This Selected Issues paper analyzes the medium-term macroeconomic outlook for India. The paper highlights that in the strong adjustment scenario, the joint effect of strong fiscal consolidation and ambitious structural reforms would bring the Indian economy onto a sustainable high growth path, reaching 7 percent around the turn of the century. Although there could be some initial dip in growth, owing to the contractionary effects of fiscal retrenchment, this should be temporary as a strong surge in investment, together with productivity improvements related to structural reforms, should drive an acceleration in growth performance.

Abstract

This Selected Issues paper analyzes the medium-term macroeconomic outlook for India. The paper highlights that in the strong adjustment scenario, the joint effect of strong fiscal consolidation and ambitious structural reforms would bring the Indian economy onto a sustainable high growth path, reaching 7 percent around the turn of the century. Although there could be some initial dip in growth, owing to the contractionary effects of fiscal retrenchment, this should be temporary as a strong surge in investment, together with productivity improvements related to structural reforms, should drive an acceleration in growth performance.

I. Medium-Term Macroeconomic Outlook1

In announcing its Common Minimum Program, the Government has adopted the target of sustaining a 7 percent growth rate over the next decade. To achieve this goal, the authorities have established a number of intermediate targets, including a reduction in the central government’s fiscal deficit, increasing investment in crucial infrastructure areas, and greater use of foreign capital, particularly foreign direct investment. This chapter discusses the quantitative macroeconomic framework needed to achieve the Government’s growth target, and assesses implications for India’s external viability.2 The analysis is based on two medium-term macroeconomic scenarios. The first scenario—strong adjustment—embodies a deep upfront fiscal consolidation package together with ambitious structural reforms, including continuing liberalization of restrictions on foreign investment inflows. The second scenario—gradual adjustment—contains a slower path of fiscal adjustment, less aggressive reforms, and a more cautious attitude toward opening to foreign inflows.

The central message of the scenarios is that achieving high sustained growth will depend on policies that ensure an adequate supply of saving for investment, and rising investment efficiency. While the private saving rate has followed an upward trend that should continue,3 public saving will need to be improved significantly to make room for a rise in investment consistent with sustained 7 percent growth. In the context of sound domestic policies, greater recourse to foreign savings could also contribute to augmenting investment. At the same time, continued forceful structural reforms are necessary to increase productivity and ensure that the additional investment is put to its most effective use. With a more gradual fiscal adjustment path and a less ambitious reform effort, the Government’s high growth objective would be unlikely to be achieved.

A high-growth strategy, involving a continued opening of the Indian economy to trade and capital flows, would be likely to involve a current account deficit rising significantly above its present level of 1½ percent of GDP. To assess the medium-term sustainability of such an outcome, the external current account paths in the two scenarios are compared to the experience of other countries. The results suggest that, in the context of strong fiscal adjustment and continued reforms, a widening of the current account deficit from its present level to the range of 3–4 percent of GDP over the medium term would not leave India unduly exposed to external risks, and would be well within the range of other successful countries’ experience. However, with a more gradual adjustment and reform path, the risks to both internal and external viability would be considerably greater.

A. Saving-Investment Framework

The medium-term scenarios are constructed around a saving-investment framework in which growth is modeled as depending on two factors: (1) the projected path for investment, consistent with saving performance; and (2) the trajectory for the incremental capital output ratio (ICOR), a measure of investment efficiency. Policy choices affect growth through their impact on these two factors:

  • The central fiscal policy variable in the projections is the path of the primary deficit of the overall public sector.4 With interest payments being determined by the public debt stock and prevailing interest rates, public saving depends on the primary deficit and the allocation of public expenditure between current and capital accounts.

  • Policies affecting private capital inflows—such as liberalization of regulations limiting foreign investment or external commercial borrowing, or steps to make domestic financial markets more attractive to foreign investors—will have a key influence on the use of foreign savings.5 Foreign saving will also tend to respond positively to the more secure macroeconomic environment provided by fiscal consolidation.

