III The Adjustment Program of 1991/92 and Its Initial Results
Author: Mr. Ajai Chopra and Mr. Charles Collyns
Language:
English
Keywords:
OP; investment; India; liberalization; per capita income; import intensity; consumer goods; consumer durables; capital goods sector; Imports; Exports
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Abstract

By the end of the 1980s, macroeconomic fundamentals in India were seriously deficient, leaving the country vulnerable to both domestic and external shocks. The deterioration in the fiscal accounts that began in the first half of the decade was not corrected, leading to a worsening of the external current account deficit. These internal and external imbalances were accompanied by large-scale borrowing, and both public and external debt accumulated rapidly. With much of the new debt on commercial terms, the debt-service burden increased substantially. The impact of the macroeconomic imbalances was exacerbated by the continued rigidities and distortions in the economy.

By the end of the 1980s, macroeconomic fundamentals in India were seriously deficient, leaving the country vulnerable to both domestic and external shocks. The deterioration in the fiscal accounts that began in the first half of the decade was not corrected, leading to a worsening of the external current account deficit. These internal and external imbalances were accompanied by large-scale borrowing, and both public and external debt accumulated rapidly. With much of the new debt on commercial terms, the debt-service burden increased substantially. The impact of the macroeconomic imbalances was exacerbated by the continued rigidities and distortions in the economy.

Thus, there was little to cushion the adverse effects of the 1990 disruptions in the Middle East that led to a sharp—albeit temporary—increase in the cost of imported oil and loss of workers’ remittances. Concerns about the deteriorating external position and domestic political tensions caused a downgrading of India’s international credit rating, and access to external commercial borrowing almost ceased by mid-1990. Combined with large outflows of nonresident deposits, the result was a major foreign exchange crisis that brought India to the brink of default in early 1991. Usable foreign exchange reserves were negligible, and the authorities were able to maintain debt-service payments only through a severe administrative squeeze on imports and the provision of emergency financing by the IMF.

The Stabilization and Adjustment Strategy

The adjustment strategy adopted in mid-1991 contained four major elements: (1) immediate stabilization measures, notably a 19 percent devaluation of the rupee and increases in interest rates, designed to restore confidence and reverse the short-term capital outflow; (2) fiscal consolidation aimed at reducing the central government deficit from about 8½ percent of GDP in 1990/91 to 5 percent in 1992/93; (3) the mobilization of substantial exceptional financing from the IMF, the World Bank, and bilateral donors to maintain a minimum level of imports; and (4) the initiation of major structural reforms. The early emphasis of the reforms was on industrial deregulation and trade liberalization, in a push to reduce drastically licensing requirements for investment and imports. Subsequently, the focus turned to tax reform, further trade liberalization (including reduction in tariffs), and financial sector reforms.

The magnitude of external effects and some rough measures of performance outcomes can be estimated using the approach developed by McCarthy, Neary, and Zanalda (1994). The first step involves estimating the effects on the balance of payments of three kinds of shocks—changes in the trade-weighted terms of trade, changes in global demand, and changes in international interest rates affecting debt-service payments.1 Second, the economy’s response to these shocks is disaggregated into various measures of adjustment: through expenditure switching (that is, changes in export performance and the degrees of import intensity) and through demand squeezes affecting economic activity.2 Third, the need for additional net external financing is calculated as the difference between the effect of all shocks and policy responses. Responses are evaluated in terms of deviations from historical trends and obviously cannot be attributed to changes in policies alone since other factors would also have been at work, including indirect effects of the shocks themselves on the balance of payments through their impact on income and wealth. Nevertheless, in the absence of a fully specified and estimated model, these measures do provide useful summary indicators of the economy’s response to external shocks.

Based on the approach of McCarthy, Neary, and Zanalda (1994), the negative terms of trade shock in 1990 amounted to over 1 percent of GDP, while the effect of changes in global demand and world interest rates were negligible. As noted above, this external shock acted as a trigger for the 1990–91 crisis, rather than being the fundamental cause. The initial 1990 adjustment to the external shock and the sharply reduced availability of external financing was achieved through a temporary administrative squeeze on imports. Subsequently, in 1991 the rupee was devalued and fiscal and monetary policies were tightened. As these policies took hold, the import restrictions were relaxed in March 1992. The tightening of import restrictions and the sharp depreciation of the rupee brought about a change in import intensity equivalent to over 1½ percent of GDP in 1991 (Chart 3.1, top panel).3 In addition, export market shares rose markedly in 1993 and 1994 as a result of the depreciation of the real exchange rate and a reduction in the antiexport bias as the exchange and trade regime was liberalized. Thus, expenditure switching played a major role in the adjustment process.

