Assessing India's economic reforms

Print edition : January 19, 2002

India needs to launch a second generation of reforms after undertaking an in-depth analysis of what has gone wrong until now during the course of the ongoing round of reforms.

THE two decades since 1980-81 have been easily the best in India's economic performance in the last century.

After averaging about 3.6 per cent a year in GDP (gross domestic product) growth rate during the 30 years between 1950-51 and 1980-81 and less than 1 per cent a year in the half century before that, GDP growth accelerated to 5.6 per cent in the 1980s (5.3 if 1991-92 is included) and averaged even higher at 6 per cent in the final decade up to 2000-01. Indeed, if the crisis-affected year of 1991-92 is omitted, GDP growth in the past nine years (1992-93 to 2000-01) averaged an unprecedented 6.3 per cent (Table 1). And between 1992-93 and 1995-96, the growth rate averaged even higher at over 7 per cent a year.

This vindicates the stand of this author since 1971 that economic liberalisation, de-regulation, and market principles were essential for raising the growth rate in the economy that required eschewing the then current command economy ideology copied from the USSR, and which failed there too. In his 1971 book Indian Economic Planning, an Alternative Approach (Vikas, New Delhi), this author had predicted that such a transformation in policy toward market economy would raise the growth rate to 10 per cent a year, but alas had then found little acceptance because of Indian economists: that India was bound by the "Hindu rate of growth" of 3.5 per cent a year.

The past trend in decadal growth rates looks increasingly better, partly because of the declining population growth rate over the years. When we look at per capita GDP growth, we find that it has accelerated from 0.8 per cent in the 1970s to 4.6 per cent in the last nine years. Furthermore, while the growth performance in the 1980s was bedevilled by unsustainable fiscal deficits and increasing drain in external reserves, which led to the balance of payments crisis of 1990-1991, in the last nine years, the external sector has been manageable despite the fiscal imbalances deteriorating.

What is significant is that in an international perspective India's growth performance of the last two decades ranked amongst the top six in the world growth league, along with China, Korea, Thailand, Singapore and Vietnam. Moreover, since the 1997 East Asia meltdown, India's rank is now second only to China in growth rates. In PPP (purchasing power parity) terms, the 1990s growth has also put India among the top four in the world. In fact, on corrected data, the growth rates of China and India in the 1990s have been about equal [see the author's Economic Growth in China and India (1980-99) presented at the Fairbank Centre's New England China Seminar, Harvard University, October 15, 2001], and unless the present dispensation in power makes an even bigger mess than it managed to do since 1998, the Indian growth rate can exceed China's during the first two decades of the 21st century.

Much of this growth has been due to macroeconomic policy changes since 1991, but also due in part to fortuitous international circumstances and to the global environment. While P.V. Narasimha Rao as Prime Minister deserves credit for implementing the first generation reforms, he obviously could not have done so soon after taking office (within 10 days) unless the blueprints were ready. These had been, in fact, prepared under my supervision as Minister by the previous government headed by Chandra Shekhar. I had also held a Cabinet rank position in Narasimha Rao's government as Chairman of a Commission on issues relating to the General Agreement on Tariffs and Trade. Sadly, it is now quite clear, however, that reforms in India have run out of steam (Table 2).

What is more alarming is that since the departure of Narasimha Rao, and since 1996-97, even the relatively high growth rates are not sourced to agricultural and industrial growth but to the services sector.

If we subdivide the nine years following the 1991 crisis into an initial period of five years (corresponding to the Eighth Plan) and the subsequent four years up to 2000-01, the following points are worth nothing: First, the acceleration of GDP growth to -6.7 per cent from the pre-crisis decadal (1980-89) average of 5.6 per cent is remarkable and attributable to reforms. Second, it is noteworthy that in the post-crisis quinquennium, all the major sectors (agriculture, industry, services) grew at a noticeably faster pace than in the pre-crisis decade.

