VII Structural Reforms and the Implications for Investment and Growth
  • 1 0000000404811396 Monetary Fund
  • | 2 0000000404811396 Monetary Fund


Since 1991, India has introduced major reforms to improve the efficiency of resource allocation and expand the productive capacity of the economy. These reforms have focused on liberalizing product markets, particularly by removing impediments to private investment (both domestic and foreign), and liberalizing the trade and external payments regimes. The liberalization of factor markets has so far centered on financial markets, with emphasis on increasing the role of market mechanisms in the allocation of credit.

Since 1991, India has introduced major reforms to improve the efficiency of resource allocation and expand the productive capacity of the economy. These reforms have focused on liberalizing product markets, particularly by removing impediments to private investment (both domestic and foreign), and liberalizing the trade and external payments regimes. The liberalization of factor markets has so far centered on financial markets, with emphasis on increasing the role of market mechanisms in the allocation of credit.

Although the reforms are by no means complete, much has been accomplished and the private sector’s response has been positive. However, obstacles to a stronger and broader investment response remain. Despite efforts to attract private investment, inadequate infrastructure is still a major constraint, preventing industry from committing itself to large-scale investments. Moreover, in other areas—such as public enterprises, labor market and exit policies, and the agricultural sector—little has been done as yet to address serious distortions.

This section focuses on four areas of reform: (1) the external trade regime;1 (2) the investment regime; (3) public enterprises; and (4) the financial sector. The issue of labor markets and exit policies is discussed in the context of both industrial policy and public enterprises. The progress in reducing distortions and changing incentives is discussed, and the initial outcome of the reforms is assessed. The major remaining structural impediments and the unfinished agenda for reforms are highlighted.

Trade Reform

For most of the postindependence period, India’s trade policy was largely geared toward self-reliance through import-substitution policies. Quantitative restrictions were pervasive, and import tariffs were extremely high. There were also numerous other restrictions on trade as outlined in Table 7.1. Direct restrictions on exports, a protected domestic market with a high cost structure, and restricted access to inputs for export production resulted in a strong antiexport bias. Heavy protection, together with restrictions on foreign investment that limited opportunities for adopting new technology and learning by doing, also fostered low productivity and inefficient domestic industries.

Table 7.1.

Trade Policy Reform: Progress to Date and Future Reform Areas

The trade reforms undertaken since 1991 have reduced substantially the antiexport bias of Indian industry. The level and dispersion of tariffs have been cut sharply and quantitative restrictions have been eased. These reforms were preceded by a substantial devaluation of the rupee, which led to a 15 percent depreciation of the real effective exchange rate between 1991 and 1992. The real effective exchange rate has remained essentially unchanged since then. These policies, together with industrial delicensing and a more liberal foreign investment regime, contributed to strong export growth in 1993/94 and 1994/95. Nevertheless, India’s trade regime remains one of the most protected in Asia and progress in trade liberalization lags behind most other developing economies.

Progress in Reducing Distortions

The maximum tariff was lowered from 400 percent in 1990/91 to 110 percent in 1992/93, and most recently to 50 percent in 1995/96. Average (import-weighted) tariffs have been reduced from 87 percent in 1990/91 to 27 percent in 1994/95 (Table 7.2). Both the nominal and effective rates of protection have come down sharply, with capital goods facing the lowest effective rate (39 percent in 1994/95) and consumer goods the highest (81 percent).2 With efforts to achieve a more uniform tariff structure, tariff dispersion—as measured by standard deviations—has fallen from 41 percent in 1990/91 to 21 percent in 1995/96. In addition, the gradual elimination of tariff exemptions has narrowed the gap between the average tariff and the collection rate: a gap of some 45 percentage points in 1990/91 was reduced to 19 percentage points by 1993/94.

Table 7.2.

Effects of the Reform on Trade Regime

(End of period; in percent, unless otherwise indicated)

Sources: Data provided by the Indian authorities; and the World Bank.

With the elimination of import licensing requirements for intermediate and capital goods, the share of value added subject to quantitative restrictions in the manufacturing sector decreased from about 90 percent in the pre-reform period to 51 percent in 1994/95 (Table 7.2). The inclusion of more consumer goods in the open general license list starting in 1995/96 is expected to lower this figure further. Nevertheless, imports of consumer goods remain severely restricted. Quantitative restrictions on agricultural imports are also still pervasive, covering over 90 percent of value added as of 1994/95.

Restrictions on exports have been relaxed, with the number of restricted items falling from 439 in March 1990 to 210 in March 1994. The remaining restrictions are mostly in the agricultural and mining sectors. Along with the elimination of export restrictions, various export incentive schemes have been revamped to streamline procedures and reduce distortions, while sector-specific direct export subsidies have essentially been eliminated.

The Impact on the Economy

The economy has reacted positively to the reduction in trade distortions and change in relative prices. The country is now more open, with the ratio of total trade to GDP rising from an average of 12.7 percent in the 1980s to nearly 19 percent in 1994/95 (Table 7.3).3 Furthermore, the premium on smuggled goods has been reduced sharply.

