India: Recent Economic Developments and Selected Issues

India rebounded strongly from its 1991 balance-of-payments crisis, aided by structural reforms and other policy adjustments. The government has sought to reinvigorate the process of structural and fiscal reform. The paper examines trends in interstate differences in rural poverty; reviews India's postal saving system and possible reform issues; describes and evaluates the current system of pensions and provident funds, and discusses reform options. The paper also briefly reviews the structure of and recent developments in the Indian foreign exchange market.

Abstract

India rebounded strongly from its 1991 balance-of-payments crisis, aided by structural reforms and other policy adjustments. The government has sought to reinvigorate the process of structural and fiscal reform. The paper examines trends in interstate differences in rural poverty; reviews India's postal saving system and possible reform issues; describes and evaluates the current system of pensions and provident funds, and discusses reform options. The paper also briefly reviews the structure of and recent developments in the Indian foreign exchange market.

VI. Structural Policies and the Report of the Prime Minister’s Economic Advisory Council1

A. Introduction

1. It has been long acknowledged among analysts and policy makers in India that productivity and growth have been constrained by a complex regulatory system and structural rigidities. There is a similar consensus that broad-based structural reforms are a critical prerequisite for moving the economy to a higher growth path and facilitating poverty reduction, and for enabling the economy to cope with a rapidly changing external environment, including market opening under WTO commitments.

2. It is also widely acknowledged that these reforms also are needed to support fiscal consolidation. Subsidies were estimated to have exceeded 14 percent of GDP during the mid-1990s, and are poorly targeted and highly distortive. Only a relatively small share of subsidies are explicitly identified in the budgets of the central and state governments—most are implicit and take the form of cross subsidies and user charges that are below economic costs.

3. Significant structural reform was introduced during the period following the 1991 balance of payments crisis, and the process continued during the latter half of 1990s at a pace that was sometimes undermined by political uncertainties and macroeconomic shocks—including the Asian crisis. During 2000/01, further progress was made in a number of key areas: rules governing foreign direct investment were liberalized; the number of small-scale industries receiving preferences was reduced; the telecom sector was further liberalized; steps were taken to facilitate the privatization of public enterprises; tax reforms were introduced; and the insurance sector was opened to private competition (Box VI.1).

4. The apparent reinvigoration of the momentum for reform culminated in the release of a long-delayed comprehensive program of “second-generation” reforms in January 2001, prepared by the Prime Minister’s Economic Advisory Council (EAC). Encouragingly, many of the proposals were taken up in the Finance Minister’s February 2001 budget and the government’s March 2001 Export-Import policy. This chapter briefly summarizes the EAC’s program, and describes the measures that have been subsequently announced.

B. The EAC Report

5. The EAC’s report covered a broad range of recommendations, including industrial and agricultural policies, economic infrastructure, social sector issues, financial sector reform, and fiscal policy. The key issues are summarized below.

India: Major Reform Initiatives in 2000/011

Industry

Foreign direct investment permitted through automatic route in all industries, subject to a negative list and foreign ownership caps; removal of the garment sector from the list of products reserved for production by small-scale industries.

Infrastructure

Domestic long distance telephone service opened to private sector; corporatization of the Department of Telecom Services and Department of Telecom Operations by creating Bharat Sanchar Nigam Limited (BSNL); replacement of a fixed license fee system with a revenue sharing fee system for basic and cellular service operators.

Fiscal policy

Nonagricultural income of farmhouse made taxable; the “one-by-six” criteria for identifying potential taxpayers extended to 79 additional cities (from 54 previously); peak customs duties reduced from 40 percent to 35 percent, and the number of ad valorum duties reduced from five to four; a timetable for removing the exemption from income tax that had been allowed for all income generated from exporting was established—the exemption would be phased out over a five-year period in equal increments; excise duty system overhauled with the establishment of the CENVAT—a single rate of 16 percent, with few exemptions.

The Fiscal Responsibility and Budget Management Bill was introduced to the parliament, which would establish binding deficit reduction targets for the central government.

Financial sector

The interest rate on general provident funds was reduced from 12 percent to 11 percent; legislation was introduced to allow reduction of the minimum government shareholding in public sectors banks from 51 percent to 33 percent; the insurance sector was opened to private sector entrants, subject to minimum capital requirements and a 26 percent cap on foreign ownerships, and an insurance regulator was established.

