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p. 31 of 54 BACK | NEXT I. Developing Asia and the World - Economic Developments and Prospects II. Economic Trends and Prospects in Developing Asia Newly Industrialized Economies Central Asian Republics, Azerbaijan, and Mongolia People’s Republic of China Southeast Asia South Asia Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka The Pacific III. Asia's Globalization Challenge

Asian Development Outlook 2001 : II. Economic Trends and Prospects in Developing Asia : South Asia

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India

As reforms have slowed, the impulses to economic growth generated by earlier reforms have almost faded. Furthermore, structural impediments have prevented the economy from taking full advantage of the liberalized economic environment. A concerted effort is thus needed to prevent the economy from slipping to a slower growth path of 5–6 percent in the medium term, that is, well below the Government’s target of 9 percent.

Recent Trends and Prospects

The optimism that prevailed at the beginning of 2000 over the prospects for economic expansion became more muted in the face of unfavorable weather conditions and sluggish industrial recovery. The real GDP growth rate in 2000 is estimated to have been 6.0 percent, supported by growth of 0.9 percent in agriculture, 6.6 percent in industry, and 8.3 percent in services. With this trend, the average growth rate of GDP during the first four years of the Ninth Five-Year Plan (1997–2002) is estimated at around 6 percent a year, compared with a plan target of 6.5 percent, and an average annual growth rate of 6.7 percent during the Eighth Five-Year Plan (1992–1997). This decline in the growth rate during the current Plan, however, has to be seen in the context of a series of exceptional circumstances in recent years. These include the fallout effects of the Asian financial crisis, economic sanctions following nuclear testing at Pokhran, border conflicts with Pakistan at Kargil, and a sharp increase in international oil prices. Despite these adverse developments, the Indian economy was one of the best performing in Asia in 2000.

Compared with 1999, the Reserve Bank of India (RBI) faced generally unfavorable policy conditions in 2000, characterized by a sharp depreciation of the rupee and higher inflation. Rising US interest rates and the consequent depreciation of the rupee against the dollar prompted the RBI to take reactive measures in July 2000 to prevent a further fall in the currency. The bank rate was raised to 8 percent and the cash reserve ratio to 8.5 percent; this was followed by a hike in prime lending rates by commercial banks. Despite the higher interest rates, though, bank credit to the commercial sector showed steady growth, reflecting the unusually large financing needs of oil companies to cover the high cost of imported oil. Slow growth in net bank credit to the Government and in banks’ foreign exchange assets contributed to a deceleration in growth of broad money (M3) during the first half of 2000, though M3 showed a sharp increase in November due to capital inflows linked to the Indian Millennium Deposits (IMD) Scheme designed to raise financing from nonresident Indians.

The inflation rate for 2000, measured by the year-on-year change in the monthly average of the wholesale price index, was 7.0 percent—a marked increase from 3.3 percent in the previous year. This was primarily the result of a rise in oil prices. For instance, the Government raised the administered prices of liquefied petroleum gas and kerosene by 18 percent and 50 percent, respectively, on 1 October 2000. However, the ample supply of agricultural goods and excess capacity in manufacturing helped contain price rises to some extent. Prices of food items increased by only 1.5 percent, and those of manufactured goods by 3.0 percent.

The central Government’s direct tax revenues strengthened in 2000. This was due to a broadening of the tax base, an increase in dividend taxes, and a higher corporate tax collection (due to a lower depreciation allowance). The Government announced a number of expenditure control measures, such as retrenchment of surplus staff, cuts in its foreign travel budgets and nonsalary current expenditure, and reduction of subsidies through the use of cost-based user charges for the supply of goods and services. For medium-term management of the fiscal deficit, the 2000 budget proposed to introduce an institutional mechanism, called the Fiscal Responsibility Act. With these initiatives, the actual deficit of the central Government in 2000 has been contained within the budget estimate of 5.1 percent of GDP. Although direct tax collection and nontax receipts were buoyant, the performance of indirect taxes was poor due to sluggish industrial production and a lower growth rate of non-oil imports. In addition, privatization receipts fell short of the budget target because of the slowing pace of divestment.