Table 7.3.

Exports and Imports Relative to GDP

(In percent)

Source: Ministry of Finance, Economic Survey, various issues.

Export volumes increased by an average of nearly 19 percent a year in 1993/94 and 1994/95, after a weak performance in the previous two years (Table 7.4). This strong performance was spurred by the depreciation of the real exchange rate and a reduction in the antiexport bias of the trade system. The export surge has affected a broad range of products, both manufactured and agricultural. Thus, a major shift in the composition of exports is not yet evident.4

Table 7.4.

Effects of the Reform on Trade

Sources: Data provided by the Indian authorities; Ministry of Finance, Economic Survey, various issues; Reserve Bank of India, Annual Report, various issues; and IMF staff estimates.

Imports contracted sharply in 1991/92 owing to the imposition of administrative controls, but rebounded strongly in 1992/93. With the increasing momentum of economic activity, imports rose markedly in 1994/95, with non-oil imports growing by over 30 percent. Imports of capital and export-related items still account for a large proportion of imports, with imports of consumer goods still quite limited.

Future Priorities

Notwithstanding the progress in reforming the trade regime, tariffs and the rate of protection in India are much higher than those of East Asian economies, and indeed of many developing countries (Table 7.5). To a degree, concerns about the loss of revenue have affected the pace of tariff reductions. There have also been concerns about the ability of certain industries to adjust to increased competition, which has led to higher tariffs for some sectors and effective rates of protection may even have risen in some instances.5

Table 7.5.

International Comparison of Openness

(In percent)

Sources: Kirmani and others (1994); and IMF staff estimates.

Based on information available in May 1994.

Unweighted average.

Merchandise trade only; hence figures for India differ from Table 5.3, which are for exports and imports of goods and nonfactor services.

For comparability, the figures shown for India are those applicable in May 1994. In the 1995/96 budget, the maximum tariff was lowered to 50 percent and the unweighted average tariff is now estimated to be 42 percent.

The main tasks remaining are the elimination of quantitative restrictions and a further reduction of tariff levels. As long as imports of consumer goods remain heavily constrained, the danger of misallocation of investment and lack of competition will be serious and India’s performance in what could be a dynamic sector will remain subdued.6 Replacing the ban on the import of these goods with appropriate tariffs would also raise revenue, which would strengthen the fiscal situation. Restrictions on trade in agricultural goods also need to be lifted to allow this sector greater opportunity to compete in world markets.7 Along with the reduction of tariff levels, variations depending on the types of goods, sectors, and end uses should be reduced so as to make the tariff structure more uniform.

The Investment Regime

Prior to the middle of 1991, private investment was not permitted in many key sectors of the economy. In areas where such investment was allowed, a complex web of regulations and licensing requirements inhibited productivity and growth. Over the past four years, major steps have been taken to liberalize India’s investment regime and dismantle the system of controls. This section reviews progress of reforms in five key areas (see also Table 7.6): (1) deregulation of the industrial sector; (2) upgrading of infrastructure; (3) reforms of exit policies to reduce labor and property market rigidities; (4) liberalization of the foreign investment regime; and (5) agricultural reform.

Table 7.6.

Industrial Policy Reform: Progress to Date and Medium-Term Objectives

Deregulation of the Industrial Sector

The deregulation of the industrial sector has been an important element of the reforms initiated in the middle of 1991. Until then, India was one of the most heavily regulated economies in the world. Domestic competition was hindered by licensing, which limited entry, changes in product mix, and the expansion of successful firms. In addition to licensing requirements, the Monopolies and Restrictive Trade Practices Act placed further barriers to expansion for large firms. Industrial efficiency was also undermined by preferences granted to public enterprises, policies that encouraged excessive capital intensity, administered prices, and a regional price equalization scheme that discouraged geographic specialization.

These policies led to a number of highly protected manufacturing industries with low efficiency. During the 1980s, protected industries (such as petroleum, coal, chemicals, steel, and fertilizers) accounted for over half of fixed capital formation in manufacturing, but contributed only about two fifths of the sector’s value added. Moreover, these industries were three times as capital intensive and twice as power intensive as those industries with low protection.

Deregulation and decontrol measures have included (1) removing investment licensing requirements in most industrial sectors, leaving only a few areas (for example, petroleum, coal, and agro-processing) still subject to these requirements; (2) amending antitrust legislation to eliminate the restraints to large firms’ expansion, diversification, merger, and acquisition; (3) gradually reducing the areas reserved for the public sector; and (4) eliminating many price controls, for example on steel, aluminum, and cement.

