Report No.8360-IN India Trends, Issues and Options (In Two Vo,umes) Volume l: Executive Summary and Main Report May1, 1990 Country Operations Division India Country Department AsiaRegion FOROFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the perforrnance of their officialduties. Its contents maynototherwise bedisclosed withoutWorldBank authorization. Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
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Report No. 8360-IN
IndiaTrends, Issues and Options(In Two Vo,umes) Volume l: Executive Summary and Main ReportMay 1, 1990
Country Operations DivisionIndia Country DepartmentAsia Region
FOR OFFICIAL USE ONLY
Document of the World Bank
This document has a restricted distribution and may be used by recipientsonly in the perforrnance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.
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CURRENCY AND OTHER EQUIVALENTS
Currency
Prior to June 6, 1966: US$1.00 - 4.7619Rs 1.00 - US$0.21
From Juae 6. 1966 to mid-December 1971: US$1.00 - Rs 7.50Rs 1.00 = US$0.13333
Mid-December 1971 to end-June 1972: US$1.00 - Rs 7.27927Rs 1.00 - US$0.1374
After end-June 1971: Floating rate
Rate end-March 1990: US$1 00 = Rs 17.227Rs 1.00 = 0.05805
Rupee values have been converted into dollars by using the prevailing exchangerates indicated above up to 1970/71. For subsequent years the followingaverage rates in rupees per US dollar have been used:
1971/72 : 7.4441972173 : 7.7061973/74 : 7.7911974175 : 7.9761975/76 : 8.6531976/77 : 8.9391977/78 : 8.5631978/79 : 8.2061979/80 : 8.0761980/81 : 7.8931981182 : 8.9291982183 : 9.6281983/84 : 10.3121984/85 : 11.8871985/86 : 12.2371986/87 : 12.7871987/88 : 12.9681988/89 : 14.477
Source: IMF, International Financial Statistics (IFS), line wrf.
In this report an estimate of 16.633 Rupees per US Dollar was used for1989/90.
Weights
Unless otherwise specified all weight measures are metric.
Years
The Indian fiscal year runs from April 1 through March 31.
TITLE : INDIAt TRENDS, ISSUES AND OPTIONS
VOLUME I: EXECUTIVE SUMMARY AND MAIN REPORT
COUNTRY: I INDIA
REGION X ASIA
SECTOR COUNTRY ECONOMIC
REPORT TYPE CLASSIFICATION MM/YY LANGUAGE8360-IN CEM Restricted 05/90 English
ASBSTRACT s Despite significant improvements in economic policy andconsequent improvements in economic growth and productivityduring the 1980s, the newly elected government that assumedoffice in November, 1989, facrs several difficult economicproblems. The most urgent of these is growing macroeconomicimbalance. Propelled by rapidly growing goveranentconsumption, domestic absorption became excessive during thelate 1980s, spilling over into the balance of payments andputting pressure on domestic prices. Current accountdeficits reached 3.3Z of GDP in 1988/89 and 1989/90, andwholesale price inflation touched 8.5Z in the latter yeardespite a second successive bumper foodgrain crop. Withreserves critically low and uncomfortably high borrowing inthe last few years, the report argues that the Governmentwill have to move promptly to reduce fiscal pressure on theeconomy by restraining Government consumption and otherexpenditures. Over the medium term, these efforts need tobe complemented by steps to improve the economic andfinancial performance of India's public sector enterprises,and by rationalizing its tax structure. The Government alsofaces difficult but crucial structural issues in the majorproductive sectors of the economy. To continue thedevelopment of a modern, efficient nud rapidly growingindustrial sector, steps need to be taken to eliminatequantitative restriction on imports, rationalize thestructure of taxation, strengthen the financial system, andfurther relax regulations that circumscribe the flexibilityof firms and individuals to respond to economic incentives.To maintain or perhaps accelerate growth in agriculture,steps will need to be taken to mprove surface irrigationsystem performance, ensure adequate investment (includinginvestment in new technology), and ensure adequateincentives to farmers. India's prospects for growth aregood, provided that the Government acts decisively tostabilize the economy and proceeds at a reasonable pace withprograms to strengthen agricultural development. Thebalance of payments will continue under pressure and will bevery sensitive to disturbances. India's macroeconomicmanagement will thus have to be exceedingly careful duringthe next few years.
This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.
Acknowledgements
This report was written at headquarters by Robert J. Anderson, based oncontributions by Sarthi Acharya (consultant), Ataman Aksoy, Deepak Ahluwalia(consultant), Sajitha Bashir, William Byrd, Hans Genberg (consultant), James A.Hanson, Nizar Jetha, Samuel Lieberman, Samuel Otoo, Peter Pollak, V.J Ravishankar,Roger Slade, Nancy Stavrou, Helena Tang, and Mark Tomlinson. Numerous helpfulcomments and suggestions from David Greene, Enzo Grilli, and Yukon Huang are alsogratefully acknowledged.
Statistical and computational assistance was provided by Sajitha Bashir,Beatrice Laury, and Manisha Singh.
INDIATrends, Issues and Options
Table of Contents
VOLUME I: Executive Summary and Main Report
Page No.
Abbreviations
Executive Sunnary .................................................... i
Recent Trends ...................................................... iIssues and Options ................................................. iProspects and Financing Requirements ....................... ........ iv
Chapter 1: Recent Developments and Trends in theIndian Economy ..................................* .*..... 1
A. Introduction ... 1
B. Economic Developments During 1989/9O .. 2
C. Policy Developments in Late 1989/90 . . . 6(a) The 1990191 Central Government Budget ....................... 6(b) Three-Year Import/Export Policy, 1990/91-1992193 . . 8
D. Recent Developidents in Perspective .............................. 9(a) Output Growth .............................................. . 10(b) Input Growth and Productivity .............................. . 13(c) Domestic Absorption ..................................... ..... . 18(d) Saving and Investment ..... ...... 20(e) Public Sector Finances ... .... .... 22(f) Money and Prices ...................................... .... .. 25(g) Balance of Payments ....... .. ........................ 26(h) Poverty and Social Services ................................. 32
Chapter 2: Issues and Options .......... ..... ............... ....... $*. 37
A. Restoring and Maintaining Sustainable Macroeconomic Balance ..... 37(a) Near-Temn Options.. . ... . . ...... .. . 39(b) Medium-Term Options . .... ............ .... . 42
B. Increasing Productivity and Growth in Industry ............... O.. 47(a) Background on Policies Affecting Industrial Development ..... 47Cb) Effects of Recent Policy Changes on the Incentive Framework. 51(c) Medium-Term Policy Issues ................................... 55
C. Increasing Agricultural Growth and Productivity ............... .. 57
.
Chapter 3: Macroeconomic Prospects and External FinancingRequirements .................................. 71
A. Balance of Payments Adjustment and Financing in 1990 /91 ......... 71
B. Medium-Term Prospects. ... *..so ....... .......................... 72
C. Financing Requirements.o ........ ... 77
Annex I: Sustainability of Recent Budget Deficits .................. 79
Annex II: Deficits and Long-Run Tradeoffs Between Growth,Inflation, and Indebtedness ...........................-. 89
Bibliography .......... ......................................... 95
L'r.t if Tables
Tables Page No.
1.1: Recent Balance of Payments Developments . . 31.2: Industrial Production Growth Rates . . 41.3: Agricultural Production .. 61.4: GDP Growth Rates .. 101.5: Real GDP Growth Rates by Sector . .111.6: Organized Sector Employment Growth. 141.7: Real Gross Domestic Investment Growty Rates, by Sector 161.8: Capital-Output Ratios by Sector . .171.9: Real Domestic Absorption Shares . .191.10: Saving-Investment Balances .. .21
1.11: Expenditure Ratios to GDP, by Function . .231.12: Expenditure Ratios to GDP, by Economic Classification 241.13: Consolidated Government Deficit . .251.14: Mouetary and Price Developments . . 261.15: Balance of Payments ... 271.16: Imports: Comparieon of Customs Data to Payments Data 291.17: Financing the Current Account Deficit, 1984/85 - 1989/90. 32
2.1: Comparison of Nominal Tariff Rates .532.2: Tariff Collection Rates on Capital Goods and
Intermediaries .542.3: All-India Trend Growth Rates of Production .582.4: Wheat and Rice Yields on Irrigated and Unirrigated Lands. 602.5: Progress of HYVs in Rice and Wheat, by Region 63 62.6: Fertilizer Consumption by Region.. 642.7: Gross Capital Formation, Total (All Sectors) and in
Agriculture, in 1980/81 Prices .66
3.1: Balance of Payments, 1989190 - 1994195................... 733.2: Financing the Current Account Deficit . .743.3: Medium-Term Projections. 76
ABBREVIATIONS
CIL Coal India LimitedDGCI&S Directorate General of Commercial Intelligence and StatisticsEFF Extended Fund FacilityFCI Food Corporation of IndiaFERA Foreign Exchange Restriction ActGDI Gross Domestic InvestmentGDP Gross Domestic ProductGNS Gross National SavingsGOI Government of IndiaHYV High Yielding VarietyIRDP Integrated Rural Development ProgramMLT Medium- and Long-TermMOC Ministry of CommerceMOU Memorandum of UnderstandingMODVAT Modified Value Added TaxMRTP Monopoly and Restrictive Trade Practices (Act)NEI Not Elsewhere IncludedNHPC National Hydroelectric Power CorporationNPTC National Power Transmission CorporationNREP National Rural Employment ProgramNTPC National Thermal Power CorporationNRI Non-Resident IndianOGL Open General LicenseOIL Oil India LimitedO&M Operation and MaintenanceONGC Oil and Natural Gas CommissionPAP Plant Availability FactorPLF Plant Load FactorPMP Phased Manufacturing ProgramsPOL Petroleum, Oil, and LubricantQR Quantitative RestrictionRBI Reserve Bank of IndiaREP Replenishment (License)RLEGP Rural Landless Employment Guarantee ProgramSEB State Electricity BoardSSI Small-Scale IndustryST Short-TermUT Union Trust (Territory)UTI Unit Trust of India
ECONOMIC DEVELOPMENT DATA
GNP PER CAPITA IN 1987 USS30L.e/
GROSS DOMESTIC PRODUCT IN 1988/89 b/ ANNUAL RTE OF GROWTH! M I Constant Prices)61/62- 65/66- 70/71- 75/76- 80/81- 85/86 -64/65 69;70 74/75 79/80 84/85 88/89
US$ Bln.
GDP at Market Prices 270.21 100.0 3.2 3.9 2.9 4.0 5.4 5.7Gross Domestic Investment 65.89 24.4 6.2 2.6 5.2 5.5 4.3 3.3Gross National Saving 56.97 21.1 8.0 4.6 5.3 5.1 4.u 6.0Current Account Balance 8.92 3.3 - - - -
OUTPUT. LABOR FORCE AND PRODUCTIVITY IN 1981
Value added (at factor cost) Labor For46 c/ V.A Per WorkerUSS Bln. X M!il. X US S of Nat,
Average
Agriculture 58.9 38.0 172.7 70.6 341 53.9Industry 40.1 25.9 31.6 12.9 1268 200.3Services 55.9 36.1 40.3 16.5 1387 219.1Total/Average 154.9 100.0 244.6 100.0 633 100.0
GOVERNMENT FINANCE
General Government d/ Central GovernmentAs. Bln. X of GDP Rs. Bln. I of GDP1988/89 1988/89 1984/85-1988/89 1988/89 1988/89 1984/85-
1988/89
Current Receipts 769.62 19.7 19.6 433.29 11.1 10.9Currant Expenditures 900.77 23.0 22.1 543.59 13.9 13.2Current Surplus/Deficit -131.15 -3.3 -2.6 -110.30 -2.8 -2.4Capital Expenditures e/ 262.42 6.7 7.4 221.42 5.7 6.1External Assistance (net)f/ 36.00 0.9 0.7
MONEY. CREDIT AND PRICES 70/71 75/76 80/81 83/84 84/85 85/86 86/87 87/88 88/89 &9/90(Rs. Billion outstanding at end of period)
Money and Quasi Money 8/ 109.8 224.8 557.7 860.9 1023.6 1186.8 1407.1 1631.4 1988.4 2374.6Bank Credit to Government (net) g/ 54.6 106.3 257.2 406.4 503.4 583.2 720.2 843.7 973.7 1172.1Bank Credit to Commercial Sector g/ 64.6 156.2 366.4 607.3 709.5 828.0 947.4 1074.9 1326.6 1551.6
(Percentage or Index Numbers)
Money and Quasi Money as Z of GDP 27.3 30.3 ..1.1 41.6 44.4 45.2 48.0 49.1 50.8 53.8Wholesale Price Index (1981/82=100) - - - 112.9 120.1 125.4 132.7 143.6 154.3 166.6
Annual Percentage changes in:Wholesale Price Data - - - 7.6 6.4 4.4 5.8 8.2 7.5 8.0Bank Credit to Government (net) g/ 15.0 22.7 28.5 15.3 23.9 15.9 23.5 17.1 15.4 20.4Bank Credit to Commercial Sector g/ 19.4 22.7 18.2 18.7 16.8 16.7 14.4 13.4 23.4 17.0------------------------------------------------------------------- __--------__----------------------------------------------
a/ The per capita GNP estimate is at market prices, using World Bank Atlas methodelogy. Other conversions to dollarsin this table are at the prevailing average exchange rate for the period covered.
b/ Quick Estimates, Central Statistical Organization.c/ Total Labor Force and percentage breakdown from 1981 Census. Excludes data for Assam.d/ Transfers between Centre and States have been netted out.e/ All loans and advances to third parties have been netted out.f/ World Bank estimates of net disbursement of official loans (including IMF Trust Fund).8/ Figures for 89/90 are preliminary estimates based on provisional data for March 23, 1989 and March 24, 1990.
BALANCE OF PAYMENTS 1986/87 1987/88 1988/89 1989/90a/
(USS miltion) MERCHANDISE EXPORTS (AVERAGE 1985/86-1988/89 b/)
Exports of Goods b/ 10460 12644 14208 17050 USS min XImports of Goods b/ 17728 19812 23849 25332 ======= ==Trade 6alance -7268 -7168 -9641 -8282 Tea 458 4.9XNon Factor Services (net) 995 544 732 625 Iron Ore 446 4.01
Chemicals 634 4.5XResource Balance -6273 -6624 -8909 -7658 Leather and Leather products 811 6.61
Textiles 1241 11.21Garments 1179 9.7X
Interest income (net) c/ -2045 -2471 -2985 -3622 Gems and Jewellery 1961 14.01Net Transfers d/ 2327 2698 2979 2720 Engineering Goods 1092 8.41
others 3872 36.61Balance on Current Account -5991 -6397 -8915 -8560
Total 11693 100.01==a==
Direct Investment 208 181 287 425Official Loans & Grants (net) 1764 2932 3035 2589Gross Disbursements 2604 4036 4006 3674Amortization 840 1104 971 1085
EXTERNAL DEBT, MARCH 31, 1989 USS MillionPrivate Borrowing (net) 2067 1140 1641 3291 3.==… …= …
Non-Resident Deposits 1812 1970 2608 2298Net Transactions with IMF -648 -932 -1068 -870 Outstanding and Disbursed 57513ALl other Items e/ 962 1498 1392 297 Undisbursed 20646Errors and Omisssions -102 -731 -412 -280 Outstanding including Undisbursed 78159
Increase in Reserves -72 339 1432 810Gross Reserves (end of year) f/ 6730 6391 4959 4149 DBBT SERVICE RATiO FOR 1988/89 a/ h/ 29.31Net Reserves (end of year) g/ 2439 2737 2594 2555 =…
Fuel and Related Materials IBRD/IDA LENDING, MARCH 31, 1989 USS Million
Imports (Petroleuma) b/ 2187 3148 2938 3686 IBRD IDAof which: Crude 1672 2395 1910 2572 =- 3
Products 515 753 1028 1114 Outstanding and Disbursed 5403 12019Undisbursed 7217 3822Outstanding including Undisbursed 12620 15841
RATE OF ExCHANGE
June 1966 to mid-December 1971 US$1.00 = Rs. 7.50Re 1.00 = USSO.13333
Mid-December 1971 to end-June 1972 US$1.00 = Rs. 7.2797Re 1.00 = USS0.137376
After end-June 1972 rloating Rate
Spot rate end-March 1990 US$1.00 = Rs. 17.194Re 1.00 = USSO.05816
ai Estimatedb/ Net of crude petrolemn oil exportsc/ Figures given cover all investment income (net). Major payments are interest on foreign loans and charges
paid to IMF, and major receipts is interest earned on foreign assets.d/ Figures given include workers, remittances but exclude official grant assistance which is included within
official loans and grants, and non-resident deposits which are shown separately.e/ Includes exchange rate adjustments to the valauation of reserves and financing of imbalances in rupz: trade.ft Excluding gold.g/ Exclude net use of IMF credit.h/ Amortization and interest payments on foreign loans as a percentage of total current receipts.
Social ndicators ofDevelopmera, 1989
India
most Sa rmore I incomte gtoup Next25 30 JS 20 Mecent hi8her
Unit of years ytrs suziua Low- L'comeiNSUWW ago a8g (Owe) Auia income group
HIMAN RESOURCESSke, growtb, drctre o populdwTotal population (mme - 1988) milunili 487 613 814 2.1 2 881 629
14 siSunder % of pop. 40.4 39.8 37 33.21 5.4 38.315.64 56.1 564 58.7 62.1 62.2 57.4Age dependency rato unait 0.78 0.77 0.70 0.61 0.66 0.74Pee,ge inuuban amas % of pop. 1878 21.5 268 36.68 34.2 56.1
Femalet per lOOnmales 8UFban number 86 89Rural 9 96
Pulaioa gowth nrc al 2.3 2.3 2.0 1.8 2.0 2 .2Urba 3.2 3.9 4.4 3.2 3.7 3.5
Urbantnuel growith differentisl differnce 1.0 2.0 3.2 1.9 2.2 2.5Projected populain: 2000 milliata .. .. 1,010 3.055 3.625 805Staionay popliatin .. .. 1.766Determinants of popultado growthFertility
Crudebi lnrata perthou.pop. 44.8 37.5 31.6 26.8 30.4 31.5Totl fertility rat births per woman 6.23 5.35 4.26 3.34 3.89 4.08Contracqptive prvalenc % of women 15-49 .. 19.0 48.0 57.8 57.4
ChOild (0-4)/woman (15.49) mos.Urban per l0OOWomenna 58 48Rural .. 67 61
MonalityCrZdedauh ate perthou.pop. 20.3 15.1 11.0 8.8 10.0 8.6Infatcmonalyate per thulivebahs 149.8 129.6 99.0 61.5 72.6 59.1Undrmrthyrae. 28.0 101.7 174.8 96.5
overou YI'An ~~~45.2 504 57.9 63.7 61.4 63.8Uife expeccy tya binbh:ovefalil 44.4 49.8 57.9 64.6 62.3 66.1
Labor force (Ve4)Totallaborfor . milLoas 207 243 311 1,212 1,343 232
Agnculure oflaborfoece 72.9 70.7 ..Industuy 11.9 12.9
Fanle 3Q7 28.5 25.6 36.6 36.0 31.2Fanales per 100 males
Urban number .. 81 88 Rural .96 94
Paricipationrnue:overall % Oflaborfo=c 41.8 39.2 38.9 SAS 49.2 39.0fealne 265i 23.2 20.6 36.6 34.9 23.5
Educatnal attalment oflabor forceSchool yecars mpleted: overall yeaMM 0.5 19 1.9
mallue .........NATURAL RESOURCESArea tbou. sq. Im 3 ,288 3 ,288 3,288 18.343 36.997 17,083
Dendrv =p Q. km 148 187 243 135 76 36Agrcuaiaunland S% land area53.9 55.0 55.1 38.5 36.1 38.3Agnculallddensity pok,pr s. n 275 339 441 350 211 94Fovsts and woodlind 6ou.sQ.bn 612 656 673 4,8u3 9.154 5,449Defoearinon te (net) enal % 03 -0.2 0.0 -0.2 -0.3 -0.7Aceintoafewatar % op... 31.0 57.0
Urban .. 80.0 76.0 72.5 73.4 76.7Rura I . O. 50.0... 46.3
Population growth Infant mortalit Primary school enrollment6 ISO 120#
5 2QO 100
4 sI50
3 6D
2 40
1 so ,_
0 a0 0ewlyft mf7b - WtIEh ewu7b cm onty" Cly7b5 m
S " - Lo_-m
Sodal Indicators ofDewlopment. 1989
India FM
S~m regime t u.eme gre Nutmost Neu25.30 15.20 recant hiher
flilOJ yS yw* ettwt Low- iaoIwaswa ita ago (aVe) Aao income ar'.
INCOME AND POVERTYIncameGNP per capita (mrm = 1988) uss 100 160 330 410 310 1,270Total household incame
Share to op lOb of 'ouseholds % of tcne 35 34 ..Share o top 20% of househods 48 49 ..Shan to b tam 40% of households 17 16 ..Share to bottm 20% of households 7 6 .
PovetAbsute poveny coeme: wn USS pern .. .. ......
Pop. in absolute povexty: urban l ofpep. .. .. ..
Prvalence of malnutrin (under 5) % of age groap .. .. 49.3
EXPENDITUREFood * of GDP .. 43.6 35.3
Staples .. 20.6 12.4Meat, fish, nmlk cheuse, eggs .. 6.5 7A ....Mea almepons thou. metric uwm 7.878 7,669 46 33,549 27,738 36,712
Foodiddmccls .. 1108 223 3461 7 122 7.8SIFoodproducionpcar 1979-81=100 89.2 10.6 103.7 118.7 116.4 97.0Shre of agin uren mDP 1, of GDP 465 42.0 30.5 27.S 33.0 1660Daily caloie supply caloiese persn 2.111 1,940 2,238 2,452 2,392 2.767Dailypoteanw y runs per pero 53 48 55 58 S7 70Houdng % of GDP .. 44 7.1Averge household size pesons per houebld .. S ...
Urban .. 5 ..Fixed invessnu housing %*fGDP .. 2.3 2.8Fud and power of GDP .. 2.4 2.3E =a pii a kg of lenequivl 100.1 130.5 208.1 386.8 323.7 886.3
Ueoan %of housholds .. .. ..Rural
Transport and communlcetbon Of GDP .. 4.7 5.1Population per passeger car ps 1.138 807 S43 .. .. 27Fixed investment transpots e m %af GDP .. 1.4 2.4Total oed length thou. in .. 1,215 1,50Poupaion per- L & pernons .. 352 189 .. .. 16
INVESTMNT IN HUMAN CAPrrALMedical cae % of GDP .. 23 2.0Papulatriper. physician per 4,880 4.900 2S521 1422 1.462 1,S47
nure 6,500 3.709 1.700 1,674 1,746hospizalbed .. 1,70 1.300 733 756
Access tohealth care % of op. .. .. 75.0Immunized (under 12 mnths): measles lofb ae group .. .. 17.0 41.6 43.4 62.6
DPT .. .. 5.0 48.6 41.3 64.7Orl Rehydraion herapy us (nderS) bofcas .. .. 22.5 27.9 21.6 28.2EducaUon % of GDP .. 2.6 2.8Gross enrolment utics
Pdmney:atolel l ofschool-agegBMp 74.0 79.0 92.0 105.3 99.3 106.8feale *57.0 62.0 760 94.4 87.8 1013
Secondary: total , 27.0 26.0 3S.0 37.5 33.4 52.0female 13.0 16.0 24.0 30.S 26.1 51.8
Tertiary: sciencelmgineering lb of teriy studenu .. 28.S ..Papil-zeacheernsao: primak pupIs per teader 42 42 58 10 10 28
seconaqy 21 20 21 19 19 18Puptea ching grade 4 * of cchbo .. 51.3 S6.0 .. .. 81.0Repeater raze: pnmay * of ot enrollment 19.9 17.4 8.0m11eacyrate:overall %Ofp (a2e15+) 7.2 65.9 56.5 39.5 43.3 26.2
female %bOffeae(glS) . 71.1 S2. 56.5 32.5Newspapercirunalaziai per tho. pop. 13.0 15.3 19.8 266 204 79.3
5= WOW Bu* 1hmIBa-ua B e Ds) = p 15a, ' S.
Explanation of Terms
Despite considerable effort to standardize the data, staistical vaiables perining to births and deaths, which are likely tomethods, covage, acces, and definiions differ widely. In differ bet men urban and rdu areas.addition, the staistical systems in many developing econo- Projected population: 2000 - Information on total popula-mies ar still weak, and this affects the availability and reli- tion by age and sex, fertility rates, mortality rMes, and inter-ability of data. Morver, intercouniby and inemtporal national migration in the base year 1985, project accordingcomparsons always involve complex technical problems, to country-specific trends, moderated by overall regional orwhich cannot be fuly and unequivocaly esolved. The data global circumstances. The projections are based on a Bankate dawn from sources thought to be most authoritative, but modeLmany of them are subject to conuderable margins of erro. Stationary populaton - Projected population level whenReaders are uwged to take these limitations into account in zero population growth is achieved i.e., when the birth rate isinterting the indicators, paricularl when making compar- constant and equal to the death rame and the age structure isisons across countries and economies. stable.
Crude birth rate -The number of births per 1,000 populationHuman Resources in a given year. The data are a combination of observed values
based on a census or survey and interpolated and extWapolaedPopuluadn (UN and World Bank) estimates based on projection models.TotaI Dpopution -World Bank estimates for 1988, based, in Totalferility rate - Average number of children hat wouldmost cases, on a de facto definitio Note that refugees not be born alive to a woman dring her lifetime, if she were topermanently sealed in the country of asylum are generally bear children at each age in accordance with prevailng age-considered to be part of the popuation of their country of specOic fertility rates. As in crude birth rate, the data are a
Igin. cxnbina;aon of observed values and interpolated and prc-Age dependency ratio - Ratio of population defined as de- jec,ed estimates.pendent (under 15 and over 64 years) to the working-age Contraceptiveprevalence- Percentage of mared women ofpopulation (15-64). childbearing age who are using, or whose husbands are using,Females per 100 males - Raio of females to males fos the any form of contraception (i.e. modern or traditional method).toal population. Under normal demographic and economic Childbeaing age is gnerally defined as 15 to 49, although forcircumstances, a female to male ratio significantly below 100 some countries contraceptive usage is measured for other agein the geneml population reflects the effects of discrimination grows.against women especially with regard to nutrition and access Child/woman ratio -The number of children mider 5 yearsto health care, as well as the cumulative effects of excessive of age per 100 women age 15.49. As a gender atio, this is anchildbearing. important measure of the reproductive/child care burden thatPopulation growth rate - Amual growth rate (1964-65, women have to shoulder, and its implications for income ,en-1974-75, and 1987-88) calculaed from mid-year total and erting opporunities.wban populations. Crude death rate -The number of deaths per 1,000 popula-UrbaWlruralgrowthdffwrendal-Thetempoof urbanizaton, tion in a given year. As in crude birth rate, the data are acacuated as the net difference between the uban and rural combination of observed values and interpolated and pro-growth razes. Note that it is not a net urban-rnu migration jected estimates.measure beawse it also incopotes the basic demographic I'fantmortalityrate-Numberof deathsof infants underone
year of age per 1,000 live birhs in a given year. As in crude
birth rate, the data are a combination of observed values and from springs, sanitary wells, and protected boreholes). In aninterpolated and projected estmates. One or two counties, urban area this may be a public fountain or standpost locatedsuch as the USSR, employ an btypicl definition of live births, not more than 200 meters away. In rural areas it implies thatwhich reduces the reported infant monality rates relative to the members of the household do not have to spend a dispropor-standard (World Health Organization) definition. tionate part of the day fetching water. The definition of safeUnder S mortality rate -Number of deaths of children und x has changed over time.5 years of age per 1,000 live birts in a given year.Life expectancy at birth - Number of yeas a newborn infant Income and Povertywould live if prxevailing patterns of mortality at the time of itsbirth were to stay the same throughoutits life. As in crude birth Income (World Bank)rate, the data are a combination of observed values and inter- GNP per capita - Esimates are for 1988 at current marketpolated and projected estimates. prices in U.S. dollars, calculated by the conversion method
used for the World Bank Atlas. Because they are not rounded,Labor Force (ILO) these figures differ marginally from those in other Bank pub-Total laborforce -The "zconomically active" population; a lications.restrictive concept that includes the armed forces and the Total household income - Income (both in cash and kind)unemployed, but exclude homemakers and other unpaid car- accruing to percentile groups of households ranked by totalegivers. household income. In somecases statistics obtained from otherAgriculture - Labor force in farming, forestry, hunting and agencies are revised by Bank staff.fishing as a perces. age of total labor force.Industry - Labor force in mining, manufacturing, construc- Poverty (World Bank, UN)tion, and electricity, water, and gas as a percentage of total Absolute poverty income - The estimated level below whichlabor force. a minimal nutritionally adequate diet plus essential nonfoodFemale - Female labor force as a percentage of total labor requirements are not affordable. These estimates are based onforce. Labor force numbers in seeral developing countries special surveys that, in most cases, are now over ten years old.reflect a significant underestimate of female participatior Population in absolute poverty - Percentage of urban andrates. rural populations who live in "absolute poverty," mostly basedParticipation rate - Percentage of population of all ages in on the surveys mentioned above.the labor force, based on DLO data, on the age-sex structure of Prevalence of malnutrition (under 5) - Percentage of chil-the population. dren under 5 years with deficiency or excess of nutrients thatFemales per I 00 males (15-64) - Ratio of females to males produce disorders within cells, issues, or the whole body,for the working age population. The significant differences which are sufficientto interfere with aperson's health, geneticbetween the urban and rural gcnder ratios reflects mugration potential for growth, normal psychological functions and abil-patterns. ity to interact with other individuals and with their physicalEducational attainment of the laborforce - Mean years of and social environmenL Methods of assessment vary, but theschooling embodied in the labor force. most commonly used are less than 80 percent of the standard
weight for age, less than minus two standard deviations fromNatural Resources (FAO) the 50th percentile of the weight for age reference population,
or the Gomez scale of malnutrition. Note that for a fewArea - Total surface area in square kilometers, comprising countries the figures are for children 4 or 3 years and younger.land area and all inland waters.Density - Population per square kilometer of total surface ExpenditureareaAgricultural land-Estimate of area used for crops, pastures, Food (UN, FAO, World Bank)market and kitchen gardens, or lying fallow, as a percentage Food as percentage of GDP - Percentage share of food inof total land area (excluding area under inland water and total household consumption expenditure, computed from therivers). SNA defined details of GDP, collected for ICP Phase IIIAgricultural density - Populaton per square kilometer of (1975),PhaseIV (1980) and Phase V(1985). Forcountries notagricultural land. covered by ICP, less detailed national accounts estimates areForests and woodland- Land under natural or planted stands included, where available.of trees, whether productive or not, including land fmm which Staples-Bread, cereals, potatoes and tubers: a major subitemforests have been cleared but that *rill be reforested in the of food relating to the consumption of carbohydrates.foreseeable future. Meat, fish. nik, cheese, eggs - Approximating a proteinDeforestation rate (net) - Annual rate of change of forests measure but excluding beans, nuts, and other high protein-and woodland area. A positive sign indicates an increase in the content food products.forested area. Cereal imports - Measured in grain equivalents and definedAccess to safe water- Percentage of population with reason- as comprising all cereals in the Standard International Tradeable access to safe water supply (includes teated surface Classification, revision 2, groups 041-046. Cereal imports arewaters or untreated but uncontamned water such as that based on calendar-year data.
