India At The Crossroads 8120727002, 9788120727007

Table of contents :
India at the Crossroads ..............3
Is Vajpayee the Trump Card of NDA? ..............7
A Call for Introspection ..............10
Pakistan Doublecrosses USled Coalition ..............14
Will India Strike Back? ..............18
Is Pakistan the Next Target? ..............21
Is Musharrafs Crackdown Real? ..............25
Vajpayees Moment of Truth ..............28

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INDIA at the Crossroads SUSTAINING GROWTH AND REDUCING POVERTY

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INDIA at the Crossroads SUSTAINING GROWTH AND REDUCING POVERTY

EDITED BY

Tim Callen Patricia Reynolds Christopher Towe

INTERNATIONAL

MONETARY

FUND

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© 2001 International Monetary Fund Production: IMF Graphics Section Cover design: Lai Oy Louie

Library of Congress Cataloging-in-Publication Data India at the crossroads p. cm. ISBN 1-55775-992-8 (alk. paper) 1. India—Economic policy—1980. 2. India—Economic conditions—1947- 3. Fiscal policy—India. 4. Sustainable development—India. HC435.2 .I484 2001 330.954-dc21 00-054132

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Contents

Page

Foreword

vii

Acknowledgments

ix

1. Overview Christopher Towe

1

PART I. Preserving External Stability 2.

India and the Asia Crisis Christopher Towe

3. Assessing India's External Position Tim Callen and Paul Cashin

11 28

PART II. Fiscal Challenges 4. Tax Smoothing, Financial Repression, and Fiscal Deficits in India Paul Cashin, Nilss Olekalns, and Ratna Sahay

53

5. Fiscal Adjustment and Growth Prospects in India Patricia Reynolds

75

PART III. Monetary and Financial Sector Policies 6. Modeling and Forecasting Inflation in India Tim Callen

105

7. The Unit Trust of India and the Indian Mutual Fund Industry Anna Ilyina

122

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CONTENTS

PART IV. Growth, Poverty, and Structural Policies 8. Growth Theory and Convergence Across Indian States: A Panel Study Shekhar Aiyar

143

9. Structural Reform in India Daniel

Kanda,

Patricia

Reynolds,

and Christopher

Towe

... 170

List of Contributors

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191

Foreword

India is a land of contrasts. One billion people live in a vast territory among architectural and sculptural wonders that give vivid testimony to its ancient and rich history, as well as to its powerful and age-old customs. Yet, there is also a very modern face of India, which is responding to the growing forces of globalization and where information technology has found a fertile environment. These contrasts and the force of tradition appear to have contributed to a cautious approach to change. Tentative and slow moving attempts to free the economy from pervasive controls were started in the 1980s, but it was not until the serious balance of payments and macroeconomic crisis of the early 1990s that India introduced significant and wideranging policy reforms. These reforms are widely considered to have been successful in promoting a marked improvement in macroeconomic performance. Nevertheless, the subsequent pace of reform has been less even and bold, and the question remains whether the basis has been laid for the sustained and rapid growth that will be necessary to alleviate the deep poverty that still afflicts more than a third of the population. That India emerged relatively unscathed from the financial crisis that affected most of Asia as well as many emerging economies is testimony to the country's resilience. Many sectors of the economy—and above all the information technology sector—have shown extraordinary dynamism and remarkable vitality. At the same time, India is today at a crossroads and a number of macroeconomic indicators display worrisome trends. In particular, the fiscal situation has worsened in recent years and requires concentrated and determined attention to reduce the risk of financial instability. Fiscal consolidation in combination with more rapid pace of structural reform, liberalization, and infrastructure development is also necessary to lay the foundation for strong growth. The challenge for the government is to forge a political consensus across a diverse range of interest groups that is necessary to sustain rapid and consistent reform on broad range of fronts. The chapters in this volume seek to address the implications of these challenges and opportunities. For the most part, they were written during

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FOREWORD

1999—2000 in the context of the IMF staff's ongoing policy discussions with India. By bringing these issues together in a single volume, the macroeconomic and structural challenges that are highlighted can be given greater prominence and thus contribute to the policy debate, both in India and, more broadly, in other reform-oriented economies. M A R I O I. BLEJER

Senior Advisor Asia and Pacific Department

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Acknowledgments

The papers included in this volume were largely prepared in the context of the IMF's Article IV consultation discussions with India during 1999—2000, under the leadership of Mario I. Blejer. His support and encouragement during this process are gratefully acknowledged. The papers also benefited from comments received from Dr. V. Kelkar, IMF Executive Director; his Advisor, Dr. N. Jadhav; and from the staff of the Reserve Bank of India and the Indian Ministry of Finance. The authors would also like to thank Mary Abraham and Irene Aquino for their infinite care and patience in preparing the manuscripts, and Alex Hammer and Aung Thurein Win for their research assistance. Sean M. Culhane, of the IMF's External Relations Department, edited the volume and was masterful in guiding it to completion. The views expressed in this book are those of the authors, and do not necessarily represent those of the Indian authorities, IMF Executive Directors, or other IMF staff.

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1 Overview CHRISTOPHER TOWE

India's macroeconomic performance during the past decade has in many respects been remarkable. Since the early 1990s, India has been among the fastest growing economies in the world, inflation has been relatively well contained, and the balance of payments has been maintained at comfortable levels. This performance was achieved despite poor weather that caused negative agricultural growth in fiscal year (FY) 1995/96 and again in FY 1997/98, the Asian financial crisis in 1997 and 1998, international sanctions imposed on India and Pakistan following tests of nuclear devices in 1998, and the considerable volatility in world oil and commodity prices that occurred in 1998-2000.1 Much of India's economic strength during the early and mid-1990s can be ascribed to the broad-ranging fiscal and structural reforms undertaken following the 1991 balance of payments crisis. These included reforms to the tax system, substantial cuts in the deficit of the consolidated public sector, liberalization and deregulation in the industrial sector, trade and tariff reforms, and measures to recapitalize and strengthen the supervision of banks and other financial intermediaries. These policies helped spur a strong recovery, with real G D P growth accelerating to an average of IVA percent in the mid-1990s from as low as Vi of 1 percent at the beginning of the decade. Although economic activity slowed somewhat in subsequent years, it remained relatively robust, especially when compared with the other emerging markets that were buffeted by the Asian financial crisis. During the last two years of the 1990s, growth averaged 6V2 percent, as lr

The Indian fiscal year begins on April 1.

1

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2

OVERVIEW

agricultural output recovered strongly from poor weather in late 1997 and industrial production rebounded in response to the turnaround in agricultural incomes and the recovery elsewhere in the region. India's inflation performance has also been relatively favorable—inflation generally trended downward during the 1990s, reaching as low as 3lA percent by FY 1999/00. Following the 1991 crisis, India's balance of payments also strengthened. Indeed, in the latter half of the decade, despite the effect of the regional crisis on merchandise exports, the current account deficit began narrowing. The deficit fell to less than 1 percent of GDP in FY 1999/00, partly reflecting the impact of India's growing exports of information technology (IT)-related services. Although inward portfolio and foreign direct investment were hurt by the erosion of international market sentiment in 1997 and 1998, other private inflows were maintained, and with the recovery in international investor sentiment in FY 1999/00, India's foreign exchange reserves reached $38 billion by March 2000, a gain of almost $12 billion from three years earlier. By the end of the decade these favorable macroeconomic trends contributed to growing optimism about India's longer-term growth prospects. Indian equity prices strengthened enormously, benefiting from the global boom in IT stocks, and private sector forecasters steadily revised upward their projections for GDP growth to 7 percent or more. This optimism carried over to the political arena, with the new government elected in late 1999 setting a growth target of 7—8 percent over the medium and longer terms—recognizing the importance of fast growth for improving the welfare of the large share of India's population still in poverty. However, macroeconomic developments during 2000—including a rebound of inflation, slowing industrial production, and downward pressure on the rupee and stock prices—have tempered some of this optimism. They also underscore the longer-standing question of whether the basis for achieving sustained and rapid growth has yet been established. Most notably: • Fiscal policy. After considerable progress following the 1991 balance of payments crisis, the fiscal situation deteriorated from the mid-1990s. Weak revenue performance and lack of expenditure control at both the central and state government levels caused the consolidated deficit of the public sector to rise sharply to over 11 percent of GDP in FY 1999/00, with public sector debt exceeding 80 percent of GDP. This raises the question of how India has been able to achieve high growth and a relatively comfortable balance of payments position despite massive public sector deficits. It also creates doubt about whether this favorable performance can

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be sustained without significant policy adjustments, especially as trade and financial systems become increasingly integrated with the rest of the world. • Structural policy. Following rapid progress in the early and mid1990s, the momentum for reform and liberalization appeared to slow in the latter half of the decade. This partly reflected political constraints—between early 1996 and the end of 1999 there were three general elections and six changes in coalition governments. As a result, difficult reforms in a broad range of areas—including agriculture, small-scale industry, and labor markets—were not addressed, potentially undermining growth and leaving the economy ill-prepared to benefit from increased access to global goods and capital markets. A notable example of the lack of coherence in the area of structural reform is the fact that, with the complete removal of quantitative restrictions on imports in early 2001, domestic producers will be exposed to external competition well before the legal, labor market, and regulatory impediments to effective restructuring have been addressed. • Poverty. Despite the gains in the area of poverty reduction since Independence—the poverty rate has fallen by over 20 percentage points since the 1950s and 1960s—roughly 35 percent of the population still remains below the poverty line.2 Moreover, poverty statistics during the 1990s generally stagnated or, in some cases, worsened, and per capita income in India still lags well behind that in other fast-growing Asian economies. Notably, rural poverty rates have tended to increase and the regional distribution of income has become more stratified. This has reflected both weak fiscal discipline (constraining public development spending) and slowing structural reform (concentrating growth in the less-regulated services sector), which have left little scope for income gains for lower-skilled agricultural and industrial workers. These issues have been at the core of the ongoing policy dialog between the IMF staff and the Indian authorities, and this volume brings together some of the IMF staff's more recent analysis of these topics (Box 1.1 lists a number of previous analytical studies). In particular, the following chapters address four main issues. Part I explores the factors underlying India's success in avoiding significant fallout from the Asia crisis and addresses broader questions regarding India's external vulnerability. Part II discusses the fiscal situation and the extent to which recent policies pose risks to India's growth prospects and debt 2

Analysis of poverty trends in India is complicated by questions about tbe quality of the data. See Chapters 8 and 9 for a discussion.

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OVERVIEW

Box l . L Recent Staff Studies, 1995-98 India—Selected Issues, IMF Staff Country Paper No. 98/205 (August 1998) • Tax Revenue Performance in the Post-Reform Period, by Martin Mtihleisen • Foreign Exchange Markets: Developments and Issues, by Martin Miihleisen • Exports and Competitiveness, by Dimitri Tzanninis • The Financial Performance of Public Sector Commercial Banks in India, by Tim Callen • Nonbank Finance Companies in India: Development Issues, by Nirmal Mohanty India—Selected Issues, IMF Staff Country Report No. 97/154 (June 1997) • The Virtuous Circle of Growth and Saving: Lessons from the Experience of Selected Asian Countries, by Kalpana Kochhar • Petroleum Price Liberalization, by Richard Hemming • The States' Fiscal Problem, by Dimitri Tzanninis • Trade Reforms and Economic Response, by Martin Miihleisen India—Selected Issues, IMF Staff Country Report No. 96/260 (October 1996) • Medium-Term Macroeconomic Outlook, by Martin Miihleisen • Improving Domestic Savings Performance, by Martin Miihleisen • Poverty in India, by Martin Miihleisen • Controlling Central Government Expenditures, by Dimitri Tzanninis • Strengthening Public Enterprise Performance, by Richard Hemming • Public Sector Banking Reform, by Marjorie Rose • Long-Term Savings Instruments, by Martin Miihleisen • Capital Account Liberalization, by Peter Dattels India—Economic Reform and Qrowth, IMF Occasional Paper No. 134 (December 1995) • Overview, by Ajai Chopra and Charles Collyns • Long-Term Growth Trends, by Ajai Chopra • The Adjustment Program of 1991/92 and Its Initial Results, by Ajai Chopra and Charles Collyns • The Behavior of Private Investment, by Karen Parker • Fiscal Adjustment and Reform, by Richard Hemming • Recent Experience with a Surge in Capital Inflows, by Charles Collyns • Structural Reforms and the Implications for Investment, by Ajai Chopra, Woosik Chu, and Oliver Fratzscher

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5

sustainability. Monetary policy and financial sector reform are considered in Part III, and structural issues—including those related to poverty and interstate growth and structural policy implementation— are covered in Part IV. Having experienced a balance of payments crisis only ten years ago, issues related to external vulnerability remain extremely topical in India. Against this background, Chapter 2, "India and the Asia Crisis," reviews India's experience during the Asia crisis and the factors that helped insulate it from the worst of the financial market turmoil that afflicted the rest of the region. The chapter explains India's success in terms of its strong macroeconomic fundamentals, modest systemic vulnerability in the banking and corporate sectors, flexible exchange rate management, the relatively closed nature of the economy, and capital controls. However, the chapter cautions that, as capital controls are gradually eased and trade barriers reduced, it will become increasingly important to ensure sound macroeconomic policies—including with regard to the fiscal position—and strong prudential and supervisory systems. India's external vulnerability is examined in more detail in Chapter 3, "Assessing India's External Position," by estimating models of the equilibrium current account. The results illustrate that India's equilibrium current account deficit has been constrained by its lack of openness on both the capital and trade accounts and suggests that deficits in the range of Wi—lVi percent of GDP appear sustainable, given India's stage of development. The paper uses the experience of the 1991 balance of payments crisis, however, to illustrate risks to the external position from weak fiscal policies, low reserves, short-term debt exposure, and exchange rate overvaluation. Issues related to fiscal sustainability are the focus of the subsequent two chapters. Chapter 4, "Tax Smoothing, Financial Repression, and Fiscal Deficits in India," examines data through 1996/97 and asks whether fiscal policy has been effective in avoiding disruptive changes in tax rates in the face of temporary shocks, and whether there has been a bias toward deficit financing. The results suggest that fiscal policies in India have been consistent with tax-smoothing behavior. However, there also appears to be evidence pointing to a significant bias toward deficit financing, leading to excessive public borrowing, as well as resort to seigniorage and financial repression. Consequently, the authors argue that government debt is well in excess of levels that would be considered optimal or consistent with intertemporal solvency. Fiscal sustainability and developments since FY 1996/97 are explored further in Chapter 5, "Fiscal Adjustment and Growth Prospects in India." Using a simple growth model, the chapter illustrates that India's

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6

OVERVIEW

ability to avoid a fiscal crisis, despite high deficits, has largely reflected a favorable differential between real interest rates and overall economic growth. The simulations suggest, however, that a continuation of recent policies would risk putting India on an explosive debt path, by undermining growth and putting upward pressure on interest rates. This risk would be exacerbated as financial sector reform and liberalization reduce the scope for the government to place its debt with captive financial institutions at nonmarket rates. The paper concludes that ambitious fiscal reforms are needed to ensure sustainability, including measures to improve fiscal discipline at the state level, tax measures to boost the revenue/GDP ratio, and cuts in unproductive spending that would provide greater room for needed infrastructure investment. Monetary policy and financial sector issues are addressed in Chapter 6, "Modeling and Forecasting Inflation in India." The chapter discusses the Reserve Bank of India's (RBI) downgrading of the money supply as an intermediate target in response to financial sector liberalization and innovation, which has reduced the strength of the statistical relationship between money and economic activity. The paper tests the extent to which money versus other indicators provide useful leading information of inflation pressures and cautions that the monetary aggregates continue to be useful for predicting inflation, albeit with significant lags. The paper concludes by suggesting that improvements in the quality of the monetary and price data could further strengthen the RBI's ability to implement monetary policy, but it also cautions that, until a more reliable anchor for monetary policy is found, the RBI will need to be especially careful to avoid undermining the credibility of its commitment to reasonable price stability. Chapter 7, "The Unit Trust of India and the Indian Mutual Fund Industry," explores the issue of financial sector reform and regulation from the perspective of the mutual fund industry. In particular, while the mutual fund industry has played an important role in mobilizing financial saving in India, its systemic vulnerability was illustrated in 1998 when India's largest fund, the government-sponsored Unit Trust of India, faced significant financial difficulties. As the chapter notes, this episode provided a stark illustration of the importance of continued efforts to strengthen regulation and transparency in the mutual fund industry, a conclusion that applies more generally to the financial sector as a whole. Structural issues are explored in more detail in the final two chapters. There is deep concern about the apparent widening of regional income disparities, as it suggests a risk that growth will not be sustained or be of a high quality. In Chapter 8, "Growth Theory and Convergence Across Indian States: A Panel Study," interstate growth differentials are

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7

examined and the empirical evidence pointing to a widening of per capita income gaps is presented. This lack of convergence is determined to have been partly due to differences across states in literacy and private investment rates. The chapter then demonstrates that these rates appear to have been adversely affected by inadequate public funding of social and public infrastructure investment. Thus, the chapter provides a strong illustration of the damaging effect that weak fiscal policies have had on slower-growing states. Finally, "Structural Reform in India" provides an overview of structural reform policies that have been implemented since the 1991 balance of payments crisis. The chapter describes empirical evidence that suggests that reforms can significantly enhance India's growth potential and points to signs that the apparent slowing of the momentum for reform has adversely affected productivity, especially in the agricultural and industrial sectors. The chapter concludes by stressing the need to reinvigorate the reform process and by summarizing the areas where policies are needed to support strong and sustained growth over the medium term. Taken together, these papers suggest that India stands at the crossroads. The experience of the last decade has illustrated the enormous capacity that India has for absorbing structural change and the significant benefits that sound policies can yield. A t the same time, however, the process of structural reform is unfinished and much of the fiscal adjustment that was achieved has been reversed. This book suggests that ensuring strong, sustained, and high-quality growth in the coming decade will require a broad-based and deep commitment to fiscal deficit reduction, wide-ranging structural reform, and prudent and careful management of monetary and exchange rate policies.

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PART I

Preserving External Stability

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2 India and the Asia Crisis CHRISTOPHER TOWE

Introduction India's recent economic performance has been remarkable, particularly in view of the economic and financial turmoil that afflicted the region during 1997-99. In the face of the Asia crisis, as well as the imposition of international sanctions in early 1998, volatility in domestic financial markets and the exchange rate was contained and overall economic activity accelerated in 1998/99. Spillovers to India's balance of payments were also comparably modest—the current account deficit was held to around 1 percent of GDP in 1998/99, capital inflows were sustained, and official reserves increased. This chapter describes the factors that helped insulate India from the regional turmoil. The following section examines the extent to which standard indices would have signaled external vulnerability and concludes that India's financial and macroeconomic fundamentals were significantly stronger than those economies affected by the crisis. The third section discusses in more detail India's capital controls and their role in reducing India's external vulnerability. The chapter concludes on a cautionary note, stressing that the favorable experience during the past two years should not lead to complacency. India's previous balance of payments crises clearly demonstrated that the balance of payments is vulnerable to external shocks.1 This vulnerability 1 India experienced balance of payments crises in 1980 and 1990/91, necessitating Fund programs. The 1990/91 crisis was precipitated by the Gulf war, which resulted in a sharp

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INDIA AND THE ASIA CRISIS

has likely increased as a result of the ongoing liberalization of domestic financial markets, as well as the gradual easing of controls over capital inflows that has taken place in recent years. This only increases the importance of ensuring a sound macroeconomic environment, including a more sustainable fiscal position, and of continuing to promote a strong prudential and supervisory framework for the financial system.

Macroeconomic and Structural Factors A broad range of macroeconomic and structural factors help explain why India was relatively unscathed by the recent crisis. In particular, when the regional crisis arose in 1997, India did not exhibit many of the macroeconomic, financial sector, and external imbalances that afflicted other countries in the region, in large part owing to the years of structural and macroeconomic reforms that had followed India's 1990/91 balance of payments crisis. As a result, estimates of crisis probabilities based on macroeconomic fundamentals—including the real exchange rate, the current account, reserves, export growth, and shortterm debt exposure—were relatively benign in the case of India in late 1996, especially when compared to other Asian economies (Figure 2.1).2 Besides these relatively good macroeconomic fundamentals, India was also insulated from financial market contagion and trade spillovers by the relatively closed nature of its economy, a long history of capital controls, and modest financial links with the region. India's external current account going into the crisis was relatively strong. The current account deficit had fallen to only 11/4percent of GDP in 1996/97, reflecting the effect of strong export growth in previous years, as well as a surge in inward remittances. Although the crisis contributed increase in India's oil import bill, as well as a reduction in remittances from Indians abroad. However, the economy's vulnerability to the external shock reflected underlying structural weaknesses, including a deterioration in the fiscal position (the overall public sector deficit rose to over 12 percent of GDP), excessive monetary growth, large external debt servicing requirements (partly related to previous IMF loans), and a growing current account deficit. 2 The crisis probabilities shown are estimates of the probability of balance of payments crisis 24 months hence, and are based on a model maintained by the Developing Country Studies Division of the IMF's Research Department. This model and other studies, including those by J. Sachs, A. Tornell, and A. Velasco (1996), J. Frankel and A. Rose (1996), and G. Kaminsky, S. Lizondo, and C. Reinhart (1998), identify a range of variables that can help signal crisis, including real exchange rate appreciation, banking crises, growth of M2/reserve growth, stock price inflation, export growth weakness, output growth slowdown, excess Ml balances, falling external reserves, excess domestic credit growth, high real interest rates, and a decline in the terms of trade.