The reforms have energized the Indian private sector. Investment picked up markedly in 1994/95, and output in most sectors is increasing rapidly (see Section III for details). Investment in such areas as automobiles and consumer electronics has been particularly strong.8 In other areas, such as telecommunications, power, petrochemicals, and oil exploration, major investments are being planned, although the process is slow (see below on infrastructure policies). However, a number of obstacles remain. First, concerns about the ability of public enterprises to compete have continued to impede private activity in some areas.9 Second, the process of obtaining all the necessary licenses and permits at the state level is still extremely cumbersome.10 A third obstacle is the continued policy of reserving production of some 850 items (including most nondurable consumer products) for small-scale enterprises. Small-scale industries also receive purchase and price preferences, subsidized loans, tax exemptions at the state level, and protection through the quantitative restrictions on imports of many consumer goods. Nevertheless, the inability to exploit economies of scale has inhibited investment, innovation, and production efficiency in sectors where India should have considerable export potential.11

Infrastructure Policies

The poor quality of India’s infrastructure (especially in power, roads, water, and telecommunications) is likely to be a major obstacle to India’s economic development in the coming years.12 Most existing infrastructure facilities are state monopolies. Although public investment in infrastructure has been substantial in recent years (an estimated 43 percent of total public investment planned for 1991–96), provision of infrastructure has suffered from poor financial management, operational inefficiency, and inadequate maintenance.

The authorities have recognized the advantages of private sector investment in these sectors, to provide both financing and technical expertise. In principle, all these sectors have been opened to private participation. However, notwithstanding considerable private sector interest, actual progress has been slow so far for a number of institutional and financial reasons. First, attracting infrastructure investment requires an appropriate licensing and regulatory framework. The process of establishing these frameworks has been slow and key regulatory and administrative arrangements are still in the process of being established. For example, the deadline for bids to provide both basic and cellular telephone services had to be extended while the government replied to numerous queries from potential bidders on issues such as interconnectivity of public and private networks, the intended regulatory regime, and revenue sharing.13 Second, a viable commercial framework must be established. Investment in the power sector has been limited by concerns about the solvency of the main purchasers, the state electricity boards.14 Third, there are issues of financing: a more mature debt market with a longer-term segment needs to be developed, and ways need to be found to tap small savers and appropriate forms of foreign financing.15

Exit Policies

The terms “industrial sickness” and “exit policy” are peculiar to the Indian situation. Industrial sickness refers to public and private enterprises that chronically make losses but continue to operate. Exit policy refers to regulatory policies that block the liquidation of these loss-making enterprises.

The Goswami Committee report (1993) points out several reasons for the phenomenon of industrial sickness:16 (1) the focus in the financial system (at least until 1991) on maximizing loans for industrial development;17 (2) weak banking supervision that allowed continued lending to overleveraged and undervalued companies through interest capitalization; (3) substandard management, compounded by inadequate monitoring and supervision by shareholders, who were often dominated by public financial institutions; and (4) legal obstacles to restructuring, with considerable interference by state and local authorities. Thus, although industrial sickness is often associated with surplus labor, other factors have been at least as important constraints to efficiency.

Progress on institutional reforms to provide for restructuring of sick companies has been slow. A quasi-judicial body, the Board of Industrial and Financial Restructuring (BIFR), was created in 1987 as a fast facilitation agency to frame restructuring and bankruptcy packages based on careful consultation among interested parties.18 The BIFR now deals with both public and private chronically sick enterprises. However, its procedures have proven to be extremely slow moving and have not provided a mechanism for efficient restructuring.19 Moreover, even after the BIFR has reached a decision, impediments remain. Thus, due to elaborate legal procedures, none of the 150 cases where the BIFR has recommended closure has yet been shut down.

The restructuring of sick companies has also been difficult because of inflexible labor laws (the Industrial Disputes Act), which require firms employing more than 100 workers to obtain prior approval of the state government to retrench labor.20 Similarly, under existing property laws (the Urban Land Ceiling and Regulation Act), firms are unable to sell urban land and liquidate assets or use the resources for restructuring without state approval. These rigid labor and property laws mean that firms are unable to restructure or close even though they are effectively bankrupt, while also impeding the adjustment of the economy in response to changing economic conditions.21 Labor market rigidities also encourage excessive capital intensity in the organized sector.22 In addition, the combination of rigid property laws and tight rent controls have led to enormous misallocation of land. For example, property values in Bombay are among the highest in the world.

A workable exit policy for unviable units will require an overhaul of labor and land use legislation to ensure flexibility of factor use, as well as major changes in the BIFR mechanism.23 It will be particularly important to provide greater room for free bilateral negotiation between management and workers, without requiring that the government approve any labor force reduction before it can occur. Such steps would need to be backed up by an adequate social safety net to ameliorate the transitional costs. The National Renewal Fund (established in 1991) already provides resources that can be used for voluntary retirement schemes for public units, but the scope for the fund would need to be broadened for it to become more effective.