Food aid in cereals- Covers wheat and flour, bulgur, coarse Energy consumption per capita - Annual consumption ofgrains, andthe cereal componerntof blended foods and istbased commercial primary energy (coal, lignite, petroleum, naturalon data for crop years reported by donor counties and inter- gas, and hydro, nuclear, and geothermal electricity) in kilo-national organizations, including the International Wheat grams of oil equivalent per capita.Council and the World Food Programme. Food aid infoma- Households with electricity - Conventional dwellings withtion by donors nay not correspond to actual receipts by electricity in living quarters, as a percentage of all dwellings.beneficiaries during a given period because of delays in tazns-pomtion or recording, or because it is sometimes not reported Transport and Communicadonto the FAO or other relevant international organizations. Transport and communication (as percentage of GDP)-Food production per capita - Shows the average annual Percentage is computed as in Food. Includes the purchase ofquantity of food produced per capita in 1985-87 in relation to motor cars.that produced in 1979-81. Food is defined as comprising nuts, Population per passenger car - Total population divided bypulses, fruit, cereals, vegetables, sugacane, sugar beets, the number of private motor cars seating nine people or less.starchy rwots, edible oils, livestock, and livestock products. Fixed investment: transport equipmen - Computed as inQuantites of food produced are measured net of animal feed, food. Includes all outlay, public and pnvate, on transportseeds for agriculture, and food lost in processing. (The data equipment, plus net changes in level of inventory.are weighted by value and not calorie content which gives rise Total road length - Includes main paved and unpaved roadsto a different perspective depending on the relative share of as well as unclassified lower standard roads.low- value high-calorie carbohydrates versus high-value Population per telephone -The figures relate to the numberlower- calorie livestock products.) of public and private telephones installed which can be con-Share of agriculture in GDP - Agriculture covers forestry, nected to a central exchange. The data are generally thosehunting, and fishing, as well as agriculture. In developing published by the International Telecommunication Union, ascountries with high level of subsistence farning, much of of December 31 of the year stated.agricultural production is either not exchanged, or not ex-changed for money. This increases the difficulty of measuring Investment in Human Capitalthe contribution of agriculture to GDP and reduces the reli-ability and comparability of such numbers. Medical Care (WHO)Daily calorie supply - Computed from energy equivalent of Medical care (as percentage of GDP) - Percentage is com-net food supplies in a country, per capita, per day. Available puted as infood, covers goverment as well as private spend-supplies comprise domestic production, imports less exports, ing on medical care.and changes in stock. Net supplies exclude animal feed, seeds Population per physician - The figure for physicians in-for use in agriculture and food lost in processing. cludes, in additicn to the total number of registered practition-Daily protein supply - Protein content of per capita net ers in the country, medical assistants whose medical trainingsupply of food. Net supply of food is defined above. Require- is less than that of qualified physicians, but who neverthelessments for all countries, established by the United States De- dispense similar medical services, including simple opera-partment of Agriculture, provide for minimum allowances of tions. Note that the definition of recognized medical praco-60 grams of total protein per day and 20 grams of animal or tioners differs among countries.pulse protein. Population per nurse - Nursing persons include graduate.
practical, assistant, and auxiliary nurses, as well as parapro-Housing fessional personnel such as health workers, first-aid workers.Housing (as percentage of GDP) -Percentage, computed as traditional birth attendants, etc. Inclusion of auxiliar) andinfood and reflecting actual and imputed household expendi- paraprofessional personnel provides a more realistic esumateture outlays, such as actual and imputed rents, and repair and of available nursing/health care overall.maintenance charges, as well as fuel and power for heating, Poputlaion per hospital bed - The number of hospital bedslighting, cooking, and so forth. available in public and private, general and specialized hospi-Average household size - A household consists of a group of tals, and rehabilitation centers. Hospitals are establishmentsindividuals who share living quarters and main meals. permanently staffed by at least one physician.Fixed investment: housing - Percentage is computed as in Access to health care - Indicates the percentage of popula-food. Includes all outlays, public and private, on residential tion that can reach local health services by the usual means ofbuildings, plus net changes in the level of inventory which in transportation in no more than one hour. Note that facilitiesthis context relates primarily to work in progress. (A major tend to be concentrated in urban areas. Some separate figuresrenovation or reconstruction would be included as capital forruralareas showamuchlowerlevelofcoverage,andhencefonmation). access.
Immunized- Measures the full vaccination coverage of chil-Fuel and Power dren under one year of age for two of the target diseases of theFuel and power (as percentage of GDP) - Percentage is Expanded Programme of Immunization. This means thfrcecormputed as infood. Includes electricity, gas, liquid and other doses for DPT. Coverage rates are supplied by member states.fuels, and ice. Note that for some countries the ages at which children are
vaccinatd may difer from the recommended ages. Tis is publicandpnvateiu mionsatthethirdleve.asaprcentagepacuarly muc of Europ countries. of all students enroled at the thud leveL Field of study meansOral Rehydration Therapy use - Percentage of diuahoea the student's main area of specialization, bad on the Inter-episodes in children under 5 years of age neated with oral national Standard Classification of Eduan defuintion.rehydration salts or a physiologically appropriate household Pupil-t'acherratio-Thenumberofpupilseolledoin schoolsolution. divided by the total number of teachers.
Pupils reaching grade 4-lhe pentage of children startingEduoadon (Unesco) prnmary school and continuing until grade 4, based on enroll-Educaton (asapercentage ofGDP) -Percentage, computed ment records. The data are affected by repeaters.asinfood,includesgovemmentaswellasprivateconsumption Repeater rate prmary - Children in primary school whoexpenditre on educaion. repeat a grade as a percentage of all enrolled children.Primary school enrollment - Gross enrollment of all ages at Illiteracy rate - Defined here as the propmtion of the pWpu-prmary levelasapercentageofschool-agechildren asdefined lation 15 years of age and older whocannot, with understand-by each country and reponed to Unesco. Although many ing, both read and write a short simple statement on everydaycountries consider prary school age to be 6-1 years, others life. Ihis is only one of three widely accepted definitions anduse different age groups. Gross emollment may be reported in its application is subject to significant qualifiers in a numberexcess of 100 percent if some pupils are younger or older than of countries (see Unesco's Compendium of Statistics on Ililt-the country's standard range of primary school age. eracy).Secondary school enroUlnent - Computed in the same man- Newspaper circulation - Average circulation of a "daily,ner as the primary school ratio; the age group again varies but general interest newspaper," defined as a news periodicalisusually 12-17. published at least four times a weekTertary enrollment: science and engineering - Studentsenrolled in science and engineering fields of study at both
I
EXECUTIVE SUMMARY
Recent Trends
1. With growth of 10.42 during the 1988/89 drought recovery year, and morethan 42 in 1989/90, India closed out the Seventh Five Year Plan (1985/86-89/90) having met many of the ambitious targets it set for the period. Fort1'e most part, this growth has been based on increases in total factorproductivity, which averaged about 2.92 p.a. Several chronic problem sectorslike coal, power, rail, and manufacturing, where productivity had beenstagnating or declining have achieved significant gains. Export volume growthsurpassed 10? in each of the last 4 years, largely dispelling the exportpessimism that had gripped India since Independence. Continuing if slowprogress has been made in reducing the prevalence of poverty and instrengthening the delivery of basic social services.
2. Significant strides have also been made in adapting economic policiesand institutions to emerging economic conditions. Important steps have beentaken to improve the policy environment and encourage more efficient resourceallocation: measures were taken to strengthen the tax system, relax the scopeand intensity of domestic regulation, develop a modern domestic capitalmarket, and reduce the anti-export bias of the trade regime. Much of theacceleration of growth and gains in productiviL' are attributable to thesepolicy changes.
Issues and Options
3. These successes notwithstanding, the government that assumed office latein 1989 faces a number of difficult economic problems and issues. Three ofthese have dominated debates on the nation's future economic course.
4. Macroeconomic Imbalances. Growing fiscal and balance of paymentsdeficits pose the most serious threat to the economy and the most urgentproblem confronting policymakers. Driven by rapidly increasing governmentconsumption, aggregate demand has become excessive, spilling over into thebalance of payments and putting pressure on domestic prices. The currentaccount deficit reached 3.3Z of GDP in 1988/89 and 1989/90, and inflationappears to have accelerated in the latter year, despite a second successiverecord foodgrain crop.
5. Increasing current account deficits have been financed by reserve lossesand relatively high levels of external borrowing. Reserve losses during1988/89 - 1989/90 totaled $2.3 billion. At the end of 1989/90, gross reserveswere equivalent to less than 2 months of imports, their lowest absolute andrelative levels of the decade. Total external debt outstanding and disbursedreached $63.0 billion, increasing by about 152 over its 1987/88 level, androughly doubling since the beginning of the Seventh Plan.
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6. While there seems to be a consensus in India that the fiscal deficit isresponsible for recent macroeconomic deterioration and needs to be reduced ifbalance-of-payments pressures are to be alleviated, effor s over the lastthree years to do so have not been successful. The persin;tence of largefiscal deficits has inhibited policy action on other fronts, us many of thesteps that need to be taken to make the economy more efficient involve somerisk of additional budget and balance of payments pressure. Moreover, as longas macroeconomic imbalances persist, there is a continuing danger that, in aneffort to contain further deterioration, the Government might feel compel'edto reverse some of the positive economic policy steps taken over the past 10to 15 years.
7. With reserves uncomfortably low and domestic price pressures increasing,India needs to move promptly to restore balance to its economy. This willrequire measures to reduce and reallocate domestic expenditure. Governmentinvestment spending has been shrinking over the past two years and needs to beprotected. To hit at the heart of recent excessive expenditure growth, theprimary near-term focus needs to be on compression of government consumptionand transfer expenditures. Consumption expenditure restraint could take anumber of different forms: broadly-based limitations on the growth ofgovernment employment; control of growth of government wage and salary rates;or controlling net purchases of goods and services. Limiting other currentexpenditures, such as food and fertilizer subsidies and the many othersubsidies that are provided implicitly in kind (e.g., electricity, highereducation, and financial services offered at below cost) could also help.These subsidies, in addition to the fiscal pressure they place upon theeconomy (about 3.7Z of GDP), also distort production and consumptiondecisions. Whatever specific restraints are applied, the objective must beto hold the rate of growth of expenditure below that of real GDP growth.
8. Over the medium term, expenditure restraint efforts need to becomplemented by efforts to strengthen the economic and financial performanceof public sector enterprises, and to rationalize the structure of the taxsystem. Improving performance of public sector enterprises such as Coal Indiaand the State Electricity Boards could help to maintain fiscal balance byfurther reducing explicit and implicit subsidy requirements, reducing claimson the budget for investment resources, and increasing dividends on governmentinvestment. Rationalization of the tax structure would remove distortionsthat constrain India's growth, and could increase the tax ratio.
9. The 1990/91 Central Government budget addresses many of these issues.It projects a reduction in the Center's deficit of about 1.4Z of GDP. Areduction of this magnitude would be a significant achievement. The reductionis to be achieved by raising additional revenues equivalent to O.5Z of GDP,restraining current outlays by C.4Z of GDP, and reducing capital expenditures(primarily loans to public enterprises) by O.5Z of GDP. While the Center'scapital spending will fall relative to GDP, this is to be counterbalanced byimproved resource mobilization by public enterprises. The Government has madeclear that the 1990/91 budget is only a first step. A multi-year program offiscal adjustment and tax rationalization will be put forward in the new Long-term Fiscal Policy to be laid before Parliament later in 1990.
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10. Industrial development issues. Despite significant steps during thelate 1970s and the 1980s to relax investment and import licensing constraintson manufacturing, the sector remains subject to a number of efficiency sappingregulatory requirements. Much of the relaxation of regulations governing newinvestment, capacity expansion, product diversification is conditioned on thelocation of firms, with firms locating/operating in backward areas exemptedand firms in other areas not. Many basic problem areas in the regulatoryframework remain to be addressed. Adequate procedures to allow firms to sellassets or merge have not been worked out. Shedding of labor is, by law,extremely difficult. Reservation of production of many commodities to smallscale industry and public sector firms continue to limit competition andadaptation. Effective steps have yet to be taken to improve the performanceof public sector manufacturing enterprises. Domestic direct and indirectstructures have distorted choices regarding firm size, firm organization andfinancing, and capital-intensity of production. On the trade side, India'snominal and effective tariff levels (as measured by collection rates) remainamong the highest in the world. The combination of relaxed domesticregulation and high protection continues to attract investment in highlyprotected, capital- and import-intensive subsectors in which India may nothave a comparative advantage. Despite the rapid expansion of exportincentives, improved access of exporters to inputs at world prices and activeexchange rate management, exports are in general only profitable at themargin, and are still far less profitable on average than producing for thedomestic market.
11. There are a wide range of views represented in India on the wisdom andappropriateness of domestic deregulation and trade reform. Early indicationsare, however, that the gradual relaxation of domestic regulation of industryand increasing liberalization of the trade regime of the past 10 to 15 yearswill continue. The new Three-Year Import-Export Policy for 1990/91 - 92/93further simplifies import and export procedures, provides some new incentivesto stimulate exports and, for the first time, extends certain exportfacilities to exporters of services. In addition, the 1990191 CentralGovernment budget provides customs relief on capital goods imports forexporters, reduced excise tax rates on domestically-produced capital goods,and eliminates some tax features that bias entrepreneurial decisions in favor '.
of capital-intensive production methods. A comprehensive statement regardingfuture industrial policies is being developed for release later in the springof 1990.
12. These promising initial steps notwithstanding, the basic focus ofIndia's future policies affecting the industrial sector needs to place stillgreater emphasis on increasing efficiency and competitiveness. A workableframework for policy reform, in addition to sound macroeconomic management,would include four elements: (i) elimination of quantitative restrictions onimports; (ii) reform and rationalization of taxation; (iii) improvements inthe financial system; and (iv) further relaxation of regulationscircumscribing the flexibility of firms and individuals to respond to economicincentives. Steps that are likely to further constrict the sector's abilityto compete and adapt such as broader application and enforcement of minimumwages, increased numbers of products reserved for small scale industry, orfurther restrictions on retrenchment of labor will need to be avoided.
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Indeed, India now needs to address whether present policies in these areasleave sufficient latitude for efficient private sector growth.
13. Improving Agricultural Growth and Productivity. Post-independenceperformance of agriculture has been a success story. Average growth ofproduction of about 2.6 Z per year has been sustained for more than 40 years.The country has become self-sufficient in foodgrain production and has, infact, been able to accumulate a substantial foodgrain reserve. Moreover,there has been remarkable growth and social transformation in parts of therural sector.
14. Yet there are problems and questions for the future. It is not certainthat the sources of past growth, i.e., expansion of irrigation and spread ofhigh yielding varieties of crops, can be sustained. The geographic potentialfor new irrigated area is diminishing and unit costs of new surface irrigationare increasing. During the 1980s, both public and private investment inagriculture began to decline. The agricultural credit system is weighed downby loan arrears. The diffusion of new technology appears to be slowing instep with the slowdown in the spread of surface irrigation, and newtechnologies for either irrigated or rainfed agriculture with "greenrevolution" potential are not yet on the horizon. Finally, there are concernsabout the adequacy of incentives in the sector, which appears to bedisprotected relative to industry.
15. With 60Z of the populace still dependent on agriculture for theirlivelihood and India's poor still predominately rural, the Government viewsthe performance of this sector as key to attainment of its employment, povertyalleviation and growth objectives. Its approach to these sectoral problems isstill emerging, but apparently will continue input supply initiatives to makehigh yielding varieties and other new technologies more widely available,targeting assistance and technology packages on the basis of assessments ofagroclimatic potential, and technology initiatives to speed the developmentand diffusion of new technologies. A significant increase in allocations ofresources under the Eighth Five Year Plan has also been promised, along with anew employment guarantee program, and a major write-down of agricultural debt.It is hoped that this renewed emphasis will lead to the formulation of amultifaceted approach based on a careful diagnosis of the constraints andpolicy issues confronting the sector.
Prospects and Financing Requirements
16. The Indian economy appears to be headed for a difficult period duringthe early 1990s. Growth may be somewhat lower than that achieved during the1980s (in the range of 4.5-5.02), and the balance of payments situation willrequire very careful management. Public sector fiscal deficits will need tobe further reduced, and policies maintained that continue the stimulus torapid export growth. Even so, current account deficits and debt serviceobligations are likely to remain high. However, projections of the currentaccount for the coming years are very difficult to make with confidence due touncertainties surrounding the likely future course of import payments. Theseuncertainties arise primarily from growing and as yet unexplained differencesbetween imports recorded onI a customs basis and imports recorded on a payments
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basis. The 'hatter now exceed the former by over $4 billion. Customs baseddata on imports indicate that growth of commercial imports was very moderatedespite the liberalization of the trade regime that took place during the1980s. Imports on a customs basis actually declined in relation to GDP. Iffuture imports payments are projected on the basis of relationships betweencustoms imports and growth, together with buoyant export expectations, a veryfavorable scenario results in which trade and current account balances improverapidly. On the other hand, projection of future imports on the basis ofrelationships between import payments and growth results in deterioratingtrade and current account balances. Our projections assume that the gapbetween imports on a payments basis and imports on a customs basis continuesto grow, albeit at a slower pace than in the 1980s. If it grows at anythingapproaching the average rate of the last few years, the balance of paymentscould quickly become very difficult to manage.
17. Relatively high levels of external borrowing, including continuation ofsignificant levels of commercial borrowing, will have to be maintained tocover current account deficits and reconstitute reserves. The continuedgenerous support of the Consortium will be essential during this period ifIndia is to achieve the necessary macroeconomic and structural adjustments ofits economy. To moderate the burden of borrowing during the early 1990s onthe economy's longer term growth prospects, it is important to increase theshare (on a disbursements basis) of external financing provided by theConsortium. This will require, as a minimum, maintaining plecOes andcommitments at last year's level and substantially improving disbursementperformance. The entire aid process must be strengthened, with India and thedonor community working together to insure the smooth progression from pledgesof a^qistance to project/program commitments, and from commitments todisbursements. Consortium members can help by increasing the concessionalcomponent of the assistance they provide, by untying aid to the maximumpossible extent, facilitating cofinancing arrangements, re-evaluating designsof existing projects to facilitate implementation and disbursements, ensuringthat project savings resulting from depreciation of the rupee are channeledback into the Indian economy, and by emphasizing disbursement performance indesigning new project starts. India, for its part, needs to make improveddisbursement performance the highest priority of its external resourcemobilization strategy.
18. A minimum goal for these efforts, given the present pipeline andassuming maintenance of adequate commitment levels, would be to increaseConsortium disbursements at an annual rate to about $5.1 billion in 1994/95,the terminal year of the Eighth Plan (1994/95). To achieve this result, thelevel and concessional component of Consortium commitments will need, at aminimum, to be maintained during the next several years. New commitmentsshould also, to the maximum possible extent emphasize quick disbursingassistance designs.
19. If the Government adopts a more rapid, time-bound approach to policyreform, it would be possible to envision somewhat more rapid growth of GDP inthe medium term. These reforms necessarily would also entail more importcompetition to the economy and potentially higher import outlays. Were Indiato undertake such programs, the Consortium should be prepared to support themwith increased overall assistance levels, with a large quick disbursingconcessional component.
1
CHAPTER 1
RECENT DEVELOPMENTS AND TRENDSIN THE INDIAN ECONOMY
A. Introduction
1.1 India's economic growth during the Seventh Five Year Plan period en-ding in March, 1990, exceeded plan targets, with most sectors meeting orsurpassing expectations. Agriculture recovered from its weather-induceddoldrums during the first three years of the plan, as growth returned to trendon the strength of excellent crops in 1988/89 and 1989/90. Growth inindustry, and more narrowly in manufacturing, was, apart from an apparentslowdown in 1989/90. particularly strong, with clear evidence that industrialgrowth in the 1980s was significantly faster than in the 1960s and 1970s.Moreover, while a number of sector specific factors explaining growthperformance can be identified, much of the growth -- in each sector andeconomywide -- is attributable to increases in productivity.
1.2 Export performance was also noteworthy. After more than two decadesof relative stagnation, export volume growth exceeded 102 in each of the lastfour years, largely dispelling the pessimism about exports that had grippedIndia since Independence.
1.3 These developments raise hopes for a more dynamic Indian economyduring the 19909. There are, however, some serious problems to be confronted.Driven by rapidly increasing government consumption, the public sector deficitduring the late 1980s averaged about 8.92 of GDP, 1.6 percentage poi$nts of GDPmore per year than during the first half of the decade. This was more thancould be accommodated by the rising private sector saving surplus (up 0.4percentage points of GDP from the early 1980s). Domestic aggregate demandbecame excessive. The excess spilled over into the balance of payments,financed by foreign saving (up 1.2 percentage points of GDP from the early19808), and began to put upward pressure on prices. As a result of expandeddomestic deficits and greater reliance on external borrowing, public sectorinternal and external debt accumulated rapidly, roughly doubling since1984!85, and gross international reserves fell. By the end of 1989j90, theywere only $4.1 billion (excluding gold), about 2 months of import coverage,their lowest level in both absolute and relative terms during the 1980s.
1.4 In addition to this serious macroeconomic problem, two longer-termconcerns about the structure of recent growth are very much on Indianpolicymakers' minds. First, the high growth rates of the 1980s tended to beconcentrated in the more modern, capital and import intensive industrialsectors, while traditional activities associated with the employment andconsumption of lower income groups lagged. The agricultural sector as a wholecontinued on a path of slow, low productivity growth. Growth of rainfedagriculture stagnated, leaving large regional disparities in average incomelevels. Second, organized sector employment data show that the faster outputgrowth of the 1980s was associated with slower growth or, in some cases, an
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absolute decline in organized sector employment. At the same time, real wagesof organized sector employees increased about twice as fast as the economywideaverage real wage rate, suggesting a substantial increase in the relativeshare of wage income accruing to this group. While organized sectoremployment accounts for only a small part of total employment in the economy(about 25 million persons) and is atypical (about 2/3 work in the publicsector), these patterns nonetheless have raised broader concerns that recentgrowth may not be generating employment, may be depleting the country's scarcecapital and foreign exchange resources, and may not be contributing to closingthe gap between India's more fortunate citizens and her poor.
B. Economic Developments During 1989/90
1.5 Three developments during 1989/90 underscore the seriousness of thenear-term economic problems India faces. The fiscal deficit worsened.Despite a budget that envisioned a reduction (approxLnately 1.5 percentagepoints of GDP), the Centre's deficit (total borrowing requirement) actuallyincreased by about 0.7Z of GDP. The budgeted improvement was to be derivedfrom increased taxes and restraint on capital spending. Excise taxes on ironand steel and consumer durables were raised significantly, and excises onother non-essential commodities were increased across the board by 5Z.Revenue collections were roughly as budgeted. However, the disciplinenecessary to meet expenditure targets never materialized. Defenseexpenditure, which was to decline slightly in nominal terms in 1989/90 afternominal growth of 18.9Z p.a. in 1985/86-1988/89, increased by 11.5Z. Severalother expenditure items were above budget, including outlays to subsidizeinvestment in backward areas, urban and rural public worksipoverty alleviationprograms, export subsidies, and fertilizer subsidies. Deteriorating stategovernment finances also appear to have added to the deficit.
1.6 The increase ir the deficit required substantially higher borrowingfrom the Reserve Bank of India than envisioned. RBI net credit to governmentwas approximately Rs 70 billion (about 1.52 of GDP) above budget, increasingover the year by 21.7?. Reserve money increased by 17.22. In consequence,monetary growth was also relatively rapid, with broad money growth of about19.4Z, over 2 percentage points above the RBI's monetary targets for the year,and almost 2 percentage points higher than the 17.6? broad money growth duringthe 1188/89 recovery.
1.7 Inflation, as reflected in the new (1981/82 base) wholesale priceindex, after falling into the range of 5-6Z during the last trimester of1988/89, has ranged between 6 and 8Z during much of 1989/90. On a point-yo-point basis, wholesale price inflation of about 8.5Z over all commodities isexpected for the year. The wholesale price increase for primary products,despite the good crops during 1989/90, was about 7.32, due to sharp increasesin oilseeds prices and the year-end increase in petroleum prices. Wholesaleprices of manufactured products, however, increased by about 10, with severalimportant product groups at or near double digits, including sugar (12.2?),tobacco products (21.6Z), cotton textiles (12.5?), jute, hemp and mestatextiles (44.4?), paper and paper products (9.92), inorganic chemicals (8.4Z),cement (9.2?), iron and steel (11.8?), and metal products (14.72). Thesesharp increases in wholesale prices of widely used intermediate goods suggest
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broadly based inflationary pressures that could carry into 1990191. Rapidmonetary growth (particularly currency) relative to nominal GDP growth furthersuggests that there could be a significant overhang of liquidity that mayintensify these pressures.
1.8 Although some improvement was expected in the balance of paymentsafter the difficult 1987/88 drought year and $1.4 billion reserve loss during1988/89, performance was disappointing. Export performance was excellent, asthe estimated dollar value of merchandise exports reported by the Ministry ofCommerce (MOC) based on customs dat&, grew by more than 202, while importgrowth (also customs basis) was only 7.72. The merchandise deficit (customsbasis) was thus about US $1.6 billion lower in 1989/90 than in 1988/89. Thisimprovement was parti-lly offset by a deterioration in the invisibles balanceof about $1.0 billion due to an increase of $590 million in net factorpayments abroad, a $260 million decline in net current transfers, and adecline in net exports of nonfactor services of $100 million.
Table 1.1Recent Balance of Payment Developments
(billions of US$)
1988189 1989/90 Change
Merchandise customs basis -5.8 -4.2 1.6Merchandise exports 13.7 16.8 3.1Merchandise imports 19.5 21.0 1.5
Merchandise, payments basis -9.6 -8.3 1.2Merchandise exports 14.2 17.0 2.8Merchandise imports 23.8 25.4 1.6
Invisibles 0.7 -0.3 -1.0Non Factor Services (net) 0.7 0.6 -0.1Net Current Transfers 3.0 2.7 -0.3Net Factor Income -3.0 -3.6 -0.6
Net Financing 7.5 7.8 0.2
Current Account -9.0 -8.6 0.5
Reserve Accumulation (-) 1.4 0.8
Source: Government of India and World Bank staff estimates.
1.9 Given estimated net capital accnunt flows (net of repurchaces fromthe IMF) of about $300 million higher ir 1989/90 than in the preceding year,India's gross foreign reserves would have been expected, based on these data,to increase substantially. In fact, reserves fell. Reserve losses during1989/90 are now estimated at e 850 million. While no official payments dataare as yet available for either 1988/89 or 1989/90, the Bank's current
4
estimates suggest that the gapl' between imports according to merchandise datarecorded by the Ministry of Finance on a customs basis and RBI import paymentsdata was about $4.4 billion in each of these years. As in the pre%ious twoyears, this difference thus played a critical role in the overall balance ofpayments outcome. Another factor that may have depressed reserve accumulationis that a portion of the export growth reported during the year may representin-kind servicing of external debt to rupee trade area countries.
1.10 Overall, including estimated provisions for differences betweencustoms and payments data for merchandise imports and exports, the currentaccount deficit is estimated at $8.6 billion ($7.7 billion exclusive ofinterest on NRI bank deposits), or about 3.3Z of GDP. With estimated lossesof $850 million, reserves (excluding gold) stood at an estimated $4.1 billion(or about 1.9 months of imports) at the end of 1989/90, their lowest level(both absolute and relative to imports) of the decade with external debtdisbursed and outstanding at an estimated $63.0 billion.
1.11 A third setback during the year was the sudden and unexpectedslowdown in industrial production growth. After averaging 8.52 p.a. over thefirst four years of the Seventh Plan, including the severe 1987/88 droughtyear, industrial growth dropped from 8.8Z in 1988/89 to an estimated 5.21 in1989/90.
Table 1.2:Industrial Production Growth Rates
Weight 1985/86 1986/87 1987/88 1988/89 1989/90e/
General Index 100.0 8.72 9.1Z 7.3? 8.8Z 5.2ZMining & Quarrying 11.5 4.2Z 6.2Z 3.8Z 7.9Z 8.4ZElectricity Generated 11.4 8.5Z 10.3Z 7.6Z 9.6? 12.2ZManufacturing Index 77.1 9.7Z 9.3Z 7.92 8.9? 3.7?
Source: Government of India.
e/ April - November.
This decline was due primarily to slowdowns in several manufacturing sectors.Mining and quarrying production increased sharply (8.4Z) due to a substantialincrease ir. coal output. Electricity generation also showed a large increase(12.2Z), reflecting excellent thermal and hydro plant availability. Outputgrowth slowed sharply in manufacturing to less than 4?. Several important
1/ This gap, and the key role it has played in the recent weakening of India'sbalance of payments, are discussed further in paragraph 1.59.
5
subsectors reported actual output declines over the first nine months of1989/90 as against the corresponding pericd of 1988/89: steel (-3.2?), cottontextiles (-6.3Z), sugar (-9.9X), jute textiles (-7.5?), motor cycles (-2.7?),vanaspati (-2.7Z), and phosphate fertilizers (-31.6?).
1.12 The specific reasons for the slower growth in manufacturing vary fromsubsector to subsector. For example, phosphate fertilizer production declineddue to a trade dispute that interrupted raw material imports; declining suzarproduction reflects the diversion of cane from refiners (who pay anadministratively capped price for the cane they purchase) to uncontrolledmarkets; declining steel production and lower cement output growth appears toreflect some decline in investment demand; declines in production of someconsumer durables may reflect temporary market saturation, and/or the effectsof excise tax increases. Broadly speaking, however. the slowdown in manysubsectors appears to be attributable to supply side factors. Subsectorsexperiencing production declines overlap substantially with subsectors whosewholesale prices have increased relatively rapidly (see above). In someinstances, these price increases may be related to steep hikes in selectedindirect tax rates (e.g., iron and steel). In others, selective tightening ofquantitative restrictions on imported inputs may have played a role.
1.13 Overall, the economy still grew by about 4.6? despite slowerindustrial growth. Agricultural output remained on trend with better thanaverage rainfall conditions in 1989/90. The major states dependent on rainfedagriculture received good rains, while rainfall deficiencies in the north andnorthwest were mitigated by well-developed irrigation systems. Consequently,1989190 production is expected to surpass the previous year's record levels.Total foodgrain output for 1989/90 is now expected to reach 175mmt, up 2.8?from the Lecord 170.3mmt reported for 1988/89. Oilseeds production isexpected to nearly equal last year's bumper crop (16.5mmt). Good cash cropproduction is also anticipated.
1.14 Services growth of 6.0' is now estimated for the year. As in recentyears, public administration and defense appears to have grown relativelyrapidly.
