Financing

INDIA TRYING TO LIBERALISE: ECONOMIC REFORMS SINCE 1991
CHARAN D. WADHVA1 INTRODUCTION

The foundation of credible national security is based on the level of Economic prosperity and well-being of the population of any country. This is Especially so for developing countries like India. The attainment of sustained High economic growth is a necessary condition for improving the national security and the quality of life of the people throughout the country. Many developing countries in the Asia-Pacific region, including China and India where nearly one third of the world·s population live, are currently going through economic transitions. The central objective of transition through economic liberalization is to improve the competitive efficiency of the economy in the global marketplace to sustain accelerated rates of economic growth and thereby continuously improve the security and well being of the people. India launched its market-oriented economic reforms in 1991. China launched similar reforms from 1978 and is now well ahead of India in integrating its national economy with the global economy. However, India is slowly but surely catching up in this race. The contrast in the experiences of these two countries with economic reforms under radically different political systems is remarkable. While comparisons between China and India are often made by development analysts and are inevitable when we discuss economic transitions in Asia, a more realistic assessment of the experiences of both these major countries of Asia can only be made if we explicitly take into account the stark contrast in their political systems. In India, post-1991 economic reforms have been evolutionary and incremental in nature. There have been delays and reverses in some areas due to the interplay of democratic politics, coalition governments, and pressure groups with vested interests. However, each of the five successive governments that have held office in India since 1991 have carried on these
1I

thank Dr. N K Paswan for his help in preparing the statistical tables included in this paper.

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economic reforms, which have been based on market liberalization and a larger role for private enterprise. WHY THE POST-1990 REFORMS? It is well known that from 1951 to 1991, Indian policy-makers stuck to a path of centralized economic planning accompanied by extensive regulatory controls over the economy. The strategy was based on an ¶inward-looking import substitution· model of development. This was evident from the design of the country·s Second Five-Year Plan (1956-61), which had been heavily influenced by the Soviet model of development.2 Several official and expert reviews undertaken by the government recommended incremental liberalization of the economy in different areas, but these did not address the fundamental issues facing the economy.3 India·s economy went through several episodes of economic liberalization in the 1970s and the 1980s under Prime Minsters Indira Gandhi and, later, Rajiv Gandhi. However, these attempts at economic liberalization were halfhearted, self-contradictory, and often self-reversing in parts.4 In contrast, the economic reforms launched in the 1990s (by Prime Minister P V Narasimha Rao and Dr. Manmohan Singh as his Finance Minister) were ¶much wider and

deeper·5 and decidedly marked a ¶U-turn· in the direction of economic policy followed by India during the last forty years of centralized economic planning.6 THE DRIVING FORCES BEHIND THE REFORMS As in many developing countries, India also launched its massive economic reforms in 1991 under the pressure of economic crises.7 The twin crises were reflected through an unmanageable balance of payments crisis and a socially
2 See 3 Reference

Government of India, Second Five-Year Plan, (New Delhi, 1956). may be made to following illustrative books for tracking down these ¶tinkering· changes in the thinking of Indian policy makers and planners : Bimal Jalan ed., The Indian Economy: Reforms and Prospects, (New Delhi : Viking Publishers, 1991); Charan D Wadhva ed., Some Problems of India¶s Economic Policy (New Delhi : Tata McGraw Hill, 2ed 1977); and Charan D Wadhva, Economic Reforms in India and the Market Economy (New Delhi: Allied Publishers, 1994), Ch. II. 4 See for example, John Harris, ¶The state in Retreat? Why has India experienced such Halfhearted Liberalization in the 80s? IDS Bulletin (Institute of Development Studies, Sussex, U.K.), Vol. 18, No. 4, 1987. 5 Jeffrey D Sachs; Ashutosh Varshney; and Nirupam Bajpai eds., India in the Era of Economic Reforms (New Delhi, Oxford University Press, 1991), p.1. 6 Charan D Wadhva, Economic Reforms, op.cit., p.xviii 7 For details of magnitude and diagnosis of causes of this economic crisis, see Ibid.
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intolerably high rate of inflation that were building up in the 1980s and climaxed in 1990-91.8 This can be seen from the data provided in Table 1.9 The current account deficit as a percentage of GDP peaked at a high of 3.1 percent (compared to an average level of 1.4 percent in the early 1980s). The inflation rate (as measured by point-to-point changes in the Wholesale Price Index) had also climbed to the socially and politically dangerous double-digit level, hitting 12.1 percent in 1990-91.
TABLE 1: SELECTED MACRO ECONOMIC INDICATORS 1989-2003

Indicators 1989-90 1994-95 1999-00 2000-01 2001-02 2002-03
A. Growth of GDP (%) 5.6 6.3 6.1 4.4 5.6 4.4 B. GDP Growth by Sectors (%): i. Agriculture & Allied 2.7 4.9 0.3 -0.4 5.7 -3.1 ii. Industry, of Which Manufacturing 6.7 8.3 4.0 7.3 3.4 6.1 iii. Services 6.7 6.0 10.1 5.6 6.8 7.1 C. Inflation Rate (WPI Index (%)) 9.1 10.4 4.8 2.5 5.2 3.2 D. Current Account Balance as % of GDP -3.1 -1.1 -0.5 -0.5 na E. Foreign Exchange Reserves (US $ Bn.) 3.37 19.65 35.06 39.55 51.05 69.89 F. Exchange Rates (Rs/US $) 16.6 31.4 43.33 45.51 47.69 48.44 G. Rate of Growth of : i. Exports (%) 18.9 18.4 10.8 21.0 -1.6 20.4 ii. Imports (%) 8.8 22.9 17.2 1.7 1.7 14.5 iii. Exports as % of GDP 6.4 9.6 9.1 10.4 9.9 na iv. Imports as % of GDP 9.3 10.5 12.4 11.8 11.6 na H. Fiscal Deficit as % of GDP 7.9 4.7 5.4 5.6 5.9 5.5 I. Revenue Deficit as % of GDP 2.6 3.1 3.5 4.1 4.2 3.9 J. Saving Ratio as % of GDP 22.3 24.9 24.1 23.4 24.0 na K. Investment as % of GDP 24.9 25.4 25.2 24.0 23.7 na

Source: Ministry of Finance, Government of India, Economic Survey, (New Delhi, various years). Most economic policy makers and analysts held widely convergent views on the causes of the unprecedented economic crisis faced by India in 1990-91. The root cause of the twin crisis could be traced to macro-economic mismanagement throughout the 1980s as reflected in an unsustainably high
8 This

can be seen from all references cited in footnotes 1,2,4 and 5. In addition see, Vijay Joshi and I.M.D. Little, India¶s Economic Reforms 1991-2001 (Delhi, Oxford University Press, 1997).

9 Other

data used in the text (that is, not in the tables) is taken from Ministry of Finance, Government of India, Economic Survey (New Delhi, various years) unless otherwise noted.
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fiscal deficit, in particular the revenue deficit and the monetized deficit.10 The central government·s fiscal deficit alone peaked at 7.9 percent as a percentage of GDP in 1989-90. Thus growing fiscal profligacy (and irresponsibility) and the unviable financing patterns of the fiscal deficit prevailing in the 1980s made high levels of annual GDP growth (peaking at 5.6 percent in 1989-90) unsustainable.11 Foreign-exchange reserves dwindled to a low of US$2.2 billion (with less than 15 days· cover against annual imports). India stared bankruptcy in the face as it struggled to meet external debt obligations. Prime Minister Narasimha Rao converted the prevailing economic crisis into an opportunity to launch massive economic reforms. First, he introduced an economist (rather than a politician) into the Cabinet as Finance Minister and gave the new Minister his full support, allowing him to evolve and implement path-breaking economic reforms. The new economic policies radically departed from the economic policies and regulatory framework pursued in India during the previous forty years.12 The Rao government recognized in 1991 that the time had come to reshape India·s economic policies by drawing appropriate lessons from the ¶East Asian Miracle· based on more export-oriented and more globally connected strategies of development, as successfully practiced earlier by Japan and South Korea and also by the South East Asian tigers Malaysia, Singapore, Indonesia and Thailand.13 The East Asian development model had been remarkably successful in achieving sustained high growth rates accompanied by rapid growth in the living standards of the people in just two decades. India had missed on both these fronts by relentlessly pursing import substitution and a relatively closed economy model of development. The Rao government, after launching the relatively aggressive (by past Indian standards) reforms, was soon confronted with the political constraints of ¶competitive populism· during elections held at the state level in 1993. Therefore, the government adopted a ¶middle path·, furthering the economic
further details, see Wadhva, Economic Reforms, op.cit., ch. I. the claim that India had clearly transcended the so-called ¶Hindu rate of growth· of GDP at 3.5 percent per annum (trend annual growth rate) achieved for the two decades of 1960s and 1970s and had moved over to higher annual average growth rate of 5.5 percent in the 1980s could not be accepted since the latter jump proved to be financially unsustainable. 12 The major economic reforms launched during the full five-year tenure of the Narasimha Rao Government (1991-96) are highlighted below. 13 There are of course, lessons to be learnt by India from the ¶East Asian debacle· of 1997-98 (the so-called ¶East Asian Financial Crisis) but these need not detract us here as most South Asian and Southeast Asian countries had overcome this crisis by 1999.
10 For 11 Thus

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reforms in an ¶incremental· fashion in order to continue to extending their width and depth during the remainder of the government·s term. The government took two years to get over the immediate macroeconomic crisis, initially with the help of a balance of payments loan facility from the International Monetary Fund. The government came out with a clear enunciation of its vision and the objectives of its economic reforms only after regaining macro-economic stability. This was contained in the Discussion Paper on Economic Reforms brought out by the Ministry of Finance in July 1993. To quote:
The fundamental objective of economic reforms is to bring about rapid and sustained improvement in the quality of the people of

India. Central to this goal is the rapid growth in incomes and productive employment« The only durable solution to the curse of poverty is sustained growth of incomes and employment«. Such growth requires investment: in farms, in roads, in irrigation, in industry, in power and, above all, in people. And this investment must be productive. Successful and sustained development depends on continuing increases in the productivity of our capital, our land and our labour. Within a generation, the countries of East Asia have transformed themselves. China, Indonesia, Korea, Thailand and Malaysia today have living standards much above ours«. What they have achieved, we must strive for.14

MAJOR ECONOMIC REFORMS Economic reforms launched since June 1991 may be categorized under two broad areas:
‚ major macro-economic management reforms; and ‚ ‚ structural and sector-specific economic reforms ‚

Naturally, the attention of the new government that took office in June 1991 was primarily focused on crisis management dealing with the balance of payments. It was of the utmost importance to restore India·s international credibility by meeting its scheduled external debt liabilities and through maintaining a more realistic exchange rate consistent with market obligations. Achieving macro-economic stabilization was also an urgent priority, necessitating control of intolerably high inflation. It was recognized that
14 Government of India, Ministry of Finance, Department of Economic Affairs, ¶Economic Reforms : Two Years After and the Task Ahead·, Discussion Paper, New Delhi : July 1993, pp.1-2.