Policies on Foreign Direct Investment

The liberalization of the foreign investment regime has been another major advance in India’s industrial policy since 1991. Key measures include (1) allowing up to 51 percent foreign participation in 35 high-priority industries on an automatic approval basis, with the possibility of approval up to 100 percent on a case-by-case basis;24 (2) streamlining government approval procedures with a fast-track mechanism even where the automatic route cannot be used; and (3) preferential tax rates and tax holidays, bilateral investment treaties, and accession to the Multilateral Investment Guarantee Agency.

Between 1991 and March 1995, a cumulative $6 billion of foreign direct investment had been approved. However, just over $2 billion has actually materialized, a large proportion of which consists of increased equity shares in existing joint ventures rather than new projects. This slow response partly indicates the normal lags involved in launching new projects. However, a large number of disincentives remain. Apart from the constraints noted earlier, foreign investors are particularly concerned by perceived political interference in screening proposed investments and a slow-moving legal system. Also, unlike some other countries, privatization has progressed slowly and has not involved substantial foreign participation.

Agricultural Reform

India has devoted considerable resources to agricultural and rural development over the past three decades. The spread of irrigation, fertilizers, and high-yielding seed varieties has led to a “green revolution” in parts of the country and has alleviated food shortages. Despite these successes, important restrictions on agricultural activity inhibit the development of this key sector of the economy. These restrictions include licensing requirements in agro-processing industries; restrictions on agricultural exports; and barriers to internal trade and storage. Extensive controls on commerce in agricultural products, together with input price distortions, have reduced incentives for producers and inhibited productivity growth.25 As a result, labor productivity in India’s farm sector has grown by an average of ½ of 1 percent a year over the past two decades, compared with productivity growth in East Asian farming of over 2 percent a year. Much of the increase in food production has been due to an extension of cropped areas, supported by costly subsidies that are no longer sustainable. Low productivity has contributed to slow growth of farm wages and persistent poverty in rural areas.

Liberalization of agricultural policies has the potential for dynamic, labor-intensive growth that would be conducive to a more rapid spread of the benefits of reform.26 The first priority should be to dismantle the pervasive controls on agricultural commerce, in the way the industrial sector was deregulated in 1991. This would involve eliminating licensing requirements for wholesale trade and storage, phasing out public sector procurement, abolishing the remaining controls on imports and exports of many agricultural items, and ending the licensing of agro-processing industries. Second, the system of price incentives should mirror market conditions. The resources presently devoted to farm subsidies could be better spent on rural infrastructure development, particularly transport, storage, and rural credit systems.

Public Enterprise Reform

Although the private sector has been invigorated by the reform process, the large public enterprise sector remains a drag on the economy.27 There has been some success in lowering the budgetary cost of this sector, but public enterprises continue to suffer from low profitability and limited managerial autonomy. Public enterprises have often not been in a position to respond forcefully to increasing competition from the private sector in many areas, resulting in continued inefficient use of a large part of India’s capital and labor force.

Public Sector Performance

The public sector’s share in GDP increased from about 8 percent in 1960 to over 25 percent in 1993/94. In 1994, India had more than 1,000 public enterprises, about 800 of which were owned by the states.28 About 240 nonfinancial central government enterprises employ about 2.2 million people and account for about 13 percent of GDP. Public enterprises continue to dominate industries such as coal mining and energy (close to 100 percent share), nonferrous metals (over 80 percent), steel (over 60 percent), and fertilizers (about 40 percent).29 The public sector’s share of output in basic metals and machinery sectors remained above 25 percent in 1994, whereas it was about 15 percent in manufacturing.30 Public enterprises are generally highly capital intensive: in the manufacturing sector, at the end of the 1980s the public sector accounted for 55 percent of total investment but only 15 percent of total output.31

The financial performance of public enterprises is poor and has not improved much in recent years. Gross profit over capital employed was about 11 percent in central public enterprises in 1993/94, compared with nearly 20 percent in the private sector.32 After taxes, net profits of public enterprises amounted to less than 3 percent of employed capital, which in most cases was insufficient to cover depreciation (Table 7.7). Although the petroleum sector remains profitable, public enterprises show negative profit margins in many sectors (for example, textiles, fertilizer, steel, and heavy engineering).33 Heavy capital investments in the past, combined with a large interest burden have reduced the profit margins of public enterprises. Annual net financing needs of public enterprises under the central government have exceeded 5 percent of GDP (about one fourth of domestic savings) in the last four years.

Table 7.7.

Profitability of Central Government Public Enterprises

(In billions of rupees, unless otherwise noted)

Sources: Ministry of Finance, Economic Survey, 1994–95; Ministry of Industry, Public Enterprise Survey; budget documents; Center for Monitoring of the Indian Economy; World Bank.Note: DP = departmental (i.e., fall under government departments); N D = nondepartmental.

Profits are net of taxes and relative to sales.

Sold in domestic capital markets.

Includes supplier’s credit.

Includes public deposit accounts and intercorporate borrowing.

Includes loan and equity contributions, excludes subsidized grants.