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Figure 2 . 1 . Crisis Probabilities, December 1996 (In percent)

to a weakening of export growth, owing to the decline in regional demand and a fall in export unit values, this effect was partly offset by lower oil prices and the strength of IT-related services exports. Spillovers from the Asia crisis were also moderated by the relatively closed nature of the Indian economy—exports represent less than 10 percent of India's GDP, and the share directed to Asia was relatively small (less than 2 percent of GDP). The current account deficit remained at11/4percent of GDP in 1997/98, and fell to 1 percent of GDP in 1998/99. The impact of the crisis and sanctions on capital flows was also relatively modest, partly reflecting the fact that capital controls have limited India's dependence on foreign saving. Private capital inflows reached just over $10 billion in 1996/97, owing to increases in foreign direct investment (FDI), commercial borrowing, and deposit inflows by nonresident Indians (NRIs), but fell only marginally in the following two years to an average of around $9 billion. While portfolio investment, short-term credits, and NRI deposits were adversely affected, FDI and commercial borrowing were sustained, and capital inflows were also bolstered by the authorities' issue of the Resurgent India Bond.3 As a result, India's external reserves actually increased over the crisis period, and stood at almost $35 billion at end-1999, the equivalent of over six months of imports of goods and services. 3 The Resurgent India Bond (RIB) was marketed to nonresident Indians by the State Bank of India (which is mainly owned by the central bank). The RIB is a five-year bond, denominated in U.S. dollars, pounds sterling, or deutsche marks (paying an interest rate of

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INDIA AND THE ASIA CRISIS

Table 2 . 1 . External Debt, 1997 1 (In percent of GDP)

Total Of which: Short-term

India

Indonesia

Korea

Malaysia

Philippines

Thailand

24.4

61.3

33.2

38.7

59.3

62.0

1.8

10.0

13.3

...

13.5

23.1

1

Data for India are at end-March 1997.

India's external debt position (Table 2.1) had also improved considerably during the mid-1990s. Total external debt as a share of GDP had fallen to 24 percent of GDP in 1996/97 from 33 percent of GDP at end 1993/94, while short-term debt remained under 2 percent of GDP during the same period.4 Accordingly, the debt service ratio improved considerably, falling to 22 percent in 1996/97 from 32 percent of exports of goods and services in 1990/91. The structure of external debt was also relatively favorable. Although concessional debt fell slightly as a share of total external debt during the mid-1990s, by end 1996/97 it remained around 40 percent. The fact that the rupee's exchange rate was not obviously overvalued at the beginning of the crisis, and that monetary policy was geared toward allowing the exchange rate to depreciate in an orderly fashion in the face of market pressures, also helped sustain financial market confidence (Figure 2.2). The rupee had already depreciated sharply following India's balance of payments crisis in 1991, and by March 1997 it was roughly 25 percent below its 1990 value in real terms, a level that most indicators suggested was broadly in line with medium-term fundamentals.5 This movement in the real exchange rate was facilitated by the shift in the exchange rate regime from a basket peg system to a managed float following the 1991 crisis. The Asia crisis did result in pressures on the rupee in the latter half of 1997 and early 1998. The authorities responded by tightening money market conditions while permitting an 18 percent depreciation against the U.S. dollar. However, the interest rate hikes and the depreciation in real terms were considerably less than what was experienced among the 73/4percent, 8 percent, and 61/4percent per year, respectively). The proceeds were used to make rupee loans at 121/2—13percent to development institutions, which were supposed to fund their loans for infrastructure projects. The exchange loss, if any, would be shared between the State Bank of India (SBI) and the Reserve Bank of India (RBI), although the SBI's liability is limited to 1 percent per annum of the rupee value of the original amount credited to the institution plus accrued interest. 4 Note that these debt figures understate the vulnerability of many southeast Asian economies, since they do not include off-balance sheet liabilities, which in some cases were substantial. 5 See the analysis of misalignments by D. Tzanninis (1998), and Chapter 3.

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Figure 2.2. Real Exchange Rate Indices (1990= 100)

Christopher Towe

Source: IMF staff estimates.

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INDIA AND THE ASIA CRISIS

Asia crisis countries, and the rupee settled in a relatively narrow trading range after August 1998.6 India's success in resisting the crisis also reflected the fact that corporate and household balance sheets did not exhibit the same fragilities found in many crisis countries. For example, debt-equity ratios for the manufacturing sector declined from over 200 percent in 1991/92 to a more manageable 121 percent in 1997/98.7 Moreover, although stock prices fell sharply (by roughly 40 percent) following the onset of the Asia crisis and the imposition of sanctions, this had not preceded a long-term run-up in equity prices fueled by excessive credit creation, which was seen in many other emerging markets ahead of the crisis. Indeed, most monetary indicators were comparably benign ahead of the crisis; credit growth had been decelerating since the beginning of 1995, and the ratio of broad money to reserves had declined sharply since early 1996. The banking sector was also comparatively less vulnerable than elsewhere in Asia, partly reflecting the effort of the reforms that had been initiated in the early 1990s. For example, risk-weighted capital adequacy ratios (CARs) had risen to nearly 12 percent by 1997/98, largely as a result of substantial capital injections by the public sector. Nonperforming loans as a percent of total loans had fallen to around 8 percent in 1997/98 from around 11 percent in 1994/95. Systemic risks also were moderated by the fact that roughly 80 percent of the system was already state owned. Credit and market risk was mitigated by the fact that roughly half of bank assets were taken up by reserve and liquidity requirements—including holdings of government debt—and loans to the property sector were relatively modest. In addition, extensive capital controls restricted the size and term of external bank borrowing, minimizing banks' exposure to regional and foreign exchange risk. Although India's fiscal situation was considerably weaker than the Asia crisis economies, the public sector deficit had been on a downward trend in the period leading up to the crisis. The deficit had fallen to a recent low of 8 percent of GDP in 1997/98 from almost 12 percent of GDP in 1989/90, owing to a sharp compression of capital and other spending. As a result, the public sector debt-to-GDP ratio had begun to decline, reaching as low as 75 percent at end-1996/97. 6

RBI exchange rate policy has been characterized as aimed at maintaining "orderly conditions in the foreign exchange market, and to curb destabilizing and self-fulfilling speculative activities." See Dr. Y.V. Reddy, Deputy Governor, Reserve Bank of India (RBI), address to the Fourth Securities Industry Summit, May 26, 1999. 7 Although this gearing ratio compares favorably with a number of other emerging mar' kets in Asia, some analysts express concern with the leverage of Indian businesses, and the extent to which public sector banks are required to provide financing to loss-making firms.

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Broader macroeconomic developments in India were also favorable. In a number of economies, a sharp slowdown in domestic growth, following years of rapid expansion, was an important precursor to crisis. Slow growth contributed to weaknesses in the financial and corporate sectors, since large (often foreign currency) loans had been made on the assumption of continued strong growth and limited the scope for central banks to raise interest rates to defend existing exchange rate parities. Although growth did slow in India during 1997/98, it remained relatively robust at just under 5 percent. The slowdown also reflected mainly domestic supply shocks, such as the effect of weather-related problems on agricultural output, rather than the precrisis slowdown in export growth that afflicted many other countries in the region. The importance of macroeconomic and other fundamental factors as preconditions for crisis has been illustrated by statistical analysis in the IMF's May 1999 World Economic Outlook (Figure 2.3). This study

Figure 2.3. Crisis Vulnerability Indicators (Difference of crisis to noncrisis economies)

Composite Indicators

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showed that a number of economic fundamentals for crisis economies were different than those for noncrisis countries. For example, in Figure 2.3, real effective exchange rates for 90 percent of those economies that fell into crisis were significantly higher than that exhibited by noncrisis economies during the Asia and earlier Mexico crises. Of the variables examined, exchange rate overvaluation, current account deficits, shortterm external debt, real interest rates, and common creditors were found to be significant signals of crisis.8 Most of the variables that provided an indicator of crisis vulnerability in other countries did not signal vulnerability for India during the 1997/98 period. Notably, India's reserves, current account deficit, real interest rate, and exchange rate movements were not typical of the behavior shown by crisis economies. In addition, crisis economies typically were more exposed to a common creditor—i.e., had a larger proportion of international bank loans from a single creditor country—but this was not the case for India. Real interest rates also did not signal a risk of crisis. The only variables that did appear to point to vulnerability for India were those that proxied the spillover of crises in other countries on India's real exchange rate and export growth. Composite vulnerability indices also suggest the same conclusion. Only four of these indices appear to signal vulnerability (Figure 2.4): reserve adequacy, reflecting the high level of M2/reserves; trade spillovers, owing to India's trade links to other crisis countries; the composite financial indicator, again owing to the high M2/reserves ratio; and domestic macroeconomic imbalances, owing to the large fiscal deficit/GDP ratio.9 Although the external imbalance and portfolio spillover variables were significant, the Indian data did not signal vulnerability. While the value of the index for domestic macroeconomic imbalances was relatively high in the case of India, reflecting the large fiscal deficit and high monetary growth, this variable did not provide a reliable signal of crisis vulnerability for other crisis economies.

8 In Figure 2.3, the vertical lines represent the 90 percent range for crisis economies of each variable, normalized by the sample standard deviation less the average for the noncrisis sample. In other words, the lines represent the standardized difference between 90 percent of the crisis economies and the noncrisis economies. Details are provided in the IMF's May 1999 World Economic Outlook. The figures for India were calculated on the basis of data available during August-November 1998. 9 The M2/reserves ratio proxies both the effect of reserve inadequacy (of less concern in the case of a country such as India with a floating exchange rate) and also excess credit creation. In the WEO study, this variable was found to be a significant crisis indicator in the composite indices.

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Figure 2.4. Crisis Vulnerability Indicators (Difference of crisis to noncrisis economies)

The Role of Capital Controls 10 India's macroeconomic and other fundamentals were not uniformly favorable, and this suggests that capital controls contributed to India's favorable experience during the regional crisis. In particular, India's relatively closed capital account meant that external debt—especially short-term external debt—was modest, and restrictions on capital movements also helped lessen the impact of the sharp turnaround in investor sentiment on the capital flows. Indeed, this view is confirmed by statistical analysis suggesting that capital controls may have helped insulate countries during the Asia and Mexico crises (see the May 1999 World Economic Outlook).

India maintains relatively strict control over capital flows, and the IMF's index of capital controls places India among the most restrictive economies. In general, outflows by residents are prohibited, and inflows by nonresidents are subject to constraints (Figure 2.5 and Box 2.1). Although a timetable for the phased withdrawal of most capital account controls over the 1997/98-1999/2000 period was established in June 1997, progress toward capital account liberalization has been slower 10

This section draws upon K. Habermeier (2000).

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Figure 2.5. Index of Capital Controls

Source: N.Tamirisa, "Exchange and Capital Controls as Barriers to Trade," IMF Staff Papers, March 1999.

than envisaged. This reflected concern that the Asia crisis had increased the vulnerability of emerging markets to shifts in investor sentiment. It also recognized that many of the preconditions that had been identified by the report for successful liberalization—including significant fiscal consolidation and a strengthened financial system—were not yet in place.11 Capital controls have limited India's access to foreign capital compared with that of other developing countries. Net private capital inflows were only about 21/2percent of GDP in 1996 (prior to the Asia crisis), compared with a developing country average of around 3 1/2 percent of GDP and considerably higher rates among other fast-growing Asian economies (Figure 2.6). Despite less restrictive constraints on inward foreign direct investment, this too has been very modest in India—less than 1 percent of GDP in 1996 compared with 2 percent of GDP for the developing country average. Nonetheless, capital controls did not completely insulate India from the Asia crisis. Net private capital inflows, as high as $5 billion in 11

For a useful discussion, see "Managing Capital Flows," address by Dr. Y.V. Reddy, Deputy Governor, Reserve Bank of India, at the Seminar at Asia/Pacific Research Center, Stanford University, November 23, 1998.

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Box 2.1. Capital Controls Loans. Generally, Indian residents are prohibited from borrowing from nonresidents. However, there is a window that permits external commercial borrowing (ECB) by Indian corporate entities, subject to government approval. Indian corporations are allowed to apply for permission to borrow abroad, but the total amount of loans made to all corporations is subject to an annual ceiling ($8.5 billion in 1999/00). Companies are restricted from paying more than 350 basis points above LIBOR/U.S. Treasuries. Portfolio flows. Portfolio outflows by residents are subject to prior approval. Indian-registered mutual funds may invest in overseas markets up to a maximum of $500 million. Portfolio inflows by nonresidents are permitted by registered foreign institutional investors (FIIs) subject to certain limits. In particular, a single FII's ownership share in Indian companies cannot exceed 10 percent, and short sales by FIIs are prohibited. The aggregate permissible holdings of an Indian company by FIIs has been increased to 40 percent, subject to Board approval. Portfolio investments by nonresident Indians also are permitted. In both cases, there are no restrictions on repatriation. In addition, resident corporations are permitted to raise equity abroad by issuing Global or American Depository Receipts. Foreign direct investment. Inward foreign direct investment is permissible subject to prior notification and approval, as well as restrictions on the foreign ownership of projects. However, "automatic" approval is permitted for smaller amounts, or investments directed toward sectors not on a negative list. Limits on equity participation are also relaxed for high-priority sectors. Restrictions on outward direct investment by residents were eased in 1999, with the limits for fast-track approval raised to $15 million; otherwise prior approval is required. Bank deposits. Deposits by residents abroad and resident deposits in foreign currency are permitted, subject to prior approval. Deposits to Indian banks by nonresident Indians (NRIs) and overseas corporate bodies (OCBs; i.e., corporations owned by NRIs) are permitted, both in rupees and foreign currencies. Depending on the scheme, such deposits can be repatriated. Restrictions are placed on the interest paid to NRI deposit holders.

1997Q2, tapered off in the latter half of 1997, and, except for a spike in 1998Q1 related to unidentified capital inflows, were relatively modest into 1999. The weakening in capital inflows largely reflected bankrelated outflows; nonresident Indian deposits fell sharply in late 1997 and other net bank foreign assets also declined from 1997Q3. However, a drop in investment and nonbank flows was also evident after the onset

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Figure 2.6. Capital Inflows in Percent of GDP, 1996

Source: WEO database.

of the Asia crisis, reflecting weak demand for funds related to the industrial slowdown and difficulties that domestic commercial entities faced in accessing external loans. In addition, weaker investor sentiment contributed to outflows of portfolio investment. The impact on the overall capital account position was more than offset, however, by the government's flotation of the Resurgent India Bond, which netted over $4 billion in 1998Q3. Despite capital controls, stock market fluctuations also illustrate that domestic financial markets have become more responsive to international developments. For example, prior to the crisis, prices in the Indian stock market and those in other regional stock markets were not highly correlated (Figure 2.7).12 Since the crisis, however, Indian equity prices have responded much more closely to prices elsewhere in the region, suggesting that India's equity markets have become more integrated than in the past (see also Box 2.2).* There are also signs that domestic and international debt markets are becoming increasingly integrated. Until early 1999, the exchange-rateadjusted gap between U.S. and Indian government Treasury bill yields 12

Precrisis correlations are with regard to daily data from January 1995 to June 1997. Postcrisis correlations are with regard to daily data from July 1997 to November 1999. *Note that the correlations are with regard to levels that are not obviously stationary, and therefore may partly be spurious.

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Figure 2.7. Correlation Between Indian and Regional Stock Prices

Source: CEIC.

Box 2.2. Regional Stock Market Spillovers— Pre- and Post-Asia Crisis In order to examine the proposition that spillovers from Asian stock markets to India have increased following the Asia crisis, regressions were estimated relating the daily log change in the Indian Bombay SENSEX index (rt) as a function of its lagged value, and the log change in other regional markets (r't) -constant terms and other lags were not found to be significant: r t = c l r t-1 + c2rit

The regressions were estimated over a precrisis period (October 1994—May 1996) and during the postcrisis period (July 1997-November 1999). The estimated impact of regional stock markets is proxied by the C2 coefficients, which are reported below ("—" indicates that the coefficient is insignificant from zero at the 95 percent confidence level). As can be seen, except for the case of Korea, the proposition that the impact of regional stock market developments on the domestic stock market has increased since the Asia crisis cannot be rejected. HKSAR Indonesia Korea Malaysia Singapore Thailand Taiwan Precrisis Postcrisis

— 0.12

— 0.80

0.17 0.08

— 0.07

0.10

0.07

—

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was large, with the yield on U.S. securities tending to exceed that on Indian securities, pointing to an inability of financial markets to arbitrage unexploited profits. Since the beginning of 1999, however, this gap has narrowed considerably, and, while it remains significantly different from zero, there are indications that market participants are becoming better able to arbitrage the difference between domestic and foreign yields (Figure 2.8).13 Finally, the growing stock of the more volatile sources of financing is significant and a potential source of vulnerability. Cumulative portfolio inflows—on which there are no repatriation restrictions—totaled over $15 billion during 1990Q1-1999Q1, and the outstanding stock of repatriable NRI deposits was around $14.5 billion at end-March 1999.

Concluding Remarks This discussion has suggested that India's favorable economic performance in the face of the recent regional financial crisis can be ascribed to a combination of relatively strong fundamentals, the closed nature of the economy, and a legacy of capital controls that insulated India from contagion effects. India's past balance of payments crises, however, and the experience of the rest of the region during the past several years suggest a number of important lessons: • Effective exchange rate management. During the Asia crisis, the RBI was effective in facilitating an orderly adjustment in the rupee/dollar exchange rate. This experience, and the experience of other countries in the region that had more rigid nominal parities against the dollar, illustrates the advantage of a flexible exchange rate system and highlights the risks that arise when the monetary authorities seek to maintain an excessively stable exchange rate against one particular currency. • The importance of sustaining the macroeconomic adjustment. The multicountry studies described above illustrate the importance of macroeconomic fundamentals—a sustainable current account balance, an appropriate and flexible exchange rate, high levels of reserves, and low levels of short-term external debt—for avoiding balance of payments crisis. Although India was well positioned 13 Capital controls constrain the scope for arbitrage, but, as domestic corporates can borrow abroad, this tends to limit the extent to which domestic rates can exceed foreign rates. For a discussion of the interest parity conditions in India, see H. Joshi and M. Sagger (1998). The increasing integration of the domestic capital, money, and foreign exchange is discussed by B.K. Bhoi and S.C. Dhal (1999).

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Figure 2.8. Six-Month Covered Interest Rate Differential1 (In percent)

Christopher Towe

Sources: Data provided by the Indian authorities; and staff calculations. 1 1ndian Treasury bill yield less U.S. Treasury bill yield less the six-month forward premium.

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ahead of the Asia crisis, this was mainly the result of policy measures that had been set in train in response to India's earlier balance of payments crisis, including trade liberalization, tax reform, fiscal adjustment, and financial sector reform. However, progress along many of these fronts in recent years has been less favorable. For example, the momentum for structural reform appears to have slowed in the latter half of the 1990s, and most of the progress in reducing the fiscal deficit has been eroded. Thus, in the absence of ambitious measures to improve public saving and reinvigorate the structural reform process, balance of payments vulnerability, especially in the face of adverse external shocks, cannot be ruled out. Capital controls and financial sector stability. India's capital controls

also played an important role in helping to insulate it from the financial contagion that afflicted other countries in the Asia region. The same can be said for the pervasive government control over the banking sector and the relatively modest pace of liberalization in the domestic financial sector, since high reserve and liquidity requirements, priority lending regulations, and an underdeveloped domestic debt market discouraged the asset price inflation and balance sheet weaknesses seen elsewhere in Asia. As liberalization continues, however, the systemic vulnerabilities to contagion increase. The balance of payments is becoming more dependent on gross private inflows of portfolio investment, as well as investments by nonresident Indians. In addition, recent financial market developments have increased the scope for arbitrage.14 This only increases the importance of ensuring that the prudential and supervisory systems covering the domestic financial sector are strong and that macroeconomic imbalances are addressed.

References Bhoi, B.K., and S.C. Dhal, 1999, Integration of Financial Markets in India: An Empirical Evaluation, RBI Occasional Paper, April 7. Frankel, J., and A. Rose, 1996, "Exchange Rate Crashes in Emerging Markets: An Empirical Treatment," Journal of International Economics, Vol. 41, pp. 351-66. Habermeier, Karl, 2000, "India—Experience with the Liberalization of Capital Flows Since 1991," in Capital Controls: Country Experiences with Their Use and 14 Although the RBI sought to restrict foreign exchange market speculation in 1998 by restricting the ability of participants to cancel and rebook forward contracts, the nondeliverable forward market for Indian rupees in Singapore remains an avenue for hedging. Moreover, swap transactions have recently been permitted in India.

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Liberalization, A. Ariyoshi, K. Habermeier, B. Laurens, I. Otker-Robe, J.I. Canales-Kriljenko, and A. Kirilenko, eds. (Washington: International Monetary Fund), Chapter II. Joshi, H., and M. Sagger, 1998, Excess Returns, Risk-Premia, and Efficiency of the Foreign Exchange Market, RBI Occasional Paper, Vol. 19, No. 2. Kaminsky, G., S. Lizondo, and C. Reinhart, 1998, "Leading Indicators of Currency Crises," Staff Papers, International Monetary Fund, Vol. 45 (March), pp. 1-48. Sachs, J., A. Tornell, and A. Velasco, 1996, "Financial Crises in Emerging Markets: The Lessons from 1995," Brookings Papers on Economic Activity (May), pp. 147-98. Tzanninis, D., 1998, "Exports and Competitiveness," India: Selected Issues, IMF Staff Country Report No. 98/112 (October), pp. 66-91.

