INDIA’S present growth story dates to 1991, when a cycle of economic reforms was introduced. But, except for industrial delicensing, most initial reforms concerned the external sector. Because of the federal nature of the constitution, reforms in the domestic economy (most factor markets) are state subjects. Consequently, beyond the financial sector, most domestic reforms have been slow. The major pending reforms are in the rural economy, taxation, public expenditure (including targeting of subsidies) and the legal system.

Since 1991, real GDP growth picked up to an average of around 6%. But what is more interesting is a further pick-up in growth from 2003, attributed largely to a decline in interest rates. Average growth was 8.8% from 2003-04 to 2007-08, translating into per capita income growth of 7.3%. More specifically, growth was 8.5% in 2003-04, 7.5% in 2004-05, 9.5% in 2005-06, 9.7% in 2006-07 and 9.0% in 2007-08. Gross domestic saving has steadily increased to 37.7% of GDP in 2007-08, 4.5% from the public sector and 33.2% from the private sector. Of the 33.2% from the private sector, 24.3% was from the household sector and 8.8% from the private corporate sector. Gross capital formation also steadily increased to 39.1% of GDP in 2007-08.

A Fiscal Responsibility and Budget Management (FRBM) Act was passed by the Centre in 2003, with similar legislation subsequently passed by states. This originally required a fiscal deficit/GDP ratio of 3.0% in 2008-09, with a revenue deficit of 0%. The FRBM targets of fiscal consolidation have now been postponed. Three points need to be made about these deficit figures. First, these are central figures alone and do not include a gross fiscal deficit of 2.3% of GDP contributed by states in 2007-08. Second, they do not include off-budget items that have the same effect as deficits. Third, this widening of deficits is attributed to fiscal packages introduced after September 2008. But this is not entirely correct. The emphasis on public expenditure through flagship programmes, the National Rural Employment Guarantee Scheme (NREGS), farmers’ debt relief and the 6th Pay Commission for government employees predated September 2008. A slowdown had also begun before September 2008 and this had adversely affected tax revenue. Unlike developed countries, the tax revenue base in developing countries like India is narrower and is disproportionately affected in terms of downturn.

 

There are two kinds of issues that need to be mentioned in policy priorities prior to the crisis. The first UPA (United Progressive Alliance) government led by the Congress came to power in 2004, following a NDA (National Democratic Alliance) government led by the BJP between 1999 and 2004. It was perceived that the UPA government came to power in 2004 because the high growth phase after 2003 had bypassed certain sections of society. Accordingly, the 11th Five Year Plan (2007-2012) document flagged ‘inclusive growth’.

Though the document was drafted in 2008, the emphasis on inclusive growth characterized the first UPA government right from the start in 2004, partly explained by the inclusion of Left parties in UPA-I. For instance, the Approach Paper to the 11th Five Year Plan, drafted in 2006, also had inclusive growth in the title. This flagged divides between rich and the poor, deprivation among SCs, STs and some minorities and OBCs, deprivation based on gender and regional backwardness, concentrated in some states and districts. Thus, the Economic Survey lists the Bharat Nirman programme, Mid-day Meal Scheme, National Rural Health Mission, Jawaharlal Nehru National Urban Renewal Mission and the National Rural Employment Guarantee Scheme (NREGS). To these flagship schemes one can add farmers’ debt relief, preferential measures in favour of SCs/STs/OBCs, special grants for backward districts and, more recently, a right to free and compulsory elementary education. All of these led to greater public expenditure. Unfortunately, beyond Right to Information (RTI) legislation and greater vigilance by civil society, not much could be done to improve transparency, accountability and efficiency of public expenditure. But the UPA government was voted back to power in 2009, regarded as vindication of the left-wing policies that had been pursued. Consequently, though left parties are no longer part of the government, the Congress-led UPA-II has occupied a left-of-centre space.