6
Table 1.3:Agricultural Production
1983/84 1985186 1986/87 1987/88 1988/89a 19 89/9Op
Foodgrains(mmt) 152.4 150.4 143.4 140.4 170.3 175.0Rice 60.1 63.8 60.6 56.9 70.7 72.5Wheat 45.5 47.1 44.3 46.2 54.0 54.0Pulses 12.9 13.3 11.7 11.0 13.7 14.8
Oilseeds(mmt) 12.7 10.8 11.3 12.6 17.9 16.5Sugarcane(mmt) 174.1 170.7 186.1 196.7 204.6 206.6Cotton(m bales) 6.4 8.7 6.9 6.8 8.7 9.6.;ute/mesta(m bales) 7.7 12.7 8.6 6.8 7.7 8.2
a/ Estimatedb/ Preliminary
C. Policy Developments in Late 1989/90
1.15 India's future policy course is being charted by the newly-electedgovernment that assumed office in late 1989. Early indications, as reflectedin the Central Government budget for 1990/91 and the new Three-Year Import-Export Policy, both of which were released in March, 1990, are that theGovernment will make a determined effort to reduce the fiscal deficit, andwill continue the gradual evolution of regulatory and trade policies tosupport the transition toward a more open, modern economy. A number of otherpolicy documents that are expected t, further clarify the Government'sstrategies for achieving these ends, including a new Long-Term Fiscal Policy,an Industrial Policy paper, and an Eighth Plan Approach Paper have beenannounced for release later in the spring of 1990.
(a) The 1990/91 Central Government Budget
1.16 The Government has taken an important first step to deal with itsfiscal and brlance of payments problems in its strict 1990/91 centralgovernment t!dget. This budget provides for a substantial reduction (about1.42 of GDP) in the Central Government deficit (total borrowing requirement)relative to the 1989/90 revised budget estimate, to be achieved by additionaltax effort (0.5Z of GDP), and restraint of current and capital expenditures(0.4Z and 0.52 of GDP, respectively). The buageted increase in the tax ratiois based primarily on increased customs tariff rates on selected products(mainly crude petroleum) and, to a lesser extent, increases in excise taxrates and in effective taxation of corporate incomes. Customs revenues are toincrease by about 0.32 of GDP, with smaller increases (about 0.12 of GDP each)anticipated for corporate and central excise tax revenues. The trend toward
7
increasing dependence on indirect taxes levied on a few products is thuscontinued. Tax concessions, primarily for exporters, are also provided,underscoring the importance attached to continued export growth.
1.17 Along with measures to mobilize additional tax revenues, someimportant changes are being introduced in the structure of the direct taxsystem. The Personal Income Tax has been made simpler and more progressive bydelinking saving incentives from the level of taxable income. Under the newsystem, a tax credit calculated at the rate of 20Z of eligible saving will beprovided, up to a maximum of Re 10,000 (Rs 14,000 for artists and athletes).The base of the tax on personal income is being narrowed by raising the basicexemption from Rs 18,000 to Rs 22,000, reducing the number of taxpayers fromabout 4 million to an estimated 3 million. The Corporate Tax has also beensignificantly restructured, reducing rates by 10 percentage points, abolishingtax incentives for investment and complementary provisions (the so-calledminimum profits tax) designed to prevent the use of investment incentives toescape the tax net altogether, making the system neutral as between small andlarge companies, and simplifying its administration.
1.18 On the expenditure side, the budget programs reductions in nominaloutlays for food, fertilizer and interest rate subsidies, which will declinecollectively by about 0.4? of GDP, and continues the restraint on capitaloutlays that characterized the 1988/89 budget. Capital spending restraint isto be achieved primarily by shifting a larger share of the burden forfinancing public sector enterprises' investment to the enterprises themselves.Some public enterprise prices (e.g., railway, postal, and telecommunicationrates. and prices of selected petroleum products) jave been increased toincrease internal generation of funds, and increased reliance on capitalmarkets is also envisioned. While defense spending will increase, theGovernment has been commendably cautious in starting up new programs.Agricultural debt relief promised during the 1989 campaign, which under thebroadest interpretation could have cost about Rs 130 billion, will beavailable only on small loans (less than Rs 10,000) made by Public Sector andRegional Rural Banks to poor farmers, artisans, and weavers who have notwillfully defaulted. The cost of providing this more limited relief isestimated to be Rs 10 billion. The start-up of a proposed employmsentguarantee scheme has been phased to reflect the availability of resources.
1.19 if the budget targets envisioned in the 1990/91 budget are achievedand are complemented by corresponding fiscal discipline at the state andpublic enterprise levels, balance of payments pressures should be reducedsignificantly. The budget's overall effects on near-term price developmentsare less clear since higher administered prices and indirect tax rates willincrease the prices of some widely used intermediates. On the positive side,however, the monetary restraint implied by the budget, which would limit netcredit to the Central Government to 1.52 of GDP, down from 3.22 in 1989/90,will help to contain inflationary pressures.
1.20 The budgets of the last three years (1987/88 - 1989/90), each of whichprojected reduced deficit ratios, have foundezed for lack of adequateexpenditure control. Efforts to hold the line on expenditures through suchdevices as zero based budgeting, cabinet-level expenditure committee reviews,
a
and by better design and targeting of programs have not been successful. Theexpenditure targets contained in the 1990/91 budget are simLlarly ambitiousand may also prove difficult to meet. To contain the food subsidy, forexample, the Government will have to contend with higher procurement pricesand higher Food Corporation of India costs associated with larger procurementsand stocks. This means that issue prices will also have to be increasedcommensurately, which may be politically difficult. Likewise, potentiallysensitive increases in the farm price of fertilizer and/or reductions inprices paid to producers will be required to contain fertilizer subsidyoutlays. The Government has candidly recognized the difficulty of controllingthese and other expenditures and of curbing the tendency of outlays to creepabove budget during the year. To deal with these problems, the Minister ofFinance plans to increase awareness and visibility of budget issues bymonitoring and reporting revenues and expenditures on a monthly basis, and byconducting a budget review in the Parliament every four months.
1.21 The Government will also try to improve the stability/predictabilityof the fiscal system by placing its annual budgets in the context of a Long-Term Fiscal Policy (LTFP), which it will lay before the Parliament later inthe spring of 1990. while this approach was tried with only limited successduring the Seventh Plan, it is in principle an excellent way to set the stagefor the stabilization and restructuring of the economy. To increase itseffectiveness as an instrument for guiding future policy, the Government couldconsider couching both its annual budget presentations and the new trimestralbudget reviews in terms of the measures and targets set forth in the new LTFP.
(b) Three-Year Import Export Policy, 1990/91-92/93
1.22 The new Three Year Import Export Policy for 1990/91-92193 affirms thecontinuity of recent trends in trade policy. The new policy strengthensexport promotion incentives, offers some new, potentially important capitalgoods import concessions to exporters, extends export promotion incentives toexporters of services (which have been growing more slowly than merchandiseexports in recent years), and simplifies the administration of previouslyexisting incentives. Import policy, apart from new facilities for exporters,is broadly unchanged from the previous three-year policy. Eighty-two capitalgoods items have been added to the Open General License (OGL) list, whiie 17others have been dropped. Five items are freed from canalization.
1.23 Perhaps the most important step taken under the new policy is thestrengthening of the incentives to export provided by the import replenishment(REP) system. This system effectively transfers premia on some imports toexporters by granting them transferable licenses to import selected items, upto a stated percentage of the value of their exports. Under the new scheme,exporters (or holders in due course of REP licenses) will be entitled to useREP licenses to replenish any inputs on an approved list. Approval forimports of specific inputs on the list, as was required under the previouspolicy, will no longer be necessary. REP licenses will continue to be freelytransferable for all export products except those (such as gems and jewelry)specifically excluded. REP licences are to be extended to service exportssuch as computer software and overseas consultancy contracts. The number of
9
different replenishment rates will be reduced to four, and will be based onvalue added, giving higher allowances to higher value-added products.
1.24 The new policy also increases access to imported capital goods.Actual users of capital goods and trading houses (on naming the final user)will be allowed to use their earned REP licenses to import non-OGL capitalgoods via a streamlined procedure. Registered exporters will be able toimport capital goods at a concessional duty rate of 252 up to a value of Rs100 million on undertaking an obligation to realize additional exports equalto three times the value of capital goods imported over a stipulated period oftime. These new provisions should introduce a greater measure of flexibilityin capital goods imports and provide significant cost relief to exporters.
D. Recent Developments in Perspective
1.25 While its fiscal and balance of payments performance during the late1980s indicate the need for prompt strengthening of its macroeconomicmanagement, sight should not be lost of India's recent economicaccomplishments. After centuries of little or no growth, and three decades ofpost-Independence growth averaging only 3.5? per annum, India achieved growthof 5.22 during the 1980s, and, during the latter half of the decade,decisively discredited the myth that it cannot compete in world markets.Significant strides were made in adapting policies and institutions toemerging economic conditions. While the pace of policy change has been unevenand incremental, viewed as a process, substantial progress has been made instrengthening the tax system, relaxing the scope and intensity of domesticregulation, developing a modern domestic capital market, and reducing theanti-export bias of the trade regime. Much of the improvement in India'sgrowth and export performance is attributable to this measured evolution ofeconomic policies. Detailed analyses of the recent surge in the rate ofgrowth of exports, for example, show without exception that the adoption of amore flexible approach to exchange rate management has been instrumental inpromoting rapid export growth. The easing of licensing policies andquantitative restrictions on imported capital goods and raw materials hasrelaxed supply bottlenecks in manufacturing that in earlier decadesconstrained growth and/or produced spurts of inflation.
10
Table 1.4:GDP Growth Rates
1980-85 1985-90p 1985/86 1986187 1987/88 1988/89e 1989/90p
Agriculture 3.7 5.0 0.3 -2.3 0.5 17.4 1.8Industry 7.2 6.8 8.2 8.4 5.5 7.7 5.9Services 5.8 6.3 7.3 6.2 6.0 7.0 6.0
Overall a/ 5.4Z 5.8Z 5.12 4.02 4.1Z 10.4Z 4.6Z
a/ Least squares trend growth rates for 1980-85 and 1985-90.p/ World Bank estimate.
(a) Output Growth
1.26 With estimated GDP growth of 4.62 in 1989190, India exceeded the 5Zobjective it set for the Seventh Plan period (1985/85 - 1989/90). The trendgrowth rate increased by about 1.5 percentage points between the 1970s and1980s, and by about 0.4 percentage points between the Sixth (1980/81 - 84/85)and Seventh Plans. The process of structural transformation of the economyaccelerated. The share of real output originating in agriculture declinedfrom about 38? of real GDP at factor cost in 1980/81 to a little over 30? by1989/90, while the shares originating in the rapidly growing industrial andservices sectors increased correspondingly. Th.e decline in agriculture'srelative weight in the economy was accompanied by a diminution of the effectof shocks emanating from this sector on the rest of the economy.
r,
11
Table 1.5:Real GDP Growth Rates by Sector*
(percent)
1950-60 1960-70 1970-80 1980-89
Agriculture 2.7 1.5 1.7 2.6Agriculture 2.9 1.2 1.9 2.9Forestry 0.3 3.3 -0.6 -3.9Fishing 5.8 4.0 2.9 6.1
Industry 6.0 5.5 4.7 7.4Mining & Quarrying 4.1 5.0 4.6 9.2Manufacturing 6.1 4.7 4.9 8.0Registered 7.2 5.6 4.8 9.7Unregistered 5.1 3.7 5.0 5.6
Electricity, Gas & Water 10.2 11.5 7.4 9.8Construction 5.9 6.9 3.1 3.1
Services 4.1 4.4 4.6 6.2Transport, Storage, Comm. 5.7 5.5 6.4 7.9Trade, Hotels 5.1 4.5 4.9 5.3Banking, Finance, Real Estate 3.2 3.1 4.4 6.2Pub. Admin. & Defense 5.2 7.6 4.9 8.1Other Services 2.9 4.0 2.8 5.0
GDP @ Factor Cost 3.7 3.3 3.4 5.2
* Least squares trend growth rates. "1950-60" is 1950/51 - 1959160, andsimilarly for other periods.
1.27 Agricultural growth (value added) over the first 9 years of the 1980saveraged about 2.62, which is above the sectoral long run trend growth rate ofabout 2.4Z. This difference is due primarily to the excellent monsoon in1988/89. Preliminary estimates including 1989/90 suggest that growth duringthe decade was about equal to the long-term trend rate. Examination of moredetailed data for specific crops, crop groups and regions shows, however, thatmuch of Indian agriculture remains caught in a slow growth, low productivitytrap (see Chapter 2).
1.28 The lower overall growth performance of industry in 1989190notwithstanding, output growth in most of the sector was clearly much fasterduring the late 1980s than at any time in India's recent history. All of themajor industrial subsectors have done reasonably well. Manufacturing growth,
12.
which was disappointing throughout much of the 1960s and 1970s, "took off",with gross output of a number of subsectors growing at very high rates since1984/85: commercial vehicles (7.3Z p.a.), passenger cars and jeeps (20.02p.a.), nitrogenous fertilizers (11.82 p.a.), cement (8.1Z p.a.), and refinedpetroleum products (10.22 p.a.).
1.29 Some of the differences between the growth rates of manufacturingsubsectors during the 1980s appear to be explained by the pattern of reform ofdomestic regulation and changes in import controls. Many subsectors in whichbarriers to entry and/or growth were lowered grew relatively rapidly (e.g.,cement, passengeL cars, electronics, fertilizers). Many other subsectors inwhich barriers were maintained (e.g., via public sector and small scalereservations or restrictive licensing requirements) appear to have grown moreslowly.
1.30 The performance of several of the infrastructure subsectors alsoimproved significantly during the Seventh Plan, helping to relax constraintson production in other sectors of the economy. Production of crude oil andgas increased substantially, with crude oil production rising by about 142despite the peaking of production from the Bombay High field. Discoveries ofnew oil reserves boosted the reserve/production ratio from 17 years in 1984/85to 23 years in 1988/89. Gas production, although short of the Plan target dueto delays in bringing pipeline and compressor capaclty on line, increased byabout 63Z. Substantial quantities of new gas reserves were also found duringthe period, although the reserve/production ratio fell from 61 years in1985/86 to 49 years in 1988/89.
1.31 There were also significant advances in power. Total generation(excluding captive power) increased at a rate of about 9.62 per year, up from8.42 during the Sixth Plan. A total of 24,685 MW of additional generatingcapacity was added during the Seventh Plan, much of it in short-gestation gas-fired thermal plants. The efficiency of thermal power plant operation (asmeasured by the plant load (PLF) and plant availability (PAF) factors) alsoincreased substantially. The average PLF increased from 442 in 1980/81 to 55Zin 1989/90, while the average PAF increased from 552 to 742. Theseimprovements in averages, however, mask a great deal variability in state-to-.sta!e performance. They also have as yet to be translated into animprovement in the finances of state electricity boards, which remain aserious drain on public sector finances. In addition, transmission anddistribution losses increased from 20 to 222 of send out. This reflects someincrease in the theft of electricity (mainly in rural electrification areas)and lagging investment in transmission capacity. Finally, the shelving ofhydro projects and shift to gas-fired capacity, while bringing capacity online much faster than otherwise would have been achieved, sacrificed somesystem efficiency because gas plants are having to be used increasingly tomeet base load requirements.
1.32 Coal production also exceeded Seventh Plan targets, growing atabout 7.32 during the plan period as against 6.82 during the Sixth Plan.Labor productivity in coal mining, which has been a long standing problem,increased et a rate of over 62 per year since 1985/86. Virtually all of thisproductivity increase, however, reflects a shift from low productivity, high
13
wage, labor intensive underground mining (where the average rate ofproductivity increase was 1.82 pa) to capital intensive open cast mining(which averaged labor productivity growth of 8.3Z pa). Almost all investmentin the Seventh Plan has been channeled toward surface mining due to a wage,manning, and work rule structure that render deep mining financiallyinfeasible. The improvement in average labor productivity was achieved atsome cost in terms of coal quality. While surface coal is inherently lowerquality than deep coal, administered prices for coal do not distinguishadequately between coal qualities, and thus provide no inducement to carefulmining or other practices that increase quality of coal extracted from surfacemines. Poor quality has become a major problem for users. Despiteproductivity improvements and efforts to strengthen the finances of India'sailing coal industry, Coal India is one of the 10 leading loss-making centralpublic enterprises in India, and is heavily dependent on the CentralGovernment budget for financing of its investmenta; (see Chapter 2).
1.33 Transportation growth rates, despite a significant backlog of needsto rehabilitate and modernize infrastructur. for all modes, also met orexceeded Sixth Plan rates. Railway freight traffic grew by 5.9Z pa (up from4.12 pa during the Sixth Plan) largely on the strength of improvedproductivity. Indian Railways overall operating performance continues toimprove, and is among the bost in the developing world in terms of trackutilization, output/employeet, and equipment utilization, especially wagonutilization. Cargo handled at major ports grew by about 6.32 (about the samerate achie-ved during the Siz'h Plan). Port productivity improved as averageturnaround time for all ports fell by about 202.
1.34 Like industry, services output also grew faster than the overalleconomy. The fastest growing subsectors were banking and finance and publicadministration and defense. Since value added in the latter subsector isalmost wholely accounted for by outlays for government and armed forcessalaries, this development is closely linked to the growth of governmentdeficits.
(b) Input Growth and Productivity
1.35 Though difficult to measure precisely, available data suggest thatcapital and labor use has grown more slowly than output in most sectors of theeconomy. Much of the growth of the 1980s thus seems to be due to productivitygrowth. Unfortunately, the data do not permit correction for changes incapacity utilization, improved efficiency of resource use, and better factorquality, so it is not feasible to make a more refined accounting of sources ofrecent growth.
1.36 Employment. There are no economy-wide time series data onemployment. The data that are available only cover employment in a very smallportion (the organized sector) of the economy, which accounts for employmentof only about 25 million people. Of these, about two-thirds are public sectoremployees. Much of the current concern being expressed in India aboutinadequate employment generation seems to be based on the unsatisfactorygrowth of employment in this small, and somewhat atypical segment of the labormarket. These data show employment growth declining from 2.6Z in the latter
14
half of the 1970s to about 1.7Z during the 1980s (Economic Survey, 1988-89).This decline in employment growth is observed for both public and privatesectors, and in most subsectors.
Table 1.6:Organized Sector Employment Growth
(2 per annum)
1975/76 - 1981/82 -
1980/81 1986/87
Public Sector 31 2.5Agriculture, hunting, etc. 4.7 3.2Mining & Quarrying 2.2 2.9Manufacturing 6.7 3.5Electricity, Gas & Water 5.4 2.6Construction 1.7 1.4Wholesale & Retail Trade 16.2 2.8Transport, Storage & Communication 2.4 1.5Financing, Insurance, Real Estate 6.8 5.8Community, Social & Personal Services 2.1 2.4
Private Sector 1.6 -0.3Agriculture, hunting, etc. 0.8 -0.6Mining & Quarrying -1.6 -5.1Manufacturing 1.8 -0.8Electricity, Gas, & Water 22.2 2.4Construction -5.1 -2.4Wholesale & Retail Trade -0.7 0.0Transport, Storage & Communication -0.3 -2.6Financing, Insurance, Real Estate 3.1 2.4Community, Social & Personal Services 2.5 1.6
Source: Computed from data in Economic Survey, 1988-89.
1.37 National Sample Survey data, which cover the entire economy at five-year intervals, suggest a somewhat different employment picture economywide.Comparison of data for 1982-83 and 1987-88 suggests that economywide dailyunemployment rates may have fallen over the 1980s, with much of the declinedue presuma"ily to growth of employment opportunities in the unorganized sectorof the economy. Data on organized sector employment (which may also besubject to increasing underreporting) thus do not warrant the broaderconclusion that employment generation in India has been inadequate. They do,however, point to some problems in the organized segment of the labor market.A recurring finding in studies of factor employment in the Indian economy isthat labor employment in the organized sector is subjected to a number ofimplicit and/or explicit "taxes' that increase real wages to above marketclearing levels. Virtually all of these taxes derive from India's labor laws.
15
Although intended to protect the interests of workers, these laws andregulations increase the costs of hiring labor, and thus constitute adisincentive to labor employment falling within their ambit.
1.38 The size of this "tax" is increasing. The real product wage inmanufacturing declined during the latter half of the 1970s at an average rateof about -0.92 per year; during the first half of the 1980s the real productwage increased at a rate of 5.4Z per year (Hanson and Sengupta, 1989). Realper capita emoluments (using the GDP deflator) of public sector employeesincreased at 3.2Z during the late 19709. and 4.5z during the 1980s. Theserates are well above the economywide average rate of increase of real GDP percapita, which is a rough benchmark for economywide real wage increases.
1.39 Other transitional factors were also important in limiting organized-sector employment growth during the 1980s. In industry, for example, withrelaxation of regulations governing investment and production and more liberalaccess to imported inputs, firms were able to make better use of capacity bymodernizing, expanding output and diversifying into new products. Thistemporarily reduced the employment creation associated with output growth.With the completion of these adjustments, the employment growth associatedwith any given rate of output growth should increase.
1.40 Investment. Real growth of gross domestic investment also slowed inthe 1980s, averaging 3.82 pa as against 5.8Z in the 1970s. On a sectoralbasis, investment growth slowed in agriculture and industry, and acceleratedslightly in services. Part of the observed decline in growth rates may be dueto the fact that the series used ends in 1987/88, when investment wasdepressed due to the severe drought. However, one clear and somewhatworrisome trend, given the importance of agriculture in the economy, is theabsolute decline of real investment in this sector. This decline is not astatistical artifact, and is discussed in more detail in Chapter 2.
16
Table 1.7:Real Gross Domestic Investment Growth Rates, by "Sector*
(Z per annum)
1950-60 1960-70 1970-80 1980-88
Agriculture 1.7 6.5 7.5 -1.4Agriculture 1.2 6.6 7.6 -1.9Forestry 15.8 3.7 6.7 2.7Fishing 9.4 6.5 6.1 9.7
Industry 11.5 4.4 7.1 5.0Mining & Quarrying -2.2 3.7 18.5 8.4Manufacturing 10.6 4.0 5.7 4.3(Registered) (10.4) (1.8) (6.2) (3.6)(Unregistered) (16.6) (16.1) (4.3) (6.2)
Electricity, Gas & Water 17.6 7.8 8.1 7.3Construction 18.6 2.5 8.2 -4.1
Services 8.3 0.2 3.7 3.9Transport, Storage, Comm. 13.9 -0.8 2.2 7.6Trade, Hotels -4.1 7.6 6.0 -5.2Banking, Finance, Real Estate 3.0 2.0 5.1 1.8Pub. Admin. & Defense 16.6 -3.2 1.2 4.6Other Services 10.0 6.8 6.6 7.2
Gross Domestic Investment 7.8 3.0 6.8 3.8
* Least Squares trend growth rates. '1950-60" is 1950/51-1959/60 andsimilarly for other periods.
1.41 Productivity Growth. The employment and investment trends discussedabove suggest that the faster growth of the 1980s can be attributed, insubstantial measure, to faster productivity growth. Capital productivity, asreflected in roughly estimated capital-output ratios, was dramatically higherduring the 1980s in all major sectors. Economy-wide, capital productivityduring the 1980s increased by almost 25Z over its level during the 1970s, with54Z increase in agriculture, a 40Z increase in industry, and a 26Z increase inservices. Capital productivity in manufacturing increased by about 72Z.Vaile estimates of growth in total factor productivity
17
Table 1.8:Capital-Output Ratios by Sector*
1950-60 1960-70 1970-80 1980-89
Agriculture 2.0 4.7 5.4 3.5Agriculture 2.0 6.0 5.1 3.1Forestry 2.2 0.4 ND NDFishing 2.9 3.5 4.6 2.6
Industry 4.2 6.0 7.7 5.5Mining & Quarrying 2.8 4.8 10.3 8.5Manufacturing 4.3 7.C 6.9 4.0(Registered) (6.9) (9.0) (9.0) (4.1)(Unregistered) (1.0) (3.1) (4.0) (3.8)
Electricity, Gas & Water 16.3 15.2 18.5 15.7Construction 1.2 1.5 3.1 4.0
Services 6.1 5.7 5.3 4.2Transport, Storage, Comm. 12.8 14.6 8.8 6.5Trade, Hotels 1.6 1.4 3.2 3.7Banking, Finance, Real Estate 10.0 9.8 6.2 5.0Pub. Admin. & Defense 10.9 6.0 7.4 4.3Other Services 2.4 2.2 2.4 1.7
GDP e Factor Cost 3.9 5.7 6.2 4.7
* 1950-60 is 1950/51 - 1959/60, and similarly for other periods. Capital-outputratios shown in this table are obtained by dividing average real investment asa share of real gross value added at factor cost in each period by thecorresponding rate of growth of real gross value added at factor cost. Theseestimates are not directly comparable to estimates prepared by the PlanningCommission, which value output at market prices instead of factor cost.
ND - not defined due to negative output growth over the corresponding period.
are hazardous and depend, as noted above, on the degree of refinement ofmeasurement of factor inputs and corrections for capacity utilization andincreased efficiency of resource utilization, a very rough estimate of
18
economywide total factor productivity growth durini the 1980s indicates totalfactor productivity growth of about 2.9Z per year.-_
1.42 This calculation is buttressed by the few in-depth studies ofsectoral productivity trends (or their correlates) that have been undertaken.Detailed studies of manufacturing show total factor productiv'ty growth ofover 4? per annum dating from the late 1970s (Hanson, 1989). In agriculture,calculations for the 1970s and early 1980s show total factor productivitygrowth of about 1.02 p.a. (Evenson and McKinsey, 1989). Other evidence forthe 1980s shows generally increasing real wages for unskilled agriculturallabor (Acharaya, 1988 and 1989), and increasing agricultural yields (Evenson,1988, and Lieberman and Ahluwalia, 1989). As noted above, productivityindicators in key infrastructure sectors also show gains.
(c) Domestic Absorption.
1.43 The structure of real domestic demand underwent some important shiftsin the late 1980s. The five-year average share of real gross domesticinvestment declined (about 0.3 percentage point of GDP) for the first timesince 1950. This decline was due to a sharp drop in the public sectorinvestment share that was only partially offset by increased privateinvestment. Government consumption, as in earlier periods, assumedsubstantially greater importance, increasing by almost 2 percentage points.The main factor in the increasing government consumption share has beenrapidly-growing net purchases of commodities and services (average real growthof 17.51 over the first 3 years of the Seventh Plan). Corpensation ofemployees increased at about half this rate (8.4Z).
2I Rearranging the Solow decomposition of sources of growth, growth of outputper unit of labor input (g8 - gn) may be expressed in terns of the rate ofgrowth of the capital output ratio (gk - gx) and the rate of productivitygrowth gp as follows:
(gX - gn) = [(1 - a)/a](gk - gx) + gp Ia,
where a is the elasticity of output with respect to labor. Using thepopulation growth rate of 2.2? as a proxy for the rate of growth of the laborinput, an estimated average output growth rate of 5.2?, and a rate of growthof the capital output ratio of -2.9? p.a., and an estimated labor share of0.6, yields an estimated rate of productivity growth of 2.9Z.
19
Table 1.9:Real Domestic Absorption Shares*
(Z of Real Gross Domestic Absorption)
1960-64 1965-69 1970-74 1975-79 1980-84 1985-88
Private Consumption 74.7 72.7 70.9 69.4 68.6 67.0Government Consumption 6.4 7.8 8.7 8.8 9.4 11.3Grosa Domestic Investment 18.9 19.5 20.4 21.7 22.0 21.7Gross Domestic Private Invest. 11.2 12.1 12.5 12.3 11.6 12.1Gross Domestic Public Invest. 7.7 7.4 7.9 9.4 10.4 9.6
* 81960-65" is 1960161 - 1964/65, and similarly for other periods.
1.44 Perhaps most surprising in light of recent expressions of concernabout growing "consumerism' in India was a relatively large decline (almost1.6 percentage points of GDP) in the share of real private consumption. Whileincreased consumption propensities may be observed in some segments of theIndian populace, the phenomenon was not sufficiently widespread to counteractthe longer term tendency for the share of real private consumption in domesticabsorption to decline. There has, however, been a slight shift (about one-half-of-one percentage point) from nondurables to durables in the distributionof private consumption expenditure in nominal terms during the first threeyears of the Seventh Plan.
1.45 The recent sharp decline in real private consumption propensities andslight shift in the composition of private spending may. in part, beassociated with recent changes in the distribution of income in favor ofsegments of the population with relatively high saving propensities,particularly organized sector employees.37 One can infer from the limitedemployment and real wage data that organized sector employees real incomes arehigher and increasing much faster than those of the general population. Atan average rate of growth of real wages in the organized sector of say 4.7Z(e.g., 4.52 in the public sector, and 5.42 in the private sector), realincomes of organized sector employees would increase at about twice thenational average rate. Giver rough constancy of the size of this group (i.e.,organized sector employees), these growth differentials would imply a sizableshift in the distribution of income over a period of time. This shift inincome distribution has been identified (Bhattacharya and Mitra, 1989, andEconomic Advisory Council, 1989) as a factor contributing to the slow growth
3/ The most important factor in the decline of the ratio of privateconsumption to gross domestic absorption, however, has been the decline in theratio of private disposable income to gross domestic absorption associatedwith the increasing tax ratio. See paragraph 1.49.
20
of agriculture and industries producing widely consumed items, relative torapid recent growth of some of the new, consumer goods industries (e.g., motorvehicles and television receivers).
(d) Saving and Investment
1.46 India's generally strong growth performance during the 1980s wasmarred by worrisome trends in its internal and external finances. Overall,the picture that emerges is of a growing public sector saving investment gap,financed by a compression of private investment relative to private saving,and by a substantial increase in utilization of foreign saving.
1.47 The most striking trend in saving-investment balances has been theprecipitous drop in public sector saving. This has led to greater reliance onforeign saving despite a rise in private saving. The deterioration indomestic saving-investment baiances was particularly pronounced in 1985/86 andagain in 1988/89 when buoyant private sector investment spending reduced theprivate sector surplus of saving over investment. The national saving rate(GNS/GDP) declined in the second half of the 1980s, averaging 21.22 of GDP1985/86-1989190 as against 21.9Z during the first half of the decade. Theprivate saving rate increased from 18.2Z in the early 1980s to 19.12 in thelate 1980s. Public sector saving, in contrast, declined from a decade high of4.61 of GDP in 1981/82 to 2.1Z of GDP in the late 1980s. The decline wasparticularly sharp over the late 1980s as, public saving fell from 3.32 of GDPin 1985/86 to an estimated 0.6Z in 1989/90. Current revenue growth, whichincreased the ratio of public sector income to GDP by 1.1 percentage pcints(from 22.92 in 1985/86 to 24.02 in 1989/90) was more than offset by anincrease of 3.8 percentage points in the current expenditure ratio (from 19.6Zof GDP in 1985/86 to 23.4Z in 1989190). Overall saving of public sectorenterprises increased (4.9Z in 1985/86 as against 5.52 1989/90), dueprincipally to the large surpluses generated by a few large central publicenterprises (ONGC, OIL). Saving on government administration account declinedsharply, however, since current expenditure growth outpaced the growth of taxand non-tax income accruing to government.
