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Indian reforms spark gains, but more are needed to sustain higher growth and reduce poverty

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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India has been among the fastest growing economies in the world over the past two decades. It has achieved trend improvements in growth, literacy, mortality, and poverty rates (see chart, top panels, this page). In recent years, India’s deft handling of monetary policy has helped it successfully weather the Asian crisis while maintaining low inflation and a comfortable external position. Yet despite these gains, poverty rates remain high, with more than one-third of the population still living below the official poverty line. This uneven progress raises questions about the impact of recent economic and structural reforms and about what more can be done to reduce poverty.

Period of low growth

In the three decades following independence in 1947, per capita GDP in India rose only 1½ percent a year (see table, page 171). Throughout this period, the country’s economy was characterized by a high degree of government planning and regulation and pervasive industrial controls. Increasingly, restrictions on private credit, the role for the public enterprise sector, and subsidy programs also expanded. Strict controls on foreign direct investment, an elaborate import licensing system, and—from the 1970s—high tariff rates further stifled the economy’s growth potential.

In the 1980s, liberalization of import and industrial controls and improved agricultural performance helped accelerate real per capita GDP growth to an average rate of 3¾ percent. But this expansion also reflected other developments, notably increased fiscal stimulus and a debt-financed consumption and investment boom that became unsustainable toward the end of the decade.

India: economic indicators

Note: Data shown are for fiscal years, which begin in April.

1 Consolidated public sector comprises the central and state governments, central public enterprises, and the accounts of the Oil Coordinating Committee.

Data: IMF, World Economic Outlook, April 2000, Box 4.2

Crisis and reform

A balance of payments crisis ensued in 1991, reflecting a deteriorating fiscal position, rising external debt (especially short-term debt), a surge in world oil prices, and a sharp decline in remittances from Indian workers in the Middle East. As capital flight accelerated and official reserves rapidly declined, the Indian government entered into a Stand-By Arrangement with the IMF and embarked on a program of fiscal and structural reforms.

Corrective policy measures successfully restored macroeconomic stability. The central government deficit declined to 4¾ percent of GDP in 1996/97 from 8 percent before the crisis through tax reforms, cuts in subsidies, and reduced defense and other expenditures (see chart, lower panels, this page). The lower deficit, in turn, reduced the financing that had to be provided by the central bank, and wholesale price inflation declined to nearly 6 percent by 1996/97 from a precrisis level of almost 14 percent.

In addition, India introduced important structural reforms. It liberalized industrial licensing and investment approval procedures and reduced the number of industries reserved for the public sector. External sector reforms reduced the import-weighted tariff rate to 25 percent by 1996/97 from 87 percent in 1990/91, eased import licensing requirements, relaxed controls on foreign direct and portfolio investment, and provided greater exchange rate flexibility. In the financial sector, the authorities implemented measures to liberalize interest rates, strengthen prudential norms and supervision, encourage greater competition in the banking system, and improve the operation of capital markets.

Photo credits: Denio Zara, Padraic Hughes, Pedro Marquez and Michael Spilotro for the IMF, pages 161—162, 164—165, and 168; Kemal Jufri for AFP, pages 166 and 167.

In response to the government’s policy package, the recovery from the 1991 crisis was rapid. Private investment rates rose sharply, and real per capita GDP growth increased to more than 6 percent by 1995/96. Productivity improved significantly as well—as evidenced by increased total factor productivity growth at both the aggregate and firm levels and by declining incremental capital output ratios, particularly in the services sector (see table, this page).

Unfinished business

More recently, however, per capita growth has slowed, averaging closer to 4 percent between 1997/98 and 1999/00, compared with 4¾ percent between 1992/93 and 1996/97. To some extent, this reflected a cyclical catchup following the 1991 balance of payments crisis, as well as the adverse impact of the Asian crisis and agricultural supply shocks. But economic performance also appears to have been adversely affected by a reversal of fiscal adjustment, infrastructure bottlenecks, and delays in implementing structural reforms. Increased civil service wages and subsidies, as well as rising debt service, pushed up the fiscal deficit and resulted in higher real interest rates. These higher rates, combined with banks’ efforts to improve their balance sheets, slowed credit growth. Infrastructure constraints also continued to bind, as the earlier fiscal consolidation had relied too heavily on reduced public investment. Consequently, the contribution of private investment to growth fell by one-half from earlier in the decade, and measured productivity growth, particularly in the industrial sector, deteriorated (see table, this page).

