Abstract

India has made substantial progress since 1991 on the path toward macroeconomic and structural reform. The benefits are becoming evident in a robust economic expansion, led by a recovery of private investment and rapid export growth. The external position has also strengthened considerably, while inflation has come down. Nonetheless, major economic policy challenges lie ahead, and the Indian Government will need to persevere with reform if India is to emulate the rapid economic growth and durable progress in poverty reduction achieved in countries in East Asia.

India has made substantial progress since 1991 on the path toward macroeconomic and structural reform. The benefits are becoming evident in a robust economic expansion, led by a recovery of private investment and rapid export growth. The external position has also strengthened considerably, while inflation has come down. Nonetheless, major economic policy challenges lie ahead, and the Indian Government will need to persevere with reform if India is to emulate the rapid economic growth and durable progress in poverty reduction achieved in countries in East Asia.

Long-Term Growth

Although India has generally followed prudent macroeconomic policies, its long-term growth record has been disappointing, with per capita income increasing by less than 2 percent annually since 1960. The fast-growing economies in East Asia, by contrast, recorded annual per capita growth rates of 5–6 percent during this period. Decades of pervasive government interference in economic decision making, together with an inward-oriented trade and investment policy, have resulted in low rates of return to investment in India and in excessively high capital-labor ratios.

Output and productivity growth showed a clearly improving trend during the 1980s. The shift was related primarily to changes in policies, including partial deregulation and increased market orientation. An additional element was a substantial real depreciation of the rupee, which provided a strong boost to exports. Furthermore, expansionary fiscal policies stimulated domestic demand, which played an important role in coaxing extra output from the economy, although growth of this nature could not be sustained.

Response to the 1991 Crisis

Since 1991, the Indian authorities have made a determined effort to correct many of the serious distortions in the economy and to reduce pervasive state intervention. The initial impetus came from a severe balance of payments crisis in 1990–91. That crisis prompted the Indian authorities to adopt an adjustment program that contained both immediate stabilization measures and ambitious structural reforms. Despite some policy slippage, the stabilization effort proved sufficient to restore external confidence and led to the buildup of foreign exchange reserves. After an initial period of slow growth, the economy responded vigorously to the reforms.

In the early stages of the adjustment program, India placed considerable emphasis on reducing imports temporarily through administrative controls. Subsequently, stabilization measures centered on monetary tightening and fiscal consolidation, supported by a devaluation. Structural reforms were initially concentrated in the industrial sector and in trade liberalization—aimed particularly at eliminating most investment and import licensing requirements. The foreign investment regime was also liberalized substantially. The focus then shifted to tax reform, further trade liberalization (including continued reductions in tariffs), and financial sector reform.

Results of Adjustment

The fiscal retrenchment and monetary tightening in response to the crisis led to a contraction of demand. This, combined with the withdrawal of external financing and restrictions on imports, contributed to a slowdown in economic growth to 1 percent in fiscal year 1991/92 (April 1–March 31). The downturn was short-lived, however, as the external financing constraint eased considerably after 1991. Indeed, beginning in 1993, private capital inflows surged. The surge, combined with the demand stimulus arising from a widening of the fiscal deficit in 1993/94, buoyant export growth, and a growing investment response to the reform program, helped generate a broadly based economic recovery. Growth rebounded to 4½ percent annually in both 1992/93 and 1993/94 and reached 6¼ percent in 1994/95, three years after the launching of reforms (Table 1.1).

Table 1.1.

Key Economic Indicators

Sources: Data provided by the Indian authorities; and IMF staff estimates.

The performance of various sectors has nonetheless diverged substantially. Initially, industrial growth fell well below its long-term trend, while growth in agriculture and services was steadier. Signs of an industrial recovery emerged beginning in the first quarter of 1992/93, but the recovery stalled toward the end of the year and did not resume until late 1993/94. In the following period, industrial growth picked up markedly. In particular, the capital goods sector, which had suffered a sharp recession for three years and had previously been heavily protected, bounced back vigorously with production rising by about 20 percent in 1994/95.