Third, the average growth performance in the four most recent years is, in sharp contrast, disappointing (Table 3). Overall GDP growth drops to 5.8 per cent. Of much more concern is the collapse of agricultural growth to 1.4 per cent and the significant fall in industrial growth to 4.9 per cent. In 2000-01, the rate only dropped to 2.1 per cent. Indeed, the drop in GDP growth in these four years would have been much steeper but for the extraordinary buoyancy of services, which averaged a growth of 8.8 per cent. This growth in services was much faster than in the case of industry, a pattern which raises questions of sustainability. No economy can continue to grow this way for long.

The importance of services in India's economic growth is brought out in Table 4. For the full nine years (1991-92 to 2000-01), the growth-contributing role of services was nearly 60 per cent. This proportion rose to 70 per cent in the last four years.

A part of the services sector growth in the last four years was, furthermore, bogus in the sense that it simply reflected the revaluation of the value-added in the subsector "Public Administration and Defence" because of higher pay scales resulting from decisions based on the Fifth Pay Commission Report. This may be called the "Chidambaram hoax". National income accounting practice requires that value added in non-marketed services be estimated on the basis of "cost" and in current prices. These Pay Commission effects, including in States, were spread mainly over three financial years 1997-98, 1998-99, 1999-2000, when growth of "Public Administration and Defence" soared to 14.5 per cent, 10.3 per cent and 13.2 per cent, respectively, compared with an average growth in the previous five years of less than 4 per cent.

Thus, the nation needs to launch on a second generation of reforms after an in-depth analysis as to where we have gone wrong.

THERE are four major areas of the Indian economy summarised below, which require urgent attention.

Fiscal deficit

There has not been too much progress in cutting the fiscal deficit. Whatever little the Central government has managed up to 1999 has been cancelled out by the deteriorating fiscal position of the State governments. Since 1999, even the Centre has failed to curb fiscal deficit. The combined fiscal deficit is now near 10 per cent of GDP. High fiscal deficit crowds out private investment and banks' capacity to lend, since the government corners the lion's share of the bank's funds. Fiscal measures to encourage domestic saving and foreign direct investment (FDI) are essential now.

Poverty

There is no consensus yet on the key question: have the reforms helped the poor? The data put out by the National Sample Survey Organisation suggests that poverty rates have remained static, but National Council for Applied Economic Research (NCAER) data show that poverty rates have fallen. But since the rent-losers from economic reforms are entrenched and organised, and the gainers are not, the legitimacy of reforms is being eroded every day. This needs to be set right.

Growth distribution

Growth has been unevenly distributed, especially in terms of regions. Some dynamic States like Maharashtra are sprinting ahead, while the likes of Bihar have stagnated. This could put pressure on the federal system, since the bulk of the poor and rapidly growing population lives in the already populous northern States. The North-South divide (as it is seen globally) is reversed in India, and could upset the polity in the future.

Growth impulses

The economy's growth impulses are getting weaker, while domestic industry, with exceptions like TVS, is caving in to foreign companies in hostile take-overs. While the government still talks about pushing GDP growth rate to 8 per cent, the harsh reality is that India seems stuck in the 5-6 per cent range during the last four years. Talk cannot be a substitute for action.

While growth is the ultimate target of macroeconomic policy, low fiscal deficit, high savings, and investment are intermediate targets. Controlled inflation, increasing employment, and decreasing poverty are immediate targets of macroeconomic policy. Macroeconomic policy needs to be designed keeping all three types of targets in mind.

If growth is the key measure of macroeconomic performance, inflation (or rather its absence) is the generally preferred indicator of macroeconomic stability. In the 1980s, India's average inflation rate of 7.2 per cent was close to the average rate for Asian developing countries as a group (7.1 per cent), a little above the average rate for the developed countries (5.6 per cent) and much lower than the average for all developing countries (39 per cent), which was driven high by Latin American inflation (145.4 per cent). In the 1990s the conspicuous difference was that inflation in developed countries dropped to a low 2.6 per cent, or one-third the average rate for India. And in the last three years, inflation in the Latin American countries came down to single-digit figures.