Chart 3.1.
Chart 3.1.

Response Indicators1

(In percent of GDP)

Sources: Indian authorities and IMF staff estimates.1 See text for definition of responses.2 A positive value means a positive response, that is increasing export market share or decreasing import intensity.

The fiscal retrenchment and the tightening of monetary conditions undertaken as a part of the adjustment program led to a squeeze in domestic demand, which fell by 2½ percent in 1991/92 (Table 3.1 and Chart 3.1, middle panel).4 Combined with the withdrawal of external financing and the constraints on imports (which fell heavily on intermediate inputs), this contributed to a downturn in growth. The constraints on external financing, however, eased considerably after 1991 (Chart 3.1, bottom panel). Combined with the demand stimulus arising from a widening of the fiscal deficit in 1993/94 and buoyant export growth, this surge helped generate a broad-based economic recovery.5 On the supply side, industrial deregulation and trade liberalization contributed to the strong positive response.

Table 3.1.

Domestic Demand

(Percent change in real terms)

Source: Government of India, National Account Statistics, 1994.

Including errors and omissions.

Contributions to GDP growth.

Excluding errors and omissions.

The Response to the Reforms

Output performance since the implementation of the 1991 adjustment and reform program has had three noteworthy aspects:

First, the initial impact on output of the stabilization measures taken in response to the crisis was fairly modest. Economic growth slowed to 1 percent in 1991/92, before rebounding to nearly 4½ percent a year in the following two years. A time-series analysis of potential GDP and output gaps indicates that the 1991–93 recession was considerably milder than previous recessions.6 Over the last 35 years, India has had three severe recessions (1965–67, 1972–74, and 1979–82) with output gaps of more than 4½ percent of potential GDP (Chart 3.2). By contrast, the gap was less than 2 percent in 1991–93.

Chart 3.2.
Chart 3.2.

Actual and Potential GDP and the Output Gap

(In billions of rupees at 1990 prices)

Sources: IMF staff estimates based on Government of India, National Account Statistics.

Second, notwithstanding favorable monsoons, the recovery following the stabilization program took time in gathering momentum. After the slowdown in growth in 1991/92, there were signs of a recovery beginning around the first quarter of 1992/93. However, this incipient recovery stalled toward the end of that year, and economic activity was again lackluster until about the third quarter of 1993/94. This pattern was particularly striking for industrial output, private fixed investment, and stock building. Third, beginning in late-1993 economic growth gathered substantial momentum across the board and is estimated to have reached nearly 6¼ percent in 1994/95, three years after the launching of reforms. Investment appears particularly strong, and output in most sectors is increasing rapidly.

Against this background, this section looks at how sectoral performance has been affected by the combination of macroeconomic and structural measures. It must be emphasized, however, that interpreting the output and investment response to the reform program is complicated by the lack of data on capacity utilization.7 In addition, national accounts data for 1994/95 are not yet available and information on a range of other variables (for example, employment and performance across regions) is sketchy or nonexistent. Furthermore, questions can be raised about the reliability of even the aggregate demand and output data that are available.

The Supply Side and Sectoral Performance

Within the overall growth picture since the 1991/92 crisis, sectoral performance has diverged markedly, with industrial growth falling well below long-term trends while agriculture and services grew more steadily. Industry contracted in 1991/92, and then rose by only 3.5 percent a year in the following two years, well below the 7.2 percent annual growth achieved during the 1980s (Table 3.2 and Chart 3.3). Since late 1993/94, however, industry has recovered broadly, with output estimated to have increased by about 8 percent in 1994/95. By contrast, the agricultural sector has grown at close to its trend rate of the 1980s after a poor year in 1991/92.8

Table 3.2.

GDP by Sector of Production

(Percent change)

Source: Government of India, Central Statistical Organization.
Chart 3.3.
Chart 3.3.

Industrial Production

(In percent)

Source: Government of India, Central Statistical Organization.

Several factors had a depressive effect on the industrial sector in 1991/92–1992/93. On the supply side, measures to restrict imports imposed in 1990/91 affected the availability of raw materials, spare parts and components, and capital goods that were important for a number of import-dependent manufacturing industries. In addition, tighter credit conditions affected the availability and cost of finance, especially working capital.

Total domestic demand was weak in 1991/92–1992/93 (see Table 3.1), owing to slow growth of agricultural output and incomes, a reduction in public expenditures, and sluggish private investment. Sales of manufactured goods were affected by weaker external demand because of the recession in member countries of the Organization for Economic Cooperation and Development (OECD) and the collapse of export markets in the former Soviet Union.