Real gross fixed investment declined sharply in 1991/92 and recovered slowly in the following two years. The downturn resulted mainly from tight financial policies, which raised the cost of credit to the private sector. The available evidence points to a resurgence of private investment in 1994/95. This would be consistent with the recovery of industrial production, increased credit availability, rising corporate profitability, and growing business confidence.

Fiscal Initiatives

Stabilization of the Indian economy owed much to the initial fiscal adjustment undertaken by the central government, which increased the credibility of macroeconomic policy. Given the subsequent fiscal slippage at the center, however, and a deterioration of the states’ fiscal position, the consolidated public sector deficit in 1994/95 remained close to the deficit in 1990/91. The continuing large deficit and high public indebtedness raise concerns about the sustainability of fiscal policy. Increasing pressures on real interest rates have emerged, and these threaten to crowd out private investment. These fiscal pressures underscore the need to strengthen state finances, given the risk that fiscal adjustment by the central government could be undermined by expansionary policies by states.

Turning to the structure of government finances, substantial progress has been made toward creating a simpler and fairer tax system. A principal feature of the tax reform has been the general lowering of tax rates. This, together with a narrowing of the dispersion in tax rates, has helped reduce distortions and disincentives. Nevertheless, additional efforts by both the central government and state governments are needed to broaden the tax base and reduce distortions further. Less has been achieved on the expenditure side. The interest burden is substantial, with the composition of noninterest spending skewed toward unproductive expenditures. Furthermore, inadequate attention to infrastructure and education—both primarily state responsibilities—have large spillover costs.

Structural Reforms

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

The private sector’s response to these reforms has been impressive:

  • Trade liberalization has led to an increasingly open economy; the ratio of exports and imports of goods and nonfactor services to GDP rose to more than 23 percent in 1994/95 from an average of 15 percent in the 1980s.

  • Investment picked up markedly in 1994/95, notably in such areas as automobiles and consumer electronics. New private enterprises have been established in banking and other financial services, commercial aviation, and software development, while major investments are taking place in telecommunications, power, petrochemicals, and oil exploration.

  • The reforms have stimulated the interest of foreign investors, with foreign investment surging in the year beginning in November 1993. During this period, India accounted for a larger volume of international equity issues than any other emerging market. Shares purchased on local exchanges were also heavy, while foreign direct investment increased substantially.

The Road Ahead

Although much has been accomplished, the reforms are by no means complete, and persisting obstacles constrain a stronger and broader investment response. The overall fiscal deficit needs to be reduced substantially to relieve pressure on domestic savings. And despite efforts to attract private investment, inadequate infrastructure remains a major barrier. Moreover, little has been done to address the serious distortions in public enterprises, labor markets, and the agricultural sector. Further reforms in these areas, implemented in a steady and transparent fashion, are essential for sustaining rapid growth in India. Indeed, broadening the reforms to cover agriculture—which employs the bulk of the population—should spread the benefits of reform and help improve income distribution.

The following policy areas also merit attention:

  • Tariff rates remain relatively high by international standards, while imports of consumer goods and trade in agricultural commodities continue to be subject to quantitative restrictions.

  • A number of important internal restrictions remain on private sector activity (for example, reserving certain sectors of the economy for small-scale enterprises), which constrain the development of key sectors of the economy. Reforms have also lagged at the state level, where distortions and inefficiencies remain widespread.

  • Limited progress in restructuring public enterprises and in reforming inflexible labor and property laws has perpetuated the inefficient use of a sizable part of India’s capital and labor force.

  • Limited progress in fiscal consolidation has hampered financial sector reform. Although the cash reserve requirement and the statutory liquidity ratio have been lowered, the flow of funds from the banking system to the public sector remains substantial.

The sections that follow analyze India’s growth record and the impact of macroeconomic and structural policies implemented since 1991 on investment and growth. Section II reviews longer-term trends for growth and factor accumulation, based in part on a “growth accounting” framework. Section III documents the response of the economy since the launching of the reform and stabilization program in 1991. Section IV examines in more detail the behavior of private investment, particularly the impact of financial policies. The implications of fiscal adjustment and reform for growth are analyzed in Section V. Section VI reviews the recent experience with a surge in capital inflows and assesses its impact on the Indian economy. Finally, Section VII investigates the impact of recent structural reforms on investment and growth and identifies a number of remaining structural impediments.

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