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3 Assessing India's External Position TIM CALLEN AND PAUL CASHIN

Introduction India has generally followed cautious external sector policies, with trade intervention and capital controls used extensively as instruments of balance of payments control and adjustment. It has nonetheless experienced several balance of payments crises, most recently in 1991. The policy of restricting trade and capital flows may also have entailed costs in terms of forgone resources. Despite recent reforms, India retains one of the world's most restrictive trade regimes, and the inflow of foreign capital remains well below that of other countries in Asia. This paper uses a number of methods to assess developments in India's external position. First, an intertemporal model of the current account and a composite model of external vulnerability indicators, which generates probabilities of the occurrence of a balance of payments crisis, are used to consider the solvency, sustainability, and optimality of the external position. Second, a model of the medium-term saving-investment balance is used to derive estimates of the "equilibrium" current account balance against which the actual balance can be compared. Lastly, the possible sustainable current account deficit over the medium term is examined through conditions for intertemporal solvency under different economic scenarios. The results indicate that India's current account deficits have been consistent with intertemporal solvency, but the evidence on whether

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external borrowing has been optimal, even when allowance is made for capital controls, is mixed. However, the path of the current account prior to 1991 is found not to have been consistent with solvency. The composite model of external vulnerability indicators also raised questions about external sustainability during this period, while estimates of the equilibrium current account deficit were smaller than the actual outcomes during the 1980s. Since 1991, the estimated probabilities of external crisis in India have remained low, and they rose little during the Asia crisis, while the current account deficit is currently around its estimated equilibrium level. Finally, estimates of the sustainable level of the current account deficit over the medium term range from11/2to 2 1/2 percent of GDP, depending on the growth rate and the cost of external finance. The remainder of the chapter provides a brief overview of external sector developments and policies in India, and a discussion of the methodologies for assessing external sector developments.

Overview of External Sector Developments and Policies Following independence, economic policies focused on rapid industrialization with the aim of achieving economic self-sufficiency. This goal resulted in a trade system that strictly regulated imports through exchange controls and trade restrictions, which were supplemented by a tariff structure with high and differentiated rates across industries (Joshi and Little, 1994). Little emphasis was placed on promoting exports, and the inefficiency of domestic industry, engendered by extensive protection, resulted in a distinct anti-export bias. The investments in goods essential for industrialization and the continuing need to import many essential consumer items, including food during periods of drought, resulted in strong import growth in the late 1950s and early 1960s. With export performance remaining poor, the trade deficit widened, and the current account deficit increased to around 21/2percent of GDP as the surplus on the invisibles account also narrowed (Figure 3.1, top panel). Improved export performance in the late 1960s and 1970s, aided by the expansion of world trade and a depreciation of the real exchange rate, led to an improvement in the current account position. While this was temporarily reversed in the aftermath of the oil price shock of 1973, a tightening of import controls and restraint of domestic expenditures brought import growth down. Remittances also increased during the 1970s as the number of Indians employed in the oil-producing nations of the Middle East increased, and the current account position improved,

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Figure 3.1. Current Account Balance, 1950/51-1998/99 (In percent of GDP)

-5

Source: Data provided by the Indian authorities.

recording a surplus in a number of years during the second half of the 1970s (Figure 3.1, bottom panel). The current account was largely financed by concessional aid flows prior to the 1980s. Recourse was also made to IMF financing on several occasions. Private capital movements were limited as foreign investment policy was marked by very tight regulation during the late 1960s and 1970s, particularly with the introduction of the Foreign Exchange Regulation Act (FERA) in 1973 (Kapur, 1997).

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The 1980s witnessed a gradual deterioration in the current account position and a profound change in its financing. The second oil price shock in 1979 placed considerable pressure on the balance of payments. Imports rose, exports slowed in response to the worldwide recession and the appreciation of the real exchange rate, and the current account moved back into deficit. As reserves fell critically low, India entered into a program with the IMF in 1981. However, unlike after the first oil price shock, no significant current account adjustment followed, and with large macroeconomic imbalances developing in the second half of the 1980s, particularly a deterioration in public finances, the current account deficit rose to a peak of 3 percent of GDP in 1990/91.1 The proportion of concessional debt in total external debt declined from over 80 percent at the beginning of the 1980s to under 45 percent by the end, due to the widening of the current account deficit and constraints on access to concessional funds. The additional financing came from private sources, mainly rupee and foreign currency deposits from nonresident Indians (NRIs) and external commercial borrowing from international banks (Figure 3.2, top panel). Much of the latter was undertaken by public enterprises and used to finance projects in the oil, power, aluminum, steel, and transportation sectors, and for on-lending by official financial institutions. While foreign direct investment (FDI) increased slightly, it remained a marginal source of funds, and portfolio investment was not permitted. External debt rose rapidly from 11 to 31 percent of GDP between 1980/81 and 1991/92, with short-term debt representing around 10 percent of this total from the mid-1980s compared to negligible amounts pre-1980 (Figure 3.2, bottom panel). The debt servicing ratio also increased to over 30 percent of exports. These problems came to a head with a sovereign debt rating downgrade in October 1990 (subsequent downgrades followed in March and May 1991). The rollover of shortterm loans became more difficult, and expectations of a depreciation of the rupee rose, leading to a loss of confidence among investors and a flight of NRI deposits out of the country. With the rise in oil prices and the decline in remittances following the crisis in the Gulf region, the external position became untenable. As reserves declined, India was brought to the brink of default in January 1991 (Jalan, 1992). This was avoided by purchases through the IMF's Compensatory Financing Facility (in January and July 1991) and by the adoption of an IMF program in October 1991. The reforms implemented in the wake of the 1991 balance of payments crisis have resulted in a more open external sector (Box 3.1). 1

The fiscal year in India runs from April 1 to March 31.

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ASSESSING INDIA'S EXTERNAL POSITION

Figure 3.2. Capital Flows and External Liabilities, 1971/72-1998/99 (In percent of GDP)

Sources: Data provided by the Indian authorities; and the World Bank Global Development Finance Database. 1 Not all components of the capital account are shown; hence, components do not sum to total capital flows.

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Exports and imports have both risen as a share of GDP. Exports have responded strongly to the liberalization measures and the decline in the real exchange rate, while imports have grown rapidly in response to strong domestic growth and the reduction in tariffs and quantitative restrictions. The current account deficit has been markedly smaller than in the 1980s, averaging only 1 percent of GDP. The financing of the deficit has also been much different in the 1990s, with a shift away from short-term debt financing toward equity and longer-term debt flows as restrictions on FDI and portfolio inflows have been eased. Restrictions on debt flows, particularly of a short-term nature, however, have been tightened. Strict controls have been placed on short-term debt, medium-term borrowing from private commercial sources has been made subject to annual caps and minimum maturity requirements, and interest rates or interest rate ceilings have been specified for NRI deposits of different maturities and under different schemes (Acharya, 1999).2 Consequently, between 1991/92 and 1998/99, FDI accounted for 21 percent of total capital inflows, and portfolio investment a further 25 percent. Meanwhile, the outstanding stock of external debt fell to around 23 percent of GDP. By March 1999, short-term debt (on a contracted maturity basis) accounted for only 41/2percent of total external debt.

Assessing India's External Position Several approaches to assessing India's external sector developments are discussed in this section. First, issues of external solvency, sustainability, and optimality are examined. Second, estimates of the "equilibrium" current account are presented against which actual developments can be compared. Lastly, the issue of what is likely to be a sustainable current account deficit over the medium term is considered. Solvency, Sustainability, and Optimality

Three questions are usually asked when evaluating a country's external position: • Is the debtor country solvent? Solvency requires that the present discounted value of future current account surpluses equals the value of its existing net external liabilities. In other words, a country is 2

In October 1999, the Reserve Bank of India (RBI) announced that the minimum maturity for foreign-currency-denominated NRI deposits would be raised from six months to one year.

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Box 3.1. External Sector Liberalization in the 1990s Some progress was made in liberalizing current account transactions during the 1980s, but it was not until the early 1990s that significant steps were taken. The Export and Import Policy in April 1992 focused on the gradual removal of quantitative restrictions on machinery and equipment and manufactured intermediate goods, reduction in tariff rates, and the modification of export promotion measures. Subsequent policies have continued this trend, and India has committed to remove all quantitative restrictions by April 2001. In August 1994, India accepted the obligations of Article VIII of the IMF's Articles of Agreement and the rupee was made fully convertible for current account transactions. On the capital account side, given the experience with the buildup of short-term, high-cost borrowing in the 1980s, policies in the 1990s have focused on encouraging equity and long-term debt flows. Measures include •

Foreign direct investment (FDl). Liberalization began with the new industrial policy in July 1991. Initially, automatic approval by the Reserve Bank of India (RBI) for FDI of up to 51 percent of equity in 35 priority industries was permitted. Over time it was expanded. In February 2000, the government announced that FDI under Rs 6 billion would be available through the RBI automatic route except for 13 sectors that have been placed on a negative list, areas reserved for the small-scale sector where foreign investment already exceeds 24 percent, and seven sectors where sectoral investment caps apply. To invest in these sectors, or above the investment caps, permission is required from the Foreign Investment Promotion Board. • Portfolio investment. In September 1992, approved foreign institutional investors (FIIs) were permitted to invest in primary and secondary markets for listed securities, and foreign brokerage firms were allowed to operate in India the following fiscal year. While there is no restriction on the total volume of inflows, total holdings by FIIs

expected to generate sufficient earnings to repay all its external liabilities. Is the extent of international capital flows optimal? Optimality of capital flows requires that, in the face of shocks to net output, capital flows are used to smooth the path of consumption to ensure there are no avoidable welfare losses. Is the external position sustainable? Even if a debtor country is technically solvent, questions may arise about the sustainability of its current account if lenders perceive that the intertemporal falls in consumption, implied by the path of the current account imbalances, raise doubts about the willingness of the debtor to meet its

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cannot exceed 24 percent (can now be raised to 40 percent by the company's Board), and total holdings of a single FII cannot exceed 10 percent. Nonresident Indians (NRIs) and overseas corporate bodies can hold an additional 10 percent (this can be raised to 24 percent through a general resolution of the company), with a 5 percent individual limit. To provide an incentive to longer-term investors, the capital gains tax rate is 10 percent if the investment is held for over one year (30 percent otherwise). More recently, foreign investors have been allowed to invest in Treasury bills. In February 1992, Indian companies were allowed to issue Global Depository Receipts on approval of the Ministry of Finance and subject to rules relating to repatriation and end use of funds. Since January 2000, no prior approval has been required. External borrowing. Approval from the Ministry of Finance is required for all external commercial borrowing and is subject to an annual indicative ceiling (borrowing in excess of 8 and 16 years' maturity is outside the ceiling if the loan amount exceeds $200 million and $400 million, respectively). Borrowing is also subject to minimum average maturities, although, more recently, companies have been given some scope to prepay outstanding borrowing. Terms permitted on NRI deposits have been made considerably less attractive than those available in the late 1980s, and interest rates have been linked to LIBOR/swap rates. In April 1998, the interest rate ceiling on nonresident foreign currency deposits of one year and above was raised, and the ceiling on maturities of less than one year was lowered. In October 1999, the RBI announced that the minimum maturity would be raised from six months to one year. Outward capitalflows.Controls on such flows remain quite stringent. Banks have recently been allowed to invest up to 15 percent of their Tier I capital in foreign currency assets, while mutual funds have also been allowed to invest overseas up to certain limits.

payment obligations (Milesi-Ferretti and Razin, 1996; Cashin and McDermott, 1998). Capital Controls and the Consumption-Smoothing Approach to the Current Account The question of whether a given current account position is appropriate can be answered only within the context of a model that yields predictions about the optimal path of external imbalances and liabilities. The most common such model is the intertemporal model of the current account, in which the current account is used to smooth consumption

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and maximize welfare in the face of temporary shocks to the net income of an economy—usually defined as output less investment and government consumption. The basic model derives from the permanent income theory of consumption, in the context of a small open economy with access to world capital markets, and under the assumptions of a given world real interest rate, a government that has access to lumpsum taxation to finance expenditure and chooses a spending and taxation path that ensures intertemporal solvency, and output that is determined by exogenously given investment.3 The consumption-smoothing model predicts that the current account will be in deficit when future changes in net income are expected to be positive. Future income is then transferred to the present (by external borrowing) to smooth the path of consumption. For example, a temporary adverse shock to exports implies that expected future net income will be higher, and that the consumption-smoothing component of the current account deficit will widen. Permanent shocks, in contrast, which by implication have no effect on expected changes in net income, will have no impact on the current account.4 A limitation of the standard intertemporal model for analyzing India is the assumption of unfettered access to world capital markets, as controls on capital movements are an important component of India's external policies.5 Deviations of the current account from an optimal benchmark derived on the assumption of free capital mobility could simply reflect the presence of capital controls. The standard model can, however, be extended to incorporate capital controls by allowing for asymmetric behavior on the part of economic agents in seeking to respond to temporary shocks to net income (Kent, 1997). Specifically, agents are constrained from responding to a temporary reduction in net income (they are unable to borrow externally), but they are able to respond to temporary increases in net income (capital outflows are not restricted).6 3 Details of the model and its application to India are presented in Callen and Cashin (1999). 4 As noted by Sachs (1982), movements in the current account can be decomposed into a consumption-tilting component, where the country tilts consumption toward the present or future, driven by differences between its discount rate and the world real interest rate, and the consumption-smoothing component. 5 While a number of studies have suggested that the degree of effective capital mobility in developing countries is higher than generally supposed due to widespread evasion of capital controls, Montiel (1994) finds that capital controls in India have been relatively effective. 6 Given that controls on outflows also exist, this is still not an ideal characterization. Further, the degree of controls on inflows has varied over time so that the assumption of no capital inflows in the constrained model is extreme for some time periods.

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India's external solvency can be tested in this framework by examining the relationship between consumption and net income less payments on the outstanding stock of external liabilities during the sample period (1952/53-1998/99). If these variables are cointegrated, then, over the long run, consumption does not deviate too far from movements in the available resources of the economy and the solvency constraint is satisfied. If the variables are not cointegrated, then consumption may be growing in excess of what is supportable from the resources available to the country. The results of the cointegration test indicated that capital inflows to India were not in breach of the solvency condition. When the regression was run on data up to the 1991 crisis, however, evidence of cointegration could not be found, indicating that during this period private consumption tended to deviate from movements in the available resources of the economy. Accordingly, under unchanged policies, capital inflows during this period were not consistent with the intertemporal budget constraint, and a return to smaller current account deficits during the 1990s was needed to reestablish solvency. The actual current account and estimates of the unconstrained (assuming no capital controls) and the constrained (assuming controls on inward capital flows) current accounts are shown in Figure 3.3.7 As would be expected, the constrained current account is generally in a smaller deficit than the unconstrained measure. The unconstrained deficit has typically been larger than the actual deficit, indicating that in the absence of constraints on capital flows more external borrowing would have been appropriate to smooth consumption in the presence of net income shocks experienced during the period. During the 1970s, the actual current account position was in a smaller deficit (and even in surplus in some years) than implied by either the constrained or unconstrained models. This probably reflects the tightening of controls on capital flows during this period and the models' inability to pick this up because of its assumption of no restrictions on capital outflows. During the 1980s, however, the actual deficit was generally larger than the constrained deficit, and toward the end of the decade it also exceeded the unconstrained deficit. This was corrected in the wake of the 1991 crisis, and the difference between the actual and constrained deficits has narrowed substantially in the 1990s. 7 While the Central Statistical Office (CSO) has recently revised and rebased (to 1993/94) national accounts data, the old GDP series was used in the estimation work as, at the time, a comprehensive breakdown on the expenditure side of the accounts in the new data was not available. As the newly revised series raised the estimated level of nominal GDP by around 10 percent relative to the old series, the ratios to GDP present in this section need to be scaled down by about 10 percent. All nominal series were deflated by the implicit GDP deflator.

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Figure 3.3. Current Account Balance, 1952/53-1998/99 (In percent of GDP)

ASSESSING INDIA'S EXTERNAL POSITION

Sources: Data provided by the Indian authorities; and staff calculations.

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A simple method to examine the relative performance of the two models is to compare the correlation between the actual current account and the unconstrained and constrained current accounts over the sample period. The correlation for the unconstrained model is actually much higher over the whole sample period than for the constrained model (0.7 against 0.23). The ability of the models to track the data, however, varies substantially during different time periods. The correlation of the unconstrained model with the actual deficit is high in the 1950s and 1980s, while the correlation between the actual and constrained current accounts is much higher during the 1960s-70s and the 1990s. Formal tests of the appropriateness of the two models are mixed. While evidence from Granger causality tests indicates that the constrained model performs better (as a predictor of changes in net income) than the unconstrained model, a Wald test is unable to reject the unconstrained model in favor of the constrained model, possibly due to the lack of precision with which the latter model is estimated. A Composite Model for Assessing External Sustainability

While the above results indicate that India satisfies its intertemporal budget constraint, questions may still arise as to the sustainability of its current account imbalances if lenders perceive that the intertemporal adjustments to consumption implied by the path of the imbalances raises doubts as to the willingness of a country to meet its external obligations. A recent approach to assessing external sustainability is to develop an empirical framework for predicting balance of payments crises (a socalled "early warning system") using economic and financial indicators likely to provide timely indications of a country's potential vulnerability. This approach attempts to determine if a country is vulnerable to the imposition of liquidity constraints by foreign investors who may become unwilling to continue lending on current terms if economic difficulties are experienced. These limits may be over and above those imposed by intertemporal solvency of the current account, the traditional approach to gauging external sustainability. The predictability of balance of payments crises has been examined in a number of recent papers (Kaminsky, Lizondo, and Reinhart, 1998; and Berg and Pattillo, 1999). In this section we apply the model developed by Berg and Pattillo to India. The approach is basically a multivariate probit model estimated on monthly data for a panel of 23 developing economies. The dependent variable takes a value of one if there is a balance of payments crisis within the next 24 months and zero otherwise. A crisis occurs when a weighted average of monthly percentage exchange rate depreciations and monthly percentage declines

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in reserves exceeds the mean by more than three standard deviations. Berg and Pattillo find that the probability of a crisis increases when the bilateral real exchange rate is relatively overvalued, reserve growth and export growth are low, and the ratio of the current account deficit to GDP and short-term debt to reserves are high. The estimated coefficients from the model can be used to generate predictions in the form of the probability of a crisis occurring in any one country during the next 24 months, given the current values of the explanatory variables in that country. Predicted probabilities above a certain threshold (typically taken as either 25 or 50 percent) indicate that the model is signaling the likelihood of a crisis (assuming unchanged policies) within the next 24 months. The signaling of an imminent crisis is, in effect, tantamount to the model indicating that under unchanged policies the external position is unsustainable. Of course, a crisis may not eventuate if appropriate policy actions are taken to address the underlying problems. The estimated probability of a crisis in India was high and rising during the second half of the 1980s, and well above the 25 percent threshold (Figure 3.4). Had the threshold level instead been 50 percent, this was crossed on two occasions in mid-1988 and late 1990. The crisis probability reached a peak in May 1991 at over 60 percent, just five months before the commencement of the IMF program. Crises, as defined in the model, occurred in April and July 1991 and also in March 1993 (represented by the bold vertical lines in the figure).8 These results are in line with evidence from the previous section that India breached its solvency constraint prior to 1991 by running excessive current account deficits in the 1980s. The aggregate crisis probability can be decomposed into the contributions of each of the five variables. As can be seen, the steadily rising probabilities during the second half of the 1980s were largely due to the widening current account deficit and the increase in short-term debt. The crisis probabilities declined quickly following the reform program implemented after the 1991 crisis and have generally remained low since. During 1997 and 1998, when the economy was buffeted by the Asia crisis, sanctions following the nuclear tests in May 1998, and the turmoil in world financial markets following the Russian default in August 1998, the crisis probabilities rose only moderately and remained well below the 25 percent threshold. This suggests that the reforms undertaken since the early 1990s, which have sought to encourage equity 8 The model's dating of the third crisis of March 1993 can be explained by that month's unification of the dual exchange rate system that had been in place since 1991, which resulted in a large effective devaluation of the rupee.

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Figure 3.4. 24-Month Ahead Crisis Probability and Relative Contributions of Economic Factors, 1986-99 1

Tim Callen and Paul Cashin

Source: Staff calculations. Calculations are based on the Berg et al. (1999) model. The solid vertical lines represent crisis dates (as defined in the model).

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and longer-term debt flows while also liberalizing current account transactions, have laid the foundation for a more sustainable external position.