Thus inflation was contained worldwide, and India was a beneficiary. It is therefore not merely because of India's macroeconomic policy that inflation was contained, but because of the global environment of price stability.

In the next wave of reforms, what is going to be crucial is the launching of what India's representative at the International Monetary Fund (IMF), Vijay Kelkar, calls meso-economic reforms, otherwise known as second generation reforms: that is, major infrastructure sector reforms in energy, irrigation works, transportation, telecommunications, universities and other higher institutions of learning and housing construction. In a growing economy, these sectors will require enormous amounts of new investment. That is easier said than done in India, because no country in the world has achieved a sustained growth rate or high rate of investment with such high interest rates as in India (of 6-8 per cent in real terms). Bringing the real interest rates in the neighbourhood of 3-4 per cent is therefore essential. It can trigger a spectacular investment boom throughout the economy.

Such a reduction in the long-term interest rates will also be essential to maintain an exchange rate regime that is supportive of trade liberalisation, that is, avoid the over-valuation of the rupee. Thus, the reduced interest rate and competitive exchange rate can become the "Archimedean" lever to propel the economy on the high growth path.

Currently, by and large all infrastructural sectors are in the public sector and in some cases they are monopolies. If in these sectors we introduce both privatisation of public sector enterprises and the entry of the private sector, the gains to the economy are likely to be quite spectacular. In the Indian economy the benefits of these meso-economic reforms could add 3-4 per cent of GDP per annum, which can accrue with little capital, and provide the springboard for further gains, particularly by inspiring new private investment and productivity growth. In this list of meso-economic reforms, emphasis needs to be laid on reforms in higher education, that is colleges and universities, to dismantle, for example, the severe entry barriers to start a private university in India, to permit collaboration or alliance of Indian educational institutions to be outsourced for academic research and even teachers by cost-strapped academic institutions of the U.S. and other developed countries.

A major implication thus of these meso-economic reforms is a need to create a new institutional and financial architecture for the management of the Indian economy to sustain a full-fledged modern market economy, where stability, predictability and transparency of policies are seen to be of fundamental importance by foreign investors.

The new institutional architecture will also imply the strengthening of independent regulatory agencies such as the Securities and Exchange Board of India (SEBI), the Telecom Regulatory Authority of India (TRAI) and the Central Electricity Regulatory Commission (CERC), and to their independence being treated on a par with the independent judiciary. Such a new institutional architecture will have an independent monetary authority. This will be achieved by giving greater independence to the Reserve Bank of India on the lines of the autonomy enjoyed by the Federal Reserve in the U.S. and the Bank of England. This will inspire confidence amongst both investors and consumers and promote competition in these sectors since it would end the crony capitalism that plagues India and inundates the economy with mega scandals involving insider trading and plain fraud.

In the reforms initiated in 1991, the emphasis was on reforms of product markets by abolishing industrial licensing and import barriers. These reforms, however, left the factor markets such as labour markets, land markets and capital markets, the natural resources market such as water, and institutions mostly untouched.

However, now, among the necessary factor market reforms, two are crucial: reforms, first, of the labour markets, and second, of the financial sector. India's present laws of bankruptcy (exit policy) and corporate control require reforms so that the market for corporate control becomes competitive. The financial sector reforms would involve reforms of the banking sector, equity markets, debt markets and foreign exchange markets. In this, privatisation of state-owned banks is perhaps the most essential, but preceded by strengthening of the regulation and supervision of financial institutions and of capital markets, which are really non-existent at present. The recent developments in the Indian stock market vividly show how the actions of one private bank, one cooperative bank, one major stock exchange management, and a giant mutual fund of 20 million subscribers can have a deleterious impact on national equity markets and particularly on small shareholders, because of a lack of strong supervision.