  • The pace of structural reforms is taken as the main factor affecting the efficiency of investment. Absent a reliable estimate for the production function of the Indian economy,6 a simple measure of capital productivity is the ICOR—the ratio of investment (as a percentage of GDP) to the real growth rate. Reforms that would affect ICOR would include: infrastructure policy; labor market and exit policy; trade liberalization; deregulation of the industrial sector, including privatization of public sector enterprises; and financial market reform.

In addition, the scenarios embody the following relationships and assumptions:

  • As a result of financial sector liberalization and increasing integration into global financial markets, real interest rates in India will increasingly be determined by world market conditions. The premium paid by India over international rates is assumed to mainly depend on public sector indebtedness, and hence is affected by the degree of domestic fiscal consolidation.

  • Private saving is projected to continue along a gradually rising trend, notwithstanding some Ricardian offset in response to increasing public saving. The private saving path is generated from the econometric model presented in Chapter II, which takes into account fundamental saving determinants (rising per-capita income, continued financial deepening, a diminishing share of agriculture, and a falling age dependency ratio).

  • Inflation is assumed to be primarily determined by the growth of broad money,7 which is related to the Government’s financing needs. Broad money velocity is projected to decline gradually with increasing financial deepening.

  • As a simplifying assumption, the real effective exchange rate is assumed constant in all scenarios.

The scenarios are based on a comprehensive accounting framework with inter-sectoral linkages. Care has been taken to properly identify the debt dynamics of both the public and external sector. Some relationships draw on specific empirical work—for example the econometric analysis reported in Chapter II—while other relationships draw on broader work on developing countries.8 While paths for key variables are imposed exogenously, each scenario is intended to be internally consistent.

B. Public Debt Dynamics and Fiscal Adjustment

With external public debt accounting for only one quarter of total public debt, and a substantial portion of this on concessional terms, the path for the overall fiscal deficit is mainly determined by the projected path of the primary deficit and developments in the domestic interest rate. A basic feature of both scenarios is that the average real interest rate on domestic government debt follows a rising trend, reflecting the continuing impact of financial liberalization and opening the economy:

  • Long-term securities contracted at below-market interest rates before the reduction in statutory liquidity requirements and the introduction of the auction system in the early 1990s will need to be rolled over at market rates.

  • It is assumed that direct financing from the Reserve Bank is phased out, curtailing a source of cheap credit for the Government.

  • Relaxation of restrictions on portfolio allocation by insurance and provident funds would imply that the public sector will have to compete for savings which it previously obtained at below-market rates.

  • While market rates on new issues may decline in real terms from the cyclically high level of 1995/96, an increasingly open capital account means that real interest rates on government paper in India are unlikely to fall on a sustained basis below rates observed in other Asian developing economies.

In 1995/96, the average real interest rate on government debt was about 2 percent, compared to a real rate of return on new government issues of 4–5 percent.9 Even with strong fiscal adjustment, it is projected that the average real interest rate on government debt would rise to 3½ percent early in the next century. This increase would reflect the rising share of debt at market determined rates, assuming that the real marginal rate remains at 4–5 percent, which is broadly in line with East Asian experience. With less fiscal adjustment, the increase in average interest rates would be higher, as the marginal rate would also rise to reflect increasing risk premia associated with higher debt stocks (the average interest rate is assumed to increase by 50 basis points for a 10 percentage point increase in the debt-to-GDP ratio).10

Fiscal adjustment scenarios

The strong adjustment scenario (Table I.1) is based upon strong, front-loaded fiscal consolidation embedded in an ambitious second wave of reforms. It is assumed that the overall public sector deficit would be halved—from about 9 ¼ percent in 1995/96 to 4½ percent in 2001/02—and then be reduced further to 3½ percent of GDP by 2002/03, achieved entirely through higher public saving (Chart I.1). This would require achieving a primary surplus of about one percent of GDP—an adjustment of 3½ percentage points from the deficit of around 2 percent of GDP in 1995/96. The debt-to-GDP ratio would be lowered from 87 to 67 percent, implying that interest payments would fall significantly.11 The bulk of this adjustment—especially in the initial stage—would come from the central level, and the central government deficit would be reduced to 1½ percent of GDP by 2002/03. A significant privatization program—which would help accelerate the lowering of the debt to GDP ratio and thus reduce the interest bill—would be an important part of such a deficit-reduction strategy. Finances of state governments and public enterprises are also assumed to contribute to the process of fiscal consolidation, particularly toward the end of the period, which would depend on thorough-going reforms at the state and enterprise level.