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macro-economic stabilization would provide a sound foundation for mediumand long-term structural economic reforms and accelerate the rate of economic growth in a sustained manner. This would be possible by removing distortions created by controls and by improving the competitive edge for Indian goods and services in global markets as well as in the markets of major regional trading blocs. I describe below the major economic reforms, with greater focus on structural economic reforms in selected sectors of the economy.15
MACRO-ECONOMIC MANAGEMENT REFORMS

Macro-economic management reforms have focused on controlling the politically difficult problems of reducing the fiscal and (even more so) revenue deficits. The capital account deficit does not pose long-term problems as investment in productive capital made in the present, if prudently carried out, will generate an adequate income stream to pay for capital costs incurred and generate positive returns in the future. India·s problem is primarily in the area of revenue deficits. From 1950 to 1980 the national budget was usually characterized by revenue surpluses and capital account deficits . However, after 1980, all (democratic) governments for political reasons had willingly allowed the revenue deficit to rise over the years to dangerously high levels, and had found it increasingly difficult to reduce. The revenue deficits reflected an excess of annual consumption expenditure by the government over its annual income. The deficit was caused by excessive employment in the government sectors, uneconomical pricing of goods and services by public sector enterprises, a growing interest burden, mounting subsidies, and rising defense expenditures. Downsizing the government (through the bureaucracy or public sector enterprises and banks)

was also difficult and met staff resistance from the organized employees.
Attempts at Reducing the Fiscal Deficit

Faced with the necessity of reducing the fiscal deficit in the crisis year of 1991-92, Finance Minister Singh attempted to reduce fertilizer and food subsidies in 1991-92 and to some extent in 1992-93. Simultaneously, he (and several subsequent finance ministers) resorted to the softer options of reducing public investment expenditure and reducing public expenditure on social welfare services from 1991 to 1995. These measures did help reduce the fiscal deficit of the central government to 4.8 percent of GDP at the end of
15 I have drawn upon various annual issues of Economic Survey produced by the Government of India (Ministry of Finance) for this section.

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1992-93. However, further cuts in fertilizer and food subsidies could not be carried out as these measures were opposed in Parliament and proved suicidal for the ruling Congress Party, which lost power in state elections in 1993-94. Meanwhile, the fiscal position of the state governments also started deteriorating. The combined fiscal deficit of the central government and the states climbed to the unacceptably high level of 10-11 percent of GDP in 2002-03. Some state governments have begun to address their fiscal deficit problems. The central government has recently started linking further transfers of resources to the states to the progress of state-specific economic reforms aimed at reducing deficits.16 The good news for macro-economic management reforms is that the pre1990 pattern of ¶deficit financing· (that is, the printing of currency) to meet the fiscal deficit has now been effectively curbed. The autonomy of the central bank (the Reserve Bank of India) in regulating the money supply to control inflation has been assured within the limits of monetary policy. This has led the government to resort to larger and larger domestic borrowing. The bad news is that government borrowings have risen so high that the economy is moving towards an ¶internal debt trap·.17 Further growth of internal debt needs to be curbed but the government is in no mood to close off this easy way of financing its rising fiscal deficit. The finances of most state governments are in even poorer shape and some have occasionally resorted to market borrowings to meet their payrolls.
Tax Reforms

Since 1991 several efforts have been made through the annual budget process to achieve tax reforms.18 These have focused on: (i) expanding the tax base by including services (not previously taxed); (ii) reducing rates of direct taxes for individuals and corporations; (iii) abolishing most export subsidies, (iv) lowering import duties (covered below by us under structural reforms relating to trade policies/external sector); (v) rationalizing sales tax and reducing the cascading effect of central indirect taxes by introducing a Modified Value Added Tax and a soon-to-be implemented nationwide Value Added Tax; (vi) rationalizing both direct and indirect taxes by removing unnecessary exemptions; (vii) providing for tax incentives for infrastructure
details see Government of India, Economic Survey 2002-03. is estimated that the interest payments currently pre-empt more than 60 percent of the total revenue of the central government leaving very little resources for fresh public investment. See Economic Survey 2002-03. 18 For details see the relevant official annual documents for the Union Budget usually presented by the Finance Minister to the Parliament each year on February 28, 2003.
16 For 17 It

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and export-oriented sectors, including setting up special (Export) Economic

Zones; and (viii) simplification of procedures and efforts for improving the efficiency of the tax administration system especially through computerization.19
Resource Generation through Divestment

The governments of India, both at the central and state government levels, have initiated divestment programs to sell government equity in several public-sector enterprises. Unfortunately, the sales proceeds have mostly been used to finance fiscal deficits rather than for fresh public investment, socialsector spending, or reducing the interest burden on ballooning public debt.
STRUCTURAL ECONOMIC REFORMS

Structural reforms since 1991 have been sector-specific. The sectors subjected to reform have been carefully selected and the coverage of sectors under structural reforms has been extended over time. The major structural economic reforms carried out since 1991 have been primarily in the following areas: Trade Policy/External Sector; Industrial Policy; Infrastructural Sector Policies; Divestment/Privatization Policies; the Financial Sector; and in Policies for Attracting Foreign Direct Investment.20 The thrust of the reforms in all areas has been to open India·s markets to international competition, remove exchange rate controls, encourage private investment and participation in industry and, in the finance markets, to liberalise access to foreign capital and to ensure that foreign investment is not penalized merely for being foreign.21
19 For the latest proposals for tax reforms, see the two (published) reports of the Committee on Reforms of Direct and Indirect Taxes (Chairman Dr. Vijay L Kelkar), New Delhi : Government of India, Ministry of Finance, 2003. 20 It may be pointed out that in the vital areas of macro-economic policy including fiscal policy monetary policy and exchange rate policy, there is an overlap between macroeconomic stabilization policies and structural reforms. The long-term growth inducing roles of all macroeconomic policies can be considered under structural reforms. We focus here on sectorspecific reforms although overlaps exist with agro-economic policies in our discussion. For an annual overview of structural reforms carried out in India, see Government of India Economic Survey for the relevant year (latest available being 2002-03). 21 Financial sector reforms were initiated on the basis of two reports by the Narasimham Committee. Government of India, Ministry of Finance, Report of the Committee on Financial System (Chairman : Mr. M Narasimham), New Delhi : November 1991; and Report of the Committee on Banking Sector Reforms (Chairman : Mr. M Narasimham), New Delhi 1996.

CHARAN WADHVA

267 Reorientation of Planning

Consistent with the spirit of the market-oriented and private sector-led economic reforms launched since 1991, the government has reoriented the role of planning in India. It has been recognized that market forces and the state should be given roles that play to their comparative advantages and that they should work together as partners in the economic development of the nation. While private initiative should be encouraged in most areas of business activities, the state should increasingly play a pro-active role in areas in which the private sector is either unwilling to act or is incapable of regulating itself in the social interest. The areas in which the state has a comparative advantage over the private sector include poverty alleviation programs; human resource development; provision of social services such as primary health and primary education; and similar activities categorized as building human capital and social infrastructure. The state also has a new role in setting up independent regulatory authorities to encourage genuine competition and to oversee the provision of services by the private sector in critical areas such as utilities, water supply, telecommunications, and stock market operations to avoid the ill effects of speculation and to maintain a workable balance between the interests

of the producer and the consumers. Economic liberalization in the organized manufacturing sector (subjected to rigid labor laws for retrenchment) has led to growth with very little additional employment. This can create serious social unrest and fertile ground for terrorist and other anti-social activities that attract unemployed youths in the absence of gainful employment. Market-based economic reforms also often lead to increasing disparities between the rich and the poor and between infrastructurally backward and more developed states. The government has to intervene and calibrate the contents and speed of market-based economic reforms to more effectively address the specific areas of ¶market failures and weaknesses· to optimize growth with social justice. The new role assigned to planning, consistent with market-based economic liberalization, can perhaps best be illustrated with the goals and the strategies incorporated in India·s Tenth Five-Year Plan (2002-07).22 The Plan has targeted an annual growth rate of eight percent. Along with this growth target, the government has laid down targets for human and social development. Timely corrective actions will be proposed to ensure growth is accompanied by social justice. The key indicators of human and social development targeted
22 See, Government of India, Tenth Five Year Plan 2002-07 (in three volumes) (New Delhi : Planning Commission, 2002).

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under this Plan include: a reduction of the poverty rate by five percentage points by 2007; providing gainful employment to at least those who join the labor force during 2002-07; education for all children in schools by 2003; and an increase in the literacy rate to 75 percent by March 2007. The development strategy adopted for the Tenth plan envisages:
redefining the role of Government in the context of the emergence of a strong and vibrant private sector, the need for provision of infrastructure and the need for imparting greater flexibility in fiscal and monetary policies. With a view to emphasizing the importance of balanced development of all states, the Tenth plan includes a state-wise break-up of broad developmental targets including targets for growth rates and social development consistent with national targets. The Tenth Plan has emphasized the need to ensure equity and social justice, taking into account the fact that rigidities in the economy can make the poverty-reducing effects of growth less effective. The strategy for equity and social justice consists of making agricultural development a core element of the Plan, ensuring rapid growth of those sectors which are most likely to create gainful employment opportunities and supplementing the impact of growth with special programs aimed at target groups.23

THE POLITICAL ECONOMIC DIMENSIONS OF THE REFORMS India·s heterogeneity and unity in diversity through a stable democratic system must be appreciated. A country like India, with more than one billion people, some 16 officially recognized major languages, and vast ethnic and religious diversities, poses major governance challenges. India has achieved remarkable success in holding the country together. India had governed its economy through a policy regime of centralized planning accompanied by an extensive regulatory framework for more than forty years before it launched economic reforms in 1991. It has, therefore, not been easy to change the mindsets of policy makers (especially at the lower levels of bureaucracy) and of other beneficiaries of the entrenched regime. Building a political consensus on economic reforms across the various political parties with their vastly different ideologies has been a very difficult

process. This has been especially true under coalition governments but also even when a single party has held a majority. Consensus building and reform
23 As

summarized in Government of India, Economic Survey 2002-03, pp.41-42.

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implementation is complicated further when the central government and the states are in the hands of different parties (or coalitions). The rapidly increasing frequency of elections at the central and state levels during the post-1990 period of economic reforms has led the incumbent governments and the contesting opposition parties to resort to ¶vote-bank· politics or ¶competitive populism·. The vested interests of groups such as trade unions, producers with licenses and holding monopoly interests, and bureaucrats with ¶rent seeking· capabilities have often scuttled or delayed further market-based economic reforms. These factors explain well India·s ¶stalled· reforms in certain areas directly hurting vested interests of selected lobby groups.24 The growth of regional parties and their assumption of power in many Indian states has further delayed the percolation of central-level economic reforms down to the state level. Weiner has recommended the need for a change in the mindsets of state policy makers:
The pursuit of market-friendly policies by state governments requires a change in the mindsets of state politicians, new skills within the state bureaucracies, and a different kind of politics. More fundamentally, it requires rethinking on the part of state politicians, activists in non-governmental organizations, journalists and politically engaged citizens as to what is the proper role of government, and how and to what end limited resources should be used.25

Considering the compulsions arising from the above political factors, Montek S. Ahluwalia explains the rational for adopting the ¶gradualist· approach in implementing of economic reforms and the resultant ¶frustratingly slow· pace of reforms (compared to East Asian standards):
The compulsions of democratic politics in a pluralist society made it necessary to evolve a sufficient consensus across disparate (and often very vocal) interests before policy change could be implemented and this meant that the pace of reforms was often frustratingly slow. Daniel Yergin (1998) captures the mood of frustration when he wonders whether the Hindu rate of growth has been replaced by the Hindu rate of change!26
¶Introduction· in Jeffrey D. Sachs, Ashutosh Varshney and Nirupam Bajpai, op.cit. Weiner, ¶The regionalization of India·s Politics and It·s Implications for Economic Reforms· in Ibid., Ch. 8, pp.292-3. 26 Montek S Ahluwalia, ¶India·s Economic Reforms: An Appraisal·, in Ibid., pp.26-27. See also Daniel Yergin, The Commanding Heights, New York: Simon and Schuster, 1998.
24 See, 25 Myron

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Finally, most (if not all) political parties implementing market-based economic reforms since 1990 have failed to ¶market· these reforms to the masses as being highly beneficial for them. The opposition parties have often termed these reforms as ¶pro-rich· and ¶anti-poor·. Ironically, even the Congress Party, which initiated the economic reforms when in power, has, as an opposition party, opposed some of them (such as further public-sector divestments) Varshney has made a valid distinction between ¶elite-based· reforms versus ¶mass-based· reforms. Market-based reforms have not drawn mass appeal nor aroused mass passions. This dichotomy between the concerns

of the urban elite and the mass of the population has clearly defined the limits to economic reforms in India.27 STATE-LEVEL ECONOMIC REFORMS To increase the effectiveness of the post-1990 economic reforms, they must be simultaneously extended from central to state governments and below to the third tier of local governments. The maladies afflicting the finances of the state governments are similar in nature to those afflicting the central finances described earlier. According to the Reserve Bank of India, the Gross Fiscal Deficit of all the states of India (including the Union Territories) was estimated at 3.3 percent in 1991-92.28 Throughout the 1990s the state governments also experienced a rapid rise in their revenue expenditures mainly through salaries, pensions, interest payments and subsidies (including free power to farmers in some states out of political considerations). This trend has ¶severely constrained the states· ability to undertake development activities· and to devote more funds to provide social services such as primary education.29 The situation worsened after the states were forced to follow the center to implement generous pay increases for government employees recommended by the Fifth Central Pay Commission in 1997-98. Despite initial resistance in the Communist Party-ruled state of West Bengal, all state governments (including West Bengal), in their own ways and suiting their own conditions, implemented economic reforms in the 1990s and are continuing these reforms broadly in line with the ongoing national economic reforms. This owes in part to enlightened self-interest combined
27 For further details, see Ashutosh Varshney, ¶Mass Politics or Elite Politics?·, in Jeffrey D Sachs, Ashutosh Varshney and Nirupam Bajpai, op.cit., Ch.7. 28 Reserve Bank of India, ¶Finances of state Governments : 1992-93·, in the Reserve Bank of India Bulletin, March 1993. 29 Government of India, Economic Survey 2002-03, op.cit, p.5.