Estimating the "Equilibrium" Current Account Deficit Several recent studies have applied a medium-term saving-investment balance approach to derive the fundamental or "equilibrium" current account position, although most of this work has focused on industrial countries (see Isard and Faruqee, 1998). A recent exception is the work of Chinn and Prasad (2000) who apply this framework to a large panel of industrial and developing countries. While this approach does not directly address the question of current account sustainability, it provides an indication of the current account level that may be considered "normal" based on the country's structural and macroeconomic attributes. Several factors affect saving and investment and the medium-term current account balance: • Fiscal policy will affect national saving through changes in public saving unless full Ricardian equivalence holds. Fiscal policy may also affect investment through real interest rates and its impact on business confidence. • Demographic factors affect private saving if, as the life cycle hypothesis suggests, older people save less. If a country has a relatively low dependency ratio, it would be expected to have a higher private saving rate than one with a higher dependency ratio. The dependency ratio may also affect public saving through its impact on the fiscal accounts. To the extent that capital-labor ratios are affected by the number of available workers, demographics may also affect investment. • The relative stage of a country's development also matters, as a country starting from a low-income base would be expected to narrow this gap over time. To do this it will need to undertake a higher rate of investment during the catch-up period. • Terms of trade volatility may induce countries to save more as a buffer against the variability of their income. Systematic changes in terms of trade volatility could affect saving and the current account balance. • Countries with a greater degree of openness to international trade may be able to finance larger current account deficits in the short run, as more open economies can have a greater capacity to generate foreign exchange earnings through exports, and hence be better able to service external debt.

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• Financial deepening can induce greater private saving by providing a vehicle for the accumulation of surplus funds, and thus be positively correlated with current account imbalances. The following equation (1) from Chinn and Prasad (2000) was used to derive estimates of the fundamental current account balance in India:9 Current Account/GDP = -0.033 Constant (1) +0.224 Govt. budget balance/GDP -0.091 Relative income (to the U.S.) +0.278 Relative income squared -0.045 Young dependency ratio -0.169 Old dependency ratio +0.038 Standard deviation of terms of trade/100 -0.027 Openness ratio +0.034 M2/GDP The equation suggests that both the large public sector deficit and the relatively low stage of economic development contribute to a larger current account deficit in India. The relatively low and declining dependency ratio has recently had a positive impact on the current account position through its impact on private saving. In addition, India's stable terms of trade and its relatively low level of financial development have both worked toward a larger current account deficit, by obviating the need for precautionary saving and by constraining the opportunities for private saving. India's lack of openness to trade, however, has had a positive impact on the current account by inhibiting its capacity to service (and thus to accumulate) external debt. While for most of the 1980s the actual current account deficit was close to the estimated equilibrium, in the late 1980s, just prior to the crisis, the actual deficit exceeded the equilibrium (Figure 3.5). The sharp contraction in the deficit during the crisis, however, saw it move closer to equilibrium, and, in general, it has stayed there during the 1990s. Indeed, during the past two years, the actual deficit has been roughly equal to the estimated "equilibrium" of around 11/4percent of GDP.

9 This is a restricted version of the equation presented by Chinn and Prasad. The constant term was set so that the average equation error was zero over the period 1980—95. Relative income is defined as per capita income relative to the United States. Dependency is defined as the share of the population under 15 years of age (young) and over 65 years of age (old) as a share of the population between 15-65 years of age, both measured relative to the mean of all developing countries.

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Figure 3.5. Actual and Fitted Current Account Balance, 1980-99 (In percent of GDP)

ASSESSING INDIA'S EXTERNAL POSITION

Sources: Data provided by the Indian authorities; and staff calculations.

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Assessing the Sustainable Current Account Over the Medium Term While the previous section provided an assessment of historic external sector developments, the methodologies employed generally do not permit an assessment of what current account deficit may be appropriate in the future. This is an important question, however, given that capital inflows have the potential to aid India's development process, while there is also a need to ensure these inflows are sustainable and used in an efficient manner. Addressing the issue of what is the appropriate current account level is difficult, and the answer will depend on many different factors. The 1993 High Level Committee on the Balance of Payments recommended that the current account deficit be contained to 1.6 percent of GDP "given the level of normal capital flows,"10 while in its 1996/97 Annual Report, the Reserve Bank of India suggested that under the circumstances prevailing at the time, India could sustain a current account deficit of 2 percent of GDP. A common approach to assessing the sustainability of a given path of the current account is to project into the future the current stance of macroeconomic policy and private sector behavior, and calculate the path of the current account that ensures the country's intertemporal budget constraint is not breached. This typically involves ensuring that the ratio of net external liabilities (NEL) to GDP remains at its current level (on the assumption that if this level is currently sustainable, then it should remain sustainable into the future). The dynamics of NEL (and thus the current account balance) can be shown to be determined by the following equation (assuming the "no Ponzi game" constraint is valid): Ab' (+1 =

r - y- Ae - yA€ (l + y)(l+Ae) b'-q',

(2)

where ' indicates that the variable is a ratio to GDP, /is the growth rate, X is the fraction of NEL denominated in foreign currency,11 r is the real rate of return on foreign liabilities, e is the rate of real appreciation of the domestic currency, bt is NEL, and qt is the current account balance net of payments on foreign liabilities. From equation (2), the q\ required to achieve any given level of b\ can be calculated given assumptions 10 Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan), 1993, Reserve Bank of India Bulletin, August. u A t end-1998, around 11 percent of India's external debt was denominated in rupees (Government of India, 1999). In the following sustainability scenarios, we assume that this ratio also applies to total external liabilities.

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ASSESSING INDIA'S EXTERNAL POSITION

about economic growth, the exchange rate, and the rate of return on foreign liabilities. In the first scenario (Table 3.1), the current account deficit that stabilizes the NEL-to-GDP ratio at its end-1998/99 level of 31 percent is calculated, given a constant real exchange rate and varying assumptions about the real growth rate and the real cost of foreign liabilities.12 For example, assuming that real GDP grows at 5 percent a year and the real cost of foreign liabilities is 4 percent, then the deficit on goods, services, and transfers must average 0.3 percent of GDP to maintain the NEL-toGDP ratio at 31 percent. With the cost of servicing the outstanding stock of external liabilities at 1.2 percent of GDP, this results in an overall annual current account deficit of 1.5 percent of GDP (compared to the actual deficit of 1.0 percent of GDP in 1998/99). If a higher growth rate of 7 percent per annum is achieved, a current account deficit of around 2.1 percent of GDP could be run. For each 1 percentage point increase in the cost of external liabilities or fall in the growth rate, the required increase in the goods, services, and transfers balance, required to keep the ratio of NEL-to-GDP constant, is about 0.3 percent of GDP. If, instead, a real depreciation of the rupee of 1 percent per year is assumed, a current account deficit of 1.3 percent of GDP would stabilize the NEL-to-GDP ratio at 31 percent of GDP with a growth rate of 5 percent per annum (Scenario 2). Given that the choice of maintaining a constant NEL-to-GDP ratio is somewhat arbitrary, two other scenarios are presented for comparison. In Scenario 3 the objective is to lower the NEL ratio to 21 percent of GDP over the next ten years. Under the same growth and interest rate assumptions as above, a current account deficit of only 0.5 percent of GDP could be run. If a rise in the NEL ratio to 41 percent of GDP could be accommodated—perhaps through an increase in foreign direct investment—a much larger current account deficit of 2.5 percent of GDP could be run (Scenario 4). These scenarios are designed only to be illustrative of the size of the current account deficits that could be sustainable into the future. What will actually prove sustainable will also depend on a large number of 12

While official estimates of external debt are regularly published, no estimates of equity liabilities are readily available. To derive an estimate of the outstanding stock of NEL, we therefore added the stock of external debt (23 percent of GDP at end-1998/99) to an estimate of the stock of equity liabilities calculated by accumulating (from 1970 onward) the flows of foreign direct and portfolio investment flows in the capital account of the balance of payments. This methodology obviously does not allow for valuation changes that have occurred since the flows were received. Using this method, the outstanding stock of equity liabilities was estimated at about 8 percent of GDP at end1998/99.

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Table 3.1. Scenarios of the Current Account Position (In percent of GDP)

Real Interest Rate (percent) 2 3 4 5 6

Net Investment Balance -0.62 -0.93 -1.24 -1.55 -1.86

Scenario 1 (Stabilize NEL)

Scenario 2 (Stabilize NEL with depreciation)

Scenario 3 (Reduce NEL)

Growth Rate of Real Income 3.00 5.00 7.00

Growth Rate of Real Income 3.00 5.00 7.00

Growth Rate of Real Income 5.00 7.00 3.00

-1.51 -1.52 -1.54 -1.55 -1.56

-0.30 0.00 0.30 0.60 0.90

-0.89 -0.59 -0.30 0.00 0.30

-2.07 -2.09 -2.11 -2.13 -2.15

Current Account Balance -0.65 -1.24 -1.80 -0.65 -1.25 -1.82 -0.66 -1.26 -1.84 -0.66 -1.27 -1.86 -0.67 -1.28 -1.87

0.08 0.07 0.06 0.05 0.04

Of which: Goods, Services, and Transfers Balance -1.45 -0.03 -0.62 -1.18 0.70 -1.16 0.28 -0.32 -0.89 1.00 -0.87 0.58 -0.02 -0.60 1.30 -0.58 0.89 0.28 -0.31 1.60 -0.29 1.19 0.58 -0.01 1.90

-0.51 -0.52 -0.54 -0.55 -0.56

-1.07 -1.09 -1.11 -1.13 -1.15

-1.92 -1.93 -1.94 -1.95 -1.96

-2.51 -2.52 -2.54 -2.55 -2.56

-3.07 -3.09 -3.11 -3.13 -3.15

0.11 0.41 0.70 1.00 1.30

-0.45 -0.16 0.13 0.42 0.71

-1.30 -1.00 -0.70 -0.40 -0.10

-1.89 -1.59 -1.30 -1.00 -0.70

-2.45 -2.16 -1.87 -1.58 -1.29

Notes: The entries in the upper panel of the table are the minimum current account balances required to meet certain objectives. The objective under Scenario 1 is to stabilize India's net external liabilities (NEL) at its current level of 31 percent of GDP, under the assumption of a constant real exchange rate. The objective under Scenario 2 is to stabilize NEL at its current level of 31 percent of GDP, given a real exchange rate depreciation of 1 percent per year. The objective under Scenario 3 is to reduce NEL to 21 percent of GDP by the year 2008/09, under the assumption of a constant real exchange rate. The objective under Scenario 4 is to raise NEL to 41 percent of GDP by the real exchange rate. In Scenario 2, it is assumed that the share of external debt, which is denominated in foreign currency, is 89 percent.

Tim Callen and Paul Cashin

-0.92 -0.93 -0.94 -0.95 -0.96

Scenario 4 (Increase NEL) Growth Rate of Real Income 5.00 3.00 7.00

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other factors. For example, if the deficits were to be financed mainly from direct investment flows, a larger outstanding stock of foreign liabilities could be maintained than if they were financed out of short-term debt flows (as was the case in the second half of the 1980s). Further, the sustainable level of capital flows is likely to be dependent on the continuation of structural reforms in the domestic economy, which will influence the return on the investment projects undertaken (represented by the high-growth scenarios in Table 3.1). As previously indicated, what may be a sustainable deficit under certain conditions in world capital markets may prove to be unsustainable under different circumstances. For example, a downturn in international investor confidence in developing markets may result in a reduction in capital inflows to India.

Summary and Conclusions This paper has applied a number of methodologies to examine India's external developments. The results indicate that the path of the current account deficit has been consistent with intertemporal solvency as it did not breach the intertemporal budget constraint. There is evidence, however, that the intertemporal budget constraint was not satisfied in the period up to 1990/91, and the return to smaller current account deficits in the 1990s has been needed to reestablish solvency. The composite model of early warning indicators also indicated that the path of the current account deficit in the period preceding the 1991 crisis was not sustainable, while the actual deficit was above its estimated equilibrium for much of the 1980s. The economic reforms undertaken since the early 1990s have brought about a more sustainable external position. The crisis probabilities also remained low during the Asia economic crisis, while the current account deficit appears to be around its equilibrium level at present. Estimates of what could be a sustainable current account deficit for India over the medium term indicate a range of11/2—21/2percent of GDP, although this is dependent on the economic and policy environment.

References Acharya, Shankar, 1999, "Managing External Economic Challenges in the Nineties: Lessons for the Future," Anniversary Lecture to the Centre for Banking Studies, Central Bank of Sri Lanka, Colombo, September. Berg, Andrew, and Catherine Pattillo, 1999, "Predicting Currency Crises: The Indicators Approach and an Alternative," Journal of International Money and Finance, Vol. 18, No. 4, pp. 561-86.

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Callen, Tim, and Paul Cashin, 1999, "Assessing External Sustainability in India," IMF Working Paper 99/181 (Washington: International Monetary Fund). Cashin, Paul, and C. John McDermott, 1998, "International Capital Flows and National Creditworthiness: Do the Fundamental Things Apply as Time Goes By?" IMF Working Paper 98/172 (Washington: International Monetary Fund). Chinn, M., and E. Prasad, 2000, "Medium-Term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration," IMF Working Paper 00/46 (Washington: International Monetary Fund). Debelle, Guy, and Hamid Faruqee, 1996, "What Determines the Current Account? A Cross-Sectional and Panel Approach," IMF Working Paper 96/58 (Washington: International Monetary Fund). Government of India, 1999, India's External Debt: A Status Report, Government of India Printer (India: New Delhi). Isard, Peter, and Hamid Faruqee, 1998, Exchange Rate Assessment: Extensions of the Macroeconomic Balance Approach, IMF Occasional Paper No. 167 (Washington: International Monetary Fund). Jalan, Bimal, 1992, "Balance of Payments, 1956-1991," in Bimal Jalan (ed.), The Indian Economy: Problems and Prospects (India: New Delhi). Joshi, Vijay, and Ian Little, 1994, India: Macroeconomics and Political Economy, 1964-1991 (Washington: The World Bank). Kaminsky, Graciela, Saul Lizondo, and Carmen Reinhart, 1998, "Leading Indicators of Currency Crises," Staff Papers (Washington: International Monetary Fund), Vol. 45, pp. 1-48. Kapur, Muneesh, 1997, "India's External Sector Since Independence: From Inwardness to Openness," Reserve Bank of India Occasional Papers, Vol. 18, Nos. 2 and 3, June and September. Kent, Christopher, 1997, "Essays on the Current Account, Consumption Smoothing, and the Real Exchange Rate" (Ph.D. dissertation; Cambridge, Massachusetts: Massachusetts Institute of Technology). Milesi-Ferretti, Gian-Maria, and Assaf Razin, 1996, Current Account Sustainability, Princeton Studies in International Finance No. 81, October, International Finance Section (Princeton, New Jersey: Princeton University). Montiel, Peter, 1994, "Capital Mobility in Developing Countries: Some Measurement Issues and Empirical Estimates," The World Bank Economic Review, Vol. 8, No. 3, pp. 311-50. Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan), 1993, Reserve Bank of India Bulletin, August. Reserve Bank of India, Annual Report, various issues. Sachs, Jeffrey, 1982, "The Current Account in the Macroeconomic Adjustment Process," Scandinavian Journal of Economics, Vol. 84, No. 2, pp. 147-59.

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PART II

Fiscal Challenges

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4 Tax Smoothing, Financial Repression, and Fiscal Deficits in India PAUL CASHIN, NILSS OLEKALNS, AND RATNA SAHAY1

Introduction Budget imbalances are pervasive in developing countries. Yet there are few studies asking whether this outcome is consistent with optimal fiscal policy. Five decades of time series data for India are examined to answer this question. The optimality criteria used to examine Indian fiscal policy is based on the concept of tax smoothing. Tax smoothing recognizes that in the presence of an increasing marginal social cost of raising tax revenue, it is optimal if the planned tax rate is constant (smoothed) over time (Barro, 1979).2 A smooth tax rate implies that temporary shocks to government spending and output yield fiscal imbalances, and it provides a rationale for the issuance of public debt. In this sense, the tax-smoothing hypothesis is the fiscal analog of Campbell's (1987) consumptionsmoothing model. l

The authors are grateful to Eduardo Borensztein, Timothy Callen, Ajai Chopra, Pietro Garibaldi, Nadeem Ul Haque, Mohsin Khan, Paul Masson, John McDermott, Xavier Sala-i-Martin, Patricia Reynolds, Parthasarathi Shome, M.R. Sivaraman, Peter Wickham, and especially Martin Muhleisen for their valuable comments and suggestions on earlier drafts, and Manzoor Gill for valuable research assistance. Any remaining errors are our responsibility. 2 As noted by Barro (1979, 1995), for a given amount of public expenditure, if taxes are lump sum and the other conditions for Ricardian equivalence are present, there are no

5.3

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TAX SMOOTHING, FINANCIAL REPRESSION, AND FISCAL DEFICITS

This paper tests for the presence of tax-smoothing behavior in India using data from 1951/52-1996/97 and the vector autoregressive approach of Huang and Lin (1993) and Ghosh (1995). This approach generates a time series for the optimal budget surplus, assuming that the government tax smooths, which is compared to the actual surplus. If smoothing is to hold, any differences between the two series should be quite small. We are also able to control for nontax-smoothing causes of fiscal deficits, enabling a more accurate test of the tax-smoothing model. The intertemporal tax-smoothing model successfully explains the behavior of Indian fiscal deficits. Our results also confirm previous findings that financial repression traditionally made a significant contribution to Indian net revenues. The financial repression-induced overborrowing of the 1970s and 1980s has yielded a stock of liabilities that deviates from the stock of liabilities generated from the series of optimal (tax-smoothing) fiscal deficits. As of 1996/97, the government's actual stock of public liabilities was about 18 percent of GDP higher than it would have been under optimal tax-smoothing policies, implying that fiscal surpluses (or at least smaller deficits) will need to be run in the future to ensure intertemporal solvency. The paper presents an overview of some features of Indian public finance. Key issues involved in testing for tax smoothing are then outlined, followed by a description of the econometric methodology and relevant data. The results from tests of tax smoothing and fiscal sustainability are then presented, and are followed by some concluding comments.

Issues in Indian Public Finance Indian Fiscal Outcomes Figure 4.1 (top panel) plots the fiscal position (gross fiscal deficit) of the Indian central government (CENGFD) between 1951/52 and 1996/97, where the gross fiscal deficit is the excess of aggregate disbursements (net of recovery of loans and advances) over receipts (revenue receipts, including external grants, plus nondebt capital receipts of government).3 The fiscal deficits of the center can be financed by borrowing real effects from shifts between taxes and the issuance of public debt as modes of financing fiscal imbalances. However, if taxes are distorting then the timing of taxes will matter, and it will be desirable to smooth tax rates over time, financing any temporary difference between public revenue and public expenditure by creating public debt. 3 The definition of the gross fiscal deficit follows that of the publications of the government of India, as it includes the proceeds from disinvestment in public sector enterprises in the center's revenue.

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Figure 4 . 1 . Indian Fiscal Outcomes, Central Government (In percent of GDP)

Sources: Government of India, Report on Currency and Finance (various issues); IMF, IFS (various issues); IMF staff estimates.

externally or domestically, chiefly through the issuance of public debt (see below for further details). Figure 4.1 (top panel) reveals that fiscal deficits (as a percent of GDP) have been large and persistent for the Indian central government. They can be characterized as growing during the 1950s, 1960s, and 1980s and contracting during the 1970s and the first half of the 1990s.

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TAX SMOOTHING, FINANCIAL REPRESSION, AND FISCAL DEFICITS

The balance of payments crisis of 1991 resulted in the near exhaustion of India's foreign exchange reserves, largely caused by the withdrawal of foreign currency deposits by nonresident Indians. While the trigger for the crisis lay in domestic political difficulties and the Persian Gulf war, concern over the sustainability of Indian fiscal policy, due to rising debt and debt servicing, was a key factor underlying the crisis (see Chopra et al., 1995, for details). Prior to the crisis, India financed its fiscal deficits largely through financial repression, with high reserve deposit requirements and statutory liquidity ratios inducing commercial banks to hold below-market-yielding public debt. Following liberalization of the financial system beginning in 1991, the government increasingly had to borrow at close to market rates of interest. This shift to market borrowing in the context of high primary deficits resulted in a sharp increase in the government interest bill. For example, central government interest payments (CENINT) rose by almost1/2of 1 percent of GDP between 1990/91 and 1996/97, even though the center's liabilities fell by over 6 percent of GDP over the same period. Figure 4.1 (bottom panel) illustrates that central government liabilities (CENLIAB) doubled as a percentage of GDP between the early 1950s and mid-1990s. Indian Financial Repression

As in many developing countries, governments in India have found it difficult to satisfy their intertemporal budget constraint with conventional revenue and borrowings of the type discussed above. In addition to market borrowing as a means of deficit financing, governments have also used the implicit taxation of financial intermediation, using quasifiscal activities such as seigniorage and financial repression as sources of fiscal revenue and reduced interest costs, respectively. Seigniorage—the purchasing power over real goods and services that comes about due to a central bank's monopoly over the issuance of reserve money—is typically passed on to the government either through central bank profits or via no- or low-interest loans to the government. Seigniorage taxes—the change in reserve money as a share of GDP— were an important component of Indian taxation over the period 1960/61—1994/95, representing on average 1.5 percent of GDP per year. Similarly, Fischer (1982) calculated that annual average Indian seigniorage revenues amounted to about 1 percent of GNP between 1960-76, or about 10 percent of government revenue. Click (1998) also recently calculated that annual average Indian seigniorage revenues over the period 1971-90 were about 1.7 percent of GDP, or about 12 percent of government spending.