 

It is important to bear this in mind when trying to understand responses to the global crisis. Prior to 2004, before UPA-I came to power, there was a debate about the efficacy and efficiency of public expenditure. However, as the focus on inclusive growth gained momentum, greater public expenditure came to be taken for granted, certainly within political circles. This was particularly evident in 2007-08 and the first half of 2008-09 and the fiscal stimulus following September 2008 was only regarded as a natural continuation of the trend. Beyond emphasizing efficiency, at best an argument was made about front-loading fiscal reform. There had earlier been two reports on reforming direct and indirect taxes, both chaired by Vijay Kelkar. These culminated in a 2004 report on implementation of the FRBM Act, making the point that the right time to introduce fiscal reform was when growth was high and tax revenue buoyant. In that sense, fiscal reform should have been front-loaded. But the public expenditure commitments of UPA-I made this difficult to implement and consequently, in September 2008, there was little fiscal latitude.

 

The second policy priority was that of containing inflation. India has a wholesale price index (WPI) and two separate consumer price indices – CPI(IW) and CPI(AL/RL).¹ RBI’s attempt to prevent rupee appreciation led to accumulation of foreign exchange reserves and liquidity in the system. In addition, global oil and commodity prices increased. In August 2008, the annual WPI-based inflation was 12.8%. RBI therefore tightened monetary policy and this began to slow down growth even before September 2008.

If one considers the inflation debate, some trends emerge. First, policy decisions are being taken on the basis of the WPI and this is inappropriate.² The price series therefore need to be revised and revamped. Second, inflation was an outcome of food price increases and hikes in prices of global commodities. Therefore, monetary policy was singularly ineffective in addressing this. Hikes in interest rates would only serve to reduce growth, as they did. Third, excess liquidity in the system was a function of RBI’s intervention in foreign exchange markets and the accumulation of foreign exchange reserves was sub-optimal in the sense of being excessive. Instead, while cushioning volatility, the rupee should be allowed to appreciate. Fourth, high government borrowing led to upward pressures on interest rates. The central bank’s task of managing public debt should therefore be delinked from its task of monetary policy.

 

When the global crisis hit, UPA-I was in its last year, heading towards elections. After the Left Front withdrew support because of the Indo-US nuclear deal, UPA-I comfortably survived a trust vote in August 2008. Since non-reform during UPA-I is usually ascribed to Left parties, subject to two caveats, any policy response should have been easier after the trust vote in August 2008, because UPA-I had obtained greater credibility. First, elections were imminent and second, much of implementation was a state government subject. There was also some opposition on land acquisition, compensation, resettlement and rehabilitation, the most obvious of which was for the special economic zones (SEZs).

Conceptually, policy responses can be of three types – structural reforms, fiscal policy and monetary policy. UPA-I was unsuccessful in introducing substantial structural reform. If one tracks the debate and distils out where there is lack of consensus, the debate boils down to one simple issue, regardless of the reform area. There is lack of consensus about the role of the government and core governance areas. While this was ascribed to the left parties being part of UPA-I, that was not the entire story. Consequently, it was unrealistic to expect structural reforms post-September 2008.

 

The FRBM Act has already been mentioned. Had the good growth years, also reflected in good tax revenue collections, been used for fiscal consolidation, there would have been greater latitude in using fiscal policy. But this didn’t happen. Also relevant is the timetable of a unified goods and services tax (GST) from April 2010, regarded as desirable because it also reduces compliance costs through standardization and harmonization and elimination of discretionary exemptions. While this still remains on the agenda and the time line has not been pushed back, fiscal stimuli generally involve discretion and arbitrary reduction of indirect tax rates for specific sectors. That’s also true of direct taxes. A new Direct Tax Code has now been proposed by the Finance Ministry. This is still at a discussion stage and public comments have been invited. If and when implemented in 2010, this will mean an end to several exemptions and a phase out of some discretionary direct tax packages introduced consequent to the global crisis.

This leaves monetary policy. There was scope for loosening monetary policy, once global slowdown meant lower global prices too. But beyond the point about monetary policy not being delinked from public debt management (large government borrowing exerted upward pressures on interest rates) and a time-lag, there were other problems with the transmission mechanism. There was an administered interest rate for small savings and this set a floor to deposit rates, exerting upward pressure on interest rates. Priority sector lending, such as for agriculture and exports, at concessional interest rates also make lending rates less flexible. A lot of borrowing also occurs in the informal and unorganized market.

There is a bridging gap that has always existed between household savings being pre-empted by government instruments and credit needs of the unincorporated sector. But, despite talk of micro-finance and integration of non-banking financial sectors with banking service providers, nothing very much has happened. However, an aftermath of the global financial crisis has been a renewed emphasis on financial inclusion.