By all accounts, performance is much worse in the enterprises at the state level; in 1992/93 the losses of state electricity boards alone amounted to 14 percent of total plan outlays of states and union territories. Pricing policies are a major factor underlying the poor performance of these boards, as administered prices for electricity have often been fixed below the average cost of production excluding depreciation.34

The goals of public enterprise reform are greater efficiency, productivity, and competitiveness. The reforms have focused on (1) creating internal competition by eliminating entry barriers, subsidies, price distortions, and preferential access to budget and bank resources; (2) improving the management of public enterprises by increasing autonomy and the mandate to become profit-oriented centers; (3) introducing restructuring policies and establishing a social safety net program; and (4) implementing several rounds of divestment. Table 7.8 summarizes the progress to date in these areas and the medium-term objectives.

Table 7.8.

Public Enterprise Reform: Progress to Date and Medium-Term Objectives

Competition Policies

Reforms in competition policies have been the most extensive. The number of areas reserved exclusively for the public sector has been reduced from 18 in 1991 to 6 (defense products, atomic energy, coal and lignite, mineral oils, railway transport, and radioactive minerals). Thus, public enterprises face competition in sectors as diverse as mining, oil refining, power, air transport, telecommunications, banking, and all lines of manufacturing. Trade liberalization and a more liberal foreign direct investment regime also added pressure for innovation and cost-effective production. Financial market reforms have created more equal and efficient financing opportunities, and fiscal reform has resulted in a harder budget constraint for most public enterprises.

However, as noted earlier, the expansion of private activity has at times been restricted by concerns regarding the ability of some public enterprises to compete effectively. Furthermore, reforms at the state level are generally lagging behind, especially in the power sector, where the poor financial position of most state electricity boards limits their ability to pay for private power. Finally, there is scope for reducing subsidies by comprehensive price adjustments, especially for power, petroleum, and fertilizers.

Management Policies

Increasing competition for public enterprises has prompted changes in the organizational structure to provide more operational autonomy, including setting out in a memorandum of understanding (MoU) an objective basis for evaluating the management of a public enterprise by the ministry responsible for its administration. Although the MoU system now covers some 106 central public enterprises (about half of the total, including nearly all loss-makers), it does not appear to have achieved its objective of providing greater autonomy. In 1993/94, 75 percent of the evaluated public enterprises were rated “excellent” or “very good,” and only 10 percent were rated “fair,” suggesting that the criteria for ratings were not very stringent.

A key problem with the MoU system has been the lack of credible sanctions against management that fail to meet commitments in an MoU. Allowing effective restructuring of the public enterprise and implementing exit policies (including firing management) would be one route to strengthening sanctions. The MoU system could also be strengthened with more comprehensive multiyear contracts that further improve incentives, flexibility, and accountability. Another drawback is the conflict of interest inherent in an administrative ministry rating and supervising the public enterprises that fall under its jurisdiction.

Restructuring Policies

Since December 1991, 140 central and state enterprises have been referred to the BIFR, of which 56 cases meet the criteria of sickness. As discussed earlier, BIFR procedures have proven extremely cumbersome and none of the public enterprises recommended for closure has actually been shut down. In addition to strengthening BIFR procedures, overhauling labor policies, and improving the social safety net, there is also a need to identify loss-making public enterprises at an early stage rather than when they are already chronically sick.

Divestment Policies

Since October 1991, several rounds of divestment of shares in centrally owned public enterprises have raised some Rs 102 billion (equivalent to $3.6 billion or about 1.4 percent of average annual GDP for the period). So far, divestment has been limited to a maximum of 49 percent of equity and has covered 35 profitable central public enterprises concentrated mainly in the manufacturing sector.35 On average, some 15 percent of the shares in these companies have been sold, with the highest being 43 percent in the case of Hindustan Organic Chemicals (Table 7.9). Central government holdings have been reduced to less than 60 percent in only three of these companies.

Table 7.9.

Public Sector Enterprises: Divestment

(In percent)

Source: Ministry of Finance (1995).

The divestment program has had mixed success, in part because the objective of raising revenue has often superseded the objective of improving efficiency. Initially, bids were invited for a basket of company shares; later bidding for individual shares was allowed. The investor base was gradually widened to include a full range of domestic investors and foreign institutional investors. The government expects to raise an additional Rs 70 billion from divestment in 1995/96, possibly by allowing sales through fixed-price offers rather than auctions, which would allow tapping of a broader investor base.

Unless they serve a clear social purpose, most public enterprises should eventually be privatized. As a transitional step, it would be important to accelerate the divestment program, extending the process to a broader range of companies and also reducing government share holdings below 51 percent in at least a few key enterprises. The report of the Rangarajan Committee on Divestment of Shares in Public Sector Enterprises proposed majority or full privatization of selected enterprises in sectors where there is no compelling rationale for public participation (Rangarajan and others (1993)). This report—completed in March 1993—has not yet been adopted by the government.