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Financial repression in India traditionally involved domestic borrowing by the government at below-market interest rates, owing to banking regulations.4 The Indian cash reserve ratio (CRR) historically ranged between 4-7 percent of bank deposits, yet was steadily raised to 15 percent by the late 1980s to bolster demand for reserve money. Similarly, the statutory liquidity requirement (SLR) was raised from about 20 percent of deposits in the early 1960s to 38.5 percent in the early 1990s. Both requirements enabled the government to garner about half of all credit extended by the banking system between the early 1960s and early 1990s, at interest rates below those required to voluntarily acquire the debt. Consequently, banks invested in assets (consistent with CRR and SLR requirements) that barely covered their cost of funds (see Joshi and Little, 1996; IMF, 1996, 1997). At end-1999, the CRR and SLR (as shares of bank deposits) stood at 9 and 25 percent, respectively. Financial repression was also facilitated by a network of publicly controlled financial institutions. Nominal ceilings on institutional interest rates were used to limit competition from the private sector for the pool of loanable funds. Thus financial intermediaries typically set loan rates on private domestic credit that differed from the exchange-rateadjusted world interest rate. Indian governments also required their public financial institutions to undertake additional quasi-fiscal operations, involving activities such as the promotion of subsidized credit to priority areas of the private sector (such as agriculture and small-scale manufacturing), the setting of credit ceilings and floors, exchange rate guarantees, loan rate ceilings, and loan guarantees. The liberalization of India's financial sector in the 1990s, however, reduced the impact of many of these quasi-fiscal activities. For example, exchange guarantees were transferred to the government from the central bank, reserve requirements on commercial banks were reduced, and there occurred the removal of many of the restrictions on the setting of commercial bank interest rates (see Joshi and Little, 1996; IMF, 1996, 1997). Sustainability of Indian Fiscal Policies

India has a low level of public saving relative to other developing countries and experienced a steady decline in public saving over the past two decades (Muhleisen, 1997). Previous work examining the historical 4 Annual average revenue from financial repression in India has been estimated by Giovannini and de Melo (1993) at a sizable 2.86 percent of GDP and over 22 percent of government revenue (excluding revenue from financial repression) for the period 1980-85.

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TAX SMOOTHING, FINANCIAL REPRESSION, AND FISCAL DEFICITS

path of India's fiscal imbalances found that continuation of the trend of growing fiscal deficits during the 1980s was not consistent with the eventual repayment of public sector debt, and that there was little scope for seigniorage revenues to fill the fiscal gap (see, for example, Buiter and Patel, 1992). In addition, these studies argued that the positive value of India's primary fiscal deficit was inconsistent with a shrinking present discounted value of the debt stock. That is, if nominal interest rates exceed the GDP growth rate, primary surpluses (which have not been forthcoming) would be required to stabilize the debt-to-GDP ratio and ensure the sustainability of fiscal imbalances (see Reynolds, 2000, for a discussion of fiscal sustainability and solvency).

Testing the Tax-Smoothing Hypothesis The previous section highlighted how Indian governments have used revenues from financial repression to compensate for a shortfall in revenues from more conventional sources. This and later sections consider whether the raising of these revenues, with respect to both their magnitude and timing, has been optimal. This analysis uses the tax-smoothing model as our optimality benchmark. It also examines whether the accumulation of public liabilities, which involves both the tax-smoothing and tax-tilting components of fiscal deficits, is on a sustainable path. The tax-smoothing model assumes that, in the absence of a first-best system of lump-sum taxes, the government seeks to minimize the welfare losses arising from its choice of tax rate. These losses are assumed to be an increasing, convex, and time-invariant function of the average tax rate. The government's ability to minimize the tax-induced distortions is conditioned by its adherence to the intertemporal budget constraint. This requires the present value of tax receipts to be sufficient to cover all current and future government spending together with the government's initial debt. In order to meet the intertemporal budget constraint, taxes cannot remain invariant to changes in either current or expected future expenditure. Welfare losses will be minimized, however, if, in response to newly acquired information indicating a future change in government expenditure, the government smooths the implied tax change over time. Following the approach of Barro (1979), Ghosh (1995), and Olekalns (1997), the optimal budget surplus at time t (surt*) is given by surt*= | R ' E ( A g J l t )

(1)

where it is assumed that the effective interest rate faced by the government is R; the expectations operator is E; the information set available

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to the government at time t is It; A is the first difference operator; and gt is (exogenously given) government outlays excluding interest payments, Gt, normalized by the level of output, Yt.5 Implications of the Tax-Smoothing Hypothesis

Equation (1) states that the optimally chosen budget surplus is a linear function of expected future changes to government expenditure. The implication of an expected decline in government expenditure is that the government will reduce its budget surplus (possibly running a budget deficit), so that the tax reduction can be smoothed over time. An increase in the budget surplus is a signal that the government is anticipating an increase in its expenditure and is seeking to smooth the tax increase. The government's behavior is analogous to that of a consumer in consumption-smoothing models, who adjusts savings based on the expectation of future "rainy days" (see Campbell, 1987). There are four testable implications of tax smoothing that can be derived from equation (1). These are 1. The optimal tax rate changes only if there is new information concerning government expenditure. Accordingly, under rational expectations, tax changes should not be forecastable and should follow a random walk. 2. The budget surplus should Granger-cause (help predict) changes in government spending. This will be true whenever the government has better information about the future path of its expenditure than is contained in past values of the expenditure series. 3. The smoothed budget surplus should be stationary. Assuming that gt is I(1), then Agt will be I(0); since under the null hypothesis the actual (tax-smoothed) budget surplus is the discounted sum of Agt (see equation (1)), then the smoothed budget surplus will also be

I(0). 4. The optimal smoothed surplus derived from equation (1) should differ from the actual, smoothed surplus by at most a random sampling error. Why Run Deficits? Separating Tax Smoothing and Tax Tilting

There are two broad considerations motivating any government to run a budget deficit: tax tilting and tax smoothing. The analysis, up to 5

When the rate of real output growth, n, is positive, the effective interest rate faced by the government (R-1 = (1+r)/(1+n)) will be smaller than the actual market interest rate, (1+r), where r is the assumed (constant) real rate of interest.

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this point, has assumed that only tax smoothing motivates the government to run either a budget deficit or a budget surplus. However, other intertemporal incentives for running unbalanced budgets exist. Even if we assume that government spending as a share of GDP will remain constant into the future (in which case there would be no need for tax smoothing), if the government's subjective discount rate (reflecting the preference for current taxation over future taxation), B, differs from the effective interest rate, R, then the optimal tax rate will be affected by the government's desire to engage in tax tilting. As noted by Ghosh (1995), the relationship between B and R is given by y=[(1-(R/B)R)/(1-R)], where y, the tax-tilting parameter, accounts for the fact that the optimal tax rate incorporates incentives for the government to defer taxes or enlarge surpluses, depending on the relationship between B and R. That is, when P=R (y=1), the government's optimal tax profile will be "tilted." Tax tilting results in a bias toward either budget deficits or budget surpluses, which are created in a manner consistent with intertemporal solvency. For example, if Bt (1) where i indexes the economy, t is time, T is the length of the observation period, y denotes per capita income, and £ is a random disturbance term. X is the convergence coefficient, which gives a measure of how quickly an economy is closing the gap between its current position and its steady state.6 It is apparent that X may be recovered from the coefficient on lagged income. It is useful to note two key features of equation (1). The first is the constant term C , which is not indexed by economy and therefore incorporates the assumption that all economies have the same steady state. The second is that the length of the observation period, T, is crucial to the exercise undertaken. This is because equation (1) is valid only under the assumption that there are no factors at work to change the steady state during the observation period; this may be valid for small values of T, but certainly not for large values. Cashin and Sahay take T=10 and examine the four subperiods between 1961 and 1991, for a sample of 20 Indian states. Although they find evidence of convergence in all four subperiods, their results are not statistically significant. It is only when they introduce additional variables that control for the share of agriculture and manufacturing in total output (which can be viewed as structural variables that proxy for differing steady states) that some, but not all, of the estimated coefficients 5

Equation (1) is derived from the standard Ramsey model with a Cobb-Douglas production function. In this model one is able to obtain two differential equations: one describing the evolution of capital per effective worker and the other describing the evolution of consumption per effective worker. A log linearization of this system of differential equations enables us to express the growth rate of the economy near the steady state as a function of lagged income, to which we add an error term to obtain equation (1). For a complete derivation see Appendix 2 A of Chapter 2 in Barro and Sala-i-Martin (1995). 6 It can be shown that the "half-life" of the convergence process is given by (In2)/A. Thus, for example, a convergence coefficient of .05 corresponds to a half-life of 14 years—this is the period it takes for the economy to close half the distance between its current level of output per effective worker and its steady state level.

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become significant. They conclude that there is evidence of (weak) convergence over the period taken as a whole.7 Bajpai and Sachs follow a very similar approach, examining a sample of 19 Indian states between 1961 and 1993, which is subdivided into three periods. They, too, have difficulty in obtaining statistically significant results. Only for the subperiod 1961-71 do they find evidence of convergence; for the period as a whole, the hypothesis of convergence is rejected. When the initial share of agriculture in output is included as a control variable, the results improve marginally but their qualitative conclusions are not altered. Rao, Shand, and Kalirajan look at a sample of 14 states over the period 1965—94, divided into various subperiods. They find evidence of divergence in every subperiod they consider, both in the basic regression and the regression with the share of the primary sector as a control. The difference between their results and those of the other two papers mentioned is startling. So, it is worth emphasizing that they work with a smaller sample of states and that their data source for state product estimates is different. Certain common points may be noted about all three papers. First, they assume a common intercept for different regions, implying that all the states of India have an identical steady state toward which they are converging or from which they are diverging. In doing this, they follow in the tradition of the interregional empirical work discussed earlier. Second, all these studies introduce an explanatory variable—such as the share of agriculture, the share of manufacturing, or a weighted sectoral index—to control for production shocks that are correlated across regions. As would be expected if there were heterogeneous steady states, the introduction of these additional variables causes an increase in the estimate of A. For example, Cashin and Sahay find that introducing the control not only leads to a significant estimate of X for the period as a whole, but also drastically raises the estimate. Similarly, in Bajpai and Sachs, the one significant convergence coefficient found (for the period 1961-71) is raised with the introduction of the control. In Rao et al., the speed of divergence is reduced for every subperiod that they examine once the share of the primary sector is taken into account. While these earlier studies point in the direction of conditional convergence, however, the fact that they do not explicitly consider the possibility of different intercepts is an important drawback. 7 Cashin and Sahay also carry out an exercise that is not repeated in this paper: they examine the role of interstate migration in the convergence process. They find that the response of migration to interstate differences in income is "anemic," and that controlling for migration makes very little difference to their estimate of convergence.

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Regional Disparities: The Empirical Record Facts Tables 8.1-8.4 and Figures 8.1-8.3 (on the following pages) highlight some of the regional disparities among 19 of India's states for which data have been gathered. It will be immediately apparent that these disparities are both enormous and persistent. The dispersion of per capita income, literacy rates, rates of urbanization, and other social and demographic indicators are all greater than those commonly found in relatively homogenous groups of countries (such as the OECD, or Europe). Table 8.1 and Figures 8.1 and 8.2 summarize movements in per capita real income during the 1971-96 period. The states can be conveniently grouped into three categories according to their status in 1971: the six poorest—Manipur, Bihar, Orissa, Madhya Pradesh, Uttar Pradesh, and Tripura; seven middle-income states—Assam, Jammu and Kashmir, Tamil Nadu, Andhra Pradesh, Kerala, Rajasthan, and Himachal Pradesh; and the five richest states—Punjab, Haryana, Gujarat, Maharashtra, and West Bengal. The income gaps have been profound. In 1971, Punjab, the richest state, was more than twice as rich as the poorest state, Manipur; by 1996 the difference was even more marked, with Punjab enjoying more than three times the income-level of the poorest state, Bihar. Differences in growth rates also have been large. For example, Maharashtrian incomes grew annually at a rapid pace of 3.4 percent over the period as a whole, while Bihari incomes remained almost stagnant, increasing at an annual rate of only 0.2 percent. There has also been considerable variation in performance within the three groups. Regional disparities are seen in other indicators of development (Table 8.2). Annual population growth in the two southernmost states of India, Tamil Nadu and Kerala, was only about 1.4 percent and 1.5 percent, respectively, during the period, whereas population growth reached 2.5 percent in Rajasthan and 2.4 percent in Manipur. There are significant differences in urbanization across states—for example, Himachal Pradesh in 1991 was still overwhelmingly rural, while in Maharashtra the proportion of city dwellers was approaching 40 percent. Table 8.3 and Figure 8.3 document literacy across states. In 1971, Kerala, with a literacy rate of 60 percent, was well ahead of any other state; all other states had a rate under 40 percent. In 1991, Kerala remained at the top of the list, and Bihar and Rajasthan remained the most illiterate states.8 During this 20-year period, literacy improved in every state 8

Kerala is exceptional among the Indian states for the sharp and persistent dichotomy between its social indicators, which are of an almost first-world standard, and its levels

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Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Orissa Punjab Rajasthan Tamil Nadu Tripura Uttar Pradesh West Bengal

2,992 2,737 2,056 4,240 4,486 3,468 2,803 3,279 3,038 2,476 4,005 1,949 2,445 5,473 3,330 2,972 2,568 2,486 3,693

Rank in 1971

Income in 1996 (1990/91 prices)

Rank in 1996

10 13 18 3 2 6 12 8 9 16 4 19 17 1 7 11 14 15 5

5,504 3,872 2,170 7,375 8,324 5,386 3,806 5,778 5,126 4,014 9,518 4,257 3,813 9,879 4,285 6,294 3,130 3,617 5,178

7 14 19 4 3 8 16 6 10 13 2 12 15 1 11 5 18 17 9

Source: Central Statistical Organization.

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Annualized Growth Rate 1971-96 (percent) 2.4 1.4 0.2 2.2 2.5 1.8 1.2 2.3 2.1 1.9 3.4 3.1 1.8 2.4 1.0 3.0 0.8

1.5 1.4

Rank

5 14 19 8 4 12 16 7 9 10 1 2 11 6 17 3 18 13 15

GROWTH THEORY AND CONVERGENCE ACROSS INDIAN STATES

Andhra Pradesh Assam Bihar

Income in 1971 (1990/91 prices)

150

Table 8.1. Per Capita Real Income, 1971-96

Shekhar Aiyar

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Figure 8 . 1 . Per Capita Income in Selected States, 1971-96

Source: Central Statistical Organization.

without exception, but not at a rapid pace (apart from Haryana and Himachal Pradesh, which both doubled their literacy rates over 20 years). The literacy charts for 1996 show a remarkable improvement for almost every state.9 Bihar and Rajasthan are now the only states in India of per capita income and growth performance, which are relatively mediocre. For a discussion of this issue, see Ramachandran (1997). Statistics like this inevitably lead to suspicions about the quality of data available. In fact the literacy charts for 1991 are from the population census while the charts for 1996

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Figure 8.2. The Evolution of Real Per Capita Income Across States (In 1990/91 rupees)

GROWTH THEORY AND CONVERGENCE ACROSS INDIAN STATES

Source: Central Statistical Organization.

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Table 8.2. Population and Urbanization, 1971-96 Population 1996 (millions of persons)

Annualized Population Growth Rate 1971-96 (percent)

43.5 14.6 56.4 26.7 10.0 3.5 4.6 29.3 21.3 41.7 50.4 1.1 21.9 13.6 25.8 41.2 1.6 88.3 44.3

72.0 26.7 95.4 44.8 18.2 5.6 8.5 48.2 31.0 72.5 86.3 2.0 34.4 22.1 48.4 58.4 3.0 150.7 73.6

2.0 2.4 2.1 2.1 2.4 1.9 2.5 2.0 1.5 2.2 2.2 2.4 1.8 1.9 2.5 1.4 2.5 2.1 2.0

Land Area (square kilometers)

Population Density 1971 (persons per square kilometer)

Population Density 1996 (persons per square kilometer)

Urban Population 1961 (percent of population)

Urban Population 1991 (percent of population)

275,045 78,438 173,877 196,024 44,212 55,673 101,236 191,791 38,863 443,446 307,713 22,327 155,707 50,362 342,239 130,058 10,486 294,411 88,752

158 186 324 136 226 63 45 153 548 94 164 49 141 270 75 317 153 300 499

262 340 549 229 412 101 84 251 798 163 280 90 221 439 141 449 286 512 829

17.4 7.2 8.4 25.8 17.3 6.4 16.6 22.3 15.1 14.3 28.2 9.0 6.3 23.1 16.3 26.7 8.8 12.9 24.5

26.8 11.1 13.2 34.4 24.8 8.7 23.8 30.9 26.5 23.2 38.7 27.7 13.4 29.7 22.9 34.2 15.3 19.9 27.4

Source: Central Statistical Organization.

ShekharAiyar

Andhra Pradesh Assam Bihar Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Orissa Punjab Rajasthan Tamil Nadu Tripura Uttar Pradesh West Bengal

Population 1971 (millions of persons)

153

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Literacy in 1971 (percent of population) 25 29 20 36 27 32 19 31 60 22 39 33 26 34 19 39 31 22 33

Rank in 1971

Literacy in 1991 (percent of population)

14 11 17 4 12 8 19 9 1 15 3 7 13 5 18 2 10 16 6

44 53 38 62 56 64 48 56 90 44 65 60 49 58 38 63 60 42 58

Rank in 1991

Literacy in 1996 (percent of population)

Rank in 1996

16 12 19 5 11 3 14 10 1 15 2 7 13 8 18 4 6 17 9

51 73 44 66 62 71 58 57 91 52 72 68 57 66 48 66 76 50 66

16 3 19 10 11 5 12 14 1 15 4 6 13 9 18 8 2 17 7

Source: National Sample Survey Organization.

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Andhra Pradesh Assam Bihar Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Orissa Punjab Rajasthan Tamil Nadu Tripura Uttar Pradesh West Bengal

154

Table 8.3. Literacy, 1971-96

Figure 8.3. The Evolution of Literacy Rates (In percent)

ShekharAiyar

Source: Central Statistical Organization.

155

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Figure 8.4. Standard Deviation of Log Real Income

Source: Central Statistical Organization.

with a literacy rate under 50 percent, and Kerala is approaching OECD standards of literacy. The dispersion of literacy rates, as shown in Figure 8.4, after increasing steadily up to the 1990s, also diminished over the last five years. Regional disparities remain profound, however, and female literacy continues to lag in every state. In Bihar and Rajasthan female literacy in 1996 was only 29 percent. Other social indicators also vary widely across the states (Table 8.4). For example, the gap between infant mortality and poverty rates in the best-off and worst-off states is enormous in both cases. In the case of infant mortality, Kerala's record is again outstanding, and that of the "heartland" states is dismal. In accordance with the conventional wisdom that diverse social indicators tend to move together, the infant mortality rate is fairly closely correlated with the literacy rate across the Indian states— in 1996 the correlation was 0.74, with the expected negative sign. Patterns The evidence surveyed so far presents a picture of large disparities in both levels and growth rates of per capita income. Some interesting patterns may be gleaned from this record, which have a bearing on whether or not the convergence predicted by growth theory has been at work, and, if it has, whether it is conditional or absolute in nature. are from the 52nd round of the National Sample Survey. While the two sources often arrive at different estimates of the number of people in the economy, the number of literate persons, etc., their estimates of literacy rates are usually thought to be comparable.

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Table 8.4. Social Indicators, 1976-96

123 144 — 154 114 115 68 80 54 151 92 — 149 98 155 112 — 198 —

Rank in 1976

Infant Mortality Rate 1996 (percent of live births)

Rank in 1996

9 10 — 13 7 8 2 3 1 12 4 — 11 5 14 6 — 15 —

63 76 73 62 69 61 — 62 15 99 55 — 103 54 86 54 — 86 58

9 12 11 7 10 6 — 7 1 15 4 — 16 2 13 2 — 13 5

Poverty Rate 1978 (percent of population below poverty line)

Poverty Rate 1994 (percent of population below poverty line)

Annualized Percent Change in Poverty Rate

47.0 — 64.8 39.9 —

29.4 — 60.4 33.8 —

2.9 — 0.4 1.0 —

— 52.9 53.2 63.9 67.8 — 62.1 26.9 51.6 54.9 — 46.7 51.8

— 37.6 29.2 44.1 43.5 — 40.3 21.6 43.5 34.9 — 40.2 26.0

— 2.1 3.7 2.3 2.7 — 2.7 1.4 1.1 2.8 — 0.9 4.2

Source: The World Bank.

