Abstract

For most of the period since independence, India has combined a highly interventionist and inward-looking approach to economic development with generally conservative macroeconomic policies. The development strategy was to build a large, publicly owned, heavy industry sector while leaving the production of consumer goods (imports of which were banned) and agriculture mainly to the private sector. To support this strategy. India relied on a complex system of industrial licensing, high protection against imports, and extensive government intervention in financial intermediation. Macroeconomic policies were driven by the overriding desire for stability and low inflation; on the whole, public sector deficits were moderate and monetary growth was low. Household savings grew quite rapidly as the deleterious effects of financial repression were partly mitigated by low inflation, the spread of bank branches, and the introduction of small savings schemes.

For most of the period since independence, India has combined a highly interventionist and inward-looking approach to economic development with generally conservative macroeconomic policies. The development strategy was to build a large, publicly owned, heavy industry sector while leaving the production of consumer goods (imports of which were banned) and agriculture mainly to the private sector. To support this strategy. India relied on a complex system of industrial licensing, high protection against imports, and extensive government intervention in financial intermediation. Macroeconomic policies were driven by the overriding desire for stability and low inflation; on the whole, public sector deficits were moderate and monetary growth was low. Household savings grew quite rapidly as the deleterious effects of financial repression were partly mitigated by low inflation, the spread of bank branches, and the introduction of small savings schemes.

Chart 2.1.
Chart 2.1.

Real GDP Growth

(In percent)

Source: Government of India, National Account Statistics.

Output, Investment, and Macroeconomic Conditions

Economic performance since independence has been mixed. Once the initial impetus of large investment for import substitution subsided, low productivity increases in inefficient public enterprises together with weather-related fluctuations in agricultural output constrained the growth of economic activity. Overall growth slowed from an average of some 3½ percent a year in the 1950s and the 1960s to about 2½ percent a year in the 1970s (see Chart 2.1 and Table 2.1). Manufacturing and services have grown relatively more rapidly, resulting in a decline in the share of agriculture in GDP (Chart 2.2). The share of GDP produced by the public sector, however, increased steadily from 10 percent in the early 1960s to 18 percent in 1980/81 and further to nearly 27 percent in 1990/91.

Table 2.1.

Compound Annual Rates of Growth

(In percent)

Source: Government of India, National Account Statistics.
Chart 2.2.
Chart 2.2.

Structure of GDP

(In percent)

Source: Government of India. National Account Statistics.

Underlying these growth trends was an increase in the rate of both public and private investment, with the total rising from about 15 percent of GDP in the early 1960s to 25 percent by the late 1980s. Investment has grown somewhat faster than output as gross domestic capital formation increased by a compound rate of 4.4 percent a year between 1960/61 and 1993/94, compared with 4 percent for GDP. Domestic savings, particularly of the private sector, were high and rose broadly in line with investment (Table 2.2). Both investment and domestic savings in India, however, remain substantially below those of fast-growing East Asian economies such as Indonesia, Malaysia, Singapore, and Thailand (Chart 2.3).

Table 2.2.

Average Investment and Domestic Savings1

(In percent of GDP)

Source: Ministry of Finance (1995).

Investment figures are for gross domestic capital formation, with errors and omissions allocated to the private sector. Savings figures are for gross domestic savings.

Chart 2.3.
Chart 2.3.

Saving and Investment in Selected Countries1

(In percent of GDP)

Source: IMF staff estimates.1 Fiscal year for India (that is, 1985 = 1985/86).2Refers to general government saving.

In the absence of large imbalances between investment and domestic savings, the external accounts were generally satisfactory. Current account deficits were financed by large aid inflows, while official reserves were maintained at a comfortable level (Chart 2.4). With a cautious monetary policy, inflation reached double-digit levels only sporadically in the wake of unfavorable harvests or external shocks (Chart 2.5).

Chart 2.4.
Chart 2.4.

External Indicators

Source: Indian authorities.
Chart 2.5.
Chart 2.5.

Inflation and Exchange Rate Developments

Sources: Indian authorities; and IMF staff estimates.1 Excluding Brazil. Despite its small weight in the indices, Brazil has a significant impact on them because of its high and volatile inflation rate.