Financial Market Reform

Prior to the latest round of reforms, the financial system in India was severely repressed. As in other such regimes, the government intervened in the market for a variety of reasons—to finance the fiscal deficit at low cost, to subsidize strategic industries, to provide support for the underprivileged, and to control markets directly in the absence of indirect instruments of monetary control.

The government pre-empted a substantial portion of available financial savings through the cash reserve requirement (CRR) and the statutory liquidity ratio (SLR) imposed on bank deposits. Moreover, administered lending and deposit rates created distortions in both savings and the demand for credit. Directed credit programs further contributed to resource misallocation and weakened the credit analysis function of banks. In a context of inadequate prudential regulations and bank supervision, these distortions resulted in the accumulation of nonperforming assets. The lack of competition implied by a predominantly government-owned banking system also contributed to costly yet poor quality financial services.36

Wide-ranging reform measures implemented since 1991 have sought to make the financial system more market oriented, thereby increasing its efficiency. In the banking sector, these reforms have included interest rate deregulation, a phased reduction of the cash reserve requirement and the statutory liquidity ratio, simplifying directed credit programs, development of money markets, relaxation of barriers to entry for private banks, and measures to strengthen banks’ balance sheets, including through capital replenishments and tighter prudential regulations and supervision (see Table 7.10 for details). Similarly, capital market reforms have aimed at improving market efficiency, making transactions more transparent, curbing unfair trade practices, and establishing an effective regulatory framework.

Table 7.10.

Financial Sector Reform: Progress to Date and Future Reform Areas

Sources: Indian authorities; and IMF staff.

Progress in Reducing Interest Rate Distortions

Prior to 1991, a multitude of fixed lending and deposit rates favored borrowers in small-scale industry and agriculture (the “priority sectors”) and offered relatively low yields on longer-term savings. The rates were adjusted periodically in light of changing macroeconomic circumstances; however, this sometimes occurred with a lag, resulting in negative real interest rates. This complex structure of administered rates was simplified in 1992/93. A small number of fixed rates for priority sector loans were retained, while larger commercial borrowers faced a floor lending rate. Bank deposit rates were subject only to a single ceiling rate. This system guaranteed banks a minimum interest rate spread and a measure of protection against mounting losses.

In 1993/94, the markets for commercial paper and certificates of deposit were deregulated, allowing companies to access credit at market terms that were considerably below the minimum lending rate. In October 1994, the minimum lending rate was eliminated. At present, the remaining interest rate controls comprise two fixed rates (12 percent and 13.5 percent) for small- and medium-sized borrowers and the maximum deposit rate (12 percent). The deregulation of interest rates has been accompanied by a variety of other measures that have given banks greater flexibility in setting credit limits, screening borrowers, and participating in consortium arrangements.

Prior to the deregulation of lending rates, the gap between the minimum lending rate and the equilibrium market rate (proxied by the discount rate on commercial bills) had narrowed from 4.7 percentage points in 1989/90 to an average of 3.2 percentage points in 1992/93–1993/94 (Table 7.11). Although the “Montiel measure” of the lending rate gap fell from 41.6 percent in 1989/90 to an average of 27 percent in 1991/92–1993/94, it remained fairly high.37 The gap between the maximum deposit rate and the market rate (proxied by the interest rates on certificates of deposit) also decreased from 3.9 percentage points in 1990/91 to an average of 2.8 percentage points in 1993/94–1994/95. However, the Montiel measure (22.6 percent in 1994/95) is not much below than that prior to 1991, suggesting that the repression of deposit rates has not been significantly reduced.

Table 7.11.

Effects of the Reform on Interest Rate Structure

(End of period; in percent unless otherwise noted)

Sources: Reserve Bank of India, Annual Report, various issues, and Report on Currency and Finance, various issues; and IMF staff estimates.

Commercial bank minimum lending rate. For 1994/95, liberalized bank lending rate (prime rate).

Lower limit of discount rates on commercial bills.

{(Market interest rate – regulated interest rate)/market interest rate} × 100.

From 1992/93, commercial bank deposit rate ceiling. Before 1992/93, highest fixed deposit rate.

Deposit rate ceiling as of April 1995.

Upper limit of interest rates on certificates of deposit.

The spread between lending and deposit rates fell from 5 percentage points in 1990/91 to 3 percentage points in early 1995/96.38 The wedge created by nonremuneration of the cash reserve requirement contributed about 2 percentage points to the spread in 1994/95.39 Subsidies implicit in priority sector credits, loan losses, and high operating costs (owing to considerable overstaffing in the banking system) also contributed to the spread.

Growth and Development of Financial Markets

As measured by the ratio of various monetary aggregates to GDP, there has been some financial deepening since 1991. The ratio of broad money (M3) to GDP rose from about 50 percent in 1990/91 to 56 percent in 1994/95 (Table 7.12). The rapid growth of time and savings deposits largely accounted for the increase; narrow money (currency and demand deposits) increased by about 2 percentage points of GDP during this period.