Shekhar Aiyar

Andhra Pradesh Assam Bihar Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Orissa Punjab Rajasthan Tamil Nadu Tripura Uttar Pradesh West Bengal

Infant Mortality Rate 1976 (percent of live births)

157

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It is generally the case that initially rich states have tended to remain rich and initially poor states have tended to remain poor. This implies a positive correlation between initial income and final income. But, more troublingly, there is also a positive correlation between initial income and growth. Table 8.5 shows the simple correlation coefficient between growth rates (broken up by decade) and the initial values of certain variables. The correlation between income at the beginning of the decade and the growth rate over the decade is negative only for the 1970s. It is small but positive for the 1980s, and large and positive for the five years of the 1990s. For the period as a whole, the correlation between initial income and growth is positive. All this is at least suggestive of absolute divergence since the 1980s (if not before) and, moreover, of accelerating divergence. This conjecture is reinforced by Figure 8.5, which depicts the standard deviation of the log of real per capita income over time.10 Again, there is a clear upward trend for the period as a whole, which grows more pronounced from the mid-1980s onward. It is interesting that the rapid absolute divergence of the 1990s coincides with the period of India's economic liberalization program. Although the precise relationship between liberalization and divergence must await a study that focuses specifically on this issue, liberalization appears to have disproportionately benefited those states with high current per capita incomes. One possible explanation is that these states had better social and economic infrastructures in place and were in a better position to take advantage of the reduction in impediments to private economic activity. Conditional convergence is examined by considering two variables that might have a bearing on a region's steady state, the literacy rate (LIT) and private capital investment (PVK), the latter of which is proxied by the amount of credit extended in a region by India's Scheduled Commercial Banks (SCB).11 The correlation of private investment in the initial year with growth in the subsequent decade is positive for all three subperiods. Moreover, in each subperiod, this correlation is stronger than the correlation with initial income. As with initial income, the correlation is weakest in the 1970s and strongest in the 1990s. 10 A narrowing trend for this measure of dispersion is sometimes referred to as oconvergence, which is quite different from the (B-convergence discussed in this paper. 11 PVK is measured in thousands of rupees per person. There are reasons to be somewhat wary of this proxy. Although lending by the SCBs to the private sector dwarfs lending by other institutions, credit tends to be extended not just for new investments but also as working capital. Nonetheless, we would expect there to be a strong correlation between credit extended for the two different purposes. This is certainly the case at the national level—the correlation between SCB credit extended and gross private capital formation was 0.93 over the period in question.

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Table 8.5. Correlations Between Growth Rates and Initial Values of State and Control Variables Annualized Annualized Annualized Annualized Growth Growth Growth Growth Rate Rate Rate Rate 1971-81 1981-91 1991-96 1971-96

Log Real Per Capita Income 1971 Log Real Per Capita Income 1981 Log Real Per Capita Income 1991

-0.26

0.33 0.04 0.60

Literacy Rate 1971 Literacy Rate 1981 Literacy Rate 1991

0.11

Literacy Rate (excluding Kerala) 1971 Literacy Rate (excluding Kerala) 1981 Literacy Rate (excluding Kerala) 1991

0.18

PVK 1971 PVK 1981 PVK 1991

0.01

0.48 0.04 0.53 0.66 0.16 0.56 0.51 0.34 0.69

Figure 8.5. Standard Deviation of Literacy Rate

Source: Central Statistical Organization.

As expected, initial literacy is also positively correlated with growth in every subperiod. For the period as a whole, this correlation is stronger than that with initial income. As noted earlier, Kerala is also an outlier with respect to the other states in our sample. Excluding Kerala leads to much higher correlations in every subperiod, and a very high positive correlation for the period as a whole. Correlations by themselves establish very little, but Table 8.5 does comprise circumstantial evidence that literacy and private investment are variables that influence subsequent growth, and that should therefore be controlled for in ascertaining conditional convergence.

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Econometric Analysis Methodology The previous discussion strongly suggests that an econometric study of convergence across regions in India needs to control for differences in steady states. This can be achieved in a framework consisting of a dynamic panel with fixed effects, as described in Knight, Loayza, and Villanueva (1993), Islam (1995), and Lancaster and Aiyar (1999). Our general specification is described by the following equation: lrvy y\nyit_Te-r + S'W Tfc + $, ^,t In*,,i|t = rln;y,, &Witltt + r?,

(2) (2) where i indexes the region, t the time period, y denotes real per capita income, T denotes the number of years between each successive observation, 7] is a region-specific time invariant fixed effect, and £ is a random disturbance term. W is a vector of explanatory variables, which in our case comprises two variables, LIT and PVK. S is the corresponding coefficient vector. The coefficient on the log of lagged income, y, is equal to e~^T, where X is the convergence coefficient. This fixed-effects formulation allows us to control for unobserved differences between the steady states of regions in addition to the observed differences captured by the W vector.12 Identification of the fixed effects is only possible in a panel framework—the previously cited studies of Indian regional development all used a cross-section approach and so could not identify fixed effects. To the extent that the fixed effects are correlated with the explanatory variables (including lagged income), their omission leads to an omitted-variable bias. Since the presumed correlation with lagged income is positive, the coefficient for this variable would be biased upward in a cross-section study, implying that the convergence coefficient A will be underestimated.13 Thus, consideration of a fixed-effects framework would be expected to yield higher estimates of convergence relative to the cross-section studies that have gone before. 12 The reason for adopting a fixed-effects formulation instead of a random effects one is that, in the latter approach, one must assume that the effects are uncorrelated with the exogenous variables included in the model. This is almost certainly not the case in the framework assumed above. The fixed effect may be thought of as representing "technology," or the efficacy with which inputs are transformed into outputs; it seems inevitable that this is not independent of an explanatory vector of variables important to the growth process. 13 This is just another way of making the point that absolute convergence differs from conditional convergence: the former will always tend to be smaller than the latter because of the bias arising from the omission of appropriate conditioning variables.

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Estimation of a dynamic panel with fixed effects presents technical difficulties. Lancaster (1997) describes a method for obtaining consistent, likelihood-based estimates by seeking an orthogonal reparameterization of the fixed effects in the model. Unfortunately, this estimator is not applicable in the present case since it does not allow for the possibility of heteroskedasticity in the sample. Chamberlain's Il-matrix approach has been widely used for panel studies of this nature. Its use is precluded here, however, since we have only 19 states in our sample, and the weighting matrix becomes nearly singular. We therefore employ the Least Squares with Dummy Variables (LSDV) estimator. This estimator is known to be inconsistent in the direction of N, but Amemiya (1967) has shown that it is consistent in the direction of T and asymptotically equivalent to maximum likelihood estimation. Moreover, it seems that in practice the estimates obtained by LSDV and the IImatrix approach are very similar, at least in cross-country panel studies (Islam, 1995). Using data for each consecutive year has the disadvantage of increasing the likelihood of serial correlation due to business cycle effects. Using long period averages, however, risks obscuring changes in the steady state that have occurred during the period. In order to balance these two concerns, the present study uses a panel of five-year spans ( T = 5 ) . For example, for the first observation, the dependant variable is the log of real per capita net state domestic product in 1976, and lagged income on the right-hand side (RHS) is for the year 1971. To minimize the risk of simultaneity bias, the other control variables are also lagged five years. Standard errors are estimated using White's variance-covariance matrix, which is robust to heteroskedasticity of an unknown form. Results Table 8.6 presents the results of two regressions. Regression 1 illustrates the statistical effect of assuming a common steady state. In this case, a common intercept is assumed for every region and the other control variables are omitted. The results are dramatic—the coefficient on lagged income is a statistically significant 1.07, with an implied convergence rate of minus 0.013. In other words, we find evidence of absolute divergence at the rate of 1.3 percent over a five-year period. Regression 2 includes fixed-effects coefficients for each state, and the control variables, LIT and PVK. An F-test rejects, at the 5 percent level of significance, the null hypothesis that all the fixed effects are equal to one another. In other words, the hypothesis of a common steady state is implausible.

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Table 8.6. Regressions with the Log of Real Per Capita Income as the Dependent Variable1 Regression 1 Constant y i,t-t LIT PVK Lambda2 R-squared Adjusted R-squared

Regression 2

-0.469 (0.272) 1.069 (0.033)

-0.013 (0.006) 0.902 0.902

0.369 0.762 0.147 0.199 0.946 0.930

(0.129) (0.277) (0.035) (0.070)

1

Standarderrors reported in parentheses. Coefficientof convergence.

2

Both control variables have a positive and significant effect on growth. The coefficient on LIT is 0.76, which implies that a 1 percentage point increase in literacy corresponds to an increase in the five-year period growth rate of per capita income of almost8/10of a percentage point- The strength of this relationship probably reflects the fact that literacy proxies for other social indicators that tend to move in a similar direction, such as life expectancy and various measures of health. The coefficient on PVK is 0.15, which implies that a 1 percentage point increase in investment per person raises the growth rate by 0.15 percentage points. The effect of the conditioning variables in Regression 2 is extremely strong, and so we would expect to find much stronger convergence than that found by previous studies. This is indeed the case; the coefficient on lagged income is 0.0379, which implies an extremely high convergence coefficient of 0.199 and a half-life of about 31/2years.14 Table 8.7 lists the fixed effects recovered from Regression 2. Since we did not, in our study, work from an explicit production function, it is not possible to attach a precise interpretation to these region-specific effects, other than to note that they act as proxies for each region's steady state.15 However, in their role as steady state proxies, and given 14

Although this convergence coefficient is quite high, it is worth bearing in mind that this is the rate of convergence after controlling for steady states, and that inequalities of income and growth in India are seemingly driven by wide differences in steady states rather than by slow convergence. Other studies have also found very high rates of convergence with the introduction of suitable control variables—notably Caselli, Esquivel, and Lefort (1996), who estimated a convergence rate of 0.128 (implying a half-life of 5 1/2 years) for a sample of 97 heterogeneous countries. 15 Knight, Loayza, and Villanueva (1993) and Islam (1995) start with an explicit neoclassical production function, and are thus able to derive the relationship ui = (1 — e-At)lnA(0),-, where u is the fixed effect and A(0) represents "technology" broadly defined in the initial period of observation.

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that we have already controlled for literacy and the amount of investment, we may regard them as a measure of the efficiency with which the different regions are converting inputs into outputs. Thus they are related to the conventional notion of total factor productivity (TFP) with the important difference that TFP is computed for individual economies on the basis of only their own time series data, whereas the fixed effects here are inherently based on an interregional comparison. We find that the fixed effects are highly and positively correlated with initial income; the simple correlation coefficient is 0.65. Their correlation with growth rates over the period as a whole is also positive at 0.32. These results are in line with what we would expect from studies of samples of heterogeneous countries. An examination of the regions by rank of their fixed effects yields one rather striking result, namely, Kerala's place at the bottom of the table, comfortably under even Bihar. This would be an indication that Kerala has been inefficient in translating its enviable human capital resources into commensurate increases in output per capita, but may also reflect the fact that much of Kerala's educated population has been able to migrate elsewhere. Punjab and Haryana top the table, and, in general, initial income is a good predictor of a state's rank by this measure. Note that the large values obtained for the fixed effects and their considerable dispersion suggest that there are important factors determining the steady states of regions that are not accounted for by this study.

Table 8.7. Fixed-Effects Estimates

Andhra Pradesh Assam Bihar Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Orissa Punjab Rajasthan Tamil Nadu Tripura Uttar Pradesh West Bengal

Fixed Effect

Rank

4.891 4.769 4.631 4.917 5.130 4.887 4.897 4.800 4.550 4.857 4.846 4.828 4.760 5.130 4.867 4.716 4.697 4.802 4.779

5 14 18 3 1 6 4 12 19 8 9 10 15 2 7 16 17 11 13

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Policy Implications

These results strongly suggest that states in India are converging to different steady states, and that these steady states are determined, at least in part, by literacy rates and private investment. The question then naturally arises as to what governments can do to improve literacy and attract private investment, thus raising the steady state output of their region and generating rapid growth. There are undoubtedly numerous factors that determine LIT and PVK for a given region. Here we consider only two that are amenable to direct manipulation by policymakers—capital expenditures by state governments on social infrastructure (SOC) and capital expenditures by state governments on economic infrastructure (ECO). The first variable measures expenditures on categories such as education, water supply, sanitation, and medical and public health, while the second variable represents expenditures on transportation, power and electricity, telecommunications, and irrigation projects. Both variables are measured in thousands of Rs per person. It seems reasonable that government spending in these areas contributes to human capital and promotes private investment.16 Therefore we regress LIT and PVK in turn on both SOC and ECO, in the same fixed-effects panel framework followed thus far. Table 8.8 documents the results, which suggest that both SOC and ECO are significant in accounting for the literacy rate, with coefficients of 2.54 (0.50) and 0.69 (0.22), respectively. These policy variables appear to play an even more important role in influencing private investment; in the equation for PVK, the coefficients on SOC and ECO are 4.77 (1.77) and 3.64 (1.03), respectively. These regressions are therefore indicative of two channels through which governments can attempt to alter the steady states of their economies. To test the robustness of these results, we also fit a Cobb-Douglas "production function" with LIT and PVK taken one by one as the outputs; the inputs are SOC and ECO, along with a multiplicative regionspecific efficiency parameter. The results of this regression, in which coefficients represent elasticities, are detailed in Table 8.9. The elasticities of the literacy rate with respect to SOC and ECO are, respectively, 0.24 (0.05) and 0.10 (0.08), although the latter estimate is no longer statistically significant. The elasticities of private investment with respect to SOC and ECO are, respectively, 0.65 (0.10) and 0.46 (0.15). These elasticity estimates, which are both large and highly significant, appear to confirm the efficacy of government investment in infrastructure in 16 Studies indicating a complementarity between public infrastructure and private investment include Greene and Villanueva (1991) and Seitz and Licht (1992).

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Table 8.8. "Production Function" Regressions with LIT and PVK as Outputs1 Dependent Variable SOC ECO R-squared 1

LIT

PVK

2.54 (0.50) 0.69 (0.22) 0.64

4.77 (1.77) 3.64 (1.03) 0.78

Standard errors reported in parentheses.

Table 8.9. "Production Function" Regressions with In (LIT) and In (PVK) as Outputs 1 Dependent Variable In (SOC) In (ECO) R-squared 1

In (LIT) 0.24 (0.05) 0.10 (0.09) 0.61

In (PVK) 0.65 (0.10) 0.46 (0.15) 0.81

Standard errors reported in parentheses.

attracting private investment and improving the stock of human capital. It is noteworthy that the regressions indicate that social expenditures have an even greater impact than expenditure on physical infrastructure.17

Conclusion One of the main purposes of this study was to show that in a country as diverse as India, there is a meaningful difference between conditional and absolute convergence. It has been shown that the neoclassical model's prediction of convergence is of a conditional nature and that convergence among the Indian states is proceeding apace. By demonstrating a concomitant process of absolute divergence, however, our work suggests that the really important and interesting feature of regional growth is not an economy's distance from its steady state (that is being closed rapidly at any point in time), but the factors that determine that steady state. This conclusion is important, since it suggests that there is scope for policy to improve the growth rate of per capita incomes. We have identified two factors that seem to be extremely important in determining a region's steady state level of income: literacy and per capita private investment. In particular, even modest improvements in literacy and private investment appear to have a substantial positive effect on growth. Furthermore, the results suggest that both literacy and 17

The positive impact of state government health and education expenditures on human capital formation has also been studied in Reserve Bank of India (1993).

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private investment can be influenced by policy, and hence individual state governments can play an important role in enhancing their own growth prospects. In practice, however, the ability of state governments to increase expenditures on social and economic infrastructure is greatly dependent on their financial positions. This ability has been adversely affected by rising deficits in recent years, owing to stagnant revenue collections and increasing expenditures on civil service salaries and interest payments. Thus, fiscal reform—particularly at the state level and with respect to fiscal-federal relations—will be an important ingredient for improving steady state levels of incomes across India. Enhancing the flow of private investment spending on infrastructure will also be important. Recent efforts by some states to liberalize private sector participation in the power sector and to implement Build, Operate, and Transfer systems for roads and bridges are encouraging and would be bolstered by further liberalization and deregulation at the central government level. In addition, significant differences in growth performance and steady states have been found that are not explained by literacy and private investment rates. If cross-country studies and anecdotal evidence are anything to go by, we would suspect the fixed effects to capture factors like the degree to which the rule of law is observed and enforced, the degree of bureaucratic control and inefficiency in the economy (which bears a strong relationship to the pervasiveness of corruption), the relations between organized labor and industry and the laws governing these relations, the laws pertaining to other spheres such as land reform, tax regimes, and urban regulation, and the extent to which foreign investment permits diffusion of new technologies and products and breeds competition. This study does not establish these relationships. By showing how important differences in steady states are, however, and by assessing the importance of two key variables in their determination, it does leave the door open for future research (which must await the availability of appropriate data) to investigate the role played by these other suggested factors.

References Amemiya, T., 1967, "A Note on the Estimation of Balestra-Nerlove Models," Technical Report No. 4, Institute for Mathematical Studies in Social Sciences, Stanford University. Bajpai, N., and J.D. Sachs, May 1996, "Trends in Inter-State Inequalities of Income in India," Development Discussion Papers, Harvard Institute for International Development, No. 528.

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Barro, R.J., 1991, "Economic Growth in a Cross-Section of Countries," Quarterly Journal of Economics, Vol. 106, No. 2 (May), pp. 407-43. , and X. Sala-i-Martin, 1992a, "Convergence," Journal of Political Economy, Vol. 100 (April), pp. 223-51. ,1992b, "Regional Growth and Migration: A Japan-United States Comparison," Journal of the Japanese and the International Economy, Vol. 6 (December), pp. 312-46. , 1995, Economic Growth (New York: McGraw-Hill). Barro, R.J., N.G. Mankiw, and X. Sala-i-Martin, 1995, "Capital Mobility in Neoclassical Models of Growth," American Economic Review, Vol. 85 (March), pp. 103-15. Baumol, W.J., 1982, "Productivity Growth, Convergence and Welfare: What the Long-Run Data Show," American Economic Review, Vol. 6 (December), pp. 1072-85. Caselli, D., G. Esquivel, and F. Lefort, 1996, "Reopening the Convergence Debate: A New Look at Cross-Country Growth Empirics," Journal of Economic Growth, Vol. 1, pp. 363-89. Cashin, P.A., 1995, "Economic Growth and Convergence Across the Seven Colonies of Australasia: 1861-1991," Economic Record, Vol. 71 (June), pp. 132-44. , and N. Loayza, 1995, "Paradise Lost? Growth, Convergence, and Migration in the South Pacific," IMF Staff Papers, International Monetary Fund, Vol. 42 (September), pp. 608-41. Cashin, P.A., and R. Sahay, 1996, "Internal Migration, Center-State Grants, and Economic Growth in the States of India," IMF Staff Papers, International Monetary Fund, Vol. 43 (March), pp. 123-71. Chamberlain, G., 1983, "Panel Data," in Handbook of Econometrics, Vol. II, ed. by Z. Griliches and M.D. Intriligator (Amsterdam: North Holland). Chaudhry, M.D., 1966, Regional Income Accounting in an Underdeveloped Economy: A Case Study of India (Calcutta: Firma K. L. Mukhopadhyay). Easterlin, R.A., 1960a, "Regional Growth and Income: Long Term Tendencies," in Population Redistribution and Economic Growth: United States 1870-1950, Vol.2: Analyses of Economic Change, ed. by S. Kuznets, A.R. Miller, and R.A. Easterlin (Philadelphia: American Philosophical Society). , 1960b, "Interregional Differences in Per Capita Income, Population and Total Income, 1840-1950," in Trends in the American Economy in the Nineteenth Century, Vol. 24 of NBER Studies in Income and Wealth. Ghuman, B.S., and D. Kaur, 1993, "Regional Variations in Growth and Inequality in the Living Standard: The Indian Experience," Margin, Vol. 25 (April-June), pp. 306-13. Govinda Rao, M., R.T Shand, and K.P. Kalirajan, 1999, "Convergence of Incomes Across Indian States: A Divergent View," Economic and Political Weekly, Vol. 34 (March 27), pp. 769-78.

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Greene, ]., and D. Villanueva, 1991, "Private Investment in Developing Countries," IMF Staff Papers, International Monetary Fund, Vol. 38 (March), pp. 33-58. Islam, N., 1995, "Growth Empirics: A Panel Data Approach," Quarterly Journal of Economics, Vol. 110 (November), pp. 1127-70. Knight, M., N. Loayza, and D. Villanueva, 1993, "Testing the Neoclassical Theory of Economic Growth: A Panel Data Approach," IMF Staff Papers, International Monetary Fund, Vol. 40 (September), pp. 512-41. Lall, S.V., 1999, "The Role of Public Infrastructure Investments in Regional Development: Experience of Indian States," Economic and Political Weekly (March 20). Lancaster, T , 1997, "Orthogonal Parameters and Panel Data," Brown University Working Paper, No. 97-32 (April). , and S. Aiyar, S., 1999, "Econometric Analysis of Dynamic Models: A Growth Theory Example," Brown University Working Paper, No. 99-28 (May). Lucas, R., 1988, "On the Mechanics of Development Planning," Journal of Monetary Economics, Vol. 22 (July), pp. 3-42. Majumdar, G., and J.L. Kapur, 1980, "Behaviour of Inter-State Income Inequalities in India," Journal of Income and Wealth, Vol. 4, No. 1 (January), pp. 1-8. Mankiw, N.G., D. Romer, and D.N. Weil, 1992, "A Contribution to the Empirics of Economic Growth," Quarterly Journal of Economics, Vol. 107 (May), pp. 407-37. Nair, K.R.G., 1985, "A Note on Inter-State Income Differentials in India 1970-71 to 1979-80," in Regional Structure of Growth and Development in India, Vol. 1, ed. by G.P. Misra (New Delhi: Ashish Publishing House). Ramachandran, V.K., 1997, "On Kerala's Development Achievements," in Indian Development: Selected Regional Perspectives, ed. by J. Dreze and A. Sen (Oxford: Oxford University Press). Ramsey, F., 1928, "A Mathematical Theory of Saving," Economic Journal, Vol. 38, No. 152 (December), pp. 543-59. Rao, H., 1985, "Inter-State Disparities in Development in India," in Regional Structure of Growth and Development in India, ed. by G.P. Misra, (New Delhi: Ashish Publishing House). Reserve Bank of India, 1993, "Social Sector Expenditures and Human Development—A Study of Indian States," Development Research Group Study. Seitz, H., and G. Licht, 1992, "The Impact of the Provision of Public Infrastructures on Regional Development in Germany," Discussion Papers, Zentrum fur Europaische Wirtschaftsforschung Gmbh, No. 93-13. Shioji, E., 1993, "Regional Growth in Japan," unpublished manuscript, Yale University. Solow, R.M., 1956, "A Contribution to the Theory of Economic Growth," Quarterly Journal of Economics, Vol. 50 (February), pp. 65-94.