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with a healthy competitive spirit designed to improve their position and ranking among the states. There is also the states· desire to avail themselves of larger transfers of development funds from the center, which the central government linked to economic reforms at the state level. Every state has recognized the need to attract private investment flows from both domestic and foreign investors. State governments have therefore progressively liberalized their policies and procedures on a competitive basis. Several of them have also explicitly recognized the need to improve human resource development and have progressively expanded activities to provide a better quality of life to the population of their states.
Incentives and Conditionalities

The government of India has introduced a scheme called the States· Fiscal Reforms Facility (2000-05). Under the Facility, the central government set up a five-year incentive fund ¶to encourage states to implement monitorable fiscal reforms·. Additional amounts by way of ¶open market borrowings· are allowed if the state is faced with a structural adjustment burden. State governments may draw up a Medium Term Fiscal Reforms Programme (MTFRP) to achieve specified targeted reductions in their consolidated fiscal deficit, especially the revenue deficit. The coverage of the MTFRP has been extended to cover a Debt Swap Scheme in order to help state governments reduce their growing public debt. This scheme is designed to help liquidate the burden of high-cost loans taken from the central government through the allocation of additional market

borrowings at currently prevailing lower interest rates. The major structural reforms carried out by several state governments include: (i) Measures to improve quality of life through improvements in basic public services such as primary health, primary education, and rural infrastructural services such as electricity, water, and roads. Madhya Pradesh has brought out the first state-level Human Resource Development Report. Other states have followed suit. The Planning Commission has also published a comprehensive National Human Development Report assessing human development nationwide and in the major states.30 (ii) Clustering high-tech industries and services (for example, in software parks).
30 Government

of India, National Human Development Report 2001 (New Delhi : Planning Commission, 2002).
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(iii) Setting up Special Economic Zones and Agri-Economic Zones to promote exports. (iv) Formulating state-level industrial policies to attract investments. (v) Power-sector reforms that restructure state Electricity Boards by separating generation, transmission and distribution activities, encouraging independent power producers in the private sector to invest in the power sector, and setting up independent state Electricity Regulatory Authorities. THE PERFORMANCE OF THE INDIAN ECONOMY Despite the slow pace of implementation of the economic reforms and certain hiccups and delays caused primarily by the compulsions of democratic politics, the performance of the Indian economy under the reforms carried out so far shows a mixed picture of notable achievements and weaknesses. The performance has been impressive on some fronts, satisfactory on several other fronts, and inadequate in certain respects. India has still to launch deeper (socalled ¶second-generation·) reforms in various areas to get the best results.
Areas of Impressive Performance

Through reform, India overcame its worst economic crisis in the remarkably short period of two years. Macro-economic stabilization reforms (along with structural economic reforms) were launched in June 1991. Through prudent macro-economic stabilization policies including devolution of the rupee and other structural economic reforms the balance of payments crisis was clearly over by the end of March 1994. Foreign exchange reserves had risen to the more than adequate level of US$15.07 billion and the current account deficit as a percentage of GDP was nearly eliminated. Export growth rate at 20.0 percent in 1993-94 over the previous year was quite encouraging. Macro-economic stability has endured in the ten years of economic reforms to 2003. Foreign-exchange reserves peaked at US$70 billion at the end of March 2003 (and touched US$80 billion in June 2003).31 The current account ¶recorded a surplus³equivalent to 0.3 percent of GDP³in 200102·.32 Food stocks with the Food Corporation of India, held to ensure national food security, peaked at sixty million tons (compared to the required twenty million tons). It took longer to control inflation but this led to relatively more enduring results (excluding the impact of externally determined fuel prices). Since 2002, the country has enjoyed a low interest-rate regime. These
31 The 32 Government

Rupee had started appreciating against US$ after April 2003. of India, Economic Survey 2002-03, op.cit., p.3.

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performance indicators have helped to provide an ¶enabling environment for the macroeconomic policy stance.·33 India has also increasingly integrated its economy with the global economy. After half a century of inward-orientation, the share of India·s trade as a proportion of GDP rose from 13.1 percent in 1990 to 20.3 percent in 2000. By Indian standards this is an impressive performance. India·s economy has also successfully moved into a higher trajectory of growth and displayed strong dynamism in selected sectors. This encouraging performance brightens the prospects for stepping up India·s growth rate and improving the competitive edge in the years to come through further appropriate economic reforms. The average annual growth rate of 5.8 percent achieved by the Indian economy during the years of economic reforms since 1992 is encouraging. Currently, after China, India is among the fastest-growing countries in Asia. Since the annual rate of population growth has slowed significantly to nearly 1.8 percent during the 1990s, per capita income has been growing at a healthier real rate of four percent per annum. India·s growing middle class of more than 350 million people, with a reasonably affluent standard of living, provides a huge market for foreign corporations, especially since April 2003, when all quantitative restrictions on imports were lifted. Along with its fairly good growth rate (which, however, is far below the potential growth rate of eight percent targeted by India·s Tenth Five-Year Plan), India has been successful in reducing poverty. The poverty ratio (that is, people below the poverty line as a percentage of the population) as estimated by the Planning Commission at the national level came down from 36 percent in 1993-94 to 26.1 percent in 1999-2000. The poverty ratio during this period declined both in rural areas and in urban areas. There is little doubt that poverty in India has been reduced during the last decade. The Planning Commission has set a poverty ratio target of 19.3 percent by the end of the Tenth Plan period (to March 2007). An important indicator of gains from economic reforms, reflecting the attractiveness of India as an investment destination, is shown by the increasing inflows of both FDI and Foreign Institutional Investment (FII) into India. Inflows of both FDI and FII into India has increased in the decade to 2002. On average, according to the Ministry of Finance·s Economic Survey, India has
33 Reserve

Bank of India, Annual Report 2001-02, Mumbai, Reserve Bank of India, p.1.

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been attracting US$2.5 billion to US$3 billion and nearly US$4 billion in 200102 in FDI per annum mostly in various infrastructural sectors such as large power and telecommunication projects. India·s economy under the reforms has made rapid strides in selected industrial areas and knowledge- and skill-intensive services. These specific growth areas have experienced significant restructuring under more competitive conditions in the marketplace through mergers and acquisitions and technological and managerial innovations. This has led to the achievement of recognizable increases in international competitiveness in a number of sectors including auto components, telecommunications, software, pharmaceuticals, biotechnology, research and development, and professional services provided by scientists, technologists, doctors, nurses, teachers, management professionals and similar professions. The spillover effects of India·s increasing international competitiveness have helped in improving the

rate of growth of export earnings. They have also directly benefited Indian consumers by making better quality, lower-priced goods available.
Areas of Weakness

The most notable weakness of the reform process has been in fiscal consolidation. Indian governments at both the central and state levels have failed miserably to reign in growing revenue deficits and reduce the overall fiscal deficit. The foundations for a sustainable high growth rate in any economy lie in maintaining fiscal discipline. This has not been adequately achieved by Indian policymakers. Excessive use of market borrowing to cover budget deficits has often put upward pressure on interest rates and pre-empted (¶crowded out·) borrowings by the private sector. The structure of revenue expenditure and political obstacles to any reduction of subsidies and downsizing the government at all levels have been primarily responsible for the lack of progress on fiscal reforms. The real issue in restructuring government finances is ¶right-sizing· the government by adequately increasing government expenditure on infrastructure of both the hard and soft varieties, based upon growing resources. India·s record on social development expenditure has been poor considering Indian requirements and poor also in relation to many developing countries, including some of the least developed countries in Sub-Saharan Africa. The abysmally low ranking of India on the Human Development Indices computed by the United Nations bears testimony to this assertion.34 Dreze and Sen remarked in 1995 that India·s social development indicators in
34 United

Nations, Human Development Report, available annually at http://hdr.undp.org.

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1991 (when reforms were launched) were lower than in several East and Southeast Asian countries three decades ago.35 India must bridge this social development gap by significantly increasing its public expenditure on social services if it wishes to achieve the targeted annual growth rate of eight percent set by the country·s Tenth Plan. As Ahluwalia has remarked, larger investment in the social sectors is ¶necessary not only because social development is an end in itself, but also as a precondition of accelerating growth·.36 The massive shift required in the pattern of government expenditure in India in favor of social sectors and infrastructure can only be carried out through structural fiscal reforms. The Fiscal Responsibility and Budget Management (FRBM) Act (2003) provides for complete elimination of the revenue deficit by 31 March 2008. This Act is, therefore, a step in the right direction. Despite ¶dilution· of the original draft bill, it is important legislation because it sets the condition that the government can run a fiscal deficit only if borrowings are made to finance investments which will enhance productive capacity·.37 Another major weakness of the Indian economic reforms is the economy·s experience with ¶jobless growth· in the post-1990 period. Rigid labor laws relating to retrenchments have constricted growth in the organized manufacturing sector. As a labor surplus country, there already exists a huge backlog of both ¶open· and ¶disguised· unemployment. With a growing population, every year adds to the labor force. Economic reforms have accelerated growth but failed to generate adequate employment. For example, the rural unemployment rate, after declining to 5.61 percent in 1993-94, rose to 7.21 percent in 1999-2000 as did the All-India (urban plus rural) rate of unemployment. If this disturbing trend is allowed to continue, it will breed

social unrest and add to the ranks of terrorists and other anti-social elements in the country. Last but not least, the reforms have led to growing disparities between richer and poorer states (more and less developed, especially in terms of infrastructure) within India. Although the all-India average annual growth rate in the reform era has been on the order of 5.8 percent, this masks wide
35 Jean Dreze and Amartya Sen, India : Economic Development and Social Opportunities, (New Delhi : Oxford University Press, 1995). 36 M S Ahluwalia, op.cit., p.74. 37 C Rangarajan, ¶Focus on Revenue Deficit·, Business Line (New Delhi), June 10, 2003, p.4

