The tasks ahead

ISHER JUDGE AHLUWALIA

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THE state of the Indian economy is far from satisfactory and mostly for reasons of our own making. India’s policy-makers have been ‘planning’ for 50 years and ‘reforming’ for the past ten. Even so, the growth potential of the economy remains substantially unexploited. In fact, it has taken a sharp turn for the worse after 1996-97. The investment outlook continues to be uncertain and macro-economic management has deteriorated. The slump in the IT sector worldwide and the slowdown in the global economy are likely to take a further toll on the economy. It is no comfort that we are doing better than most other developing economies. The real question to ask is if we are doing our best and whether we are realizing our enormous potential.

In the period prior to 1980, the Indian economy struggled along at what Raj Krishna famously described as the ‘Hindu’ rate of growth of GDP of about 3.5% per annum. At the macro level, while savings and investment rates increased impressively over these three decades, the gains from resource mobilization were offset by losses on the productivity front. The acceleration in agricultural growth after the Green Revolution was largely offset by the deceleration in the growth of the non-agricultural sector.

A serious attempt was made in the 1980s to address the problem of declining industrial productivity through measures of domestic deregulation and better coordination in the planning of investment and management of infrastructure sectors. However, the public sector remained unreformed even as attempts were made to grant greater autonomy to public sector enterprises. The overall return on the capital invested in the public sector was much lower than the rate of interest at which the government was borrowing in order to subsidize or invest in these enterprises.

Although the trade policy regime was operated more flexibly to ensure easier access to imports of intermediate and capital goods, tariffs on these goods were increased further from their high levels so as to ensure that the economy remained as closed to foreign competition at the end of the 1980s as at the beginning. Despite these limitations, the policies of the 1980s were successful in generating a better productivity response, and GDP growth accelerated from an average of 3.6% per annum in the earlier three decades to 5.6% per annum in the 1980s.

All was not, however, well with the economy. The 1980s witnessed for the first time the emergence of fiscal deficits, which worsened through the decade mainly on account of the sharply increasing government consumption, particularly salaries, subsidies and interest payments. As the Government of India took recourse to borrowing from the domestic capital market as well as external sources to finance the deficits, the consequent interest liability put further upward pressure on the deficit. With macro-economic imbalances becoming worse through the decade, the Gulf War of 1990 was the last straw that precipitated a serious balance of payments crisis.

 

 

The dimensions of the crisis are too well-known to be recounted here. The current account deficit of the balance of payments touched 3% of GDP, foreign exchange reserves dipped to less than $1 billion, the external debt service ratio soared to 35%, and the rate of inflation accelerated to 17%, a rate admittedly much lower than what many developing economies, particularly in Latin America, have seen at crisis times but much higher than what India’s tolerance limits permit.

The crisis was used as an opportunity to launch wide-ranging economic reforms in 1991. Fiscal reform was designed to restore macro economic balance. Reforms directed at opening up the Indian economy to foreign trade and investment, though modest by international standards, represented a radical departure from the autarkic past. In a prescient move, financial sector reforms were identified as crucial and an expert committee was set up to review and recommend policy changes in this sector.

In industrial policy, emboldened by the favourable response to the process of domestic deregulation in the 1980s, significant reform was put in place to reduce the barriers to entry in business and provide larger scope to private sector for participating in the growth process. The reform of the public sector, however, was not given the importance it deserved. The thinking seemed to be that with the dereservation of many areas where earlier only the public sector could invest, private investment would flow in and particularly help release critical bottlenecks in the infrastructure sectors.

India’s response to the crisis through the reform programme of 1991 has been widely acclaimed. A determined reduction in the fiscal deficit by 2% of GDP, helped by good agricultural performance in the years following the crisis, ensured a smooth recovery over a two-year period. The monsoon gods were on the side of the reformers! But the success proved to be too good for India’s own good. As the crisis faded, so did the resolve to be fiscally prudent.

 

 

In the 10 years that have elapsed since then, three different political formations have been at the helm of the central government They have all carried the reform further in the usual noisy and haphazard Indian way. State governments also joined the fray, some more than others. The rest of this paper provides a broad assessment of the progress on reform and the unfinished agenda as India addresses the challenges of development in the years ahead.

Indian policy-makers have used the past 10 years to bring about a very significant reform of the Indian tax structure. On direct taxes, improvements in the rate structure are in line with international best practice of moving towards modest tax rates. As this requires reliance on improved tax administration to increase revenues, it is very important to get on with the task of modernizing the tax administration through introduction of computerization and other modern methods.

