India at the Crossroads: Sustaining Growth and Reducing
Tim Callen, Patricia Reynolds, and Christopher Towe
©2001 International Monetary Fund
February 15, 2001
List of Contributors
India's macroeconomic performance during the past decade has in many respects been remarkable. Since the early 1990s, India has been among the fastest growing economies in the world, inflation has been relatively well contained, and the balance of payments has been maintained at comfortable levels. This performance was achieved despite poor weather that caused negative agricultural growth in fiscal year (FY) 1995/96 and again in FY 1997/98, the Asian financial crisis in 1997 and 1998, international sanctions imposed on India and Pakistan following tests of nuclear devices in 1998, and the considerable volatility in world oil and commodity prices that occurred in 1998–2000.1
Much of India's economic strength during the early and mid-1990s can be ascribed to the broad-ranging fiscal and structural reforms undertaken following the 1991 balance of payments crisis. These included reforms to the tax system, substantial cuts in the deficit of the consolidated public sector, liberalization and deregulation in the industrial sector, trade and tariff reforms, and measures to recapitalize and strengthen the supervision of banks and other financial intermediaries. These policies helped spur a strong recovery, with real GDP growth accelerating to an average of 7¼ percent in the mid-1990s from as low as ½ of 1 percent at the beginning of the decade.
Although economic activity slowed somewhat in subsequent years, it remained relatively robust, especially when compared with the other emerging markets that were buffeted by the Asian financial crisis. During the last two years of the 1990s, growth averaged 6 ½ percent, as agricultural output recovered strongly from poor weather in late 1997 and industrial production rebounded in response to the turnaround in agricultural incomes and the recovery elsewhere in the region. India's inflation performance has also been relatively favorable—inflation generally trended downward during the 1990s, reaching as low as 3½ percent by FY 1999/00.
Following the 1991 crisis, India's balance of payments also strengthened. Indeed, in the latter half of the decade, despite the effect of the regional crisis on merchandise exports, the current account deficit began narrowing. The deficit fell to less than 1 percent of GDP in FY1999/00, partly reflecting the impact of India's growing exports of information technology (IT)-related services. Although inward portfolio and foreign direct investment were hurt by the erosion of international market sentiment in 1997 and 1998, other private inflows were maintained, and with the recovery in international investor sentiment in FY1999/00, India's foreign exchange reserves reached $38 billion by March 2000, a gain of almost $12 billion from three years earlier.
By the end of the decade these favorable macroeconomic trends contributed to growing optimism about India's longer-term growth prospects. Indian equity prices strengthened enormously, benefiting from the global boom in IT stocks, and private sector forecasters steadily revised upward their projections for GDP growth to 7 percent or more. This optimism carried over to the political arena, with the new government elected in late 1999 setting a growth target of 7–8 percent over the medium and longer terms—recognizing the importance of fast growth for improving the welfare of the large share of India's population still in poverty.
However, macroeconomic developments during 2000—including a rebound of inflation, slowing industrial production, and downward pressure on the rupee and stock prices—have tempered some of this optimism. They also underscore the longer-standing question of whether the basis for achieving sustained and rapid growth has yet been established. Most notably:
These issues have been at the core of the ongoing policy dialog between the IMF staff and the Indian authorities, and this volume brings together some of the IMF staff's more recent analysis of these topics (Box 1.1 lists a number of previous analytical studies). In particular, the following chapters address four main issues. Part I explores the factors underlying India's success in avoiding significant fallout from the Asia crisis and addresses broader questions regarding India's external vulnerability. Part II discusses the fiscal situation and the extent to which recent policies pose risks to India's growth prospects and debt sustainability. Monetary policy and financial sector reform are considered in Part III, and structural issues—including those related to poverty and interstate growth and structural policy implementation—are covered in Part IV.
Having experienced a balance of payments crisis only ten years ago, issues related to external vulnerability remain extremely topical in India. Against this background, Chapter 2, "India and the Asia Crisis," reviews India's experience during the Asia crisis and the factors that helped insulate it from the worst of the financial market turmoil that afflicted the rest of the region. The chapter explains India's success in terms of its strong macroeconomic fundamentals, modest systemic vulnerability in the banking and corporate sectors, flexible exchange rate management, the relatively closed nature of the economy, and capital controls. However, the chapter cautions that, as capital controls are gradually eased and trade barriers reduced, it will become increasingly important to ensure sound macroeconomic policies—including with regard to the fiscal position—and strong prudential and supervisory systems.
India's external vulnerability is examined in more detail in Chapter 3, "Assessing India's External Position," by estimating models of the equilibrium current account. The results illustrate that India's equilibrium current account deficit has been constrained by its lack of openness on both the capital and trade accounts and suggests that deficits in the range of 1½–2½ percent of GDP appear sustainable, given India's stage of development. The paper uses the experience of the 1991 balance of payments crisis, however, to illustrate risks to the external position from weak fiscal policies, low reserves, short-term debt exposure, and exchange rate overvaluation.
