I. Introduction and Summary¹

1. India rebounded strongly from its 1991 balance-of-payments crisis, aided by structural reforms and other policy adjustments. By the middle of the 1990s, growth had accelerated to an average of 7½ percent, and substantial improvements had been achieved in a number of social indicators, including of health, education, and poverty. Through the end of the decade, inflation generally remained on a downward trend—reflecting careful monetary policy management—trade and financial sector reforms were sustained, and external developments were broadly favorable despite a number of external and domestic shocks. The current account deficit generally remained under 1½ percent of GDP, and foreign reserves increased to around six months of imports.

2. Economic activity, nonetheless, slowed in the latter part of the decade, and since 1997/98, growth has averaged just under 6 percent. This reflected the effects of various shocks—including the Asian financial crisis, volatile world oil prices, patchy monsoons that led to weak agricultural output, and natural calamities, including the devastating earthquake that struck the state of Gujarat in January 2001. However, deeper structural factors appear to have played a role, including infrastructure constraints, uncertainty about the impact of the removal of quantitative import restrictions, excessive regulatory constraints in the industrial and agricultural sectors, and high real interest rates.

3. The fiscal situation also deteriorated markedly during the second half of the 1990s. The consolidated public sector deficit reached a peak of 11¼ percent of GDP in 1999/2000, and while the deficit may have narrowed somewhat in 2000/01, public sector debt rose further to over 83 percent of GDP. This reflected difficulties at both the central and state government levels with central excise and customs collections, pressures to hike civil service salaries and pensions, and rising interest burdens.

4. In order to address these issues, the government has sought to reinvigorate the process of structural and fiscal reform. Fiscal responsibility legislation has been tabled in Parliament and the recent report of the Eleventh Finance Commission has established modalities for encouraging fiscal consolidation at the state level. A long-delayed comprehensive program of “second-generation” reforms was released in January 2001, and many of the measures were endorsed in the context of the government’s 2001/02 budget.

5. These broader macroeconomic developments are discussed more fully in Chapters II-VI, while Chapters VII-X consider additional selected issues.

• Chapter VII examines trends in interstate differences in rural poverty. It finds that growth has been pro poor in India, and the incidence of poverty has declined in all states during the last two decades, although poverty initially increased in the post-1991 reform period, before declining in the latter part of the decade. Moreover, while differences between states’ poverty levels had been narrowing during the 1980s, this convergence has weakened in the 1990s—although this is likely the result of interstate differences in structural factors, rather than differences in growth.

• Chapter VIII reviews India’s postal saving system and possible reform issues. This system provides important savings vehicles for the rural population with limited access to the banking system. However, high and inflexible interest rates on these schemes, combined with substantial tax advantages, have led to discrimination against other savings instruments—particularly bank deposits—and the system also suffers from a significant asset-liability maturity mismatch and a cumbersome administration. Moreover, state governments have automatic access to a large share of the funds deposited, which has undermined fiscal discipline at the state level.

• Chapter IX describes and evaluates the current system of pensions and provident funds, and discusses reform options. These issues are a subject of active debate in India today, owing to the complexity and narrow coverage of currently available pension programs. Moreover, while rapid aging of the population is a less pressing concern in India than in other countries in the region, low returns on invested funds imply potentially large liabilities on the government budget.

• Chapter X briefly reviews the structure of and recent developments in the Indian foreign exchange market. The currency’s flexibility, offshore market dynamics, and responsiveness to intervention are analyzed, and tests suggest that rupee/dollar rate has been remarkably stable, especially compared to other floating rate currencies. In addition, movements in the offshore nondeliverable forward premia tend to provide significant leading information regarding movements in the spot rate. Finally, intervention in the foreign exchange market appears to have had a small and negative impact on the rupee.