The adverse supply-side factors that contributed to a contraction in industrial output in 1991/92 were largely removed by the end of that year. Indeed, the industrial deregulation and trade liberalization made imported inputs cheaper and more accessible for industry, thus removing a major constraint on the supply side. Although industrial growth started to pick up in 1992/93, it continued to be constrained by weak demand. In addition, temporary setbacks in 1992 and 1993 had an impact on confidence, thus affecting business plans and expectations. First, the stock market scam uncovered in May 1992 affected liquidity and temporarily affected investor confidence. Second, and perhaps more important, riots and other civil disturbances in the period December 1992 to March 1993 led to considerable sociopolitical uncertainty that affected industrial production. Thus, the growth of industrial output continued to be weak for much of 1993/94.

There is ample evidence of a broad-based recovery of the industrial sector in 1994/95. The capital goods sector, which had suffered a sharp recession for three years, bounced back vigorously. The production of capital goods in 1994/95 was a remarkable 24 percent higher than the previous year (Table 3.3), suggesting a pickup in investment in new machinery to install fresh capacity. The initial decline in capital goods production in 1991/92–1993/94 was related mainly to the weakness of domestic investment demand, particularly by the public sector. Contrary to the concerns that had been expressed, the liberalization of capital goods imports does not seem to have had a strong impact on the domestic capital goods industry as a whole.9 Capital goods imports fell sharply in the initial adjustment year and stayed low in the following year as well (Table 3.4). Despite the sharp rebound in 1993/94, the ratio of capital goods imports to domestic value added still remained at around its level of 1990/91.

Table 3.3.

Index of Industrial Production

(Percent change)

Source: Government of India, Central Statistical Organization.
Table 3.4.

Capital Goods Sector

(In millions of U.S. dollars)

Sources: Indian authorities; and IMF staff estimates.

Estimated from value-added data in 1989/90, industrial production information, and import unit value index for capital imports.

The consumer goods sector, which grew by less than 2 percent a year in 1991/92 and 1992/93, has also picked up markedly. The production of consumer durables was particularly hard hit by the demand squeeze in 1991/92, but by 1993/94 it had recovered strongly, in part because of substantial reductions in excise duties on automobiles and electronic goods in the budget for that year. Although growth of the consumer durables sector slowed somewhat in 1994/95, possibly because of capacity constraints, this sector is likely to grow rapidly in the years ahead in view of major investments made possible by the end of licensing and the liberalization of foreign investment rules. For example, joint ventures have either been launched or are planned by a number of companies producing passenger cars and consumer entertainment electronics.

The production of consumer nondurables has also picked up in 1994/95.10 In general, however, this sector has not registered particularly rapid growth. Data problems may have been the cause of the low recorded growth of this sector. For example, the index of industrial production does not provide good coverage of the small-scale sector. Thus, despite the strong export performance of textiles and garments, measured output in these sectors was stagnant.11 The continued policy of reserving production of many consumer nondurables for small-scale industries is also likely to have restrained growth in this sector by restricting investment and perpetuating its greater difficulty in accessing financing and foreign expertise.

The production of basic goods has increased fairly steadily over the last three years. To a large extent, output in infrastructure sectors such as electricity, petroleum, and coal mining is determined by investment trends in earlier years and is therefore little affected by short-term fluctuations in aggregate demand. Moreover, any supply response to the liberalization that has occurred will only be evident after a substantial lag given the long gestation period of projects in this sector. However, there has not yet been much new investment in this sector largely because frameworks for investment in areas such as power and hydrocarbons have been delayed. The lack of adequate infrastructure may prevent industry from committing itself to major investments in a number of other areas as well. Uncertainty about the policy framework, as demonstrated by marked shifts in the policy on subsidies, has also inhibited investment in the fertilizer industry.

Among the nonindustrial sectors of the economy, agriculture has benefited from good monsoons after 1991/92. Nevertheless, growth in output of the major food grains has been relatively slow. The increased procurement prices and some relaxation of constraints on exports of high-value grains should have increased production incentives. However, the pattern of input costs remains highly distorted and cutbacks in public spending on agricultural infrastructure are apparently having a negative impact on growth. More positively, partial liberalization of restrictions on internal and external trade and improved technologies have encouraged rapid growth in high value-added products such as fruits and vegetables, cut flowers, and marine products, and exports have grown rapidly, although the total amounts remain small.