 

Initially, there was some discussion about whether the Indian economy was decoupled, at least for the real sector. This was never a tenable proposition, because the dichotomy between the real and financial sectors is at best an artificial one. India was impacted in several ways. First, many Indian companies had short-term debt in foreign currencies. When foreign currency credit to roll over short-term debt was no longer available, many Indian companies used rupee debt and converted rupees to foreign currencies, thereby sucking out liquidity domestically. A severe credit crunch therefore adversely affected India from the second half of September 2008, and banks became unwilling to lend, even to other banks. This is despite banks and financial institutions having limited exposure to structured financial instruments.

Second, net portfolio inflows turned negative as foreign institutional investments pulled out, adversely affecting the capital account and the stock market, apart from making the exchange rate volatile. Third, the current account was adversely impacted through a slowdown in exports and some decline in remittances.

 

There are no firm estimates of employment generation in the export sector, meaning in this context, exports of goods. There are rough estimates from the commerce ministry of direct employment of 6.5 million in exports, with perhaps 15 million if indirect employment is included. Based on a survey undertaken by the labour ministry and commerce ministry together, there have been government estimates that around one million jobs may have been lost, especially in sectors like gems and jewellery, garments, leather and handicrafts.

Export growth is not evenly spread throughout the country. It tends to be concentrated in clusters. Among some major clusters are Surat (diamonds), Panipat (blankets), Tirupur (hosiery), Agra (leather), Ludhiana (woollen garments), Jaipur (hand-printed textiles), Pune (food processing), Ahmedabad (pharmaceuticals), Ambur (leather) and Bangalore (machine tools) and there are reports about these having been adversely affected, particularly in Surat, Tirupur and Ludhiana. While recognizing the difficulties in classifying exports according to states, the bulk of exports originate in Maharashtra, Gujarat, Tamil Nadu and Karnataka, with Andhra Pradesh, Delhi, West Bengal, Haryana, UP and Rajasthan following some distance behind, in that order.

Also, 64.4% of India’s exports are manufacturing, with a share of 89.9% for the US and 78.5% for EU. Therefore, when one is talking about job losses in exports, this means job losses in manufacturing, especially job losses for those who are informally employed. There is informal employment not only in the unorganized sector, but also in the organized sector, with wage workers recruited through informal networks, such as through contractors, and without formal contracts. When there are job cuts, it is these informal jobs that are slashed first. This leads to reverse migration from urban to rural areas and raises questions about the rural sector’s capacity to absorb such returning migrants. There has also been reverse migration from abroad, particularly from the Middle East and back to Kerala.

GDP growth slowed from 9.0% in 2007-08 to 6.7% in 2008-09. What is particularly significant is a slow-down in manufacturing from 8.2% to 2.4%, in construction from 10.1% to 7.2%, in trade, hotels, transport and communication from 12.4% to 9.0%, and in financing, real estate, insurance and business services from 11.7% to 7.8%. Had the growth in community, social and personal services not increased from 6.8% to 13.1% because of the 6th Pay Commission, the GDP performance would have been worse. Quarterly data show the slowdown even more clearly. In Q1 and Q2 of 2008-09, real GDP growth was respectively 7.8% and 7.7%, reflecting the slowdown that occurred on account of hikes in interest rates. In both Q3 and Q4, growth declined to 5.8%. Subsequently, Q1 of 2009-10 showed growth of 6.1%.

 

In discussing the employment implications, it is necessary to distinguish between losses in existing jobs and the non-creation of jobs that would otherwise have been created. Most media reports are about losses in existing jobs. But outside the external sector, there is little robust empirical evidence to substantiate this. The last firm employment elasticities available are those that were worked out by C. Rangarajan and his colleagues when he was Chairman of the Prime Minister’s Economic Advisory Council. These used NSS (National Sample Survey) data for the period 1999-2000 to 2004-05. The derived employment elasticity was 0.48 for total employment. In an aggregated and back-of-the-envelope kind of sense, lowering of growth from 8.5% to 6.5% means a counter-factual job loss of around five million. The counter-factual job loss of five million has primarily been in manufacturing, construction, trade, hotels and restaurants and transport, storage and communications.