Trade policy

Special Economic Zones were established to encourage export industries; rules restricting the import of second-hand capital goods were relaxed.

Capital account

FDI up to 100 percent was allowed in e-commerce; dividend rebalancing requirement for FDI in 22 consumer goods industries removed; sectoral cap on the amount of FDI in electricity sector projects removed; FDI under the automatic route permitted up to 100 percent in all manufacturing activities in Special Economic Zones; rules governing external borrowing under the External Commercial Borrowing window and the issuing of ADRs were relaxed.

1Adapted from The Economic Survey, 2000-2001 (Government of India).

Industrial and agricultural sector reforms

6. The EAC emphasized that high tariffs, preferences for small-scale industry, and weaknesses in bankruptcy laws have reduced the ability of domestic industry to restructure and take advantage of economies of scale. As a result, industry is not well placed to benefit from increased market opening under existing trade arrangements, including the withdrawal of quantitative import restrictions as of April 2001 and the withdrawal of MFA quotas in 2005. Key recommendations for reforms included: (i) a phased reduction in tariffs—from an average rate of around 34 percent to 10–12 percent—with the initial emphasis on basic intermediate goods; (ii) phased elimination of preferences for small-scale industries; (iii) elimination of the Sick Industrial Companies Act as a vehicle for bankruptcy, strengthened mechanisms for debt recovery under the Debt Recovery Tribunals, and the introduction of modern bankruptcy legislation, including amendments to the Companies Act that facilitate reorganization and/or liquidation.

7. The EAC stressed that privatization needs to be actively pursued, as government enterprises are extensive, inefficient, and contribute to substantial quasi-fiscal deficits. In this regard, an emphasis was laid on the government following through on its commitment to lower its equity stake in enterprises and to allow them to operate on a corporate basis. The EAC also suggested that revenues received from privatization should be used to pay down public sector debt, rather than fund general government operations.

8. Labor market rigidities—including legislation that effectively prohibits layoffs and requires government intervention in all labor disputes—were identified as severely constraining the scope of industrial sector restructuring and adversely affecting labor incomes. Key reforms include: (i) relax and eventually abolish the requirement under the Industrial Disputes Act for Government permission for layoffs from firms employing more than 100 workers; (ii) increase the compensation paid to retrenched workers from the present 15 days average pay for every completed year of service to 30 days; and (iii) ease constraints under the Contract Labor Act to hire labor on a contract basis. Plans to implement reforms along these lines were announced in the February 2001/02 budget, although the proposed separation benefit to be paid to retrenched workers was increased to 45 days per year of service.

9. In the agricultural sector, price controls, regulations, subsidies, and the tax-free status of agricultural incomes have undermined productivity and incomes in rural areas, where poverty is endemic. Key reforms recommended by the EAC included: (i) elimination of controls on the movement and stocking of agricultural commodities (food grains, edible oils, cotton or sugar); (ii) the repeal of the Essential Commodities Act, which requires sales to government procurement agencies; (iii) abolition of levies on commodities like rice, sugar, etc.; (iv) the drastic reduction in the role of government procurement agencies including the Food Corporation of India; (vi) the abolition of controls on the distribution and marketing of sugar; (vii) the dereservation of agro-processing and the freeing of milk processing to large-scale producers; (viii) the abolition of the retention price scheme for urea (fertilizer) manufacturers and the freeing of urea marketing. However, the EAC did not address the issue of the need to promote measures at the state level to bring the agricultural sector under the tax net.

Infrastructure

10. The power sector, which is largely under state control, provides massive subsidies in the form of free or low cost power to the agricultural sector, and is also highly inefficient—losses due to technical weaknesses and corruption are as high as 50 percent. High tariffs charged to industrial consumers to cover losses have undermined manufacturing competitiveness and encouraged wasteful investment by industrial users in captive generating capacity. The financial situation of the state electricity boards has deteriorated as industrial users have left the system (in favor of self generation) and financial losses are presently estimated to be in the range of 1 percent of GDP. The EAC stressed that reforms should include: (i) hikes in tariffs for nonindustrial consumers to meet economic costs; (ii) privatization of the distribution system to contain costs and improve efficiency; (iii) clearance of arrears of the state electricity commissions, which some estimates place at over 1 percent of GDP.