Table I.1.

India: Strong Adjustment Scenario, 1992/93–2002/03

(In percent of GDP unless otherwise noted)

article image
Sources: Data provided by the Indian authority; staff projections.

Investment is unadjusted for errors and omissions; domestic saving is calculated as total investment less foreign saving.

The public sector comprises the consolidated accounts of central and state governments and central public enterprises.

Including Fund transactions.

CHART I.1.
CHART I.1.

INDIA: MEDIUM-TERM MACROECONOMIC SCENARIOS- FISCAL INDICATORS 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Sources: Data provided by the Indian authorities; and staff estimates and projections.1/ Data are for April-March fiscal years.

Under the second scenario—gradual adjustment (Table I.2)—the government would achieve its target, announced in the Common Minimum Program, of reducing the central deficit to 4 percent over the next several years. However, state and public enterprise deficits would remain broadly at current levels. The overall public sector deficit would fall to 7 ¾ percent of GDP. This path would require a 1½ percent of GDP reduction in the primary deficit, leaving interest payments relative to GDP about unchanged, despite some progress toward a lower debt-to-GDP ratio.

Table I.2.

India: Gradual Adjustment Scenario, 1992/93–2002/03

(In percent of GDP unless otherwise noted)

article image
Sources: Data provided by the Indian authority; staff projections.

Investment is unadjusted for errors and omissions; domestic saving is calculated as total investment less foreign saving.

The public sector comprises the consolidated accounts of central and state governments and central public enterprises.

Including Fund transactions.

C. Response of the Economy

The domestic response

In the strong adjustment scenario, the joint effect of strong fiscal consolidation and ambitious structural reforms would bring the Indian economy onto a sustainable high growth path, reaching 7 percent around the turn of the century. While there could be some initial dip in growth, owing to the contractionary effects of fiscal retrenchment, this should be temporary as a strong surge in investment, together with productivity improvements related to structural reforms, should drive an acceleration in growth performance.12 Once infrastructure and other supply-side constraints are addressed, the economy’s potential growth could increase even further.

Total saving availability would be augmented mainly through a strong rise in public saving. Private saving is expected to rise gradually, reflecting developments in fundamental saving determinants, despite a partial Ricardian offset. Consistent with these trends, and a gradually rising use of foreign savings, investment would rise by 6 percentage points to 30 percent of GDP (Chart I.2).13

Chart I.2
Chart I.2

INDIA: MEDIUM-TERM MACROECONOMIC SCENARIOS- ACTIVITY INDICATORS1/

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Sources: Data provided by the Indian authorities; and staff estimates and projections.1/ Data are for April-March fiscal years.2/ Data exclude errors and omissions.

What would be the quantitative impact of structural reforms on capital productivity, as reflected in changes in the ICOR? An Indian expert group (EGO [1996]) that investigated infrastructure requirements for achieving the Government’s growth target, recently projected that the ICOR would decline to 3½ by the turn of the century—comparable to efficiency levels of East Asian economies.14 However, a long-term analysis of East Asian countries’ growth-investment relationships suggests a somewhat less optimistic assumption would be warranted. It appears that: (1) ICOR levels differ significantly across economies; and (2) even strong reform programs do not necessarily lead to a dramatic downward shift in the ICOR (Table I.3). One relevant factor in all these countries is the substantial need for infrastructure investment to remove supply-side bottlenecks. Therefore, under the strong adjustment scenario, it is assumed that the ICOR would decline to around 4 by early next century, compared to an average value of 4½ in India over 1975–95. There would be an initial rise in the ICOR resulting from a strong initial increase in investment at a time of slowly accelerating growth rates.

Table I.3.

ICOR Measures for India and East Asian countries

(Average values)

article image
Source: World Economic Outlook database.