Issues related to fiscal sustainability are the focus of the subsequent two chapters. Chapter 4, "Tax Smoothing, Financial Repression, and Fiscal Deficits in India," examines data through 1996/97 and asks whether fiscal policy has been effective in avoiding disruptive changes in tax rates in the face of temporary shocks, and whether there has been a bias toward deficit financing. The results suggest that fiscal policies in India have been consistent with tax-smoothing behavior. However, there also appears to be evidence pointing to a significant bias toward deficit financing, leading to excessive public borrowing, as well as resort to seigniorage and financial repression. Consequently, the authors argue that government debt is well in excess of levels that would be considered optimal or consistent with intertemporal solvency.
Fiscal sustainability and developments since FY 1996/97 are explored further in Chapter 5, "Fiscal Adjustment and Growth Prospects in India." Using a simple growth model, the chapter illustrates that India's ability to avoid a fiscal crisis, despite high deficits, has largely reflected a favorable differential between real interest rates and overall economic growth. The simulations suggest, however, that a continuation of recent policies would risk putting India on an explosive debt path, by undermining growth and putting upward pressure on interest rates. This risk would be exacerbated as financial sector reform and liberalization reduce the scope for the government to place its debt with captive financial institutions at nonmarket rates. The paper concludes that ambitious fiscal reforms are needed to ensure sustainability, including measures to improve fiscal discipline at the state level, tax measures to boost the revenue/GDP ratio, and cuts in unproductive spending that would provide greater room for needed infrastructure investment.
Monetary policy and financial sector issues are addressed in Chapter 6, "Modeling and Forecasting Inflation in India." The chapter discusses the Reserve Bank of India's (RBI) downgrading of the money supply as an intermediate target in response to financial sector liberalization and innovation, which has reduced the strength of the statistical relationship between money and economic activity. The paper tests the extent to which money versus other indicators provide useful leading information of inflation pressures and cautions that the monetary aggregates continue to be useful for predicting inflation, albeit with significant lags. The paper concludes by suggesting that improvements in the quality of the monetary and price data could further strengthen the RBI's ability to implement monetary policy, but it also cautions that, until a more reliable anchor for monetary policy is found, the RBI will need to be especially careful to avoid undermining the credibility of its commitment to reasonable price stability.
Chapter 7, "The Unit Trust of India and the Indian Mutual Fund Industry," explores the issue of financial sector reform and regulation from the perspective of the mutual fund industry. In particular, while the mutual fund industry has played an important role in mobilizing financial saving in India, its systemic vulnerability was illustrated in 1998 when India's largest fund, the government-sponsored Unit Trust of India, faced significant financial difficulties. As the chapter notes, this episode provided a stark illustration of the importance of continued efforts to strengthen regulation and transparency in the mutual fund industry, a conclusion that applies more generally to the financial sector as a whole.
Structural issues are explored in more detail in the final two chapters. There is deep concern about the apparent widening of regional income disparities, as it suggests a risk that growth will not be sustained or be of a high quality. In Chapter 8, "Growth Theory and Convergence Across Indian States: A Panel Study," interstate growth differentials are examined and the empirical evidence pointing to a widening of per capita income gaps is presented. This lack of convergence is determined to have been partly due to differences across states in literacy and private investment rates. The chapter then demonstrates that these rates appear to have been adversely affected by inadequate public funding of social and public infrastructure investment. Thus, the chapter provides a strong illustration of the damaging effect that weak fiscal policies have had on slower-growing states.
Finally, "Structural Reform in India" provides an overview of structural reform policies that have been implemented since the 1991 balance of payments crisis. The chapter describes empirical evidence that suggests that reforms can significantly enhance India's growth potential and points to signs that the apparent slowing of the momentum for reform has adversely affected productivity, especially in the agricultural and industrial sectors. The chapter concludes by stressing the need to reinvigorate the reform process and by summarizing the areas where policies are needed to support strong and sustained growth over the medium term.
Taken together, these papers suggest that India stands at the crossroads. The experience of the last decade has illustrated the enormous capacity that India has for absorbing structural change and the significant benefits that sound policies can yield. At the same time, however, the process of structural reform is unfinished and much of the fiscal adjustment that was achieved has been reversed. This book suggests that ensuring strong, sustained, and high-quality growth in the coming decade will require a broad-based and deep commitment to fiscal deficit reduction, wide-ranging structural reform, and prudent and careful management of monetary and exchange rate policies.
1The Indian fiscal year begins on April 1.
2Analysis of poverty trends in India is complicated by questions about the quality of the data. See Chapters 8 and 9 for a discussion.