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variations in inter-state growth rates, growth of per capita income, and social development. Most state governments are not well prepared to meet the challenges posed by globalization. The farming sector and the innumerable small-scale industrial units are vulnerable to the impact of global competition. The government and economic players in the private sector need to work more closely as partners to evolve strategies to meet the challenges of global competition more effectively. THE ECONOMY IN THE INTERNATIONAL ARENA The Indian economy has been moving towards closer integration with the global economy and with the leading regional trading blocs. This can be seen using three indicators: (i) Trade in goods and services as a proportion of GDP; (ii) Gross Private Capital (In)flows; and (iii) Gross Foreign Direct Investment as a proportion of GDP. In all three areas, China has had the most outstanding performance and is clearly far ahead of India. However, within the constraints of democratic politics (which have forced India to adopt incremental and relatively ¶softer· economic reforms), and despite being a late starter in the economic reform process, India can be seen to have done ¶reasonably well· in globalizing its economy. The ratio of trade to GDP increased from 13.1 percent in 1990 to 20.3 percent in 2000. The proportion of Gross Capital Inflows to GDP during the same period increased from 0.8 percent to 3.0 percent. Gross Foreign Direct Investment as a percentage of GDP (which was zero in 1990) rose to 0.6 percent in 2000. India·s trading relations with major regional trading blocs in 1990 and 2000 can be seen in Table 2. For the year 2000, APEC countries were India·s largest trading partners, accounting for 47.4 percent of India·s global exports and 57.4 percent of global imports. India has, therefore, shown keen interest in joining this forum. Unfortunately, APEC has currently imposed a moratorium on new membership. There is naturally a sharp contrast between India and East Asian countries in their relative rates of export growth due to sharp differences in their export strategies. The contrast is the sharpest when we compare India and China for the period 1950-2000. In 1950, both had roughly similar shares in world trade. China pursued a more aggressive export strategy in 1978 when it created export-oriented Special Economic Zones in Southern China. By 2000, China had captured around 4.0 percent of world trade. In contrast, India·s share of world trade had stagnated at around 0.5 percent for the three decades 1960-90
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due to its inward-looking policies.38 By 2000, this share had moved up to 0.7 percent. India has formulated and is further strengthening its latest MediumTerm Export Strategy (MTES) (2002-07), coinciding with the period of the

Tenth Five-Year Plan.
TABLE 2: TRENDS AND PROJECTIONS FOR INDIA¶S EXTERNAL TRADE 2000-2025
Year Exports

to Imports from 1990 2000 2020 1990 2000 2020 Actual/Projected A P p A P P
India¶s Global Exports and Imports (US $ Billion)

18.2 37.1 63.6 23.3 41.3 61.2 1. APEC-21 52.06 47.4 43.44 40.98 58.68 57.41 2. ASEAN-10 4.99 6.87 7.38 6.92 9.41 13.1 3. BIMSTEC-4 2.91 4.65 5.45 1.55 1.28 1.45 4. BISTEC-3 2.9 4.51 5.3 1.55 0.8 0.98 5. EU-15 27.6 24.76 25.14 36.62 25.72 23.79 6. GCC-6 5.21 7.17 7.71 8.7 21.05 32.57 7. IOR-ARC-18 13.55 19.26 22.22 13.4 20.93 30.76 8. NAFTA-3 17.13 19.65 16.08 11.2 10.14 11.01 9. SAARC-7 2.65 4.12 4.52 1.78 0.47 0.68
Note : A-Actual and P-Projected APEC ² 21: Asia Pacific Economic Cooperation ASEAN-10: Association of South East Nations BIMSTEC-4: Bangladesh-India-Myanmar-Sri Lanka-Thailand Economic Cooperation BISTEC-3:Bangladesh-India-Sri Lanka-Thailand Economic Cooperation EU-15: European Union GCC-6: Gulf Cooperation Council IOR-ARC-19: Indian Ocean Rim Association for Regional Cooperation NAFTA-3: North America Free Trade Area SAARC-7: South Asia Association for Regional Cooperation Source : Charan D. Wadhva, ³India·s External Sector´ Chapter - 12 in the Report of Research Project on India-2025: A Study of the Social, Economic and Political Stability, Centre for Policy Research, New Delhi, May, 2003.
38 As

per World Bank·s annual World Development Report, various issues and other sources.

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The MTES for 2002-07 envisages the achievement of India·s target of one percent of global trade by 2007 and provides sector-wide targets for niche products and targets for selected niche markets.39 The active participation of state governments is being sought in establishing and strengthening Special Economic Zones (SEZ) modeled on Chinese SEZs and setting up AgriEconomic Zones to provide a strong push to raise the country·s export growth rate. The development of world-class infrastructure in the SEZs will take more time. A new labor policy regime allowing freedom for entrepreneurs in the SEZs to ¶hire and fire· labor according to the needs of the market (as permitted in the highly successful Chinese SEZs) will have to be put in place to maximize gains from India·s SEZs. As of May 2003, eight SEZs had been approved and have became operational. More such SEZs will be set up in India in the future. India is trying its best to liberalize and to transform itself into a global player of consequence in the world economy by 2020. It has been ranked by the World Bank as the world·s fourth-largest nation in terms of the size of GNP measures in terms of Purchasing Power Parity (PPP) in 2001. Ahead of India in 2001 on this front were only Japan, the US, and China. The World Bank has projected that by the year 2020, China will take the top spot, followed by India.

India·s economy clearly is on the move and most certainly has the potential to emerge as a global economic power within next twenty to twenty-five years. However, this potential can be made a reality only if India mobilizes adequate political will and quickly commits itself to design and fully implement the next phase deeper ¶second-generation reforms·. The concept of ¶second-generation· reforms has been in the making for some years. However, these are yet to take concrete shape. Considering that India currently has no social security system in place for nearly 90 percent of its labor force employed in the unorganized sectors, India needs to evolve a well-calibrated approach to its future economic reforms. This would also be necessary to meet the challenges posed by the further intensification of the process of globalization. However, clear prioritization of future economic reforms in India will have to be laid down during implementation of the most critically needed ¶second-generation reforms·.
39 Government

of India, Export Import Policy 2002-07, New Delhi : Ministry of Commerce

2002.
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THE NEXT GENERATION OF REFORMS The following are ten recommended areas of special focus in the second generation of economic reforms: 1. Political Reforms for Good Governance; 2. Re-engineering the Role of the government; 3. Administrative and Legal Reforms; 4. Strategic Management of the Economy with a focus on knowledgebased HRD Activities; 5. Fiscal Prudence; 6. Agricultural Sector Reforms; 7. Industrial Restructuring; 8. Labor Sector Reforms; 9. Foreign Trade and Outward Investment Policies; 10. Financial Sector Reforms.
Political Reforms for Good Governance

Political reforms are urgently required in concert with economic reforms.40 Both are essential to ensure good governance. A paradigm shift is required in the prevailing system of governance. Serving the people and putting their interests above the interests of the ruling elite must be the prime motivating force driving the reformed system of governance. Good governance can be ensured through the provision of an adequate quantity of public services and by improving their quality. Indian politicians need to become fully aware of the costs and benefits of economic reforms. Ruling politicians with limited terms in office are often guided by narrow and short-term motivations while formulating policies in the national interest. The Indian public at large also needs to be thoroughly educated on the inevitable need to bear short-term pain in order to reap the somewhat uncertain longer-term gains from economic reforms. Economic reforms in the future must be more people-centered. They must be given a human face so as to continuously enhance the social empowerments of the poorer and most vulnerable sections of the society. They must be gender-sensitive to improve the status of women and girls. The burden of adjustment to structural reforms must be more heavily borne by the richer sections of the society. Appropriate electoral reforms, including state
40 For a discussion of the required political reforms in India, see Subhash C. Kashyap, Political Reforms for Good Governance: A Policy Brief (New Delhi: Shipra Publications, 2003).

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funding of elections, will help to reduce the lobbying power of the entrenched vested interests.
Re-Engineering the Role of the Government

Reforms must be aimed at ¶right-sizing· (often involving downsizing) the government. Governments must specialize in performing roles that they can perform better than free-market private enterprise. The government must expand its role in areas such as the provision of public goods, especially primary health, primary education and the creation of social infrastructures. The role of the Planning Commission must be changed to that of a strategic think tank. The mindset of the politicians and the administrators needs to be changed to accept the re-engineered role of government in the context of market-oriented economic reforms. The intensification of economic reforms at the state level needs to be given a higher priority in the future since most social services and infrastructural activities are primarily the responsibility of the state governments.
Administrative and Legal Reforms

No matter how good the design and intent of economic reforms, their success ultimately depends on efficient and speedy implementation through sensitive and responsive administrative and legal systems. Transparency and accountability must be guiding principles for the formulation and implementation of policies and procedures. Improved administrative systems should be devised to ensure that merit subsidies directly benefit the targeted (generally the underprivileged) sections of society. Legal support services should be made available with more public funding and must be strengthened to provide justice to genuinely aggrieved sections of society more quickly and affordably.41 Second-generation economic reforms also must focus on changing the mindset of administrators (especially at the grass-roots level) and of the judiciary (especially at the lower level) to support administrative and legal reforms that synergize with economic reforms for maximizing social welfare.
Strategic Management of the Economy

Macroeconomic management must be dovetailed with a well-formulated strategic national vision for the economy for the year 2020 (and beyond). Clarity, transparency and accountability (through identifiable responsibility centers) with properly designed incentive (and disincentive) systems should be the guiding principles governing strategic management of the economy. An
41 See Subhash C Kashyap (ed.), The Citizen and Judicial Reforms under Indian Polity (New Delhi : Universal Law Publishing Company, 2002).

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appropriate code of conduct should be evolved and observed by economic actors under a new managerial system of governance. The strategic management of the Indian economy in the twenty-first century must focus on human resource development to promote knowledge-based and skill-intensive economic activities in line with India·s dynamic competitive advantage.
Fiscal Prudence

The fiscal deficit (especially the revenue deficit) needs to be quickly reduced. India must sincerely implement the Fiscal Responsibility and Budget Management Act . Simultaneous action is required at both central and state levels to raise the tax-to-GDP ratio by expanding the tax base (for example, by taxing services and rich agriculturists) and improving tax administration (for example, through computerization). The revenue deficit must be brought to

zero within five years.
Agricultural Sector Reforms

While some agricultural reforms have already been carried out, these are highly inadequate. Primacy must be given to the agriculture sector in all future reforms since many more jobs can be created in the agricultural sector, broadly defined, including activities related to rural industrialization and overall rural development. Both on-farm and off-farm employment potential must be fully exploited. This will raise incomes of farmers and rural labor on a sustainable basis and provide a much-needed boost to demand for industrial products and services, thus spurring all-around economic growth. There is an urgent need to raise public investment in agriculture substantially. Areas needing investment include: irrigation; watershed development; rural infrastructure; drinking water; housing and sanitation. This will help raise the productivity of Indian agriculture to international levels and help in promoting rural (and interlinked urban) prosperity in India. Second-generation reforms must reduce the perennial anti-agricultural bias by permitting free® exports of all primary products. This will provide a major boost to India·s exports consistent with the rules set by the World Trade Organization. Simultaneously, India must improve its marketing infrastructure. Agricultural reform will unleash high growth rates in agriculture, on which nearly sixty percent of India·s population is still dependent for employment. Agricultural prosperity will help to markedly reduce endemic rural poverty.
Industrial Restructuring

Industrial reforms must be geared to explicitly improve the productivity and international competitiveness of Indian industry by focusing on niche products and niche markets. Economic policy in this respect must facilitate
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mergers and acquisitions and the winding up of terminally ill enterprises in both the public and private sectors by restructuring bankruptcy laws. Massive restructuring is required of Public Sector Units. Most non-performing public sector units should be quickly sold through a privatization process that also safeguards the interests of workers through fair compensation for loss of jobs. Public sector enterprises should be governed by a commercial culture in which government holdings are no more than 26 percent of equity and are retained only to preserve strategic control. It is of the utmost importance that microlevel reforms must supplement macro-level reforms in the future to achieve synergy. The private sector in India needs to become more international in its outlook to become more competitive and to increase its overseas presence through outward FDI.
Labor Reforms

A properly formulated labor policy must form the core of secondgeneration reforms. This will require viable alternative social safety nets and effective retraining and re-employment opportunities. Once satisfactory safety nets are in place, more intensive competition should be injected into the labor market by allowing ¶hire and fire· policies unambiguously linked to the productivity and profitability of micro-enterprises. The government should start by exempting units in the newly created Special Economic Zones from the rigors of labor laws. These measures would be of great help in redressing inefficiency of workers in public enterprises and public services (such as health care in rural areas).
Foreign Trade and Outward Investment Policies