In the gradual adjustment scenario, reforms would be slower, and the public sector would continue to absorb a substantial share of private saving, leaving little room for the increase in private sector investment needed to sustain high growth. Private participation in infrastructure—a key part of the development strategy—could be particularly affected, especially if the continued high public borrowing requirements deter development of robust long-term debt markets. Against this background, investment and saving would remain lower compared to the strong adjustment scenario, productivity increases would remain small (reflected in an ICOR above 4½), and growth would be close to the average rate of 5½ percent achieved in the 1980s and early 1990s.

The response of the external sector

In the strong adjustment scenario, it is envisaged that better economic fundamentals, together with phased liberalization in access to foreign capital markets, prompts rising foreign capital inflows consistent with a gradual increase in the current account deficit to 3½ percent of GDP over the medium term (Chart I.3). The rising current account deficit would largely reflect a substantial increase in imports related to buoyant demand for capital goods, although a supply response to reforms in the traded-goods sector would also lead to significant export growth. The bulk of the capital inflows would consist of growing foreign direct investment and portfolio equity inflows. These inflows, together with a substantially stronger fiscal position, would allow the gradual liberalization of restrictions on foreign borrowing without jeopardizing a viable external position. Despite a declining share of debt at concessional rates, external debt and debt service indicators would be brought down sharply once the current hump of amortization related to exceptional financing of the 1990/91 crisis is complete.15

Chart I.3
Chart I.3

INDIA: MEDIUM-TERM MACROECONOMIC SCENARIOS- EXTERNAL INDICATORS 1/

(In percent of GDP; unless otherwise noted)

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Sources: Data provided by the Indian authorities; and staff estimates and projections.1/ Data are for April-March fiscal years.

By contrast, under the gradual adjustment scenario, India would continue with its cautious approach to foreign capital, and the external current account deficit would be kept to a substantially lower level. Although foreign direct and portfolio investment are projected to continue on a rising path, use of foreign savings would be constrained by continued limits on external commercial borrowing and less attractive opportunities for foreign investors. The current account deficit is projected to remain below 3 percent of GDP.

D. Sustainability of the Current Account Path

The external current account deficit is projected to widen in both medium-term scenarios. Although the external situation appears stable in each case, a global environment of volatile capital flows warrants a more detailed analysis of the possible risks. Sustainability is usually assessed on the basis of a range of indicators of external vulnerability, generated from medium-term balance of payments projections.16 Following this approach, external indicators derived from the two scenarios are compared with the experience of other developing economies. Two sample groups of countries have been created for this purpose:

  • The “East Asia” group (China, Indonesia, Malaysia, Thailand) is composed of high growth countries, which have run significant current account balances while largely avoiding external crises.

  • By contrast, all of the countries in the “Latin America” group (Argentina, Brazil, Chile, Mexico) experienced severe crises in the early 1980s as a result of an unsustainable debt build-up.

The indicators used include the current account balance, saving and investment ratios, and openness, debt and debt service, and the composition of external financing, both current and cumulative.

  • Current account balance. The rising deficits under both scenarios stay within the range experienced by East Asian countries (and remain substantially less than those of Malaysia and Thailand in the early 1990s) (Chart I.4). The deficits are well below those of Latin American countries involved in the debt crisis in the early 1980s, and also below the deficit observed in Mexico prior to its recent foreign exchange crisis.

  • Saving and investment. India’s saving and investment rates, while comparable to those in Latin America, have historically been far below the levels reached by the East Asian countries (Chart I.5). This would remain true even in the strong adjustment scenario, suggesting the need for a more cautious approach to a widening of the current account deficit than in East Asia.

  • Degree of openness. While India’s openness has increased significantly in the first half of the 1990s, India remains relatively less open than most other countries, in particular those in East Asia (see Chart I.5). To some extent, this observation reflects India’s large size, although size has not prevented China from opening its economy much more strongly. Even in the context of the strong adjustment scenario, India’s degree of openness would remain significantly below the current Chinese level.

  • Debt and debt service. India’s external debt has come down from 36 percent of GDP in 1993/94 to 29 percent in 1995/96, a ratio lower than for both East Asia and Latin America, even before taking into account the higher proportion of concessional debt in India’s debt stock (Chart I.6).17 The debt service ratio has also declined significantly in recent years, mainly a result of strongly growing exports, while the share of short-term debt in total external debt has declined from 10 percent in 1990/91 to 5 percent in 1995/96.