Despite a slowing economy and rising inflation, the impressive performance of the export sector in 1999 continued in 2000. Exports rose by 17.0 percent in 2000 from 11.6 percent the previous year. Exports’ strong performance ensured that the balance of payments did not come under pressure: however, imports also grew strongly at 13.0 percent, partly because of a surging oil import bill. This resulted in a 4.0 percent increase in the trade deficit. The current account deficit is expected to have widened to around 1.3 percent of GDP during 2000.

Net capital inflows are estimated to have risen from $10.0 billion in 1999 to $12.0 billion in 2000, with inflows of more than $5.5 billion from the issuance of IMD. Foreign currency reserves rose to $42.1 billion, equivalent to 8.1 months of imports at the end of the year.

The rupee lost almost 7 percent of its value against the dollar between March and December 2000 (from Rs43.5 to Rs46.7 to the dollar). Despite this sharp fall in the nominal value of the rupee, the depreciation of the real effective exchange rate was much more modest—less than 2 percent in 2000. The rupee could experience further volatility in the coming months.

In the medium to long term, the prospects for the economy look favorable as ongoing reforms bring significant gains in supply-side efficiency. Indeed, India’s relatively high economic growth over the 1990s was made possible mainly by efficiency gains with little increase in investment rates. Improved economic efficiency was a critical factor in bringing the economic growth rate to over 6 percent at the end of the 1990s, substantially higher than the earlier average of about 3 percent a year in the 1970s and the early 1980s. Furthermore, the reforms are attracting new foreign investment and stimulating new industries based on information and communications technology. India’s capabilities in this area are expanding rapidly and the country now offers a range of products, including computer software. Yet skepticism abounds because of India’s past record of being very slow to accommodate change. Thus, the Government must remain firmly committed to its reforms, which include improvements in fiscal management.

On the assumption that no major internal or external disturbances arise, such as adverse weather patterns or oil price increases, the economy can sustain real GDP growth rates of 6–7 percent a year in 2001 and 2002. In fact, much depends on the performance of agriculture and progress in industrial recovery. The recent beginning of a slowdown in the US economy will add uncertainty to the overall investment climate and export performance.

The annual inflation rate in 2001 and 2002 in terms of the wholesale price index is likely to fall to around 5 percent. Despite the slowdown in global demand, exports are projected to show steady growth at 12–13 percent. The balance of payments is likely to remain stable, with the current account deficit improving slightly to about 1 percent of GDP in 2002. On the capital account, access to international financial markets will be renewed as international credit ratings improve and as the composition of capital flows continues to shift in favor of nondebt-creating financial flows in response to economic reforms.

Issues in Economic Management

Although the economy has performed well over the past few years, it is not fully utilizing its growth potential. In particular, the deteriorating fiscal health of the central and state governments is significantly undermining the economy’s long-term growth potential because of inadequate public investment. In agriculture, wide swings in production and very low productivity have been, to a large extent, the result of declining public investment in irrigation. The rate of capital formation in agriculture declined to 9.2 percent in the 1990s, from about 21 percent during the 1970s and 1980s. So, while agriculture has the potential to grow at more than 4 percent annually, sectoral performance has fallen far short of this.

Industrial growth recovered from its low point of 3.6 percent in 1998 to 6.4 percent in 1999, but insufficient investment in both public and private physical infrastructure remains a major constraint to the expansion of industrial activities in the long run. In particular, the failure of state governments to provide basic infrastructure severely undermines the long-term growth potential of the economy, which is prevented from reaping the full benefits of market reforms and liberalization. In the power sector, new generating capacity during the Eighth Five-Year Plan fell short of the target by 50 percent, due primarily to inadequate investments by state governments. The state electricity boards suffered from a deteriorating financial situation. Similarly, in the road sector during the Eighth Five-Year Plan, only $3.2 billion was provided for state and major district roads, against a requirement of $5.5 billion. The deterioration of state finances suggests that the quality of infrastructure services is likely to get worse (see Box 2.5). Recognizing the severity of the problem, in July 2000 the Eleventh Finance Commission recommended structural reform along with other fiscal changes to help state governments achieve zero revenue deficits by 2005.