21
Tobl-e 1.10Saving-Investment Solances
(X of OP at current morket priceo)
Average Average1980-88 1985/86 1986/8? 1987/66 1968/69 1989/90 1986-90
Foreign Saving 1.7X 2.7X 2.68 2.65 8.83 8X.3 2.9X
Resource Cap 2.83 8.1X 2.7X 2.68 8.83 2.9X ^.9X
Net Factor Inco O.3X 0.7X 0.9X 1.0X 1.1X 1.4X 1.0XNot Current Transfers -1.4X -1.1X -1.0X -1.1X -1.1X -1.0X -1.1X
Private Sector
Gross Domestic Investmnt 12.63 14.2X 12.83 12.2X 18.8X 12.9X 13.1X
Fixed 10.0% 10.5X 10.4X 9.8X 10.13 10.2X 10.2X
Chnnge In Stocks 2.6X 8.8X 1.9X 2.5X 8.73 2.73 2.9X
Saving 18.2X 19.9X 19.0X 18.83 19.43 19.13 19.1XHousehold 16.53 17.83 17.3X 16.6X 17.63 17.33 17.83
Corporate 1.6X 2.13 1.'X 1.7X 1.83 1.8X 1.83
Investment-Saving -5.6X -6.73 -6.7X -8.1X -5.63 -8.1X -8.OX
Public Sector
Gross Dtomtic Investont 11.0X 11.7X 12.0X 10.6X 10.53 10.03 11.03Fixed 9.7X 10.5X 11.2X 10.65 10.43 9.9% 10.65Change in Stocka 1.43 1.2X 0.8X 0.13 0.2X 0.1X 0.6X
Saving 3.73 8.3X 2.7X 2.13 1.7X 0.63 2.1X
Current Income 20.23 22.93 28.83 24.13 28.43 24.0X 23.86
Tax Revenue 16.4 16.6X 17.13 17.43 16.93 17.1X 17.03Direct 2.7X 2.5X 2.65 2.45 2.4X 2.5X 2.65Indirect 12.83 14.1X 14.63 16.03 14.53 14.6X 14.63
Public Ent Surplus 8.7X 4.9X 6.6X 6.63 6.43 6.5X 6.43Interest Receipts ?'.8X 0.93 0.8X 0.83 0.83X 0.8 0.8318Misc. Receipts 0.83X 0.b 0.4X 0.43 0.43 0.5X 0.43
Current Expenditure 16.56 19.63 21.1X 22.0X 21.7X 28.4% 21.6XConsumption 10.13 11.13 12.03 12.83 11.93 12.8X 12.03Subsidies 2.6X 8.83 8.40 8.63 8.6X 8.6X 8.65Interest Paymnts 1.6X 2.83X 2.6X 2.91 8.13 3.5X 2.VACurrent Transforo 2.83 2.9X 8.1X .83X 8.2X 8.43 8.2X
Investmont-Snving 7.3X 8.43 9.83 8.63 8.93 9.45 8.9X
Sources: Government of IndiaWorld Bank *etimates
22
1.48 On a five-year average basis, the investment rate (GDI/GDP) increasedmodestly from 23.62 of GDP (1980/81-84/85) to 24.12 (1985/86-89/90), with aslight shift in composition toward more private investment. Privateinvestment rates increased marginally (12.6? of GDP 1980/81-84185 versus 13.1?1985/86-89/90). The public investment rate was constant. These five-yearaverages may, however, mask a recent trend for investment ratios to fall. Thepeak years for both public and private investment during the Seventh Plan cameduring the first two years of the Plan. Public investment declinedcontinuously thereafter. While private investment recovered in 1988/89 and1989/90, it still fell short of its 1985/86 peak. The rapid recent downwardtrend of public fixed investment from 11.2? of GDP in 1986/87 to 9.8? in1989/90 is particularly troubling. Although care must be taken in drawingconclusions from short-time periods for volatile variables like capitalspending, the investment ratio merits close monitoring over the next fewyears.
(e) Public Sector Finances.
1.49 The decline in public sector saving during the 1980s was dueprimarily to a steady deterioration of government saving. Saving (currentrevenues less current expenditures) of the centre, states, and unionterritories fell from -1.9? of GDP in 1984/85 to an estimated -3.8? in1989/90. The current revenue ratio increased by about 1.7Z of GDP, largely asa result of buoyant central tax collections. These (including the share ofcentrally-collected taxes devolved to the states) increased from 10.2? of GDPin 1984/85 to 11.5? in 1989/90. Most of this was due to increased customsrevenues, which grew from 2.5? of GDP in 1980/81 to 4.0? in 1989/90. Thegrowth of states' collections was somewhat less, from 5.42 in 1984/85 to about5.7Z in 1989/90.
1.50 Current expenditures grew disproportionately, however, increasing by3.6 percentage points of GDP in just 5 years, and were clearly the principalcause of India's recent fiscal problems. About half of the increase was dueto interest payments, which rose from 3.0? of GDP in 1984/85 to 4.8? in1989/90. This trend was the product of two factors. First, with large andgrowing deficits, the stock of government debt increased rapidly in relationto GDP. Consolidated centre and state government debt increased from 55.1? ofGDP in 1984/85 to an estimated 66.02 of GDP at the end of 1989/90. Even ifinterest rates had remained constant, this would have resulted in a 20?increase in government interest payments relative to GDP. Second, averageinterest rates on government debt increased reflecting adjustments in the1980s to reduce cross-subsidization of public sector debt, and to inducesavers to hold, directly or through intermediaries, a growing volume ofgovernment debt. Average interest rate adjustments, at a constant debt stock,imply roughly a 35? increase in the interest-GDP ratio.
1/ In real terms, however, the investment rate declined as investmentdeflators increased far more rapidly than the overall GDP deflator due -- inpart -- to relatively rapid depreciation of the rupee and the increasingweight of indirect taxation on investment.
23
1.51 Increases in non-interest current expenditures also accounted for 1.8percentage points of the estimated increase in the current expenditure ratiosince 1984185. Data up to 1987188 (the most recent year for which detailedexpenditure accounts data are currently available) suggest that three items --defense services, subsidies to the Food Corporation of India (FCI), andfertilizer subsidies -- account for about 402 of this. The balance isaccounted for by outlays for education (about 202 of the increase), grantsfrom the Centre to the states for a number of development schemes (such asRural Water Supply, National Rural Employment Program, and the Rural LaborEmployment Guarantee Program (about 202 of the increase), and centre and statespending for agriculture (about 202), and miscellaneous items accounted forabout 10X.
Table 1.11Expenditure Ratios to GDP, by Function
(percent)
1984/85 1987/88 Change
Noninterest Current Expenditure 17.5 19.3 +1.8of which:Defense Services (Centre) 2.8 3.1 +0.3Subsidy to FCI (Centre) 0.5 0.7 +0.2Fertilizer Subsidy (Centre) 0.5 0.7 +0.2
Grants to States & UTs (Centre) 1.4 1.8 +0.4Agriculture (Centre, States, & UTs) 2.3 2.5 +0.2Education (Centre, State, & UTs) 2.8 3.2 +0.4
Source: Ministry of Finance (Indian Economic Statistics)
24
Table 1.12Expenditure Ratios to GDP, by Economic Classification
(percent)
80/81-84/85 85186-87/88 Change
Compensation of Employees 6.2 6.8 +0.6Central Government 1.8 2.0 +0.2State Government 3.4 3.8 +0.4
Net Purchases 3.3 4.0 +0.7Central Government 1.8 2.6 +0.8State Government 1.3 1.2 - 0.1
Source: Central Statistical Organization.
1.52 Another perspective on sources of current expenditure growth is providedby data on government expenditure according to its economic classification.Over half of government current spending is devoted to purchase of final goodsand services (see Table 1.10). Both of the major components (compensation ofemployees and net purchases of commodities and services) increasedsubstantially during the Seventh Plan. Central net outlays for purchases ofgoods and services increased at an average of over 38Z p.a. in nominal terms.Center and state payrolls increased at a rate of over 17Z p.a. Employmentdata (see Table 1.6) indicate that government employment grew atapproximately 2.5Z, which taken with the high rate of growth of the nominalwage bill, suggests that average wages of government workers have increasedvery rapidly.
U
25
Tablo 1.18:Cansol idat FCoveFnment Deficit(X of GDP at market price.)
1980-85 1985/88 1986/87 1987/88 1988/89 1989/90 1986-90
Revonuo Rcolpto s18.2X 19.45 19.9x 20.1X 19.75 20.8X 19.95Tax Revenue 16M.2 -16. SX .M TY 18.x1.X i7X 17 1X _16.sxDirect Taxes 2.4X 2.4X 2.8X 2.2X 2.3X 2.8X 2.3XIndirect Taxes 12.8X 14.1X 14.6X 14.95 14.4X 14.8X 14.6X
Nontax Revenue 8.05 2.9x 8.0x 8.0x 2.9X 8.1X 3.05
Revenue Expenditure l.85 21.35 22.6x 23.2x 28.0x 24.1X 23.0XNondevelopmental 9.8x 11.43 12.23 12.83 12.2X 14.1X 12.65Of Which Interest 2.8X s.8x 8.ex 3.9s 4.2X 4.8x 4.1XCentre other than to States 2.8X 2.9x 3.25 3.45 8.8x 4.25 3.6XStates other than to Centre 0.45 0.45 0.SX 0.65 o.ex 0.8x 0.6%
Developmental 9.ox 9.9x 10.45 10.9X 1O.8X 10.0X -3.0%
Net Current Balanco -o.8x -1.9X -2.6x -3.1X -3.45 -3.8x -3.1%
Capital Expenditur- 7.5X 7.4X 8.2x 7.ox 6.11 6.3% 7.0%Nondevelopmental 0.56 0.6e oM 1.33 I 1.82 1.15 Developmental 4.7X 4.7X 4.8x 8.8x 8.75 3.45 4.0%Loans A Advances 2.8x 2.0X 2.6X 1.8x 1.8x 1.8x 1.95
Total Borrowing Requirmnt -8.1x -9.3x -10.95 -10.0X -10.1X -10.1% -10.1%
Non-interest overall surplus -5.55 -6.ox -6.8x -6.15 -5.9x -5.3X -6.0%
Source: Ministry of Finance and World Bank Staff estimates.
1.53 The Government's efforts to contain the deficit (particularly after1986/87) fell heavily on investment expenditures. After rising from 7.8X ofGDP in 1984/85 to a peak of 8.2Z of GDP in 1986187, capital expenditures(centre, states, and union territories) fell to an estimated 7.OZ of GDP in1987/88, and 6.32 of GDP in 1989/90. Moreover, the defense component ofcapital expenditures rose from 0.3Z of GDP in 1984/85 to 0.92 in 1987/88, andto an estimated 1.02 in 1989/90. Thus capital spending for development forwas curtailed even more sharply.
1.54 Government deficits have increased despite the decline in investment.The consolidated government deficit averaged 10.12 of GDP during the SeventhPlan, up from 8.12 during the period 1980/81-84/85. The primary deficit(i.e., deficit excluding interest payments), which is a key parameteraffecting the build-up of government debt in the economy also increasedmarkedly, from an average of 5.52 of GDP (1980-85) to 6.02 of GDP (1985-90).
(f) Money and Prices.
1.55 The large fiscal deficits of the late 1980s, a sizable fraction ofwhich were financed by net borrowing from the RBI, contributed to rapidmonetary expansion. Overall, the change in base money measured as apercentage of GDP
26
Table 1.14:Monetary and Price Developments*
1970-74 1975-79 1980-84 1985-89
Broad money growth (2 p.a.) 15.6 19.3 16.8 18.1Base money growth (2 p.a.) 12.2 17.2 16.4 15.7Base money growth (2 GDP) 1.2 1.8 2.0 2.1RBI net credit to govt. growth (2 GDP) 1.4 1.0 2.4 2.0Inflation (WPI), 1970/71 base 2 p.a.) 15.3 4.7 9.4 6.4
* 1970-74 is 1970/71 - 1974/75, and similarly for other periods.
averaged 2.02 dturing the first half of the 1980s and 2.1Z during che secondhalf (the highest of any five-year period during the last 20 years). Duringboth periods, the flow of RBI net credit to the government accounted forvirtually all of this growth. The RBI limited the monetary growth emanRtingfrom the rapid growth of the base by increasing the cash reserve requirement.Nonetheless, growth of broad money averaged about 18.12 p.a. during the late19808, as these adjustments were not sufficient to offset the tendency for thecurrency-deposit ratio to decline.
1.56 Despite rapid monetary growth, the rate of inflation (measured bywholesale prices) remained modest, averaging only 6.4X per annum. Thepotential inflationary effects were dampened by relatively rapid money demandgrowth, domestic output expansion and, during the last few years, by balanceof payments deficits. During much of the decade, increasing monetization ofthe growing fiscal deficit and consequent rapid monetary growth moderatedpreasures on credit availability and interest rates and thereby accommodatedthe growth of domestic demand. Domestic output expanded to meet this demandrelatively easily at first as capacity utilization increased and, mor3recently, as relaxation of regulations on trade and industry and improvedinfrastructure services made it possible to use capacity more efficiently.Increasingly, however, this demand has spilled over into the balance ofpayments.
(g) Balance of Payments
1.57 India's balance of payments has been under severe pressure throughoutthe Seventh Plan period. Apart from some modest "supply shock" effectsassociated with the 1987/88 drought, all indicators point to excessivedomestic absorption resulting from overly expansionary fiscal and monetarypolicy as the basic cause of these difficulties. Private sector investmentdemand was strong throughout most of the Plan period. Brisk investment demandwas superimposed upon rapidly increasing government consumption expenditures,which generated excess demand that could only be met, without inflation,through a larger trade deficit. This basic balance of payments problem hasbeen compounded by three other factors: (i) rapidly increasing factorpayments; (ii) stagnating private remittances; and (iii) substantial IMFrepurchases.
27Tablo 1.15:
Balance of Payments, 1984/85 - 1989/90
(Millions of USS)
1980/81 1984/86 1986/86 1988/88 1987/88 1988/89 1989/90- - = = 5===~~== = - _= -_ =
Exports of Goods and Non-Factor Services 11281 13216 12771 13877 18216 18184 21216Merchandise (fob) /a/ 8382 9769 9461 10460 12844 14208 17060Non-factor Servies 2949 8447 8810 8217 8571 8978 4165
Imports of Goods and Non-Factor Services 17408 17774 19419 19950 22839 27093 28956Merchandise (cif) /o/ 15892 15424 17295 17728 19812 28849 25416Non-factor Services 1618 2350 2124 2222 8027 8244 3640
Resource Balance -6127 -4658 -8648 -8278 -6824 -8909 -7740
Net Factor Income 868 -1449 -1562 -2046 -2471 -2986 -3622Factor Receipts 1083 493 547 501 446 397 395Factor Payments /b/ 727 1942 2099 2548 2917 8382 3994Interest Payments on NRI Dep. 117 285 891 512 692 920 976
Net Current Transfers 2860 2809 2306 2827 2698 2979 2720Transfer Receipts /c/ 2874 2622 2317 2339 2724 3005 2760Transfer Payments 14 18 12 12 26 28 30
Current Account Balance -2911 -3398 -5895 -5991 -8397 -8216 -8642
Foreign Direct Investment 8 62 160 208 181 287 426Official Grant Aid 643 463 369 403 410 406 S00Net Medium & Long-Term Loans 1426 2697 2546 8278 3872 4102 5470Disbursements 2180 8787 3654 6206 5915 6218 7601Repayments 765 1090 1809 1933 2043 2118 2131
Net IMF Credit 1014 67 -264 -648 -932 -1068 -870Purchases 1028 201 0 0 0 0 0Repurchases 9 134 264 848 932 1088 870
Capital Flows NEI 386 1265 2248 1776 1297 2178 2268Non-Resident Deposits 828 772 5l01 1710 1806 2337 2298Mzt Short-Term Capital 228 220 273 168 222 263 250Errots A omissions /d/ -200 273 474 -102 -731 -412 -280
Change in Reserves /e/ 846 -268 -548 -72 339 1432 860(- = increase)
End of Year Reserves (Excl. Cold) f685 6110 8657 8730 8391 4959 4109{ # Months of Imports 5 5.2 4.8 4.6 4.6 3.9 2.5 1.9
Memo. Items:Debt Service Ratio 9.2x 18.2X 22.7X 29.SX 29.4x 29.3% 27.3XCurrent Account Balance (X GDP) -1.71 -1.3x -2.7X -2.61 -2.5X -3.3% -3.3XImport Statistical Discrepancy -7 2324 1231 1930 2539 4386 4410
/a/ Net of crude petroleum exports./b/ Includes interest on non-resident deposits and IMF Interest./c/ Includes payment for Bhopsl settlement in 1988/89./d/ As estimated by Government of India./e/ Excluding Gold
28
1.58 Merchandise Deficit. After narrowing during the Sixth Plan, themerchandise deficit has remained relatively large ($7-$10 billion per year)over the Seventh Plan period despite relatively rapid export growth, due toexcessive domestic absorption. Trade (customs) data show that importsdeclined in relation to GDP, although imports of intermediate and capitalgoods increased. A substantial portion of these increases was directly linkedto increased exports. Over half of the increase in imports of intermediates,for example, was due to imports of gems for processing and export. Some,however, was imports of inputs for domestic demand driven import substitution.These played an accommodating role, permitting excess domestic demand to bedispelled indirectly through the balance of payments (via increased productionof highly protected import-intensive domestic industries) rather than throughinflation.
1.59 The reasons for the continuing large merchandise deficit are unclear.Trade data, compiled monthly on the basis of customs information, indicate arapidly narrowing merchandise deficit. Payments/receipts data, on the otherhand, show no such tendency. The growing discordance between these datasources has been due mainly to a rapidly growing gap between import paymentsreported by the RBI in India's official balance of payments statistics andimports recorded by customs officials. In every year since 1980/81, the valueof import payments has exceeded the value of imports reported on a customsbasis. During the first half of the decade, however, the difference was ofthe order of 5Z (generally about $500 million or less except in 1984/85) ofimports or less. The picture changed dramatica ly in the late 1980s. Overthe four year period 1985/86-88/89, the cumulat ve difference between thesedata sources amounted to almost $10.1 billion or about 15Z of the value ofimports on a trade basis. In 1988/89 alone, the difference amounted to almost$4.4 billion.
. -~~
29
Table 1.16:Imports: Comparison of Customs Data to Payments Data
Average Average1980-84 1985/86 1986/87 1987/88 1988/89 1985-88
Imports, Customs Basis (bil. US$) 15.3 16.1 15.8 17.3 19.5 17.1(Z of GDP) 7.6% 7.5Z 6.92 6.8Z 7.22 7.12
Intermediate: Primary (Z GDP) 0.92 1.02 1.12 1.2Z 1.52 1.2%Fertilizer raw materials 0.12 0.12 0.12 0.1Z 0.12 0.1%Gems 0.4Z 0.42 0.52 0.62 0.72 0.62Other 0.42 0.4Z 0.52 0.52 0.7Z 0.5%
Intermediate: Manufactured (2 GDP) 2.02 2.21 2.02 1.82 2.62 2.1%Fertilizer 0.32 0.42 0.2Z 0.12 0.12 0.2%vIrou & Steel 0.62 0.52 0.52 0.42 0.52 0.52Nonferrous Metals 0.22 0.22 0.12 0.22 0.22 0.2%Other 0.92 1.12 1.22 1.22 1.82 1.32
Capital Goods (Z GDP) 1.42 1.62 2.12 1.92 1.42 1.72
Imports, Payments Basis (bil. US$) 15.2 17.3 17.7 19.8 23.8 19.7(2 GDP) 8.12 8.12 7.72 7.82 8.92 8.2%
Difference:Payments - Customs (bil. US$) 0.8 1.2 1.9 2.5 4.4 2.5
1.60 Given its magnitude and the enormous effect it has had on recentbalance of payments outturns, an understanding of the nature, causes of, andprognosis for this growing difference is essential to sound policymaking. It'.is now on the order of three or more times recent estimated reserve losses,and exceeds disbursements of medium- and long-term loans and the level ofreserves (excluding gold). Substantially reducing or eliminating it would besufficient to turn a precarious balance of payments situation into acomfortable one. The potential sources of differences between customs andpayments import figures are qualitatively known: (i) imports of nondutiedand/or nondutiable items; (ii) differences in the method of recording imports(payment data are recorded generally at the time that payment is made, whereastrade data are recorded when the import crosses the customs frontier); and(iii) differences in methods of conversion of values from foreign to domesticcurrency (MOC converts at an exchange rate that changes only once every threemonths, whereas RBI data are converted at the average monthly rate for themonth in which payment occurs. Qualitative information alone is not adequate,however. Quantification of the relative importance of each of these factorsand the corresponding commodity composition of import payments is absolutelynecessary if appropriate and timely policies are to be identified andimplemented. If, for example, the differences were mainly due to timing, someadjustment of interest and exchange rate policies could be in order.
30
Differences due primarily to imports of nondutied and/or nondutiable items, incontrast. would call for expenditure reduction, complemented by appropriateexchange rate management policies.
1.61 Apart from the minor role it played in supporting importsubstitution, the effects of liberalization on the merchandise balance appearto have been positive and felt primarily on the export side. After a slowbeginning in 1985186, export growth responded to the decidedly more favorableincentives created by the rapid depreciation of the rupee that necessarilyaccompanied liberalization and by enhanced subsidies and access to importedinputs offered to exporters. In volume terms, export growth has averaged over12? p.a. since 1985/86 (about 9.6Z including 1985/86), and may beaccelerating, exceeding 12Z in 1988/89 and about 192 in 1989/90. The recentrapid growth is due to a near doubling of the volume of manufactured exports.Among manufactured exports, a -elatively small number of items account formost of this spectacular growth -- gems and jewelry, textiles and garments,leather and leather products, and more recently, chemicals and engineeringgoods. Non-factor service exports have also done reasonably well, as earnings .from tourism, computer software, and a few other services have grown rapidly.Overall, however, growth has been substantially slower than that ofmerchandise, particularly manufactured, exports. Primary exports declined dueto a combination of world market factors and to the press of growing domesticdemand.
1.62 Despite its recent rapid growth, the base of nontraditional exportsin India is still narrow. Moreover, exporting industries are still dependenton direct fiscal and other incentives. In addition to complete exemption fromtaxes on income and profits from export activities, there are now severalincentives amounting to about 13Z of total merchandise export earnings.Incentives to manufactured exports (excluding gems and jewelry) amount to 252of the value of foreign exchange earnings from such exports (Kishor (1989)).These incentives have been essential to offset cost disadvantages derivingfrom the very high levels of indirect taxes applied to widely used inputs.
1.63 Increasing Factor Payments. Factor payments abroad increased rapidlyas a result of growing external debt and sharply hardening terms on India'sexternal borrowing. The hardening of terms was due to an increase in theshare of India's external borrowing from private creditors, and a generaldeterioration in the terms on which external finance was available. The shareof total public borrowing (gross disbursements) provided by private creditorsrose from 19.82 in 1980/81 to 48.5? in 1989/90. In addition to the rise inaverage borrowing costs stemming from increased use of private credit, theterms of borrowing from official sources also hardened as India's access toconcessional funds was curtailed. Official grant aid declined in absoluteterms over the 1980s. Capital inflows from IDA have also declined from a peakof US $ 1.1 billion in 1982/83. The hardening in official terms is largelydue to the substitution of IBRD borrowings for IDA assistance. As aconsequence, the weighted average rate interest charged on multilateral loans(which accounted for 48Z of total public borrowing in the 1980s) has risenfrom 2.6Z p.a. in 1980 to an average of 6.6Z between 1986/87 and 1988/89. Theweighted average interest rate charged on all public and publicly guaranteedexternal debt has increased from 3.9? in 1980 to 6.3Z in 1988/89, and theaverage grant element of new borrowing has fallen from over 55Z to about 27Z.The average maturity of external loans has declined from 44 years to less than
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21 years. Almost 162 of total public and publicly guaranteed external debt isnow at variable interest rates. compared to about 12 in 1980.
1.64 As a result of heavy borrowing requirements driven by growing tradedeficits and hardening interest terms, factor payments (in US dollars) haveincreased more than six-fold since the beginning of the 1980s. The averageinterest rate on outstanding debt has doubled, thus accounting for about 402of the increase in factor payments. The buildup of debt, which increasedabout 2.8 times during the 1980s, accounted for the remaining 60Z. However,over che late 1980s, as worldwide interest rates fell, increased payments weredue primarily to growth of the debt stock. Total external debt increased by862 (i.e., $63 billion at the end of 1989/90 as against $33.9 at the end of1984/85) during the Seventh Plan. The medium and long term component morethan doubled (i.e., from $27.1 billion to an estimated $57.:. 'illion).
1.65 India's debt service ratio has risen sharply as well, increasing from18.22 of current receipts in 1984/85 to 29.32 in 1988/89 (including intereston non-resident Indian deposits). Any unutilized borrowing capacity thecountry might have had at the beginning of the 1980s has been utilized. Thesize of the current account deficit and external borrowing must now becarefully managed so that future growth of debt service obligations does notexceed growth of exports of goods and services.
1.66 Remittances. Receipts from private (worker) remittances, which werean important factor during the 1970s, stagnated during the 1980s, fallingslightly with declining oil prices in the mid 1980s, but remaining in therange of $2.3 to $3.0 billion.
1.67 IMF Repurchases. Repurchase obligations under India's 1981 EFFprogram with the IMF increased from $134 million in 1984185, to a peak of $1.1billion in 1988/89. Cumulative repurchases over the Seventh Plan amounted toabout $3.6 billion. India "self financed" much of this by running downreserves, with an estimated cumulative loss of gross reserves (excluding gold)of about $2.0 billion during the Seventh Plan. On a net basis, however,reserves remained about constant as outstanding repurchase obligations to theIMF declined by about the same amount.
1.68 Capital Account. The high current account deficits of 1988/89 and1989/90 were financed by a combination of increased borrowing and losses ofreserves. Net disbursements of medium and long term loans from officialcreditors fell from the drought relief peak level in 1987/88 ($2.5 billion) toabout $2.1 billion in 1989/90, when many official lenders experienced severedisbursement performance difficulties. Increasing net disbursements fromprivate creditors more than offset this decline, rising from $1.1 billion in1987/88 to an estimated $2.3 billion in 1989/90. Inclusive of accruedinterest, inflows of deposits from non-resident Indians (NRIs) also increasedfrom about $1.8 billion to an estimated $2.3 billion in 1989190.
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Table 1.17:Financing the Current Account Deficit, 1984/85 - 1989/90
(billions of US$)
1984/85 1985/86 1986/87 1987/88 1988/89 1989/90
Current Account Deficit 3.4 5.9 6.0 6.4 8.9 8.6
Capital Flows 3.7 6.4 6.1 6.1 7.5 7.8MLT (net) 2.7 2.5 3.3 3.9 4.1 5.5NRI (a) 0.8 1.5 1.7 1.8 2.3 2.3Grant Aid 0.5 0.4 -.4 0.4 0.4 0.5Direct Investment 0.1 0.2 0.2 0.2 0.3 0.4Net Use of IMF Credit 0.1 -0.3 -0.6 -0.9 -1.1 -0.9Other (Residual) -0.4 2.1 1.1 0.7 1.4 0.0
Reserve Loss (- = Gain) -0.3 -0.5 -0.1 0.3 1.4 0.8
(a) Including a provision for accumulated interest.
1.69 Direct foreign investment also increased significantly, albeit from avery low base. Much of the flow is accounted for by NRIs' investments, manyin the form of equity securities. For example, growth of about $150 millionin flows in 1989/90 over 1988/89 primarily reflects offerings of the StateBank of India's Magnum Fund in the USA and UTI's rights issues of the IndiaGrowth Fund in the UK. Despite recent rapid growth, direct fore.gn investmentcovers a much smaller portion of India's current account deficit than istypical in many other Asian developing countries.
1.70 Cumulative reserve losses during _he Seventh Plan amounted to about$2.0 billion. Import coverage dropped from 4.8 month in 1984/85 to less than2 months in 1989/90, the lowest level of the 1980s, and a level which isclearly not comfortable. Future balance of payments management and externalborrowing policy will have to allow for a reconstitution of reserves.
(h) Poverty and Social Services!./
1.71 Perhaps the most hopeful development of the 1980s was the first clearevidence that the prevalence of poverty in India has begun to trend downward.This is reflected both in an increase in real agricultural wages, and inincreasing consumption levels of people at the lower end of the incomedistribution. The combination of accelerated growth of per capita income andexpenditures on anti-poverty programs seems to have stabilized the absolute
2IA more complete discussion of trends in poverty and of recent developmentsin social sectors is contained in the 1989 Country Economic Memorandum, India:Poverty, Employment and Social Services, A World Bank Country Study.
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number of people whose incomes are below the poverty line at about 320million, and resulted in a reduction of the proportion to about 402 of thepopulation (IBRD (1989), Kakwani and Subbarao (1989)).
1.72 Despite the recent gains, the incidence of poverty in India remainsunacceptably high. Moreover, the plight of the poor is not adequatelycaptured by data on the numbers of people whose income is below a fairlyarbitrary threshold. Malnutrition remains prevalent among India's poor,especially among their children, not only in caloric consumption, but inproteins and micronutrients. In many states 402 of children show signs ofmoder te malnutrition. Rates of mortality and morbidity remain high. Poorgirls and women are disproportionately burdaned by sickness. The overalldeath rate has fallen only gradually and the infant mortality rate hasdeclined even less rapidly. Life expectancy increased from 46 to 57 for menand 44 to 56 for women between 1965 and 1985. The rate of infant mortalityremains high, at 86 per thousand, compared to 72 for all low-income countries.Only 35Z of married women report using family planning methods, and populationgrowth rates remain unacceptably high. School enrolment rates remain low. In1983 only 742 of male children between the ages of 5 and 14 in urban areasattended school. The proportions were progressively lower for rural boys,55Z, urban girls, 522 and rural girls 35Z. The low school enrolment ratestranslate Into a low adult literacy rate of 44Z.
1.73 Several initiatives were undertaken during the Seventh Plan tofurther expand and strengthen the social services delivery network.Implementation of a new National Policy on Education, a wide-ranging programaimed at revitalizing the education system and achieving universal primaryschool enrollment, began in 1987188. In health, a substantial increase in thenumber of health care facilities was initiated, a massive UniversalImmunization Program was launched, and steps were taken in 1986 under theFamily Welfare Strategy to strengthen public provision of maternal and childhealth, and family planning information and services.
1.74 Increasingly, efforts to improve access to and effectiveness ofsocial services appear to be hampered by lack of adequate funding. Ingeneral, resources allocated to the social sectors have been far below what isrequired in view of the low education and health status of much of thepopulation. The experience of developing countries that have reached muchhigher life expectancy and literacy levels indicates that higher proportionsof GDP have to be spent on education and health. The effects of underfundingare being magnLified by organizational problems inherent in some programs'designs, and a lack of clear priorities in the use of the resources available.The allocation of available funds across states and between and within sectorshas not been congruent with demonstrated needs. Social spending remains wellbelow the all-India average in the states with the lowest educational andhealth indicators. In many states, education and health have lost ground tovarious welfare schemes in the allocation of social sector resources. Severalstates operate antipoverty programs such as the Two Rupees per Kilo ricescheme in Andhra Pradesh and the Chief Minister's Mid-day Meal Scheme in TamilNadu. These types of programs typically are not need related, and have becomeincreasingly large claimants on states' budgetary resources. And within thehealth anti education budgets, there has been no significant shift incomposition towards services (principally primary schooling and primaryhealth) which are essential to longer-term poverty reduction.
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1.75 Direct antipoverty interventions such as IRDP and rural employmentprograms have also competed with health and education for scarce budgetaryfunding. The reach of direct poverty alleviation schemes was significantlyexpanded during the Seventh Plan. At the Centre, coverage of the IntegratedRural Development Program (IRDP), which assists low income families infinancing investments in minor irrigation, and purchase of livestock, bullockcarts and other self-employment ventures, has been significantly expandedreaching an estimated 18 million families during the Seventh Plan. Nationaland state-run employment programs also achieved broad coverage in rural areas.The National Rural Employment Program (NREP), whose costs were shared by theCentre and the states, and the Rural Landless Employment Guarantee Program(RLEGP), which was initiated in 1984/85, provided an average of about 6'WOmillion work days per year during the first three years of the Seventh Plan.These programs were merged into a new employment program (the Jawahar RozgarYojana) in 1989/90, and a new Urban Poverty Alleviation Program was launched.