 

Both on monetary and fiscal policy, India’s responses were reasonably swift. In successive doses, RBI reduced the CRR, the repo rate and the reverse repo rate. The SLR was reduced from 25% to 24% on 8th November 2008. While the aforementioned rigidities in the transmission mechanism remained, there was little that could be done about these in the short-term and necessary reforms concerned the government, since they were outside the Central Bank’s purview. The reductions were in incremental tranches rather than one-shot, because the severity of the credit crunch unfolded gradually and the RBI continued to be concerned about inflation, much higher under the CPI than the WPI. For instance, food price inflation remained high.

Three fiscal stimuli packages were introduced between December 2008 and February 2009. Other than FRBM constraints, the fiscal response was more delayed than the monetary response for two reasons. First, there was initially some acceptance of the idea of decoupling and it was felt that the real sector might not be that seriously affected. Second, it was thought that public expenditure had already occurred through farmers’ debt relief, NREGS, the 6th Pay Commission and higher procurement prices paid for rice and wheat. Eventually, the fiscal packages involved cuts in indirect taxes, and sector-specific measures for textiles and some other sectors.

It is impossible to give a clear answer about the size of the Indian stimulus package. There is an IMF figure of 0.6% of GDP for each of the calendar years 2008 and 2009. At a dinner on the occasion of the G-20 meeting in London in April 2009, the Indian prime minister talked of ‘a total fiscal stimulus or expansion of the fiscal deficit above the planned level of almost 4 percentage points of GDP in 2008-09.’³ In the budget speech for 2009-10, the finance minister mentioned 3.5%.⁴ Whether it is 3.5% or 4%, apples and oranges are being compared. The 3.5 or 4% represents additional public expenditure by the government and this includes expenditure that doesn’t have anything to do with immediate fiscal packages consequent to the crisis.

 

Barring the specific reductions in indirect taxes, the other elements of the stimulus package fit into the spectrum of UPA government policies. India’s relatively good performance was read as attributable to endogenous and rural sources of growth, through hikes in procurement prices, NREGS and farmers’ debt relief. NREGS was also perceived to have offered a safety net to migrants who returned from urban export-oriented locations to rural India, such as from parts of Gujarat to parts of Bihar. In a perverse kind of way, India’s relative insulation from the global shock was because large chunks of the economy weren’t integrated, globally and even nationally.

The fiscal stimulus policies cause a distortion from the overall goal of tax reform, but are likely to be eventually withdrawn. The major distortion, however, that has been created is in the mindset of state intervention, reinforced by such feelings across the globe. Instead of being interpreted as a case for greater regulation, with focus on the content of regulation, the global crisis has been interpreted as signalling that market-oriented reforms are bad.

 

In hindsight, there were two aspects where policy-making and individual responses both went wrong. First, in the years of high growth, it was assumed that growth would continue indefinitely and there would be no cyclical downturn. Standard indicators on financial crises don’t factor in the inevitable ups and downs of the business cycle. At an individual level, in extremely visible sectors, high wages and high consumption expenditure, often debt-driven, weren’t backed up by insurance against the possibility of downturn. Nor had government policy-formulation factored in the possibility of downturn. Second, government policy-formulation hadn’t recognized the extent to which financial operations of Indian companies were globalized. Consequently, the shock of the initial foreign exchange liquidity crunch caught the government unawares. Hopefully, these lessons will now be imbibed.

The Q2 2009-10 GDP figures now show growth of 7.9%. No one expected 7.9% and there are legitimate reasons for that. First, there was the spectre of drought, even if it didn’t turn out to be as bad as was initially feared. Second, exports are still declining (6.6% dollar decline in October), though the rate of decline is slowing. Third, Q2 of 2008-09 didn’t have low base of 5.3%; growth for second quarter last year was 7.1%. For 2009-10, most forecasts are in a band of 6 to 7%, with government estimates veering towards the higher end of range and non-government ones towards lower end. Consequently, most people would have expected a shade over 6% in Q2 (including the PM’s Economic Advisory Council) and 7.9% is way out of line.

 

There are indeed post-facto rationalizations of why everyone went wrong. First, agriculture has done better than expected. Decline due to drought will show up in Q3. Second, liquidity has stimulated domestic demand more than expected and the festive season distorted trends. Third, industry (and manufacturing) has done better and that is perhaps explained by a build-up of inventories. Fourth, services (overall growth of 9.3%) did much better because of Pay Commission instalments. (Community, social and personal services grew by 12.7%.) Fifth, numbers are often revised later and perhaps the agriculture number will be revised downwards later.