The services sector has consistently outperformed the rest of the economy in recent years, and by a wider margin than in the 1980s. Services have clearly benefited from a relatively high marginal propensity to consume. Moreover, technological advances have made it possible for India to compete on a global basis in areas such as software development and information services. Reduced restrictions on private sector involvement have also played an important part, and indeed the response to liberalization has probably been quicker than in other sectors, partly because of lower fixed-investment requirements. A good example is the very rapid growth of passengers carried on private airlines since the opening up of this sector in 1992. There has also been substantial change in the financial services industry following liberalization in this sector, including the expansion of the mutual fund and investment banking sectors and the entry of private banks, although large parts of the retail banking and insurance sectors remain dominated by the public sector.

Regional Patterns

Growth across states varied considerably during the 1980s, with Andhra Pradesh, Gujarat, Haryana, Maharashtra, and Punjab achieving relatively high per capita income growth, while per capita income in other highly populated states such as Bihar, Orissa, Uttar Pradesh, and West Bengal was well below the national average (Table 3.5).12 Preliminary data indicate that these differences are likely to have been maintained if not accentuated since 1991/92. Although data on growth performance across states are only available with a considerable lag, information on the statewise distribution of new investment from memorandums of investment intention shows that 60 percent of new investment since 1991 has been located in only four states representing 37 percent of the population: Gujarat, Maharashtra, Tamil Nadu, and Uttar Pradesh. (Comparable figures prior to 1991 are not available.) Approvals for foreign direct investment have also been quite heavily concentrated with over half of approvals being directed at four states (Delhi, Gujarat, Maharashtra, and West Bengal).

Table 3.5.

Per Capita State Domestic Product

(In 1970/71 rupees)

Source: Ministry of Finance (1995).

The marked differences across regions are not surprising for two reasons. First, the previous licensing system that tried to allocate investment across states has been dismantled. Thus, new investment is likely to flow to states that offer a more hospitable environment. Second, states such as Maharashtra and Gujarat have lighter, more dynamic industries that are primarily in private hands. These states are therefore better placed to take advantage of the new policies not only because they are richer but also because of their greater outward orientation. By contrast, states such as Bihar and Orissa are better endowed with natural resources such as iron ore and coal, and hence are the base of heavy public sector industries, which have not yet benefited from the reform process.

Table 3.6

Unemployment Trends1

(In percent)

Source: Government of India, National Sample Surveys.

Usual status “adjusted” unemployment refers to persons who were not working but were seeking or available for work for more than half of the 365 days in the reference year, adjusted for those unemployed but working in a subsidiary capacity. Weekly status unemployment refers to persons who did not work for even one hour or any one day but were seeking or available for work at any time during the reference week.

Table 3.7.

Percentage of Persons Below Poverty Line1

Source: Planning Commission.

The poverty estimates up to 1987–88 are based on the quinquennial national sample surveys, whereas the poverty estimates for 1988–89 to 1992 are based on “thin samples” each year with sample size of about one fifth of the detailed quinquennial surveys. The results of these “thin samples” must therefore be interpreted with caution when assessing trends in poverty over time.

The Impact on Unemployment and Poverty

Official estimates indicate that total economywide employment increased by an average of 5 million a year in the second half of the 1980s. In the crisis year of 1991/92, employment increased by only 3 million (that is, less than 1 percent). The pace of job creation has picked up since then, with the increase in employment averaging 6.3 million a year during 1992/93–1994/95. As employment in the organized sector has been essentially flat, much of the increased employment has been in the informal sector.

National Sample Surveys for 1991 (July–December) and 1992 (full year), the most recent period for which surveys are available, suggest that there was no discernable change in unemployment in the first 18 months after the initiation of the adjustment and reform program (Table 3.6).13 Indeed, contrary to the expectation that the reforms might have led to an increase in urban unemployment, the data suggest that urban unemployment for males (who account for the bulk of urban jobs) actually declined marginally.14

Official estimates based on the latest survey data also indicate that the proportion of the population that is below the poverty line rose somewhat in the initial adjustment period. This ratio increased from 19.7 percent in 1990/91 to nearly 22.9 percent in 1992 in the rural sector; there was also a rise—from 10.8 percent to 13.0 percent—in the urban sector (Table 3.7). The marked increase in rural poverty is likely to have been largely related to the cyclical decline in agricultural production in 1991/92, rather than any structural shift.15

1

The terms of trade shock is measured as the net import effect, that is, the change in export prices multiplied by the export volume minus the change in import prices multiplied by the import volume. The interest rate effect is calculated as the change in world interest rates (approximated by the London interbank offered rate) multiplied by the estimated stock of interest-sensitive external debt. Finally, the impact of changes in global demand is calculated as the deviation of the growth of world export volume from its estimated trend multiplied by the initial volume of Indian exports.

