federal democracy, these economic strains are bound to be reflected at a broader social level. As such, the challenges are as much political as they are economic.