11. Although considerable progress has been made toward telecom reform, the EAC noted that additional measures that would help reduce costs to the consumer include: (i) license fee reform; (ii) ensuring that service taxes do not undermine the use of telecom services as an input to production; (iii) proceeding with the planned dismantlement of the government monopoly on international long-distance service and facilitating the licensing of entrants; (iv) promoting the use of right-of-ways along railway lines for fiber optic cables.

12. The EAC emphasized that the Indian transportation system also is a significant impediment to industrial productivity and foreign direct investment. Notably, the Indian highway system is inadequate and poorly maintained, and losses by state-run road corporations are estimated at around 0.1 percent of GDP. Against this background, the EAC urged improved efforts at cost recovery, including by a greater reliance on tolls, and more private sector investment on a build-and-operate basis. Indian ports also are inefficient, owing to obsolete equipment, inadequate mechanized handling facilities, poor port management techniques and outdated labor practices. Corporatization and privatization must be actively pursued, coupled with a rationalization of the pricing of port services.

Social sector issues

13. Educational attainment in India is weak—those aged 25 and above, on average, have less than three years of schooling. The EAC stressed that improving education, especially access to primary schools, would be essential for poverty reduction. Although increased funding for education would be important, the EAC noted that the large implicit subsidy for university education needed to be severely reduced—university fees were estimated to cover only about 5 percent of costs.

14. As regards the health system, while life expectancy and mortality rates have improved considerably since Independence, the EAC noted that indicators are much weaker in rural areas. Increased efforts toward measures to ensure immunization, clean drinking water, and provision of sanitation facilities are critical for poverty reduction and improvements in productivity. Social safety nets are relatively porous in India, and appear to be largely limited to formal sector employment. The EAC called for an emphasis on employment programs, child development services, and micro credit facilities.

Financial sector reform

15. The EAC stressed the importance of continued progress in the area of financial sector reform, and emphasized the importance of bringing prudential and supervisory norms in the banking sector up to international standards and of implementing the government’s decision to reduce its minimum ownership of public sector banks to 33 percent. In this latter regard, the EAC cautioned that the government’s desire to retain the “public sector character of public sector banks” could undermine the benefits that would accrue from increasing competition in the sector.

Fiscal reform

16. The EAC strongly urged the government to correct the fiscal situation, cautioning that inaction could lead to inflation and exchange rate instability, low growth, and external crisis. The EAC argued that the consolidation recommended by the Eleventh Finance Commission was too modest and called for a reduction in the combined fiscal deficit of the central and state governments to around 5 percent of GDP by 2006/07. In order to achieve this objective, measures would be required to boost tax revenues at the central level by 2 percent of GDP, mainly through a widening of the excise tax base.

17. Expenditure reforms were also strongly recommended in a number of areas, including with regard to downsizing the civil service and rationalizing Plan outlays, in the latter case by establishing “sunset” provisions for all programs. Other recommendations included:

  • Food and fertilizer subsidies total around 1¼ percent of GDP and are very poorly targeted. The EAC called for reforms in line with the recommendations outlined by recent reports of the Expenditure Reforms Commission, which would involve curtailing outlays, devolving responsibility to the states, and providing lump sum benefits.

  • Kerosene subsidies are estimated at around 0.4 percent of GDP and, while these are typically met from charges on other petroleum products, large price differentials create incentives for consumers to adulterate other fuels with substantial adverse environmental effects. The EAC recommended that kerosene prices be increased significantly in the coming year, in line with the Government’s commitment to eliminate the administered pricing mechanism.

  • Railway fares for passengers do not cover costs, implying a subsidy of nearly 0.2 percent of GDP and requiring high charges for industrial users. The EAC recommended hikes in passenger fares to cover costs, a reduction in freight charges, and mechanisms to depoliticize fare setting. The corporatization and eventual privatization of the six manufacturing units of Indian Railways, and greater private sector participation in railway operations, were also recommended. In addition, the EAC also recommended increases in postal and water charges in order to cover costs.

  • Pension-related reforms would include establishing a system for automatic adjustment of the rate of return on the Public Provident Fund and National Saving Certificates to 2 percent plus the rate of inflation, and shift pensions in the public service to a fully funded, defined benefit basis.

