India

Tim Callen

India has had an impressive economic performance over the past decade. Its growth rate has been among the highest in the world, inflation has been relatively well contained, and the balance of payments has been maintained at comfortable levels. This performance has been achieved despite the Asian financial crisis, the international sanctions that were imposed following the nuclear tests in 1998, and a series of adverse weather-related shocks and natural disasters. While poverty has declined over time, it remains at a high level, with more than one-quarter of the population living below the poverty line. Moreover, macroeconomic imbalances, particularly on the fiscal side, and slow progress in key structural policy areas appear to be dampening growth prospects. Against this background, recent IMF research on India—much of which is collected in the new book, India at the Crossroads: Sustaining Growth and Reducing Poverty—has focused on what policies are needed to sustain the rapid growth that is essential to reducing poverty.¹ This article provides an overview of this research.

India achieved considerable fiscal consolidation during the first half of the 1990s, but subsequent policy slippages, at both the central and state government levels, resulted in the consolidated public sector deficit ballooning to over 11 percent of GDP and public debt rising to 80 percent of GDP by the end of the decade. These developments have naturally raised questions about whether the country’s recent strong economic performance can be sustained without fiscal policy adjustment. IMF staff research has focused both on the reasons for the deterioration in the fiscal position and on the sustainability of current fiscal policies.

Muhleisen (1998) assessed the revenue impact of tax reforms implemented by the central government during the 1990s.² He found that, while elasticity estimates point to a small improvement in the revenue-generating capacity of the tax system, overall tax revenue declined relative to GDP due to the substantial cuts in tax rates. Muhleisen concluded that the disappointing revenue performance reflected the partial nature of the reforms. Regarding the sustainability of fiscal policies, Reynolds (2001) used a simple growth model to show that, despite the high deficits incurred in recent years, India has been able to avoid a fiscal crisis largely because of the favorable differential between real interest rates and overall economic growth rates.³ However, Reynolds’s simulations suggested that a continuation of recent fiscal policies would risk putting India on an explosive debt path.

An alternative approach to assessing Indian fiscal policy was followed by Cashin, Olekalns, and Sahay (1998) who used an intertemporal model to demonstrate that policy has been consistent with tax-smoothing behavior.⁴ They also found, however, a significant bias toward deficit financing—which has led to excessive government borrowing, as well as the resorting to seniorage and financial repression—and government debt was estimated to be in excess of levels considered optimal or consistent with intertemporal solvency. Muhleisen (1997) looked at determinants of saving in India and found that improving public saving was one of the keys to raising national saving.⁵

With regard to India’s external sector, Cerra and Saxena (2000) examined the causes of the 1991 balance of payments crisis.⁶ Since this crisis, India has maintained a sustainable external position, and a number of papers have looked at the factors behind this success. Towe (2001) assessed the factors that helped insulate India from the turmoil of the Asian financial crisis, attributing the success to effective exchange rate management, generally sound macroeconomic fundamentals, and the presence of capital controls.⁷ Tzanninis (1998) looked at exports and competitiveness in light of the currency realignments in the Asian region during the financial crisis.⁸ Using several statistical and econometric techniques, he found no evidence to indicate that the rupee was overvalued relative to its fundamentals. Callen and Cashin (1999) used a number of methodologies to analyze external sector developments in India since independence.⁹ They found that, while models of external sustainability raised questions about India’s external position prior to the 1991 balance of payments crisis, these models have not highlighted significant risks since then.

In the area of monetary policy, the Reserve Bank of India (RBI) shifted away from a broad-money target to a multiple-indicators approach to policymaking in the late 1990s. Callen and Chang (1999) assessed the forecasting ability of single-equation models of the inflation process and a series of vector autoregressions to identify which of the many available indicators provide the central bank with the most reliable and timely guides of future inflation developments.¹⁰ They found that developments in monetary aggregates continued to provide the most useful information, but that the long lags between money and inflation suggested the need for a broader set of indicators for policymaking.

The financial sector has also been a key focus of the reform agenda in recent years. Callen (1998) compared the financial performance of the public sector banks during the 1990s with those of the domestic and foreign private sector banks.¹¹ He found that, both in terms of interest spreads and cost structure, the public sector banks fared worse than their private sector counterparts, but he also noted that there was a significant divergence between the performance of “strong” and “weak” public sector banks. Two other papers—Mohanty (1998) and Ilyina (2001)—explored issues relating to the mutual fund and nonbank financial company (NBFC) sectors, respectively.¹² Both sectors have faced recent difficulties that highlighted weaknesses in their regulatory environments; the papers assessed the reforms that have been undertaken by the authorities to strengthen these sectors and made recommendations for further action. These recommendations include further strengthening of financial sector regulation and supervision, reductions in problem loans, steps to increase competition among institutions, and measures to reduce the role of the government in the financial sector.

The impact of economic reforms on interstate growth, income disparities, and poverty have been taken up in a number of studies. Cashin and Sahay (1996) looked at the role of internal migration and grants from the central government to the states in influencing the growth performance of the states.¹³ Aiyar (2001) found that the per capita income gap between states has widened in recent years and that differences in literacy and private investment rates across states were part of the reason for the lack of convergence.¹⁴ Lastly, Aziz (2001) looked at trends in interstate differences in rural poverty and found that, while economic growth has been strongly positive for the poor and a force of convergence in the post-1991 reform period, nongrowth factors have widened interstate poverty differentials.¹⁵