No economic reforms can succeed in India without ensuring adequate

growth of exports of goods and services to ensure longer-term viability of its balance of payments. While anti-dumping measures need to be strengthened to protect Indian industry from unfair import competition, the longer-term reforms must continue to lower import duties to levels comparable to those in leading Southeast Asian countries. Simultaneously, measures should be taken by the government to replace quantitative restrictions (wherever they still remain in place) through appropriately determined tariffs. The second generation of economic reforms must facilitate the growth of India·s own Multi-National Corporations (MNCs). The government must further liberalize outward foreign investment to allow potentially competitive Indian MNCs to establish production bases abroad and trade internationally. Finally, industry and government must make cooperative efforts to prepare Indian industry to meet the new and ever-emerging challenges posed by the
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new world trade order and the new world investment order being evolved under the World Trade Organization.
Financial Sector Reforms

India must heed the lessons of the East Asian economic crisis and recovery, and attached the utmost urgency the next phase of financial-sector reforms. The high level of Non-Performing Assets plaguing long-term Development Financing Institutions and commercial banks must be dramatically reduced. To summarize, greater competition in the financial sector with an appropriate exit policy to reduce overstaffing together, along with sound macro-economic policies, will help to lower the real rate of interest and spur investment and efficiency, thereby raising growth rates and benefiting consumers. Coupled with the current regime of falling interest rates, greater competition in the financial sector in general and among the commercial banks in particular will help to increase the rate of investment in the economy. Simultaneously, foreign insurance and pension funds should be allowed to operate with fewer restrictions to make more resources available to finance the modernizing of India·s infrastructure. Further policy and procedural reforms (especially in the power sector) will help to attract substantially higher investment in India·s infrastructural sectors. Finally, credible policy measures that protect investors, especially individual investors with small savings must be adopted. These measures, if effectively implemented, will help to revive growth in India·s capital and stock markets. It must be remembered at all times that the be-all and end-all of all economic activities is the consumer. Future economic reforms must aim to directly benefit Indian consumers through cost reductions, enhanced quality of goods and services, and by expanding customer choice through competition. CONCLUSIONS Within the constraints of democratic politics and the relatively ¶soft· nature of the economic reforms implemented since 1991, the Indian economy has reaped several welcome rewards from its reforms. These have strengthened the conviction that the broad direction of the reforms is right and, in that sense, made the reform process irreversible. However, India needs to launch a ¶second generation· of economic reforms, with a more human face, if it is to reap their full potential. Politicians and administrators need to display greater pragmatism while designing and implementing future economic reforms. The
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reforms must be based on the long-term vision of transforming India into a

global economic power in the next twenty to twenty-five years. It will be of the utmost importance that all sections of society are educated as to the long-term benefits of reform in order to mobilize public support. These reforms, therefore, will have to be drastically redesigned and politically ¶marketed·. Future economic reforms must be seen and experienced as not only good economics but also good politics. Two paradigm shifts in the reforms, backed up by the effective fulfillment of the promises made, will help to garner the support of the Indian people. First, these reforms must aim to raise the productivity of Indian labor and improve the work culture and, over time, provide significant rewards to the people of India by spurring growth, providing a higher level of real wages, and generating wider avenues for employment and re-employment. Growth with employment is the most effective strategy for eliminating poverty and improving the quality of life of the people. Second, the reforms must aim to directly benefit Indian consumers. Over a reasonable time span, the reforms must reduce prices of goods and services (including public goods), improve their quality, and allow much more freedom of choice by maximizing the benefits of healthy competition. This will further expand the size of the market³both domestic and international³and provide incentives to entrepreneurs to raise their investment, output, and employment. A combination of more productive labor and pro-consumer economic reforms will be a win-win, proving to be both good economics and good politics. Visionary political statesmanship will be required for this. It should not be slogan-oriented but more result-oriented since it will likely be perceived and experienced as ¶pro-people·.
Economic Reforms in India since 1991: Has Gradualism Worked? by Montek S. Ahluwalia*

India was a latecomer to economic reforms, embarking on the process in earnest only in 1991, in the wake of an exceptionally severe balance of payments crisis. The need for a policy shift had become evident much earlier, as many countries in east Asia achieved high growth and poverty reduction through policies which emphasized greater export orientation and encouragement of the private sector. India took some steps in this direction in the 1980s, but it was not until 1991 that the government signaled a systemic shift to a more open economy with greater reliance upon market forces, a larger role for the private sector including foreign investment, and a restructuring of the role of government. India¶s economic performance in the post-reforms period has many positive features. The average growth rate in the ten year period from 1992-93 to 2001-02 was around 6.0 percent, as shown in Table 1, which puts India among the fastest growing developing countries in the 1990s. This growth record is only slightly better than the annual average of 5.7 percent in the 1980s, but it can be argued that the 1980s growth was unsustainable, fuelled by a buildup of external debt which culminated in the crisis of 1991. In sharp contrast, growth in the

*

Montek S. Ahluwalia is at present Deputy Chairman, Planning Commission, Government of India. Prior to this, he was working as Director, Independent Evaluation Office International Monetary Fund, Washington, D.C. Prior to July 2001 he served in the Government of India as Member Planning Commission and before that as Finance Secretary in the Ministry of Finance. The article has been published in Journal of Economic Perspectives, Summer 2002.

1990s was accompanied by remarkable external stability despite the east Asian crisis. Poverty also declined significantly in the post-reform period, and at a faster rate than in the 1980s according to some studies (as Ravallion and Datt discuss in this issue). However, the ten-year average growth performance hides the fact that while the economy grew at an impressive 6.7 percent in the first five years after the reforms, it slowed down to 5.4 percent in the next five years. India remained among the fastest growing developing countries in the second sub-period because other developing countries also slowed down after the east Asian crisis, but the annual growth of 5.4 percent was much below the target of 7.5 percent which the government had set for the period. Inevitably, this has led to some questioning about the effectiveness of the reforms. Opinions on the causes of the growth deceleration vary. World economic growth was slower in the second half of the 1990s and that would have had some dampening effect, but India¶s dependence on the world economy is not large enough for this to account for the slowdown. Critics of liberalization have blamed the slowdown on the effect of trade policy reforms on domestic industry (for example, Nambiar et al, 1999; Chaudhuri, 2002).i However, the opposite view is that the slowdown is due not to the effects of reforms, but rather to the failure to implement the reforms effectively. This in turn is often attributed to India¶s gradualist approach to reform, which has meant a frustratingly slow pace of implementation. However, even a gradualist pace should be able to achieve significant policy changes over ten years. This paper examines India¶s experience with gradualist reforms from this perspective. We review policy changes in five major areas covered by the reform program: fiscal deficit reduction, industrial and trade policy, agricultural policy, infrastructure development and social sector development. Based on this review, we consider the cumulative outcome of ten years of gradualism to assess whether the reforms have created an environment which can support 8 percent GDP growth, which is now the government target. Savings, Investment and Fiscal Discipline Fiscal profligacy was seen to have caused the balance of payments crisis in 1991 and a reduction in the fiscal deficit was therefore an urgent priority at the start of the reforms. The combined fiscal deficit of the central and state governments was successfully reduced from 9.4 percent of GDP in 1990-91 to 7 percent in both 1991-92 and 1992-93 and the balance of payments crisis was over by 1993. However, the reforms also had a medium term fiscal objective of improving public savings so that essential public investment could be financed with a smaller fiscal deficit to avoid ³crowding out´ private investment. This part of the reform strategy was unfortunately never implemented. As shown in Table 2, public savings deteriorated steadily from +1.7 percent of GDP in 1996-97 to ±1.7 percent in 2000-01. This was reflected in a comparable deterioration in the fiscal deficit taking it to 9.6 percent of GDP in 2000-01. Not only is this among the highest in the developing world, it is particularly worrisome because India¶s public debt to GDP ratio is also very high at around 80%. Since the total financial savings of households amount to only 11 percent of GDP, the fiscal deficit effectively preempts about 90 percent of household financial savings for the government. What is worse, the rising fiscal deficit in the second half of the 1990s was not financing higher levels of public investment, which was more or less constant in this period. These trends cast serious doubts on India¶s ability to achieve higher rates of growth in future. The growth rate of 6 percent per year in the post-reforms period was achieved with an average investment rate of around 23 percent of GDP. Accelerating to 8 percent growth will require a commensurate increase in investment. Growth rates of this magnitude in east Asia were associated with investment rates ranging from 36-38 percent. While it can be argued that there was overinvestment in East Asia, especially in recent years, it is unlikely that India can accelerate to 8 percent growth unless it can raise the rate of investment to around 29-30 percent of GDP. Part of the increase can be financed by increasing foreign direct investment, but even if foreign direct

investment increases from the present level of 0.5 percent of GDP to 2.0 percent -- an optimistic but not impossible target -- domestic savings would still have to increase by at least 5 percentage points of GDP. Can domestic savings be increased by this amount? As shown in Table 2, private savings have been buoyant in the post-reform period, but public savings have declined steadily. This trend needs to be reversed.ii Both the central government and the state governments would have to take a number of hard decisions to bring about improvements in their respective spheres. The central government¶s effort must be directed primarily towards improving revenues, because performance in this area has deteriorated significantly in the post reform period. Total tax revenues of the center were 9.7 percent of GDP in 1990-91. They declined to only 8.8 percent in 2000-01, whereas they should have increased by at least two percentage points. Tax reforms involving lowering of tax rates, broadening the tax base and reducing loopholes were expected to raise the tax ratio and they did succeed in the case of personal and corporate income taxation but indirect taxes have fallen as a percentage of GDP. This was expected in the case of customs duties, which were deliberately reduced as part of trade reforms, but this decline should have been offset by improving collections from domestic indirect taxes on goods and by extending indirect taxation to services. This part of the revenue strategy has not worked as expected. The Advisory Group on Tax Policy for the Tenth Plan recently made a number of proposals for modernizing tax administration, including especially computerization, reducing the degree of exemption for small scale units and integration of services taxation with taxation of goods (Planning Commission, 2001a). These recommendations need to be implemented urgently.iii There is also room to reduce central government subsidies, which are known to be highly distortionary and poorly targeted (e.g. subsidies on food and fertilizers), and to introduce rational user charges for services such as passenger traffic on the railways, the postal system and university education. Overstaffing was recently estimated at 30 percent and downsizing would help reduce expenditure. State governments also need to take corrective steps. Sales tax systems need to be modernized in most states. Agricultural income tax is constitutionally assigned to the states, but no state has attempted to tax agricultural income. Land revenue is a traditional tax based on landholding, but it has been generally neglected and abolished in many states. Urban property taxation could yield much larger resources for municipal governments if suitably modernized, but this tax base has also been generally neglected. State governments suffer from very large losses in state electricity boards (about 1 percent of GDP) and substantial losses in urban water supply, state road transport corporations and in managing irrigation systems. Overstaffing is greater in the states than in the center. The fiscal failures of both the central and the state governments have squeezed the capacity of both the center and the states to undertake essential public investment. High levels of government borrowing have also crowded out private investment. Unless this problem is addressed, the potential benefits from reforms in other areas will be eroded and it may be difficult even to maintain the average growth rate of 6 percent experienced in the first ten years after the reforms, let alone accelerate to 8 percent. Reforms in Industrial and Trade Policy Reforms in industrial and trade policy were a central focus of much of India¶s reform effort in the early stages. Industrial policy prior to the reforms was characterized by multiple controls over private investment which limited the areas in which private investors were allowed to operate, and often also determined the scale of operations, the location of new investment, and even the technology to be used. The industrial structure that evolved under this regime was highly inefficient and needed to be supported by a highly protective trade policy, often providing tailor-made protection to each sector of industry. The costs imposed by these policies had been extensively studied (for example, Bhagwati and Desai, 1965; Bhagwati and Srinivasan, 1971; Ahluwalia, 1985)