A number of important changes took place in the 1980s that set the stage for an increase in growth, but also a rise in inflation and a deterioration in the external accounts. First, dissatisfaction with the prolonged period of slow growth prompted the first steps in a process of gradual liberalization. Industrial licensing requirements were eased, exporters were given greater access to imports, some quantitative restrictions were replaced by tariffs, and toward the end of the decade there was a modest liberalization of financial markets. Second, the exchange rate depreciated by 45 percent in real effective terms during the 1980s (Chart 2.5), which provided a strong stimulus to previously lackluster export growth. Third, the deficit of the central government widened, rising to about 8–9 percent of GDP from the mid-1980s onward (Chart 2.6). The fiscal deterioration mainly resulted from rising current expenditures, especially for interest and subsidies, with loans and grants to states, wages, and defense also contributing. Thus, the fiscal impulse during the 1980s averaged 0.5 percent of GDP a year, compared with 0.1 percent of GDP a year in the previous two decades.1

Chart 2.6.
Chart 2.6.

Public Sector Accounts

(In percent of GDP)

Source: Government of India, National Account Statistics.1 Central government, states and union territories, and central public enterprises.

The combination of strong domestic demand, rapid export growth, and more liberal supply-side policies supported a broad-based increase in average output growth to over 5½ percent a year during the 1980s. However, with the large government deficit fueling rapid credit expansion and with the continuing depreciation of the rupee, inflation rose from about 5 percent in the mid-1980s to over 12 percent at the end of 1990/91. Moreover, notwithstanding the unprecedented growth of exports, the current account deficit widened from under 2 percent of GDP during the early part of the decade to 3.5 percent of GDP in 1990/91. These deficits were increasingly financed by borrowing on commercial terms, including inflows of short-term deposits by nonresident Indians, while official reserves were drawn down. These developments led to a marked rise in the external debt-service burden (Table 2.3).

Table 2.3.

Debt Indicators

(In percent)

Sources: Joshi and Little (1994), Table 9.2; and IMF staff estimates.

Education, Labor, Employment, and Poverty

Steady growth has led to gradual improvements in social indicators such as life expectancy, infant mortality, and literacy. Similarly, the incidence of poverty has declined, although it remains a serious problem.

Indicators of educational attainment have also improved steadily over the past three decades; gross enrollment ratios have risen and illiteracy rates have fallen. Nevertheless, these indicators still lag far behind those of most East Asian countries (Table 2.4). Moreover, data on the stock of educational attainment compiled by Barro and Lee (1993) show that much of the improvement between 1960 and 1985 was due to increased secondary education, while the proportion of the population completing primary school actually declined (Table 2.5). Still, in 1985, 70 percent of the population had received no formal schooling. These observations are at variance with the well-accepted notion that the returns for primary education are higher than the returns for secondary and higher levels of education.2

Table 2.4.

India and Selected Country Groupings: Indicators of Educational Attainment

Sources: World Bank, Social Indicators of Development; and Ministry of Finance (1995).

Consistent with the definitions of the World Bank’s World Development Report, South Asia covers the Islamic State of Afghanistan, Bangladesh, Bhutan, India, Nepal, Pakistan, and Sri Lanka; and East Asia covers Cambodia, China, Indonesia, the Democratic People’s Republic of Korea, the Republic of Korea, the Lao People’s Democratic Republic, Malaysia, Mongolia, Myanmar, Papua New Guinea, the Philippines, Thailand, and Vietnam.

Gross enrollment may be reported in excess of 100 percent if some pupils are younger or older than the country’s standard range of primary school age (typically 6–11 years for primary school).

For South Asia and East Asia comparators, illiteracy rates are for percent of population over 15 years of age.

Table 2.5.

Stock of Educational Attainment

(Percent of population over age of 25 years)

Source: Barro and Lee (1993).

Although the average number of years of schooling in India has risen considerably, it remains well below that of East Asian and Pacific economies, where it increased from 2.3 years in 1960 to 5.2 years in 1985.

The annual growth rate of the labor force fell from about 2.5 percent during the 1970s and early 1980s to 1.4 percent between 1983 and 1987/88.3 A fall in the labor participation rate led to the decline, as a larger number of children and young persons withdrew from the labor force to attend school.4

The great majority of the labor force is employed in the informal sector. Employment in the formal or organized sector of the economy has been constrained by rigidities arising from legislation that only applies to this part of the market. The proportion of employment in the organized sector has remained essentially unchanged at 8 percent of total employment. Growth in organized sector employment has been dominated by the public sector, while private employment in this sector has been stagnant (Table 2.6).5

Table 2.6.