1.76 Progress in alleviating poverty will depend in the 1990s, as it didin the 1970s and 1980s, on maintaining overall growth of the economy above 5Zper annum. However, growth of the economy is a necessary but not sufficientcondition. Measures to broaden participation in the growth process are alsorequired. This means strengthening of programs in health, family planning,education and nutrition aimed at human resource development, and eliminationof institutional and legal barriers or inhibitions to access to employment andcapital. Even with this, some sort of safety net in the form of guaranteedemployment will be required to protect those who, because they lack skills orcapital, or live in chronically depressed areas, cannot benefit directly fromthe growth process.
1.77 The massiveness of India's poverty problem and the urgency of dealingwith it make quick-fixes such as debt forgiveness, expanded publicexpenditures and guaranteed employment tempting. However, bc'th ;he changingcharacter of poverty (which is increasingly associated with laridlessness andwage dependency in unirrigated rural areas, especially in the Eastern regionof the country) and the fiscal constraints faced by government suggest thatmore efficient and effective means will have to be found to address theproblems of poverty directly. Broad-based, target-driven, non-selectiveapproaches are expensive and ineffective. Programs designed to increase theability of the poor to participate in the growth process by improving theirphysical and educational status will have to be more precisely targeted,simplified administratively, and more closely attuned to community needs.Service delivery should focus on the most vulnerable, lowest income groups andregions.
1.78 Large-scale public programs in health and education will have to bereoriented to give more emphasis to provision of basic services. In the caseof health, this means preventive medicine and primary care; in the case ofeducation it means basic literacy and primary schooling. Additional resourcescan be generated by cost-recovery, especially for higher-level services suchas secondary and tertiary health care and secondary and higher education, andby relying on private providers to supply a greater share of services.
1.79 Efforts to reform the country's rural works schemes must seek areasonable balance between income transfer/safety net (equity) objectives and
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efficiency objectives. With respect to equity, the issues to be resolved arcwhether market, below-market or official minimum wages are to be paid; whetheremployment is to be offered year round or only seasonally or du ing crises;whethar jobs are to be guaranteed; and how to ensure that the most indigenthave access to jobs. Efficiency concerns relate to the selection of works tobe undertaken, design and construction standards, and maintenance of assets.
1.80 Rural employment schemes should be seen as a safety-net, providingemployment at wages sufficient to sustain families during time of low-employment or natural disaster. Payment of minimum wages, which are wellabove market level in most rura: areas, and provisioi of large scale year-round employment, beside making such scheme: nrohibitively expensive, wouldmake them too attractive, eliminating their self-;argeting character, anddrawing needed labor away from on-farm employment.
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CHAPTER 2
ISSUES AND OPTIONS
2.1 The developments and trends reviewed in the preceding chapterindicate that India faces some difficult economic problems and issues in thenear-to-medium term. This chapter examines three of the most important ofthese: (i) restoring and maintaining macroeconomic balance; (ii) developingan efficient, competitive, high growth industrial sector; and (iii) increasingproductivity and growth in agriculture.
A. Restoring and Maintaining Sustainable Macroeconomic Balance
2.2 Current fiscal deficits are not sustainable.l/ They imply a verylarge future imbalance between the total sources of domestic finance providedby the private sector's financial saving and the requirements for domesticfinance generated by the public sector's deficit alone. Indeed, at thepresent time, the deficit ratio is approximately equal to the householddomestic financial saving ratio (both are about lOZ of GDP). In other words,today's government deficit levels would, if financed domestically, absorb theentire current annual household financial saving. Nothing would be left overfrom this source to finance investments elsewhere in the economy. This is whvdeficits are spilling over into the balance of payments and putting pressure 5on domestic prices.
2.3 Unless the primary deficit (i.e., overall deficit less interestpayments) is cut, the situation will tend to become even worse, as rising debtand interest thereon would tend to push the deficit higher. Late 1980sfinancial parameters imply that, in the long run, the ratio to GDP of thetotal gross stock of financial assets held by the domestic private sector,including all forms of financial assets, will attain a maximum value of about73Z. The ratio to GDP of domestic financial claims (reserve money, marketloans, small savings, etc.) issued by the public sector to finance a long-runnon-interest deficit of 6Z of GDP, (holding constant the rates to GDP ofreserve money and external debt) would, however, amount to 116X. TheGovernment's requirement for finance thus implies a stock of domesticfinancial claims that is over 40 percentage points of GDP higher than stock ofdomestic financial claims implied by the private sector's current financialsaving behavior.
2.4 The Government has had to make a number of stopgap adjustments overthe last few years to forestall this impending financial imbalance. Realinterest rates on government debt have been increased by about 6 percentagepoints since the late 1970s, and are now only slightly lower than the growthrate of the economy. As rates have been adjusted upward, increasingly
1/ This conclusion is explained in Annex I.
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attractive tax advantages have also been offered. Absent these advantages,adjustments in interest rates would have had to be substantially larger.Portfolio restrictions requ_.ring that financial intermediaries hold certainproportions of their portfolio in the form of claims on government have beentightened. The Statutory Liquidity Ratio, a ratio that commercial banks mustmaintain between holdings of approved securities (mainly government debt) andnet time and demand deposits, was raised from 34S in 1981 to 38.52 currently.The Cash Reserve Ratio, a required ratio between banks' deposits with theReserve Bank of India and their net time and demand deposit liabilities, wasraised from 62 in 1980 to 15T, the maximum under current law, in 1989.Monetization of the deficit (borrowing from the RBI) has been increased,averaging about 2.2Z of GDP during the Seventh Plan, the highest average in 20years. And external borrowing and international reserves have been reliedon increasingly to close any financing gap remaining after domestic sourceswere fully exploited. As a result, external debt has piled up rapidly andreserves have fallen to precariously low levels.
2.5 The scope for further adjustments and accommodations along theselines is very limited. Moreover, none offers a sustainable solution to theproblem of financing current deficit levels. Increasing real interest ratesby the amount necessary to induce large enough domestic holdings of governmentdebt could push India into a debt trap. Tightening portfolio requirementswould not provide a lasting solution either since even 100' preemption ofprivate saving would leave the Government 40 percentage points of GDP short ofits financing needs (see paragraph 2.3). Monetization of the deficit isalready at the limit of what can be sustained without tending to pushinflation into double digits. Increasing monetization to the degree thatwould be required to solve the government's financing problem would produceunacceptably high inflation. External debt has been growing at uncomfortablyfast rates and needs to be moderated, not accelerated. Reserves are atminimum safe levels and should not be further depleted.
2.6 Reducing the primary deficit is thus an essential element of anyeffort to bring government's financing requirements into line with availablefinancing. Combined with a program of structural adjustment and financialliberalization, reducing the primary deficit would materially increase growthand reduce inflation.I'
2.7 Over the last three years, efforts to reduce the deficit andstabilize the economy have emphasized increasing taxes on imports and selecteddomestic transactions (particularly manufacture of items considered to beluxuries), income tax surcharges, restraining capital expenditure other thandefense, and accelerating depreciation of the rupee. These efforts were notentirely successful. The combined effects of tax adjustments and investmentspending restraint were inadequate to offset rapidly increasing currentexpenditures. On the balance of payments front, while exports performed welland commercial imports rose only moderately, the potential positive impact on
I/A discussion of tradeoffs between deficits, structural adjustment, financialliberalization, growth and inflation is contained in Annex II.
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the merchandise deficit was overwhelmed by continuing increases in paymentsfor noncommercial imports. Moreover, this policy mix had some undesirableside effects: the growing reliance on trade taxes increased the importsubstitution bias of the trade regime, and restraints on capital spending mayhave delayed some important investments. Reduced availability of budgetaryfunds may also have had some negative effect on net foreign capital flows fromthe Consortium due to shortages of counterpart funds.
(a) Near-Term Options
2.8 With reserves at their lowest level in over a decade (2 months ofimports), India needs to move promptly to reduce domestic and externalimbalances. Action on two fronts is required: (i) domestic expenditure needsto be contained; and (ii) the composition of domestic demand needs to bealtered to encourage net exports. In the near term, the range of choicesavailable to the Government is relatively narrow. Emphasis will have to beplaced on measures, such as reduction of government consumption expendituresand exchange rate depreciation, that can be taken quickly to reduce pressureon the balance of payments without sacrificing longer term developmentobjectives.
Domestic Expenditure Reduction
2.9 The logical place to attack excess domestic absorption directly,without jeopardizing investment needed for output and employment growth, is torestrain government consumption, i.e., spending for compensation of governmentemployees and net purchases of goods and services. In large measure, it hasbeen the growth of these expenditures that has been responsible for growingexcess demand. Moreover, their very rapid recent growth suggests thatrestraints could be applied with at most only marginal sacrifice of economicand social objectives. Restraint could take a number of different forms:broadly-based limitations on the growth of government employment; control ofgrowth of government wage and salary rates; or controlling net purchases ofgoods and services. Whatever specific restraints are applied, the objectivemust be to hold the rate of growth of reel government consumption below thatof real GDP growth, thereby reducing the excess of domestic aggregate demandover domestic output. For instance, holding government consumptionexpenditure constant in real terms over (say) 5 years could (assuming 52 p.a.real GDP growth) reduce the government consumption ratio by 2 percentagepoints of GDP (i.e., bring it back to its average level during the Sixth Plan)and correspondingly reduce the deficit.
2.10 Limiting other current government expenditures could also help,although the links between these expenditures and domestic aggregate demandare less direct. Ideal candidates are subsidy expenditures that, in additionto the fiscal pressure they place upon the economy, distort production and orconsumption decisions. Such outlays are pervasive but difficult to quantify,because substantial subsidies are provided in kind, with no budgetaryaccounting, such as electricity, higher education, and financial servicesoffered at below cost. Each of these forms of subsidy merits scrutiny. Inaddition, there are easily identifiable, quantifiable, and rapidly growing
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subsidies, those for food and fertilizers (See Table 1.11), that could beconsidered for reduction.
2.11 The fertilizer subsidy provided by the Central Government has grownrapidly from Rs. 5.0 billion (0.4Z of GDP) in 1980181, to Rs. 36.5 billion(0.9Z of GDP) in 1989/90. In the absence of a major policy reform, costs canbe expected to escalate further as substantial new high cost capacity comes onatream in the next few years.
2.12 Conceived with the objectives of increasing agricultural productionand maintaining a high degree of self-sufficiency in fertilizer production,the fertilizer subsidy may no longer efficiently serve these purposes. Exportperformance during the last four years demonstrates that India need not targetproduct-by-product self-sufficiency. It can earn rapidly growing amounts offoreign exchange though exports to pay for imports of goods such as fertilizerthat can be obtained more efficiently at the margin through trade than throughdomestic production. The production responsiveness of key foodgrain crops(rice and wheat) with respect to fertilizer input price changes is relativelylow (about 0.3). There are other more effective, lower cost incentivestrategies for stimulating agricultural production, e.g., eliminating theimplicit taxation of agricultural production inherent in relatively highindustrial protection and attendant currency overvaluation (See Section C ofthis chapter).
2.13 These considerations argue for a coordinated, phased reduction offertilizer subsidies. Achievement of the restraint envisioned in the 1990/91budget would be a good first step. Over time, on the farm side, fertilizerprices need to be moved toward market levels. This would require someincrease in prices to farmers to approach world price levels expected toprevail over the next one to two years. World market fertilizer prices arepresently below long-run marginal costs of efficient production. If they movehigher, as expected during the 1990s, additional price adjustments would berequired. On the producer side, the present system of tailoring prices toproduction costs should be phased out in favor of a uniform price, with pricesdetermined basically by world market levels plus a modest tariff. Thisapproach to price reform has worked well in the deregulation of cement andaluminum. Restrictions on entry and the choice of technology in thefertilizer industry should be relaxed. Restrictions on exit need to berelaxed as well. Several Indian plants currently in operation are not likelyto be economic at procurement prices approximating the long-run marginal costof efficient production, much less at present world market price equivalents.These plants should be restructured if they can be made viable, or closed ifnot.
2.14 The food subsidy, like the fertilizer subsidy, has claimed anincreasing share of budgetary resources. Central subsidy outlays associatedwith the public distribution system have increased from 0.5Z of GDP in198C/81, to 0.7? at its pre-1987 drought peak. Many states also subsidizefood consumption. Low levels of procurement since the 1987188 drought havehelped to keep food subsidy outlays in check. Indeed, the central subsidy isbudgeted to decline in 1990/91. As procurement and storage build up again,however, the subsidy may tend to rise.
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2.15 The basic rationale for food subsidy programs is simple andcompelling. National Sample Survey data show that, despite significantprogress against poverty over the last decade, a large number of Indians stillcannot afford a basic 2,200 calorie/day diet. Food subsidies, in principle,help meet this need. However, the targeting of subsidies and the efficiencyof Food Corporation of India (FCI) operations are important issues. A largenumber of middle income Indians are entitled to purchase food at subsidizedprices at "Fair Price, shops. A recent estimate puts the fraction of rationcard holders who are well above the poverty line at about 30Z of the total.Moreover, data on food releases from public supplies show that the bulk ofsubsidized food is distributed in four urban areas -- Delhi, Bombay, Calcutta,and Madras; poverty data, ir contrast, suggest that 802 of India's poor livein rural areas of the country.
2.16 FCI's handling, storage and distribution costs appear to besubstantially higher than those of private sector operators. Increasingefficiency of its operations could reduce costs and budgeting outlays. Arelated set of issues concerns the appropriate size of stocks. Studies shouldbe undertaken of the optimum size of buffer/operating stocks given the costsof holding physical stocks relative to costs of holding additional foreignexchange reserves to cover imports in an emergency situation.
2.17 In addition to restraining government consumption, there may beanother, even more direct route to strengthening balance of paymentsperformance via expenditure cuts. Recent expenditures for imports ofequipment to modernize India's defense forces appear to have increased bothgovernment capital expenditures and imports. While these expenditures aredriven by overriding national security objectives, the present tight budgetand balance of payments situations demand that they be closely andcontinuously scrutinized. Reductions in these outlays, if and when feasible,could materially reduce both the fiscal and balance of payments deficits withno sacrifice of economic or social objectives.
2.18 Some economies in nondefense public investment expenditures may alsobe possible, including elimination of projects of questionable economic and/orsocial value and better, more timely execution of the remaining projects.Nonetheless, large unmet infrastructure investment needs, the fact that nondefense capital spending has already been sharply curbed, and the recentdisproportionate growth of current expenditures point to the latter as thelogical focus of near-term expenditure restraint efforts.
2.19 If some increase in taxation is necessary to round out the effort tocontain domestic demand, this should be done in a way that does not push theeconomy toward increased import substitution or further away from the tariffreform that will be needed to develop India's full industrial potential. Oneway this might be achieved, would be through across-the-board increases inexcise rates applied to domestic production, matched by equivalent increasesin the countervailing duty portion of the tariff structure. The highlyselective increases in and surcharges on tax rates, particularly customs andexcise rates, that typified late 1980s tax policy should be avoided. Thepotential for worsening distortions, particularly the risk of further
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increasing the import substitution bias of the trade regime is great, and adhoc adjustments are not an effective demand management tool.
Encouraging Net Exports
2.20 The second essential component of a near-term program to stabilizethe balance of payments is continuing flexible management of the exchangerate. This would enhance the relative profitability of exporting, diminishthe relative profitability of importing, and thereby strengthen the tradebalance. Moreover, provided imports and exports are sufficiently responsiveto relative price changes, appropriate exchange rate management would help toincrease demand for domestic output, thus mitigating the contractionary effectof expenditure reductions. There is increasing empirical evidence that bothimports and exports are quite responsive to real exchange rate changes. Thesestudies also generally show that the trade deficit is sufficiently responsiveto relative price changes that depreciation would mitigate the effect ofgovernment expenditure reduction on domestic output.
(b) Medium-Term Options
2.21 The medium term opens up some additional options that would alsoimprove the efficiency of resource mobilization and/or utilization in thepublic sector: (i) increasing resource mobilization in public enterprises;and (ii) rationalizing tax structures.
Increasing Internal Resource Generation in Public Enterprises
2.22 Increasing resource mobilization by public enterprises could play animportant role in maintaining macroeconomic balance. While the contributionof public enterprises to overall public sector saving increased during the1980s, surpluses were accounted for by a handful of enterprises in oil, power,transport and telecommunications. Moreover, the after-tax profitability ofthe sector (center, state and union territory enterprises) is very low(recently estimated at perhaps 1.52 of invested capital) and the capitalinvested in it is enormous (Kelkar, 1989). Achievement of a modest overallafter-tax rate of return of 3.02 on invested capital would increase publicsector saving, through its effect on both tax revenues (due to higher pre-taxprofits) and after-tax profits, by approximately 3.0 percentage points of GDP.
2.23 Profound structural changes will be required, however, to achievethis kind of financial performance (IBRD, 1988). Simple adjustment of pricesto cover costs plus an allowance for profit is not an appropriate course ofaction since costs throughout the sector are inflated by inefficiency. Forexample, incremental capital-output ratios of public sector manufacturingfirms are three times greater than those of comparable firms in the privatesector. Overmanning in central public enterprises engaged in manufacturingalone is estimated at between 235,000 and 300,000 workers, or about one-fourthto one-third of the total labor force of these firms. The extra labor costsdue to this overmanning are between Rs 4.7 billion and Rs 6.0 billion peryear, more than the losses reported by these enterprises. In mining, CoalIndia alone is overmanned by more than 200,000 workers.
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2.24 A successful strategy for improving performance in the publicenterprise sector must attack the root causes of inefficiency: (i) lack ofcompetition or (in cases in which competition is not feasible) other stimulito efficiency; (ii) lack of autonomy and accountability of managers; and (iii)lack of an effective means for winding up or restructuring nonviable publicsector enterprises.
2.25 The first priority should be to ensure that public enterprises arestimulated to be efficient by creating an increasingly competitive environmentand/or by providing other incentives to efficiency. The approach to be takento achieve this depends upon the industry in question. In some industries,splitting up large public sector firms or permitting private entry may be theanswer; in others, increased foreign competition could be the best approach;in natural monopolies (e.g., the distribution of electric power), efficientregulation could be considered; in still others, privatization might provide asolution.
2.26 Autonomy (embracing the authority to enter, exit, hire, retrench,negotiate compensation, adjust prices, arrange financing, and make othermanagement decisions so as to best achieve the objectives of the enterprise ina competitive environment) and commensurate accountability for the achievementof those objectives, are the other essential elements of a strategy forstrengthening the public sector. The recently inaugurated practice ofexecuting a Memorandum of Understanding (MOU) between the Central Governmentand selected central public enterprises offers a promising start in thisdirection that may be applicable more broadly. The MOU should be a 'contract"between the government and a public enterprise. It must substitute for,rather than add to, the existing system and procedures for government controlof public enterprises. The MOU should cover a fixed period of time (not lessthan three years), set forth objectives and targets based on each enterprise'slonger-term corporate plan, stipulate all criteria to be used for evaluatingmanagement performance, and stipulate all government commitments, particularlythe subsidies to be provided to compensate for non-commercial obligationsassumed by the enterprise under the MOU.
2.27 While performance problems are pervasive in the public sector, a fewenterprises, such as State Electricity Boards and Coal India, account for adisproportionate share of the losses. Successfully restructuring theseenterprises, and others like them, would have beneficial effects an efficiencyand competitiveness throughout the economy and make a major contribution toredressing fiscal imbalances.
2.28 State Electricity Boards are a serious drain on the fiscal resourcesof the public sector. During the Seventh Plan, commercial losses of the SEBs(not including subsidies) totaled Rs 113.32 billion (nearly US $ 7 billion).Internal resource generation has been negative since 1987/88, and the majorityof financing has come from state government loans. The rate of return oninvestments (including subsidies) has declined to -9.8Z.
2.29 The poor financial performance of SEBs is attributable to a number ofserious technical and economic inefficiencies. For the most part, thesederive from the institutional environment in which SEBs operate. The
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Electricity Supply Act establishes SEBs as autonomous enterprises, vholly-owned by their respective state governments. As amended in 1985, the Actstipulates that SEBs earn a minimum return of 31 on net assets at historiccost, after provisions for interest and depreciation. Sitting uneasilyalongside this modest target are provisions in the Act that require SEBs toundertake investments as directed by their si:ate governments and to settariffs in consultation with their state governments. In practice, stategovernments tend to dominate this relationship, and decisions correspondinglytend to be dominated by non-commercial considerations. The result has, ingeneral, been inefficient siting of power plants, suboptimal integration ofpower systems and inefficient systems operation, excessive concentration ofinvestment in additional capacity at the expense of transmission anddistribution investments and rehabilitation of existing supply facilities, andtariffs well below the cost of power supply.
2.30 There is substantial potential for reorganizing the sector so that itis more responsive to commercial and financial considerations and better ableto reap the benefits of specialization of function (i.e., generation, ;transmission, and distribution) and system integration. Increasingspecialization of SEBs in distribution, with a concomitant increase in therole of central transmission and generation through expansion of NTPC, NHPCand the newly established National Power Transmission Corporation (NPTC) wouldimprove financial discipline. At the same time, the SEBs' charters would needto be redrawn to grant them more autonomy, and demand more accountability.Prices could be regulated by an independent commission, set on the basis ofthe cost of efficient operation plus a reasonable return on capital. Anysubsidies to power users should be covered by explicit budgetary allocationsto SEBs.
2.31 There are a number of relatively straightforward steps that can betaken to remedy technical operational problems and adjust tariffs that couldhave sizeable near-term benefits. Changing the monitoring of power stations'operations to give less importanc- to the plant load factor, eliminating thepractice of rationing supply thro. ,-h low frequency operation, eliminatingoverloading of transmission and distribution systems, and boosting poor powerfactors, could save an estimated Rs. 42 billion annually (about 12 of GDP).
2.32 Even a comparatively modest reform of retail power tariffs could havea sizable and immediate impact on sector finances: for SEBs to meet the 3Zminimum rate of return requirement prescribed by the Electricity Act wouldrequire an increase in electricity rates of only about 20Z. This wouldgenerate additional annual revenue equivalent to approximately Rs. 40 billion(about 1Z of GDP). Although most rates would remain well below economicsupply costs and (for most consumers) well below willingness-to-pay, tariffincreases would also choke off some of the excess demand for power and hencetrim back sector investment requirements.
2.33 Coal India's operating losses over the four year period 1985/86-1988/89 averaged Rs. 2.7 billion per year, or almost O.1Z of GDP. The companymet only a fraction of its scheduled interest obligations to the CentralGovernment, paid no dividends on government equity in the company, andrequired average annual financing (debt and equity) from the Central
45
Government (net of actual repayments of principal and interest) of Rs. 6.4billion, or ab3ut 0.21 of GDP.
2.34 CIL operates in a policy environment that provides few incentives toimproved efficiency and satisfactory financial performance. The Governmentcontrols nearly all facets of CTL's operations through the Department of Coal.the Planning Commission, and the Public Investment Board. It sets productiontargets, approves operating budgets, decides on the allocation of coalsupplies to major consumers, sets coal prices, fixes the investment program,negotiates wages and working conditions, and appoints the senior staff.
2.35 CIL and its subsidiaries have a virtual monopoly on coal production.Major coal consumers, such as power stations and steel plants, are linked tospecific mines. Imports require the approval of the Government. This haspermitted deferring hard decisions (such as closing unprofitable miningoperations, reducing the current 302 overmanning (200,000 workers), linkingreal wage increases to productivity gains, modernization of mining techniques,and differential pricing of coal by quality that could materially strengthenCIL's financial performance and reduce its draft on the budget.
2.36 Recently, mounting budget pressures have forced CIL to address someof these problems. In 1989, it commenced an 'Efficiency Improvement andFinancial Recovery Program". This program provides for phasing out operationsthat cannot be made profitable, improving the efficiency of the remainingoperations through reducing overmanning, improved mining practices, improvingthe profitability of new investments, and steadily increasing real coalprices. Even if successfully implemented, however, the program would reduceCIL's net claims on the budget only marginally. Moreover, the program doesnot provide for payment of any dividends on the Government's equity. CILshould be expected to earn an economic return on resources employed (includingequity) and its negative impact on the budget should be reduced sharply. Thiswill require steps to further foster CIL's managerial and financial autonomyand to promote competition from other sources of coal supply. A restructuredcoal industry should be able to finance its investments out of internallygenerated resources or in India's growing capital markets, eventuallyeliminating the claim on budgetary resources.
Rationalizing The Tax Structure
2.37 India faces the dual challenges of changing the structure of its taxsystem to eliminate its inequities and growth-sapping distortions, whilemaintaining (or perhaps achieving an increase in) the overall tax ratio. Thebroad outlines of the needed structural changes in the tax system are clear.which is not to say easily achievable. The indirect tax system needs to beredesigned to broaden its base, increase its elasticity and stability,eliminate distortions, and to shift, insofar as possible, the incidence ofthese taxes from investment (which now appears to bear the brunt of indirecttaxation) to consumption. Needed changes in the indirect tax system arediscussed in Section C of this chapter.
2.38 The rapidly growing dependence on indirect taxes, particularly tradetaxes, and corresponding decline in the relative importance of direct taxes
46
needs (on equity grounds) to be reversed. Low direct tax yields are due tothe narrowness of the bases on which they are levied. To some degree, this isa result of administrative and/or institutional problems that are difficult(or perhaps, in some instances, practically impossible) to overcome. Forexample, under the Constitution, the power to tax agricultural income restswith the states, which have thus far not attempted to exploit this source ofrevenue. Evasion (of both direct and indirect taxes) is also a seriousproblem. However, the reach of the direct taxes that are currently levied mayalso be unnecessarily circumscribed by the numerous and generous deductionsand exemptions that are built into them. There are only about 3 millionassessees, and personal income tax revenues amount to barely 1Z of GDP. Roughestimates indicate that saving-related deductions have cost about 12 of GDP inpotential revenues. They have also introduced potentially serious distortionsinto household resource allocation decisions. While intended to induceprivate saving, there is some evidence that the principal effects of theseincentives are on the form (as opposed to the volume) of private saving,inducing substitution among assets in savers portfolios to take maximumadvantage of available tax preferences (Bhattacharya, 1985). Nationally,these incentives may actually reduce total saving if they reduce public savingmore than they promote private saving.
2.39 Scope also exists for reducing distortions and increasing revenuesfrom Company Taxation. The accelerated depreciation allowances anddifferential taxation of income according to the form of organization of thecompany both distort investment choices and result in substantial losses ofincome. They also introduce additional administrative complexity into thesystem.
2.40 The changes put forth in the Central Government's 1990/91 budget,apart from the increase in the basic exemption level, constitute a significantimprovement in the structure of the main centrally-levied direct taxes.Nonetheless, all of the remaining concessions need to be scrutinized for theireffects on equity and efficiency. The most expensive concessions in terms ofthe revenue forgone -- the basic exemption and saving deduction provisions ofthe Personal Income Tax and the backward area relief, the relief for newindustrial undertakings, and the depreciation allowance under the Company Tax-- need particularly careful review. Also, while the complete exemption ofincome from exports is necessary as long as the trade regime is skewed towardimport substitution, as trade reforms are instituted and exchange ratescorrespondingly adjusted, income from exports could also appropriately betaxed.
47
B. Increasing Productivity and Growth in Industry
2.41 The accelerated growth of industry in the 1980s, particularly post-1983, is attributable to the cumulative impact of gradual deregulation andtrade liberalizationl/ since the mid-1970s, to transitional bursts ofproduction as newly-freed supply grew fast to catch up with pent-up consumerdemand (e.g., motor vehicles, electronics), and to the environment of high,rapidly-growing demand occasioned by the expansionary macroeconomic policiespursued by the government. With the clear need to reduce the stimulus togrowth provided by overly expansionary macroeconomic policies, the concernsabout the structure of recent growth mentioned in Chapter 1, tid some signsthat the stimulus provided by past policy reforms may be flp:,tling, it isopportune to take stock of recent policy achievements and to assess the extentto which modifications are in order.
(a) Background on Policies Affecting Industrial Development
2.42 A central objective of India's planned development policy frameworkhas been to promote self-sufficiency in industry. In practice, this has meantthat incentives have had to be distorted purposefully in such a way as toprevent economic specialization from occurring. To achieve this objective,the Government developed and has maintained, with modification, acomprehensive body of laws and regulations governing investment anddisinvestment, domestic competition, trade and payments, technology, and laborrelations, and invested heavily itself in key industrial sectors. Thecornerstone of the regulatory framework has been industrial/capacitylicensing, which meant that Government approval was required for all sizableinvestments, by existing companies or new entrants, in all industries. Thiswas augmented by restrictions on large and/or foreign controlled firms, byreservation of some industries and products for the public sector or forsmall-scale industry (SSI), by policies to promote the speed of industrialdevelopment to backward areas, by regulations to protect labor in theorganized sector and to govern labor relations, and by controls over imports,technology transfer from abroad, and foreign collaborations. The principalmeans of regulating imports and protecting local industries have been non-tariff controls, embedded in import licensing requirements, public sectormonopolies on importation of certain items (canalization), restrictionslimiting imports to actual users, restrictions requiring the phasing out ofimports used in domestic manufacturing (phased manufacturing programs), andgovernment purchase preferences given to domestic producers.
2.43 The complex system of industry-specific, firm-specific, regtin-specific, good and/or factor market-specific incentives created by thesepolicies resulted in a broad and diversified industrial structure spanning thecapital intensity spectrum. The realization, however, began to grow as earlyas the 1960s that the skewed incentive system created by the drive for self-
l/*Liberalization" when used here refers to increasing reliance ondecentralized decision-making in response to financial incentives, as opposedto direct controls, for the allocation of resources.
48
sufficiency was slowing industrial growth and strangling manufactured exports.To stem India's loss of share in manufactured export markets, a number ofexport incentive schemes were introduced in the mid-1960s which have beenmaintained, albeit with significant recent improvements, to this day.These were complemented by a gradual process of relaxation of regulation ofdomestic industry that began in the early 1970s, and limited liberalization ofthe trade regime beginning in the late 1970s.
2.44 The pace of policy change picked up perceptibly in 1985. As in theyears prior to 1985, the most significant recent changes in the policy regimeaffecting industry have come in the regulations governing domestic investment,production, marketing, exit, and the taxation of industry. The pace of tradepolicy reform has lagged that of regulatory reform, with the most significantactions being taken in the field of export promotion. Major changes since1985 are summarized briefly in the following paragraphs.
2.45 Licensing. Thirty-one (31) industries were completely delicensed,2 /and the investment limit below which no industrial license would be requiredwas raised to Rs 500 million in backward areas and Rs 150 million elsewhere,provided in both cases that the i,vestments were located stipulated minimumdistances from urban areas of stipulated sizes. Twenty-seven (27) majorindustries still require industrial licenses regardless of the size orlocation of investment. These include a number of major industries like coal,large textile units using power, motor vehicles, sugar, steel, and a largenumber of chemicals. Products reserved for SSI or the public sector are stilloff limits.
2.46 Broad banding (allowing firms to switch production between similarproduct lines) was significantly expanded in a number of important industries.In some industries, broad-banding greatly enhanced flexibility; in others, theimprovement has been marginal, with a large number of separate (for industriallicensing purposes) product categories remaining.