Two major areas requiring further action on the indirect tax structure are (i) introduction of a value added tax (VAT) and (ii) reduction in custom duty to levels prevailing in other countries. A move to a unified VAT regime requires introducing essential elements of value added tax into sales tax, i.e. rebate of earlier stage duties, and harmonization of sales tax rates across states. Consultations among the different governments are underway for this purpose.

 

 

As regards custom duty reduction, India had come part of the way, reducing these duty rates between 1991-92 and 1996-97 but there has been reversal since then. In the first six years of reform, the import-weighted tariff declined from 87% to 25%, but in the subsequent five years it has increased to 35%. The Government of India is still committed to lowering custom duties to ‘international levels’ that might mean an average of 10-15% but action needs to follow words in this area. Revenue raising compulsions in a recessionary economy are acting as constraints to further tax reform. More generally, a concerted effort needs to be made towards better tax enforcement.

Unlike with taxes, reform on the expenditure front has been little if any. Typically, the need for cuts in government expenditure was accommodated by downward adjustments in government’s capital expenditure. An opportunity for reform was lost when the central government chose to ignore the recommendation of the Fifth Pay Commission to reduce government employment by a tenth as a first step, going up to a third in the final analysis, while granting a liberal award of an increase in salaries. The fiscal impact was compounded as one state government after another followed this lead in granting large salary increases. Considering that food and fertilizer subsidies still remain largely untargeted and user changes fail to cover costs for services provided by the public sector, there is a large unfinished agenda of reform on the expenditure budgets of the central and state governments.

 

 

The Expenditure Commission set up by the Government of India in 2000 recently submitted its report and made recommendations on how to accomplish this task. There is no reason or excuse for any further delay. Even more important in pursuing the goal of expenditure reform is to ensure that the quality of the deficit is maintained, if not improved. Expenditure reform should include the task of how to spend more and better on health, education and governance, while cutting unproductive and unnecessary spending on a bloated bureaucracy, untargeted subsidies and budgetary support for loss-making public sector enterprises and departments, be they state electricity boards, railways, irrigation or transport departments.

A review of the deficits consistently defined over the entire decade shows that the wheel has come full circle. The consolidated fiscal deficit for the year 2000-01 is back where it was, at about 9.4% at the time of the crisis 10 years ago. The current year’s performance is likely to show further deterioration as the consolidated deficit of the Centre and states is expected to be in the range of 10.5-11%. The deterioration in the revenue deficit is particularly marked. This shows that the problem of public dissaving is becoming more serious with time.

India ranks among the top 10 economies with the highest fiscal deficit as per cent of GDP. Clearly, much remains to be accomplished in reducing the size of the deficit through fiscal reform. The Fiscal Responsibility Bill is clearly a step in the right direction. It is not enough to be transparent. The government must explicitly commit to reducing the size of the fiscal deficit. Otherwise, public savings that turned negative in 1999-2000 for the first time in the history of independent India will further deteriorate. Private savers will not stand by and see the erosion of their savings through more and more government borrowing in order to finance government consumption. Government consumption will crowd out private investment and the economy will head for a downward spiral.

 

 

The most radical aspect of India’s economic reform of the 1990s has been the opening up of the Indian economy to competition from foreign trade and foreign investment. While there has been some reversal of the trend in import duty reduction in recent years, the gradual removal of quantitative restrictions on all imports within a declared time frame has kept up the momentum of subjecting the Indian economy to external competition. Of course, protectionist sentiment has at times been directed at competitive imports in the form of anti-dumping duties. This is no different from what happens in many other economies, developing and developed, but at this stage of India’s economic reform, zeal for anti-dumping should not become a parallel route for pulling the economy away from the goal of becoming more competitive in cutting costs and improving quality.

The lowering of the protective barriers for Indian industry in the course of the 1990s had a major impact in levelling the playing field for Indian agriculture. But agriculture has suffered from the problem of over-subsidisation and underinvestment in the 1980s and 1990s. To some extent, the overemphasis on a policy of self-sufficiency in foodgrains has meant that the potential for the development and export of other agricultural products has been ignored.

 

 

The removal of quantitative restrictions on the import of agricultural commodities has created some apprehension, but the freedom to levy custom duties up to 100% for primary commodities, 150% for processed goods and 300% for edible oils leaves enough room for adjusting to competition from imports. The challenge of reform lies in building agricultural infrastructure – roads, irrigation networks and power – which would allow the agricultural sector in India to realize its potential rather than promise to provide irrigation, power and fertilizers at subsidized rates and fail to make these available. The political economy of the public distribution system also needs to be addressed fairly and squarely if food security is to be provided to one and all within the country.