Employment in the Organized Sector

Sources: Ministry of Finance (1995); and International Labor Organization (1993).

According to the International Labor Organization (1993), overall employment improved in the 1980s as both rural and urban underemployment fell substantially. The rise in the real wage rate for casual labor in both sectors provides further evidence of some tightening of labor markets. Rural employment improved largely because of the rapid growth of nonagricultural employment. Employment in the organized segment of the urban economy, however, grew at a much slower rate than it had done in the 1970s, despite the rapid growth of output in this sector.

With underemployment being the immediate source of poverty, the pace of poverty reduction also increased in the 1980s (Table 2.7).6 Poverty remains overwhelmingly a rural phenomenon. Nevertheless, along with the urbanization of the population, urban poverty has also risen.

Table 2.7.

Rural and Urban Population Below the Poverty Line

(In percent of rural or urban population)

Source: International Labor Organization (1993).

Growth, Accumulation, and Productivity

The longer-term trends described above indicate that India has generated reasonably high rates of both investment and savings and that the macroeconomic situation has generally been stable.7 Yet, India’s growth record has been disappointing relative to the fast-growing economies in East Asia. By implication, productivity in India has risen only modestly. Empirical studies, in which the rate of growth is related to the rate of accumulation of productive assets and total factor productivity (TFP), support this proposition.8

One approach to examining relative contributions of factor accumulation and productivity growth assumes that production technology is characterized by constant returns to scale. TFP growth is then calculated by subtracting from output growth the contributions made by labor and capital accumulation.

Table 2.8.

India and Selected Country Groupings: Factor Contributions to Output Growth1

(Average annual percent change in real terms)

Sources: IMF staff estimates based on Fischer (1993) formulation and data, with the exception of capital growth data, which are taken from King and Levine (1994). Summers and Heston (1994) data for real GDP growth in constant international prices and World Bank data for labor force growth were used.

The contributions of capital and labor are derived by multiplying their respective growth rates by the share of each factor in output. Factor shares are imposed as 0.4 for capital and 0.6 for labor. Total factor productivity (the Solow residual) is calculated as the residual after taking account of the contributions of capital and labor.

Includes only high-performing East Asian economies: Hong Kong, Indonesia, the Republic of Korea, Malaysia, Singapore, Taiwan Province of China, and Thailand.

Includes Bangladesh, India, Nepal, Pakistan, and Sri Lanka.

The results of this exercise for India, as well as for other country groups, are presented in Table 2.8.9 These results show that the high-performing East Asian countries grew significantly faster than India because of much faster growth of their capital stocks as well as higher TFP growth. The results for the subperiod 1980–88 suggest, however, that India’s productivity improved markedly in the 1980s to levels comparable to East Asia, contributing to the acceleration in output growth in the 1980s (Chart 2.7).

Chart 2.7.
Chart 2.7.

Contribution of Total Factor Productivity to Growth1

(In percent)

Source: IMF staff estimates.1 Five-year backward-looking moving average of residual GDP growth after subtracting the estimated contributions of capital and labor inputs.

Another approach to analyzing growth performance relies on cross-country regressions that relate per capita income growth to investment in human and physical capital, while controlling for the population growth rate and initial level of per capita income. Based on the parameters from such a regression (see Table 2.9), India’s rate of factor accumulation and its relatively low starting position could have been expected to result in per capita income growth of about 1.9 percent a year between 1960 and 1992; actual growth over this period was 2.2 percent, suggesting that about 15 percent of long-term growth in India is attributable to influences other than the accumulation of factors of production. By contrast, for a group of successful East Asian countries, an average of some 40 percent of long-term growth is attributable to other influences. Compared with world “average” growth, however, India’s growth performance has been reasonably good.

Table 2.9.

Contribution of Accumulation to Growth1

Sources: IMF staff estimates. Data for per capita growth, investment, GDP relative to the United States, and population are taken from Summers and Heston (1994). Primary and secondary school enrollment data are taken from the World Bank’s World Tables.

The dependent variable for the regression was per capita income growth, measured at international prices. The regression was estimated for 103 countries over the 1960–92 period.