2.47 The ability of existing licensed units to expand capacity by variousmeans has also been greatly enhanced. For example, an increase in capacity ofup to 49Z (previously the limit was 252) is now allowed if it occurs as aresult of modernization investment. And expansion of licensed capacity isallowed for all firms which had achieved at least 801 of licensed capacity in X
any of the five years preceding 1985.31
2.48 Monopoly and Restrictive Trade Practices Act (MRTP). MRTPregulations provide additional barriers to large firms seeking to expand orenter new lines. The asset limit above which firms are subject to MRTPregulations was quintupled from Rs 200 million to Rs 1,000 million, and therequirement of MRTP clearances was waived for 27 designated industries. MRTP
2/Industrial licenses were no longer required for either new facilities orexpansions. This provision did not apply to MRTP/FERA firms, however, whichstill had to obtain a license.
3VThe previous requirement had been 94Z.
49
firms in a number of industries were exempt from industrial licensing, butthis was restricted to companies located at least 100 km away from largecities. Finally, firms subject t^ the MRTP Act because they are classified as"dominant undertakings" by virtue of market share, are now allowed to availthemselves of the general delicensing measure in industries in which they arenot considered dominant undertakings. These measures significantly enhancedthe freedom of large companies subject to the MRTP Act to enter into newactivities.
2.49 Small Scale Industry. The asset ceiling of firms designated assmall-scale industry units for purposes of SSI reservation and other benefitswas raised from Rs 2.0 million to Rs. 3.5 million, and for ancillary units(those selling mostly to specific large companies on a long-term basis) fromRs. 2.5 million to Rs. 4.5 million.
2.50 Price and Distribution Controls. Complete abolition of price anddistribution controls on cement and aluminum were a major advance. But in ahandful of industries like chemical fertilizers and pharma:euticals, formalprice and distribution controls still constitute a major hindrances to firms'conduct of business. Mc:'eover, canalization of imports of certain keyintermediate goods results in de facto controls over their distribution, withproblematic results fur downstream producers.
2.51 Foreign Technology and Foreign Collaboration Licensing. There havebeen no major formal changes in the regulations governing the licensing offoreign technology and foreign collaborations. In practice, however, theGovernment has been less likely to deny technology import and collaborationlicenses, particularly in industries it has designated as "thrust areas." TheGovernment retains its discretionary control and the ability to tighten up inresponse to industry-specific or general balance of payments and macroconsiderations.
2.52 Sick Industries and Industrial Labor Relations. Restrictions againstretrenchment of labor have been tightened, backed up by a requirement forlocal government approval for closure of any major plant. While there is moreflexibility de facto than is implied by a literal interpretation of theapplicable regulations, smooth exit is greatly impeded. The main initiativeto deal more effectively with the problem of sickness was the creation of theBoard for Industrial and Financial Reconstruction, which is charged withdetermining which sick firms can be rehabilitated and which should be a..lowedto go out of business. For the former, the BIFR tailors financial packages tosupport the approved rehabilitation program. In addition, the Government haspledged not to take over sick firms.
2.53 Domestic Indirect Taxes. The most important recent changes in theindirect tax system were the introduction of a more smoothly graduatedschedule for small scale enterprise excise tax concessions and the conversionof multi-point excise duties into a value-added tax. The change in the SSIconcession reduced tax incentives to firms to remain small. The conversion ofthe excise tax into a modified value added tax (MODVAT) enabled manufacturersto deduct excise paid on domestically-produced inputs and countervailingduties paid on imported inputs from their excise obligation on output, thereby
50
mitigating the distorting effects of excise taxes on input prices. MODVAT nowcovers all subsectors of manufacturing except petroleum products, textiles,and tobacco.
2.54 Import Licensing. In 1985 and more recently again in 1988, theGovernment announced Three-Year Import-Export Policies to provide a stableenvironment for decisions. A substantial number of items were added to theOGL (Open General License) list (736 additional intermediates, raw materials,and component items were added in 1985, and another 329 items were added inApril, 1988 and 82 were added in April, 1990). Most of the items added to theOGL list, however, are not locally produced, and there appears to be atendency to move items off of OGL when domestic production starts.
2.55 Canalization. A number of items, the most important of which wascement, were decanalized (21 items were decanalized in 1985, and 26 weredecanalized in 1988). The share of canalized imports in total importsdeclined from 672 in 1980/81 to 43Z in 1987/88 and the share of non-POL(petroleum, oil, and lubricant) canalized imports in total non-POL importsdeclined from 442 to 352. However, this decline reflects changes in thecomposition of imports as well as decanalization, i.e., elimination of grainand cotton imports, and declines in world prices of important canalized itemssuch as fertilizers, edible oil, and iron and steel.
2.56 Phased Manufacturing Programs. Trends in Phased ManufacturingPrograms (PMPs), which require graduated increases in domestic content, may becounter to these steps to liberalize other import controls. Although PMPs insome industries (e.g., the automotive industry) are less restrictive thanearlier policies requiring more or less complete indigenization, they arebeing used with increasing frequency, especially in new industries such aselectronics and pharmaceuticals and as an accompaniment to the modernizinginvestments in the vehicle, vehicle component and machinery industries.
2.57 Tariffs. The most important changes with regard to tariffs have beenan apparent tendency to reduce the number of exemptions granted, and toincrease the rates applied to previously low-rated items. Thus, the initiallow rates assigned to capital goods moved to OGL were, in general,substantially increased. These changes have reduced slightly the dispersionof nominal protection, as reflected in estimated standard deviations of tariffrates, and increased average nominal protection.
2.58 Export Promotion. The main thrust of recent changes in India's traderegime, as in earlier years, has been to reduce the incidence on exporters ofthe taxes, explicit or otherwise, imposed by QR.s, high administered prices,high excises and high tariffs. The import policy for exports has been mademuch more liberal for virtually all types of imported commodities than it isfor non-exports. Machinery and equipment for export-oriented industries areon the OGL list. All exporters are now entitled to REP licenses with whichthey can import any item on the limited permissible list or on the canalizedlist up to specific percentages of the value of exports. Further, imports ofrestricted capital goods by exporters are exempted from indigenous angleclearance. Administration of the various export promotion schemes has been
l
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under continual scrutiny to find ways of streamlining their operation andenhancing their effectiveness.
(b) Effects of Recent Policy Changes on the Incentive Framework
2.59 Given the complexity of the present system, the frequency with whichit is altered, and the considerable administrative leeway it affords, it isimpossible to draw any conclusions directly from an accounting of changes madein the structure of the system about the economic significance of the changesthat have taken place. The fundamental questions in this context are theextent to which these changes have (i) removed regulatory/administrativebarriers to efficient use of resources, and (ii) realigned the incentivesystem from one that promotes narrowly construed self-sufficiency to one thatpromotes efficiency, equity and growth.
2.60 Overall, the recent policy changes have materially reducedregulatory/administrative barriers to efficient resource use. Delicensing,expansion of OGL, strengthening of the export promotion incentive framework,the decision not to take over sick firms, have materially increased the roleof financial incentives relative to that of direct controls in resourceallocation. At the same time, however, it is clear that much of the directcontrol apparatus for resource allocation remains intact. Substantialsegments of industry remain subject to licensing, reservation (for publicsector or small-scale industry), control of foreign collaborations andtechnology imports, import licensing, and other instruments of discretionaryresource allocation. Exit is still severely impeded. Despite movement ofmore items to OGL, the share of imports unencumbered de iJure by QRs remainsrelatively small. Of total intermediate and capital good imports in 1987/88(the most recent year for which detailed data are available), only about 12?remained in the restricted category. However, of the rest, 40? werecanalized, and 321 remained on the limited permissible list.
2.61 Progress has been mixed in realigning financial incentives to supportrapid, efficient growth. The most substantial changes have been made inexchange rates, mitigating input taxation and export promotion policy. Afterpermitting the exchange rate to appreciate in real effective terms over thefirst half of the 1980s, a policy of relatively rapid real effectivedepreciation has been followed since the summer of 1985. The rupee hasdepreciated in real effective terms by 402 since the start of the SeventhPlan. Anecdotal evidence suggests that this sharply eroded import premia, andincreased domestic currency prices of exports substantially. Empiricalstudies credit the latter with a substantial portion of the export growtnsurge of the last 4 years.
2.62 MODVAT has materially reduced the taxation of inputs and thedistortions this engenders. The tax on final manufacturing output, however,is quite high, averaging about 302 of manufacturing value added. The mostimportant remaining distortions stem from the exclusion of capital goods fromthe MODVAT scheme, which may distort factor choices, and from the multiplicityof special rates and exemptions in the system, which may distort consumptionchoices and render the system difficult to administer efficiently andhonestly. The system also depends increasingly on specific rates, which
52
sharply reduces its elasticity and renders it non-neutral in the face ofinflation.
2.63 Export promotion policy, judged both by the effort the Government hasinvested in it and recent export performance4/, also earns good marks. It hassucceeded in reducing the anti-export bias of the trade regime. However,these schemes may favor expansion of existing exports over exportdiversification and have created very large differentials in prices of inputsfor export production and domestic production that invite arbitrage. Firmsalso report that these schemes carry a heavy burden of red tape and delayswhich make them less valuable than they appear on the surface.
2.64 Progress has been most uneven in rationalization of the tariffstructure. On the positive side, the intrasector dispersion of tariffs forsector/product groups appears to have been reduced by a reduction in thenumber of exemptions and by increasing low tariff rates. However, theintersectoral dispersion has not declined, average nominal tariff rates havenot declined, and average collection rates remain high. For example, theaverage tariff collection rate (in 1987/88 -- the most recent year for whichdata are available) was 114Z in chemicals, 80Z in metals, and 67? inmachinery. Overall, the nominal protective effect of tariffs averages about60Z. For manufacturing, excluding gems and other duty free imports, theeffective nominal tariff rate is 80Z.
4/ Some observers attribute recent export performance primarily to the rapidreal effective depreciation of the rupee, and argue that export promotionincentives have had relatively little effect in encouraging exports.
i
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Table 2.1:Comparison of Nominal Tariff Rates
(percentages)
Protective Tariffs Total Tariffs*Trade Actual Trade ActualWeighted Collection Weighted Collection(1988) (1988) (1988) (1988)
Agriculture 38 22 40 22Food, BeveragesAnd Tobacco 80 60 87 61Petroleum and Coal 104 12 131 33Chemicals 94 70 124 87Metal 89 71 101 80Machinery 89 63 101 67Electrical Appl.and Electronics 97 48 129 58Transport Equipment 75 50 91 58Textiles and Leather 121 44 172 72
Total 80 53 94 60
Source: World Bank Staff Estimates (Aksoy and Tang, 1989).
* Includes collections of countervailing duties, equal to excise collected ondomestically manufactured products, as well as the basic and additional dutieswhich constitute the protected part of the tariff.
2.65 These patterns may reflect the expected progression of eventsduring the first phase of a transition from quantitative restrictions onimports to tariff-based controls. In the second phase, a reduction of thedispersion of collection rates would be expected, accompanied by a decline inthe overall collection rate. The danger in this process is that growingGovernment and industry joint dependence on trade taxes could make it moredifficult to embark upon the second phase. Statement of a clear, time-boundstrategy for the tariff reduction phase in the forthcoming Long-Term FiscalPolicy could help to ward off these difficulties.
2.66 Trade taxes still incide heavily on input prices. Collectionrates for 'universal intermediates" and capital goods are very high. As aresult, prices of intermediate and capital goods are much higher on averagethan in the rest of the world, which pushes up costs throughout the economy.
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Table 2.2:
Tariff Collection Rates on Capital Goods and Intermediaries
Year Capital Goods Intermediates
(Z of import value) (Z of import value)
1980/81 49.092 5:.9321981/83 61.74Z 56.9021982/83 64.802 71.5821983/84 59.99Z 68.4321984/85 75.142 69.9421985/86 59.60X 75.44Z1986/87 59.79Z 75.1321987/88 65.44Z 80.792
Source: World Bank Staff Estimates (Aksoy and Tang, 1989).
2.67 A final worrisome, though less clear-cut, feature is that in a numberof key areas such as capital goods, steel, and petrochemicals, effectiveprotection rates remain very high. With relaxed licensing requirements, thesehigh effective protection rates are attracting new investment to theseprotected industries, in some of .hich India may not have a comparativeadvantage. The disproportionate incidence of protection on investment goods,moreover, is, with stepped up investment, building more inertia into thecurrent high protection system. Entrepreneurs incurring high fixed costsshielded by protection of their output face grave difficulty or perhaps ruinwhen and if this protection is significantly reduced, and could become avociferous lobby against trade reform. A credible program for relativelyprompt reduction of protection levels, which would dissuade potentialinvestors from financially attractive but economically questionableinvestments, is urgently needed.
2.68 The evidence suggests, then, that while recent reforms haveincreased the scope for decentralized private decision-making and the role offinancial incentives in resource allocation decisions, distortions inindustrial incentives now in place may still be pulling resources in the wrongdirection. The vestiges of an incentive system that accords more weight toobjectives other than economic efficiency and growth are still very much inevidence. High and variable excise tax rates and import duty rates are amajor source of problems for all companies. Not only is the cost structureinflated, but tax exemptions, drawbacks, etc. remain the major focus ofattention because these largely determine the financial viability ofactivities. As a result, there are still substantial financial returns tosuccessful lobbying and bargaining for special treatment.
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(c) Medium-Term Policy Issues
2.69 The strategic framework for industrial incentive reforms per se hasbeen well mapped out in the reports of several Government commissions. Aworkable framework should include five elements: (i) elimination ofquantitative restrictions; (ii) rationalizing and lowering of tariffs; (iii)rationalization of excise taxes; (iv) indexation of indirect tax rates; and(v) further relaxation of industrial regulations. Progress on these frontswill not be easy. Changes that could materially affect tax collections and/orimports must necessarily be approached cautiously in the present budget andbalance of payments situations. Some changes will also renuire the solutionof difficult administrative problems.
2.70 Elimination of quantitative restrictions. Over the medium term, theobjective should be to move all items to OGL and to permit their import forstock and sale (i.e., decanalize them). A reasonable near term goAl would beto move all noncanalized imports of nonconsumer goods to OGL. A sensiblefirst transitional step toward this goal would be to move all intermediate andcapital goods now on the restricted list to the limited permissible list,enabling them to be imported under REP licenses. These imports account forabout 12 percent of intermediate and capital goods imports, and about 8percent of total imports.
2.71 Another important medium-term goal should be elimination of the"actual user* policy. With appropriate adjustment of the exchange rate,relaxation of non-tariff barriers, adjustment of tariffs, import premia wouldbe sharply reduced, eliminating one of the reasons for restrictions on who canimport (canalization and actual users). The other objective of theserestrictions, insuring that opportunities to secure low prices through bulkdiscounts are exploited, can better be served by allowing competition betweenimporters.
2.72 Rationalization and lowering of tariffs. Overall, tariff rates mustdecline from their very high average levels and dispersion of rates should bereduced. Given India's heavy dependence on tariff revenues and its precariousfiscal and balance-of-payments situations, reductions in tariff levels willhave to be coordinated carefully with reforms of other taxes and withadjustment of the exchange rate. The incidence of indirect taxes needs to beshifted from intermediate and capital goods to consumption. This could beachieved by reducing the protective component of tariffs (i.e., basic andauxiliary duties) and compensating this reduction by increases incountervailing duties (i.e., the duty component designed to place imports on acomparable footing with domestic output on which excises have been levied).Given the substantially larger base to which excises apply and the effect ofexchange rate depreciation on revenues, the required adjustment in exciserates would be substantially less than proportionate to protective tariff ratereductions. Reduced dispersion of tariff and excise rates would simplifyadministration and increase collections, further mitigating the need forexcise rate adjustments.
2.73 Rationalization of excise taxes. There are two areas (in addition toindexation) in which the structure of the central excise tax could be
56
strengthened. First, in an attempt to use rate differentials to achieveequity objectives, rates have proliferated as MODVAT has shifted much of theburden of the excise to domestic consumption. Product differentiation ofindirect tax rates is not a very good instrument for achieving equityobjectives. Consumption patterns of different income groups overlap too much.In addition to its distorting effects on consumption decisions and itsshortcomings in targeting income groups, the dispersion of rates complicatesadministration and facilitates evasion and corruption. While India clearlywill have to continue to rely on differentiation of excises (and perhaps otherindirect taxes) as a tool for achieving equity given the very narrow base ofthe personal income tax, some reduction of the dispersion of excises couldprobably be achieved with little or no real sacrifice of equity objectives,and could foster efficiency and boost excise collectiou rates.
2.74 Second, capital input prices remain distorted by excises andcountervailing duties due to the exclusion of capital goods from the ambit ofMODVAT. This distortion was reduced recently with the reduction of the exciserate on capital goods from 15Z to 1O2 in the 1990/91 budget. To eliminate italtogether, consideration should be given to bringing the countervailing dutypaid on imported capital goods and excise on domestically produced capitalgoods under MODVAT and made deductible from the excise taxes paid by the userindustry. Procedures would have to be worked out to deal with the 'lumpinessoand joint product aspects of most capital goods investments, but this has notbeen an insurmountable barrier in other countries. The revenue effects ofthis measure could be offset via a modest adjustment of excise rates.
2.75 Indexation of indirect taxes. Most revenues derive from taxes leviedat specific as opposed to ad valorem) rates. While overall collection rateshave increased (the central excise, however, has declined in relation tomanufacturing gross output), this has been achieved through ad hoc, rate-by-rate step adjustments. Indexation of rates could be considered as a way ofincreasing the elasticity and stability of the system and making it morenearly neutral with respect to inflation.
2.76 Further relaxation of industrial regulation. There are three keyareas for action here. First, procedures for exit and retrenchment need to bestreamlined to increase the speed and degree of adaptation of firms to marketforces. Impediments to the transfer of resources between alternative usesshould be kept to a minimum, as potentially mobile resource must be employedin their most productive use if they are to contribute as much to nationaloutput. Second, delicensing should be delinked from other policy objectives(location, export promotion, environmental protection). In this vein,monopoly regulation (MRTP) should be redefined in terms of firm behaviorrather than size alone. Third, industrial labor relations need to bestreamlined to focus less on preserving existing employment in sick firms andthe disproportionately high wages of labor in the organized sector and more onaccelerated industrial development. To do this, the Industrial Disputes Actshould be modified to provide firms with greater autonomy to relocate orretrench labor within guidelines for working conditions, remuneration, andcompensation for employees who lose their jobs. Concurrent efforts shouldalso be made to increase the mobility of employees, thereby facilitating theacceptance of more rapid employment turnover.
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C. Increasing Agricultural Growth and Productivity
2.77 In many respects, the long term performance of India's agriculturalsector has been a success story. At Independence, India's agricultural sectorhad been virtually stagnant for decades. The country had been wracked byperiodic droughts and famines, and was highly dependent on food aid.Performance after Independence shows a clear break with the past. Growth ofoutput of about 2.6Z per year has been sustained for more than 40 years. Thecountry has become self-sufficient in food grain production and has, in factbeen able to accumulate a substantial food grain reserve. This reserveenabled the country to withstand the severe drought of 1987 without aninterruption in food supply to even the most severely affected regions.Moreover, there has been remarkable economic growth and social transformationin parts of the rural sector.
2.78 Yet, there are problems and questions for the future. First, whilefrom some points of view the 2.62 growth rate is encouraging, agriculture,unlike industry, has yet to show clear signs of an acceleration of overallgrowth or productivity. Second, it is not certain that the sources of pastgrowth, expansion of irrigation and spread of high yielding varieties, can besustained. Finally, there is reason to believe that more rapidly increasingper capita income, coupled with a fairly low starting point in terms of percapita caloric consumption, could lead to more rapid increases in demand forfood than in the past.
2.79 The trend growth rates of real GDP originating in agriculture and ofgross real output of crops (accounting for about 84Z of the total value ofagricultural production) have remained constant since the early 1960s, with nobreak in trend between the 1970s and 1980s.51 The overall slow-to-modestgrowth reflects varied paces of production increase in key crop sub-sectors.Wheat, oilseed crops like rapeseed and mustard, and to some extent sugar (inthe 19709) and rice (1980s) acted as engines of growth. Jowar (sorghum),pulses like gram and tur, jute, and groundnut acted as a drag on overallagricultural growth.
5/ Each crop was valued at constant (1983-85) average wholesale procesprevailing in major markets during harvest time.
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Table 2.3:All India Trend Growth Rates of Production
(1970/71-1988/89, 1970/71-1980/81, and 1981182-1988/89)(Z per annum)
1971-81 1982-89 1971-89 SignificantChange
19 Crops 2.06* 2.24 2.47* NoFoodgrains 2.25* 2.54 2.61* NoNon-foodgrains 1.63* 1.63 2.18* NoCereals 2.58* 2.84* 2.86* NoPulses -0.36 -0.23 0.58 NoOilseeds -0.01 3.13 1.89* NoFibres 2.87* 0.20 1.83* No
Rice 2.3* 3.6* 2.7* NoWheat 4.5* 3.5* 4.8* NoJowar 4.6* -1.6 1.7* YesGram -0.9 -1.2 -0.3 NoTur 0.8 1.6 2.3* NoGroundnut 0.1 1.8 1.1 NoRapeseed/Mustard seed 0.4 8.2* 4.4* YesCotton 3.1* 0.2 1.8* NoSugarcane 2.4* 1.2 2.7* NoJute 2.1 0.8 2.3* No
* Indicates significance at 5S level or less
Source: Lieberman and Ahluwalia, 1989.
2.80 This growth performance, while satisfactory in the sense ofpermitting India to attain foodgrain self-sufficiency, is below that achievedin other Asian developing countries (China (4.92), Sri Lanka (4.12),Philippines (4.02), Indonesia (3.72), Thailand (3.7Z), Bangladesh (3.12), andPakistan (3.02)) and below the average for all low income countries (3.6Zp.a.) in the 1973-84 period. A low agricultural growth rate also sets Indiaapart from higher-incrme Asian countries whose agricultural growth acceleratedsharply, typically from 22 or less to over 32, during the early phases ofdevelopment.
2.81 Four critical factors will determine whether agricultural growth canbe accelerated: the efficiency and effectiveness of irrigation investmentsand systems; the availability and adoption of yield increasing technology; the
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adequacy of investment in rural areas and; the structure of agriculturalprices and incentives.
2.82 Increasing the Returns to Irrigation Investment. Much of the growthof output of Indian agriculture since Independence is attributable to therapid expansion of irrigated area and the associated introduction of highyielding varieties (HYVs) and use of fertilizers. Starting with the FirstPlan, there was a steady increase in irrigation potential created.l1 The areaunder irrigation increased from 0.7 million ha per year in the First Plan to1.6 million in the Fifth and Sixth Plan and 2.5 million in the Seventh. Bythe end of the Seventh Plan 70 million ha of irrigation potential will havebeen created, covering 602 of potentially irrigable land. Approximately eightmillion ha has not yet been utilized.
2.83 At the current rate of increase, all irrigation potential will havebeen exhausted by early in the next century. Moreover, unit costs of newsurface irrigation works are increasing because the best sites for systems arebeing used up. Remaining sites where water supplies are available generallyinvolve progressively less favorable dam sites, more difficult terrain and/orpoorer soils. Rates of return to new irrigation investment are probablydeclining. With fiscal resources under pressure, the allocation of resourcesbetween new works, rehabilitation and efficiency improvements on existingsystems, and investments in rainfed agriculture is a critical issue.
2.84 About 601 of the increase in India's agricultural output has beendirectly attributable to irrigation and perhaps 80? to the combined impact ofirrigation and modern inputs. Nevertheless, the productivity of irrigation inIndia is low. Crop yields in East Asia tend to be in the range of 5-6 tonsper ha; yields in irrigation projects in India typically foresee yields on theorder of 3-4 tons; actual yields under irrigated conditions turn out moretypically to be on the order of 2.2 tons. This compares, however, with yieldson the order of one ton per ha without irrigation.
1' Investment creates irrigation potential when the system can deliver waterto the canal outlet. Irrigation potential is the theoretical gross croppedarea that can be irrigated (cultivated area x cropping intensity). Potentialis counted as utilized when farmers actually convey water from the outlet andapply it to their fields.
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Table 2.4:Wheat and Rice Yields on Irrigated and Unirrigated Lands(Major Producing States: Peak Foodgrain Production Years)
Yield (kg/ha) Growth (Z p.a.)1970/71 1978/79 1983184 1970/71 1978/79 1970/71
1978/79 1983/84 1983/84
Wheat *Irrigated 1726 1920 2184 1.3 2.6 1.8Unirrigated 803 909 1055 1.6 3.0 2.1
Rice **Irrigated 1441 1690 1864 2.0 2.0 2.0Unirrigated 868 953 1054 1.2 2.0 1.5
* Weighted average yields for Bihar, Haryana, MP, Punjab, Rajasthan, and UP** Weighted average yields for AP, Assam, Bihar, Karnataka, MP, Orissa,
Punjab, TN, UP, and WB.
Source: Lieberman and Ahluwalia (1989).
2.85 To some extent, the low productivity per unit of land irrigated inIndian projects reflects the fact that India has been following a 'protective"or extensive irrigation strategy, i.e., building systems designed to spreadwater thinly so as to irrigate the greatest possible land area and offer somemeasure of drought-proofing and income protection to as many rural families aspossible: Nevertheless, significant improvements in results, measured interms of production, are possible without sacrificing social and equityobjectives.
2.86 The factors that underlie the relatively low productivity of Indianirrigation are complex. They include issues at each stage in projectdevelopment from planning through design and construction to operations andmaintenance. At the planning stage, inadequate importance has been attachedto the evaluation of long-term water resource development. Projects have beenpursued in isolation without proper assessment of interactions in the basineither in terms of the resource itself (rainfall and groundwater as well assurface water) or in terms of competing demands on the resource (non-agricultural users as well as other surface irrigation schemes). As a result,over-development has occurred, for instance in some water-short southernbasins. More generally, resource development and use have not been optimized.At the design stage, inadequate consideration has been given to how systemscan operate under the highly varying conditions met in the different regionsof India. Solutions are often adopted which assume a degree of control overwater flows that cannot in practice be achieved, resultlng in difficulties indistributing water in an equitable, reliable and productive manner. At theconstruction stage, delays and poor quality frequently result in a drawn-out
61
process of development which postpones benefits and results in high subsequentrequirements for maintenance and, eventually, rehabilitation. Finally,inadequate attention to and funding of O&M undermines system performancealready made difficult as a consequence of deficiencies in planning, designand construction.
2.87 Water is one of the most difficult and politically sensitive issues inIndia today. If performance is to be improved, therefore, not only mustobjectives be clarified and supported at the highest level but irrigationplanners need to be more realistic about the conditions they face. Thisapplies in particular to issues of design and management. In the successfulschemes of NW India, and in certain southern river valleys and deltas,management is relatively straightforward since there is little need forresponse to changing rainfall conditions, either because rainfall is limitedand farmers can successfully plan their activities in the light ofpredictable, but rationed, irrigation supplies (as in NW India) or becausewater is locally in surplus and there is no need for careful management (asfor instance in some southern deltas). Over most of India, irrigation watersupplies must be managed in response to changing rainfall and drainageconditions. When rainfall is good, no irrigation is required; when it ispoor, as in a prolonged dry spell, irrigation is needed by all crops. Largevariation in needs greatly complicates water management, leading to conflictsamong farmers and between farmers and system managers. A vicious circle iscreated, resulting in waste, damage to the physical infrastructure and lowmorale and farmer confidence.
2.88 The first priority in all cases must be to establish control over thedistribution of water in the system. Without this, programs to improvedistribution to farmers, or to promote water user groups and other forms offarmer participation, are unlikely to be successful. Establishing control inthe face of vested interests will not be easy, and will require strong,persistent support at the highest levels of Government. It will undoubtedlyalso require a simplification of the management task since detailed control inthe massive, extensive irrigation systems of India is simply not possible.Nor is it necessary to meet the specific needs of individual farmers, as inmany command areas there is a large and growing area under private tubewellirrigation, which complements surface irrigation. What is needed in publicly-operated surface systems is, therefore, a simplified management system whichprovides a predictable "base load" and which encourages the farmer to makebest use not only of the surface supply but also of rainfall and groundwater.
2.89 Conditions vary widely over India's irrigation sector and solutionswhich work under in one context are not necessarily appropriate in another.Any interventions must therefore start with careful diagnostic analysis of thescheme in question, leading to pragmatic and clear operational objectives.Only then is it possible to clarify investment priorities in each specificcase and design interventions in support of the "operational plan' proposed.In most cases, simplified water distribution methods will prove to beappropriate. If water distribution is in practice manageable, then otherinterventions can Le effective, including promotion of farmer involvement indetermining the irrigation service and in assuming responsibility fordistribution and maintenance at higher levels in the system. The enormous
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extent of Indian irrigation, and continuing severe financial constraints, willlimit what can be done. Priorities must be established in each case butexperience to date suggests that significant impzovements in systemperformance and agricultural productivity are often possible througlt wellconceived operational change, supported by low cost but widespread physicalmodifications, communications facilities and system monitoring.
2.90 Increasing Availability and Adoption of Yield-increasing Technology.As the spread of irrigation slows and the "land constraint' to increasingagricultural output becomes more binding, agricultural growth and developmentwill depend increasingly on productivity gains. The past increase inirrigation has been accompanied by the complementary adoption of HYVs andinputs including fertilizers and pesticides. This "green revolution' wasfacilitated by an expansion of agricultural education, research and extensionand by a strengthening of policies and organizational arrangements forprovision of inputs and credit. However, this revolution was very much tiedto irrigation and only a relatively small part of Indian agriculture benefitedfrom it. In addition, the sector strategy was aimed primarily at obtainingrapid increases in food grain output and research, extension and publicinvestment programs were strongly influenced by this objective.
2.91 The spread of yield-increasing technology is slowing. Diffusion ofHYVs slowed sharply in the 1980s. Virtually all irrigated wheat is alreadyHYVs, as is the major part of rice.
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Table 2.5:Progress of HYVe in Rice and Wheat, by Region
(Three-year Averages)
HYV Area Rate of Growth1 of Total Under Crop of HYV Area (Z p.a.)
71-73 79-81 86-88 71-73/ 79-81/ 71-73/79-81 86-88 86-88
RiceAl 18.9 42.7 56.6 11.7 4.1 8.1NW 24.3 56.7 70.8 14.6 4.7 9.9E 9.2 26.6 44.3 14.3 7.9 11.3C 10.9 35.1 46.2 17.0 4.0 10.8S 42.9 70.4 82.7 7.0 0.3 3.8
WheatAI 43.3 70.1 84.1 8.4 3.0 5.9NW 51.1 81.9 92.1 9.0 3.2 6.2E 76.6 85.2 90.0 2.1 2.9 2.5C 19.5 45.5 61.7 12.9 2.8 8.1S 24.4 40.9 37.1 8.2 -6.0 1.3
Note: AI refers to All-India. NW comprises Haryana, Punjab, Uttar Pradesh,Himachal Pradesh and Jammu & Kashmir. E comprises Assam, Bihar, Orisscand West Bengal. C comprises Gujarat, Maharashtra, Madhya Pradesh andRajasthan. S comprises Andhra Pradesh, Karnataka, Kerala and TamilNadu.
Source: Lieberman and Ahluwalia, 1989.