and by 1991 a broad consensus had emerged on the need for greater liberalization and openness. A great deal has been achieved at the end of ten years of gradualist reforms. Industrial Policy Industrial policy has seen the greatest change, with most central government industrial controls being dismantled. The list of industries reserved solely for the public sector -- which used to cover 18 industries, including iron and steel, heavy plant and machinery, telecommunications and telecom equipment, minerals, oil, mining, air transport services and electricity generation and distribution -- has been drastically reduced to three: defense aircrafts and warships, atomic energy generation, and railway transport. Industrial licensing by the central government has been almost abolished except for a few hazardous and environmentally sensitive industries. The requirement that investments by large industrial houses needed a separate clearance under the Monopolies and Restrictive Trade Practices Act to discourage the concentration of economic power was abolished and the act itself is to be replaced by a new competition law which will attempt to regulate anticompetitive behavior in other ways. The main area where action has been inadequate relates to the long standing policy of reserving production of certain items for the small-scale sector. About 800 items were covered by this policy since the late 1970s, which meant that investment in plant and machinery in any individual unit producing these items could not exceed $ 250,000. Many of the reserved items such as garments, shoes, and toys had high export potential and the failure to permit development of production units with more modern equipment and a larger scale of production severely restricted India¶s export competitiveness. The Report of the Committee on Small Scale Enterprises (1997) and the Report of the Prime Minister¶s Economic Advisory Council (2001) had both pointed to the remarkable success of China in penetrating world markets in these areas and stimulating rapid growth of employment in manufacturing. Both reports recommended that the policy of reservation should be abolished and other measures adopted to help small-scale industry. While such a radical change in policy was unacceptable, some policy changes have been made very recently: fourteen items were removed from the reserved list in 2001 and another 50 in 2002. The items include garments, shoes, toys and auto components, all of which are potentially important for exports. In addition, the investment ceiling for certain items was increased to $1 million. However, these changes are very recent and it will take some years before they are reflected in economic performance. Industrial liberalization by the central government needs to be accompanied by supporting action by state governments. Private investors require many permissions from state governments to start operations, like connections to electricity and water supply and environmental clearances. They must also interact with the state bureaucracy in the course of day-to-day operations because of laws governing pollution, sanitation, workers¶ welfare and safety, and such. Complaints of delays, corruption and harassment arising from these interactions are common. Some states have taken initiatives to ease these interactions, but much more needs to be done. A recently completed joint study by the World Bank and the Confederation of Indian Industry (Stern, 2001) found that the investment climate varies widely across states and these differences are reflected in a disproportional share of investment, especially foreign investment, being concentrated in what are seen as the more investor-friendly states (Maharashtra, Gujarat, Karnataka, Andhra Pradesh and Tamil Nadu) to the disadvantage of other states (like Uttar Pradesh, Bihar and West Bengal). Investors perceived a 30 percent cost advantage in some states over others, on account of the availability of infrastructure and the quality of governance. These differences across states have led to an increase in the variation in state growth rates, with some of the less favored states actually decelerating compared to the 1980s (Ahluwalia, 2002). Because liberalization has created a more competitive environment, the pay off from pursuing good policies has increased, thereby increasing the importance of state level action. Infrastructure deficiencies will take time and resources to remove but deficiencies in governance could be handled more quickly with sufficient political will. Trade Policy Trade policy reform has also made progress, though the pace has been slower than in industrial liberalization. Before the reforms, trade policy was characterized by high tariffs and pervasive import restrictions. Imports of

manufactured consumer goods were completely banned. For capital goods, raw materials and intermediates, certain lists of goods were freely importable, but for most items where domestic substitutes were being produced, imports were only possible with import licenses. The criteria for issue of licenses were nontransparent, delays were endemic and corruption unavoidable. The economic reforms sought to phase out import licensing and also to reduce import duties. Import licensing was abolished relatively early for capital goods and intermediates which became freely importable in 1993, simultaneously with the switch to a flexible exchange rate regime. Import licensing had been traditionally defended on the grounds that it was necessary to manage the balance of payments, but the shift to a flexible exchange rate enabled the government to argue that any balance of payments impact would be effectively dealt with through exchange rate flexibility. Removing quantitative restrictions on imports of capital goods and intermediates was relatively easy, because the number of domestic producers was small and Indian industry welcomed the move as making it more competitive. It was much more difficult in the case of final consumer goods because the number of domestic producers affected was very large (partly because much of the consumer goods industry had been reserved for small scale production). Quantitative restrictions on imports of manufactured consumer goods and agricultural products were finally removed on April 1, 2001, almost exactly ten years after the reforms began, and that in part because of a ruling by a World Trade Organization dispute panel on a complaint brought by the United States. Progress in reducing tariff protection, the second element in the trade strategy, has been even slower and not always steady. As shown in Table 3, the weighted average import duty rate declined from the very high level of 72.5 percent in 1991-92 to 24.6 percent in 1996-97. However, the average tariff rate then increased by more than 10 percentage points in the next four years.iv In February 2002, the government signaled a return to reducing tariff protection. The peak duty rate was reduced to 30 percent, a number of duty rates at the higher end of the existing structure were lowered, while many low end duties were raised to 5 percent. The net result is that the weighted average duty rate is 29 percent in 2002-03. Although India¶s tariff levels are significantly lower than in 1991, they remain among the highest in the developing world because most other developing countries have also reduced tariffs in this period. The weighted average import duty in China and southeast Asia is currently about half the Indian level. The government has announced that average tariffs will be reduced to around 15 percent by 2004, but even if this is implemented, tariffs in India will be much higher than in China which has committed to reduce weighted average duties to about 9 percent by 2005 as a condition for admission to the World Trade Organization. Foreign Direct Investment Liberalizing foreign direct investment was another important part of India¶s reforms, driven by the belief that this would increase the total volume of investment in the economy, improve production technology, and increase access to world markets. The policy now allows 100 percent foreign ownership in a large number of industries and majority ownership in all except banks, insurance companies, telecommunications and airlines. Procedures for obtaining permission were greatly simplified by listing industries that are eligible for automatic approval up to specified levels of foreign equity (100 percent, 74 percent and 51 percent). Potential foreign investors investing within these limits only need to register with the Reserve Bank of India. For investments in other industries, or for a higher share of equity than is automatically permitted in listed industries, applications are considered by a Foreign Investment Promotion Board that has established a track record of speedy decisions. In 1993, foreign institutional investors were allowed to purchase shares of listed Indian companies in the stock market, opening a window for portfolio investment in existing companies. These reforms have created a very different competitive environment for India¶s industry than existed in 1991, which has led to significant changes. Indian companies have upgraded their technology and expanded to more efficient scales of production. They have also restructured through mergers and acquisitions and refocused their activities to concentrate on areas of competence. New dynamic firms have displaced older and less dynamic ones: of the top 100 companies ranked by market capitalization in 1991, about half are no longer in

this group. Foreign investment inflows increased from virtually nothing in 1991 to about 0.5 percent of GDP. Although this figure remains much below the levels of foreign direct investment in many emerging market countries (not to mention 4 percent of GDP in China), the change from the pre-reform situation is impressive. The presence of foreign-owned firms and their products in the domestic market is evident and has added greatly to the pressure to improve quality. These policy changes were expected to generate faster industrial growth and greater penetration of world markets in industrial products, but performance in this respect has been disappointing. As shown in Table 1, industrial growth increased sharply in the first five years after the reforms, but then slowed to an annual rate of 4.5 percent in the next five years. Export performance has improved, but modestly. The share of exports of goods in GDP increased from 5.7 percent in 1990-91 to 9.7 percent, but this reflects in part an exchange rate depreciation. India¶s share in world exports, which had declined steadily since 1960, increased slightly from around 0.5 percent in 1990-91 to 0.6 percent in 1999-2000, but much of the increase in world market share is due to agricultural exports. India¶s manufactured exports had a 0.5 percent share in world markets for those items in 1990 and this rose to only 0.55 percent by 1999. Unlike the case in China and southeast Asia, foreign direct investment in India did not play an important role in export penetration and was instead oriented mainly towards the domestic market. One reason why export performance has been modest is the slow progress in lowering import duties that make India a high cost producer and therefore less attractive as a base for export production. Exporters have long been able to import inputs needed for exports at zero duty, but the complex procedure for obtaining the necessary duty-free import licenses typically involves high transactions cost and delays. High levels of protection compared with other countries also explains why foreign direct investment in India has been much more oriented to the protected domestic market, rather than using India as a base for exports. However, high tariffs are only part of the explanation for poor export performance. The reservation of many potentially exportable items for production in the small scale sector (which has only recently been relaxed) was also a relevant factor. The poor quality of India¶s infrastructure compared with infrastructure in east and southeast Asia, which is discussed later in this paper, is yet another. Inflexibility of the labor market is a major factor reducing India¶s competitiveness in exports and also reducing industrial productivity generally (Planning Commission, 2001). Any firm wishing to close down a plant, or to retrench labor in any unit employing more than 100 workers, can only do so with the permission of the state government, and this permission is rarely granted. These provisions discourage employment and are especially onerous for labor-intensive sectors. The increased competition in the goods market has made labor more willing to take reasonable positions, because lack of flexibility only leads to firms losing market share. However, the legal provisions clearly remain much more onerous than in other countries. This is important area of reform that has yet to be addressed. The lack of any system of unemployment insurance makes it difficult to push for major changes in labor flexibility unless a suitable contributory system that is financially viable can be put in place. The government has recently announced its intention to amend the law and raise the level of employment above which firms have to seek permission for retrenchment from 100 workers at present to 1000 while simultaneously increasing the scale of retrenchment compensation. However, the amendment has yet to be enacted. These gaps in the reforms provide a possible explanation for the slowdown in industrial growth in the second half of the 1990s. It can be argued that the initial relaxation of controls led to an investment boom, but this could have been sustained only if industrial investment had been oriented to tapping export markets, as was the case in east Asia. As it happened, India¶s industrial and trade reforms were not strong enough, nor adequately supported by infrastructure and labor market reforms to generate such a thrust. The one area which has shown robust growth through the 1990s with a strong export orientation is software development and various new types of services enabled by information technology like medical transcription, backup accounting, and customer related services. Export earnings in this area have grown from $100 million in 1990-

91 to over $6 billion in 2000-01 and are expected to continue to grow at 20 to 30 percent per year. India¶s success in this area is one of the most visible achievements of trade policy reforms which allow access to imports and technology at exceptionally low rates of duty, and also of the fact that exports in this area depend primarily on telecommunications infrastructure, which has improved considerably in the post-reforms period. Reforms in Agriculture A common criticism of India¶s economic reforms is that they have been excessively focused on industrial and trade policy, neglecting agriculture which provides the livelihood of 60 percent of the population. Critics point to the deceleration in agricultural growth in the second half of the 1990s (shown in Table 2) as proof of this neglect.v However, the notion that trade policy changes have not helped agriculture is clearly a misconception. The reduction of protection to industry, and the accompanying depreciation in the exchange rate, has tilted relative prices in favor of agriculture and helped agricultural exports. The index of agricultural prices relative to manufactured products has increased by almost 30 percent in the past ten years (Ministry of Finance, 2002, Chapter 5). The share of India¶s agricultural exports in world exports of the same commodities increased from 1.1 percent in 1990 to 1.9 percent in 1999, whereas it had declined in the ten years before the reforms. But while agriculture has benefited from trade policy changes, it has suffered in other respects, most notably from the decline in public investment in areas critical for agricultural growth, such as irrigation and drainage, soil conservation and water management systems, and rural roads. As pointed out by Gulati and Bathla (2001), this decline began much before the reforms, and was actually sharper in the 1980s than in the 1990s. They also point out that while public investment declined, this was more than offset by a rise in private investment in agriculture which accelerated after the reforms. However, there is no doubt that investment in agriculture-related infrastructure is critical for achieving higher productivity and this investment is only likely to come from the public sector. Indeed, the rising trend in private investment could easily be dampened if public investment in these critical areas is not increased. The main reason why public investment in rural infrastructure has declined is the deterioration in the fiscal position of the state governments and the tendency for politically popular but inefficient and even iniquitous subsidies to crowd out more productive investment. For example, the direct benefit of subsidizing fertilizer and underpricing water and power goes mainly to fertilizer producers and high income farmers while having negative effects on the environment and production, and even on income of small farmers.vi A phased increase in fertilizer prices and imposition of economically rational user charges for irrigation and electricity could raise resources to finance investment in rural infrastructure, benefiting both growth and equity. Competitive populism makes it politically difficult to restructure subsidies in this way, but there is also no alternative solution in sight. Some of the policies which were crucial in promoting food grain production in earlier years, when this was the prime objective, are now hindering agricultural diversification. Government price support levels for food grains such as wheat are supposed to be set on the basis of the recommendations of the Commission on Agricultural Costs and Prices, a technical body which is expected to calibrate price support to reasonable levels. In recent years, support prices have been fixed at much higher levels, encouraging overproduction. Indeed, public food grain stocks reached 58 million tons on January 1, 2002, against a norm of around 17 million tons! The support price system clearly needs to be better aligned to market demand if farmers are to be encouraged to shift from food grain production towards other products. Agricultural diversification also calls for radical changes in some outdated laws. The Essential Commodities Act, which empowers state governments to impose restrictions on movement of agricultural products across state and sometimes even district boundaries and to limit the maximum stocks wholesalers and retailers can carry for certain commodities, was designed to prevent exploitive traders from diverting local supplies to other areas of scarcity or from hoarding supplies to raise prices. Its consequence is that farmers and consumers are denied the benefit of an integrated national market. It also prevents the development of modern trading companies, which have a key role to play in the next stage of agricultural diversification. The government has recognized the need for change and recently removed certain products -- including wheat, rice, coarse grains, edible oil, oilseeds and sugar -- from the purview of the act. However, this step may not suffice, since state governments may be able to take similar action. What is needed is a repeal of the existing act and central