The link between macroeconomic and structural conditions and growth is examined next. Following Fischer (1993), time series and cross-country regression analysis can be used to examine correlations between the various proxy measures for the impact of policies, and output growth, factor accumulation, and TFP growth. The evidence suggests that macroeconomic instability is associated with lower growth and that the links operate through a dampening of both investment and productivity.10 Specifically, high inflation, budget deficits, and parallel exchange market premiums are all associated with lower output growth. The results also suggest that structural distortions—proxied, for example, by high tariff protection and an underdeveloped financial system—and low educational attainment are negatively correlated with output and capital accumulation.

Table 2.10.

Impact of Policies on Growth, Capital Accumulation, and Factor Productivity, 1970–92

(In percent)

Source: IMF staff estimates.

The correlations are estimated from three panel regressions with growth in real GDP, capital accumulation, and TFP as dependent variables. TFP residuals are calculated as follows: TFP = ZGDP – 0.4 ZKAP – 0.6 ZLAB, where ZGDP is the rate of growth of real GDP, ZKAP is the rate of growth in the real capital stock, and ZLAB is the growth rate of the labor force. The data for ZGDP and GDP in 1970 are measured at purchasing power parity prices and are taken from Summers and Heston (1994); data for ZKAP are from King and Levine (1994); data for the budget surplus, government capital expenditure and savings, and the average effective import tax rate are from the IMF’s Government Finance Statistics Yearbook; data for inflation and broad money are from the IMF’s International Financial Statistics; and all other variables are from Fischer (1993). The symbols +++ and — mean that the correlations are significant at the 1 percent level, and ++(—) and +(–) imply significance at the 5 and 10 percent levels, respectively.

Whole sample averages for inflation exclude Argentina, Bolivia, Brazil, and Nicaragua.

In percent of GDP. The effects of the budget deficit, on the one hand, and capital expenditures and government savings, on the other, were estimated in separate panel regressions. The estimated effects of the other macroeconomic variables did not differ significantly between the two regressions.

Table 2.10 presents the estimated correlations of macroeconomic and structural factors with the growth of output, capital, and TFP growth and compares the sample averages for the “policy” variables in India with those of other country groupings. Compared with the whole sample, India’s macroeconomic policies—with one important exception—were conducive to relatively rapid output growth, capital accumulation, and productivity gains. The exception is fiscal policy, which has likely had a negative influence on long-term growth, as India’s performance regarding the budget deficit, government capital expenditures, and government savings was noticeably worse than for other country groupings. In addition, the measure of tariff protection in India is quite high by international standards, suggesting that distortions in the trade regime are likely to have been an important factor explaining India’s poor growth performance relative to other Asian countries.11 The measure of human capital accumulation is also low by international standards, suggesting that insufficient investment in education could have impeded more rapid capital accumulation and long-term growth. The financial development indicator, however, suggests that India’s financial market is relatively well developed by international standards.

Table 2.11.

Productivity Trends in Manufacturing by End-Use

(Percent change a year, compound)

Source: Ahluwalia (1995).

Results of India-Specific Studies

The most comprehensive study of TFP trends in India is that of Ahluwalia (1991).12 Her study examined the growth of TFP in the organized manufacturing sector (which accounts for 11.5 percent of GDP) from 1960 to 1989. Using data on value added, capital stocks, employment, and wages collected from the Annual Survey of Industries, she estimated annual TFP by industry as the difference between value added and weighted shares of capital and labor inputs. The results, which are summarized in Table 2.11, indicate that after a long period of stagnation during 1960–80, TFP growth improved significantly in the 1980s.13 The overall improvement reflects improvements in both labor and capital productivity.

To account for variations in TFP growth across industries, Ahluwalia ran cross-industry regressions of TFP as a function of various factors. Several significant conclusions emerge. Industries established for import substitution (for example, capital goods) experienced lower TFP growth. By encouraging industries lacking a market-based reason for growth, inefficient enterprises were promoted. Moreover, industries with high capital-to-labor ratios at the beginning of the period of study had lower rates of TFP growth. A possible explanation is that those industries with high capital-to-labor ratios were the ones targeted by the government as part of its heavy industry promotion. Under the relatively stringent control of government regulation, these industries tended to show lower rates of TFP growth. Indeed, Ahluwalia (1995) notes that a significant feature of the Indian industrial experience has been a sharply rising capital-labor ratio over the period 1960–90. This trend reflects both the inflexibility of labor laws with respect to hiring and firing, thus making labor much more costly than suggested by the real wage rate, and the bias toward capital intensity, which is inherent in a highly protective trade policy regime.