Chart I.4.
Chart I.4.

INDIA: CURRENT ACCOUNT BALANCE: COUNTRY COMPARISONS

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Source: World Economic Outlook, and staff projections.
Chart I.5.
Chart I.5.

INDIA: SAVING, INVESTMENT AND OPENNESS

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Source: World Economic Outlook, and staff projections.1/ Domestic saving for India.2/ (Exports+Imports)/GDP.3/ Excluding China.
Chart I.6.

INDIA: DEBT AND DEBT SERVICE

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Source: World Economic Outlook, and staff projections.

The debt and debt service ratios would continue to decline in both the gradual and strong fiscal adjustment scenarios, particularly after 1996/97, as a lump of amortization related to emergency financing in 1990/91 is repaid. Thereafter, the falling trend is maintained through the full projection period, with debt service falling to current East Asian levels.

  • Composition of external financing. In the past, India has relied much more heavily than East Asian or Latin American comparators on debt financing (Chart I.7). However, equity investment has increased strongly since 1991/92, and is projected to continue growing. With an ambitious reform program on course, it is expected that India could attract at least 1 percent of GDP (up to US$ 5 billion) of direct investment inflows per year, close to the Latin American average of the past decade, although still significantly less than the East Asian average of some 2 percent of GDP per year. Portfolio inflows could contribute a similar scale of inflows, implying that total equity financing would provide somewhat more than half of total capital inflows in the strong adjustment scenario. In the gradual scenario, however, the proportion of equity would be less, owing to slower equity inflows associated with less aggressive reforms.

  • Cumulative external financing. Traditionally, external viability has been analyzed by looking at debt and debt-service indicators. However, foreign equity inflows also imply a future burden on the balance of payments (dividend payments and potential capital repatriation). To reflect this, a broader measure of total external liabilities has been calculated, obtained by adding the cumulative sum of equity investment inflows to the outstanding debt stock.18

Chart I.7.
Chart I.7.

INDIA: COMPOSITION OF EXTERNAL FINANCING

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Source: World Economic Outlook, and staff projections.

In 1995/96, India’s cumulative external financing in relation to GDP was substantially below levels in the comparator countries, with the amount of foreign investment particularly low (Chart I.8). However, reflecting the relatively closed nature of India’s economy, accumulated financing relative to exports was higher (by about one quarter) than in East Asia, although still only about half the Latin American average.19 At the end of the projection period for the strong adjustment scenario, India would have accumulated foreign financing at around 40 percent of GDP (with a slightly rising trend), still well below the levels of both East Asia and Latin America. Cumulative financing relative to exports would have declined somewhat, but would remain above East Asian levels.

Chart I.8.
Chart I.8.

INDIA: CUMULATIVE EXTERNAL FINANCING

Citation: IMF Staff Country Reports 1996, 132; 10.5089/9781451818598.002.A001

Source: World Economic Outlook, and staff projections.

E. Risk Assessment

The strong adjustment scenario, with a projected current account deficit of 3½ percent of GDP in 2001/02, appears consistent with a sustainable balance of payments. Indicators of debt, debt service, and cumulative external obligations show declining trends and compare well to East Asian (and especially Latin American) examples. The one cautionary note is that although saving, investment, and openness increase, levels remain substantially below those in East Asia.

The gradual adjustment scenario also shows an improvement in most external sustainability indicators, although saving, investment, and exports are projected to grow more slowly than in the strong adjustment scenario. However, such a scenario would imply a slower growth path for the economy while at the same time entailing greater risks for internal and external viability:

  • With public debt staying high relative to GDP, the budget would remain very sensitive to possible interest rate changes. With this continuing threat, the pace of reforms in sensitive areas such as trade liberalization and financial sector reforms could be slowed by concerns not to jeopardize stability in foreign exchange and financial markets, which would further weaken the supply-side response.

  • The disappointing growth performance would be likely to lead to pressures for more expansionary policies (and increased external borrowing) similar to those last seen—with detrimental consequences—in the late 1980s.