legislation that would make it illegal for government authorities at any level to restrict movement or stocking of agricultural products (Planning Commission, 2001). The report of the Task Force on Employment has made comprehensive proposals for review of several other outdated agricultural law (Planning Commission, 2001b). For example, laws designed to protect land tenants, undoubtedly an important objective, end up discouraging marginal farmers from leasing out nonviable holdings to larger farmers for fear of being unable to reclaim the land from the tenant. The Agricultural Produce Marketing Acts in various states compel traders to buy agricultural produce only in regulated markets, making it difficult for commercial traders to enter into contractual relationships with farmers. Development of a modern food processing sector, which is essential to the next stage of agricultural development, is also hampered by outdated and often contradictory laws and regulations. These and other outdated laws need to be changed if the logic of liberalization is to be extended to agriculture. Infrastructure Development Rapid growth in a globalized environment requires a well-functioning infrastructure including especially electric power, road and rail connectivity, telecommunications, air transport, and efficient ports. India lags behind east and southeast Asia in these areas. These services were traditionally provided by public sector monopolies but since the investment needed to expand capacity and improve quality could not be mobilized by the public sector, these sectors were opened to private investment, including foreign investment. However, the difficulty in creating an environment which would make it possible for private investors to enter on terms that would appear reasonable to consumers, while providing an adequate risk- return profile to investors, was greatly underestimated. Many false starts and disappointments have resulted. The greatest disappointment has been in the electric power sector, which was the first area opened for private investment. Private investors were expected to produce electricity for sale to the State Electricity Boards, which would control of transmission and distribution. However, the State Electricity Boards were financially very weak, partly because electricity tariffs for many categories of consumers were too low and also because very large amounts of power were lost in transmission and distribution. This loss, which should be between 10 to 15 percent on technical grounds (depending on the extent of the rural network), varies from 35 to 50 percent. The difference reflects theft of electricity, usually with the connivance of the distribution staff. Private investors, fearing nonpayment by the State Electricity Boards insisted on arrangements which guaranteed purchase of electricity by state governments backed by additional guarantees from the central government. These arrangements attracted criticism because of controversies about the reasonableness of the tariffs demanded by private sector power producers. Although a large number of proposals for private sector projects amounting to about 80 percent of existing generation capacity were initiated, very few reached financial closure and some of those which were implemented ran into trouble subsequently.vii Because of these difficulties, the expansion of generation capacity by the utilities in the 1990s has been only about half of what was targeted and the quality of power remained poor with large voltage fluctuations and frequent interruptions. The flaws in the policy have now been recognized and a more comprehensive reform is being attempted by several state governments. Independent statutory regulators have been established to set tariffs in a manner that would be perceived to be fair to both consumers and producers. Several states are trying to privatize distribution in the hope that this will overcome the corruption which leads to the enormous distribution losses. However, these reforms are not easy to implement. Rationalization of power tariffs is likely to be resisted by consumers long used to subsidized power, even though the quality of the power provided in the pre-reform situation was very poor. The establishment of regulatory authorities that are competent and credible takes time. Private investors may not be able to enforce collection of amounts due or to disconnect supply for nonpayment without adequate backing by the police. For all these reasons, private investors perceive high risks in

the early stages and therefore demand terms that imply very high rates of return. Finally, labor unions are opposed to privatization of distribution. These problems are formidable and many state governments now realize that a great deal of preliminary work is needed before privatization can be successfully implemented.viii Some of the initial steps, like tariff rationalization and enforcing penalties for non-payment of dues and for theft of power, are perhaps best implemented within the existing public sector framework so that these features, which are essential for viability of the power sector, are not attributed solely to privatization. If the efforts now being made in half a dozen states succeed, it could lead to a visible improvement within a few years. The results in telecommunications have been much better and this is an important factor underlying India¶s success in information technology. There was a false start initially because private investors offered excessively high license fees in bidding for licenses which they could not sustain, which led to a protracted and controversial renegotiation of terms. Since then, the policy appears to be working satisfactorily. Several private sector service providers of both fixed line and cellular services, many in partnership with foreign investors, are now operating and competing with the pre-existing public sector supplier. Teledensity, which had doubled from 0.3 lines per 100 population in 1981 to 0.6 in 1991, increased sevenfold in the next ten years to reach 4.4 in 2002. Waiting periods for telephone connections have shrunk dramatically. Telephone rates were heavily distorted earlier with very high long distance charges cross-subsidizing local calls and covering inefficiencies in operation. They have now been rebalanced by the regulatory authority, leading to a reduction of 30 percent in long distance charges. Interestingly, the erstwhile public sector monopoly supplier has aggressively reduced prices in a bid to retain market share. Civil aviation and ports are two other areas where reforms appear to be succeeding, though much remains to be done. Two private sector domestic airlines, which began operations after the reforms, now have more than half the market for domestic air travel. However, proposals to attract private investment to upgrade the major airports at Mumbai and Delhi have yet to make visible progress. In the case of ports, 17 private sector projects involving port handling capacity of 60 million tons, about 20 percent of the total capacity at present, are being implemented. Some of the new private sector port facilities have set high standards of productivity. India¶s road network is extensive, but most of it is low quality and this is a major constraint for interior locations. The major arterial routes have low capacity (commonly just two lanes in most stretches) and also suffer from poor maintenance. However, some promising initiatives have been taken recently. In 1998, a tax was imposed on gasoline (later extended to diesel) , the proceeds of which are earmarked for the development of the national highways, state roads and rural roads. This will help finance a major program of upgrading the national highways connecting Delhi, Mumbai, Chennai and Calcutta to four lanes or more, to be completed by the end of 2003. It is also planned to levy modest tolls on these highways to ensure a stream of revenue which could be used for maintenance. A few toll roads and bridges in areas of high traffic density have been awarded to the private sector for development. The railways are a potentially important means of freight transportation but this area is untouched by reforms as yet. The sector suffers from severe financial constraints, partly due to a politically determined fare structure in which freight rates have been set excessively high to subsidize passenger fares, and partly because government ownership has led to wasteful operating practices. Excess staff is currently estimated at around 25 percent. Resources are typically spread thinly to respond to political demands for new passenger trains at the cost of investments that would strengthen the capacity of the railways as a freight carrier. The Expert Group on Indian Railways (2002) recently submitted a comprehensive program of reform converting the railways from a departmentally run government enterprise to a corporation, with a regulatory authority fixing the fares in a rational manner. No decisions have been announced as yet on these recommendations. Financial Sector Reform

India¶s reform program included wide-ranging reforms in the banking system and the capital markets relatively early in the process with reforms in insurance introduced at a later stage. Banking sector reforms included: (a) measures for liberalization, like dismantling the complex system of interest rate controls, eliminating prior approval of the Reserve Bank of India for large loans, and reducing the statutory requirements to invest in government securities; (b) measures designed to increase financial soundness, like introducing capital adequacy requirements and other prudential norms for banks and strengthening banking supervision; (c) measures for increasing competition like more liberal licensing of private banks and freer expansion by foreign banks. These steps have produced some positive outcomes. There has been a sharp reduction in the share of non-performing assets in the portfolio and more than 90 percent of the banks now meet the new capital adequacy standards. However, these figures may overstate the improvement because domestic standards for classifying assets as non-performing are less stringent than international standards. India¶s banking reforms differ from those in other developing countries in one important respect and that is the policy towards public sector banks which dominate the banking system. The government has announced its intention to reduce its equity share to 33-1/3 percent, but this is to be done while retaining government control. Improvements in the efficiency of the banking system will therefore depend on the ability to increase the efficiency of public sector banks. Skeptics doubt whether government control can be made consistent with efficient commercial banking because bank managers are bound to respond to political directions if their career advancement depends upon the government. Even if the government does not interfere directly in credit decisions, government ownership means managers of public sector banks are held to standards of accountability akin to civil servants, which tend to emphasize compliance with rules and procedures and therefore discourage innovative decision making. Regulatory control is also difficult to exercise. The unstated presumption that public sector banks cannot be shut down means that public sector banks that perform poorly are regularly recapitalized rather than weeded out. This obviously weakens market discipline, since more efficient banks are not able to expand market share. If privatization is not politically feasible, it is at least necessary to consider intermediate steps which could increase efficiency within a public sector framework (see for example Ahluwalia 2002). These include shifting effective control from the government to the boards of the banks including especially the power to appoint the Chairman and Executive Directors which is at present with the government; removing civil servants and representatives of the Reserve Bank of India from these board; implementing a prompt corrective action framework which would automatically trigger regulatory action limiting a bank¶s expansion capability if certain trigger points of financial soundness are breeched; and finally acceptance of closure of insolvent public sector banks (with appropriate protection for small depositors). Unless some initiatives along these lines are taken, it is highly unlikely that public sector banks can rise to the levels of efficiency needed to support rapid growth. Another major factor limiting the efficiency of banks is the legal framework, which makes it very difficult for creditors to enforce their claims. The government has recently introduced legislation to establish a bankruptcy law which will be much closer to accepted international standard. This would be an important improvement but it needs to be accompanied by reforms in court procedures to cut the delays which are a major weakness of the legal system at present. Reforms in the stock market were accelerated by a stock market scam in 1992 that revealed serious weaknesses in the regulatory mechanism. Reforms implemented include establishment of a statutory regulator; promulgation of rules and regulations governing various types of participants in the capital market and also activities like insider trading and takeover bids; introduction of electronic trading to improve transparency in establishing prices; and dematerialization of shares to eliminate the need for physical