But the most deleterious effects are from rogue empires, which no government wants to regulate, and whose suffocating tintacks are everywhere choking off competition. Thus the downside risks of globalisation get amplified if the financial sector is weak and more so as the economy liberalises and integrates with the world economy. This is the main lesson of the 1997 Asian crisis and the recent crisis in Turkey, and the 2001 meltdown in Argentina.

THE question that remains is: where can the funds to finance these reforms come from? Three sources seem feasible in the Indian context: a rise in domestic savings prodded by attractive tax policies; a sharp increase in FDI by means of appealing reforms in regulations and labour laws; tapping the liquidity in the banking sector.

The first phase of reforms, which started in 1991, essentially concentrated on reforms at the Central government level. Now these have to be taken to the level of the States and district local bodies. Almost 40 per cent of our revenue and fiscal deficit are because of poor State finances. A number of reforms are required to improve the delivery system, too, since all social services such as education, health, and so on are delivered at the State level. The State-level reforms are of particular importance to promote regional equity, which is a matter of fundamental significance for a federal polity like India.

P.V. Narasimha Rao, who was Prime Minister from 1991 to 1996, deserves credit for implementing the first generation reforms, but the blueprints were ready already.-K. RAMESH BABU

These reforms should be designed also to have India playing its rightful role in the world so as to provide growth and stability to the global economy, an aspiration China is meticulously working to fulfil. In the age of globalisation, this means not just achieving a high growth rate of the gross national product, but more on what India can contribute to the global pool of knowledge and technological progress. While India's potential in this area stands demonstrated, the nation with the world's third largest scientific manpower has a long way to go to become a world player in information technology (IT).

For instance, if patents are taken as one of the quantitative indicators of innovation or growth of knowledge, in the year 1999, the most recent year for which data are available, the number of patents India obtained in U.S. was only 114 compared with Taiwan or South Korea, which got as many as 4,000. For the developed countries such as the U.S., Germany or Japan, the numbers are much higher. Even in the case of domestic patents, there were 1,660 in India, 12,000 or so in China and 3,00,000 in Japan.

As we have seen in earlier sections here, in the growth of "total factor productivity", an index of technological progress, India's performance has been lower than in countries such as China, Japan, Korea or the U.S. Even the research and development (R&D) expenditure that India devotes as a percentage of GDP is far lower than that of Japan, Korea and other developed countries. When it comes to education, whether in terms of literacy or the amount of support to the universities, India's performance, vis-a-vis other high-performing developing countries such as China and Korea, is woefully inadequate. In other words, this "knowledge or innovation deficit" is a big problem, which India will have to overcome in order to compete successfully in the emerging knowledge-based world economy and become a source of technological progress for the world. Once again, media-projected bald prognostications of a Prime Minister or Finance Minister cannot be a substitute for urgent action on a well-designed strategy.

Daily-wage labourers outside Hi-Tech City in Hyderabad. There is no consensus yet on the key question: have reforms helped the poor?-A. ROY CHOWDHURY

As India faces the new century, the Indian economy stands at a crossroads. Either it can take the "business as usual" road, which also means continued poverty and a low growth trap, or take the high road to achieve prosperity, global prominence and a more egalitarian society through accelerated reforms and by energising the national innovation system. This means that government's national orientation has to shift from religious fundamentalism, re-writing history and terrorising minorities to achieving economic goals, and concomitantly the voter has to rise, or be encouraged by the intellingentsia to rise, above caste, religion and inducements to vote for performance. The task is achievable, but not by wishful thinking and armchair pontification of intellectuals.

Experience and economic theory tell us that the impact of such micro-meso-macro economic reforms can be multiplicative, exploiting their synergy. Hence, I am quite confident that with these reforms the Indian economy can grow at the rate of 10 per cent per annum over the next two decades or so. This would make India's economy by the year 2020 the world's third largest, after the U.S. and China, perhaps even bracketed second, overtaking all the major European economies such as Germany, France and the U.K.

Dr. Subramanian Swamy, a former Union Minister for Commerce, is currently a member of the faculty in the Department of Economics, Harvard University (2000-02).

This article is closed for comments.
Please Email the Editor