While the Government recently announced an economic growth target of 8–9 percent a year, this will require a substantial increase in public and private investment from the current 23.5 percent of GDP. The household savings rate, which is close to 20 percent of GDP, is already high, compared with other developing economies at similar income levels. Thus, the Government needs to make India a favored destination for foreign investment, although it is not possible to fill the resource gap from external resources alone. In order to boost domestic savings, the central Government needs to make a greater effort to mobilize public savings, while state governments must explore the scope for expenditure control at all levels. Politically difficult decisions may be required to reduce expenditure, including serious downsizing of state bureaucracies and cuts in subsidies. Privatization will have to be placed at the top of the central Government’s reform agenda. The financial waste in public sector undertakings is substantial and must be addressed promptly. On the revenue side, the tax-to-GDP ratio needs to be improved through rationalizing taxes, expanding the tax base, and overhauling tax administration. It is particularly important to bring more services into the tax base because of the increasing importance of the services-oriented economy.

Policy and Development Issues

After the balance-of-payments crisis of 1991, the Government undertook significant structural changes. Reforms included liberalization of trade and gradual opening up of the capital account. The volume of total trade as a proportion of GDP rose from about 15 percent in 1990 to over 20 percent in 1998. The economy has also achieved greater competitiveness in services, particularly in the area of information technology. The opening up of the capital account has spurred capital inflows, leading to greater capital formation in the economy and an increase in foreign exchange reserves. The heavier reliance on direct investment has facilitated technology transfer and reduced the risk of another balance-of-payments crisis. The role of external assistance has shrunk, while that of commercial borrowing has increased. Finally, the volume of private transfers has risen significantly, due to the more liberal environment.

India’s trade regime was one of the most protected in the world until the beginning of the 1990s, heavily depending on both quantitative restrictions (QRs) and high tariff levels. However, with the introduction of new policies, the share of value added in manufacturing protected by QRs declined from 90 percent in 1990 to 47 percent by May 1992 and to 36 percent by May 1995. In fact, QRs were virtually eliminated for imports of industrial raw materials, intermediate components, and capital goods. However, the corresponding decline was much less steep in agriculture, from 94 percent in 1990 to 93 percent by May 1992 and to 84 percent by May 1995. The import of industrial consumer goods also remains under control because of perceived political sensitivity, although some restricted items are imported freely through transferable special import licenses (SILs). SILs, which can be sold, are granted to selected exporters as export incentives. SIL coverage has been extended significantly since April 1999, with various items removed from the restricted list and put on the SIL list, as well as from the SIL list to the open general license list.

The Government’s balance-of-payments justification for using QRs had become untenable given the strong current account, substantial capital inflows, and large foreign exchange reserves during the years following the rupee’s devaluation in 1991. India’s unrestrained use of QRs was challenged in the World Trade Organization balance-of-payments committee by the EU, US, and other developed economies in December 1995. India lost the case and is required to abolish its QR regime by April 2001 under a bilateral agreement signed with the US in December 1999.

The Government does not provide direct subsidies to exporters. They are provided indirectly through duty and tax concessions, export finance, export insurance and guarantees, and export promotion and marketing assistance. However, the actual effectiveness of this complex structure in enhancing exports is unclear. Though some efforts have been made since 1991 to reduce administrative problems and delays in implementing the various export incentives, the sharp growth of exports during 1993–1995 cannot be attributed to changes in incentives. Rupee devaluation, removal of industrial licensing and other controls over industry, and the opening up of imports of intermediate and capital goods were more proximate causes. The Government plans to phase out income tax exemptions for exports through 2004, as well as expand the use of import duty exemptions.