Joshi and Little (1994) estimated real rates of return to investment in India in the public sector and in organized manufacturing of the private sector from 1960/61 through 1986/87.14 They focused on two distinct time periods—1960/61 to 1975/76 and 1976/77 to 1986/87—to assess whether a discernable change in the returns to investment had taken place. They found that the rates of return on public investment, especially in manufacturing, were very low in both periods (Table 2.12), which they attribute in part to the allocation procedures for public investment (for example, inadequate project appraisal and political factors) that resulted in investment in sectors where India had little comparative advantage. In contrast, rates of return on private manufacturing nearly doubled from the first period to the next, to a level comparable to those found in industrial countries.

Table 2.12.

Real Rates of Return to Investment

(In percent a year)

Source: Joshi and Little (1994), p. 325.

Joshi and Little offer several reasons for the apparent increase in growth and the efficiency of private sector investment in the second period. To some extent, greater aggregate demand pressures accounted for higher growth rates and also increased the returns to investment. More significantly, public investment increased, especially public infrastructure investment, which in turn may have contributed to the productivity of both public and private investment by reducing the problems of bottlenecks in the supply of power, transport, and communications. In addition, reforms begun in the late 1970s incorporating limited liberalization of industrial, trade, financial, and tax policies probably accounted for some of the improvement in efficiency.

1

The fiscal impulse measure used here is the same as that used in the IMF’s World Economic Outlook exercise. It is calculated by separating the actual budget balance into two components: a cyclically neutral component and a fiscal stance component. The cyclically neutral component is defined by assuming that government expenditures increase proportionately to nominal trend output and that government revenues increase proportionately to nominal actual output. The fiscal stance component—the residual between the cyclically neutral and the actual budget balance—then captures the full effect of automatic stabilizers and discretionary changes in fiscal policy. The fiscal impulse is the annual change in the fiscal stance measure, expressed as a share of GDP. A negative number would indicate a contractionary demand impulse emanating from fiscal policy, and a positive number would indicate an expansionary demand impulse.

2

See, for example, Psacharopoulos (1993).

4

A moderate decline in the rate of population increase also contributed to the slowing of labor force growth.

5

The organized sector includes all establishments in the public-sector irrespective of the number of employees and nonagricultural establishments in the private sector employing ten or more persons.

6

The International Labor Organization (1993) report notes that the poor live in households that have few assets other than labor resources and poverty arises fundamentally because these labor resources cannot find adequate and adequately remunerative employment.

7

The empirical results reported in this section are from Golds-brough and others (forthcoming).

8

These models generally decompose growth into the contributions of factors such as capital (physical and human) and labor. Typically, however, output growth cannot be explained fully by increases in these factors. The part of growth not explained by the factors of production—that is, the residual—usually reflects more efficient use of resources or the adoption of new production technologies; in other words, improvements in total factor productivity.

9

The TFP estimates in Table 2.8 are referred to as the “Solow residuals” and assume a production function in which factor shares are 0.4 for capital and 0.6 for labor. TFP estimates assuming a function that also includes human capital as a factor of production, as in Mankiw, Romer, and Weil (1992), were also calculated. The two sets of TFP estimates were highly correlated.

10

In view of the difficulty in constructing measures of variables that are directly controlled by policies, it becomes necessary to proxy policies and distortions using variables that can be both the outcome of policies and also affected by nonpolicy-related factors. Thus, the policy implications of the observed linkages between these proxy variables and growth should be drawn with caution. Moreover, the estimated equations should not be viewed as structural equations explaining growth.

11

Moreover, with significant quantitative restrictions, especially for consumer goods imports, in place for the period under study, the indicator of protection is biased downward in the case of India.

12

An update of this study is contained in Ahluwalia (1995).

13

In an attempt to improve on the Ahluwalia study, Balakrishnan and Pushpangadan (1994) use a double-deflation method to construct a time series of value added. Using this time series, they do not find that TFP growth improved in the 1980s. Ahluwalia (1995), however, questions these new results because of the empirical compromises made in the process of attempting to derive the price index for intermediate inputs to perform the double deflation.

14

Estimates for the whole public sector exclude banking, administration and defense, and other services. In addition, the estimates do not take into account social returns.

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