movement and storage of paper securities. Effective regulation of stock markets requires the development of institutional expertise, which necessarily requires time, but a good start has been made and India¶s stock market is much better regulated today than in the past. This is to some extent reflected in the fact that foreign institutional investors have invested a cumulative $21 billion in Indian stocks since 1993, when this avenue for investment was opened. An important recent reform is the withdrawal of the special privileges enjoyed by the Unit Trust of India, a public sector mutual fund which was the dominant mutual fund investment vehicle when the reforms began. Although the Unit Trust did not enjoy a government guarantee, it was widely perceived as having one because its top management was appointed by the government. The Trust had to be bailed out once in 1998, when its net asset value fell below the declared redemption price of the units, and again in 2001 when the problem recurred. It has now been decided that in future investors in the Unit Trust of India will bear the full risk of any loss in capital value. This removes a major distortion in the capital market, in which one of the investment schemes was seen as having a preferred position. The insurance sector (including pension schemes), was a public sector monopoly at the start of the reforms. The need to open the sector to private insurance companies was recommended by an expert committee (the Malhotra Committee) in 1994, but there was strong political resistance. It was only in 2000 that the law was finally amended to allow private sector insurance companies, with foreign equity allowed up to 26 percent, to enter the field. An independent Insurance Development and Regulatory Authority has now been established and ten new life insurance companies and six general insurance companies, many with well-known international insurance companies as partners, have started operations. The development of an active insurance and pensions industry offering attractive products tailored to different types of requirements could stimulate long term savings and add depth to the capital markets. However, these benefits will only become evident over time. Privatization The public sector accounts for about 35 percent of industrial value added in India, but although privatization has been a prominent component of economic reforms in many countries, India has been ambivalent on the subject until very recently. Initially, the government adopted a limited approach of selling a minority stake in public sector enterprises while retaining management control with the government, a policy described as ³disinvestment´ to distinguish it from privatization. The principal motivation was to mobilize revenue for the budget, though there was some expectation that private shareholders would increase the commercial orientation of public sector enterprises. This policy had very limited success. Disinvestment receipts were consistently below budget expectations and the average realization in the first five years was less than 0.25 percent of GDP compared with an average of 1.7 percent in seventeen countries reported in a recent study (see Davis et.al. 2000). There was clearly limited appetite for purchasing shares in public sector companies in which government remained in control of management. In 1998, the government announced its willingness to reduce its shareholding to 26 percent and to transfer management control to private stakeholders purchasing a substantial stake in all central public sector enterprises except in strategic areas.ix The first such privatization occurred in 1999, when 74 percent of the equity of Modern Foods India Ltd. (a public sector bread-making company with 2000 employees), was sold with full management control to Hindustan Lever, an Indian subsidiary of the Anglo-Dutch multinational Unilever. This was followed by several similar sales with transfer of management: BALCO, an aluminium company; Hindustan Zinc; Computer Maintenance Corporation; Lagan Jute Machinery Manufacturing Company; several hotels; VSNL, which was until recently the monopoly service supplier for international telecommunications; IPCL, a major petrochemicals unit and Maruti Udyog, India¶s largest automobile producer which was a joint venture with Suzuki Corporation which has now acquired full managerial controls. The privatization of Modern Foods and BALCO generated some controversy, not so much on the principle of privatization, but on the transparency of the bidding process and the fairness of the price realized. Subsequent

sales have been much less problematic and although the policy continues to be criticized by the unions, it appears to have been accepted by the public, especially for public sector enterprises that are making losses or not doing well. However, there is little public support for selling public sector enterprises that are making large profits such as those in the petroleum and domestic telecommunications sectors, although these are precisely the companies where privatization can generate large revenues. These companies are unlikely to be privatized in the near future, but even so, there are several companies in the pipeline for privatization which are likely to be sold and this will reduce resistance to privatizing profit-making companies.x An important recent innovation, which may increase public acceptance of privatization, is the decision to earmark the proceeds of privatization to finance additional expenditure on social sector development and for retirement of public debt. Privatization is clearly not a permanent source of revenue, but it can help fill critical gaps in the next five to ten years while longer term solutions to the fiscal problem are attempted. Many states have also started privatizing state level public sector enterprises. These are mostly loss making enterprises and are unlikely to yield significant receipts but privatization will eliminate the recurring burden of financing losses. Social Sector Development in Health and Education India¶s social indicators at the start of the reforms in 1991 lagged behind the levels achieved in southeast Asia 20 years earlier, when those countries started to grow rapidly (Dreze and Sen, 1995). For example, India¶s adult literacy rate in 1991 was 52 percent, compared with 57 percent in Indonesia and 79 percent in Thailand in 1971. The gap in social development needed to be closed, not only to improve the welfare of the poor and increase their income earning capacity, but also to create the preconditions for rapid economic growth. While the logic of economic reforms required a withdrawal of the state from areas in which the private sector could do the job just as well, if not better, it also required an expansion of public sector support for social sector development. Much of the debate in this area has focused on what has happened to expenditure on social sector development in the post-reform period. Dev and Moolji (2002) find that central government expenditure on towards social services and rural development increased from 7.6 percent of total expenditure in 1990-91 to 10.2 percent in 2000-01, as shown in Table 4. As a percentage of GDP, these expenditures show a dip in the first two years of the reforms, when fiscal stabilization compulsions were dominant, but there is a modest increase thereafter. However, expenditure trends in the states, which account for 80 percent of total expenditures in this area, show a definite decline as a percentage of GDP in the post-reforms period. Taking central and state expenditures together, social sector expenditure has remained more or less constant as a percentage of GDP. Closing the social sector gaps between India and other countries in southeast Asia will require additional expenditure, which in turn depends upon improvements in the fiscal position of both the central and state governments. However, it is also important to improve the efficiency of resource use in this area. Saxena (2001) has documented the many problems with existing delivery systems of most social sector services, especially in rural areas. Some of these problems are directly caused by lack of resources, as when the bulk of the budget is absorbed in paying salaries , leaving little available for medicines in clinics or essential teaching aids in schools. There are also governance problems such as nonattendance by teachers in rural schools and poor quality of teaching. Part of the solution lies in greater participation by the beneficiaries in supervising education and health systems, which in turn requires decentralization to local levels and effective peoples¶ participation at these levels. Nongovernment organizations can play a critical role in this process. Different state governments are experimenting with alternative modalities but a great deal more needs to be done in this area.

While the challenges in this area are enormous, it is worth noting that social sector indicators have continued to improve during the reforms. The literacy rate increased from 52 percent in 1991 to 65 percent in 2001, a faster increase in the 1990s than in the previous decade, and the increase has been particularly high in the some of the low literacy states such as Bihar, Madhya Pradesh, Uttar Pradesh and Rajasthan. Conclusions The impact of ten years of gradualist economic reforms in India on the policy environment presents a mixed picture. The industrial and trade policy reforms have gone far, though they need to be supplemented by labor market reforms which are a critical missing link. The logic of liberalization also needs to be extended to agriculture, where numerous restrictions remain in place. Reforms aimed at encouraging private investment in infrastructure have worked in some areas but not in others. The complexity of the problems in this area was underestimated, especially in the power sector. This has now been recognized and policies are being reshaped accordingly. Progress has been made in several areas of financial sector reforms, though some of the critical issues relating to government ownership of the banks remain to be addressed. However, the outcome in the fiscal area shows a worse situation at the end of ten years than at the start. Critics often blame the delays in implementation and failure to act in certain areas to the choice of gradualism as a strategy. However, gradualism implies a clear definition of the goal and a deliberate choice of extending the time taken to reach it, in order to ease the pain of transition. This is not what happened in all areas. The goals were often indicated only as a broad direction, with the precise end point and the pace of transition left unstated to minimize opposition²and possibly also to allow room to retreat if necessary. This reduced politically divisive controversy, and enabled a consensus of sorts to evolve, but it also meant that the consensus at each point represented a compromise, with many interested groups joining only because they believed that reforms would not go ³too far´. The result was a process of change that was not so much gradualist as fitful and opportunistic. Progress was made as and when politically feasible, but since the end point was not always clearly indicated, many participants were unclear about how much change would have to be accepted, and this may have led to less adjustment than was otherwise feasible. The alternative would have been to have a more thorough debate with the objective of bringing about a clearer realization on the part of all concerned of the full extent of change needed, thereby permitting more purposeful implementation. However, it is difficult to say whether this approach would indeed have yielded better results, or whether it would have created gridlock in India¶s highly pluralist democracy. Instead, India witnessed a halting process of change in which political parties which opposed particular reforms when in opposition actually pushed them forward when in office. The process can be aptly described as creating a strong consensus for weak reforms! Have the reforms laid the basis for India to grow at 8 percent per year? The main reason for being optimistic is that the cumulative change brought about is substantial. The slow pace of implementation has meant that many of the reform initiatives have been put in place recently and their beneficial effects are yet to be felt. The policy environment today is therefore potentially much more supportive, especially if the critical missing links are put in place. However, the failure on the fiscal front could undo much of what has been achieved. Both the central and state governments are under severe fiscal stress which seriously undermines their capacity to invest in certain types of infrastructure and in social development where the public sector is the only credible source of investment. If these trends are not reversed, it may be difficult even to maintain 6 percent annual growth in the future, let alone accelerate to 8 percent. However, if credible corrective steps are taken on the fiscal front, then the cumulative policy changes that have already taken place in many areas, combined with continued progress on the unfinished agenda, should make it possible for India to accelerate to well beyond 6 percent growth over the next few years. Acknowledgements

The views expressed in this article are those of the author and do not necessarily reflect the views of either the International Monetary Fund or the Government of India. Thanks are due to Suman Bery, Ashok Gulati, Deena Khatkhate, Arvind Panagariya, Parthasarathi Shome, TN Srinivasan, Nicholas Stern and Timothy Taylor.

i

This approach reflects to some extent the revisionist view of the role of trade policy reforms being expressed internationally as for example by Rodrik (1999). For a critique of the revisionist view, see Bhagwati and Srinivasan (2001).
ii

An increase in public savings will have some negative effect on private savings as for example, when higher tax revenues lead to a reduction in disposable income in the private sector which in turn reduces private savings but the net effect will still be positive.
iii

Many countries have increased revenues substantially by switching to an integrated value-added tax covering both goods and services. This is not possible in India because of the constitutional division of taxation powers between the center (which can tax production) and the states (which can tax sales). The inability to switch to an integrated value-added tax is a major hindrance to tax reform.
iv

The sharp increase in average duty rates in 2000 ± 01 reflects the imposition of tariff on many agricultural commodities in anticipation of the removal of quantitative restrictions. Since these items were protected by quantitative restrictions in the mid-1990s, the combined protection provided by tariffs and quantitative restrictions was probably higher in the mid-1990s.
v

India¶s reforms are often unfavorably compared with the very different sequencing adopted in China, which began with reforms in agriculture in 1978, extending them to industry only in 1984. The comparison is not entirely fair since Chinese agriculture faced an extremely distorted incentive structure, with virtually no role for markets, which provided an obvious area for high priority action with potentially large benefits. Since Indian agriculture operated to a much greater extent under market conditions, the situation was very different.
vi

Underpricing of water and fertilizer leads to excess usage and waterlogged soil. Free electricity enables larger farmers to pump water from deep wells at relatively low cost. This encourages a much more water using cropping pattern than would be optimal and also leads to overexploitation of ground water and lowering the water table, which in turn hurts poorer farmers relying upon shallow wells.
vii

The best known of these was the Dabhol project of the Enron cooperation which became mired in controversy because of the high cost of power from the project especially as a consequence of a pricing arrangement which meant that most of the tariff was U.S. dollar denominated and that the risk of rupee depreciation against the dollar was borne by the buyer. These problems surfaced in a recent effort to privatize the distribution system in Delhi. The terms offered were publicly criticised as being too generous because tariff setting was based on a relatively modest pace of reduction in transmission and distribution losses. Nevertheless, all bids received were below the reserve price set by the government. This was a consequence of several factors: information on the quality of assets and the financial position of the system was very poor; private investors were expected to take on the responsibility of excess staff with inadequate information on the costs of retrenchment; enforcement of payment and disconnection for non-payment can create law and order problems in parts of the city; and there was lack of regulatory certainty about the way tariffs would be set in future. These deficiencies inevitably led to very low bids.
ix viii

The definition of strategic for this purpose covers enterprises related to defense, atomic energy, and the railways. This would exclude only a handful of the 232 public sector enterprises of the central government.
x

The Ministry of Disinvestment in its website (http://www.divest.nic.in) has made a valiant effort at explaining the case for privatizing even profit making companies on the grounds that government ownership makes it impossible to achieve commercial efficiency.