2

Changes in export performance are measured as the initial export volume multiplied by the excess of actual export volume growth over world export volume growth. Changes in import intensity are calculated as the difference between import volumes expected on the assumption of historical import elasticity of GDP and actual import volumes. The import adjustment induced by the demand squeeze is calculated as the difference between import volumes expected on the assumption of historical import elasticity of GDP using the trend GDP growth rate versus the actual GDP growth rate.

3

The volume of imports fell by over 20 percent in 1991/92.

4

The growth of consumption expenditures slowed to about 1½ percent a year in 1991/92 and 1992/93. Gross fixed investment also declined by 4 percent in 1991/92 followed by slow growth in the next two years. The decline in fixed investment in 1991/92 was accompanied by a sharp decline in stock building, resulting in a deeper fall in gross domestic capital formation.

5

Both government consumption and public investment in 1993/94 grew at rates similar to those achieved in the 1980s, with the result that domestic demand grew by 3 percent.

6

Potential GDP was estimated using a filter developed by Hodrick and Prescott (1980). This filter defines a trend γt for the series yt, which minimizes the weighted sum of two components: the squared distance between γt and yt, and the squared distance between γt and γt-1, with a weight of λ = 100 commonly used for the second component when annual data are used.

7

The substantial shifts in relative prices implied by the reforms may have made a significant part of existing capacity obsolete. A recent study by the Industrial Credit and Investment Corporation of India Limited (1994) indicates that capacity utilization dropped in 1991/92 and 1992/93, the latest period for which data are available. The study identifies a decline in demand (measured in terms of the growth of real sales) as the main reason for the initial decline in capacity utilization. Business surveys suggest that capacity utilization has increased somewhat since 1992/93, and these surveys cite plant capacity as an important constraint on production. Detailed information on capacity utilization is also compiled by the Central Statistical Organization, but is available with a considerable lag and only for a limited sample of industries.

8

The decline in agricultural production in 1991/92 can be ascribed in large part to an erratic monsoon that year that led to a 4.5 percent fall in food grain production.

9

One concern was that the reduction of trade barriers would affect the capital goods sector in particular because the tariffs on finished capital goods were lowered by more than the tariffs on the inputs into the production of capital goods.

10

The weak performance of this sector in 1993/94 reflected in part a sharp decline in sugar production due to a drop in sugarcane cultivation.

11

Analysis of production trends for other categories is also complicated by weaknesses in the statistics. The present index of industrial production has not been rebased since 1980/81 and does not necessarily capture the substantial changes in India’s industrial structure since then. Many fast-growing sectors such as automobiles, electronics, and computers are substantially under-represented in the index. A second difficulty is that the index is based largely on information from the registered sector, while nearly half of output from Indian manufacturing is in the small-scale and village sectors. Little comprehensive information is available on how the informal sector has fared in recent years, although some industries—such as garments—seem to have done particularly well. Third, with the dismantling of the industrial licensing system in August 1991, the response rale may well have deteriorated as the incentives for prompt and accurate reporting have been reduced.

12

Cashin and Sahay (1995) examine the determinants of growth for 20 Indian states during 1961–91, using cross-sectional estimation and the analytical framework of the neoclassical growth model. They find evidence of absolute convergence, but at a very slow rate of 1.5 percent a year, which is substantially below convergence rates found across regions in industrial countries. This implies that in the Indian context it would take about 45 years to close half of the gap between any state’s initial per capita income and the steady-state per capita income.

13

Unemployment data for India need to be treated with caution as there is considerable underemployment.

14

Although India’s rigid labor laws likely prevented some unemployment, these laws cover only the organized sector, which is just 8 percent of the labor force. Thus, even if large-scale layoffs were possible in the organized sector it is unlikely that the overall picture would be dramatically altered.

15

The 1992 National Sample Survey data are based on a smaller than normal sample of 12,000 to 15,000 households and are hence not deemed reliable enough for assessing trends in poverty over time. A broader survey of 100,000 households was conducted in 1993/94 and the results are being compiled.

Within Same Series

Other IMF Content

Other Publishers Content

Cover India
India
Economic Reform and Growth
Author: Mr. Richard Hemming, Woosik Chu, Mr. Charles Collyns, Ms. Karen Elizabeth Parker, Mr. Ajai Chopra, and Mr. Oliver Fratzscher
ISBN:
9781557755391
ISSN:
0251-6365
Publication Date:
01 Jun 1995
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557755391.084
Pages:
88

Response Indicators1

(In percent of GDP)

Actual and Potential GDP and the Output Gap

(In billions of rupees at 1990 prices)

Industrial Production

(In percent)

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