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Swan, T.W., 1956, "Economic Growth and Capital Accumulation," Economic Record, Vol. 32, No. 63 (November), pp. 334-61. Uzawa, H., 1965, "Optimal Technological Change in an Aggregative Model of Economic Growth," International Economic Review, Vol. 6 (January), pp. 18-31.

Appendix 8.1: Data An important starting point for constructing the database used was data provided by Cashin and Sahay, which is gratefully acknowledged. This data was extended and updated using data on Net Domestic Product for each state taken from the consolidated series prepared by the Central Statistical Organization (CSO). Population charts were from the census for those years in which the census was conducted; midyear estimates are available in different issues of CSO publications such as the Statistical Pocket Book of India and the Statistical Abstract of India.

Literacy rates were obtained from census data when available and survey rounds conducted by the National Sample Survey Organization (NSSO) otherwise. Survey results are reported in the NSSO's journal, Sankhya. For 1976 and 1986 literacy rates were constructed by linear interpolation. Infant mortality rates and poverty charts were based on World Bank estimates. The charts for state capital expenditures on social and economic infrastructure were taken from various monthly issues of the Reserve Bank of India Bulletin and Supplements to the Bulletin. Data on credit extended by India's Scheduled Commercial Banks are available at the state level in different issues of the Reserve Bank of India's Statistical Tables Relating to Banking. Urbanization charts were taken from census data.

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9 Structural Reform in India DANIEL KANDA, PATRICIA REYNOLDS, AND CHRISTOPHER TOWE

Introduction Tremendous strides have been taken during the past decade in unshackling the Indian economy from widespread regulatory and other structural impediments. Nonetheless, there is widespread agreement among policymakers and analysts that more needs to be done in order to sustain and improve India's recent growth performance, and to reduce the large share of the population that remains below the poverty line. This consensus was most striking during the general elections of 1999, where the manifestos of both major parties—the National Democratic Alliance and the Congress Party—demonstrated remarkably similar calls for a "second wave" of reform. Following the elections in October 1999, the new government established an ambitious objective for growth of at least 7—8 percent, and acknowledged that achieving this objective would require both sound macroeconomic policies and broad-based reform. Policy action was swift and included legislation to open the insurance sector, liberalization of the foreign exchange system, and tax reforms. However, a well-defined medium-term strategy and implementation timetable has yet to emerge.1 x

TKis deficit appears to have been acknowledged by the government, which requested the Economic Advisory Council in July 2000 to prepare a strategy paper identifying reform priorities, as a vehicle for establishing a political consensus for action on a broad front.

170

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This chapter provides a brief overview of the recent experience in the area of structural reform, and suggests a number of areas where priority is needed in the period ahead. In particular, the next section broadly describes the post-1991 balance-of-payments crisis liberalization and discusses the cross-country evidence on the link between growth and .reform. A more detailed discussion of the areas where reforms should be focused in the period ahead is presented later.

Recent Reforms and Their Implications Important structural reforms were initiated in India in the mid-1980s, and the pace of reform accelerated following the balance-of-payments crisis in 1991. Prior to this period, government policies were predominantly inward looking and involved significant regulation and public ownership in all areas of the economy, with the objective of building industrial and agricultural self-sufficiency and reflecting a strongly socialist political environment. During the past 15 years, however, partly in response to concerns regarding India's halting growth and vulnerability to external crises, deregulation and liberalization have been significant. Notably: • In the industrial sector, licensing requirements were dismantled, and steps were taken to liberalize investment approvals procedures. Also, many areas of the economy that had previously been reserved for the public sector were opened for private investment, including power, telecommunications, mining, ports, roads, river transport, air transport, and banking. • External sector reforms included reductions in tariffs, the easing of import licensing requirements, a relaxation of controls on foreign direct and portfolio investment, and greater exchange rate flexibility. Cuts reduced the import-weighted tariff rate from 87 percent in 1990/91 to 25 percent by 1996/97, and there were substantial reductions in the number of quantitative restrictions on imports. The approvals process for foreign direct investment (FDI) was simplified, portfolio investment was allowed for registered foreign institutional investors, and Indian companies were allowed to issue global depository receipts (GDRs), subject to restrictions. The exchange rate regime was also liberalized. The rupee was floated in March 1992, and full current account convertibility was established in August 1994, earning India Article VIII status with the IMF. • Liberalization and reform in the financial sector were particularly significant during the 1990s. Interest rates were liberalized,

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prudential norms and supervision were strengthened, private sector competition in the banking system was increased, and measures were taken to develop and strengthen capital and debt markets. These measures enabled a gradual shift toward implementing monetary policy by means of indirect rather than direct instruments. • Fiscal reforms focused on rationalizing tax rates, cutting expenditures, and privatizing public enterprises. The public sector deficit, at the same time, which reached just over 11 percent before the 1991 crisis, was lowered to 81/4percent by 1995/96. These efforts appear to have paid important dividends. The recovery from the 1991 crisis was rapid, with a sharp rise in private investment and an increase in real GDP growth to 73/4percent by 1995/96 (Table 9.1). Significant improvements in productivity were also achieved—as evidenced by increased total factor productivity growth at both the aggregate and firm levels (World Bank, 2000; Krishna and Mitra, 1998). Most impressive was the performance of the services sector. Out of average GDP growth of 53/4percent in the 1990s, the service sector contributed 31/4percentage points, compared to only11/2percentage points out of average GDP growth of33/4between 1951/52 and 1979/80. This rising contribution was accompanied by a steady decline in the incremental capital output ratio (ICOR) in the provision of services, indicating that rising productivity played an important role in fostering high-quality growth in this sector. There is the perception that the reform process has slowed over the past few years, however, owing largely to political difficulties, and recent economic performance raises questions about the sustainability of the strong growth that was experienced in the mid-1990s—or the feasibility of achieving even more rapid growth. In particular: • The fiscal situation deteriorated significantly from FY 1996/97, with the consolidated deficit of the public sector is estimated to have exceeded 11 percent of GDP in FY 1999/2000. The weakening of the fiscal position reflected stagnant revenue collections, sharp increases in civil service wages and subsidies, and rising debt service payments—all of which have limited the scope for funding needed for infrastructure and other investments. • Real growth has slowed since the mid-1990s—averaging around 6 percent in 1997/98-1999/2000. While this partly reflected temporary factors such as agricultural supply shocks and the adverse effect of the 1997 regional crisis, structural impediments may also have been significant. In particular, the relatively weak performance of the agricultural and industrial sectors, relative to the services sector, supports anecdotal and other evidence that infrastructure and regulatory constraints have helped to restrain

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Table 9.1. Expenditure and Sectoral Components of Growth in India, 1951/52-1999/20001 (In percent) Avera ge 1951/521979/802

1980/811990/91

1992/931996/97

1997/981999/20003

3.7 1.5

5.9 3.8

6.4 4.5

5.9 4.3

2.6 2.1 0.4 0.7

4.2 3.5 0.7 1.4 0.8 0.5 0.6

4.4 3.9 0.5 1.9 2.1 -0.2 0.2

4.4 2.7 1.6 1.0 0.6 0.4 0.6

Contribution to growth, by sector:6 Public Private

1.1 2.2

1.7 4.2

1.3 5.7

3.9 2.2

Contribution to growth, by sector:6 Agriculture Industry Services

1.0 1.1 1.4

1.5 1.9 2.4

1.4 2.1 3.2

0.6 1.6 3.9

4.2 2.0 5.7 4.0

4.1 1.5 6.8 2.9

4.8 2.6 10.7 2.1

Real GDP growth4 Real per capita GDP growth4 Contribution to growth, by expenditure item:4 Consumption Private consumption Public consumption Gross fixed investment Private investment Public investment Net exports5

ICORs, by sector:7 Overall Agriculture Industry Services

... ... ...

... ... ...

Sources: Central Statistical Organization (CSO); National Accounts Statistics. 1 Calculations based on constant price data; base year is 1980/81 for data until 1993/94, and 1993/94 thereafter. 2 Average contributions of consumption spending, and public and private sectors are calculated over 1961/62-1979/80. 3 1999/2000 figures on GDP and sectoral production are CSO revised estimates; 1999/2000 figures on expenditure categories and 1998/99 and 1999/2000 figures on public and private sector GDP are staff estimates; incremental capital output ratios (ICORs) computed over 1997/981998/99. 4 Measured at market prices. 5 Includes statistical discrepancy. 6 Measured at factor cost. 7 The ICOR is the ratio of the investment rate to the GDP growth rate; a falling ICOR over time therefore indicates improved capital productivity.

growth. In addition, the sharp decline in the contribution of private investment spending to overall growth, at the same time that the growth contribution of government consumption has increased sharply, suggests that higher fiscal deficits have crowded out private activity.

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• There also is concern that progress toward poverty reduction has slowed during the past decade. Although the poverty rate fell from 55 percent in 1973/74 to 36 percent in 1993/94, unofficial survey data point to relatively modest progress in reducing the poverty rate during the 1990s. At the same time, there is evidence that the income distribution across Indian states has become increasingly skewed.2 These suggest that the more recent pace and scope of structural reform may not be sufficient to sustain needed income gains. Indeed, a number of analysts—both inside and outside the policymaking sphere in India—have argued for the establishment of an ambitious "second wave" of reform to address a number of difficult issues that have so far remained relatively untouched (see, in particular, Kelkar, 1999). Indeed, a number of analytical studies have stressed that, notwithstanding the experience of the mid-1990s, India's GDP growth performance has lagged behind a number of other Asian economies, and the benefits from deeper structural reform could be significant (Table 9.2). These include studies that have analyzed the nature of the structural impediments in India (World Bank, 1998; Bajpai and Sachs, 1997), the reasons for the differences in the growth performances of India relative to China and other developing countries (World Bank, 2000; Bajpai, Jian, and Sachs, 1999), and the effects of structural reforms at the state level (Chapter 9; Bajpai and Sachs, 1999). For example, Bajpai and Sachs (1997) estimated that annual per capita growth in India could be raised by as much as 3.5 percentage points by adopting extensive market reforms, including domestic deregulation, greater openness, and reforms to exit policies and labor and land laws (Table 9.2). Empirical work by Kongsamut and Vamvakidis (2000) confirms the potential for structural reform to promote faster growth in India. In particular, their analysis suggests that measures to promote private investment, FDI, trade, and educational attainment could add 3.4 percentage points to average growth. Comparisons of India and China have also concluded that the much higher growth rates experienced by China—over 4 percentage points during 1980—96—have been due to the more liberal regulatory environment enjoyed by China's non-state sector (particularly with respect 2

Interpretation of poverty trends is complicated by the fact that the results of more recent smaller-sample surveys have not yet been confirmed by the official large-sample survey that is due to be released in 2001. Moreover, analysts have suggested that the decline in poverty in the 1970s and 1980s was overstated by underestimates of in-kind income during the early part of the period, while other analysts argue that the downward trend has been underestimated by overestimates of inflation. For a discussion, see Chapter 8 and Ahluwalia (2000).

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Table 9.2. Explaining India's Relative Growth Performance Average Value (in percent)

Real per capita GDP growth (1970-95 average) Factors contributing to growth during 1992-95, as estimated by Bajpai and Sachs (1997): Saving/GDP Efficiency index Convergence effect and other factors Real per capita GDP growth (1992-95 average)

India

East Asia

21.9

29.6

0.1 4.5

2.5

-1.2 -0.8 -1.1 0.0 -0.3 0.0 0.2

10.3 35.2

113.5 10.4 50.5

8.8

8.4

2.4

5.7

-3.3

22.4 -0.7 ...

35.0 0.6 ...

-1.2 -3.6 2.1

3.6

6.3

-2.7

Sources: Kongsamut and Vamvakidis, 2000; Bajpai and Sachs, 1997. Calculated as the estimated coefficient times the difference in the independent variable value (India-East Asia). Reported difference in growth rates of real per capita GDP are actuals.

Daniel Kanda, Patricia Reynolds, and Christopher Towe

Factors contributing to growth during 1970-95, as estimated by Kongsamut and Vamvakidis (2000): Investment/GDP NetFDI/GDP Trade/GDP Government consumption/GDP Secondary school enrollment rate CPI inflation rate Convergence effect and other factors

Estimated Difference in Growth Rates1 (in percentage points)

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to agricultural sector pricing and labor laws), as well as the more attractive incentives offered by its Special Export Zones. A study of the effects of structural reforms at the state level in India found that reform-oriented states (such as Gujarat, Tamil Nadu, and Maharashtra) grew faster and attracted much more private investment—both domestic and foreign—than those that have lagged behind in the reform process (Bajpai and Sachs, 1999).

The Outstanding Agenda As noted above, there is a widespread consensus in India on the need for a reinvigoration of the momentum for reform. There is also considerable agreement on where the emphasis needs to be placed. A brief summary of the principal issues that a number of analysts—in both the public and private sectors—have raised follows.3 Financial Sector

Considerable progress has been made in reforming the financial sector since the early 1990s, following blueprints laid out by a series of government commissions. In the banking sector, for example, capital adequacy has been improved, interest rates have been largely deregulated, priority-lending requirements were eased, and new entrants have increased competition. More recent reforms included the opening up of the insurance sector—long dominated by the state-owned Life Insurance Corporation and the General Insurance Corporation—to private and foreign competition beginning in 2000. In capital markets, other recent initiatives include the passage of legislation to provide a framework for trading in derivatives, allowing mutual funds to trade in derivatives, relaxing entry norms for initial public offerings, and establishing regulations to allow employee stock options. The Foreign Exchange Management Bill was passed in 1999, which significantly streamlined foreign exchange regulations Nonetheless, significant challenges remain to be addressed in order to ensure that the financial sector is well placed to provide the necessary underpinning for strong growth. Government-owned banks still account for roughly 80 percent of the banking sector, which has contributed to 3

In particular, see the discussions by the Ministry of Finance and Reserve Bank of India in various issues of the Economic Survey and Annual Report, respectively; Ahluwalia (1999); Acharya (1999); Rajiv Gandhi Institute for Contemporary Studies (1998); World Bank (2000); and Desai (1999).

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weak governance and efficiency. Despite repeated commitments to reducing government ownership, progress has been slow, due in large part to union resistance. The government announced in February 2000 its intention to reduce minimum public ownership share to 33 percent, although this was accompanied by statements that employment levels and the "public sector character" of these institutions would be preserved. Further improvements in the regulatory and supervisory system are needed. These include the early increase in the capital adequacy requirement to 10 percent, reductions in cash and statutory liquidity requirements, an easing of restrictions on foreign bank branches, and the abolition of remaining interest rate regulations and priority-lending requirements. In addition, the lack of an effective and rules-based exit strategy for chronically undercapitalized banks continues to undermine governance and creates significant moral hazard. The growing importance of nonbank financial institutions and the trend toward universal banking also pose important challenges to the regulatory and supervisory system. Another important issue is the appropriateness of existing systems for administering interest rates on postal saving and provident funds. Notwithstanding recent rate reductions, these deposits earn very high rates of return, especially given their tax advantage, and are not flexibly adjusted in line with market conditions—the government's decision in early 2000 to lower the rate on deposits with the Employee Provident Fund (EPF)—for the first time since the early 1990s—from 12 percent to 11 percent was overturned in July by the EPF's trustees. High rates on these deposits have put the banking sector at a competitive disadvantage while imposing a significant fiscal burden. The fact that 80 percent of many of these deposits are automatically loaned to the states also has the effect of undermining their fiscal discipline. As a number of commentators have suggested, the medium-term objective should be to reduce the government's role as a financial intermediary by privatizing the functions of the postal saving and provident funds and reducing restrictions on their investment. Recently approved liberalization of the insurance sector promises to provide a significant opportunity to deepen capital markets and increase the funding for productive investment. However, it remains to be seen whether foreign ownership limits will unduly restrict the scope for private sector participation, so that new entrants will be largely funded by the banking sector, itself dominated by public institutions. Moreover, existing public sector insurers continue to be responsible for significant quasi-fiscal activities—including the provision of subsidized insurance to low-income households—and these activities would need to be eliminated and/or brought on budget. It will also be important to

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resist pressure to impose similar quasi-fiscal responsibilities on new entrants—including priority sector requirements. Infrastructure

Infrastructure deficiencies—particularly in power, transportation, and communications—are among the most important impediments to growth in India. The 1998 Global Competitiveness Report of the World Economic Forum, which examined the strengths and weaknesses of 53 countries and provided an assessment of their medium-term growth prospects, ranked India's overall infrastructure fifty-third. All aspects of infrastructure were found to have severe weaknesses. The lack of consistent and reliable access to power remains an important obstacle to growth. Although capacity has grown rapidly in recent years—61/2percent in 1998/99—energy and peaking shortages remained high at 6 percent and 14 percent, respectively. An important factor is the inefficiency of thermal plants and the State Electricity Boards (SEBs), which distribute electricity to most customers. SEBs have typically provided energy to the agriculture sector at well below cost, leading to heavy financial losses. Operational inefficiencies have also meant that the SEBs' transmission and distribution losses—estimated at 25 percent by the authorities and at 40 percent by the World Bank—are among the highest in the world. In 1997/98, only three SEBs had a rate of return higher than the legally mandated minimum of 3 percent, which has limited the ability of the SEBs to invest in capacity. In response, power sector reforms have begun both at the state and central government levels. Several states, including Orissa and Andhra Pradesh, have enacted legislation to reform their power sectors and to establish independent State Electricity Regulatory Commissions (SERCs). Reforms at the central government level include the promotion of "mega" power projects,4 the creation of a Power Trading Corporation that will purchase energy from large power projects and sell only to states that have embarked on reforms, and the provision of tax incentives for private power projects. A new Electricity Bill, which could introduce further reforms, including compulsory metering and the gradual reduction of subsidies, is slated to be discussed in Parliament during FY 2000/01. The telecommunications system also represents an important challenge. Notwithstanding rapid growth in capacity in recent years, telephone density in India remains among the lowest in the world and regulatory 4

Mega power projects are defined as thermal plants that will generate at least 1,000 mw annually, or hydro plants that will generate at least 500 mw annually.

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constraints are significant.5 To enhance private sector participation in the sector, the government announced a new telecom policy in 1999 that allowed multiple fixed service operators, opened domestic long distance telecom services to private operators, and permitted private operators to provide international long distance service in 2000. It also allowed the migration of telecom operators from the previous fixed-fee regime to a revenue-sharing arrangement. In August 2000, the government permitted the sale of equity stakes between foreign partners in the industry, although total foreign equity participation remains capped at 49 percent. Further reforms to the telecommunications sector should include a clearer delineation of the roles of the Telecom Regulatory Authority of India (TRAI) and the Department of Telecommunications, which have clashed frequently in the past over jurisdiction and policies, creating unease among current and potential investors. To this end, TRAI was reconstituted in January 2000 to give a clearer distinction between its advisory and regulatory functions; however, the extent of its independence is still to be tested. India faces significant transportation bottlenecks. The national highways, which account for about 40 percent of the movement of goods and passengers, are very congested. As a result, commercial vehicles are only able to run 200—250 km per day compared to 600 km per day in developed countries. The government has estimated that an additional 15,766 km of highway will be required by the year 2020, out of which 4,885 km is needed by 2005. Port capacity is also insufficient to meet existing demand. The major ports (handling 90 percent of all cargo) processed 252 million tons of cargo as of end-March 1999, in excess of their 240-million-ton capacity, resulting in substantial delays in pre-berthing and turnaround. Productivity at Indian ports is considered much lower than that of other ports in the Asian region.6 The railway system also suffers from undercapacity (capacity utilization is estimated at 100—120 percent along major routes), pressures to maintain and add uneconomic passenger lines, and weak revenue generation. These problems are exacerbated by a fare system that requires freight traffic to cross-subsidize passengers, encouraging a diversion of freight traffic to other transport modes, including roads. Recent government initiatives have sought to address these shortcomings. A National Highway Development Program aims to upgrade 5 In particular, switching capacity increased by 23 percent in 1998/99 alone. However, telephone density in India is 1.7 percent, compared to 11.4 percent in Thailand, 7.3 percent in China, and 2.9 percent in Indonesia (World Bank, 2000). 6 Average turnaround time fell from 6.6 days in 1997/98 to 5.9 days in 1998/99, compared to about 8 hours turnaround in competitor ports.