Table 7.12.

Effects of the Reform on Financial Market Structure

Sources: Reserve Bank of India, Annual Report, various issues, and Report on Currency and Finance, various issues; and IMF staff estimates.

Nevertheless, there is evidence of disintermediation from the banking system since the late 1980s, both because of the disincentives created by interest rate controls and the emergence of alternative financial instruments. The share of bank deposits in households’ financial savings declined from 41 percent in 1987/88 to 29 percent in 1990/91, partly owing to the impact of inflation on real returns. As prices began to stabilize, bank deposits recovered to 37 percent of household savings in 1993/94. By contrast, savings held as equity and debentures showed strong growth during this period; their combined share rose from about 2 percent in 1987/88 to 9 percent in 1993/94.

On the lending side, the pattern is similar. The share of bank borrowing in total commercial financing declined from 68 percent in the late 1980s to 37 percent in 1993/94. Financing from capital markets increased from 16 percent to 36 percent over the same period, while the share of foreign financing rose from 3 percent to 15 percent. The liberalization of capital markets, particularly the ability of firms to raise capital without prior approval, has led to a rapid expansion of both public stock issues and rights issues.40

The proportion of bank deposits pre-empted by the government through the mechanism of cash reserve requirements or statutory liquidity ratios has gradually been reduced. The combined marginal rate declined from 54 percent in 1990/91 to 40 percent in 1994/95. The development of a primary market in government securities has facilitated the reduction in the cash reserve requirement and statutory liquidity ratio; a large proportion of the public sector’s borrowing requirement is now met through market borrowing. The pace of reduction of the cash reserve requirement and statutory liquidity ratio, however, has been constrained by the continued large financing needs of the public sector.

Forty percent of bank credit must still be directed to priority sectors, although the subsidy element has been reduced and the definition of priority industries (some of which are not subsidized) has been expanded to make it easier for banks to comply with the guidelines.41

Future Priorities

Considerable progress has been made over the last several years in restructuring the domestic banking system. However, additional reforms are still needed to ensure that this important sector provides a sound foundation for growth in the rest of the economy.

At 15 percent, the cash reserve requirement remains at its 1990/91 level—well above the authorities’ target of 10 percent for 1996/97, and a substantial tax on intermediation through the banking system. Even if the cash reserve requirement and statutory liquidity ratio were lowered to their target levels by 1996/97, some 35 percent of bank deposits would still be channeled to the public sector. Continued reliance on the statutory liquidity ratio sends a signal that the government must still rely on financial controls to manage its fiscal affairs.

It will also be important to develop longer-term money markets as well as an active secondary market in government securities. Such steps would permit greater reliance on indirect instruments of monetary control. Additional measures to strengthen the commercial banks are also essential. In the face of increased competition from new private banks and capital markets, government-owned banks will need to reduce their costs further and find a definitive solution to the problem of nonperforming assets. Stronger prudential regulations and supervision are crucial and would allow complete deregulation of bank deposit rates as moral hazard is reduced. Improved management systems and greater operational autonomy for government-owned banks are also needed. Finally, the government has not accepted the Narasimham Committee’s recommendation to reduce the share of priority credit in bank loans and advances to 10 percent and, as noted, two fifths of bank credit must still be directed to priority sectors (Narasimham (1991)).

In the equities market, risks of disruption remain that could retard market development or trigger an outflow of portfolio capital. The proposed central depository system should help to improve market transparency and efficiency, while the primary dealer system will add depth and liquidity to the government securities market. The establishment of a regulatory body for the insurance industry will be an important step toward private participation in that sector.


Tariff reductions have been closely connected with tax reforms, which were discussed in Section V.


Estimates of effective protection are from the World Bank (1994).


These changes cannot be attributed to trade reform and exchange rate policy alone. Cyclical and exogenous events have also likely played a role.


For example, ready-made garments and handicrafts still accounted for about 16 percent of total exports in the first half of 1994/95, essentially unchanged from the late 1980s.


For example, tariffs were typically reduced faster on capital goods than on the ferrous metals used to manufacture these products.


As noted earlier, there has not yet been much diversification in the structure of exports. In contrast to a number of successful Asian economies, India has not significantly expanded exports of light consumer goods such as toys, watches, electronics, and computers.


For example, quantitative restrictions were imposed in 1994 on coffee exports to protect the domestic market at a time of a sharp rise in global prices.


Software has been a special success story as Indian firms have taken advantage of low-cost, highly skilled workers and technological advances that have allowed programming activity to be decentralized from its point of use.


For example, in civil aviation, the expansion of private activity has been slowed by regulatory constraints apparently because of concerns for the implications for publicly owned carriers as well as strains on infrastructural capacity.


See Confederation of Indian Industry (1994) for a compendium of various clearances (for example, for land acquisition, electricity and water connections, and sales tax registration) that must be obtained from state governments to set up an industry.