Moreover, the poverty rate remains very high, suggesting a possible slowing in the impressive rate of decline that had extended from the mid-1970s through the 1980s. This outcome partly reflects the relatively poor performance, in the 1990s, of the agricultural sector—a key sector, since some 70 percent of the labor force still relies on the land for its livelihood. While adverse supply shocks played a role, the lack of agricultural reform also contributed to low investment rates and low productivity. In addition, the scope for mobility of low-skilled labor out of the agricultural sector has likely been limited by the absence of robust and sustained growth in the industrial sector and by the relatively larger contribution of the higher-skilled service sector to GDP growth.

What new measures would sustain high growth rates in all sectors and achieve more substantial poverty alleviation? Faster growth would require durable fiscal consolidation to raise national saving and crowd in private investment spending; further liberalization of foreign trade and investment flows; and additional reforms in labor markets and in the agricultural, industrial, and financial sectors to promote greater efficiency and export competitiveness. These reforms will need to remove domestic pricing distortions, improve bankruptcy procedures, and ease restrictions on firm and farm size and regulations that make it difficult to shed labor (and therefore impede job creation). Fiscal priorities would also need to redirect resources into human and physical capital investments.

India: expenditure and sectoral components of growth

(Average annual percent, unless otherwise noted)1

1951–791980–901992–961997–992
Real per capita GDP growth31.53.84.74.1
Real GDP growth33.75.96.75.8
Contribution to growth, by expenditure
Private consumption2.43.83.92.5
Public consumption0.40.80.51.4
Gross fixed investment0.81.51.91.2
Private investment0.81.80.9
Public investment0.60.10.3
Net exports40.10.10.6
Contribution to growth, by sector
Public1.11.72.85.2
Private2.24.23.80.7
Contribution to growth, by sector
Agriculture1.11.61.40.5
Industry1.01.72.01.5
Services1.42.53.23.8
ICORs, by sector5
Overall4.24.14.8
Agriculture2.01.52.6
Industry5.76.810.7
Services4.02.92.1

Averages computed over fiscal years beginning in April.

1999 figures on GDP and sectoral production are CSO Advance Estimates; annual population growth assumed constant at 1.7 percent; average contribution of expenditure categories and private and public production computed over 1997–98.

Measured at market prices; base year is 1980 for data until 1993, and 1993 thereafter.

Includes statistical discrepancy.

The incremental capital output ratio (ICOR) is the ratio of the investment rate to the GDP growth rate; a falling ICOR over time therefore indicates improved capital productivity.

Data: IMF, World Economic Outlook April 2000

Averages computed over fiscal years beginning in April.

1999 figures on GDP and sectoral production are CSO Advance Estimates; annual population growth assumed constant at 1.7 percent; average contribution of expenditure categories and private and public production computed over 1997–98.

Measured at market prices; base year is 1980 for data until 1993, and 1993 thereafter.

Includes statistical discrepancy.

The incremental capital output ratio (ICOR) is the ratio of the investment rate to the GDP growth rate; a falling ICOR over time therefore indicates improved capital productivity.

Data: IMF, World Economic Outlook April 2000

The experience of the 1990s has demonstrated the potential benefits of reform, and there is broad agreement in India that further reforms are needed. Several factors argue for translating this consensus into swift action. First, the establishment of a bold agenda would be facilitated by the relatively favorable current economic situation and the significant majority enjoyed by the ruling coalition. Second, with the consolidated public sector deficit rising again and the public sector debt stock close to 80 percent of GDP, fiscal sustainability is a serious concern. Third, India is committed to trade liberalization measures under the World Trade Organization, including removing all quantitative restrictions by 2001. For India to achieve the maximum benefits from a more liberal trade system, the structural impediments affecting domestic producers must be addressed in the interim.

Encouragingly, India’s new government has taken a number of initiatives that suggest a strengthened commitment to structural reform, including liberalization of the insurance sector, automatic clearance for foreign direct investment in many sectors, and a landmark agreement on state sales tax rationalization. At the same time, however, the budget passed by parliament in May 2000 targets only modest deficit reduction in the coming fiscal year, and a clearly defined agenda for reform has yet to be established. Critical and difficult challenges thus remain to be addressed.

The full text of the box that was the source of this article, as well as an additional table, appears as Box 4.2 in the World Economic Outlook, April 2000. Printed copies of the World Economic Outlook will be available by end-May. Please contact IMF Publication Services for ordering details.

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