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Table 2.6:Fertilizer Consumption by Region (N + P205+K20)
(Three-year Averages)
Annual Consumption Growth Rates(kg/ha) 71-73/ 79-81/ 71-73/
71-73 79-81 86-88 79-81 86-88 86-88
AI 15.25 30.74 48.93 9.2 6.9 8.1NW 23.63 53.95 85.10 10.9 6.7 8.9E 8.95 17.27 38.42 8.6 12.1 10.2C 8.64 15.75 24.85 7.8 6.7 7.3S 23.56 44.87 67.01 8.4 5.9 7.2
Note: Regions are as in Table C.
Source: Lieberman and Ahluvalia, 1989.
In addition, despite the fact that fertilizer consumption, at 50 kg/ha is wellbelow levels in other countries, the rate of growth in fertilizer use hasfallen by over 20Z. Finally, use of irrigation in cultivation of paddy, wheatand other crops also grew more slowly in the 1980s. Irrigated area in paddyactually declined in India as a whole and in the East and South through 1985.Apart from sugarcane, little use is made of irrigation in the cultivation ofother crops.
2.92 This apparent decline in the adoption of modern inputs should not bemisconstrued. India's strategy for the past thirty years has been to raisethe production of staple foods (mostly rice and wheat) by simultaneouslyexpanding the area irrigated and introducing a package of technologies basedon HYVs. This allowed capturing the easiest gains in output first. Theseeasy gains having, for the most part, been made means that those left to bemade are harder (more expensive) to accomplish. For example, the simpletransfer cf HYV technology to rainfed areas is impractical: new technologiesare needed. Even in irrigated agriculture, not only is the expansion ofirrigated area slowing but, in the absence of new breakthroughs in the geneticpotential of the major cereals, so is the rate of growth in crop yields.Moreover, serious soil problems (waterlogging and salinization) have emergedin many older irrigated areas together with other "second generation"problems.
2.93 The strategy of concentrating on foodgrains under irrigatedconditions needs to be reexamined. First, as already indicated, theprobability is that the spread of irrigation will slow. Second, there is someevidence that the returns to expenditures of modern technology is declining.Yields in wheat and rice production in key states such as Punjab, Haryana andTamil Nadu show signs of stabilizing. Finally, there is an increasing
65
concentration of poverty in states which either have little irrigationpoteatial or inefficient water management systems.
2.94 The Government's strategy for boosting productivity and outputcontinues to focus on institutional and organizational strengthening ofagricultural support and input supply services. However, such programs willhave little impact on areas where modern input use is already high and yields -
plateauing. On the other hand, increasing input supply and traditionaltechnological packages in the areas where water supply is unreliable can beeffective only to the extent that it is preceded, or at least accompanied by,improvements in the reliability of irrigation. Finally, in rainfed farmingareas, problems of raising output are even more difficult. Farming systemsare more complex, involving intercropping and other risk-reduction techniques,and greater reliance on animal power. Here, new farming systems have to bedeveloped involving in-situ soil and moisturp ronservation techniques, new,stress-resistant crops or crop varieties and lot.er-risk, higher-yield farmingsystems. Little of this is on the horizon. to some extent, this reflectsfalling real public expenditure on agricultural research and the slowness ofthe research establishment to adjust its priorities and resource allocationsappropriately. This is probably traceable to weaknesses in the organizationand management of the research system and, more importantly, to anoverconcentration on applied research to the detriment of both basic researchand adaptive, farmer-focused research. It is and will continue to beimportant to raise the productivity of agricultural research. This changewill require that the research system determine its priorities more carefully,optimize resource allocations, enhance the relevance of its work and increasequality.
2.95 Expanding Investment in the Rural Sector. Real investment inagriculture in the 1980s, particularly since the middle of the decade, hasbeen lower in absolute terms, and much lower proportionately than the levelsreached at the end of the 1970s. In terms of net additions to the capitalstock, this probably understates the decline since a larger fraction of theinvestment of the 19809 almost certainly represents replacement investment.2/
21 It has been estimated that half of the tractors sold during the 1980s werefor replacement purposes and did not constitute an addition to theagricultural capital stock. However, the improved quality and performance ofsuch capital replacements has increased substantially during the last decade.
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TaIb l q 2. ZOroms Capital Formation, T ~~t `bcors) and in Agriculture.
Jin ;et{^ P (in Kn14 II ion)
Oro" Fixed Chun e in Gro Oro" Cross aroma CrossInvestnt Stork. Investment Dosetic Private Public InvestmentAgriculture Agriculture Agriculture /a Inveatmnt Invetment in Investment in Agricultur
Yesr Agriculture in Apricultur. Using Alter-Public native Deflator a
(1) (2) (3) (4) (5) (6) (7)
1960/61 15.660 8SO i6 680 97930 16.2 /b 10.790 5 8So 16 9601966/66 2256d0 600 16'680 186,990 16.6 15.100 7.980 28.7501970/71 26,260 1 8SO 27.'d0 137.620 19.1 19.690 7'890 28.8901971/72 27'670 1'570 29,240 148,510 19.3 20.730 8,810 30,2801972/78 29,380 2,420 81.080 162,770 18.0 20,590 10.490 32'1601978/74 29.020 3,060 32'0d0 157,670 18.4 22,150 9e9's 38.6701974/75 27.0eo 2,660 29.7io 158,150 17.5 20.560 9.190 30.1601975/76 29e350 4.860 33'880 181.170 16.2 23S470 10,410 34.0201976/77 J6.460 6,120 42'580 168,590 19.3 28,800 13,780 48.4001977/78 37'440 3'290 40,730 199270 18.8 25,390 15.340 42,3201978/79 42,460 10,000 52,460 221,300 19.2 35, 49 16.970 53,4701979/80 44,440 7.750 32.1i0 216'530 20.5 34'430 17,720 62.420
80/81 48,870 1,380 46,700 236'170 19.2 28'S50 18,350 46,7001981/82 48,460 2'100 45'S60 264,080 16.5 27'570 17.990 45,0501982/83 44.00S 1,600 46'690 286,070 15.4 28,370 17.320 45.6701988/84 39,570 1'600 41,170 287,080 18.8 23,840 17,330 40.7201984/85 41,030 2,540 43,570 S00,580W 13. 26,660 16,910 4,S6001985/86 37,740 2,220 39,960 814,410 12.0 24,580 15S380 40'8701986/87 58,250 2,830 41,080 34,280 11.2 26,240 14,840 42,8901987/88 89,240 2,580 /a 41,980 N. A. N. A N. A. N.A.
/a Estimated using the average for 1984/85-1986187/b Share of Agriculture in total Capital Formation./c Calculated using the deflator for gross fixed capital formation in the econosy *s a whole.
Source Central Statistical Oranization 1989, National Account Statistics (New Series). 1950/51 - 1979-80,' and CentaloStatistical Organization, 1987, lNew Serie on National Account Statistics with 1980-81 as Bse Year. 1980-81 to1 9C..8 7 ,8 and Central Statistical Organiztion. 1989, aQuick Estimtes of National Income, Consumption Expenditure,Saving, and Capital Formation, 1987-88 0 Lieberman and Ahluwalia (1989).
2.96 There is reason to believe that public investment in agriculture,which declined 122 between 1978/81 and 1984/87, has been "crowded out" byrapidly rising non-investment expenditures such as salaries and other currentoutlays on some ongoing projects, expenditures associated with employmentschemes, and a range of implicit and explicit subsidy programs of stategovernments. Thus, while total public expenditure on agriculture grew from8.82 of agricultural GDP in 1980/81 to 11.92 in 1987/88, the public investmentcomponent declined from 4.32 to 3.02.
2.97 The decline in public investment, the major part of which isallocated to expenditure on dams, canal, and flood control works, is reflectedin the non-fulfillment of physical targets (such as area irrigated) andspending obJectives. For example, only 602 of the Sixth Plan objective formajor and medium surface water projects was attained; not more than 502 of thetarget was reached during the first three years of the Seventh Plan.
2.98 The decline in private investment was even sharper, 21? over the1978/81 - 1984/87 period. Moreover, the composition of this investment haschanged substantially, with a rapiily growing (after 1979) fraction of thetotal reflecting investments funded through the Integrated Rural DevelopmentProgram. Many of these investments are not directly related to agriculture(e.g., support of projects in rural industry, services, and other non-agricultural uses). The productivity of these investments, as reflected inthe high incidence of project failures, low repayment rates, and low ex postrates of return, appears to be low.
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2.99 The weakness of private agricultural investment may reflect anunfavorable structure of incentives. Cross-sectoral comparisons of incentivesshow that agriculture is disprotected relative to manufacturing. Moreover,scattered data suggest that the terms of trade for agriculture andagricultural profitability may be deteriorating. In addition, tax adjustedyields on investments in financial assets have risen rapidly in the 1980s.This may be pulling resources away from agricultural investment towardfinancing of government expenditures. Finally, declining public sectorinvestment may also account for some of the drop in private investment. Farmlevel investments (especially in tubewells) complement public sectorinfrastructure investments; when the latter are missing or inadequate, theformer may not take place.
2.100 Concern about the decline in rural capital formation, the increasingconcentration of poverty in some rural areas and the possibility of an upsurgein rural-urban migration has led the Government to pledge a major increase inresources for agriculture and rural development in the Eighth Plan. Accordingto the Action Plan released in January, 1990, 50Z of Plan resources will beallocated to agriculture and rural development.
2.101 It is hard to judge how meaningful this target is; much depends onwhat is included in the definition of agriculture and rural development. IfSeventh Plan allocations for agriculture and allied programs, irrigation andflood control, rural development (including IRDP, employment schemes andspecial area programs), rural energy, rural industry, rural infrastructure andthe rural component of social services like health and nutrition are addedtogether the total would be on the order of 45 Z. Many of these programsalready have difficulty attaining their spending targets. Moreover, there aresubstantial doubts about the efficacy and efficiency of many of theserural-based programs. Simply pumping more money into the rural sector bysetting spending targets is not the way to a lasting solution to the problemsof low growth and persistent poverty.
2.102 Rationalizing the Incentive Structure. Government interventions inagricultural markets are pervasive and complex. They include price supportsystems, explicit and implicit subsidies on inputs, and exchange ratepolicies, tariff protectio. and nontariff trade barriers, which determine thelinks between domestic and external markets. Ensuring remunerative prices tofarmers has only been one objective of these interventions; others haveincluded encouraging food self-sufficiency, ensuring low-cost grain suppliesfor the public distribution system and producing efficient patterns ofproduction and resource use.
2.103 Some of these goals may conflict and it is not altogether clear whatthe effect of intervention has been overall. There are, however, clear signsof distress in the rural sector. The rate of private investment inagriculture has been declining, adoption of advanced technology has slowed andthe agricultural credit system is weighed down by loan arrears. The Governmenthas reacted recently to improve incentives by changing procurement pricedetermination rules in a way that should result ia higher farm prices,expanding existing procurement operations and instituting new ones for oilseeds, pulses and coarse grains, and promising forgiveness of at least a part
68
of agricultural debt. These changes do not, however, get at the heart of theproblem, which is the potentially conflicting nature of policy goals and theuncertain impact of the various interventions on these goals.
2.104 The effects of government intervention have two broad dimensions: themacroeconomic, which involves the disprotection of agriculture and itscompensatory subsidization; and the microeconomic, which concerns the effectson the structure of agricultural prices, profitability and production.
2.105 Indications are that high levels of industrial protection in Indiaresult in disprotection, or, in effect taxatlon, of the agricultural sectorand tend to draw resources away from agriculture to positively protectedsectors, especially industry. Moreover, protection levels within agriculturediffer between commodities (or regions) and result in distortions inproduction patterns.
2.106 Nominal protection coefficients for major agricultural commodities(the ratio of domestic prices to world prices, measured in rupees) tend to bebelow one. Effective protection coefficients (the ratio of value added inagricultural production measured in domestic prices to the value addedmeasured in international prices) are generally even lower, reflecting thehigh level of protection afforded agricultural inputs such as fertilizers,pesticides and agricultural machinery and equipment. For example, averageeffective protection rates during the 1980s for wheat and rice, evaluated atteh procurement price, were respectively 0.75 and 0.65, and 0.69 for cotton.In the case of groundnuts, where domestic prices have been set well aboveworld prices in recent years, effective protection has been positive (1.56).3/
2.107 The Government attempts to offset the disprotection of agriculturethrough subsidies on inputs. For the agricultural sector as a whole thesubsidies amount to 16 - 172 of value added and the equivalent of over 2.52 ofGDP. Subsidies associated with irrigation account for about 702 of the total;those for electricity, credit and fertilizers represent a much smallerproportion, although their direct effect on the budget looms larger. Thefertilizer subsidy, which is a major drain on the budget, only lowers thedomestic price to slightly below the world price and is therefore not a majorsubsidy to farmers. Most of the subsidy goes to inefficient domesticfertilizer producers in order to allow them to maintain their profitability.
2.108 The combined impact of the policies of implicit taxation ofagriculture through protection of industry and subsidization of agriculturalinput supplies on agricultural production and income distribution isdifficult to assess. However, some things are clear. First, subsidies do notfully offset the disprotection of agriculture relative to industry and,therefore, the incentive structure pulls resources away from agriculture.Subsidies do reduce the costs of inputs and encourage increases in the outputof farmers with acce.ss to these inputs, but their effect on total outputdepends on the extsnt this additional production displaces output by
V These crops together account for roughly 452 of gross cropped area and 502of value of crop production.
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unsubsidized farmers. Second, the subsidies may have a direct, regressiveimpact o3n rural income distribution, since they are not available to allfarmers, only those with access to institutional credit.
2.109 Disprotection of agriculture at present price and subsidy levelsdoes not mean that increases in the levels or coverage of procurement pricesor subsidies are warranted. Indeed, a thorough rethinking of the ends andmeans of interventions in product and input markets is in order. It isimportant that clear priorities be enunciated and the decision-making processbe made more transparert and less subject to political expediency. Also inneed of review are various operation facets of these initiatives including thescale and geographic scope of procurement and stockpiling, possibilities ofcooperating with rather than competing with private traders, and the risksthat different initiatives will negate each other.
2.110 Industrial policy reform has usually been recommended because of itsbeneficial effects on industrial growth, real incomes of consumers andindustrial imports. In fact, the most important benefits may be the indirectones provided to agriculture. Reduced protection can be accompanied byexchange rate changes which would soften the impact on industry and shift thedomestic terms of trade in favor of agriculture. Such a shift would tend toimprove the distribution to income and stimulate agricultural growth. First,higher agricultural prices would raise the rate of return to agriculturalinvestment relative to investment elsewhere in the economy. Innovation andintensification would become more profitable. Second, an increase inagricultural prices would provide farmers with the wherewithal to undertakeinvestment and innovation.
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CHAPTER 3
MACROECONOMIC PROSPECTS AND EXTERNAL FINANCING REQUIREMENTS
3.1 The Indian economy faces a difficult period during the early1990s. The relatively high levels of commercial borrowing undertaken tofinance the large current account deficits of the late 1980s andremaining IHF repurchase obligations (particularly up to 1992/93) willkeep debt service in the neighborhood of 25-302 of current receiptsthroughout the first half of the decade. Growing interest paymentobligations and the normal rising import payments associated withmoderate GDP growth rates will, despite relatively rapid expected exportgrowth, keep current account deficits at about 3.1-3.3Z of GDP.Moreover, even to keep current account deficits and debt service ratiosfrom exceeding these levels, the Government will have to reduce fiscalpressure on the economy significantly, and maintain policies conducive tocontinued rapid export growth. Overall growth prospects for the early1990s generally are good, but rates are likely to be lower (in the rangeof 4.52-5.0? of GDP) than achieved during the 1980s.
A. Balance of Payments Adjustment and Financing in 1990/91
3.2 If the fiscal adjustment envisioned in the 1990/91 budget isrealized and the flexible management of the exchange rate continues, asubstantial reduction of the trade deficit and correspondingimprovement in the current account could be expected in 1990/91. Highexport volume growth (11.62), based on continued flexible management ofthe exchange rate and other measures to encourage exports, is likely.Import volume growth (5.9X) is expected to be higher than in 1989/90, butsufficiently lower than export volume growth to result in a narrowing ofthe trade deficit from an estimated $8.4 billion in 1989/90 to about $7.7billion in 1990/91.
3.3 The invisibles balance is expected to decline to about -$0.5billion in 1990/91, with an increase in the surplus of net e-ports ofnonfactor services and a modest increase in transfer receipts more thanoffset by higher net factor payments abroad. Overall, the currentaccount deficit before official transfers would decline to about $8.2billion (3.1? of GDP), down from $8.6 billion (3.3Z of GDP) in 1989/90.
3.4 The financing necessary to cover the current account deficit isthus expected to be slightly lower in 1990/91 than it was in 1989/90.With gross reserves uncomfortably low, however, India will also need toborrow to increase import coverage and to cover IMF repurchases of about$0.6 billion. Capital inflows of $9.1 billion (as against $7.8 billionin 1989/90) are envisioned. The share of this coming from officialcreditors would increase, reversing trends of the last several years whendisbursements fell from about $3.6 billion in 1987/88 and 1988/89 toabout $3.2 billion 4n 1989/90. Borrowing (net disbursements) from
72
private creditors is expected to increase by about $0.4 billion. Basedon these factors, an accumulation of gross reserves of about $ 0.8billion could be expected.
B. Medium-Term ProsDects
3.5 During the Eighth Plan period, India needs to maintain growthmomentum in order to improve the growing population's living standards,absorb the rising labor force productively and reduce poverty. Somemodest slowing of growth from the high rates of the 1980s is probablyunavoidable as the Government moves to stabilize the economy andrestructure it to improve efficiency. However, there should be nofinancial constraints to satisfactory growth over the medium term,provided that the Government moves decisively to reestablish and maintainmacroeconomic balance, and proceeds with a coordinated program toincrease competition and responsiveness to incentives and upgradetechnology in industry and agriculture. The near-term policies needed tostabilize the economy mesh easily with the medium-term reforms needed toincrease efficiency and sustain growth. Restraining governmentconsumption and stimulating net exports, other things being equal, woulddecrease reliance on foreign saving, while providing the necessaryresources to maintain investment rates needed to support growth.Continuation of gradual deregulation of the economy, some progress inreducing the import substitution bia' of the trade regime, steps tomaintain agricultural output growth and continuing access to worldmarkets should make it possible for India to maintain stable, equitable,GDP growth rates in the range of 4.5-5Z pa. Higher average growth (sayin the 5Z-6Z p.a. range) could also be feasible, but could only beachieved within a viable macroeconomic framework with substantiallyfaster productivity growth in industry and agriculture and higher exportgrowth than now seems likely. This would require prompt implementationof a comprehensive program of trade, regulatory, and fiscal reforms alongthe lines outlined in Chapter 2. It would also require a larger volumeof quick disbursing concessional support than is projected here.
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Table 8.1
Bolance of Payments(Millions of US$)
1989,90 1990/91 1991M92 1992/98 1993/94 1994/95
Exports of Goods and Non-Factor Services 21216 24192 27451 81112 86146 89761Morchandise (fob) /a/ 17060 19756 22679 25742 29201 88129Non-factor Services 4165 44a8 4872 6570 6946 6832
Imports of Goods and Non-Factor Services 28956 81299 84856 87922 41871 4e261M*rehandise (cif)/a/ 25416 27484 80248 3sas 88es56 40718Non-factor Services 8640 8786 4114 4541 601a 6638
Resource B lance -7740 -7007 -4905 -6810 4726 -6489
Net Factor Income -8622 -4022 -4591 -5106 -5676 -6077Factor Receipts 896 448 S16 581 646 723Factor Paymnts /b/ 4017 4470 6107 5687 6220 6801
Interest Payments on NRI Dep. 976 1224 1891 1550 1890 1848
Net Current transfers 2720 2787 2868 2927 2999 8078Transfer Recolpts 2750 2819 2889 2961 8085 8111Transfor Paymnt. 8o 81 88 85 a8 as
Current Account Balance -8642 -8241 -8640 -8989 -9801 -9493
Foreign Direct Investment 426 464 529 6ol 668 783Official Grant Ald 500 524 649 575 608 682Net Medium A Long-Term Loans 5470 o105 6289 6874 6496 6630
Disbursement. 7601 8641 8899 10886 12707 I18l1Repayment. 2181 2486 2610 4612 6211 69o9
Net IMF Credit -870 -411 -449 -822 -182 -171Purchases 0 0 0 0 0 0Repurchases 870 611 449 822 182 177
Capital Flows NEI 2268 2671 2698 2641 2678 2818Non-Resident Deposit. 2298 2809 2824 2865 2872 2508kat Short-Term Capitol 260 262 274 287 801 816Errors & Omissions /c/ -280 0 0 0 0 0
Change in Resorves /d/ 860 -812 -876 -880 -1002 -1142(- s increaso)
End of Year Resrves (Excl. Gold) 4109 4921 6796 6876 7679 8821{ # Months of Import. 1.9 2.2 2.8 2.4 2.6 2.6
Memo. It enDebt Service Ratio 27.8x 26.0X 25.2X 29.1X 81.2X 81.01Current Account Balance (X GDP) -8.81 -8.11 -8.2X -. 2X -8.ax -8.1
/a/ Net of crude petroloum *xports./b/ Includes Interest on non-resident deposit. and IMF interest./c/ As estimated by Government of India./d/ Excluding Gold
3.6 A balanc,.-of-payments scenario to 1994195 is contained in Table 3.1. This envisionsGDP growth averaging about 4.62, and current account deficit in the range of 3.1Z-3.3z ofGDP. Export volume growth woald average slightly in excess of 91 p.a. This, combined with
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import volume growth averaging 5.42 p.a. would result in a significant reduction in theresource gap from 2.92 of GDP in 1989/90 to 2.12 of GDP in 1994/95. However, factorpayment obligations would increase from 1.4Z of GDP in 1989/90 to 2.01 in 1994/95. Thus.the decline in the current account deficit would be smaller thatn the decline in theresource gap.
3.7 Current Account. In dollar terms, the current account defioit would range between $8.2and $9.5 billion throughout the Eighth Plan. Overall, a shrinking merchandise tradedeficit and growing surplus on nonfactor services would be offset by growing factorpayments obligations. Only a modest rise (2.52 p.a. in nominal terms) in privateremittances is expected. The dollar value of merchandise exports is projected to grow at arate of about 14.2Z p.a. Virtually all of this is expected to come from continued rapidexpansion of manufactured exports, for the most part in the same product groups that haveled recent growth. Merchandise imports are expected to grow by 9.91, led by intermediategoods (12.72 pa), capital goods (13.02 pa), and petroleum and petroleum products (12.72pa).
Table 3.2:
Financing of the Current Account Deficit(billions of US$)
1989190 1990/91 1991/92 1992/93 1993/94 1994/9S
Current Account Deficit 8.6 8.2 8.6 9.0 9.3 9.5
Total Capital Flows 7.8 9.1 9.5 9.9 10.3 10.6
Official Transfers 0.5 0.5 0.5 0.6 0.6 0.6Net Official Lending 2.1 2.4 2.7 2.8 2.8 2.7Disbursements 3.2 3.7 4.2 4.5 4.7 5.1Repayments 1.1 1.3 1.5 1.7 2.0 2.3
Net Private Lending 5.6 6.0 5.8 5.8 5.9 6.2Net Foreign Direct Investment 0.4 0.5 0.5 0.6 0.7 0.7Net Use of IMF Credit -0.9 -0.6 -0.4 -0.3 -0.1 -0.2Other (Residual) 0.0 0.3 0.3 0.3 0.3 0.3
Change in Reserves (- w gain) 0.8 -0.8 -0.9 -0.9 -1.0 -1.1
a/ Including a provision for accumulated interest.
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3.8 Capital Account. India will need to continue to borrow in excess ofcurrent account financing needs to meet IMF repurchase obligations and rebuildreserves. Some medium-term shift in t-e composition of this borrowing towardheavier reliance on official creditors will also be necessary to curb therapid growth of relatively expensive commercial debt. Thus, grossdisbursements from official creditors should rise from $3.2 billion in 1989/90to a peak of $5.1 billion in 1994/95. Official credit needs to be on termsthat are not less concessional than the present mix. Net flows from privatecreditors (including net inflows of NRI deposits and a provision for accrualof interest whereon) can be expected to increase from $5.6 billion in 1989/90to $6.2 billion in 1994/95.
3.9 The scenario envisions only moderate increases in direct foreigninvestment considering the small base (from about $425 million in 1989/90 toabout $730 million in 1994/95) and official grant aid (from about $500 millionin 1989/90 to $630 million in 1994/95). While there is little prospect thatgrant aid will increase more rapidly than this (indeed it may be verydifficult to meet these levels), the increase in net direct foreign investmentis very small in relation to what India might expect to attract under a moreliberal set of policies. In recent years, the net flow of foreign directinvestment has amounted to no more than 1.32 of merchandise imports comparedto 6.5Z in Malaysia and 3.7? in the People's Republic of China. TheGovernment of India has been concerned that the high effective protection ofthe domestic market (and consequent economic rents) it has provided tostimulate the development of domestic industry should not be appropriated byforeign firms. As protection levels come down, however, the grounds for thisconcern will disappear and greatly increased net foreign investment could beencouraged to meet a much greater share of India's financing requirementswithout materially increasing foreign ownership in relation to the size of theeconomy.
3.10 Debt and Debt Service. In this scenario, publicly guaranteed mediumand long term debt would rise from about $55.7 billion at the end of 1989/90to about $96.5 billion at the end of 1994/95, while total external debt wouldincrease from $63.0 billion to $105.8 billion. The percentage of total debton concessional terms would decline from about 41? to about 29?. Thedebt/export ratio would decline (from 2.6 in 1989/90 to 2.4 in 1994/95) andthe debt service ratio, sustained by a bulge in scheduled repayments of loansfrom private creditors beginning in 1992/93 and by IMF repurchases before thatyear, would increase from 27.3Z to 31.0?. After this bulge, the debt serviceratio would be expected to decline gradually in the late 1990s.
3.11 Implications of faster export growth and/or slower import growth.While the debt service ratio will remain high during the early 1990s (above25? of current receipts) by historical standards under almost arv plausibleset of circumstances, higher export volume growth or lower import wumegrowth than that envisioned in this scenario could result in signi) .cantlyfaster reductions in the current account deficit, slower buildup of debt, andsignificantly better growth prospects in the latter part of the decade. Forexample, average merchandise export growth of 10.5? p.a. (i.e., about 1.4percentage points higher than envisioned in the scenario described above butin line with recent performance) sustained over the early 1990s would bring
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the current account deficit do-in to 2.22 of GDP by 1994/95, resulting in totalexternal debt (DOD) in that year of $100.6 billion and a debt service ratio of26.72. The basic issue is whether the present export promotion policy, absentdeeper structural trade reforms to reduce the preponderant import substitutionbias in the economy, will be sufficient to broaden the economy's export baseand sustain rapid export growth rates.
Table J.8
Mediu_-Term ProjectionsSensitivity of Resulte for 1994/96
Assumptions Base Case if High Exports Low Imports k/ High Export/Low Imports
Merchandise Export Growth SI 951X 1056X 941X 10 6XImport Difference t8,6 U ,606 t4,410 t4,410
Results Base Case High Exports Low Imports High/ ExportLow Imports
Trade BalanceUSS .) -7564 -6526 -5389 -8181Resource Balance (X GDP) -2.1 -1.8 -1.8 -0.6Current Account (USS m.) -9493 -B711 -6622 -8840Current Account (1 GDP) -a.1 -2.2 -2.2 -1.8Debt Service (X Exports) 81.0 28.7 2906 27.8External Debt (DOD, USt m.) 106796 100586 97922 92718
Notes:7 Corresponds to Table 8.1/ Difference between imports on a payments *nd customs basis constant In nominal USt terms/ Annual average from 1990/91 to 1994/96.
3.12 The import volume growth envisioned in the scenarios described aboveassumes implicitly that the gap between imports on a payments basis (which isthe relevant concept for balance of payments projections) and imports on acustoms basis continues to grow, albeit at a slower pace than in the 1980s.Absent information about the nature of the transactions reflected in the gap,there is really no way to be sure whether or not this assumption isreasonable. Its future course, however, will make a very large difference inthe future evolution of the balance of payments. If it grows at anythingapproaching the average rate of the last few years the balance of paymentscould quickly become very difficult to manage. The current account deficitwould remain above 32 of GDP, and tend to increase. Policymakers would befaced with an unenviable choice between unsustainable levels of externalborrowing, or very harsh adjustment to reduce other components of imports.Since the latter are already severely compressed, this would entail aconsiderable sacrifice of growth.
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3.13 On the other hand, if the payments gap were to stabilize at recentnominal values, this would materially reduce overall import payment growth andquickly strengthen the balance of payments. In this case, the current accountdeficit would fall to about 2.2Z of GDP by 1994/95, debt outstanding anddisbursed would stand at $ 97.9 billion, and the debt service ratio woulddecline to 29.5Z in that year.
3.14 A combination of faster export volume growth and slower importpayments growth, along the lines described in the preceding paragraphs, wouldproduce a dramatically stronger balance of payments in relatively short order.The current account deficit would decline to 1.3Z of GDP by 1994/95 and theexternal debt carried into the late 1990s would be about $ 13 billion lower.Debt service, however, would stand at about 27Z, but would decline rapidly Inthe late 1990s.
3.15 These considerations suggest that the Indian economy will be runningon a "razor's ed6e" during the early 1990s. What could be regarded underother circumstances as relatively minor policy slippage and/or smallunfavorable disturbances could result in serious balance of payments problems.Strong policy performance and/or favorable events, on the other hand, couldstrengthen the outlook considerably. In any event, however, debt service willremain a significant claimant on India's foreign exchange receipts during thisperiod.
C. Financing requirements
3.16 The continued generous support of the Consortium will be essentialduring this difficult period to help India achieve the necessary macroeconomicand structural adjustments of its economy. To moderate the burden ofborrowing during the early 1990s on the economy's longer term growthprospects, it is important to increase the share of total external financeprovided by the Consortium over the next few years. The recent levels andcomposition of commitments are the minimum required to support this shift. Inaddition, substantially improved disbursement performance will be necessary.India and the members of the Consortium will need to work together to theseends. The entire aid process needs to be strengthened to ensure the smoothprogression from pledges of assistance to project/program commitments, andfrom commitments to disbursements. Consortium members can help by increasingthe concessional component of the assistance they provide, by untying aid tothe maximum possible extent, facilitating cofinancing arrangements,re-evaluating designs of pipeline projects to facilitate implementation anddisbursements, insuring that project savings resulting from depreciation ofthe rupee are channeled back into the Indian economy to the maximum possibleextent, and by emphasizing disbursement performance in designing new projectstarts. India, for its part, needs to make improved disbursement performancethe highest priority of its external resource mobilization strategy.
3.17 A minimum goal for these efforts, given the present pipeline andassuming maintenance of adequate commitments levels, would be to increaseConsortium gross disbursements to about $5.1 billion by 1994/95. To achievethis, the recent levels and concessional composition of Consortium commitmentswill need at a minimum to be maintained during the next several years. Newcommitments should also, to the maximum ?ossible extent, emphasize quickdisbursing assistance designs. I
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3.18 If the Government adopts a more rapid, time-bound approach to policyreform intended to support more rapid restructuring of the economy and thefaster export growth that would flow from this, it would be possible toenvision somewhat more rapid growth in the medium term. These reformsnecessarily would also entail more import competition to the economy andpotentially higher import outlays. Were India to undertake such a program.the Consortium should be prepared to support it with increased overallassistance levels, with a large quick disbursing concessional component.