Some progress has been made in relaxing reservation policies where an export commitment is made. For example, in the garments industry investment up to Rs 30 million is allowed if a company exports 50 percent of its output. The reservation policy has also been relaxed on a case-by-case basis if an export commitment of 75 percent of output is provided.


See World Bank (1995) for a thorough survey of issues in this area.


The results of a first round of auctions for licenses for cellular services had to be quashed because of legal challenges to the system for allocating licenses.


In 1994, the central government identified power projects as a key target for private sector investment and agreed to provide counterguarantees to a limited number of projects to “jump-start” the process. The counterguarantees by the central government would ensure payments by state electricity boards. These boards are to set electricity rates on a cost-plus basis sufficient to yield a guaranteed rate of return on equity of about 16 percent. Some state governments have started to privatize the distribution process, thus increasing the security of returns to investment.


Discussions on alternative financing schemes are under way. One option being considered is some type of postal savings, which has been successfully implemented in Japan, channeling small savers’ funds to a variety of infrastructure projects.


See also Anant and others (1994) for a discussion of the institutional background that gave rise to industrial sickness.


Bank credit to sick companies has risen steadily. By 1992, the total had reached Rs 84 billion in over 2,000 large and medium-sized sick private enterprises and Rs 31 billion in over 250,000 small-sized sick private firms. Textile and engineering industries have been two major problem areas. Ahluwalia (1995) reports that the performance of public sector enterprises has been even worse. About 58 chronic loss-making central government enterprises accumulated losses of Rs 99 billion compared with their paid-up capital of Rs 30 billion, while more than 500 chronic loss-making state government enterprises have accumulated losses of Rs 20 billion compared with a paid-up capital of Rs 23 billion.


As discussed below, income recognition norms for banks have also been tightened and banking supervision has been strengthened.


See Anant and others (1994). During the period July 1987 to July 1992, 44 percent of the 1,014 cases referred to the BIFR remained undecided.


As a result, only a tiny fraction (about 3 percent) of India’s labor force is employed in the private organized sector. About 7 percent is employed in the public sector.


For example, the transfer of resources from import-competing sectors to the export sector in response to trade reform would be impeded by present labor laws.


Despite rapid growth in output in the private organized sector in the 1980s, there was virtually no increase in employment over this period. See International Labor Organization (1993).


The Goswami Committee report on industrial sickness made a number of relevant recommendations that have not yet been acted upon (Goswami and others (1993)).


The limit is 40 percent in all other industries (except 24 percent in small-scale sectors); in these cases as well, up to 100 percent foreign equity is permitted on a case-by-case basis.


Heavily subsidized fertilizers and electricity on the one hand, and implicit taxation through trade restrictions and domestic price intervention on the other, have created a complex web of distortions.


See Pursell and Gulati (1993) for a discussion of the agenda for agricultural reform.


For a more extensive discussion see Mohan (1995).


State electricity boards and state transport boards account for a large share of state public enterprises’ assets and production. Other state public enterprises are considerably smaller and of much less economic significance than the central public enterprises.


The share in manufacturing refers to output share of central public enterprises in organized and unorganized manufacturing.


See Ahluwalia (1995). These figures not only indicate capital intensity, but also inefficiency.


The 1994—95 Economic Survey reports that out of the 15 large central public enterprises operating in the core sector, 7 are loss-makers (Ministry of Finance (1995)).


Moreover, certain sectors such as agriculture receive highly preferential tariffs; in some states, electricity is provided free to farmers.


Divestment programs for public enterprises owned by states have been more ambitious as some enterprises have been sold outright.


For a discussion of the problems of the banking sector and reform of the financial system see, for example, Ministry of Finance (1993), Khatkhate (1993), Iyer (1994), Nayak (1993), and Rangarajan (1994). The Reserve Bank of India’s Annual Reports and Reports on Currency and Finance also contain details regarding the financial sector.


The Montiel measure is the ratio of the gap between market and regulated rates to the market rate. That is, [(im – ir)/im] × 100, where im is the market interest rate, and ir is the regulated interest rate.


The spread refers to the difference between the maximum deposit rate (12 percent) and the newly deregulated prime rate. The corresponding percentage spread (that is, the ratio of the spread between lending and deposit rates to the deposit rate) fell from 45 percent to 27 percent.


To compute the impact of the cash reserve requirement on the interest rate spread, it is assumed that banks have no operating costs, no defaults, and are perfectly competitive. Then, i1/id = 1/(1 — r), where i1 and id are the nominal loan and deposit rates and r is the reserve requirement.


The 1,032 issues launched during April-December 1994 were 37 percent higher than issues in the same period a year earlier.


The 1995/96 budget requires that banks not meeting the agricultural lending guidelines deposit a part of the shortfall with the National Bank for Agriculture and Rural Development. The resources will be directed toward rural infrastructure programs.

Economic Reform and Growth