The fact remains these are post-facto rationalizations and the economy has performed better than expected. Yet, there is no question of getting back to 8.5%-plus trends until the global economy and exports recover. Until then, we are on a band of 6 to 7%. However, because of these better-than-expected numbers, for 2009-10, most projections will now switch from closer to 6% to closer to 7%. And that band will be changed from 6 to 7% to 6.5 to 7.5%. Unsurprisingly the Sensex (and capital markets) have over-reacted though there are legitimate concerns about how strong revival is. Also there can be an exit from the stimulus packages.

 

What does exit from stimulus packages mean? No structural reforms worth the name have surfaced since the global financial crisis. On fiscal policy, there is the expenditure part and tax exemption part (concentrated in three packages between December 2008 and February 2009.) Contrary to impressions about a wonderful counter-cyclical fiscal package devised by the government after the global crisis, expenditure (and resultant widening of deficits) occurred before September 2008. Given the UPA’s predilections, is there any reason why public expenditure (regardless of efficiency) should not continue? The Pay Commission will spill over into state and local governments. NREGS remains. Right to education (and perhaps right to food) expenditure will follow. On fiscal policy, exit therefore means exit from tax reductions, not public expenditure cuts.

If direct taxes are reformed and if there is GST, tax exemptions will go, as they should. Given the inflation bogey, exit from monetary policy is different. Tightening is certain. What is unclear is timing (January/April) and its content (mopping up liquidity, CRR hike, repo or reverse repo hikes). However, Q3 and Q4 are good quarters for exports and there are signs of some revival in the external sector. Low bases in Q3 and Q4 of 2008-09 also help the cause of higher growth in the last half of this financial year.

While scepticism about recovery is fine, it is useful to remember that all recovery is with respect to a benchmark. We aren’t back on 8.5% and 9% trajectories. But we aren’t on 5 or 5.5% either. We seem to be inching up to something like 7% in 2009-10 and 7.5% in 2010-11. Whether that is good or bad is relative. After all, a difference between 7.5% and 8.5% translates into (depending on composition of growth) something like 1.5 million fewer jobs created. There is also the point about government patting itself on the back for having ensured India’s weathering the storm well. That’s a proposition that has to be taken with several pinches of salt. As mentioned earlier, public expenditure occurred before September 2008 and even in 2007-08. To interpret such government action as counter-cyclical, one would have to agree that the UPA anticipated the global crisis and acted accordingly, a dubious proposition.

 

A counter-factual proposition also remains, worth remembering since tight monetary policy is almost certain. What would have happened to growth had the RBI not hardened interest rates in 2007-08? And there’s a final speculative proposition too. Post-1991, has there been enough unshackling of entrepreneurship to ensure the economy chugs along at around 7%, regardless of what government does, as long as government doesn’t do something positively malign. Consequently, imagine what growth will be like if government becomes benign and introduces sensible policies for infrastructure (roads, electricity), law and order and public goods and services.

Where do the slowdown and the recovery now leave us? Since the rural sector has offered some of the cushion, will we now finally introduce agricultural and rural sector reforms? With the emphasis on public expenditure, will there finally be emphasis on its efficiency? Will urban consumption patterns become a bit more realistic and provide for insurance and uncertainty, recognizing that there are business cycles and downturns to neutralize upswings?

 

Footnotes:

1. Earlier, there were four consumer price indices (CPIs). CPI-UNME, the CPI for urban non-manual employees has now been discontinued. CPI-IW, the CPI for industrial workers, is now going to become a CPI for urban India. CPI-AL, the CPI for agricultural labour (meaning agricultural workers) and CPI-RL, the CPI for rural labour, are now being merged to become a CPI for rural India. Meanwhile, the WPI is also being revised.

2. They are taken on the basis of the WPI, because this is a weekly series and comes out with a time-lag of two weeks. The CPIs are monthly series and only become available with a time-lag of two months. However, a decision has now been taken to make the WPI monthly.

3. http://pmindia.nic.in/speeches.htm

4. http://indiabudget.nic.in/ub2009-10/bs/speecha.htm