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ANNEX I
Sustainability of Recent Budget Deficits
The Sustainability Issue
The buildup of domestic debt and liquidity fueled by the high deficitsof the 1980s has galvanized concern in India that fiscal imbalances may makeit impossible to sustain rapid, stable, low inflation growth over tl}e longerterm even if the balance of payments were not presently a problem.11 Theseconcerns are well placed. Rough, but conservative calculations (in the sensethat the impact of high deficits is understated), raise grave doubts about thelong-run compatibility of public sector financial performance characteristicof the late 1980s (the key parameters of which are summarized in Table I.1)with continued relatively rapid growth and moderate inflation.
Table I.1Key Fiscal Parameters
Parameter Value Comment
Primary deficit/GDPmp 6.0? Centre and states,85/86-88/89Reserve money/GDPmp 16.0? Currency + deposit e RBI,89/90External debt/GDPmp 20.0OHousehold gross financial saving/GDPmp 10.0Z Average, 1985/86Interest RatesSmall savings outstandings 11.2? Average rate on outstandingsGovt bond outstandings 9.3? Average rate on GOI market debtExternal debt outstandings 3.0? Average real rate on new GOI
external obligationsCurrency depreciation (Rs/$) 6.8Zpa Average, 1985/86-1989/90Inflation 7.3?pa GDPmp deflator, 1985/86-
1989/90(e)GDP growth 6.0?pa GDPmp, 1985/86-1989/90(e)
Source: World Bank staff estimates.
I/ The debt problem has been identified both officially (e.g., by the NinthFinance Commission, the Comptroller and Auditor General of India, the PlanningCommission), by distinguished Indian policy analysts, and most recently in theReport of the Economic Advisory Council on The Current Economic Situation andPriority Areas for Action, as a potential threat to India's longer termgrowth. Recent papers by Rangarajan et al. (1990) and Buiter and Patel (1990)contain technical analyses of the problem.
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Continuing deficits at these levels would require India's government to issuerelatively large volumes of financial claims year in and year out. Theseclaims, broadly speaking, take one of three forms: (i) claims issued to theReserve Bank of India (e.g., ad hoc treasury bills, claims in virtue of loansand advances received, etc.); (ii) claims issued to the general public (e.g.,small savings instruments, National Saving Scheme deposits, etc.) and tofinancial intermediaries (e.g., bonds purchased/held by commercial banks,insurance companies, etc.); and (iii) claims issued to nor.-residents of India(i.e., external debt). The issuance of these claims sets in motion a complexprocess of adjustment that affects both financial markets and the underlyingreal economy. Borrowing from the Reserve Bank of India, for example,increases the money supply and potentially affects both real output and theprice level in the economy. Domestic borrowing from the public and/or fromfinancial intermediaries puts upward pressure on real interest rates,stimulating private saving and squeezing out interest sen-itive investment,with implications for the future growth potential of the economy. Borrowingabroad, as has been amply demonstrated over the last decade, carries with itthe obligation to make future transfers abroad with a concomitant reduction inresources available for domestic use.
Relationships Between Deficits, Their Financing, and Debt
These issues are most easily and clearly analyzed in terms of afundamental identity relating the fiscal deficit to money creation andinternal and external debt. This identity provides a useful framework foranalyzing the long run consistency between the financing requirements impliedby a given fiscal deficit and the sources available of finance. The basicrelationship is
Primary deficit + interest on domestic debt + interest on external debt =
net domestic borrowing + net external borrowing + net borrowing from the RBI =
PRIM + iB + ei*B* - AB + e AB* + AH (1)
where PRIM stands for the primary deficit,2/ i the average interest rate ondomestic debt, B is the stock of domestic debt, e is the exchange rate, B* isthe stock of external indebtedness, and H is the RBI's net credit to thegovernment. The left hand side of this equation represents the totalfinancing required (primary deficit plus interest on domestic debt plusinterest in rupee terms on external debt); the right hand side represents thesources of finance (increase in stock of domestic debt held by the public andby financial intermediaries plus the rupee value of the increase in the stockof external debt plus the increase in credit from the RBI).
2/The primary deficit is defined as the public sector borrowing requirementless interest payments.
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To be useful for analyzing long-run consistency questions, Eq (1) needsto be restated in terms of long-run ratios to GDP. This is accomplished bydividing through equation (1) by py, where p is the GDP deflator and y is realGDP, and using approximate mathematical relationships for the change terms onthe right hand side of the equation of the form that
Ab = AB/py - (y + p), (2)
'where y is the rate of growth of real GDP and p is the rate of inflation.Substituting these approximate relationships back into Eq (1) expressed inratio to GDP form, Eq (1) can be rewritten in the form of ratios to GDP asfollows:
prim + lb # (i*4*)eb* c Ab + 1;4pb * ehb + [;4Qeb* * Ah + 6-7p]h (a)
where lower case letters stand for ratios to GDP (e.g., "prim" is the ratio ofthe primary deficit to GDP), y stands for the rate of growth of real GDP,and e^ stands for the rate of depreciation of the currency, and p stands forthe rate of inflation.
Steady state equilibrium, ox what has been termed the "long run" inSection A (a), requires that the ratios to GDP of domestic, external debt, andRBI credit to government be constant, i.e., that
fb = eAb* = Ah = 0
which when substituted back into equation (2) yields the following equation:3/
prim + ib + (i*+ e) eb* [y + p] b + [y + p] eb* + [y + p] h (4)
The left-hand side of Eq (4) defines the gross financing requirements ofthe government as a ratio to GDP as a function of the primary deficit ratio.the stocks (in ratio to GDP) of domestic and external debt, domestic andexternal interest rates, and the rate of depreciation of the currency. Theright hand side represents the sources of finance available to the governmentas a function of the ratios of the three different kinds of governmentliabilities to GDP, and real growth and inflation. The overall equation
3/Equation (4) is usually stated in the rearranged form given below toemphasize key real parameters of the real economy such as the real interestrate, real exchange rate and real effective depreciation rate.
pri. a - (l-ji)] b [ (I- [(.-p) * (- (p- u))] eb. E y. h
where (i - p) is the domestic real interest rate, (i* - p*) is the externalreal interest rate, and (e - (p - p*)) is the rate of real effectivedepreciation.
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yields a long-run financial consistency condition in which debt stocks, realgrowth, inflation, interest rates, and exchange rate uepreciation must adjustto balance sources and uses of public sector finances.
The adjustment of the economy to accommodate a continuing governmentfinancing requirement and balance sources and uses, in general, involveschanges in all of the variables in Eq (4).41 However, a great deal can belearned from equation (4) about the potential risks associated with India'srecent fiscal posture, as reflected in the data reported in Table I.1, by somerelatively simple and approximate calculations in which all but one of thevariables are held constant and the required adjustment in the remainingvariable is calculated. In all of the calculations reported below, the rateof real effective depreciation of the rupee is assumed to be zero.
An Analysis of India's Recent Fiscal Posture
The basic problem with the high deficits of the late 1980s is that theyimply a very large future imbalance between the total sources of domesticfinance provided by the private sector's financial saving and the requirementsfor domestic finance generated by the public sector's deficit alone. Indeed,at the present time, the deficit ratio (10.4Z of GDP -- see Table 1.10) isapproximately equal to the household domestic financial saving ratio (102 ofGDP -- see Table I.1). In other words, today's government deficit levelswould, if financed domestically, absorb the entire current annual householdfinancial saving. Nothing would be left over from this source to financeinvestments elsewhere in the economy. This is why deficits are spilling overinto the balance of payments.
In the long run, unless the primary deficit is cut, the situation wouldtend to become even worse as rising debt and interest thereon would tend topush the deficit higher. Late 1980s parameters imply that, in the long run,the ratio to GDP of the total gross stock of financial assets held by thedomestic private sector, including all forms of financial assets, will attain -a maximum value of about 73Z.51 The ratio to GDP of domestic financial claims(reserve money, market loans, small savings, etc.) issued by the public sectorto tinance a long-run non-interest deficit of 6% of GDP, (holding constant therates GDP of reserve money and external debt) would, however, amount to116X.60 The public sector's requirement for finance thus implies a stock of
4/ A small, general equilibrium model built around the variables in equation(3) that can be used to examine these adjustments is described in Annex II.
5/ Holding constant real GDP growth and inflation at the values in Table I.1,a 102 financial saving rate implies, using an equation of the form of Eq (2)above, a long-run ratio of total domestic household holdings of financialclaims of 72.8Z of GDP (i.e., 0.10/.133).
6/ Holding constant RBI credit to government (h), external indebtedness(eb*), real GDP growth, inflation, and interest rates, at the values reportedin Table I.1, and calculating the adjustment in the stock of domestic debt (b)that would be required to balance financing requirements and sources underthese conditions, yields an estimated required value of b of 100.0% of GDP,and total domestically held liabilities of the government (b plus h) wouldthus amount to 116% of GDP.
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domestic financial claims that is over 40 percentage points of GDP higher thanstock of domeatic financial claims implied by the private sector's currentfinancial saving behavior.
Consideration of the mechlanisms by which this potenticl gap between thepublic sector's domestic financing requirements and available domestic financecould be closed leads to the heart of the medium- to long-term tradeoff issuesraised by India's high fiscal deficits. There are five main kinds ofadjustments that could redress this potential imbalance: (i) increasing realinterest rates on government debt to induce larger holdings by the privatesector; (ii) increasing the cross subsidy on government debt by tighteningportfolio restrictions on intermediaries; (iii) increasing monetization byincreasing dependence on RBI borrowing of the deficit; (iv) increased externalborrowing, which is the option pursued in the late 1980s; and (v) reducing theprimary deficit. While these alternatives are not mutually exclusive, themagnitude of the potential supply-demand imbalance and the tradeoffs betweengrowth, inflation, and indebtedness objectives are framed most clearly byexamining the potential of each, taken separlately, for closing the gap.
Increasing real interest rates. Domestic demand for publi sector bondscould be increased by raising real interest rates, thus inducing privatesavers to save more and/or devote a larger share of their portfolios to publicsector debt. The size of the required increase depends upon theresponsiveness of demand to real interest rates. Recent data (i.e., from the1970s and 1980s) indicate that private sector demand for public sector debt isnot very interest elastic (Genberg, 1989b). Substantial increases in nominaland real rates have been required to accommodate the growing volume ofgovernment debt. Under India's administered interest rate regime, rates donot adjust automatically to changes in asset market supply and demandconditions. Rather, adjustments are made administratively, reflecting policymakers' perceptions of the relative costs and benefits of domestic borrowing.external borrowing, increasing taxation of financial intermediation, and/ormonetization. As rates have been adjusted upward, increasingly attractive taxadvantages have also been offered. Absent these advantages, adjustments ininterest rates per se would have had to be substantially larger to induce thenecessary portfolio adjustment.7/
These phenomena are most evident in the evolution of interest rates andtax concessions on public sector debt instruments held voluntarily byhouseholds, e.g., small saving instruments, pension and provident funds, andannuities, etc. A useful indicator of these rates is provided by two ratescomputed for small saving instruments: an average rate obtained by weightingneminal rates for the various instrumerts offered by their corresponding
7/Hany of the tax breaks offered are subject to restrictions that limit, inprinciple, the total tax benefit that may be claimed by any individual taxpayer. These limits are quite high, however. A taxpayer positioned to takemaximum advantage of available deductions could deduct up to Rs 70,000 peryear in virtue of investments made in public sector instruments carryingpreferences (i.e., Rs 40,000 under Section 80C and Rs 30,000 under Section 80CCA) and a virtually unlimited amount per year in virtue of income frominstruments carrying preferences.
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proportion of outstandings (column 1 of Table 1.2), and a ma.ginal rateobtained by weighting nominal rates by proportions of changes in outstandings(column 2 of Table I.2). Interest rates thus calculated increased from roughly4.5Z at the beginning of the 1970s to between 10.9Z and 11.5Z in 1986/87. Inreal terms, this represents an adjustment from about -3.OZ at the start of the1970s to over 3.5Z in the late 19809. Tax preferences available on many formsof small saving instrument have boosted the after-tax return still further.In assessment year 1988/89, the highest tax adjusted yields were offered onNational Savings Certificates (Series VI), which yielded (nominal terms) 32.8Zafter tax to a taxpayer able to make maximum use of the deductions andexemptions available. (Dasgupta, 1989)
Table I.2Domestic Debt and Small Savings Interest Rates
1/ 2/ 3/ 4/Year Average Marginal Gov. Debt Go,. Debt
Rate Rate RBI Non RBI(Z) (Z) (Z GDP) (Z GDP)
1970-71 4.39 4.59 8.87 25.161971/72 4.74 6.11 10.15 25.441972/73 5.10 6.42 10.75 25.281973/74 5.23 6.07 9.92 23.891974/75 7.12 9.96 8.85 22.821975/76 7.40 7.87 8.45 24.701976/77 7.32 8.51 8.10 25.691977/78 7.75 8.90 7.72 29.581978/79 8.45 9.78 8.23 28.711979/80 8.64 9.56 12.49 26.891980/81 8.64 9.03 12.11 28.471981/82 9.26 10.07 12.82 27.441982/83 9.82 10.92 12.85 30.211983/84 10.06 11.21 12.93 31.211984: 3 10.46 11.67 14.91 33.18198: 36 10.83 11.78 14.78 36.321986/87 10.88 11.54 15.81 39.76
Source: World Bank staff estimate.
1/ Average rate paid on small savings, weights based on outstandings.2/ Average rate paid on small savings, weights based on changes in
outstandings.3/ RBI net credit to government.4/ Government domestic debt not held by RBI.
To eliminate the supply-demand gap completely through an increase ofinterest rates would require an increase in real rates to a conservatively
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estimated 10.7Z, or about 18.0 in nominaL terms.61 The nominal rate ofinterest would be well above the nominal rate of growth of 'he economysubsumed in these calculations (13.7Z). This would mean that the stock ofdomestic debt would tend to grow ever larger in relation to GDP, the so-called"debt-trapu condition. It is therefore not a viable alternative. Even if itwere feasible to resolve the gap by a sustainable interest rate adjustment,this policy would reduce interest sensitive investment (i.e., private fixedand private inventory investment) and thereby reduce the economy's growthpotential.
Tightening Portfolio Restrictions. Demand for government bondsand/or reserve money can be increased by requiring financial intermediaries toincrease the proportion of claims on government in their portfolios. Allimportant Indian financial intermediaries are subject to portfolio restric-tions, which in the past have been adjusted frequently to ensure adequatedemand for public sector liabilities. These portfolio restrictions create aninvoluntary market for government debt, reducing the rate the government hasto pay (on at least some portion of its debt) to below the market rate, whichresults in cross subsidization of government debt. However, this kind ofadjustment alone will not work in cases of extreme imbalance such as the onehere. In the absence of significant interest rate adjustments, thegovernment's domestic debt would absorb more than the entire financial savingof the private sector. In other words, even portfolio restr.ctions requiringthat 10O of assets be held in the form of claims on government would not besufficient.
While tightening portfolio restrictions in less extreme cases and theensuing increase in cross subsidization may reduce the public sector'sinterest costs, it is not costless to the economy. To maintain profitability,intermediaries either have to charge more for loans to other borrowers, pay
L. Using the following empirical relationship between total domestic debt ofthe consolidated centre and state governments (BD/y) and average small savingrates (IAVG) (i.e., the data reported in Table 2.2, column (1) and the sums ofcolumns (4) and (5)) taken from Genberg (1989b),
IAVG = 0.47 + 12.67 BD/Y + 0.98 iBRdev + 0.33 iUS R2 _ 0.98(10.12) (14.81) (12.52) DW = 1.77
and setting the difference between the US T-Bill rate (iUs) and the RBI's BankRate (iBRdev) at 2.8Z (roughly representative of the late 1980s)andconsolidated domestic debt at 116Z of GDP, we obtain an estimated requirednominal interest rate of 18Z on small savings. Holding the ratio of averagerates for small savings and bonds at its value as per Table I.1 (i.e.,11.25/9.3 - 1.21) and financing proportions (of one (at the small savingsrate) to three (at the bond rate) implies an average rate on government bondsof 15.OZ for an average interest rate on debt not held by the RBI of 15.8Z.This exceeds the assumed nominal growth of the economy--the so-called debttrap condition. Moreover, this calculation ignores any effects thatincreasing interest rates on government bonds and debt may have on the demandfor base money, and the recent tendency for bond and small saving rates tobecome more nearly equal. Finally, this estimate neglects the effect that aninterest rate increase may have on the demand for base money.
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lower rates to their lenders (depositors), and/or absorb losses that even-tually have to be made up by the public sector. This crowds out investment,reduces growth, and may result in widening deficits if the government isforced to compensate intermediaries for losses. At present, existing bonesheld by intermediaries pay about 30? less than average small savings rates.The picture is roughly the same with respect to new bonds, which pay between10 and 11 percent, versus more than 14 percent for the most popular smallsavings instruments. Most of the remainder of the intermediaries' portfoliospays more than 10 percent, with rates on some types of loans reaching the highteens. Overall, in 1986 (the most recent year for which data are available)banks' rates on investments not approved for meeting portfolio requirementsaveraged about 122, compared to 82 on securities so approved (Hanson, 198&).
Increasing monetization of the deficit. The third way in which thepotential gap could be closed would be to reduce ttie need to issue domesticbonds by greater reliance on monetization of the deficit, i.e., borrowing fromthe RBI. A signiticant (and growing) share of public sector deficits in Indiahas been financed in this manner. During the late 1980s, government netborrowing Lrm the RBI averaged about 2.25Z of GDP, or slightly more than theaverage annual change :dserve money.
A rough calculation indicates that monetization would have to be heldto about 2.1Z of GDP per year to maintain inflation at the Seventh Planaverage -- 7.3Z. Moreover, this calculation assumes that all the assets ofthe RBI are devoted to the finance of public sector deficits. No provision ismade for accumulation of net foreign assets, cr for RBI rediscount operations.Disregarding the effect of higher sustained inflation on the demand for realreserve money balances and possible effects on the size of the primary deficitand investment rates9/. Eliminating the supply-demand gap for public debtcalculated above would require borrowing from the RBI to average at lea&t 3.7percentage points of GDP per year (assuming 6? real growth) and would resultin an inflation rate of at least 16.8?, over twice as high as the Seventh Planaverage. 0/ This would obviously not be acceptable given the probable effectin the Indian context of double digit inflation on poverty.
Increasing external borrowing. The fourth alternative would be toborrow more externally. As explained in Chapter 1, however, the environmentfor doing so is not conducive since additional borrowing would necessarilyhave to be done on costly commercial terms. Using external borrowing to close
9I There is a substantial body of cross-country empirical evidence which showsthat primary deficits are themselves likely to inc-ease as inflation ratesincrease. This is particularly likely to occur when the tax system is incomeinelastic, as it is in India. Investment rates may also be adversely affectedby inflation.
10/ Holding real interest rates, real depreciation, and the ratios to GDP ofexternal debt and base money constant, eq (4) is solved for the rate ofinflation that yields a value of h plus b equal to 72.8? of GDP.
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the gap would result in a conservatively estimated fovernment external debt toGDP ratio of 62.62, more than a five-fold increase-'
Reducing the non-interest deficit. These considerations concerningthe threats posed by high deficits and growing debt to India's longer termdevelopment objectives lead to the conclusion that the fifth alternative--reducing the primary deficit--is an essential element of any coherent programfor sustainable faster, low inflation growth. Deficit reduction is thusindicated both on near-term stabilization grounds, as well r.s on the basis oflonger-term objectives for sustainable, low inflation growth. Roughcalculations indicate that a reduction of at least two percentage points ofGDP -- i.e., from 6Z of GDP to 42 of GDP -- would be consistent with 6? realgrowth, a slight moderation of inflation (to about 5?), and maintenance ofcurrent real interest rates, current ratios of reserve money and (assuming noreal effective depreciation) external debt to GDP.12
11. Holding real interest rates, real depreciation, and the ratios to GDP ofbase money and bonds at 16Z and 56.8Z respectiveiy, eq (4) is solved for thesteady state external debt stock.
12/ A more detailed analysis of long-run tradeoffs between deficits,growth,and inflation is contained in Annex II.
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ANNEX II
Deficits and Long-Run Tradeoffs Between Growth, Inflation, and Indebtedness
The maintenance of a high rate of economic growth requires high ratesof investment which, in turn, are facilitated by access to finance atrelatively low cost. A government deficit that is financed by debt issues mayslow growth by driving up domestic interest rates and thereby crowding outprivate investment. If, instead, the deficit is financed by recourse tocentral bank credit, the outcome is likely to be a rate of inflation higherchan desired. Greater external borrowing can ease the growth-inflationtradeoff, as it has during the 1980s, but only at the cost of higher andperhaps unsustainable external debt service.
This annex explores the longer run tradeoffs between deficits,growth, inflation and indebtedness using a small empirical general equilibriummodel of the Indian economy. The model, which is more fully described inGenberg (1989a), is used to examine the long-run consistency between inflationand growth objectives, on the one hand, and budget deficits and theirfinancing on the other. Caution is warranted in drawing conclusions about thelikely near-term behavior of the economy from the simulations of long-runbehavior presented here. In the near term, dynamic adjustment andexpectational phenomena are very important. These are not captured by thelong-run relationships included in the model.
An empirically-based simulation model.
The right hand side of Eq (1), Annex I represents the increase in thesupply of various types of government liabilities. These must necessarily beheld bv private sector and/or foreign creditors. The fundamental question is.however, on what terms -- especially at what rates of interest -- they will beheld willingly. To answer this question it is necessary to use demandfunctions for these instruments. It is the introduction of these behavioralrelationships and the requirement that asset stocks be willingly held thattransforms the budget constraint in Eq (4) of Annex I from an identity into aneconomic model, and makes it possible to investigate the longer-termrelationship between deficits, debt, growth and irflation.
The model may conveniently be divided into five blocks: (i)investment, growth and bank credit demand; (ii) household demand for financialassets; (iii) banks' demand for government bonds and cash reserves; (iv) flowsupply of government debt; and (v) equilibrium conditions.
Investment, Growth, and Bank Credit Demand
The production function in the model, Eq (1) is the standard relationbetween the investment rate (INV -- total public and private) and growth (gy)used in long-run analysis, where K is the capital output ratio.
gy = (1/K) INV (1)
9o
Public investment is treated as exogenous. Private investment(INVf), in turn, is related negatively to the average cost of capital tofirms, r.ccording to Eq (2).
INVf = cl - C2 ravg (2)
The model posits that firms finance their investments either throughbank credit, at a real interest rate of rc, or by borrowingdirectly from the public, at a real interest rate of rfa. The average cost ofcapital to firms is then a weighted average of the two,
ravg ' w/(l+w) r. + 1/(l+w) rfa. (3)
The mix of financing between these two sources depends on theirrelative cost. This is modeled as
w = c3 + exp(c4 - c5 ( rc - rfa)) (4)
Firms' demand for bank credit then can be derived as the fraction ofprivate .nvestment financed by bank credit times private investment.
Cbf = w/(l+w) INVf (5)
Household Demand for Financial Apsets
Households' long run demand for financial assets as a proportion toGDP (fa) is a function of the real interest rate on financial assets availableto households.
log(fa) = c6 + c 7 rfa (6)
Households are assumed to divide their holdings of financial assetsbetween government bonds (and assets with si.ilar yields such as small savinginstruments, etc), bH, and banks deposits, D, depending upon the relativereturns between the two. The ratio of bonds to deposits, 6, is modeled as
5 = c8 + exp(cg (rb - rdep)) (7)
where rb and rdep are respectively the real interest rates on government bondsand bank deposits. Tax preferences available to households are assumed toaffect the value of the constant c8.
The real yield on financial assets is defined as a weighted averageof the government bond rate and the bank deposit rate
rfa = 61(1+6) rb + 1/(146) rdep (a)
The demand of households for currency is taken to be a function ofthe rate of inflattoanj the real rate of return on financial 2ssets
cu = exp(c 1 o - cll t - c 1 2 rfa) (9)
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where cu is the ratio of holdings of currency to GDP.
Banks' Demand for Government Bcads and Cash Reserves
Batiks' demand for government bonds and cash reserves arise fromlegally-imposed portfolio restrictions and legal reserve requirements.Assuming that the proportions of deposits required to be kept in bonds and onreserve are X and p respectively, banks' demand for bonds and reserves aregiven respectively by
bB = X D (10)
RES p D (11)
Flow Supply of Government Debt
The flow supply of government bonds is equal to the public sectorborrowing requirement, i.e., the sum of the primary budget deficit, andinterest payments on outstanding externally-held (b ) arnd domestic governmentdebt (b).
psbr = prim + i* b* + ib bH + ibB bB (12)
where i*, ib, and ibB are respectively nominal rates on external debt, bondsheld by households, and bonds held by banks. Nominal interest rates are equalto the corresponding real rates plus the rate of inflation.
Portfolio requirements permit government to pay banks (and otherfinancial intermediaries) lower interest on bonds than is required to placethem wiLth the private sector, implicitly taxing them. That is, it is assumedthat the two rates are related by
ibB = (l-t) ib (13)
Equilibrium Conditions
The flow demand for government debt is comprised of the demand forincrements to the monetary base and a.ditions to external and domesticholdings of government debt. Equilibrium requires that the flow supply ofgovernment debt (psbr in eq (12) above) and the flow demand for governmentdebt be equal
psbr = cu(y + p)+p d (t+P-iR)+b*(Y+P)+(bH+bB)(t+P) (14)
where iR is the nominal interest rate on reserves held with the central bank.
The market for bank credit clears when the funds leftover aftermeeting portfolio and reserve requirements is equal to the demand for bankcredit.
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(1- A - p)D - Cbf (15)
The final relationship is a viability (zero profit) condition onbanks which requires that rates ci'arged on credit to firms, together withrates received on government bonds and reserves, be sufticient to cover thecost of deposits.
ic ' 1/(1-X-p) (idep - X (1-t) ib - p0 iR) (16)
Parameter Estimates 'sed in Simulations
The parameter values used in the simulations discussed in the textare as shown in Table II.1. The derivation of these values is described inGenberg (1989a).
Table II.1:Model Parameter Values
Parameter Value
K 4.0C1 0.565C2 0.00915C3 0.1C4 0.034C5 0.01C6 -0.802445
C7 0.1515C8 -0.3C9 0.5C1o -1.915Cl1 -0.032C1 2 -0.019X 0.38p 0.15t 0o.0iR 0.07i* 0.07
An Examination of Some Adjustment Alternatives
The rough calculations of Annex I showed that India has to reduce itsprimary deficit. The present level is not sustainable. Four differentapproachew which highlight some aspects of the tradeoffs involved areexamined. In one, the "gradual fiscal adjustment' scenario (GFA), theadjustment of the primary deficit is done at the pace necessary to maintainthe overall deficit (i.e., government borrowing requirement) at 1OZ of GDP,roughly its level at the end of the 1980s. This appears to have been thepolicy pur*ued by the Goverr4nnt after 1986/87 as it controlled the primarydeficit by reducing capital expenditures so as to hold the overall deficit in
93
the 10-lZ range. In the long run, this adjustment strategy implies a primarydeficit ratio that is lower than the present 62 ratio. In effect, under thisstrategy, high primary deficits today would be "financed" by lower primarydeficit ratios in the future. At current rates of growth of interest outlays,the GFA scenario would require primary deficit reductions of about 0.7percentage points of GDP per year over the next few years. In the otherscerario, the *immediate fiscal adjustment" scenario (IFA), the deflcit iste4uced immediately by approximately the amount necessary to achieve a longrun primary deficit that is approximate. equal to the current primary deficitafter adjustment. That is, the IFA scenario implies no sacrifice of futuregovernment programs for current ones.
As noted above, the primary deficit was controlled after 1986/87primarily by restraining non-defense capital expenditures. In the scenariosexamined here, it is assumed that the reauctions in the primary deficit areachieved primarily via reductions in current expenditures. If achieved viacuts in government nondefense capital spending rates, growth rates would beexpected to be mt.ch lower and inflation rates much higher than calculatedbelow. In both t;cenarios, the rate of credit extended by the RBI to thegovernment is held constant so as to maintain inflation at 7Z or less, andexternal borrowing is limited so as to maintain interest on external debt to14Z of export receipts (roughly their current level).
Table II.2:
Fiscal Adjustment, Growth, and Inflation in the Long Run
GFA IFA FAST FAFI
Overall Budget Deficit (Z of GDP) 10.0 7.3 8.0 7.6Primary Deficit (Z of GDP) 2.1 3.3 4.0 3.6Real Interest on Financial Asset (Z) 5.2 3.6 3.5 2.9Growth (? p.a.) 4.5 4.9 5.9 6.4Inflation (t p.a.) 7.0 6.2 4.8 4.6
The results of the analysis are reported in Table II.2. Under theGFA scenario, the required long run adjustment of the primary deficit isalmost 4 percentage points (i.e., 6-2). Inflation remains at about 7?, andgrowth at about 4.5:. The long-run growth rate falls in this scenario fromthat achieved during the 1980s (more than 5? p.a.) due to the higher realinterest rates needed to accommodate the rapidly growing volume of governmentdebt produced by slowly declining primary deficits. The IFA scenariorequires an immediate and long run adjustment of the primary deficit of about2.7 percentage points of GDP. This achieves growth of 4.9?, through its
94
effect on real interest rates and, due both to higher growth and lower realinterest rates, inflation at a rate of about 62 p.a.
If fiscal adjustment is complemented by reforms that increaseefficiency in the economy, thereby lowering the capital output ratio, andfurther increase the attractiveness of exports, the size of the immediatefiscal adjustment required is smaller, and growth and inflation outcomes arebetter. The nature of the refirms that could accomplish this are discussed inSection B of Chapter 2. A scenario reflecting immediate fiscal and structuraladjustment (FAST) is also shown in Table II.2 in which it is assumed thatstructural reforms are undertaken which reduce the capital-output ratio byabout 202 and increase the export share of GDP to 102. (These estimatesreflect the estimated range of policy reform effects on growth and exportshare found in Anduw;son, 1989, and Otoo, 1989a). Under these conditions, therequired reduction in the primary deficit drops to 2 percentage points of GDP,growth increases to 6.OZ p.a., and inflation falls to about 4.82 p.a.
Reducing the deficit would also greatly simplify the problem offunding government debt. This would make it possible to relax the portfoliorestrictions on financial intermediaries that implicitly tax saving andinvestment. The result of eliminating this tax wedge would be higher savingand _nvestment, and higher growth. A scenario "FAFI5 in which a slightlylarger immediate deficit reduction (2.42 of GDP) than in the FAST scenario iscombined with the FAST structural reform assumptions and a financial reform inwhich the "taxation" of government bonds held by banks is reduced to zero, therequirement on intermediaries holdings of government debt reduced from 382 to25Z, and in which interest is paid on bank reserves at the same rate earned ongovernment bonds produces still aigher growth (6.42 pa) and lower inflation(4.6Z pa).
These results point to the conclusion that India faces a relativelyrich and attractive menu of possibilities for faster growth, lower inflation, Uand strictly controlled external indebtedness. The sharper the restraint athat can be exercised on the government deficit without cutting intoexpenditures ne.essary to sustain growth, the more attractive the range ofpossible outcomes. Combinations of strict fiscal management with reforms toimprove the efficiency of the real and financial sectors of the economy havethe potential to boost growth and lower inflation substantially. Moreover,these policies are mutually reinforcing: steps taken to improve efficiency inthe real and financial sectors of the economy reduce the size of the fiscaladjustmetn necessary to attain growth, inflation, and indebtedness targets.
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