C. Recent Structural Measures

18. Encouragingly, the 2001/02 budget speech and the 2001/02 Export-Import policy statement introduced a number of important structural reform measures, and signaled a commitment to carry forward the recommendations of the EAC in a number of other important areas:2

  • Food subsidies: Although details were not announced, the budget indicated that the proposal by the Expenditure Reforms Commission to devolve responsibility for managing food subsidies to the states would be adhered to. The budget also promised a review of the Essential Commodities Act, with a view to removing obstacles to the free flow of agricultural commodities.

  • Fertilizer subsidies: The budget announced that, in line with the recommendations of the Expenditure Reforms Commission, urea prices would be decontrolled by 2006, and that beginning in April 2001, the existing retention price scheme would be replaced by a group concession scheme.

  • Sugar subsidies: In a first step to eliminating sugar subsidies, futures/forward trading would be introduced in 2001/02.

  • Labor market: The budget committed the government to introducing legislation that would amend the Industrial Disputes Act so that its restrictions on layoffs would apply only to firms with 1,000 workers or more, rather than the current limit of 100 worked or more. Legislation that would ease restrictions on contract labor would also be introduced.

  • Small-scale industries (SSI): 14 previously reserved industries were opened to production by large-scale producers, and size limit for firms to qualify for SSI status and tax exemptions was doubled.

  • Power sector: The budget announced for state-level reforms of State Electricity Boards (SEBs)—supported by conditional grants and loans under memoranda of understanding to be negotiated between the center and the states—that would require full metering, energy audits, independent tariff determination, commercialization of distribution, and SEB restructuring. A new Electricity Bill, which would facilitate SEB restructuring, would be introduced in 2001.

  • Petroleum sector: The budget announced that the March 2002 deadline for dismantling of the administered pricing mechanism in the petroleum sector would be adhered to.

  • Social security: Various schemes were introduced to extend security cover to workers affected by economic liberalization, including a new unemployment insurance scheme that would cover for one year 30 percent of lost compensation of workers up to a maximum of Rs 36,000, as well as modest education and pension benefits for the rural poor.

  • Banking sector and debt recovery: Public sector banks were to be accorded full autonomy in the area of recruitment. In order to facilitate debt recovery, several additional Debt Recovery Tribunals were to be established in 2001/02. The Sick Industrial Companies Act would also be repealed and an alternate legal framework for bankruptcy would be introduced during 2001/02.

  • Securities markets: The budget announced plans to establish a range of measures to deepen the government debt market, including a clearing corporation, a screen-based trading system, and the introduction of a Real Time Gross Settlement system.

  • Pension reform: The budget called for proposals for reforms to the provident fund system by October 1, 2001, but also lowered the interest rate on provident fund deposits by 150 basis points.

  • Capital account liberalization: The budget announced an easing of restrictions on outward FDI and inward FDI in nonbanking financial companies, and an increase in the limit on foreign portfolio investment from 40 percent to 49 percent of firms’ equity. Subsequently, foreign ownership caps were raised to 100 percent in drugs and Pharmaceuticals, hotels and tourism, courier services, airports, and mass rapid transport services, to 74 percent for Internet service providers, and to 49 percent for banks.

  • Trade policy: The budget contained commitments to reduce the peak tariff rate from 35 percent to 20 percent in three years, and the 2001/02 Export-Import policy eliminated all remaining quantitative import restrictions. However, various measures were introduced to mitigate the impact on domestic industry, including the requirement that some sensitive commodities could only be imported through state trading companies, that agricultural products be subject to import permits based on sanitary and phytosanitary provisions, that imports of second-hand cars would be banned, and hikes in tariff duties on certain agricultural products.

D. Concluding Remarks

19. Encouragingly, the 2001/02 budget, which was tabled in late February, reiterated the government’s commitment to fiscal reform and consolidation, and signaled a willingness to press forward with many of the recommendations that had been made by the EAC. At the same time, however, considerable further work needs to be done to meet the ambitious agenda set by the EAC. Implementing the measures that were identified in the budget will require legislative support, and important reforms emphasized by the EAC still need to be tackled. However, as has been clearly emphasized by the authorities and many other analysts, determined implementation of this reform agenda is critical for ensuring that India achieves its full growth potential and succeeds in addressing the needs of the poorest of its population.

1

Prepared by Christopher Towe.

2

Chapter V discusses the fiscal reforms that were introduced with the budget.