Journal Issue

Fischer address: India must revitalize reform effort to boost growth, move out of third world

International Monetary Fund. External Relations Dept.
Published Date:
January 2002
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We should not underestimate the economic and social gains made in India since reforms began 10 years ago. Nonetheless, the economic momentum achieved through the early part of the 1990s has not been maintained, and more recently, there has been a slackening in the pace of reform. What then has to be done to accelerate growth, so as to lead India from the third world to the first? Indian policymakers know full well the important impediments to stronger growth: poor infrastructure, a high cost of capital, and persistent fiscal imbalances. All have dampened investment spending by the private sector. In addition, growth is being hampered by relatively low rates of foreign direct investment and a tendency to waste precious tax revenues on unproductive subsidies rather than worthwhile investments in, for example, primary education and health care.

All these obstacles, and more, need to be tackled. And there is no better guide to what must be done to raise India’s growth to 8–9 percent a year than the excellent report in 2001 of the Prime Minister’s Economic Advisory Council. This report laid out an impressive and comprehensive agenda for second-generation reforms.

I would like to focus on five key areas covered by that report—embracing globalization, structural reform in product and labor markets, education, strengthening the financial sector, and fiscal consolidation.

Embracing globalization. The Economic Advisory Council eloquently made the case for further opening the economy and undertaking the reforms necessary to benefit from doing so. It notes that globalization is unavoidable and that “there is no divine dispensation that gives India alone the power to survive and prosper as an isolationist island in a globalized world.” Globalization should be embraced purposefully, cautiously, and with the appropriate safeguards, but embraced nonetheless.

Take the critical area of openness to international trade. India has made important strides in trade liberalization, but its tariffs remain very high by international standards, and the authorities frequently resort to antidumping measures. Moving quickly to further lower trade barriers would have a significant payoff. The Advisory Council suggested moving the average industrial tariff from the current level of 34 percent to the East Asian average of 12 percent by 2005. That goal remains a sensible one.

India’s cautious approach to capital account liberalization probably helped limit contagion during the Asian crisis by containing short-term debt and limiting linkages between India’s financial system and the rest of the region. But there are many benefits to greater openness to capital flows, especially foreign direct investment. During the past decade, foreign direct investment in India averaged ½ of 1 percent of GDP; in China it was 5 percent of GDP. With private investment in India at around 15 percent of GDP, greater openness to foreign direct investment would permit a nearly one-third increase in private investment relative to GDP and a significant increase in growth.

Cumbersome approvals processes, questions regarding the legal system, regulatory impediments to doing business, poor infrastructure, and a perceived slowdown in the pace of economic reform have all impeded foreign direct investment. For the rest, capital account liberalization should take place gradually, but steadily, as the financial system and fiscal policy framework are strengthened.

Structural reform. India has taken important steps to deregulate telecoms, pursue privatization, and place some industrial activities outside of state control. But more needs to be done—principally in deregulating industry, reforming labor markets, reforming the agricultural sector, and improving the power sector.

During the past decade, foreign direct investment in India averaged ½ of 1 percent of GDP; in China it was 5 percent of GDP.

–Stanley Fischer

Education. Despite gains, India’s literacy rates are still only 68 percent for men and 45 percent for women—compared with 91 percent for men and 76 percent for women in China. Literacy, as the Economic Advisory Council observed, is “the first step toward empowerment.”

Financial sector strengthening. If we have learned one lesson from the Asian crisis, it is the importance of a strong and well-regulated financial sector. India has tightened prudential norms, bolstered bank capital, strengthened its supervisory systems, and benefited from participating in a Financial Sector Stability Assessment. But important weaknesses remain and need to be addressed. The stock market scandal points to the need for further improvements in governance. Problems with the Unit Trust of India, the development finance institutions, urban cooperatives, and weak banks all underline the importance of strengthening supervision, governance, and mechanisms for the resolution of nonperforming loans, which are high by international standards.

The government’s commitment to reduce its ownership in the financial sector is welcome and should be pursued. But it is not at all clear that private investors will enter the sector, and strengthen it, so long as the government retains a controlling share in each institution, for government control over financial institutions has led almost everywhere to their progressive deterioration. This is a change that needs to be made sooner rather than later if the financial system is to do its job efficiently—particularly the job of financing investment, which is too low in India.

Fiscal reform. At nearly 10 percent of GDP, India’s general government deficit is among the highest in the world. As a result, general government debt has risen to almost 65 percent of GDP, and all the consolidation since the 1991 crisis has been erased. A deficit this large cannot be sustained. Unless convincing steps are taken to reduce the deficit in an orderly fashion, it will likely decline in a disorderly way, with serious consequences for growth. The deficit is already crowding out private investment and imposing a heavy interest burden on the budget, using resources that could otherwise be directed to development needs.

Draft legislation to eliminate the revenue deficit is welcome as far as it goes. But lasting fiscal stability will require harder budget constraints at the state government level, tax reform, reductions in subsidies, and more rapid progress with privatization. Further, the so-called golden rule of a budget balanced on current expenditures has no particular analytic backing, and it would be more useful to focus on the overall deficit.

Effort on all these fronts will no doubt take years to implement fully, but international experience suggests that there will be large payoffs in terms of macroeconomic performance and the economy’s capacity to cope with shocks. The sooner action is taken—and sustained—the better. The plans for very gradual improvement in the 1990s failed; a more determined rate of reduction would make more economic and political economy sense.

I have seen what happens to too many countries in the phase in which India is now—with the government borrowing heavily but with few visible adverse macroeconomic consequences—to take any comfort from the present fiscal situation. And, in any case, there are adverse consequences even now, for too large a share of private saving is being used to finance the government rather than finance investment and contribute to growth.

These measures constitute a formidable reform agenda, but they can and must be taken if India is to fulfill its economic potential, increase growth to 8–9 percent, and, over time, move out of the third world. India is also in a position—as the world’s largest democracy and home to one billion people—to inspire many other countries to undertake needed reforms.

The challenge is a mighty one, but it is time for India to meet it. Over a decade ago, I was asked how the needed reforms could be implemented. Indian policymakers need to answer that question in detail, but I would repeat what I said then, “Just do it.”

At nearly 10 percent of GDP, India’s general government deficit is among the highest in the world.

–Stanley Fischer

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