Prior to 1991, India’s import duties were among the highest in the world. The Chelliah Committee (1992) proposed that the average import-weighted duty rate should be reduced from 87 percent in 1990 to 45 percent by 1995 and further to 25 percent by 1998. The Government lowered its average applied tariff rate from 125 percent in 1990 to 71 percent in 1993, to 41 percent in 1995, and to 35 percent in 1997 (see Figure 2.15). The corresponding levels of average import-weighted tariffs were 87 percent in 1990, 47 percent in 1993, 25 percent in 1996, and 30 percent in 1998. The average import-weighted tariff on consumer goods was also reduced from 153 percent in 1990 to 39 percent in 1998. On the other hand, the maximum tariff rate declined from 355 percent in 1990 to 45 percent in 1997 and to 40 percent in 1999. It was reduced to 35 percent in 2000 but has been subjected to a 10 percent surcharge, thus making it 38.5 percent.

In February 2000, the Government took several steps to further liberalize the capital account. Foreign investment played a very limited role in the economy prior to 1991. It was permitted in industries where the Government believed foreign technology to be necessary for economic growth. Foreign equity participation was tightly regulated, usually to a limit of 40 percent of total equity capital. A new industrial policy announced in July 1991 liberalized foreign direct investment, foreign technology agreements, and compulsory industrial licensing. Automatic approval was permitted for investments of up to 51 percent equity in 34 industries. In February 2000, the Government took a major decision to place all items under the automatic route for foreign direct investment except for a small negative list. This was an important step in dispensing with the previous case-by-case approval procedure and in imparting greater transparency to the foreign investment process. Furthermore, subject to sectoral policies and caps, the automatic route would be made available to all foreign and nonresident Indian investors who could secure 100 percent foreign investment. The Government had already established the Foreign Investment Implementation Authority in 1999 to ensure that the approvals granted for foreign investments actually reached financial closure.

Policies relating to investments by foreign institutional investors and to global depository receipts (GDRs) have undergone various changes since 1991. Indian companies were permitted to raise capital through Euromarket issues of GDRs and foreign currency convertible bonds, and to have access to international capital markets, in 1992. Also that year, certain foreign institutional investors, including pension funds, mutual funds, asset management companies, investment trusts, nominee companies, and incorporated or institutional portfolio managers were permitted to invest in the Indian capital market. These investing institutions need to be registered in their home country or country of origin, and registered with the Securities and Exchange Board of India. The profits from portfolio investment can be repatriated freely subject to India’s foreign exchange regulations. Since February 2000, Indian companies no longer needed prior approval from the Government to issue GDRs; the equity ceiling for foreign institutional investors was raised from 30 to 40 percent in the same month.

External commercial borrowings (ECBs) provide an additional source of funds to Indian companies, allowing them to augment domestically available resources and to take advantage of lower international interest rates. From February 2000, ECBs were permitted within a higher annual ceiling, for example, three times average annual export earnings for exporters, or double the previous limit. Other ECB guidelines were relaxed and several procedures were simplified so as to make it easier for Indian companies to borrow abroad.

As discussed above, the Government has substantially liberalized trade-related policies since 1991. However, these policies have covered mainly intermediate and capital goods in manufacturing. Agriculture remains least touched by the trade reforms. Consumer goods imports are also restricted. Although the Government has reduced average import-weighted tariffs significantly over the last decade, India’s rates are still among the highest in the developing world. A reduction in import tariffs may lead to some loss in revenues, but this is likely to be made up for when the QRs on consumer goods are dismantled from April 2001. In the long run, there is an implicit agreement among policymakers to phase down Indian customs duties to the 12 percent level of the countries of the Association of Southeast Asian Nations. Trade in services remains another area for future reform. During the 1990s, increased earnings from services and other invisibles helped the economy maintain a strong current account. Opening the services sector to international competition is expected to make it more efficient and to generate additional foreign exchange earnings.

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