In industry, there has been significant progress in reducing the barriers to entry for the private sector, although reservation in production for the small scale units continues as a legacy of an era bygone. Even in December 2001, nine months after the liberalization of the import of consumer goods into India, imports of ‘reserved’ goods produced by large or small scale units are allowed to compete with production of small scale units in India, but the large scale units in India cannot produce and compete with small scale domestic producers in these items. Since a large number of the items reserved are labour intensive, the reservation policy has stood in the way of India’s realization of her export capacity.

While China has flooded the world markets with her exports of garments, leather products, sports items and other consumer goods, India has only recently dereserved some of the ‘reserved’ areas with demonstrated export ability. Another major area crying for domestic reform is that of labour laws, bankruptcy laws, rent control laws and the legal enforcement mechanism that stands in the way of an effective restructuring of the industrial sector.

 

 

The public sector was singled out for being in need of reform as early as the 1980s when the process of domestic deregulation first began, but no worthwhile effort was made to bring about better efficiency and/or improved financial results of public sector enterprises. In the early 1990s, better performing public sector enterprises were given greater autonomy in their corporate decision-making, but for the large majority of enterprises which were loss making, the government had neither the resources to engineer a turnaround nor the political will to sell or close them down. Indeed, privatization was not on the agenda until the second half of the 1990s, and then too, the progress has been very slow indeed. The first major successful privatization was that of Balco in September 2001.

The basic problem with the public sector, particularly in the crucial infrastructure sectors such as power, transport, irrigation, and so on, has been excessive effective control of the administrative ministries and the inability of the system to levy user charges which would cover costs. For example, new private independent producers of power have to rely for their economic viability on the ability of the state electricity boards to pay for their power. The continued losses of the state electricity boards and their delayed reform thus has had serious adverse impact on the viability of the new investments in power.

More recently, regulatory commissions have been set up at the Centre as well as in several state governments to help devise a rational pricing framework for power. As the Enron case has amply demonstrated, no amount of fast tracking and no number of guarantees and counter-guarantees by governments can be a substitute for charging a price that covers costs. If power sector reforms are crucial to break the infrastructure deadlock, reforms in railways, ports, civil aviation and roads also need to be addressed urgently if investments are to be attracted to these sectors to build capacities to sustain the growth of the Indian economy at 7-8% per annum in the medium run. Efforts at attracting direct foreign investment in the infrastructure sectors have not been successful mainly because of the constraints imposed by the need to interact with the unreformed public sector.

 

 

More generally, direct foreign investment flows into India have been small by international standards. After reaching a peak of $3.6 billion in 1997-98, direct foreign investment declined steadily to reach a level of $2.2 billion in 1999-2000 and is expected to remain at about the same level in 2000-2001. This slowdown is in keeping with the uncertain outlook for domestic investment in the economy over the same period.

To some extent, the rising fiscal deficit has crowded out private investment in the economy. Reforms in the financial sector have also played a role in that the banks are looking for ‘good borrowers’ and are not finding it easy to locate them. This may well be a transient phase before both borrowers and lenders learn the new competitive rules of the game. Privatization of the public sector banks and a strong regulatory framework is urgently required to create a financial system capable of meeting the needs of a competitive economy.

The economy is now at a stage where the slowing down of the pace of reform is making it difficult for Indian industry and agriculture to rise to the challenges of meeting the external competition in an effective manner. The quick recovery from the crisis and the subsequent three year period of high growth of GDP (7.5% per annum), robust growth of exports (over 20% per annum), the boom in investment levels – all now seem like a dream.

 

 

In the late 1990s, the economic performance as well as the pace of reform have taken a turn for the worse. Not only has the growth of GDP decelerated to less than 6% per annum over the past three years but performance in each successive year has been worse than before. There has been a loosening of fiscal discipline and some increase in protectionism. However, the tone of the retreat has been defensive. Also, while the reformist zeal weakened somewhat at the Centre, the state governments have become active participants in the reform process in trying to attract private investment.

The prolonged recession, however, has once again led to talk of pump priming the economy. Mere pump priming will only lead to larger government consumption and create more problems of macro-economic management for the future. If public investment has to be increased, such increase should be linked to a sharp reform in the power sector. This would at least create an environment in which more private investment would be encouraged. The ultimate solution will have to be found in regaining the momentum of reform in the economy.

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