  • Even with declining debt service ratios, the balance of payments would remain vulnerable to a sudden sharp decline in private capital inflows—a decline that would be more likely within a less favorable domestic policy environment.

The danger of insufficient fiscal adjustment becomes even more evident in the absence of any further improvement in the public sector’s primary deficit. The rising trend in public interest rates would raise the overall public sector deficit, and debt and interest payments would spiral upwards. In this situation, an effort to sustain growth through greater reliance on foreign savings would lead to widening current account deficits and deteriorating debt indicators; and an eventual external crisis would become unavoidable.

References

  • Expert Group on the Commercialization of Infrastructure Projects (EGO; 1996), The India Infrastructure Report: Policy Imperatives for Growth and Welfare [Mohan Report]: New Delhi.

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  • IMF (1995a), India-Background Papers, IMF Staff Country Report No. 95/87: Washington, DC.

  • IMF (1995b), Staff Studies for the World Economic Outlook, Washington, DC.

  • Milesi-Ferretti, G.M., and A. Razin (1996), “Persistent Current Account Deficits: a Warning Signal?”, International Journal of Finance and Economics, 1, 161181.

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1

Prepared by Martin Mühleisen.

2

The scenarios build on earlier work (see IMF [1995a], Chapter II).

3

See Chapter II of this report.

4

The public sector comprises central and state governments and central public enterprises.

5

Equity investment is assumed to rise (at different rates) in both scenarios, particularly direct foreign investment, but financing at the margin is assumed to be debt related.

6

Data on capital stock and labor force are partly available; however, attempts to estimate a production function did not yield sensible results. Capital stock estimates suffer from the low quality of investment data, while labor force estimates do not account for workers in the large informal sector.

7

The relationship between money and price increases has been quite stable, notwithstanding the financial reforms in progress (e.g., IMF [1995a], Chapter V).

8

This approach reflects the difficulties in finding stable econometric relationships in the Indian data. Most estimated equations yield poor forecasts and applying them in the model would have required extensive use of ad hoc adjustment factors. Moreover, with the continuing structural change in the Indian economy, the underlying empirical relationships are expected to shift as well, rendering regression results obsolete.

9

Relative to an estimated increase of 8 percent in the GDP deflator.

10

This relationship is broadly in line with results cited in the World Economic Outlook (IMF [1995b]).

11

The envisaged adjustment assumes an increase in the tax ratio to 18 percent of GDP by 2001/02, while nontax revenue rises by about 1 percentage point of GDP through improved public enterprise profitability. On the expenditure side, the scope to lower total noninterest expenditure is limited, given pressing needs for infrastructure and social spending that would absorb cutbacks in unproductive spending areas. Hence, expenditure reduction reflects mainly lower interest payments.

12

The initial adverse effect on demand would be diminished by maximizing the credibility of the fiscal adjustment package to prompt a strong private investment response.

13

The numbers for investment and saving presented in the scenarios are consistent with the different treatment of errors and omissions described in Chapter II, Appendix II. 1. These figures are 2–3 percentage points lower than the official numbers.

14

The expert group projects an increase of 1 percent of GDP in public saving, 2 percent in private saving, and 1 percent in the current account deficit (reaching 2½ percent of GDP by 2000/01). This would finance a 4 percentage point increase in the investment to GDP ratio, translating into a growth rate of 7½ percent by 2000/01.

15

In particular, substantial Fund repurchases and the repayment of a US$ 2.2 billion India Development Bond issue fall due in 1996/97.

17

The share of concessional lending to India is projected to fall from its current level of 40 percent to below 20 percent by 2001/02. It would still remain higher than current levels for East Asia or Latin America.

18

Cumulative equity investment figures have been derived from data going back to 1970.

19

A country’s external obligations should also be related to its ability to generate foreign exchange receipts to service these obligations. For example, cumulative external financing to both East Asia and Latin America is close to some 60 percent of GDP. However, the East Asian countries’ better export performance translates into a much lower ratio of cumulative financing to exports (140 percent, as opposed to 400 percent for Latin America).

India: Selected Issues
Author: International Monetary Fund