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highways linking the "golden quadrilateral" of Delhi, Mumbai, Chennai, and Calcutta, and excises on petrol and diesel have been earmarked to finance road projects. Private sector participation in road transport is being encouraged through Build-Operate-Transfer (BOT) schemes. Greater private sector investment is also being encouraged in ports (including airports) and at the state level. Despite recent steps to address infrastructure bottlenecks, deeper and more rapid progress will be needed to provide the basis for sustained and strong economic growth. First, the conditions necessary to encourage greater private sector participation—including through privatization— need to be established. These should include the development of more rational pricing policies, which would remove or substantially reduce subsidies, and the enforcement of a sound regulatory environment. Bureaucratic and other impediments to private sector participation also need to be addressed, including nontransparent approval procedures.7 Second, fiscal reforms are urgently needed to increase the availability of public funds for infrastructure investment and maintenance. The deterioration in the overall fiscal situation at both the central and state levels has diverted resources from public investment toward debt service and other current spending—especially wages and salaries. As the World Bank notes, while private sector investment could take up part of the slack, the significant externalities associated with infrastructure suggests that the major role will need to be taken by the public sector. External Sector8 Openness has increased significantly since before the 1991 crisis. On the trade side, reforms have reduced tariffs by more than two-thirds, and licensing requirements were liberalized for imports of capital goods, raw materials, and components. Since 1997, substantial progress has been made toward phasing out remaining quantitative restrictions (QRs) on agricultural, textile, and industrial products, and the government has announced that remaining QRs will be removed by April 2001. A number of measures have also been adopted recently to ease restrictions on capital flows. In February 2000, the use of External Commercial Borrowings (ECBs) was opened to all sectors except real estate 7 An important example of the adverse effects of these regulatory problems is the recent decision by the U.S. company Cogentrix to pull out of a power project in Karnataka, after 10 years and $27 million in expenditures, due to clearance delays. Approval of power purchase agreements at the state level can require clearances by as many as 27 interministerial committees (Economist Intelligence Unit, 2000). 8 A discussion of recent trade policy developments is contained in Herderschee (2000).

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and the capital market, and quantitative limits were relaxed.9 In order to promote FDI, the central government established a system of automatic approvals for FDI for investments up to Rs 6 billion, and constituted the Foreign Investment Implementation Authority (FIIA) as a single interface for foreign investors in obtaining all necessary approvals and to approve FDI proposals not covered under the automatic approvals route. In addition, restrictions on the ability of Indian corporations to issue equity abroad through American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) were liberalized in January 2000, so that prior government approval is no longer required— although companies are subject to reporting requirements and caps on the percentage of foreign ownership of equity. Notwithstanding this liberalization, the level of protection in India remains very high. The import-weighted average tariff rate, at 25 percent, is well above the world average of 7 percent. A sizable FDI negative list remains, including investment in agriculture, the petroleum industry, defense-related equipment, and industrial explosives. Pervasive caps on foreign equity in various industries have also served as a disincentive for foreign investors.10 The approvals process—particularly at the state level—is still dogged by long bureaucratic procedures and delays.11 The IMF's index of capital controls places India among the most restrictive economies. Consequently, trade (exports plus imports) is relatively low as a share of GDP—27 percent in 1999/2000. Capital inflows are similarly small; for example, in 1998, FDI in China was $45.5 billion—about 20 times larger than for India ($2.3 billion).12 In order to reap the benefits from trade and capital mobility achieved elsewhere in the region, future reforms in India should focus on reducing remaining bureaucratic and regulatory impediments to direct investment at both the central and state government levels, relaxing caps on foreign equity participation in 9

Companies implementing infrastructure projects via subsidiary joint ventures are permitted to tap ECB up to $200 million (the previous limit was $50 million), and ECB exposure limits on infrastructure projects have been increased to 50 percent from 35 percent (the limit can also exceed 50 percent in special cases). Export units are now allowed ECB exposure up to 60 percent of project cost. ECB clearance procedures were simplified, and 100 percent prepayment of borrowing through export earnings is now allowed. 10 For example, foreign ownership of equity is limited to 49 percent in telecommunications; 74 percent in bulk pharmaceuticals, mining of diamonds and precious stones, and advertising; and 51 percent in hotels and tourism-related industry. Also, foreign investment in small-scale industries is limited to 24 percent of capital. 11 See footnote 7 for an example. 12 Chapter 2 contains a more detailed discussion of capital account restrictions and their impact in recent years.

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Indian ventures, and improving the fiscal situation—which has impeded implementation of the government's recent commitment to reduce tariff rates to "Asian levels." Agriculture

Although only about one-quarter of GDP is derived from the agricultural sector, down from about one-third two decades ago, some 70 percent of the labor force still relies on the land for its livelihood. Thus, the slowdown of growth in the agricultural sector during the 1990s (Table 9.1) has been directly correlated with the stagnation and worsening of rural poverty rates. The growth slowdown can be partly ascribed to the conclusion of the "green revolution" that significantly boosted production and efficiency in previous decades, as well as to adverse weather conditions. However, structural factors have also contributed to low investment rates and productivity—the rate of capital formation in agriculture fell from over 20 percent during the 1970s and 1980s to only around 7 percent in the 1990s—and, for example, the lack of cold storage facilities is estimated to have resulted in substantial losses of perishable fruits and vegetables. As a result, most commentators agree that there is enormous potential for agricultural reform to improve rural living standards (see, in particular, Tendulkar, 1998). While recent efforts to increase fertilizer prices, improve foodgrain storage and distribution, and liberalize some agro-processing industries are steps in the right direction, key issues that still need to be addressed include the following: • Subsidies on power, water, and fertilizer inputs have distorted production decisions and contributed to environmental degradation, which has adversely affected productivity. Their high cost, moreover, has crowded out public spending on much needed agricultural investment, in particular rural roads and irrigation. • The operations of the Food Corporation of India (FCI) and the Public Distribution System (PDS) have distorted normal regional and seasonal commodity price variations, prevented or constrained efficient private trade, and distorted production decisions.13 Most recently, distorted pricing has led to significant overaccumulation of foodgrains by the FCI, implying an even greater fiscal burden. • Trade distortions have also prevented the proper functioning of market mechanisms, with most agricultural imports and exports 13 Operations of the FCI and PDS are discussed in greater detail in Radhakrishna and Subbarao (1997) and Tzanninis (1996).

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(including farm inputs) subject to high tariffs, licensing requirements, and/or "canalization"—which grants monopoly rights for trade in particular commodities. • Reservation policies, which restrict domestic production of most processed agricultural commodities and farm inputs to small-scale manufacturers, have adversely affected product quality, the level of technology, and marketing (see below). Small-Scale Industries

As noted by the government-commissioned Hussain Committee report in 1997, the reservation of certain products for exclusive production by small-scale industries (SSI reservation) has crippled the growth of several industrial sectors. SSI reservation also has restricted exports in many areas—including garments, toys, leather products, and agroprocessing—where India has a potential comparative advantage.14 SSI reservation has also been an impediment to FDI, since many of the industries that would otherwise be attractive to foreign investors are reserved. The need to eliminate SSI reservation has recently become more urgent, as the removal of quantitative import restrictions in April 2001—in line with India's World Trade Organization (WTO) commitments—will create an anomalous situation where small-scale industries face competition from imports, while large domestic firms are restricted from entry into those industries. Similarly, the elimination of quotas under the Multi Fibre Agreement by 2005 is likely to increase competitive pressures on the Indian textiles industry, which is also reserved for small-scale units. The July 2000 interim report of a government Study Group on the SSI sector recognized that globalization and India's commitments to trade liberalization will place increasing pressures on small-scale industries, and that liberalization is required to promote domestic efficiency and competitiveness. Against this background, however, the report would only reduce the many advantages enjoyed by the sector, and did not acknowledge the need to eventually eliminate reservations. In particular, the exemption from excise taxes and priority lending from banks at subsidized interest rates would be continued under the Study Group's recommendations.15 As a number of analysts have suggested, the 14 Small-scale industries are defined as firms with investment in plant and machinery not exceeding Rs 1 million—the limit was reduced to this level in FY 1999/2000, after having been increased from Rs 30 million to Rs 50 million in FY 1998/99. Production of over 800 manufactured items is reserved for SSIs, and they account for roughly 40 percent of manufacturing. See Hussain Committee (1997). 15 The report suggested reducing the export requirement for larger firms producing reserved items from 50 percent to 30 percent, indexing of investment ceilings, raising the

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system's web of relatively arbitrary investment limits and tax advantages for small units, as well as the complex bureaucracy and regulations involved, will continue to undermine the productivity and efficiency of the sector. Delaying the complete dismantlement of the system is only likely to exacerbate the ultimate costs. Labor Markets

About 8 percent of India's labor force is employed by the "organized" sector, which enjoys extensive social protection and effectively guarantees lifetime employment under the Industrial Disputes Act, the Companies Act, and the Sick Industrial Companies Act. A range of other labor legislation has been introduced at both the central and state government levels, leading to considerable interstate variation in definitions and coverage of requirements for minimum wage, social security, job security, etc. In contrast, the "unorganized" sector is largely marketdriven and subject to little regulation or protection. The 1998 Global Competitiveness Report ranked India's labor market flexibility forty-fifth out of 53 countries. Labor relations are considered extremely fractious—roughly 22 million work days were lost in 1998 due to strikes and lockout (Government of India, Economic Survey, 1999-2000), and Basu et al. (1999) note that, on a per worker basis, India ranks well above most industrial countries in days lost. The link between wages and productivity in the industrial sector is also undermined by the large role played by periodic Pay Commissions established for the central government (Industrial Labour Organization, 1996). Surveys of industry carried out by the World Bank and the Confederation of Indian Industry (World Bank, 2000) identified labor regulations as the second biggest obstacle to business operations and growth. In late 1998, a new National Labour Commission was established to prepare proposals for the rationalization of existing legislation and for extending legislation to the unorganized sector. Numerous studies, however, have already identified several of the major areas where reform is urgently needed:16 • Simplification and harmonization. There are roughly 45 separate labor laws at the central level alone, many of which overlap with state-level legislation. This has resulted in substantial variation in regulation of hours, minimum wages, pension benefits, child labor, investment ceilings for six sectors, trimming the list of reserved items, and raising the limit on foreign equity participation in SSI units from 24 percent to 49 percent. 16 See for example the Rajiv Gandhi Institute (1998); Basu, Fields, and Desgupta (1999); Zagha (1998); and International Labour Organization (1996).

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etc. across industries and regions. Simplification and harmonization of regulations would improve compliance and worker protection, while reducing the scope for corruption. • Flexibility and coverage. Existing legislation imposes a significant burden on the organized sector. The use of contract labor is severely constrained, and firms employing 100 workers or more are required to seek prior government permission for layoffs or plant closure, which appears difficult to obtain. At the same time, legislation that ensures worker protection does not apply to the unorganized sector—for example, the Factories Act covers only firms with 20 or more people. As Basu et al. (1999) note, there is considerable empirical evidence to suggest that this has significantly reduced the demand for labor in the organized sector, adversely affecting wages and reducing productivity. However, workers in the unorganized sector—comprising over 90 percent of the workforce—are left without mandatory pension and medical benefits, and other legal protections. Legislative reform is needed, therefore, to gradually increase the scope for firms to restructure, to extend the scope of labor protections to the unorganized sector, and to establish a well-funded social safety net. • The role of government in dispute resolution. As Zagha (1998) notes, disputes between employers and employees are frequently protracted—most take over one year to settle, and 20 years is not uncommon. The Industrial Disputes Act requires a government arbitrator to be involved in all disputes, rather than only after negotiations have broken down. This has impeded the speedy resolution of disputes and also has increased the scope for parties to challenge arbitration decisions in the courts. Legal Framework for Corporate Restructuring Industrial and corporate restructuring, contract enforcement, and debt recovery have been impeded frequently by the enormous backlog of cases and excessively complex legislative and administrative procedures. In particular, the Sick Industrial Companies Act (SICA) operates as an important disincentive to early restructuring by providing protection from creditors only after a company's net worth has been completely eroded. Once a medium-sized or large company is declared "sick," it no longer has the power to restructure on its own, as SICA requires that restructuring of such units be handled by the Board of Industrial and Financial Reconstruction (BIFR). Procedures employed by the BIFR encourage long delays, undermine governance of sick units, and adversely affect creditors (including banks), since they require

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consensus by all concerned parties at every stage of the restructuring process.17 Weaknesses in the legal framework, particularly those dealing with debt recovery, have been blamed for a substantial portion of the high nonperforming assets of the banking system. In recognition of this, debt recovery tribunals (DRTs) were formed. New legislation has been passed recently strengthening the powers of DRTs over debt recovery cases in the banking sector. However, more fundamental reforms—many of which were spelled out in the report of the National Task Force on Judicial Reforms in 1996—are needed to simplify, strengthen, and improve the efficiency of the entire legal framework (World Bank, 2000). Divestment of Public Sector Undertakings (PSUs) There are about 240 central public enterprises in India, operating in a wide range of industries and services, and accounting for about 7 percent of employment in the organized sector. Given their quasi-governmental nature, many PSUs carry out activities that would not be justifiable on purely commercial grounds. This has reduced incentives for profit maximization and efficiency and, as a result, after-tax profits averaged less than 4 percent of capital employed between 1990/91 and 1997/98—a very low return on the government's large cumulative investment in PSUs.18 Moreover, nearly half of all PSUs made losses throughout the 1990s. A number of these PSUs have been registered with the Board for Industrial and Financial Reconstruction and received substantial government support—roughly Rs 33 billion has been channeled to 12 PSUs under the control of the Ministry of Heavy Industry since 1995. The resulting drain on the central government's budget has highlighted the need for a strong divestment program, which would improve PSU governance and efficiency, as well as the fiscal position of the public sector. However, progress in divesting PSUs has been disappointing. Of the 37 PSUs that were recommended for strategic sale between 1991 and 1997, only one occurred, and the government has appeared unwilling to act on the recommendations of the Disinvestment Commission that was established in 1996—indeed, the Commission was disbanded in 1999. Key impediments appear to be the large fiscal burden that would be associated with funding early retirement schemes for employees of 17

As of end-November 1999, less than 1 percent of companies referred to the BIFR had been revived. 18 The operations and profitability of PSUs are discussed in greater detail in Hemming (1996).

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uneconomic PSUs, and an unwillingness of ministries to give up control over the enterprises they administer. During the past year, there have been signs of renewed commitment to divestment. The government announced its willingness to reduce its ownership in nonstrategic PSUs up to 100 percent.19 A new Department of Disinvestment was constituted in December 1999 to administer the divestment process, and the February 2000 budget set an ambitious Rs 100 billion target for divestment receipts. More recently, however, there has been continued evidence of reluctance to divest several large enterprises, including in the oil, telecommunications, and auto sectors. Against this background, the recommendations of the Divestment Commission just prior to its dissolution appear to remain important priorities, namely to:20 • Establish a vehicle for effective, coordinated, and timely implementation of government decisions on divestment. • Delink divestment from short-term budgetary priorities, by establishing an extra budgetary Disinvestment Fund into which all divestment proceeds would be channeled, to be used either for funding voluntary retirement schemes, social infrastructure projects, or government debt reduction.

Concluding Observations There is broad agreement in India that further reforms are needed. The experience of the early 1990s has demonstrated the potential benefits of reform, and consistent views on many of the key issues emerged from the major parties during the October 1999 election. In particular, faster growth would require durable fiscal consolidation to raise national saving and crowd-in private investment; further liberalization of foreign trade and investment flows; additional reforms to labor markets and the legal framework; and greater liberalization of the agricultural, industrial, infrastructure, and financial sectors to promote greater efficiency and export competitiveness. These reforms need to include removal of domestic pricing distortions; enforcement of a sound, transparent, and efficient regulatory system; improvements to bankruptcy procedures; an easing of 19

PSUs in strategic sectors—defense, railways, and atomic energy—would not be divested. 20 Report IX, Disinvestment Commission, March 1999. In 1998, then Finance Secretary Kelkar also proposed to overcome bureaucratic resistance to assets sales by transferring majority ownership of PSUs to a Special Purpose Vehicle, which would then be responsible for asset sales.

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restrictions on firm size; and reform of regulations that make it difficult to shed labor (and therefore impede job creation). Fiscal priorities also need to be redirected toward investment in human and physical capital. The new government has taken a number of important initiatives in many of these areas, suggesting a strengthened commitment to structural reform. Measures have included the liberalization of the insurance sector, the adoption of automatic clearance for foreign direct investment in many sectors, and a landmark agreement on state sales tax rationalization. At the same time, however, a clearly defined agenda for reform has yet to be established, and critical and difficult challenges remain to be addressed.

References Acharya, S., 1999, "Managing External Economic Challenges in the Nineties: Lessons for the Future," Anniversary Lecture delivered at the Centre for Banking Studies, Central Bank of Sri Lanka, September 19. Ahluwalia, M.S., 2000, "Economic Performance of States in Post-Reforms Period," Economic and Political Weekly, May 6, pp. 1637-48. , 1999, "Priorities for Economic Reforms," 13th Jawaharlal Nehru Memorial IFFCO Lecture, November. Aiyar, S., 2001, "Growth Theory and Convergence Across States: A Panel Study," in India: Prospects and Challenges, ed. by T. Callen, P. Reynolds, and C. Towe (Washington: International Monetary Fund), Chapter 8. Bajpai, N., T. Jian, and J.D. Sachs, 1999, "Economic Reforms in China and India: Selected Issues in Industrial Policy," Development Discussion Paper No 580, Harvard Institute for International Development. Bajpai, N., and J.D. Sachs, 1997, "India's Economic Reforms: Some Lessons from East Asia," The Journal of International Trade & Economic Development, Vol. 6, No. 2, pp. 135-64. , 1999, "The Progress of Policy Reform and Variations in Performance at the Sub-National Level in India," Development Discussion Paper No. 730, Harvard Institute for International Development. Basu, K., G.S. Fields, and S. Desgupta, 1999, "Retrenchment, Labor Laws and Government Policy: An Analysis with Special Reference to India," World Bank, unpublished mimeo. Desai, A.V., 1999, "The Economics and Politics of Transition to an Open Market Economy," OECD Technical Paper No. 155, October. Economist Intelligence Unit, 2000, India Country Report, First Quarter. Government of India, Ministry of Finance, Economic Survey, various issues.

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Hemming, R., 1996, "Strengthening Public Enterprise Performance," in India—Selected Issues (IMF Staff Country Report No. 96/132, January). Herderschee, ]., 2000, "Trade Policy Developments," in India—Recent Economic Developments (IMF Staff Country Report No. 00/106). Hussain Committee, 1997, Report of the Expert Committee on Small Enterprises, New Delhi. International Labour Organization, 1996, "India: Economic Reforms and Labour Policies" (New Delhi: UNDP). Kelkar, V, 1999, "India's Emerging Economic Challenges," Economic and Political Weekly, August 14-20. Kongsamut, P., and A. Vamvakidis, 2000, "Economic Growth," in The Philippines: Toward Sustainable and Rapid Growth, IMF Occasional Paper 187 (Washington: International Monetary Fund). Krishna, P., and D. Mitra, 1998, "Trade Liberalization, Market Discipline and Productivity Growth: New Evidence from India," Journal of Development Economics, Vol. 56 (August), pp. 447-62. Radhakrishna, R., and K. Subbarao, 1997, "India's Public Distribution System: A National and International Perspective," World Bank Discussion Paper No. 380, November. Rajiv Gandhi Institute for Contemporary Studies, 1998, Agenda for Change, March. Reserve Bank of India, Annual Report, various issues. Tendulkar, S., 1998, "Indian Economic Policy Reforms and Poverty: An Assessment," in India'sEconomic Reforms and Development: Essays for Manmohan Singh, ed. by I.]. Ahluwalia and I.M.D. Little (Delhi: Oxford University Press). Tzanninis, D., 1996, "Controlling Central Government Expenditure," in India—Selected Issues (IMF Staff Country Report No. 96/132, January). World Bank, 1998, India: Macroeconomic Update 1998. , 2000, India: Policies to Reduce Poverty and Accelerate Sustainable Development, Report No. 19471-IN, January. World Economic Forum, 1998, 1998 Global Competitiveness Report. Zagha, Roberto, 1998, "Labor and India's Economic Reforms," Policy Reform, Vol. 2 (September), pp. 403-26.

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List of Contributors

Shekhar Aiyar is a doctoral student at Brown University. He was an intern in the IMF's Asia and Pacific Department while the work presented in this book was being prepared. Tim Callen is a Senior Economist in the IMF's Asia and Pacific Department. Prior to joining the IMF, he worked for the Bank of England, the Reserve Bank of Australia, and Hambros Merchant Bank. He holds a master's degree from Warwick University. Paul Cashin is an Economist in the Commodities and Special Issues Division of the IMF's Research Department. During his career at the IMF he has undertaken research on industrial and developing countries, including fiscal and current account sustainability issues. He holds a doctorate from Yale University. Anna Ilyina is an Economist in the IMF's Research Department. While the work for this book was being prepared, she was in the IMF's Asia and Pacific Department. She holds a doctorate from the University of Pennsylvania. Daniel Kanda is an Economist in the IMF's Asia and Pacific Department. He holds a doctorate from Queen's University. Nilss Otekalns is Associate Professor of economics in the Department of Economics of the University of Melbourne, Australia. While the work on this book was being prepared, he was a Visiting Scholar in the IMF's Research Department. He holds a doctorate from La Trobe University. Patricia Reynolds is a Senior Economist in the IMF's Asia and Pacific Department. Prior to joining the IMF, she was Assistant Professor at the University of Southern California. She holds a doctorate from Northwestern University. Ratna Sahay is the Advisor to the First Deputy Managing Director of the IMF. While work for this book was completed, she was in the IMF's 191

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Research Department, where she worked on a variety of issues related to developing and transition countries. She holds a doctorate from New York University. Christopher Towe is a Division Chief in the IMF's Asia and Pacific Department. Prior to joining the Fund, he worked at the Bank of Canada and holds a Ph.D. from the University of Western Ontario.

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